Tainted Libor Guessing Games Face Replacement by Real Trades
The London interbank offered rate, the benchmark for $360 trillion of securities, may not survive allegations of being corrupted unless it’s based on transactions among banks rather than guesswork about the cost of money.
“The methodology used to formulate Libor is totally unsuitable for the modern world,” said Daniel Sheard, chief investment officer of asset manager GAM U.K. Ltd., which manages about $60 billion. “The British Bankers’ Association needs to come out on the front foot and say ‘this is a system that was appropriate 20 years ago but is no longer appropriate and we are going to change it.’”
The BBA, the lobby group that has overseen Libor for 26 years, is under pressure to find an alternative way to calculate the benchmark, or cede control of it. Regulators from Canada to Japan are probing whether banks lied to hide their true cost of borrowing and traders colluded to rig the benchmark, the basis for interest rates on securities from mortgages to derivatives.
“It can’t be beyond the wit of man to come up with a rate that is based on actual trades rather than guesswork,” said Tim Price, who helps oversee more than $1.5 billion at PFP Group LLP, an asset-management firm in London. “The idea that you can trust the banks and the BBA with this is laughable.”
Libor, a gauge of how much it costs banks to borrow from one another, is so deeply embedded in the financial system it can’t be replaced without potentially voiding existing contracts, academics said. The BBA may instead overhaul Libor by making banks base their submissions on actual trades, open submissions to independent verification and increase the number of firms that set the rate, investors said.
“You might be able to call the new benchmark Libor, but because it’s not exactly the same measure, would that invalidate all these thousands and thousands of contracts?” said Donald Mackenzie, a professor at the University of Edinburgh who specializes in the sociology of financial markets. “It’s difficult to see that you can do much more than what the BBA is already trying to do in terms of trying to improve an estimate-based measure.”
The BBA is reviewing potential changes to the benchmark and met regulators and bank executives last week. The rate is set through a daily survey of firms conducted on behalf of the BBA by Thomson Reuters Corp. in which banks are asked how much it would cost them to borrow from one another for 15 different periods, from overnight to one year.
Because banks have to submit a rate when no market exists, and their estimates aren’t subject to outside verification, the benchmark is vulnerable to manipulation, investors said.
The U.S. is conducting a criminal investigation into suspected manipulation of benchmark rates including Libor, the Justice Department said in a letter to a federal judge that was made public earlier this month. The European Union, the U.K. Financial Services Authority and the Monetary Authority of Singapore have all started their own probes.
The BBA will shortly start a “technical” discussion with Libor users and will update the FSA, Treasury and Bank of England as it progresses, the group said in an e-mailed statement. Brian Mairs, a spokesman for the lobby group, declined to comment further.
One way of restoring confidence would be for the BBA or regulator such as the Bank of England’s proposed Prudential Regulatory Authority to check that the rates submitted by banks correspond with actual trades made by those firms on any given day. Firms that misstate their cost of borrowing could be fined or forced to compensate investors.
‘Lack of Confidence’
Godfried de Vidts, president of Euribor-ACI, a lobby group that represents about 5,000 money-market traders in the euro area, made such a proposal to BBA Chief Executive Officer Angela Knight in July 2008, when the group last reviewed how Libor is set after the Bank for International Settlements said banks may have been wary of revealing their real borrowing costs.
“There has been a clear lack of confidence in the monitoring of the Libor fixings,” de Vidts wrote in the letter, published on the group’s website. “To make the scrutiny mechanism more efficient and trustworthy local independent supervisors should carry out periodical controls on contributions.”
The BBA should also increase the number of banks that submit the rate to make it more representative and less open to claims of manipulation, said Christoph Rieger, head of fixed-income strategy at Commerzbank AG in Frankfurt.
Libor would be more reliable if banks were allowed to make their submissions anonymously, Rieger said. That would reduce the incentive on banks to under-report their borrowing costs to appear stronger to investors, he said.
Such a move would also bring Libor closer into line with Euribor, the rate at which European banks say each other can lend in euros. While 15 banks set yen Libor and 18 set dollar Libor, 44 set the Euribor equivalent.
Euribor rate-setting banks are asked each day in a survey how much a “prime bank,” rather than themselves, would pay to borrow euros for different maturities. The results are collated and published by Thomson Reuters on behalf of the European Banking Federation, the BBA’s Brussels-based equivalent. Bloomberg LP, the parent of Bloomberg News, competes with Thomson Reuters in selling financial and legal information and trading systems.
ICAP Plc (IAP), the biggest broker of transactions between lenders, started the New York Funding Rate, a measure of U.S. bank rates, in 2008. The measure is based on a survey of how much contributors estimate a “representative” lender would pay to borrow each day.
Some firms are already turning away from Libor and using alternative rates to price trades. Barclays Plc, Britain’s third-biggest lender, said in its annual report last week it’s increasingly using the overnight indexed swap rate, a gauge of expectations for central bank rates, rather than Libor as the basis for prices on collateralized derivatives.
The London-based lender is switching to the “more relevant” overnight indexed swap rate “in line with changes in market practice,” the bank said in the filing. A Barclays spokesman declined to comment beyond the document.
Overnight indexed swaps are over-the-counter traded derivatives in which one party agrees to pay a fixed rate in exchange for the average of a floating central-bank rate over the life of the swap. For dollar swaps, the floating rate is the daily effective federal funds rate, for euros the euro overnight interbank average rate, and for pounds the sterling overnight interbank average rate.
Rates based on recorded trades such as Eonia and Sonia are gaining in popularity, said Mikhail Chernov, a professor of finance at the London School of Economics. The Eonia and Sonia indexes are weighted averages of the cost for banks to borrow from one another overnight in euros and sterling. The gauges are based on weighted averages of all overnight unsecured lending trades in the interbank market and are compiled by the EBF and the Wholesale Markets Brokers’ Association, a London-based industry group.
Using a transacted rate as the benchmark instead of Libor carries its own problems, analysts said. In times of stress, only the most creditworthy banks would be able to access the short-term money markets, skewing the aggregate figure lower, said Joseph Abate, a strategist at Barclays in New York. Volume data as well as price data should be referenced to measure unsecured funding costs, he said.
The BBA has changed Libor before. Before 1998, the question banks were asked was “At what rate do you think interbank term deposits will be offered by one prime bank to another prime bank for a reasonable market size today at 11 a.m.?” That year, it changed to “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 a.m.?”
The switch, which forced banks to provide estimates of their own cost of funding, had the “advantage of linking the figures submitted by banks to their own activity,” the lobby group said on its website.
After the 2008 review, the BBA increased the number of banks on the dollar Libor panel to 20 from 16. Two firms have since quit the panel. Lenders were also asked to justify any discrepancies between their submissions and their competitors.
John Ewan, the BBA executive responsible for managing the process by which Libor is set, said that Libor couldn’t be more radically changed because the group has a duty to all users of the rate -- including borrowers.
“We have a duty to all users, including those who have taken out agreements with life-spans of decades into the future based on a benchmark that they think they understand,” he said in a July interview. “If we suddenly switched the benchmark radically, that may give them problems.”
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