In support of transparent financial benchmarks — Darrell Duffie , Piotr Dworczak, Haoxiang Zhu

MIT Sloan Asst. Prof. Haoxiang Zhu

From Vox, CEPR’s Policy Portal

Benchmarks are heavily wired into modern financial markets. For example, trillions of dollars in bank loans and several hundred trillion dollars (notional) of derivatives transactions depend on daily announcements of LIBOR. The WM/Reuters foreign exchange fixings dominate the currency markets, in which there are over $5 trillion of transactions per day. Benchmarks are the basis for trade of a wide range of commodities such as gold, silver, oil, and natural gas. They have also been the focus of scandals (Brousseau et al. 2013).

Almost weekly revelations of corrupt manipulation of these benchmarks call into question the continued reliance on them by market participants. What would happen if the financial industry and regulators were to find themselves unable to support reliable benchmarks?

Without a benchmark, it is impossible to contract in advance for the formulaic cash settlement of asset trades. (Physical delivery of an asset is usually much more costly.) Without benchmarks, moreover, investors would have difficulty monitoring the execution quality of trades conducted on their behalf by dealers or brokers, through a comparison between the benchmark price and the price actually paid or received.

In recent research (Duffie et al. 2014), we show that benchmarks also provide valuable pre-trade price transparency in over-the-counter (OTC) markets. For many types of financial instruments and commodities, benchmarks offer less informed market participants a much better idea of the ‘going price’. By reducing the informational disadvantage of ‘buy-side’ market participants relative to dealers, benchmarks encourage greater market participation, lower the cost of delays associated with ‘shopping around’ for a better price, and improve the ability of OTC markets to efficiently match buyers with the most cost-effective sellers, and vice versa.

Consider, for example, a world without LIBOR, and a firm that is anxious to quickly obtain $100 million in six-month financing. The firm’s CFO is only vaguely aware of the best available interest rates. The CFO contacts Bank A, which, after some discussion, offers the loan at an interest rate of 3.7%. Unsure of how much profit margin is built into the quote from Bank A, the CFO discusses terms with Bank B, which eventually offers to lend at 3.8%. The loan discussions are already costing precious time for the CFO and his firm. Rather than contacting additional banks in search of a lower rate, the CFO simply takes the rate offered by Bank A. The opaqueness of this market reduces competition among banks, even to the point in some cases of raising average lending rates enough to discourage the CFO from entering the market.

Read the full post at Vox, CEPR’s policy portal. 

Haoxiang Zhu is an Assistant Professor of Finance at the MIT Sloan School of Management.

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