UK Will Reform Libor or Replace It with Alternative Benchmark After Review by FSA Managing Director Martin Wheatley

Since the attempted manipulation of the London Inter-Bank Offered Rate (Libor) has cast a shadow over the financial industry at large and the governance of the benchmark, the UK has begun a review of the benchmark with an eye towards reforming it or replacing it with an alternative benchmark. Retaining Libor in its current state is not a viable option given its identified weaknesses and the loss of credibility it has suffered. The review is under the direction of Martin Wheatley, Financial Services Authority Managing Director. Mr. Wheatley is also the Chief Executive-designate of the new Financial Conduct Authority.

Libor is a benchmark used to gauge the cost of unsecured borrowing in the London interbank market and sets the price for hundreds of trillions of dollars worth of derivatives and other financial contracts worldwide. In recent remarks, Mr. Wheatley noted that Libor is an integral part of the modern financial system, referenced in a huge number and variety of financial contracts. Although Libor is calculated in London, it is based on daily submissions from a number of international banks and is used as a global benchmark.

A consultation was published August 10, 2012 under a very tight time frame. The comment period ends on September 7. After the review, Director Wheatley will make recommendations by the end of the summer to the UK Government, which will then make a decision and implement any changes in the Financial Services Bill or the Banking Reform Bill.

The Government will also be engaging with a wide range of international regulators as part of the reform process, including IOSCO, the SEC, CFTC and US Treasury. Mark Hoban, UK Financial Secretary said that the UK will work with international partners to ensure a globally consistent solution.

As part of the review, the Managing Director will look at how Libor can be reformed, including whether actual trade data can be used to set the reference rate, the governance of Libor, and whether the setting of Libor should be brought into statutory regulation. The process of how Libor is compiled will have to be reformed by minimizing judgment in Libor submissions and using better transaction-based data. There would also have to be a standard procedure to corroborate individual submissions.

While basing the rate on actual money market transaction data could help with subjectivity and corroboration issues, noted the FSA official, a concern would be the low volume of transactions in particular currencies. One solution could be coupling the use of actual transaction data with a broadened definition of relevant funding to include other products such as commercial paper.

Improvements might also be made through a reduction of the less-used maturities and currencies that are quoted. The FSA official suggested a hybrid of transaction data and a hypothetical rate, using judgment to fill in the gaps when data is scarce, all within a specified framework. But this comes back around to the use of judgment, said Mr. Wheatley, and so some kind of trade reporting mechanism may also be needed to supplement it.

A new Libor governance framework must ensure that the compilation process is subject to a much greater degree of independence, transparency and accountability

The Managing Director will also look into replacing Libor with other benchmarks. He cautioned that a migration to a new benchmark would require a carefully planned and managed transition in order to limit disruption to the huge volume of outstanding contracts that reference Libor. In addition, a decision to migrate to an alternative benchmark should be considered at an international level by relevant authorities.

An alternative benchmark would have to satisfy certain standards. For example, it should have a maturity curve to allow flexible use of the rate in different contracts and the hedging of different interest rate exposures. Also, an alternative benchmark should have sufficient transaction volume to establish a rate, noted the consultation, and the provided rates should be resilient through periods of illiquidity.

Ultimately, the choice of benchmarks for financial contracts is largely market-driven. If market participants decide that alternatives to LIBOR are more appropriate, they will move towards using these alternatives. This said, migration to an alternative benchmark might be hindered by market inertia regarding the adoption of a new global benchmark. However, decisions taken by regulators will influence the choices made by the market. If regulators reform LIBOR so that problematic issues are dealt with, markets might well take this action as an implicit approval to continue using Libor.

Given the importance of regulators in guiding market behavior on benchmark usage, as well as the need for a carefully managed transition if an alternative to Libor is used, the UK Government urged either IOSCO or the Financial Stability Board  to take a proactive role in coordinating the approach to the use of benchmarks in financial markets.