Alternatives to LIBOR

Joseph A. Grundfest is the W. A. Franke Professor of Law and Business at Stanford University Law School. The following post is based on an article co-authored by Professor Grundfest and Rebecca Tabb.

Revelations that bank traders attempted to manipulate LIBOR, the London Interbank Offer Rate, on a widespread and routine basis over the course of many years have rocked the global financial community and fueled international calls for reform. In response, the U.K. Government completely overhauled the governance of LIBOR, adopting in full the recommendations of the Wheatley Review, an independent review of LIBOR led by Martin Wheatley, CEO of the new Financial Conduct Authority (FCA) in the UK. Among other reforms, effective April 1, 2013, both “providing information in relation to” LIBOR and administering LIBOR are regulated activities in the United Kingdom. In addition, a new, independent administrator will provide oversight of LIBOR. NYSE Euronext, selected as the first administrator under the new regime, will begin oversight of LIBOR at the beginning of next year.

These reform efforts are an important first step towards restoring the credibility of LIBOR as an interest rate benchmark. The reforms instituted to date, however, do not address more fundamental concerns with LIBOR. In particular, even non-manipulated submissions sometimes bear little relation to actual market transactions because few market transactions occur in certain interbank unsecured lending markets, particularly in times of market stress. As Mervyn King has observed, LIBOR “[i]s in many ways the rate at which banks do not lend to each other…it is not a rate at which anyone is actually borrowing.”

The interbank lending markets have undergone significant structural changes since LIBOR was created. Banks now rely to a much greater extent on shorter-term and secured funding in their interbank lending transactions. That trend began in the mid-1990s and accelerated during the recent global financial crisis. At some points during the financial crisis, banks essentially stopped lending to one another on an unsecured basis.

For some currencies and tenors, volumes in unsecured interbank lending markets have rebounded since the depth of the financial crisis. Nonetheless, even for higher volume LIBOR panels, the trend towards shorter-term and secured financing is likely to continue unabated as a result of Basel III capital requirements and as a consequence of the global push towards collateralization of derivatives trading. As a result, the London unsecured interbank lending markets LIBOR references may become increasingly illiquid and even more divorced from the reality of how banks finance their activities over time.

If LIBOR only represents a hypothetical interest rate, it likely is not an accurate and reliable measure of the cost of unsecured interbank funding, even with completely revamped governance. Or, to borrow from an observation often attributed to Ludwig Wittgenstein, it can be difficult to paint a clear picture of a fuzzy object. Inasmuch as the illiquid markets that underlie many of the LIBOR rate-setting processes are themselves “fuzzy objects,” there should be little surprise in the broad-based dissatisfaction with any effort—no matter how well monitored or principled—to describe that amorphous market condition in the form of a simple, crisp, precise statistic upon which trillions of dollars of market value depend.

Because of changes in interbank lending markets, when contemplating how to reform LIBOR, the Wheatley Review considered a number of alternative benchmarks. This review included, among others, the Sterling Overnight Index Average (SONIA), Overnight Index Swap (OIS) rates and repurchase agreement (repo) rates, such as the Depository Trust & Clearing Corporation General Collateral Finance Repo Index (DTCC GCF Repo Index). Although the Wheatley Review acknowledged certain virtues of these alternatives, it ultimately recommended that LIBOR not be replaced and that it continue to reference the same underlying interbank lending markets. This decision was made in part to maintain continuity of LIBOR for the trillions of dollars of legacy contracts that currently reference LIBOR and thereby avoid the risk of significant litigation claiming frustration of contract that might occur were the basis of LIBOR to change substantially.

The Wheatley Review recommendations also reflect that there are no perfect substitutes for LIBOR. As explored more fully in our article, OIS rates and repo rates, the most attractive alternatives to LIBOR, have appealing attributes and could be potential replacements for certain current uses of LIBOR. However, neither currently is fully suitable as a LIBOR replacement. First, neither captures the same credit and liquidity risk premiums reflected in LIBOR. Repo rates also reflect the risks of underlying collateral, which can be inappropriate for certain market participants. Second, both rely on actual transactions, the observance or thinness of which could be problematic during times of market stress. Finally, liquidity in these alternatives is concentrated in shorter maturities. These differences make it difficult for these LIBOR alternatives to fully replace LIBOR in all instances.

A closely related issue with the LIBOR reforms is the decision to continue to rely on a rate-setting mechanism of uncommitted quote submissions. Previously, banks had no obligation to tie their LIBOR submissions to actual transaction data. Under the new regime, submitting banks are supposed to make “explicit and clear use of transaction data to corroborate their submissions.” This change is an improvement, but still intentionally leaves room for banks to exercise judgment in their submissions. The concerns with this approach are: (1) even with greater oversight, the new regime will still be insufficient to deter manipulation, particularly if the underlying interbank unsecured lending markets have low trading volumes; and (2) reliance on judgment as opposed to actual transactions may mean LIBOR is not as accurate a measure of interest rates as other benchmarks might be.

Two alternative rate-setting mechanisms might potentially better address some of these concerns: (1) reliance solely on actual transaction data, as has been proposed in Australia for the local bank bill swap reference rate, a local version of LIBOR, and (2) a committed quote system. We explore both of these alternatives in greater detail in our article. Assuming a sufficient mechanism can be incorporated to deal with issues raised by periods of market stress, reliance on actual transaction data could be a better option than uncommitted quotes.

When considering alternatives to LIBOR we also question the current emphasis on finding a single LIBOR substitute for each currency and tenor. The challenge of reforming LIBOR is quite different for contracts that already exist and that clearly reference LIBOR than for new contracts as to which counterparties are potentially free to select any LIBOR substitute that is mutually agreeable. With regard to existing contracts, legal issues associated with the complexity of finding substitutes for LIBOR and reformulating these contracts to refer to these substitutes, make it very difficult to move away from LIBOR as a single benchmark. Internal reform and enhanced monitoring of the rate setting process, as urged by the Wheatley Review, may be the best available solution to the problem, at least in the short term.

The situation is, however, drastically different with regard to new contracts yet to be written. Here, counterparties are technically unburdened by commitments to price with reference to LIBOR and are free to select from among many different potential LIBOR substitutes. Because of the potential plasticity of this process, no single best alternative to LIBOR need be identified on a prospective basis. Instead, experimentation by market participants can, over time, lead to the evolution of many different LIBOR substitutes depending on the nature of the underlying contracts and the preferences of the counterparties.

Identifying a single, best substitute for LIBOR may thus be a fool’s errand. Creating an environment in which many different alternatives can legitimately co-exist may be a preferred strategy.

The full article is available for download here.

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