Inter-bank interest rates: Fixing LIBOR

EVERY weekday, at around 11.30am UK time, trading screens update with that day’s new London inter-bank offered rates (LIBOR). The numbers are supposed to measure the interest rates banks pay when they borrow from each another. Along with other benchmarks like central-bank rates and government-bond yields, LIBOR rates are one of the foundations of finance. Contracts worth around $360 trillion, five times global GDP, are based on them.

Something this important needs to be rock solid, and there are concerns that LIBOR is not. A 2008 study by the Bank for International Settlements, for instance, spotted days when financial risks spiked but LIBOR did not. Given that lending rates should be highly influenced by credit risk, such disconnects have led some to suspect foul play. The Canadian antitrust watchdog is searching for evidence of collusive conduct between banks, including price-fixing. Competition authorities in Switzerland, America and the European Union are likely to probe the same thing. Financial regulators in America, Britain and Japan are also investigating LIBOR; they may look at whether banks have acted alone to manipulate LIBOR to their advantage.

LIBOR was developed in the 1980s to simplify the pricing of interest-rate derivatives and syndicated loans. Such loans blend funds provided by several banks; a common yardstick for the cost of cash was needed. In response the British Bankers’ Association (BBA) started publishing LIBOR rates in 1986 and they quickly became a vital reference point for the pricing of financial instruments.

Libor is set, or “fixed”, every day. Unlike other benchmarks it is not based on actual borrowing costs. Instead, each bank estimates the rate it would be charged if it borrowed cash that day, across 15 maturities in ten different currencies. The amount borrowed in this hypothetical contract is not specified, it just has to be a “reasonable” amount. This process ensures that full LIBOR coverage is available every day, even in lesser-used currencies.

Up to 20 banks submit their best guesses of lending costs. Once these are all in, Thomson Reuters, on behalf of the BBA, ranks them, removes the top and bottom 25%, averages the rest and then publishes the day’s LIBOR fixing. At this stage every bank’s individual estimate is revealed, too.

So LIBOR is subjective by design. It is a bankers’ poll, not a statistical measure. And there are reasons to believe that banks have an incentive to cook the numbers. Banks whose actual borrowing costs are high do not want to admit they are seen as risky by creditors. And some banks’ liabilities are more closely tied to LIBOR than their assets. By lowering LIBOR, these banks’ interest costs would fall more than interest revenues, boosting profits.

Accurate benchmarks are vital if risk is to be correctly priced. According to Zohar Hod of SuperDerivatives, a derivatives-pricing firm, there has already been movement away from LIBOR towards using overnight index swaps to discount cash flows on certain instruments. In the meantime the BBA is considering a LIBOR revamp. It is needed. Where actual rates are available, these should be used. If estimated rates are required, incentives to report accurately need to be sharpened. Collecting each bank’s estimates of its rivals’ borrowing rates would help identify any over-optimistic self-assessment. Keeping these cross-checks anonymous could promote truth-telling. Such steps could lead to an accurate LIBOR fix, not just a fixed one.

Source: http://www.economist.com/node/21549961

Thomson Reuters: Screen test

IN SEVEN years as head of Reuters, Tom Glocer brought the British-based news agency from the verge of bankruptcy to a state of rude health. But he has done less well as chief executive of Thomson Reuters, the company created when Thomson, a Canadian purveyor of professional information for lawyers, accountants and others, bought Reuters in 2008. Bloomberg, the firm’s American rival, has almost wiped out its once-clear lead (see chart). On December 1st Mr Glocer said he would step down at the end of the year. His replacement, James Smith, the chief operating officer, is a former Thomson man.

The revenues of the professional division of Thomson Reuters grew by 10% in the year to the third quarter, but those of the markets division—which provides financial data and services, and accounts for more than half of total sales—managed only 1%. Last year that division launched a new information platform, Eikon, to compete with the terminals offered by Bloomberg, but just 8,000 customers have taken it up. The company has 400,000 financial-data subscribers in all.

Thomson Reuters and Bloomberg are the big fish in the professional-publishing pond, at least eight times larger than their nearest competitor. Bloomberg, besides expanding its terminals business, which has over 300,000 customers (at about $20,000 a pop), is pushing into government-related news and data. In 2010 it launched Bloomberg Government, which competes with Congressional Quarterly, a sister company of The Economist. In September it made its biggest purchase ever, spending $990m on BNA, a legal- and tax-information firm.

So what happened to Mr Glocer’s winning streak? His allies say his departure was always just a matter of time: once a firm buys another, it completes the takeover by putting its own people in charge. The Thomson family still owns 55% of the company, and some think the generous price Mr Glocer secured from Thomson for Reuters made him all the more vulnerable.

But he might have stayed longer were it not for a mix of bad luck and overconfidence. Eikon, intended to replace Reuters’ grab bag of services with a single offering, was designed to be more user-friendly than Bloomberg’s devices, but it was launched hastily and with flaws. With hindsight, a more gradual upgrade might have been more prudent. This summer, under pressure from the Thomson family, Mr Glocer fired Devin Wenig, a close ally he had put in charge of creating Eikon, and took it over himself—tying his prospects even more closely to Eikon’s.

Perhaps Mr Smith can do better. He will almost certainly have a freer hand, and some upgrades to Eikon are planned for next year. But these are still stormy seas. According to Claudio Aspesi, an analyst at Sanford C. Bernstein, an investment bank, it took most professional-publishing firms three to four years to recover from the 2001 recession. This time, Bernstein predicts, revenue growth at Thomson Reuters will not reach pre-crash levels until at least 2015.

One area of potential growth, though, is trading services. Changes in financial regulation in America and Europe will force a lot of trading in derivatives from the murky world of private “over-the-counter” deals onto exchanges, where contracts will be standardised and prices quoted. This presents both Thomson Reuters and Bloomberg with an opportunity to gather and sell data on these markets and perhaps to capture a share of the trade by linking banks and their clients through their own electronic trading platforms. The market for these derivatives is gigantic. A competitive edge there could make a big difference to both companies’ fortunes.

Source: http://www.economist.com/node/21541413?fsrc=rss%7Cbus