If you are aware of some of the specific derivatives and securities that are traded by banks and other financial services firms, you know that actual transactions in many of them occur infrequently. Prices based on what a willing buyer would pay a willing seller are difficult to come by. Let’s say you are a risk manager at one of these firms or perhaps a regulator curious about market exposures of a bank that you are tasked to monitor. How do you ascribe a value to a derivative or security if you cannot find a price in the market?
For many instruments, an index is used. Often indices are generated by brokers. Brokers match buyers and sellers over the phone or using matching platforms so they are connected to trading desks. A broker might publish an index of rarely traded derivatives or securities based on polling various trading desks. This practice is particularly common in energy markets (oil and its derivatives, natural gas and electricity). In these markets, delivery location or specific physical characteristics (of petroleum derivatives) greatly impact the forward price of the product. The markets for specific delivery points or physical products are idiosyncratic and often only loosely related to other similar delivery points or products. Indices compiled by polling are commonplace in these markets, but they are not the only ones. Another market that comes to mind is the large and problematic credit default swap market.
If this way of pricing an instrument sounds vaguely familiar, it is because you have been reading about the massive LIBOR rigging scandal. The process that Barclays (and likely others) manipulated operated very much like a broker sponsored index based on polling). There is no doubt that the size of the markets that are indexed to LIBOR dwarfs energy markets. However, CDS is a large and critically important market. And energy markets are strategically very important. The smaller, specific markets are also very easy to manipulate. Consider the possibility of a bank that targets specific power and gas delivery locations strategically so that it can achieve a dominant role as the major trading firm in that market. It can then influence the index results by using its role as a price provider in the polling process. While the numbers are much less than the hundreds of trillions of dollars associated with LIBOR, the bang for each buck of fudged price reporting is significant because it is unlikely to be rectified quickly by other market participants.
And the moral bankruptcy of such behavior would be the same.
The absurdity of market practices is even worse, it is sad to say. For some derivatives and securities, there is no reliable index. In such a case, the risk manager and the regulator mentioned above is likely to rely on a price estimate provided by the traders who took on the position in the first place. Now, there is a group likely to exercise disciplined prudence in measuring the risk of a trading book! Remember that higher risk means that more capital must be reserved and the traders are constrained from doing additional trades. Using trader estimates is likely to be as reliable as the response of an alcoholic when asked how much he had to drink last night.