Wednesday, June 27, 2012

Libor manipulation could have cost borrowers billions

The first rule of very large numbers is:  multiplying a very large number by a small number results in a large number.

When it comes to manipulation of the Libor interest rate, we are talking about small number.  When we are talking about the value of the financial instruments that reprice off of Libor we are talking about a very large number.

By applying the first rule of very large numbers, we know that the result of the manipulation will be a large number.

According to a Telegraph article,

The British and US authorities said they had found evidence Barclays had attempted to manipulate a key borrowing rate for years, meaning that home owners could have paid millions more in mortgage payments than they might otherwise have had to. 
Traders at the bank were discovered to have engaged in regular attempts to determine the London Interbank Offered Rate (Libor) from as early as 2005. 
The manipulation of Libor saw the bank make submissions to the setters of the rate that they knew to be wrong as they attempted to influence the level at which it was fixed. 
Barclays also attempted to suppress Libor, which means that savers could have potentially lost out on millions in interest due to the rate being lower than it should otherwise have been.
Please re-read the highlighted text as by itself it shows why the only way to restore confidence in Libor going forward is to base it off of actual trades.

Trades that are disclosed as part of each bank providing ultra transparency and disclosing on an on-going basis their current asset, liability and off-balance sheet exposure details.

By requiring the banks to disclose all of their liability details, banks are prevented from manipulating Libor by cherry-picking one or two trades.

By requiring the banks to disclose all of their liability details, market participants can do a better job of assessing the true cost of funds to the banks.  For example, they might take the average cost of funds for all trades or they might take the average cost of funds for trades after excluding the most expensive and least expensive trades.

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