With $150 Trillion at Stake, Tainted Libor Benchmark Won't Die Quickly

Dogged by one of the worst price-manipulation scandals in the financial industry's history, JPMorgan Chase & Co.  (JPM) , Citigroup Inc.  (C) and other big banks are slowly moving to change the way global interest rates are set, setting up a costly shift that could disrupt markets worth more than $150 trillion.

But the sweeping changes could take years to put into effect. And it's possible they may never happen.

The firms, including European rivals Barclays (BCS) , Deutsche Bank AG (DB) and UBS Group (UBS) , already have paid more than $9 billion of fines to U.S. and European regulators over alleged manipulation of the London Interbank Offered Rate, or Libor -- the benchmark used to set short-term interest rates on everything from trading contracts and corporate loans to adjustable mortgages and bonds.

Now, after a three-year push by regulators, the banks have agreed on a new benchmark rate that could eventually replace Libor. On June 22, a committee of 15 of the world's largest banks settled on the "broad Treasuries repo financing rate," developed by the Federal Reserve Bank of New York. The rate is linked to the cost of borrowing U.S. Treasury bonds overnight, a common practice among Wall Street dealers and big money managers.

Yet much remains to be done before the new rate displaces Libor as the global standard. The New York Fed won't start publishing the rate until the first half of next year. After that, banks would have to convince big corporations and other borrowers to switch over, or to renegotiate loans and financial contracts that have been based on Libor for more than three decades.

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Given the costs and hassle of making the transition, as well as the built-in advantages that big lenders reap from setting Libor, the banks have little motivation to move quickly, said Kurt Dew, an economist who helped develop interest-rate futures contracts at the Chicago Mercantile Exchange in the 1980s.

"It's all smoke and mirrors," Dew said in an interview. "The rate they use doesn't really matter. The real question is whether the banks are willing to surrender their oligopoly."

Libor is supposed to represent the average cost banks have to pay to borrow money from each other. For years, daily surveys to determine it were conducted by the British Bankers' Association, putting the lenders themselves in charge of determining the benchmark interest rate that customers would pay.

During the financial crisis of 2008, suspicions grew that the banks were low-balling the rates in the surveys, to hide the fact that their own borrowing costs had skyrocketed -- a sign of weakness. Then in 2012, investigators discovered that some banks had for years intentionally manipulated the rate to increase profit; traders betting on interest rates colluded with colleagues to skew the surveys for their own benefit.

After Barclays agreed to pay $453 million in 2012 to settle allegations of manipulation, regulators in the U.S., U.K. and elsewhere began pressing for changes to the Libor-setting process while looking for an alternative method that would be based on actual market transactions instead of surveys.

A major problem is that the Federal Reserve, European Central Bank and Bank of Japan have flooded global markets with so much money since the financial crisis that banks rarely borrow from each other anymore. That means banks' submissions in the Libor surveys of interbank borrowing rates often amount to little more than educated guesses.

The lenders began seriously discussing alternatives to Libor in 2014, when they delivered a 758-page report on the topic to the Financial Stability Board, a global consortium of financial regulators. Also that year, the Fed created the Alternative Reference Rates Committee to lead the effort in the U.S.; members included most of the banks who helped set Libor.

According to the committee's records, it took the group of lenders, led by JPMorgan Treasurer Sandie O'Connor, about three years of deliberation and more than 20 meetings to reach last month's decision. Their recommended alternative, the Treasuries repo rate, derives from a market with roughly $2 trillion of volume, satisfying regulators' requirement that the new benchmark be based on market transactions.

The selection reflected "the depth of the underlying market and its likely robustness over time," the committee said in a statement. A final report will be published later this year. A JPMorgan spokeswoman said O'Connor wasn't available to comment.

"It's such a big market that it would be almost impossible for anyone to manipulate it," said Stanford University finance Professor Darrell Duffie, who in 2014 led a panel convened by the Financial Stability Board to study the problem.

Starting in 2014, Intercontinental Exchange Inc. (ICE) took over administration of Libor from the British Bankers' Association, to give the rate-setting process more independent supervision. Yet Libor remains under such a cloud of suspicion that banks are likely relieved to be moving toward a new regime, said Nellie Liang, a former Fed official who worked with then-Fed Governor Jeremy Stein on the issue.

"I would think they would be very tired by now of being open to being questioned," said Liang, now a senior fellow at the Washington-based think tank Brookings Institution. "If you were part of the survey and you haven't done a lot of trades recently, and you're supposed to write something down, that gets you a little nervous."

The new rate is an overnight borrowing rate, so one crucial stumbling block could come from translating it to longer borrowing periods; Libor rates are produced for seven maturities, ranging from overnight to one year.

Determining the amount of interest a corporation would have to pay on a three-month loan would likely involve a backward-looking process, where payment wouldn't be known until the end of the period -- at which time the cumulative overnight interest charges could be calculated, according to Duffie.

Corporate treasurers might find such a process hard to budget for, Dew said. And exchanges like CME Group Inc. (CME) will likely need to develop new futures contracts to allow traders to bet on the repo rate before it gains full acceptance in money markets. Even if the new rate gains momentum, banks would then have to retool their lending, trading and marketing operations to replace Libor.

During the transition, the two rates probably would run in parallel, meaning borrowers may be forced to choose between the older, familiar Libor or the new preferred rate. There's also the possibility that a financial crisis could intervene, putting the effort on hold to avoid sowing further confusion.

"That'll be the bigger lift, developing the plumbing, the operational side, and getting the market to gradually develop liquidity in this benchmark," Duffie said.

If it takes a long time, the banks will probably be just fine with that, Dew said. Even without manipulation, Libor is designed to assure extra profitability for the banks at the expense of their customers, he said.

"You can ask people to do things for the common good, but if it is not to their benefit, they don't do such things," Dew said.

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