Reforming LIBOR and Other Financial Market Benchmarks by Darrell Duffie and Jeremy C. Stein

Reforming LIBOR and Other Financial Market Benchmarks

Darrell Duffie and Jeremy C. Stein
Journal of Economic Perspectives—Volume 29, Number 2—Spring 2015—Pages 191–212

LIBOR is determined each day - or "fixed" - based not on actual transactions between banks but rather on a poll of a group of banks, each of which is asked to make a judgement-based estimate of the rate at which it could borrow.
The thinness of the underlying interbank markets has made it difficult to come up with reliable daily fixings that are transactions-based.
The solution proposed in the policy reports of our groups is to fix the IBORs using a much wider set of unsecured bank-borrowing transactions, not just those in the interbank market. Second, the reform process should strongly encourage heavier use of alternative benchmark reference rates.
Agglomeration effect is beneficial from the standpoint of liquidity, it increases incentives for market manipulation.
Many of the interest-rate trading applications currently served by the IBORs could be as well or better served by risk-free or near-risk-free benchmarks that are not tied to banks' costs of funds.
Financial market participants rely on benchmarks for a range of purposes that are primarily related to reducing asymmetric information regarding the value of underlying traded financial instrument.
Adverse selection makes it hard for the bank to negotiate a contract that is based on its own future credit spread. This market breakdown might be overcome to some extent with hedging contracts that are instead linked to market-wide. A benchmark based on the interbank offered rate allows banks to hedge at least the common component of their borrowing costs.
A benchmark can become a powerful "basin of attraction" for related trades:

• the incentive for market participants to reap the information-related benefits of a benchmark
• the incentive to lower trading costs that are associated with illiquidity

During the financial crisis of 2007-2009, no bank wished to appear to be less creditworthy than others.
If traders are able to benefit their swap positions by causing a benchmark to move one way or the other, the least ethical of them may attempt to do so.
In order to mitigate manipulation, tighter governance and regulatory monitoring of the fixing process may be somewhat effective.
Reform LIBOR:

• two-benchmark approach
• one of these two benchmarks, would continue to be based on banks' wholesale unsecured funding costs and would be appropriate for applications that rest on that credit risk component.
• the second would be based on a diskless or near-diskless rate that is established in a broad and deep market
• three questions need to be addressed
• how does one most effectively design an improved version of LIBOR (LIBOR+), so that it is based to the maximum extent possible on actual market transactions, rather than on banks' discretionary reports of their funding costs?





• the Market Participants Group (2014) built a prototype LIBOR+ fixing algorithm. On any given day t, for any given bank i, and for any tenor of interest, if bank i has an available transaction, the rate on that transaction is entered with a weight of unity into the index. If bank i does not have an available transaction, the algorithm goes backto the nearest prior date t − k when there is a transaction, and enters the rate on that transaction into the index with a reduced weight—one that gets smaller as the distance k from the present gets larger. Thus the algorithm includes noncontempo- raneous data to compensate for the low density of transactions on any given day, but downweights the older data in light of its staleness (Duffie, Skeie, and Vickrey 2013).
• a key to reforming interest rate benchmarks is to encourage the transition of a large fraction of derivatives trading to a more robust benchmark based on interest rates that are risk-free, or nearly so.
  




• what is the appropriate diskless or near-diskless rate to use for pure rates-trading applications?
• it would be a mistake for such a benchmark to shoulder the burden of being the primary reference rate for the entire interest-rate derivatives market.
  
  
• how can policymakers help to break the stranglehold of existing LIBOR and pave the way for transition to a two-rate regime?

Rather than restating our arguments, we close by highlighting a fundamental limitation of our analytical approach. From the outset, we have taken as given two policy objectives:

1. it is desirable to maintain large, deep, and liquid interest-rate derivatives markets
2. it is also desirable to design markets in a way that leans against manipulation. 

But as we have seen, there is a fundamental tension between these two objectives: the deeper and more liquid a derivatives market becomes, the more tempting it is for market participants to manipulate the underlying benchmark referenced by these derivatives. 

This suggests that even the best market design can only go so far, and that if one wishes to support the existence of a very large derivatives market, some equi- librium level of manipulation may be an inevitable cost of doing business.  

Given that one cannot count on market design as a panacea for preventing manipulation, vigorous enforcement of the civil and criminal statutes against market manipulation will continue to play an important role no matter what other reforms are undertaken.