Perhaps the only thing more surprising than the LIBOR rate-fixing scandal that engulfed Barclays last week is the method by which the rate is set. For more than four decades, the benchmark interest rate has been set by a group of banks, based on voluntary declarations of each bank’s borrowing cost, not actual trades.
But the LIBOR determination isn’t the only arcane banking convention that has come under question in recent weeks. The flubbed Facebook IPO has cast doubt on the book-building process by which equity offerings have been managed for decades.
Thanks to these two high profile incidents, every opaque process in the financial market is likely to face scrutiny – and growing pressure to change. Today’s financial markets are globally connected, with instant information flow and trades that are measured in milliseconds. Yet, in a quiet precinct of London’s financial district, the British Bankers Association presides over the daily determination of LIBOR, untouched by these modern forces. It is a quaint relic of a bygone age, but it affects some $500 trillion of transactions, from home mortgages to complex derivatives.
It is a process that relies on private estimates of where each bank could borrow instead of actual trades visible to all. We now know this process was manipulated by Barclays (and certainly other banks as well) to favor their own trading positions, particularly on interest rate swaps and other derivatives. (Expect whopping lawsuits from clients soon.)
Yet the LIBOR rate-setting isn’t the only part of the financial market where transparency is lacking.
Gold is priced at daily “fixings” by a committee of five banks (one of which is Barclays). Prices for municipal bonds are set by dealers and are hard for investors to find anywhere. Pricing an IPO still relies on a secretive dance between investors and underwriters to determine demand for a company’s shares.
No one trusts the banks to handle these roles any longer, so markets suffer from a lack of investor confidence and diminished liquidity. The answer is more transparency, better communication and leadership from major institutions.
Technology is available to bring these processes into the open. Google and a few other companies have used a Dutch auction to price their share offerings, but the practice is still resisted by large banks since the fees for managing an auction are a fraction of those for a traditional underwriting.
The fallout from the LIBOR scandal could not only spell the end of its rate-setting process but hasten changes in other opaque financial practices as well. If it’s clubby, subjective and secretive, its integrity is suspect.
Dealers should expect these practices to be examined by regulators and the media. They’ll need to make changes to improve transparency or see reforms imposed on them.