LIBOR

On the 27th

of June an

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investigation by the FSA (Financial Services Authority), the DoJ (Department of Justice) and the CFTC (Commodities Futures Trading Commission) on the manipulation of LIBOR rate fined Barclays Bank a then record $400 million jointly.

What is the history of LIBOR and how does it function and what are the issues associated with this mechanism

Outline the history of this investigation and the evidence presented against the banks in question What are the implications of LIBOR manipulation for derivative instruments priced relative to the LIBOR? Speculate on the nature of the future civil litigation between traders in derivative markets associated with the

LIBOR rate

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ContentsHistory of LIBOR, its functions and issues........................................................................................................................3

History of investigation, evidence presented against the banks in question..................................................................3

Barclays Bank plc.........................................................................................................................................................4

UBS AG and UBS Japan Securities Co. LTD...................................................................................................................4

Implications of LIBOR manipulation for derivatives instruments....................................................................................5

Nature of civil litigation between traders in derivatives markets associated with the LIBOR rate..................................6

Appendix (data retrieved from FSA’s Final Notice Report (2012))..................................................................................7

References:.....................................................................................................................................................................8

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Barclays Bank plcBNP ParibasCitibank NACredit SuisseDeutsche Bank AGHampshire Trust plcHSBC Bank plcJ.P Morgan Europe LimitedLloyds banking groupSantander UK plcStandard Chartered BankThe Royal Bank of Scotland

History of LIBOR, its functions and issues

London Inter-Bank Offer Rate, one of the closely followed aspects in the financial world today. The best explanation for this concept is the cost of borrowing for the banks from each other and London is the financial hub where selected banks generate the most accurate rate for this variable.

History of LIBOR is not medieval and dates back to 1984, when the trial periods of this financial instrument took place. Banks were trading in a range of new markets by then, which included interest rate swaps, forward rate agreements and foreign currency options. The uniform measure of BBAIRS (British Banking Association Interest Rate Swaps) was formed on the 2nd of September 1985; however BBA LIBOR fixings did not formally begin until the 1st of January 1986. In short the LIBOR has been an initiative of the British Banking Association, which set out to protect the ever growing inter-banking activities.

The inter-bank lending in London expanded quite rapidly and the number of BBA members has been increasing. Today the board of the association consist of the senior executives from the following financial institutions:

LIBOR rates are calculated for ten currencies and fifteen borrowing periods ranging from overnight to one year and are published daily by 11:30AM (London time) by Thomson Reuters. It functions as an index of cost of funds for the banks that either operate in London’s financial markets or with other London based parties. Every day BBA surveys a panel of banks in terms of their most favourable level of borrowing costs in a reasonable market size, thereby every financial institution decides on the rate that it would in turn be willing to accept as its borrowing cost and submits it accordingly. For instance, there are 18 major institutions submitting their own rate for the USD LIBOR. Trimming the mean is then carried out by the BBA, when the highest 4 and the lowest 4 submitted rates are taken out of the list for the purposes of calculating the mean more accurately. This measure can be referred to as the interquartile mean where the mean is 25% trimmed.

One of the issues with LIBOR is the integrity of the system. In order for this financial instrument to run properly banks need to accept a partially self-regulatory role. Self-regulation in some ways contradicts the fact that banks are run as profitable organisations and at times need to exploit the opportunities available in order to generate sufficient returns on investments. The question of LIBOR itself can be viewed as a vague aspect of today’s financial world. Figuratively speaking it is like going to the supermarket and buying things at the prices you think are the right ones. One might also find it surprising that such an important benchmark is simply calculated using the arithmetic mean and not a more complex method. Submitting traders have previously not been heavily monitored in terms of not collaborating with other banks through various means of communication. Collaborating with traders from other banks to affect the LIBOR rate is not allowed.

History of investigation, evidence presented against the banks in question

Investigations by the FSA with regards to misconduct in LIBOR and EURIBOR had shown the true colours of Barclays and a number of other institutions. The issue was regarded equally serious in the US by the DoJ and CFTC agencies.

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Chairman:Sir Nigel Leonard Wicks GCB CVO CBE(Director of the Edinburgh Investment Trust)

Barclays Bank plc

According to the FSA’s (June 2012) “Final Notice” report, pages 1-4, on their investigation of Barclays bank, it identified wrong doings as early as January 2005, when the bank was found to breach FSA’s Principle 3. This meant that the bank failed to have adequate risk management systems or effective controls in place in relation to LIBOR and EURIBOR submission processes. Between September 2007 and May 2009 Barclays was accused of inappropriate submission in order to avoid negative media comments causing the bank to threaten its credibility amongst the public. Liquidity issues were one of the main drivers that led the bank to pursue an inflated submission policy. In defence Barclays attempted to blame the other contributing banks for submitting measurements that were too low for the market conditions back then. Compliance failings included the breach of Principles 2, 3 and 5 of the FSA’s Principles of Business, which threatened the integrity of the benchmark reference rates.

Principle 5 was breached on numerous occasions between January 2005 and July 2008 by carrying out inappropriate submissions following requests by derivatives traders, at times these traders were from other banks. This issue was profit driven and correlates closely to the issues of LIBOR, regarding the fact that banks are profit driven organisations.

To enhance upon the importance of this investigation here are some market values:

OTC interest rate derivatives contracts in the first half of 2011 were estimated at $554trillion, according to the Bank for International Settlements (November 2011)

NYSE LIFFE Statistics (2006-2011) and the Futures Industry Association (2011) Annual Volume Survey, state that short term interest rate contracts traded on LIFFE in London in 2011 were totalled at €447trillion out of which €241trillion related to the three-month EURIBOR futures contract

It was identified that:

Between January 2005 and May 2009, 173 requests for manipulation occurred (11 from other banks) for US dollar LIBOR

Between September 2005 and May 2009, 58 requests for manipulation (20 from other banks) for EURIBOR

Between August 2006 and June 2009, 26 requests for Yen LIBOR

Statistical evidence was analysed by the FSA and it was found that from January 2006 to August 2007, that US dollar LIBOR submissions were 70% consistent with the requests. This is followed by the fact that 16% of the requests were not clear. Traders tended to be very informal in some of their communications amongst each other which has most certainly complicated this analysis. Submissions were inconsistent with the requests in only 14% of occasions. Discussed figures are stated in the FSA’s Final Notice statement.

The FSA decided to impose a £59.5 million in accordance with section 206 of the Financial Services and Markets Act 2000. Because Barclays has cooperated with the investigation, the bank qualified for a 30% (Stage 1) discount, otherwise the fine would have stood at £85 million.

As well as the FSA the CFTC has taken action with regards to banks manipulating LIBOR and Other Benchmark rates. Barclays bank was ordered to pay $200 million penalty to the US authorities for attempted manipulation and false reporting concerning LIBOR and EURIBOR Benchmark Interest Rates.

UBS AG and UBS Japan Securities Co. LTD

Across the ocean in the US, CFTC has not taken the rate rigging lightly. Barclays was fined comparatively more and UBS was hit hard with a fine of around $700 million. The bank was also motivated by the negative impacts the financial crisis had on the industry and its operations. Protecting the reputation during the global financial crisis through LIBOR seemed a good solution at the time, as it brought about the possibility to make large profits and minimise any loses. Although UBS manipulated benchmarks very similarly to Barclays, often in conjunction with Barclays, the one difference that stands out of the CFTC’s Press Release (19 th December 2012) is the fact that they had more Yen LIBOR manipulations. The most active “Senior Yen Trader”, whose name is not provided by the Press

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Release, conducted sustained manipulative operations for weeks to move the Yen LIBOR in the favourable direction. From a statistical perspective it is estimated that this particular trader made approximately 2000 requests, by e-mail or other written communication, in a period of three years. The operations were referred to as “the Turn Campaign” and “Operation 6m”, the latter giving a clue of the particular maturities linked to manipulation. To give an idea of the size of the rewards in this for traders, some individuals at UBS received an estimated $216,000 of bonuses from the bank, over the period of two years. This evidence strongly suggests that management were not exactly going to stand in their employee’s way in terms of unlawful actions and instead decided to collectively benefit from this regulatory loophole.

Due to the cooperation of UBS AG and UBS Japan Securities Japan Co. LTD with the US Department of Justice, the fine from the CFTC totalled a value of 500$ million. FSA also fined UBS by imposing a penalty of $259.2 million against the bank. Swiss Financial Market Authority (FINMA) also jumped on the band wagon and issued a $64.3 million fine. Overall the size of the financial penalties even exceeded the headlined $700 million stated in the beginning of the CFTC Press Release (19th December 2012).

Although some can and indeed did complain about the fines being low in comparison to the actual illegal profits that the banks and traders made, there were also a number of obligations implemented towards UBS in order to ensure the integrity and the reliability of the benchmark interest rates, which should tip the scale toward the long term insurance against such regulatory loopholes. Reliability and the integrity are the most valuable assets in any industry, particularly in any financial sector. Some do refer to financial crime not being punishable to a sufficient extent and indeed this side of the argument is legitimate. Slightest adjustments can significantly impact people’s borrowing costs, which is why the LIBOR scandal was so clearly painted all over the media, with some trader communications being disclosed to the general public, making nearly impossible for the financial institutions that took part in these operations to defend. Simply justifying the events was tough enough. The hidden costs of winning customers’ and investors’ credibility back are not obvious for those criticising the penalties.

Implications of LIBOR manipulation for derivatives instruments

Deciphering this section is a little challenging. Derivatives instruments will now be monitored a lot more closely by the regulatory authorities. This is likely to close off many profitable opportunities for the banks, as authorities will work towards preventing manipulation happening in the future. Klinkowska (2014, lecture) stated that derivatives are instruments whose values depend or are closely linked to other asset values. Derivatives play a huge role in shifting risks in the economy; they are used to hedge risks, change the nature of liability or to change the nature of an investment without incurring the costs of selling one portfolio and buying another.

As previously discussed the OTC market (Over the Counter) has been growing rapidly. The appeal of OTC markets can be influenced by the fact that participants are free to negotiate any mutually attractive deals, giving more flexibility, which is very highly valued in any industry. Exchanges are becoming dependant on electronic trading, which is no surprise as many industries, not just the financial sector, are adapting to the computer-based operations which are more efficient and incur less costs.

The indirect link that can be traced between LIBOR manipulations and the derivative instruments is one of forward contracts. The LIBOR manipulation allowed traders from numerous financial institutions to have an equivalent of a forward contract market in their own terms. In other words this mutual understanding they have created amongst each

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other formed an oligopolistic market for derivatives instruments, but there was no price for these instruments. Sometimes traders did reward each other for assisting them with manipulations; however, there was no set pricing strategy for the assistance they provided each other.

Because of these manipulations being illegal it is likely that investor confidence will take some time to recover. When markets have a lack of confidence, lack of activity brings about a form of a downturn to the future forecasts and trading quantities. This is likely to produce another dip in the size of the OTC market in the coming 2 years. From June 2010 to June 2015 it is likely that the size of the OTC market will fall by approximately $100 trillion. Growth is then likely to stabilise and not be as rapid as it was between June 2006 and June 2008. Stability will be taking over the derivatives market as a result of regulation improvements. It is a smaller scale of the global financial crisis, hence has similar strategies of recovery, meaning that stable as oppose to rapid growth will be pursued.

Nature of civil litigation between traders in derivatives markets associated with the LIBOR rate

The US Department of Justice has been investigating alongside the FSA and CFTC. On June 26, 2012 the DoJ’s Criminal Division issued a public statement with regards to the criminal actions taken against Barclays. The statement points to the fact that Barclays admits, accepts and acknowledges responsibility for the conduct. Alongside to this acknowledgement Barclays was the first bank to cooperate in a very extensive and assistive manner by disclosing all the relevant facts that at the time had not come to the government’s attention. To top this off, the bank’s cooperation with this investigation has helped further the investigation. This assisted the authorities to investigate and impose the relevant financial penalties to the other banks who were responsible for the events that have become so widespread in the markets across the world.

Establishing the terms of cooperation is very important as it cuts investigatory costs for the government authorities. In today’s financial climate, when budgeting needs to be accountable to the public whose money is spent on such investigations. Cooperating with investigation has and will hurt Barclays in terms of future prospects. Although they have limited the financial penalties, the fact that they are now obliged to cooperate with the authorities for the following two years will have a caging effect on the bank. It is unlikely that the management at Barclays will be willing to undertake any risky strategies or decisions that will be profitable to the same extent as the LIBOR manipulations. Yes, having sympathy for the bank is no option, however, it is important to take into account that the banks exist with the main goal of generating profit. It is very difficult for some to understand that balancing the profit hunting goals and providing financial services for the communities will take some time. This situation has had its share of negative impacts from the media, who can sometimes pour a little too much petrol into fire and add a little too much chocolate syrup on an ice cream. Regaining an individual’s trust is hard, so imagine what it will be like to regain the trust of thousands of individuals whose finances came under risk.

In terms of actual figures for Barclays, its branch in New York has agreed to pay a $160,000,000 penalty, with no tax deductions to be sought in connection with this payment. In terms of regulatory actions the Barclays has agreed to the following for the period of the next two years:

a) Commit no United States crimes whatsoever

b) Disclose information (some limitations apply)

c) Bring to attention any potential crimes

d) Bring to attention any investigations by other authorities

Additionally assist the Federal Bureau of Investigation with any aspects

In conclusion it is important to point out that this has been a clear case for the authorities. Banks are not questioning the penalties imposed against them and many have fired, or are disciplining those responsible with regards to the benchmark manipulation actions. Although in the short term the investigation might come across more banks and financial institutions practicing these cases, in the long term the effects will restore integrity and honesty in the LIBOR market. The banks that have been analysed are the two biggest participants in LIBOR manipulations; some others including RBS have been similarly at fault.

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Appendix (data retrieved from FSA’s Final Notice Report (2012))

*Graphical evidence of LIBOR data manipulation

References:

BBA (2014) about us. Available at: <https://www.bba.org.uk/about-us/bba-board/ [Accessed 13 April 2014].

Alex Jennings, Guy Smith, Ruth Shurman (2013) “Fixing The System” BBC Documentary, 8 May, [Online].

Available at: http://www.bbc.co.uk/programmes/b01sf11c [Date viewed: 8th May 2013].

Robert Peston (2012) “Barclays fined for attempts to manipulate Libor rates”, BBC News, 27 June, [Online]. Available at: http://www.bbc.co.uk/news/business-18612279 [Accessed 14 April 2014].

Robert Peston (2013) “Timeline: Libor-fixing scandal”, BBC News, 6 February, [Online]. Available at: http://www.bbc.co.uk/news/business-18671255 [Accessed 14 April 2014].

Financial Services Authority, William Amos (27 June 2012) Final Notice 2012, FSA Reference Number: 122702. Cheshunt: FSA

Denis Holden, CFTC Press Release (19 December 2012) “CFTC Orders UBS to Pay $700 Million Penalty to Settle Charges of Manipulation, Attempted Manipulation and False Reporting of LIBOR and Other Benchmark Interest Rates” [Online]. Available at: http://www.cftc.gov/PressRoom/PressReleases/pr6472-12 [Accessed 11 April 2014].

Olga Klinkowska (2014), lectures FI 4502, 10 February and 17 February

U.S. Department of Justice, Denis Mcinerney (26 June 2012) Barclays Bank PLC 2012, Washington D.C. 20530. Cheshunt: U.S. Department of Justice

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