Thursday, April 17, 2008

Lenders examine LIBOR alternatives

(Gillian Tett in the FT) Investment banks are incr-easingly exploring alternatives to the use of Libor - or the London interbank offered rate - amid frustration with the way that the index is constructed.

In particular, some banks are now calling for the greater use of the overnight index swap (OIS), or other market measures, to replace the use of Libor in derivatives contracts and other financial structures.

The move is likely to be fiercely resisted by the British Bankers Association, which is responsible for devising the Libor benchmark, and draws revenues from this task.

BBA officials have told private sector bankers in recent months that it would be foolish to undermine Libor, given the crucial role it plays in the derivatives market. However, in a sign of the growing debate about Libor, the BBA said yesterday that it would accelerate a review of how it calculates the rate, and exclude any banks found to be quoting rates that distort the market.

"Economic conditions are difficult, especially in the lending and credit market. In response, the BBA has brought forward the regular review of the BBA Libor settings process," the trade body said.

Libor is calculated each day by looking at the interest rates at which banks offer to lend unsecured funds to each other in 10 major currencies in the London interbank market.

It is a key benchmark for short-term interest rates and is used as the basis for settlement of interest rate contracts on many of the world's futures and options exchanges. It is calculated over a range of maturities, but the overnight and three-month rates are typically the most closely watched.

Libor has become increasingly volatile. The overnight rate typically traded at just 12 basis points above the OIS before last summer, but this gap widened to more than 100bp on one occasion this year.

Officials at the BBA say this simply reflects the volatile nature of markets in the current crisis. However, some bankers fear Libor may be distorted because it is compiled from quotes that bankers submit - and there is little way of checking whether trades are conducted at these levels.

Given this, some bankers argue that alternative measures need to be considered. "Continuing to base an enormous amount of derivative contracts on an index with credibility problems is a serious issue we must address," Paul Calello, head of investment banking at Credit Suisse, told a conference in Vienna yesterday. "We as an industry need to look at strengthening some of the alternatives available. The industry might consider pushing the development of long-dated OIS swaps, for example."

David Rule, a former head of sterling money markets at the Bank of England, wrote in the Financial Times last week: "Overnight interbank rates are now a superior basis for interest-rate derivatives and floating-rate debt. Overnight interest rate fixings have the additional advantage they are based on actual transactions rather than bankers' quotes."

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