On August 10, 2012, Martin Wheatley, Managing Director of the U.K. Financial Services Authority and Chief Executive Designate of the Financial Conduct Authority (one of the successors to the FSA), and his review team issued an Initial Discussion Paper setting out the direction of their initial thinking on the necessary reforms to the current framework for setting and governing LIBOR, the sanctions to appropriately combat LIBOR abuse and whether the failings of LIBOR have implications on other global benchmarks, and inviting responses from interested parties.

On July 2, 2012, the Chancellor of the Exchequer, Rt. Hon. George Osborne MP, commissioned Mr. Wheatley to undertake a review (the "Wheatley Review") of the structure and governance of LIBOR and the corresponding criminal sanctions regime. The Wheatley Review will report its findings by the end of the summer so that its immediate recommendations can be considered for inclusion in the Financial Services Bill which is currently being considered by the House of Lords. Responses to the Initial Discussion Paper are requested by September 7, 2012. The list of consultation questions is set forth in Annex A attached hereto.

1. Introduction

The Initial Discussion Paper identifies the failures within the current LIBOR processes, explores the options to strengthen LIBOR, considers whether LIBOR could be replaced by an alternative benchmark and addresses the question of whether the analysis of the issues raised with respect to LIBOR is relevant to other benchmarks in financial and other markets.

2. Issues and Failings with LIBOR

While LIBOR is the most frequently utilized benchmark for interest rates globally (referenced in transactions with a notional outstanding value of more than $300 trillion), the Initial Discussion Paper identifies a number of weaknesses that have eroded its credibility as a benchmark:

• As the unsecured inter-bank term borrowing market has come under severe stress, banks have been relying on other sources of funding, including secured borrowing, retail deposits and liquidity from central banks, resulting in a smaller volume of inter-bank borrowing, resulting in LIBOR submissions¹ becoming increasingly reliant on judgment rather than transaction data.
• Banks and individuals working for banks have an incentive to manipulate their LIBOR submissions to signal their perceived credit worthiness or to support trading positions.
• The mechanism by which LIBOR is administered leaves opportunity for submitting banks to attempt to manipulate submissions in line with the incentives described above and the process is self-policing.
• The governance arrangements for the LIBOR compilation process are weak both within the independent Foreign Exchange and Money Markets Committee (the "FX & MM Committee") that oversees the operations and management of the LIBOR compilation process, and the submitting banks themselves.

3. Strengthening LIBOR

The Initial Discussion Paper sets out detailed ideas on how LIBOR could be comprehensively reformed:

• The mechanism for calculating LIBOR could be significantly improved with more robust and transparent calculations and compilation methodologies, including by way of establishing a trade reporting mechanism to improve the availability of transaction data.
• The governance of the LIBOR process could be amended to make it more independently robust and transparent within the contributing banks, BBA LIBOR Ltd., Thomson Reuters and the FX & MM Committee, including by introducing a code of conduct to establish clear guidelines relating to the policies and procedures concerning LIBOR submissions.
• The legal and regulatory framework could be reformed to bring LIBOR submissions and the LIBOR administration process explicitly within regulatory purview, and strengthening sanctions for misconduct, including by enacting specific criminal sanctions.

4. Alternatives to LIBOR

The Initial Discussion Paper states that it is likely that markets will want to consider alternative benchmarks for some of the types of transactions that currently rely on LIBOR and that such consideration must focus on three issues:

• Determining an appropriate alternative interest rate instrument;
• Determining an appropriate mechanism for compiling a benchmark; and
• Addressing the costs and impacts of migrating to an alternative benchmark.

The Initial Discussion Paper identifies criteria that can be used to determine the suitability of a particular interest rate instrument for a particular use or transaction:

• Whether the instrument reflects counterparty credit risk;
• Whether the instrument reflects liquidity risks of using cash for period of time;
• Whether the benchmark has a maturity curve;
• Whether the benchmark has sufficient transaction volumes with which to establish a rate;
• Whether the rate provided is resilient throughout periods of illiquidity;
• Whether the instrument is simple and standardized, particularly across multiple currency jurisdictions; and
• Whether the instrument has a long data series.

The Initial Discussion Paper identifies six types of instruments that may be appropriate for use as a reference for interest rates:

• Central bank policy rates;
• Overnight unsecured lending rates;
• Certificates of deposit or bank commercial paper rates;
• Overnight index swaps (interest rate swaps between a fixed rate and the overnight cash lending rate for a specific maturity);
• Treasury bill rates;
• Repurchase agreements (including indices based on rates paid for repo transactions). The Initial Discussion Paper notes that each interest rate instrument has advantages and disadvantages and includes the following table comparing the six instruments to existing LIBOR (term unsecured lending):

The Initial Discussion Paper identifies a number of criteria that can be used to measure the utility of a methodology to compile a benchmark:

• Simultaneous publication globally for different currencies and maturities;
• Deep and liquid market to reach a significant value of data inputs;
• The reference transactions continue to occur in significant volume even in a stressed market;
• The methodology not imposing a large burden on contributor balance sheet;
• The number of participants and transactions represented in the benchmark should be high;
• The methodology should not discourage participation of contributors, particularly in stressed conditions;
• The operational costs to contributors should not be prohibitively high; and
• The methodology should be transparent.

The Initial Discussion Paper identifies three potential mechanisms which can be used to calculate a benchmark:

• Uncommitted submissions - the mechanism currently used for LIBOR;
• Average transaction prices - transactions are required to be reported to a central repository that uses a calculation methodology (e.g. weighted average) to create a final interest rate fixing;
• Committed quote-based trading platform - banks would submit quotes to a trading auction platform for unsecured cash or commercial paper which are executable if matched by another participant.

The Initial Discussion Paper identified the difficulty in a migration from LIBOR to an alternative rate, including as it relates to existing contracts that reference LIBOR and particularly non-standardized contracts such as loan agreements. Four possible migration alternatives are identified:

• Allow LIBOR and an alternative benchmark to co-exist;
• Peg LIBOR to an alternative benchmark after co-existence;
• Discontinue LIBOR after co-existence; or
• Switch to an alternative rate on a specific deadline.

5. Potential Implications for Other Benchmarks

The Initial Discussion Paper concludes that the issues that have been identified with respect to LIBOR have broader implications for other benchmarks, including other interest rate benchmarks such as EURIBOR and non-financial benchmarks such as oil spot prices. It proposes consideration of whether a clear set of principles or characteristics should be applied to all globally used benchmarks, that could include:

• A robust methodology for calculation;
• Credible governance structures;
• An appropriate degree of formal oversight and regulation; and
• Transparency and openness.

Annex A

Consultation Questions

Issues and failings with LIBOR

Do you agree with our analysis of the issues and failings of LIBOR?

Strengthening LIBOR

Can LIBOR be strengthened is such a way that it can remain a credible benchmark?

Could a hybrid methodology for calculating LIBOR work effectively?

Could the number of maturities and currencies currently covered by the LIBOR benchmark be reduced?

Is an alternative governance body for LIBOR required in the short term?

Should the setting of and/or the submission to LIBOR be regulated activities?

Should the regulator be provided with specific powers of criminal investigation and prosecution in relation to attempted manipulation and manipulation of LIBOR?

What role should authorities play in reforming the mechanism and governance of LIBOR?

Which types of financial contract, if any, would be particularly affected by the risks of a transition from LIBOR?

Alternatives to LIBOR

Are there credible alternative benchmarks that could replace LIBOR's role in the financial markets? Should an alternative benchmark fully replace LIBOR, or should it substitute for LIBOR in particular circumstances?

Should particular benchmarks be mandated for specific activities?

Over what time period could an alternative to LIBOR be introduced?

What role should authorities play in developing and promoting alternatives to LIBOR?

Potential implications on other benchmarks

Are there other important markets or benchmarks that could face similar issues to those identified relating to LIBOR?

Should there be an overarching framework for key international reference rates?

Footnotes

1. LIBOR is calculated for 15 different maturities and 10 different currencies each trading at 11:00 AM, London Time, using submissions from a panel of banks for each currency (ranging in size from six to eighteen banks), by BBA LIBOR Ltd., a subsidiary of the British Banking Association. Submissions take the form of an answer to the following question: "At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 A.M.?" Thomson Reuters receives the individual submissions and calculates the LIBOR rates using a "trimmed arithmetic mean" of the submissions - a percentage of the highest and lowest submissions are excluded and the mean of the remaining submissions is the published LIBOR rate.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.

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