LIBOR’s London Market Origins and Use as a Benchmark
Summary
The document explains why LIBOR was tied to London while appearing in contracts and mortgages elsewhere. London hosted an offshore dollar money market, and the benchmark’s role spread internationally through markets such as interest rate swaps. Some markets adopted local benchmarks, while US dollar swaps retained LIBOR for historical and market convention reasons. The responses distinguish this setting from domestic overnight interbank lending through the Federal Funds market.
LIBOR also supported derivatives pricing because swap market prices could be used to infer benchmark yield curves. Mortgages linked to a LIBOR tenor could therefore reference a rate reflecting term funding and credit risk, rather than an overnight rate. The explanations are historical and partly qualified: one answer explicitly frames its account of mortgage benchmark selection as a conjecture. The discussion reflects a period when LIBOR reform was underway and should not be read as a current guide to benchmark availability or market conventions.
Key ideas
- LIBOR referred to a London-based interbank market, including offshore dollar funding.
- US domestic overnight interbank lending is associated with the Federal Funds market.
- Swap conventions spread internationally, with some currencies adopting local benchmarks and others retaining LIBOR.
- Swap prices helped market participants infer yield curves for LIBOR-linked derivatives.
- A term LIBOR mortgage reference could include credit risk that an overnight rate does not capture.
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Full text
# What does LIBOR really represent? # What does LIBOR really represent? LIBOR - rate at which banks in LONDON would lend to each other. Is there a similar index for banks in New York (or any other major financial city) would lend to each other? For example, what is the rate that JPMorgan would lend to Bank of America in New York, is it still LIBOR or somethign else? Is 'LONDON' here just for legacy purposes, and LIBOR today really means the rate at which major banks would lend to each other, regardless of city? eg, USD Libor is the rate bank would lend money in USD to each other, TIBOR is the rate at which banks would lend money in JPY to each other. If the answer to the above is NO: it is still specific to banks in london. Then why would say a swap contract made purely between 2 US counterparties still be based no LIBOR rate? How is it got anything to do with London? Simialr, why would US mortgages, which are purely domestic, be based on LIBOR? ## Answer by dm63 (score 5) https://quant.stackexchange.com/a/32658 Good questions! Libor is indeed specific to London, Tibor is specific to Tokyo. In New York banks lend to each other overnight in the Federal Funds market (confusingly, the Fed is not a counterparty to those trades; they are overnight interbank trades). The interest rate swap market started in London in the 1980s , and spread worldwide. As it spread, some local markets changed the index to a local one (eg Tibor for Yen swaps, or Euribor for Euro swaps). Some retained the Libor (eg in New York for USD swaps). Why are some US mortgages based on Libor? Here I am guessing a bit, but I would say (1) when the mortgages are sold to investors, they need an index that is familiar to those investors (2) lack of a comparable US index - there is Fed funds, but that is an overnight rate rather than a 3 month lending rate. Your questions are highly relevant at the current time. Following the Libor scandals of recent years, regulators are hoping an that alternative indices will be developed, in the US and elsewhere. ## Answer by nbbo2 (score 4) https://quant.stackexchange.com/a/32659 Many major currencies/money markets have both an onshore money market and an offshore market. London is the offshore market for the USA. All major US banks have a branch in London. Historically this offshore market developed to escape US domestic regulations in the 1960's, but it still survives and even thrives, despite major changes (for example the volume of interbank borrowing nowadays is very very small, and the regulations of the 1960's have been largely abolished). Nowadays Libor is useful mainly as a benchmark because it is (was thought to be) an objective standard, free of government regulation and difficult to manipulate (ha!). The skill and creativity of the London banking community also played a role in keeping London important (can this continue after Brexit?). In the US banks can lend/borrow from each other through the intermediary of the Federal Reserve: the Federal Funds market, and in some other ways also (but again this activity is very low right now). ## Answer by Math (score 3) https://quant.stackexchange.com/a/32689 The other answers have answered why swaps are based on LIBOR (historical reasons). The reason mortgages are based on LIBOR given this is a bit easier to understand. Swaps are traded instruments with market prices, and we can use the prices to infer a yield curve for, say, 1M LIBOR. This allows for more intelligent pricing of other derivatives based on LIBOR. A mortgage would be based on 1M LIBOR specifically because this is determined by the market with one month of credit risk built in.
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