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LIBOR Transition and the Introduction of “Risk-Free” Rates

During the Great Recession starting in 2008, financial products known as collateralised debt obligations (CDOs) are considered to be blame for the worst recession since the Great Depression of the 1930s. These CDOs, specifically a type of derivation (a financial product deriving its value from underlying assets) were increasingly being based on baskets of mortgages. The runaway ever-increasing pricing of property due to the exponential demand for particularly housing coupled with the hunger for CDOs created an endless demand and supply loops: demand of housing, increasing prices, additional requests for mortgages, supply of mortgages, creation of more CDOs, demand for mortgages, dropping of standards to obtain mortgage, thus increasing demand of housing.

Unbeknownst to many, although mentioned here and there by players in the banking and financial industries, including through the media, there was an additional underlying potential aggravation as to the eventual collapse of markets: LIBOR. The London Interbank Offering Rate (LIBOR) was a measure of the interbank cost in terms of interest of lending money to one another usually in a specified period (e.g. overnight, 1 month, 3 months, etc.). Traditionally a panel of banks would self-report this rate to the British Banking Association (BBA), an independent body, of which an average was taken and published every day at 11am. The reported rates were effectively estimates of expectations often loosely and not categorically based on bank’s perceptions of market conditions. Of course, this led to many years of manipulation of said rates by individual banks, attempting to impact the published rate of LIBOR underlying trillions of dollars worth of even consumer based financial products such as variable rate mortgages. Very often, those that were given authority of reporting to the BBA within banks were closely associated or directly involved in trades, providing a great deal of incentive to move LIBOR in their favour even by as little as a basis point (0.01%). This manipulation extended to collusion amongst traders and teams across multiple banks and brokerages with management in many cases knowing of this behaviour, but otherwise ignoring it.

After a significant investigation was conducted on both sides of the Atlantic by numerous US and UK government agencies, arrests were eventually made. Oversight of LIBOR was handed to UK financial regulators to ensure integrity and reliability moving forward. It was recommended that from 2012 that the panel of banks reporting rates should do so based on sets of recorded transactions, and with the publication of individual bank’s rates submissions every three months. More recently it has been decided that LIBOR should be replaced altogether with what the Bank of England has termed risk free rates (RFRs). One of these is the Sterling Overnight Interbank Average Rate (SONIA). This currently exists and is the effective interest rate charged overnight on unsecured transactions in Sterling (the equivalent being SOFR in the US overseen by the NY Federal Reserve).

SONIA is a weighted average of a previous day’s overnight Sterling transactions and is published daily. The other rates likely to be picked up in the EU and the US follow similar calculations. However, after all the realisation, scrutiny and subsequent criminal conviction surrounding LIBOR it seems somewhat ironic that a replacement rate categorised as being “risk free” are being used. Intrinsically it could be argued that no rate is without risk, especially when again like LIBOR, in effect, these “risk free” rates, speaking particularly of SONIA, are subject to the rates the banks themselves set on their own transactions with one another. In saying this, there is of course an inherent reduction in potential risk of blatant making up of rates entirely due to those being set and therefore fed into SONIA being used in the past to affect real transactions. But to imply then that banks or financial institutions could not on a subtle level (e.g. a basis point of movement) affect overall averages of SONIA through their own decisiveness of transactional interest rates seems far fetched. Continued trust of these behemoths of complex, profit driven, financial networks may be detrimental to much more than these networks themselves which was seen in the Great Recession. This is not to say that outright distrust is warranted, or there is an existing or otherwise interest rate calculation that does more to drive home or enforce integrity. However, using one that fundamentally appears vulnerable to similar nefarious activity seems counter productive.

by Maurizio J Liberante

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