Dec 20 2012

LIBOR Part 1

For the past week news has been exploding out of the London Inter Bank Offered Rate fraud.

LIBOR is (supposedly) the interest rate a small group of very large London Banks charged each other for short term (overnight or 24 hour) loans to each other.  This number was not constant from day to day or even from institution to institution, for instance Peter Bank might loan Paul Bank X amount at a rate of Y while John Bank might loan W amount at a rate of Z.  Paul Bank might accept a loan from either Peter Bank or John Bank with no particular preference for the lowest cost and no actual transaction might take place at all.

These ‘potential’ trades were reported to the British Bankers Association who sampled and normalized them to come up with a number, LIBOR, that allegedly represented the typical cost of money to the most credit worthy companies.

Since all other companies were, by definition, less credit worthy their cost for borrowing was higher and frequently formalized in contracts for actual loans as LIBOR + some amount that represented how much less credit worthy (riskier) they were.

Fair enough.

But it doesn’t stop with loans, LIBOR + risk was used to value many other financial products including pretty fancy and complicated derivatives and foreign exchange transactions.  The problem was that LIBOR was not only as entirely fictional as I am, but it was also thoroughly corrupt with the divisions of the Banks in charge of providing the data on which it was based co-operating to manipulate the value to benefit their own transactions in ways that are not obviously transparent.

It’s easy to understand how in the dark days of the financial crisis Banks liked to pretend they were more solvent and credit worthy than they actually were, but it had been commonly calculated fraudulently for years before that.

Some details of this practice are now emerging in a series of regulators’ reports, settlements, and (as unlikely as it seems) prosecutions.

Bloomberg News pursued these documents through reporting and public information requests and published an article last week that attracted a lot of attention.  It’s kind of long so I’ve excerpted a small portion below.  The title is Secret Libor Transcripts Expose Trader Rate-Manipulation but the URL says “Rigged LIBOR With Police Nearby Shows Flaw Of Light Touch”.  The “Police Nearby” simply refers to the fact that one of the most notorious trading desks where this crime occured happened to be very close to a police station.  Of more significance is “Shows Flaw Of Light Touch” which is a regulatory strategy advocated by Alan Greenspan and other Chicago School economists who argued that actual government supervision of the operations of these very large Banks wasn’t necessary because honesty could be assumed since according to their now discredited theories there was no advantage in cheating.

Secret Libor Transcripts Expose Trader Rate-Manipulation

By Liam Vaughan & Gavin Finch, Bloomberg

Dec 13, 2012 11:01 AM ET

For years, traders at RBS, Barclays Plc (BARC), UBS AG (UBSN), Deutsche Bank AG (DBK), Rabobank Groep and other firms that stood to profit worked with employees responsible for setting the benchmark to rig the price of money, according to documents obtained by Bloomberg and interviews with two dozen current and former traders, lawyers and regulators. Those interviews reveal how the manipulation flourished for years, even after bank supervisors were made aware of the system’s flaws.

The conspiracy wasn’t confined to low-level employees. Senior managers at RBS, Britain’s largest publicly owned lender, knew banks were systematically rigging Libor as early as August 2007, transcripts of phone conversations obtained by Bloomberg show. Some traders colluded with counterparts at other banks to boost profits from interest-rate futures by aligning their submissions. Members of the close-knit group knew each other from working at the same firms or going on trips organized by interdealer brokers such as ICAP Plc (IAP) to Chamonix, a French ski resort, or the Monaco Grand Prix.

“We will never know the amounts of money involved, but it has to be the biggest financial fraud of all time,” said Adrian Blundell-Wignall, a special adviser to the secretary general of the Organization for Economic Cooperation and Development in Paris. “Libor is the basis for calculating practically every derivative known to man.”

Libor is calculated daily through a survey of banks asking how much it costs them to borrow in different currencies for various durations. Because it’s based on estimates rather than actual trade data, the process relies on the honesty of participants. Instead, derivatives traders at banks around the world sought to influence their firms’ Libor submissions and managers sometimes condoned the practice, according to documents and transcripts of instant messages obtained by Bloomberg.

“Through all of my experience, what I never contemplated was that there were bankers who would purposely misrepresent facts to banking authorities,” Alan Greenspan, chairman of the U.S. Federal Reserve from 1987 to 2006, said in a phone interview. “You were honor-bound to report accurately, and it never entered my mind that, aside from a fringe element, it would be otherwise. I was wrong.”

Sheila Bair, a former acting chairman of the U.S. Commodity Futures Trading Commission and chairman of the Federal Deposit Insurance Corp. from 2006 to 2011, said the scope of the scandal points to the flaws of light-touch regulation.

“When a bank can benefit financially from doing the wrong thing, it generally will,” Bair said in an interview. “The extent of the Libor manipulation was eye-popping.”

In 1997, the Chicago Mercantile Exchange switched the rate used in pricing Eurodollar futures contracts to Libor, solidifying its position as the principal benchmark for the swaps market, which by June 2012 had a notional value of $639 trillion, according to the Bank for International Settlements.

That decision created a temptation for swaps traders to game Libor, particularly in the days before International Money Market or IMM dates, when three-month Eurodollar futures settle. The value of traders’ positions, often billions of dollars, was affected by where the dollar Libor rate was set on the third Wednesdays of March, June, September and December.

The manipulation of Libor was discussed openly at banks.

It didn’t take a conspiracy involving large numbers of traders at different firms to move the rate. By nudging their submissions, traders at a single bank could influence where Libor was fixed. Even inputting a rate too high to be included could push up the final figure by sending a previously excluded entry back into the pack. A move in Libor of less than 1 basis point, or one-hundredth of a percentage point, could be valuable for traders managing billions of dollars in swaps.

“If you have a system like Libor, where highly subjective quotes are built into the process, you have a lot of opportunity for manipulation,” said Andrew Verstein, a lecturer at Yale Law School in New Haven, Connecticut, and co-author of a paper on Libor rigging to be published in the Winter 2013 issue of the Yale Journal on Regulation. “You don’t need a cartel to make Libor manipulation work for you. It certainly wouldn’t hurt, but it didn’t have to happen.”

At UBS, Deutsche Bank, Barclays, Rabobank, RBS and JPMorgan Chase & Co. (JPM), rate-setters were given no training or guidelines for making submissions, according to former employees who asked not to be identified because investigations are continuing. At RBS and Frankfurt-based Deutsche Bank, derivatives traders on occasion made their firm’s submissions, they said. Spokesmen for all the banks declined to comment.

By failing to act, regulators allowed rate-rigging to continue over the next two years. At RBS, the abuse was most pronounced from 2008 until late 2010, according to people close to the bank’s internal probe. At Barclays, manipulation continued until the second half of 2009. Japan’s financial services agency banned Citigroup from trading derivatives linked to Libor and Tibor for two weeks in January in punishment for wrongdoing that started in December 2009.

The settlement revealed how widespread the manipulation was. The bank’s derivatives traders made 257 requests for U.S. dollar Libor, yen Libor and Euribor submissions between January 2005 and June 2009, according to the settlement. The requests for U.S. dollar Libor were granted about 70 percent of the time.

The extent of the rate-rigging surprised Martin Taylor, Barclays’s CEO from 1994 to 1998.

“Pretty much anything you could do to increase the revenue of your organization appeared legitimate,” Taylor said in an interview. “Here was the market doing something blatantly dishonest. I never imagined that people in the financial markets were saints, but you expect some moral standards.”

In the final chapter of his report, published in September, Wheatley said Libor wasn’t the only rate vulnerable to abuse. Two months later, the U.K.’s $480 billion gas market came under the spotlight for alleged manipulation after a journalist at the ICIS price agency reported deals he suspected were being done below “prevailing” levels. UBS and RBS suspended four traders in Singapore for rigging benchmarks used to set prices on foreign-exchange contracts.

“Libor is just the beginning,” said Rosa Abrantes-Metz, an economist with New York-based consulting firm Global Economics Group Inc., an associate professor at New York University’s Stern School of Business and co-author of “Libor Manipulation?” a paper published in August 2008. “Regulators are carrying out a general review of dozens of benchmarks around the world” and most have problems similar to Libor, she said.

1 comment

  1. ek hornbeck

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