Libor: Deep trouble for a benchmark rate

Regulators mount up

An independent committee set up by regulators in the United Kingdom has taken at least one step to deal with Libor's issues. Starting in 2014, responsibility for administering Libor will be transferred to NYSE Euronext, the company that currently runs the New York Stock Exchange.

U.S. regulators have their own ideas of what else should be done, but there's not much they can do directly at this point, Cannon says.

"It's a little bit hard for U.S. regulators at this point because the 'L' in Libor stands for London," he says. "There's a real jurisdictional issue."

Still, in its annual report released in late April, the Financial Stability Oversight Council took aim at the very idea of survey-based benchmarks, calling out Libor but also the similar Euro Interbank Offered Rate and the Tokyo Interbank Offered Rate benchmarks.

The oversight council called for international regulators and businesses to abandon Libor altogether and move toward benchmarks based on real-world transactions. That approach would definitely make it harder to manipulate benchmarks, Cannon says.

"If it's an actual transaction, you can't manipulate it. You could actually say, 'We traded this bond for this amount on this day,'" Cannon says.

To be sure, that's easier said than done. There are already trillions of dollars' worth of long-term contracts that specifically name Libor as the benchmark rate. Trying to fundamentally alter that benchmark after the fact is pretty much impossible, Cannon says.

"With all those contracts, all the interested parties are going to say, 'Wait a second, if we're going to call this Libor and it's still going to be part of this contract, we want to be very sure it's going to act essentially the same as Libor,'" Cannon says.

Trouble with transaction-based benchmarks

Beyond those types of nuts-and-bolts issues, there is a fundamental problem with only using transaction-based data for rate benchmarks: not enough data, Subrahmanyam says.

"It's very nice to say 'market-based,' but what market are you talking about?" Subrahmanyam says. "If there were no transactions today, what are you going to do?"

While there are usually plenty of data on lending rates for standard maturities and widely used currencies such as the U.S. dollar, finding enough data on other types of lending can be difficult or impossible, he says.

Instead, Subrahmanyam suggests forcing banks to put their money where their mouth is. In that scenario, regulators would randomly choose a bank and force it to lend to or borrow from the central bank at the interest rate they're submitting for the Libor survey. If the rate is kosher, it won't hurt the bank, but if the rate is artificially high or low, the bank will lose money on the transaction -- punishment for their dishonesty.

While Cannon agrees the prospects for transaction-based benchmarks are fairly grim right now, if Dodd-Frank's regulation can force more transactions that would have previously been private onto public exchanges, the transparency will help with the data problem, he says.

"As you push more swaps to exchanges, we may well be able to move to a more transaction-based index over time," Cannon says.


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