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Sometimes markets work. Other times they’re just dumb. Using the London interbank lending rate as the basis for $350tn of derivatives is at the dumber end of stupid ideas.
Libor has become shorthand for everything wrong with the banking system after Barclays, UBS and Royal Bank of Scotland were fined $2.6bn for rigging the market, as revealed in a series of blunt emails .
Sir Mervyn King, Bank of England governor, quipped that Libor was “the rate at which banks do not lend to each other”. Since the crisis there has been so little interbank lending that the numbers are all but imaginary – obscure Libors like Australian dollars for nine months are just made up, as typically there are no trades. Manipulation was easy.
Replacing Libor is harder. It mixes three different risks: interest rates, duration (the cost of money over time) and average bank credit quality.
Banks like lending at rates which move both with interest rates and bank credit quality, shielding them from two key risks. Derivative markets are mostly just for speculating on or hedging rate and duration.
Regulators want derivatives to be based on a market price – overnight indexed swaps, for example, or the active secured lending market. This would stop multibillion-dollar transactions being based on a figure plucked from the air. But it is not perfect. As Julian Wiseman, a former bond strategist at Société Générale, points out, these markets are small compared to the weight of derivatives which would rest on them. The vast profits to be made from changing the rate would surely encourage rigging of whichever market is chosen.
So what? you might say. The same is true of equity futures and occasionally someone is even caught. Nothing is ideal. But on that basis one could keep a heavily-regulated Libor too and see if traders trust market prices: would contracts switch to a potentially fiddled market rate or a now-honest but still imaginary Libor? My guess is the status quo would prevail. After all, no one is likely to tamper with Libor anytime soon.
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