Libor Can Be Whatever You Want It To Be

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There is much to ponder in the continuing saga of Libor but this sounds like an excuse:

The U.K. bankers and regulators charged with reviewing Libor in the wake of regulatory probes are resisting calls to overhaul the rate because structural changes risk invalidating trillions of dollars of contracts. ... [They] won’t propose structural changes such as basing the rate on actual trades or taking away oversight of the benchmark from the BBA ....

Any substantial changes could affect existing contracts that reference Libor, according to Simon Gleeson, a partner at law firm Clifford Chance LLP in London. ... “There’s a tail of contracts that may take 10, 20, 50 years to run off which use Libor as an undefined term, because nobody felt it needed defining,” Gleeson said. “The more changes you make, the more likely it is that somebody will be able to argue this is a material change to their contract.”

Is this true? I mean, it's probably true, whatever, I am not a London lawyer, but it's really tempting to take the other side here. Here is a pretty normal and alphabetically privileged credit agreement:

“LIBO Rate” shall mean, with respect to any LIBOR Borrowing for any Interest Period, an interest rate (rounded upwards, if necessary, to the next 1/100 of 1%) equal to the offered rate for deposits in either Dollars or Euros for a period equal to the Interest Period for such LIBOR Borrowing that appears on the Reuters LIBOR01 Page (or any page that can reasonably be considered a replacement page) at approximately 11:00 a.m., London time, two Business Days prior to the commencement of such Interest Period. If such rate is not available on the Reuters LIBOR01 Page, the “LIBO Rate” shall be the rate (rounded upwards, if necessary, to the next 1/100 of 1%) equal to the arithmetic average of the respective rates per annum at which Dollar or Euro, as applicable, deposits approximately equal in principal amount to such LIBOR Borrowing and for a maturity comparable to such Interest Period are offered in immediately available funds to the London branches of the Reference Banks in the London interbank market at approximately 11:00 a.m., London time, two Business Days prior to the commencement of such Interest Period.

Or if your preferred flavor of Libor is swap rather than loan, here is the Annex to the 2000 ISDA Definitions*:

"USD-LIBOR-BBA" means that the rate for a Reset Date will be the rate for deposits in U.S. Dollars for a period of the Designated Maturity which appears on the Telerate Page 3750 as of 11:00 a.m., London time, on the day that is two London Banking Days preceding that Reset Date. If such rate does not appear on the Telerate Page 3750, the rate for that Reset Date will be determined as if the parties had specified "USD-LIBOR-Reference Banks" as the applicable Floating Rate Option.

I think the takeaway from this is that for most users of Libor, it is neither an abstract correct-interest-rate concept nor a specific set of procedures by which the British Bankers Association transmutes some lies that banks tell about their funding costs into an actual funding cost for zillions of dollars of swaps and floating rate loans. Instead it is the output of a Reuters or Telerate or Bloomberg page. I for one would love to see Reuters try to fix Libor on their own - just find some actual interbank unsecured lending transactions that look like what you think Libor should be,** and drop those prices into your Reuters Libor page. Problem solved.

That's only half serious - I suspect Reuters would run into some liability there, especially since they're the BBA's contracted calculation agent for Libor - and even if the BBA and Reuters agreed to do something similar (find real transactions, use them for Libor, report result on Reuters page) some Libor contract users would have some cause to complain based on the savings clauses in those contracts,*** or based on general ill humor.

But the point is that this is the way it's supposed to work: nobody refers to Libor because they want to enshrine (or even know) the exact procedure by which its calculated; they refer to it because they want to get at the underlying concept and they'd rather leave to the BBA the mechanics of getting to that concept. If BBA Libor once represented the unsecured borrowing costs of prime banks - or something else, like "the risk-free rate"**** - and now it doesn't, then that is a really good reason for contract users to be pissed off. If it was once calculated by a poll and tomorrow it starts being calculated by trades, that is less clearly a good reason to be pissed off. That's just, like, an administrative thing.

It is hard to spell out everything in a contract and so the financial world is full of shorthand ways of doing so. CDS contracts, for instance, basically say "if the issuer defaults you will be made whole on your defaulted bonds," but they say that by reference to a whole big pile of rules. And those rules mostly didn't work when Greece picked a creative way to default on its bonds, so ISDA went and fixed them. And now if you have a CDS contract it should work for when Spain defaults ha kidding Spain will never default got you there. (Actually the fix is not automatic - you have to agree to apply the new rules to your old trades - but close enough.)

You'd think Libor would work in the same way: that it would be a seamless plug-in to your contract that can be left in the hands of people whose job is to worry about Libor, and that their occasional fine-tuning, or coarse-tuning I guess, of the best way to measure bank borrowing costs or risk-free rates or whatever would flow through your contract without blowing you up. And that's kind of how the contracts are written isn't it? They refer to the result, the Reuters page, not the process. So the fact that the Libor, um, "guardians," don't see their job that way - that they see themselves as constrained by the contracts that refer to them, rather than as obligated to the users of those contracts to change - is pretty weak.

There are lots of potential reasons for the BBA to resist, of course: maybe they don't like change, or they don't think it's that broken, or they actually can't find sensible traded/executable substitutes, or they are after all a bankers' association and so have a residual fondness for letting their members nudge Libor a bit. One potential problem, though, is that it's a lot harder to identify a single concept behind Libor than it was five years ago. If Libor isn't just a trimmed average of some numbers that some banks tell someone from Reuters every day, then it is ... the risk-free rate? The unsecured borrowing rate for AA banks? The unsecured borrowing rate for an actual assortment of disparately rated, often barely investment grade, rather tarnished banks that mostly don't actually lend to each other? Any move to an actual traded thing will require making clearer choices on that question, and it's pretty understandable that nobody would want to actually make those choices.

Libor Guardians Said To Resist Changes To Broken Rate [Bloomberg]

* There are other options for Reuters pages too. They all default-in-absence-of-pages to:

"USD-LIBOR-Reference Banks" means that the rate for a Reset Date will be determined on the basis of the rates at which deposits in U.S. Dollars are offered by the Reference Banks at approximately 11:00 a.m., London time, on teh day that is two London Banking Days preceding that Reset Date to prime banks in the London interbank market for a period of the Designated Maturity commencing on that Reset Date and in a Representative Amount. The Calculation Agent will request the principal London office of each of the Reference Banks to provide a quotation of its rate. ...

** I gather this is harder than it sounds, and there's a reason beyond orneriness and existing contracts that the BBA doesn't just do that, but ignore that for a minute.

*** I.e.: if in the absence of the Reuters page you default to actual offers to reference banks, then you could I guess argue that a big change in the Reuters page makes it a non-successor and defaults you to those actual offers etc., whatever, it's boring, I'd note that BBA Libor is not really calculated based on offers to banks but based on those banks' imaginations of what they'd be offered so it's not clear that that argument really works.

**** Isn't that weird? This is from Investopedia but that doesn't make it wrong:

The LIBOR curve and the Treasury yield curve are the most widely-used proxies for the risk-free interest rates. Although not theoretically risk-free, LIBOR is considered a good proxy against which to measure the risk/return tradeoff for other short-term floating rate instruments.

I mean, it's wrong, I guess, but it's what I was taught too. Like, if short-term unsecured lending to AA banks isn't risk-free, what is? And there you go. Remember AA banks? I feel old.