What is the Wheatley Review?

At the end of July, HM Treasury confirmed the Terms of Reference of the review the Government asked Martin Wheatley to carry out following the LIBOR setting issues (the Review). It said the Review should cover:

  • the current framework for settling and governing LIBOR, and whether activities related to it should come within the Financial Services and Markets Act 2000 (FSMA) regulatory perimeter;
  • the scope for criminal and civil sanctions to address LIBOR-related activities; and
  • whether the recommendations the review will make in relation to LIBOR should apply to other price-setting mechanisms.

The Review published a consultation paper on 10 August, setting out its initial views. It will need comments by 7 September to meet the challenging deadline of reporting by the end of September.

The main messages

The paper identifies many significant weaknesses in how LIBOR works and concludes that keeping LIBOR in its current state is not viable. It says this is because of both the weaknesses identified and the lack of credibility in LIBOR that recent events have caused. It also notes initiatives by other regulators, specifically the European Commission in relation to EURIBOR and the International Organisation of Securities Commissions (IOSCO) in relation to oil spot prices, and recommends consistent action.

The Review believes it must act on two fronts

  • a comprehensive reform and strengthening of LIBOR; and
  • identifying and evaluating other benchmarks that can take on some of the roles LIBOR currently performs.

It also believes there are arguments for a global regulator of benchmarking practices.

LIBOR’s weaknesses

The Review has identified key weaknesses of LIBOR:

  • the increased focus on expert judgement rather than actual transaction data, as the market in unsecured interbank borrowing has declined;
  • incentives for banks and individuals within them to try to manipulate the data (to support trading positions or to improve the impression of creditworthiness); and
  • inadequate governance of the submission process within banks and of the compilation process generally.

It says the method of LIBOR administration exacerbates the weaknesses as it is self-policing and the data is often not transaction-based.

Strengthening LIBOR and looking at alternatives

The Review considers the history of LIBOR and its development into the leading global benchmark. It looks at how changing markets have altered the basis of LIBOR submissions and how the changing model for bank funding arguably gives LIBOR less meaning than it has traditionally had.

The paper looks at the role of the banks and of BBA LIBOR Limited (which is responsible for the day-to-day running of LIBOR), Thomson Reuters (which collects, checks, verifies and publishes information) and the Foreign Exchange and Money Markets Committee (FXMMC) which has overall responsibility for the design and review of parameters of submissions). It notes several significant limitations in this structure, including lack of independence and transparency, and inadequate supervision and governance. Also, participation in LIBOR is voluntary.

It suggests a few methods for strengthening LIBOR, such as:

  • introducing transaction-based reporting and making the reporting process more transparent;
  • establishing a code of conduct or similar check to improve transparency and make the LIBOR process more robust and independent, at both bank and administrator level;
  • bringing submission and administration of LIBOR within the regulatory remit and, if necessary, strengthening sanctions.

Alongside this, there should be international initiatives to improve or create alternatives to LIBOR. The Review notes that in some cases, there are existing rates but in others there may be a need to develop new benchmarks. Whichever way the market goes, there must be a carefully planned transition period to allow orderly migration of the many contracts that reference LIBOR.

In this context, the Review suggests it might be appropriate to have a set of principles that govern global benchmarks, to ensure they are transparent, well governed and subject to appropriate regulatory oversight and the calculation methodology is robust. It suggests the IOSCO or the Financial Stability Board might have a role to play in international coordination.

The choices

The Review analyses several ways that might address the weaknesses:

  • moving to a transaction reporting-based system: these systems exist for interest rate benchmarks that rely on transaction data. Clearly, to introduce one for LIBOR would entail, among other things, setting up a central repository for information. The Review sees other potential problems with this solution, including timing of the “fix”, its usefulness given only a small number of reportable transactions and the fact that transaction data-based systems are not immune to manipulation;
  • setting up a process for independent corroboration of individual submissions or widening the scope of submissions to include all wholesale deposits and allow corroboration of submissions against transactions. Alternatively, reducing the number of maturities and currencies submissions should cover but broadening the scope of transactions, or just narrowing the scope of LIBOR by reducing the maturities and currencies covered;
  • changing what is included in the calculation rate (rather than just discarding the highest and the lowest submissions) to reduce vulnerability to manipulation;
  • aggregating, ceasing or delaying publication of individual submissions: the Review says this would be an obvious fix, but would come at a cost to transparency. Alternatively, the process could revert to the question banks were asked before 1988, which is “At what rate do you think inter-bank term deposits will be offered by one prime bank to another prime bank for a reasonable market size today at 11am?”.The Review says this would help address conflicts of interest but would introduce more inference and judgement to the process, which is not ideal;
  • to increase the quality of scrutiny and oversight, there are several options
    • making more of the FXMMC independent, with members from non-participating banks;
    • introducing a Code of Conduct setting out what is required of participants, including having clearly accountable individuals responsible for the process within participants and introducing sanctions for breach that would be meaningful – so "dropping" participants from the panel would not be sufficient;
    • increasing transparency, either within the current governing structure or by setting up a new body along the FTSE model.  

The Review does not seriously consider increasing the number of participants in LIBOR, as it does not see an easy way of encouraging institutions to join.

Regulating LIBOR-based activities

The Review notes that, although FSA is currently investigating several institutions for (presumably) breaches of its Principles in relation to LIBOR, the basis of its investigations is connections between LIBOR setting and other regulated activities. Without specific regulated activities related to LIBOR setting, regulatory powers are limited. Also individuals involved within the banks do not need to be approved persons (and therefore are not subject to FSA’s “fit and proper” checks nor to direct regulatory action against them as individuals). The Review also notes that many allegations of misconduct relating to LIBOR are likely to fall outside the market abuse regime.

The paper considers self-standing sanctions regimes. In terms of criminal prosecutions, the Review notes that LIBOR-related activities are most likely to fall within fraud offences that the Serious Fraud Office can prosecute (and has suggested that it will). FSA’s only relevant criminal powers come under s397 FSMA (misleading statements and market manipulation) and much of the relevant activity is likely to fall outside the scope of this article. One possibility would be to broaden the scope of s397. The European Commission’s proposals to strengthen criminal sanctions under the EU market abuse regime to include benchmark manipulation would increase UK regulatory powers, but cannot take effect for at least two years. Also, the UK has currently chosen not to opt into the Commission proposals, pending seeing the results of the debate on the proposal for a Directive on Criminal Sanctions for Market Abuse.

The choices

The paper looks at whether LIBOR activities should come within the scope of regulated activities under FSMA, which would give FSA a clear mandate to regulate them and take action against those who breach its rules. The paper addresses:

  • which activities should potentially fall within FSMA scope: Contributing to setting LIBOR is an obvious one, and all banks that contribute are already regulated, so a change of this nature would not bring any additional entities within the scope of regulation. But the Review also identifies administering the benchmark as a potential addition;
  • which individuals should be approved persons: The Review suggests this could be any of (a) the senior management responsible for the overall LIBOR process, (b) managers responsible for LIBOR-related activities and (c) individuals responsible for LIBOR submissions; and
  • whether contributing to LIBOR should be compulsory and, if so, how regulation could achieve this.

Alternative benchmarks

Finally, the paper considers whether it would be possible to create alternative benchmarks. It analyses various instruments and the possible scope of benchmarks, some of which already exist. It looks at the conditions that should apply to creating benchmarks and the mechanisms for compiling them and then assesses the cost and complexities of transitioning away from LIBOR.

It analyses various indicators, including:

  • the Central Bank policy rate;
  • SONIA (the UK overnight unsecured lending rate);
  • Certificates of Deposit or Commercial Paper;
  • Overnight Index Swaps;
  • Treasury bills; and Repo rates.

For each of these it identifies whether it addresses counterparty risk, liquidity risk/cash usage, maturity curve, transaction volume, resilience, standardised terms and long data series. Not all products need to address all of these.

It asks several questions, including whether:

  • one benchmark should replace LIBOR, or be used instead of it in specific circumstances; and
  • different benchmarks should apply to different products.

It also considers the timescales within which an alternative could be introduced.

Where next?

The paper asks 16 specific questions. Each question is based on a complex analysis of current practices and future possibilities. The Review has come a long way in a short time, and it will be interesting to see which proposals it includes in its final recommendations paper at the end of September.