Alternatives to LIBOR

Abstract

Evidence of extensive fraud in LIBOR submissions has fueled international calls for reform. A common theme is that the current rate setting process, in addition to being subject to manipulation, relies on conjecture as to rates that might prevail in markets that can often be illiquid, and should be replaced with a process that relies more directly on actual transactions. There are no perfect substitutes for LIBOR. Overnight index swap rates and repo rates, the most attractive alternatives to LIBOR, do not incorporate the same counterparty credit risk or term premiums. Repo rates also reflect the risks of underlying collateral, which can be inappropriate for certain market participants. Liquidity in these alternatives is also concentrated in shorter maturities. These differences make it difficult for LIBOR alternatives to fully replace LIBOR in all instances.The challenge of finding a LIBOR substitute can be reframed along three dimensions. With regard to existing contracts, the challenge may be to reform the current version of LIBOR so it better reflects legitimate market expectations while being less susceptible to self-serving panel bank manipulation. With respect to new contracts, parties can look to a wide variety of LIBOR alternatives to select a substitute. Put another way, it makes little sense, on a prospective basis, to require a single substitute for LIBOR when the market may rationally prefer any of several viable alternatives. And, once new metrics have been established in the market for new contracts, renegotiating existing contracts to substitute a new metric for the current LIBOR, or improved version of LIBOR, may be easier.Identifying a single, best substitute for LIBOR may thus be a fool’s errand. Creating an environment in which many different alternatives can legitimately co-exist may be a preferred strategy.