Wednesday, September 26, 2012

Libor reform should not be a 'tricky balancing act'

Only in a world where complicated regulations and regulatory supervision are routinely substituted for transparency is reforming Libor by basing it on actual transaction viewed as a 'tricky balancing act'.

The Telegraph ran an article suggesting that substituting transparency for either the current opaque, manipulated manner in which Libor is set or the combination of complicated regulation and regulatory supervision could disrupt the market.

Under the FDR Framework, governments and their regulators are given the responsibility for ensuring that market participants have access to all the useful, relevant information they need in an appropriate, timely manner so they can make a fully informed investment decision.

Given this responsibility, the only thing that the regulators need to do to reform Libor is to require that the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, the interbank lending market unfreezes and remains unfrozen as banks with deposits to lend can assess the risk on a continuous basis of banks looking to borrow.

With this information, market participants can calculate Libor rates using all or some subset of the actual transactions.  As a result, Libor truly reflects what it costs banks to borrow money.

With this information, market participants can chose if and how they want to handle setting a Libor rate for maturities which have few transactions.
Derivatives, banking and asset management industry sources say the UK's financial watchdog has a tricky balancing act to win back confidence in the London Interbank Offered Rate, that was rigged by Barclays and other banks. 
Martin Wheatley, the Financial Services Authority's managing director who has warned banks to clean up their act, faces global calls for speedy reform of the Libor rate as well as pressure from cautious users who are resisting radical change. 
Mr Wheatley is expected to recommend on Friday the use of actual market trades rather than quotes to compile Libor and to formally end the role of the British Bankers' Association (BBA) in overseeing it in favour of more formal regulation....
Hopefully this is done using a formal regulation that requires banks on the Libor panels to provide ultra transparency.
His biggest challenge will be how fast and far to change Libor's composition by including actual market transactions....
Gary Gensler, chairman of the U.S. Commodity Futures Trading Commission (CFTC), which fined Barclays in June, is pressing for swift changes, saying Libor should simply be based on actual market transactions. 
"If benchmark rates don't have transactions to rely on, the credibility and reliability of the benchmark is limited," Gensler told the European Parliament on Monday.
So the solution to the challenge is to include actual market transactions as quickly as possible.
Users of Libor fear market disruption. 
"It's critical that we restore market confidence in Libor by evolution rather than revolution. We don't believe a single alternative benchmark can replace Libor," said Joanna Cound, European head of government affairs at BlackRock, the world's biggest asset manager.
There is nothing revolutionary about basing Libor off of actual market transactions.  Libor was originally intended to reflect the actual price at which banks could borrow.
Supervision is another sensitive area as Mr Wheatley will scrap the BBA's sole oversight role for Libor so that it is directly supervised by regulators. What is unclear is which supervisor will end up with this role....
Mr Wheatley has warned that while regulators can impose conditions on how benchmarks are put together, they cannot force markets to use them.
Mr. Wheatley's comment that regulators can impose conditions on how benchmarks are put together, but cannot force markets to use them supports my observation that regulators should not directly supervise Libor.  Their focus should be on requiring ultra transparency.

With ultra transparency, market participants can determine who they want to put the benchmarks together and every market participant can independently confirm the Libor interest rate by reviewing the actual transactions on which it is based.

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