CFTC Gensler discusses market reform in FIA address

LIBOR

As important as the continued implementation of swaps market reform and finalizing customer protections will be this year, the work we do related to LIBOR and similar rates is likely to be just as critical.

There is a growing recognition that the financial system’s reliance on interest rate benchmarks, such as LIBOR and Euribor, is particularly fragile.

I believe that continuing to reference LIBOR and similar benchmark rates is unsustainable in the long run. A reference rate has to be based on facts, not fiction.

Let’s look at what we’ve learned to date.

First, the interbank, unsecured market to which LIBOR and other such rates reference has changed dramatically. Some say that it is has become essentially nonexistent.

In 2008, Mervyn King, the governor of the Bank of England, said of LIBOR: “It is, in many ways, the rate at which banks do not lend to each other.” He went on further to say: “[I]t is not a rate at which anyone is actually borrowing.”

There has been a significant structural shift in how financial market participants finance their balance sheets and trading positions. There is an increasing shift from borrowing unsecured (without posting collateral) toward borrowings that are secured by posting collateral.

The London interbank, unsecured market used to be where banks funded themselves at a wholesale rate. But the 2008 financial crisis and subsequent events have shattered this model.

The European debt crisis that began in 2010 and the downgrading of large banks’ credit ratings have exacerbated the hesitancy of banks to lend unsecured to one another.

Other factors have played a role in this structural shift. Central banks are providing significant funding directly to banks. Banks are more closely managing demands on their balance sheets. Looking forward, recent changes to Basel capital rules will take root, making it unlikely that banks will lend to each other unsecured for three months, six months or a year.

The Basel III capital rules now include an asset correlation factor, which requires additional capital when a bank is exposed to another bank. This was included to reduce financial system interconnectedness.

Furthermore, the rules introduce a liquidity coverage ratio (LCR). For the first time, banks will have to hold a sufficient amount of high quality liquid assets to cover their projected net outflows over 30 days.

One major bank has indicated that the LCR rule alone would make it prohibitively expensive for banks to lend to each other in the interbank market for tenors greater than 30 days.

Second, LIBOR – central to borrowing, lending and hedging in our economy – has been readily and pervasively rigged.

Barclays, UBS and RBS were fined approximately $2.5 billion for manipulative conduct by the CFTC, the U.K. Financial Services Authority (FSA) and the U.S. Justice Department.

At each bank, the misconduct spanned many years.

At each bank it took place in offices in several cities around the globe.

At each bank it included numerous people – sometimes dozens, and even senior management.

Each case involved multiple benchmark rates and currencies. In each case, there was evidence of collusion.

In the UBS and RBS cases, one or more inter-dealer brokers painted false pictures to influence submissions of other banks, i.e., to spread the falsehoods more widely.

Barclays and UBS also were reporting falsely low borrowing rates in an effort to protect their reputation.

Thirdly, we have seen a significant amount of publicly available market data that raises questions about the integrity of LIBOR today.

A comparison of LIBOR submissions to the volatilities of other short-term rates reflects that LIBOR is remarkably more stable than any comparable rate. For instance, how is it that in 2012 – if we look at the 252 submission days for three-month U.S. dollar LIBOR – the banks didn’t change their rate 85 percent of the time?

When comparing LIBOR submissions to the same banks’ credit default swaps spreads or to the broader markets’ currency forward rates, why is there a continuing disconnect between LIBOR and what those other market rates tell us?

While ongoing international efforts will focus on principles for benchmarks, including governance, conflicts of interest and their administration, these efforts can do little to address the key weakness of these benchmarks: the absence of real transactions underpinning the reference rate.

Given what we know now, market participants and regulators around the globe have begun to discuss two critical questions:

• First, what best alternatives anchored in real transactions are there to LIBOR, Euribor and other similar benchmarks?

• And second, what are the mechanisms and protocols for the financial system and market participants to transition to reliable alternatives?

The International Organization of Securities Commissions Task Force on Financial Market Benchmarks stated in its January consultation with the public: “The Task Force is of the view that a benchmark should as a matter of priority be anchored by observable transactions entered into at arm’s length between buyers and sellers in order for it to function as a credible indicator of prices, rates or index values.”

I agree with this.

There are alternatives that are grounded in real transactions. These include the overnight index swaps rate, benchmark rates based on actual short-term collateralized financings, and benchmarks based on government borrowing rates.

The second question is already upon us. Martin Wheatley of the FSA recommended Canadian dollar LIBOR and Australian dollar LIBOR will cease to exist. Far more challenging is addressing possible transition from U.S. dollar LIBOR, Euribor and other widely referenced benchmarks.

The market has some experience with transition, albeit for smaller contracts, such as for energy and shipping rate benchmarks. The basic components of such transitions have included:

• Identifying a reliable alternative benchmark, one that is anchored in transactions;

• Allowing the new and existing benchmarks to run in parallel for a period of time to allow market participants to transition; and

• Discontinuing, at some point, the unreliable or obsolete benchmarks.

I recognize that moving on from LIBOR and Euribor may be challenging. It may be unpopular. But continuing to support LIBOR and Euribor to maintain stability – particularly as the interbank, unsecured market is essentially nonexistent – may only create more instability in the end.

I believe it best not to fall prey to accepting that LIBOR or any benchmark is “too big to replace.”

The American financial system has always been and will continue to be resilient. The American financial system has proven time and again it can adapt.

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