Tuesday, March 13, 2012

Libor 'guessing games face replacement by real trades'

A Bloomberg article reports that the discussion for how to fix Libor and end the ability of banks to manipulate this rate is focusing on requiring the banks to report their actual trades.

The driving force behind this solution is the buy-side.

Regular readers know that your humble blogger recommended this solution.  It was one of the benefits of requiring banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

To implement this solution requires the creation of a Deposit data warehouse.  This data warehouse would collect for each bank every one of its trades.  This data would then be made available to all market participants, including the British Bankers' Association and Thomson Reuters, who could use it to calculate Libor.

One of the reasons for creating the Deposit data warehouse is that it is easy for each bank's auditors to confirm the accuracy of each bank's data in the data warehouse.

As the conflict of interest free coordinator for the Deposit data warehouse, your humble blogger's firm would oversee the development and on-going operation of the warehouse.

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.”...
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....
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.... 
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.
The deposit data warehouse would facilitate this.
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.” 
With the deposit data warehouse, the identify of the banks can be hidden while at the same time ensuring that the data ties out to each bank's audited financials and therefore is trustworthy.
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....
The Deposit data warehouse could be extend for Euribor and the Asian market equivalents.
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...
Using actual trades eliminates the need for banks to provide estimates and answers the question:  "at what rate did you borrow funds?"
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.”
The problem with the benchmark is it was suppose to reflect the banks' actual experience and not a manipulated number.  Using actual trades is radical in that it eliminates manipulation.

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