Tuesday, June 10, 2008

BBA: Understanding the construction and operation of BBA LIBOR - strengthening for the future

LIBOR (the London Interbank Offered Rate) is the most widely referenced interest rate index in the world. It is set at 11am UK time in 10 currencies and for several maturities.

LIBOR is owned by the BBA, the data compilation and calculation is undertaken by Reuters for the BBA and the process is overseen by an independent committee of market participants, the Foreign Exchange and Money Market Committee.

In this current historically difficult period for credit markets, liquidity and credit premia have risen very significantly since August 2007. LIBOR is a benchmark representing the rate at which contributor banks perceive they could raise unsecured funds depending on a number of factors.

LIBOR panel banks, for example, are invariably those with the best credit ratings and in the current diminished credit capacity of the market it is therefore not surprising that some institutions will not be able to access funds at the LIBOR rate.

The four major LIBOR currencies are US Dollar, Sterling, Euro and Yen, but the recent commentary has been primarily in respect of Dollar LIBOR. Whist some institutions (primarily European) consider that the current US Dollar LIBOR fix can be too low, others (primarily US) consider it can be too high. However, like the other LIBOR currencies, US Dollar LIBOR is a benchmark set by panel banks in the London market; it is the rate for the Euro Dollar, not the domestic US Dollar; and not only are participants in this market extremely risk averse, but there is also a relative shortage of US Dollar funding in European markets.

This paper "Understanding the Construction and Operation of BBA LIBOR – Strengthening for the Future" explains in some detail how LIBOR is set and emphasises that it is a benchmark for cash and is not a derivative or FX benchmark.

It also gives some insight into the panel selection process, explaining that any bank with significant business in the relevant currency in the UK market can apply to join the panels. There have, though, been no new applications from banks over the last 12 months who are not currently on the selection lists. Those who move from the selection list to a panel do so because of the volume of the relevant business that they undertake in London.

The BBA is grateful for the input from the public and private sectors in the preparation of this paper.

Strengthening LIBOR for the future includes taking a number of steps.

  • As of now, the BBA is strengthening the governance by the Foreign Exchange and Money Market Committee to incorporate a tight scrutiny mechanism that will require any contribution discrepancies to be reviewed and justified.
  • The membership of the Committee is being widened to include non contributing banks from Europe, the USA and elsewhere as relevant. Arrangements are also being put in place to invite interested parties from the public and private sectors to provide ongoing commentary and opinion into the process.
  • In addition, although the current currency panels capture a very large majority of the activity that takes place in the London markets (and indirectly elsewhere in Europe) and there have not been any new banks asking to participate, discussions have commenced with a number of other US and EU banks for the purpose of establishing whether their business qualifies for inclusion on the relevant panels.

    It is important to note that any bank may volunteer to join the BBA LIBOR panel for any currency. Similar discussions will need to take place with banks from other major LIBOR currency countries. This may well result in panel sizes being increased but there will be no changes without clear rationale. Again this work will be done in close dialogue with interested parties from the public and private sectors.
  • Transparency has long been one of the key attractions of LIBOR. Other indices either keep their contributors confidential (H15) or the bank is asked to contribute the rate at which it considers a hypothetical bank would borrow (EURIBOR).

    LIBOR contributors on the other hand provide the rate at which they believe they could borrow should they propose so to do. The issue has been raised as to whether this has the potential to stigmatise contributions and therefore the BBA proposes to explore options for avoiding any stigma whilst maintaining transparency.
  • Whilst this paper sets out predominantly the steps that are already being taken in respect of LIBOR there are three questions on which specific comments are sought.

    1. Whether in addition to the 11am fix of US Dollar LIBOR there is demand for another London fix later in the day after the US market has opened. Hitherto market participants on the Committee have suggested that this would raise considerable legal issues in respect of contract currently linked specifically to the 11am fixings, as well as cause confusion, particularly in standardised netting contracts. Nevertheless, but comments would be appreciated from all others who hold a view.

    2. Whilst the majority of Euro Dollar trading takes place in London, the BBA will investigate demand for the creation of an additional European Dollar index that seeks to capture US Dollar trading in Europe.

    3. Whether the description "reasonable market size" would benefit from being more specifically defined.

This paper represents the views of the Foreign Exchange and Money Markets Committee, many other members of the BBA and incorporates the overwhelming number of informed comments that the BBA has received. As the BBA takes the steps outlined in the paper, the receipt of any further comments from market participants and interested parties is welcomed.

Download the full paper from the pdf link below

BBA_LIBOR_Strengthening_paper (PDF)

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