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Self-regulation leads to self-doubt

The European Commission (EC) is threatening to move setting of the London Interbank Offered Rate (LIBOR) to Paris, after the exposure of the current process as “the rate at which banks do not lend to each other” in the words of Mervyn King, former governor of the Bank of England. An interbank benchmark system must be found that engenders trust, but can banks trust themselves?

How have Interbank Offered Rates (IBORs) gained such bad press?

LIBOR was used by banks as a benchmark to underpin trillions of dollars of derivatives. Overseen by the British Bankers Association (BBA), it was the average rate that banks either were paying, or predicted they would pay, to borrow money from other banks. As the rates submitted to the BBA were not taken directly from actual borrowing data but relied on banks to report the rates accurately and honestly, they were open to manipulation.

In the event it was found they were subject to manipulation. Several big banks have been fined for their involvement in submitting data based upon the wishes of traders, rather than of the actual borrowing rates they saw in the market. Many more are undergoing investigation around the world.

What does one IBOR have to do with another?

The rate setting systems are all operated along similar models leaving them all exposed. Having examined LIBOR and found fault, it has been discovered that many of the banks were happy to manipulate rates wherever they were. The damning email evidence shows that it was casually done and that the banks often did not have the systems or capacity to spot the dodgy behaviour that accompanied the business such as wash trades - buying and selling the same security in order to create a commission to pay a broker involved in the rigging.

What effect did rigged rates have?

The Bank of International Settlements says that US$10 trillion of bonds a “significant share” of mortgages and other retail loans are linked to EurIBOR and LIBOR while market estimates connect derivatives with a value of some US$350 trillion to LIBOR. The underpinning of financial products, from mortgages to derivatives, with these rates means that the cash flows around these products may not have reflected the genuine position that the market saw and therefore buyers could have lost or saved money based on erroneous data. Several lawsuits are from in play from the owners of derivatives who say they have lost out.

What are regulators doing?

There are different reactions from different regulators. Gary Gensler, head of the Commodity and Futures Trading Commission (CFTC) the US derivatives regulator, has called for the scrapping of LIBOR. Following the collapse of Bear Stearns and Lehman Brothers in 2007/08, who had exposure to enormous levels of bad mortgage debt, banks did not trust one another as counterparties. The interbank market disappeared during the financial crisis as a result and Gensler has noted that basing financial products upon the measure of a market “that does not exist” is questionable to say the least.

Martin Wheatley, head of the UK’s market regulator the Financial Conduct Authority, has called for reform rather than replacement, with transactional data used to underpin the submissions.

The EC agrees with Wheatley but wants the European Securities and Markets Authority, a pan-European regulator, to run it.

It seems the banks do not trust one another and the regulators do not agree with, or trust one another. A battle of willpower shall ensue. 

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