The Americanization of LIBOR?

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The American Enterprise Institute (AEI) has tabled a few proposals regarding the setting of the new LIBOR that can govern the financial systems of the world. The LIBOR had been suspected of being manipulated over the last decade and the last straw was the recent admission of the manipulation by many of the banks of which Barclays was seen as the initiator of. LIBOR is a rate which puts into place many of the rates for the key financial products around the world and is the benchmark rate upon which other products are based on.

The rate is more of an index which sets the tone for the financial markets in the West. The new proposals say that the new rate would also be centred in the UK and under the control of the UK government, even though it’s widely used in the US as well. It might seem confusing as why the rate is set in the UK rather than the US but this was due to the gold standard that the US was not able to set in the 1960s giving the power of determination away.

The rate has morphed over time as first it was seen as a risk free rate to borrow from one bank to another but as time has gone on, the inclusion of troubled banks has changed it from a risk free to a risky rate. Banks still used to borrow from it for a day to cover its deposits overnight.

The background of the manipulation that was seen recently is centred on the fact that there had been concerns about the rate for some time. The Federal Reserve of New York had raised questions in the 1980s when the rate was being set and questioned the methodology and control that the banks had over the rate. This was seen in 2011 in the case of Barclays quite obviously. Red flags were further raised by different organizations as recent as 2008 but the issues and doubts were not addressed even then.

The problem seen right now had two key motivations. First, the derivatives traders who traded on the LIBOR influenced the rate in order to make profits on their positions and that even when LIBOR was set at a record low; nothing was done as it was used as a rationale to protect the deposits. This shows that not only were some of the banks able to gain from setting the rates but even the checks and balances that were put in placed worked effectively enough to stop it.

Due to this, the rate is now being proposed to move away from people’s own discretion and move towards actual transaction data which is more grounded in economic reality. There are also suggestions to develop an index based on other economic data like mortgage data in the US which is seen to closely mirror the LIBOR in perfect market conditions and it also breaks some of the monopoly of the LIBOR in the market.

The US market would be able to develop its own measure without paying a lot more than they would under LIBOR and be able to regulate the rate more efficiently as they see fit. The proposals show that there is a wide range of options that the people have at their disposal from better supervision of the current system to the development of a new substitute index. Even though the people are divided over the methodology, the one thing that everyone is in agreement over is that going forward changes have to be made. It would be interesting to see what proposals are crystallised over the next few months and how the US deals with its own part of the LIBOR manipulation case.

LIBOR explained -Infographic
LIBOR explained -Infographic. Image credit: http://healthcareadministration.com
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