The London Interbank Offered Rate (LIBOR) is considered one of the most important interest rates in the financial world. It underpins approximately £225 trillion of financial products ranging from interest rate swaps and corporate loans to credit cards, mortgages and savings accounts. It is a benchmark reference rate fundamental to the operation of both UK and international financial markets. In the past month, evidence of deliberate manipulation of LIBOR submissions and news of the ensuing public scandal has made global headlines. Aside from financial penalties and possible criminal prosecution of the main perpetrators of the scandal, the role, purpose and function of LIBOR has been placed under intense scrutiny by regulators, the financial markets and the public.
Who Oversees and Sets LIBOR?
The governing body for LIBOR is the British Banking Association (BBA), the leading trade association for the UK banking and financial services sectors. Within the BBA, a subdivision committee—the Foreign Exchange and Money Markets Committee (FEMMC)—is responsible for directly overseeing LIBOR. The FEMMC is composed of active market practitioners, including corporate treasurers and representatives from banks, the money markets, and exchanges.
The LIBOR rates are set and distributed by Thomson Reuters, which undertakes the work for, and is supervised by, the BBA. The rates become available to all market participants simultaneously via a number of different information providers. If any person wishes to receive, display or use LIBOR rates, they must obtain a licence from the BBA. There are seven different tiers of licence that vary according to the user’s requirements.
What Does LIBOR Represent?
The LIBOR rates are calculated as a “trimmed” average of statistics submitted by contributory banks. The rates submitted demonstrate a subjective evaluation of the rate at which each contributory bank believes it could borrow funds, were it to do so by asking for and then accepting interbank offers of reasonable market size. The calculation process is repeated for all borrowing periods and all currencies to which the LIBOR relates. There are 150 different LIBOR rates in total, calculated for 15 different maturities and 10 different currencies. Maturities range from one day (overnight) to 12 months and currencies include (aside from Sterling), US Dollars, Euros, the Yen and Swiss Francs. The average calculated becomes the LIBOR rate for the relevant currency and maturity.
Which Are The Contributory Banks?
The number of contributory banks varies according to currency, with a separate panel for each currency to which LIBOR relates. The number of members on each panel ranges from a minimum of six to a maximum of 18. There are currently 16 banks on the Sterling panel, 15 banks on the Euro panel and 18 on the US Dollar panel. There is no ideal number of banks on any one panel as the aim is to ensure that a cross section of contributors is established that reflects the balance in the financial markets.
Any bank can apply to join the contributor panel. There is no requirement to be a UK (London) bank, or a member of the BBA, but the bank must trade in the London market. Banks are selected on the basis of their market activity, which means that usually the leading banks are selected to join the panel. Membership is determined by the FEMMC with regard to each currency panel. The FEMMC looks, in particular, at the London market activity of the bank, its reputation, its perceived expertise in the currency concerned and its credit standing.
The FEMMC assesses the panel of contributing banks for each currency every six months. The assessment comprises a detailed review of the contributory banks with the intention of determining whether each bank continues to meet the criteria that are a pre-requisite for joining the panel. Only those banks that continue to meet the criteria in a manner satisfactory to the FEMMC will remain eligible to contribute to LIBOR.
How is LIBOR Set?
Contributory banks must make daily submissions to Thomson Reuters between 11.00 am and 11.10 am Greenwich mean time (GMT). This time is non-negotiable and irrespective of the local time zone for the contributory bank. Rates submitted are for deposits made in the London interbank market that are of reasonable market size, are simple and unsecured, are governed by the laws of England and Wales and undertaken by parties subject to the jurisdiction of the courts of England and Wales. Rates should be submitted to at least two, and no more than five, decimal places.
The trimmed average is determined by discarding the rates that fall in the top and bottom two quartiles of all submissions and calculating the mean average of the remaining middle two quartiles. Between 11.10 am and 11.30 am GMT, Thomson Reuters aims to identify any errors in the rates submitted by individual banks and arrange any incidental corrections necessary. During this time, Thomson Reuters also makes a preliminary calculation of the average. This average is known as the LIBOR “fixing”. At or around 11.30 am GMT, Thomson Reuters publishes the LIBOR fixings as well as the individual contributor rates submitted by the contributory banks. Any remaining manifest errors that were overlooked initially are corrected in the 30 minutes between 11.30 am and 12.00 midday, at which time Thomson Reuters publishes the finalised rate as the BBA LIBOR calculation.
Is LIBOR Set in “real-time”? And What Happens on a Public Holiday?
LIBOR centres around two specific dates: the fixing date and the value date. The fixing date is the date upon which a contributory bank makes a submission to LIBOR. It is also the date that Thomson Reuters calculates the trimmed average of submissions received. The value date is the date to which any particular LIBOR rate relates, once it has been set. For Sterling, the fixing and value dates for LIBOR are the same and so LIBOR is set in “real time”. For all other currencies, the value date for LIBOR rates falls two business days after the fixing date. Both dates must be business days both in London and in the principal financial centre of the currency concerned. For all currencies other than the Euro, business days are determined using the International Swaps and Derivatives Association Modified Business Day Convention. In the case of Euro LIBOR, business days are determined using the TARGET2 system.
As LIBOR is constructed in London, rates are neither fixed nor valued on a day that is a public holiday in the United Kingdom. For value dates, however, the next business day is used as a substitute value date for that particular rate. In the case of a public holiday in the local jurisdiction of a contributory bank outside the United Kingdom, the LIBOR will still be either fixed, or valued (as the case may be) unless this date is also a public holiday in the United Kingdom.
What is EURIBOR And How Does it Differ From LIBOR?
The Euro Interbank Offered Rate (EURIBOR) is the rate at which the leading European banks are prepared to lend Euros to each other. It is controlled by the European Banking Federation (EBF), an organisation within the European banking sector that acts as a forum where members’ initiatives are proposed and debated and plays a role in determining relevant legislation in the European banking sphere. The EURIBOR panel comprises the 43 banks with the highest volume of business in the Eurozone money markets. Contributory banks come from countries that participated in the Euro from the outset, as well as from jurisdictions that joined the Euro more recently. Large international banks that are based in non-EU countries but have important Eurozone operations may also apply to join the panel.
EURIBOR differs from LIBOR in that it does not set rates for a multitude of different currencies as LIBOR does. Aside from Euros, the only other currency for which rates are set is the US Dollar, which is referred to as US Dollar EURIBOR. Consequently, EURIBOR results in a separate base rate for Euros (and US Dollars) that is comparable with the LIBOR rates. EURIBOR also sets separate rates for overnight maturities as well as for the derivatives market and the “repo” market. Each rate is overseen by a separate committee of the EBF. EURIBOR rates are published by Thomson Reuters at 11.00 am central European time. Just as for Euro LIBOR, the TARGET2 system is followed for determining business days.
What is The LIBOR Scandal About?
Between January 2005 and May 2009, false rates were submitted to Thomson Reuters for both US Dollar LIBOR and US Dollar EURIBOR. Submissions were false as they took into consideration requests for upwards or downwards alterations made by certain derivative traders to benefit their trading position and therefore increase profit. Requests were made by email, verbally and by instant message. In total, it was revealed that more than 200 requests for US Dollar submissions were made by derivatives traders to submitters. Derivative traders also sought to manipulate US Dollar submissions from other contributory banks, albeit to a lesser extent. Between February 2006 and October 2007, more than 60 such requests were made.
Following the onset of the financial crisis, liquidity conditions in the financial sector changed significantly. Focus on liquidity intensified and LIBOR was used by both the financial sector and the media as a means of determining a bank’s ability to raise funds. Between September 2007 and May 2009, the media speculated about the possibility of substantial liquidity problems at the contributory banks that were regularly making LIBOR submissions that were amongst the highest submitted. This led to banks making lower submissions of up to as much as 46 basis points (almost 0.5 per cent) in an attempt to reduce negative market perceptions.
What Rules Were Breached?
In the United Kingdom, any financial institution regulated by the Financial Services Authority (FSA) is required under the Financial Services and Markets Act 2000 (FSMA) to demonstrate and maintain adequate systems and controls to govern risk management. This includes implementing systems and controls in relation to their contributions to LIBOR and EURIBOR. These requirements derive from the FSA Handbook, which forms part of the FSA rules under FSMA, in particular principles 2, 3 and 5 of the Principles for Businesses:
A firm must conduct its business with due skill, care and diligence…[it] must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems…and [it] must observe proper standards of market conduct.
LIBOR and EURIBOR submitters should have been trained on the submissions process and the (in)appropriateness of favourable requests. There should have been formal monitoring and spot checking procedures to ensure the integrity of the submissions, and there should have been clear lines of responsibility and periodic reviews of the systems and policies in place. The scandal has revealed that such systems and policies were either not in place or insufficient, or that when concerns were raised internally various compliance failings meant that misconduct was allowed to continue.
In the United States, the Commodity Futures Trading Commission (the Commission) found that manipulation of LIBOR and EURIBOR submissions had breached Sections 6(c) and 6(d) and 9(a)(2) of the Commodity Exchange Act that deal with the manipulation of the market price of any commodity. Apart from the fines that the FSA and the Commission are able to impose, they also expect offenders to adhere to the regulatory principles to which they are subject in order to ensure the future integrity of submissions. Offenders are also expected to identify, construct and promote effective processes to ensure reliability going forward.
What Criminal Sanctions or Other Measures Will be Taken?
The US Department of Justice has so far not pursued the possibility of criminal prosecution for fraud. While the FSA does not have authority to impose criminal sanctions for the manipulation of LIBOR, the Serious Fraud Office (SFO) has confirmed that existing criminal offences are capable of covering conduct in relation to LIBOR misconduct. A formal investigation headed by the SFO was begun in July 2012 with a view to determining whether there is enough evidence to support criminal prosecutions of traders involved in the misconduct. The FSA has also launched a UK Government-commissioned review (the Wheatley Inquiry, headed by Martin Wheatley, a senior FSA official) into the LIBOR-setting process with a view to determining whether HM Treasury should take over the process from the BBA. There are currently no dates set for the completion of either investigation, although a draft discussion paper is expected later this month from the Wheatley Inquiry. It is expected that the two bodies will work closely and share their evidence and findings.
The UK Government has called for a parliamentary inquiry into the banking sector in light of the LIBOR scandal. The inquiry is expected to examine current banking standards with a view to determining how weaknesses can be addressed and which specific areas of the sector should be taken into account. The panel is expected to assess specific areas such as global banking culture, regulatory arbitrage and corporate governance weaknesses. Initial findings are expected to be submitted in late December 2012. The FSA and the US regulators are also continuing investigations that centre on several banks that contribute to both LIBOR and EURIBOR.
Isobel Lloyd-Davies, a trainee solicitor in London, also contributed to this article.