10 January 2014

Rosa M Abrantes-Metz: Time is nigh to rethink the role of benchmarks

Market innovation will provide new, robust indices, reflecting the lessons learned from recent scandals. Such developments should be encouraged and welcomed, writes Abrantes-Metz in the FT.

Re-establishing confidence will require a major restructuring of the ways in which these benchmarks are set. To this end, IOSCO’s guidelines for financial benchmarks provide a good starting point, but such changes still need to be put in place and adequately monitored.

Restoring confidence will also require market participants to understand better which indices are more appropriate to their needs. Not every benchmark reflects the same type of risk or the same type of lending, and understanding these differences will be important. Expect to see innovative benchmarks, some of which may replace existing benchmarks while others serve the needs of particular market niches...

How do these benchmarks differ from each other? During normal economic times, the credit risk of Libor contributing banks is quite low but is highly correlated with other low risk/high liquidity rates. During stressful economic times these measures can significantly diverge, since at the same time that credit risk may increase leading to higher Libor and credit default spreads, softer monetary policy will lower interest rates. But “stressful times” are precisely when an investor wants to be referencing the appropriate benchmark. It is also the reason why indices such as Libor, which reflect credit risk, will always have a role to play.

That said, in the last few years collateralised lending has been increasing in importance to the detriment of unsecured lending. This is not surprising given the depth of the financial crisis and the market’s stronger preference for collateral. This, coupled with the flawed structures of many existing benchmarks opened the doors for newer indices to be developed. An example of such a benchmark is DTCC GCF Repo Index, based on actual repo transactions. This index contains a small portion of credit risk and, when coupled with futures contracts traded on this benchmark, it provides the maturity structure necessary for broader adoption.

Benchmarks of the future need to be based on actual trades whenever possible, and be administered by independent bodies without direct financial interests in the values taken by the benchmarks.

These administrators need to be appropriately equipped to screen actively and regularly any attempts at abuse, perhaps with the assistance of independent third parties, as even market prices can be manipulated. This may require clearing houses observing the whole universe of risk with infrastructures such as those of the Depository Trust and Clearing Corporation, CME Group, and IntercontinentalExchange.

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