“The integrity of benchmark reference rates such as LIBOR and EURIBOR is of fundamental importance to both UK and international financial markets,” says the UK’s Financial Services Authority (FSA) in a notice announcing a £60 million fine imposed on Barclays for conduct “threatening the integrity of those reference rates”.
LIBOR and EURIBOR underlie a large part of the over-the-counter (OTC) and exchange-based derivatives markets, which together account for well over US$500 trillion in notional exposures. They also serve as the basis for many other financial transactions, including loans and mortgages.
Swap dealers created LIBOR in the 1980s to serve as the reference rate for derivatives pricing. The rate is calculated as the result of a daily survey of dealers, who are asked: “at what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size, just prior to 11am?”
But twenty years after the benchmark first appeared the LIBOR-setters within the banks were leant upon by colleagues with requests like the following (from a Barclays derivatives trader).
“I really need a very very low 3m fixing on Monday...we have about 80 yards [billion] fixing for the desk and each 0.1 [one basis point] lower in the fix is a huge help for us. So 4.90 or lower would be fantastic.”
The LIBOR scandal poses questions for the index fund and ETF market.
Self-indexing, which we’ve written about in a recent feature article, involves promoters of index-tracking financial products then getting involved in developing those products’ underlying benchmarks.
In the US, there’s been a flurry of recent applications by ETF managers to the securities market regulator to grant an exemption to the prohibition, set in the 1940 Investment Company Act, on funds’ dealings with affiliated parties. In these applications fund managers seek permission to run their own indices, often involving newer concepts offering so-called “smart beta” and the promise of outperformance.
In Europe, where there are no legal restrictions on self-indexing, it’s already common for ETFs to track benchmarks that are run in-house.
The firms that develop their own indices will tell you that there are Chinese walls in place between traders and the index calculation teams, and that the selection of index components or their pricing cannot be influenced by commercial interests. Self-indexers may also outsource the index calculation function to an independent third party.
All the same, today’s revelations of Barclays’ misdeeds remind us to treat reassurances over conflicts of interest with scepticism.
There may be a better separation of duties on the indexing side of the business than on banks’ interest rate desks, but that’s not saying much. According to a report yesterday on Bloomberg, little has changed in the way LIBOR operates: there are still no real barriers between the treasury staff charged with answering the daily rate survey and traders who stand to profit or lose, depending on where the rate is set each day.
And the more indices stray from the traditional, capitalisation-weighted approach towards more complex methodologies, the more opaque the benchmark becomes to the end-investor and the more scope there is for things to go wrong. The risk of index manipulation is also higher in the many areas of the market where trading remains non-transparent.
After its phenomenal early success, LIBOR is now “broken” as a benchmark, say market observers. That’s partly because banks now struggle to borrow money on an unsecured basis, but also because of the misdeeds of traders such as those at Barclays. Index-following investors would do well to double-check that their funds’ benchmarks cannot be tarnished in a similar way.