Afma: what Libor can learn from Australia’s benchmark rate

Author: Danielle Myles | Published: 24 Jul 2012
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Principles underpinning Australia’s benchmark interest rate could be extended to the London Interbank Offered Rate (Libor) to improve its transparency, integrity and avoid scope for manipulation.

The benefits of a prime-bank system based on actual trades in homogenous paper, as is used to calculate Australia’s bank bill swap reference rate ( BBSW), have become apparent in the wake of the rate-fixing scandal. Libor could be improved by looking at the Australian model.

“The BBSW process of itself isn’t easily transferable but some key principles could apply,” David Lynch, executive director of the Australian Financial Markets Association (Afma), which publishes BBSW, told IFLR.

The accuracy of a prime-bank actual trade system makes it unlikely that the BBSW will ever face the allegations surrounding Libor’s interbank system. “There are a number of factors that militate against that,” said Lynch.

The primary factor is that BBSW is calculated based on 14 panel banks’ observed rates in an actively traded market for paper of the country’s four biggest, or prime, banks. Prime paper, as it is known, trades on a homogenous basis, rather than individually, which helps promote liquidity.

The fact that prime paper is traded in a broker-based market adds to the rate’s credibility.

“The trades are being conducted by brokers in the market, which means it’s pretty transparent. There is a great degree of price discovery in terms of the trades that are taking place,” said Bryan Paisley, a partner with Baker & McKenzie based in Sydney.

In contrast to the bilateral nature of Libor calculation, the BBSW measures the rate at which the market is willing to lend to the prime banks (ANZ, Commonwealth Bank, Westpac and National Australian Bank).

In contrast to the interbank nature of Libor, entities other than banks hold prime paper. “So those giving oversight of the market, in that sense, extend beyond banks to investor managers, for example,” Lynch said.

Transferability to Libor

Since June 28 when Barclays was fined by US and UK regulators for falsifying Libor rates, market commentators have debated how Libor must change.

As indicated in IFLR’s poll earlier this month, a new version of Libor based on actual trades has some support.

According to Lynch, this is one of the BBSW principles that could be applied to Libor. “The extent to which you have a foundation in actual transactions, the more likely you will have an accurate rate. It also creates an audit trail for an interbank system like Libor,” he said.

This audit-trail, along with the fact reported rates are observable in the market leading up to the 10am reporting deadline, would help avoid criticisms over lack of regulation or supervision as has been directed at Libor.

The accuracy of the actual-rates system is reflected in the small number of outliers in rates reported by the panel.

“For Libor, in the normal course you’ll find that you get a natural spectrum of contributions by panellists, whereas for BBSW the panellists should all be reporting essentially the same rate,” Lynch added.

The website of the British Bankers Association, which publishes Libor, states that Libor was calculated on a prime-bank basis prior to 1998, but not actual trades.

For a system based on actual trades, liquidity is the key. “The question appears to be how to make the interbank market more active, so it produces more transactions and therefore rates that are observable,” said Lynch.

An obvious difficulty extending the actual trade model to Libor is the sheer number of indices it encompasses. Every day Libor generates 150 rates – based on 15 maturities and 10 currencies. BBSW, on the other hand, produces 6 rates.

This begs the question whether the full range of indices is needed, or if Libor could be scaled back to focus on areas where there is sufficient liquidity to accurately price paper.

Rate of choice

Libor’s Australian dollar rates could be a prime candidate, in this regard.

“For syndicated loans denominated in Australian dollars, it [BBSW] is basically ubiquitous in the local market,” Paisley said. Its dominance means the country’s bank Australian dollar sector could operate without Libor.

It’s a testament to the market’s faith in the BBSW model.

“The robustness of Australia’s financial system and broker regulation means people are positive about the regulatory set up, and pretty positive about BBSW being an accurate benchmark,” Paisley said.

New Zealand’s reference rates, as published by the New Zealand Financial Markets Association, are also based on actual trades.