During this Thanksgiving holiday, we at Chatham got to thinking about the things for which we are thankful. Family, friends, health – the list contained the usual suspects. But this Thanksgiving, we had another reason to be thankful as we dug into the independent findings of Martin Wheatley, Managing Director of the Conduct Business Unit at the Financial Services Authority (FSA) and active Chief Executive of the newly created Financial Conduct Authority. In September, Mr. Wheatley released to the public “The Wheatley Review of LIBOR: Final Report,” a detailed, ten-step plan designed to give guidance for a policy response aimed at preventing future abuses of LIBOR and other financial benchmarks. After reading the Wheatley Review, we are thankful that the LIBOR calculation process is getting an apparently much-needed revamping.

The Scandal

In July, Chatham brought to your attention the economic impact of Barclays’ LIBOR manipulation. We reported that while it was most certainly scandalous, the economic impact for the hedger was marginal at most, as hedgers that both pay and receive LIBOR are indifferent to individual settings. The real loss was damaged market confidence resulting from a breach of public trust. The effects of such a breach weren’t to be fully understood until regulators, participating banks, and customers using financial contracts tied to LIBOR (futures, swaps, floating rate debt, etc.) determine what to do going forward. There was a general sense that LIBOR was the best we had, even if it was flawed… that is, until the Wheatley Review.

Pending Regulatory Changes

At a high level, Wheatley supports the continued existence of LIBOR. The Review’s findings confirm what we’ve experienced: there has been no recognizable market change in use or structure of LIBOR-based contracts. What will change is the institutional framework. Questions like, “What organization will be responsible for collecting and publishing LIBOR?” are the ones that will be answered in the immediate future.

Wheatley recommends that the British Bankers’ Association (BBA), under guidance from regulatory authorities, immediately begin to transfer to an independent party its administrative role in calculating LIBOR. The BBA has affirmed its support of Wheatley’s recommendations and will transfer its responsibility to a new sponsor. Those responsible for manipulating the rate in the future will face criminal charges and broader FSA investigative powers into LIBOR by amendment to Britain’s Financial Services and Markets Act 2000.

Wheatley recommends that LIBOR settings be corroborated with actual interbank lending data and use in financial contracts, suggesting that BBA member banks’ submissions are hypothetical and not necessarily reflective of the market for interbank lending. As an example, Wheatley notes that in the wake of the financial crisis and credit crunch of 2008, interbank lending had all but dried up except for the most short-dated maturities, especially in the Eurozone. If LIBOR is to be an accurate reflection of the banks’ unsecured lending, then it must be tied to transaction data. Where there isn’t supporting data, Wheatley recommends that these tenors not be reported. Specifically, Wheatley recommends that (a) the Australian, New Zealand and Canadian Dollars, Danish Kroner, and Swedish Kronor be discontinued; and (b) the remaining currencies have the four, five, seven, eight, ten, and eleven month tenors discontinued. Per Wheatley’s recommendations, the LIBOR benchmarks would be reduced from 150 to 20 rates over a 12-month transition period.

Currently, the daily submissions of each member bank are published daily as a mechanism to promote transparency and general accountability for the determined rate. Wheatley notes that this could provide incentives for each member bank to provide inappropriate rates because each submission can be perceived as an implicit signal of the individual bank’s creditworthiness. Wheatley recommends that individual submissions be made available after a period of at least three months. Additionally, he recommends greater bank participation, noting that larger panels discourage manipulative attempts and increase the representativeness of the LIBOR benchmark.

Questions Persist

Wheatley’s findings include much to be thankful for: LIBOR will benefit from needed reform to discourage manipulation; rate settings will be made with greater fidelity; and LIBOR will continue to be used as a benchmark for financial products. But other market participants are looking into alternative benchmarks based on secured lending, which includes considerations of liquidity and collateral value and does not take into consideration bank credit risk. If market participants are to find a valid replacement, a large amount of research and ingenuity is required to develop an adequate replacement.

But post-Wheatley Review, questions remain. As a borrower, how do I anticipate the risk that the benchmark I’m using won’t change during the life of my financial contract? Is there a way to “hedge” that uncertainty by including language that addresses LIBOR’s going away or fundamentally changing? Lenders are asking themselves these questions too. As each party navigates the uncertainty with the best information available, that information is hard to unpack and often is nuanced, theoretical, and legalistic. Fortunately, we at Chatham have our fingers on the pulse of these and other issues, and we’re thankful that our clients trust us to keep them informed. As always, please don’t hesitate to reach out to us for an update!