By Douwe Miedema and William James

LONDON, March 8 (Reuters) - An arcane system at the heart of a global investigation into whether banks colluded in setting interest rates may endure simply because it is so deeply embedded in trillions of dollars' worth of financial contracts.

The London Interbank Offered Rate, known as Libor, is a daily poll that asks a group of banks at what rate they think they will be able to borrow. The rate is supposed to reflect the level at which banks lend to one another.

Despite the club-like way in which it is determined, Libor is the benchmark for some $360 trillion worth of financial products such as loans, derivatives, mortgages, bonds and interest rate swaps - causing a headache for regulators who are looking into claims the rates may have been fixed.

"As soon as you've got a load of deals that are tied to one benchmark, then it's extremely difficult for banks to change to another benchmark," said Nicholas Motson, financial lecturer at CASS Business School in London.

"If someone's issued a 10-year bond that's tied to Libor then you can't switch part-way through," he said.

Since the start of the banking crisis in the middle of 2007, banks such as Citigroup, HSBC, RBS and UBS have been approached by watchdogs investigating how Libor is set. Several have suspended traders - though there have so far been no criminal charges.

The investigations are examining whether traders at the banks tried to influence whether the rate went up or down, which could mean a windfall of tens of millions of dollars if a trader has bet correctly on the direction of Libor.

As a result, market participants have been brainstorming for months to figure out a way of reforming the rates, according to one senior figure active in the market, who asked not to be identified because the probes are ongoing.

FIT FOR PURPOSE?

One of Libor's most obvious flaws is that there is almost no actual basis for many of the rates, because banks have been so twitchy about lending to each other since the financial crisis.

Some traders said that Libor dollar rates were quoted as much as 150 basis points below market rates in October 2008 when in the wake of the collapse of Lehman Brothers, banks struggled to convince markets about their creditworthiness.

While conditions have calmed somewhat since, the basis for the fixing still factors in more hunch than data.

Libor rates are set for different currencies based on different panels of banks - which may contain as few as seven members - by asking them at what rate they could borrow funds "in a reasonable market size".

The banks provide answers for lending of up to one year which are then averaged, with the highest and lowest excluded. Based on these submissions, Thomson Reuters compiles the rate on behalf of the British Bankers' Association.

The British Bankers' Association (BBA), which establishes the parameters for Libor, has hired consultants to see if the rate is still fit for purpose, Reuters reported in February.

The BBA said on Wednesday it was "committed to retaining the reputation and integrity" of Libor following a meeting with banks to consider the implications of new bank regulations being imposed globally with the aim of reducing risk in the system.

The meeting triggered speculation that the Bank of England - which under a planned supervisory shake-up will regulate banks from 2013 - could wrest control of Libor.

ALTERNATIVES

Against the sentiment-driven interbank rate others such as the Euro Overnight Index Average (EONIA), a benchmark for overnight lending in the euro zone which is based on actual trades, have been growing in popularity.

EONIA and its sterling equivalent SONIA only exist for overnight cash, but they could function as a reality check for LIBOR if available in maturities of up to one month, say some market operators.

"EONIA and SONIA (measure) what banks are really doing. There's definite merit in that and that's why those indices have gone from being a niche area when they were launched to become clear benchmarks now," Motson said.

Other suggestions have included measuring short-term lending between banks based on deals in the market for short-term secured borrowing -- or repo trading -- where banks get cash in return for a financial asset such as a bond.

One such benchmark is the Eurepo rate, which is sponsored by the European Banking Federation. But there are no overnight repos, because the underlying collateral cannot technically be settled at such short notice.

So investors keep coming back to Libor. While the fixing may seem opaque at times, a cash benchmark is far easier to understand than repo rates, which can have differences in collateral as diverse as German or Greek government bonds.

And with concern about the state of Europe's liquidity and debt levels still very much present, some think the sentiment underpinning Libor makes it most relevant for uncertain times.

"It tends to capture some of the intrabank tensions that are absent from purely looking at overnight interest rates," said David Page, an economist at Lloyds Bank in London.

• A Permanent Economic Emergency