Friday, August 10, 2012

Pre-results of Libor review: base Libor on actual trades and interpolate rates for maturities with no trades

According to a Reuters article, Martin Wheatley, the individual in charge of the UK's Libor review, will recommend that Libor be based off of actual trades and where no trades exist for a given maturity that the interest rate for that maturity be interpolated from maturities that do have trades.

Regular readers will recognize that these recommendations are part of the simple fix for Libor proposed by your humble blogger.

What remains to be seen is just how much transparency Mr. Wheatley recommends.

I have recommended that banks provide ultra transparency and disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details.

This information is necessary if the interbank lending market is to unfreeze and remain unfrozen.  It is the information that banks with deposits to lend need to assess the banks looking to borrow.

In addition, this is the information needed so that Libor can be based off of actual transactions.

In future, fewer transactions are likely to be based on the London interbank offered rate (Libor) and regulation could be tightened for all financial benchmarks, including those for oil, gold and stock prices, Martin Wheatley, managing director of the Financial Services Authority, told Reuters. 
On Friday, he is due to publish his review of Libor at the request of the British government.... 
"Whatever the improvements made to Libor, we will want to consider alternative benchmarks for at least some of the types of transaction that currently rely on Libor," Wheatley said. 
It was impossible to replace Libor straight away because so many contracts were linked to it and it might not be possible to replace completely because alternatives are not perfect, he said. 
Other changes he suggested included basing Libor rates on actual trades rather than bank estimates. When there aren't changes for a specific rate - a particular problem for longer-term rates - rate setters could use "interpolation" based on the more frequently traded short-term rates....
The industry will have until Sept 7 to respond to the so-called Wheatley Review with final recommendations to be made by the end of next month. Some of those are expected to be enshrined in a new law next year.... 
The tougher regulation for benchmark interest rates could be extended to stock market indexes and benchmarks for commodity prices, Wheatley said. Although stock indexes are based on trades, the others are often set by panels and less transparent. 
"It's the slightly more esoteric ones that have become very important in global markets like gold and oil and other commodities where they are not subject to price or other regulatory oversight," Wheatley said....
Bank of England governor Mervyn King said on Wednesday that Libor had ceased to work and a fix was needed. 
Wheatley said supervision of Libor could be handled by a "college of supervisors" from across the world -- a system common for cross-border banks -- with Britain in the chair.
Finally, ultra transparency provides the information that the college of supervisors needs if it is to monitor Libor.

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