The answer to the problems with LIBOR — the London interbank offered rate — is to use a market rate not subject to manipulations by a few institutions.
It won't be easy replacing the influential interest-rate benchmark, either in searching for an acceptable alternative or getting support for the change from people in the banking and financial management industry. Even so, institutional investors as well as banks must do so to ensure a benchmark rate that reflects reality and the market.
The revelations about manipulation of LIBOR, as well the related euro interbank offered rate, ought to draw institutional investor attention to other benchmarks they use that might also potentially be subject to manipulations, such as peer performance benchmarks and fair valuations based on infrequent trading and less transparency pricing.
Increasingly pension funds and other institutional investors are allocating a larger share of their total assets to alternative investments. As a result, asset valuations are tied ever more closely to non-marketable securities and other hard-to-value assets where prices are not readily and publicly available. With non-publicly traded pricing, data are subject to conflicts of interest. The LIBOR and EURIBOR misconduct raises the question of what other indexes — such as hedge fund indexes — lure institutional investors to think performance and risk characteristics are superior.
LIBOR might not actually reflect the market rate of borrowing costs or, for instance, the financial condition of the banks participating in setting the rate, according to a report by the Department of Justice.
“For years, traders at Barclays encouraged the manipulation of LIBOR and EURIBOR submissions in order to benefit their financial positions; and, in the midst of the financial crisis, Barclays management directed that U.S. dollar LIBOR submissions be artificially lowered,” the report said.
“Barclays' disclosure included relevant facts that at the time were not known to the government,” the report noted. The department's investigation is continuing against other financial institutions, the report added.
The cost of manipulation of the data that comprise the set of benchmark rates collectively called LIBOR is a challenge to determine.
No one has measured the total cost or potential gain to pension funds and other institutional investors — or calculated the total amount of institutional assets under investment management subject to LIBOR pricing.
The potential scope is broad. “Because of the high value of the notional amounts underlying derivative transactions tied to LIBOR and EURIBOR, even very small movements in those rates could have a significant impact on the profitability of a trader's trading portfolio,” the report said.
Depending on their investments tied to LIBOR, manipulation could engineer a gain as well as a loss or even both at the same time on different exposures of pension funds.
As fiduciaries, pension fund executives have an obligation to assess the impact to their investments of any manipulation. It will help them determine the risk of being subject to such potential misconduct and the potential cost of using an alternative mechanism for price references. It is possible manipulation provided pension funds with gains. But if there are losses, the executives have a fiduciary obligation to recover them, whether through litigation or other legal means.
At present, LIBOR is indispensable to the market. Derivative financial instruments, including futures, options and swaps, are settled worldwide using LIBOR as a reference rate for pricing transactions. Some $554 trillion in notional amount was outstanding in over-the-counter interest-rate derivatives in the first half of last year, according to the U.K.'s Financial Services Authority.
The market is dependent on LIBOR. Such a large amount of assets makes steering to another course an enormous objective to address.
The International Financial Law Review, a publication for attorneys in the financial industry, shows few lawyers want to replace the benchmark. Its recent survey of lawyers from the U. S., U.K. and the rest of Europe found 90% of respondents against the idea of an alternative benchmark.
A U.S. law firm partner was quoted by the IFLR remarking, “If Boeing and Airbus were found to be colluding on jet aircraft prices, would we abolish jet aircraft?”
Well, such a scandal would serve to look for better ways to build and price aircraft.
The British Bankers' Association, a trade association of more than 200 banks, defines LIBOR as the rate at which each bank within the group of banks that sets LIBOR could borrow unsecured interbank funds. LIBOR represents a set of benchmark rates calculated for 10 currencies and for rate periods ranging from overnight to 12 months. In the U.S. market, for example, 18 banks make up the group, including Barclays.
The time has come to transform the reference rate. The market is tremendously changed since LIBOR's creation in the 1980s; it is bigger, more complex and more global. The tools the market has for trading and measuring pricings are more sophisticated.
Generally, investors aren't required to use LIBOR as a reference rate. But convenience has trumped development of a widespread acceptable alternative.
Bankers and investors, as well as regulators, ought to develop an alternative to LIBOR, whether working together or independently. Their goal ought to be to develop new benchmarks, while keeping existing contracts intact and policing them.
And pension fund executives ought to scrutinize other indexes for manipulation as well as the data inputs for valuing non-publicly traded assets. n