Financial Market Faith: Libor Scandal Reveals What We Don't Know About Global Markets

"Libor? Libor? What the (expletive) is Libor?"

So begins a particularly hilarious passage in Michael Lewis' best-selling sell-out of Wall Street: "Liar's Poker"

The question was asked among the highly-educated members of training class for new recruits at the infamous investment bank Salomon Brothers.

Lewis was attempting to show, as he does with particular skill, the knowledge gulf between the real business of trading in global financial markets and the common understanding of those outside its protected walls.

The fact that a secretly-auctioned level of inter-bank lending rates - which banks have *no* obligation to honour - underpins an estimated $350tn in global securities - is terrifying enough.

That its veracity has been questioned by regulators for years (aside from being a long-running inside joke among financial market professionals) is even more shocking.

But the truth is that the anachronisms, inaccuracies and outright manipulation alleged in Libor merely represent the tip of the proverbial ice-berg in terms what we *don't* know about global capital markets.

Take stocks, for example. Even in today's fully-joined-up world of global finance, a trader who asks "What's the market doing?" will normally be told the most recent quote of the "Dow", the eponymous short-hand of the Dow Jones Industrial Average that acts not only as a de-facto barometer for US corporate health but also the sole indication (along the price of oil and the price of gold) of daily financial market activity for the vast majority of those watching mainstream TV news each and every evening.

The Dow, however, is little more than a crude average of the prices of only 30 widely held US stocks, adjusted for splits and dividends by a number called the "Dow Divisor".

Those stocks, it might surprise you to learn, are selected by the editors of the Wall Street Journal (the Dow was first created by the founders of news and data provider Dow Jones & Co. back in the late 1800s) and better represent an American economy that existed 30 years ago as opposed to the one we have today (DuPont is in: Apple isn't).

Furthermore, the average is influenced not by a company's size or importance to the US or the global economy, but merely by its arithmetic share price. In other words, Exxon's (market value: $400bn) lower-price shares have less impact on the Dow's daily moves than 3M Co.'s (market value: $60.7bn) more expensive shares.

Of course, the "market value" of many of these firms is just as suspect, and in fact much more stochastic than sacrosanct.

Take, for example, the idea of "goodwill". It's an accounting entry that allows companies to book, as an asset, the difference between the "book value" of a company it bought and the price it actually paid for that company.

In other words, if a company "overpays" to buy one of its competitors, it matters not a whit, because that "goodwill" sits on its balance sheet. Sadly, we can't do the same with the Ford Mustang we saw on ebay last week. (Try paying $50,000 for a classic car worth $30,000 and then asking your bank manager for a loan against the difference).

Would it surprise you to know that the size of that mysterious "goodwill" is more than the annual GDP of the United Kingdom?

Global stock markets are worth around $57tn. If normal estimates of goodwill are accurate (which itself is a bit of an issue) we can assume around $1.8tn of that value is, at best, nothing more than a guess (after all, how does one define "overpay")?

And speaking of guessing, we all wonder why petrol costs as much as it does, even if we have the kind of mathematical nous that allows us to navigate the complicated thicket of "fuel tax escalators". In fact, the Telegraph reports that Downing Street has asked regulators to look into allegations of price-fixing at the base price level of petrol costs: crude oil.

It's priced in barrels, of course. We know this from watching financial television and reading the business pages.

But would it surprise you to know that oil barrels don't really exist and that oil hasn't been stored, sold or shipping in barrels for over 100 years? The common 40 gallon measurement dates back to the 1860s and bears no relation to actual day-to-day oil usage. Yet our base understanding of the world's most important industrial commodity remains fixed to a "per barrel" description.

As does our "guesstimates" of global crude supplies. It'd be nice to think the "smartest guys in the room", as Enron's energy traders were once described, could tell us how much crude oil sits above the ground.

They can't.

A Wall Street Journal report looking into the data collection methods of the Energy Information Administration a couple of years ago found gaping holes in both the collection, calculation and accuracy of the data which most of the global oil markets use as a barometer for US consumer demand for crude.

Flawed as they might be, at least the US tries to put a finger-in-the wind. The worlds' largest energy consumer, China, has given up publishing information on its stockpiles of crude, gasoline and diesel, leaving accurate estimations of the world's most important industrial commodity left up to individual professionals and larger trading firms, some of whom pay for infra-red photographs of storage installations to make their investment decisions.

Imagine trying to make a bet on IBM's stock price based on a complete guess, while your broker was armed with paid-for information that gave him an enormous trading advantage?

It almost makes you want to retreat to the safe, definitive confines of Gold: the safest investment since the Pharaohs.

Or is it?

Estimates (again with that word?) suggest we humans have pulled around 157,000 metric tonnes of gold from Mother Earth since the first know gold aretfacts were built in Varna Necropolis. That's about 5.1m troy ounces and enough to fill around 3.3 Olympic-sized swimming pools from bottom to deck.

Not so much for 7,000 years' worth of effort.

Of course, not all of it is marketable. Central Banks around the world hold around 22,000 metric tonnes and more than a significant portion of the yellow metal is shaped into artefacts, symbols,

A further 2,469 metric tonnes is linked to global Exchange Traded Fund (ETF) sales, making the sector, in effect, the fourth largest holder in the world. (Incidently, 8 percent of the biggest gold etf, State Street's SPDR (GLD) is held by two people: hedge fund guru John Paulson and billionaire investor and thorn-in-the-side-of-Britain George Soros.

Which leads us to new global debate: the value of paper gold versus physical gold. You might think that, given gold's psychological hold over man as an historical "store of value" we'd have more accurate measures of this scary fact, but you (and I) would be wrong.

Although the figures differ from source to source, there could be as much as 100 times more paper gold in circulation than there is physical gold to back it, meaning the value of the one "safe investment" is built on the same money-multiplier assumptions as fractional reserve bank lending. In other words, as long as we all don't cash in our chips at the same time, we'll be fine. If we do, then it's musical chairs (at best) to find out who's going to get what they think they own.