LIBOR rigging

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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There is a straightforward reason for this: call deposits don’t have a term; they can be withdrawn at any time.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. 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. 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

• LIBOR rigging part 2
• Interest rate swap mis-selling scandal
• Contract
• LIBOR