The London interbank offered rate, the benchmark for $360trillion of securities, may not survive allegations of beingcorrupted unless it's based on transactions among banks rather thanguesswork about the cost of money.

“The methodology used to formulate Libor is totally unsuitablefor the modern world,” said Daniel Sheard, chief investment officerof asset manager GAM U.K. Ltd., which manages about $60 billion.“The British Bankers' Association needs to come out on the frontfoot and say 'this is a system that was appropriate 20 years agobut is no longer appropriate and we are going to change it.'”

The BBA, the lobby group that has overseen Libor for 26 years,is under pressure to find an alternative way to calculate thebenchmark, or cede control of it. Regulators from Canada to Japanare probing whether banks lied to hide their true cost of borrowingand traders colluded to rig the benchmark, the basis for interestrates on securities from mortgages to derivatives.

“It can't be beyond the wit of man to come up with a rate thatis based on actual trades rather than guesswork,” said Tim Price,who helps oversee more than $1.5 billion at PFP Group LLP, anasset-management firm in London. “The idea that you can trust thebanks and the BBA with this is laughable.”

Libor, a gauge of how much it costs banks to borrow from oneanother, is so deeply embedded in the financial system it can't bereplaced without potentially voiding existing contracts, academicssaid. The BBA may instead overhaul Libor by making banks base theirsubmissions on actual trades, open submissions to independentverification and increase the number of firms that set the rate,investors said.

“You might be able to call the new benchmark Libor, but becauseit's not exactly the same measure, would that invalidate all thesethousands and thousands of contracts?” said Donald Mackenzie, aprofessor at the University of Edinburgh who specializes in thesociology of financial markets. “It's difficult to see that you cando much more than what the BBA is already trying to do in terms oftrying to improve an estimate-based measure.”

The BBA is reviewing potential changes to the benchmark and metregulators and bank executives last week. The rate is set through adaily survey of firms conducted on behalf of the BBA by ThomsonReuters Corp. in which banks are asked how much it would cost themto borrow from one another for 15 different periods, from overnightto one year.

Because banks have to submit a rate when no market exists, andtheir estimates aren't subject to outside verification, thebenchmark is vulnerable to manipulation, investors said.

Libor Review

The U.S. is conducting a criminal investigation into suspectedmanipulation of benchmark rates including Libor, the JusticeDepartment said in a letter to a federal judge that was made publicearlier this month. The European Union, the U.K. Financial ServicesAuthority and the Monetary Authority of Singapore have all startedtheir own probes.

The BBA will shortly start a “technical” discussion with Liborusers and will update the FSA, Treasury and Bank of England as itprogresses, the group said in an e-mailed statement. Brian Mairs, aspokesman for the lobby group, declined to comment further.

One way of restoring confidence would be for the BBA orregulator such as the Bank of England's proposed PrudentialRegulatory Authority to check that the rates submitted by bankscorrespond with actual trades made by those firms on any given day.Firms that misstate their cost of borrowing could be fined orforced to compensate investors.

Godfried de Vidts, president of Euribor-ACI, a lobby group thatrepresents about 5,000 money-market traders in the euro area, madesuch a proposal to BBA Chief Executive Officer Angela Knight inJuly 2008, when the group last reviewed how Libor is set after theBank for International Settlements said banks may have been wary ofrevealing their real borrowing costs.

“There has been a clear lack of confidence in the monitoring ofthe Libor fixings,” de Vidts wrote in the letter, published on thegroup's website. “To make the scrutiny mechanism more efficient andtrustworthy local independent supervisors should carry outperiodical controls on contributions.”

The BBA should also increase the number of banks that submit therate to make it more representative and less open to claims ofmanipulation, said Christoph Rieger, head of fixed-income strategyat Commerzbank AG in Frankfurt.

Libor would be more reliable if banks were allowed to make theirsubmissions anonymously, Rieger said. That would reduce theincentive on banks to under-report their borrowing costs to appearstronger to investors, he said.

Barclays Report

Such a move would also bring Libor closer into line withEuribor, the rate at which European banks say each other can lendin euros. While 15 banks set yen Libor and 18 set dollar Libor, 44set the Euribor equivalent.

Euribor rate-setting banks are asked each day in a survey howmuch a “prime bank,” rather than themselves, would pay to borroweuros for different maturities. The results are collated andpublished by Thomson Reuters on behalf of the European BankingFederation, the BBA's Brussels-based equivalent. Bloomberg LP, theparent of Bloomberg News, competes with Thomson Reuters in sellingfinancial and legal information and trading systems.

ICAP Plc, the biggest broker of transactions between lenders,started the New York Funding Rate, a measure of U.S. bank rates, in2008. The measure is based on a survey of how much contributorsestimate a “representative” lender would pay to borrow eachday.

Some firms are already turning away from Libor and usingalternative rates to price trades. Barclays Plc, Britain'sthird-biggest lender, said in its annual report last week it'sincreasingly using the overnight indexed swap rate, a gauge ofexpectations for central bank rates, rather than Libor as the basisfor prices on collateralized derivatives.

The London-based lender is switching to the “more relevant”overnight indexed swap rate “in line with changes in marketpractice,” the bank said in the filing. A Barclays spokesmandeclined to comment beyond the document.

Overnight indexed swaps are over-the-counter traded derivativesin which one party agrees to pay a fixed rate in exchange for theaverage of a floating central-bank rate over the life of the swap.For dollar swaps, the floating rate is the daily effective federalfunds rate, for euros the euro overnight interbank average rate,and for pounds the sterling overnight interbank average rate.

Eonia, Sonia

Rates based on recorded trades such as Eonia and Sonia aregaining in popularity, said Mikhail Chernov, a professor of financeat the London School of Economics. The Eonia and Sonia indexes areweighted averages of the cost for banks to borrow from one anotherovernight in euros and sterling. The gauges are based on weightedaverages of all overnight unsecured lending trades in the interbankmarket and are compiled by the EBF and the Wholesale MarketsBrokers' Association, a London-based industry group.

Using a transacted rate as the benchmark instead of Liborcarries its own problems, analysts said. In times of stress, onlythe most creditworthy banks would be able to access the short-termmoney markets, skewing the aggregate figure lower, said JosephAbate, a strategist at Barclays in New York. Volume data as well asprice data should be referenced to measure unsecured funding costs,he said.

The BBA has changed Libor before. Before 1998, the questionbanks were asked was “At what rate do you think interbank termdeposits will be offered by one prime bank to another prime bankfor a reasonable market size today at 11 a.m.?” That year, itchanged to “At what rate could you borrow funds, were you to do soby asking for and then accepting interbank offers in a reasonablemarket size just prior to 11 a.m.?”

The switch, which forced banks to provide estimates of their owncost of funding, had the “advantage of linking the figuressubmitted by banks to their own activity,” the lobby group said onits website.

After the 2008 review, the BBA increased the number of banks onthe dollar Libor panel to 20 from 16. Two firms have since quit thepanel. Lenders were also asked to justify any discrepancies betweentheir submissions and their competitors.

John Ewan, the BBA executive responsible for managing theprocess by which Libor is set, said that Libor couldn't be moreradically changed because the group has a duty to all users of therate — including borrowers.

“We have a duty to all users, including those who have taken outagreements with life-spans of decades into the future based on abenchmark that they think they understand,” he said in a Julyinterview. “If we suddenly switched the benchmark radically, thatmay give them problems.”

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