As the primary global benchmark for short-term interest rates/ the London Interbank Offered Rate (LIBOR) serves as an indicator for many currencies. It is tied to over $350 trillion of financial and retail products/ including loans/derivatives/ interest rate futures and options contracts/ mortgages and student loans. Since 1986/ LlBOR has been regarded as a barometer of the money markets and a transparent reflection of economic reality.
A number of banks have recently admitted that they attempted to manipulate LIBOR for years. 1 This white paper provides an overview of the LIBOR framework/ the allegations of LIBOR manipulation/ and the regulatory and institutional changes that have been implemented to date to help restore LIBOR/s integrity and avoid future manipulations.
Most importantly/ this white paper highlights the role financial benchmarks play in modern finance. Benchmarks provide concise and practical financial information that is relied upon to set base rates in many financial products from crude oil/ to interest rate derivatives to foreign currency exchange. Often these essential benchmarks are
set by banks and companies that participate in the relevant market. The recent history of LIBOR points to a fundamental issue in the design of financial benchmarks that will not be resolved easily- should benchmarks rely solely upon raw empirical data gleaned from real-time transactional data/ or should benchmarks be built upon the collective judgments of experts without requiring evidence of actual market transactions?
THE BBA BENCHMARKING PROCESS
Prior to February 1/ 2014/ the British Banker/s Association (BBA)/ an unregulated U.K. trade association for the U.K. banking and financial services sector/ administered the daily calculation and global publication of LIBOR for various currencies. 2 The BBA calculated LIBOR using a I/ polling I/ system/ in which a group of selected banks (the
I/ panel banksl/)3 each submitted the rate at which it could borrow unsecured funds in
reasonable market size in the London interbank market just prior to 11:00 a.m. each business day.
Concerns have also been raised that other benchmarks may have been manipulated, including Euro Interbank Offered Rate (EURIBOR) and Tokyo Interbank Offered Rate (TIBOR).
BBA LIBOR was calculated for ten currencies and fifteen tenors li.&.,., maturities) ranging from overnight to one year.
The selection of panel banks was rnade annually by the BBA with assistance frorn the Foreign Exchange and Money Markets Committee (FX&M MC). Each panel for each currency consisted of at least eight and a rnaxirnurn of 16 banks that were regarded to be representative for the London money market based on market volume, reputation and assumed expertise with the specific currency. As a result, the interbank rates submitted by the panel banks were generally considered to be the lowest interbank lending rates on the London money market.
The banks' submissions were based on their individual estimates of borrowing costs and no actual borrowing was required to be referenced.
The BBA then performed a "tops and tails" ca lculation that eliminated the highest and lowest 25% of submissions, and averaged the 50% remaining "mid values" in order to produce the official LIBOR rate. Every business day at around 11:45 a.m . (London time) , the BBA, through Thomson Reuters and other data vendor s, publicized the officia l daily LIBOR for each
currency and maturity, as well as the daily submissions of each panel bank.
INVESTIGATIONS INTO LIBOR MANIPULATION
Since 2009, the U.K. Financial Services Authority (FSA), the U.S. Commodity Futures Trading Commission (CFTC), the U.S. Department of Justice (DOJ), and other regulators and public author ities in a number of different juri sdictions - including Canada, Japan, Switz erland
and the European Union - have been investigating
financial institutions for alleged misconduct relating to LIBOR and other financial benchmarks.4 Multiple investigations and lawsu its are still ongoing . To date, the LIBOR investigations have led to fines of about $6 billion against severa l institutions .5
Various settlements between banks and government regulators revealed that, beginning in 2005 through as late as 2011 (by which time invest igations into LIBOR manipulations had begun), traders at some of the submitting panel banks attempted to manipulate or actua lly manipulated their banks' LIBOR submissions for
U.S. Dollar, Japanese Yen, Pound Sterling and Swiss
Franc, to benefit their derivatives trading positions, such as interest rate swaps, that were based on LIBOR. Depending on the trade rs' requests, it appears that submitters would agree to attempt to influence the official LIBOR fixing by setting their daily subm ission in a particular currency and tenor higher or lower . This included setting rates so low or so high as to ensure that the bank would get "kicked out" from the LIBOR
calculat ion because they fe ll in the top or bottom quartile .6 In addition, it now appears that some traders at certain banks colluded with each other in an effort to obtain LIBOR fixings that would be beneficia l to their trading positions, and that they requested their respective submitters to adjust their submiss ions accordingly. The commun ications between swaps traders and subm itters to influence LIBOR submissio ns
for the purpose of increasing profits or decreasing losses
on specif ic transactions created a glaring conflict of interest . Rather than employing systems designed to guard against such conflicts, some banks instead sat their submitters next to their der ivatives traders thereby making it easier for such practices to continue.?
Beginning in late 2007 and during the financia l crisis, some of the panel banks experienced seve re liquidity problems that resu lted in a higher cost of borrowing in the interbank market. In addition, the London interba nk money market at times experienced sever e illiquidity during the financia l crisis, resulting in no interbank lending in certain maturities.8
LIBOR rates during the financia l crisis should have reflected the illiquidity in the money markets and adverse economic conditions. Instead, LIBOR fixings continued to be unrealistica lly low. Suspect ing that the daily submissions for USD LIBOR were artificia lly low
Richards Kibbe and Orbe LLP cu rrently represents several clients in matters relating to the ongoing LI BOR investigations.
Bloomberg, "Libor Traders Sa id to Face U.K. FCA Fines of U p to $4.2 M i ll ion, " Suzi R ing, February 24, 2014.
See generally In the Matter of Barclays PlC, Barclays Ba nk PLC and Barclays Capit a/Inc , CFTC Docket No . 12-25, Order Institut i ng Proceedings Pu rsuant to Sections 6(c) and 6(d) of the Comm odity Exchange Act, as Amen ded, M a king Find ings a nd Im posi ng Remed ial Sanctions(" Sarelays CFTC Order"); In the Matter of UBS AG an d UBS Securiti es Japan Co., ltd., CFTC Docket N o. 13-09, Order Institutin g Proceedings Pu rsuant to Sections 6(c) and 6(d) of the Com modity Exchange Act, Makin g Findings and Im posing Remedial Sanction s ("U BS CFTC Order"); In the M atter of The Royal Bank of Scotland pic and RB S Securities J apan Limited, Respond ents, CFTC Docket N o. 13-14, Order Inst ituting Proceedings Pu rsuant to Section s 6(c) and 6(d) of the Com mod ity Exchange Act, M aking Findin gs and Imposing Remedia l Sanction s ("RBS CFTC Order"); In the Matter of Cooperatieve Centrale Railfeisen
Boeren!eenb ank, B.A., CFTC Docket N o. 14-02, Order I nstituting Proceedings Pursuant to Sections 6(c) and 6(d) ofth e Comm odity Exchange Act, M a king Finding s and Imposing
Remedia l Sa n ctions, at ("Rabobank CFTC Order") (collective ly, hereinafter referred to as th e "CFT C Orders").
UBS CFTC Order, at 10-11; Rabobank CFTC Order, at 2-3.
8. Barclays CFTC Order, at 19.
RK&02 from real-time transactional data, or should benchmarks be built upon the collective judgment of experts without requiring evidence of actual market transactions? A bulletproof benchmark is difficult to achieve. While the LIBOR settlements have demonstrated that the
collective judgm ent of experts ca n be influenced by outside forces, benchmarks based on transactional data may be prone to a similar risk springing from a different kind of bad behavior, manifested through improper tradin g activity intended to influence that transa ctional data. Focusing on this fun damental design issue will help sepa rate the signal f rom the noise as other financial benchmarks are tested and examined in the future.