How Did LIBOR Work?
Each day, a panel of major London-based banks submitted the interest rates they would expect to be charged for borrowing from other banks. These submissions were made for five currencies and across seven different loan maturities, ranging from overnight to one year.
To calculate the final rate, the highest and lowest quartiles of submissions were discarded, and the remaining figures were averaged. This daily published average became the reference point for a vast network of financial products. For example, the interest rate on an Adjustable-Rate Mortgage (ARM) might be set as “LIBOR + 2%,” meaning your rate would adjust as the underlying LIBOR figure changed.
Why Was LIBOR Phased Out?
LIBOR’s influence declined due to two main factors: a manipulation scandal and a shrinking pool of underlying data. In 2012, investigations revealed that some panel banks were manipulating their submissions to profit from trading positions or to appear more financially secure than they were. This misconduct eroded trust in LIBOR as a reliable benchmark.
Additionally, after the 2008 financial crisis, the volume of interbank lending decreased significantly. This meant LIBOR was often based on expert estimates rather than actual transactions, making it less representative of the market. In response, global regulators initiated a transition to more transparent and trustworthy benchmark rates.
What Replaced LIBOR?
The transition from LIBOR led to the adoption of new benchmarks called Risk-Free Rates (RFRs), which are based on a high volume of actual, observable overnight market transactions. In the United States, the primary replacement for USD LIBOR is the Secured Overnight Financing Rate (SOFR).
According to the Consumer Financial Protection Bureau (CFPB), this shift was necessary to create a more stable financial system. Most LIBOR rates were discontinued by the end of 2021, and the remaining U.S. dollar LIBOR panels ended on June 30, 2023.
Key differences between the old and new benchmarks are:
| Feature | LIBOR | SOFR |
|---|---|---|
| Basis | Based on estimates of unsecured interbank borrowing costs. | Based on actual transactions in the U.S. Treasury repurchase market. |
| Risk | Included bank credit risk. | Considered nearly risk-free, as it is secured by U.S. Treasury bonds. |
| Transparency | Vulnerable to manipulation due to its reliance on estimates. | Highly transparent and based on robust, verifiable market data. |
How Does the LIBOR Transition Affect Consumers?
If you had a legacy financial product tied to LIBOR, such as a private student loan or an ARM, your lender was required to transition it to a new index, like SOFR. Lenders must provide a “spread adjustment” to ensure the new rate is economically comparable to the old one. For new variable-rate loans, lenders now use SOFR or other new benchmarks from the outset. Always review your loan agreements to understand which benchmark rate applies and how it affects your payments.
