The ‘mystery Libor’ precedent | FT Alphaville

The ‘mystery Libor’ precedent

By now everyone is well aware of the flaws associated with the Libor-setting process. As yet, however, no alternative has been deemed full-proof enough to replace it.

The search for a better system, however, is on.

One option pitched thus far is a rate that’s based on real trades. But this system is seen as problematic for liquidity reasons (because there may not be enough trades, or any trades for that matter). Continuing to set the rate on bids and offers, meanwhile — even ones that traders would be obliged to trade at — still leaves the door to unrealistic bids and offers being  submitted.

Then there’s the option of moving to an alternative funding market, such as repo. But this has its problems too. Not only does it risk killing the unsecured market completely, it presents a “base” collateral problem — since your rate is only as good as your collateral, and this can vary across jurisdictions.

All of which leaves the rate market in a state of worrying inertia.

Yet there is one other option being discussed: A rate setting system that’s based on a random and anonymous sample of actual trades, bids and offers.

And, as it turns out, there’s even a precedent already for the system.

Writing in American Banker this week Richard Robb, chief executive of Christofferson, Robb & Co, an investment management firm, explains that the CME devised exactly such a system when it launched its Eurodollar futures contract in 1981.

The process, as he describes, went as follows:

The CME would select 20 banks at random from a much larger pool and survey those banks for their perception of interest rates. It would discard a subset of the highest and lowest and average the responses that remained. At a randomly selected time within the next 90 minutes, the CME would conduct a second survey with a fresh random set of banks. Finally, it would publish the average of the results of the two surveys without revealing the identities of the banks that participated.

Unfortunately, the system was abandoned. By 1996, the BBA rate had become dominant in the market and the CME, fearing that it might lose market share to another exchanged if it didn’t rebase to the BBA benchmark, applied to the US Commodity Futures Trading Commission (CFTC) for permission to switch from its own sensible Libor calculation to the BBA’s.

Though, as Robb points out, it’s not as if the CFTC wasn’t warned about the risks associated with switching systems.

Indeed, Robb himself filed a public comment letter with the regulator objecting to the plan.

The following is an extract from the letter:

“In a severe funding crisis … banks might respond to the BBA survey with a rate substantially below their true lending rate. Since the BBA survey results appear on Telerate [a Bloomberg-like information service widely used at the time], the banks may want to hide the extent of their troubles…The CME randomly draws a limited number of reference banks from a larger pool on the futures settlement date. This ensures that banks will not know ahead of time whether they will be able to participate in the survey. The BBA, on the other hand, surveys the same sixteen banks every day. To see how a bank could exploit this feature of the BBA survey to manipulate the index, suppose that the four high quotes are expected to be the three Japanese banks (Bank of Tokyo/Mitsubishi, Fuji, and Sumitomo Trust) and the Bank of China.

Then, any of the remaining banks can raise their quote, and the effect will flow directly to the final index. A British bank, for example, might raise its quote by 12.5 basis points. Since eight banks make up the average, the average will rise by 12.5/8 = 1.5626 basis points. If two banks worked together, they could raise the average by 3 basis points.

The CME claims the BBA survey will self-correct if markets become more volatile. They argue that ‘[t]he outstanding notional value of instruments tied to the BBA fixings is enormous…’ But enormous markets create enormous temptations.

So, the question is, would it not be wise to return to the original CME mystery Libor system?

Related links:
Libor’s Risks Emerged From Clubby London Banking Culture
–  Bloomberg
Libor rate overhaul launched by UK regulator – Reuters
Libor coverage
– FT Alphaville