Libor Manipulation

LIBOR - what is it?

The London Interbank offered rate is the rate at which leading banks in London would be charged if they will borrowing from other banks. This is usually shortened two LIBOR.

In the early 1980s as banks were starting to trade actively in a number of new market instruments such as options interest rate swaps and Forward rate agreements. Many banks considered the new instruments to be extremely attractive however one of the drawbacks wasn't the underlying rates used within these agreements had to be defined before entering into contracts.

The British bankers' association was passed by the banks it represents to bring a measure of the uniformity to the market and devise a benchmark to act as a reference for these new instruments. Rather than negotiating the underlying rate or forming rates by taking and use of alcohol panels, banks could now use the standard rate. This facilitated the operation of markets and made benchmarking more transparent and objective. I am

In October 1984 the British bankers' association (BBA) working with other parties including the Bank of England established a working party which culminated in producing BBAIRS terms, the BBA standard for interest rate swaps. From the 2nd of September, 1985 the use of BBAIRS became the standard market price.

This led to the first local rates being published on January 1986 initially in a only three currencies, U.S. dollars, Japanese yen and Sterling. The range of calculated currencies has now increased significantly pound LIBOR is calculated for 10 currencies with 15 maturities for each currency.

The question that is used to establish LIBOR rate is, "At what rate could you borrow funds, were you to do so by asking for and then excepting Interbank offers is in reasonable market size just prior to 11.00 AM"

LIBOR is calculated and published by Thompson Reuters, on behalf of the BBA, who take the responses from 18 major banks then throws out the four highest and the four lowest and takes an average of the remaining 10 on a variety of different timetables, the result is published each day at 11.30 AM, and is the daily LIBOR rate..

This publication of LIBOR was to try and provide a benchmark by which specific institutions could understand and judge the creditworthiness or risk associated with lending between themselves or other institutions. The method of arbitration between multiple banks is such that it is intended to provide a stable and multi referenced position and thereby give a formal indication of market conditions between banks. This is the spirit in which he was intended.

Governance of LIBOR

LIBOR is calculated for 15 different maturities and 10 different currencies using submissions from a panel of between six and 18 contributing banks. Management of the process is undertaken by BBA LIBOR Ltd, a subsi diary of the BBA which is run by an executive known as the BBA LIBOR manager.

Source: The Wheatley Review of LIBOR: initial Discussion Paper: HM Treasury

In total, 24 banks currently contribute to LIBOR, although not every bank is a member of every currency panel; each panel contains between six and 18 banks. Individual banks apply to become a member of a particular LIBOR panel and are assessed for their suitability against three criteria by the body responsible for overseeing the LIBOR process (the Foreign Exchange and

Money Markets (FX&MM) Committee), taking into account :

* the scale of market activity of the bank;

* the bank's reputation; and

* the bank's perceived expertise in the particular currency.

While this approach is intended to ensure that the most relevant banks participate, it does have the effect of restricting the pool of contributors to a fairly narrow set of institutions, the implications of which are discussed below.

Reliability of LIBOR method

In the late eighties and early nineties as complex derivatives markets grew and a number of new Financial Instruments were introduced LIBOR had by this time become the benchmark by which rates were set for these instruments, and according to the Financial Times, it is estimated that between $300trn - $400trn of onward financial transactions is pegged to the LIBOR rate.

Source: The Wheatley Review of LIBOR: initial Discussion Paper: HM Treasury

It difficult to know when LIBOR may have started to be being manipulated, and it is possible that a number of the manipulations may have been unintentional. For example a research paper from the Federal Reserve's Jeremy Berkowitz (now a professor at the University of Houston) indicates that the US Federal Reserve was concerned about the possible manipulation of LIBOR manipulation as early as February 1998.

Within the document he publishes, Jeremy Berkowitz puts forward an alternative method of calculating LIBOR rates, he did this because it became clear that the Fed has already seen three examples of misreporting from one UK bank in early 1996.

He indicates that these may have been "undoubtedly...unintentionally misreported," and his writing of a paper to put forwards possible scenarios to prevent against such errors suggests a great deal of interest from the Fed in this subject.

Because the BBA currently controls misreporting for LIBOR Sterling and Dollar rates by throwing out the four highest and lowest estimates that banks submit and averaging the remaining rate, this is called the "trimmed-mean" approach.

Berkowitz expresses concern about the soundness of this practice, and another alternative he suggests ("Winsorized-mean"):

"Unfortunately, both the trimmed-mean and Winsorized-mean tend to be quite sensitive to faulty data in small samples. In fact, it is possible to show that a 10% trimmed-mean based on fewer than 20 observations can break down in the presence of even 2 outliers. This means there is no bound on the bias or variance of the estimate, given sufficiently bad outliers."

Berkowitz calculates that as few as four inaccurate reports (unintentional or manipulative) could bias the BBA LIBOR rate in that system (which at the time saw contributions from 16 banks). This led him to suggest the use of other methods to determine the rate.

It is easy therefore look back and at the mechanism by which LIBOR has been calculated since its inception, and argue that it is somewhat naive as a mechanism to establish a "true"