Monday, March 16, 2015

Duffie and Stein on Libor

Darrell Duffie and Jeremy Stein have a nice paper, "Reforming LIBOR and Other Financial-Market Benchmarks" I learned some important lessons from the paper and discussion.

Libor is the "London interbank offering rate." If you have a floating rate mortgage, it is likely based on Libor plus a percentage.
In its current form, LIBOR is determined each day (or “fixed”), not based on actual transactions between banks but rather on a poll of a group of panel banks, each of which is asked to make a judgmental estimate of the rate at which it could borrow.
As soon as money changes hands, there is an incentive to, er, shade reports in the direction that benefits the trading desk.
Revelations of widespread manipulation of LIBOR and other benchmarks, including those for foreign exchange rates and some commodity prices, have threatened the integrity of these benchmarks.. 
or report a rate that makes your bank look better (lower rate) than it really is:
During the financial crisis of 2007-2009...Some banks did not wish to appear to be less creditworthy than others... The rates reported by each of the panel of banks polled to produce LIBOR were quickly published, alongside the name of the reporting bank, for all to see. As a result, there arose at some banks a practice of... understating true borrowing costs when submitting to a LIBOR poll. 

An important point as we get in to security design mode:
many of the documented cases of LIBOR manipulation...involved only very small rate distortions, with the guilty parties often misstating their borrowing costs by just one or two basis points. 
OK, what to do? Rather obviously, publishing the individual bank quotes and not just the average is not a good idea, and I gather will end.

In Darrell and Jeremy's view, we really need two indices for the two separate purposes of Libor.

Libor is used as an index for banks who issue adjustable rate mortgages. For that use, an index of bank borrowing costs is appropriate. But bank borrowing from each other has dried up considerably. Interbank borrowing is really no longer a marginal source of funds. And the market is so small these days that a transactions-based index would be unreliable -- and also open to manipulation.

They suggest an index based on a larger set of securities more representative of actual borrowing costs,
LIBOR ... fixing must be broadened so as to be based on unsecured bank borrowings from all wholesale sources—not just other banks, but non-bank investors in bank commercial paper and large-denomination CDs.
There is an important (very stylized, and likely inaccurate) story here. Why do we have indices anyway?  In the old days, you went to the bank to borrow money. It was like going to a car dealer in the 1950s. Each bank might quote you a price, but you don't really have a good idea if you're getting a good deal without a lot of shopping. In this environment, you can't really have variable rate loans where the bank just announces a new rate.

A better system: The bank quotes you "prime" rate plus some percentage points. But what's "prime?" Well, at least you know it's the basis for the bank's lending to all its other customers. If they say "prime went up you have to pay a higher rate on the loan" you know they're doing the same to all their customers, not just you. That makes variable rate loans more possible and reduces haggling and shopping.

Better yet: The dealer shows you his invoice (the real one, not the phoney one at car dealers!) That's the Libor idea. It's an index of the rates banks pay for funding at the margin. So if Libor goes up, it's much more transparent that the bank is just passing costs on to you.

Don't banks like the obscure system to charge higher profits? Well, not necessarily, which is another important lesson. Haggling over each item and dealing with customers who feel like they're in the 1950s Chevy showroom from "Tin Men" turns out to be less profitable than running a large volume transparent Car-Max operation.

So far so good, but now a second lesson comes to the fore. Libor, as constructed, was a lot better than "prime" announced by each bank. But once markets and contracts settle on Libor, it's awfully hard to move to something better yet.

This gives a role for policy, as Jeremy and Darrell point out, in setting standards, or moving markets to another focal point. We can all use feet or meters, miles or kilometers, dollars or euros.

Being a popular interest rate index, Libor was the natural choice for interest rate derivatives. For example, a swap is a contract in which I promise to pay you $x dollars per year, and you pay me a floating rate. What's a good floating rate... Well, the banks are all using Libor, let's use that!

So now we are in this puzzling point that a huge amount of money changes hands based on a tiny market.
...Unfortunately, there are surprisingly few actual loan transactions between banks that could be used to fix most of the IBORs...
At the commonly-used three-month tenor, transactions in the underlying market for unsecured bank funding are roughly on the order of a billion dollars on a typical day, while the volume of gross notional outstanding in the swap market that references LIBOR at this tenor is on the order of $100 trillion, or 100,000 times larger. [See Table 1 and Table 2.]
And Libor really isn't the right index here. Most derivatives traders are interested in hedging the overall level of rates. They don't mostly care about the bank credit spreads. If treasury rates go down but bank rates go up, because people get scared about banks as in 2008, these traders want an index that goes down.
...IBORs have been heavily used in contracts whose purpose is to transfer risk related to general market-wide interest rates. These “rates trading” applications are not specifically tied to the borrowing costs of banks. It is a self-reinforcing choice by market participants, however, to trade in more liquid high-volume markets, all else equal. In part through an accident of history, this desire to belong to the high liquidity club has led to a massive agglomeration of trade based on the IBOR benchmarks.
So, Darrell and Jeremy propose a second, transactions-based index to be used for derivatives contracts. They have a brilliant idea. Currently, most derivatives are based on three month rates. So, in January 1, we look at the rate for borrowing and lending from January 1 to March 31, and settle derivatives. But there is very little volume in three month rates. Instead, watch the general collateral overnight rate, which has tremendous volume, and pay off contracts on March 31, based on the average of the one-day rates in the quarter.

They have a lot of useful thought on implementation and transition, of course.


  1. Libor based derivatives are computed and calibrated by bootstrapping libor futures with a multi curve framework. While libor funding may not be heavily used, the futures contracts are highly liquid and these discount rates are what really determines the valuation of interest rate derivatives. So determining a more robust reference rate sounds all fine and well but how then do your price interest rate derivatives? Price with one rate then settle on a different rate?

  2. "volume of gross notional outstanding in the swap market that references LIBOR at this tenor is on the order of $100 trillion"

    The global bond market is about 100 Trillion dollars. For the interest rate swap market to be as large as the underlying market would require that basically EVERYONE who issues or buys bonds is swapping interest rates on EVERYTHING and ties the swap to LIBOR. There would be other interest rate swaps. It confirms my belief that there is something profoundly wrong at the core of the derivatives markets. There can be no legitimate commercial reason for that level of nominal outstanding. One of these days those markets are going to blow up in spectacular fashion (or be exposed as one giant set of off-setting wash trades designed to evade taxes).

  3. "Notional" means notional. If I promise to pay your fixed on $100 in return for you paying my floating, the notional is $100, but no money changes hands initially and only the difference of interest rates ever changes hands. Then if I hedge that by entering in to another identical swap at slightly different rate, profiting from the spread, we have $200 notional outstanding. Notional is an easy number to collect, but vastly overstated for many purposes.

  4. John - I understand what notional means. And I understand that banks write off-setting interest rate swaps that can be based on the same underlying bonds with the result that $100 in bonds can "support" $200 or $300 or maybe "$500" in notional values on swaps that are all outstanding at the same time.

    I'm a lawyer (and a fair mathematician). My training is to look for things that make no business sense as an indicator that something is "hinky". The global bond market is about $100 Trillion in total principal outstanding. Not every market participant is going to want to swap all of their interest rate exposure for something else - and the $100 Trillion is just the interest rate swaps tied to LIBOR. If I am reading the BIS statistics correctly there over $400 Trillion in outstanding notional on interest rate swaps. Global GDP is only about $75 Trillion per year. The total notional for all types of derivatives is about $700 Trillion which is about $100,000 for every man, woman and child on the face of the earth.

    Given the deficiencies in LIBOR is seems unlikely that anyone would actually trade billions or trillions of dollars using it as a reference rate.

    So I reach two working conclusions: (1) Even though we are only talking about interest on the notional, a tiny error (or unexpected rate move) could have huge impacts. One tenth of one percent of $400 Trillion would be $400 Billion. (2) The notional is so disproportionate to the underlying that there cannot be a legitimate business reason for the market so I expect that there is some other purpose being served. Cooking Greece's national accounts can only explain so much. I expect that a lot of derivatives are done to move income and expenses between jurisdictions, between income and capital gains, and between time periods.

    1. Absolon,
      You should think about the ratio of notional/actual debt the way you think about the transactions velocity of money. The difference is that because the bond derivative transaction has delayed settlement there is a record-keeping reason to “account for” the notional pool of transactions generated debt.
      To what I think is your point, these large chains of time-shifted settlement transactions can become long and complex, and a credit failure by just one major counterparty can cause immense confusion and panic because the linkages (and offsets) in the counterparty credit chains are not transparent.
      The essence of run-free banking is to hold these types of assets somewhere other than in the balance sheets of the commercial banks where they can potentially threaten the “settlement system”.

  5. This article has been an interesting read, I hope to see more like this in the future. Thank you John for keeping this awesome blog running!


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