Not far enough

The International Organization of Securities Commissioners (IOSCO) published a report this week calling for the London interbank offered rate (Libor) and other such benchmark interest rates to be tied more closely to actual transactions.

Sadly, the proposal does not go far enough.

I have written about Libor on a number of occasions (see here, here, and here, for example) and was interviewed by Law360 on the subject a few days ago.  As currently constituted, Libor is constructed by averaging the estimates of the cost of funds submitted by less than two dozen large financial institutions.  And, as we discovered last year, these estimates have not always been made in good faith.

The incentive to “cheat” in Libor submissions is strong.  So strong, that no matter how effective the regulatory structure or diligent the regulators, cheating will eventually reemerge.

A better solution would be for the new benchmark to be based on a highly visible, market-determined interest rate (there a number of possible candidates), which cannot be altered by any individual participant.  The most important characteristic of the new benchmark is that those who engage in financial transactions that depend on it are confident that the rate is not being manipulated.  If they are not, they will withdraw from those transactions and the economy will be poorer.

The IOSCO committee that issued the report was chaired by Gary Gensler, Chairman of the US Commodity Futures Trading Commission, and Martin Wheatley,  the chief executive of the UK Financial Conduct Authority.  In justifying the report’s conclusions that the benchmark be tied to observable transactions, Gensler said “To promote market integrity, it is critical that benchmark interest rates be anchored in observable transactions and supported by appropriate governance structures.”

Better government oversight would certainly help deter cheating. Wouldn’t it be simpler– and more effective–to make it impossible to cheat by instituting a market-based benchmark?

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