Restoring trust in financial benchmarks

Prior to the London interbank offered rate (LIBOR) fixing scandal in 2012, very few people outside of the professional financial services sector paid any attention to financial benchmarks, despite the significant bearing they had on one’s ability to do such things as buying a home by taking out a mortgage, borrowing for higher education, or putting the trip of a lifetime on a credit card. Yet until 2012 access to all of these things was influenced by the unregulated daily fixing of financial benchmarks by an unregulated committee of the world’s largest banks.

The LIBOR scandal

LIBOR was a benchmark interest rate that influenced around $350 trillion of securities and loans around the world, affecting everything from giant corporations’ loans to home mortgages. It was set by a self-selected, self-policing committee of the world’s largest banks, with the rate measuring how much it cost them to borrow from each other, and the players involved were driven largely by the desire to maximise profits while limiting risk. Every morning each bank submitted an estimate, an average was taken, and a number was published at midday. But in 2012 it came to light that traders at many of these banks had been submitting artificially low or high interest rates to try and force the LIBOR higher or lower, to support their institutions’ own activities. The scandal led to fines amounting to billions of dollars for some of the banks involved, as well as a slew of criminal charges.

Course correction

Policy makers urgently needed to restore confidence in rate setting procedures that underpinned trillions of pounds worth of contracts in the markets for everything from foreign exchange to oil, gold and silver. LIBOR and other benchmarks were gradually put under the control of financial regulators, the largest and most consequential of those being the ISDAFIX, which used to fix the price at which interest rate swaps could be traded in the $289 trillion swap market and was also linked to pricing for the $544 trillion private derivatives market. It was set each day based on submissions by a panel of 16 banks, and was largely defined by old fashioned financial principles of dictum meum pactum – my word is my bond. Lacking objectivity, transparency and oversight, ISDAFIX also invited questions about accuracy, namely: how representative of the fundamentals in the underlying swap market were the submissions of the 16 banks?

In 2015, the unregulated ISDAFIX became the regulated ICE swap rate. Contemporary, data-led and based on continuous, randomised snapshots of order books from multiple trading venues, the benchmark reflects what is tradable in the swap market rather than the views of a select few privilege banks. Subject to better governance and greater oversight by a diverse committee of independent and market representatives, one would expect this new process to result in a more efficient and accurate rate-setting process. To be sure, however, the new process required prompt and comprehensive assessment, and that’s where University of Edinburgh expertise came in.

Responsible regulation

Gbenga Ibikunle, Professor and Chair of Finance at the University of Edinburgh Business School, was invited by economists at the UK’s financial markets and services regulator the Financial Conduct Authority (FCA), to conduct research into the efficacy and accuracy of ICE. Together with then PhD student Tom Steffen, FCA economist, Dr Matteo Aquilina and Macquarie University’s Professor Vito Mollica, who was co-supervising Mr Steffen’s PhD, Professor Ibikunle found substantial evidence that the market is in a much better condition under the ICE regime than it was under ISDAFIX. They found the market to be more liquid, which implies that trading of swaps has become easier, with an 11% reduction in the implied execution costs for the most traded swap instrument, the 10-year tenor. The market being more transparent also encourages greater levels of participation by players in the market – a 10% increase was observed on just a single platform for trading swaps. Overall, the research team found that the market for trading interest rate swaps has become more efficient.

The positive changes ICE has brought are not only beneficial for financial markets players, they hold significant consequence for us all. Since ICE swap rate is used by financial institutions to hedge interest rate risk, and therefore reduce uncertainty, the improvements we observe in the economics of the rate setting process can be the difference between whether we can afford to pursue many of our dreams, such as owning a home.

Perhaps the most fulfilling aspect of my job is knowing that I am making an impact through my research and teaching. I was fortunate to be able to do so with this project by working with a talented team of international researchers. Our findings basically take what we always suspected about the benchmarking process from the realm of theory to practice – we expect them to influence policy for some time to come.

Gbenga Ibikunle