Thursday, June 6, 2013

Euribor managers mull using real transactions to set benchmark rate

Bloomberg reports that the Euribor managers are considering using real transactions to set the benchmark interest rate and end the ability of banks on the rate panel to manipulate the rate.

Regular readers know that your humble blogger recommended and the Wheatley Review rejected (it wouldn't even publish my submission) that benchmark interest rates be based off of actual transactions made available by requiring the banks to provide ultra transparency.

By disclosing their current global asset, liability and off-balance sheet exposure details, the banks end two major problems with the benchmark interest rates.

First, ultra transparency thaws the unsecured inter-bank lending market.  Banks with deposits to lend can use the disclose data to assess the risk and solvency of banks looking to borrow.

Second, ultra transparency ends manipulation because market participants can use all of the transactions in the inter-bank market or a subset.

Of course, this eloquent solution was rejected by both the banks and their guardians, the regulators.

The group that manages the Euro Interbank Offered Rate, or Euribor, is considering setting up a parallel benchmark based on real transactions rather than estimates. 
Euribor-EBF is exploring the move as part of its response to revelations that some lenders tried to rig interbank lending rates, tarnishing credibility of the indexes. The European Central Bank is providing technical assistance for a feasibility study, according to Euribor-EBF’s response to a review by global regulators. 
Any new benchmark would be set up in addition to Euribor, according to the letter, sent to the International Organization of Securities Commissions. It wouldn’t affect any contracts linked to Euribor rates, the group said. 
The move echoes comments made last month by Martin Wheatley, the head of the U.K. markets regulator. He said the London interbank offered rate should eventually be replaced with a transaction-based benchmark using a dual-track system. ... 


benchmarker said...

Euribor = "Where do you think Prime Banks are dealing in the market?"

1) Name the Prime Banks
2) Would any bank you could define as "prime" wish to support the whole market by disclosing confidential data? Would you, had you dealt with a "prime" bank, be happy with your confidential data being disclosed?

Libor = "where could you borrow in the market?"

Completely different issue

Richard Field said...

Benchmarker, thanks for the comment. Let me see if I can answer your questions.

Prime banks: At there is a list of the prime banks that were on the Euribor panel as of 1/8/2013. I am aware that several of these banks have withdrawn or are in the process of withdrawing.

Disclosure: In the 1930s, it was the banking industry standard to disclose their current global asset, liability and off-balance sheet exposure details. Disclosure of these details was seen as a sign of a bank that could stand on its own two feet as market participants could assess its risk.

Today, exposure details are seen as confidential information. Why is it confidential? For example, GE reports that it borrows. Do you think GE cares if banks it borrows from disclose that fact?

Next, why are the securities a bank invests in confidential? Only reason is because bank is engaged in proprietary trading. Otherwise, why would a bank want to hide the information?

The irony of banks is that there is no reason for their on and off balance sheet exposures to be confidential.

But what about confidential data of individuals or private companies that haven't issued any public securities? No reason that their anonymity cannot be protected at the same time as bank discloses exposure detail. Disclosure and anonymity are not mutually exclusive.

One might carve out an exception to this anonymity when it comes to hedge funds ....

Finally, I agree that Euribor and Libor are asking different questions in rate setting process.

I am simply saying why ask a question when we could use what is a knowable fact.

Based on actual trades, it is knowable where Prime Banks are dealing. Based on actual trades, it is knowable where banks can borrow in the market.

benchmarker said...


I'm not really talking about the market's ability to assess the credit risk of potential counterparties, although I believe they report as you suggest, quarterly, but I suspect that assessment may not be totally straightforward from those disclosures (credit risk is obviously not my area of expertise).

My comment is aimed at the IOSCO opinion that transaction data should be used, where it exists, in supporting expert judgement in submissions to benchmark creation.

If Euribor was to adopt this methodology, the benchmarks would be set by (how many prime banks are there - two?) an extremely small sample of the market.

Euribor is, I believe, intended to be the level at which it is 'fair' for banks to lend to their customers - if the rates achievable by a tiny, unrepresentative sample of the market were applied to the balance sheets of the whole European industry - that is the rates at the extreme of one end of the bell-curve - then this would severely penalise most national financial markets to the point where all but the Dutch/German markets were lending at a substantial loss. Euribor is already causing this effect but the use of trade evidence would, I suspect, compound the issue further.

The issues in Euribor and Libor should, to my mind, be divided into two; legacy dependencies on the historic questions and getting the benchmarks right for the future.

If the Euribor question were changed to the Libor version, it would cause a hike in rates by, what, 3%, 4% for the current topped/tailed panel? The lawyers would be all over this as a fundamental change in all existing contracts, from residential mortgages to exchange-traded contracts.

Libor is not in a vastly better place, but at least the question makes allowance for the varying creditworthiness of the individual panel members.

So, to my mind, to maintain the publication of both sets of benchmarks for legacy purposes ad infinitum, the same questions must continue to be answered. It is not practical to use transaction evidence in the case of Euribor (even if it existed in substantial enough quantities) and Libor, given the evidence of expert judgement being falsified, but conversely given that there is better transaction evidence available, the method should be applied to the London benchmarks.

Looking forward, there is little likelihood of the EUR banks continuing with the Euribor benchmark for new business; as soon as an alternative is agreed and available - (national IBORs based on each nation's GC Repo rates? OIS-curve related? who knows?) it will be adopted as a replacement - Mr Gensler has been extremely vocal on this one in the USD context.

The solutions to the two issues, ongoing publication for legacy purposes and alternatives for new business, are not easy to solve, but knee-jerk fixes, without considering the full implication of the change in method, will most likely introduce unintended consequences which are at least as problematic as the status quo.

Yes, almost all IBORs need to be repaired or, most probably, replaced, but let's get the repairs/replacements right.

Richard Field said...

Benchmarker, thank you for the excellent comment! I always appreciate when a reader takes the time to challenge a solution I propose and explains why it might not work.

I happen to agree with you that we need to divide the problem into "legacy dependencies on the historic question" and "getting the benchmarks right for the future".

Furthermore, I happen to agree with you that we need to continue to produce the "legacy" benchmarks while there are still transactions outstanding that are based on them.

My solution is directed at solving the problem of "getting the benchmarks right for the future". This solution just happens to have implications for the "legacy" benchmarks.

Historically, Libor is suppose to answer the question of what is the "cost" of borrowing on an unsecured basis by the banks on the panel.

Asking this question made sense as the cost of borrowing on an unsecured basis is a proxy for a bank's cost of funds. This proxy is then used as the starting point for pricing a loan.

Requiring the banks to disclose their exposure details addresses the problems we have found with "legacy" Libor without having to change the historical question or usage of Libor.

I address freezing in the unsecured debt market by providing the disclosure necessary so that banks with deposits to lend can always assess the risk of the banks looking to borrow. The unsecured debt market is currently frozen because banks don't provide this disclosure and banks with deposits to lend cannot assess the risk/solvency of the borrowing banks.

I also address misreporting of what it actually costs a bank to borrow by making the actual trades available to the market (so reported trades can be confirmed).

In the case of legacy Libor, implementing "new" Libor has real implications. Specifically, there shouldn't be any divergence between the two rates.

Finally, with regards to Libor, my proposed solution keeps the rate as based on a bank's unsecured borrowing rate. Repo or OIS-curve related rates reflect a bank's cost to borrow on a secured basis. I don't think there is any reason to change from unsecured to secured rates as this would cause a major disruption.

As for Euribor, you are absolutely right that even IOSCO's modest solution that transaction data be used in support of expert judgment could and most likely would have a major impact.

Finally, I happen to agree with you that we need to get the replacements right for the benchmark interest rates. I happen to think that the right benchmark interest rates are constructed based on actual transactions disclosed as part of each bank being required to disclose its current exposure details.