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Why Overnight LIBOR Can Trade Below the BoE Base Rate

Article Quant Q&A · Author: Samuel B
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Summary

This note explains why overnight sterling LIBOR can sit below the Bank of England base rate, despite the intuition that unsecured borrowing should command a higher rate. It distinguishes LIBOR, which is based on trimmed submissions from panel banks, from an overnight index rate based on executed lending transactions. The difference between these benchmarks is not mechanically constrained to be positive, even though offered IBOR rates tend to exceed overnight index rates.

The response identifies market liquidity and access to central bank deposit facilities as important context. It attributes a lower overnight market rate to abundant sterling cash associated with quantitative easing, and describes how banks without direct access to the BoE facility may place cash through intermediaries. It suggests the spread could move in the other direction as liquidity is withdrawn, while noting that adjustment may be slow. The explanation is specific to the cited historical setting and is not a universal rule for benchmark spreads.

Key ideas

  • LIBOR submissions and transaction-based overnight index rates are constructed from different data.
  • The spread between IBOR and an overnight index rate is not required to remain positive.
  • Excess sterling liquidity can push the overnight market rate below the central bank deposit rate.
  • Intermediary access to central bank facilities can affect the rate paid on overnight cash.
  • The proposed spread reversal as liquidity contracts is a market expectation, not a fixed rule.

Tags

Fixed incomeForexMarket microstructure
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# Why is Overnight LIBOR lower than BoE Base Rate?


# Why is Overnight LIBOR lower than BoE Base Rate?












According to this site, the current overnight GBP LIBOR is 0.45638%, and the Bank of England base rate is 0.5%.

My understanding is that the overnight LIBOR should always be higher than the base rate, since it's unsecured.

So, why is it lower?

## Answer by Attack68 (score 4, accepted)

https://quant.stackexchange.com/a/40937

IBOR (Interbank Offered Rate) and OIS (Overnight Index Swap) are two fundamentally different forms of published interest rates. IBOR is calculated as an average of interest rate submissions from a series of panel banks, ignoring upper and lower outliers to improve robustness, and OIS is calculated as a weighted average of executed traded volume in an overnight unsecured cash lending market. Different currencies have different nuances but the principles are generally the same. However, these fundamental differences give rise to a variation known as the IBOR/OIS basis, essentially the spread between the two. The variation has greater variance when you compare longer tenors (1M, 3M, 6M etc.) but, for simplicity, lets restrict this to simply a 1D tenor (or overnight) as per your question.

In the case of 1D the difference between IBOR and OIS is actually negligibly small and stable. IBOR tends to stay above OIS, since by definition it is an 'offered' rate, and not a 'bid' or 'mid' rate but there is no specific reason it cannot be lower.

In this case the main driver, or the dominantly observed variable is the OIS rate since it is derived from actual trading liquidty and data, so the real question you should be asking is why is the OIS rate, or SONIA (Sterling Overnight Index Average) lower than the deposit rate? And from that answer you derive the answer to your question.

The answer to this new question is ultimately due to Quantitative Easing (QE) and the surplus amount of GBP liquidity cash in the system. You may legitimately question why any bank would lend money to another bank at below 0.5% when the ability to deposit funds at the Bank of England (BoE) base rate is a better credit quality and a higher rate? The answer is access and availability. In order to access the 0.5% rate, any bank must have gone through the approval process associated with the BoE and become registered. No doubt this additionally results in some form of regulatory and on going demands. As such I expect that a large number have not done this and in order to access the facilities they deposit cash with UK banks who then deposit with the BoE. The intermediate facilitation fee is made up by the difference by BoE rate minus SONIA rate. When there is more GBP in the system spread around multiple counterparties this effect is greater, hence the reason the SONIA price steadily dropped over the years as more and more QE had an effect.

When liquidity is withdrawn from the system you can expect this to reverse, although it generally processes slowly, and currently I do not believe there are any real plans to withdraw QE at an accelerated pace (although I have no traded Sterling for many years now).

My comments here are supported by the analysis of E Gagnon, D Bowman and M Leahy. in their article “Interest on Excess Reserves as a Monetary Policy Instrument” from the series: International Finance Discussion Papers.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.