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How Will the Search for a 'New Libor' Impact Carry Trades?

Thursday, 29 May 2008 18:37:59 GMT  |  Terri Belkas, Currency Analyst

The British Bankers’ Association’s (BBA) Libor rate has come under major scrutiny as the global credit crunch has exposed cracks in the methodology used to calculate this critical interest rate. Various solutions have been presented, including scrapping Libor altogether and creating a brand new benchmark rate. However, nothing has been decided upon yet, but when it is, the news could spark significant volatility in the global financial markets and trigger major moves in carry trades like EUR/JPY and GBP/JPY.

What is the Problem with Libor?

The global credit crunch has had repercussions on various markets, but the most obvious result was the surge in borrowing costs. However, when Libor rates did not appear to be accurately reflecting the tighter credit conditions, the BBA became suspicious and enacted a review of the system that sets Libor. Why is Libor so important? It serves as the global basis for interest rates on everything from derivatives contracts to corporate loans to mortgages. The calculation of Libor depends on banks - including Credit Suisse, UBS, HSBC, and Deutsche Bank among others - submitting on a daily basis what it would cost for them to borrow money across 10 currencies and 15 maturities, ranging from overnight to a year. However, the rates being incurred by banks may actually be higher than Libor suggests, as they under report borrowing costs in the fear of appearing desperate for funding. As a result of this, the trillions of dollars worth of financial instruments that rely on Libor may actually be mispriced, and the situation is so dire that US Federal Reserve officials have been in contact with the BBA regarding the issue.

What Are the Alternatives?

·         Fix the BBA Libor Rate - The BBA is currently conducting a review that could ultimately lead to changes in the way the rate is defined and set, as the first results of the review are due on May 30. However, the BBA is unlikely to recommend sweeping changes, as the group is surely well aware that this could destabilize already-fragile sentiment in the credit markets. Currently, most of the surveyed banks are based in Europe and surveyed in London before the US markets open, which leaves rates unlikely to be able to accurately gauge market conditions in the US. As a result, there is speculation that the BBA will expand the list to include more US-based institutions, or that they will move to calculate the rate again later in the day. In order to deal with the issue of confidence in individual financial institutions, another possible change would be to get a quote on what rate the bank is lending to other banks, rather than asking what it costs for the surveyed banks to borrow.

·         Create a New “Benchmark” Rate

Ø       ICAP - New York Funding Rate – London bond broker ICAP announced plans last week to launch a US-based index on dollar-denominated interbank borrowing rates, which would be called the New York Funding Rate (NYFR). The benchmark would be based on an anonymous daily poll of 40 banks, including foreign banks that have US offices, and exclude the top six and bottom six quotes. Instead of asking the banks at what rates they would be likely to borrow, they will be asked to estimate the rate at which they are likely to obtain funding. The anonymity factor is considered to be crucial, as individual banks would no longer have to worry being branded the next Bear Stearns if funding problems occur again and borrowing costs jump. There is no set date for launch quite yet, though it could be as soon as this week.

Ø       Liffe - Sonia, Eonia - NYSE Euronext's Liffe derivatives market - best known for Euribor - will start trading futures contracts in June based on Eonia, the euro overnight interbank average, and on Sonia, the sterling overnight interbank average. However, Garry Jones, an executive director at Liffe, said that the new contracts are intended to be “complementary” with Libor and are not designed to replace the rate.

How Will This Impact Carry Trades?

Trends for carry trades such as EUR/JPY and GBP/JPY are inherently dependent upon risk sentiment in the markets, as traders that utilize the pairs are usually looking to benefit from the yield benefits that come along with buying the pairs. As a result, it is no surprise that when investors become risk averse and the equity markets tumble, the Japanese yen tends to skyrocket across the majors.  As Technical Strategist Jamie Saettele discusses in his most recent technical analysis of the yen crosses, there is substantial downside potential for pairs like EUR/JPY and GBP/JPY. Furthermore, a piece of news such as the announcement of a change in the way Libor is calculated, or worse, signs that investors will stop using the benchmark interest rate altogether and will switch to an alternative like the New York Funding Rate could trigger significant volatility in the markets. As a result, yen traders should keep an eye on the news wires, as the search for a “new Libor” could be the biggest event risk in near-term.

Written by Terri Belkas, Currency Analyst, DailyFX.com

Tell us what you think about this article. Email tbelkas@dailyfx.com

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