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Monday, 28 July 2014

A world without Libor or interest-rate derivatives

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The scandal poses some serious questions about the shape of markets, says IFR editor-at-large Keith Mullin

IFR Editor-at-large Keith Mullin

IFR Editor-at-large Keith Mullin

IS LIBOR FINISHED as a benchmark? Maybe. Are composite rates created using short-term interbank loans the most relevant benchmarks on which to base non-bank borrowing in the capital markets? Not necessarily. What would happen if there were no floating rates and everything was based on spreads over official policy rates? Not sure. Would the world come to an end if there were no interest-rate derivatives? No.

We often forget that most of the trappings of today’s financial markets are relatively recent. The first floating-rate note was issued by Enel as late as 1970 and the swap market was only created in late 1979. The first swapped bond was a DM60m issue from Roylease, guaranteed by the Royal Bank of Canada, which was swapped two-thirds into Canadian dollars and one-third into US dollars. The exponential growth of the interest-rate swap market took place through the 1980s; pricing bonds over mid-swaps has been much more recent; while Libor only got going in 1986.

What’s going on around Libor has certainly posed some fundamental questions about the shape of today’s financial markets. The markets of the 1970s and before were no more dysfunctional for their lack of modern-day tools and instruments. We may have gained sophistication but it came accompanied by convolution.

The Financial Stability Board has entered the fray on Libor and is looking at either reforming it or coming up with alternatives; repos and OIS are out there as possibilities. Certainly, if the way Libor is constructed doesn’t change and switch to a composite of traded rates, it will be finished as a benchmark. And rightly so.

Claims, counter-claims and general obfuscation have rendered the exercise futile

UK regulators and the British Bankers’ Association have been dragging their feet for years on imposing reforms. I fail to understand why the BBA doesn’t pursue the idea of using actual trades as a basis. The concern most often expressed is that there’s no guarantee that a sufficient number of banks will borrow in all Libor currencies across all maturities every day. Fine, well expand the panels. The biggest Libor panel is the US dollar panel, with 18 banks. Euribor, by contrast, has 43 contributing banks.

Mervyn King, governor of the Bank of England, favours the actual trades approach. At his Treasury Select Committee hearing, he referred to the notion that there will always be a benchmark interest rate against which to fix derivatives as an illusion.

HAVING WATCHED or read transcripts of pretty much all of the soap opera that the Treasury Select Committee hearings into Barclays and Libor have become, I don’t really feel any more informed than I did before the sorry affair began. Claims, counter-claims and general obfuscation have rendered the exercise futile.

What is clear, however, is the Bank of England, Financial Services Authority and British Bankers’ Association have been made to look like a trio of dangerously inept buffoons who were asleep at the wheel. The Bank and FSA repeatedly denied knowledge of any wrongdoing around Libor submissions until recently and did very little in the face of media coverage from 2008 that the fixings were unreliable. Their testimony was scarcely believable.

Neither Mervyn King, BoE deputy governor Paul Tucker nor FSA chairman Adair Turner came out of the hearings in glory. King – irritable, pompous and making little effort to hide his general disdain towards the whole thing – constantly hid behind the UK’s tripartite regulatory set-up and used the fact that during the period in question the BoE lacked supervisory powers to bat blame and responsibility away from himself and the Bank. It’s also pretty clear that King merely forwarded the 2008 communication he received from Tim Geithner about Libor rigging to the BBA without really taking its contents seriously or following up.

THE MULTIPLE EXAMPLES of rigged Libor submissions contained in excerpts of emails and phone transcripts between Barclays derivatives traders and Libor submitters that were discovered in the US Department of Justice and CFTC investigations are shocking. They portray an industry of sleazy, immoral chancers acting with impunity and no management oversight. And it clearly wasn’t just Barclays, evidenced by the cabal of banks under investigation and evidence of collusion between Barclays traders and traders at other banks.

The Commodity Exchange Act, which Barclays violated, is crystal clear that it’s a felony to attempt to manipulate the price of any commodity, knowingly deliver false, misleading or inaccurate reports concerning market information or conditions that affect the price of any commodity.

What’s less clear is whether Paul Tucker told Barclays to lower its Libor submissions in 2008. If anyone’s got a smoking gun, though, it’s Tucker. Only he really knows what he meant when he spoke to Bob Diamond, but his testimony lacked credibility. He certainly didn’t intend Barclays to violate any laws, but in the panicked market of late 2008, was he wrong to have made the call? It’s questionable. I can’t think what impression he was expecting to leave other than Barclays lowering its submissions.

His clarification in testimony, that Diamond’s file note of the conversation “should have said something along the lines of, ‘Are you ensuring that you, the senior management of Barclays, are following the day-to-day operations of your money market desk, your treasury? Are you ensuring that they don’t march you over the cliff inadvertently by giving signals that you need to pay up for funds?’” doesn’t change that impression.

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