In saying this, I want to make it clear that LIBOR has been significantly improved... However, the term money market borrowing by banks that underlies U.S. dollar LIBOR has experienced a secular decline. As a result, the majority of U.S. dollar LIBOR submissions must still rely on expert judgement, and even those submissions that are transaction-based may be based on relatively few actual trades. This calls into question whether LIBOR can ultimately satisfy IOSCO Principle 7 regarding data sufficiency, which requires that a benchmark be based on an active market. That Principle is a particularly important one, as it is difficult to ask banks to submit rates at which they believe they could borrow on a daily basis if they do not actually borrow very often.
That basic fact poses the risk that LIBOR could eventually be forced to stop publication entirely. Ongoing regulatory reforms and changing market structures raise questions about whether the transactions underlying LIBOR will become even scarcer in the future, particularly in periods of stress, and banks might feel little incentive to contribute to U.S. dollar LIBOR panels if transactions become less frequent. Market participants are not used to thinking about this possibility, but benchmarks sometimes come to a halt. The sudden cessation of a benchmark as heavily used as LIBOR would present significant systemic risks. It could entail substantial losses and would create substantial uncertainty, potential legal challenges, and payments disruptions for the market participants that have relied on LIBOR. These disruptions would be even greater if there were no viable alternative to U.S. dollar LIBOR that market participants could quickly move to.
These concerns led the FSB and Financial Stability Oversight Council to call for the promotion of alternatives to LIBOR...

[T]here is a perception that FICC markets and their participants are highly sophisticated and do not need protection. While that may be generally true, the perspective is too narrow, because the importance of these markets extends far beyond the largest participants in them. The market mechanism allocates credit and determines the borrowing costs of households, companies and governments. Proper market functioning is really a public good that relies on confidence and trust among market participants and the public. Bad conduct, weak internal firm governance, misaligned incentives, and flawed market structure can all place this trust at risk.
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The Dodd-Frank Act also imposed rules requiring greater transparency in over-the-counter derivatives markets through the use of central clearing, trade repositories, and swap execution facilities. Given the issues around OTC derivatives during the recent crisis, these clearly are important initiatives. But despite significant progress, there are still a number of impediments to sharing trade report data across regulatory agencies and jurisdictions, leaving us with only a piecemeal picture of the overall market rather than the full transparency that we desire.
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With surveillance and penalties in place, and a new administrator, one might be excused for thinking that there is nothing more to be done {about LIBOR}. In fact, some people do think that. That is emphatically not the view of the FSB Official Sector Steering Group that I now co-chair with Martin, which concluded that it is essential to develop one or more risk free (or near risk free) alternatives to LIBOR for use in financial contracts such as interest rate derivatives. The reasons are related to the structure of both LIBOR and the market that underlies it. Unsecured interbank borrowing has been in a secular decline for some time, and there is a scarcity, or outright absence in longer tenors, of actual transactions that banks can use to estimate their daily submission to LIBOR or that can be used by others to verify those submissions. LIBOR is huge--there are roughly $300 trillion in gross notional contracts that reference it--so the incentives to manipulate it still remain in place. And the structural problems go much further than the incentives for manipulation. Markets need to be fair, effective, and also safe. If the publication of LIBOR were to become untenable because the number of transactions that underlie it declined further, then untangling the outstanding LIBOR contracts would entail a legal mess that could endanger our financial stability.

For these reasons, the Federal Reserve has convened a group of the largest global dealers to form the Alternative Reference Rates Committee. We have asked them to work with us in promoting alternatives to U.S. dollar LIBOR that better reflect the current structure of funding markets. As the Review's consultation document notes, issues of this kind are really global in nature; U.S. dollar LIBOR contracts are traded throughout the world, not simply in the United States. For this reason we are working in close consultation with our foreign regulatory counterparts in this endeavor.

Reference rates have become a ubiquitous but largely hidden fiber in the fabric of financial markets. They play a critical role in making financial markets more efficient by reducing information frictions, lowering transactions costs and mitigating the moral hazard. The FSB report10 was released in July and Governor Powell11 has recently described the Federal Reserves plans to support the two primary components of the reform of LIBOR. First, we are considering, in cooperation with the LIBOR administrator and other members of the official sector, ways to broaden the definition of LIBOR to more adequately represent current patterns of bank funding and to anchor it more firmly in observable transactions. Second, we believe it is important for market participants to have access to a range of appropriately created and governed reference rates that best suit their particular business needs. For example, some activities such as interest rate derivatives might be better served with a risk-free or near risk-free reference rate, rather than one that embeds a bank credit risk component. I would like to emphasize three points in support of the FSB recommendations and our own efforts. First, the FSB recommendations make clear that there is not one single path for all jurisdictions to achieve the common objective of more robust and resilient reference rates. Rather, each jurisdiction must take into account its own specific institutional, legal and market practices and arrive at its own best solution. In the U.S., I believe it is important to identify alternative reference rates that are grounded in a strong governance framework as laid out in the IOSCO principles and that are supported by market transactions. This brings me to my second pointgiven a set of robust reference rates that meet IOSCO standards, the choice among these reference rates should be left to market participants who can best identify the specific rate that is most appropriate for a specific business need. Third, the Federal Reserve is committed to working with market participants of all kindsdealers, end users, legal and accounting expertsto help develop robust reference rates that meet the needs of all types of market participants. In addition to these specific efforts around improving and finding alternative benchmarks, the New York Fed is sponsoring other efforts related to the reform of market practices and benchmark rates. The Foreign Exchange Committee (FXC) and Treasury Market Practices Group (TMPG), for example, are two groups of senior market practitioners sponsored by the New York Fed that are working within their markets to identify best practices for trading and behavior related to benchmark rates. Both groups also have published broader sets of best practices for the foreign exchange markets, and for Treasury, agency debt and agency MBS markets. I would ask all market participants to ensure that these and other best practices guide the behavior that we should expect from participants in financial markets.

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. 

…

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.

   ``The relatively modest changes, reforms, related to the Libor panel were anticipated so I was not at all surprised on
where they came out.
     ``As I step back from this I think the mechanism of setting the Libor rate is an enormously important part of our financial system. Even if it says `London' at the beginning of the phrase, it has an enormous effect on U.S. interest rates, including mortgage resets and corporate borrowing.
     ``It has had over the years a record of serving well and with some tweaks and reforms I think it can continue to serve. It would be extremely difficult to move wholesale to a different index.''

From Q&A session with the press, as reported by Bloomberg News