The London Inter-Bank Offered Rate (LIBOR) is a measure of the interest rates at which major banks borrow funds from other major banks in the London market. Rates are calculated and published daily for 15 different maturities ranging from overnight to 12 months, denominated in 10 different currencies. Of these 150 different interest rates, the 3-Month US Dollar rate is the most widely followed.

Over the past several weeks there has been a flood of news reports on efforts by participating banks to manipulate or otherwise distort various LIBOR rates. At least one bank so far has admitted guilt and several others are reportedly trying to negotiate a plea bargain with regulators. Beyond the potential impact these activities may have had on interest rates, it is worthwhile to review the LIBOR affair in the context of prices paid and received by agricultural producers.

A close examination reveals a number of structural weaknesses in the LIBOR process. One problem is that LIBOR is based on estimates, not actual transactions. In a transaction, the buyer tries to get the lowest possible price, the seller tries to get the highest possible price, and the economic interests of both parties are reflected in the price when the deal is finally struck. This is why transactions are considered the “gold standard” for prices and other types of market data. However, LIBOR reflects “offers” – for example, the rate quoted by Bank B to lend funds to Bank A.

Read: Low interest rates and strong commodity prices helping fuel farmland demand

The quotes submitted by each bank are publicly available, based on the belief that transparency will help discourage any shenanigans. However, the borrowing banks – Bank A in the example above – are the ones that submit the interest rates used for the survey. These quoted rates also reflect the creditworthiness of the borrowing bank, with higher rates charged to weaker, riskier banks. Therefore, a less creditworthy bank has an incentive to put a downward bias on the rates they report, to give the appearance of being more financially solid than they actually are. The problem is compounded when weaker banks submit borrowing rates that are below those of the stronger banks. This puts the stronger banks that are reporting honestly at a competitive disadvantage, gives the stronger banks an incentive to also under-report the interest rates on their borrowings, and soon the survey degenerates into a race to the bottom.

But the problems don’t end there. In the LIBOR survey, traders are asked the following question:

“At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?”

When conducting a survey, the answer received often depends on how the question is asked, and the LIBOR question allows for considerable wiggle-room in the answer. Notice that it doesn’t ask “At what rate did you borrow funds just prior to 11 am?” but rather “At what rate could you borrow funds, were you to do so, just prior to 11 am?” Similarly, the reference to “reasonable market size” is designed to reflect the quantity of funds borrowed – the interest rate to borrow $1 billion presumably should be higher than the rate to borrow $1 million, everything else being the same – but what is “reasonable” to one bank might be unreasonably large or small to another.