Transparency is essential to healthy markets. Active markets that determine prices based on supply and demand as revealed by arm's length transactions are a key requirement of transparency. The London interbank offered rate violates this standard. As such, it is time to consider a replacement.
Libor is not an average of arm's length market transactions, but rather rates derived by a survey of a few large global banks which report estimates of what it would cost them to borrow from other such large banks on any given day. Survey results are calculated and published by Reuters on behalf of the British Bankers' Association. Severe weaknesses in this process have been exposed by recent events.
Alleged illegal attempts at manipulation, along with large civil money fines paid by various banks involved with the Libor setting process, clearly imply substantial problems exist with respect to measurement and reporting protocols. Hundreds of millions of dollars in losses by unsuspecting market participants around the world may have resulted from rate-rigging. Despite this, Libor remains the primary contractual reference for some $350 trillion of financial contracts, according to data published by the Bank for International Settlements. If Libor is set artificially high, the floating rate payer loses. If Libor is set artificially low, the floating rate recipient loses. How can we know what is right with a rate not based on actual transactions?
This key component of financial markets is in serious need of reform. Replacing Libor with a new reference rate driven by actual market transactions is clearly the best remedy for the flaws inherent in the current system. Achieving transparency and confidence by trying to fix the problems with Libor by modifying existing procedures offers formidable, perhaps insurmountable, obstacles.
Ongoing investigations by the U. S. Department of Justice and the U. K. Serious Fraud Office, as well as the potential for future civil penalties and lawsuits, confirm the serious nature of existing flaws and point to the need for a better alternative. Even if building safeguards to reduce the likelihood of attempted manipulation of Libor rates were achieved, we are left with the central problem: Libor is not a market rate.
To establish a suitable replacement for Libor, we need to identify essential criteria. We need complete transparency with respect to price discovery and reporting, a true market price that is the result of arm's length transactions between informed buyers and sellers in a sufficiently deep and liquid market so the index can be readily calculated and insulated from manipulation by a few large players. We also need a system that is dependable and in consistent issuance, denominated in U. S. Dollars, derived from very high credit quality instruments and not used as central bank policy targets or for market intervention. Lastly, we need an index based on a market that can be relied on to continue to function well under all market conditions, including those of great market stress.
Is there such a market on which an alternative to Libor can be based? While investigation may develop multiple possibilities, there is one large market which clearly meets all of the required criteria: the market for the discount notes of the Federal Home Loan Banks (FHLBs), as first suggested by Alex Pollock of the American Enterprise Institute.
Yields on FHLB securities are the result of arm's length transactions with some 80 approved debt underwriters in the U.S. and abroad and among hundreds of end buyers. The discount note market is deep and liquid with average term issuance of over $ 1.3 trillion annually since 2001. The average annual amount outstanding was over $200 billion over the same time frame.
This market attracts investors from around the globe, offering maturities ranging from overnight to one year. The notes are denominated in dollars. The market is much too large and broadly distributed to be easily manipulated. FHLB notes are rated A1+/PI from Standard & Poor's and Moody's, and backed by the high credit quality of a resilient credit structure: All discount notes are the joint obligation of the 12 Federal Home Loan Banks. Interest rates on FHLB discount notes are not the target of any government policy nor are they used for market intervention. Moreover, they are readily linked to the overall financial system through the 8,000 financial institutions which can borrow from the FHLBs. Lastly, the reliability of the discount note market under the most difficult of circumstances was demonstrated by its robust performance during the recent financial crisis.
Convincing market and government actors to adopt a replacement for Libor, even with all its flaws, is a large undertaking. Major market participants, including international banking agencies and regulators, would have to participate. Considerable legal, operational and political time and effort would be required. The effort is nonetheless worth it when compared to the restoration of market transparency and confidence in the central interest rate index for the world's principal currency.
Allan Mendelowitz is a financial consultant and former chairman of the Federal Housing Finance Board. Mike Moore is a financial consultant and former executive vice president of the Federal Home Loan Bank of Chicago.