After Libor - the search for a new benchmark Back in the 1980s, traders and bankers who specialised in the new and exotic fields of loan syndication and forward rate agreements found themselves in desperate need of a benchmark against which to price their deals. There were not enough trades for a market-based index, so the British Bankers" Association, with the backing of the Bank of England, stepped up to create an alternative, based on an average of daily estimates from participating banks. That rate, the London Interbank Offered Rate, or Libor, now serves as the benchmark for $500tn in derivatives contracts, as well as many credit cards, corporate loans and mortgages around the world. But its reliability has been undermined by Barclays" admission that it - and traders at other banks - sought to manipulate the rate, either to make money on derivatives or to reassure the markets about the bank's financial health. "If you had a blank piece of paper and were creating a derivatives market from scratch you would not use Libor as the floating rate benchmark," says Michael Cloherty, head of interest rate strategy at RBC Capital Markets. Politicians, regulators and bankers are casting about for another benchmark. They would like it to be less dependent on subjective estimates from a club of banks, who generate vast revenues from the opaque business of transacting over-the-counter derivatives based on the very rate they are charged with setting. The UK government has announced a review of the Libor-setting process that is expected to conclude in the autumn with recommendations for changing the way rates are set and the regulatory oversight of the process. But the same dilemma that led to Libor's creation continues to dog the search for an alternative. There simply is not enough trading, particularly at longer 6-month and 12-month lending periods, to be sure that the rate genuinely reflects the market. Libor purports to measure the rate at which banks can borrow from one another. But in the real world banks do not generally hand cash to each other. Money market funds do that kind of lending but only for short periods. It means quotes for six-, nine-, and 12-month Libor are based on estimates and not on actual flows. "The fundamental problem is that Libor is a poorly conceived benchmark for over-the-counter derivatives, which by their nature are opaque," says Satyajit Das, a derivatives trader turned consultant and author. It's a deep-seated problem and not easy to fix. For its part, the BBA is leading a working group looking at overhauling the Libor-setting process with the International Swaps and Derivatives Association. The rate-setting process already involves a "trimmed average," in which the top and bottom estimates are thrown out, but that precaution does not seem to have stopped the Barclays" traders from seeking to influence the overall rate. "Libor lacks the transparency the market and regulators want it to have," say analysts at JPMorgan. While regulators are plotting the redesign of Libor, market sponsorship for this benchmark may decay as market participants seek alternatives. ISDA is prepared to listen to whether the market wants an alternative benchmark. "We will, as a matter of course, consult with our members on the findings of the [BBA] review and if the consensus is that changes to ISDA documentation are necessary as a result, we will facilitate those changes," it says. One possibility that has appeal in Europe would be to base the new rates on a combination of actual trades and binding estimates. Banks would have to be willing to enter into transactions at their quoted rate, rather than just calling it an estimate. In the US, the focus is on the federal funds effective rate, the Treasury bill rate or using the General Collateral Finance Repo rate. "All three rates can be traded and hedged individually, which is an important prerequisite for managing interest rate exposure of a swap based on the index," says Fidelio Tata, strategist at Société Générale. Of the three, the repo - or repurchase - rate is seen having the best prospects, as it is based on actual interdealer Treasury bond repo trades, a $400bn market. As a candidate to replace Libor, the Treasury repo rate could gather steam if the planned debut of repo futures this month gains momentum, boosting its prospects of becoming the benchmark for a new floating Treasury note expected next year. From July 16, NYSE Liffe will start trading futures based on the Depository Trust and Clearing Corporation's repo index, which follows the average interest rate paid each day for the most actively traded US repo market. "Whatever index is chosen for the Treasury programme may have the inside track as the next Libor," say analysts at JPMorgan. Ultimately, the task of replacing Libor boils down to how willing the industry is to sacrifice short-term cost for a better and more reliable benchmark. "Getting from point A to B will be very challenging," says Mr Cloherty. It comes down to whether the goal of getting to a derivatives market based on a liquid benchmark is large enough to outweigh the costs of transformation.