LIBOR, the London Interbank Offered Rate, served historically as a primary benchmark interest rate at which major global banks offered to lend unsecured funds to one another in the international interbank market. This rate influenced the pricing of a vast array of financial products worldwide, directly impacting borrowing costs for both consumers and corporations. While primarily tied to fiat currencies, its eventual cessation and replacement by risk-free rates directly affect the valuation and structuring of various financial instruments, including certain derivatives with crypto underliers.
Mechanism
LIBOR was calculated daily based on submissions from a panel of banks, who reported their estimated borrowing rates for different currencies and maturities. An administrator then computed an average, excluding the highest and lowest submissions to mitigate potential manipulation. This mechanism relied significantly on expert judgment rather than observable, transactional data, a fundamental factor that contributed to its eventual phase-out and replacement by more robust, transaction-based benchmarks.
Methodology
The ongoing transition away from LIBOR involves financial institutions and systems architects systematically identifying, renegotiating, and repapering contracts that reference the benchmark rate. The methodology entails developing new valuation models for derivatives and loans, adapting existing trading and risk management systems to new risk-free rates (RFRs), and ensuring legal and operational readiness for the paradigm shift. The objective is to manage the systemic risk associated with replacing a deeply embedded global financial benchmark while ensuring market continuity and stability.
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