By Rhodri Preece, CFA
Stories over the possible manipulation of LIBOR have abounded in the financial press for some time now, but there has been precious little action. At stake is the integrity of $350 trillion of financial contracts that reference this key interest rate, not to mention the countless other financial products whose prices are ultimately linked back to LIBOR. The ripple effect of the potential mis-pricing of LIBOR is huge, ranging from complex swaps and derivatives traded among sophisticated investors to residential mortgages sold to ordinary households.
Put in this context, it perhaps seems odd that there has been hitherto an absence of formal regulatory oversight over the setting of LIBOR. For decades, a panel of banks has submitted its expected borrowing rates in different currencies at a set time each day, from which LIBOR is calculated (essentially as an average after adjusting for outliers). This process has been carried out under the auspices of the British Bankers’ Association (BBA), which publishes the daily fixings.
The alleged malpractice stems from two sources: firstly, falsified submissions on the part of some of the panel banks, and secondly, collusion between the trading desks and those responsible for the bank’s rate estimates. A total of a dozen traders have been fired or suspended over the alleged abuse. And in recent weeks, the role of inter-dealer brokers — market makers in the over-the-counter (OTC) bond and derivatives markets — has also been brought into question. At the same time, it should be noted that there has been no suggestion of any impropriety on the part of the BBA.
As stories like these continue to make the headlines, it is little wonder the financial industry continues to suffer from a lack of trust. If the allegations are true, then not only will they highlight widespread ethical shortcomings, they will have a financial impact on sophisticated investors and ordinary consumers alike — because of the centrality of LIBOR to the pricing of so many financial instruments and products. At this stage, it is too early to say what the financial ramifications might be, but it is possible that the legality of various contracts could be called into question if they are deemed to have been mis-priced. In other words, it might not be a “simple” case of market abuse of the type commonly found in the equity markets because the implications of LIBOR are so widespread.
The recent news that “technical discussions” have taken place between industry representatives and UK regulators (FSA, Bank of England, and the Treasury) are welcome, but they must translate into concrete actions to improve the integrity of LIBOR. Moreover, strong enforcement action is needed to ensure that anyone guilty of market abuse is duly punished.
The industry faces a long road to restore trust. Sorting out the mess over LIBOR is one big, important step.