Barclays' recent admission to manipulating Libor elevated the debate about this once obscure but widely used benchmark interest rate. We explore the origins of Libor – why it was created and by whom – and discuss why its structural flaws left it vulnerable to possible wrongdoing.
What is Libor?
The London Interbank Offered Rate (Libor) was launched in the mid-1980s under the auspices of the British Bankers Association (BBA) in an effort to establish a new standardized interest rate calculation. In the years since, Libor has evolved and has come to serve both as an indicator of interest rates at which banks are willing to lend each other money on a short-term basis and as a leading benchmark against a variety of other interest rates – including interest rate swaps, corporate loans, credit cards and some mortgages, are pegged.
The dual role that emerged for Libor carried the potential to create a conflict of interests within Libor panelist banks because of the amount of money that could be made by knowing the direction of Libor. The same banks that help determine the rate for interbank lending also have trading desks that could benefit from knowing where Libor will settle.
Good faith and guessing: How Libor calculations are supposed to work
Libor rates are calculated by Thomson Reuters on behalf of BBA, based on daily quotes received from participating banks. Libor rates are produced for 10 currencies with 15 maturities, ranging from overnight to 12 months, quoted for each currency, producing 150 rates each business day. Thomas Reuters publishes the rates in the press, the wire services and online.
This is how it's supposed to work: Each cash desk in a Libor contributor bank has a Thomson Reuters application that allows that institution to confidentially submit rates. Every contributor bank is asked to base their submissions on the following question: "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 a.m. GMT?"
The number of banks contributing to the process varies according to the currency, although there is no requirement to be in London or to be a member of the BBA. The contributing banks are selected on the basis of their scale of market activity, credit rating and perceived expertise in the currency concerned. The BBA maintains a reference panel for each currency between six and 18 contributor banks with the euro panel composed of 15 banks, the sterling panel of 16 banks, and the US dollar panel of 18 banks.
In an effort to eliminate outliers, every Libor rate is calculated using a trimmed arithmetic mean which excludes the highest and lowest 25% of submissions. For example, the US dollar panel rates would be calculated based on the rates submitted by the 18 contributors with the four highest rates and the four lowest rates removed from the calculation resulting in a simple average of the remaining 10 contributors. The result of this process is the quoted Libor rate.
This process is repeated for every currency and maturity on every business day.
An imperfect benchmark: What Libor is and what it is not
The description of the process above is meant to highlight what Libor is and what it is not. Libor was created by a trade group. It is not set or supervised by a regulatory agency, nor is it an interest rate set by the central bank. As indicated by the submission question, Libor is based on a self-reported hypothetical. It's a guess, it may even be a very good guess, but it is not based on actual transactions or public data. Interestingly, this is to some extent by design, as the BBA has indicated "not all banks will require funds in marketable size each day in each of the currencies/maturities they quote and it would not be feasible to create a suite of Libor rates if this [actual transactions] was a requirement."1 This is especially true, in a post-Lehman financial world in which interbank lending practically froze.
What emerges from these observations is a picture of an imperfect benchmark, in some ways a relic of a financial world that has evolved tremendously from when the Libor was first introduced. It is an instrument that was initially meant to bring consistency and harmonization to lending among banks, but has since come to underpin more than $800 trillion in securities and loans that are linked to the Libor, including $350 trillion in swaps and $10 trillion in loans.2
The Scandal: Barclays Admits to Manipulating the Libor Process
An extensive investigation by authorities concluded that Barclays manipulated the vulnerabilities of the system by rigging its submission for the US dollar Libor rate over an extended period of time. Specifically, the investigation identified three types of wrongdoing.
First, between 2005 and 2007 and then occasionally thereafter through 2009, certain Barclays traders requested that the Barclays Libor submitters contribute rates that would benefit the financial positions held by those traders, since small daily moves up and down in the Libor rate can cause derivatives traders to lose or profit tremendously.
Second, between August 2005 and May 2008, certain Barclays traders communicated with traders at other financial institutions, including other banks on the Libor panels, to request submissions that would be favorable to their or their counterparts' trading positions.
Third, during the depths of the 2007-09 financial crisis Barclays artificially lowered its Libor submissions to improve market perception of its financial health. According to The Economist, "in terms of the scale of manipulation, this appears to have been far more egregious—at least in terms of the numbers. Almost all the banks in the Libor panels were submitting rates that may have been 30-40 basis points too low on average."3 Having said that, submitted Libor rates across other panelist banks were also conspicuously low on average during this period despite the difficult credit and liquidity conditions following the bankruptcy of Bear Sterns and Lehman Brothers.
On June 27 Barclays admitted to misconduct in regards to their submission of Libor rates and were fined €59.5 million by the UK Financial Services Authority, €102 million by the U.S. Department of Justice and €128 million by the Commodity Futures Trading Commission for a total of approximately €290 million. The fines and investigations have also resulted in the resignation of Barclays Chief Executive Officer Bob Diamond and the Chief Operating Officer Jerry del Missier.4
Now what? The good, the bad and the ugly, but not in that order
- The ugly: Some market observers are referring to the Libor scandal as the UK's "Lehman moment" or as the financial sector's "tobacco moment". What do they mean? In part, they are referring to the civil lawsuits and settlements that Libor panelist banks or even the BBA could potentially face going forward. But they are also suggesting that this is another watershed event which could further undermine confidence and credibility in the financial sector. Moreover, there's a concern that regulators will squander rather than seize this opportunity – one that they have been seeking for a while – to reform and improve Libor as a benchmark. As reiterated by the International Monetary Fund (IMF) "The most serious consequence of this scandal, which is under investigation, is that it undermines the certainty and the trust that markets have in benchmarks that are used to price many contracts. But it also underscores the importance of regulatory reform."5
- The bad: In the aftermath of the Barclays admission, investigations are widening into wrongdoing by other panelist banks, including Bank of Tokyo-Mitsubishi UFJ, Citigroup, Credit Suisse, HSBC, JPMorgan, RBS and UBS. Financial regulators, including in the US, Canada, European Union and Japan have initialized probes into potential manipulations of Libor, so this scandal is not likely to go away anytime soon.
- The good: The investigations into Libor fixings have reasonably raised questions related to its credibility and appropriateness as a benchmark rate. Criticism has been building and had largely focused on the imperfections described above and in particular the absence of any transactions underlying the rate submissions compared to other rates where transactions do take place. However, surveyed submissions can still be credible and Libor's strengths come from the high-frequency of reporting, the transparent methodology of calculation and the publication of every contributor's rates individually.6 Further, Libor is a rate which should reflect term and credit premiums not just interest rate expectations from Overnight Index Swap (OIS) contracts that are based on an overnight rate, the Fed Funds Effective rate. Finally, initial indications are that Libor fixings were generally close to officially published rates for actual traded instruments such as Certificate of Deposit (CD) and Commercial Paper (CP) rates, although a notable exception is found in the aftermath of the Lehman Brothers collapse.
Regardless, we anticipate that further reform will be necessary to enhance the credibility of the submitted rates if Libor will continue to serve as an important benchmark interest rate.