Libor reform may add volatility, increase some funding costs

NEW YORK Fri Sep 28, 2012 4:03pm EDT

NEW YORK (Reuters) - Libor reforms announced on Friday are seen as unlikely to cause large market shifts in the near term, though some see changes as likely to add some volatility in short-term bank funding, and push borrowing rates at least marginally higher.

Some market participants also remain concerned about conflicts of interest at banks that contribute the rate and also run large interest rate swap books, despite assurances of greater regulatory oversight, as the benchmark will continue to be determined via a poll of funding costs.

Britain's Financial Service Authority (FSA) delivered a 10-point plan to fix the benchmark, which underpins over $300 trillion contracts and loans, but found that rate is too entrenched to replace, and struggled to identify alternative market based measures that could be used as a substitute.

The rate has lost credibility on revelations that swaps traders at large banks sought to manipulate the rate to benefit trading positions, and after banks lowballed their borrowing costs in the financial crisis in a bid to reduce fears over their credit health.

An expansion of the panel of banks that submit rates to Libor, a three-month blackout on the disclosure of individual bank's lending rates and a requirement to back submissions with evidence of borrowing costs in other markets are among reforms designed to reduce attempts to manipulate the rate.

It's too early to know the effect on markets of the changes, though much will depend on which banks are added to the panel.

"There is a lot of uncertainty over what the Libor panel will look like in the future," said Brian Smith, vice president in rates trading at TCW in Los Angeles, which manages $130 billion in assets.

Many see few benefits for banks to contribute to the rate, as regulatory and public scrutiny of the process increases.

Interdealer broker ICAP said in August that it would discontinue a rate survey it had created as a substitute for Libor, due to a decline in bank participation.

The European Banking Federation also launched a dollar-Euribor index earlier this year, which is meant to represent the cost of U.S.-dollar funding in the European interbank market, and the panel included none of the 18 banks that currently submit to dollar-based Libor.

Friday's FSA report recommended legislation that would allow the regulator to "compel" banks to submit rates if required.

MORE VOLATILITY, HIGHER COSTS

Adding more banks may push rates higher, if the panel extends to lower-rated banks and those that borrow in the short-term markets less frequently.

"In general I think more banks translates into a higher benchmark rate because you included banks that aren't as efficient as borrowers in the wholesale markets and tend to pay higher rates," said Alex Roever, a money market analyst at JPMorgan in New York.

The requirement to reference market borrowing rates when making Libor submissions may also add to volatility in rates, said Roever, noting that volatility in Barclays Libor submissions picked up after the bank settled charges with U.S. regulator the Commodity Futures Trading Commission in June.

The settlement included a requirement that the bank back up its submissions by referencing other borrowing rates including its commercial paper and certificates of deposits, and with reference to markets including overnight index swaps, futures, and repo.

"The change increased the volatility of Barclays submissions, at least temporarily, I think in part because they are living more under a microscope," said Roever.

FIGHTING OVER FRACTIONS

Some market participants, however, remain concerned that swaps traders may continue to try to influence Libor settings, as even minute changes can drive large gains or losses for banks with interest rate derivatives positions based on the rate that can be in the hundreds of billions of dollars.

As an example, take a bank that owes a trading partner quarterly payments on a $50 billion portfolio of derivatives. Here, a move as minute as one-tenth of a basis point in three-month Libor, or one-thousandth of a percentage point, will represent around $125,000. That means the bank will gain or lose $1.25 million for each one-basis point change in the rate.

For some traders, the temptation to hold swap over the setting may be too much.

"It may just create a better thief," said one former swaps trader at a bulge bracket bank.

In this respect, the precision of Libor settings is an issue. Banks report rates out to five decimals of a percentage point in Libor, while short-term lending in markets including commercial paper more typically rounds out to three decimals of a percentage point.

"The system delivers on a daily basis a very precise measure of a market that actually doesn't trade that much, or isn't observable, and is an opinion poll," the trader said.

"It's ripe for error, it's a difficult task to perform accurately on a daily basis because of the design," he said.

(The story corrects name in seventh graph.)

(Reporting by Karen Brettell)

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