Saturday, June 30, 2012

Fixing LIBOR

The recent scandal with Barclays (which, rumours suggest, may soon spread) rigging their LIBOR submissions to enrich themselves and mislead investors, according to the FSA, has exposed some rather strange features of the system.

By far the biggest use of LIBOR is to set the value of EuroDollar (US dollars held outside the US) futures traded on CME. Each of these ED futures contracts represent the interest on a notional $1m loan for three months, and over 1.5m such contracts are traded every day - $400 trillion of notional lending per year.

The settlement price of a ED future is determined from the LIBOR fixing on the second business day before the third Wednesday of the delivery month, which means that they are equal to LIBOR at settlement, and very close (and converging) before that.

So why fix ED prices on LIBOR rather than the other way around?

Here we have an extremely liquid market, of synthetic loans with zero counterparty risk, which is arguably the definitive price of borrowing money. Why are we not using the well-honed pricing mechanism of that market?

During the financial crisis, Barclays reduced its LIBOR submissions from the actual rate at which it was borrowing (paras 12-14, 102-145 in the FSA report) to avoid media speculation about its financial position. On the other hand, the ED futures market is independent of the creditworthiness of the LIBOR submitters as the loans are never disbursed, only the interest which would be paid if they were, so this source of stress is simply not present. In a credit crunch, lenders (ED buyers) will back off, forcing sellers (borrowers) to lower prices (increase rates, and pay more interest), but not in a way related to the creditworthiness of a particular counterparty, only to the market in general.

Is this not exactly what we want to see in a published interest rate figure?

The ED futures price is determined by a liquid market, independent of the creditworthiness of any particular bank, and provides a yield curve in quarterly increments out to 10 years. Surely this is what we should be using instead of having a small panel of bank representatives "exercise their subjective judgement" to determine "rates at which money may be available in the interbank market" (FSA report, para 30)?

The market is already there, we're just not using it for historical reasons. This scandal has shown that, as ever and always, concentrating power in the hands of a few individuals leads inexorably to corruption. Let the sunlight in, and determine LIBOR from EuroDollar futures prices - not the other way around.

- KoW

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