The LIBOR Fix
By Satyajit Das

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 Bank £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.

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.

The Fix...

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, pound, yen and Swiss franc) 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. 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.

First Fix....

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 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".

Second Fix....

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 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 competitors 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 by 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.

Damage & Damaged...

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 reasonable proxy.

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.

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. 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.

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.

The Long Fix ...

Lord Turner, the head of UK FSA, told a UK parliamentary committee that it hadn't occurred to him before 2009 that the rate was something that could be manipulated.

However, anecdotal evidence suggests that LIBOR submissions may have been manipulated over a long period. Banks and regulators may have been aware of these practices for some time but did not take corrective action.

Barclays' senior management and board of directors have indicated that they became aware of the problem recently. Banks offer the same excuse as JP Morgan Junior in 1933: "Since we have not more power of knowing the future than any other men, we have made many mistakes (who has not during the past five years?), but our mistakes have been errors of judgment and not of principle."

Between 2007 and 2008, it appears that Barclays' compliance department did not act on three separate internal warnings about conflicts of interest and "patently false" rate submissions.

In an opinion piece published in the UK's Independent on 7 July 2012, a former Barclays' employee alleged that problems with LIBOR fixings were escalated by several people up to their directors and further within the organisation.

Recent disclosures indicate that UK and US regulators knew that banks were posting artificial rates which did not correspond to the actual rates that the banks would pay to borrow.

In April 2008, a Barclays' employee notified the Federal Reserve Bank of New York ("New York Fed") that the bank was underestimating its borrowing costs. A transcript of the telephone call is revealing: "....we know that we're not posting um, an honest LIBOR ... we are doing it because um, if we didn't do it ... it draws, um, unwanted attention on ourselves."

On 1 June 2008, Timothy Geithner, then head of the New York Fed, emailed Mervyn King, Governor of the BoE, urging changes in the way the LIBOR is calculated. Internal New York Fed reports reveal concern about possible misreporting of LIBOR.

None of these concerns were made public or steps taken to address the problem. Regulators, it seems, feared that the truth would destabilise already panicked markets.

TBTF to TBTJ...

Large banks are too big to fail (TBTF), a concept now codified in bank regulations. It remains to be seen whether large banks and their employees are too big to jail (TBTJ).

Authorities have settled cases of LIBOR manipulation, perhaps driven by a desire to avoid creating a banking panic in an environment where financial institutions are vulnerable.

The UK FSA case was based on breaches of various parts of its Principles for Businesses code, specifically Principle 5 which requires a firm must observe proper standards of market conduct. The US Department of Justice ("DoJ") cited violations and misconducts, without specifying offences.

The actions prima facie constitute manipulation and fraud, violating applicable securities laws. It may also breach anti-trust and criminal law. Evidence released shows possible criminal intent.

Emails indicate awareness of the illegality: "don't talk about it too much"; "don't make any noise about it please"; "this can backfire against us". Individual traders and the bank which is responsible for its employees' actions would be liable.

Facing media attention and public fury, US and UK authorities are belatedly exploring possible criminal charges.

Big Fix...

Responsibilities for oversight of the LIBOR setting process are unclear.

The BBA insists that its process is transparent and unambiguous. As all contributing banks are regulated, the BBA argues that regulators are responsible for individual banks behaviour. The BBA knows each person responsible for submitting information and can demand to see the actual trades on which these figures are based. No evidence that this was done has been disclosed.

The UK FSA does not have a specific regime governing LIBOR submissions, relying on broad rules governing identification and prevention of conflicts of interest.

Increased oversight and regulation of the rate setting mechanism is proposed.

Proponents of "narrow" banking argue that the separation of commercial and investment banking would solve the problem. But interest rate benchmarks affect normal lending and deposit taking activity as well trading activity.

Proponents of the Volcker Rule argue that preventing proprietary trading by banks would minimise the problem. In reality, manipulation was not only related to trading positions but general banking activity.

UK regulators seem resistant to more stringent regulations. BoE Governor Mervyn King noted: "The idea that one can base the future calculation of LIBOR on the idea that 'my word is my LIBOR' is now dead". But the Governor cautioned that: "I think it's very important that people don't expect too much from regulation".

UK authorities nostalgically hanker for an anachronistic time when most bankers in London were located in the Square Mile of the City and relied on mutual trust. According to folklore, nothing more than a central-bank governor's raised eyebrows was necessary to prevent unsatisfactory conduct.

The good old days were not what they seemed. In the 1980s, the head of a UK merchant bank told new employees that he didn't know how they would get rich given that insider trading was being banned.

A battle between major financial centres underlies the regulatory debate. In the 2000s, London became the world's dominant finance hub. Non intrusive, market responsive "light touch" regulation was a factor in its success.

Damage to London's reputation and stricter regulation would allow New York and European centres to regain competitive ground. US authorities hinted that they forced reluctant UK regulators to act and are at the forefront of driving reform. European Union banking and anti-trust regulators have launched major investigations which may affect London's competitive advantage.

Fixing the Fix...

Amusingly, a recent BBA review proposed no changes to the rate setting methodology, merely proposing a code of conduct and greater scrutiny of LIBOR's correlation with other financial data over time. A "shocked" BBA is now reviewing the process

Given the large volume of transactions linked to the benchmark, it is essential that changes do not disrupt the operation of the market. Changes that affect legacy contracts may create significant legal problems.

There is agreement that the rates should be based on actual transactions rather than theoretical estimates. There should be independent oversight of the process. Banks should be required to segregate the function for fixing rates from other activity to prevent conflicts of interest. Rate submissions should be documented to provide transparency and an adequate audit trail.

The approach specified by the US CFTC (Commodity Futures Trading Commission) in its enforcement order imposed on Barclays embraces most of these principles. But the changes pose different problems.

While basing LIBOR on actual transactions is desirable, the theoretical benefits may be difficult to achieve in practice due to the shrinking size of the market and reduced activity levels.

As Sean Keane, a former head of Money Market Trading at Credit Suisse, wryly observed: "...over the last 4 years there have been fewer actual transactions in the unsecured cash market than there have been discussions about how to reform LIBOR". Where trading is disrupted as in 2007/2008, it is unclear how an accurate submission can be determined.

As differences in bank credit ratings and quality increases resulting in greater variations in borrowing costs, LIBOR rates will become variable and less meaningful.

Instruments suggested by the CFTC to calibrate submissions in the absence of money market transactions ignore the creditworthiness of the bank. These include OIS, futures contracts and collateralized currency transactions or repos.

Membership of a LIBOR fixing panel, once considered prestigious, may no longer be attractive. Constant regulatory and public scrutiny as well as risk of criminal and civil prosecution outweighs benefits. If banks become reluctant to participate in the process then the importance and acceptance of the benchmark will decrease.

For loans and deposits, banks may move to internal rates, which reflect their cost of borrowing. The biggest effect will be on derivatives transactions.

Created in simpler times, LIBOR was designed for pricing loans and deposits. Over time, derivatives based on LIBOR have become dominant. Perversely, the cash market on which LIBOR is based now supports a vastly larger derivatives market.

Curiously, generations of quantitative experts have built elegant models based on advanced mathematical techniques to price complex derivative instruments on a deeply flawed and easily manipulated base.

Christoph Rieger, Head of Fixed Income Strategy at Germany's Commerzbank, told a reporter: "LIBOR is not a market interest rate. The spot fixings are at best bank guesses of a hypothetical interbank borrowing rate. For that reason, this will always be subject to controversy".

Given this fact, a UK member of parliament Steve Baker asked the obvious question: "Members are increasingly wondering how such a large industry has been allowed to grow up on such a finger-in-the-wind number".

In the Fix...

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) US$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.

Fixing Banality....

Described by Lord Mandelson as "the unacceptable face of banking", Mr. 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. Mr. Del Missier, one of Mr. 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.

Regards,

Satyajit Das