The Libor Fix

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.

In June this year, UK and American authorities fined UK’s Barclays Banks £290 million ($450 million) for manipulating key money market benchmark rates, such as the London Interbank Offered Rate, or Libor, and Euro Interbank Offered rates, or EuroIBOR.

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.

Libor originally reflected the rates at which banks in the euro-dollar market lent surplus liquidity to each other. Demand for a standard benchmark for instruments based on money market rates led to the creation of the British Bankers’ Association (BBA) Libor fixings, which commenced officially in 1986.

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, 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 am, generally around 11:45 am 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) and derivative transactions. 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. 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. 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 September 13, 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 October 13, 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 October 26, 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 October 26, 2006, Barclays submitted a three-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 one 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 Bank of England’s (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.

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 Diamond (curiously one of only three 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. 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 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 bank’s 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.

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 reason proxy.

Small changes have a material impact in dollar terms where large sums are affected. Assuming a total of $800 trillion of affected transactions, the potential amount per 0.01% is $80 billion per annum or $220 million per day. Actual damages would be significantly lower as rates fixes are for shorter term, one or three months. 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. BBA Libor is not used in some markets at all due to history or differences in market convention such as settlement protocols.

Determining the affected parties is also complex. 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. End-users, corporate or retail borrowers and investors, would be the major parties affected. As banks act as intermediaries in the main, there would be a transfer of wealth between parties. During the GFC, low rates benefitted borrowers but penalised depositors. Low Libor sets penalised some participants in derivative transactions.

Barclays faces further prosecutions, including possible criminal charges. Other banks under investigation. Civil suits, including class actions brought on behalf of affected parties, are likely.
Investment bank Morgan Stanley estimates that losses to banks could total (up to) $22 billion in regulatory penalties and damages to investors and counterparties, equivalent to around 4-13% of banks’ 2012 earnings per share and 0.5% of book value. In reality, it is difficult to accurately quantify potential losses.

Other rates and prices set by banks will come under scrutiny. The US DoJ is prosecuting US energy trading companies for allegedly submitting false trade data to Platts and other publishers of price indices used to price and settle natural gas transactions.

There is now significant uncertainty about potential litigation and unquantifiable losses faced by banks. Already facing weak earnings, asset quality problems, higher funding costs and increased regulations, banks are likely to remain under severe pressure.

Described by Lord Mandelson as “the unacceptable face of banking”, Diamond is an ideal villain. The fall of a brash American not noted for humility provides a suitable narrative arc. His statement to the UK House of Commons Treasury Committee that the “period of remorse and apology for banks... needs to be over” now smacks of hubris.

Betrayal and fractured friendships are evident. Del Missier, one of Diamond’s trusted lieutenants, insists that he acted on instructions from his CEO sanctioned by the BoE in ordering staff to submit false rates. Deputy governor Paul Tucker and FSA head Lord Turner are using the occasion to avoid collateral damage and burnish reputations in their rivalry for the high office of BoE governor. Suggestions of senior government officials and ministerial involvement add political intrigue. The contest between great nations seeking to dominate global finance provides a suitable background.

But the Libor fix may be a simple example of “beezle”. Coined by economist John Kenneth Galbraith, the term describes the fraud or embezzlement that occurs in booms as sharp people take advantage of the favourable conditions and abundance of money.
Like mis-selling of complex products and the inability to manage risk, the manipulation of Libor reemphasises the deep seated problems of large banks and global finance. A review of the role of finance in modern economies and societies is overdue.

Unfortunately, recent history suggests the political will for the necessary corrective actions may not be present.

But like Al Capone who was ultimately convicted of tax offences, banks may yet find that the Libor fix forces significant changes to banking regulation and practice. In an age of super computers and complex financial instruments, it would be a delicious irony if banks were to be undone by something as banal as an ancient rate setting process.

Satyajit Das is author of Extreme Money and Traders Guns & Money