Yves here. This post includes some details on the background of the Libor scandal that were new to me and I believe readers will find informative.
By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011). Jointly posted with roubini.com
The scandal surrounding the manipulation of LIBOR sets raises a number of issues. In the first part of the two part piece, the known facts are outlined. In the second part, the broader implications of the episode are discussed.
Depending on context, the word “fix” can mean “set” or “determine”, “manipulate” or “rig” as well as “repair” or “correct”. “In a fix” means to be in difficulty. In colloquial use, “fix” is a dose of an addictive substance that is habitually consumed. The current furore surrounding manipulation of money market rates contains all these meanings and more.
An objective mechanism is needed to set money markets rates used in a variety of instruments. A number of traders at leading banks submitted false rates seeking to manipulate the outcome. Banks are in a fix. If the current arrangements are unsatisfactory then it will be necessary to repair the mechanism.
In a Fix…
In June 2012, UK and American authorities fined UK’s Barclays Banks £290 million (US$450 million) for manipulating key money market benchmark rates, such as the London Interbank Offered Rate (“LIBOR”) and Euro Interbank Offered rates (“EuroIBOR”).
The settlement follows a lengthy investigation into fixing money market rates by regulators, under way for at least 2 or more years.
In 2011, Swiss bank UBS disclosed that as part of the investigation it had received demands for information on “whether there were improper attempts by UBS, either acting on its own or together with others, to manipulate LIBOR rates at certain times”. The Wall Street Journal in May 2008 published a study suggesting that banks might have understated borrowing costs. An academic study published the same year found that LIBOR had remained low whilst bank risk was increasing. Individual bank’s rate quotes remained very close, surprising given divergences in perceived credit quality.
The exact circumstances remained unclear until the UK Financial Services Authority (“FSA”) released detailed evidence indicating that Barclays had manipulated rates. Barclays’ Chief Executive Officer (“CEO”) Robert E. Diamond Jr. and Chief Operating Officer Jerry del Missier were forced to resign. Barclays’ Chairman Marcus Agius resigned but agreed to remain temporarily to find a new CEO.
An unknown number of traders and inter-bank brokers have been dismissed, suspended or put on leave by their employers as a consequence of the investigations. Institutions affected allegedly include Deutsche Bank, JPMorgan Chase, Royal Bank of Scotland and Citigroup.
LIBOR stands for the London Interbank Offered Rate. This originally reflected rates at which banks in the Euro-dollar market lent surplus liquidity to each other. As the market grew, an accepted pricing benchmark was required.
In the 1980s, the British Bankers’ Association (“BBA”) working with major global financial institutions and regulators, primarily the Bank of England (“BoE”), created the BBA rates. Initially, these were standard only for interest rate swaps (known as BBAIRS terms). Demand for a standard benchmark for instruments based on money market rates led to the creation of the BBA LIBOR fixings, which commenced officially around 1 January 1986 following a trial period commencing in December 1984.
LIBOR is defined as: “The rate at which an individual Contributor Panel bank could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size, just prior to 11.00 London time”. Each bank must submit a rate accurately reflecting its belief about its cost of funds, defined as unsecured interbank cash borrowings or fund raised through issuance of interbank Certificates of Deposit (“CDs”), in London as at the relevant time.
There are 150 different LIBOR rates published every day, covering 10 currencies (including US$, C$, A$, NZ$, Euro, £, yen and Swiss Francs) and 15 maturities (ranging from overnight rates to 12 months).
There are between 8 and 20 banks on each currency panel. Each bank provides its quote. The top and bottom 25% are ignored and the remaining quotes are averaged (the inter-quartile mean) to arrive at the quoted LIBOR. The process is overseen by the BBA but daily calculations are undertaken by Thomson Reuters, which publishes the rate after 11:00 a.m. generally around 11:45 a.m. each trading day London time.
The rates are a benchmark rather than a tradable rate. The actual rate at which specific banks will lend to one another varies. The rate also changes throughout the day.
LIBOR is used for loans, bonds (such as floating rate notes (“FRNs”)) and derivative transactions. Derivatives that use LIBOR to determine payments include various futures and options contracts, forward rate agreements, interest rate and currency swaps and various interest rate options.
The exact volume of transactions using LIBOR is unknown, as most are over-the-counter (“OTC”) bilateral transactions. Estimates suggest that LIBOR is used to establish the interest costs of $10 trillion of loans, $350 trillion of OTC derivatives and over $400 trillion of Euro-dollar futures and option contracts traded on exchanges.
Pre-2007, Barclays manipulated rates in order to obtain financial benefits. Subsequently, during the global financial crisis (“GFC”), Barclays manipulated rates due to reputational concerns.
The pre-2007 episode relates primarily to mismatches in banks’ asset and liabilities. For the most part, banks simultaneously borrow and lend money. In derivatives, they both receive and pay the same or similar rates.
For example, a bank may have borrowed 1 month money to finance a loan where the rate is based on the 3-month rate. Derivative traders may receive 3-month LIBOR but pay 6-month LIBOR. Mismatches arise from timing differences; a bank may have a transaction pricing of 3 month LIBOR on one day offsetting a position pricing off 3 month LIBOR the next day or a few days later.
Mismatches may be deliberately created to increase profit. Mismatches also result from the natural flow of customer transactions.
Mismatches (known as reset risk) can be managed by entering into transactions such as reset swaps. A bank might pay 1 month LIBOR against receiving 3 month LIBOR. Hedges are expensive and not always readily available.
The incentive to manipulate rates for profit arises from these mismatches. The evidence is consistent with this pattern of activities.
On 13 September 2006, a trader in New York writes: “Hi Guys, We got a big position in 3m libor for the next 3 days. Can we please keep the libor fixing at 5.39 for the next few days. It would really help. We do not want it to fix any higher than that. Tks a lot”. On 13 October 2006, a senior Euro swaps trader states: “I have a huge fixing on Monday … something like 30bn 1m fixing … and I would like it to be very very very high ….. Can you do something to help? I know a big clearer will be against us … and don’t want to lose money on that one”. On 26 October 2006, an external trader makes a request for a lower three month US dollar LIBOR submission stated in an email to a trader at Barclays “If it comes in unchanged I’m a dead man”.
Traders sought to fix the rate sets to increase the firm’s profits and ultimately their own bonuses. Following the request of 26 October 2006, Barclays submitted a 3- month US dollar LIBOR quote that was half a basis point lower than that the day before. The external trader thanked the Barclays’ trader: “Dude. I owe you big time! Come over one day after work and I’m opening a bottle of Bollinger”.
During the GFC, the FSA alleges that Barclays sought to manipulate LIBOR to minimise reputational concerns about its financial position.
Money market conditions were extremely difficult from late 2007 until early 2009 when massive central bank intervention alleviated funding pressures. There was little or no trading in money markets, especially beyond 1 week.
Individual bank funding activity and LIBOR quotes were intensely scrutinised. There was focus on any banks which were accessing emergency central bank funding, such as the BOE’s emergency standby facility. During this period, a high LIBOR post was interpreted as a sign that a bank was struggling to raise deposits leading to withdrawal of money market limits exacerbating funding difficulties. Equity markets too reacted savagely, selling bank stocks at any sign of funding stress.
The uncertainty was evident in the excess reserve balances held by banks with central banks as institutions assumed the worst about their peers. It was also evident in the difference between 3 month dollar LIBOR and the overnight indexed swap rate, which is an indicator of banks’ willingness to lend to each other. This spread peaked at a record 364 basis points on 10 October 2008, compared to an average of 10 basis points in period 2003-2008 and 45 basis points since 2008.
Banks also found it difficult to accurately calculate exactly rates because of illiquid money markets. Submissions became a guess of the level if a market existed, based on discussion with other market participants and checking competitor’s previous submissions.
The FSA Report refers to media reports that Barclays had been posting high LIBOR rates and market concern about the bank. The BoE was also concerned leading to a number of discussions between official and Barclays’ management. BoE concern is understandable given the difficulties of other major UK banks, such as RBS and Lloyds/HBOS.
An October 2008 file note written Barclays’ CEO Mr. Diamond (curiously one of only 3 he ever wrote) states that BoE Deputy Governor Paul Tucker advised that the bank’s high LIBOR submissions were gaining the attention of “senior figures” in Whitehall. Mr. Diamond recorded that Tucker felt Barclays did not need to keep posting such high LIBOR fixings, intimating that “it did not always need to be the case that we (Barclays) appeared as high as we have recently”.
Barclays would have been concerned that incorrect price signals could set off panic and massive funding pressures.
In a Bloomberg Television interview in May 2008, Tim Bond, a former Barclays Capital executive, indicated that banks routinely misstated their borrowing costs in the BBA process to avoid the perception that they faced difficulty raising funds during this period. This is consistent with a 2008 Bank for International Settlements (“BIS”) report which questioned the accuracy of LIBOR quotes, stating that they could be influenced by “strategic behaviour” with banks “wary of revealing” information that could signal stress.
While the banks manipulation for the purposes of financial gains is indefensible, Barclays’ officials argue that during the crisis it acted with the explicit or implicit agreement of the BoE.
While there is little doubt that incorrect rates were submitted, the effect is more difficult to establish. A single high or low quote would be eliminated from the calculation.
Collusion between the banks could affect the rate. The FSA Report suggests that Barclays worked with other banks. In court filings, Canada’s Competition Bureau disclosed that one bank had confessed to participating in a conspiracy to manipulate LIBOR to affect the price of derivatives globally, involving employees of HSBC, Deutsche Bank, JPMorgan, RBS and Citigroup as well as a money market broker ICAP.
Even without collusion, small changes in submissions can affect the LIBOR set. Setting rates very low or very high may ensure that the bank’s submission is excluded, allowing another rate to be included in the calculation. If a bank sets rates very low then it ensures that lower rates are included in the calculation decreasing the average. Similarly, setting rates higher pushes higher rates into the calculation increasing the average.
The ability to manipulate rates depends on the number of banks on the panel and the dispersion of the original submissions. A small panel makes the rate easier to manipulate. Where the submissions are highly dispersed, it may be easier to influence the final outcome, even without collusion. The differences between rates around the cut-off point for inclusion are critical. It is helpful to know what individual submissions are, although the previous day’s quote may provide a reasonable proxy.
Table 1 sets out an example which illustrates how rates are affected.
Table 1 sets out an example which illustrates how rates are affected.
Effect of Submission Manipulation
In the following example, assume quotes are as follows:
Quote 1 – original bank submissions.
Quote 2 – Bank 5 manipulates the quote by increasing its submission.
Quote 3 – Bank 5 manipulates the quote by decreasing its submission.
In all case the top and bottom 3 quotes (25% each) are ignored with the LIBOR rate being determined by the arithmetic average of the remaining 6 quotes.
Differences are given in percentage and dollar amounts calculated for a full year assuming a principal of US$ 1 billion.
In the first case, dispersion (range) of 2 basis points between top and bottom quotes is assumed.
If the dispersion decreases (increases) the effect on LIBOR similarly decreases or increases. The following Tables assume dispersion of 0.5 and 5 basis points respectively.
If there is a large difference (jump) between rates around the cut-off point for inclusion, then the effect on LIBOR is exacerbated. The following Table assumes a dispersion of 2 basis points respectively but larger difference around the relevant points than the previous example.
Small changes have a material impact in dollar terms where large sums are affected. A 1 basis point change on US$ 1 billion is equivalent to US$100,000 per annum. Assuming a total of US$800 trillion of affected transactions, the potential amount is US$80 billion per annum or $220 million per day. Actual damages would be significantly lower.
Rates fixes are for shorter term, 1 or 3 months. Where they reflect spread between say 1 month and 3 month rates, the amount involved would be smaller.
Damage & Damaged…
LIBOR is not used for all financial transactions. They are primarily used in wholesale loan transactions and derivative transactions. Retail or small business loans are based on the bank’s own base rate reflecting its funding cost. Bank retail deposit rates are rarely based on LIBOR.
According to the US Office of the Comptroller of the Currency, the proportion of US mortgages priced directly off LIBOR is estimated at around 2-3% of all mortgages, about 900,000 loans totalling $275 billion. The proportion of UK mortgages priced off LIBOR is similar. In the US the predominance of fixed rate mortgages makes a money market benchmark like LIBOR irrelevant.
BBA LIBOR is not used in some markets at all due to history or differences in market convention such as settlement protocols. Derivative and loan transactions in Australia are priced off the indigenous A$ bank bill rate (BBSW). Transactions in the US use a variety of rates including US Prime Rate or US Commercial Paper rates.
Manipulation could indirectly affect interest rates. Changes in a bank’s wholesale funding might affect its lending and deposit rates. Retail mortgages and credit card loans are refinanced through securitisation transactions, which are linked to LIBOR.
Determining the affected parties is also complex. During the GFC, low rates benefitted borrowers but penalised depositors. Low LIBOR sets penalised payers of fixed rate in an interest rate swap but benefitted receivers.
In derivative transactions, there may have been transfers of value between banks. One swaps trader states that a large bank is on the other side of a fix with opposing financial interests. Individual desks or traders within a bank may have different interests in a particular LIBOR set. There will also be differences between banks that contribute to the LIBOR fix and those who do not.
End-users, corporate or retail borrowers and investors, would be the major parties affected.
A perverse outcome is likely in litigation. As banks act as intermediaries in the main, there would be a transfer of wealth between parties. Losers will sue banks who will be unable to recover their losses from the parties that may have benefitted.
Clients suing banks is now passé. The sight of banks suing each other seeking compensation promises ribald entertainment. Goldman Sachs (who do not contribute to the fix) claiming that they were innocent victims and unsophisticated investors may provide a suitable coda to the episode.