In 2012, the London interbank offered rate -- Libor -- gained worldwide notoriety when it emerged that traders had conspired to manipulate this vital financial benchmark. Clearly, the system was broken and would have to be mended. Four years later, the repairs aren‘t finished.
Given the stakes, regulators are right to tread carefully. That said, they need to start making progress -- not so much toward mending Libor as toward creating an alternative.
Libor is constructed by polling banks on the interest rates at which they can borrow, in various currencies and at various maturities. It has long played a crucial role in pricing credit and managing risk. Lenders use it to ensure that payments on mortgages and corporate loans rise and fall with their financing costs. Investors use it to make bets on changes in rates. It’s a benchmark for some $350 trillion in debt and derivatives, much of which will be around for decades.
Regulators have concentrated on preventing banks from submitting false rates for the Libor calculation -- with tougher penalties, clearer reporting guidelines and a new administrator. This has certainly made the system better.
Yet even the best-designed reforms can‘t address the main problem: Banks simply don’t do much of the wholesale short-term borrowing that Libor is meant to track. During the second half of 2015, only about 30 percent of submissions for the key three-month US dollar rate were based on actual transactions. The rest is educated guesswork, allowing banks to engage in wishful thinking or follow the pack to avoid attracting attention. Not the best formula for a reliable benchmark.
A group of regulators and market participants, led by the Federal Reserve, has been working on an alternative (a process in which Bloomberg LP has participated). Ideally, it would rely on observable transactions that wouldn‘t cease in a crisis (as interbank lending did in 2008). Among the most promising is so-called general-collateral repo, a market where borrowers such as banks and hedge funds get short-term loans against collateral such as US Treasury bonds. Hundreds of billions of dollars in such loans are made every day, and the quality of the collateral cushions the market against shocks.
As things stand, though, the repo market isn’t ready for prime time, because nobody is gathering all the data needed to produce a benchmark rate. There‘s also a chicken-and-egg problem. Investors won’t be interested in loans and securities tied to a new benchmark unless derivatives are available for hedging, and the necessary derivatives won‘t be supplied until loans and securities have been issued.
These obstacles can be overcome. The first step is to collect more data on the repo market, a move that’s overdue in any case. This would give regulators a better grasp of risk taking in the financial system, as well as furnishing the basis for a new measure of borrowing costs. If a transparent and reliable repo rate can be established, gaining market acceptance will be easier.
Despite its flaws, Libor retains advantages -- not least, a user base built up over decades. Even so, financial markets and the customers that depend on them would be better served if it weren‘t the only choice.
