LIBOR, foreign exchange and the illusion of liquidity

Abstract

The London Interbank Offered Rate (LIBOR) and foreign exchange (FX) controversies revealed that prices and benchmarks related to money and currencies were highly susceptible to manipulative and collusive practices. The reform process since has strived to ensure that market participants and end-users can rely on a fair price determination process. Put differently, the emphasis has been on the price aspects of LIBOR and FX. When studying market liquidity, however, the price always needs to be put into a broader context. This paper uses two case studies to illustrate how ignoring other dimensions of market liquidity, such as volume and speed, can result in misleading assessments of the state of the market. At worst, it can lead to, and perhaps even sustain, an illusion of liquidity. This is of particular relevance for over-the-counter (OTC) markets, which ultimately depend on human relationships and trust.