In the wake of news that a US court has overturned two former Rabobank traders’ convictions over a conspiracy to fix yen and dollar Libor rates, comes an announcement from the head of the Financial Conduct Authority, Andrew Bailey, that it has become ‘not only unsustainable, but also undesirable’ for Libor to continue in its current form.
The decision was taken because banks no longer want to participate in setting the rate, which, at its peak, was used to price more than $350tn of financial products around the world. Plans are currently being made to move to alternative benchmarks by the end of 2021.
System exploited by unscrupulous traders
Ex-Rabobank traders Anthony Allen and Anthony Conti may have been the first to face prosecution over manipulation of Libor rates in the US, but they weren’t the only ones to fall foul of the rigging scandal.
The former UBS and Citigroup derivatives trader Tom Hayes was recently handed a 14-year sentence following a trial in London for his part in the fraud. Hayes was the alleged ringleader in a complex conspiracy to distort the London interbank offered rate (Libor) in the years between 2006 and 2010. Four ex-Barclays bankers were also jailed as part of a separate investigation.
Libor has been reformed but system isn’t working
During this period, those responsible for submitting daily estimates of interbank borrowing rates were targeted by traders looking to massage their banks’ rates in order to bolster their own commercial position.
Once the abuse was exposed, it fell to central banks, regulators and lenders to find a way to reform or replace the standard to prevent it happening again. Changes were made to the way the rate was set, allowing it to more accurately reflect the actual price paid by banks to borrow from each other, rather than relying on the previously estimated and aggregated system.
But because of the fall in benchmarking activity over the past few years – due, in part to the reduction in interbank lending following the 2008 crisis – it’s thought that there’s simply no longer enough data to price rates accurately using this new format.
Finding a new benchmark
Bailey said that the FCA has been concerned that the withdrawal of panel banks could disrupt the market and that work ‘must begin in earnest’ on phasing out Libor and shifting to an alternative benchmark.
A total of 20 banks have agreed to continue making submissions for the next five years but the race is on to find a replacement. One possible solution is the sterling overnight index average – Sonia – which tracks bank and building societies’ overnight funding rates in sterling. This index was recently backed by the Bank of England as a new reference rate for valuing sterling-based derivatives and is the front-runner to take over from Libor.
Similar systems are used to calculate benchmarks in Europe (Eonia) and Japan (Tonar), both based on unsecured lending. Other banks are proposing to use interest rates derived from the repo market – a form of secured lending – including the Federal Reserve Bank of New York, which will publish a daily Treasury repo rate based on market transactions, starting from next year.