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P2.T9.605. Reforming LIBOR and other financial market benchmarks

Nicole Seaman

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Learning objectives: Discuss the recommended principles to make benchmark rates such as LIBOR and other interbank offered rates less susceptible to manipulation. Evaluate the implications, advantages, and disadvantages of using benchmarks. Assess the types of agglomeration effects after a benchmark has been established. Explain the motives for manipulating benchmarks and describe the processes to alleviate manipulation. Describe how the US dollar LIBOR is used and identify the costs associated with the increase in trading of LIBOR linked contracts. Explain and assess some proposed methodologies to reform LIBOR.

Questions:

605.1. Each of the following is a economic advantage of an effectively administered interbank offered rate (IBOR) used as a benchmark EXCEPT which is NOT a valid expectation of a benchmark rate?

a. An effective benchmark rate increases profit margins to financial intermediaries by utilizing an opaque fixing methodology
c. An effective benchmark rate reduces asymmetric information regarding the value of the underlying traded financial instrument
d. An effective benchmark rate reduces search costs in bilateral over-the-counter markets by improving matching efficiency and increasing participation by less-informed agents
b. An effective benchmark rate confers transparency benefits when investors delegate their trading decision to agents who otherwise might not always make their best efforts to obtain good trade execution


605.2. LIBOR (the London Interbank Offered Rate) is a measure of the interest rate at which large banks can borrow from one another on an unsecured basis. LIBOR is often used as a benchmark rate. Which of the following statements about LIBOR is TRUE?

a. LIBOR is based on actual transactions rather than judgments submitted by market participants
b. An advantage of LIBOR, especially for lending applications that appear on bank balance sheets, is that it represents a pure risk-free rate absent the distortion of a credit risk component
c. Among US dollar interest rate markets, a small minority of products are tied to LIBOR where less than than 10% of conventional loans and derivatives are tied to LIBOR, and among those that are tied to LIBOR, the majority have long-range tenors greater than one year
d. LIBOR suffered manipulation in the crisis due to two motivations: banks understated their true borrowing cost in order to avoid appearing less creditworthy; and some banks biased their reported rates because their traders had positions in LIBOR-linked derivative contracts


605.3. In regard to the reform of LIBOR, according to Duffie and Stein each of the following statements is true EXCEPT which is false?

a. The two-benchmark approach entails an improved version of LIBOR (ie, LIBOR-plus or LIBOR+) based on banks' wholesale unsecured funding costs plus a second benchmark based on an established riskless rate in a broad and deep market
b. The design of LIBOR+ would shift to a fixing methodology that is BOTH anchored in observable, verifiable market transactions AND entirely algorithmic, which would tend eliminate the potential threat to financial stability of member banks deciding to defect from the LIBOR panels
c. The two best candidates for a riskfree rate proxy are the Fed's overnight reverse repurchase rate, despite its penchant for manipulation by market participants; and the short-term Treasury bill rate which is heavily favored by market participants due to its insensitivity to safe haven "flights to quality"
d. A good candidate for a riskfree rate proxy is the overnight index swap (OIS) because it neither tends to spike upwards during market stress nor spike downwards during safe haven flights (ie, flights to quality), but it has the salient drawback of being currently set in a thinly traded market

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