What Is LIBOR Rigging? Why Should You Care?

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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