Focus on regulation - US study examines strengths and weaknesses of Libor and its alternatives

By: David Walker

Libor, one of the fundamental measures used in capital markets, has now been widely discredited due to the unfolding scandal of its production. However, as practitioners hunt for replacements, research by Finadium suggests the major alternatives also have their own strengths and weaknesses.

The research house based in Massachusetts says weaning the present benchmark off $800trn of assets - mostly loans and debt instruments - is "a daunting task".

In a comprehensive report on Libor and its alternatives, author and senior consultant Jonathan Cooper writes: "The usefulness of Libor had been suspect for years; it was advertised as an executable rate that reflected low and homogeneous counterparty credit risk, but the wheels came off during the financial crisis."

The researchers explain false daily Libor submissions by banks - revealed as Barclays admitted its own Libor quotes were less than accurate - are "just the start, [and] the weaknesses in Libor go far beyond the current scintillating scandal," he writes.

Quotes for Libor are meant to reflect rates that banks pay to deal between one another, so they necessarily include elements of credit risk, which can take pre-eminence in stressed moments, the report notes.

Another weakness is Libor quotes represent non-binding offers rather than actual trades, Finadium adds.

Another ‘weakness' now might be Libor's discrediting in the public's eyes although Finadium says that, while the scandal has "given the regulators and public (yet) another reason to suspect intentional wrongdoing in financial markets, the problems are, as usual, more nuanced and layered than the sound bites."

Cooper concludes his comments on Libor's shortcomings by noting: "Even traders quoting it on a daily basis have no one rate to guide them, but instead go through a process of triangulation to find the best figure. When there is no data on actual trades, inserting a value for LIBOR becomes a matter of guesswork."

The report noted here the spread between the highest and lowest quotes for three month Libor in the month after Lehman Brothers' collapse increased from just 7bps to 115bps.

What should one use instead, if a replacement is to be found?

Maybe Fed Funds, and its derivative Overnight Index Swaps?

But these each rely on "a robust underlying Federal Funds loan market, and decisive policy actions by US regulators have greatly diminished recent loan volumes", Finadium says.

"The Fed Funds rate is subject to substantial market and technical factors, including changes in Reg D and FDIC insurance rules that have reduced its liquidity by 80% since early 2008. And Fed Funds, like LIBOR, are unsecured deposits.."

What about repo then?

This is "the alternative with promise" according to Finadium, "and specifically repo on ‘safe assets' like US Treasuries, Agencies, and Mortgage-Backed Securities.

But Finadium's Cooper adds: "Repo can be very ‘clubby' and lacks transparency, a major concern for regulators thinking about shadow banking. This is changing however, with the growing popularity of repo indices and the licensing of these indices by NYSE Liffe for a repo futures product."

The repo business has traditionally been opaque - notwithstanding new repo indices the DTCC and ICAP have created - and "not without its issues in the financial crisis. It is also part of the shadow banking investigations currently underway by the Financial Stability Board," Finadium says.

"Ultimately, we believe that the markets will turn to the secured collateral of repo as the solution, although there are multiple hurdles that need to be overcome," Finadium concludes.

For more on Finadium including details of its various other reports see www.finadium.com.

Courtesy: http://www.investmenteurope.net/investment-europe/news/2199399/focus-on-regulation-us-study-examines-strengths-and-weaknesses-of-libor-and-its-alternatives