Policy initiatives are key to restoring the broken interest rate benchmark, writes Rhodri Preece of CFA Institute.
Since Barclays settled with UK and US regulators in late June over its involvement in the manipulation of the London Interbank Offered Rate (Libor), policymakers have been busy developing initiatives to reform this key but manifestly broken interest rate benchmark.
The restoration of public trust and financial market integrity depend in no small part on the success of these initiatives.
Reform of Libor, which underpins the pricing of more than $300 trillion (€229 trillion) of financial contracts, is long overdue – it has been more than four years since allegations of manipulation first surfaced. The limited action taken by regulators to date has not only left many stakeholders feeling aggrieved; it has allowed a flawed system beset by opacity, inadequate controls and weak governance, to fester.
Part of the reason for the absence of regulatory action in the intervening period has been the limited powers of authority held by regulators to police Libor. Until now, the lending rate has been administered and overseen by the British Bankers Association, the trade body, and has thus operated outside the perimeter of regulatory purview. Widening this perimeter is the first and most obvious step for regulators to take.
The UK government’s Wheatley Review of Libor, published at the end of September, calls for its substantial overhaul, including closing the regulatory void. Under the recommendations of the review, the submission to, and administration of, Libor, will be regulated by the Financial Services Authority (FSA) – to be replaced by the Financial Conduct Authority next year – and the regulator will have powers to pursue criminal sanctions where appropriate.
These efforts will be complemented at European level, where the European Parliament has been updating the EU’s market abuse legislation to define manipulation (actual or attempted) of benchmarks explicitly as a form of market abuse.
Formal regulatory oversight, particularly with criminal sanctioning powers for the regulator, should provide a more credible deterrent to market abuse and will help to strengthen investor and consumer protection.
The second key element of reform is fixing the methodology for the calculation of Libor, which is plagued by subjectivity and a lack of transparency. The Libor calculation involves contributing banks submitting the rates at which they expect to be able to borrow unsecured funds for a given currency and time period, the average of which (after discarding the highest and lowest submissions) determines Libor.
However, the absence of clear standards governing rate submissions has allowed banks considerable judgment in their estimates. Such subjectivity is prone to abuse, particularly when combined with weak internal controls or absent firewalls between those submitting rate estimates and the trading desks within banks. This situation makes the system vulnerable to manipulation.
To address the shortcomings of this judgment-based mechanism, the review calls for banks’ Libor submissions to be explicitly supported by actual transaction data, along with a new code of conduct over submissions to establish standards over the rate setting process.
That code of conduct will be drawn-up by a new administrator who will take over from the BBA. Other measures include limiting the production of Libor to only those currencies and time periods where there is a liquid underlying market and encouraging more banks to participate in the Libor process to reduce the influence of any one bank in the calculation of the benchmark.
Of all these measures, the use of actual transaction data for the basis of Libor submissions is the most impactful. At present, it appears that Libor rates have become somewhat detached from market reality when one considers the stability of Libor relative to other market-based indicators of banks’ credit risk, such as credit default swaps.
Use of actual transaction rates as the basis for Libor will ensure that the reference rate is anchored in objective, transparent inputs, enabling greater scrutiny by investors and regulators and thereby minimising the scope for potential manipulation. Greater transparency, along with a new code of conduct over rate submissions, will also help to mitigate conflicts of interest within banks.
Overall, though, the review’s recommendations are welcomed.
A recent survey of CFA Institute members made it clear that Libor can be improved through use of actual transaction rates and better oversight. In the same survey, investment professionals called for the development of a global framework of key principles or best practices for internationally-used benchmarks.
To that end, the parallel effort by the International Organisation of Securities Commissions to develop international standards for interest rate benchmarks – an initiative co-chaired by Martin Wheatley of the UK FSA, and Gary Gensler of the US Commodity Futures Trading Commission, must also be welcomed.
Although it has been a long time coming, the efforts by policymakers to reform Libor and other interest rate benchmarks are encouraging. Allied to a greater emphasis among financial institutions on ethical practices and a renewed focus on putting clients interests’ first, these measures can help begin the long process of rebuilding trust and integrity in our capital markets.
Rhodri Preece is a chartered financial analyst and director of capital markets policy at CFA Institute.
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