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A blog on financial markets and their regulation
Andrew Verstein has an interesting paper on the Law and Economics of Benchmark Manipulation. One of the gems in that paper is the title of this blog post: “A benchmark is to price what a credit rating agency is to quality.” Verstein is saying that just as credit rating agencies became destructive when their ratings were hardwired into various legal requirements, benchmarks also become dangerous when they are hardwired into various legal documents.
Just as in the case of rating agencies, in the case of price benchmarks also, regulators have encouraged reliance on benchmarks. Even in the equity world where exchange trading eliminates the need for many kinds of benchmarks, the closing price is an important benchmark which derives its importance mainly from its regulatory use. Verstein points out that “Indeed, it is hard to find an example of stock price manipulation that does not target the closing (or opening) price.” So we have taken a liquid and transparent market and conjured an opaque and vulnerable benchmark out of it. Regulators surely take some of the blame for this unfortunate outcome.
Another of Verstein’s points is that governments use benchmarks even when they know that it is broken: “the United States Treasury used Libor to make TARP loans during the financial crisis, despite being on notice that Libor was a manipulated benchmark.” In this case, Libor was not only manipulated but had become completely dysfunctional – I remember that the popular definition of Libor at that time was that it was the rate at which banks do not lend to each other in London. That was well before Libor became Lie-bor. The US government could easily have taken a reference rate from the US Treasury market or repo markets and then set a fat enough spread over that reference rate (say 1000 basis points) to cover the TED spread, the CDS spread, and a Bagehotian penal spread. By choosing not to do so they lent legitimacy to what they knew very well was an illegitimate benchmark.