June 2 (Bloomberg) -- The British Bankers' Association's failure to change the way it calculates the London interbank offered rate may cause ``dislocations'' in money markets and send traders in search of alternative benchmark interest rates.

Following a two-month review of its rate-setting process, the London-based BBA said May 30 it would increase ``oversight'' of Libor rather than alter how the rate is set. ``Details will be published in due course,'' the association said in an e- mailed statement. Financial products worth about $150 trillion are indexed to Libor, according to the BBA's Web site.

The BBA has been under fire since the Bank for International Settlements said in March the banks that set Libor understated their borrowing costs to avoid speculation they were in financial straits as losses in credit markets mounted. The decision may further erode confidence in Libor's accuracy and in the 16 banks surveyed daily about their borrowing costs.

``I now expect dislocations in the money-markets to continue,'' said Kornelius Purps, a fixed-income strategist at UniCredit SpA in Munich. ``The BBA has spent the last six weeks investigating this and I would think they will take at least another month.''

In the first four months of 2007, the difference between the highest and lowest rates for three-month dollar Libor didn't exceed 2 basis points, or 0.02 percentage point, according to JPMorgan Chase & Co. research. In the same period this year, it was as wide as 17 basis points.

`Inherently Flawed'

The BBA fell short of the type of changes to Libor that investors said could have ranged from removing banks that are found to misrepresent their borrowing costs to adding an extra survey each day to reflect trading in U.S. hours.

``Libor is an inherently flawed index,'' said Willem Buiter, who served on the Bank of England's Monetary Policy Committee from 1997 to 2000. ``Libor is an unresolved problem, especially dollar Libor, as it's not based on actual trades and actual borrowing costs but on people's guesses. Either it will die or it will change.''

Angela Knight, the BBA's chief executive officer, declined to comment on when any changes will be announced or how the group intends to improve oversight. Lesley McLeod, a spokeswoman, also declined to elaborate other than to say the group views the issue ``very seriously indeed and will be progressing as soon as possible.''

`Status Quo'

The BBA sets Libor each day by asking members how much it would cost them to borrow from each other for 15 different periods, from overnight to one year, in currencies from dollars to yen. It then calculates averages, discarding the four highest and lowest quotes, and publishes them before noon in London.

``Some type of change would have been good and people would have felt the BBA is concerned about Libor,'' said Priya Misra, an interest-rate strategist at New York-based Lehman Brothers Holdings Inc. ``With them not adjusting things, it's back to status quo, which means the other alternatives will become more liquid.''

Trading in Eurodollar futures fell 7.5 percent in April from the previous month to an average of 2.6 million contracts a day, while federal fund futures rose 55 percent to about 98,000, according to CME Group Inc. Futures are agreements to buy or sell assets at a set date and price.

Eurodollar Risk

``The risk of trading Eurodollars has become so great that people have stopped doing it,'' said Stan Jonas, who trades interest-rate derivatives at Axiom Management Partners LLC in New York. ``Because Eurodollar futures, which have become the dominant interest-rate vehicle in the world, are set to Libor, Libor has become a real issue to the market place.''

Libor won't go away because it's tied to everything from derivatives to U.S. mortgages, according to JPMorgan analysts led by Terry Belton, global head of fixed-income and foreign- exchange research. Libor is a benchmark for about $350 trillion of debt-related securities and derivatives, according to the BIS in Basel, Switzerland. Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events, such as changes in the weather.

One alternative to Libor is overnight indexed swaps, a gauge of expectations for central bank rates. The Federal Reserve uses the one-month OIS rate to set the minimum bid level when it lends cash to banks through its Term Auction Facility. The Fed has auctioned $510 billion through the TAF since December.

OIS as Proxy

OIS rates can be used as a proxy for interest-rate expectations and tend to be lower than Libor ``under normal market conditions,'' the BIS said in its March report.

The three-month dollar OIS rate was 2.01 percent today, while three-month dollar Libor was 2.68 percent, a difference of 67 basis points. The gap averaged 11 basis points in the 10 years prior to August, before widening to as much as 106 basis points on Dec. 4. A basis point is 0.01 percentage point.

``The OIS is one that definitely could be an alternative to it, but you don't have an OIS or Fed fund futures in all currencies that they have in Libor,'' said Jim Bianco, president of Bianco Research LLC in Chicago. ``The only thing the BBA can do is what they said they are going to do. That is, they are going to really scrutinize more the people that report Libor.''

To contact the reporters on this story: Liz Capo McCormick in New York at Emccormick7@bloomberg.net; Ben Livesey in London blivesey@bloomberg.net

Last Updated: June 2, 2008 07:48 EDT