[Marxism] LRB: What's in a Number?

["Pance Stojkovski" <pance@xxxxxxxxxx>]

http://www.lrb.co.uk/v30/n18/mack01_.html

What's in a Number?

Donald MacKenzie on the Importance of Libor

Judged by the amount of money directly dependent on it, the British Bankers'
Association's London Interbank Offered Rate matters more than any other set
of numbers in the world. Libor anchors contracts amounting to some $300
trillion, the equivalent of $45,000 for every human being on the planet.
It's a critical part of the infrastructure of financial markets but, like
plumbing, doesn't usually get noticed. Only a handful of economists, and no
other academics, have ever looked in any detail at Libor, and even the
financial press didn't show much interest in how Libor is calculated until
this spring, when there was sharp controversy over whether these crucial
numbers could be trusted.

The calculation of Libor is co-ordinated by just two people, who work in an
unremarkable open-plan office in London's Docklands. I watched the process,
which seemed utterly routine, a couple of years ago. Just after 11 a.m. on
every weekday that's not a bank holiday, traders at leading banks send in
their estimates of the interest rates at which their banks could borrow
money. They do this electronically, but sometimes the co-ordinators make a
phone call to a bank that hasn't sent in its estimates, and if the latter
seem implausible - typos, for example, are fairly common - they're checked,
also with a quick call: 'Hi there, is the Kiwi chap [provider of the
estimates for borrowing New Zealand dollars] about? . . . Bit of a spread on
the two month. Everyone else is coming in a good bit under that.'

A simple computer program discards the lowest quarter and highest quarter of
the estimates, and calculates the average of the remainder. The result is
that day's Libor. The calculation is repeated for each of ten currencies and
15 loan durations (from overnight to 12 months), so 150 Libors are published
daily: overnight sterling Libor, one-week euro Libor, one-month yen Libor,
three-month US dollar Libor and so on.

It's the back-up arrangements that tell you something about how much the
calculation matters. The co-ordinators have dedicated phone lines laid into
their homes so they can still work if a terrorist attack or other incident
stops them reaching the office. A similarly equipped building, near the
office, is kept in constant readiness, and there's a permanently staffed
back-up site in a small town around 150 miles from London (I won't be any
more precise than that). Its employees periodically work in the London
office, so that they're ready to take over if need be.

The precautions are necessary because if Libor suddenly became unavailable,
large parts of the global financial system would be paralysed. The 150
numbers constitute the dominant global benchmark for interest rates. The
rates on borrowing, amounting to around $10 trillion (corporate loans,
adjustable-rate mortgages, private student loans and so on), are pegged to
Libor. For instance, the level of Libor determines the monthly payments on
around half of the adjustable-rate mortgages in the US: rates are set as
Libor plus a fixed margin, and are reset periodically as Libor changes. Even
in the UK, where explicit pegging of this kind is rarer, Libor is a big
influence on mortgage rates.

Libor is an even more important factor in the huge market for interest-rate
swaps. These are contracts in which one bank or other organisation pays a
fixed rate of interest on a given amount of money to another bank, which
pays a floating (that is, variable) rate - such as three-month US dollar
Libor - on the same amount. The total amounts involved, added up across the
globe, exceed $300 trillion. Measured that way, the swaps market is the
biggest financial market of them all, and most of it depends on Libor.

Invented only at the start of the 1980s, swaps enable lenders and borrowers
to eliminate the risk of interest-rate changes. Take fixed-rate mortgages,
for example. Without swaps, a bank might be reluctant to offer them, because
it generally pays its depositors floating rates, and also borrows from other
banks at floating rates. If interest rates go up, the bank will therefore
have to pay out more, while its revenue from its fixed-rate mortgages stays
the same. (As rates rose sharply in the 1980s, almost all the savings and
loan associations in the US - the equivalent of the UK's building societies
- were caught out in this way. The resulting crisis, a precursor of today's
credit crunch, pushed more than 700 savings and loans into insolvency, and
the rescue operation ended up costing US taxpayers around $130 billion.)
Entering into a swap in which the bank pays a fixed rate and receives a
floating rate enables it to cancel out the effect of changing interest
rates, and conditions in the swaps market are thus a major influence on the
terms on which fixed-rate mortgages are available. The very possibility of a
large-scale swaps market depends on the availability of a measure of
interest rates that is unequivocal and credible enough to form the basis for
contracts denominated in billions of dollars. Libor has provided that
measure.

In a financial world dominated since 1945 by the US, it's striking that the
global benchmark is a set of London rates. Paradoxically, the reason for
this is Britain's failure - crystallised in the 1957 sterling crisis - to
re-establish the pound as a major international currency after the war. That
prompted the leading British banks increasingly to lend, borrow and accept
deposits in US dollars ('eurodollars', as they came to be called). The Bank
of England overcame its initial anxieties and came tacitly to support the
eurodollar market, and the Johnson administration inadvertently encouraged
it by trying to stem the flow of dollars overseas. Eurodollar operations
conducted in London allowed US banks to circumvent the new controls.

The result was that London became - and in many ways remains - the centre of
the international money markets. 'Money' here does not mean cash, but
short-term loans between banks and other major institutions; more than a
fifth of international lending of this kind still takes place in London.
Crucial to facilitating this market - and to enabling Libor to be calculated
- were, and are, London's money brokers. They emerged in the 1960s as a
challenge to the traditionally staid, gentlemanly, top-hatted sterling money
markets, in which lending took place via designated 'discount houses' backed
by the Bank of England. Money brokers put lenders and borrowers directly in
touch with each other, charging a fee for doing so. The business is
fast-moving, and competition fierce and sometimes not at all gentlemanly. If
you listen to brokers' voices, you hear the tones of the East End and Essex
more often than those of Eton or Harrow. Open-necked shirts are more common
than suits and ties. While banks' dealing rooms are now often
disappointingly quiet and orderly places - in reality there's far less
shouting and swearing than in film portrayals - brokers' offices are more
tightly packed (there's less space between desks) and more raucous.

Suppose a bank wants to borrow or lend in the interbank market. (It might
want to lend because no bank likes to leave cash idle, even for the shortest
period. Indeed, overnight lending is the busiest sector of the interbank
market, with banks that have excess cash at the end of the working day
lending to those that need it.) A bank's money-market traders could directly
contact their counterparts in other banks, but it's usually quicker and
easier to work through the brokers. This can now be done on-screen, but -
especially if large sums are involved or market conditions are tricky and
changing rapidly - it's often better to use the 'voicebox'. This is a
combination of microphone, speaker and switches that instantly connects each
broker by a dedicated phone line to each of his clients in banks' dealing
rooms.

If a bank wants to borrow money, a broker needs quickly to find someone who
is prepared to lend at an attractive rate; if a bank wants to lend, he -
it's a predominantly male profession - needs to find a borrower ready to pay
a good rate. So at any given time a broker needs to know who wants to
borrow, who is prepared to lend, and on what terms. As one of them said to
me, a broker might 'speak to his big clients . . . maybe 25 times a day,
which is 25 times as often as they speak to their wives'.

A broker needs to pass information to his clients as well as to receive it:
that's a major part of what they want from him, and a good reason to use the
voicebox rather than the screen. The brokers' code of conduct prohibits
passing on private knowledge of what a named bank is trying to do (unless a
client is about to borrow from it or lend to it), but that restriction
leaves plenty of room for brokers to tell traders what has just happened and
to convey the 'feel' of the market. There's a grey area in which euphemisms
can be used: in context, a trader might know exactly which bank is meant
when the broker tells him that 'the usual German' has just done something.

Brokers in major money-market currencies don't work as individuals, but in
teams of up to a dozen or more, sitting close together in subsections of
large, open-plan offices. Good eyesight is useful - trainees still sometimes
called 'board boys' write unfilled bids to borrow and offers to lend on
whiteboards surrounding clusters of brokers' desks, and you can occasionally
see a broker using binoculars to read a distant whiteboard or screen - but a
more crucial skill is 'broker's ear': the capacity to monitor what is being
said by all the other brokers at nearby desks, despite the noise and while
at the same time holding a voicebox conversation with a client. As one
broker put it to me: 'When you're on the desk you're expected to hear
everyone else's conversations as well, because they're all relevant to you,
and if you're on the phone speaking to someone about what's going on in the
market there could be a hot piece of information coming in with one of your
colleagues that you would want to tell your clients, so you've got to be
able to hear it coming in as you're speaking to the person.'

When you first encounter it, broker's ear is disconcerting. You'll be
sitting beside a broker at his desk, thinking he's fully engaged in his
conversation with you, when suddenly he'll respond to a question or comment,
from several desks away, that you simply hadn't registered. It's an embodied
skill that affects the way Libor is calculated. The inputs to the
calculation are provided daily by the money-market traders from banks that
are on panels established by the British Bankers' Association. There is one
panel for each currency, and those for the main currencies each have 16
banks on them. What each bank has to provide is the rate at which it could
borrow funds ('unsecured' - that is, backed only by the bank's
creditworthiness, not more specific collateral - and 'governed by the laws
of England and Wales'), 'were it to do so by asking for and then accepting
interbank offers in reasonable market size just prior to 11.00' in the
currency and for the time period in question.

Note the conditional: a Libor input is what a bank could do, not what it has
done. So judgment is involved. A bank might not have borrowed anything in
the minutes before 11 a.m. Deals for longer than overnight are intermittent,
and there is little borrowing at some of the time periods involved, such as
11 months. 'Reasonable market size' is deliberately not defined exactly: it
will vary from currency to currency and according to time period and market
conditions. The need for judgment is why the information provided by brokers
is important to the calculation of Libor. It helps a bank's traders to
estimate the rate at which they could borrow money, even if they're not
trying to do so. They get some of the information they need from the screens
provided by their various brokers: all serious traders employ several. The
screens indicate the lowest rate at which banks are currently offering to
lend and the highest rate at which they are prepared to borrow. Only the
naive, however, would give the former rate as their Libor input. The screens
don't reveal the amount actually available for borrowing at the lowest
quoted rate, and it may fall short of 'reasonable market size'. It could
range from a mere $50 million or so to a yard or more ('yard' - originally
an abbreviation of 'milliard' - is the money-market term for billion, a word
that in a noisy environment is all too easy to confuse with 'million').

The screens can't be expected to tell you with any precision how much you
would have to pay to borrow a few hundred million dollars (reasonable market
size for short-term borrowing in a major currency), and are even less
reliable when it comes to borrowing several yards. It can take an
experienced trader talking to a number of brokers with good ears to form a
realistic estimate. There's also an element of judgment in the rates that
brokers put on the screens: they can, for example, consider it as misleading
their clients to quote a bid to borrow at an unusually high rate, if it
comes from a bank with poor credit standing to which many of their clients
would be reluctant to lend.

Originally, Libor was an informal notion, and when different sets of banks
were polled the resultant Libors could differ by as much as 25 basis points
(a basis point is a hundredth of a percentage point). The current British
Bankers' Association system for calculating Libor, involving a fixed
procedure and predetermined panels of banks that change only infrequently,
was set up in 1985, and has worked remarkably well, which is why the
participants in financial markets are prepared to have $300 trillion indexed
to Libor.

The obvious risk to the integrity of the calculation is that a bank on a
Libor panel might make a manipulative input, trying to move Libor up or down
so as to influence interest rates or the value of its swaps portfolio. That
risk is the main reason for the exclusion from the calculation of the
highest quarter and lowest quarter of inputs. Furthermore, once a day's
Libor rates are set, each input - and the name of the bank that has made it
- is also disseminated electronically, and so attempts at manipulation would
have to take place in what is in effect the public gaze. The inputs to Libor
can be viewed around 45 minutes after they are made on more than 300,000
computer terminals worldwide, and they are thoroughly scrutinised. On one
occasion, well before the recent problems, a banker showed me the day's
inputs into three-month sterling Libor, pointing with suspicion to a bank
that had reduced its input - by a single basis point - from the previous
day's, while all the others had either increased theirs or left them
unchanged. The brokers see and hear a lot. An input wildly at odds with what
their screens show would be obvious, and word of persistent attempts at
manipulation would quickly spread as brokers chat with their clients. The
ultimate sanction - used in the past, I was told, but not recently - is a
bank's removal from a Libor panel. In the current climate, that would deeply
damage the bank's reputation.

The strength of these long-standing fortifications around Libor's status has
been questioned over the course of the last twelve months. Ever since the
rescue of Northern Rock, whether or not banks are sound, whether they are
prepared to lend to each other, and sometimes even the levels of Libor have
been topics for TV news, not just the Financial Times. Much of the most
vocal criticism of Libor has come from the US, and has focused on dollar
Libor - especially three-month dollar Libor, the rate used more than any
other in the swaps market. Some seem unhappy that the benchmark dollar
interest rates are set in London just after 6 a.m. New York time, when
traders are only starting to arrive at their desks, and that the US dollar
Libor panel contains only three recognisably 'American' banks. The British
Bankers' Association - membership of which is open to any bank operating in
the UK, wherever it is domiciled - counters by pointing out that all the
banks on the panel are global institutions, some with a major presence on
the ground in the US, and that collectively they are responsible for most
London interbank dollar lending and borrowing.

The most prominent critic has been the Wall Street Journal. It has suggested
that the public dissemination of banks' inputs - which is intended to make
the process more transparent - has the effect of biasing inputs downwards,
because banks fear that reporting publicly that they can borrow only at high
rates would spark rumours about their creditworthiness. On 16 April, under
the headline 'Finance markets on edge as trust in Libor wanes,' the WSJ
reported a claim by Scott Peng, an analyst at Citigroup, that although,
because of the credit crunch, Libor was already high relative to the rates
set by central banks, it should be even higher. Three-month US dollar Libor,
Peng suggested, should actually be 30 basis points higher than it was - a
difference that represents huge amounts of money, given the trillions of
dollars indexed to it.

The British Bankers' Association responded by telling the WSJ that it was
monitoring inputs closely and that if it was 'deemed necessary', it would
'take action to preserve the reputation and standing in the market of our
rates' - a warning that the WSJ read as a threat to remove any bank making
dubious inputs. Over the next two days, three-month dollar Libor rose by 16
basis points, but in a context in which rates have been highly volatile it's
impossible to be certain that this was because of the WSJ's reporting, the
British Bankers' Association's statement, or different factors altogether.
Central bankers began watching the controversy over Libor closely, the FT
reported, 'because some officials fear that the debate could be contributing
to a broader sense of investor unease in the money markets'.

Given the criticism of Libor, why not abandon its conditional aspect (the
submission of rates at which banks could borrow), and shift, as some critics
have suggested, to an index based on actual transactions? At least two such
indices already exist. Eonia (Euro Overnight Index Average), calculated by
the European Central Bank, is a weighted average of the rates of overnight
interbank loans denominated in euros. Sonia, its sterling equivalent, is a
similar average of overnight loans transacted via London's main money
brokers.

Eonia and Sonia have their attractions. In June, LIFFE, the London
International Financial Futures Exchange, whose interest-rate contracts have
traditionally been based on Libor, launched additional contracts based on
Eonia, and it would like to do so using Sonia, although it hasn't yet got
permission from the index's owners (the leading brokers). But the names of
the two indices indicate their limitations. They are averages of overnight
lending, and the market for longer-duration interbank loans is probably too
patchy to sustain credible indices based directly on the transactions that
have actually taken place. Right now, much more than a week can seem far too
long a time for a bank to lend its carefully husbanded cash to one of its
peers. It's also the case, brokers and traders told me, that until the Bank
of England applied sustained pressure - and eventually, in May 2006,
instigated reforms - the sterling overnight market could be unruly, with
surprisingly volatile rates strongly influenced by position-taking on the
part of individual big banks.

It's also an illusion to think that indices based on transactions can't ever
be manipulated. 'Closing prices' - the average of the day's final deals on
an exchange - are widely used as indices, but there's then sometimes an
incentive to 'bang the close', in other words to trade aggressively in the
final minutes or seconds so as to influence the closing price. In July, the
US Commodity Futures Trading Commission charged three oil traders with
allegedly doing just that.

A potential alternative to Libor as a benchmark, at least as far as the US
dollar is concerned, is the New York Funding Rate, launched by the brokers
Wrightson ICAP in June. Its poll of banks is conducted in the US at 9.15
a.m. New York time; inputs are anonymous; and each bank is asked to report
the rates at which a typical bank with a high credit rating could borrow,
not those at which it itself could. Despite these differences, however, the
resulting numbers have tended not to differ much from US dollar Libor. What
could have been a rival has in practice provided a confirmatory second
opinion that has helped restore confidence in Libor. The membership of the
panels of banks that make Libor inputs may now be broadened, and a new
British Bankers' Association subcommittee will draw on independent
third-party analysis of inputs and have the power to demand that banks
justify any that seem anomalous. So the controversy seems to be passing.
Nevertheless, its sharpness, and how unsettling some market participants
seem to have found it, indicate just how important Libor is to the world's
financial system.

Donald MacKenzie's Material Markets: How Economic Agents Are Constructed
will be published in January. He teaches in the School of Social and
Political Studies at Edinburgh University.



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