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Scandal-hit Libor faces change, but has no formidable contenders

LONDON -- A scandal over the rigging of the Libor interest rate that underpins financial contracts worth hundreds of trillions of dollars is likely to force regulators to reform the way it is set.

But any decision they take will, at best, be a compromise rather than a solution that will fully restore the reputation of what is often referred to as the world's most important financial instrument, many market participants believe.

Libor's credibility was severely damaged during the 2007-2009 financial crisis as some of the banks contributing to its daily fixings were accused of manipulating the rate.

Barclays was fined US$453 million by U.S. and British authorities last w eek, becoming the first bank to settle in an investigation that is looking at more than a dozen other banks and submissions they made for calculating Libor rates.

Under the terms of the settlement, Barclays will help improve the reliability of the rate-setting system.

Libor rates are used in an estimated US$360 trillion worth of financial contracts, ranging from credit cards to complicated derivatives transactions, and it would be almost impossible to replace it quickly with another rate because of the financial and legal chaos it would cause, market participants say.

“It has lost a huge amount of credibility as a benchmark and barometer, but it was always known that it was open to abuse and it was heavily (exposed to) potential conflicts of interest,” said Chris Huddleston, head of money markets at Investec.

“(However) there is so much (money) tied up to it that it needs to be fixed rather than replaced,” he said.

It is therefore more likely that the way Libor is set and regulated will be overhauled to make it more transparent rather than the instrument being replaced altogether.

Its shortcoming is that it is based on the rate at which a contributing bank says it can borrow funds in the unsecured money market rather that the rate at which it actually obtained a loan. There are no further checks made on its submission.

One way to make the rate-setting process more transparent would be to base it on real transactions. Bank of England Governor Mervyn King has said “the time has now come to move it away from quotes, towards observations based on actual market transactions.”

But the eurozone sovereign debt crisis has hit banks so hard that they have been less willing to lend money without collateral, particularly for periods longer than three months.

As a result any reform to Libor may always be imperfect as it may not reflect the true state of the market.

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