In five years, Libor could be no more.
On Thursday a top U.K. regulator said it would phase out the London interbank offered rate, a scandal-plagued benchmark that is used to set the price of trillions of dollars of loans across the world.
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Andrew Bailey, the chief executive of the U.K.'s Financial Conduct Authority, which regulates Libor, said that work would begin to plan for a transition to alternate benchmarks by the end of 2021. "We do not think markets can rely on Libor continuing to be available indefinitely, " he said.
Libor is calculated every working day by polling major banks on their estimated borrowing costs. Its integrity was called into question following a rate-rigging scandal where traders at numerous banks were able to nudge it up or down by submitting false data. Banks were fined billions of dollars and several traders were sent to jail.
Over the last five years regulators have tried to find ways to tie Libor submissions to actual trades, as opposed to estimations. But in several cases that proved impossible because interbank lending has hugely diminished, Mr. Bailey said.
In one case, banks setting the Libor rate for one version of the benchmark executed just 15 transactions in that currency and duration for the whole of 2016, he said. The U.K. regulator has the power to compel banks to submit data to calculate the benchmark. "But we do not think it right to ask, or to require, that panel banks continue to submit expert judgments indefinitely," he said, adding that many banks felt "discomfort" at the current set up. The FCA recently launched an exercise to gather data from 49 banks to see which institutions are most active in the interbank lending market.
Libor, created in the early 1980s, was previously overseen by a British banking lobby group. During the financial crisis it was closely watched as a gauge of a bank's health. The lower other banks charged an institution to borrow, the safer it was deemed to be. The problem: bank lending largely froze up, so the Libor rate was based on guesses and in some cases on deliberately skewed data.
Following the rate-rigging scandal, the bank lobby was stripped of its control of the benchmark. In 2014 IBA, a subsidiary of Intercontinental Exchange Inc., became the new administrator of Libor. The IBA implemented a series of changes -- including instating a surveillance team that evaluates the data coming out of the banks -- to ensure that the lenders' submissions are more accurate. A spokeswoman for the IBA declined to comment.
Mr. Bailey didn't set out exactly what a potential replacement for Libor might look like but a group within the Bank of England is already working on potential replacements.
However, any shift will have to be phased in slowly.
Some GBP30 trillion ($39.4 trillion) of over the counter derivatives reference the rate, while dollar Libor contracts run to the hundreds of trillions, according to the central bank. Mr. Bailey said it was up to the IBA and banks to decide how to move Libor-based contracts to new benchmarks. After 2021 IBA could choose to keep Libor running, but the U.K. regulator would no longer compel banks to submit data for the benchmark.
Regulators have already been working with banks for several years to find alternatives to Libor.
Last month the U.S.'s Alternative Reference Rates Committee, which is made up of a group of big banks, voted to use a benchmark based on short-term loans known as repurchase agreements or "repo" trades, backed by Treasury securities, to replace U.S. dollar Libor. The new rate is expected to be phased in starting next year.
In the U.K., one potential replacement is the Sterling Overnight Index Average, which is calculated using banks' overnight funding rates in the sterling unsecured market. This rate is currently being reformed by the Bank of England. The euro's overnight interbank lending rate, Eonia, could also be a possible Libor replacement, said the FCA's Mr. Bailey. Both these rates are administered by central banks.
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(END) Dow Jones Newswires
July 27, 2017 09:49 ET (13:49 GMT)