Thursday 6 June 2019 5:58 pm

Libor isn’t dead yet, even if the banks and traders would like to bury it

Oonagh McDonald is a consultant and the author of "Holding Bankers to Account"

Oonagh McDonald is a consultant and the author of "Holding Bankers to Account"

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The London Interbank Offered Rate (Libor) was once arguably the most important number in the world. It was the reference rate that banks used for variable rate mortgages, car loans, credit card debt, and much more besides.

It was defined as the interest rate at which banks would lend to each other. Global banks reported the rate to the British Bankers Association every day for publication at 11am, and derivative traders relied on the rate for settling contracts worth trillions of dollars.

But Libor’s reputation was severely damaged in 2008 when it was discovered that a group of traders in a few leading banks colluded with each other via email and electronic chat to try to manipulate the rate each day so that their derivative contracts would close at a rate which benefited them – and their bonuses.

Once regulators’ suspicions were aroused, collusion was easily established. Traders lost their jobs and reputations. Some ended up in prison. Banks paid huge fines.

A new dawn

Since then, Libor has undergone a radical transformation. It is now defined as a “wholesale funding rate anchored in Libor panel banks’ unsecured wholesale transactions to the greatest extent possible”.

This definition provides a much wider base for estimating Libor. It is based on funding from central banks, multilateral development banks, and non-bank financial institutions such as money managers or sovereign wealth funds – a much longer list than the days of submissions based on unsecured interbank lending. Since the latter has declined following the financial crisis, the range provides a sound basis for the daily calculation of the Libor benchmark.

The whole process is now supervised by the ICE Benchmark Administration (IBA) and the Financial Conduct Authority. The IBA itself has an oversight committee, composed of independent members.

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All of this is a far cry from the days when banks estimated the rate at which they would borrow from each other, and traders shouted the interest rate they wanted across the room they shared with the submitters who actually report the daily rate.

Submitters are now required to be separate from the traders. Since each bank does not know what rate the other has submitted for three months, that alone makes collusion virtually impossible – no one trader could be sure that a trader in another bank had submitted the agreed rate, even if the submitters were persuaded to do their bidding.

Moving on

Despite all these reforms, and given Libor’s checkered history, regulators have tried to create new benchmarks, such as the Secured Overnight Funding Rate, and the Bank of England’s Sterling Overnight Index Average. Work on similar “risk-free rates” is in progress for the euro, Swiss franc, and the yen.

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But Libor offers something these alternatives do not. They suffer from one major disadvantage: the lack of a yield curve. The market requires a yield curve for contracts ranging from one day to one year.

The overnight rates cannot offer that. To date, there are over three trillion dollars of new contracts linked to Libor just for that reason.

While some may wish to sweep Libor under the carpet because of its past sins, it remains useful. It should not be buried, but should remain as one benchmark among others.

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