Libor, one of the main interest rate benchmarks used in financial markets, determines interest rates for financial contracts worth trillions of pounds and is expected to be discontinued after end-2021.
Since the global financial crisis, activity in the markets that Libor measures has reduced. The low volume of transactions makes Libor a less reliable benchmark.
Market volatility in response to Covid-19 (as set out in the interim May Financial Stability Report and the August Financial Stability Report) highlighted Libor’s weakness and reinforced the need for financial markets to use alternative benchmarks.
During this shock to markets in March, the already limited market activity underpinning Libor reduced even further, meaning that rates were determined almost entirely by expert judgement from banks (Chart A). Libor rates — and hence costs for borrowers — rose, while Bank Rate was reduced to historically low levels, making cheaper funding available to banks (Chart B).footnote  In contrast, SONIA, the preferred alternative benchmark in sterling markets, remained closely in line with Bank Rate and the value of transactions underpinning SONIA increased from an average of £40 billion per day to over £60 billion in April.
The conditions observed in March have therefore reinforced the importance of the transition to alternative reference rates in advance of end-2021.
Both international authorities and industry working groups have been clear that transition from Libor in advance of end-2021 remains essential, and have revised plans to meet that timeline despite the temporary disruption to progress from Covid-19.
In the UK, the next key milestone is for loan products linked to alternative rates to be available from the end of September 2020, with Libor-linked products phased out by the end of March 2021. Businesses seeking new loans or refinancing should be offered products linked to robust alternative rates by their banks. We have published materials to help businesses understand these new products and any changes they may need to make.
Chart A The low number of transactions in the market that underpins Libor means the rate is largely based on expert judgement by banks
Proportion of ‘Level 1’, ‘Level 2’ and ‘Level 3’ submissions underlying three-month sterling Libor (a)
(a) Input data to Libor are categorised using a ‘waterfall’ with increasing levels of judgement. The waterfall can be summarised as follows:
Level 1 is ‘transaction-based’ submissions — an average of transactions in unsecured deposits and primary issuances of commercial paper and certificates of deposit;
Level 2 is ‘transaction-derived’ data, including information from historical transactions; and
Level 3 is ‘expert judgement’ — where a panel bank has insufficient Level 1 or 2 transactions, it estimates the rate at which it could fund itself in the unsecured wholesale funding market, based on an approved procedure.
Chart B During the Covid-19 shock to markets, Libor failed to track Bank Rate
FootnotesSources: Bloomberg Finance L.P., ICE LIBOR and Bank calculations. See disclaimer at bottom of the page.
This post has been prepared with the help of Stefania Spiga and Alieda Moore.
This analysis was presented to the Financial Policy Committee in May 2020 and August 2020.
Share your thoughts with us at BankOverground@bankofengland.co.uk
Footnotes3M sterling LIBORTM is administered and published by ICE Benchmark Administration Limited (IBA). LIBOR, ICE LIBOR and ICE Benchmark Administration are trade marks of IBA and/or its affiliates.
Historical ICE LIBORTM information may not be indicative of future ICE LIBORTM information or performance. IBA and its affiliates make no claim, prediction, warranty or representation whatsoever, express or implied, as to the results to be obtained from any use of ICE LIBORTM, or the appropriateness or suitability of using ICE LIBORTM for any particular purpose.
To the fullest extent permitted by applicable law, all implied terms, conditions and warranties, including, without limitation, as to quality, merchantability, fitness for purpose, title or non-infringement, in relation to ICE LIBORTM, are hereby excluded, and none of IBA or any of its affiliates will be liable in contract or tort (including negligence), for breach of statutory duty, nuisance or misrepresentation, or under antitrust laws or otherwise, in respect of any inaccuracies, errors, omissions, delays, failures, cessations or changes (material or otherwise) in ICE LIBORTM, or for any damage, expense or other loss (whether direct or indirect) you may suffer arising out of or in connection with ICE LIBORTM or any reliance you may place upon it.
See Bailey (2020).