Banks and regulators around the world have successfully replaced plumbing throughout the financial system, although hardly anyone has noticed.
Driving the news: As of Monday, Libor – the interest rate that once underwritten some $ 300 trillion in financial contracts, from derivatives to corporate lines of credit – will effectively be dead.
Why is this important: The easily manipulated Libor was at the center of one of the biggest scandals in the history of finance, which erupted in 2012.
- Banks have racked up some $ 9 billion in fines and a number of traders have been sentenced to prison terms.
- The Libor has now been replaced by much more solid and reliable benchmarks.
How it works: Banks make money by lending money at an interest rate that is higher than their own cost of funding. Libor was supposed to be a measure of banks’ cost of funds, so if a bank priced a loan at, say, 1 percentage point above Libor, then it knew its profit margin would be 1 point. percentage.
- Billions of dollars in loans and derivatives have been traded on the basis of the Libor, meaning that if traders could – illegally – push it up or down by a few hundredths of a percentage point, they could win. huge sums of money.
- Since Libor was generated by polling banks and asking them what their interbank lending rates were, it was easy for banks to lie in the direction that would make the most money for their traders.
Where he is : The Libor is replaced by a series of new products – Sonia for the pound sterling, Tona for the Japanese yen, Saron for the Swiss franc, etc.
- The American dollar is the only currency that will continue to post an official Libor rate, but even that will only be used for existing loan products. All new loans will need to be appraised at another price. An old but less well-known reference called SOFR, which is released by the New York Fed, is the primary replacement.
Between the lines: The transition from Libor to the new benchmarks has been a colossal undertaking. Global financial markets couldn’t just shut down for scheduled maintenance and come back refreshed Monday morning.
- Instead, the deeply integrated infrastructure had to be replaced while it was still being used extensively.
- Even the Federal Reserve, who led the charge to end Libor in the United States, ended up using the old benchmark for its loan program on Main Street during the time of the pandemic.
The bottom line: The days of Libor are over. It’s a testament to the hard work of thousands of companies – greatly exacerbated by the pandemic – that nothing broke during the transition.