The future of LIBOR

LIBOR, or more precisely the London Interbank Offered Rate, has been given many column inches over the past ten years. Before the financial crisis, most people hadn’t heard of LIBOR, even though it is a key part of the functioning of financial markets. It grew up so to speak with the eurocurrency markets, and like a number of things that came to be a focus of attention in the financial crisis, before then it was largely taken for granted, part of the financial landscape.

My remarks today (27/7) will not go over the details of LIBOR’s past scandals, but instead examine important questions about the sustainability of the LIBOR benchmarks, the way that LIBOR is used now and in the future, and give an insight into the work that we, and our domestic and international partners, have been doing to reform the interest rate benchmark landscape.
Can I also be very clear about one other related point. What I will say this morning does question the sustainability of LIBOR in its current form, but this is not because we suspect further wrongdoing or have any evidence of such.
Recent Developments in LIBOR
We at the FCA have regulated LIBOR since April 2013. Since then, significant improvements have been made to LIBOR through the work of its administrator, ICE Benchmark Administration (IBA), and the work of the twenty panel banks that submit contributions to the benchmark. Together they have introduced a step change in the quality of governance around submissions to this important reference rate.
For example, IBA has put in place an oversight committee to provide independent challenge on how it is operating the benchmark and on the underlying methodology for creating it. It publicly consulted on plans that would, where feasible, tie the rate more closely to transactions rather than judgements.
Firms submitting to LIBOR have, rightly, made significant investments in their controls around submissions. Each submitting bank must now have a senior executive responsible for benchmark contributions as part of our Senior Managers regime.  These changes have been made in careful consultation with the FCA, and, where appropriate, other regulators and central banks.
One of the aims of this reform, highlighted in the Financial Stability Board’s July 2014 report on “Reforming Major Interest Rate Benchmarks”, has been to try to anchor LIBOR submissions and rates to the greatest extent possible to actual transactions. This is to ensure the rate is genuinely representative of market conditions.
That change, however, has been more difficult to realise than the governance improvements.  This is not because the administrator or panel banks do not want to base their submissions on transactions. It is not because the composition of the current panels is unrepresentative of the underlying market, and transactions in that market. It is because the underlying market that LIBOR seeks to measure – the market for unsecured wholesale term lending to banks – is no longer sufficiently active. To take an extreme example, in one currency–tenor combination, for which a benchmark reference rate is produced every business day using submissions from around a dozen panel banks, these banks, between them, executed just fifteen transactions of potentially qualifying size in that currency and tenor in the whole of 2016.  LIBOR is sustained by the use of “expert judgement” by the panel banks to form many of their submissions.
Last month, the FCA launched an exercise to gather market data from 49 banks1 to ensure we have an up-to-date picture of which banks are the most active “actual and potential” participants in unsecured wholesale bank borrowing and related markets. This data gathering is not yet complete, but data from IBA and from central banks indicate that there are relatively few eligible term borrowing transactions by any large banks – i.e. these banks receive few loans or deposits of a twelve, six or even three month term from other banks or eligible corporate depositors. We will have a fuller picture once we have received and analysed the returns from the banks. But, on the basis of what we can currently observe, activity in these markets is limited, and there seems little prospect of these markets becoming substantially more active in the near future.
The absence of active underlying markets raises a serious question about the sustainability of the LIBOR benchmarks that are based upon these markets. If an active market does not exist, how can even the best run benchmark measure it?
Moreover, panel banks feel understandable discomfort about providing submissions based on judgements with so little actual borrowing activity against which to validate those judgements.
Public good
LIBOR is a public good, and it is in the interests of all involved that we sustain the current arrangements until such time as alternatives are available and transition arrangements are sufficiently well advanced, the subject I will come to shortly.
UK and European legislation does give us the power to compel banks to contribute to LIBOR where necessary. We will use those powers if we need – though we would much prefer not to have to do so.
The nature of the powers will change once LIBOR is designated as a critical benchmark under the European Benchmark Regulation, and our consultation launched on 12 June3 set out our thinking on how we would use our powers in the light of the requirements in that Regulation, were it necessary. But we do not think it right to ask, or to require, that panel banks continue to submit expert judgements indefinitely. Indeed, the powers available to us under European Benchmark Regulation, do not allow us to compel indefinitely.
Conclusion
We have worked hard to maintain and improve LIBOR. That work has been aimed towards the destination of interest rate benchmarks that are based on transactions, not on judgements. That offers a better model for those whose data are needed to produce the benchmark. Most importantly, it is also a better model for those that rely on the benchmark.
We do not think we will complete the journey to transaction-based benchmarks if markets continue to rely on LIBOR in its current form. And while we have given our full support to encouraging panel banks to continue to contribute and maintaining LIBOR over recent years, we do not think markets can rely on LIBOR continuing to be available indefinitely.
Work must therefore begin in earnest on planning transition to alternative reference rates that are based firmly on transactions. Panel bank support for current LIBOR until end-2021 will enable a transition that can be planned and can be executed smoothly. The planning and the transition must now begin.
Source: elements of the speech by Andrew Bailey, Chief Executive of the FCA. www.fca.org.uk