“We need reform not replacement.” – Guy Sears, Investment Management Association to the Financial Times on September 10, 2012
“Despite a long and painful recovery, sometimes replacement is the better choice when a hip or a knee or even a benchmark rate has worn out.” – Gary Gensler, Chairman, Commodity Futures Trading Commission quoted in the New York Times on September 24, 2012.
The Wheatley Review:
On Friday, the Financial Services Authority (the “FSA”) unveiled the findings of its study of the future of the London interbank lending rate (“LIBOR”). Martin Wheatley, Managing Director of the FSA and Chief Executive-designate of the Financial Conduct Authority, delivered a speech setting out the findings of the study and proposed recommendations on how the system should be reformed (the “Review”).
LIBOR is used as a benchmark for interest rates around the world. Each day, banking institutions set an estimated borrowing rate at which they are willing to lend to other institutions. The top and bottom 25% of estimates are discarded, and LIBOR is the average of the remaining 50% of estimates.
Wheatley’s investigation began after the alleged misconduct by traders at global banks, most notably Barclays PLC, relating to the manipulation of LIBOR. On August 10, 2012, Wheatley published a discussion paper that called for LIBOR reform; interested parties were encouraged to submit responses to the discussion paper. Friday’s Review is the culmination of Wheatley’s investigation.
Reforming LIBOR:
Industry experts disagree as to whether LIBOR should be reformed or replaced. Practical challenges and disruption to financial markets suggest that replacing LIBOR can only be justified if LIBOR is severely damaged and that a new, suitable benchmark could replace it. The Review concludes that, although LIBOR is damaged, a comprehensive program for reform can alleviate problems associated with setting LIBOR.
The Review suggests the following reforms: 1) the Financial Services and Markets Act 2000 (“FSMA”) should regulate submissions to and administration of LIBOR; 2) the British Bankers Association (“BBA”) should transfer responsibility of LIBOR to a new administrator; and 3) the number of published LIBOR benchmarks should be reduced.
Regulating LIBOR:
The Review concludes that the submission process for LIBOR should be regulated under the FSMA. Because the potential for misconduct is greatest in relation to rate submissions, the process of submitting rates should be a regulated activity.
The Review also proposes that the administration of LIBOR should be a regulated activity. Such “regulation of the administrator would allow the regulator to ensure that the administrator maintains proper systems and controls for identifying and investigating suspicious submissions, and reports these to the FSA”. The goal is to increase supervision of rate submissions and provide a method of regulatory action for misconduct.
The Review notes that the disadvantages of regulating LIBOR include increased compliance costs for institutions and supervisory burden on the regulator. The Review also confirms that although submissions to LIBOR should be regulated, the rates submitted by firms should continue to be dictated by the market.
Administration of LIBOR:
The Review concludes that insufficient independence of governance structures, inadequate oversight and limited transparency relating to the administration of LIBOR allow for potential abuse and misconduct in setting the rate. Considering these factors, the Review recommends that the BBA should transfer responsibility for LIBOR to a new administrator – a private organization rather than a public body.
The new LIBOR administrator, in collaboration with market participants, should draft a code of conduct detailing, among other things, specific procedures for submissions to LIBOR. The code of conduct should specify the explicit use of inter-bank deposit transactions and other transaction data used to set LIBOR and the requirement to retain records of all transactions in the inter-bank deposit market. The code of conduct should also specify detailed procedures for validation and corroboration of submissions to LIBOR.
The Review acknowledges that the unsecured inter-bank deposit market may be thinly traded and, in the absence of transaction data relating to this market, contributing institutions should look to other variables including transactions in unsecured deposit markets and other related markets.
Reduction of LIBOR Benchmarks:
LIBOR is currently published for ten currencies and fifteen maturities. The Review recommends that the LIBOR administrator should cease the publication of LIBOR for those currencies for which there is insufficient trade data to corroborate submissions. Given the low usage of many LIBOR benchmarks, the Review concludes that reduction of published LIBOR benchmarks is possible without significant market disruption.
The Review recognizes that, despite the infrequent use of some benchmarks, there are likely outstanding contracts that use such benchmarks as a point of reference. The reduction of particular LIBOR rates would necessitate these contracts being changed. Given this potential disruption, the Review recommends a 12-month transition period to adapt to the reduction.
The Review also noted the importance of ensuring large LIBOR panel sizes. There are currently twenty-three banks that are members of LIBOR panels, with six to eighteen banks on each panel. The Review concludes that larger panel sizes could discourage attempts to manipulate LIBOR.
The Wheatley Review of LIBOR: final report is published on the HM Treasury website.