What Is USD LIBOR and Why Did It End?

The London Interbank Offered Rate, commonly known as LIBOR, served as a foundational benchmark interest rate for global financial markets for decades. It represented the average rate at which major banks could borrow from one another in the London interbank market. This rate became a widespread reference point for an immense volume of financial products and transactions across the world.

LIBOR’s influence extended to trillions of dollars in financial contracts, including derivatives, corporate loans, adjustable-rate mortgages, and credit cards. It provided a standardized measure for calculating interest payments, facilitating a vast array of financial activities.

Understanding USD LIBOR

USD LIBOR was the U.S. dollar component of the London Interbank Offered Rate. It represented the average rate major global banks could obtain short-term, unsecured funding from other banks in the London interbank market. The Intercontinental Exchange (ICE) administered this rate, deriving it from submissions by a panel of major banks.

LIBOR’s calculation involved a daily survey where contributing banks estimated their borrowing rates. ICE collected these rates, discarded the highest and lowest submissions, and then averaged the remaining values to determine the final rate.

USD LIBOR was widely used as a reference rate for diverse financial products. These included adjustable-rate mortgages, student loans, corporate loans, and various derivatives like interest rate swaps.

LIBOR rates were published for several maturities, or tenors, ranging from overnight to one year. These included overnight, one-week, one-month, three-month, six-month, and twelve-month periods. The three-month USD LIBOR tenor was commonly referenced in many financial contracts due to its balance between short-term responsiveness and longer-term stability.

The Cessation of USD LIBOR

The discontinuation of USD LIBOR stemmed from issues with its underlying methodology and calculation integrity. Its reliance on expert judgment, rather than actual transactions, made it susceptible to manipulation. The market it measured became increasingly illiquid, eroding confidence in its accuracy.

Manipulation scandals, revealed around 2012, significantly contributed to LIBOR’s phase-out. Investigations uncovered instances where banks colluded to submit false interest rate estimates. This damaged public trust and highlighted the structural vulnerability of a rate based on subjective submissions.

The Financial Conduct Authority (FCA), the UK regulator overseeing LIBOR, announced in 2017 it would no longer compel banks to submit rates. For USD LIBOR, new contracts were prohibited from using the rate after December 31, 2021. The final cessation for most widely used USD LIBOR settings occurred on June 30, 2023.

This transition was a global undertaking involving regulators and financial institutions. The goal was to replace an unreliable benchmark with robust, transparent alternatives based on actual market transactions. This effort aimed to enhance financial stability and integrity.

New Reference Rates

The discontinuation of LIBOR led to the adoption of alternative reference rates (ARRs), with the Secured Overnight Financing Rate (SOFR) becoming the primary replacement for USD LIBOR. SOFR is based on actual, observable transactions in the U.S. Treasury repurchase agreement (repo) market. This transaction-based approach makes SOFR robust and less susceptible to manipulation.

SOFR is an overnight rate, reflecting the cost of borrowing cash overnight collateralized by U.S. Treasury securities. Its secured nature means it carries minimal credit risk, as it is backed by high-quality collateral. This contrasts with LIBOR, which incorporated bank credit risk and was forward-looking.

While SOFR is the focus for U.S. dollar markets, other jurisdictions adopted their own ARRs. For instance, the Sterling Overnight Index Average (SONIA) replaced GBP LIBOR in the United Kingdom. The Euro Short-Term Rate (€STR) became the alternative for EUR LIBOR in the Eurozone. These rates, like SOFR, are backward-looking and nearly risk-free.

The move to these new rates signifies a change in how interest rates are determined for financial products. Unlike LIBOR’s forward-looking, credit-sensitive nature, ARRs like SOFR are backward-looking and reflect actual, observed transactions. This offers greater transparency and stability, providing a more accurate foundation for financial contracts.

Transitioning Financial Contracts

The transition of financial contracts from USD LIBOR to new reference rates involved mechanisms to ensure continuity. For existing contracts, “fallback language” within agreements outlined what would happen if LIBOR ceased. These clauses typically specified a successor rate and necessary adjustments. If fallback provisions were absent, parties renegotiated to amend contracts and incorporate new benchmark rates.

New financial products, including loans, derivatives, and bonds, now use SOFR or other alternative reference rates. For example, adjustable-rate mortgages often reference SOFR instead of LIBOR. Corporate loans and derivatives have also adopted SOFR-based pricing.

A key aspect of transitioning existing contracts was the application of “spread adjustments.” This adjustment is added to the new risk-free rate, such as SOFR, to account for the historical difference between LIBOR and the alternative rate. LIBOR included a credit risk component that SOFR does not. The spread adjustment aimed to preserve the economic terms of the original LIBOR-based contract.

For instance, a loan previously priced at “LIBOR + 2%” might transition to “SOFR + spread adjustment + 2%.” The spread adjustment ensures the borrower’s payments remain economically equivalent before and after the transition.