Commentary by John Waites, BSc (Econ), FCA
10 June 2013
LIBOR is rarely mentioned in the press without it being followed by the word “scandal”. What is LIBOR, and has it really caused a scandal? John Waites investigates.
Definition of LIBOR
LIBOR is a benchmark reference rate, produced for 10 currencies with 15 borrowing periods quoted for each – ranging from overnight to 12 months. LIBOR gives an indication of the average rate at which a LIBOR contributor bank can obtain unsecured funding in the London interbank market for a given period, in a given currency.
What is LIBOR used for?
LIBOR is meant to indicate the interest rate that banks use when lending to each other. It is used in over the counter (OTC) interest derivative contracts and exchange traded interest rate contracts. It is also used as a reference point for retail products such as mortgages and loans.
What is the fixing process?
The LIBOR fixing process refers to the mechanism by which contributor banks determine their individual submissions and how these are checked, processed and averaged to produce fixings.
How long did the “scandal” period last?
On 5thMarch 2013, The Financial Services Authority (“FSA”) published a report “A review of the extent of awareness within the FSA of inappropriate LIBOR submissions”. This review covered the period January 2007 to May 2009. For the purposes of this article, we will consider this to be the “scandal” period.
How was LIBOR calculated during this period?
Contributor banks submitted a rate at which they believed they could borrow unsecured funds in the interbank market for a given currency and borrowing period (for example overnight, 1 week or 3 months). The rates submitted were collated, the top and bottom 25% of those submitted rates were excluded and the average was then taken of the remaining rates. This process would determine that day’s LIBOR fixing. Contributor banks (also known as panel banks) were selected, by the British Bankers’ Association (“BBA”), based on three factors: scale of market activity, credit rating, and perceived expertise in the currency concerned.
LIBOR was defined by the BBA at the time as “the rate at which a contributing bank believes it could borrow funds should it wish to do so, by asking for and then accepting interbank offers in a reasonable market size just prior to the fix time, which is 11am London time.” The submitted rates could therefore be a subjective measure rather than being necessarily based on actual transactions.
The “scandal” period coincides with a period of intense market instability. Market conditions deteriorated significantly in the second half of 2007 as the subprime mortgage crisis developed, and worsened considerably in September 2008 before improving towards the end of the year and into 2009 following interventions by central banks. Deteriorating market conditions were interacting with structural issues in the LIBOR fixing process causing dislocation between LIBOR and other indicators (hereafter referred to as “LIBOR dislocation”) as follows:
- Banks’ experienced difficulties in providing accurate LIBOR submissions because some markets became very illiquid with few transactions occurring at some maturities;
- As LIBOR is fixed at a point of time, actual trades could be expected to differ from the 11am fixing, particularly during periods of volatility;
- The fact that the BBA definition of LIBOR included submissions being based on ‘reasonable market size’ borrowings. Trades of different amounts, particularly in stressed market conditions, could attract different funding rates.
This manifested itself in five main ways:
- The spread between LIBOR fixings and other rates (such as the Overnight Indexed Swap rate) widening’
- The volatility in LIBOR fixings and spreads;
- The divergence between LIBOR submissions and actual rates that could be
obtained in the market;
- A wider dispersion of LIBOR submissions; and
- Greater divergence between funding rates for different banks depending on their perceived creditworthiness.
Why and how did the banks want to manipulate LIBOR rates?
It appears that the banks sought to manipulate LIBOR rates for two main reasons:
- Lowballing for reputational reasons. Firms reduced their LIBOR submissions during the financial crisis in an attempt to avoid negative media comment on their cost of borrowing; and to avoid the appearance that they were struggling to obtain finance;
- Manipulation of rates to increase position-taking profit. Traders, whose bonuses depended on complex deals linked to LIBOR, had an interest in pushing LIBOR up or down depending on their dealing positions. Webs of traders within and across banks systematically attempted to manipulate LIBOR to benefit themselves and one another.
What was the FSA’s role in relation to LIBOR?
The LIBOR scandal exposed a fundamental flaw in relation to the setting of LIBOR rates and its regulation, or lack of it. The BBA was responsible for overseeing the LIBOR fixing process, but it was effectively a banking trade body, with little or no powers. The activities of contributing to or administering LIBOR were not ‘regulated activities’ as defined under the Financial Services and Markets Act 2000. Manipulation and attempted manipulation of LIBOR was also unlikely to fall under the market abuse regime, so the FSA could not utilise these regulations.
However, the FSA was responsible for regulated firms’ conduct in relation to its Principles for Businesses. This was deemed to be relevant to regulated firms’ LIBOR submissions. Using this rather blunt tool, the FSA investigated, issued final notices and significant fines against Barclays Bank, UBS and RBS. On 27 June 2012, Barclays was fined £59.5 million by the FSA, as well as £102m by the US Department of Justice (“DoJ”) and £128m by the Commodity Futures Trading Commission (“CFTC”), a total of around £290m.
On 19 December 2012 UBS were fined £160 million by the FSA, £740m in combined fines to DoJ and the CFTC and £40m to the Swiss Financial Market Supervisory Authority, a total of £940million. The US Assistant Attorney General also confirmed that the US would seek the extradition of two former UBS traders criminally charged over the rigging of the LIBOR rate. On 6 February 2013 RBS was fined £87.5 million by the FSA, £100 million by the DoJ and £220 million by the CFTC, a total of £407.5 million. It is likely that fines will follow for other banks involved in rigging the LIBOR rates.
THE FSA’s reports
These contained many comments from traders in the banks. Some were lurid, some prosaic.
Barclays, FSA Final Notice dated 27th June 2012:
- “Trader B” said that the manager submitting the LIBOR rates for the bank was “the highest LIBOR of anybody […] He’s like, I think this is where it should be. I’m like, dude, you’re killing us”. Manager B instructed Trader B to: “just tell him to keep it, to put it low”. Trader B said that he had “begged” the Submitter to put in a low LIBOR submission and the Submitter had said he would “see what I can do”;
- Trader C (a US dollar Derivatives Trader) requested a “High 1m and high 3m if poss please. Have v. large 3m coming up for the next 10 days or so”. Trader C also expressed his preference that Barclays would be “kicked out” of the average calculation. Trader C’s aim was therefore that Barclays’ submissions would be high enough to be excluded from the final average calculation, which could have affected the final benchmark rate;
- Trader C stated “We have an unbelievably large set on Monday (the IMM). We need a really low 3m fix, it could potentially cost a fortune. Would really appreciate any help”;
- An exchange between Trader C and the Barclays submitter for LIBOR fixing: Trader C: “The big day has arrived…..MY NYK are screaming at me about an unchanged 3m LIBOR. As always, any help wd be greatly appreciated. What do you think you’ll go for 3m?” – Submitter: “I am going 90 altho 91 is what I should be posting” Trader C: ….when I retire and write a book about this business, your name will be written in golden letters….” – Submitter: “I would prefer this [to] not be in any book”;
- Another exchange between Trader B and the submitter:
Submitter: “ Hi, all. Just as an FYI, I will be in noon’ish on Monday….”
Trader B: “Noonish? Who’s going to put my low fixings in? hehehe”;
- In response to a request from Trader C for a high one month and low three month US dollar LIBOR submission on 16 March 2006, a Submitter responded: “For you…anything. I am going to go 78 and 92.5. It is difficult to go lower than that in threes, looking at where cash is trading. In fact, if you did not want a low one I would have gone 93 at least”;
- Trader C requested low one month and three month US dollar LIBOR submissions: “If it’s not too late low 1m and 3m would be nice, but please feel free to say “no”… Coffees will be coming your way either way, just to say thank you for your help in the past few weeks”. A Submitter responded “Done…for you big boy”;
- A submitter responded to Trader E’s request for EURIBOR (Euro Interbank Offered Rate) submissions “with the offer side at 2.90 and 3.05 I will input mine at 2.89 and 3.04 with you guys wanting lower fixings (normally I would be a tick above the offer side)”;
- Trader F emailed a Submitter, requesting a low three month US dollar LIBOR submission; “For Monday we are very long 3m cash here in NY and would like the setting to be set as low as possible…thanks”. The Submitter instructed another Submitter to accommodate the request; “You heard the man” and confirmed to Trader F “[X] will take notice of what you say about a low 3 month”. Two seconds later, that Submitter sent himself an electronic calendar reminder to make a low three month submission: “USD 3mth LIBOR DOWN”;
- An external trader made a request for a lower three month US dollar LIBOR submission. The external trader stated in an email to Trader G at Barclays “If it comes in unchanged I’m a dead man”. Trader G responded that he would “have a chat”. Barclays’ submission on that day for three month US dollar LIBOR was half a basis point lower than the day before. The external trader thanked Trader G for Barclays’ LIBOR submission later that day: “Dude. I owe you big time! Come over one day after work and I’m opening a bottle of Bollinger”;
- Trader E stated in an instant message with a trader at Panel Bank 6: “if you know how to keep a secret I’ll bring you in on it …
we’re going to push the cash downwards on the imm day … if you breathe a word of this I’m not telling you anything else … I know my treasury’s firepower…which will push the cash downwards …please keep it to yourself otherwise it won’t work”. Trader E commented to the external trader at Panel Bank 6 “this is the way you pull off deals like this chicken, don’t talk about it too much, 2 months of preparation … the trick is you must not do this alone …. this is between you and me but really don’t tell ANYBODY”. On the same day, Trader D stated in an instant message to an external trader “look at the games in EURIBOR today …. I am sure a few names made a killing”. A trader at a hedge fund communicated with Trader E, also on 19 March 2007, stating “it’s becoming dangerous to trade in 3m imms …, especially when Barclays sets the 3m very low … it does draw attention to you guys. It doesn’t look very professional”.
UBS, FSA Final Notice dated 19th December 2012
- In a telephone conversation on 18 September 2008, Trader A explained to Broker A of Broker Firm A: “if you keep 6s [i.e. the six month JPY LIBOR rate] unchanged today… I will fucking do one humongous deal with you … Like a 50, 000 buck deal, whatever. I need you to keep it as low as possible … if you do that … I’ll pay you, you know, 50,000 dollars, 100,000 dollars … whatever you want … I’m a man of my word”. In the period 19 September 2008 to 25 August 2009, Trader A and another Trader entered into nine “wash trades”, an illegal form of stock manipulation in which an investor simultaneously sells and buys shares in order to artificially increase trading volume and thus the stock price, or to generate artificial commissions, with Broker Firm A which generated fees of more than £170,000 to reward Broker A for his efforts on behalf of UBS. In addition, for a period of at least 18 months, UBS made additional payments to Broker Firm B of £15,000 per quarter as a reward for the provision of a “fixing service”, which were paid in addition to an existing contractual agreement for brokerage services. These payments were subsequently shared internally by a number of the Brokers at Broker Firm B, with Broker C receiving £5,000 per quarter for his particular “fixing service”;
- Trader A also asked certain Brokers to make false bids and offers (referred to as “spoofs”) on cash trades in the market in order to skew market perceptions of the rates at which cash could be borrowed or lent in the interbank market. The intention was that the JPY LIBOR submissions of Panel Banks that observed cash market rates when determining their submissions would be skewed. For example, between 7 July 2008 and 29 June 2009, false offers were discussed on the telephone by Trader A with Broker A on at least 12 occasions. In one such conversation on 27 January 2009, Broker A explained that he had been: “… offering…some cheap 3s all morning and 1 shouted them- down at [Panel Bank 3] as well…we were offering them at 50 mate… that wasn’t even true”;
- In an electronic chat on 2 February 2007, Trader A explained the aim of the 2007 campaign to an External Trader at a Panel Bank. He explained that: a. He would take trading positions that would benefit from a reduction in the spread between the three month JPY LIBOR rate and another reference rate, TONAR6, in April and May 2007; b. His efforts to date were already producing results because he was: “…mates with the cash desks, [Panel Bank 3] and I always help each other out” with the result that “3m libor is too high cause I have kept it artificially high.” and that he was currently keeping that LIBOR rate one basis point too high; and
c. In May 2007, he would manipulate three month JPY LIBOR one basis point too low;
- On 19 January 2007 in an electronic chat, Trader A asked External Trader B at Panel Bank 3 to help him obtain a high three month JPY LIBOR submission from Panel Bank 3 because he had: “absolutely massive 3m fixes”. Trader A said: “Anytime i can return the favour let me know as the guys here are pretty accommodating [sic] to me”;
- During a discussion in a public chat group with 58 participants on 25 June 2009, Trader-Submitter C openly solicited several colleagues for Internal Requests in respect of EURIBOR submissions. Later on the same day, in a private chat Manager D said to Trader-Submitter C: “JUST BE CAREFUL DUDE”. Trader-Submitter C replied: “I agree we shouldn’t have been talking about putting fixings for our positions on public chat”.
RBS, FSA Final Notice dated 6th February 2013:
- On 16 March 2009, Derivatives Trader A asked Primary Submitter B, “can we pls get a very very very low 3m and 6m fix today pls, we have rather large fixings!” Primary Submitter B responded, “Perfect, if that’s what you want.” Derivatives Trader A then responded with a thank you and further instructions, “tks …., and then from tomorrow, we need them thru the roof!!!!:)” Primary Submitter B then wrote back, “:-)” RBS’s 3 month LIBOR submissions were consistent with Derivatives Trader A’s requests on these days. In this exchange, Derivatives Trader A’s motivation for making requests to Primary Submitter B is clearly stated;
- With respect to RBS’s JPY LIBOR submission, Derivatives Trader B requested “high 3 and 6s please,” The following exchange then occurred: Trader B: can we lower our fixings today please….
Primary Submitter B: make your mind up, haha, yes no probs
Derivatives Trader B: I’m like a whores drawers;
- On 2 March 2007, Derivatives Trader D told External Trader A at Panel Bank 1, “please please low 6m fix on Monday. I have got a big fix.” External Trader A then said, “No worries.”;
- On 19 September 2008, in a series of telephone communications, Broker A and Derivatives Trader B discussed and arranged wash trades. Broker A asked Derivatives Trader B: “can you do me a favour … you’re not going to get paid any bro [brokerage] for this and we’ll send you lunch around for the whole desk. Can you flat…can you switch two years semi at 5 ¾, 100 yards…between [Panel Bank 1]. Just get …take it from [Panel Bank 1], give it back to [Panel Bank 1]. He wants to pay some bro. We won’t bro you but he wants to put …he wants to give us some bro.” Derivatives Trader B replied “yeah, yeah.” Seconds later, Broker A asked Derivatives Trader B to increase the value of the trade and Derivatives Trader B agreed. In addition, Derivatives Trader B agreed that RBS would pay Broker Firm 1 brokerage on one leg of the transaction. Later the same day, Broker A asked Derivatives Trader B if he could, “do another 100 yards? Flat switch…I know I’m pushing my luck.” The two then discussed why Broker A was making the request and Broker A responded that it was to enable a derivatives trader at another bank to pay Broker Firm 1 brokerage. Broker A then informed Derivatives Trader B that the total commission to Broker Firm 1 on these particular trades would be approximately £20,000.
Alongside the FSA investigations, in July 2012 the Chancellor of the Exchequer commissioned Martin Wheatley, then managing director of the FSA and Chief Executive-designate of the Financial Conduct Authority, to undertake a review of the framework for the setting of LIBOR.
His three key recommendations were:
- That LIBOR should be reformed rather than replaced;
- That submissions used for fixing LIBOR should be supported by transactional evidence rather than by estimates;
- That market participants should continue to play a significant role in the production and oversight of LIBOR.
He proposed a 10 point plan:
Ten point plan
- The authorities should introduce statutory regulation of administration of, and submission to, LIBOR. To implement this key reform, the Wheatley Review specifically recommended that:
- administering LIBOR and submitting to LIBOR become regulated activities under the UK Financial Services and Markets Act 2000 (Regulated Activities) Order 2001;
- the UK supports efforts in the EU to proceed swiftly with developing and implementing a new civil market abuse regime and open and transparent access to benchmarks; and
- Section 397 of the UK Financial Services and Markets Act 2000 is amended to enable the FSA to prosecute manipulation or attempted manipulation of LIBOR.
- publication of LIBOR for Australian Dollars, Canadian Dollars, Danish Kroner, New Zealand Dollars and Swedish Kronor should be discontinued;
- for remaining currencies, publication of LIBOR for 4, 5, 7, 8, 10 and 11 months tenors should be discontinued; and
- continued publication of overnight, 1 week, 2 weeks, 2 months and 9 months should also be re-considered.
So what is the position of LIBOR today, and its outlook for the future?
In the USA Gary Gensler, the chairman of the Commodity Futures Trading Commission is pushing to get rid of LIBOR entirely. He argues that it no longer really exists, assuming it ever did, and wants to find a new benchmark for floating interest rate contracts.
Britain and the European Commission appear to be determined to save LIBOR. Since April 2013 the setting of LIBOR has been a regulated activity in the UK. The European Commission is moving in the same direction, with proposals to introduce strengthened governance.
Some banks, understandably, would just as soon get out of a business that has sullied reputations and cost billions in penalties. Some have tried to resign from the panels that determine Libor and Euribor. However, European and British regulators view the existence of the benchmarks as critical and have warned banks not to leave.
“Interbank interest rate benchmarks are of systemic importance,” said Michel Barnier, the European commissioner in charge of markets. He said European legislation would force banks to submit rates.
The new British regulations, when first proposed, called for auditors to certify bank LIBOR policies every year, and allowed private lawsuits by persons or institutions who believed they had been harmed by manipulative and inaccurate LIBOR submissions. Banks complained that regular audits might cost so much that the requirement would “adversely affect the incentives for firms to participate in the benchmark.” When the regulations came out, they made a couple of important changes. Audits may be less frequent than every year. And private lawsuits would be prohibited in Britain.
Whether such suits can proceed in the rest of the world is unclear. A federal judge in New York has allowed some claims of commodity price manipulation to proceed, although she rejected others because reports of possible problems in the Libor market, starting in 2007, meant that the US statute of limitations had expired.
It is not clear whether statute of limitations issues could derail a suit filed by Freddie Mac, the US government-owned mortgage company, against the banks that set Libor and the British Bankers Association, which administered it. Freddie argued that it had entered into many contracts under which it received payments based on Libor. If the banks depressed those rates by submitting artificially low rates, as some have admitted, Freddie was harmed. It would be interesting if the courts ruled that because everyone should have known the market was fixed, those who fixed it are not liable.
Post FSA investigations, Wheatley Review and regulatory changes, the jury is still out as to whether LIBOR is now fit for purpose, or is likely to be in the future. Some banks believe that the new Basel III capital rules regarding liquidity will make it prohibitively expensive for one bank to lend to another for more than 30 days at a time. If so, there will be no such lending, making LIBOR rates beyond 1 month meaningless.
10 June 2013