Thursday, June 28, 2012

'Manipulating Libor is manipulating the price of money itself'

In his Telegraph column, Damian Reece explains the true implications of Barclays admitting that it manipulated the Libor benchmark interest rate means:

Libor – the London Inter Bank Offered Rate – is the primary market rate of interest. The Bank of England sets the official policy rate but Libor is the actual cost to a bank of borrowing unsecured funds from one another overnight. Without that flow of funds the financial system doesn't work. 
Please note that the interbank unsecured lending market froze at the beginning of the financial crisis.  It froze because in the absence of ultra transparency no bank could determine which banks were solvent and which banks were not and as a result they were unwilling to lend.

One of the reasons for requiring banks provide ultra transparency and disclose all of their exposure details is to prevent the interbank unsecured lending market from freezing in the future and keeping the financial system working.
That's why interest rates on subsequent loans of any shape or size are set at a margin above Libor. It's where the market pricing of money, or credit, begins. 
And given these loans become tradeable assets in themselves, with a multitude of derivative contracts – or financial bets – attached to them, Libor is used to price these markets too. It's the rate of interest charged at the very base of the financial pyramid. 
US regulators on Wednesday gave a useful sketch of what that global pyramid looks like and why Libor is so important. At the apex it reckons there are loans worth $10 trillion (£6.4 trillion) priced off Libor. There are then interest rate swaps (derivatives which are insurance against adverse interest rate movements) worth $350 trillion, also priced with reference to Libor, and then at the base of this tower eurodollar futures (short-term loans which are also bets on interest rate movements) worth $564 trillion.
Based on the US regulators pyramid, the value of any change in Libor is calculated by multiplying the change in Libor by $900 trillion by the number of days the change occurs over divided by 360.

If Libor moves up or down by 1/100 of 1%, otherwise known as 1 basis point, we are talking $90 billion on an annualize basis.

This is a really big number.

Said another way, look at the size of the incentive to move Libor by say 3 basis points.  We are talking over $250 billion or a quarter of a trillion annually!  Even by government standards, we are talking about real money.
Given this, it's surprising that setting the rate for Libor is unregulated. But it's not even subject to the full forces of the free market either. It emerges from a 16-strong cartel of banks which, as we now know, was ripe for abuse. 
Regular readers are not surprised that Libor is unregulated.  They know that it is another example of the regulators allowing the banks to bring opacity into the financial system.

Had the regulators required banks to provide ultra transparency, Libor would not have been ripe for manipulation.  Instead it would have been based off of actual trades from the beginning.
By manipulating Libor, up or down, Barclays could variously make profits on its own interest rate punts or give a dishonest impression to the market of its own cost of funding. It was, according to its own staff, "being dishonest by definition". 
It can't get much worse. Except it can, because Barclays is just the first bank to settle. 
There's a string of Libor-related cases about to break, that will drag a number of household names into a scandal. The fines meted out to Barclays totalling £290m ($452m) will surely top $1bn before regulators are through.

Since the cost of manipulating the benchmark interest rate is a small fine which pales in comparison to the value of manipulating Libor, it would be surprising that banks did not manipulate the rate from Day 1.  The regulators were able to track manipulation back to at least 2005.

This fine is a trivial cost of doing business.

At this point, there is only one way to restore confidence in the global financial system.  That is to recognize that sunshine is the best disinfectant and shine it onto all of the opaque corners of the financial system.

Your humble blogger would recommend that we start with the banks and structured finance securities.

Given the Libor Scandal there is no excuse for the global financial regulators not to require banks to provide ultra transparency or require structured finance securities to provide observable event based reporting effective immediately.

Every day the global financial regulators fail to do so will be another day that erodes investor confidence in the markets.

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