19 March 2013

Bundesbank/Dombret: Call for greater diversity in reference interest rates

The reliability of Libor has been in question since it became known that it had been rigged. The main reason that Libor, Euribor and similar reference interest rates are open to manipulation is that they are derived from expert judgement rather than actual transactions.

However, besides this susceptibility to manipulation, there are other factors undermining the usefulness of the reference rates for unsecured lending. For instance, structural changes on the interbank money market have resulted in banks now lending much less money to one another on an unsecured basis than they did before the onset of the financial crisis. Furthermore, some reference rates risk becoming less representative, with banks withdrawing from the rate-setting panels.

Manipulation and weaknesses in the way rates are produced are of such concern because Libor, Euribor and Co are extremely important for the financial markets. In particular, they are used as a reference for a large number of derivative financial instruments. Many variable-rate loans and investments are also linked to these reference rates. Financial contracts with an estimated value of more than US$300 trillion are based on Libor rates alone. Therefore, manipulated benchmarks have the potential to cause considerable loss, and to undermine confidence both in the banks involved and in the financial system as a whole.

With these issues in mind, a working group of 13 central banks, including the Bundesbank, has drawn up reform options aimed at producing more reliable and robust benchmark interest rates. The final report was issued yesterday. According to this report, the first priority is to reduce susceptibility to manipulation. To this end, those involved in setting the benchmarks are to be subject to closer supervision. In addition, greater use of transaction data in the rate-setting process is recommended. The rate-setting process also needs to be governed by clear and binding rules, in order to prevent potential conflicts of interest for those involved.

From the Bundesbank's perspective it is of particular importance that market participants have a wider range of reliable and robust benchmark rates to choose from, which would make the financial system less dependent on only a few reference rates. Different rates measure different risks. Market participants can hedge their risk positions with greater precision if they have the right benchmark rate available on which to base their hedge contracts. The central banks therefore propose, as examples of potential alternatives, overnight rates and interest rates based on overnight index swaps (OIS) and on general collateral repo transactions.

Central banks can assist in various ways in putting these recommendations into practice. As it will obviously take time to implement the working group’s recommendations, the relevant bodies are currently working very hard to put in place regulatory measures aimed in particular at reducing susceptibility to manipulation.

The reform process sketched out above will only be a success if market participants are fully involved in shaping it. Ultimately, market participants themselves are responsible for making a careful selection from the available options. And, obviously, the banks’ involvement in setting the reference rates will continue to be required. In view of the latest departures from the Euribor panel, this also means that large market participants, as responsible parties in the financial system, should commit themselves to contributing to the provision of benchmark interest rates. In this way, potential disruptions to the functioning of the financial markets can be prevented.

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