Libor in a Fix

In the wake of the rate-rigging scandal, corporate treasurers want the governance of Libor to be overhauled — but not the benchmark itself.
Andrew SawersSeptember 12, 2012

Fix Libor, don’t replace it. That, in short, is the message coming from corporate treasurers and financial-industry associations to an independent inquiry commissioned by the U.K. government. They are concerned, says one treasury expert, that a forced move to a successor benchmark rate could cause “chaos.” But the governance of that rate needs to be repaired.

The inquiry team, headed by Martin Wheatley, managing director of the Financial Services Authority (FSA), the industry regulator, was established in July to look at the framework for the setting of Libor, the London interbank offered rates that are set in a range of currencies and maturities and used in trillions of dollars’ worth of derivatives and debt contracts.

Libor was at the center of a rate-rigging scandal in June when U.S. and U.K. regulators hit Barclays with fines of $451 million for manipulating its rate submissions to the British Bankers’ Assn. (BBA), the trade association responsible for administering Libor. The so-called Wheatley Review, a commission appointed by the Chancellor of the Exchequer, published a consultation paper in August and is expected to issue a final report at the end of September.

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The U.K. Association of Corporate Treasurers (ACT) said in its submission to the commission that if Libor rates ceased to be published and a successor rate was not compatible with current contractual definitions of Libor, the impact would be “disruptive.” More bluntly, as ACT technical director John Grout told CFO European Briefing, “If you could argue in court that the [financial] contract was frustrated because the rate is no longer what everybody had in mind it would be, that’s when you begin to get financial chaos.”

What is needed, the association contends, is a tougher governance regime, with strict adherence on the part of banks to protocols recently recommended by U.S. regulators and the involvement of compliance departments. The task of administering Libor should be taken away from the BBA and handed to the Bank of England or the FSA, according to the treasurers’ group.

For its part, the International Capital Market Assn. (ICMA), a European group of capital-market participants, said in its submission to the Wheatley commission that it was “particularly concerned by the potential for disruption in the market which could arise . . . regarding the continuity of existing securities contracts.” It warned against “switching off” Libor, but also said that changes in the derivation of the benchmark rate (as opposed to changes in its governance or of regulation) could be just as disruptive.

To get an idea of the scale of the problem, consider this: the ICMA’s calculations suggest that at the end of 2012 there will be $1.3 trillion of floating rate notes (FRNs) outstanding that use Libor. This figure will fall to $961 billion by the end of 2013 and to $526 billion by the end of 2014. By the end of the decade, there will still be some $150 billion of Libor-based FRNs.

Grout tells CFO European Briefing that corporations are still using Libor. But he believes contracts are currently being worded in a way that removes any doubt that counterparties can continue assuming there is no fundamental change in the way the benchmark rate is determined. “It’s a case of everybody making sure that their paperwork is satisfactory,” he says.

The European Association of Corporate Treasurers (EACT) — a trade body that counts some 20 national associations as its members — said in its submission to the Wheatley commission that it was “not aware of any credible alternative benchmarks that could immediately replace Libor.” But it suggested there was some support for the use of overnight index swaps (OIS) as an alternative. (Those rates are based on risk-free rates, such as the Fed Funds rate, whereas Libor rates reflect bank credit risk.) The EACT added, however, that it was important that “any move to introduce an alternative to Libor recognises the need to allow for continuity in old contracts.”

The ACT — which itself is a member association of the EACT — is opposed to the use of the OIS as a replacement for Libor. The two rates usually track each other to within about 10 basis points or so, but during the post-Lehman period of the financial crisis, Libor went 350–450 basis points above the OIS because of the sudden concern about credit risk at banks. “If you were trying to introduce something that would behave like Libor, then OIS is not the answer,” says Grout.

The ACT believes that since the regulators started looking into Libor manipulation at a number of banks about three years ago, reported rates have been much more sound. So there may not be a need to fundamentally change the benchmark rate. As FSA chairman Lord Turner recently told a U.K. parliamentary committee, “[Libor] has been pretty robust since 2009 and 2010. . . . People are trying to do it as honestly as they can.”

Andrew Sawers is editor of CFO European Briefing, a CFO online publication.