The Chosen Few Keep Benefitting from LIBOR

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LIBOR seems to have become from a benchmark to the most maligned word in the financial industry right now. From being set up by handful of banks a few months ago, it seems now that – even as investigation goes on into the matter – smaller groups of companies are still involved in setting the rate by themselves. The parties named for the manipulation are Bank of America, Citigroup, Bank of Tokyo Mitsubishi, Royal Bank of Canada, Sumitomo Mitsui Financial Group and Lloyds Bank. The period covered is the last four months where these institutions have been most active in setting the rate on an almost daily basis.

The method used before this one used a mixture of mean and median to average out the rates and exclude the outliers that did exist in the market. This allowed all banks to participate and gave a fairer view of the market as a whole. Now it seems that there is a smaller more centralised group which is more active and has a louder say in the matters of LIBOR fixing. This not only skews the markets into the hands of the smaller group, it also eliminates the risk and uncertainty that these banks are exposed to create a risk-less profit situation and being unfair to the competition.

Since the investigation into this matter started, the FSA has recommended that a bigger pool of banks should be used in order to break down the monopoly these companies have over the rates that are set. Another suggestion has been to use market and transaction data rather than ask for rates from the banks directly. This would base the rates on concrete information which can be backed and collateralised. The pitfalls of the old mechanism were blatantly obvious but still the method was used as it was based on tradition and had been followed for some time.

The rigging was suspected in the market and it was confirmed when Barclays was fined for doing this. Other institutions are still being probed and new names and punishments are expected in near future. The public outcry is justified as LIBOR is used to set everything from home mortgage rates to 401k plans of the employees set aside for retirement.

The role of the new smaller group of banks is now being touted as it seems that when BBA does set the rates, it mostly consults big institutions like BoA, Citigroup etc and the data that has been compiled does show that for the last 6 months, all these organisations took an active part in determination of the LIBOR. In line with this, a solution can be that a blind test or average can be taken so even if the institution is part of the rate determination process, it does not know how influential it actually is which will take away most of the power that they hold.

Another solution that has been discussed is to introduce an alternative for the whole rate. However, there seems to be a divided view on its effectiveness. Market participants feel that changing the rate would face a lot of volatility as the fair rate or the translation of rate into different currencies would be difficult and this could highly disrupt the credit markets of the world. If a new rate is introduced, it will be open to new distortion and manipulation and would destroy the investor confidence, market trust and the old system that exists. A better solution would be to use LIBOR but with better safeguards and market protection than before, based on regulation and dialogue between the different stakeholders. Even though the Head of FSA, David Wheatley, has said that the governance of LIBOR has failed, it is felt that through regulation and better mechanisms for the future, this could be avoided. He has also hinted towards a mechanism for punishments to deter future manipulations.

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