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Libor: the authorities can be radical

Julian D. A. Wiseman

Abstract: Libor is whatever the British Bankers’ Association says it is. That allows very radical reform of Libor, without damaging existing contracts.


Publication history: only at Usual disclaimer and copyright terms apply.

Contents: Libor and the authorities’ interest?; Continuity of contract; Possible changes; Practical steps; Conclusion; Afterword.

 Libor and the authorities’ interest

Gary Gensler, the Chairman of US Commodity Futures Trading Commission, had an interview with Bloomberg about Libor, as reported on 21st February 2013:

“Anchoring to real transactions is essential to have confidence in these benchmarks,” Gensler said in an interview in London today. “The banks are right now estimating something that isn’t an active market.” …

“One of the really challenging things is how systemic this is,” Gensler said. “This is like a reference rate that is too big to replace, but I don’t think we want to fall prey to that because it’s so unstable.”

Mr Gensler is quite right. Some Libors are an estimate, based on very little trading. E.g., there is not much inter-bank unsecured lending of Swiss francs for terms as long as six months. So CHF 6M Libor is an average of guesses of a price that has an existence that is only ephemeral. That is not dishonesty on the part of the banks, indeed, everybody in the process is paranoid about being able to justify everything. But if there is no price, the question “what is the price?” cannot have a precise answer.

But the authorities have the power to do radical things to Libor. There are things that could be done that would make it really robust. The authorities might or might not wish to do any of these radical things, but they should not pretend that they cannot do them.

 Continuity of contract

First, we must discuss the legal situation. There are many contracts outstanding that reference Libor, with a total notional of hundreds of trillions. Whatever is done to Libor must allow these contracts to continue. Were some or all of these contracts voided, there would be a massive reassignment of wealth in an effectively random manner. The financial consequences, and ensuing real-economy consequences, would be terrible.

Libor is published under the auspices of the British Bankers’ Association. A swap contract might reference GBP-LIBOR-BBA 6M, being the BBA’s 6-month £ Libor. My hypothesis is that, legally, the BBA’s 6-month GBP Libor is whatever the BBA says it is. If the BBA were to change the manner of computation (more banks, fewer banks, something much more radical), the contracts would continue, referencing whatever it is that the BBA says is 6-month GBP Libor. (If the change were very dishonestly done, if there were something like malfeasance, there might be a fair argument, but this essay will propose a step to eliminate this class of argument.)

Happily for this hypothesis, there is precedent. There used to be a French-franc Pibor (Paris Inter-Bank Offered Rate). At the start of the Euro, this was merged into Euribor, just as FRF Libor was merged into EUR Libor. The French Banking Association said that the FRF Pibor fixing on any day is henceforth equal to the Euribor fixing on the same day.

This was an error. Pibor was for T+1 settlement: monies borrowed arrived the following day. Euribor is T+2: monies borrowed arrive in two days.

So a fixing against 3-month FRF Pibor on Wednesday 29th September 1999 was the cost of borrowing money from Thursday 30th September 1999 to Thursday 30th December 1999. But, by replacing Pibor with Euribor for same fixing date, these dates changed, instead referencing the cost of borrowing money from Friday 1st October 1999 to Tuesday 4th January 2000. This mess-up changed non-turn-millennium money into turn-millennium money, which meant a big change in the price.

But it stood. Pibor was replaced with Euribor for same fixing date, because Pibor is whatever the French Bankers’ Association says it is, whether or not they have said it wisely or fairly.

 Possible changes

That precedent allows radical change in Libor. So let us consider some possible changes, the top of the table having better continuity of Libor’s meaning, and the bottom having more robustness.

# Change Advantages Disadvantages

More supervision.

Vaguely reassuring.

Banks would continue to estimate a non-existent price.


Price determined by an auction, contributors submitting bids and offers (see the Economist and the FT).

Auctions are generally believed to find the market price. But →

There is a lemon problem. An offer of money is most likely to be accepted by the weakest bank. So it must be priced for the weakest bank, which means that no stronger bank will accept it. So this would not be an average of several banks’ prices, this would the price of one bank’s funding, and that bank would be the worst bank. In some sense, there is not one market price, there are ≥ n market prices, or perhaps even n (n–1), that is, a different price for each possible pair of banks. Countering this with an overlay of complicated rules would incentivise complicated behaviours—also not good.


Libor succeeded by an index based on bank bills.

Bank bills are tradeable.

• Australia’s BBSW fixings and New Zealand’s bank Bill fixings use this. But both those fixings have more day-to-day volatility than most Libors, volatility that does not always seem to be driven by fundamentals.  • The authorities might fear that traders at pairs of banks will quietly ‘agree’ to buy each other’s bills at artificially low yields.


Libor succeeded by a cost of secured money, perhaps + a fixed spread (say +20bp).

The market in term secured money is currently more active than that in term unsecured.

• This would be a change in the meaning of Libor, from unsecured to secured + 20bp.  • There is currently a working market in term unsecured, but we cannot be certain that this will continue.  • In £ $ ¥ the choice of collateral is easy (repo against gilts, US Treasuries, JGBs). But in euro which countries’ bonds would be acceptable collateral? There’s little trading in the repo against the weakest euro sovereigns, but if they aren’t included, expect lots of squabbling from the strongest of the excluded.


Libor succeeded by a derivative settling against an unsecured overnight index, with same dates (fixing, settlement, maturity). I.e., a £ Libor fixes at the price of the same-date Sonia swap.

The market in OIS derivatives has recently been more active than that in term unsecured money. Also, retains the unsecuredness of Libor.

• This would remove the term premium from the meaning of Libor.  • There is currently a market in OIS derivatives, but one cannot be certain that this will continue.  • The authorities are unlikely to welcome the nested complexity of one derivative settling against another. (E.g., Andy Haldane’s dog.)


Same as previous, but the derivative settling against a secured overnight index.

Secured overnight money more robust than unsecured.

• Same problems as the previous row, and a bigger change in meaning (Libor becoming secured).  • Currently there is less trading in OIS against secured than against unsecured (e.g., in £ there is activity in swaps settling against Sonia, but about nothing in swaps settling against Ronia).


Libor equalling the compounded overnight index, so not being known until the end of the period.

Does not assume the existence of any derivatives.

• Again, removes the term premium from the meaning of Libor.  • But more importantly, Libor not known until the end of the period. Does this matter? Slightly. Issuers of FRNs would no longer have advance notice of the size of their payments. However, a week before payment the size would be known to ± a small amount. E.g., for a £100m note, a ±25bp move in the overnight rate a week before the coupon date would change the coupon by ±£4.8k, a small uncertainty for a company able to borrow £100m.  • This would also affect options, including caps and floors, ISDA having to choose between two possibilities. Either the option expiry would be deemed to be the moment Libor is known, which used to be the start and would become the end of the period (the author’s preference). Or, at the start of the period, the option holder must choose either to discard the option, or to replace it with a one-period swap.


Same as above, but the index would be the policy rate, perhaps + a fixed spread (so index might be policy + 25bp). If there are multiple policy rates, the CB to choose which.

This is maximally robust: it does not assume the functioning or existence of any market instruments.

A big change in meaning: not term, not unsecured, not even a market price. And not known until the end of the period. But as a measure of banks’ cost of funding, compounded policy + 25bp is not wrong by much.

This methodology is the preferred solution of the author, the robustness outweighing the change in meaning.

 Practical steps

Assume that the authorities particularly like one of the rows of the above table for USD Libor (even if a different row is liked for other-currency Libors). What should be done?

Obviously it would be necessary to persuade the British Bankers’ Association. That is not necessarily trivial, but nor would it be difficult. No financial entity wants to refuse a joint request from the central banks and regulators. Additionally, the authorities have means of persuading the banks, the BBA’s members, to concur. And finally, the BBA said, on 28th September 2012, “The BBA Council has indicated it would support any recommendation that responsibility for LIBOR should be passed to a new sponsor”: this is not fighting talk. So if the authorities, acting together, want something sensible, the BBA is likely to play nice.

That done, the object is to improve Libor without breaking any contracts. So there should be a joint announcement, by all of the following:

That announcement should state that, as of some date, that the rules for the computation of USD Libor will change, and to what they will change.

The multi-headed announcement is to simplify and strengthen continuity of contract. If the BBA did something by itself, somebody would argue in some state court somewhere that “the wicked Brits are robbing my client”. But if that becomes “the wicked Brits, jointly with the Federal Reserve and the SEC and the CFTC and the OCC”, that argument would lose its appeal.


Hitherto, the authorities having been tinkering with Libor. But if they really believe that it is unacceptably unstable, the authorities can be far more radical, without voiding contracts, without causing chaos. The authorities have all the power they need, should they wish to use it.

That does not mean that the authorities will do anything radical. But it does mean that they can think about it.

 Footnote: this essay is not about the price consequences of any of these possibilities. Nonetheless, some readers might welcome comment. One consequence of the more radical suggestions is that all sufficiently-forward-starting single-currency floating-floating sixes-threes basis swaps should be about zero. Some obvious variants would have them non-zero, but all the same non-zero price, so the sufficiently-forward-starting single-currency floating-floating sixes-threes basis curve would be flat. A similar effect might be seen in sufficiently-forward-starting floating-floating Euribor–Libor basis swaps. Of course, other possible reforms of Libor might have different consequences, probably less-hyphenated consequences. Anyway, most market participants do not trade these obscure instruments. Obviously, more details would have more consequences: if policy + spread, knowledge of the spread would affect asset swaps of short-dated government bonds.

— Julian D. A. Wiseman
London, 8th March 2013


This page, and other comments on the possible futures of Libor, were discussed on FT Alphaville on 13th March 2013: Some Libor frustration.

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