Two years after news broke that traders at the world's largest banks had been manipulating interest-rate indicators used to value hundreds of trillions of dollars in securities and derivatives, a crucial question remains: How can we restore confidence in benchmarks on which the financial system depends the way the rest of us depend on tap water?
Today, an international group of regulators known as the Financial Stability Board issuedtwo reports-- to which we contributed -- that offer what we see as viable answers. Turning the proposals into a solution, though, will require further action from national policy makers.
Our vision of reform is founded on two overarching principles. First, benchmark rates such as the London interbank offered rate, or Libor, along with its European and Japanese counterparts Euribor and Tibor, were vulnerable in large part because they relied on banks to accurately and honestly report their own borrowing costs. To the extent possible, these benchmarks should be based on actual transactions in the markets for unsecured bank borrowing -- a recommendation that previous policy groups have also made.
The problem is, there are surprisingly few actual loan transactions among banks -- remember, the "i" in Libor stands for "interbank" -- that could be used to calculate most of the benchmarks, including the hugely popular ones that track loans with three-month and six-month maturities. Hence, our report proposes using a much wider set of transactions, gleaning information on banks' borrowing costs from their certificates of deposit and from IOUs known as commercial paper.
Second, and crucially, the reform process should strongly support alternative benchmarks. Libor and similar reference rates are now used for a range of applications that go well beyond their original purpose, which was to set the interest rates on banks' loans to their customers above the banks' own cost of borrowing. With the enormous growth in derivatives since the 1980s, the benchmarks have also been heavily used to hedge or speculate on changes in the general level of interest rates.
This agglomeration effect can be helpful: When everyone is using the same benchmark, it's easier to find someone to trade with. But it also greatly increases the incentives for manipulation. Given the size of some of the derivatives contracts involved, a mere 0.01 percent change in a benchmark rate can be worth millions of dollars to a derivatives trader. If the underlying market is thin, even a transactions-based benchmark will be vulnerable to manipulation if it serves as the foundation for hundreds of trillions of dollars in derivatives.
Fortunately, many of the "rates trading" applications could be as well or better served by benchmarks that are not tied to banks' cost of funds. In the U.S., for example, yields on Treasury bills, or rates on "repo" loans in which high-quality securities such as Treasuries are used as collateral, would be adequate for many purposes. Globally, including in the U.S., the market for overnight index swaps -- which reflect the longer-term cost of borrowing at overnight rates controlled by central banks -- could soon evolve for heavy use in contracts related to the overall level of interest rates.
It won't be easy to get market participants to opt for alternative reference rates because of the big advantages of using the established benchmarks. This is a coordination problem: No individual actor may be willing to switch, even if a world in which many have switched would be less vulnerable to manipulation and offer investors a menu of reference rates with a better fit for purpose.
This is where national policy makers come in. By speaking publicly about the advantages of reform -- or, if necessary, by using their power to regulate -- they can guide markets in the desired direction. In financial benchmarks as in tap water, markets might not reach the best solution on their own.
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Jeremy C Stein
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Mark Whitehouse at email@example.com