Reforming LIBOR: The $300 trillion question IT DETERMINES the interest payments on almost half of flexible-rate mortgages in America and underpins financial contracts worth an estimated $300 trillion worldwide. But having been tarnished by a rate-rigging scandal, LIBOR (the London Inter-Bank Offered Rate) is now set for big changes. The first step will be a report due on September 28th. The report's chief author, Martin Wheatley of Britain's Financial Services Authority (FSA), needs to give solid answers to some thorny questions. Everybody agrees that the current set-up is broken. LIBOR (there are actually 150 rates for 15 maturities in 10 currencies) is set, every day, by the British Banker's Association (BBA), and aims to measure banks" own cost of borrowing. Lenders estimate what they would have to pay if they asked other banks to lend to them, and submit these guesses to the BBA. Once all the estimates are in, the extreme values are thrown out and the remainder averaged. If the estimates were honest, the system would work. But traders employed by banks submitting rates stood to win or lose millions based on the level of LIBOR. This allegedly led to systematic fiddling with the rate. Estimates were based not on banks" borrowing rates, but set at levels that would inflate traders" profits. At least 12 banks are being investigated globally. The first hard question Mr Wheatley must answer is how to come up with accurate rates. He is expected to demand increased use of hard data from actual lending transactions. This would improve accuracy, but it would bring problems too. LIBOR rates are needed in currencies and maturities that are not traded every day. One solution is to use extrapolation to fill in the data gaps; another is to opt for a narrower set of LIBOR rates. Whatever the FSA's decision on how to find accurate rates, the new LIBOR will be very different. On September 24th Gary Gensler, the boss of America's Commodity Futures Trading Commission, presented an analysis which shows that LIBOR is oddly low compared with other benchmarks. It is also strangely stable: most banks in the sample changed their LIBOR estimates fewer than 30 times, even though they could have done so 182 times. The implication is that new LIBOR rates are likely to be higher and more volatile. How quickly the new LIBOR should be implemented is another big problem. Those holding existing contracts that use LIBOR could face a sudden jolt when the new system is switched on. This could affect interest payments and asset values, leaving investors and borrowers out of pocket. If so, they will have two options: live with the new version of LIBOR or try to prove that contracts have been broken. Yet it is unlikely that many contracts will have anticipated changes in the benchmark rate. Disgruntled investors will find it hard to prove that the new system has broken these contracts, says Lianne Craig of Hausfeld, a law firm. Finally, Mr Wheatley needs to decide who should own LIBOR. In a statement on September 25th the BBA made clear that it is happy to walk away from the mess. Responsibility is likely to end up in regulators" hands, with most bets on Mr Wheatley's employer, the FSA. Whoever inherits LIBOR faces a tough clean-up job.