Market Memo: What's next for Libor


Before we look to its future, it may be worthwhile to look at how Libor came about.

The London Interbank Offered Rate evolved as a direct result of the Cold War and the freezing of dollar assets of communist countries held in U.S. banks. Then as now, global trade was principally denominated in dollars and Russia needed dollar-denominated accounts to accept payments for oil and wheat exports and make payments on imports since Rubles were not accepted. So the Moscow Narodny Bank was set up in London to transact dollar business with British banks, which would act as the intermediary with the U.S. banking system.

Sir Bolton and the Russians
Sir George Bolton, CEO of the Bank of London and South America (BOLSA) who had extensive experience in global finance as a former director at the Bank of England, the International Monetary Fund and the Bank for International Settlements, recognized an opportunity. Primarily a financial facilitator of British trade with South America that was heavily transacted in dollars, BOLSA in the 1960s started accepting dollar-denominated accounts from Russia and other communist countries who feared having their U.S. accounts frozen.

Midland Bank and Manufacturers Hanover quickly joined in the banking group, and so-called “eurodollars”—U.S. dollars on deposit in Europe—started circulating within the London banking system. They amassed quickly in the 1970s, as fears of asset-freezing drove Middle Eastern oil money into the eurodollar market.

Libor evolved as the wholesale interbank market for these dollars in London. Eurodollar loans would be priced on a spread over Libor, which was generally determined by a panel of 3-5 specific banks listed in loan documentation. Libor eventually became so popular that other transactions globally were priced with a Libor reference. The British Bankers Association formalized this process in 1985 with the creation of the Libor index, used to price the multitrillion-dollar swaps and derivatives markets.

What will replace Libor?
Libor is unlikely to vanish rapidly—U.K. regulators don’t envision it being phased out before the end of 2021—or completely. Many banks and borrowers are sure to prefer to continue having their transactions based on Libor.

As it stands currently, the Alternative Reference Rates Committee—15 major banks convened by the New York Federal Reserve Bank to help select an alternative to Libor based on transparent observable transactions—favors a rate based on repo transactions. As proposed, it would include only repo transactions that are settled through one of the recognized clearing entities.

How will this affect trade-finance yields?
Libor will not disappear. There will still be an interbank market for dollars as well as all other currencies. The regulatory changes are intended to create a new index that facilitates the pricing of swaps and derivatives.

Our current best guess is that banks will continue to price trade-finance loans based on their wholesale cost of money, and yields should not be significantly impacted.