The London Interbank Offered Rate (LIBOR) is a global benchmark interest rate, which is calculated in five difference currencies. US Dollar LIBOR alone is referenced in approximately $200 trillion of outstanding financial products. The LIBOR benchmark is used for nearly all financial products, including commercial, consumer, and mortgage loan products. Numerous outstanding loan transactions have maturities well into the future. The problem is that LIBOR has become less reliable and trustworthy, and it may not exist after 2021.
LIBOR is determined daily based on the representations of certain large, international banks regarding what they believe they would have to pay to borrow unsecured funds from each other on the London interbank lending market. US Dollar LIBOR is calculated from an average of 18 bank submissions after excluding the four highest and lowest submissions. Since LIBOR is not set by the cost of funds that banks actually pay, it was always susceptible to manipulation by stakeholders and traders. And when widespread LIBOR manipulation was discovered, regulators assessed billions of dollars of penalties and fines against institutions and individuals. While panel banks have continued to participate in the LIBOR survey at the insistence of regulators, that voluntary agreement to sustain LIBOR will cease at the end of 2021, when LIBOR will either disappear entirely or become unreliable.
In response to this potentiality, the Federal Reserve Board and the Federal Reserve Bank of New York (New York Fed) created the Alternative Reference Rate Committee (ARRC) “to identify a set of alternative reference interest rates that are more firmly based on transactions from a robust underlying market and that comply with emerging standards,” as well as to establish best practices for contract quality, and to develop and create an implementation plan. In 2017, the ARRC announced that the Secured Overnight Financing Rate has been chosen as the recommended primary replacement rate for LIBOR.