Introduction

On 28 September, HM Treasury published the Final Report of the Wheatley Review of LIBOR.

This advisory provides a brief outline of the Report’s key recommendations and conclusions, and considers some of their wider implications.

Essential Principles

The Wheatley Report notes that its analysis of the LIBOR issue rests on three fundamental principles.

Reform of LIBOR

First of all, and as we noted in our earlier advisory (“LIBOR – The Wheatley Review”),  the adoption of an entirely new interest rate benchmark would have led to uncertainty in a vast range of financial contracts, both in the United Kingdom and internationally.  Such a changeover could not readily be managed and efforts to do so could lead to contractual disputes that could undermine market stability.

The Wheatley Report adopts this view and notes that LIBOR “…can be rectified through a comprehensive and far-reaching reform, and that a transition to a new benchmark would pose an unacceptably high risk of financial instability…”

This view was reinforced by the conclusion that – despite recent damage to its credibility—LIBOR continues to be used as a benchmark in new financial agreements.

Use of Transaction Data

Panel banks submitting data for the calculation of LIBOR are currently required to indicate the rates at which they could borrow interbank funds in reasonable market size just prior to 11.00am on each business day.

As explained in our previous advisory, this process involves a degree of assessment and subjectivity, since banks would not necessarily be in the market for funds on each relevant day.

It appears that the question to be posed to panel banks will not change or, if it does, the changes will be led by the market, rather than by the regulator. But the Wheatley Report has concluded that the future credibility of LIBOR will depend on the use of actual trade information that is capable of scrutiny. Partly for this reason, the Report considers that LIBOR should no longer be published for “thin” currencies or “thin” maturities, where rates cannot readily be verified by reference to market activity.

Role of Market Participants

The current issues confronting LIBOR do, of course, arise from the improper approach to the quotation process adopted within certain panel banks.

Nevertheless, the Report notes that the benchmark is intended for use by the financial markets and that market participants should therefore remain involved in the LIBOR process.  In particular, it would not be appropriate for the setting of the benchmark to be the sole responsibility of an official or governmental agency.

Regulatory Issues and Sanctions

We observed in our earlier advisory that the process of submitting data as a LIBOR panel bank is not a regulated activity under the UK’s financial services legislative framework. Although the Financial Services Authority is currently taking action in relation to the LIBOR process, it is doing so on the basis of the link between that process and other business lines that are subject to regulation. This is obviously an unsatisfactory position from a regulatory perspective.

Unsurprisingly, the Report considers that “a purpose built regime” is necessary in order to facilitate the proper supervision of LIBOR. The Report accordingly recommends that:

  1. the LIBOR submission process should be designated as a “regulated activity”, so as to bring it within the statutory framework; and
  2. the individuals having management responsibility for the submission process should be subject to the “approved persons” regime, with the results that (i) such individuals will have to demonstrate that they are “fit and proper” persons to hold that position and (ii) those individuals will become amenable to disciplinary/enforcement processes.

The Report also considers that the existing regime dealing with market abuse –which currently deals only with activities in relation to investments--should be extended to deal with manipulation of benchmarks. In most respects, this mirrors proposals put forward by the EU Commission for the revision of its Market Abuse Directive, its replacement by a new Market Abuse regulation and the introduction of a new Markets in Financial Instruments Regulation (see our earlier advisory, “LIBOR and EURIBOR – Proposals for EU Regulation”).. As a result, the Report suggests that the UK should not take unilateral action in this sphere, but should instead assist in the completion of legislation at the EU level.

The final recommendation in this area involves the extension of existing criminal offences to allow for criminal prosecution of the manipulation or attempted manipulation of LIBOR.

It is anticipated that the necessary legislative amendments for these purposes could be introduced via the Financial Services Bill that is currently before Parliament, and through delegated legislation.

Institutional Reform

As had been widely anticipated, the British Bankers Association will cease to have any role in the setting of LIBOR. The BBA is an industry association and its governance structures were not seen to be sufficiently independent of the market itself.

The role will instead be transferred to a new administrator, which will be responsible for the governance and oversight of the benchmark. This will include surveillance, scrutiny of submissions and the periodic publication of statistical information designed to ensure transparency and to demonstrate reliance on trade data. The Report does, however, note that LIBOR is a market-led benchmark and accordingly concludes that the new administrator should be a private organization, rather than a public body.

In order to ensure a sufficient degree of oversight, it is proposed that the LIBOR administrator role will also be made a regulated activity under the UK’s financial services framework. The regulator would then be able to make rules as to the conduct of the administrator’s functions, to require the establishment of proper systems and controls and to subject the administrator to enforcement proceedings, if necessary. Regulation at this level is of some importance, since the LIBOR administrator will be best placed to detect and report any possible manipulation of submissions and will thus be the first line of defence in securing the future credibility of the benchmark.

The Report recommends that many decision-making and other technical aspects should be delegated to an oversight committee which will comprise LIBOR users beyond the realm of the rate-submitting banks.  The oversight committee would be responsible for matters that require input from a wider pool of stakeholders. In particular, it would be responsible for the definition and scope of LIBOR and, hence, would be responsible for the formulation of the question to be answered by rate-submitting banks in formulating their responses. The Committee would also be responsible for the Code of Conduct, discussed below. In the interests of transparency, the Committee’s terms of reference, membership and minutes should be made public.

The identification of the successor to the BBA is to be achieved through a tender process to be run by an independent committee. The new administrator should be able to demonstrate a greater degree of independence, will have to establish transparent oversight systems and controls and meet various other criteria.    

LIBOR Submissions and Guidelines

Recognising that full implementation of its recommendations may take some time and that there is an urgent need to restore the credibility of LIBOR, the Report sets out proposed LIBOR submission guidelines that should be observed with immediate effect. The guidelines provide a hierarchy of criteria to be assessed. Prime consideration should be given to the submitting bank’s own activities in the unsecured interbank deposit market and other, similar markets. Thereafter, the submitter may take account of third party transactions and quotations in the same markets. If no such information is available, then the submitter may resort to his expert judgment.

Thus, notwithstanding its emphasis on the use of actual trade data, the Report accepts that a degree of subjectivity will be required in certain cases. This no doubt reflects experience from 2008, where LIBOR had to be quoted even though interbank market activity was subdued.

In due course, the new LIBOR administrator, acting through the oversight committee, is to introduce a detailed code of conduct for rate submitters, which should include (i) guidelines for the use of trade data in formulating submissions, (ii) requirements fro appropriate systems and controls, (iii) record-keeping obligations, (iv) provision for the validation of submissions, (v) a requirement to report suspicious conduct and (vi) a requirement for external audit of the submission process.

Immediate LIBOR Changes

The Report also recommends that, pending the appointment of a new LIBOR administrator, certain reforms should be adopted by the BBA with immediate effect. In particular:

  1. given the need for the benchmark to be supported by actual trade data, the BBA should cease to publish interest rates for currencies and tenors which are too thinly traded. The Report therefore states that LIBOR should no longer be quoted for Australian, New Zealand or Canadian dollars, or for the Swedish and Danish currencies. For the remaining currencies including US dollars, euro, sterling and yen, the quotation process should focus on the more frequently used maturities (one, three, six and twelve months), and other maturities should either be dropped or reconsidered. These recommendations would obviously sharpen the process by substantially reducing the number of rates that have to be set. The Report does, however, recognize that a period of consultation and advance notice may be required before quotations cease, so as to avoid undue disruption to contracts which do reference minor currencies/maturities, and to allow parties to make appropriate alternative arrangements;
  2. the BBA should only publish individual bank submissions three months after the dates concerned. Until now, such rates have been published on a daily basis, but this laudable attempt at transparency may have had the effect of both facilitating manipulation and incentivizing panel banks to quote lower rates in order to avoid adverse credit inferences; and
  3. a wider range of banks should participate in the LIBOR setting process. This would both enhance the overall representativeness of LIBOR and render manipulation more difficult. Although not recommended at this stage, the Report contemplates a power to compel banks to provide rate submissions, if it proves impossible to expand panels on a voluntary basis.

International Coordination

The Report recommends that the UK should work with EU and other international authorities to promote a debate on the longer term use of LIBOR and other global benchmarks.

In particular, the Report notes that:

  1. LIBOR assumes a permanent and deep market for unsecured interbank lending. The increasing use of overnight, collateralized borrowing tends to undermine this fundamental assumption; and
  2. parties to rate swaps may be using them to manage exposure to changes in interest rates, and a LIBOR rate which incorporates bank credit and liquidity risk may not be the appropriate benchmark for these purposes.

It is therefore appropriate to review the availability or promotion of other benchmarks that may be more suitable in particular contexts or markets. The Report discusses alternatives such as the central bank policy rate, overnight index rates, CD/CP rates, repo rates and government debt yields.

Conclusions

For reasons noted above, the recommendation that the LIBOR benchmark should be retained but extensively reformed is perhaps unsurprising.

The Wheatley Report has generally been welcomed and its broad recommendations have been endorsed by HM Treasury. It must therefore be assumed that these proposals will be translated into formal legislation in the relatively near term.

It must remain to be seen whether markets generally will seek to retreat from the use of LIBOR where alternative benchmarks may be available. This will depend in part on the extent to which the proposed reforms will enhance the status of LIBOR, and the extent to which the available alternatives are seen to be credible.