Given that LIBOR is used as a benchmark index by an estimated $300 trillion of financial products, it is perhaps surprising that the method for calculating LIBOR has been relatively informal. One of the difficulties is that the panel of submitting banks is responding to a hypothetical question; "At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?". It is not necessary for a bank's response to this question to be based on actual transaction data (in fact in some cases it would not be possible to do this), as inter-bank lending in some currencies and maturities has been very thin, especially during some of the banking crisis period in 2007-8. Therefore a LIBOR submission is a "best estimate", involving an element of judgement. But as the discussion paper indicates, this judgement can be warped by several potential inherent conflicts of interest. First, if a bank makes a high submission (compared with other submitters), this could be interpreted as an indicator of credit worthiness of that bank, so there is an incentive to lower submissions (especially during periods of market stress) to lower the submission. Second, since contributing banks will have some financial products that are impacted by LIBOR, this provides a strong incentive to influence the submission. To avoid these issues, the ideal would be to base LIBOR submissions on actual transactional data. The paper suggests that a trade reporting mechanism requiring participating banks to report all relevant transactions to a central repository might be a possibility. However, trading might still be thin in certain maturities and currencies, and manipulation of transactions is still possible, particularly where trading volumes are low. Nevertheless, the use of actual transactions data, even if only used to corroborate submissions, seems like a better starting point for an index than the current "educated guess" arrangement, which need not take actual transactions into account.

The paper also discusses various options for strengthening governance and oversight for the LIBOR setting process. The current oversight committee is dominated by the contributing banks, and the paper suggests that the membership could be broadened to include representatives from exchanges and clearing houses, non-contributing banks and other users of financial products that reference LIBOR. It would also be possible to include a representative from the regulator. Broadening the membership of the oversight function would increase the scope for challenging outcomes from the setting process, and give a better appearance of independence. It is hard to see how this can be resisted in the current climate.

More controversial are the options for strengthening the regulatory and enforcement regime. The LIBOR setting and administration process is not a regulated activity under the Financial Services and Markets Act 2000 (FSMA). This is perhaps mainly for historic reasons, since the LIBOR process was viewed as a wholesale activity between major banks, and therefore not requiring intervention by the regulator. One suspects also that the rather arcane submission and calculation processes may not have appealed to the regulator. It would be relatively straightforward to define LIBOR submitting and administration as regulated activities by amending FSMA. In addition, given the FSA's emphasis on individual accountability, it would be tempting for the government to bring the individuals involved in the LIBOR process within the regulatory net as approved persons, to the extent they are not already. This could be either the person responsible for making the LIBOR submission, or the responsible manager (creating a new controlled function similar to the CF10a CASS operational oversight function) or a member of senior management. It is likely that the effect of increased regulation in this area would be to encourage higher standards from firms and individuals involved in the LIBOR setting process.

There are additional enforcement options. The current civil market abuse regime under section 118 of FSMA is not specifically targeted at the manipulation or attempted manipulation of benchmarks such as LIBOR. This could also be changed by amending FSMA, but in fact the European Commission has already announced amendments to its MAD II proposals to ensure that they cover the manipulation of benchmarks, and that manipulation of benchmarks is a criminal offence (see Legal update, European Commission publishes amendments extending MAD II to benchmark manipulation). The criminal regime under section 397 FSMA (misleading statements and practices) does not capture manipulation of LIBOR. The paper suggests that section 397 could be broadened by removing the requirement that the misleading statement or action must have been made for the purpose of inducing another person to act. However, this would need careful drafting, otherwise it could capture conduct unrelated to LIBOR or benchmarks. It should be noted that the House of Commons Treasury Select Committee, in its report on LIBOR published on 20 August 2012, made some similar recommendations in this area (see Legal update, Treasury Committee publishes LIBOR report). It recommended that the Wheatley review should consider the case for widening the meaning of market abuse to include the manipulation, or attempted manipulation of LIBOR and other benchmark rates. The committee also recommended that Mr Wheatley should consider the case for widening the definition of the criminal offence in section 397 to include a course of conduct that involves the intentional or reckless manipulation of LIBOR and other benchmark rates. Some legislative action around section 397 therefore appears likely, but will need to have regard to the Commission's proposals.

There may also need to be improvements in the operating arrangements between the potential prosecuting authorities in cases where there is serious fraud committed in the financial markets. The Treasury Select Committee is critical in its report of the stance taken by the FSA and the time taken by the Serious Fraud Office (SFO), in deciding whether or not to conduct a criminal investigation into LIBOR. The SFO did not announce that it had commenced a LIBOR investigation until 6 July 2012 (see Legal update, SFO announces LIBOR investigation). The report recommends that the Wheatley review examine whether there is a legislative gap between the responsibility of the FSA and the SFO to initiate a criminal investigation in a case of serious fraud committed in relation to the financial markets.

The discussion paper contains less detail on the alternatives to LIBOR, and attempts to set out a conceptual framework for what an alternative benchmark might look like. However, it emphasises the transitional issues in moving to an alternative benchmark. LIBOR is a global benchmark, and the UK could not take action by itself. The paper suggests that there might be a role for the International Organisation of Securities Commissions (IOSCO) or the Financial Stability Board (FSB) to provide global co-ordination.

Whatever Mr Wheatley recommends, following consultation (which closes on 7 September 2012), will not be the end of the story. The government will need to decide on its preferred option, in time for legislative changes to be included in the Financial Services Bill 2012-13 (FS Bill). My money would be on a substantially reformed benchmark (maybe Super LIBOR or LIBOR on steroids), transformed by an improved setting process, stronger governance and oversight, tighter regulation and clear sanctions for non-compliance.