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LIBOR Belabored

July 16, 2012

Sometimes it’s easy to disengage from the news of the latest major, economy-melting financial crisis. We feel scandal fatigue. The emotional receptors for outrage have been blown out.

When we hear things like JP Morgan paid $190,000 per year to the wife of the President and CEO of the New York Fed (JP’s top regulator), since she was a former Vice President at JP, it raises hackles and increases the squirm index. It’s been pretty clear for a while now that cozy relationships are sometimes just too cozy for comfort.

And especially when it’s something complicated and opaque like an acronym like LIBOR, it’s extra hard to put in the effort to comprehend the complexity and nuance of what has happened to the planet while we were busy doing other things.

I’m no exception, but fortunately, there are folks who somehow still have careers in journalism that can explain what LIBOR means to everyone, and not just some investors who are about to be criminally charged.

What we have here is a somewhat natural byproduct of what happens when markets get “too” efficient for the fallible humans at the helm. In the heavily data-dependent economy we now find ourselves in, information asymmetries are more ripe for abuse and manipulation than ever before. And if we allow the all-powerful data to be manipulated by those with interests that may be best served at the expense of everyone else, we might want to rethink just how we should be handling that data.

It is often too tempting to simply take up the mantel of labor and “the people” in these kinds of situations, especially because free markets are fundamentally a good thing to attempt to promote where possible. There is a bit of a residual false stigma about how greed should be squelched that continually embitters Wall Street to the point where they really dig down hard and advance some seriously regressive policy.

But If it takes some of the smartest people on the planet a full-time career (and then some) just to understand what they themselves are doing, it is impossible to expect a casual investor or observer of markets to effectively learn about what is going on in their own time, let alone respond in a way that could provide an effective, market-based check to bad behavior through their own consumer choices. Markets simply cannot be expected to work on their own here.

Over the past 25 years the forces of regulatory liberalisation and demutualisation of markets have allowed the largest global banks to set the rules, processes and infrastructure of global markets to their own self-interested requirements. Regulatory complexity and harmonisation benefit the biggest banks disproportionately, eroding the competitive stance of smaller, local banks and market participants. This has led to a very high degree of concentration in a very few banks in most markets that determine global reference rates for interest rates, currencies, commodities and investments. If those few collude with each other – as Adam Smith warned was always the result – then they impoverish us all.

We have allowed markets to evolve in ways that make supervision of markets almost impossible. Many instruments trade off-exchange or in multiple venues, making it nearly impossible for any single investor or regulator to supervise trading to prevent or detect manipulation or abuse. Many financial instruments are now synthetic compilations of underlying assets and derivatives, with multiple pricing components determined by reference to other prices or rates. Demutualisation and regulatory reforms stripped exchanges of the self-regulating interest in preventing manipulation and abuse by their members as mergers, profits and market share came to dominate governance objectives.

This is simply a pure example of the need for regulation. And I’m not just talking about the corporate-captured regulatory scheme we currently have in place. I’m not talking about the paltry $450 million settlement with Barclays bank that investigators “negotiated.”

LIBOR could prove to be the most powerful example of the need for regulation in a generation if its causes and effects are thoroughly articulated in the public sphere, especially given the residual belief by some that the banks should have just been allowed to fail. And if this is anything like JP Morgan’s recent trading debacle, we’re going to find out that things are at least three times worse than the responsible parties ever let on when the story has anyone’s attention.

And we can’t just keep on rattling on about this without some fundamental, playing-field altering changes. It’s bad for morale.

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