In recent years, two separate developments have called into question the wisdom of that arrangement. I have already mentioned the first one--the emergence of a pervasive pattern of attempted manipulation of LIBOR dating back many years…
A second problem is that unsecured interbank borrowing has been in a secular decline that predates the global financial crisis. Changes in bank behavior following the crisis exacerbated the decline and further weakened the foundation of LIBOR. The result is a scarcity, or outright absence in longer tenors, of actual transactions that banks can use to estimate their daily submission to LIBOR. Ongoing regulatory reforms and the shift away from unsecured funding raise the possibility that unsecured interbank borrowing transactions may become even more infrequent in the future. While it is also possible that activity in these markets could rebound, the threat that this form of borrowing may decline further, particularly in periods of stress, seems likely to remain.
So let me pose a question: Is it wise to rely on a critical benchmark that is built on a market in decline? Clearly not. The risks to market functioning are simply too great. For example, market activity could decline to the point where publication of a rate becomes untenable. And many of the panel banks have expressed concerns about the ongoing legal risks of remaining on the panel. If the publication of LIBOR were to become untenable or if we were to simply "end LIBOR," as some have urged, untangling the $150 trillion in outstanding U.S. dollar LIBOR contracts would entail a protracted, expensive, and uncertain process of negotiating amendments to an enormous number of complex documents--a horrible mess and a feast for the legal profession, to be sure. It does not help matters that the hundreds of trillions of dollars' worth of derivatives contracts referencing LIBOR do not, in general, have robust backups in the event that publication of a rate ceases.
The FSB report identifies ways to improve U.S. dollar LIBOR, and to create alternatives to it, while minimizing transition costs, particularly for end users who bear no blame for the misconduct.
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In the near term, the Federal Reserve, along with other government agencies, intends to meet with a wide range of market participants, including end users, to hear their views as to how cge can be effected and to begin the work of developing alternatives to LIBOR. Later this year, we will convene a group of the largest global dealers to discuss these issues, following a model that was successfully used to promote derivatives reform… [T]he markets that reference dollar LIBOR are so enormous that there will surely be more than enough liquidity to support both a new risk free rate as well as LIBOR itself.
One of the lessons that I take from our study of LIBOR is that these existing legacy contracts are quite important. As I mentioned earlier, many financial contracts, including derivatives contracts, do not have robust backups in the event that the reference rates they use cease to exist. Some derivatives, such as interest rate swaps, can be quite long lasting, and, over a long enough period of time, there is always a risk that any given reference rate will cease being published. It is important that financial contracts address the need for a backup plan if a reference rate does cease to function. This issue is something that we intend to bring up with market participants and end users as we meet with them.