Britain's top financial watchdog, in a much-awaited reform of benchmark interest rates that have been plagued by scandal, outlined a 10-point plan to fix Libor but stopped short of scrapping the rates.
Martin Wheatley, head of the Financial Services Authority, acknowledged problems with London interbank offered rates, but said that Libor is so deeply entrenched in the financial system that it cannot be easily replaced. There are no better alternatives now, and any transition to a new benchmark would be difficult, he said.
"The system is broken and needs a complete overhaul," Wheatley said in a speech made available in advance.
Longer term, it makes sense for market participants to examine whether there are other possible benchmark rates, Wheatley said.
The plan marks regulators' first effort to fix the tarnished benchmark, but rulemakers have to thread the needle carefully.
On the one hand, they must restore confidence in the financial system, but on the other hand, they cannot take steps that are too radical without creating big trouble with existing transactions that use the benchmark.
More than $300 trillion of contracts and loans - from US mortgages to Japanese interest-rate swaps - refer to Libor.
Dramatic changes to the rates would have resulted in a "huge amount of legacy contracts to resolve, introducing a lot of disputes," said Darrell Duffie, a derivatives expert and finance professor at Stanford University.
Charges of manipulation
Multiple banks have been accused of trying to manipulate Libor, a series of rates set daily in London. Barclays in June agreed to pay $453 million to U.S. and British authorities to settle allegations that it tried to move Libor to help its trading positions.
Wheatley's programme for reform includes auditing banks that contribute data used to calculate the rates, to ensure they are not submitting false rates to benefit trading positions.
Libor, which is meant to reflect the rates at which banks borrow from one another, will be based on actual borrowing transactions, Wheatley said. Previously, banks could estimate where they think they would borrow, which left room for manipulation.
Transactions will be recorded with regular external audits of banks that participate. Bank employees making Libor submissions will have to be approved by the FSA. Wheatley is looking for authorisation to criminally sanction those who attempt to manipulate the rate.
Reuters parent company Thomson Reuters collects information from banks, and uses it to calculate Libor rates for 10 currencies and 15 maturities according to specifications drawn up by the British Bankers Association.
Shrinking the number of rates
Rates that are infrequently referenced in trades, such as Australian and Canadian dollar rates, will be phased out, Wheatley said. Maturities that are infrequently used, such as four, five, seven, eight, 10 and 11 months, will also be ended.
The reductions will shrink the current number of Libor rates set daily to 20 from 150. Rates that are rarely traded are easier to manipulate.
More banks will be required to submit their borrowing rates, Wheatley said.
"Libor requires collective responsibility if it is to work effectively," Wheatley said.
As expected, the British Bankers' Association, which had overseen the rate, will be replaced with a new, as-yet unidentified oversight panel.
"The British Bankers' Association clearly failed to properly oversee the Libor setting process and should take no further role in the administration and governance of Libor," Wheatley said.
The BBA said it worked closely with Wheatley on his review and it has strongly stated the need for greater regulatory oversight of Libor and tougher sanctions against manipulation.
A major problem that remains is that in financial crises, such as the one in 2008, banks cease lending to one another, effectively causing the evaporation of data needed to calculate Libor.
"There isn't enough transaction data during a financial crisis," said Rosa Abrantes-Metz, principal at Global Economics Group and adjunct professor at New York University's Stern School of Business.
The reforms come amid more crackdowns on the banks that submitted rates used to calculate Libor. Royal Bank of Scotland
is expected to be next to settle Libor charges, with other banks to follow.
Britain's government commissioned Wheatley to report on reforming Libor and is expected to back the findings in full. Legislative changes will be inserted into a financial services bill now being approved by parliament.