Seven Principles for Reforming Financial Benchmarks

A number of regulators have been looking at how to dig financial markets out of the Libor mess. There isn’t much disagreement that bank-run benchmarks based on made-up numbers that can be readily manipulated have to be very significantly reformed. The problem is figuring out how to reform and what to replace them with, particularly given the large variety of benchmarks potentially at stake. It isn’t possible to simply abandon these benchmarks and parties to contracts have continued to use the existing ones, well-known warts and all, because they need something.

The International Organization of Securities Commissioners (IOSCO) is the latest body to weigh in on what to do. We were invited to comment on it. You can read what we said here. We used this as an opportunity to elaborate on our earlier analysis of the Wheatley Review findings. We make seven key points:

1. First, whenever possible benchmark indices should be based on actual transactions as opposed to quotes. This offers a number of advantages, not the least of which being its robustness (though not immunity) to fraud and manipulation. Where a transactions basis is not viable, the second-best alternative is to use committed quotes. The final option, uncommitted quotes of the type used for LIBOR, should not be adopted.
2. Second, some care should be taken in the manner of calculating the benchmark given the input data (either transactions or committed quotes). While a