Libor guessing games face replacement by verified trades

Benchmark for $360 trillion of securities at risk

March 13 (Bloomberg) -- The London interbank offered rate, the benchmark for $360 trillion of securities, may not survive allegations of being corrupted unless it’s based on transactions among banks rather than guesswork about the cost of money.

“The methodology used to formulate Libor is totally unsuitable for the modern world,” said Daniel Sheard, chief investment officer of asset manager GAM U.K. Ltd., which manages about $60 billion. “The British Bankers’ Association needs to come out on the front foot and say ‘this is a system that was appropriate 20 years ago but is no longer appropriate and we are going to change it.’”

The BBA, the lobby group that has overseen Libor for 26 years, is under pressure to find an alternative way to calculate the benchmark, or cede control of it. Regulators from Canada to Japan are probing whether banks lied to hide their true cost of borrowing and traders colluded to rig the benchmark, the basis for interest rates on securities from mortgages to derivatives.

“It can’t be beyond the wit of man to come up with a rate that is based on actual trades rather than guesswork,” said Tim Price, who helps oversee more than $1.5 billion at PFP Group LLP, an asset-management firm in London. “The idea that you can trust the banks and the BBA with this is laughable.”

Deeply Embedded

Libor, a gauge of how much it costs banks to borrow from one another, is so deeply embedded in the financial system it can’t be replaced without potentially voiding existing contracts, academics said. The BBA may instead overhaul Libor by making banks base their submissions on actual trades, open submissions to independent verification and increase the number of firms that set the rate, investors said.

“You might be able to call the new benchmark Libor, but because it’s not exactly the same measure, would that invalidate all these thousands and thousands of contracts?” said Donald Mackenzie, a professor at the University of Edinburgh who specializes in the sociology of financial markets. “It’s difficult to see that you can do much more than what the BBA is already trying to do in terms of trying to improve an estimate- based measure.”

The BBA is reviewing potential changes to the benchmark and met regulators and bank executives last week. The rate is set through a daily survey of firms conducted on behalf of the BBA by Thomson Reuters Corp. in which banks are asked how much it would cost them to borrow from one another for 15 different periods, from overnight to one year.

Because banks have to submit a rate when no market exists, and their estimates aren’t subject to outside verification, the benchmark is vulnerable to manipulation, investors said.

Next: How the Libor will be reviewed

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