Sunday, October 14, 2012

The Wheatley Review of LIBOR – Why setting and applying law are not the same!

Marcus Junianus Justinus
Historiarum Philippicarum libri XLIV – Liber III

Dum haec in Persis geruntur, interea Graecia omnis ducibus Lacedaemoniis et Atheniensibus in duas diuisa partes ab externis bellis uelut in uiscera sua arma conuertit. Fiunt igitur de uno populo duo corpora, et eorundem castrorum homines in duos hostiles exercitus diuiduntur. Hinc Lacedaemonii communia quondam ciuitatum auxilia ad uires suas trahebant, inde Athenienses et uetustate gentis et gestis rebus inlustres propriis uiribus confidebant. Atque ita duo potentissimi Graeciae populi institutis Solonis et Lycurgi legibus pares ex aemulatione uirium in bellum ruebant. Namque Lycurgus cum fratri suo Polydectae, Spartanorum regi, successisset regnumque sibi uindicare potuisset, Charillo, filio eius, qui natus postumus erat, cum ad aetatem adultam peruenisset, regnum summa fide restituit, ut intellegerent omnes, quanto plus apud bonos pietatis iura quam omnes opes ualerent. Medio igitur tempore, dum infans conualescit tutelamque eius administrat, non habentibus Spartanis leges instituit, non inuentione earum magis, quam exemplo clarior: siquidem nihil lege ulla in alios sanxit, cuius non ipse primus in se documentum daret. Populum in obsequia principum, principes ad iustitiam imperiorum formauit. Parsimoniam omnibus suasit, existimans laborem militiae adsidua frugalitatis consuetudine faciliorem fore. Emi singula non pecunia, sed conpensatione mercium iussit. Auri argentique usum uelut omnium scelerum materiam sustulit.

When Lycurgus had succeeded Polydectes his brother, king of the Lacedaemonians, and might have secured the kingdom for himself, he restored it, with the noblest integrity, to Charilaus, the posthumous son of Polydectes, as soon as he became of age; that all might see how much more the laws of integrity prevail with good men than all the charms of power. In the meantime, while the child was growing up, and he had the guardianship of him, he composed laws for the Spartans, who previously had had none. Nor was he more celebrated for the making of these laws, than for his exemplary conformity to them; for he imposed nothing by law upon others, of the observation of which he did not first give an example in his own conduct. He trained the people to be obedient to those in authority, and those in authority to be just in the exercise of their government. He enjoined frugality on all, thinking that the toils of war would be made more endurable by a constant observance of it. He ordered all purchases to be made, not with money, but by exchange of commodities. The use of gold and silver he prohibited, as being the origin of all evil.

Administrationem rei publicae per ordines diuisit: regibus potestatem bellorum, magistratibus iudicia et annuos successores, senatui custodiam legum, populo sublegendi senatum uel creandi quos uellet magistratus potestatem permisit. Fundos omnium aequaliter inter omnes diuisit, ut aequata patrimonia neminem potentiorem altero redderent. Conuiuari omnes publice iussit, ne cuius diuitiae uel luxuria in occulto essent. Iuuenibus non amplius una ueste uti toto anno permissum, nec quemquam cultius quam alterum progredi nec epulari opulentius, ne imitatio in luxuriam uerteretur. Pueros puberes non in forum, sed in agrum deduci praecepit, ut primos annos non in luxuria, sed in opere et in laboribus agerent. Nihil eos somni causa substernere et uitam sine pulmento degere, neque prius in urbem redire quam uiri facti essent, statuit. Virgines sine dote nubere iussit, ut uxores legerentur, non pecuniae, seueriusque matrimonia sua uiri coercerent, cum nullis frenis dotis tenerentur. Maximum honorem non diuitum et potentium, sed pro gradu aetatis senum esse uoluit, nec sane usquam terrarum locum honoratiorem senectus habet.

He divided the administration of the government among the several orders; to the kings he gave the power of making war, to the magistrates the seats of justice in yearly succession; to the senate, the guardianship of the laws; to the people, the power of choosing the senate, or of creating what magistrates they pleased. The lands of the whole state he divided equally among all, that equality of possession might leave no one more powerful than another. He ordered all to take their meals in public, that no man might secretly indulge in splendour or luxury. He would not allow the young people to wear more than one dress in a year, nor anyone to walk abroad in finer garments than another, or to fare more sumptuously, lest imitation of such practices should lead to general luxury. He ordered boys to be carried, not into the forum, but into the field, that they might spend their early years, not in effeminate employments, but in hard labour and exertion; not suffering them to put any thing under them to sleep upon, or to live on high seasoned food, and forbidding them to return into the city till they arrived at manhood. He caused virgins to be married without portion that wives, not money, might be sought; and that husbands might govern their wives more strictly, being influenced by no regard to dowry. He ordained that the highest respect should be paid, not to the rich and powerful, but to the old, according to their degrees of seniority; nor had old age, indeed, a more honourable habitation anywhere than at Sparta.

Haec quoniam primo solutis antea moribus dura uidebat esse, auctorem eorum Apollinem Delphicum fingit et inde se ea ex praecepto numinis detulisse, ut consuescendi taedium metus religionis euincat. Dein ut aeternitatem legibus suis daret, iure iurando obligat ciuitatem, nihil eos de eius legibus mutaturos, priusquam reuerteretur, et simulat se ad oraculum Delphicum proficisci, consulturum quid addendum mutandumque legibus uideretur. Proficiscitur autem Cretam ibique perpetuum exilium egit abicique in mare ossa sua moriens iussit, ne relatis Lacedaemonem solutos se Spartani religione iuris iurandi in dissoluendis legibus arbitrarentur. His igitur moribus ita breui ciuitas conualuit ut, cum Messeniis propter stupratas uirgines suas in sollemni Messeniorum sacrificio bellum intulissent, grauissima se execratione obstrinxerint, non prius quam Messeniam expugnassent reuersuros, tantum sibi uel de uiribus suis uel de fortuna spondentes.

But seeing that such laws would at first be thought severe, as the state of manners had previously been relaxed, he represented that Apollo of Delphi was the author of them, and that he had brought them from thence at the command of the deity, in order that reverence for religion might overbalance the irksomeness of compliance with them. And to secure perpetuity to his laws, he bound the city by an oath “to make no change in them till he should return,” pretending that he was going to ask the oracle at Delphi whether any thing seemed necessary to be added to his institutions, or changed in them. But he went in reality to Crete, and continued there in voluntary exile; and, when he was dying, ordered his bones to be thrown into the sea, lest, if they were taken back to Lacedaemon, the Spartans might think themselves absolved from their oath respecting alteration in his laws. Under such a state of manners, the city acquired, in a short time, such a degree of strength, that, on going to war with the Messenians for offering violence to some of their maidens at a solemn sacrifice of that people, they bound themselves under a severe oath not to return till they had taken Messene, promising themselves so much either from their strength or good fortune.

Can bankers be trained to be obedient to those in authority? Should they take their meals in public? One dress in a year? Would all this make LIBOR become more accurate? Today, the above techniques would probably not prosper. Therefore, Martin Wheatley had to turn to other solutions. His recent report sticks to the following six questions:

  • Should we regulate LIBOR?
  • How should LIBOR be constructed?
  • How could LIBOR’s governance structure look like?
  • Are there alternatives to LIBOR?
  • How should we accomplish the transition period to new regulation?
  • Which sanctions should encompass the new LIBOR fixing?

1. Should we regulate LIBOR?

Yes! “LIBOR administration should also be a regulated activity.”, says the report. In the authors' view, this is necessary to counter the risks of potential manipulation. Not only should the conduct of firms and individuals involved in the LIBOR process be subject to supervison; but regulatory action for misconduct is also necessary.

However, to avoid any uncertainty of interpretation of existing contracts, the intention is to „reform rather than replace“ LIBOR.

On the merits, the new regulation shall cover the production of submissions; the calculation of the benchmark; and its publication.

2. How should LIBOR be constructed?

Martin Wheatley and his team address five major issues as regards LIBOR construction:

  • LIBOR submissions should be explicitly and transparently supported by transaction data. The hierarchy of transaction types to be taken into account looks like this:

  • Over a 12-month transition period, LIBOR's number of currencies and maturities should be reduced. This should apply to those currencies and tenors for which there is insufficient trade data to corroborate submissions and, ultimately, will reduce published benchmarks from 150 to 20.

  • The banks providing LIBOR submissions will need to put in place, at manager level, a „controlled function“ (Whatever this means...) for the LIBOR administration process. Contributors shall come from the banks' liquidity and liability management.

  • Relevant transactions will have to be recorded and individual submissions be published after a three months' period.

  • Sufficiently large panel sizes must be secured through increasing the number of contributors: If necessary, the FSA should have an explicit right to compel LIBOR submissions.

3. How could LIBOR’s governance structure look like?

Today, LIBOR suffers of

  • insufficient independence of governance structures;
  • too heavy reliance on participating banks;
  • limited transparency and accountability.

As a solution and to restore credibility, Martin Wheatley suggests to transfer, through a tender process, LIBOR administration and governance from the BBA to a new administrator. This new administrator should be a private organization rather than a public body. The reason is that a private company will “have a greater incentive to ensure that the benchmark is fit for purpose and evolves to meet the changing needs and nature of the market”. However, rules and guidance for such private administrator shall be set by public authorities.

It will be up to the new administrator to design an internal governance framework. However, the report already specifies the following 2 main features of such future framework:

  • The benchmark administrator will be obliged to analyze and scrutinize submissions from contributing banks.
  • The framework must provide for an independent committee which shall exercise a decision-making and oversight role.

In addition to the governance framework, a code of conduct for contributing banks shall be put in place. This new code of conduct, endorsed by the FSA, must

  • include guidelines for the use of transaction data to determine submissions, while retaining the existing definition of LIBOR based on unsecured inter-bank lending;
  • detail the above described hierarchy of transaction types;
  • provide for internal and external control of submitting firms;
  • request a record keeping of transaction data.

4. Are there alternatives to LIBOR?

The Wheatley report suggests to think about alternatives to LIBOR benchmarks:

  • Lawyers should develop feasible and robust LIBOR contingency provisions in contracts such as ISDA and LMA. The Wheatley commission criticizes the fact that those provisions usually refer to a mechanism that is based on interrogations of reference banks. In its view, this not only questions the practical feasibility in terms of work-load but may also involve exactly the same banks that were not able to provide LIBOR submissions in the first place.
  • Astonishingly, the Wheatley report suggests to reconsider the use of LIBOR in situations where it might not be the most suitable benchmark. For example, the authors consider that there may be no need to refer to LIBOR in derivative contracts intended to manage interest rate exposure. Possible alternatives to LIBOR can be the central bank policy rate, overnight index rates, overnight index swaps, short-term government debt yields, REPO rates, or synthetic rates.

5. How should we accomplish the transition period to new regulation?

The authors argue that the necessary amendments to LIBOR should come into force in 2013, together with the Financial Services Bill.

6. Which sanctions should encompass the new LIBOR fixing?

New enforcement mechanisms and sanctions should be introduced.

First the report thinks highly of EU legislation on market abuse that is currently under review. The central point of today's reforms is to expand the definition of a market abuse to providing false or misleading inputs or otherwise manipulating the calculation of a benchmark.

Second, the report recommends to introduce, at UK level, additional criminal sanctions into the Financial Services and Markets Act (FSMA).

The introductory story shows that setting and applying law are not same.

The Wheatley report is a about setting the structure. For example, the word “process” appears 90 times, more than once per page! Applying it will be another story.

In my view, the report focuses too much on the procedural aspects of setting LIBOR. In the end, it is employees who will submit LIBOR quotes. They must understand the obvious conflict of interest they were exposed to and handle it properly. Besides the usual call for education and training, the report is pretty silent on this issue.


  • The Wheatley Review of LIBOR – Final Report – September 2012