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Streetwise Professor

April 17, 2008

Here We Go Again

Filed under: Derivatives,Economics — The Professor @ 8:23 am

Today’s WSJ also carries a thorough article about growing doubts concerning the reliability of the widely-used LIBOR index. This is a big deal, in large part because trillions of dollars of notional amount of interest rate swaps have cash flows tied to LIBOR.

This story is becoming tediously familiar. Market participants rely extensively on price benchmarks created from the unverified reports of self-interested market participants. Rampant misreporting wreaked havoc in the energy business in the early-2000s. Similar stuff went on in the corporate bond and muni markets in the 1990s and before. A lot of the chaos in the credit derivatives and structured products derives from the lack of reliable pricing information.

The tragedy is that the technology certainly exists to collect, validate, and disseminate actual transaction information, thereby eliminating the need to rely on self-interested self-reporting. Especially in markets where more and more trades are taking place through electronic intermediaries as well as traditional voice brokers, massive amounts of data can be captured, verified, and streamed to users at very little cost.

The powers that be like the current system, however. Their preferences, though relevant, should not be determinative. There are serious public policy issues here, and potentially massive externality and public good problems. Markets discover prices, and price information is extremely valuable. Prices guide resource decisions. Moreover, regulators use price signals; in the LIBOR case, for instance, banks’ little white lies to the BBA (that collects the LIBOR data) may mask vulnerabilities in the banking system, meaning that regulators may be blindsided by the cracking of the next big financial institution.

I am not regulation-happy, by any means. For instance, I think that most of the hue and cry over the need for additional regulations in the derivatives markets is unadulterated BS. But here is a situation where (a) there is a clear benefit to a regulatory mandate to improve the quality of price information, and (b) the social costs are very small. It may well be that there are large private costs–a lack of transparency redounds to the benefit of big bank trading desks, and improved transparency will reduce trading profitability. But I have yet to see a credible argument made that these private costs represent anything but a transfer; indeed, real resources are expended to reap these transfers.

Congress and the regulators would do well to focus on this situation in LIBOR, and in other markets including energy and OTC credit products. The cost-benefit ratio of regulations that would improve the quality of price information, and centralize the dissemination of prices discovered in fragmented OTC markets is highly favorable. I would hope that regulators will pursue this with vigor, but fear that this will remain only a hope given the intense opposition of vested interests.

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  1. [...] wrote several of posts about Lie-bor back before the financial crisis climaxed.  The story seemed to fade from [...]

    Pingback by Streetwise Professor » Lie-bor Lives! — March 15, 2011 @ 11:15 am

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