Introduction to Design and Production
Introduction to Design and Production THE 150
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realworld economics review issue no 47 What s in a number The importance of LIBOR1 Donald MaCKenzie University of Edinburgh UK Copyright Donald MacKenzie 2008 Judged by the amount of money directly dependent on it the British Bankers Association s London Interbank Offered Rate matters more than any other set of numbers in the world LIBOR anchors contracts totalling around 300 trillion the equivalent of 45000 for every human being on the planet It s a critical part of the infrastructure of financial markets but like plumbing doesn t usually get noticed Only a handful of economists and no other academics have ever looked in any detail at LIBOR and even the financial press has taken an interest in how LIBOR is calculated only this past spring when there was sharp controversy over whether these most crucial of numbers could be trusted The process of calculating LIBOR yields no immediate clues as to how vital it is Its central coordination requires only two people who work in an unremarkable open plan office in London s Docklands and seemed utterly routine when I watched them at work a couple of years ago Just after 1100 am every weekday that s not a bank holiday traders at leading banks send in electronically their estimates of the interest rates at which their banks could borrow money Sometimes the coordinators make a reminder phone call to a bank that has not sent in its estimates and if the latter seem implausible typos for example are fairly common they re checked also with a quick call Hi there is the Kiwi chap provider of the estimates for borrowing New Zealand dollars about Bit of a spread on the two month Everyone else is coming in a good bit under that A simple computer program discards the lowest quarter and highest quarter of the estimates and calculates the average of the remainder The result is that day s LIBOR The calculation is repeated for each of ten currencies and fifteen loan durations from overnight to twelve months so 150 LIBORs are published daily overnight sterling LIBOR oneweek euro LIBOR onemonth yen LIBOR threemonth US dollar LIBOR and so on It s the backup arrangements that provide the first hints of how much the calculation matters Those who superintend the process have dedicated phone lines laid into their homes so they can still work if a terrorist attack or other incident stops them reaching the office A nearby similarlyequipped building is kept in constant readiness and there s a permanentlystaffed backup site which I shall describe only as being in a small town some 150 miles from London Its employees periodically work in the London office so that they re fully ready to take over if needs be The precautions are needed because inability to calculate LIBOR would quickly paralyse large parts of the global financial system The 150 numbers are the dominant global benchmark for interest rates The rates on borrowing totalling around 10 trillion corporate loans adjustablerate mortgages private student loans and so on are pegged to LIBOR For instance the level of LIBOR determines the monthly payments on around half of the adjustablerate mortgages in the US rates are set as LIBOR plus a fixed margin and reset 1 This article was completed before the bankruptcy of Lehman Brothers and the most recent bout of turmoil It originally appeared in the London Review of Books httpwwwlrbcouk and appears here with the Reviews permission 237 RER issue no 47 periodically as LIBOR changes Even in the UK where explicit pegging of this kind is rarer LIBOR is a big influence on mortgage rates LIBOR is even more central to the huge market for interestrate swaps These are contracts in which one bank or other organisation pays a fixed rate of interest on a given amount of money while another bank pays a floating that is variable rate such as three month US dollar LIBOR on the same amount The total amounts involved added up across the globe are around 310 trillion Measured that way the swaps market is the biggest financial market of them all and most of it depends on LIBOR lnvented only at the start of the 1980s swaps enable lenders and borrowers to eliminate the risk of interestrate changes Take fixedrate mortgages for example Without swaps a bank might be reluctant to offer them because it generally pays its depositors floating rates and also borrows from other banks at floating rates If interest rates go up the bank will therefore have to pay out more while its revenue from its fixedrate mortgages stays the same As rates rose sharply in the 1980s almost all the savings and loan associations in the US the equivalents of the UK s building societies were caught out in this way The resultant crisis a precursor of today s credit crunch pushed over seven hundred savings and loans into insolvency and the rescue operation ended up costing US taxpayers around 130 billion Entering into a swap in which the bank pays a fixed rate and receives a floating rate enables it to cancel out the effect of interest rates changing and conditions in the swaps market are thus a major influence on the terms on which fixedrate mortgages are available The very possibility of a largescale swaps market depends upon having a measure of interest rates that is unequivocal and credible enough to form the bases of contracts denominated in billions of dollars and LIBOR has provided that measure In a financial world dominated since 1945 by the US it s striking that the global benchmark is a set of London rates Paradoxically the ultimate cause is Britain s failure crystallised by the 1957 sterling crisis to reestablish the pound as a major international currency That prompted the leading British banks increasingly to accept deposits lend and borrow in US dollars eurodollars as they came to be called The Bank of England overcame its initial anxieties and came tacitly to support the eurodollar market and the Johnson Administration inadvertently encouraged it by trying to stem the flow of dollars overseas Eurodollar operations conducted in London allowed US banks to circumvent the resultant controls The result was that London became and in many ways remains the centre of the international money markets Money here does not mean cash but shortterm loans between banks and other major institutions and over a fifth of international lending of this kind still takes place in London Crucial to facilitating this market and to enabling LIBOR to be calculated were and are London s money brokers They initially emerged in the 1960s as a challenge to the traditionally staid gentlemanly tophatted sterling money markets in which lending took place via designated discount houses backed by the Bank of England Money brokers put lenders and borrowers directly in touch with each other charging a fee for doing so The business is fastmoving and competition is fierce and sometimes not at all gentlemanly If you listen to brokers voices you hear the tones of the East End and Essex more often than those of Eton or Harrow Opennecked shirts are more common than suits and ties While banks dealing rooms are now often disappointingly quiet and orderly places in reality there s far less shouting and swearing than in film portrayals brokers offices are more tightly packed there s less space between desks and more raucous 238 realworld economics review issue no 47 Suppose a bank wants to borrow or lend in the interbank market The desire to lend arises because no bank likes to leave cash idle even for the shortest period Indeed overnight lending is the busiest sector of the interbank market with banks that have excess cash at the end of the working day lending to those that need it A bank s moneymarket traders could directly contact their counterparts in other banks but it s usually quicker and easier to work through the money brokers This can now be done onscreen but especially if large sums are involved or market conditions are tricky and rapidly changing it s often better to use the voicebox This is a combination of microphone speaker and switches that can instantly connect each broker by a dedicated telephone line to each of his clients on banks dealing rooms If a bank wants to borrow money a broker needs quickly to find someone prepared to lend at an attractive rate if a bank wants to lend he it s a predominantly male profession needs to find a borrower ready to pay a good rate So a broker needs continuously to know who wants to borrow who is prepared to lend and on what terms As one of them said to me a broker might speak to his big clients have conversations with them maybe twenty five times a day which is twentyfive times as often as they speak to their wives A broker needs to pass information to his clients as well as to receive it that s a major part of what they want from him and a good reason to use the voicebox rather than the screen The brokers code of conduct prohibits passing on private knowledge of what a named bank is trying to do unless a client is about to borrow from it or lend to it but that restriction leaves plenty room for brokers to tell traders what has just happened and to convey the feel of the market There s a grey area in which euphemisms can be used in context a broker and a trader might both know which bank is meant when the broker says that the usual German has just done something Brokers in major moneymarket currencies don t work as individuals but in teams of up to a dozen or more sitting close together in subsections of large openplan offices Good eyesight is useful trainees still sometimes called board boys write unfilled bids to borrow and offers to lend on whiteboards surrounding clusters of brokers desks and you can occasionally see a broker using binoculars to read a distant whiteboard or screen but a more crucial skill is what s called broker s ear the capacity aurally to monitor what is being said by all the other brokers at a cluster of desks despite the noise and while oneself holding a voicebox conversation with a client As one broker put it to me When you re on the desk you re expected to hear everyone else s conversations as well because they re all relevant to you and if you re on the phone speaking to someone about what s going on in the market there could be a hot piece of information coming in with one of your colleagues that you would want to tell your clients so you ve got to be able to hear it coming in as you re speaking to the person When you first encounter it broker s ear is disconcerting You ll be sitting beside a broker at his desk thinking he s fully engaged in his conversation with you when he ll suddenly respond to a question or comment from several desks away which you simply hadn t registered It s an embodied skill that matters to how LIBOR is calculated The inputs to the calculation are provided daily by the moneymarket traders employed by banks on panels established by the British Bankers Association There are sixteen banks on each of the panels for the main currencies What each bank has to provide is as the rate at which it could borrow funds unsecured that is backed only by the bank s creditworthiness not 239 RER issue no 47 more specific collateral and governed by the laws of England and Wales were it to do so by asking for and then accepting interbank offers in reasonable market size just prior to 1100 in the currency and for the time period in question Note the conditional a LIBOR input is what a bank could do not what it has done So judgement is involved A bank may not have borrowed anything in the minutes before 1100 am Deals for longer than overnight are intermittent and there is little borrowing at some of the time periods involved such as eleven months Reasonable market size is deliberately not defined exactly it will vary from currency to currency and according to time period and market conditions The need for judgement is why the information provided by brokers is important to LIBOR It helps a bank s traders to estimate the rate at which they could borrow money even if they re not trying to do so They can glance at the screens provided by their various brokers all serious traders employ several Those screens indicate the lowest rate at which banks are currently offering to lend and the highest rate at which they are prepared to borrow Only the na39i39ve however would provide the former rate as their LIBOR input The screens don t reveal the amount actually available for borrowing at the lowest quoted rate and it may fall short of reasonable market size It could range from a mere 50 million or so to a yard or more Yard originally an abbreviation of milliard is the moneymarket term for billion a word that in a noisy environment is all to easy to confuse with million The screens can t be expected to tell you at all exactly how much you would have to pay to borrow a few hundred million dollars reasonable market size for shortterm borrowing in a major currency and are even less reliable when it comes to borrowing several yards It can take an experienced trader talking to a number of brokers with good ears to form a realistic estimate There s also an element of judgement in the rates that brokers put on the screens they can for example consider it as misleading their clients to quote a bid to borrow at an unusually high rate if it comes from a bank with poor credit standing to which many of their clients would be reluctant to lend Originally LIBOR was an informal notion and when different sets of banks were polled the resultant LlBORs could differ by as much as 25 basis points a basis point is a hundredth of a percentage point The current British Bankers Association system for calculating LIBOR involving a fixed procedure and predetermined panels of banks that change only infrequently was set up in 1985 and has worked remarkably well hence the preparedness of financialmarket participants to have 300 trillion indexed to LIBOR The obvious risk to the calculations integrity is that a bank on a LIBOR panel might make a manipulative input trying to move LIBOR up or down so as to influence interest rates or the value of its swaps portfolio That risk is the main reason for the exclusion from the calculation of the highest quarter and lowest quarter of inputs Furthermore once a day s LIBOR rates are set each input and the name of the bank that has made it is also disseminated electronically and so attempts at manipulation would have to take place in what is in effect the public gaze The inputs to LIBOR can be viewed around 45 minutes after they are made on over 300000 computer terminals worldwide and they re certainly scrutinised Well before the recent problems one banker showed me that day s inputs into threemonth sterling LIBOR pointing with suspicion to a bank that had reduced its input by a single basis point from the previous days while all others had either increased theirs or left them unchanged And brokers screens and brokers ear shouldn t be forgotten An input wildly at 240 realworld economics review issue no 47 odds with what the screens show would be obvious and word of persistent attempts at manipulation would quickly spread as brokers and their clients chat The ultimate sanction used in the past I was told but not recently is removal of a bank from a LIBOR panel In the current climate that would deeply damage the reputation ofthe bank in question The strength of these longstanding fortifications of LIBOR s status as fact has however been questioned as over the past year LIBOR has been cast into the spotlight Ever since the rescue of Northern Rock whether or not banks are sound whether they are prepared to lend to each other and sometimes even the levels of LIBOR have been topics for TV news not just the Financial Times Much of the most vocal criticism of LIBOR has come from the US and has focused on dollar LIBOR especially threemonth dollar LIBOR the main rate used in the swaps market Some seem unhappy that the benchmark dollar interest rates are set in London just after 6 am New York time when traders are only starting to arrive at their desks and that the US dollar LIBOR panel contains only three recognisably American banks The British Bankers Association membership of which is open to any bank operating in the UK wherever it is domiciled counters by pointing out that all the banks on the panel are global institutions some with a major presence on the ground in the US and collectively they are responsible for most London interbank dollar lending and borrowing The most prominent critic has been the Wall Street Journal Underlying its suspicions was a concern that the public dissemination of banks inputs which is intended to make the process more transparent had the effect of biasing inputs downwards because banks may have feared that reporting publicly that they can borrow only at high rates would spark rumours about their creditworthiness On April 16 under the headline Finance markets on edge as trust in Libor wanes the WSJ reported a claim by analyst Scott Peng of Citigroup that although because of the credit crunch LIBOR was already high relative to the rates set by central banks it should be even higher Threemonth US dollar LIBOR suggested Peng should actually be 30 basis points higher than it was representing huge amounts of money given the trillions of dollars indexed to it The British Bankers Association responded by telling the WSJ that it was monitoring inputs closely and If it is deemed necessary we will take action to preserve the reputation and standing in the market of our rates a warning that the WSJ read as a threat to remove any bank making dubious inputs Over the next two days threemonth dollar LIBOR rose by 16 basis points but in a context in which rates have been highly volatile it s impossible to be certain that this was because of the WSJ s criticism the British Bankers Association s statement or quite other factors Central bankers began watching the controversy over LIBOR closely reported the Financial Times because some officials fear that the debate could be contributing to a broader sense of investor unease in the money markets Given the criticism of LIBOR why not abandon the conditional rates at which banks could borrow and shift as some critics have suggested to an index based on actual transactions At least two such indices already exist EONIA Euro Overnight Index Average calculated by the European Central Bank is a weighted average of the rates of overnight interbank loans denominated in euros SONIA its sterling equivalent is a similar average of overnight loans transacted via London s main money brokers There are attractions to EONIA and SONIA In June LIFFE the London International Financial Futures Exchange whose interestrate contracts have traditionally been based on LIBOR launched additional contracts based on EONIA and it would like to do so for SONIA 241 RER issue no 47 although it hasn t yet got permission from the latter s owners the leading brokers to use it Yet the very names of the two indices indicate their limitations They re averages of overnight lending and the market for longerduration interbank loans is probably too patchy to sustain credible indices based directly on the transactions that have actually taken place Right now much more than a week can seem far too long a time to lend a bank s carefully husbanded cash to one of its peers It s also the case brokers and traders told me that until the Bank of England put on sustained pressure and eventually in May 2006 instigated reforms the sterling overnight market could be unruly with surprisingly volatile rates strongly influenced by positiontaking by individual big banks It s also an illusion to think that indices based on transactions can t ever be manipulated Closing prices the average of the day s final deals on an exchange are widely used as indices but there s then sometimes an incentive to bang the close in other words to trade aggressively in the final minutes or seconds so as to influence the closing price In July the US Commodity Futures Trading Commission charged three oil traders with allegedly doing just that A potential alternative to LIBOR as a benchmark at least as far as the US dollar is concerned is New York Funding Rate launched by brokers Wrightson ICAP in June lts poll of banks is conducted in the US at 915 am New York time inputs are anonymous and each bank is asked to report the rates at which a typical bank with a high credit rating could borrow not those at which it itself could Despite these differences however the resultant numbers have tended not to differ much from US dollar LIBOR That what could have become a rival has in actuality provided a confirmatory second opinion has thus helped restore confidence in LIBOR The membership of the panels of banks that make LIBOR inputs may be broadened and a new British Bankers Association subcommittee will draw upon independent thirdparty analysis of inputs and have the power to demand that banks justify any that seem anomalous So the controversy seems to be passing Nevertheless its sharpness and how unsettling some market participants seem to have found it indicate just how important LIBOR is to the world s financial system SUGGESTED CITATION Donald MacKenzie What s in a number The importance of LIBORquot realworld economics review issue no 47 3 October 2008 pp 237242 httn39lwww naernn 39 39 bdf 242