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 center of a market-manipulation scandal that resulted in jail time for some traders and billions of dollars in fines for many banks.
There are other important financial benchmarks, of course — the Federal Reserve’s fed funds rate and the yield on the 10-year Treasury note among them — but Libor has emerged over time as the dominant rate for determining interest payments on almost all adjustable-rate financial products.
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.
Warning against “misplaced confidence in Libor’s survival,” Mr. Bailey said that the number of financial contracts with interest rates derived from the benchmark continued to grow. Regulators in the United States, including the chairman of the Commodity Futures Trading Commission, have raised similar warnings.
On Thursday, a meeting that is scheduled at the Federal Reserve Bank of New York will focus on preparing for a world without Libor: A panel is expected to address crucial details, including the best ideas for language that should be used to replace Libor in contracts for financial products like business loans, derivatives and floating-rate notes.
Here’s what’s at stake.
A Daily Routine With a Big Impact
In simplest terms, Libor is a number produced daily in response 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 percent.
If you have taken a loan with a variable interest rate, there is a good chance it is based on Libor. (The interest rate on such a loan is typically Libor plus a certain number of percentage points.) The same is true for loans to big companies and other institutions that borrow money, including cities, pension funds and university endowments.
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.
(That’s trillions with a T.)
A Rate That’s Easy to Manipulate
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 coordinating with colleagues at other banks.
Because bank traders make high-stakes wagers using derivatives whose values are based in part on Libor, they could vastly improve their chances of making money if they could influence the very thing they were betting on.
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.
A Lifeline From Nervous Regulators
After all the fines, penalties and prison sentences had been handed out, the only reason some banks still respond to the Libor survey is that British regulators pressed them to do so. The regulators fear that banishing the rate in an abrupt, disorderly way could endanger the broader financial system.
Regulators decided they would give the industry time to prepare itself for a world without Libor. After 2021, regulators will not push banks to participate in the Libor survey. Many people expect that absent that prodding, banks will stop responding, and Libor will disappear.
For the record, the group that produces Libor — ICE Benchmark Administration — says it has held talks with banks about a voluntary agreement to continue submitting rates that would allow some form of Libor to be published into the middle of the next decade. No agreement has yet been struck.
“Ultimately this is up to the banks,” said Timothy Bowler, the group’s president. “The banks have got to decide whether they want to keep Libor or not.”
The transition to a post-Libor world would not be painless. Remember those $190 trillion of Libor-linked derivatives? Hardly any of those instruments — essentially contracts between two parties — provide a workable option for what to do if Libor were to vanish.
In a worst-case scenario, banks and their customers would effectively have to negotiate how to end Libor-based contracts over the phone, said Darrell Duffie, a Stanford University finance professor. For a sense of what is at stake, Lehman Brothers was a party to more than 900,000 derivatives contracts when it went bankrupt in 2008, according to research published by the Federal Reserve Bank of New York.
“It’ll be really nasty in terms of costly, difficult workouts,” he said.
‘A Lot of Inertia,’ and Perhaps a Huge Mess
The scope of the challenge is beginning to make people on Wall Street nervous. In the past few weeks, research reports have been published and conference calls with experts have been convened to consider ways to avert what could be a huge mess.
An industry group sponsored by the New York Fed has developed a new benchmark rate to replace Libor: the Secured Overnight Financing Rate, or SOFR. It began to be published in April.
Contracts must be changed. Computer systems must be updated. Customers must be communicated with. Such costly administrative work does not yield bonus-increasing fees, and it is not generally considered glamorous on Wall Street.
“There’s a lot of inertia. There’s a lot of reluctance to make the change,” said Richard Berner, a former Wall Street economist and director of the Treasury’s Office of Financial Research until the end of 2017. “There’s a lot of work to do.”