The most important number in finance is going in the vault
Libor, the interest rate benchmark, ends in 2021, but Wall St. doesn’t appear prepared
In the world of finance, there is one number that arguably matters more than any other. You can find it in the small print on adjustable-rate mortgages and private student loans, it is the basis for enormous corporate loans, and it underpins nearly $200 trillion of derivatives contracts.
But it is on the way out, and Wall Street has not worked out how to replace it.
The number in question is called Libor, which is short for the London Interbank Offered Rate. Published daily, Libor is an interest rate benchmark, or the basis for many other interest rates. If you have heard of it, that might be because it was at the centre of a market-manipulation scandal that resulted in prison time for some traders and billions of dollars in fines for many banks.
Now, regulators are stressing that the benchmark could be gone by 2021.
What will replace it? Nobody knows for sure.
As traders speculate about what will happen to financial markets when Libor disappears, regulators appear to be worried that banks are not taking the coming change seriously enough. To move away from Libor requires vast amounts of work, and given how tightly woven it is into the financial fabric, it isn’t the kind of thing anyone wants to see rushed.
“I hope it is already clear that the discontinuation of Libor should not be considered a remote probability,” Andrew Bailey, chief executive of Britain’s Financial Conduct Authority, said in a speech last week.
In simplest terms, Libor is a number produced daily in re- sponse to a theoretical question posed to a group of large banks: What interest rate would you have to pay to borrow money from other banks? Libor is calculated by stripping out the highest and lowest estimates and averaging the rest. There are many different versions of Libor, calculated in different currencies and over different borrowing time periods.
The most widely used variant applies to borrowing dollars for three months. On Tuesday, that number — expressed as an annual rate — was 2.34 per cent. If you have taken a loan with a variable interest rate, there is a good chance it is based on Libor.
Libor’s biggest use is in financial contracts known as derivatives. Some, like interest-rate swaps, are used by institutions to protect themselves from future swings in interest rates and by traders to place bets on which way rates will move in the future. At the end of 2016, there were more than $190 trillion of these Libor-based contracts outstanding all over the world.
A big problem with Libor is that it has been incredibly easy to manipulate. In part, that is because the question on the Libor survey does not ask the banks, “What did you pay to borrow this morning?” Instead, it asks the more subjective “What do you think you would have to pay?” With a relatively small number of banks responding to the survey, it did not take traders long to realize they could skew the number higher or lower by co-ordinating with other banks. The market-manipulation scheme started to unravel in 2008 when The Wall Street Journal published an article casting doubt on Libor’s integrity. That prompted government investigations that eventually revealed what was going on.
Banks collectively paid many billions of dollars in penalties for their roles in trying to rig Libor. A few former traders have gone to prison, including Tom Hayes, a former UBS and Citigroup trader who is serving an 11-year sentence in England.