After a series of scandals (see here a good summary) related to the rigging of the so called LIBOR rate (London interbank offered rate which is published over serveral tenors (1m 2m, 3m, etc.) and which works as a benchmark to the cost of unsecured borrowing in 10 different currencies over different time periods that banks face) there is reform approaching. There are two papers worth reading on the subject: The first one is a discussion paper made public on August 10th, 2012. It is called "The Wheately Review on Libor: Consultative Document". The second one is called "The Wheately Review Of Libor: Final Report.". A short summary of both document follows (mainly on the first, the second one is just the conclusions of the fist one) for all those not interested in going over the details but curious about what they are about.
The Consultative Document
The first document is, as the name implies, a document aimed at getting feedback from the market paricipants, it is orgainized in the following four sections: 1. Issues and failures withing the current LIBOR process. 2. Options to strengthening the LIBOR. 3. Could the LIBOR be replaced? 4. What lessons can be extraplated to other benchmarks used in the financial markets.
In regards to point one, the document highlights four mayor reasons why the LIBOR is in crisis: a. The unsecured lending market has become smaller after the crisis since alternative forms of funding have increased in importance: secured borrowing, retail depositis and liquitidity provided by central banks have increased in importance. b. Quote submitters are not independent market data providers, but market participants and hence have a conflict of interest. c. Given a., market quotes are many times not transaction based, but based upon judgement, which together with b., make the self-policing method unreliable. d. Given the previous three points, stronger independence and transparency is recomended.
The document then goes to tackle its core task: how to strenghthen the LIBOR? Here the document gives several ideas as to what can be done without choosing anything in particular. The main points of this section are the following ones: 1. Move away from a system based upond judgement and inference from one based upon actual money transactions like it is already the case in other benchmarks like the SONIA (Sterling Overnight index rates) which is a weighted average of interest rates from actual overnight unsecured sterling transactions. 2. Institute a procedure so that individual submissions are corroborated, i.e. challenged. 3. Widen the definition of the LIBOR rate so as to include all wholesale deposits rates. 4.Narrrow the scope of the LIBOR with less currencies and maturities covered. 5. Reduce the vulnerability to manipulation. For this, they propose the following: a. Restrict the publication of individual submissions to an oversight body and delay or agregate the daily publication of individual submissions. Note that this course of action would in fact reduce transparency as, and the comitte acknowledges this .b. Use the median instead of the median as is the current practice. c. Similar to b, change the method of calculation of libor towards one that is less prone to rigging. 6. Finally, the documents starts talking about institutional reform, it is hard to follow if you are not familiar with British regulatory framework as it is my case, so I'll leave this with their intented objective: strenghten the independence, transparency, oversight and criminal sanctions regime.
Could the Libor be changed? Here the document is very honest in their powers to move the market towards a new benchmark by mentioning an impressive statistic: there are around 300.00 trillion USD in notionals outstanding in the market referenced to LIBOR. Notwithstanding this they give a brief overview of other potential instruments to be used as substitutes. 1. Central Bank Policy Rate (e.g. Fed Fund Rate). This is the target insterest rates that central banck use for conducting monetary policy and is what they pay to member banks on reserves held at them. Banks usually do not trade among themselves at that rate. 2. Overnight unsercured lending. It is the market representation of the previous one. This form of lending has increased since the begining of the financial crisis, however, since it is overnight, is not possible to draw a maturity curve out of it and has little or not credit and liquidity risk embedded into it. 3. Certicates of Deposit (CD's) or Commercial Paper (CP's). Banks issue them to raise their cash funding needs, however they are low on trading volume and have been negatively affected by the crisis.4. Overnight index swaps (OIS). This one my personal favorite, these ones are interst rate swaps between a fixed and an overnight cash lending rate over a specified period of time. Transactions in the swap market can then be used to generate a maturity curve for overnight rates. Its drawback is again its depth, as it is currently not considered to be liquid enough. 5. Treasury Bills (T-Bills). The yield of this high quality short term debt securities could potentially be used as alternative. 6. Repurchase agreements (Repo rates). These are the rates paid by transactions of collateralized lending, Its biggest drawback is the short maturity of these transactions. '
Implications for other benchmarks. Finally this first document finishes by mentioning that there are plenty of other benchmarks which could benefinit from the Libor experience. The first one they mention is the Spot Oil Market where the Oil Price Reporting Agencies (PRA's) are privately owned and where publishers rely on information voluntarily submitted by market participants. The other benchmarks mentioned by the document are the plethora of interest rate indices in other markets where the submisison of market information is also done voluntarily by privately held companies. Examples are the EURIBOR, TIBOR, etc.
The Final Document
This one contains the main conlcusions reached after the consultation process and the steps to be followed, it has a lot of overlap with the first and is not as interesting to read, but the main conclusion are the following ones: 1. The review favors reforming rather to replacing the LIBOR benchmark. The main argument in reaching this conclusion is the widespread usage of such index. 2. Transaction data should be explicitly used to support LIBOR submissions. The number of tenors and currencies is limited to make this a more transparent process. For day to day practicioners this will mean they will be now interpolating among the available tenors. 3. Market participants should continue to play a significant role in the production and oversight of the LIBOR, but note that from now on individual submissions will only be made public after a three month period. This apparently has the objective to diminish one of the incentives institutions have in submitting "bad" quotes: signalling the market their creditworthiness. How this is a bad idea is not clear to me.
The rest of the document dwells into the new regulations to be instituted as well as the new institutions that will be carrying out such a job. Not interested in copying-pasting the rest of the article, so I'll leave it here.
