Photo Credit: miketransreal || Truly when the small seems big, and the big seems small, reality may intrude and reverse matters
Today I tweeted:
What I am about to say is speculative. For the last nine years, I have thought that the move away from LIBOR could be a case of “The cure is worse than the disease.” If you are going to have an index for short-term lending it can be created in a few ways:
- Off of surveys, like LIBOR.
- Off of transactions, like SOFR [Secured Overnight Financing Rate], or the on-the-run Treasury yield
- Off of a liability yield, like a cost of funds index
One of the virtues of a non-transactional benchmark is that you won’t have to deal with the problem where the market generating the index is smaller than the market using the index. When that is the case, you can have those in the market using the index attempting to hedge in the smaller market generating the index, leading to distortions, volatility, etc. Though the small market was created to control the large market, when hedging starts, the large market will dominate the small one, and maybe games will get played in the small market to influence the large market.
As I wrote nine years ago in The Rules, Part XXXII:
Dynamic hedging only has the potential of working on deep markets.
Arbitrage pricing can reveal proper prices in smaller less liquid markets if there are larger, more liquid markets to compare against. The process cannot work in reverse, except by accident.
The SOFR market is a lot smaller than all the floating rate financing that goes on, which is transitioning from LIBOR to SOFR. My fear is that as the conversion from LIBOR to SOFR grows, and SOFR-based new issuance expands, that hedging by taking the opposite side of a SOFR trade will come to dominate that market, leading to volatility, and the taint that comes from the appearance of playing games.
Again, I am not certain here, but I think we may regret the transition from LIBOR to SOFR.
There was apparently some manipulation of LIBOR, which was made possible because there were far fewer banks contributing rates — and the big commercial banks don’t really lend anymore. It would have made lots of sense to add more rate contributors to make manipulation more difficult… add big mutual fund companies, insurers, asset managers, etc. The more actual lenders contributing to LIBOR calculations, the more difficult for any one (or small group) to manipulate.
Instead, government officials merely replaced private manipulators with central bank manipulators. The names change, but the manipulation does not. Given the revolving door between big banks and central banks, perhaps even the names don’t change.
Government corruption is no better than big banks. Its still a crime, its still unethical. Just because Nixon does it does not make it legal.
Big banks get prosecuted infrequently, but it happens sometimes. The crooks at central banks are never prosecuted, so the problem is going to be worse, not better.
Good points.