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Why It's So Hard to Replace Libor

Key Speakers At The Confederation Of British Industry Annual Conference
Photographer: Jason Alden/Bloomberg

Libor, the London interbank offered rate, for decades was a reliable benchmark set daily by banks to determine interest rates on everything from student loans and mortgages to derivatives and credit cards. But ever since European and U.S. banks were found to have manipulated rates to benefit their own portfolios, the benchmark has been seen as tainted. Along with its kinfolk -- Euribor for the euro and Tibor for the yen -- Libor is probably headed for history’s scrap heap in a few years. But with more than $370 trillion in financial contracts pegged to Libor, it can’t just disappear. That has presented bankers with a big headache: figuring out how to cause the least amount of market disruption in the transition to more reliable and transparent substitutes.

Regulators, bankers, lawyers and investors globally are in the process of figuring that out. The challenge is to find nearly risk-free, all-purpose benchmarks for a variety of loans and contracts. They also must cover maturities running from overnight to many years in the future -- and deal with five major currencies. That implies using actual transactions as a baseline, versus the current system in which banks rely on a mix of transactions and market data to estimate what they think their short-term borrowing costs will be. If the new system relies on real loans backed by collateral or on a very liquid market, such as derivatives, the rates will almost always be lower than on riskier, unsecured loans. This will create winners and losers.