As this column from late last month discussed, the LIBOR scandal, in which a number of banks have been accused of fudging the numbers that make up the London Interbank Offered Rate (LIBOR), has a real-world impact on many companies’ finances.
In a recent speech, Martin Wheatley, a managing director with the UK’s Financial Services Authority (FSA), discussed the FSA’s response to the LIBOR scandal, and also introduced a discussion paper – the Wheatley Review – focused on the situation.
In his speech, Wheatley emphasized LIBOR’s impact: It helps determine the prices for several hundred trillion dollars worth of contracts around the world, including both consumer and corporate debt instruments and derivatives. “This means it has become an integral part of the modern financial system, referenced in a huge number and variety of financial contracts,” Wheatley said.
In fact, the use of LIBOR as a reference rate for derivative contracts has overtaken its intended use in covering the lending markets, Wheatley noted. Because of this shift, LIBOR’s existing structure no longer works, he said, Instead, the rate’s manipulation has “cast a shadow over the industry at large and the construction and governance of the benchmarks themselves.”
Moreover, “retaining LIBOR unchanged in its current state is not a viable option, given the scale of identified weaknesses and the loss of credibility that it has suffered,” the Wheatley Review notes.
Wheatley’s Review addresses several facets of LIBOR. If the decision is made to keep but reform LIBOR, that will mean reforming the current framework for setting and governing LIBOR. Among the areas potentially up for change: the ways in which banks submit data, whether actual trade data can be used to set the reference rate, and whether the setting of LIBOR should be under statutory regulation. The reviewers also are looking at other rate-setting processes, and the ways in which any transition should be managed.
For instance, one idea that’s been floated is to use actual money market data in calculating LIBOR, as this would address the issues of subjectivity in the calculation. However, Wheatley noted that some transaction data itself would be based on a low volume of trades, which also could pose problems. One solution might be to combine transaction data with a hypothetical rate.
The Review also looks at ways to tackle abuse, including an examination of the UK authorities’ ability to impose civil and/or criminal sanctions when misconduct occurs.
Third, Wheatley and his colleagues will examine others areas in which price-setting mechanisms are used in financial markets, and whether policy changes are needed.
Of course, instead of reforming LIBOR, another potential course of action would be to replace it with another benchmark, either one already in use or one yet to be developed. Such a transition would need to be carefully managed at an international level, Wheatley noted, given the volume of contracts that currently refer to LIBOR.
Wheatley indicated that the discussion paper represents the FSA’s early thinking on the subject; its intent is to generate input from others. Responses are requested by September 7, 2012, and can be emailed to email@example.com.