William C Dudley: Restoring confidence in reference rates
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal
Reserve Bank of New York, at the Salomon Center for the Study of Financial Institutions,
New York University Stern School of Business, New York City, 2 October 2014.
* * *
Thank you for the opportunity to speak with you today.1
In my remarks today, I will focus on the development and use of reference rates for financial
market contracts. This is a story of both spectacular success, and at the same time,
spectacular failure.
To borrow from Charles Dickens:2
"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of
foolishness, it was the epoch of belief, it was the epoch of incredulity...."
While Dickens was writing about events leading up to a political crisis, his words also are apt
with respect to our recent financial crisis.
Over a period of just a few decades, reference rates grew greatly in terms of their role and
importance in financial markets. For example, the use of one of the best known reference
rates - the London Interbank Offered Rate, or LIBOR - has soared, so that it is now
referenced by approximately $300 trillion dollars of financial contracts. Reference rates have
become a ubiquitous but largely hidden fiber in the fabric of financial markets. They play a
critical role in making financial markets more efficient by reducing information frictions,
lowering transactions costs and mitigating the moral hazard.
At the same time, as recent enforcement actions and criminal investigations have made all
too clear, some of these reference rates have been systematically manipulated by individuals
at key financial institutions. The assumption that the design in how these rates are
constructed would be resistant to attempts at manipulation has turned out to be wrong, and
the belief in the integrity of these rates has turned out to be misplaced.
What this means should be obvious to all of us. Reform is required if we are to restore
confidence in the financial system. In my remarks today, I will discuss the outlines of such a
reform including those important steps that are already underway, and those steps that still
must be taken. As always, my remarks reflect my own views and not necessarily those of the
Federal Reserve System.
The most recognized and prevalent of the reference interest rates is the London Interbank
Offered Rate, typically referred to as LIBOR, which measures the cost of unsecured,
interbank borrowing across different currencies and tenors. The development of LIBOR goes
back to the rapid expansion of the Eurodollar market in London beginning in the 1970s. This
was a market that developed, in part, as a means of circumventing the Regulation Q deposit
interest rate ceilings in the United States. This market provided a source of funds for
international banks, and securities that referenced Eurodollars were issued and became
actively traded. This growing market gave birth to a new financial market product - the
interest rate swap - to help investors and borrowers to better manage the interest rate risks
associated with their financial exposures.
In 1984, as part of the "Big Bang" in U.K. financial markets, the British Bankers Association
(BBA) assumed responsibility for developing a set of standards for these interest rate swaps.
One of these standards was for the reference rates used to fix the settlement of the contracts
- this led to the birth of LIBOR.3 Additional standardization followed, including establishing a
fixed schedule of settlement dates for these contracts. This further increased the liquidity in
these contracts, but also significantly concentrated the timing of settlement activity. At the
same time, new reference rates were developed that extended the LIBOR-style methodology
to many different currencies.
How LIBOR was designed to work
LIBOR is a set of reference rates that measure large banks' funding costs in different
currencies and at different maturities. For example, U.S. dollar LIBOR measures how
expensive it is for a large bank to borrow U.S. dollars in the unsecured interbank market at
different maturities. For each currency, there is a designated panel of contributing banks that
each submit an estimate of its own borrowing costs for each maturity. For each panel, these
estimates are aggregated to form LIBOR. The LIBOR rates are then used as a basis for
financial contracts ranging from adjustable rate mortgages to interest rate swaps and futures.
To make sure that the submitting banks have sufficient expertise in the funding trends in a
particular currency, it is important that they be actively involved in that market. For this
reason, the contributing banks are the large banks that have been active in the London
market and the panel of submitting banks varies across currencies. The LIBOR reference
rates were intended to capture on a daily basis borrowing costs along each currency-maturity
combination based on the experience of the submitting banks.
The actual process for fixing LIBOR each day is quite straightforward. Each morning the
submitters from each contributing bank answer the following hypothetical question: "At what
rate could you borrow funds, were you to do so by asking for and then accepting interbank
offers at a reasonable market size just prior to 11 a.m.?" The transmitted submissions are
ordered by rate for each currency and maturity pair. The ordered rates for U.S. dollar LIBOR,
for example, are then trimmed by generally dropping the top and bottom 25 percent of
submissions to remove any influence of outliers. The average of the remaining individual
submissions is calculated and then posted. Prior to the recent reforms, all submissions were
immediately made public.
The aim of the LIBOR-setting process has been to create a set of reference rates that would
be credible and would generate robust measures of bank funding costs across a wide range
of market conditions. The credibility was based on the borrowing experience from the
submitting banks represented through their submitters - those individuals responsible for
actually submitting an answer each day to the administrator. The potential conflicts of interest
between the submitters and traders within the bank were typically handled through internal
policies such as the presence of information barriers that were intended to prevent sensitive
information from flowing between the traders and LIBOR submitters. The robustness to
market conditions would be maintained even in periods of market stress or a lack of
transactions by the reliance on the hypothetical question instead of the use of actual
transaction data. That is, even if during stressed times when trading became sporadic in a
particular currency-maturity pair, all submitters could still answer the question even if their
bank did not happen to engage in any trades on that particular day in that particular pairing.
This ensured a large sample size even during stressed market conditions. The trimming of
the sample helped to minimize the influence of any outlier submission, but also limited the
ability for any one submitting bank to influence the posted rate.
As is clear from the hypothetical question, LIBOR is meant to capture a bank's cost of
unsecured borrowing. This means that the reference rate will reflect not only a risk-free
component, but also counterparty credit risk related to the specific borrower. This turns out to
be important for two reasons.
First, the growing popularity and liquidity of LIBOR indexed contracts led to an expanded use
of LIBOR to circumstances in which the credit risk of large banks was not clearly relevant.
For example, a speculative position about the future of short-term rates is predominately
based on one's view about the path of short-term interest rates, rather than how bank
counterparty risk might change and affect borrowing costs. Despite this shortcoming, LIBOR
remained popular because the benefit of its deeper market liquidity was viewed as more
important than the added complication that LIBOR included an element of counterparty risk.4
Second, variations in LIBOR submissions across the submitting banks at a point in time for a
given maturity should mainly reflect differences in the counterparty credit risk, since the
riskfree component is common to all submitters. This is important because it means that
variations in submissions may be interpreted as reflecting variations in underlying
counterparty risk. This is particularly important when the LIBOR submissions process is
transparent and the market is under stress, which was the case during the financial crisis.
How LIBOR worked in practice
Now that I have described how LIBOR was intended to work in concept, how did it work in
practice? It turns out that unappreciated design weaknesses and incentive structures at
certain large submitting banks, in combination with the phenomenal success of reference
rates, undermined the system. Conflicts and problems emerged both at the bank level and at
the individual submitter level. Investigations are on-going to determine the scale and full
extent of these problems, but I would like to discuss a few of the well-documented problems.
Let's start at the level of banks that submit estimates. The enforcement actions and
investigations into potential LIBOR manipulation have shown that, at times, individual
institutions faced incentives to understate their hypothetical borrowing rates in order to avoid
the perception that they might have higher counterparty credit risk. Some of the reported
misdeeds occurred during the heart of the financial crisis when market participants faced
considerable uncertainty about the health of particular institutions. This uncertainty was
manifest in a wide range of financial market prices for financial institutions - low and volatile
equity prices, record CDS spreads and greater variation in borrowing costs across different
LIBOR-submitting banks. At that time, the BBA was publishing firm-specific contributions to
LIBOR from submitting banks. Given this publication process, some of the submitting banks
reportedly became concerned about reporting a rate that would suggest that they were being
treated by the market as a greater counterparty credit risk than their peers. Accordingly,
some banks were alleged to have lowered their LIBOR submission below their actual likely
borrowing rate to avoid the stigma associated with posting a higher borrowing rate and the
possibility that their funding costs could increase as a result.
Conflicts also reportedly abounded at the level of the individual submitters. Again, these
highlighted profound compliance problems at some of the submitting banks. As I noted
earlier, the intent was that the expertise of the submitter would be insulated from any internal
pressures by the informational barriers within the submitting banks. The hope was that these
informational barriers separating the submitters from the traders were thick and
impenetrable. The investigations into LIBOR manipulation found that the reality was that they
were often paper thin and porous.
We have learned that false reporting and manipulative behavior was pervasive across firms
and over time, took many forms and was often conducted in a nonchalant manner. This has
been well-documented by the Commodity Futures Trading Commission in their published
findings. For example, interest rate swap traders routinely asked colleagues to submit rates
with an explicit goal to have the adjusted submission benefit the value of specific derivatives
positions they held. As an illustration, investigations discovered that one "Senior Yen Trader"
directly or indirectly made at least 800 requests in writing on UBS's email and chat systems
to their submitter.5 Requests often had a casual matter of fact nature to them. To illustrate,
an exchange in September 2007 from a trader at UBS to the submitter went as follows.6
"Hi ... could really do with a low 1M [one month] over the next few days as have 17.5m
[million] fixings if ok with you?"
Submitting banks often facilitated this type of behavior - in some cases derivatives traders
and submitters sat on the same desk, while in others the submitters were themselves
traders, both circumstances obviously representing conflicts of interest. Other investigations
documented that traders at one bank would often shout across the trading desk to fellow
traders to confirm that there were no conflicting requests before they sent their requests to
their submitter.7
The investigations also found that not only were there conflicts within the submitting banks,
but there were also active efforts by traders to collude across banks to affect the posted
rates. At times, the traders at the different banks might have similar positions and therefore a
common interest to push the posted rate in particular direction. In other times, cooperation
could be incentivized through the use of "wash" trades that generated no profit or loss, but
allowed the trader to generate commissions.
Why did this go so wrong?
As I discussed earlier, LIBOR setting involves a group of banks answering a hypothetical
question. This seemingly straightforward question actually embeds a good deal of
ambiguity and room for potentially manipulative actions. First, it is a hypothetical question
- not what rate did you borrow at that morning, but what rate do you think you could
borrow at. This potential disconnect from actual borrowing activity builds in from the
beginning a certain amount of judgment and room for manipulation. Second, some of the
parameters - "reasonable market size" or "just prior to 11 a.m." - also allow for subjective
interpretation. This type of judgment is not inherently a problem, but it does open the door for
improper behavior and also makes transgressions more difficult to identify.
At the same time, and partly in response to the lessons learned during the financial crisis,
patterns of bank funding began to shift away from unsecured funding to secured funding
markets. Investors and other market participants grew to prefer holding specific collateral
against their loans - even very short-term loans - than just trusting in the ongoing viability of
the borrower. This shift had substantive implications for money markets and the LIBOR fixing
model, which was based on the assumption that there would always be regular activity in
unsecured interbank funding markets. As those markets dried up - in some cases there were
essentially no transactions for longer-dated tenors - it became harder for banks to ground
their LIBOR submissions in actual, observable transactions. This put a greater premium on a
submitter's judgment, which increased the risk of further abuse and manipulation.
We have learned as well that compensation and hiring practices also helped to undermine
the integrity of the reporting regime. For example, we have seen that compensation and
promotion within a bank are often tied to a trader's market share and profitability. In addition,
traders often move between firms so having a network of external contacts and being viewed
as a team player could help to support job mobility. Consequently, one can conclude that
even the loss of a job is not necessarily a permanent setback, and that market participants
with allegations of improper behavior could potentially move on to other firms with the
expectation that they would generate revenue and profits for their new employer.
These incentives were amplified by the structure of the markets that underlie the setting of
LIBOR and those that use LIBOR. The interbank cash borrowing market that LIBOR
references is very small relative to the enormous markets that use LIBOR, for example
interest rate derivatives. The standardization of settlement dates further concentrated trading
activity. In this type of environment, relatively small changes in LIBOR submissions - either
because the actual borrowing costs fluctuate or a submitting bank intentionally misreports its
submissions - can have substantive effects on a trader's profitability because the trader can
hold large derivatives or futures positions that reference the cash LIBOR rate at the time
these contracts settle.
Finally, and I think perhaps most importantly, the questionable behavioral norms in the
industry - along with the weak control environments and compliance processes - that were
uncovered during the investigations, exacerbated and facilitated the misalignment of
incentives that are specific to LIBOR. It is a sad state of affairs if unethical behavior is
socialized among new traders with the explanation that this is business as usual, and, if
compliance and risk management are inadequate as a counterweight to prevent or identify
wrong-doing. It is untenable if people working in compliance and risk are treated as
secondclass citizens relative to the firms' revenue generators.
The official sector response
The international regulatory community began to address these issues when the U.K.
government published the Wheatley Review8 in September 2012. The Review recommended
a ten-point plan, subsequently accepted in full by the U.K. government, for comprehensive
reform of LIBOR. This led to many changes including the statutory regulation of the
administration and submission process with respect to LIBOR, the selection of a new
administrator for LIBOR, new governance and oversight regimes for the administrator and
submission guidelines as well as a code of conduct for submitters. The BBA, the former
administrator for LIBOR, for example, eliminated publication of certain currency and tenor
rates and delayed the publication of bank-specific submissions. Perhaps most importantly,
LIBOR-related activities are now subject to formal regulation and supervision in the U.K.
I support the changes initiated by the U.K. government and believe they have substantially
strengthened LIBOR. That said, I also believe that more work remains to be done to broaden
the definition of LIBOR so that it represents the reality of new funding patterns for banks, and
to also tie submissions more closely and systematically to observable transactions.
A second notable development was the publication of an international set of principles for
financial benchmarks developed by the International Organization of Securities
Commissions9 (IOSCO) in 2013. These principles include a set of 19 specific standards
across governance, benchmark quality, methodology and accountability that have emerged
as the international standard. IOSCO has rightly focused on tying benchmarks more closely
to observable, arms-length transactions. While a pure transactions-based rate will not solve
all problems for all benchmarks, this is an important step toward eliminating excessive
reliance on expert judgment.
As part of the international reform efforts, the Federal Reserve played a lead role in a set of
recommendations for the reform of reference interest rates produced by the Financial
Stability Board (FSB). Former Governor Jeremy Stein, followed by Governor Jay Powell,
co-chaired a working group with Martin Wheatley of the U.K. Financial Conduct Authority
(FCA). This working group was charged with reviewing existing interest rate benchmarks,
and for establishing and guiding a group of market participants to identify the feasibility and
viability of adopting alternative reference rates.
The FSB report10 was released in July and Governor Powell11 has recently described the
Federal Reserve's plans to support the two primary components of the reform of LIBOR.
First, we are considering, in cooperation with the LIBOR administrator and other members of
the official sector, ways to broaden the definition of LIBOR to more adequately represent
current patterns of bank funding and to anchor it more firmly in observable transactions.
Second, we believe it is important for market participants to have access to a range of
appropriately created and governed reference rates that best suit their particular business
needs. For example, some activities such as interest rate derivatives might be better served
with a risk-free or near risk-free reference rate, rather than one that embeds a bank credit
risk component.
I would like to emphasize three points in support of the FSB recommendations and our own
efforts. First, the FSB recommendations make clear that there is not one single path for all
jurisdictions to achieve the common objective of more robust and resilient reference rates.
Rather, each jurisdiction must take into account its own specific institutional, legal and
market practices and arrive at its own best solution. In the U.S., I believe it is important to
identify alternative reference rates that are grounded in a strong governance framework as
laid out in the IOSCO principles and that are supported by market transactions. This brings
me to my second point - given a set of robust reference rates that meet IOSCO standards,
the choice among these reference rates should be left to market participants who can best
identify the specific rate that is most appropriate for a specific business need. Third, the
Federal Reserve is committed to working with market participants of all kinds - dealers, end
users, legal and accounting experts - to help develop robust reference rates that meet the
needs of all types of market participants.
In addition to these specific efforts around improving and finding alternative benchmarks, the
New York Fed is sponsoring other efforts related to the reform of market practices and
benchmark rates. The Foreign Exchange Committee (FXC) and Treasury Market Practices
Group (TMPG), for example, are two groups of senior market practitioners sponsored by the
New York Fed that are working within their markets to identify best practices for trading and
behavior related to benchmark rates. Both groups also have published broader sets of best
practices for the foreign exchange markets, and for Treasury, agency debt and agency MBS
markets. I would ask all market participants to ensure that these and other best practices
guide the behavior that we should expect from participants in financial markets.
This will not be easy, but I believe restoring confidence in reference rates is achievable and
will greatly enhance the robustness and resilience of our financial system. I have focused
here on the reform efforts around LIBOR, which is only one reference rate, albeit one that is
widely used and a core part of our financial system. But, the need for stronger governance
and more accountability spreads much further within the set of benchmark rates, and further
to encompass a wide range of practices within the financial system. For example,
accusations have recently surfaced related to business practices within foreign exchange
markets. While the concerns are technically very different than the practices uncovered
around LIBOR submissions, the common theme is the willingness of a small number of
market participants to behave improperly and contribute to a decline in confidence in the
integrity of benchmark rates specifically and of major financial institutions more generally.
Next steps
I have discussed some of the observed problems in major reference rates that reflect
egregious personal behavior. Some individuals responded to poorly-designed incentives and
weak controls at some of the largest financial institutions. The regulatory community has
already taken important steps to mitigate those concerns and real progress has been made.
While this has helped to restore some of the integrity of particular reference rates, such as
LIBOR, more work needs to be done before confidence in these rates are put on a firmer
foundation.
I'll conclude by emphasizing two of the next steps that I think are most essential for the
successful reform of LIBOR. First, the definition of LIBOR should be broadened so that it
more accurately reflects the observed funding patterns of large banks and puts the rate on a
broader, more stable base of observable transactions. The LIBOR administrator is actively
considering ways to do this while remaining true to the spirit of LIBOR and how it is used in
financial contracts. Accomplishing this will make markets that need a reference rate that
embodies bank credit risk more robust and resilient and will strengthen the financial system.
Second, we still face the problem that the reference rate for a large stock of derivatives
contracts is based on a relatively small, underlying cash market. This means there still is a
powerful incentive for individuals to attempt to manipulate the rate for their own gains. One
promising solution, outlined in Governor Powell's recent speech on reference rates, is to
work with market participants to find an alternative reference rate that is based on a deeper
underlying cash market and that meets the needs of all market participants. Of course, any
rate that serves as a critical financial benchmark must meet the principles for good
governance and production outlined by IOSCO.
This combination - a more robust and resilient LIBOR for transactions that require a
reference rate with a bank credit risk component and the development of an alternative
reference rate for transactions like interest rate derivatives that don't - will strengthen our
financial system and help undo some of the damage caused by earlier transgressions. But
this is only a necessary and not a sufficient set of conditions. To achieve the outcome
desired, financial institutions also need to have in place the appropriate incentives and
controls.
Thank you for your attention. I would be happy to take a few questions.