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Create account Login Subscribe. This column argues that reliable benchmarks reduce informational asymmetries between customers and dealers, thereby increasing the volume of socially beneficial trades.
Indeed, the increase in trading volume may offset the reduction in profit margins, giving dealers who can coordinate an incentive to introduce benchmarks. The authors argue that benchmarks deserve strong and well-coordinated support by regulators around the world. 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. 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. 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. 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.
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. Although the CFO could contact other banks and perhaps get a slightly lower rate, the scope for improved terms is relatively small relative to the cost of delay.
The quote from Bank A is quickly accepted. It might superficially seem that dealers have little incentive to introduce a benchmark. By revealing the going price, dealers lose some of the advantage of their superior information over buy-side firms. As a result, benchmarks force dealers to compete more aggressively, narrowing their profit margins on each trade. In many cases, however, what is lost in reduced margins is more than offset by increased trading volumes.
With a benchmark, it is easier for customers to find good quotes and they are more eager to participate in the market. With the ability to coordinate, dealers may therefore collectively commit to publish a benchmark.
Dealers introduce benchmarks when and where this is profitable. Moreover, dealers that are inherently more cost effective, and can therefore offer better quotes, have an additional incentive to introduce a benchmark. When dealers would not profit by introducing an OTC market benchmark, this may sometimes be left up to governments or central banks.
Commercial information services also establish benchmarks such as the Kelley Blue Book average sale prices of automobiles.
If benchmarks are manipulated, some of the transparency benefits will be lost. Coulter and Shapiro and Duffie and Dworczak have proposed new benchmark fixing methods that are less susceptible to manipulation. Policymakers in various jurisdictions have not yet reached agreement on the best approach to benchmarks.
The UK and Japan have recently set up regulations in support of regulatory frameworks for financial benchmarks. The UK also plans to extend its framework to a wider set of benchmarks Bank of England For the reasons that we have outlined, financial benchmarks aid market efficiency in a variety of important ways, and deserve strong and well-coordinated support by regulators across the globe.
Robust financial market benchmarks. Darrell Duffie, Piotr Dworczak. Notes on a scandal: This example illustrates three types of social gains offered by reliable benchmarks: A benchmark reduces information asymmetry between customers and dealers.
With a published benchmark, customers have a better idea of the relative competitiveness of dealer quotes. Costly search is correspondingly reduced. As a result, when they trade, they do so more frequently with those dealers quoting better prices. Matching efficiency is correspondingly improved. Adding a benchmark can increase the volume of socially beneficial trades. Perhaps surprisingly, dealers often do It might superficially seem that dealers have little incentive to introduce a benchmark.
Implications for the supervision of benchmarks Policymakers in various jurisdictions have not yet reached agreement on the best approach to benchmarks. Race and economic opportunity in the United States. Chetty, Hendren, Jones, Porter. Practical macroeconomic policy evaluation. New ways of thinking about economic policy. Monetary-Fiscal Management of a Global Recession. The Economic Consequences of Brexit. Homeownership of immigrants in France: Evidence from Real Estate.
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