The most important number in finance on its way out: All you need to know

In the world of finance, there is one number that arguably matters more than any other. You can find it in the small print on adjustable-rate mortgages and private student loans, it is the basis for enormous corporate loans, and it underpins nearly $200 trillion of derivatives contracts.

But it is on the way out, and Wall Street has not worked out how to replace it. The number in question is called Libor, which is short for the London interbank offered rate. Published daily, Libor is an interest rate benchmark, or the basis for many other interest rates. If you have heard of it, that might be because it was at the centre of a market-manipulation scandal that resulted in jail time for some traders and billions of dollars in fines for many banks.

There are other important financial benchmarks, of course — the Federal Reserve’s fed funds rate and the yield on the 10-year Treasury note among them — but Libor has emerged over time as the dominant rate for determining interest payments on almost all adjustable-rate financial products.

Now, regulators are stressing that the benchmark could be gone by 2021. What will replace it? Nobody knows for sure. Here’s what’s at stake.

A daily routine with a big impact

Libor is a number produced daily in response to a theoretical question posed to a group of large banks: What interest rate would you have to pay to borrow money from other banks? Libor is calculated by stripping out the highest and lowest estimates and averaging the rest. There are many different versions of Libor, calculated in different currencies and over different borrowing time periods. The most widely used variant applies to borrowing dollars for three months.

Libor’s biggest use is in financial contracts known as derivatives.

A rate that’s easy to manipulate

A big problem with Libor is that it has been incredibly easy to manipulate. In part, that is because the question on the Libor survey does not ask the banks, “What did you pay to borrow this morning?” Instead, it asks the more subjective “What do you think you would have to pay?”

With a relatively small number of banks responding to the survey, it did not take traders long to realise they could skew the number higher or lower by coordinating with colleagues at other banks. Because bank traders make high-stakes wagers using derivatives whose values are based in part on Libor, they could vastly improve their chances of making money if they could influence the very thing they were betting on.

The market-manipulation scheme started to unravel in 2008 when The Wall Street Journal published an article casting doubt on Libor’s integrity. That prompted government investigations that eventually revealed what was going on. Banks collectively paid many billions of dollars in penalties for their roles in trying to rig Libor. 

A lifeline from nervous regulators

After all the fines, penalties and prison sentences had been handed out, the only reason some banks still respond to the Libor survey is that British regulators pressed them to do so. The regulators fear that banishing the rate in an abrupt, disorderly way could endanger the broader financial system. Regulators decided they would give the industry time to prepare itself for a world without Libor. After 2021, regulators will not push banks to participate in the Libor survey.