The last three decades have seen phenomenal growth in derivative trading, with the total outstanding amount of derivative contracts reaching US$700 trillion globally by June 30, 2012. Today, interest rate derivatives account for the bulk of that: US$550 trillion. The process of setting the daily London Interbank Offered Rate (LIBOR) was first implemented in January 1986 by the British Bankers’ Association (the “BBA”) in an effort to standardize the pricing of new instruments, including interest rate swaps and foreign currency options. LIBOR is still administered by the BBA today. Currently, there are 150 short-term benchmark rates calculated daily on 10 currencies and 15 terms (overnight to one-year).¹ The “trimmed” average rate is calculated based on contributing banks’ quote of their unsecured borrowing by currency and term, removing the highest and lowest submissions in order to arrive at the average rate. LIBOR rates have been adopted as global benchmark rates for pricing and trading of a broad variety of products, including derivatives on interest rate swaps and futures, floating-rate commercial loans, and mortgages. Table 1 below outlines an approximate total of US$300 trillion for financial contracts, mostly derivatives, that use LIBOR rates, making LIBOR the most widely used reference benchmark for such contracts and under-scoring its systemic importance.

Regulatory Interventions

In June 2012, British bank Barclays PLC was fined a record US$464 million by U.K. and U.S. regulators for wrongdoing with respect to some of its LIBOR submissions from 2005 to 2009. Recently, Swiss bank UBS agreed to pay about US$1.5 billion to U.S., U.K., and Swiss regulators for LIBOR manipulation activities from 2005 to 2010. Regulators in the U.K. and around the world are currently investigating a number of other financial institutions with respect to their submissions for LIBOR and other benchmarks, including EURIBOR and TIBOR (Tokyo Interbank Offered Rate). It is expected that more wrongdoing will be reported and sanctions imposed by financial regulators.

For those not closely following the LIBOR scandals within the financial press, this may appear to be yet another example of rogues operating without adequate oversight, or of institutional bad behaviour within the financial industry. However, the issues with LIBOR go far deeper. Last year, the U.K. government asked Martin Wheatley, the inaugural Chief Executive of the new Financial Conduct Authority, to review LIBOR-related issues and deter- mine whether a wider policy response is required. The Wheatley report was released in September 2012 and details a surprising lack of oversight and controls to protect the integrity of the LIBOR rate-setting process itself.² For example, the report finds that the governance framework that oversees how the process is administered appears to be insufficiently independent and that there is overlap between the roles of the banks that contribute LIBOR inputs and oversight for the LIBOR rate-setting process in being a BBA member itself.³ it also found that insufficient resources and processes have contributed to weakness in the oversight mechanisms. At the same time, the process lacks sufficient transparency around oversight committee membership and accountability.

“In June 2012, the British Bank Barclays PLC was fined a record US$ 464 million…”

The report finds that the activities of contributing to LIBOR and administrating it are not regulated activities as defined under financial services legislation, and this fact severely limits the ability of the Financial Services Authority to regulate those activities. The report also discusses the reforms needed to strengthen the LIBOR regime as well as possible alternative benchmarks in the longer term. It also makes the case for developing an overarching global framework for key international benchmarks. These recommendations, which have the full support of the BBA and many (if not most) others within the financial community, provide a roadmap for revamping the LIBOR process in the near term.

Three key proposed changes are:

1. The statutory regulation of the submission and administration processes around LIBOR rate setting. A comprehensive proposal for the regulatory oversight framework is outlined in the report.
2. To ensure that there are sufficient transaction data to support the daily quote process, the report recommends reducing the current 150 rates to 20 benchmark rates. Rates on only five currencies will be maintained: British pound, U.S. dollar, euro, Japanese yen, and Swiss franc. Tenors supported will be reduced to 1M, 3M, 6M, and 12M. (Chart 1 presents the Bank for international Settlements statistics on notional balances for over-the-counter interest rate derivative contracts by currency, indicating that Canadian dollar contracts account for only 1.4 percent of total balance.)
3. A code of ethics and a verification process should be developed for banks that contribute the data. Relevant transaction data should be explicitly used to support the quote submission wherever possible.

As LIBOR rates are widely used global benchmarks, investors in floating-rate loans and derivative users will benefit from the reforms.

Implications for Canada

At the local level, with the BBA’s decision to discontinue the Canadian dollar rate setting in March 2013, the impact on Canadian dollar swap and floating-rate loan pricing is not expected to be significant, based on the relatively low use of the Canadian dollar LIBOR rates in the offshore market (Appendix 1, following page).

The market has been using a broadly adopted pricing benchmark source for Canadian dollar floating-rate loan and interest-rate derivatives pricing: the daily Canadian dollar offered rates (CDOR), administered by the Bank of Canada. CDOR rates are compiled based on Bankers’ Acceptance rates, which are generally considered to be one of the most liquid instruments in the Canadian money market.^4,5

The Wheatley report, as well as other reviews of reference benchmarks currently underway, may well pave the way for the development of a global framework of key principles and best practices for internationally used benchmarks.⁶ At the same time, many users may now realize that standardization has its drawbacks and might more closely assess the costs and benefits of using alternative “fit for purpose” benchmarks (i.e., different benchmarks for derivative pricing versus floating-rate commercial loan pricing or perhaps using different bench- mark rates at specific local markets).

Over the longer term, the LIBOR scandal may bring many significant positive impacts and stronger standards to the global derivatives industry, changes that may well fuel the continued strong growth of the industry over the next several decades.

Charterholders weigh in on LIBOR

In total, 1,259 charterholders responded to a CFA institute survey of changes they would like to see in the LIBOR setting process. The results, published in September 2012, are largely consistent with the recommendations outlined in the Wheatley report. Here is what CFA charterholder respondents would like to see:

1. Transparency and transaction-based preference: 56% of respondents think the most appropriate method would be an average rate based on actual interbank transactions only. About half of this group elaborated that using estimated rates would be accepted should the interbank market be very illiquid.
2. Regulatory oversight: 70% considered it reasonable that the LIBOR submission process should be a regulated activity.
3. Alternative benchmark to LIBOR: There were mixed responses: 43% suggested using market-based interest rates, including T-bills, commercial paper, and certificates of deposit; 32% suggested using repo rates; 29% suggested using overnight index swap rates.
4. A global standard: 89% of the respondents agreed that a global framework of key principles and best practices should be developed for internationally used benchmarks.

Endnotes:

¹ The ten currencies are the British pound, U.S. dollar, euro, Japanese yen, Canadian dollar, Australian dollar, Swiss franc, Danish krone, Swedish krona, New Zealand dollar (www.bbalibor.com).
² “The Wheatley review of LIBOR: final report,” Martin Wheatley, September 2012, www.hm-treasury.gov.uk.
³ As outlined within “The Wheatley review of LIBOR: final report,” the day-to-day running of LIBOR is the responsibility of BBA LIBOR ltd., a subsidiary of the BBA. A brief description of the key entities in the administration of the LIBOR rate-setting process, their main responsibilities, and overall governance framework limitations are found in pages 82−83.
⁴ The Bank of Canada computes the average rate for Canadian bankers’ acceptances for specific terms- to-maturity, determined daily from a survey on bid-side rates provided by the principal market-makers, including the major Canadian banks.
⁵ According to “Bank of Canada Banking and Financial Statistics November 2012,” Table C4: Chartered Bank liabilities as of August 31, 2012, chartered banks bankers’ acceptances amount to CAd$60.7 billion.
⁶ For example, the international organization of Securities Commissions (IOSCO) constituted a Board level Task Force on Financial Market Benchmarks with the aim of developing by the first quarter of 2013 recommendations on safeguards against abusive practices in benchmark setting. Martin Wheatley is a co-chair of this Task Force.