Libor needs swift modernisation to recapture trust

WE SHOULD be under no illusion about how catastrophic the failure of the Libor rate setting mechanisms has been. There has been widespread manipulation of the most important price of risk. And we don’t need reminding how important the price mechanism is for the allocation of everything from goods to services, and of course capital. Any manipulation of prices naturally leads to a misallocation of capital, redistribution of wealth, and arbitrage opportunities. With Libor forming the base for over £500 trillion in securities and loans, Barclays is lucky to get away with a fine of £290m.

However, just beating up Barclays as a proxy for our frustration will do nobody any good. We must identify the source of failure and take the right steps so it doesn’t happen again. The main culprit for this misery is the British Bankers’ Association, which has allowed a price setting mechanism to persist that was wholly inadequate for the task. It was designed in a period when trading was done over the telephone, and prices communicated via newspapers. It was never updated, despite enormous technological change in the trading room, and no safeguards developed, despite its tremendous success as a reference value.

The process invited manipulation, and some traders responded to the economic incentives manipulation offered. This is obviously a failure of the traders, but also of the institution that designed the process.

To regain trust in the system, the public debate needs to focus on how to restructure Libor. It must be robust to manipulation, using technology in a clever way to minimise the ability of ex-post manipulation – by delivering prices in real time. While internal and external oversight is desirable, we have to be realistic about how much can be achieved with it. Unfortunately, if a process that offers enormous rewards can be manipulated, eventually somebody will try to do it.

There are obvious things that need fixing. Libor needs to be based on real trades, and not assumed trades. It will need to be volume-weighted, and not treat every trade equally. The information needs to be sourced directly and automatically from in-house trading systems, and this interface has to be secure against human interference.

The delivery of real-time prices will allow users to average over a longer time period, making manipulation less rewarding and less harmful. We will also need to do spot checks that trades have eventually been settled.

Any manipulation should lead to automatic disqualification by the FSA (soon to be FCA). But we should not put all the responsibility onto the supervisor. In the end, the banks must look after themselves and their clients.

Dr Tom Kirchmaier is lecturer in business economics and strategy at Manchester Business School and a fellow of the Financial Markets Group at LSE.