LIBOR manipulation
LIBOR manipulation

It appears the price of money  or interest rates may have been manipulated.  This time not by the Fed and other central banks, but by private banks. Apparently they may have been colluding to manipulate the London Interbank Offered Rate (LIBOR):

LIBOR Manipulation: A Brief Overview of the Debate: LIBOR is a key, central part of the global financial market system. Over $10 trillion in corporate loans, floating rate notes, adjustable rate residential mortgages etc., are pegged to LIBOR. Additionally, LIBOR is the key rate in the $350 trillion market for interest rate swaps. Finally, many other derivatives depend upon LIBOR in some manner or other.

Therefore, if LIBOR rates are being distorted or manipulated in any way, the ramifications extend to nearly every corner of the global money markets and to participants in many sectors of the global economy other than banks and financial institutions.

So how was LIBOR supposedly being manipulated?

Libor Manipulation: Another Black Eye for UBS: According to reports of court documents filed by Canadian regulators, traders at UBS, communicating with traders at other banks using e-mail and instant messaging, colluded on whether they wanted Libor to be set high or low on any given day. They would then pass that desire off to their bank’s representative on the Libor panel.

Why can”t they just use a different measure?:

Libor is so deeply embedded in the financial system it can’t be replaced without potentially voiding existing contracts…  “You might be able to call the new benchmark Libor, but because it’s not exactly the same measure, would that invalidate all these thousands and thousands of contracts?” said Donald Mackenzie, a professor at the University of Edinburgh who specializes in the sociology of financial markets. “It’s difficult to see that you can do much more than what the BBA is already trying to do in terms of trying to improve an estimate- based measure.”

The BBA is reviewing potential changes to the benchmark and met regulators and bank executives last week. The rate is set through a daily survey of firms conducted on behalf of the BBA by Thomson Reuters Corp. in which banks are asked how much it would cost them to borrow from one another for 15 different periods, from overnight to one year.

Because banks have to submit a rate when no market exists, and their estimates aren’t subject to outside verification, the benchmark is vulnerable to manipulation, investors said.

So it is interesting to read this justification:

In defence of Libor manipulation: The argument is simple. If no more than eight banks ended up submitting quotes for Libor benchmarks because most others had limited or no access to term funding, according to Libor methodology no official Libor benchmark could be produced.

Lacking an official benchmark, distressed banks would then have been able to substitute their own preferred funding rates into loan agreements instead — rates which would have been completely detached from funding realities, exploiting those who were funding them in the process.

Furthermore, if banks had been seen leaving the process altogether, this could have translated into serious reputational issues for the banks in question, heightening bank run fears and accelerating the panic.

So, was collusion by the banks in this instance justified? Did it arguably, in the circumstances, do everyone in the market a favour?

Of course it does not square with reports of their  colluding to set the rate higher or lower. There are also suggestions that pricing of floating rate debt is in need of a re-think:

Insight: Time to rethink floating rate debt: Rates for three-month Libor are the basis for most interest rate futures, swaps and options, and the notional outstanding of these contracts globally is in excess of $300,000bn, according to the International Swaps and Derivatives Association. Interest rates on many corporate loans, floating rate notes and residential mortgages are also tied to them.

Three-month Libor became the basis for the emerging interest rate derivatives and floating rate debt markets in the 1980s. It was seen as a reliable measure of the marginal cost of bank financing and a better anchor for the short-end of the yield curve than unpredictable policy and overnight rates.

But a lot has changed since then and for a couple of reasons three-month Libor may not now be the best measure of short-term interest rates.

First, it is no longer a good proxy for marginal bank financing costs. A Libor-contributing bank submits the rate at which it believes it could borrow funds, were it to do so by asking for and then accepting interbank offers in ‘reasonable market size’’. However, the interbank market for unsecured three-month deposits has been thin for a number of years.

Only unsophisticated banks place deposits with their competitors at maturities beyond one week. Liquidity management and credit limits deter banks from tying up their funds in this way. Rather the interbank deposit market is overwhelmingly overnight.

At longer maturities, banks borrow unsecured primarily by issuing securities to non-bank investors.

There more detailed analysis on the possible manipulation here.