LIBOR: Looking Forward, Looking Back

1. Timmy! claims that he and the FRBNY were “very forceful from the beginning” in dealing with LIBOR manipulation. This is an example of why Timmy! (AKA Rodney Dangerfield) gets no respect.  His letter to the BOE was a classic example of bureaucratic CYA and buck passing: the BOE then exchanged the buck and passed the pound to the BBA which did . . . nothing.  More nothing happened for over three years, and it wasn’t the FRBNY that drove the process.  The scary thought is that is what passes for forceful in Timmy!’s world: the scary alternative is that Geithner is just BSing about his past forcefulness.  The thought that Geithner’s 2008 actions were forceful is Pythonesque, really:

Cardinal Ximinez: Cardinal Fang! Fetch… the Comfy Chair!
Cardinal Fang: [horrified] The Comfy Chair?
[Fang scuttles off, then returns with the Comfy Chair and sits the old lady down in it] Cardinal Ximinez: Now, you will sit in this chair until lunchtime, with nothing but a cup of coffee at 11!

2. Central bankers are looking for an alternative to LIBOR, EURIBOR, etc

Central banks are exploring whether financial markets might be steered to adopting benchmarks other than Libor. Mr. Bernanke suggested a few alternatives at his hearings this week. Among them: The rate that financial institutions charge each other for short-term loans in “repo” markets in which they use their large securities portfolios as collateral for short-term loans. He said derivatives markets also provide alternatives, such as “overnight index swap,” or OIS, rates, which track central bank lending benchmarks.

That’s great going forward, but what about the $800 trillion or so in notional and/or principal amount of outstanding derivatives, loans, and other financial instruments with payments tied to LIBOR and its European and Asian cousins?  That would be a helluva lot of contracts to orphan.

LIBOR needs to be fixed, because of this massive amount of legacy contracts.  But how?  It won’t be easy, since the transactions that LIBOR et al should be related to-unsecured interbank transactions-aren’t orphaned: they’re damned near extinct.  Any decree by regulators that henceforth LIBOR should be something different than the creature that existed at the time these contracts, loans, etc., were created would potentially result in the shift of many billions of dollars of wealth, and spawn intense legal challenges.  (Ironically, any fines or damages arising from LIBOR manipulation-related legal actions will weaken banks and make the return of unsecured lending all the more remote a prospect.)

Looking for a replacement going forward is the easy problem: market participants have an incentive to come up with something more robust, there will be experimentation and competition, and perhaps with a little regulatory shepherding, in not too long something better (no doubt some sort of secured rate) will emerge as the benchmark.  Going forward, market participants can find transactions and benchmarks that are mutually beneficial.  That provides an incentive to get it right.

Finding a way to deal with the legacy of the past is going to be a much, much more difficult problem.  The primary effects of changes will be redistributive, rather than creative.  This will give rise to massive rent seeking and legal conflict.  Much fun will be had by all.  Especially the lawyers.

About Craig Pirrong 238 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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