The demise of LIBOR: the pricing scandal is only part of the problem

The simmering LIBOR/EURIBOR manipulation scandal made front page headlines yesterday when Barclays was fined by the UK’s FSA (£59.5 mm) and the US Department of Justice ($160 mm) & CFTC ($200 mm) for both manipulating the rates to suit their derivatives traders and creating a false impression about the bank’s ability to fund itself during the financial crisis. But it is not the entire story.

The regulators got the full cooperation of Barclays and, according to the US Department of Justice June 27, 2012 press release, “…Barclays’s disclosure included relevant facts that at the time were not known to the government…”. They even qualified for the FSA early cooperation discount (who knew?). From the FSA June 27, 2012 press release, “…Barclays co-operated fully during the FSA’s investigation and agreed to settle at an early stage.  The firm qualified for a 30% discount under the FSA’s settlement discount scheme. Without the discount the fine would have been £85 million…” The CFTC press release, which is the most detailed of the three, is here. Given the damning e-mails that have been disclosed, Barclays had few options but to come clean and then some. The bank will avoid prosecution.

Some $350 trillion of swaps are indexed off of LIBOR. That is on top of what is traded in the futures exchanges and $10 trillion in loans.  For EURIBOR the situation is much the same. The BIS reports that over $220 trillion worth of OTC derivatives are linked to EURIBOR rates in addition to loans and futures.

Why was it so easy to manipulate the rate? We think it is because it isn’t traded. It’s not real. An article in the BIS Quarterly Review, March 2008 “What drives interbank rates? Evidence from the Libor panel” by François-Louis Michaud and Christian Upper noted: “…The fact that Libor is based on non-binding quotes, as opposed to actual transactions, may open up the possibility of strategic misrepresentation. The BBA tries to reduce the incentives for such behavior (and to remove quotes that are untypical for other reasons) by eliminating the highest and lowest quartiles of the distribution and averaging the remaining quotes…” For LIBOR there aren’t actual trades being reported — only an estimate of where it might trade. It is a major weakness.

LIBOR had already lost its effectiveness as a short-term benchmark. It isn’t only the manipulation scandal that has done it in. During the financial crisis the market found out the hard way just how much credit risk was embedded in LIBOR. When OIS spreads were narrow, it didn’t matter much. But when they blew out (going to the mid-300bps from their “normal” range around 10bp) the situation changed completely. Inefficient forwards, a result of the credit risk, made LIBOR useless. Acknowledging that LIBOR was not an appropriate rate, broker/dealers and clearinghouses like LCH started discounting swaps, for mark to market purposes, using OIS curves. At least OIS is linked to the Fed Funds effective (which is a rate that is both observable and executable, save for some basis risk between Fed Funds Open and the Effective). Even OIS has its weaknesses. Like LIBOR it is unsecured. And the Fed Funds market is much less liquid now that the FRB pays 25bp on reserves and the FDIC includes it when calculating insurance fees. We wonder if repo on “safe assets” wouldn’t be better?

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