Introduction

The British Bankers’ Association’s (BBA) Libor rate is under review. 

BBA LIBOR was first developed in the 1980s as demand grew for an accurate measure of the real rate at which banks would lend money to each other.

16 contributor panel banks meet every morning and provide the rates at which they borrow 10 world currencies and 15 lending periods ranging from overnight to one year.

The middle 50 per cent of these rates are taken to calculate an average, which, at 11am every morning is released to Reuters and which then become that day’s BBA LIBOR rate.

The global credit problems have had repercussions on various markets, and particularly on the carry trade markets in foreign Exchange, but the most direct result was the surge in borrowing costs.  When Libor rates did not appear to be accurately reflecting these rate hikes, the BBA became concerned and has decided to review the system that sets Libor.

Julia Werdigier of the New York Times reported that “a troubling question is swirling around this elite banking club: Have some of its members been lying about one of the world’s most important interest rates?”

The findings of this review, in which the group is talking to regulators, central banks, brokerage firms, hedge funds, stock exchanges, derivative exchanges and fund managers about possible changes, are set to be released on 30^th May and they pose serious event risk for currency traders.  “The money markets are stressed at the moment, and Libor reflects this,” said John Ewan, the association’s director responsible for Libor. “Naturally we wish to ensure that the rates are as accurate a reflection of prevailing market conditions as possible,” he said.

How important is the BBA LIBOR Rate?

The Overnight BBA LIBOR rates act as a barometer of risk in the financial markets.

It is among the most common of benchmark interest rate indexes used to make adjustments to adjustable rate mortgages and therefore affects the rates banks charge on things like home mortgages, student loans and corporate I.O.U.’s.

“It’s a real cornerstone of the financial markets,” Jason Simpson, a strategist at ABN Amro in London, said of BBA Libor.

Commenting on today’s movements in interbank lending rates, Angela Knight, Chief Executive of the British Bankers' Association, said:

“The full name of the service is BBA LIBOR. The term LIBOR is often used to describe this industry standard, but as individual banks may calculate their own Libor rates, the term BBA LIBOR should be used to distinguish them. The Daily BBA LIBOR rates are published by Reuters and are available also through Thomson Financial, Telekurs, Blomberg, Infotec, IDC, Quick, Class Editori and Proquote, as well as other information providers. Because BBA LIBOR rates are calculated daily from the rates at which banks agree to lend each other money, it is a more accurate barometer of how global markets are reacting to market conditions”

BBA LIBOR is now used to calculate the interest rates for a range of financial instruments and derivatives based on the BBA LIBOR rates are now traded on exchanges such as LIFFE, the Chicago Mercantile Exchange (CME) and SIMEX. Independent research shows that financial products worth a total of around $150 trillion are indexed to BBA LIBOR.

BBA LIBOR under scrutiny

Libor is going through its worst credibility crisis since its creation in 1986, when British banks asked the association to come up with a benchmark rate to price syndicated loans and derivatives.  At a time many banks are struggling, it is not entirely surprising that interbank lending rates are behaving unusually.

Rates are quoted by 16 banks from seven countries, including the United States, Switzerland and Germany, for 15 different borrowing periods ranging from a day to a year in 10 different currencies. The banks are asked at which rate each could borrow a “reasonable amount.” The association then eliminates the four highest and lowest rates and averages the remaining ones to determine various Libor rates.

The association’s system for setting Libor has worked for the last 22 years. But under the current stressful credit conditions which came to the fore last August, many banks, concerned about their own financial positions, were no longer willing to lend money to one another. As a result, Libor shot up, even as central banks like the Federal Reserve tried to drive borrowing costs lower.

Some banks on which the calculation of Libor depends, include Credit Suisse, UBS, HSBC, and Deutsche Bank among others - however, the rates being incurred by banks may actually be higher than Libor suggests, as they under report borrowing costs in the fear of appearing desperate for funding.

The system may not have sufficient checks and balances to prevent banks from manipulating Libor to their advantage. Banks could quote lower rates to allay concern about their finances or reduce their borrowing costs during a time of financial stress.

“There are definitely incentives for banks to push the rate lower,” said Sean Maloney, a bond analyst at Nomura in London. “They would get the rate down while still charging their customers more.”

The result of any underreporting would be that trillions of dollars worth of financial instruments that rely on Libor may be priced incorrectly.  US Federal Reserve officials have been in contact with the BBA regarding the issue.

Considerations under Review

The BBA is currently conducting a review that could ultimately lead to changes in the way the rate is defined and set, as the first results of the review are due on May 30.

Because most of the surveyed banks are based in Europe and surveyed in London before the US markets open, the US figures may not be an accurate reflection.  As a result, there is speculation that the BBA will expand the list to include more US-based institutions, or that they will move to calculate the rate again later in the day.

In order to deal with the issue of confidence in individual financial institutions, another possible change would be to get a quote on what rate the bank is lending to other banks, rather than asking what it costs for the surveyed banks to borrow.

US-based Index planned

 Various solutions have been presented, including scrapping Libor altogether and creating a brand new benchmark rate. However, nothing has been decided upon.  Any major changes could spark significant volatility in the global financial markets and trigger major moves in carry trades like EUR/JPY and GBP/JPY.

London bond broker ICAP announced plans last week to launch a US-based index on dollar-denominated interbank borrowing rates, which would be called the New York Funding Rate (NYFR).

The benchmark would be based on an anonymous daily poll of 40 banks, including foreign banks that have US offices, and exclude the top six and bottom six quotes. Instead of asking the banks at what rates they would be likely to borrow, they will be asked to estimate the rate at which they are likely to obtain funding. The anonymity factor is considered to be crucial, as individual banks would no longer have to worry about their status.  The Bear Stearns predicament has left a bad taste.  There is no set date for launch quite yet, though it could be as soon as this week.

Some bankers have urged the industry to create a New York equivalent of Libor, called Nybor, although adding more American banks might provide a better reading for the cost of borrowing in dollars, Terry Belton, an analyst at JPMorgan Chase, said. “Right now, the group that determines dollar rates is skewed toward European banks.”

NYSE Euronext's Liffe derivatives market - best known for Euribor - will start trading futures contracts in June based on Eonia, the euro overnight interbank average, and on Sonia, the sterling overnight interbank average. However, Garry Jones, an executive director at Liffe, said that the new contracts are intended to be “complementary” with Libor and are not designed to replace the rate.

Expected Review Results

The BBA is unlikely to recommend sweeping changes, as the group is aware that this could destabilize already-fragile sentiment in the credit markets.

Drastic changes might do more harm than good, said Mark Durling of the London-based asset manager Brewin Dolphin. “There is a lot of criticism about Libor, but to change the mechanism that has been working for years is unwise,” he said.

According to Terry Balkas of FXCM, “Trends for carry trades such as EUR/JPY and GBP/JPY are inherently dependent upon risk sentiment in the markets, as traders that utilize the pairs are usually looking to benefit from the yield benefits that come along with buying the pairs. As a result, it is no surprise that when investors become risk averse and the equity markets tumble, the Japanese yen tends to skyrocket across the majors.  As Technical Strategist Jamie Saettele discusses in his most recent technical analysis of the yen crosses, there is substantial downside potential for pairs like EUR/JPY and GBP/JPY. Furthermore, a piece of news such as the announcement of a change in the way Libor is calculated, or worse, signs that investors will stop using the benchmark interest rate altogether and will switch to an alternative like the New York Funding Rate could trigger significant volatility in the markets. As a result, yen traders should keep an eye on the news wires, as the search for a “new Libor” could be the biggest event risk in near-term”

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