SA's vulnerability lies in the foreign exchange market

Bank of England governor Mervyn King says although he first heard about possible Libor fixing in 2010, he knew about its full extent only recently. (Reuters)

Bank of England governor Mervyn King says although he first heard about possible Libor fixing in 2010, he knew about its full extent only recently. (Reuters)

The Libor is the benchmark for $800-trillion worth of financial contracts globally, including contracts in South Africa. This is 10 times the global gross domestic product.

The South African Reserve Bank’s deputy head of financial markets, Callie Hugo, said the Libor was used in South Africa “especially in our foreign exchange market and also in foreign exchange swaps”.

He said the daily turnover in the local foreign exchange market was about $15-billion, of which $3.3-billion was spot, the forward market amounted to $1-billion and swaps were worth about $10-billion.

The Libor is at the centre of an international storm after Britain’s Financial Services Authority fined Barclays $453-million for its role in manipulating the rate. The investigation is continuing and about 20 banks are said to be implicated.

The Barclays fine follows a three-year investigation by the authority into Libor manipulation.
It is not clear what prompted the investigation.

Giving evidence to the parliamentary committee, Bank of England governor Sir Mervyn King this week suggested that fraud had taken place. King said he had learnt of the full extent of the manipulation only a few weeks ago, despite admitting to being informed of the Libor fixing allegation in 2010.

The Serious Fraud Office is investigating possible criminal cases.

In the United States, Federal Reserve head Ben Bernanke, in an appearance before the senate committee on banking, said criminal offences may have been committed.

The Libor is also the benchmark for interbank lending in the US and regulators are now extending their investigation into former US Federal Reserve Bank of New York chairperson and current US treasury secretary Timothy Geithner’s role in the formation of the Libor.

The inquiries were prompted during parliamentary hearings. The questions arose from Geithner’s email to King in 2008 listing six “Libor recommendations”, such as to “publish best practices for calculating and reporting rates, including procedures designed to prevent accidental or deliberate misreporting”.

Reasonable market size
In the 2008 memo, Geithner also recommended that banks had to specify transaction size, given that the quotes were based on the rates at which they could borrow in a “reasonable market size”.

Another concern raised by Geithner was that the British Bankers’ Asso­ciation had to create transparency by revealing the association’s relationship with the Libor panel banks. He advocated the “elimination of incentives to misreport” by randomly sampling quotes from a larger panel of banks.

Attorneys general in two US states have launched inquiries into possible Libor manipulation. A document released last week shows that the US authorities communicated their concern to the Bank of England about possible Libor manipulation in 2008.

Hugo did not indicate the extent to which South African foreign exchange markets used Libor as their reference rate. The entire foreign exchange market is not exposed to the Libor. According to George Glynos from ETM Analytics: “Only the forward and swap markets, which are exposed to interest rates, would have a risk of having being exposed to the Libor. However, the portion would be difficult to quantify.”

Hugo said when South African entities borrowed offshore, Libor would be the benchmark. “The borrowing rate would be a margin above the Libor and the margin would be determined by the bank’s credit rating.”

In cases where the Libor was manipulated downwards, such as in 2008 during the financial crisis, when Barclays claims the Bank of England put pressure on it to lower its Libor submissions, South African holders of foreign exchange contracts would have benefited from the lower rates.

“If South African corporates –  mostly the dual-listed companies and perhaps fund managers invested in fixed income and money market instruments abroad – were exposed, one does not know when the exposure took place or whether they were affected by higher or lower rates of the Libor than was appropriate,” said Glynos.

The evidence the authority has collected during its three-year investigation that suggest the banks had  been manipulating the Libor since 2005 included emails in which traders promised counterparties a bottle of Bollinger Champagne to submit favourable rates.

The Libor controversy is one of the biggest scandals in financial history, potentially even bigger than that of the financial crisis of 2008 in which banks were selling toxic debt as AAA-rated investments.

Regulators are also coming under scrutiny during the UK hearings. They are accused of not doing enough to avert the scandal and senior Bank of England officials have found themselves embroiled in the controversy.

Jibar calculated, not estimated  
The South African Reserve Bank, treasury, Financial Services Board and the JSE have evaluated the developments unfolding around the London interbank offered rate (Libor) in terms of rates in the domestic financial markets, in particular the Johannesburg interbank agreed rate (Jibar), they said in a statement this week.

The daily calculation and publication of the Jibar is overseen by the JSE, which in turn is regulated by the board.

The Jibar is the main benchmark for money market interest rates and is published daily at 11am on the JSE website and Reuters’s “Safey” page for periods of one, three, six and 12 months. The three-month Jibar is widely accepted as a benchmark in domestic financial markets.

The Jibar is compiled on the basis of contributions received from nine commercial banks, five of which are local banks and four the local operations of foreign banks. The JSE distributes a spreadsheet showing all bids and offers from contributors through its data subscription system. All contributing banks are licensed and regulated by the Reserve Bank.

The input required from contributors is bid and offer quotes on tradeable instruments issued by the contributing bank, such as negotiable certificates of deposit. The offer quote is the level at which the bank will sell this tradeable instrument to a client wishing to invest in it. The bid quote is the level at which the bank will buy back its own paper from the investor holding it. The bid and offer rates submitted are averaged for each contributor to determine the mid-rate. These mid-rates are then ranked and the top and bottom two are removed from the list. The remaining mid-rates are averaged to create the Jibar rates.

The level quoted by the banks is public information. This implies that if a bank is keeping its quotes in the Jibar process at a level lower than the “correct” one for the overall market and the credit quality of the issuing bank, the bank will be forced to buy back paper from the market as investors sell at the “incorrect” yield.

Furthermore, should the Jibar quotes not reflect the level at which investors are actually trading with the quoting bank, investors would be able to determine this and could lodge a complaint with the JSE. To date, no such complaint has been received.

Unlike the Libor, which represents an estimate by banks in the London market of the rates at which they believe they could trade funds between each other, the Jibar is based on the interest rates at which South African banks buy and sell their own negotiable certificates of deposit and represent actual rates that can be traded.

In 2011, the Reserve Bank initiated a review of the determination of domestic money market reference rates, including the Jibar. Once completed, the findings will be made public. It is expected that it will culminate in a code of conduct for banks contributing to the calculation of the Jibar. – Eleni Giokos

Banks fund UK regulator
In theory, the Libor should reflect the real cost of capital in the financial industry. The British Bankers’ Association, which oversees the daily compilation of the Libor, said that because it published the “full methodology” of calculating it and because of the “list of procedures that should be used by contributing banks”, the calculation was completely transparent.

Banks contribute to the rate daily and Thomson Reuters publishes the rates at 11am London time. The association said Libor submissions were based on the following question: “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11am?”

The association is funded by its member banks, which means price discovery is largely self-regulated. The association said the body that oversaw the Libor was “the foreign exchange and money markets committee, which is a group of active market practitioners including representatives from banks, the money markets, corporate treasurers and exchanges”. – Eleni Giokos

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