September 24, 2012,
Good afternoon Vice Chairwoman McCarthy and members of the Committee. I am pleased to appear before you today along with my friend, Michel Barnier.
This is my third time speaking to this committee but my first under these circumstances. Thank you for allowing me to appear via video.
I couldn’t be with you in person because a couple of weeks ago I fell in my house outside of Washington. The result of this clumsy fall was four broken ribs and a punctured lung, and I wasn’t yet able to travel overseas.
I will have a full recovery, but as I’ve been recuperating, I’ve had some persistent questions from friends and family: how did it happen, how extensive is the problem, and what is the healing process?
As I turned to preparing for this testimony, I found myself asking the same questions about the Barclays case that I’ve been hearing about my injury, which I will try to answer today.
How did it happen?
There are at least three issues with LIBOR and other survey rates that I would like to discuss.
The first and possibly the most significant issue with LIBOR is that the number of banks willing to lend to one another on an unsecured basis has been sharply reduced.
This is because of a number of factors, including the 2008 financial crisis, the ongoing European debt crisis, enhanced regulatory capital and liquidity rules, and the downgrading of large banks’ credit ratings.
For a benchmark rate for any commodity to be reliable and have integrity, it’s best to be anchored to real, observable transactions. It's through real transactions between arm’s length buyers and sellers coming together in a marketplace that prices are discovered and set.
When market participants submit for a benchmark rate that lacks observable underlying transactions, even if operating in good faith, they may stray from what real transactions would reflect. Like walking in a dark forest, it’s easy to get lost, particularly over time. In addition, when a benchmark is separated from real transactions, it is more vulnerable to misconduct.
The second issue with LIBOR is that the banks that make LIBOR submissions do so essentially without oversight. (There are no rules requiring controls, firewalls, independent testing, policies and procedures, or a methodology ensuring that submissions are transaction-focused, as the benchmark was originally intended.) For instance, there are no specific controls to prevent banks from intentionally or unintentionally herding together and reporting the same or similar rates.
The third issue with LIBOR is that banks that submit their estimated borrowing rates naturally have inherent conflicts of interest. For instance, their trading positions are affected by the outcome of such surveys. These conflicts of interest must be properly managed.
How extensive is the problem?
Naturally, people are wondering if the Barclays case was isolated. The case highlights the broader issue: the underlying interbank market to which LIBOR and Euribor refer has significantly diminished.
Aside from the Barclays situation, market data raises questions about the integrity of LIBOR today. I go into detail about this data in my written testimony, but in short, I have four main points:
First, there are two surveys of U.S. dollar interbank borrowing rates, U.S. Dollar Euribor and U.S. Dollar LIBOR. Yet this Euribor survey is twice as high as the Libor survey.
Second, there’s a well-known concept in finance called interest rate parity, basically that currency forward rates will align with interest rates in two different economies. But since the financial crisis, that has not been case, whether looking the dollar versus the euro, sterling or yen. Theory hasn’t been aligning with practice. The borrowing rate implied in the currency markets is quite different than LIBOR.
Third, just like stocks and bonds, short-term interest rates experience volatility. In the last few years, there has been a lot of volatility in markets. But LIBOR is far more stable than any comparable rate.
Further, individual submitters don’t change their submission very much. This year to date, the rates submitted daily by banks for three-month LIBOR have not changed 85 percent of the time.
And fourth, as LIBOR represents unsecured borrowing between banks, it should reflect the credit risk of lending to banks. In looking at publicly available data for 14 of the submitting banks, however, the one-year borrowing rates for LIBOR do not seem to reflect the market for the same banks one-year credit default swaps.
I believe this market data says something about the health of this patient, LIBOR, that goes beyond the Barclays case.
What is the healing process?
When the CFTC began to investigate the Barclays matter, the agency was guided by our founding statute, the Commodity Exchange Act, which makes it unlawful to manipulate or attempt to manipulate the price of a commodity in interstate commerce, or the price of a futures or swaps contract. It is also unlawful to knowingly publish false information that tends to affect commodity prices.
As Europe considers legislation to enhance enforcement authority regarding benchmarks, Parliament may wish to consider provisions similar to those we have in the US. Such provisions can provide your regulators with additional authority to promote market integrity and protect market participants.
As we look to next steps, I believe it is critical that benchmark rates rely upon observable transactions.
A rate that relies upon observable transactions is anchored by the reality of that price discovery.
A rate that relies upon observable transactions has a lit path to credibility.
A rate that relies upon observable transactions is less vulnerable to misconduct.
International regulators and market participants can work to address LIBOR’s issues of governance and conflicts of interest, but the fundamental issue remains: the underlying market for unsecured interbank borrowing has largely diminished.
Thus, similar to a medical problem, which I’ve had on my mind with my broken ribs, the question is can LIBOR be sufficiently mended, or is this a circumstance where it's better to be replaced with a rate based on observable transactions? Such alternatives exist, including the overnight index swap rate and repo rates.
If the market were to move to a replacement, it is crucial that there be an appropriate transition for people borrowing, lending or hedging based on LIBOR. Broad market input would be necessary to establish protocols and market mechanisms for such a transition. Any such transition should ensure the ability to smoothly migrate so borrowers, lenders and hedgers are least affected by a possible change.
Several international organizations will be examining and recommending approaches, including BIS and IOSCO. Martin Wheatley and I have been asked to co-chair the IOSCO task force, and I look forward to our work together on these issues.
In conclusion, it is time for a healthy benchmark anchored in actual, observable market transactions.
It is time to restore the confidence of people around the globe that the rates at which they borrow and lend money and hedge interest rates are set honestly and transparently.
I thank you again, and I look forward to your questions.
Last Updated: September 24, 2012