by Evan Sypek
The London Interbank Offered Rate (LIBOR) is calculated daily
by the British Banking Association (BBA) and published by Thomson Reuters. The
rates are calculated by surveying the interbank borrowing costs of a panel of
banks and averaging them to create an index of 15 separate LIBOR rates for
different maturities (ranging from overnight to one year) and currencies. The LIBOR
rate is used to calculate interest rates in an estimated $350 trillion worth of
The LIBOR Scandal
The surveyed banks are not required to provide actual
borrowing costs. Rather, they are asked only for estimates of how much peer
financial institutions would charge them to borrow on a given day. Because they
are not required to substantiate their estimates, banks have been accused of LIBOR
"fixing," or manipulating the LIBOR rate by submitting estimates that are
exaggeratedly higher or lower than their true borrowing costs. This scandal has
resulted in the firing and even arrest of bank employees.
LIBOR's reputation came under fire in June 2012 when
Barclays PLC agreed to pay over $450 million to settle allegations that some
traders fixed their reported rates to increase profits and make the bank appear
healthier than it was during the financial crisis. In the wake of this
settlement, investigative agencies around the world began to look deeper into LIBOR
rate fixing, leading to a $750 million settlement by the Royal Bank of Scotland
and a record-setting $1.5 billion settlement by UBS AG. To date, there have
been over $2.5 billion in settlements, with many more investigations ongoing.
One investment bank estimates that, in total, legal settlements could amount to
as much as $35 billion by the time investigations conclude.
Replacing the LIBOR
In the wake of the LIBOR scandal, international and
domestic agencies have advocated for its replacement. The BBA, the group
responsible for setting LIBOR since the 1980s, voted to relinquish that
authority, and a committee of the UK's Financial Reporting Council is currently
vetting bids from other independent agencies interested in administering the
The International Organization of Securities Commissions
(IOSCO) Task Force on Benchmark Rates, led by the head of the UK Financial
Services Authority Martin Wheatley and the US Futures Trading Commission
Chairman Gary Gensler, released a report last month saying that the new system
should be based on data from actual trades in order to restore creditability.
Wheatley and Gensler agree on the need to create a transaction-based rate, but
disagree on how to transition from LIBOR to the new system.
Wheatley proposes that: the estimate-based LIBOR system
be kept in place while a new transaction based rate is introduced to run
alongside it under a "dual-track" system (so as to avoid disrupting
existing transactions), and that the decision as to if and when to abandon LIBOR
be left to market participants as opposed to regulators.
Gensler proposes a wholesale replacement of LIBOR as soon
as possible and cautions that its continued use undermines market integrity and
threatens financial stability.
IOSCO is also pushing for a code of conduct that would
hold banks to a higher standard of honesty in reporting and setting index
rates, while other agencies, including the Financial Stability Board and the
European Union, are working on the development of other potential solutions
including stricter regulations and greater penalties for rate-fixing conduct.
The future of LIBOR is unclear, but it is certain that
whomever is chosen to replace the BBA will be under immense pressure and
scrutiny from the international financial community.
To stay prepared, parties to financial transactions
should view existing and future contracts with an eye towards potential
benchmark changes. Parties should perform contractual due diligence to
establish the range of LIBOR definitions and benchmarks to which they are
exposed. In addition, parties should review the fallback provisions dealing
with change or discontinuance of LIBOR and other benchmark rates to understand
the potential impact of such changes.
Going forward, parties should include fallback provisions
in their contracts to allocate risk and set up alternatives to mitigate the
uncertainty that could arise in the event of any changes to the LIBOR system or
other relevant benchmarks.
article is not a legal advice, and was written for general informational
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