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The downfall of LIBOR was largely due to manipulation by banks, which overstated or understated interest rates to benefit from trades or to create a more favorable image of their financial health. This unethical behavior came to light during the aftermath of the Global Financial Crisis (GFC) and led to significant reputational damage and loss of trust in LIBOR as a reliable benchmark.
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Ensuring that reference rates reflect actual market conditions is crucial for maintaining market integrity and stability, as they underpin the pricing of various financial instruments and loans. Accurate benchmark rates help prevent distortions in financial markets, reducing the risk of systemic issues and protecting the interests of borrowers and investors alike.
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The introduction of new reference rates to replace LIBOR raises concerns about their global acceptance and usage, as none of the alternatives, such as SONIA or BTFR, possess the same widespread recognition and liquidity. Additionally, the transition may lead to uncertainty regarding implementation, potential discrepancies in financial contracts, and the ability of new rates to adapt to market changes effectively.
LIBOR is a key reference interest used for pricing variable rate loans in the UK and
in other major markets.
Indeed, the rate is linked to more than $350 trillion in loans around the world
(Vaughan and Finch, 2017). However, the rate was subject to 'rigging' or
manipulation for a number of years prior to 2012; when the so-called 'LIBOR
Scandal' came to light in the years following the GFC, it resulted in a number of
reforms.
LIBOR was calculated as the average of interest rates submitted by banks around
the world. Banks were required to submit the exact rates they were paying but, as it
emerged, some banks were deliberately overstating or understating rates in order
to profit from certain trades or to give misleading indications about their financial
positions.
Following the scandal, LIBOR has been more tightly regulated with the aim of
ensuring that the reference rate reflects actual market conditions. In a move that has
caused some concern in the global financial community, the UK's Financial Conduct
Authority has decided to require banks to transition towards alternative interest
rate benchmarks by 2021.
In the UK, LIBOR will be replaced by SONIA (Sterling Overnight Index Average). In
the USA, LIBOR will be replaced by the Broad Treasury Financing Rate (BTFR).
Questions still remain, however, about how this will work in practice. Importantly,
none of the new reference rates will have the global reach and status as a pillar of
the financial system that LIBOR once had (Scaggs, 2017).
In the Australian economy, the Bank Bill Swap Rate (BBSW) is the short-term
interest rate benchmark that performs a similar function to other published
reference rates such as LIBOR (Bank Bill Swap Rate (BBSW), 2018). In Australia,
BBSW is administered by the ASX and efforts have been made to assure the
confidence of market participants by introducing a new method for calculation. The
new methodology came into effect from May 2018 and calculates the benchmark
directly from market transactions with a longer rate-set window and involves a
larger number of participants. This ensures that the benchmark relates to real
transactions at the traded prices. (‘ASIC and RBA Welcome the New BBSW
Calculation Methodology/ Media Releases/ RBA’, 2018).
The change in methodology also ensures that BBSW is anchored to observable arm's
length transactions in an active underlying market and the calculation mechanism is
robust to changing market conditions. However, financial analysts predict a drift
from BBSW towards risk-free rates (like BTFR) (Debelle, 2016)
1. Discuss the factors that led to the downfall of LIBOR?
2. What is the importance of ensuring that reference rates reflect actual market
conditions?
3. What concerns surround the introduction of new reference rates to replace
LIBOR?
Briefly explain the answers in 2-3 sentences
1 answer