Why should we care about the ongoing Libor manipulation scandal? Well, there are several reasons why several individuals may have very direct concerns. Some derivatives counterparts to Libor-setting banks may have suffered losses as a result of the manipulating. These counterparts could include not just buccaneering hedge funds but rather more sensitive players such as governments or non-financial corporates. Some borrowers may have suffered larger funding costs, and this too could be a sensitive zone as it would involve average people repaying a mortgage or a student loan (though, admittedly, the artificial Libor tweaking could as well have resulted in lower costs for those retail customers).
But besides specific nit-picking, there is a more overarching, more general cause for concern. Bluntly stated, we are now in a deep state of confusion as to what Libor and its overseas siblings really mean. They used to represent the average interbank unsecured funding rate, once top and bottom bank submissions are disregarded. As such, these metrics provided pretty useful information as to the state of the ever so relevant interbank lending market. More so given that one can see each bank´s individual submission to the setting panel. Libor was a wonderful thing because it provided tons of transparency as to a key variable, and could thus act as trustworthy benchmark for a myriad of rates-based transactions worldwide. If you made a bet for or against Libor, or if you swapped your fixed funding cost for the more variable Libor, you were supposed to have grounds for a reasonable assessment of the future cashflows that you would be entitled to or liable for: as true interbank lending rates would go, so would the outcome of your trade.
It should be clear now that that´s not necessarily the case. Libor and its siblings won´t necessarily represent real rates, but rather the rates that can make certain traders inside certain banks particularly happy at a given point in time. And such flaky figure is much harder to estimate and ascertain. Much harder to bet for or against. Much harder to rely on as a borrower. The precise Libor number was always going to be hard to gauge beforehand, but its direction (upwards or downwards, by a lot or by a little) could be much more accurately guessed by those in the habit of following and analyzing economic developments. A corporate treasurer could make an informed decision as to whether paying fixed or floating for a five year loan made more or less sense. But that was when Libor was supposed to stand for Libor. If Libor instead is shown to stand for “whatever trader A at bank B and trader C at bank D need it to be to satisfy their impossible-to-know temporary narrow interests” then the decision making process becomes much more clouded. So much in fact that Libor may be completely forgone as a reference.
The unbearable loss of faith in Libor is but the latest episode in a saga that has seen many of the most sacred financial variables revealed as devoid of precise meaning. We had for decades been told that those variables meant something which they clearly do not. The crisis that began in mid-2007 has firmly demolished our belief in hitherto sacred beacons. Value at Risk, which was always supposed to represent a reliable guide as to a bank´s market risks and which practical relevance is second to none, has been definitely unveiled as a big liar; its outputs are in fact utterly untrustworthy. Credit ratings, equally traditionally worshipped and equally relevant, lost an insufferable amount of credibility as the most toxic assets ever devised were categorized as worry-free and as otherwise bankrupt nations were deemed gloriously safe; no longer can we trust AAA to stand for AAA. VIX, the very ubiquitous and widely followed “volatility” index that influences so many trading decisions, also tells a deceitful tale; it simply is not what we continue to be told it is, in effect allowing an undecipherable ghost to rule markets.
Having so many meaning-less influential variables roaming around is obviously a problem. It can lead to very distorted decisions, introducing untold amounts of noise and pushing naïve people towards the precipice. Can markets be navigated when their key variables are inscrutable and easily manipulable by unknown individuals with unknown motives? When all faith in erstwhile deified indicators is lost, and agnostic cynicism runs rampant, is it possible, even unadvisable, to keep rolling the financial dice?