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Lie-bor? More like Li-BORE, am I right?

Summary:
A financial crisis followed by a rate-rigging scandal can really take the life out of a market. (And some of its usefulness as an indicator, too.)At one point, the benchmark rate for unsecured short-term loans between banks — known as the London Interbank Offering Rate, or Libor — was basically made up, as the now-infamous Tom Hayes tried to manipulate it in ways that would make his desk’s trades more profitable.And now, well… it’s still kind of made up! Just not in any way that seems particularly exciting or prosecution-worthy. Instead, it’s based on market data that could be “stale,” says Deutsche Bank in a note this week. With our emphasis:…only around one-third of USD Libor submissions at the 3M tenor are based on actual transactions, and the figures for the 6M and 1Y tenors are even

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A financial crisis followed by a rate-rigging scandal can really take the life out of a market. (And some of its usefulness as an indicator, too.)

At one point, the benchmark rate for unsecured short-term loans between banks — known as the London Interbank Offering Rate, or Libor — was basically made up, as the now-infamous Tom Hayes tried to manipulate it in ways that would make his desk’s trades more profitable.

And now, well… it’s still kind of made up! Just not in any way that seems particularly exciting or prosecution-worthy. Instead, it’s based on market data that could be “stale,” says Deutsche Bank in a note this week. With our emphasis:

only around one-third of USD Libor submissions at the 3M tenor are based on actual transactions, and the figures for the 6M and 1Y tenors are even lower. Instead, the bulk of submissions that go into factoring term Libor are based on derived data that could be potentially stale (up to 3 days old at the 3M tenor and 5 days at the 6M tenor), as well as data observed in related but not directly comparable markets such as FX swaps and repo. In these non-transaction-based submissions, the IBA relies on the expert judgment of individual contributors.

ICE Libor — as it’s been called since the Intercontinental Exchange bought the benchmark — reports how many of its submissions are based on actual transactions. In the week ended March 10, submissions for the overnight dollar-denominated Libor benchmark were still transaction-based, shown in the darker colour in the chart below. But the majority of longer-tenor benchmark submissions were based on market data, shown in the paler shade:

Lie-bor? More like Li-BORE, am I right?

Here’s Deutsche’s explanation:

We believe the fundamental problem with Libor is that there are too few transactions in its underlying market to underpin a calculation methodology that’s designed for a robust market. Regulatory changes like the Net Stable Funding Ratio and 2a-7 money market reforms have in recent years encouraged banks to shift away from borrowing in unsecured short-term markets. As a result, liquidity in those markets has significantly declined and activities are unlikely to ever return to their pre-regulatory levels.

To be sure, regulators wanted to discourage unsecured short-term lending between banks, since that reduces risk in the financial system. And regulators have responded to the lack of liquidity cited above by tasking a committee of dealers with finding a new benchmark for the swaps market.

But after the structural changes, it’s important to remember Libor-related indicators aren’t as reliable as they used to be. And that could make it tougher to get a measure of global banks’ default risk.

For example, there have been some tough-to-explain moves in the spread between dollar-denominated Libor and overnight indexed swaps (OIS), which has been described by Alan Greenspan as “a barometer of fears of bank insolvency.”

The gap between the two rates narrowed sharply recently — but that doesn’t mean that fears of bank insolvency have changed much at all. Rather, it probably narrowed because dollar Libor didn’t respond to rate-hike expectations as quickly as the (more liquid) OIS market, Deutsche says:

Following a sharp increase in the OIS rates last week which reflected expectations of a tighter Fed policy, the Libor-OIS spread has collapsed. Given various fundamentals, the current spread appears tight and we look for this to correct in due time. Additionally, we think the recent market move could draw attention to the structural flaws of Libor, which could pave the way for speeding up the benchmark rate reform.

More in the usual place.

Related links:
Alternative Rates Reference Committee interim report and consultation – NY Fed
A meeting about money markets that’s kind of a big deal – FT Alphaville

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Alexandra Scaggs
Alexandra Scaggs is a markets reporter for the Wall Street Journal in New York. She writes about the U.S. stock market and investment trends. She also covers the business of markets research, writing on the calls, personalities and moves of high-profile analysts and strategists. Ms. Scaggs graduated from Washington & Lee University with a degree in business journalism.

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