Home > finance > How do we fix LIBOR?

How do we fix LIBOR?

November 4, 2013

It’s kind of hard to believe, but it’s true: many of the problems that led up to the financial crisis are still with us and simply haven’t been addressed.

For example:

  1. There are too few banks, and they are too interconnected. This is still a huge problem, and it’s called “Too Big To Fail.”
  2. In fact they’re so big they can engage in criminal activity and not fear prosecution. Still true, and it’s got a name too, “Too Big To Jail.”
  3. Also, the credit rating agencies, who get paid by debt issuers for AAA ratings on crappy debt? They’re still alive, there are still only three of them, and they still rate debt.
  4. Also, remember the LIBOR rate manipulations? Still being run by asking individual traders what they’ve been paying recently, and the answers are still being taken on faith. Oh, and they’ve been asked “not be located in close proximity to traders who primarily deal in derivative products” based on Libor. That’ll work, because nobody know how to text!

I’d like to perform a thought experiment for this last one, because it seems like a solvable problem, although I will confess up front that I don’t have a solution off the top of my head. That’s where you readers come in.

Just a little background. LIBOR is (supposedly) the very short-term interest rate that banks pay each other for loans. A huge pile – hundreds of trillions of dollars worth – of derivatives in the form of futures, swaps, and loans are tied to the LIBOR, and most of them seems to reference the three-month rate. Here’s a NY Times graphic explaining how it works and explaining how the fraud played out at Barclay’s.

So what are the attributes of the benchmark that make LIBOR so important and so widely used? And how would we start using something else instead?

Let’s answer that second question first. If we could find another 3-month benchmark rate with good properties, we could start writing contracts based on the new rate from now on, while continuing to compute LIBOR until the existing contracts have played out and LIBOR would be grandfathered out of the market.

Now on to the first question, a list critical attributes of this rate.

  1. It’s supposed to reflect very short-term kinds of risk, which means you don’t want to base it on, say, long term treasuries.
  2. It should be public data, so we don’t have manipulation behind the scenes
  3. But it shouldn’t be based on a market that is so small that it is worth losing money on that small market to manipulate the new LIBOR rates. Remember, the derivatives market that uses that rate is enormous, so if we base the rate on a smallish if transparent market, that would just invite market manipulation for that small market.
  4. The point of LIBOR-based derivatives is that it’s a floating rate, which means that as credit gets tighter or looser so does the rate references in a given derivative. But of course LIBOR is a very bank-specific kind of credit. So it’s not just “as credit gets tighter or looser” but rather “as interbank credit gets tighter or looser” (and here I’m ignoring the manipulation, since when bank credit actually got tighter, it wasn’t actually reflected in LIBOR rates).
  5. So I guess my question is, do we actually want bank-specific credit rates? Isn’t it good enough to have a market-wide concept of credit tightness? For most people who own one side of those LIBOR-based derivatives, I’m sure their own access to credit matters more to them than some London bank’s access, although I’m also sure there’s a relationship between the two.

I’m asking you readers to put up suggestions or explain how we can do without LIBOR altogether.

Categories: finance
  1. November 4, 2013 at 7:40 am

    A number of months ago, I saw a video by a financial professional who mentioned in passing that in the wake of the rigging scandal, the Fed Funds rate was now often being used in place of LIBOR. Unfortunately, I cannot find the video now and do know neither how widespread this practice was nor whether it continues today nor whether other substitutes are being sought. Maybe another reader knows.

    • Recovering Banker
      November 4, 2013 at 8:55 am

      Yes this is correct, standard quotes for many products are now against OIS, whereas formerly the quotes were against LIBOR. OIS quotes themselves are against money market indices (EONIA, Fed Funds effective) which are based on actual market transactions rather than bank offer rates.

  2. FogOfWar
    November 4, 2013 at 9:23 am

    Stop indexing loans and derivatives to LIBOR and start indexing them to T+credit spread, where T is the (very public, very liquid, very difficult to manipulate) 3-month T-bill rate as of reset.

    Nothing stopping Mr. Market from doing this today, in fact, many participants do this if it’s important to them.

    FoW

  3. November 4, 2013 at 9:25 am

    How can we do without LIBOR altogether? Let’s do without the bank currencies altogether. We the people of the world should use a software currency like Bitcoin which we can keep in our pockets and exchange with each other for goods and services. A currency that has no central exchange and nothing for any government to track. Unless they wanted to stop and frisk everyone. (We all know they would really like that because they are kinky) When the banks fail again which is inevitable we at the ground level can still go one living, eating and working for one another.

    Don’t change the rules at the margins, change the game.

    • Terry
      November 5, 2013 at 5:28 pm

      I think that we need to simplify the libor down to simple language. Lets use mobile phones as the example. Hell-o, your contract is up and we can issue a new phone and a new three year contract. Sorry, I can’t renew my contract unless to can match the offer I got from Telus. They offered me five hundred more minutes during the week and one hundred free minutes long distance and no time charge on incoming calls. The Roger’s representative is not aware of what Telus offers. The representative does not even check to see if the customer has been communicating with Telus. There is a delay in the communication between Rogers and the customer. Rogers comes back about two minutes later and agrees to match Telus. What has happened here is the customer has taken advantage of the lack of communication between the mobile phone companies. The Rogers representative has not checked out what the competition is charging. In essence the mobile phone companies are being manipulated by the customer. However the reversal could happen if there were too much communication between the mobile phone companies and price fixing became the norm. I always thought the Rothchilds set the rate every Monday morning at ten a.m. G.M.T.

  4. Deane
    November 4, 2013 at 10:19 am

    i thought the Times article summarized the situation pretty well. It is not hard, I think, to come up with reasonable ways to resolve the LIBOR problem, but since nothing is perfect, Wall Street firms are able to scream loudly about the imperfections and paralyze the whole situation. I have no idea how this can be resolved, especially since it’s an international problem.

  5. cagauss
    November 4, 2013 at 5:50 pm

    T-Bills would be good but they are US dollar based and may not be reflective of international rates. The derivatives and securities based on rates are sold internationally.

  6. Abe Kohen
    November 4, 2013 at 8:37 pm

    I’m an equities guy who used to trade Fed Fund Futures in the past to hedge against interest rate movements. Unlike LIBOR, Fed Funds cannot be manipulated by the banks, but the rate is definitely manipulated by the Fed. See: http://www.newyorkfed.org/markets/openmarket.html

    An alternative to Fed Funds could be a requirement on all banks to report ALL (not just Fed related) overnight repo and reverse-repo transactions (much the way the exchanges have to report trades) and then have some govt agency calculate a notional-amount-weighted average rate.

    (BTW, Cathy, got your Data book from Amazon on Friday. It awaits some premium bathtub reading.)

    • A Friend
      November 4, 2013 at 11:27 pm

      This seems like a good idea. Does there exist an equally active repo market in other major currencies?

    • November 17, 2013 at 2:30 pm

      I agree with this suggestion and blogged it last year: http://expectedloss.blogspot.com/2012/07/libor-and-transparency.html

      • Abe Kohen
        November 17, 2013 at 2:53 pm

        Great minds think alike! I’m not sure why you prefer quotes to actual transactions. I’ld rather see actual time and sales with notional amounts specified. Those are a little harder to game because you can see the actual size of the trade. It can be delayed to alleviate the fears of traders being rapidly hit. And I see no need to involve data aggregators in doing anything but providing a raw unadjusted stream.

  7. November 4, 2013 at 8:50 pm

    A new documentary from the VPro folks came out today “The Wall Street Code”..very interesting as the cast of characters are varied with a HFT company who went bust and what he says…it was beyond his code calculations on what was happening…and I’m sure the Hedge Fund you worked at looked nothing like the one at the end of the video called “The Algo Arms Group”. The more that is public the better of course with LIBOR and that can be said about anything financial. It shows some of the many languages some of these folks are proficient in as well.

    http://ducknetweb.blogspot.com/2013/11/the-wall-street-codenew-documentaryi.html

  8. BM_Geek
    November 6, 2013 at 4:55 am

    There are two distinct groups of professional users of Libor (in all the CHF, EUR, GBP, JPY and USD currencies) – the first being the derivatives traders who can have large P&L sensitivity to the fixing levels and who have been proven to have influenced those levels. The second group is the cash management dealers who, primarily, lend to the banks’ customers at Libor plus a credit spread (student loans, residential mortgages, corporate loans etc. etc.). The regulated isolation of the latter from the former goes a long way to insulating Libor from the derivatives market vested interests. Going forward, the benchmark used by the derivatives markets is of relatively little relevance to Libor-related borrowers. Focusing on the cash management dealers, a Libor submission is effectively the answer to the question “what is the breakeven interest rate on your lending in the [x] tenor and [y] currency at 11:00 (London) today?”. The Wheatley Recommendations require the answer to this question to be substantiated by details of the transactions undertaken by the cash managers, adding Regulatory and Administrator (NYSE) oversight, transparency and certainty to the answers to the Libor questions.

    The replacement of the Libor question with observations of, for example, the OIS, overnight (e.g. fed funds) or repo markets (even if that was possible in all the Libor currencies, which it isn’t) would not create a benchmark suitable for fixing the banks’ lending rates, as none of those instruments reflects the cost of funding a loan book. If the lending rate does not afford the opportunity to breakeven, banks will withdraw from markets in which they are guaranteed to make a loss – like every other business, their obligation to shareholders (and, ironically, to taxpayers while they are still too big to fail) is, being pragmatic rather than idealistic, to be profitable.

    In short, the isolation of Libor fixing from the derivatives market and the enactment of the Wheatley reforms will strengthen the integrity of Libor and will protect the benchmark, and therefore customers of the banks, from manipulation and inaccuracy in the future.

    On the Bitcoin suggestion, BTW, there are central exchanges, and the volatility of the currency suggests to me that manipulation is already rife in those markets. There is also a good chance that any one of the exchanges will go bust and any funds lodged with that exchange will be lost. While not utopian, regulated markets are far safer than virtual ‘wild west’ ones.

  1. November 7, 2013 at 9:40 am
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