EC Consultation Paper on LIBOR: smarter than we thought it would be

The European Commission released a consultation document on Wed, Sept 5, 2012, “CONSULTATION DOCUMENT ON THE REGULATION OF INDICES: A Possible Framework for the Regulation of the Production and Use of Indices serving as Benchmarks in Financial and other Contracts.” Basically this is a more in-depth LIBOR review than what the Commission had released previously, which just upped the penalties for false submissions. The new document takes the starting point that LIBOR needs a potential overhaul and asks market participants to comment on how that gets done. Overall, this document focuses on the right questions and is a better piece of work than we were expecting.

The EC paper gets to some juicy issues, for example whether it is better to use actual data in indices in the place of indications. They go so far as to mention repo futures as a possible alternative. As a result of Question 9 in the paper, “Do you consider that indices that do not use actual data have particular informational or other advantages over indices based on actual data?” the EC could conceivably mandate that all financial indices must be based on actual data going forward. That would be a major market change. We are particularly interested in this topic – it was the subject of an August 2012 Finadium research report.

The document also returned to some older themes that we view as important for LIBOR but outdated for the use of Indices, such as ensuring that the existing LIBOR submission methodology is clean and that there are protections against falsifying data. The document also catches the important commingling of interest rate and credit information in the current methodology and offers potential solutions:

“With respect to transparency, by submitting information, market participants reveal information about themselves and if this is published it may give the market insight into their strategies or otherwise adversely affect them. For example, the submission by contributing banks to LIBOR may have entailed the bank displaying to the market an implicit credit assessment of itself. This introduces a credit signalling risk, which created an incentive to submit inaccurate data. It has therefore been suggested that this means that certain risks could be best addressed with greater anonymity. For instance, credit signalling risks would be diminished by allowing for anonymous or delayed publication of individual banks’ submissions. On the other hand, in the current interest rate benchmark cases, individual panel member submissions for the benchmarks were not published for some periods and this non-transparency might have increased the risk of manipulation of the benchmark rate.”

On the issue of who could be responsible for a bad benchmark underlying a financial contract (and in a tip of the hat to the many LIBOR lawsuits bubbling up now), the EC thinks that financial institutions writing contracts should be responsible:

“One option would be to place responsibility on any investment firm writing a financial instrument for a client to assess the suitability of the benchmark given the client’s needs or impose requirements that it only uses a certain type of benchmark or a benchmark that meets certain criteria. Similar provisions could be put in place in sectoral legislation for other types of contracts.”

“Alternatively, trading venues that admit financial instruments to trading may be required to assess that any referenced benchmarks are fit for purpose, and should not allow financial instruments to be traded when they are referenced to benchmarks that are susceptible to manipulation.”

This document is smarter than we thought it would be. It captures many of the nuances of how LIBOR doesn’t work today beyond the single issue of false submissions and, while as ever it targets banks to take the fall if something (anything) goes wrong, it gets the core topics right.

Meanwhile, all the focus on LIBOR may be for nothing; Bloomberg News reported yesterday that 44% of a Bloomberg survey panel said that LIBOR would be supplanted in the next five years; 34% said it would remain the same and 22% said they didn’t know what would happen.

The full EC discussion document is here.

The Bloomberg article is here.

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