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INSURANCE & REINSURANCE LIBOR BRIEFING NOTE (3) LIBOR – REFORM NOT REPLACE OCTOBER 2012 Our LIBOR briefings of July and August 2012 summarised the LIBOR story to date and the issues arising. We have been following the developments of how the UK Government wishes to address the concerns raised, and have set out in summary form, the main proposals which will hopefully go some way towards restoring credibility in the UK financial markets, and more importantly, in its participants. Background The Wheatley Review (the Review) is the UK Government’s response to the LIBOR (London Interbank Offered Rate) rate fixing scandal that emerged recently and the damage done by the scandal to the credibility of this globally used interest rate. It identifies the specific weaknesses in the system that need to be addressed in order to restore the rate’s credibility and long term future. In particular, two abuses of the system were seen as particularly damaging: 1. the misuse and manipulation of the LIBOR rate to maintain the perception that the bank’s relative creditworthiness is not being adversely affected, particularly in times of market stress; and 2. the conflict of interest that arises from banks playing the role of both contributor to and user of the rate which provided incentives for traders within those institutions to seek to manipulate LIBOR, both upwards and downwards, in order to benefit their respective trading positions. A number of further problems were identified. These included the use of discretion and not data in the development of LIBOR submissions, the limited number of transactions from which hard data reference points could be extracted in times of market slow down and the weakness of governing authorities to both oversee and sanction any misuse of the discretion inherent in the system. Summary Following the announcement of the findings against Barclays earlier this summer, Martin Wheatley, managing director of the Financial Services Authority (FSA), was tasked with conducting an independent review into a number of aspects of LIBOR. The aim of the Review, published on Friday 28 September 2012, was to make recommendations for the following: 1. reform of the framework for setting and governing LIBOR; 2. assessing the adequacy of sanctions to appropriately tackle any on-going and future abuse of LIBOR; and 3. considering whether other price setting mechanisms in financial markets require similar policy overhaul. The key findings include a preference for reforming rather than replacing LIBOR, taking account of the likely disruption that the abolition of LIBOR would cause to the estimated US$300 trillion worth of contracts that are linked to the rate. Market participants will continue to play a key role in the production and oversight of LIBOR but in order to restore faith in the benchmark, the Review concluded that hard transaction data should be explicitly used to support LIBOR submissions, in an attempt to move away from the estimate/guess model that is currently in use. With these key findings in mind, the Review proposes a 10 point plan for a comprehensive reform of LIBOR. Significantly, this includes the establishment of a new administrator to oversee the submission and compilation of LIBOR, taking over from the British Bankers Association (BBA). The BBA agreed to give up the role last week and several parties (such as NYSE, Euronext and the London Stock Exchange) are said to have already registered their interest in becoming the new, independent regulator. The final choice will be made by an independent committee convened by the UK FSA and the UK Government, and will be subject to a competitive tender process that is to begin immediately. The new and more stringent oversight is coupled with measures aimed at increasing transparency. In particular, submissions on LIBOR are to be corroborated by factual transaction data. The Review requires the new administrator to draw up a code of conduct for submitters which outlines the explicit use of transaction data. In the meantime the Review includes a set of guidelines, which are to have immediate effect. They set out the hierarchy of transactions that are to be taken into account by the submitter when developing their submission. The development of submissions was based previously, in part, on guesswork by submitters as to the rate they would have to pay to borrow funds from another bank.

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Page 1: INSURANCE & REINSURANCE LIBOR BRIEFING NOTE (3) LIBOR ... · replacing LIBOR, taking account of the likely disruption that the abolition of LIBOR would cause to the estimated US$300

INSURANCE & REINSURANCELIBOR BRIEFING NOTE (3)LIBOR – REFORM NOT REPLACEOCTOBER 2012

Our LIBOR briefings of July and August 2012 summarised the LIBOR story to date and the issues arising. We have been following the developments of how the UK Government wishes to address the concerns raised, and have set out in summary form, the main proposals which will hopefully go some way towards restoring credibility in the UK financial markets, and more importantly, in its participants.

BackgroundThe Wheatley Review (the Review) is the UK Government’s response to the LIBOR (London Interbank Offered Rate) rate fixing scandal that emerged recently and the damage done by the scandal to the credibility of this globally used interest rate. It identifies the specific weaknesses in the system that need to be addressed in order to restore the rate’s credibility and long term future. In particular, two abuses of the system were seen as particularly damaging:

1. the misuse and manipulation of the LIBOR rate to maintain the perception that the bank’s relative creditworthiness is not being adversely affected, particularly in times of market stress; and

2. the conflict of interest that arises from banks playing the role of both contributor to and user of the rate which provided incentives for traders within those institutions to seek to manipulate LIBOR, both upwards and downwards, in order to benefit their respective trading positions.

A number of further problems were identified. These included the use of discretion and not data in the development of LIBOR submissions, the limited number of transactions from which hard data reference points could be extracted in times of market slow down and the weakness of governing authorities to both oversee and sanction any misuse of the discretion inherent in the system.

SummaryFollowing the announcement of the findings against Barclays earlier this summer, Martin Wheatley, managing director of the Financial Services Authority (FSA), was tasked with conducting an independent review into a number of aspects of LIBOR. The aim of the Review, published on Friday 28 September 2012, was to make recommendations for the following:

1. reform of the framework for setting and governing LIBOR;2. assessing the adequacy of sanctions to appropriately

tackle any on-going and future abuse of LIBOR; and 3. considering whether other price setting mechanisms in

financial markets require similar policy overhaul.

The key findings include a preference for reforming rather than replacing LIBOR, taking account of the likely disruption that the abolition of LIBOR would cause to the estimated US$300 trillion worth of contracts that are linked to the rate. Market participants will continue to play a key role in the production and oversight of LIBOR but in order to restore faith in the benchmark, the Review concluded that hard transaction data should be explicitly used to support LIBOR submissions, in an attempt to move away from the estimate/guess model that is currently in use.

With these key findings in mind, the Review proposes a 10 point plan for a comprehensive reform of LIBOR. Significantly, this includes the establishment of a new administrator to oversee the submission and compilation of LIBOR, taking over from the British Bankers Association (BBA). The BBA agreed to give up the role last week and several parties (such as NYSE, Euronext and the London Stock Exchange) are said to have already registered their interest in becoming the new, independent regulator. The final choice will be made by an independent committee convened by the UK FSA and the UK Government, and will be subject to a competitive tender process that is to begin immediately.

The new and more stringent oversight is coupled with measures aimed at increasing transparency. In particular, submissions on LIBOR are to be corroborated by factual transaction data. The Review requires the new administrator to draw up a code of conduct for submitters which outlines the explicit use of transaction data. In the meantime the Review includes a set of guidelines, which are to have immediate effect. They set out the hierarchy of transactions that are to be taken into account by the submitter when developing their submission. The development of submissions was based previously, in part, on guesswork by submitters as to the rate they would have to pay to borrow funds from another bank.

Page 2: INSURANCE & REINSURANCE LIBOR BRIEFING NOTE (3) LIBOR ... · replacing LIBOR, taking account of the likely disruption that the abolition of LIBOR would cause to the estimated US$300

The guidelines now set out specific sets of actual transactions undertaken by the bank, and the rates applied to them, which are to be used as a basis for calculating the LIBOR submission. This effectively removes the informed guesswork of the previous regime, and with it the risk of manipulation. However, there remains some scope for submitters to rely on “expert judgement” in the absence of hard transaction data, despite the increased emphasis placed on the use of transactions entered into by the bank.

Any submissions on currencies or maturities (tenors) which are not supported by sufficient transaction data are no longer to be compiled or published and should be subject to a phased removal, with the number of LIBOR benchmarks published daily potentially being reduced from 150 to 20. The tenor represents the maturity for the loan; the Review concludes that the publication of LIBOR for 4, 5, 7, 8, 10 and 11 month maturities should be discontinued as these maturity periods suffer from a lack of regular trade activity making it difficult to support submissions in these periods with the hard transactional data required in the drive for transparency.

The reliance on data rather than estimates has been broadly welcomed as an effective means of avoiding abuse in the future as well as repairing LIBOR’s credibility. Others note however that there are a limited number of actual unsecured interbank transactions which are available as a factual reference point. They also question what benchmark will replace LIBOR in thinly traded markets if it was phased out due to insufficient data being available to corroborate submissions.

Additionally, the publication of submissions is to be delayed for 3 months to discourage attempted manipulation. Ensuring that the submissions remain confidential for 3 months is a means of discouraging the submitting banks from viewing the submission as indicators of creditworthiness, and is aimed at removing one of the incentives which drove the banks to underestimate the LIBOR rate as a means of preserving the illusion of solvency. Banks, including those who are not currently submitting LIBOR, will be encouraged to participate more widely in the process, with the possibility of granting the FSA the statutory power to compel participation.

In terms of regulation and sanctions, the Review recommends that the administration and submission of LIBOR should be brought under a statutory regulatory regime, with both activities becoming a ‘regulated activity’ under the Financial Services and Markets Act (Regulated Activities) Order 2001 and all persons making submissions to be approved to do so by the FSA. The FSA is also to be given new powers to prosecute manipulation or attempted manipulation of LIBOR as a criminal offence.

Notwithstanding the objective of the Review of retaining LIBOR, albeit with strengthened institutions, regulation and governance, consideration is also given to the prospect of an alternative benchmark to LIBOR. This is to take the form of cooperation between the international authorities and a review by users of the rate of whether it is the most appropriate benchmark for their purposes.

Implementation It is understood that the main legislative vehicle for implementing the recommendations in the Review will be the Financial Services Bill, currently before Parliament. Whilst some of the reforms are to have immediate effect, such as compliance with the submissions guidelines, the longer term reforms are expected to come into effect in early 2013.

Further, the reforms are likely to have implications beyond the borders of the UK, not simply because of the widespread use of LIBOR globally but also because regulators in the US, Europe and Japan have all signalled that the Review will provide a template model for their own national reform programmes. Mr Gensler, the Chairman of the US Commodity Futures Trading Commission, has stated that the review being carried out by IOSCO (The International Organisation of Securities Commissions) under his auspices will build on the Wheatley Review.

ContactFor further information please contact:

Nilam SharmaPartner, London Head of Insurance, Financial [email protected]+44 20 7481 0010

Simon CooperPartner, London [email protected]+44 20 7481 0010

Ince & Co is a network of affiliated commercial law firms with offices in Beijing, Dubai, Hamburg, Hong Kong, Le Havre, London, Monaco, Paris, Piraeus, Shanghai and Singapore.

E: [email protected] incelaw.com

24 Hour International Emergency Response Tel: + 44 (0)20 7283 6999

LEGAL ADVICE TO BUSINESSES GLOBALLY FOR OVER 140 YEARSThe information and commentary herein do not and are not intended to amount to legal advice to any person on a specific matter. They are furnished for information purposes only and free of charge. Every reasonable effort is made to make them accurate and up-to-date but no responsibility for their accuracy or correctness, nor for any consequences of reliance on them, is assumed by the firm. Readers are firmly advised to obtain specific legal advice about any matter affecting them and are welcome to speak to their usual contact.

© 2012 Ince & Co International LLP, a limited liability partnership registered in England and Wales with number OC361890. Registered office and principal place of business: International House, 1 St Katharine’s Way, London, E1W 1AY.

Joanne WatersTrainee Solicitor, London [email protected]+44 20 7481 0010