Tuesday, June 26, 2012

Surprise! Banking group overseeing Libor resists change despite manipulation of rate

Bloomberg reports that

The U.K. bankers and regulators charged with reviewing Libor in the wake of regulatory probes are resisting calls to overhaul the rate because structural changes risk invalidating trillions of dollars of contracts. 
The group, established by the British Bankers’ Association in March after probes into allegations that traders rigged the London interbank offered rate, may propose a code of conduct for banks and impose greater scrutiny of Libor’s correlation with other financial data over time, according to three people with knowledge of the discussions who asked not to be identified because the talks are private. 
It won’t propose structural changes such as basing the rate on actual trades or taking away oversight of the benchmark from the BBA, the people said. 
Libor is determined by a daily poll that asks banks to estimate how much it would cost them to borrow from each other for different timeframes and in different currencies.
This is a solution that preserves the current flawed method for calculating Libor for no apparent benefit.  

Market participants assumed that Libor reflected what it actually costs banks to borrow from each other for different timeframes and in different currencies.  Market participants didn't assume that Libor was unrelated to what it cost banks to borrow from each other and rather was a made up rate designed to maximize bank profitability.

As a result, your humble blogger suspects that the 'potential' for invalidating trillions of dollars of contracts is a fear based lobbying effort with no basis in reality. After all, doing nothing now that Libor has been exposed as manipulated should also require invalidating trillions of dollars of contracts given they were based on the assumption of that Libor reflected reality.
Because banks’ submissions aren’t based on real trades, academics and lawyers say they are open to manipulation by traders. At least a dozen firms are being probed by regulators worldwide for colluding to rig the rate, the benchmark for $350 trillion of securities. 

It is not surprising that the Opacity Protection Team is objecting to replacing how Libor is determined.  Currently, the banks can use opacity and easily manipulated the rate for their benefit. 

Regular readers will recall that your humble blogger pointed out that basing Libor off of real trades is easily done under ultra transparency (where banks have to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details).  Not only can Libor be based off of real trades, but the ability of market participants to confirm the pricing of these trades immediately restores confidence in Libor.

“I don’t see a significant enhancement to the reputation of Libor without basing it on actual transactions,” said Rosa Abrantes-Metz, an economist with Global Economics Group, a New York-based consultancy, an associate professor with New York University’s Stern School of Business and the co-author of a 2008 paper entitled “Libor Manipulation? 
“It would only be disruptive if current quotes are inaccurate,” so resistance “is suspicious,” she said.
A move to a benchmark based on actual transactions could be gradual, and a change shouldn’t result in major disruption as long as banks’ submissions reflected their true borrowing costs, she said.

Please re-read the highlighted text as Ms. Abrantes-Metz nicely summarizes what your humble blogger has been saying about Libor.
“Keeping things as they are would leave a lingering cloud over the benchmark,” said Daniel Sheard, chief investment officer of GAM U.K. Ltd., an asset manager that oversees about $60 billion. “I am yet to hear a valid argument for why it can’t be based on actual trades. Given the huge number of transactions that use Libor as a reference, it is very important to re-establish credibility.”
Please re-read the highlighted text as Mr. Sheard has summarized and offered support for my proposal for fixing Libor.


“Sadly the response looks to be very consistent with the response of policy makers to the banking disasters we’ve seen over the last four years -- cosmetic changes, but nothing substantial happens,” said Richard Werner, a finance professor at the University of Southampton. “It’s insufficient and doesn’t really go to the heart of the problem.”

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