LIBOR, the London Interbank Offered Rate, is used to price approximately $300-350 trillion in financial transactions. Most of these financial transactions are interest rates swaps, but syndicated loans and floating rate notes comprise an estimated $13+ trillion—almost equal to the debt held by the large central banks of the world!
Since these are almost incomprehensibly large numbers, even a small change in LIBOR is globally significant. LIBOR rates are set daily by a small number of traders who, as we saw during the financial crisis, have had an interest in shading the truth to benefit their trading positions and bonuses, as well as the fortunes of their employers. This is the classic smoked-filled room, which came under scrutiny during the chaos of the financial crisis.
Since then, regulators have intervened. Banks were fined about $9 billion, with potentially more to come, and better controls are now in place. But while fines have been paid and traders are now better monitored, so far little has been done to solve the underlying weaknesses in setting LIBOR rates.
Convening in a smoke-filled room is not a fair way to set rates, but it appears that replacing LIBOR with a transparent and verifiable system is difficult for regulators in both London and Washington. LIBOR is a very subjective and complex measure, as it combines both an interest rate and a credit component, covers five different currencies and spans maturities that range from overnight to one year. In essence, it is an opinion, an informed view on the markets.
So how do you standardize this complex and often conflicted opinion? Apparently, you try to compromise!
Just recently British regulators said they plan to phase out LIBOR by 2021 and replace it with a new benchmark less susceptible to manipulation. The UK’s proposed replacement, the Sterling Overnight Index Average, tracks overnight funding deals, but not longer-term rates. One problem is that any benchmark using real data lacks authority when there is no liquidity in the markets – at such times opinions are all you have to go on. In the U.S. the discussion is centered on a new rate linked to the cost of borrowing cash secured by U.S. government debt. This rate would include trades between banks and buy side firms, but would no longer be a reflection of interbank lending or bank credit strength. The compromise is still a work in progress among U.S. and UK regulators.
Because there is much debt to be repriced and many terms to be renegotiated, this will take some time and effort. Luckily, the credit quality of LIBOR based bonds will not change: an “A” rated bond will remain “A” rated. Any pricing change at the issue level should be unnoticeable, and even a very small changes could be phased in over time. Good to know we have some time to allow the smoke to clear!
Source: The Financial Times, Bloomberg, Barron’s
11 Most Read IRIS Articles of the Week!
The Cornerstone of Effective Marketing Is Understanding Your Niche
Find Your Why, Before You Give
How Will Asset Managers Find Ways to Distribute Going Forward?
Get Real: Stepping off the Hamster Wheel of Life
The Culture Perception Gaps Between Executives and Employees
Get Naked With Your Money: Wrinkles, Bulges And All!
Do This To Complete Your Vital Activities Each Day
Traditional Retailers Are Failing And It’s Not Amazon’s Fault
Why Following Someone Else’s Plan Never Works
Advisor1 day ago
Cybersecurity and Privacy: Tips for People with Substantial Wealth
Brand Strategy1 day ago
A Different Way To Think About Leverage
Equities1 day ago
What You Need to Know about Investing in Healthcare AI
Markets2 days ago
The Fed’s Next Move May Be No Move at All
Markets2 days ago
Why The Next Recession Will Be Different
Equities2 days ago
What You’re Not Hearing About the China Trade War
Development2 days ago
The Best Practice Management Idea of the Year
Advisor3 days ago
Homer Simpson vs Mr. Burns