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Buyers beware a 'fair rate'

As the digging into the scandal around London, Singapore, Tokyo and Euro Interbank Offered Rates (LIBOR/TIBOR/SIBOR and EurIBOR) continues, it seems increasingly obvious that many financial benchmarks have a veneer of respectability but little else. There is a push to include transactional data in the submissions to LIBOR, but that would only work in liquid markets.

Benchmarks for illiquid markets (which could arguably include LIBOR at present) are hard to build because of the paucity of data. If there are only two trades in Australian interbank loans in a quarter, for example, should they be used to set a rate? Small markets could be manipulated as easily as the existing model if a few transactions were all it took.

The purpose of using a fixed rate is to ensure that the banks have some protection from interest rate risk and credit risk. The Banks of International Settlements (BIS) has suggested central banks promote the use of overnight Interest swap rates (OIS) or general collateral (GC) repo rates as possible reference rates.

With some 50% of syndicated loans based on the either EurIBOR or LIBOR, using a reference rate to tie the cashflows to standard money market interest rates makes sense. Some market participants have voiced concern that OIS rates might prove too volatile. However, arguably, the reverse is also true – LIBOR has often not reflected crises, meaning debt is written out suggesting the skies are clear when storm clouds are gathering.

One thing is certain; if banks are to claim a ‘fair’ rate is being used it must be fixed for all parties and reflect the market. If there is no real rate, except for a finger in the air, buyers should be told so they can beware accordingly.

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