The intent of Libor is to reflect the interest rate that banks pay to borrow in size in the interbank loan market.
Without straying from this original intent, Libor should be based off of actual trades.
The question now becomes how to reopen the interbank lending market to insure a large number of trades?
The way to open the interbank lending market is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.
With this information, banks with deposits to lend can assess the risk of banks looking to borrow. Based on this assessment, banks with deposits to lend can set both the amount and interest rate they are willing to lend to each of the borrowing banks.
This unfreezes the interbank lending market and keeps it open going forward.
Libor, the interest rate at the centre of an international rate-rigging investigation, must not be scrapped hastily and any shift to alternatives should be made gradually to avoid market disruption, a global derivatives industry body said on Thursday....
However, the prospect of changes to a benchmark used as a basis for pricing $350 trillion of products from home loans to credit cards has alarmed the derivatives market, a major user of the rate for its complex financial products.
Stephen O'Connor, chairman of the International Swaps and Derivatives Association (ISDA), said that Libor remains hugely relevant economically and is necessary for the proper functioning of the off-exchange derivatives market.
Replicating Libor across derivatives would be a very large and difficult task, O'Connor told the ISDA's annual conference.
"Libor must continue to be published," said O'Connor, who is also managing director of Morgan Stanley....
Reform of Libor governance and setting was needed, O'Connor acknowledged, but he said that the transition of existing contracts to a new regime must be very carefully planned and managed.
"There are limits to the amount of change that can be accommodated," he said.
Hasty changes might see market participants claiming that the nature of their contracts are different to what was originally intended, which could spark disruptive legal issues.