The hunt for a credible replacement for Libor – long the most accepted market measure of short-term interest-rate moves – is heating up. Banks are testing alternatives to the London interbank offered rate, which is coming under increased scrutiny after regulators accused banks of manipulating the rate. Libor suffered a fresh blow to its credibility recently, when Barclays admitted that its traders attempted to maneuver the rate and agreed to pay fines totaling $455 million.
Libor is not a market determined interest rate; rather it is a trimmed mean from a survey of banks participating in a survey conducted on behalf of the British Bankers Association (BBA). There are a number of problems inherent in the survey-based Libor calculation. First, there is the stigma associated with a higher than average Libor posting. This stigma results in an under-reporting of Libor. Second, there have been incentives for banks to attempt to manipulate Libor by submitting Libor postings that would alter the trimmed mean. The ethics of such manipulation are materially different from the aforementioned stigma associated under-representative of Libor. Here the manipulation was an attempt to foster Libor rates that enriched trading operations of the submitting bank.
Japan’s Nomura Holdings Inc. and Swiss bank UBS AG are among banks trying out a rate linked to the market for repurchase agreements – GCF Repo Index, which is published by Depository Trust & Clearing Corp., the group that clears and settles financial contracts. Unlike Libor, the GCF index is based on actual, not estimated, rates paid for repurchase agreements, or “repos,” which are a crucial source of short-term funding for many banks. While some say the GCF Repo index might be a better barometer of bank borrowing costs than Libor, others counter that the index isn’t an easy substitute. They say repurchase agreements involve collateral such as Treasurys and are therefore less risky than loans in the Libor market.
Before Libor, banks and securities dealers tended to hedge their short-term interest-rate risk with futures on U.S. Treasurys. While bank funding costs can mirror Treasury rates, they often don’t track well during times of panic, when investors rush away from private borrowers and lend at very low rates to the U.S. government.
There are other measures of short-term borrowing costs, but none of them have become broad benchmarks on the scale of Libor. They include the Fed Funds Effective rate, an overnight rate at which banks lend to one another, as well as Treasury bill rates. Its detractors say the federal-funds rate is subject to changes in the Federal Reserve’s monetary policy. And there is uncertainty about how the market will react when the Fed eventually unwinds the entire monetary stimulus it has in place.
Finding a successor could take years. Libor has been growing in influence as a benchmark interest rate since the 1980s and currently is used to set rates for an estimated $800 trillion of derivatives and borrowings, including loans to consumers, companies and governments. Much like credit ratings, it is deeply embedded in the way financial markets function.