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Libor might be ‘broken’, yet somehow it works

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By Owen Sanderson
29 Jun 2017

In the five years or so since the Libor scandal broke, or the 10 years since Libor itself broke as the financial crisis laid waste to interbank borrowing, the rate itself has done just fine.

The various Libors, or their currency based cousin Euribor, remain the rates of choice for the world’s largest derivatives markets, swapping fixed interest rates for floating. The move towards cleared interest rate swaps has only strengthened the market’s concentration on standard, liquid contracts rather than bespoke benchmarks.

As the basis for fixed floating swaps, Libor is also, in effect, the basis for pricing Eurobonds, either indirectly through the swaps curve for fixed rate issues, or directly through the coupon for floating rate issues. In markets which are structurally floating rate based, including loans and ABS, there are essentially no new issues (please do not write in about that privately placed repack deal nobody saw) using anything else.

In other words, it continues to be far and away the dominant benchmark floating rate. But since widespread attempts to manipulate the rates have come to light, it seems that Something Must Be Done, and to that end, authorities in the UK, Japan, and now a market group in the US, have started to propose alternatives.

Regulators have got involved — the EU passed a Benchmark Regulation, International Organization of Securities Commissions outlined principles for financial market benchmarks — and there appears to be an emerging consensus that the world would be somehow better if a floating rate based on real market transactions were to replace Libor.

It’s not clear exactly who this would benefit — there are plenty of problems and challenges associated with issuing loans, ABS bonds, trading interest rate derivatives, basis swaps and so on, but the benchmark is rarely one of them — but it would certainly be intellectually neater.

Libor, in its original incarnation (a 1969 loan arranged by Milo Zombanakis for Iran), had a logic to it — the rate at which banks can obtain offshore dollars, with a spread for credit risk and profit.

Since the crisis, though, interbank markets have increased become collateralized, while extraordinary liquidity measures have pushed some institutions to borrow from their central banks as lender of first resort, rather than last resort.

Institutional loans, too, have pricing increasingly divorced from a bank’s actual cost of funds — subsidised by ancillary business in advisory and capital markets on one hand, while the constraints on volume and pricing are increasingly driven by regulatory capital, not the availability of interbank liquidity.

But it’s not obvious that this is harming the market. For lots of products, Libor has always been an imperfect benchmark — UK mortgages, to take one easy example, are benchmarked to bank rate or standard variable rate, yet funded through Libor linked securitizations. Libor is chosen because it’s a common rate across the markets, not because it is the most accurate floating rate.

That’s led to extensive basis trading markets in areas where Libor doesn’t quite fit — Eonia–Euribor, or T-bills–Libor for example. Like any market, these are occasionally distorted by technical factors, but mostly, they serve their purpose.

Libor, in effect, is the common rate, the rate which concentrates most liquidity, the central interchange by which any one rate can be transformed into any other. To fulfil this role, the only feature it needs is common agreement. Like any other fiction — money, government, the state — Libor only requires an acceptance from everyone in the market, not a specific root in objective truth.

It’s possible that another rate could achieve this same level of common understanding and dominance, over time — before the First World War, the prime bills discount rate in London was effectively the global interest rate benchmark — but it’s hard to see the urgency. Libor might not reflect any specific truth, as it once did, but it works just fine.

By Owen Sanderson
29 Jun 2017