Why and How Should the Libor Be Reformed?

Rosa Abrantes-Metz, Jul 17, 2012

Over the last year, large-scale investigations have been launched around the world on allegations of possible collusion and manipulation of the London Interbank Offered Rate (“Libor”). Late in June this year, Barclays agreed to pay $452 million dollars on its conduct related to these allegations, in a settlement involving U.S. and U.K. regulatory agencies.

The Libor has been called “the world’s most important number.” It is the primary benchmark for global short-term interest rates; the Libor is used as the basis for settlement of interest rate contracts on many of the world’s major futures and options exchanges as well as most over-the-counter and lending transactions, and other financial instruments. It is estimated to benchmark payments on several hundreds of trillions of dollars worth of financial instruments.

The Libor is supposed to measure the rate at which large banks can borrow unsecured funds from other banks at various short-term maturities, and for a variety of currencies. The U.S. dollar-denominated Libor (“U.S. dollar Libor”), for example, is set as follows: On a daily basis, 16 participating banks surveyed by the British Bankers Association (“BBA”) and submit sealed quotes which answer: “[a]t what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11:00 a.m. London time?” The Libor is then computed by averaging the middle eight quotes, disregarding the four highest and the four lowest.

Following the launch of these investigations and the discovery of documents that suggest that manipulation and collusion may have taken place, some are now calling for a comprehensive reform of the Libor. Still others, however, are reluctant to reform the Libor system, arguing that it is not fundamentally broken and reforms may prove more disruptive than helpful.

In this article I review what I believe are the inherent problems in the structure of the Libor process and put forward a proposal for its reform.

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