February 28, 2013
Good morning. Thank you, Ken, for that kind introduction. I also want to thank the Global Financial Markets Association for the invitation to speak at your conference on the Future of Global Financial Benchmarks.
This conference comes at a critical juncture.
It comes as there has been a lot of media attention surrounding the three enforcement cases against Barclays, UBS and RBS for manipulative conduct with respect to the London Interbank Offered Rate (LIBOR) and other benchmark interest rate submissions.
More importantly, it comes as market participants and regulators around the globe have turned to consider the critical issue of how we reform and revise a system that has become so reliant on LIBOR and similar rates.
I believe that continuing to reference such rates diminishes market integrity and is unsustainable in the long run.
Let’s look at what we’ve learned to date.
First, the interbank, unsecured market to which LIBOR and other such rates reference has changed dramatically. Some say that it is has become essentially nonexistent. In 2008, Mervyn King, the governor of the Bank of England, said of LIBOR: “It is, in many ways, the rate at which banks do not lend to each other.”
There has been a significant structural shift in how financial market participants finance their balance sheets and trading positions. There is an increasing shift from borrowing unsecured (without posting collateral) toward borrowings that are secured by posting collateral. In particular, this shift has occurred within the funding markets between banks.
The London interbank, unsecured market used to be where banks funded themselves at a wholesale rate. But the 2008 financial crisis and subsequent events have shattered this model.
The European debt crisis that began in 2010 and the downgrading of large banks’ credit ratings have exacerbated the hesitancy of banks to lend unsecured to one another.
Other factors have played a role in this structural shift. Central banks are providing significant funding directly to banks. Banks are more closely managing demands on their balance sheets. And looking forward, recent changes to Basel capital rules will take root and will move banks even further from interbank lending.
The Basel III capital rules now include an asset correlation factor, which requires additional capital when a bank is exposed to another bank. This was included in the new standards to reduce financial system interconnectedness.
Furthermore, the rules introduce provisions for a liquidity coverage ratio (LCR). For the first time, banks will have to hold a sufficient amount of high quality liquid assets to cover their projected net outflows over 30 days.
At a roundtable on financial market benchmarks held in London last week, one major bank indicated that the LCR rule alone would make it prohibitively expensive for banks to lend to each other in the interbank market for tenors greater than 30 days. Thus, this banker posited that it is unlikely that banks will return to the days when they would lend to each other for three months, six months or a year.
Second, we also have learned that LIBOR – central to borrowing, lending and hedging in our economy – has been readily and pervasively rigged.
Barclays, UBS and RBS were fined $2.5 billion for manipulative conduct by the CFTC, the UK Financial Services Authority (FSA) and the Justice Department. At each bank, the misconduct spanned many years, took place in offices in several cities around the globe, included numerous people – sometimes dozens, even included senior management, and involved multiple benchmark rates and currencies. In each case, there was evidence of collusion.
In the UBS and RBS cases, one or more inter-dealer brokers painted false pictures to influence submissions of other banks, i.e., to spread the falsehoods more widely. Barclays and UBS also were reporting falsely low borrowing rates in an effort to protect their reputation.
These findings are shocking, though the lack of an interbank market made the system more vulnerable to such misconduct.
Third, we have seen a significant amount of publicly available market data that raises questions about the integrity of LIBOR today.
A comparison of LIBOR submissions to the volatilities of other short-term rates reflects that LIBOR is remarkably much more stable than any comparable rate. For instance, how is it that in 2012 – if we look at the 252 submission days for three-month U.S. dollar LIBOR – the banks didn’t change their rate 85 percent of the time?
Why is it that some banks didn’t change their submissions for three-month U.S. Dollar LIBOR for upwards of 115 straight trading days? This means that one bank said the market for its funding was completely stable for 115 straight trading days or more than five months.
When comparing LIBOR submissions to the same banks’ credit default swaps spreads or to the broader markets’ currency forward rates, why is there a continuing gap between LIBOR and what those other market rates tell us?
In the fall of 2011, there was so much uncertainty in markets due to the European debt crisis and challenges here in the United States. How is it that a number of the banks were still saying they could borrow in the interbank market for one year at about 1 percent, even though the traded markets for the same institutions’ one-year credit default swaps were trading four or five times higher?
Further, 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. Why is it that since the financial crisis, that has not been the case, whether looking at 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.
Nassim Nicholas Taleb, whom you may know as the bestselling author of The Black Swan, has written a recent book called Antifragile: Things that Gain from Disorder. His main theme is: “Just as human bones get stronger when subjected to stress and tension … many things in life benefit from stress, disorder, volatility, and turmoil.”
He notes that systems that are fragile succumb to stress, tension and change. Systems that are not readily able to evolve and adapt are fragile.
One of his main points is that propping up a fragile system in the interest of maintaining a sense of stability only creates more instability in the end. One can buy an artificial sense of calm for a while, but when that calm cracks, the resulting turmoil is invariably greater.
I think that the financial system’s reliance on interest rate benchmarks, such as LIBOR and Euribor, is particularly fragile.
These benchmarks basically haven’t adapted to the significant changes in the market. The interbank, unsecured lending market, particularly for longer tenors, is essentially nonexistent. LIBOR and similar benchmarks have been readily and pervasively rigged. And there is substantial market data that raises questions about LIBOR’s continuing integrity.
Thus, the challenge we face is how does the financial system adapt to this significant shift?
At the London roundtable on financial market benchmarks held last week, a man approached me to discuss a bit of the history of LIBOR in which he had personally been involved. It seems that in 1970, as a young banker, he worked on a floating rate note deal for ENEL issued by Bankers Trust that used a reference rate called LIBOR.
A lot has changed since 1970 – Nixon was President, we were in the midst of the Vietnam War, the Beatles released their final album Let It Be, and I was a kid wearing bell-bottoms.
Sixteen years later, the British Bankers Association (BBA) began publishing LIBOR as we know it today. A lot has changed since 1986 – Reagan was President, we were in the midst of the Cold War, and I was dating the wonderful woman I would marry, Francesca.
And now, I have three wonderful daughters but am a single dad. In life, one must adapt to change.
Yet LIBOR – embedded in the wiring of our financial system – largely remains the same.
This is why international regulators and market participants have begun to discuss transition. The CFTC and the FSA are co-chairing the International Organization of Securities Commissions (IOSCO) Task Force on financial market benchmarks. The task force is developing international principles for benchmarks and examining best mechanisms or protocols for a benchmark transition, if needed.
In January, the task force published the Consultation Report on Financial Benchmarks, and a final report will be published this spring.
One of the key questions in the consultation is how do we address transition when a benchmark is no longer tied to sufficient transactions and may have become unreliable or obsolete?
The consultation seeks public input about transition in two contexts:
• Prospectively, the consultation suggests that contracts referencing a benchmark would be more resilient if those contracts had embedded in them a contingency plan for when a benchmark may become obsolete.
• And perhaps more challenging, the consultation asks what to do about existing contracts that reference a benchmark that becomes obsolete, if those contracts don’t have an effective contingency plan.
Martin Wheatley of the FSA recommended that Canadian dollar LIBOR and Australian dollar LIBOR cease to exist so a transition is necessary, at least for those reference rates.
The market has some experience with transition, albeit for smaller contracts, such as for energy and shipping rate benchmarks. The basic components of such a transition include identifying a new and reliable benchmark, one that is anchored in transactions. The new and existing benchmarks run in parallel for a period of time to allow market participants to transition.
A critical statement in the consultation report was: “The Task Force is of the view that a benchmark should as a matter of priority be anchored by observable transactions entered into at arm’s length between buyers and sellers in order for it to function as a credible indicator of prices, rates or index values.”
It went on to say: “However, at some point, an insufficient level of actual transaction data raises concerns as to whether the benchmark continues to reflect prices or rates that have been formed by the competitive forces of supply and demand.”
I agree with both of these statements. A reference rate has to be based on facts, not fiction.
Without transactions, the situation is similar to trying to buy a house, when your realtor can’t give you comparable transaction prices in the neighborhood – because no houses were sold in the neighborhood in years.
Given what we know now, it’s critical that we move to a more robust framework for financial benchmarks, particularly those for short-term, variable interest rates. There are alternatives that market participants are considering that are grounded in real transactions. These include the overnight index swaps rate, benchmark rates based on actual short-term collateralized financings, and benchmarks based on government borrowing rates.
There are important ongoing international efforts to come up with principles for financial market benchmarks. These principles will address governance, conflicts of interest and transparency of reporting.
Nevertheless, even if we’re able to address these issues, there remains the issue of whether LIBOR and similar rates continue to reference an underlying market that is essentially nonexistent.
I recognize that moving on from LIBOR may be challenging. Today, LIBOR is the reference rate for 70 percent of the U.S. futures market, most of the swaps market and nearly half of U.S. adjustable rate mortgages.
I recognize that moving on from LIBOR may be unpopular. But as the author Nassim Taleb might suggest, it would be best not to fall prey to accepting that LIBOR or any benchmark is “too big to replace.”
I believe that the best way to promote both market integrity and long-term stability is by ensuring that benchmarks are reliable and honest. And I believe it’s critical to work together to promote a smooth transition, where needed.
I recognize that change can be hard, but change is also a natural part of life.
After all, I’m sure you’re relieved I didn’t show up in bell-bottoms today.
Last Updated: March 1, 2013