Also, the implication that LIBOR is purposefully a scam is basically untrue.
When LIBOR was first developed, it was an improvement on other interest rate benchmarks, and it also reflected current market conditions at the time, as banks actually did regularly make bilateral interbank (the 'IB' in LIBOR) loans to one another.
There are checks built into LIBOR to discourage fraud: for example, the actual calculation discards the high and low outliers, so individual banks cannot manipulate the benchmark easily.
But as the interest rate market continued developing, much of the actual lending transaction volume moved towards other markets; the financial crisis just accelerated that trend.
So now we have a lot of contracts written against a benchmark that slowly stopped reflecting an actual interest rate market. The right path forward would probably be to renegotiate these contracts so that going foward, they're against OIS instead.
OIS stands for overnight indexed swap . Like the fed funds rate , it's only quoted for one tenor: overnight.
In the United States we're somewhat spoiled with having a deep, reliable, market-based yield curve calculated every business day: the Treasury yield curve . But if you want to approximate the cost of a bank borrowing for a given term on the wholesale unsecured market, Libor is still the default reference.
That's not quite true -- for example, 3m OIS swaps have fixings that are essentially the 3m average of FF over the period in question.
In fact, this is mathematically a bit cleaner. If you construct an interest yield curve off of compounded 1m LIBOR vs. 3M LIBOR, you get rather different answers, whereas OIS yield curves constructed from different tenors are much closer.
The argument for using OIS instead of Treasury yields is pretty simple: Treasuries reflect the cost of borrowing for the government and are implicitly affected by the government's creditworthiness (e.g. not raising the debt ceiling), while banks can actually borrow from the Fed at FF. While the US gov't funds at pretty close to 'risk free', in other markets the credit component would be significant.
OIS is generally closer to LIBOR than a Treasury yield curve is.
But also misleading. Bootstrapping requires making assumptions about term structure .
> OIS is generally closer to LIBOR than a Treasury yield curve is
After the crisis the Libor-OIS spread was observed as an indicator of bank instability. They're close, but not the same. When they diverge, it's for reasons incredibly important to certain users of Libor. You're correct in the OIS rate being better than the Treasuries for estimating banks' borrowing costs.
You could document a loan paying quarterly with an interest calculated as the average o/n index for these 3 months. In fact that's how weekly CSA work. But that's not very practical for smaller non financial clients. It would be better if there was an index they can observe directly.
Agree. Even for sophisticated clients, throwing a direct reference into a contract is cleaner than translating a mathematical construction into legally-binding text.
The "fantasy" the article is referring to is the fact that large banks have to submit a number for every currency and every tenor every day, even if they didn't fund in that currency and that tenor that day. They will usually interpolate based on other tenors.
However this is only a problem for the lesser used tenors (like 2m, 8m), the most referenced tenors in private contracts (1m, 3m, 6m) tend to trade very frequently.
We can all agree, though, that the next iteration could do more to stop manipulation and fraud.
My impression after reading "Too Big To Fail" -- which, BTW is an amazingly well-written book -- is that "they" will probably get away with all this confusion and obfuscation... right?
I really do want to learn at least a little bit, but it seems like such an impenetrable world of concepts, and I really do want to avoid the "news-based" or even "journalist-based" approach to learning about this subculture. (When a Dartboard fares better that your average journalist/investor-proxy, you know you have a gambling problem.)
 Not sure how accurate it is, but it's really well-written and exciting. Unfortunately, it doesn't delve that much into the technical concepts in Finance :(, though it does mention LIBOR at least once.
Note: not a substitute for formal study of these things.
Most of the harder tech HN articles would seem just as impenetrable to regular Bloomberg Terminal users.
With the "finance industry" the complexity is not a bug, it's a feature, to keep ahead of regulators. Every time some immensely profitable "market" gets regulated the "finance industry" does it best to create a new "financial vehicle" to feed that unhinged greed for the fictional perpetual economic and financial growth.
It's an endless cat&mouse game that has been going on way too long and got us into this current messy situation where the "finance industry" might just as well be considered a fantasy football league, completely decoupled from the actual day to day realities of the vast majority of human beings, yet still holding massive influence over their futures.
Likewise, plenty of clueless non-techies suspect techies are intentionally making tech seem complicated. Why can't Apple make a back door for the FBI and nobody else?
The thing is there are derivatives that are sometimes non-linear, things with triggers and barriers. When some large enough fish has one of these (eg by taking the other side vs a customer) they have an incentive to move the rate in whatever way they can. Whether it's getting someone to submit a bad rate or sitting on an FX cross, it can be worth it.
Before I went full quant I was often looking at the screens manually. You'd often see at around the WM/Reuters fix that the price would move strangely. An unusually large move would happen with no apparent news. You'd get a rumour from a broker, but who knew how they knew? And quite often the move would fade after the window closed.
This would happen even in exchange traded options. If you knew the specifics of the settlement window, you would know when the price would go wonky. You wouldn't know who, but you knew that is wasn't a normal time in the market.
The LIBOR was a bit less obvious, only really clear to me in hindsight. Swaps don't have a common schedule like listed options, so there's a fixing every day that could be in someone's interest to influence. Same goes for FX, but since LIBOR is a bunch of opinions (as opposed to trades) it's not as obvious.
But when investment and retail banking merged, the stable system of incentives disintegrated. Before the merger, retail banking was more expensive, but it was incredibly stable; that premium was more than worth the cost. I don't see why investment banking needs to merge with retailing banking anymore than VC firms need to merge with retail banking. It just results in a chaotic system.
In an increasingly electronic age where the technical transactional costs are quickly eroding to nothing, you don't gain much efficiency by merging these roles. The remaining transactional costs are functional and specifically serve to ensure that incentives are well-aligned internally and externally. Removing those barriers merely permits people to extract all that value, diminishing the overall value of the systems and the economy in general.
Likewise, the global value of assets is so tremendous that investment firms don't need direct access to the capital within the retail banking sector. We're quickly approaching something like $100 trillion in highly liquid investments globally.
Exchange-traded options settle on a predictable window; there's no "if you knew" to it . Also, the price goes wonky near expiries because that's when delta approaches one. Market makers switch from hedging with derivatives to hedging with spot; that means jitters.
Not saying there's no fraud. But pricing going wonky around a settlement event makes sense as everyone prepares for it.
Might actually be a reason for the exchange to fuzz the expiry (eg random time) but that has its own problems. People do have to look at the options as they expire for legitimate hedging reasons.
I suspect the swap traders were mostly targeting future delivery dates (4 fixings a year). That's the only way the fraction of basis points they were asking the submitters to move the fixing by would have any material P&L impact. So it's kind of like other markets with strandardised contracts.
The former manipulation would have affected every days fixings.
Single stock options tend to be settled with actual stock, and at least in Europe tend to be a lot less liquid. And there's other problems with trading them, like other people knowing a lot more than the market maker about what's happening. You also have pin risk which seems to be like a magnet.
Are you implying that, close to expiration, a large player would move the index, in order to move their option position in the money? In the case of ES, that would imply buying an impossibly large of amount of SP500 assets---which they would have to liquidate at some point after the ES settlement or liquidation...
Also not understanding your point on pin risk, pinning is the result of maintaining a delta neutral hedge, which is a well known strategy...
Back in the 1960s, a Greek banker in London wanted to find a way for banks to make syndicated floating-rate loans. He found a very simple answer: The banks would lend money to a company, charging their cost of funds plus a spread, and every three months, you'd go out and ask the banks what their cost of funds was, and you'd average their answers, and that (plus the fixed spread) would be the new interest rate on the loan. This was a simple product for the banks: They could pass their costs on directly to the customer, and make a fixed profit (the spread). And by surveying all the big banks and throwing out outlier submissions, you could get a pretty fair approximation of the overall funding cost for banks.
And so this -- Libor, the London interbank offered rate -- became the normal way that everyone did floating-rate loans, and then it became the normal way that everyone did interest-rate derivatives, and then it became the normal way that everyone did ... sort of ... everything? Libor just sort of became The Interest Rate, used for discounting cash flows in all sorts of transactions, "the most important number in the world." But it was always based on a survey of banks' funding costs, and so it was always a little hazy. One problem was that the banks could lie. But a second problem is that the banks might not even know. Libor surveys asked banks each day what they would have to pay to borrow money unsecured from other big banks, but over time the banks sort of stopped doing that, particularly in some of the more obscure combinations of tenors and currencies that nonetheless reported Libor rates. So the banks' Libor submitters would guesstimate their submissions based on deposit rates and commercial-paper rates and secured-borrowing rates and other tenors and what brokers and their buddies were telling them. It was all more or less good enough as a casual system for resetting the rates on a few billion dollars worth of syndicated loans, but it was not accurate down to the hundredth of a basis point as a foundation for the financial system, or as the source for pricing hundreds of trillions of dollars of derivatives.
 Minos Zombanakis: https://www.bloomberg.com/news/features/2016-11-29/the-man-w...
It would be helpful if people kept providing Levine pieces to accompany Taibbi pieces.
The facts are more or less the same in both stories.
Written exchanges between bank employees revealed hilariously monstrous activity, with traders promising champagne and sushi and even sex to LIBOR submitters if they fudged numbers.
"It's just amazing how LIBOR fixing can make you that much money!" one trader gushed. In writing.
Maybe this is old news, but they should be imprisoned for it.
LIBOR fixing is one thing. But the realization that there is no market that LIBOR measures is truly astonishing!
2021 will be an interesting year...
Except that's not true. Interbank lending is still a $70 billion market in the United States alone . Small compared to banks' balance sheets and less than the $500 billion from as recently as February 2008, but material nonetheless.
Good rule of thumb in finance is to ignore Matt Taibbi.
Yes. It's a subtlety bulldozed over in this article because nuance doesn't sell clicks like outrage. Recapitulating an earlier comment, the regulator Taibbi cites speaks competently about this ; the least actively-traded currency-tenor traded only about once a month. (Every other currency-tenor traded more often.)
That may be a fine frequency for 6-month wholesale interbank rates in Danish krona (which, until recent reforms, was one of the currencies Libor was quoted for ). But turning it into a daily rate with three decimal places of precision is silly.
But a second problem is that the banks might not even know. Libor surveys asked banks each day what they would have to pay to borrow money unsecured from other big banks, but over time the banks sort of stopped doing that, particularly in some of the more obscure combinations of tenors and currencies that nonetheless reported Libor rates. So the banks' Libor submitters would guesstimate their submissions based on deposit rates and commercial-paper rates and secured-borrowing rates and other tenors and what brokers and their buddies were telling them.
Last I'd checked Mr. Levine was pretty well regarded.
Not that it matters... We're well into ad hominem and argument from authority territory here.
I'm not saying it is wrong because Taibbi wrote it. It's wrong because he got basic facts about interbank lending wrong, i.e. that it exists. I'm then passing along my observation that, whenever I've fact checked Taibbi, his facts have tended to be wrong.
> Matt Levine...said the exact same thing
Taibbi said there is no interbank lending. Libor is totally made up. Levine said that there is less interbank lending and so some of the numbers had to be made up some of the time. He concludes the paragraph you quote with this sentence:
"[Libor] was all more or less good enough as a casual system for resetting the rates on a few billion dollars worth of syndicated loans, but it was not accurate down to the hundredth of a basis point as a foundation for the financial system, or as the source for pricing hundreds of trillions of dollars of derivatives."
That's important context. Libor was a good enough number for a market where precision didn't matter (syndicated loans). It proceeded to be used, and abused, improperly. It's not a totally made up number like Taibbi makes it out to be. It's a totally inappropriately-used number.
TL; DR You'll walk away better informed about almost any financial topic reading Levine over Taibbi.
Ultimately the point remains: there isn't sufficient market activity to build a real value for Libor so it's basically made up from whole cloth
Your nuance, while interesting if you care to dig deeply, doesn't change the conclusion. It's a distinction without a material difference.
The least active currency-tenor, since deprecated, traded once a month. Most currency-tenors trade many, many, many times a day. There's plenty of market activity to build Libor-esque metrics.
> It's a distinction without a material difference
It's a world of material difference. The Fed Funds rate in the United States is based on the same kind of wholesale unsecured interbank lending as Libor is supposed to be. The metric, and the market it's based on, work.
We can have something like Libor based on market activity. It just won't be published every day for every tenor and currency.
If you just read Taibbi, the answer would seem to be to scrap any attempt at measuring the market because you cannot measure something that does not exist. If you understand the nuance, you walk away better appreciating what (a) went wrong, (b) we should do to improve future metrics and (c) one should look for when evaluating other metrics purporting to do similar things. You also gain an understanding for the kinds of scaling problems financial markets run into, which are quite unlike scaling problems in other contexts.
Its not Matt Taibbi but the regulators who concluded there is no basis for LIBOR as reported in the article so perhaps you meant to accuse the regulator of sensationalism.
Regulators did not conclude this. They concluded (a) better metrics for banks' costs of capital exist (e.g. the Fed funds rate ), (b) the market Libor is based on (wholesale unsecured interbank term lending) is too small and inactive to provide the sort of precision Libor implies and (c) transitioning from Libor will be messy .
No, there is a basis. The regulator Taibbi cites speaks competently about this ; the least actively-traded currency-tenor traded only about once a month. (Every other currency-tenor traded more often.)
Please read his work and make up your own mind.
The Libor fixing is real as is the FX rate fixing. Apologists for the banking system and governments often demand the the smoking gun in fraud and conspiracy even when its not always possible, unless at great personal cost like in Snowden, but here the smoking gun and entire armory is out in the open. Attempting now to discredit the messenger is disingenuous.
"It's just amazing how LIBOR fixing can make you that much money!"
But I can't say I'm unhappy with it: never have I paid so little interest on anything I've ever owed, Euribor is negative right now and I'm loving it.
Whatever means of calculation or manipulation are being used, they are working out in my favor today. Maybe a stricter regulation would limit the banks abilities to lend competitively, which may not be in neither their, mine nor the government's favor.
The continuous easy money policies have prevented the markets to price credit risks for a long time. This has manifested itself in a series of bubbles. Weaning off will be difficult. Not weaning off will ensure collision with a brick wall eventually.
If you're going to peg transactions to a made-up number, is LIBOR really any worse than anything else?
And history teaches that there is eventually an end to governments' ability to print unrealistic amounts of money. See Zimbabwe, the Weimar Republic, etc.
EDIT: and LIBOR isn't much of a projection, it is "I believe I could borrow at this rate, today, if I needed to"
There was clear evidence of fraud and broken fiduciary responsibilities which i belive are unforgivable.
LIBOR will still be around but its importance will diminish in perpetuity.
Matt Taibbi has an unabashed, heavily liberal bias. He sells by appealing to readers like you.
I would argue that Michael Lewis is a superior popular finance writer.
The EFF is biased in favor of free speech and encryption, and markets to cyber-punk programmers. So all arguments in favor of free speech made by any EFF member in any EFF-related article can be immediately discarded.
"dogruck on HN" is biased against rollingstone.com; and gathers upvotes by appealing to people who dislike rollingstone.com(which, separately, is ineffective); so we should discard his opinions.
In fact, because you seem to know about biases, you may actually be more prone to them: http://lesswrong.com/lw/he/knowing_about_biases_can_hurt_peo...
In fact, my original post, which expressed dismay that we celebrate Rolling Stone for reporting about LIBOR, has been downvoted 4 times.