The ubiquitous benchmark interest rate applied across commercial contracts, LIBOR (the London Inter Bank Offer Rate), has made the headlines globally for all the wrong reasons. This note explains what the rate is; how it is calculated; the nature of the ongoing global investigations; and how the investigations and their outcomes might affect you.
What is LIBOR?
LIBOR is the predominant benchmark interest rate used in commercial agreements globally. Whilst definitive figures are impossible to assess, the figures suggested for the value of products tied to LIBOR globally vary from US$350 trillion to US$800 trillion. These products range from domestic mortgages through over-the-counter products, such as swaps, through to exchange-traded products, such as futures. LIBOR is also routinely used as the benchmark interest rate applicable in commercial agreements where interest is to be calculated on payments to be made between the parties.
How is it Calculated?
The LIBOR rate is calculated daily in London by the British Bankers’ Association (BBA) for 10 currencies across 15 tenors (i.e., periods of time or maturities, e.g., three month US Dollar LIBOR). The calculation of the rate is made from the submissions of banks selected by the BBA (the Panel Banks). Given that each Panel is selected in light of its experience in trading in the particular currency, the composition of the Panels changes for each currency. The current Panel Banks for each of the 10 currencies are to be found at http://www.bbalibor.com/panels/.
Each Panel Bank is required to submit a rate each day at 11.00am (London time) based on their assessment of the following test:
“The rate at which an individual contributor panel bank could borrow funds, were it to do so by asking for and then accepting interbank offers in reasonable market size, just prior to 11.00am London time.”
It is therefore not necessarily based on actual rates agreed in transactions but instead on an assessment of likely rates.
The BBA takes the submitted rates, discounts the upper and lower quartiles, and averages out the middle two quartiles to produce the daily rate for each currency and tenor. It then publishes the calculated rate each day at 11.30am (London). It also publishes the rates submitted by each Panel Bank.
What are the Allegations?
The allegations against certain of the Panel Banks centre on the process of submitting rates to the BBA. Certain of the Panel Banks are accused of having submitted figures that were artificially high or low and intended either:
- to avoid a bank being perceived as having a low credit rating during the febrile financial period from 2008 onwards (i.e., the higher the submitted rate, the higher the perceived credit risk that Panel Bank represented); or
- to benefit the trading positions of individual traders within certain Panel Banks.
To date, whilst investigations are reported to have been ongoing for some time internationally, only Barclays has been fined by U.S. and UK regulators, although Citibank and UBS have been penalised by the Japanese regulator for TIBOR (the Tokyo Inter Bank Offer Rate, a Japanese benchmark rate loosely related to LIBOR in respect of the Japanese Yen currency) irregularities.
The allegations are being investigated by a number of regulators worldwide, including the U.S. Commodity Futures Exchange Commission, the U.S. Department of Justice, the U.S. Securities and Exchange Commission, the UK Financial Services Authority, the European Commission, and the Japanese Financial Services Authority.
What are the Issues?
There are several key issues that arise from the allegations which have been made public:
1. What was the impact (if any) of the alleged manipulation on the LIBOR rate?
The impact (if any) of the alleged manipulation will likely be difficult to assess given the variables involved. Further, as the BBA itself notes, “The decision to trim the bottom and top quartiles in the calculation was taken to exclude outliers from the final calculation. By doing this, it is out of the control of any individual panel contributor to influence the calculation and affect the bbalibor quote.” (BBA LIBOR Web site)
To date the only details to have emerged publicly (of the manipulation alleged to have taken place) relate to Barclays. Litigation has been commenced in the U.S. and, more recently, in the UK in respect of both over-the-counter products and exchangetraded products affected by LIBOR. The claims range from anticompetitive (i.e., cartel) behavior to allegations of breach of contract. However, the information underpinning those claims relies in large part on media reports with attempts being made to secure disclosure from Panel Banks. Further, whilst several claims existed prior to the announcement of Barclays being penalised, there has been an increase in such claims (including class claims in the U.S.) following the announcement.
Absent a fuller understanding of the entirety of the alleged manipulative behaviour, it is only possible to speculate as to whether (and, if so, to what extent) the LIBOR rates have been influenced by that behaviour. Certainly, the comments of the regulators do not provide consistent or definitive views on this issue:
- The FSA (in its Final Notice regarding Barclays) appears to have avoided any definitive comment on a direct link between the behaviour identified and the LIBOR rate. It stated (paragraph 207): “LIBOR and EURIBOR … have a wider impact on other markets. Barclays’ misconduct could have caused serioU.S. harm to participants in any of these markets. Harm could have been caused by Barclays’ misconduct if the final reference rates were affected by Barclays’ actions on any given day. Barclays’ misconduct also created the risk that the integrity of LIBOR and EURIBOR would be called into question and that confidence in or the stability of the UK financial system would be threatened.” (emphasis added)
- The U.S. Department of Justice noted (in its Press Release dated 27 June 2012): “Because mortgages, student loans, financial derivatives, and other financial products rely on LIBOR and EURIBOR as reference rates, the manipulation of submissions used to calculate those rates can have significant negative effects on consumers and financial markets worldwide.” (emphasis added)
- The U.S. Commodity Futures Trading Commission’s Order noted (in its Press Release dated 27 June 2012) that its “Order finds that Barclays attempted to manipulate interest rates and made related false reports to benefit its derivatives trading positions.” (emphasis added)
2. If any losses have been caused by the alleged manipulation, how will they be calculated?
The calculation of any losses will be a complicated process, determined in large part by the applicable principles in the jurisdiction in which the claim arises. Assuming that it can be shown that any manipulation had an effect on the published LIBOR rate, the amount of any loss to be compensated may be reduced by any profits gained. For example, given the propensity of trading organisations to hedge their positions, where a counterparty to a swap trade lost as a result of an artificially high LIBOR rate, it may also have gained in any hedged transactions that settled on that same date.
3. Will LIBOR survive?
There are a number of dimensions to this question not least of which is the political dimension. The Bank of England has indicated that a review of LIBOR is necessary and has called on representatives from key central banks to discuss options at a meeting on 9 September 2012 in Basel, Switzerland.
Further, the BBA has recognised the need to bolster the credibility of LIBOR. On 28 June 2012 it stated “The current LIBOR review, with which our authorities are fully engaged, has been underway since March this year and is considering all aspects including the setting process. As part of this review we will now be asking the authorities to consider in what manner the LIBOR setting mechanism should be regulated in the future.”
4. What are the alternatives to LIBOR?
Whilst LIBOR is generally recognized as the pre-eminent benchmark rate in commercial agreements, there are other benchmark rates which are used. Notable amongst those alternative benchmark rates are: TIBOR, EURIBOR (Euro Interbank Offered Rate), USD EURIBOR (U.S. Dollar Interbank Offered Rate), Eonia (Euro Overnight Index Average) and the Eonia Swap Index. It would be possible (depending on the currency involved) for parties to tie payment provisions within agreements to these alternative mechanisms.
What do Organisations Need to Bear in Mind?
There are several practical matters which arise from the matters being investigated.
- What benchmark interest rate should be included in agreements currently being drafted and, if LIBOR is being used, should a substitute be provided in case LIBOR ceases to exist?
Although the Bank of England has called for consideration of the future of LIBOR, there is no current suggestion that it will be discontinued as a benchmark. Indeed, such is the current stance of the BA and the global reliance on the benchmark that its disappearance overnight seems unlikely. However, parties to new contracts will wish to provide for certainty in their arrangements and cater for the possibility of LIBOR ceasing to exist. This could be achieved without too much difficulty by inserting a mechanism for the adoption of a substitute benchmark either immediately or in certain circumstances.
- What if anything should be done to existing contracts that rely on LIBOR to calculate interest?
Whether the future of LIBOR is at real risk remains uncertain. In respect of existing contracts, there is, therefore, a balance to be drawn between re-opening contractual arrangements now by renegotiating the applicable benchmark interest rate (with the potential for unintended consequences with other contractual terms being revisited) and the desire for certainty by jumping from LIBOR at this point. The appropriate course of action for particular parties will inevitably turn on their own circumstances.
- Could the attempted manipulation that has been identified so far have caused any significant differences in applicable interest rates?
As with the determination of whether the alleged manipulation has had an impact on the LIBOR rate, much more information will need to emerge before any meaningful assessment of any impact on the LIBOR rate can be made. The BBA considers that the LIBOR rate has been insulated from such manipulation but a proper analysis of all the evidence would be needed to test that assertion.
- Is there any way to adjust payments already received or paid as between parties to commercial arrangements using ‘incorrect LIBOR rates, given the allegations that the LIBOR rate has been manipulated?
Whether there are grounds to revisit LIBOR rates already applied in the context of commercial arrangements will turn on a number of factors, including the impact of any manipulation on the LIBOR rates themselves (see comments above) and the time at which the incorrect rates were applied (re any applicable limitation periods).