LIBOR rigging

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“The courts have for many years been developing and using a broad concept which at times has threatened to bring chaos rather than light to the solution of the legal problems it has affected. This concept enunciates the division between questions of law and questions of fact.

—What is a “Question of Law”?, Arthur W. Phelps, 1949, bringing yet more chaos to the table.

“If 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.”

— Charles Dickens, Oliver Twist

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 There is a straightforward reason for this: call deposits don’t have a term: they can be withdrawn at any time.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. On the other hand, most people who borrow for a fixed term want certainty on how much interest they must pay, so they 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:

So, a foundational question: Where does this “floating rate” come from?

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 opaque and unstandardised. Rates could vary significantly between similar banks.

Enter, in the nineteen eighties, the British Bankers’ Association. This was just the sleepy, city-grandees-in-a-smoke-filled-gentlemen’s-club-in-Threadneedle-Street of your imagination. Inasmuch as it ever did anything useful, the BBA compiled the “London Interbank Offered Rate” — “LIBOR” — sleepily, by inviting 18 major banks to, literally, phone in the rate at which they believed they could borrow in various currencies and maturities in the market each day.

The BBA would compile the submissions, “trim” off the top and bottom four, average the rest and publish the result as a set of daily LIBOR rates for each currency and maturity, before toddling off for a liquid lunch at the Garrick and a regular three o’clock tee time.

You get the picture.

With LIBOR published, the banks could then set its rates for call deposits, calculate suitable fixed rates for new term loans, by reference to this standardised “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 the after-school chess club: all the cool kids were out shagging, smoking weed and shorting structured credit. No-one cared much about LIBOR.

Interest rate derivatives

As per the “basic banking model”, to manage their structural interest rate risk, banks generally would want LIBOR to be low — but deposits are not the only show in town. Banks have other exposures to the interest rate market. One notable category: interest rate swaps. Swaps emerged as an asset class in the early 1980s, and there is a good argument to be made that LIBOR — instituted in 1986 — was a direct response to the burgeoning interest rate swaps market, which could only work if floating rates were standardised.

In an interest rate swap, the bank exchanges — swaps — interest rate cashflows 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.

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 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 loss.

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

We can see in any case that, notwithstanding the bank’s structural interest rate risk, a swap trader who is, net, “long” floating rate wishes floating rates to go higher. If her position is large enough, so might the whole bank.

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

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 find the most edge where no-one else is looking. In the lead up to the global financial crisis, no-one was looking very hard at LIBOR.

Tom Hayes was a cool kid (metaphorically: he doesn’t seem to have been very literally cool at all). 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 any harm — at least, not 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 books and not, necessarily, the bank’s structural interest rate position.

The question arises: when submitting a rate, what account can you take of your bank’s 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 would 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 it need not actually do so.

Say the range of available rates on a given day was, as the court hypothesised, between 2.50% and 2.53%. Which of these was “the rate at which it could borrow funds”? Plainly, a submitter could not submit all of them.

The logical options (setting aside for now their legality) were:

Pick an “available” rate: Choose one rate from those that were genuinely available per the bank’s good faith enquiry as above.

Manufacture a blended rate from the range: Contrive some artificial rate from within that range, reflecting 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 the text, but perhaps captures its spirit. But in any case, Hayes did neither of these things. “Picking one of the available rates” is what Hayes actually did. To an uncomplicated reading of the LIBOR Definition, Hayes fell squarely inside it. This was a rate at which the bank could borrow funds.

The complication is that Hayes actively selected the available rate that best suited his derivative trading position. That is, he was guided by his desk’s commercial interest, and not, the bank’s “structural” commercial interest.

This is the crux of the case. Having this ulterior motive — dishonest in light of the proper basis for the submission of those rates so the Crown alleged — was an imprisonable conspiracy to defraud.

“A conspiracy to defraud”

Hayes was indicted on the ancient common law offence of “conspiracy to defraud”. Criminal law minutiae, perhaps, but he was not charged with a statutory criminal offence under the Fraud Act 2006. That Act followed a Law Commission survey of the criminal law of fraud, which had also recommended abolishing common law conspiracy to defraud, because it was “unfairly uncertain, and wide enough to have the potential to catch behaviour that should not be criminal”. The government did not follow the Law Commission’s recommendation.

“The government decided to retain it for the meantime, but accepted the case for considering repeal in the longer term.”

In any case, common law conspiracy to defraud was not abolished, still hasn’t been, that is what Hayes was charged with.

Being a common law offence, elements of the offence are not sharply delineated — a good policy reason to abolish all common law crimes, but anyway — but it seems to be along the lines that there was an agreement between persons who intended to defraud someone by doing something dishonest with a likelihood of resulting loss, even if no loss eventually arose..

The crux: was Hayes dishonest when he submitted his LIBOR rates?

That, in turn, came down to whether Hayes “deliberately disregarded the “proper basis” for the submission of those rates”.

The first instance court did not really dwell on the meaning of the LIBOR Definition, but rather whether Hayes’ intentions when choosing the rate he submitted were to reflect “the bank’s genuine perception of its borrowing rate”.

The court framed its instructions to the jury as follows:

“1. Did Mr Hayes agree with any individual as named in the counts, to procure the making of a submission by a bank of a rate which was not that bank’s genuine perception of its borrowing rate for the tenor in question in accordance with the LIBOR definition but was a rate which was intended to advantage Mr Hayes’s trading?

If the answer is No, Mr Hayes is not guilty on that Count. If the answer is Yes, proceed to Question 2.

2. Was what Mr Hayes did dishonest by the ordinary standards of reasonable and honest people?

If the answer is No, Mr Hayes is not guilty on that Count. If the answer is Yes, proceed to Question 3.

3. Did Mr Hayes appreciate that what he was doing was dishonest by those standards?

If the answer is No, Mr Hayes is not guilty on that Count. If the answer is Yes, Mr Hayes is guilty on that Count.”

Hayes was sent to prison for 14 years, though this was later reduced to 11. He was not the only one. A total of thirty-seven traders were prosecuted for interest rate benchmark manipulation in London and New York of whom nineteen were convicted and nine imprisoned.

This is interesting purely because of its scale — we’ll come to that — but also because of the fortunes of two Deutsche Bank submitters, also convicted for manipulating LIBOR in the United States in similar circumstances, who then appealed. There, too, the question boiled down to what the LIBOR Definition actually meant.

Meanwhile, in Gotham City

Now, an ocean away, an American appeals court had considered that very question in the matter of United States v Connolly and Black, two Deutsche Bank submitters convicted for manipulating LIBOR.

Followers of current events may even know that the US courts overturned their convictions, considering the question before them to be one of fact: the text of the “LIBOR Definition” as filtered through the prisms of grammar, usage, subject matter expert opinion and industry practice.

The question of law — whether the submitters were dishonest — depended a great deal on matters of fact — such as what did those submitting rates believe was permitted within the LIBOR Definition, and if that seemed far-fetched, what a reasonable person reading the definition would think it required.

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.

This led the US courts to conclude that picking from a range of available rates, whatever your motivations for your choice could not be fraudulent. It was within the rules.

Buoyed by the outcome in New York, Hayes persuaded the Criminal Cases Review Commission to refer his case to the Court of Appeal for reconsideration, to consider the New York Court’s interpretation of the LIBOR Definition.

The Hayes appeal

The Court of Appeal considered first a question of legal methodology: whose job was it to determine what the LIBOR Definition meant, and by reference to what?

The court was not confining itself, even “principally”, to the language of the [LIBOR Definition] but was taking into account the evidence ... as to how those particular submitters arrived at their submissions in practice. ... This means ... that the question of how the LIBOR Definition was to be construed was being treated as an issue of fact for the jury.

The Court of Appeal disagreed. Under English law, contractual interpretation is a matter of law, to be resolved by the judge. Evidence of market practice, or the belief of submitters, did not enter into it.

The Court of Appeal parsed the LIBOR Definition and interpreted it to mean the lowest of the submitted rates in the range:

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.

Crimes and contracts

Bear in mind that the “legal question” to be answered here is one of criminal law, not contract. The contract is merely the factual background upon which a crime was allegedly committed. The LIBOR definition, as near as can be approximated, formed part of a contract.

Under the intellectual theory of criminal law, ignorance or misunderstanding of the law is no excuse. This is as axiomatic for an effective criminal justice system as “all interests in cash pass by delivery” is to finance. The system would not work were defendants allowed to plead ignorance, even presumptively. Ignorantia legis non excusat, if you are blameless in your inadvertence, is a moral iniquity but still a logical imperative of government.

This same imperative does not hold for a contract. Quite the opposite: the whole theory of contract is that the parties are materially cognisant of the whole thing. That is what offer and acceptance requires.

So the rules of contractual interpretation have forged a different path:

Interpretation is the ascertainment of the meaning which the document would convey to a reasonable person having all the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time of the contract. [...] The background was famously referred to by Lord Wilberforce as the “matrix of fact,” but this phrase is, if anything, an understated description of what the background may include. Subject to the requirement that it should have been reasonably available to the parties and to the exception to be mentioned next, it includes absolutely anything which would have affected the way in which the language of the document would have been understood by a reasonable man.

—Lord Hoffman in Investors Compensation Scheme Ltd v West Bromwich Building Society [1998] 1 WLR 896

A couple of observations:

One: plainly, what a contract means is, in some way, fact-dependent. It is not, purely, a matter of law. A contract testifies to the parties’ agreement. It cannot be sovereign to it.

Another: how everyone behaved when interacting with the LIBOR Definition helps work out what a reasonable person would have understood it to mean. There is no better indication of reasonableness than direct evidence of the behaviour of fellow passengers on the Clapham Omnibus.

There is here the odd spectre of the law of contract forming the backdrop and comprising some of the elements of a criminal allegation. This is rare. Usually, the criminal authorities stay well out of commercial disputes, even where allegations of fraud are flying around — there is a civil tort of fraud — seeing it as a matter of civil loss between merchants perfectly able to look after themselves, and not one requiring the machinery of the state.

LIBOR, on whom the mortgage repayments of unwitting retail punters depend, made things a bit different. This is no private matter to be sorted out between gentlemen with revolvers. Nevertheless, still one must apply contractual principles, not criminal ones, to matters of contractual practice.

And the argument here is not about economic reality but legal meaning, and legal meaning follows natural, ordinary meaning, and in the world of contractual interpretation, that is viewed from the perspective of the person performing the contract and against the draftsperson’s interest, giving the benefit of the doubt to the reader.

The same doubt, as it happens, is given to defendants in case of ambiguously framed crimes. For if the LIBOR Definition meant to sanction mandate this “obvious” outcome, it did not do a very good job of it. As a matter of plain English, “could borrow” does not rule out a higher rate, but rather implies it: the Court of Appeal concedes as much, at para 89:

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.

The “obviousness” to which the Court appeals here, is not a legal one — show me the authority for that — but one of a certain economic intuition. If that was the intended legal meaning it would have been really easy to fix it to it was clear.

But — per the wording in the LIBOR definition — there is an upper bound to that, delimited by the range of “inter-bank offers in reasonable market size just prior to 1100”. A submitter could not submit a rate higher than any actually offered, any more than it could submit a rate lower than the actually offered range.

But to construe “the rate at which it could borrow funds” to mean “the lowest rate ... ”, involves implying a term into the contract that is not there. It would have been easy enough for the old grandees to have put the matter beyond doubt before knocking the top off that Château de Chasselas, with a single modifying adjective:

“An individual BBA LIBOR Contributor Panel Bank will contribute the lowest rate at which it could borrow funds ...

But they did not. If they wanted to isolate the risk of a bank talking its own book they could have invited LIBOR banks to submit the minimum rates they were prepared to lend to each other. They did not do that either.

As the system was configured, riven with inherent conflict of interest, there were any number of ways banks could — and for all we can tell now, probably did — skew the data: from whom do you seek bids? How late or early do you seek them? How do you phrase your request?

In the absence of clearly drafted prohibitions, given a vaguely articulated common law crime seen as unsatisfactory even by the executive, it seems pretty rich to insist upon a literal reading of a set of rules which didn’t say a lot and to which, on the evidence, no-one paid a great deal of attention. There was a ton of room for flex. We should not be surprised to see people use it to their commercial ends. That is how markets work.

Everyone was at it

And after all, everyone was at it. A fun game, if you have twenty minutes, is to google the names of the LIBOR panel banks to see which were not somehow implicated in so-called “LIBOR rigging”. If you haven’t got twenty minutes, the WSJ’s brilliant interactive spider network will give you the answer in an instant. There were thirty-nine prosecutions for LIBOR manipulation.

Everyone was at it.

We must draw one of two conclusions: either there was a colossal conspiracy by which everyone was trying to rip off the general public — and failing — or this is how everyone understood LIBOR 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 invisible hand.

Conflict of interest

It is not clear what the theory underlying the LIBOR prosecutions was. We can speculate, but none survive close inspection.

Is the idea of a merchant prioritising its own commercial interests somehow reprehensible? This will be news to economists, and indeed the commercial courts who have frequently expected merchants to do nothing else.

Should LIBOR submitters should avoid conflicts of interest? How can they? The LIBOR rate is structurally fundamental to the economics of banking. In making LIBOR submissions, all banks had an inherent conflict of interest. Any submission must be at some level, in, counter to or magically neutral to the bank’s intrinsic interest rate exposure. A submission weighted to the lowest available rate structurally favours a bank that is not hedging its interest rate risk: why is that okay?

Is the LIBOR rate designed to protect investors, and if so which ones, and why are they special? As noted, classic bank customers would benefit from a higher rate, not a low one. This is of course, all very complicated because banks are very complicated. It is not obvious what is or is not in a bank’s interest.

Stare decisis

This is a real lawyer nerd-out, but in forming its decision the Court of Appeal was confronted with some of its own prior rulings and judgments. The common law doctrine of precedent means an appeal court is generally bound by its own previous decisions in analogous cases. Usually, these cases are unrelated. But here the prior decisions were “interlocutory” hearings in the actual case being appealed — certain legal points were “escalated” to the Court of Appeal during the High Court trial.

On one hand, it should not make a difference that it is the same case. On the other, that makes a bit of a mockery of the appeal process if the appellate court is bound by the judgment being appealed against, which is what the Court found itself to be here. This should, at least, be a decent justification for a further appeal to the Supreme Court.

See also

• Contract
• LIBOR