Following the LIBOR manipulation scandal, on September 28 HM Treasury published its final report on the LIBOR review by Martin Wheatley of the Financial Services Authority (the FSA). It is a 92 page document with no executive summary. Ours is given below.
The report reaches three main conclusions:
- The LIBOR benchmark should be comprehensively reformed rather than replaced.
- Strict processes should be introduced to verify submissions with transaction data.
- Market participants (i.e. those who use LIBOR in their contracts) should play a significant role in producing and overseeing LIBOR.
The review creates a ten point plan for LIBOR reform. These recommendations will be considered by the government and if approved will be taken forward as part of the new Financial Services Bill. In summary the 10 key points for reform of LIBOR are:
- The administration of and submissions to LIBOR should be subject to statutory regulation, and this should include an "Approved Person" regime; i.e. only an approved person should be allowed to perform the key regulated activities. Heading (a) below.
- Responsibility for administrating LIBOR should be transferred from the British Bankers' Association (the BBA) to a new administrator who will compile and distribute the rate and provide oversight. Heading (b) below.
- The new administrator should fulfil certain obligations including scrutiny of submissions, publication of submission statistics and reviews of whether LIBOR meets market needs.
- Banks should immediately seek to comply with the submission guidelines of the report; in particular the use of transaction data to support their submissions.
- The new administrator should introduce a code of conduct to give clear guidance on: the use of transaction data to determine submissions; systems and controls on the submissions process; and record keeping.
- Compilation and publication of LIBOR should cease for currencies and "tenors" (i.e. borrowing periods) where there is insufficient trade data to corroborate submissions. Heading (d) below.
- Individual LIBOR submissions should not be published for three months to reduce the incentive for manipulation. Heading (d) below.
- Banks that do not currently participate in submissions to LIBOR will be encouraged to do so, to increase the sample size and therefore the benchmark's accuracy and credibility.
- Market participants should be encouraged to consider their use of LIBOR and evaluate whether it is the most appropriate benchmark for their transactions.
- UK authorities should work closely with their European counterparts and the wider international community to debate the long term future of LIBOR and other global benchmarks.
Of the above recommendations which are accepted, those requiring primary legislation will be given effect through the current draft Financial Services Bill.
(a) Regulation and Sanctions
The report proposes that administering LIBOR and submitting to it be made regulated activities under the Financial Services & Markets Act 2000 (Regulated Activities) Order 2001. These areas carry a high risk of misconduct and it is thought that making them regulated activities will give the FSA a greater ability to oversee the process and take action where there is misconduct. Although there is the disadvantage of increased compliance costs and supervisory burden it is thought that this is outweighed by the benefits.
Note: the FSA is to be abolished and most of its functions will be inherited by two new bodies: the Prudential Regulation Authority and the Financial Conduct Authority (the PRA and FCA). For the rest of this article, the "Regulatory Authority" refers to the FSA, the PRA or the FCA as appropriate.
If an approved person regime is introduced, some of the regulated activities will be defined as "controlled functions", and those functions could only be performed by someone approved by the Regulatory Authority. The report proposes that both submitting to and administering LIBOR be made controlled functions. This will ensure that those carrying out the functions are considered fit and proper and that they will be accountable for their actions. It is recommended that, on the submissions side, the approved persons be the managers of the LIBOR submitting process as they can closely oversee the submissions and supervise the conduct of other employees.
As a transitional measure (should the recommendations be approved), the report suggests that banks that are already performing the above activities be deemed authorised pending an application within a specified time scale.
The report concludes that these reforms would give the Regulatory Authority wider powers to take enforcement action against banks and approved persons. It recommends amending s397 of the Financial Services and Markets Act 2000 to include a new offence of making a false or misleading statement in order to manipulate LIBOR. Concerns were expressed in the consultation stage about the introduction of criminal sanctions but the report emphasises the importance of the Regulatory Authority being able to conduct criminal investigations and prosecutions.
- New EU legislation is being developed in the area of regulation and sanction including
- A new Market in Financial Instruments Regulation, which will bring benchmarks within the scope of regulation for the first time.
- A new Market Abuse Regulation to harmonise EU laws on market abuse and extend them to cover manipulation of benchmarks.
- A Directive establishing criminal offences for serious market abuse (CS-MAD). The UK government has not yet decided whether it will opt into this Directive.
(b) Strengthening institutions and governance
The key weaknesses identified with the current administration of LIBOR are lack of independence in governing structures, inadequate oversight structures and only limited transparency and accountability.
The report proposes that governance of LIBOR be transferred from the BBA to a new private organisation. It is suggested that the BBA immediately begin a process of tendering out the new role. The new institution should be independent with specific oversight processes and transparent systems. The tendering process should be carried out by an independent committee including representatives from the Regulatory Authority, the BBA and market participants. The new benchmark administrator would be responsible for developing and implementing a new code of conduct. Scrutiny of submissions will be a key part of the new administrator's role.
An independent oversight committee should be able to enforce low level sanctions for operational problems and such like, but would refer more serious breaches to the Regulatory Authority.
(c) Rules and guidance for LIBOR
As discussed above the report recommends the introduction of an industry-led code of conduct but until this is implemented it is suggested that a series of submission guidelines be adhered to. These prescribe that LIBOR submissions should be determined using a hierarchy of transaction types, with the greatest emphasis on the transactions of the contributing bank. These transactions sit at the top of the hierarchy above contributing banks' observations of third party transactions and quotes by third parties to contributing banks. In the case of a benchmark where there is an absence of transaction data, expert judgement should be used.
The report says that one of the key weaknesses of LIBOR is that, whilst it is intended to be representative of unsecured inter-bank borrowing, the decline in that market means submissions have been reliant on expert judgment rather than transaction data. Banks and the individuals making submissions are incentivised to manipulate the rate to make their institutions appear more creditworthy; hence the recommendations of greater oversight (above) and delayed publication (below).
In terms of the application of the new code of conduct, the report recommends the code include detailed submission guidelines - including an outline of personal responsibilities, a procedure for signing off submissions and regular compliance reviews - and requirements to keep internal records.
(d) Reforms to the LIBOR mechanism
The three key recommendations made in this respect are the reduction of the number of currencies and tenors for which LIBOR is published, a delay in the publication of individual submissions and an effort to ensure sufficiently large panel sizes for LIBOR.
The report proposes that publication of LIBORs for Australian Dollars, Canadian Dollars, Danish Kroner, New Zealand Dollars and Swedish Kroner should be discontinued. For the remaining currencies, publication of 4 months, 5 months, 7 months, 8 months, 10 months and 11 months tenors should be discontinued. The report acknowledges that this could create some market disruption and suggests a 6 or 12 month transition period after public notice has been given to facilitate the transition.
The report notes that publication of individual submissions can incentivise contributors to submit inappropriate rates. The review recommends that the publication of individual submissions be delayed by a period of at least three months.
As the benchmark is compiled from banks' submissions, the report suggests that larger panel sizes would increase accuracy of submissions and ensure individual submissions have a limited impact on the benchmark. At present 23 banks are members of LIBOR panels. Participation is voluntary. There is a suggestion that banks operating in some markets will in the future be compelled to participate in LIBOR submissions.
Many contracts reference LIBOR, and the review recommends the development of contingencies for the operation of those contracts in the event LIBOR is unavailable. Current provisions are generally intended to be used where there are occasional operational problems. In most cases an alternative rate calculation process is triggered which, given the volume of affected contracts, would be unworkable if LIBOR was unavailable. The review recommends that standard legal documentation be prepared by industry bodies.
(e) Implications for other benchmarks
The review is careful not to identify particular benchmarks in need of improvement but does set out some recommended features of credible benchmarks. There is a concern that the credibility of benchmarks could be undermined if it is possible to distort them. Particularly vulnerable methodologies include those based on transaction data, survey responses or submissions (like LIBOR), or benchmarks comprising intellectual property so access to them may be restricted.
A credible benchmark will be representative of the underlying market, transparent, subject to credible oversight and it will allow fair and non-discriminatory access. The review considers the desirability of an overarching framework for the key international benchmarks. Various bodies and task forces are examining benchmark issues including the European Commission and BIS Governors - i.e. the governors of the central banks who are members of the Bank for International Settlements. The review of the European Commission made similar findings to the Wheatley report regarding the key issues and possible remedies.