There are obviously a lot of numbers that are considered important in the world of finance. But you could make the argument that none is more important than the London Interbank Offered Rate, better known as “LIBOR”.
Since LIBOR was first introduced back in the 1980s by the British Bankers’ Association, lenders around the world have used LIBOR as a base rate when creating interest-bearing contracts for adjustable-rate mortgages, private student loans, revolving credit facilities and more.
However, there’s a chance that LIBOR is going to be phased out in the near future, leaving the financial industry to scramble to find a suitable replacement for it.
The Financial Conduct Authority, which is a financial regulatory body in the UK, has revealed that the plan is to eliminate LIBOR by 2021. There are a series of scandals involving LIBOR that have rocked the financial world over the last decade or so, and they’re at least partially to blame for its demise. Critics of LIBOR have also long criticized it for being based on a limited number of financial transactions and estimates related to borrowing costs as opposed to actual transactions taking place in the real world.
The problem with phasing LIBOR out is that, despite its shortcomings in recent years, it has become embedded within the financial community since it was created more than three decades ago. It currently serves as the foundation for more than $200 trillion worth of interest-bearing contracts worldwide, and that means that it’s going to be very difficult to replace. There are a handful of potential replacements for LIBOR, including the New York Fed’s Secured Overnight Financing Rate (SOFR). But, LIBOR is an entrenched pricing benchmark and banks and other lenders have not yet coalesced around a replacement base interest rate.
Assuming LIBOR does eventually disappear and make way for a replacement, it’s going to send shockwaves throughout the financial community. Countless contracts around the world will need to be renegotiated with a new base rate that the financial markets have not yet adopted.