As fresh details continue to emerge about the Libor fixing scandal that has already claimed the head of Bob Diamond, the American chief executive of British bank Barclays, everybody, it seems, is shocked – shocked! – to discover that this benchmark interest rate underlying trillions of dollars worth of financial transactions worldwide was allegedly being manipulated.
That’s the official line from the Bank of England, market regulators, the British Banking Association that oversees the Libor process, politicians on both sides of the Atlantic — and even from Diamond himself. He told a parliamentary hearing on July 4 that he was “sickened” to read emails by Barclays traders asking favors of their colleagues on the Barclays team that helped to fix the rate. The bank has agreed to pay $450 million in fines to the U.S. Commodity Futures Trading Commission and Britain’s Financial Services Authority.
But talk to bankers and current and former traders in the markets, especially those who specialized in interest-rate swap transactions, and it turns out that this generalized state of shock may be a tad disingenuous. For suspicions about manipulation of Libor, the London interbank offered rate, and its European cousin Euribor, the European interbank offered rate, are both manifold and long-standing. In the Barclays case, the CFTC found evidence dating back to 2005. But the bigger doubts about Libor and Euribor’s reliability became particularly apparent after the bankruptcy of Lehman Brothers in August 2007 and the ensuing turmoil in bank lending markets, when credit all but dried up.
Starting in the fall of 2007, almost five years ago, the financial press started writing about potential abuses, reflecting what their sources were telling them. Gillian Tett in the Financial Times appears to have been the first: On September 4 of that year she quoted a banker as calling Libor “a fiction.” The Wall Street Journal in April 2008 also ran the first of several articles about Libor’s reliability.
At the same time, suspicions started being aired in more official circles, including at meetings of bond trading associations and even in government publications, using data from the markets themselves. How so? Largely it has to do with the nature of Libor and Euribor themselves.
These rates are set by panels of banks who meet daily to disclose the average rate at which they can obtain unsecured funding for a given period. The Libor fixings, for example, cover 10 currencies, and the periods range from overnight up to a year. The top and bottom 25% of these submissions are eliminated, and the rate is calculated using the average of the 50% that are left.
But, critically, the rates that the banks submit in these sessions are not the rates they are actually paying to borrow money, but rather the rates that they estimate they would have to pay. Until the 2007 crisis, the Libor and Euribor rates tracked quite accurately the rates that were actually transacted, and which are noted by central banks. But suddenly, after Lehman, there was a very significant divergence between the benchmark Libor and Euribor rates, and the actual transaction rates.
Jean-François Borgy spotted that at once. He’s a French former swaps trader with a long record in the markets, having worked for Credit Lyonnais, Banque Worms and Natixis. He was so struck by the change that, in October 2007, he gave a presentation to the annual meeting of the European Bond Commission.
In a series of charts, he showed how the Euribor three-month rate had, since the 1999 introduction of the euro as a currency, almost without exception been mirrored by the effective European overnight rate based on actual transactions. The spread, or difference between this Eonia rate and the Euribor rate had consistently been 6.3 basis points, or 0.063%. But with the crisis it suddenly jumped to 40 basis points, or 0.4%. For a trader, that’s a huge and obvious change. As Borgy explained in his 2007 presentation, the Eonia rate is drawn from the same 47 banks who are involved in the Euribor fixing; the difference is that Eonia reflects real transactions by the banks, while Euribor simply reflects what the banks say they will do.
In other words, watch what they do, not what they say.
One obvious explanation for this huge discrepancy was that, in the market turmoil post Lehman, banks had a huge interest in playing down their own difficulties in the interbank lending market, to avoid scaring their counterparties, shareholders and regulators. That appears to have been what happened in the Barclays case, where Diamond’s colleagues interpreted questions from the Bank of England about the bank’s high submissions in the Libor process as a tacit go-ahead to artificially reduce those submitted rates.
Borgy’s presentation attracted the interest of the French financial authorities, and he ended up writing a short article about his observations for the French Treasury Agency’s monthly newsletter. It was published in November 2007.
If the highest French authorities were aware of the discrepancies, chances are that other authorities were too. On Tuesday, the New York Fed acknowledged that in late 2007 it had received “occasional anecdotal reports from Barclays of problems with Libor,” and that in spring 2008, it had inquired further as to how Libor submissions were being conducted. The Fed said in a statement that it had shared its analysis and suggestions for reform of Libor with British authorities.