Tour de LIBOR

Posted by Morton Lane on Jul 17, 2012

Filed Under (Finance, U.S. Fiscal Policy)

Anyone struggling to understand the LIBOR scandal could do worse than observe the way the Peloton behaves in this year’s Tour de France. All riders in the Peloton receive the same time at the end of the race. It’s like everyone getting the average rate in LIBOR rate benchmark setting. Furthermore it leads to the similar collusive behavior.

Sometimes the collusion is used to good, or at least gentlemanly, effect, such as waiting for Mark Cavendish and others who were victimized by the “tack” attack. At other times it negates the race by turning it into a rest period – a parade.

But presumably the Tour officials instituted the “same time” rule to avoid worse behavioral consequences – a scramble to the finish with attendant increased probability of crash and injury among bunched riders. Possibly it was originally also because of the difficulty of measuring individual times.

Analogous difficulties, rationales and discussions were present when the Chicago Mercantile Exchange introduced the Eurodollar futures contract in 1981. It was the first contract cash-settled to an index, LIBOR, rather than a deliverable deposit. The Exchange conducted its own standardized survey of banks for LIBOR settlement. The seemingly superior alternative, a deliverable instrument, was exposed to have its own problems when the failure of Continental Bank and the delivery of its certificate of deposit caused the failure of the domestic CD futures contract in 1984.

The BBA formalized its LIBOR calculation in 1985 in part because of the success of the Eurodollar contract itself. The exchange switched from CME calculated LIBOR to the BBA LIBOR for settlement purposes after 1997.

No doubt it is time to improve BBA the calculation. It has been gamed and gamers should suffer the consequences – that includes the calculation agent.

However, when there is an illiquid market, or when a market becomes illiquid, there are pluses and minuses to index settlement or transactional delivery. There are almost certainly better ways to provide a benchmark, but it remains the case that there is no perfect way. When changes are made or suggested lets game them in advance to anticipate behaviors. Radical changes may precipitate even worse practices.

No doubt the Tour de France officials feel the same way about the Peloton time calculation.