How LIBOR really works

Original Article by GlobalMacroForex

As we discussed in my previous article on how the interbank clearing system works, banks lend to each other for various maturity lengths on the interbank market through a few channels.  First, if it’s through the Federal Reserve for overnight lending, this is the Fed Funds rate.  If it’s through a private broker, then it’s a privately negotiated rate.  These private brokers match buyers and sellers of money for various maturity lengths.

Despite the fact that the interbank market relies on privately negotiated rates for most maturities other than overnight, many people watch LIBOR.  LIBOR (which stands for London Interbank Offer Rate) is an index compiled by ICE.  ICE took over from the British Bankers Association after they were found to have committed rampant fraud.  Now people consider this ICE LIBOR number to be more reliable than BBA LIBOR, however, they both are still the banks’ opinion of what the interbank rate is since it’s not based on actual lending.  The number is compiled by asking banks’ opinion of how much they would charge to lend at different time lengths.  Then the highest and lowest numbers are chopped out and the rest averaged.

Now the actual lending is done through private brokers at different agreed on prices and many of these loan maturity lengths may not be traded in an actual day, so in reality, we may not know what the true rate should be since no deals took place at that rate.  The US government agreed in 2017 to phase out LIBOR because it is so corrupt.

TED Spread

In the meantime, the 3 month LIBOR is the most watched number in the market because the 3-month Eurodollar rate is the most liquid contract on the Chicago Board of Trade that trades LIBOR rates and it’s generally consistent with a bank’s hedging needs.  When the 3 months LIBOR is subtracted from the 3-month T-bill, this is the TED Spread.  In other words, how much extra premium the market is asking to lend to a risky bank vs the “trustworthy” US government. 

Some consider the TED Spread as a negative indicator of volatility shorting and to use it as a screening factor in overall investing.

LIBOR alternatives

We covered How Eurodollars work in my previous article.  Eurodollars are not real US Dollars (Federal Reserve notes), they are instead leveraged claims to US Bank’s deposits that are fractionally reserved out.  American banks have to keep reserves with the Fed, but foreign banks or the foreign branches of American banks don’t.  LIBOR is supposed to be a measure of how risky these no-reserve banks are compared to safer loans like lending to the US government.  Unfortunately, LIBOR is a manipulated number.

The media presents LIBOR as only your option to understanding developments in the Eurodollar market.  There are other sources of data such as the Repo rate, which although is primarily for onshore USD banks, it gives us a good proxy.  Repo stands for repurchase agreement, when one bank lends to another with collateral, such as a US Treasury bond.  Instead of “paying back the loan”, banks instead agree to rebuy the collateral.

Making a Repo Loan:

Repaying a Repo Loan:

The best-known repo index is the Depository Trust & Clearing Corporation General Collateral Finance Repo Index (DTCC GCF Repo Index).  Another option for Eurodollar assessment is the Bank of International Settlements, which gives us a breakdown of the total USD Deposit liabilities internationally.

There’s also the Credit-to-GDP breakdown by country from the Bank of International Settlements.  This shows how much leverage and risk exists in the banking system.  You can find this information on their website, in the Q1 2017 edition’s report, it’s on page 330.