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{{cn}}{{quote|
{{a|disaster|{{image|Dramatic look|jpg|''[[Dramatic look gopher]] goes to the [[British Bankers’ Association]]'' {{vsr|2024}}}}{{Disaster roll|LIBOR}}}}{{quote|
{{drop|“I|f the law}} supposes that,” said Mr. Bumble,“the law is a ass—a idiot. If that’s the eye of the law, the law is a bachelor; and the worst I wish the law is that his eye may be opened by experience—by experience.”
{{drop|“I|f the law}} supposes that,” said Mr. Bumble, squeezing his hat emphatically in both hands, “the law is a ass—a idiot. If that’s the eye of the law, the law is a bachelor; and the worst I wish the law is that his eye may be opened by experience—by experience.”
:— Charles Dickens, ''Oliver Twist''}}
:— Charles Dickens, ''Oliver Twist''}}


This appeal from Tom Hayes’ conviction for “[[LIBOR]] rigging” follows the US acquittals in 2022 of Matt Connolly and Gavin Black of the same crimes, and centres on a two-limbed question:  
== LIBOR: deep background ==
{{L3}}What do the LIBOR and EURIBOR fixing rules mean and, given they were found in a previous trial to mean one thing, while the appellants believed them to mean another, <li>
Whose job was it to decide what they meant? Was it, in other words, a matter of fact or law?</ol>


US courts, in acquitting Connolly and Black,<ref>{{citer|United States|Connolly and Black|2d Cir. 2022|No. 19-3806|}} </ref> had considered them to be matters of ''fact''. The English court considers contractual interpretation of contracts to be a matter of law. This seems right, though it leaves something out, which is ''what did the parties believe the rules to mean?''
==== Banks have structural interest rate risk ====
{{drop|T|he basic model}} of a bank is to borrow, short-term, at a low rate, and lend, long-term, at a high rate. Generally, banks calculate interest on deposits, by which they borrow, at a [[Floating rate|floating]] rate and on term loans, by which they lend, at [[Fixed rate|fixed]] rates.


Under the intellectual theory of the common law that goes only to mitigation and not liability, though — as we will see — in a market where plainly ''everyone'' shared an opinion, different from the judge’s one, about what the “LIBOR Definition” meant, this risks rendering the law “a ass”.  
There is a straightforward reason for this: [[Deposit|call deposit]]s don’t have a term; they can be withdrawn at any time. All you can do is apply a prevailing daily rate.<ref>You could look at deposits as “rolling overnight term loans”. Their fixed interest therefore resets each day. Yes: there are such things as term deposits, but roughly 70% of deposits are overnight. (see ''{{Plainlink|https://www.bankofengland.co.uk/statistics/tables|Bank of England statistics}}'').</ref> On the other hand most people borrow for a fixed term and want certainty on how much interest they must pay, so prefer fixed interest.


There is also the odd spectre of the law of [[contract]] forming the backdrop to criminal culpability: usually, the rozzers will stay out of a contractual dispute even if fraud is alleged, preferring that to be a matter of civil loss and not one requiring the machinery of the state. LIBOR being primarily of interest to third parties to the “contract” those considerations are not present, but still one must apply contractual principles to contractual matters, and not criminal ones.  
Since banks ''borrow'' in floating and ''lend'' in fixed, they have “''structural'' interest rate risk”. It is a natural function of how banks work. They want floating rates to be low, and to move lower.  If they don’t manage this risk, things can get funky, fast. Just ask [[Silicon Valley Bank]].


====Everyone was at it====
So knowing what that floating rate is, and managing it, is an important risk management function for the bank. A risk well managed is called a “return”. The floating rate is different from the central bank’s base rate, and moves daily in response to market conditions.
A fun game, if you have twenty minutes, is to google the names of the {{plainlink|https://en.wikipedia.org/wiki/Libor|Seventeen LIBOR panel banks}} to see if any of them were ''not'' somehow implicated in so-called “LIBOR rigging”.


If you haven’t got twenty minutes, then the WSJ’s completely ''brilliant'' {{plainlink|https://graphics.wsj.com/libor-network/|spider network}} will give you the answer in an instant.
Where does this “floating rate” come from, then


''Everyone'' was at it. This means either (a) there was a collossal conspiracy at which everyone was trying to rip off the general public for personal gain and, since their efforts would naturally cancel each other out, probably failing or (b) ''this is how everyone understood to the LIBOR system to work''. It might not be edifying, but employees have fiduciary obligations to their shareholders, and if everyone acts according to those fiduciary obligations — or even their own personal self interests — the selfishness cancels itself out. This is ''exactly'' the logic of Adam Smith’s [[Free market|invisible hand]].
In the good old days, each bank worked out its own floating rates based on its own models, funding costs and market positioning. This process was neither transparent nor standardised. Rates could vary significantly between similar banks. As long as interest rates were not tradable instruments, this did not much matter to banks: they just told their customers what the floating rate was each day, and that was that.
 
In the early nineteen eighties, some [[First Men|bright sparks]] at [[Salomon Brothers]] figured out how to make interest rates into a tradable instrument. To standardise that instrument, the banks realised they would need a common way of describing how their interest rates change through time. A “benchmark”.
 
==== Chess club ====
{{Drop|E|nter the}} the [[British Bankers’ Association]]. This was just the sleepy, city-grandees-in-a-smoke-filled-gentlemen’s-club-in-Threadneedle-Street of your imagination. It began to compile what it called the “London Interbank Offered Rate” — “[[LIBOR]]”. This was to be an objective distillation of all the major banks’ borrowing rates.
 
The method the BBA chose to compile it was simple: it invited 18 major banks to
literally, ''phone in'' what they believed they could borrow in various currencies and maturities in the market each day. The BBA would then compile the submissions, “trim” off the top and bottom four, average the rest and publish a set of daily LIBOR rates for each currency and maturity, before toddling off for a liquid lunch at the Garrick and their regular three o’clock tee time at Wentworth.
 
You get the picture.
 
With LIBOR published, the banks could then set their rates for call deposits, calculate suitable fixed rates for new term loans, and more importantly trade standardised interest rate instruments  by reference to the new LIBOR “benchmark”.
 
Happy, unadventurous stuff, carried out by happy, unadventurous people. Look: we don’t want to run the interest rate-setting crowd down, but before 2007, the LIBOR rate setting process was like the after-school chess club: snoresville. All the cool kids were out shagging, smoking weed and shorting structured credit. None of the hepcats paid much attention to LIBOR.
 
Now. It is one of JC’s [[Financial disasters roll of honour|axioms of financial scandal]] that [[Air crashes v financial crashes|''calumny happens where you least expect it'']]. This is because success in financial services is in large part about “[[edge]]”, and you generally only find an [[edge]] where no-one else is looking for it.
 
==== The cool kids ====
{{Drop|T|om Hayes was}} a cool kid (''metaphorically'': literally he has been described as “socially awkward”) but he hung out in the chess club. He, and a bunch of other groovers, found some [[edge]] there, where no one was looking for it. No one bothered them and they didn’t do a lot of harm — not, at least, that anyone has been since able to point to. But they sent each other lots of [[embarrassing emails]].
 
In any case, they made an effort to submit LIBOR rates that suited their derivatives trading positions and not, necessarily, their banks’ structural interest rate positions.
 
That this all came to light as a result of the unrelated “lowballing” scandal, after which lots of people began looking very hard at LIBOR, and not liking what they saw.
 
Another one of JC’s axioms: [[If you like sausages, don’t work in a smallgoods factory|''if you like sausages, don’t work in a smallgoods factory'']].
 
As per the “basic banking model”, to manage its structural interest rate risk, a bank ''generally'' would want LIBOR to be low. But deposits are not the only show in town — there are other exposures to the interest rate market: notably, the new tradable instruments: [[interest rate swap]]s.
 
==== Interest rate swaps ====
{{Drop|I|n an interest}} rate swap, the bank “swaps” interest rates with individual counterparties: it might, for an agreed period, pay one counterparty a fixed rate and receive from it a floating rate; with another it might pay floating and receive fixed.
 
Before the advent of swaps, the only way of getting exposure to interest rates was by borrowing and lending principal. This required a lot of money down.<ref>It is a [[a swap as a loan|misconception]] that interest rate swaps do not involve principal borrowing and lending, but that is a story for another day</ref> Interest rate swaps got popular, fast. There are now trillions of dollars in notional interest rate swaps outstanding on any day.
 
Unlike basic banking, there is no structural bias to swap trading. If a bank swaps a five-year fixed rate for a five-year floating rate, and LIBOR then goes up, by definition the bank profits: the “[[present value]]” of its incoming floating rate will increase while the [[present value]]  of its outgoing fixed rate stays the same. The dealer is therefore “[[in-the-money]]”. If it swapped floating for fixed in the same case, it would book a corresponding loss.
 
While banks try to balance their books so their portfolio of customer swaps offset each other as far as possible, how they “position” the book might help manage the bank’s ''structural'' interest rate risk.
 
Under the “basic banking model”, a bank will always be “[[Axe|axed]]” for floating rates to be as low as possible. You would expect a basic bank’s LIBOR submissions to reflect that. But a swap trader who is “long” floating rates will wish floating rates to go ''higher''.
 
This prospect, we venture, was not wildly present in the minds of the Sir Bufton Tuftons who formulated the LIBOR rules that defined how submitting banks should choose the rates they submit each day.
 
The question arose later, even though it did not arise then: when submitting a rate, what account, if any, may a bank take of its own derivatives trading book? 
==== The LIBOR Definition====
{{drop|T|he [[UK Finance|BBA]]’s guidance}} came in the form of “Instructions to BBA LIBOR Contributor Banks”. The critical part of these — what the court called the “LIBOR Definition” — ran as follows:


=== The “LIBOR Definition” ===
The dispute comes down to the meaning of the rules LIBOR submitters were meant to follow when submitting their rates. The “LIBOR Definition” provided:
{{Quote|“An individual BBA LIBOR Contributor Panel Bank will contribute ''the rate at which it could borrow funds'', were it to do so by asking for and then accepting inter-bank offers in reasonable market size just prior to 1100.”}}
{{Quote|“An individual BBA LIBOR Contributor Panel Bank will contribute ''the rate at which it could borrow funds'', were it to do so by asking for and then accepting inter-bank offers in reasonable market size just prior to 1100.”}}
Now, seeing as the different desks and functions of a universal bank borrow in different markets, from different counterparties and in different circumstances, clearly there will be no single unitary rate that the market will offer. The submitter will be confronted with a range of rates. Plainly it would be odd to submit a rate that was completely ''outside'' that range, but each of those rates counts as “''a'' rate at which it could borrow funds”.
The judgment interpreted that as the ''lowest'' of the submitted rates in the range.


{{Quote|In the LIBOR Definition what is required is an assessment of the rate at which the panel bank “could borrow”.  ''That must mean the cheapest rate at which it could borrow''.  A borrower “can” always borrow at a higher rate than the lowest on offer. But the higher rate would not reflect what the LIBOR benchmark is seeking to achieve, namely identification of the bank’s cost of borrowing in the wholesale cash market at the relevant moment of time. If in a stable and liquid market a submitting bank seeks and receives offers for a reasonable market size at the very time it is to make its submission, and receives offers ranging from 2.50% to 2.53%, it would accept the offer at 2.50%. It would be absurd to suggest that the LIBOR question could then properly be answered by a submission of 2.53%. The bank “could” borrow at that rate in the sense that it was a rate which was available, but that is obviously not what “could” means.}}
On any day there will be a range of rates at which a bank ''could'' borrow. These might be firm offers from other lenders, good faith estimates or model outputs. There is an excellent [[subjunctive]] in there, by the way: “''were'' it to do so” implies that that a submitting bank need not ''actually'' do so.  


There is some economic logic to this argument, though it seems a brutal grounds for sending someone to prison for 14 years given how easy it would have been for those drafting the LIBOR rules to have put the matter beyond any doubt: namely, by inserting the word “lowest”:
Say the range of available rates a bank sees on a given day is between 2.50% and 2.53%. Which of these is “''the'' rate at which it could borrow funds”? You can only choose one.


{{Quote|“An individual BBA LIBOR Contributor Panel Bank will contribute the ''lowest'' rate at which it could borrow funds ...}}
Setting aside for a moment compliance with the LIBOR Definition, the possible avenues open to a bank in submitting a rate are:


And the argument here is not about economic reality, but legal meaning, and legal meaning follows natural, ordinary meanings, and in the world of contractual interpretation, they tend to be construed from the perspective of the person endeavouring to perform the contract and [[Contra proferentem|against the draftsperson’s interest]], giving the benefit of the doubt to the reader.  
''Pick an “available” rate'': Choose one of the rates from the range, as above.  


As a matter of plain English, the court openly concedes that “could” does not logically rule out a higher rate, but implies it: “a borrower ''can'' always borrow at a higher rate than the lowest one on offer”.  
''Manufacture a blended rate from the range'':  Contrive some artificial rate from within that range, reflecting a median, a weighted average, or some such thing.


But — per the wording in the LIBOR definition — there is not an unlimited upper bound to that: it is delimited by the range of “inter-bank offers in reasonable market size just prior to 1100”.  
''Make one up'': Submit a rate that did not fall within the estimated range, whether lower or higher.


A submitted could not submit a rate higher than that actually offered range any more than it could submit a rate lower than the actually offered range.  
“Making one up” plainly falls outside the scope of the LIBOR Definition. “Making a blended rate” does not quite conform to its text, but perhaps captures its spirit.


To conclude this “could” does not mean that, therefore, involves ''implying'' a term into the contract. Inserting an adjective that the drafters of the rules could easily have included ''but chose not to''.  
To an uncomplicated reading, “picking one of the available rates” seems to fall squarely ''within'' the LIBOR Definition. This was a rate at which the bank ''could'' borrow funds.


Evidence was not led as to how the rules were drafted, and what flexibility the British Bankers’ Association had in mind. and after all, history has borne out that, sometimes, there are times where Banks and their regulators are rightly motivated by considerations other than the actual (lowest) rate at which one could borrow.  
This is what Hayes did. The complication is that he actively selected the available rate that best suited his or, in some cases, competitors’ derivative trading positions. That is, he was guided by his own commercial interests, and not the “structural” interests of a hypothetical basic bank.  


It is not often JC favours a US interpretation of things, but consider this from {{casenote|United States|Connolly and Black}}:
This is the crux of the case: was this ulterior motive ''dishonest'' in light of the “''proper basis for the submission of those rates''”? The Crown alleged it was.
{{quote|
The precise hypothetical question to which the LIBOR submitters were responding was at what interest rate “could” DB borrow a typical amount of cash if it were to seek interbank offers and were to accept. ''If the rate submitted is one that the bank could request, be offered, and accept, the submission, irrespective of its motivation, would not be false''.}}


{{sa}}
{{sa}}
*[[LIBOR rigging part 2]]
*[[Interest rate swap mis-selling scandal]]
*[[Contract]]
*[[LIBOR]]
*[[LIBOR]]
{{ref}}
{{ref}}

Latest revision as of 08:49, 21 May 2024

Chez Guevara — Dining in style at the Disaster Café™
Extract from the JC’s financial disasters roll of honour
Scandal Date Where Loss Reason Firings Jail-Time?
LIBOR rigging 2009 Worldwide “If your mortgage or car-loan was pinned to Libor then perhaps you were disadvantaged by the manipulation of the rate. But it is also possible that you benefited from it.” To date, no one has been able to prove any loss. Bad apples Lots of firings of mid-level traders and rate submitters. Strange absence of exits from the Executive Suite, though you could say it contributed to Bob Diamond’s defenestration Tom Hayes and Carlo Palombo were among 37 City traders prosecuted for manipulating benchmarks Libor and Euribor. Both men spent time in prison before being released in 2021. Matt Connolly and Gavin Black were convicted in the US then their convictions were overturned in 2023.

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“If the law supposes that,” said Mr. Bumble, squeezing his hat emphatically in both hands, “the law is a ass—a idiot. If that’s the eye of the law, the law is a bachelor; and the worst I wish the law is that his eye may be opened by experience—by experience.”

— Charles Dickens, Oliver Twist

LIBOR: deep background

Banks have structural interest rate risk

The basic model of a bank is to borrow, short-term, at a low rate, and lend, long-term, at a high rate. Generally, banks calculate interest on deposits, by which they borrow, at a floating rate and on term loans, by which they lend, at fixed rates.

There is a straightforward reason for this: call deposits don’t have a term; they can be withdrawn at any time. All you can do is apply a prevailing daily rate.[1] On the other hand most people borrow for a fixed term and want certainty on how much interest they must pay, so prefer fixed interest.

Since banks borrow in floating and lend in fixed, they have “structural interest rate risk”. It is a natural function of how banks work. They want floating rates to be low, and to move lower. If they don’t manage this risk, things can get funky, fast. Just ask Silicon Valley Bank.

So knowing what that floating rate is, and managing it, is an important risk management function for the bank. A risk well managed is called a “return”. The floating rate is different from the central bank’s base rate, and moves daily in response to market conditions.

Where does this “floating rate” come from, then?

In the good old days, each bank worked out its own floating rates based on its own models, funding costs and market positioning. This process was neither transparent nor standardised. Rates could vary significantly between similar banks. As long as interest rates were not tradable instruments, this did not much matter to banks: they just told their customers what the floating rate was each day, and that was that.

In the early nineteen eighties, some bright sparks at Salomon Brothers figured out how to make interest rates into a tradable instrument. To standardise that instrument, the banks realised they would need a common way of describing how their interest rates change through time. A “benchmark”.

Chess club

Enter the the British Bankers’ Association. This was just the sleepy, city-grandees-in-a-smoke-filled-gentlemen’s-club-in-Threadneedle-Street of your imagination. It began to compile what it called the “London Interbank Offered Rate” — “LIBOR”. This was to be an objective distillation of all the major banks’ borrowing rates.

The method the BBA chose to compile it was simple: it invited 18 major banks to literally, phone in what they believed they could borrow in various currencies and maturities in the market each day. The BBA would then compile the submissions, “trim” off the top and bottom four, average the rest and publish a set of daily LIBOR rates for each currency and maturity, before toddling off for a liquid lunch at the Garrick and their regular three o’clock tee time at Wentworth.

You get the picture.

With LIBOR published, the banks could then set their rates for call deposits, calculate suitable fixed rates for new term loans, and more importantly trade standardised interest rate instruments by reference to the new LIBOR “benchmark”.

Happy, unadventurous stuff, carried out by happy, unadventurous people. Look: we don’t want to run the interest rate-setting crowd down, but before 2007, the LIBOR rate setting process was like the after-school chess club: snoresville. All the cool kids were out shagging, smoking weed and shorting structured credit. None of the hepcats paid much attention to LIBOR.

Now. It is one of JC’s axioms of financial scandal that calumny happens where you least expect it. This is because success in financial services is in large part about “edge”, and you generally only find an edge where no-one else is looking for it.

The cool kids

Tom Hayes was a cool kid (metaphorically: literally he has been described as “socially awkward”) but he hung out in the chess club. He, and a bunch of other groovers, found some edge there, where no one was looking for it. No one bothered them and they didn’t do a lot of harm — not, at least, that anyone has been since able to point to. But they sent each other lots of embarrassing emails.

In any case, they made an effort to submit LIBOR rates that suited their derivatives trading positions and not, necessarily, their banks’ structural interest rate positions.

That this all came to light as a result of the unrelated “lowballing” scandal, after which lots of people began looking very hard at LIBOR, and not liking what they saw.

Another one of JC’s axioms: if you like sausages, don’t work in a smallgoods factory.

As per the “basic banking model”, to manage its structural interest rate risk, a bank generally would want LIBOR to be low. But deposits are not the only show in town — there are other exposures to the interest rate market: notably, the new tradable instruments: interest rate swaps.

Interest rate swaps

In an interest rate swap, the bank “swaps” interest rates with individual counterparties: it might, for an agreed period, pay one counterparty a fixed rate and receive from it a floating rate; with another it might pay floating and receive fixed.

Before the advent of swaps, the only way of getting exposure to interest rates was by borrowing and lending principal. This required a lot of money down.[2] Interest rate swaps got popular, fast. There are now trillions of dollars in notional interest rate swaps outstanding on any day.

Unlike basic banking, there is no structural bias to swap trading. If a bank swaps a five-year fixed rate for a five-year floating rate, and LIBOR then goes up, by definition the bank profits: the “present value” of its incoming floating rate will increase while the present value of its outgoing fixed rate stays the same. The dealer is therefore “in-the-money”. If it swapped floating for fixed in the same case, it would book a corresponding loss.

While banks try to balance their books so their portfolio of customer swaps offset each other as far as possible, how they “position” the book might help manage the bank’s structural interest rate risk.

Under the “basic banking model”, a bank will always be “axed” for floating rates to be as low as possible. You would expect a basic bank’s LIBOR submissions to reflect that. But a swap trader who is “long” floating rates will wish floating rates to go higher.

This prospect, we venture, was not wildly present in the minds of the Sir Bufton Tuftons who formulated the LIBOR rules that defined how submitting banks should choose the rates they submit each day.

The question arose later, even though it did not arise then: when submitting a rate, what account, if any, may a bank take of its own derivatives trading book?

The LIBOR Definition

The BBA’s guidance came in the form of “Instructions to BBA LIBOR Contributor Banks”. The critical part of these — what the court called the “LIBOR Definition” — ran as follows:

“An individual BBA LIBOR Contributor Panel Bank will contribute the rate at which it could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size just prior to 1100.”

On any day there will be a range of rates at which a bank could borrow. These might be firm offers from other lenders, good faith estimates or model outputs. There is an excellent subjunctive in there, by the way: “were it to do so” implies that that a submitting bank need not actually do so.

Say the range of available rates a bank sees on a given day is between 2.50% and 2.53%. Which of these is “the rate at which it could borrow funds”? You can only choose one.

Setting aside for a moment compliance with the LIBOR Definition, the possible avenues open to a bank in submitting a rate are:

Pick an “available” rate: Choose one of the rates from the range, as above.

Manufacture a blended rate from the range: Contrive some artificial rate from within that range, reflecting a median, a weighted average, or some such thing.

Make one up: Submit a rate that did not fall within the estimated range, whether lower or higher.

“Making one up” plainly falls outside the scope of the LIBOR Definition. “Making a blended rate” does not quite conform to its text, but perhaps captures its spirit.

To an uncomplicated reading, “picking one of the available rates” seems to fall squarely within the LIBOR Definition. This was a rate at which the bank could borrow funds.

This is what Hayes did. The complication is that he actively selected the available rate that best suited his or, in some cases, competitors’ derivative trading positions. That is, he was guided by his own commercial interests, and not the “structural” interests of a hypothetical basic bank.

This is the crux of the case: was this ulterior motive dishonest in light of the “proper basis for the submission of those rates”? The Crown alleged it was.

See also

References

  1. You could look at deposits as “rolling overnight term loans”. Their fixed interest therefore resets each day. Yes: there are such things as term deposits, but roughly 70% of deposits are overnight. (see Bank of England statistics).
  2. It is a misconception that interest rate swaps do not involve principal borrowing and lending, but that is a story for another day