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Libor Marked for Review, Could It Get Benched?

e21 | March 26, 2012

For almost three decades the British Banking Association has determined the London Interbank Offered Rate (LIBOR), the benchmark rate for much of the global financial world and over $350 trillion in securities. However, the BBA’s days of polling the rates at which large banks lend to each other and then taking the mean of the middle 50% could be numbered.

On the heels of an antitrust suit by Charles Schwab against several banks, the U.S. Department of Justice has commenced an investigation into possible distortions of Libor by the BBA and the banks it polled. This investigation coincides with Canadian Competition Bureau filings asserting that one bank confessed to colluding with other banks in manipulating Libor for profit. With other nations also concerned, the BBA has felt the walls closing in regarding its practices. The number of member banks that have suspended or fired some of their traders that were involved in this process is also only growing.

Reacting to the new pressure and spotlight, the BBA apparently no longer “calculates and produces BBA Libor at the request of [its] members and for the good of the market.” The aforementioned statement was recently deleted from the BBA website and the calculation of the Libor rates is currently being handled by Thomson Reuters who previously handled dissemination of the benchmark rate. The financial news giant has said it will “support the BBA should any changes be recommended.” It should be noted in 2009 the BBA created BBA Libor Ltd., whose revenue stream flowed from the licensing of Libor rates, but only to “cover operating costs recharged by the BBA” according to the BBA. So what changes could be in store for what some call “the most important number”?

Increase the sample size of banks polled

After reviewing its practices in 2008, the BBA increased its respondent pool to 20 from 16. Currently, the European Banking Association uses 44 respondents in determining the European Interbank Lending Rate (Euribor) and its chief has encouraged the BBA to reach a similar sample size.

Allow banks to submit rates anonymously

In times of stress there is a tendency for banks to distort their submissions in order to avoid signs of weakness. When submitting rates for Euribor, banks remain anonymous to circumvent pressures to appear stronger.

Oversee the relationship between submissions and trades

The possibility exists the Prudential Regulation Authority of the Bank of England could begin monitoring the actions of banks submitting rates for the Libor process. Allegations assert much of the distortion of Libor has been to manipulate prices in order to profit on trades.

Find an alternative

As explored in this Bloomberg piece, Barclay’s, the U.K.’s third largest lender, has already begun to move away from using Libor and instead has opted for overnight indexed swap rates (OIS) as the basis for collateralized derivatives. OIS, reviewed in this Credit Suisse memo, is considered to be less “risky” than its Libor counterpart. The spread between OIS and Libor has been heralded by many as an important indicator of risk and liquidity in markets. It was also a closely watched metric during the heat of the financial crisis.

The BBA is clearly looking to change how it calculates Libor to restore confidence in the benchmark. How the process is ultimately changed remains to be seen, however, with trillions of dollars in investments tied to Libor there will be much red tape to navigate before a resolution.