LIBOR rigging: Difference between revisions

{{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. There is a straightforward reason for this: [[Deposit|call deposit]]<nowiki/>s don’t have a term: they can be withdrawn at any time.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 who borrow for a fixed term want certainty on how much interest they must pay, so they prefer fixed interest.  

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.

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.

{{drop|A|s 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 swap mis-selling scandal|interest rate swap]]s. Swaps [[Swap history|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 [[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 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?