Satyajit Das: A tricky path to tread if the Libor fix is to be fixed

Weekend view

Given the importance in money markets of Libor, responsibilities for oversight are remarkably unclear. The British Bankers' Association insists that its process is transparent and unambiguous. As all contributing banks are regulated, the BBA argues that regulators are responsible for individual banks' behaviour.

The BBA knows each person responsible for submitting information and can demand to see the actual trades on which these figures are based. No evidence that this was done has been disclosed. The Financial Services Authority does not have a specific regime governing Libor submissions, relying on broad rules governing identification and prevention of conflicts of interest. Amusingly, a recent BBA review proposed no changes to the rate-setting methodology, merely a code of conduct and greater scrutiny of Libor's correlation with other financial data over time

There are now no shortages of suggestions for increased oversight and regulation of the rate-setting mechanism. Proponents of "narrow" banking argue that the separation of commercial and investment banking would solve the problem. But interest rate benchmarks affect normal lending and deposit-taking activity as well as trading activity. Proponents of the Volcker Rule argue that preventing proprietary trading by banks would minimise the problem. In reality, manipulation was not only related to trading positions but general banking activity.

Resistant to more stringent regulations, UK authorities nostalgically hanker for a time when most bankers in London were located in the Square Mile and relied on mutual trust. According to folklore, nothing more than a central bank governor's raised eyebrows was necessary to prevent unsatisfactory conduct. The good old days were not what they seemed. In the 1980s, the head of a UK merchant bank told new employees that he didn't know how they would get rich given that insider trading was being banned.

A battle between major financial centres underlies the debate. In the 2000s, London became the world's dominant finance hub. Non-intrusive, market-responsive, "light-touch" regulation was a factor in its success. Damage to London's reputation and stricter regulation would allow New York and European centres to regain competitive ground.

US authorities hinted that they forced reluctant UK regulators to act and are at the forefront of driving reform. Given the large volume of transactions linked to the benchmark, it is essential that changes do not disrupt the operation of the market.

There is agreement that the rates should be based on actual transactions rather than theoretical estimates. There should be independent oversight of the process. Banks should be required to segregate the function for fixing rates from other activity to prevent conflicts of interest. Rate submissions should be documented to provide transparency and an adequate audit trail. The approach specified by the US Commodity Futures Trading Commission in its enforcement order imposed on Barclays embraces most of these principles. The review for the FSA, headed by Martin Wheatley, also accepts these principles.

But the changes pose different problems. While basing Libor on actual transactions is desirable, the theoretical benefits may be difficult to achieve in practice due to the shrinking size of the market and reduced activity levels. As Sean Keane, a former head of Money Market Trading at Credit Suisse, wryly observed: "over the last four years there have been fewer actual transactions in the unsecured cash market than there have been discussions about how to reform Libor".

As differences in bank credit ratings and quality increases resulting in greater variations in borrowing costs, Libor rates will become variable and less meaningful. Membership of a Libor-fixing panel, once considered prestigious, may no longer be attractive. For loans and deposits, banks may move to internal rates, which reflect their cost of borrowing. The biggest effect will be on derivatives transactions.

Created in simpler times, Libor was designed for pricing loans and deposits. Over time, derivatives based on Libor have become dominant. Perversely, the cash market on which Libor is based now supports a vastly larger derivatives market. generations of quantitative experts have built elegant models based on advanced mathematical techniques to price complex derivative instruments on a deeply flawed and easily manipulated base.

Christoph Rieger, head of fixed income strategy at Commerzbank, said: "Libor is not a market interest rate. The spot fixings are at best bank guesses of a hypothetical interbank borrowing rate. For that reason, this will always be subject to controversy." Given this fact, Steve Baker MP asked the obvious question: "Members are increasingly wondering how such a large industry has been allowed to grow up on such a finger-in-the-wind number."

Satyajit Das is author of Extreme Money and Traders Guns & Money