Barclays rate-fixing scandal: Libor alternatives analysed

Author: | Published: 10 Jul 2012
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Should Libor be scrapped?
Barclays' rate-fixing scandal has highlighted the widespread inefficiencies within the London Interbank Offered Rate (Libor) setting process. IFLR asked readers should Libor be scrapped? Here’s what they had to say.

Barclays was last month fined $453 million by the US’ Commodity Futures and Trading Commission (CFTC) and the UK’s Financial Services Authority (FSA) for manipulating data, which went into calculations of the Libor. The move has prompted broader investigations into the Libor-setting process within Barclays, and other global financial institutions as well as the role regulators played in both identifying and preventing the problem.

The key market index influences the costs of a wide range of financial instruments. Indeed, it has been estimated that $500tn of swaps use some form of Libor as a reference rate. Historically, however, it has not been subject to any direct regulation or sole supervision.

Bankers are searching for alternatives. But, when IFLR polled lawyers from the UK, Europe and the US on whether the Libor probe should mark the end for the benchmark measure, 81% voted against the idea.

A US law firm partner said the idea made no sense. “If Boeing and Airbus were found to be colluding on jet aircraft prices, would we abolish jet aircraft?” he asked. “It’s a major financial pricing benchmark; if you scrap it, it leaves a crucial void.”

CMS Cameron McKenna’s Daniel Winterfeldt said it was important to remember that Libor has been used extensively and successfully in the marketplace for some time.

“Eliminating Libor would potentially create liquidity issues and leave the market searching for a new benchmark rate,” he said.

Other respondents liked the elimination of Libor to ‘throwing the baby out with the bathwater’.

Baker & McKenzie global head of banking, Bernard Sharp said the idea might seem superficially attractive, now it had been revealed not to be a perfect reflection of banks' true cost of funds. “But scrapping Libor would cause chaos,” he said.

There are probably hundreds of thousands of loan contracts which have Libor-based interest rates, he explained. They all provide back-ups if Libor ceases to exist; but the backups are not the same. “Many parties to such loans have hedged their floating rate exposures by hedging, and the hedging won't work if Libor ceases to exist,” he said.

Abolishing Libor would alter contracts worth hundreds of trillions of dollars. The resulting systemic and legal backlash would be swift and expensive.

Libor alternatives

A minority of 19% of respondents believed Libor should be abolished, however. One alternative suggested is to allow truly free markets to operate by, for example, conducting independent sampling of a random selection of anonymised actual trades. 

Lawyers in the UK have acknowledged this as a realistic alternative.

One UK-based law firm partner said that if actual sampling of trades were to be used, it would require reporting of all intra-bank lending to a central body. “That may be feasible," he said. "Indeed, it may have other benefits in terms of accuracy of information for macro-economic purposes,” he said. 

However, he stressed the central body would, for competition law reasons, need to be genuinely independent and not a bank.

There would be other issues to consider too, another London-based partner said. For example, Libor currently provides rates for a number of interest periods of different lengths in different currencies - it may not always be possible to get real time sampling of loans in those different currencies - or, if it were, the samples might not be big enough not to be distorted.

If Libor were to be replaced, Sharp believed it should only be for new contracts, with the existing Libor system being run in parallel, so that existing contracts weren't affected. “Finding a replacement would be a difficult but not impossible task, with many possible sources,” he said.

But other respondents questioned the efficacy of other alternatives.

For a trades-based benchmark to work, said one US lawyer, there has to be substantial liquidity in the market being reported, otherwise the reported trade information not only is less reliable but is more subject to 'gaming' through adjusted price trades and other gambits. 

"It isn't Libor that needs to change, but bank practices and the government regulation of those practices," he said.

Another poll participant questioned whether the Bank of England should end its monopoly on fixing interest rates. Sharp disagreed with the notion. "The Bank of England only has a role to play in relation to Sterling (which is but a small part of the Libor/Euribor market), and even that is only on setting rates at which it will lend to banks supervised by it,” he said.

However, Winterfeldt believed that there was no doubt that the system for setting Libor should at least be reformed. “This could include more stringent internal compliance within participating banks and also through increasing the number of banks contributing rates,” he said.

While, Baker & McKenzie’s international capital markets partner, Adam Farlow, said that other self-certification systems also needed to be reconsidered. “There are two sides to every trade, and a review/spot check of what counterparties are saying about offered rates for the relevant banks would make a lot of sense,” he said.

His comments follow similar suggestions by the Bank of England’s Paul Tucker to the Treasury Select Committee yesterday.