By Nathan Lynch, Thomson Reuters
The regulatory maelstrom that has followed the Libor scandal in the United Kingdom has posed a chilling question for Australian regulators and market participants: could the same thing happen here? The manipulation of Libor has underscored what critics and UK parliamentarians described as the inability to rely on the honesty or integrity of the financial sector. We have entered a new regulatory paradigm, they argue, where it must be assumed that vulnerabilities in the system will be exploited for profit. Unfortunately, this cynical view of the financial markets has been perfectly illustrated by events of the past few weeks.
So is the Australian system different? In Australia the equivalent of the Libor process is the Bank Bill Swap reference rate. The BBSW, as it is known, is a traded market rate that serves as a benchmark rate in the Australian financial system. It is administered by the Australian Financial Markets Association (AFMA), which is quick to point out there are some critical differences that make the BBSW process far less prone to manipulation than the subjective Libor rate setting mechanism.
The main difference, according to AFMA, is that Australian market participants are asked about the actual rates they are observing in the market for prime bank paper. AFMA explained that Libor was a far more subjective assessment as institutions are effectively asked to give opinions on interbank borrowing rates. AFMA had tried to minimise this inherent subjectivity, and therefore the potential for conflicts of interest, when it set up the BBSW in the 1990s. In practice, the BBSW rate is set by taking data from 14 market participants at 10am each trading day. The panellists report the average mid-rate pricing that they are observing for prime bank paper with standard maturities of one to six months. Prime bank paper includes the bank accepted bills and negotiable certificates of deposit issued by banks that have met the eligibility criteria and conditions required to be an AFMA prime bank. Following the financial crisis there are now just four qualifying prime banks in Australia, the so-called “four pillars” of Commonwealth Bank, Westpac, National Australia Bank and ANZ Bank. AFMA said that the paper issued by these prime banks was traded on a homogeneous basis and was recognised as being of the highest quality with regard to liquidity, credit and consistency of relative yield. The panellists which contribute data to the BBSW rate-setting process are:
- ANZ Banking Group
- BNP Paribas (Australian Branch)
- Citibank NA (Australian Branch)
- Commonwealth Bank of Australia
- Deutsche Bank AG (Australian Branch)
- HSBC Bank Australia
- JPMorgan Chase Bank (Australian Branch)
- Lloyds TSB Bank (Australian Branch)
- Macquarie Bank
- National Australia Bank
- Royal Bank of Canada (Australian Branch)
- UBS AG (Australian Branch)
- Westpac Banking Corporation.
Once the rates submissions come in from these 14 institutions each day, AFMA uses what it terms a “rate-trimming” process to eliminate the four highest and four lowest rates from the data set. This eliminates any outliers and also makes it very difficult for institutions to manipulate the data. In effect, institutions would have to be working in concert to do so, as a single institution that mis-reported would simply have its data removed during rate trimming.
The uncomfortable fact remains, however, that Libor also uses a rate trimming process to eliminate outliers. As history has shown, that can still be manipulated as a result of either industry collusion or corruption that is so widespread that it exceeds the capacity of the rate trimming buffer to wipe it out.
A number of the institutions on the BBSW panel are implicated in the Libor scandal. AFMA has pointed out however, that these are the Australian-regulated operations of the institutions under investigation and the process in Australia is very different. The broader industry has not raised any concerns about the BBSW survey process locally.
David Lynch, executive director of AFMA, said it was critical to understand the differences between the two processes. “In essence under the Libor rate survey, banks are asked, ‘at what rate could you borrow funds on of a reasonable market size at 11am in the London market?’ Here we ask the banks on the BBSW panel to provide us with the actual rates that they’re observing in the brokered market at 10.00am,” he said.
Another difference was that the BBSW quotes were for prime bank paper, which traded as a homogenous group. By contrast, he said, Libor contributions were for each individual bank in respect of its own paper.” In Australia, there was a strict industry governance process around BBSW and the market was an institutional market. Libor, by contrast, was an inter-bank market in which banks were effectively reporting on their own paper. Lynch said the structure of the Australian market meant there were controls in place to minimise the impact of any conflicts.
“In the BBSW market many banks trade other banks’ paper but you also have investment managers and other investors who participate in the market. Together with the governance processes that the industry has put in place, this means that the market has worked well. There hasn’t been a reason to believe there’s any market failure to be addressed: the rate compilation process has been working efficiently,” Lynch said.
Governance and oversight
The BBSW process also has appropriate oversight from an independent committee; AFMA’s Market Governance Committee (MGC) is responsible for the effective operation of the Australian over-the-counter (OTC) financial markets. The MGC regularly reviews the management of the BBSW rate process and is also responsible for approving any changes to the OTC market conventions that support the BBSW process. It also reviews quarterly reports on the operation of the BBSW process and relevant developments in the financial markets.
Lynch said that AFMA was conscious of the need for broad industry representation on the MCG. It was in the industry’s interest to ensure that the BBSW process was transparent and worked effectively. He said that, like Libor, the BBSW was a reference rate and is used for a range of other financial transactions, so it was crucial that industry participants had confidence in BBSW as a reliable benchmark rate.
“The range of participants in the market is reflected in the AFMA committees that review our processes. I think that’s important and it adds to the market support for the approach that we have here,” he said.
Lynch said the problems with Libor had highlighted the importance of the controls that AFMA had put in place when setting up the BBSW framework.
“The market here is very different to the market in the UK both in terms of the structural processes that we’ve adopted and the role of panellists in the market. For example, because a panellist bank provides a contributed rate on prime bank paper as a homogeneous group, the fundamental issue of banks posting rates in relation to their own paper doesn’t arise here. Moreover, only four of the 14 panellists are prime banks. So it’s not 14 banks contributing their own view of their own paper, it’s 14 banks contributing their view of prime bank paper,” Lynch said.
Lynch said that any problems with the BBSW data would be identified quickly. The MGC regularly reviews the quality of this data to ensure that the panellists are reporting accurately. He also noted that the rate at which prime bank paper is traded is observable to market participants through broker screens. The panellists are the leading traders of prime banks paper and their individual rate contributions are available to each other, which adds an additional safety buffer.
“Given it is a highly competitive market with institutions holding different positions, rate contributions are carefully scrutinised by other market participants, so any aberrant contributions would be quickly identified. AFMA itself reviews rate contributions on a daily basis and has a number of touch points with market participants through its market committees to receive ongoing feedback on the quality of rate contributions,” Lynch added.
When looking at the key differences between the BBSW process and Libor, it raises an interesting question. Back in the 1990s, did Australian market participants foresee the very vulnerabilities in the Libor process that have now come home to roost?
EDITORS NOTE: MR LYNCH IS HEAD REGULATORY ANALYST FOR AUSTRALIA/NEW ZEALAND AT THOMSON REUTERS, WHICH ALSO PUBLISHES THE LIBOR RATE