Terms Beginning With 'l'

LIBOR

  • January 22, 2021
  • Team Kalkine

What is meant by LIBOR?

LIBOR is the acronym for London Inter-Bank Offer Rate and is the interest rate charged by banks in London from other financial institutions for short-term loans. It is a benchmark rate against which various other interest rates are set.

LIBOR is followed worldwide by banks as a benchmark rate. Commercial banks across all countries use LIBOR not as a tradeable rate of interest, rather as a mark-up over which they define their own rates. Banks may add an additional rate over LIBOR against the loans that they offer.

How does LIBOR work?

LIBOR is the interest rate that banks charge from each other against overnight loans. These loans can have maturity periods ranging from one day to one year, with a total of 7 different maturities available. The LIBOR is published each morning at 11 a.m., London time.

LIBOR is quoted in 5 different currencies for each of these maturity periods, these include: Swiss Franc(CHF), Euro(EUR), Pound Sterling(GBP), Japanese Yen(JPY), US Dollar(USD). LIBOR is used as the basis rate for asset-backed securities, adjustable-rate mortgages, municipal bonds, credit default swaps, student loans and other kinds of debt.

For instance, a bank might offer a floating exchange rate to a company that has currently opted for an interest rate swap with another company. This floating exchange rate can be offered as LIBOR+1%, thus, if LIBOR is 2.25%, the interest rate charged to the company would be 3.25%.

How is LIBOR set?

Before 2008-2012, LIBOR was known as BBA LIBOR, which refers to the British Bankers’ Association LIBOR. However, in February 2014, BBA LIBOR was changed to Intercontinental Exchange(ICE) LIBOR. This is when ICE took over the administration of LIBOR. This change led to the modifications to the currencies for which LIBOR is calculated.

LIBOR is calculated by taking an average of all the interest rates estimates offered by banks for these overnight inter-bank loans. Every day, 18 international banks submit an interest rate figure which they think would be the appropriate inter-bank rate for borrowing. The ICE Benchmark Administration removes the 4 highest and 4 lowest figures among these submissions and takes an average of the remaining figures rounded to five decimal places. The same is calculated for each currency individually.

The LIBOR is based purely on the estimates given by these banks and not on the actual lending rate that these banks pay for their borrowings. Thus, banks can easily manipulate LIBOR and set it lower than what they think the actual rate in the market is.

How was LIBOR linked to the 2008 financial crisis?

During the 2008 financial crisis, banks and lenders thought that LIBOR-based credit default swaps would protect them against the risky mortgage-backed securities. However, when subprime mortgages began to default, insurance companies could not honour these swaps.

Additionally, LIBOR is usually a few tenths of a point above the Fed funds rate. During April 2008 however, LIBOR increased to 2.9% even when the Fed dropped its rate to 2%. This led tobanks showing hostility regarding inter-bank borrowing which led to LIBOR rising to 4.8%, meaning a higher cost of borrowing. A high LIBOR consequently affected other financial products as well.

Thus, the crash in the financial industry was spread to the rest of the world through LIBOR rates. As the banks started estimating higher and higher interest rates, LIBOR increased making lending more expensive even when banks were reducing interest rates globally.

Are there any fallacies in the determination of LIBOR?

There were allegations that the banks involved in the LIBOR calculations formed an alliance to keep the LIBOR rates low. This was done in the interests of the traders who held positions in LIBOR based financial securities.

It is important to note that LIBOR is only an estimate of interest rates, which ultimately ends up affecting the real interest rates charged in the future. Thus, it gives an unfair advantage to rate-setting banks as they can manipulate the rate by forming an alliance.

The 2008 crisis was followed by intensive questioning of these rate setting banks regarding their LIBOR determination methods. Banks tried to keep the LIBOR estimates lower as it painted a relatively better image of them, pointing to lower risk of default. This investigation led to the shifting of the LIBOR administration from BBA to ICE.

However, slowly LIBOR is losing its touch in the market as banks continue to replace LIBOR with other benchmarks. It is still unclear whether ICE LIBOR would remain by the end of 2021 or not. The shift away from LIBOR makes it a less reliable benchmark for interest rates. Moreover, as there are not enough transactions happening between banks in certain currencies, it becomes more likely that LIBOR will phase out.

Some alternative benchmarks include Sterling Overnight Index Average (SONIA) and the USD LIBOR substitute called the Secured Overnight Financing Rate(SOFR). Both these benchmarks are picking up in global markets and might soon be more widely accepted than LIBOR. (SOURCE:

ALSO READ: Monetary Policy versus Fiscal Policy- The post-LIBOR world in Australia

Wash Trading When it comes to the financial markets, many fraudulent activities and malpractices happen every now and then. These white-collar crimes are often so sophisticated that sometimes they even bypass the watchdog’s guard and only comes under the radar once the damage has been done. Some of the examples of these fraudulent activities are Insider trading, Pump and Dump schemes etc.   Wash trading is also one of these fraudulent activities that is treated as a criminal offence by many regulators across the world. The basic idea of Wash trading is to make frequent transactions with particular security in a short span of time which to carryout various illegal activities. Kalkine Image Wash trading generates fake volume on the listed security to lure in other investors. This artificial volume generation is done throgh a number of buying and selling transactions and is often used in Pump and Dump schemes. Wash trading is also used for unfair tax deductions on losses, and some unethical brokers also carry out Wash trading to generate more brokerage.   So how Wash trading is being conducted for fake volume generation and why volume is so important? More often than not, investors and traders prefer to invest/trade in stocks that clock a high volume on a consistent basis. The high volume is generally associated with high-quality companies as an increased number of people, including big investors, High net worth individuals (HNIs), institutional investors etc. participate in these companies. Clearly, securities trading with higher volume attracts a higher number of people. For the intraday traders, a high volume is generally one of the most important criteria as they need to get in and out within a single day with high volume. If the security poses lower volume or lacks liquidity, then the trader would face a high impact cost which is never preferred.     To increase the volume of trading for any security, more participation is needed from diverse set of investors; however, it is just what looks on the surface. Behind the complex world of financial markets, there are many ways to pump up the volume of the security artificially. In the Wash trading, the trader places both the buy and the sell order for a specific security. This serves two purposes; first, the volume of the transaction gets counted on the exchange. Second, the trader also does not incur any loss on the trade as generally both the transactions are executed on the same price, or with a negligible difference. This transaction creates an illusion of more transaction taking place in the security as the volume data is made public by the exchanges. However, nobody knows that it is single trader/entity that is generating the excess volume as an individual’s data is never put out publicly by the exchanges.   Let's look at an example to get the practical working of a Wash trade. Suppose trader X holds 100 shares of XYZ company and somehow intends to lure in more investors to buy XYZ shares, he may start buying and selling XYX shares around the current market price of, let's say $10. Now, frequent buying and selling around $10 would keep on generating additional volume, which could become an eye candy for more investors. How is Wash trading used to claim an unfair tax deduction? Let's assume an investor X purchased 1000 shares of ABC at $10 per share. The investor sells the shares at $7 per share, making a net loss of $3,000 on his holding. Now, within a few days, the investor again purchases the same share with same quantity at $6 per share and sells them at $10 per share, making a profit of $4,000. In the above case, the investor might attempt to claim a tax deduction on his initial $3,000 loss. This deduction would offset the tax liability that is due on the $4000 gain. This would allow the investor to pay less in taxes on his capital gain even though his holding never changed materially, which is unfair and illegal. To counter this IRS (Internal Revenue Service) also has some regulations, to make the investor pay full tax liability on the entire gain on the next transaction, had the second transaction been made within 30 days of the first one. How Brokers benefit from Wash trading? Stockbrokers often come under the spotlight when unethical practices in the financial markets are talked about. However some handful unethical brokers have made a dent on the reputation of the brokerage business. Almost all of the business of a brokerage firm comes from brokerage that is being generated on every transaction, irrespective of the client’s P&L. In order to maximize the brokerage some brokers also do wash trading from their client's account which effectively generates more brokerage. The famous Libor (London Inter-bank Offered Rate) scandal also had traces of Wash trading. UBS traders colluded with the broker and paid compensation through a number of Wash trades for manipulating the LIBOR submission panels for the Japanese Yen.      The traders carried out a total of nine Wash trades and generated 170,000 pounds in fees for the brokers. This was a secret way to compensate for their services, which obviously couldn’t be paid openly. Bottom line Wash trades are being carried out since a long time for various purposes like fake volume generation, generation of excess brokerage or trying to claim an unfair tax deduction. However, the watchdogs are also aware of these fraudulent activities and authorities like IRS and SEC also have some regulations in place to counter these activities. It is just one of the numerous white-collar ways in which the manipulations and malpractices in the financial markets take place. In case, any market participant comes across any of such activity should report to the respective authorities.

What is Depression in Economics?  In economics, depression is referred to as a more severe form of the global recession, reflecting a prolonged and major downswing in economic activity. Depression is commonly characterised by widespread unemployment, sharply down industrial production, significant falls or pauses of growth in construction activity, and massive cutbacks in international trade and capital transfers. The Reserve Bank of Australia (RBA) defines depression as a broader version of recession, both in terms of duration and scale. As per the Central Bank, the scale and duration of depression imply that there are usually adverse economic outcomes that are experienced in several countries across the world. Unlike any minor business contractions that usually occur in a single country independent of economic cycles in other countries, depressions have generally been worldwide in scope. Consequently, some definitions of depression state it as a terrible recession that stems in one or more economies. ALSO READ: Recession, and how do we Measure it? What is the Difference Between Recession and Depression? The 33rd US President, Harry S. Truman gave a very famous quip - “It’s a recession when your neighbor loses his job; it’s a depression when you lose your own.” The distinction between recession and depression generally boils down to the duration and depth of an economic downturn. While a recession is commonly defined as a substantial fall in economic activity lasting for more than a few months, a depression is noted when an economic downturn lasts for years. A recession is usually characterised by considerable declines in employment, industrial production, investments, construction, international trade, stock market values and household income and spending. On the flip side, the depression is described by a period during which major macroeconomic indicators such as employment level, stock market values and business activity plummet severely or stay at a very low level for a sustained period. In other words, depression is more destructive than a recession, with its effects lasting for decades, as witnessed in the 1930s Great depression. In addition, the recession is a more localized scenario, while depressions generally have a global reach. Some economists also define depression as a period of output decline for over two years, a fall in output of 10 per cent or larger and a peak in the unemployment rate to about 20 per cent. Don’t Miss: Bells ringing around a Technical Recession for Economies across the Globe How Can We Trace Back the Origin of the Great Depression of 1930s? Fortunately, the world witnessed only one economic depression in modern times, which was the ‘Great Depression of 1930s’ that lasted from 1929 to around 1939. While the Great Depression sprouted in the United States (US), it caused dramatic falls in output, acute deflation and severe unemployment in almost every country of the globe. Recalled as the worst economic slump in the history of the US and the industrialized world, the event induced around 30 per cent fall in the real GDP and over 24 per cent surge in the unemployment rate of the US. The severity of this depression became more apparent when it was compared with the US’ next worst recession – the 2008 Global Financial Crisis – during which the nation’s GDP fell by 4.3 per cent, while unemployment rate peaked below 10 per cent. The economic depression of 1930s also delivered a heavy blow to the Australian economy, with its GDP tumbling by about 10 per cent and the unemployment rate peaking to around 30 per cent in 1932.  However, the RBA believes that Australia was less impacted by the Great Depression than some other economies in terms of social and economic consequences. What were the Key Causes of the 1930s Great Depression? There is no single event that triggers economic depression, while it is an outcome of a multitude of factors, ranging from stock market crashes to deflation. To gain a better understanding, take a look at five key reasons that sowed the seeds of the Great Depression of 1930s:   1929 Stock Market Crash: Economists cite the stock market crash of 1929 as one of the primary causes of the Great Depression. Remembered now as the “Black Tuesday”, the stock market downturn occurred on Tuesday, 29th October 1929, wiping off over USD 40 billion dollars of stockholders’ wealth within two months since the market crash. Bank Failures: The stock market crash sparked about thousands of bank failures in 1930 amid dwindling confidence in the Wall Street and American banks. With banks going bankrupt, the demand to withdraw money from banks exceptionally increased, stimulating further collapses. Some scholars believe that this problem was further aggravated by the Federal Reserve, which deliberately increased interest rates and reduced money supply to retain the gold standard. Interesting Read! Can Negative Interest Rates help Economies? Deceleration in Consumer Spending: With tight credits, diminished savings and fears of additional economic woes picking up steam, spending by consumers came to a standstill. This resulted in diminished production and a subsequent fall in the demand for labour force. The mounting layoffs further stimulated a ripple effect, triggering an additional plunge in consumer spending and business investment. Reduced International Lending: In the late 1920s, higher interest rates induced a sharp decline in lending by American banks to foreign countries, contributing to slowdown effects in some borrower nations like Argentina, Germany and Brazil. These contractionary effects resulted in an economic downturn in these nations even before the onset of Great Depression in the US. Smoot Hawley Tariff: In an effort to protect domestic industry, Congress passed the Tariff Act of 1930, termed as Smoot Hawley Tariff, which involved the imposition of a record level of tax rates on a wide array of goods imported by the US. The act prompted retaliation by American trading partners, which further levied tariffs on goods produced by the US, causing a fall in international trade. In addition to these factors, the drought that arose in the Mississippi Valley during 1930 – the Dust Bowl - is also believed to be a contributing cause of the economic depression. What are the Warning Signs of an Economic Depression? Evidence shows that economic depression exhibits several warning signs over sustained period prior to its arrival! With that said, let us quickly discuss some major threat signs of a looming depression: Mounting Public Debt Levels: As soon as a disaster kicks in, the Government intensifies fiscal spending to help the economy stand back on its feet, as evident from the COVID-19 crisis. Consequently, the fiscal deficit and public debt levels surge, potentially resulting in bankruptcies and mass defaults. Sustained Losses in Stock Market: The movement in stock prices deserve a closer attention while gauging the economic outlook. A sustained fall in the stock prices appears to be a core indicator of the softer profits likely to be earned by companies. Tumbling stock prices can eat up the savings of average consumers, inducing a decline in consumer spending. Growing Unemployment Rate: Soaring unemployment levels witnessed over prolonged periods is one of the leading indicators of an approaching recession or economic depression. Consumers tend to lose their purchasing power if job losses surge, stimulating lower demand for goods and services in the economy. Increasing Inflation: While some level of inflation is acceptable, too much inflation discourages consumer spending, triggering a sharp plunge in demand and production. Rising inflation can also provoke the Central Bank to increase interest rates, which can further deter businesses from taking loans and choke economic growth. Plunging Property Sales: The property market usually flares better when an economy is in a good spot. So, when property sales or new housing construction projects plummet, it usually indicates deteriorating consumer confidence, raising concerns of economic downturn. What are Feasible Responses to an Economic Depression? The magnitude of an economic depression is unprecedented and requires a range of solutions to wade through the crisis. Some of the key measures adopted across the world to deal with an economic depression, include: Fiscal Policy: This reflects an increased fiscal spending by the Government and an expanded investment in new infrastructure to create jobs and stimulate consumer demand. Monetary Policy: This reflects a reduction in interest rates by the Central Bank to make borrowing cheaper, quantitative easing approach and the use of helicopter money to hand cash to citizens. Mortgage Relief: This reflects the support provided by banks to consumers and businesses in terms of mortgage relief to enable them to survive through the crisis.

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