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The World after LIBOR - Part II: How to fix OTC Fixings

by Werner Broennimann

“This dwarfs by orders of magnitude any financial scam in the history of markets.” - Andrew Lo, MIT Professor of Finance
After the LIBOR scandal, the current issues with ISDAFIX for swap rates look like the next logical step in the unfolding drama. ISDAFIX is a set of daily published interest swap rates in a number of currencies and is used in some financial instruments like swaptions (options on swaps), constant maturity swaps and structured notes. The relatively simple definition of ISDAFIX contains similar flaws as the one of LIBOR. Again the rate finding process is unregulated and the submitted rates are not based on actual transactions, but on the dealer’s indication of where they would make a market. “The contributor is asked to provide a rate which is the mean of where that dealer would itself offer and bid a swap in the relevant maturity for a notional equivalent amount of US $50 million or whatever amount is deemed market size in that currency for that tenor to an acknowledged dealer of good credit in the swap market. The rate should not be where the dealer sees mid-market away from itself, but should be a function of its own bid/offer spread.” [1]
Given the relatively healthy nature of the underlying interest rate swap market, the problems of ISDAFIX can probably be fixed more easily than those of LIBOR. But in a market where levels are constantly changing, nudging the set of submitted rates up or down by a bit is also easily done and again there is a lot of money to be made for traders when doing so in their favour. ISDAFIX is a joint project of ISDA, Thompson Reuters and ICAP. The mere fact that the latter is one of the world’s biggest interdealer brokers for interest rate swaps does not help to address potential governance issues and conflicts of interest.
I would not want to imply any sinister intentions by the people who designed these fixings. They were probably a good start at the time, when those markets were still relatively small and any standardised fixing was better than none. Before the financial crisis, people generally worried less about regulation and the appropriateness of a price finding process and there is a point to be made for simple definitions, that do not need a lawyer to be written or understood. However, these days a lot of those fixing standards just seem outdated and do not fit with today’s requirements of governance and transparency in financial markets.
The investigation in ISDAFIX led the Rolling Stone journalist Matt Taibbi (of ‘Vampire Squid’ fame) to claim that “Everything is Rigged”. I do not agree with him on this rather strong statement, but he is probably not the only one thinking this way.
There are plans by the regulators to mitigate the above mentioned problems. One of the main questions is whether existing contracts should be affected, or if only new trades should use a newly defined fixing. The former approach could potentially create a lot of legal issues, as it effectively means changing the terms of existing contracts. The latter could mean a very long transition period. Interest rate swaps trade out to 60 years tenor, these are very rare, but not unheard of and 30 year trades are relatively common (often to swap the coupons of 30 year bonds). In the absence of unwinds, this could create some long lasting legacy.
When looking for improved definitions, EONIA may be a good starting point. The EUR overnight rate EONIA is one of the few OTC fixings, that does have a definition that looks at actual trades: “Eonia® (Euro OverNight Index Average) is the effective overnight reference rate for the euro. It is computed as a weighted average of all overnight unsecured lending transactions in the interbank market, undertaken in the European Union and European Free Trade Association (EFTA) countries.” [3] This could serve as a template for an improved definition of LIBOR and ISDAFIX or their potential successors, but would probably still require some amendments for longer term money market rates (LIBOR). The very short term nature of EONIA helps in this case, as the credit risk in such transactions is less of an issue and there is still some unsecured lending actually happening overnight. It is not obvious, that such an amended definition alone would help a lot on 3 months tenor and longer money market rates, as there are quite simply not a lot of transactions out there. If a market is so dried up, that every little trade represents a significant share at the time, then it typically also is prone to manipulation.
With hindsight having all those financial instruments refer to rates, that were set in such a simplistic fashion looks like an accident waiting to happen. The crucial bit will be basing the fixings on actual, observable transactions and having sufficient liquidity in the respective observed market. Also these fixings, that impact a massive number of basic financial contracts, need to be properly regulated by the appropriate authorities. Last but not least we likely need the threat of higher penalties for the individuals, who break the rules. To my knowledge nobody has gone to prison yet in the wake of the LIBOR scandal. This will not eliminate potential misconduct, but manipulating a regulated and well functioning market will be considerably more difficult than a defunct one. The chance of being caught would be higher and the potential penalties would be tougher.
The recent announcement of the MAS ins Singapore [4] concerning the rates manipulation probe, is a case in point. So far the MAS lacks the powers to fine the banks, so the banks were ordered to leave additional statutory reserves with the MAS at zero interest for a period of one year, which seems like a modest punishment. The MAS now proposes a new regulatory framework: “...MAS will introduce specific criminal and civil sanctions [...] for manipulation of any financial benchmark.” [4] and “...MAS intends to subject the setting of key financial benchmarks to regulatory oversight.” [4]
The OTC world used to have the benefit of full flexibility and quick innovation. With the pressure of having trades cleared on exchange and higher scrutiny on trade mechanics, some of that speed and flexibility may be lost. But if that makes those markets more robust and transparent, that is a price worth paying.
Photo: Singapore CBD (
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