LIBOR Alternatives

The London Interbank Offered Rate, better known as LIBOR, was once the most important benchmark interest rate for setting the price of overnight and short-term loans that banks make to one another. This reference rate served as the foundation for other types of loans made by financial institutions including mortgages, auto loans, and financial products like credit default swaps (CDS). All of these and more were tied to the LIBOR rate in some fashion.

However, since 2021, LIBOR has been phased out of use, following a series of criticisms and a major scandal involving financial collusion and manipulation by various banks in setting the LIBOR rate. Since then, several alternatives have been proposed to facilitate the interbank lending market. Here we look at a few of these benchmark rates.

The Interbank Lending Market

Modern banking works using a fractional reserve system, based on the fact that there is very little chance that all of a bank’s depositors will demand to withdraw their deposits all at once. As a result, banks have the freedom to lend out to borrowers a portion of the deposits they hold.

The amount of such lending that can take place is determined by the reserve ratio, typically set by central banks. If the reserve ratio is, say 10%, a bank can lend out 90% of deposits while keeping 10% on hand as reserve requirements (so, $100 could create $90 in loans by that bank).

Sometimes, a bank ends up with more than the reserve requirement due to a downtick in lending. Other times, a bank may end up with less than that proportion. As a result, banks with excess reserves can lend those funds on a short-term basis to those banks that need reserves. This is the interbank lending market, which involves loans with terms of overnight up to several weeks in maturity.

The interest rate attached to these loans is determined by the supply and demand for reserves. However, not all banks are active enough in this market, so they rely on benchmark interest rates to peg these interbank loans. That is where LIBOR came in and where its alternatives are filling in today.

LIBOR Alternatives

The Secured Overnight Funding Rate (SOFR)

The Secured Overnight Financing Rat (SOFR) is a benchmark interest rate for dollar-denominated derivatives and loans that is being adopted as a LIBOR replacement by many of the world’s largest financial institutions. SOFR is computed from transactions in the Treasury repurchase (repo) market and is seen as preferable to LIBOR-like rates because it is based on data from many observable transactions rather than on estimated borrowing rates set by bank trading desks.

The Federal Funds Rate

The federal funds rate is the rate at which large U.S. commercial banks lend to one another. Its target is set by the Federal Reserve’s Open Market Committee (FOMC), but the actual rate is determined in the market. However, this rate is capped by the Fed’s discount rate, the interest rate at which it charges commercial banks to borrow from it directly. Thus, if the fed funds rate were to hypothetically bid up higher than the discount rate, banks would simply borrow from the Fed directly.

Ameribor

Ameribor (short for the American interbank offered rate) is a benchmark interest rate that reflects the true cost of short-term interbank borrowing, created in 2015 by the American Financial Exchange (AFX) in collaboration with the CBOE. Unlike the SOFR, which looks at secured (collateralized) lending, the Ameribor tracks unsecured dollar-denominated interbank yields, and it is intended to aid small- and mid-sized regional banks. Ameribor rates are created from transactions observed on the AFX exchange.

Bloomberg Short-Term Bank Yield Index (BSBY)

The Bloomberg Short-Term Bank Yield Index (BSBY) provides a series of short-term rate benchmarks for banks to use in maturities of overnight, 3-month, 6-month, and 12-month. Created in 2021 by financial analytics company Bloomberg, LP, the BSBY looks at unsecured lending in a range of products such as commercial paper, CDs, demand deposits, and short-term corporate bonds. The index is constructed from observed transactions on Bloomberg’s proprietary trading platforms as well as from feeds from the Financial Industry Regulatory Authority (FINRA).

€STR

€STR stands for the Euro Shor-Term Rate, which is the benchmark rate at which European banks engage in unsecured euro-denominated short-term lending. €STR replaced the Euro Overnight Index Average (EONIA) rate in 2022.

SONIA

The Sterling Overnight Index Average, or SONIA, is the effective overnight interest rate paid by banks for unsecured transactions in the British sterling market. It is used for overnight funding for trades that occur in off-hours and represents the depth of overnight business in the U.K. financial marketplace.