Cibor

Morten Kjærgaard and Katrine Skjærbæk, Market Operations

INTRODUCTION

In line with other international money-market reference interest rates, e.g. Libor and Euribor, the Copenhagen Interbank Offered Rate, Cibor, has been characterised by heightened uncertainty during the period of financial turmoil which started in August 2007.^[1] The spreads to other interest rates have widened and been highly volatile. At the same time, the reported interest rates underlying the calculation of Cibor have shown a higher-than-normal degree of dispersion.

Cibor is a reference rate for uncollateralised money-market loans and is used as the basis for fixing the interest rates for many financial products in the professional and private markets. Cibor and the other international reference rates were constructed at a time when the money market – the market for short-term interbank liquidity – was dominated by uncollateralised transactions. The last 20 years have seen a structural shift in the money market from the uncollateralised to the collateralised segment for all but the shortest maturities.

The modest depth of the markets behind Cibor and the other reference rates is not a problem under normal circumstances as the spreads to other money-market interest rates, including collateralised interest rates, are limited and relatively stable. This provides a solid foundation for fixing Cibor in relation to other interest rates. During the latest turmoil, Cibor fixing has, however, been associated with greater uncertainty as a result of the sudden change in the liquidity and credit conditions in the market for uncollateralised lending, which has increased the focus on Cibor and other reference rates.

This article describes Cibor. It explains the rules for calculation of Cibor and outlines the implications of the turmoil, followed by a review of the underlying turnover in the money market and Cibor's role as a reference rate.

DEFINITION AND CALCULATION

Cibor is the reference rate for uncollateralised lending in kroner between prime banks. The reference rate is calculated on the basis of the interest rates provided by 12 banks, called the Cibor reporting banks. The diversity of the group of reporting banks, which includes foreign banks, enhances the quality of Cibor fixing.

No Cibor reporting bank is obliged to provide liquidity at its quoted interest rate, which must nevertheless reflect market conditions as accurately as possible. Each Cibor reporting bank reports on a daily basis to Danmarks Nationalbank interest rates for loans with maturities of 1 and 2 weeks and from 1 to 12 months. Danmarks Nationalbank then calculates Cibor as an average of the reported interest rates, after excluding the highest and lowest interest rates. This limits the effect of deviating interest rates. The calculation of Cibor is described in more detail in Box 1.

Cibor is related to Libor^[2] (London Interbank Offered Rate), Euribor (Euro Interbank Offered Rate), Stibor (Stockholm Interbank Offered Rate), etc.

At the very short end of the money market, Danmarks Nationalbank also calculates a reference rate for uncollateralised day-to-day lending, i.e. the tomorrow/next interest rate (T/N). This is a rate of interest for loans taking effect on the first banking day after the transaction date and expiring on the second banking day after the transaction date. The T/N interest rate is based on actual lending. There are 13 T/N reporting banks that report the previous day's lending volume and the average interest rate to Danmarks Nationalbank, on a daily basis. Danmarks Nationalbank then calculates the T/N rate as the turnover-weighted average interest rate.

DEVELOPMENT IN INTEREST RATES

The reference rates reflect current and expected future monetary-policy interest rates but also include liquidity and credit risk premiums. Under normal circumstances, the liquidity and credit risk premiums are small and stable for interest rates such as Cibor, Libor USD and Euribor. Interest-rate developments will thus be determined by the level and expected adjustments of the monetary-policy interest rates.

A short-term interest-rate swap is an agreement for settlement of a fixed swap rate against an average overnight (or tomorrow-next) interest rate in a given period. Since short-term interest-rate swaps reflect current and expected monetary-policy interest rates, the spreads between the reference rates and short-term interest-rate swaps provide an indication of the size of the liquidity and risk premiums^[3].

The gradual increases in Cibor and Euribor until August were driven by expectations of rising monetary-policy interest rates. Libor USD was stable, cf. Chart 1. The liquidity and credit risk premiums were small and stable. Libor USD has declined steadily since September, particularly in connection with the Federal Reserve's interest-rate cuts in 2008, and Cibor and Euribor have fallen since mid-December. The general widening of the spread to short interest-rate swaps since the beginning of August can be attributed to the increase in liquidity and credit spreads as a consequence of the financial turmoil, cf. Chart 2. The credit and liquidity premiums are described in greater detail in Box 2.

CREDIT AND LIQUIDITY PREMIUMS	Box 2
The uncollateralised interest rate (Cibor) reflects both current and expected monetary-policy interest rates, credit risk and liquidity risk, etc. The rate of interest for short-term interest-rate swaps (T/N IRS) can be used as an approximation of the risk-free interest rate, and the Cibor-T/N IRS spread thus serves as an indicator of the total credit and liquidity premiums contained in Cibor. The spread can be broken down into a credit premium and a premium for other risk factors, including liquidity risk. For example, an estimate of the credit premium can be based on the Credit Default Swap (CDS) spread which is an indicator of the credit premium in the market.1 The part of the Cibor-T/N IRS spread that is not accounted for by the credit premium reflects other factors, including the liquidity premium. However, CDS spreads are not available for all Cibor reporting banks. Comparison of the Cibor-T/N IRS spread with the average CDS spread for the two largest banks in the Danish money market provides an indication of the development. Prior to the financial turmoil, Cibor contained relatively small and stable credit and liquidity premiums, cf. Chart 3. The credit premium began to rise in July 2007, i.e. before the money-market interest rates reacted to the financial turmoil in August. In the first months after the onset of the turmoil, the liquidity premium, etc. accounted for a considerable share of the widening of the spread. The credit premium rose further in October, November and January, whereas the liquidity premium, etc. declined. The Bank of England (2007) has broken down Libor spreads for pounds sterling, euro and dollars. The spread between Libor and short-term interest-rate swaps widened even more than the spread between Cibor and short-term interest-rate swaps. The liquidity premium seems to have accounted for most of the widening of the spread at the beginning of the turmoil. Subsequently the liquidity premium declined, while the credit premium continued to rise in accordance with the development  illustrated in Chart 3.
BREAKDOWN OF 12-MONTH SPREAD BETWEEN CIBOR AND T/N IRS	Chart 3
Source: Reuters, Bloomberg and own calculations.
1     A Credit Default Swap (CDS) is a contract that provides insurance against the liquidation of a certain business enterprise. The price of a CDS reflects the premium demanded by the investor for holding bonds issued by a certain business enterprise in relation to holding risk-free bonds.

Libor, Euribor and Cibor, etc. have been used as indicators of the extent of the financial turmoil. The turmoil has induced the banks to hold more contingency liquidity, made them more reluctant to lend liquidity and increased their concern about creditrisk. The market has had to adjust liquidity and credit premium levels amidst generally heightened uncertainty, wide bid-offer spreads, and limited turnover. At the same time, the fixing of reference rates is associated with greater uncertainty due to the varying exposure to the turmoil among the banks behind the reference rates.

The uncertainty is reflected in e.g. greater dispersion of the reported interest rates, measured as the difference between the highest and the lowest reported rate, cf. Chart 4. The average dispersion among the interest rates reported by the Cibor reporting banks has been approximately 5 basis point in recent years. When the international financial turmoil spilled over into the money market, the dispersion among the reported interest rates increased to an average of 9 basis points. This trend is also observed for e.g. Libor USD and Libor EUR, for which the dispersion among the reported interest rates rose from an average of 2 basis points to an average of 10-11 basis points.

A limited depth of the markets underlying Cibor and other reference rates is not necessarily a problem if the spreads to other, more frequently traded interest rates are stable. Under normal market conditions, the reporting of interest rates for Cibor can be based on e.g. uncollateralised interbank lending in the euro area, FX swaps, repos or short-term interest-rate swaps such as Copenhagen Interest T/N Average swaps (CITA swaps).

TRADING VOLUME IN THE MONEY MARKET

Cibor was first calculated in 1988 when the structure of the money market was different from today. At that time, the uncollateralised segment accounted for a large share of the money market, but a structural shift has taken place over the years towards the collateralised segment, both in Denmark and internationally.

Uncollateralised lending accounts for about one third of the total turnover, but the largest share by far is at the short end, cf. Chart 5. Around 1 per cent of turnover in uncollateralised lending has a maturity of more than 1 month. Day-to-day T/N loans constitute the largest segment in the uncollateralised money market. The short maturities also account for the principal share of turnover of repurchase agreements and FX swaps, although a distinct shift towards longer maturities is observed compared with uncollateralised loans.

The short maturities also account for the largest share of turnover in the uncollateralised euro money market, cf. ECB (2007). The largest segment is overnight loans maturing on the first banking day after transaction, making up around 70 per cent of the total turnover. 4 per cent of the turnover has a maturity of 1 month or more. After weighting by maturity, overnight loans account for approximately 10 per cent of total uncollateralised loans, while maturities of 1 month or more make up around two thirds.

USE

The trading volume is modest in the uncollateralised interbank market underlying Cibor reporting, but Cibor is used in connection with a wide range of financial instruments. Cibor is used as the reference rate for a number of loan agreements, mortgage-credit bonds and financial derivatives. Furthermore, several banks have recently opted for Cibor as the basis for their lending and deposit rates. In many loan agreements, the interest rate is fixed as Cibor plus an individually determined premium that reflects the relative credit risk and the customer's negotiation power.

There are no statistics for the volume of variable-rate loan agreements between banks and business enterprises with Cibor as the reference rate. The volume of outstanding Cibor-based mortgage-credit bonds amounted to kr. 416 billion in mid-January. The volume has increased by almost kr. 200 billion over the last two years. The bonds are used to finance various loan types, including variable-rate corporate loans and capped variable-rate loans to households. 6-month Cibor is used as the reference rate for 88 per cent of the Cibor bonds, while the remaining 12 per cent is based on 3-month Cibor.

Interest-rate derivatives is another large group of financial instruments that are based on reference rates such as Cibor, T/N, etc. Box 3 describes various interest-rate derivatives. According to the Bank for International Settlements, BIS, the daily turnover of interest-rate derivatives in Danish kroner totalled kr. 5.5 billion in April 2007, cf. Table 1. On the basis of the BIS survey, the notional principal amount can be estimated to be around kr. 1,250 billion.^[4]

The Danish government is a big player in the market for interest-rate swaps. At the end of 2007 the central government held krone-denominated interest-rate swaps for kr. 65 billion, entirely based on 6-month Cibor, cf. Danmarks Nationalbank (2008). In addition, the central government holds euro-denominated interest-rate swaps amounting to kr. 57 billion, based on 6-month Euribor. Interest-rate swaps are used to manage interest-rate risk on the government debt.

Internationally, the interest rates for a very large trading volume of financial contracts are based on a fixed uncollateralised lending rate such as Libor, Euribor, etc. The daily trading volume of interest-rate derivatives alone exceeds kr. 9,000 billion, cf. Table 1, and the notional principal amount was 388,627 billion dollars at end-June 2007, according to BIS (2007).

CONCLUSION

The purpose of calculating reference rates such as Cibor, Libor, etc. is to provide a transparent and representative reflection of market conditions, thereby facilitating valuation of various products. The benchmark status of the interest rates ultimately depends on the market perceiving them as the best reference for the associated instruments.

The reference rates have been useful, notwithstanding the structural shift in the money market towards the collateralised segment observed since the introduction of Cibor, etc. Under normal market conditions, fixing of the reference rates is thus associated with great certainty in view of the modest and stable credit risk element.

The financial turmoil since August 2007 has increased uncertainty in connection with fixing of the reference rates. This can be attributed to a sudden and substantial change in the liquidity and credit conditions. Under such circumstances the spread between uncollateralised and collateralised interest rates will widen and uncertainty in connection with interest-rate fixing will increase. Another factor that has led to increased uncertainty is the very limited activity in the underlying market.

No reporting bank is obliged to trade at its quoted interest rate, which must nevertheless reflect the actual market conditions as accurately as possible, not least in the light of the wide range of associated instruments. The diversity of the group of reporting banks, the calculation method and publication of the individual banks' reported interest rates, all aim to enhance the quality of Cibor fixing.

LITERATURE

Bank of England (2007), Quarterly Bulletin, 2007 Q4, Volume 47 No. 4.

BIS (2007), Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2007 – Final results, December.

Danmarks Nationalbank (2003), Monetary Policy in Denmark, 2nd edition.

Danmarks Nationalbank (2008), Danish Government Borrowing and Debt 2007.

ECB (2007), Euro Money Market Study 2006, February.

Egstrup, Rune and Birgitte Damm Fischer (2007), Foreign-Exchange and Derivatives Markets in 2007, Danmarks Nationalbank, Monetary Review, 4th Quarter.

Gyntelberg, Jacob and Phillip Wooldridge (2008), Interbank rate fixings during the recent turmoil, BIS Quarterly Review, March.

Kjærgaard, Morten and Lars Risbjerg (2008), Financial Turmoil, Liquidity and Central Banks, Monetary Review, 1st Quarter.

Lund, Jakob Windfeld (2007), Turmoil in the Financial Markets, Monetary Review, 3rd Quarter.

Pedersen, Anders Mølgaard and Michael Sand (2002), The Danish Money Market, Danmarks Nationalbank, Monetary Review, 2nd Quarter.