LIBOR is an interest rate index reported each day by Thomson Reuters based upon the average rate of interest that certain large banks could borrow money unsecured in the London interbank market for a certain period. The procedure for setting daily LIBOR rates is governed by a subcommittee of the BBA, the Foreign Exchange and Money Markets Committee. From time to time since 1986, the procedures have changed. Today, there are ten separate currency calculations, each of which is based on voluntary submissions by a panel of banks selected for that purpose. The panels range in number from 6 participants (for setting rates in Swedish and Danish currencies) to 18 (for setting rates in US dollars). The participant banks are the large New York and London ‘money center’ banks, with the largest London banks on most or all panels. And, for each currency, rates are set for 15 different maturities, ranging from one day to one year.
As an interest rate index it is used in many commercial and consumer loan products. The rate was initially developed in the early 1980’s by the British Bankers Association as an impartial means of determining the rate at which banks could borrow from each other. The popularity of the rate grew over time and it is now used not only in loan products but also financial derivatives such as interest rate swaps and exchange traded interest rate contracts. To put this in perspective, the notional amount of interest rate derivatives contracts is somewhere above $500 trillion.
The rate is based upon a survey of the world’s largest banks, and is based upon an average of the rates submitted. For example, if 18 banks contribute information the rate will be based upon only 10 contributors with the highest four rates and the lowest four being tossed out. Prior to 1998 the rates sent in by contributors were based upon the following question: “At what rate do you think interbank term deposits will be offered by one prime bank to another prime bank for a reasonable market size today at 11am?” The definition was changed in 1998 due to concern over whether it was possible to define what a “prime bank” was and the fact that the rate was somewhat hypothetical. The current question is formulated as follows: “At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?”
When you look at both definitions one thing jumps out-neither definition was based on actual borrowings. This is based on the simple fact that a bank’s borrowing needs will vary from day to day and during any particular time period it may not have a need for credit for a certain maturity or currency. Bank’s are generally aware, however, of what rates they would be able to borrow if they were to go into the market. There is also an assumption that the submitting banks will provide accurate information that is not tainted by conflicts of interest. The rates themselves are an indication of the rates being charged, the contributors to the index (the BBA reviews the list on a regular basis) and overall liquidity. As noted above, the index is used in various financial contracts affecting millions of individuals and businesses around the world. Individuals and businesses have made payments on loans and paid termination fees under derivatives contracts based upon the then current LIBOR rate.
What happened at Barclays Bank? Commencing as early as 2005, Barclays began reporting LIBOR rates based upon requests by its own derivatives traders. In effect the traders were seeking to profit from Barclays’ reported rates. In the Final Notice filed by the British Financial Services Authority (“FSA”) describing the imposition of fines against Barclays, it noted that at least 14 traders, including senior personnel, made requests to the “submitters” of the rates. On occasion the request was that the submitter send in a rate that would be so high or low as to get it kicked out in the calculations by Thomson Reuters. Examples from the FSA Final Notice include the following:
(i) 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”;
(ii) Trader B explained “I really need a very very low 3m fixing on Monday – preferably we get kicked out. We have about 80 yards [billion] fixing for the desk and each 0.1 [one basis point] lower in the fix is a huge help for us. So 4.90 or lower would be fantastic”. Trader B also indicated his preference that Barclays would be kicked out of the average calculation; and
(iii) On Monday, 13 March 2006, the following email exchange took place:
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!”
The FSA determined that the Barclays traders also sought to influence rates by coordinating with traders at other institutions and seeking to have the other traders affect the rates submitted by their institutions. A sample conversation was as follows:
“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”.
Barclays continued to provide inaccurate submissions once the financial meltdown commenced in 2007 and 2008. Senior management was found to have instructed junior managers to reduce the rates being submitted in order to avoid potential negative coverage. As with any other interest rate, the rate others are willing to lend you money at are premised upon the amount of risk the lender believes is imbedded in the transactions. A higher risk borrower pays a higher interest rate. Many financial institutions were concerned during this period about the perception that submitting a high rate would send to the broader market, particularly following the failure of Lehman Brothers, RBS and Northern Rock. Barclays became concerned about articles such as one published by Bloomberg where it asked “what the hell is happening at Barclays and its Barclays Capital securities unit that is prompting its peers to charge it premium interest rates in the money market?” As a result of pressure from senior management the submitters began quoting lower rates.
Barclays agreed to settle civil charges against it with the US Justice Department, the Commodities Futures Trading Commission and the British Financial Services Authority for an amount totaling over $451 million.
Government authorities are still in the early stages of the complete investigation into the manipulation of LIBOR. The evidence cited by the FSA about conversations by traders with traders at other banks will most assuredly lead to investigations and charges against other banks and individuals. Lanny Breuer, head of the US Justice Department’s criminal division, stated when the settlement was announced that Barclays had assisted the division in its “ongoing investigation of individuals and other financial institutions in this matter.” Civil litigation has already commenced with Charles Schwab having already filed a suit against the banks that submit information for LIBOR alleging RICO and antitrust violations. Schwab alleged that the bank defendants conspired to artificially depress LIBOR as a means to pay lower interest rates on interest-bearing financial instruments and securities paying return based on, tied to or indexed to LIBOR that the defendants sold to investors. Other civil cases are expected to be filed by various parties, possibly including state attorney generals as well as municipalities. Many people will have been affected in one way or the other by manipulation of LIBOR but some parties may find that perceived damages in one area such as a lower return on certain investments were offset by payment of lower interest rates on instrument they issued during the same time period.
Where does LIBOR go from here? There have been a number of proposals floated, including some by Timothy Geithner when he was head of the NY Fed, that would serve to establish a more credible reporting procedure. Increased transparency and procedures to prevent intentional misreporting that would be overseen by internal and external auditors would certain be a good first step. Certainly, at a bare minimum, any financial institution that is involved in submitting rates should establish an information wall between the area of the institution that does the submitting and the derivatives traders at the same institution. Likewise, broadening the panel of banks that submit rates can minimize the risk of manipulation. As a practical matter, it is unlikely that LIBOR could simply be replaced in any meaningful way in a short period of time due to the immense number of loan and financial products that use the index. While many documents might allow for the substitution of a comparable index, obtaining the consent of all of the major players to a substitute index would be a daunting task and thus a better, more transparent, LIBOR is likely to be the outcome.