By John Kemp
LONDON, April 13 (Reuters) - Observers have drawn parallels between recent criticism of price-reporting agencies (PRAs) in the oil market and the current investigation into the manipulation of Libor rates by contributing banks. But the comparison is wrong and betrays confusion about the role of the PRAs and why it might or might not need to be reformed.
In a thoughtful article in the Financial Times on Friday, Gillian Tett urged price reporters and regulators to heed the lessons from the Libor scandal. “By acting now ... the International Organisation of Securities Commissions (IOSCO) seems to hope that it can stave off any truly big scandal,” she wrote.
Tett develops a criticism made by Commissioner Scott O‘Malia of the U.S. Commodity Trading Commission (CFTC) who drew a direct parallel between PRAs in the oil market and the role of the British Bankers Association in maintaining Libor rates.
“There are other PRAs out there that create critical financial benchmarks, including the most notable, the London Interbank Offered Rate. It is estimated that $350 trillion in financial products utilise Libor as their benchmark rate,” according to O‘Malia.
“In striking similarity to the issues raised with the energy PRAs ... we’ve got seasoned market players - banks no less - feeding information to the Libor’s publisher, the British Bankers’ Association. The British Bankers’ Association is not a regulator, and the contributor banks are not under its jurisdiction ... Clearly this is a benchmark to fix”.
O‘Malia expressed particular concern about the potential for PRA benchmarks to be used to manipulate the valuation of other on-exchange futures and off-exchange swaps contracts the CFTC regulates.
“Since PRA benchmarks are widely referenced in over-the-counter transactions, as well as ISDA master agreements, how do we ensure that the price discovery and influence of the PRAs do not negatively impact our jurisdictional markets. Contract settlement and pricing details in a futures market contract, which references a physical or OTC benchmark, must not be subject to manipulation or gaming.”
In response, the leading agency, Platts, has said “We see no connection whatsoever between Platts’ price assessments and recent issues concerning Libor.” Of course they would say that. But in this case Platts is right, and its critics are wrong.#
Critics have levelled many complaints about PRAs in general, Platts in particular. But they basically boil down to two issues:
(1) Benchmarks can be manipulated by selective contributions or lying among market participants, as well as the lack of robustness, appropriate controls and governance at the PRAs.
(2) As dominant providers of benchmarks used throughout the industry, PRAs and Platts in particular have too much power to impose changes in the way they calculate benchmarks unilaterally - giving them excessive power over all the other futures, swaps and physical contracts which reference their assessments.
Regulators are more worried about the issue of manipulation. Most criticism from within the oil markets concerns the issue of monopoly. But it is worth examining both complaints to see if they are valid and whether the proposed reforms represent an improvement.
Some reform of the PRA process (probably with more accountability to regulators) appears inevitable given the clamour for change. But if the current PRA process is not be perfect, many of the proposed remedies will be worse.
PLATTS’ WINDOW IS NOT LIBOR
The basic criticism of Libor is that it is based on submitted quotes by a panel of banks about rates at which they claimed they could borrow, rather than actual transactions, and that some contributors were colluding and making the numbers up, with no one querying or testing them. The market was wholly theoretical - and became fictitious, when it suited some banks to misreport their likely borrowing costs.
In contrast, the main benchmarks assessed by Platts and the other PRAs are based on actual trades, where possible, supplemented by reported quotes and a bit of editorial judgement where markets are thinly traded.
To the extent they rely on actual trades, rather than quotes, the PRAs are superior to Libor. Problems arise in thinner markets, where the PRAs rely more heavily on quotes and judgement, but it is not clear how this could be remedied.
Some refined product markets for which the PRAs assess prices do not really exist in any meaningful, continuous sense, since the commodity in question rarely trades in the assessed grade, location and form. It is not the prices but the market itself which is notional.
These tend to be minor, specialist refined product markets, however. If both buyers and sellers choose to incorporate notional prices for a notional market assessed by a PRA into their physical contracts it is not obvious that regulators should be concerned.
In particular, there is no evidence PRAs are systemically biased in favour of buyers or sellers. Unlike credit rating agencies, which derived all their income from the sell-side, and ended up being captured by it, PRAs have customers on both buy and sell sides of the market.
If benchmarks are manipulated by false or selective provision of information by market participants, the appropriate remedy is to mandate reporting and punish participants who provide incomplete or inaccurate data. But that is what the CFTC and other regulators like the U.S. Federal Energy Regulatory Commission (FERC) are already doing.
Some reformers have suggested assessments should be overseen by a panel of experts drawn from within the industry. But panels would almost certainly be dominated by those with a vested interest in the outcome.
Panelists might be asked to recuse themselves where their interests are directly concerned and give an undertaking to deliver impartial decisions as “arbitrators.” But credibility problems would be enormous.
The International Swaps and Derivatives Association (ISDA) already has a similar approach for deciding on credit events in credit default swaps which has attracted severe criticism.
The current process has been criticised for lack of accountability. “There is limited external scrutiny, let alone regulatory oversight ... because reporting activities have been defined as a journalistic activity and are shielded by free speech rules,” according to Tett. But who would you trust more to provide an accurate and impartial price assessment - a journalist or a group of oil producers, refiners and energy consultants?
The second criticism is that PRAs have too much power to alter benchmarks unilaterally, and should be forced to consult more with the industry, and possibly a committee of industry experts, before making changes.
Criticism of the PRAs has intensified following Platt’s decision last year to alter its calculation of physical Brent prices, a move which forced the futures exchanges to alter their own contracts, and which was fiercely opposed by many players in the industry.
Platts acted in response to widespread (and justified) criticism that the benchmark was becoming illiquid and increasingly prone to manipulation because of falling oil output in the North Sea and the declining number of cargoes on which the assessment was based.
In fact, Platts was arguably too slow to change its benchmark, and should have moved more quickly, as recurrent squeezes in the Brent market demonstrated its increasing vulnerability. The industry itself denied there was any problem and wanted no change at all.
The danger of having benchmarks overseen by groups of experts is that it will institutionalise vested interests. Expert groups will be populated by those who have the most direct interest in the outcome. No one can be confident a group of experts will act in the wider public interest rather than the narrow interest of the small circle of firms that employ them.
If Platts and other PRAs are indeed abusing a dominant position, the appropriate response is to subject them to an antitrust investigation. In contrast, institutionalising benchmarks by handing control to self-selected industry groups, will lessen competition even further.
Thomson Reuters competes with Platts, owned by McGraw Hill, in providing information to commodity markets.