59 Pages Posted: 1 May 2020 Last revised: 9 Feb 2021
Date Written: December 1, 2019
Over-the-counter (“OTC”) markets—those for currencies, derivatives, swaps, bonds, and commodities, for instance—make up an immense and critical component of global financial markets. Certain benchmarks, such as the London Interbank Offered Rate (“LIBOR”), are hardwired throughout these markets and play crucial roles in pricing and valuation. For example, interest payments on instruments ranging from student loans and mortgages to synthetic derivatives are tied to the value of LIBOR. In 2016, estimates of notional exposure to U.S. dollar LIBOR totaled about $200 trillion—ten times U.S. gross domestic product (“GDP”) that year. Correspondingly, minuscule variations in a benchmark’s value will impact vast numbers of assets and transactions for hundreds of millions of people.
These benchmarks have become so ubiquitous for an important reason: they have introduced substantial harmonization effects in otherwise decentralized, opaque dealer markets. These benefits fit within the prevailing view of financial regulation: because sophisticated market participants, through wealth-maximizing behavior, tend to select towards structures that maximize efficiency, in aggregate social welfare is maximized, meaning that observed equilibria are likely the most efficient equilibria. And thus, OTC markets have remained largely unregulated for decades.
This Article argues that this understanding is incomplete and identifies a fundamental misalignment between what is privately optimal and what is socially optimal in OTC markets. By undertaking a structural analysis, this Article documents overreliance by market participants on benchmarks even when they are substantially suboptimal. Thus, in contrast to existing reform proposals, which overwhelmingly assume that a single benchmark will continue to dominate, this Article proposes an alternative competitive equilibrium—one where multiple benchmarks compete.
Keywords: OTC markets, LIBOR, WM/Reuters, FX, ISDAFIX, financial regulation, market structure, benchmarks, indices, manipulation, SOFR, network effects, innovation
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