The 100-Trillion-Dollar Question

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With LIBOR fatally scandalized, banks worldwide are seeking a reliable interest-rate marker. | Reuters/Toby Melville

Here’s a puzzle: How do you replace an utterly discredited system that determines, among many other things, how much interest millions of homeowners have to pay on their adjustable-rate mortgages and thousands of firms pay on their bank loans and bonds?

That’s just one piece of the nightmare surrounding the London Interbank Offered Rate (LIBOR), which is used as the basis for calculating interest rates on an estimated $100 trillion — yes, trillion — in financial contracts.

The daily LIBOR is supposed to represent the rate that major banks charge each other for unsecured short-term loans. Its real importance, however, is as a reference point for setting rates on trillions of dollars in adjustable mortgages, business loans, corporate bonds, interest rate swaps, futures contracts, and legions of more exotic derivative financial instruments.

But LIBOR is essentially doomed, because it has become so embroiled in manipulation that banking regulators and financial executives agree that it’s unfixable. The debate isn’t about whether to replace LIBOR with something better. It’s about how to make the switch without wreaking havoc around the world.

“LIBOR is a sick man on its deathbed,” says Darrell Duffie, professor of finance at Stanford Graduate School of Business. “We have trillions and trillions of dollars in long-term financial contracts whose payments are based on LIBOR. Over the next few years, there will be a giant project to renegotiate these contracts onto new reference rates. This looks like the biggest financial engineering challenge the world has ever faced.”

How the Benchmark Became Corrupted

Duffie has been analyzing the problem since 2008, when several of the world’s major banks were caught fudging LIBOR rates. At first, during the financial crisis, banks understated the rates they were being charged in order to prevent doubts about their creditworthiness. Later, investigators discovered that many were also manipulating their LIBOR quotes to boost profits from trading activities.

When the full scope of the cheating became clear, international financial regulators enlisted Duffie to chair a special advisory group to recommend solutions. In a sweeping report in 2014, Duffie’s group recommended transitioning to a new set of alternative benchmarks that would be less corruptible.

U.S. and European regulators have imposed some $9 billion in fines, and major banks are still digging their way out of investigations and lawsuits.

Duffie and many other experts say LIBOR can’t really be fixed, mainly because there just aren’t enough unsecured interbank loans to provide a solid basis for setting daily rates. As a result, the daily benchmark is based much less on actual transactions than on “expert judgments” by the banks themselves, which opens the door to manipulation and more litigation risk for the banks.

The problem isn’t primarily about finding a better benchmark, Duffie says. The real challenge is in agreeing on a way to convert all those trillions of dollars in existing contracts without causing worldwide disruption.

The challenge also comes with a deadline. This past July, Britain’s Financial Conduct Authority dropped a bombshell, effectively announcing that it would abandon LIBOR at the end of 2021. After 2021, the major banks won’t have to report their daily LIBOR rates — and most of them don’t want to anyhow, given all the trouble they’ve had so far. In effect, LIBOR is on life support and the plug is about to pulled.

Unfortunately, says Duffie, the financial industry has barely begun to plan for the funeral.

A Postmortem Fix: Auctions

All of the proposed replacements, such as a benchmark tied to U.S. Treasury financing rates, have interest rates that are notably lower than LIBOR. The switch would equate to a vast amount of money when applied to trillions of dollars in obligations. As a result, says Duffie, the investors who collect those interest payments won’t convert to a new benchmark without being compensated for the lower rates.

But how to figure out the right amount of compensation? The math itself is complex, and there is no theoretically “correct” answer. It depends on how much compensation the creditors demand versus how much the debtors are willing to pay.

In a plan he presented in October to a conference of practitioners in New York City, Duffie recommends holding auctions for both buyers and sellers of LIBOR-based contracts. The buyers might bid on $10 billion in derivatives, for example, and the winning bidders would be those offering to accept the lowest amount of compensation. The sellers would likewise enter the auction with offers of the compensation they are willing to pay. The auction will settle at the level of compensation at which the total volumes of willing bids and offers are matched.

This same auction-determined compensation rate would be used to convert not only the contracts of active bidders but also the contracts of those who do not bid but are willing to commit in advance to have their contracts converted to the new reference rate at the same level of compensation. Essentially, nonparticipants would agree to use the auction outcome to determine benchmarks for adjustable interest rates.

The most important message right now, says Duffie, is that policymakers and market participants must start grappling with the magnitude of the challenge.

“If this LIBOR issue isn’t handled well, it could create a massive problem,” Duffie says. “But it can be reduced to a very manageable problem if market participants take this seriously and plan accordingly.”