What Is LIBOR Rigging? Why Should You Care?

By The Banker | Blog Posts, Wall Street
9 Jul 2012
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What is LIBOR Rigging? 

LIBOR, which stands for London Interbank Offered Rate, is defined as the average benchmark interest rate at which the world’s 16 most important money-center banks willingly lend money to one other for a period of time, with the most frequently quoted time periods being 1 day, 1 month, 3months, or 6 months.  The British Bankers Association[1] determines LIBOR daily (and this is important for understanding the rigging process engaged in by Barclays traders) by surveying the Treasury departments of the world’s biggest banks about what rate they pay to borrow money from other banks, and then by taking an average of their answers.

LIBOR is the most important financial benchmark interest rate for trillions of dollars in lending.  While the US Federal Reserve sets an individual benchmark interest rate in the US through overnight lending to US Banks, the Fed cannot determine at what rate most of the world’s banks and largest companies lend to one another.  LIBOR sets the standard rate for that type of interbank lending, as well as the standard rates for swaps trading.    It’s a mostly invisible (to the average citizen) piece of financial architecture underlying, frankly, almost every major lending transaction in the world.  If you can effectively manipulate LIBOR, you can end up shifting billions of dollars from one bank to the other.[2]

Barclays got fined for evidence of LIBOR-rigging in the 2005 to 2007 time period, when the bank evidently submitted lower interest rate quotes than other surveyed banks.

Barclays paid their $453 million fine based on electronic message records evidence[3] that its Treasury officials cooperated with its trading desk in reporting a LIBOR rate lower than its actually borrowing rates between it and other banks.  While we do not know precisely the reason Barclay’s Treasury department cooperated in a scheme to report artificially lower borrowing rates to its trading department, the obvious presumption is that somebody’s profit and loss in the trading department was extremely vulnerable to a rise in LIBOR rates.  Trading desks with LIBOR-dependent positions could be caught wrong-footed in a fast-moving interest rate environment, and a little help in keeping LIBOR nice and low at a certain level for a certain amount of time until the desk could unwind its position could have meant saving someone’s career or annual bonus.[4]

LIBOR’s survey and averaging method for determining rates is meant to avoid rate-rigging like this.  The only way in which Barclay’s cheating could work systematically would be if the trading desk had access to people willing to cheat at other major banks.  Therefore the interesting question of the Barclays situation is if regulators can find evidence of widespread cooperation from other banks’ Treasury departments, which of course regulators are trying to do, with investigations ongoing at a dozen of the world’s largest banks.

In the larger sense LIBOR represented, up until recently, a successful self-regulating mechanism between banks.  Self-regulation only works if participants as well as regulators feel comfortable that the system works as advertised and cannot be captured by cheaters.

What’s really interesting and ironic about the Barclays situation is that by the time the Credit Crunch of 2008 got fully underway, Barclays reported higher rates than its peers, in what’s assumed to be an honest reflection of its actual borrowing costs, which should have been lower on average than its peers because of its relatively strong financial condition.  In other words, the other 15 LIBOR survey banks, on average, lied to appear more credit worthy than they really were.

In fact, Barclay’s head Bob Diamond complained in 2008 to the Bank of England that its competitors appeared to be reporting artificially low borrowing rates, which they likely would have done to mask the fact that they were having financial difficulties in borrowing from fellow banks.  A number of commentators pointed out (e.g. here  here and here) at the time that LIBOR had ceased working in 2008 as a reliable benchmark.  Barclays was one of the good guys at the time, while shakier banks ceased cooperating appropriately, ie. telling the truth.

Barclays’ outlier status in reporting higher than average rates attracted attention from Paul Tucker, a Bank of England official[5], who suggested directly to Bob Diamond’s deputy Jerry del Missier that the Bank of England would appreciate lower reported borrowing rates from Barclays.  Lower rates, presumably, would help signal financial calm, as well as keep costs low for financial institutions, during a time of crisis.

The problem with a nudge like that is that manipulation from the Bank of England is just like trading desk manipulation, and it undermines the financial architecture in just the same way.

Again I’m speculating a bit, but Diamond appears to have made sure that particular Bank of England nudge got released to the press in advance of his fall last week, possibly in a misguided attempt to show UK regulators that they were the ones complicit in the breakdown of LIBOR during the 2008 time period, not Barclays.  Regulators and central bank officials do not appreciate being exposed as manipulative liars, so expect the blame-Bob-Diamond excitement to get full-throated support from a number of UK central bank and regulator sources.

Market participants have long known that LIBOR manipulation was rampant in the lead-up and during the Credit Crunch of 2008.  Central bankers also knew.  The self-regulating process of LIBOR, indeed the entire money market system, ceased working in 2008.  One Federal Reserve friend of mine told me in late 2008 that the interbank borrowing market (of which LIBOR is a major part) was completely frozen, and that in the US, only the dramatic intervention of the Federal Reserve[6] kept up the illusion at that time that money could properly flow between financial institutions.

Only central bankers could keep the system afloat.  Some of this intervention, we sort of know from the Bob Diamond strategic release, took the form of subtly encouraging banks to lie on their LIBOR surveys.  Other interventions came in more straightforward ways such as the unprecedented financing by the Federal Reserve of dodgy collateral. [7]

What I mean by this last point is that the central banks and regulators of the US and the UK grossly manipulated money markets regularly to hide the true financial weakness of a number of financial institutions.  Bank of America and Citigroup, to take two easy examples, should have disappeared long ago if not for the money market sleight-of-hand via:

1. The Federal Reserve providing unlimited and nearly free funding to Too Big To Fail Banks.  This it continues to do.

2. Treasury providing equity capital unavailable from the market.  This has now been paid back by Citigroup and Bank of America, but they were the last ones to do so, of  the big US Banks.

3. Frequent waivers and special treatment in the past 4 years on unmet reserve requirements.

Why do I care when this happens?  I care because tens of thousands of private individuals reap the benefits of this thumb on the scale by regulators, while the public at large remained on the hook for the liabilities.  Just as a LIBOR manipulation shifts the economics of a swap from one counterparty to another, bank bailouts shift the economics of the banking sector from a one group of losers to another group of winners, and not necessarily in a fair or transparent way.

I really do not know what to make of the “LIBOR scandal,” except that I’m torn in a few directions.

On the one hand, clearly, lying and cheating on a key market survey is bad.  Especially by traders who need a lie to fix their Profit & Loss statements and save their bonus.  Barclays got punished, and their CEO resigned, as is just.

On the other hand, the hand-wringing and heavy sighing from regulators and commentators over the ‘Barclays LIBOR scandal’ misses the big picture about all the folks who manipulated money markets in the Credit Crunch of 2008, and when, and why.  When traders distort money markets, that’s manipulation.  When regulators and central banks distort money markets to pick winners and losers, that’s just good policy?  I don’t know.  It’s not so clear to me.



[1] This is a self-regulating trade association representing approximately 250 of the world’s largest banks.  It is most famous for organizing LIBOR, in cooperation with media company Thompson Reuters, but it also advocates on policy issues on behalf of its member banks.

[2] I’m sticking an example of why this is so in the footnotes as it can get a bit technical.  LIBOR gets quoted in % terms as an interest rate.  A simple interest rate swap could go as follows:  For a period of 10 years, Counterparty A agrees to pay Counterparty B a fixed rate of 3.25% of $1Billion, in exchange for Counterparty B agreeing to pay a variable rate of 6month LIBOR +0.25% (in my example, to keep the math simple, I’ll quote 6month LIBOR at 3% to start).  At the outset of the trade, each counterpart owes each other $3.25 million per year, so the trade is done ‘at the market.’  Over time, A will always owe $3.25MM per year, but B’s payment amount resets every 6 months, as 6month LIBOR will change over the course of 10 years.  Market conditions will ordinarily shift 6 month LIBOR over time, which makes the trade economically favorable for A or B over time.  If at some point, through manipulation, 6month LIBOR could be artificially lowered by, say, 0.05% for a year, then B would owe $500,000 less in that year.  When you consider the $ Trillions in notional interbank lending and derivatives trading, it’s clearer how small changes in LIBOR drastically alter the economics of trades for counterparts.  Market participants only agree to use a benchmark interest rate like LIBOR if they believe it is not open to systemic manipulation.

[3] Traders, seriously, why are you writing this down?  The first thing you’re taught in week one of trading class is to write down nothing of consequence.

[4] A typical trading desk could have hundreds, or in the case of a major broker-dealer like Barclays, thousands of LIBOR-dependent swap/derivative positions at any one time, many of which will be off-setting one another.  I’m in the realm of speculation now, but a trading desk with heavy exposure to a particular LIBOR reading (one that would involve asking for a little cheating help from one’s own Treasury dept) probably is not looking for a long period of market manipulation, but rather just a short-term fix until risk can be reduced, or an offsetting swap trade can be put on the books.  If Barclays’ trading desk felt overexposed by a lumpy $10 Billion trade and could get an improvement of just 0.01% in the LIBOR rate from its Treasury dept, that’s a million dollars saved right there.

[5] Up until recently thought to be next in line as the Head of the Bank of England

[6] in ways largely hidden from view

[7] As in the case of the Bear Stearns shotgun marriage to JP Morgan, the AIG bailout, and the Merrill Lynch shotgun marriage to Bank of America.  The Federal Reserve and the US Treasury took on extraordinary risk on behalf of the currency and US Taxpayer respectively in order to keep up an artificial illusion of bank financial health, similar to the LIBOR manipulation by the Bank of England.  When these financial institutions, surviving under essentially false pretenses, paid bonuses to their employees, no central bankers or regulator intervened.  I find this behavior unforgiveable.

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10 Comments

  1. Sam Opitz says:

    Bravo! Once again, a refreshingly balanced and fair accounting of a widely misunderstood and politically misappropriated ‘scandal.’

    What this posting does so much better than either mainstream media or politicized media is break down what are perceived to be overly complex issues so the reader can understand what happened/how it works, and then goes on to explain the implications.

    What I hope will also emerge a fairly weighted accounting of BOE’s role. It reminds me a little of how certain healthy banks here were strongly nudged by Fed and/or UST in 2008/2009 to take ‘bailout’ money they didn’t need. Different issue, different actors, but, in my view, not enough said about Govt intervention/manipulation which can be equally powerful/destructive.

    Keep up the good work!

  2. The Banker says:

    Sam, thanks for your commentary. I agree that the Fed/USTreasury bailout situation rhymes quite a bit with the BOE nudges. At the very least, both the BOE in the UK and the FED/US Treasury in the US are conflicted, when it comes to fair and transparent money markets. They care at least as much about stability as they do about transparency and proper functioning markets. In their rush for stability (at times, admittedly, needed) they compromised on the transparency and fairness that market participants would prefer. Also, The Economist has a good take today on this inherent conflict.

  3. hikedinNH says:

    Hi Banker. One of Andrew Sullivan’s readers compares reactions to the LIBOR scandal in the UK (“shock and outrage”) and US (“verges on a colossal shrugging of the shoulders”). What’s your take on this?

    http://andrewsullivan.thedailybeast.com/2012/07/america-britain-and-the-libor-scandal.html

  4. The Banker says:

    hiked,
    Thanks for posing a good question…

    The reader’s response in that link to the Daily Beast is that in the US, our elites and the public have basically shrugged off the LIBOR scandal, while in the UK their leadership and public has gotten very appropriately upset.

    It is a bigger deal there (so far), but I think that can be explained without a resort to “the UK is a proper parliamentary democracy while the US is a society with impunity for elites.” (my paraphrase of the reader’s response)

    A few reasons why the LIBOR rigging is bigger there (so far):
    1. Barclays is a much bigger brand there. Barclays traditionally hasn’t had a big US footprint until recently, when they acquired Lehman’s operations out of bankruptcy. But the US public mostly hadn’t heard of Barclays until last week.
    2. Our officials don’t know what LIBOR is. Embarrassing, but true. And the general public hadn’t heard of it either until last week.
    3. Libor is based in London and administered by the BBA (British Banking Association), so it feels more like their thing than our thing, so far.

    In addition, not acknowledged by the writer (or generally known) is that the majority of the fines paid by Barclays last month forLIBOR rigging were imposed by US regulators. The UK press in fact was wringing its hands last week about the fact the UK is comparatively weak when it comes to punishing/regulating its financial industry, and that it took US regulators to really come down hard on Barclays.

    Also interesting about the US/UK comparisons is that departed CEO Bob Diamond is an American, and therefore has been under greater scrutiny by the UK public as a representative of a perceived nasty US style capitalism at the head of one of their historic/storied banks.

    I do admire his resignation and taking responsibility, and his forgoing of both bonus pay as well as severance pay. I agree few US-based CEOs would do the same. In fact I can’t really think of a recent example of a CEO who fell on his sword so honorably.

    While I think the LIBOR scandal is a BFD, and may become a bigger BFD if regulators find evidence of multiple banks involved in rate rigging (a dozen investigations are underway, and no doubt they would love to find something!)

    I disagree with one other point made by the Daily Beast writer…Specifically, I would argue that Eliot Spitzer was a grandstanding bully who did a great disservice to New York State as Attorney General in his financial investigations. And that was all before he was exposed as a cheating hypocrite as Governor.

  5. Michael_in_NY says:

    Excellent post! Some scary stuff going on out there… And admittedly being a perpetual bear, would love your take on Roubini’s latest prediction on catastrophe, where he says that the 2013 financial chaos may surpass the 2008 crisis: http://www.bloomberg.com/video/roubini-says-2013-storm-may-surpass-2008-crisis-HCAjTp9VTD~gm6Ux8jnQvQ.html

  6. The Banker says:

    An astute reader has pointed out that my statement above that “US officials don’t understand LIBOR” is at odds with the fact that Barclays paid $200 million to the US Department of Justice, and another $160 million to the US Commodities regulator, the CFTC. I agree those officials do understand LiBOR. I should have clarified that. Mostly I think US politicians do not understand LIBOR and they have not had to learn because their constituents do not understand it either.

  7. The Banker says:

    Michael_in_NY,
    Thanks for your post…I like Roubini’s commentary to the extent that he’s a good antidote to the typical bullish shill on TV. I also think he’s right on in that the TBTF bank issue has not gotten appreciably better in the last 4 years, so we should be very nervous about the next financial calamity.
    On the other hand, as an investor, I don’t find Roubini’s “The sky is falling! Again! and Again! and Again!” sufficiently adjusted to evolving situations. I enjoy his bearish perspective because it helps cut through the over-bullishness of other commentators, but I wouldn’t invest according to his views.
    I also think Roubini’s guilty of sensationalizing financial situations. Of course, I’m also jealous of the attention he gets, so maybe I should learn to sensationalize financial situations more.

  8. HF_Manager says:

    Very well written.

  9. David says:

    ‘When traders distort money markets, that’s manipulation. When regulators and central banks distort money markets to pick winners and losers, that’s just good policy?’

    The difference is pretty clear, actually. Traders distort markets for personal or corporate profit. Regulators and central banks distort markets for the benefit of the general public. That’s the theory anyway. As a lefty outsider, it looks to me like regulators and central banks work to protect banks in general – the ‘corporate socialism’ that so many complain of.

    • The Banker says:

      @David I absolutely agree with your distinction, and in the best case we can trust the public good is foremost in the minds of the regulators and central banks. But like you I worry that regulators may be captured by banks, rather than sufficiently independent. I assume self-interest when it comes from traders, but I’m troubled by self-interest [or a milder version, which may be better described as opaque interest] when it comes from regulators.

      Today’s news provides evidence of one of the factors which increases opacity…the revolving door between regulators and the regulated: http://www.huffingtonpost.com/2012/07/12/andrew-williams-goldman-sachs_n_1669021.html

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