By Lene Powell, J.D.
The Intercontinental Exchange group ICE Benchmark Administration (IBA) published a position paper on LIBOR, the widely referenced interest rate benchmark administered by IBA. The group called for LIBOR to be generated from observable market transactions “to the greatest extent possible” and calculated using a unified, prescriptive methodology featuring a waterfall approach.
Background. ICE LIBOR is a benchmark rate published for five currencies, with seven maturities quoted for each, indicating the interest rate that banks pay when they borrow from each other on an unsecured basis. LIBOR is referenced by about $350 trillion of outstanding business in maturities ranging from overnight to more than 30 years.
Following the discovery by regulators of widespread LIBOR manipulation and resulting sanctions for a number of banks, Martin Wheatley, head of the U.K. Financial Conduct Authority (FCA), published a review in September 2012 that concluded that there should be statutory regulation of LIBOR. The Wheatley Review set out a ten-point plan for the reform of LIBOR, including the transfer from the British Bankers’ Association (BBA) to a new administrator. IBA became authorized and regulated by the FCA as the new LIBOR administrator in February 2014.
After the Wheatley Review, changes were made to the LIBOR process, including the implementation of a surveillance system by IBA, external auditing of administrators and submitters, and the introduction of statutory regulation featuring an Approved Persons regime. As a result of these and other changes, LIBOR is now harder to manipulate, and there are appropriate legal punishments for any attempts at manipulation, said IBA.
Findings. The IBA paper confirmed some key assumptions. First, the inter-bank unsecured lending market declined precipitously during the financial crisis of 2007-2009, and is still too low in some tenors to support an entirely transaction-based rate. This decline has been driven by a significant increase in perceived risk of bank counterparty default, as well as regulatory capital charges and an increase in liquidity available to banks due to crisis measures taken by major central banks. In addition, the benchmark submitters to LIBOR have committed resources to strengthen submission processes and internal governance. Further, each benchmark submitter has developed its own methodology for establishing LIBOR submission, using a wide range of transactions to anchor their LIBOR submissions within the existing waterfall of methodologies referenced in the Wheatley Review.
Proposed enhancements. To replace the variety of methodologies used by benchmark submitters, IBA called for the adoption of a more unified transaction-based methodology. The proposed methodology will use a more prescriptive calculation, with pre-defined parameters that the IBA Oversight Committee will keep under review.
IBA will implement a waterfall of calculation methodologies in order to ensure the rate is always available, even in times of market stress. Where transactions are not available for a currency and tenor, or are below minimum transaction size or aggregate volume, interpolation techniques should be used. To ensure consistency, IBA will issue interpolation formula guidelines. If interpolation is not possible, then expert judgment should be used as a last resort. The submission and supporting data are reviewed both by additional individuals at the submitting bank and by the surveillance team at IBA.
The paper also made recommendations as to the timing of transactions, reasonable market size for transactions, panel composition, and delayed publication of individual submissions.
Timetable for change. Following recommendations of the Financial Stability Board, the IBA set out the following timetable:
- By end Q1 2015: IBA will have worked with contributing banks to analyze available transaction data.
- By end Q2 2015: In conjunction with the Bank of England and FCA, IBA will have considered the recommended LIBOR methodology and the viability of each LIBOR tenor.
- By end 2015: IBA will have publicly consulted on changes.