Special Report: How gaming Libor became business as usual
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The letter ''B'' of the signage on the Barclays
headquarters in Canary Wharf is hoisted up the side of the building in London
July 20, 2012. Credit: Reuters/Simon
Newman
NEW YORK (Reuters) - In late 1996, Marcy Engel, then a lawyer for Wall Street heavyweight Salomon Brothers Inc, fired off a warning letter to U.S. regulators: If they approved a Chicago Mercantile Exchange plan to change how a popular futures contract was priced, they would put at risk the integrity of a key interest rate in the global financial system.
The CME was already doing big business in
its Eurodollar futures
contract - a derivative product that lets traders bet on the direction of
short-term interest rates - and it had long set the price for these contracts
using a benchmark rate it tabulated itself. Now, it wanted to adopt a more
commonly used rate published by the British Bankers' Association, known as the
London interbank offered rate, or Libor. Using this benchmark, the CME said at
the time, "will make our Eurodollar futures an even more attractive risk
management tool."
The problem with the CME's plan, as Engel saw it: The banks that set the rates in London daily were also able to take positions in the CME's Eurodollar contract. In her letter to the U.S. Commodity Futures Trading Commission, she said tethering the futures contract to Libor "might provide an opportunity for manipulation" of the interest rate. A "bank might be tempted to adjust its bids and offers ... to benefit its own positions."
That was saying a lot. Libor is the
average of what a group of international banks in London say it costs to borrow
from each other for durations ranging from overnight to one year. It was, and
still is, a global benchmark, the basis for all sorts of interest rates -
everything from corporate and student loans to financial contracts. Moving it by
mere fractions of a percentage point would affect borrowing costs around the
world.
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SPEAKING VOLUMES
The CFTC received Engel's letter on
October 10. In the ensuing weeks, it received one other similar written warning
from another banker. The agency wasn't moved. In late December, it approved the
CME's request. On January 13, 1997, trading of Eurodollar contracts priced to
Libor began.
The CME was right about the allure of
pricing the contract to Libor. Trading of the Eurodollar contract exploded after
the switch - from average daily volume of 394,348 contracts in 1997 to a peak of
2.5 million in 2007. Today, the trading accounts for about 7% of revenue for CME
Group Inc.
But Engel was right, too. Since 2008,
investigators in the United States, Britain and elsewhere have been looking into
whether at least some of the 19 banks that take part in the weekday ritual of
setting Libor used their place at the table to try to routinely nudge the rate
in their favor.
One of the banks certainly did. Earlier
this year, London-based Barclays Plc, in a settlement with the U.S. and British
authorities, paid $450 million and admitted that employees attempted to
manipulate Libor. UBS AG of Switzerland, Citigroup, Bank of America Corp and
J.P. Morgan Chase & Co of the United States, Deutsche Bank AG of Germany, and HSBC Holdings Plc and Royal Bank of Scotland
Group Plc of Britain are among the banks being investigated for alleged Libor
fixing, according to regulatory filings and court documents.
Spokespeople for UBS, Citigroup, Bank of
America, J.P. Morgan, Deutsche Bank and HSBC declined to comment. In a
statement, an RBS spokesman said the bank was cooperating and that it "expects
to enter into negotiations to settle some of these investigations in the near
term" and that it will incur "financial penalties."
The investigations cover the period from
2005 to 2009. But as Engel's letter - obtained from CFTC archives - shows,
regulators were alerted to the possibility well before U.S. and British
authorities began investigating the matter in 2008. Further, a review of
investigation documents and public records, as well as interviews with dozens of
traders, suggests that Libor manipulation began as early as the 1990s, driven in
large part by the growth of the CME's Eurodollar contract into a
multi-billion-dollar casino for betting on interest rates.
Indeed, by the mid-2000s, manipulating
Libor to profit on Eurodollar futures and other derivatives had become standard
operating procedure among banks in a position to do so, according to people
familiar with the market. In at least three instances, Barclays traders sought
to manipulate Libor in the key months when Eurodollar futures contracts settled
in 2006, according to the CFTC and U.S. Justice Department inquiries into
trading at the bank.
APPARENT EASE
The tactic was so ingrained in Barclays'
New York trading operation that new recruits adopted it with apparent ease and
alacrity. Ryan Reich - 15 years old when Engel sent her letter to regulators -
had been with Barclays just a year when, in July 2007, he sent an email that the
U.S. Justice Department says became a key piece of evidence in its investigation
and subsequent settlement with Barclays.
In the email, Reich asked a colleague to
submit a three-month dollar Libor of 5.36% or higher. The young trader copied in
his New York supervisor in an email that said: "Very important that the setting
comes as high as possible." The Libor submission the next day hit the sweet spot
of 5.36%, according to the Justice Department filing.
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Reich declined to comment. A Barclays
spokeswoman declined to comment. In a statement at the time of the June
settlement, then-Chief Executive Robert E. Diamond Jr. said the trading "fell
well short of the standards to which Barclays aspires." The next month, Diamond
was forced out.
The CME, for its part, "was not
responsible for oversight of Libor," a spokesman said. That duty, he said, fell
to the British Bankers' Association.
The BBA declined to comment.
Many questions surrounding the Libor
scandal remain unanswered. Who initiated the practice of pitching skewed Libor
numbers to the BBA? What was the extent of collusion among banks? Who at the
banks, beyond their trading desks, knew of the practice? And why didn't the CFTC
heed the warnings and at least keep an eye on links between Eurodollar futures
and Libor?
Investigations under way may eventually
yield some answers. Even then, the larger question will persist: What was the
extent of the damage done?
Nudging Libor by a few one-hundredths of a
percentage point may not seem like a big deal, but in derivatives markets, those
small moves can translate into millions of dollars. And every cent by which a
bank benefited from manipulation meant an equal loss by a bank, hedge fund or
other investor on the other side of the trade.
The broader impact is less clear.
Borrowers paying an interest rate based on Libor - for a home mortgage, for
example - would get a break if the rate were pushed downward. Investors in
mortgage pools, however, would make less than they otherwise would have. And the
opposite would be true if the rate were pushed upward.
FUTURES PAST
To understand how Libor was manipulated to
enhance derivatives positions requires a look at trading in not only London, but
also Chicago. There, for more than a century, producers and users of everything
from corn to cattle have purchased contracts to buy or sell such commodities at
a fixed price on a set date.
Eventually, financial products were added
to the mix. And in 1981, the CME initiated trading in Eurodollar futures.
Eurodollars are the vast amounts of U.S. dollars held by banks outside the
United States, accumulating over the years largely as a result of international
trade and investment flows, and they constitute one of the largest short-term
money markets in the world.
When cash is the commodity, as
with the CME's Eurodollar contract, the future price of that commodity is the
interest rate; each Eurodollar futures contract thus enabled banks to bet on the
direction of interest rates.
When the CME's Eurodollar futures made
their debut on December 9, 1981, trading volume that day totaled 3,425 contracts
- a tiny fraction of the volume for more-established contracts at the
time.
It didn't take long for banks to discover
the appeal of the new product. In particular, it gave them a way to reduce their
risk on interest-rate swaps, another financial derivative product encompassing
trillions of dollars in over-the-counter deals every day. Law-enforcement
agencies in the United States, U.K. and elsewhere allege banks manipulated Libor
or related rates to benefit interest-rate swap and futures positions.
Basically, in an interest-rate swap, a
bank and one of its corporate clients exchange fixed-rate debt payments for
floating-rate debt payments, or vice versa, to help the client manage its cash
flow, based on expectations for interest rates. With the arrival of the CME's
Eurodollar contract, a bank could reduce through the futures market the risk it
had taken on with an interest-rate swap.
"It was a breakthrough contract," says Leo
Melamed, chairman emeritus of the CME. "The business community and the financial
community all recognized our market as really a breakthrough ability to hedge
interest rates."
The Eurodollar contract was even more
appealing because it allowed investors to hedge their swap positions on large
sums of money without having to make a big up-front investment. Each contract is
a bet on the interest paid on a fixed notional amount of $1 million. That $1
million is purely hypothetical; money is made or lost only on changes in the
interest rate. Every basis point, or one one-hundredth of a percentage point,
movement in the rate equates to a $25 change in the value of the contract. Those
changes are booked daily to an investor's account, typically set up with a
minimum balance of about $1,000.
CRITICAL DIFFERENCES
For the first 15 years of the Eurodollar
contract, the CME based the price on its own calculation. To do so, it randomly
surveyed banks on the rate they were willing to lend to "prime banks" - those
with top credit reputations.
It then threw out the highest and lowest submissions and averaged the rest. No bank knew whether it would be included in the pool from survey to survey, and the creditworthiness of the prime banks never varied.
It then threw out the highest and lowest submissions and averaged the rest. No bank knew whether it would be included in the pool from survey to survey, and the creditworthiness of the prime banks never varied.
Then, in 1996, the CME came up with its
proposal to switch to the British Bankers' Association's Libor. The plan made
sense. Almost all of the floating-rate obligations referenced in swaps are tied
to Libor, and the use of swaps had been growing rapidly.
The CME reached a deal with the BBA to use
the latter group's Libor calculation, which, like the CME's rate, throws out the
highest and lowest submissions. But it's the differences between the two that
are important: The BBA polls the very same banks every day around 11 a.m., not a
random selection; and it asks them for the rate they pay when borrowing from
other banks, not the rate at which they lend to prime banks. Since 2005, Thomson
Reuters has been the BBA's agent for calculating and distributing
Libor.
While the CMA's survey wasn't wholly
immune to being gamed, "the BBA's methodology seemed designed to invite
manipulation," said Richard Robb, a New York money manager whose firm,
Christofferson, Robb & Co, specializes in bank credit risk. "Banks knew that
they would be polled every day, and they pretty much know where they stood among
the participant banks."
Robb is the person who followed Engel in
writing a warning letter in 1996 to the CFTC during the "comment" period on the
CME's proposal to switch to BBA Libor. At the time, he was a 36-year-old
interest-rate trader at DKB Financial Products Inc of Japan.
In his November 18, 1996, letter, he wrote: "If two banks worked together, they could raise the average by over three basis points." A bank could take a large position in Eurodollar futures, he said, "with a view towards influencing the rate."
In his November 18, 1996, letter, he wrote: "If two banks worked together, they could raise the average by over three basis points." A bank could take a large position in Eurodollar futures, he said, "with a view towards influencing the rate."
Robb, who wrote a September 2012 column in
American Banker about his comment letter, said he doesn't know if anyone at the
CFTC followed up on his warning. Engel, now general counsel for hedge fund Eton
Park Capital Management, declined to comment.
After studying the comment letters and
interviewing banks that participated in the CME and BBA surveys, the CFTC's
Division of Economic Analysis decided in favor of the BBA survey, according to a
person familiar with the analysis at the time. In a December 18, 1996, memo to
CFTC commissioners, the analysis unit said BBA Libor "does not appear to be
readily susceptible to manipulation."
On December 20, 1996, the CFTC sent a
letter to Norman Mains, then chief economist at the CME. "The Commission hereby
approves" the change, the letter said.
Mains, now at a San Francisco investment
firm, says: "I have virtually no recollection of this as it was over 15 years
ago."
GLOBEX BOOST
With the CFTC's approval and a deal with
the BBA in place, the Eurodollar futures trade took off. It got help from
advances in technology. Initially, Eurodollar futures, like other CME contracts,
were traded in the exchange's Chicago trading pits. By the early 2000s, though,
the CME's Globex electronic exchange, which allows nearly round-the-clock
trading among investors anywhere, had helped turn the contract into a global
phenomenon.
Ease of trading and the sheer size of the
market prompted hedge funds,
corporate treasuries and pension funds to start piling in. And increasingly,
investors looking to manage risk were joined by speculators seeking solely to
profit from interest-rate movements. "Everybody could now trade" the rate bets,
said Stan Jonas, an interest-rate trading veteran in New York. "They established
this casino."
Amid all this betting on interest rates, a
few well-placed traders were systematically trying to push Libor in tiny
increments one way or the other. As Jonas put it, when the Eurodollar contract
settles where a small group of banks say it will, "you are trading in a rigged
marketplace."
If Libor moved noticeably, people involved
in the market say, traders attributed it to a blip. "Nobody really thought about
it, which is why they were able to get away with it," said David Robin, a
veteran futures broker and co-head of financial futures and options at brokerage
firm Newedge USA in New York. "It's mind-boggling to me that this would ever
take place."
It did take place.
Consider one exchange between a Barclays
trader in late 2005 and another bank employee, as revealed by the U.S. Justice
Department in filings related to the Barclays settlement.
On September 28, 2005, when three-month
dollar Libor stood at 4.02038, someone identified as "Trader 3" sought to bump
up Barclays' submission the next day. "WE WANT TOMORROW'S FIX TO BE 4.07
MINIMUM," Trader 3 wrote. The same trader noted that for every 0.25 basis points
that three-month Libor came in below 4.0525, the bank would lose
$154,687.50.
Barclays submitted a three-month Libor of
4.07 in the BBA's survey the following day, helping pull Libor higher to 4.05438
on September 29.
A person familiar with the Barclays
trading desk at the time says Trader 3 was Jay V. Merchant. This former Chicago
stockbroker joined Barclays in London in 1998, hired to work in a group led by
Eric Bommensath, a French bond trader who had risen at Barclays to become global
head of fixed income and a member of the bank's executive committee.
DERIVATIVES DESK
Merchant joined the bank at a time when it
was in the early stages of expanding its investment bank, including building out
a derivatives desk overseen by Bommensath. Merchant moved to the New York
interest-rate trading desk in 2006, according to employment records, where he
supervised several junior traders who have drawn scrutiny in the Justice
Department investigation.
Working with him at various times on that New York desk were Harry Harrison, a British banker in charge of dollar-denominated fixed-income trading, Ritankar "Ronti" Pal, who co-led interest-rate trading after joining Barclays from Citigroup in 2006, and junior traders Alex Pabon, Dong Kun Lee and Ryan Reich, the young Princeton University graduate who sent the email that caught the eye of U.S. investigators.
Reich was "everything you would want" in a
young trader, said a person who worked near his trading desk. People familiar
with the situation say greenhorns like Reich were "schooled" by colleagues on
how to seek a target Libor to benefit the bank's positions in Eurodollar
futures. And as emails from the Justice Department investigation show, by the
mid-2000s, the New York traders were comfortable with the practice.
In one March 2006 exchange, an
unidentified trader told a colleague he needed a "low" three-month dollar Libor
"fix" for a position that totaled $80 billion, according to Justice Department
and Financial Services Authority documents. "It could potentially cost a
fortune," the trader said several days before Eurodollar futures were to settle
that month.
Barclays' trading position was probably an
aggregation of interest-rate swaps and Eurodollar futures positions, according
to people familiar with the trade. After the colleague confirmed he would
produce the requested Libor posting, the trader wrote back, "When I retire and
write a book about this business your name will be in golden letters." The
colleague responded, "I would prefer this not be in any books!"
Nine months after that exchange, the CME feted the 25th anniversary of its Eurodollar contract pegged to Libor - "the world's most actively traded short-term interest rate contract," as the exchange noted.
The party might have continued. But in
2008, the global financial crisis upended priorities. Until then, "it was just a
little game" between a number of trading firms, said Jonas, the interest-rate
veteran.
As panic spread throughout the global
banking system, central bankers and the financial media began to use Libor as a
measure of a bank's health. Paying a relatively higher Libor would suggest a
weaker bank. Thus banks had an incentive to submit Libor numbers lower than
their actual cost of borrowing.
INCREASING SCRUTINY
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In April 2008, The Wall Street Journal
published the first of several articles that analyzed whether banks were
submitting proper borrowing costs used to calculate Libor. The Federal Reserve
Bank of New York and the Bank of England confidentially discussed whether Libor
needed better oversight.
That same year, CME officials became
concerned that the British Bankers' Association didn't have a handle on how
Libor was being calculated. The exchange believed the survey process was flawed,
said a person familiar with the CME.
Later that year, the CFTC launched a
probe. In 2009, Barclays began reviewing its own trading desk. That
investigation turned up emails that showed its interest-rate trading desk had
sought to manipulate Libor.
Reich was fired in March 2010 for emails
that Barclays had determined were "inappropriate," according to the Central
Registration Depository, a securities-industry employment database. Reich has
since found work at WCG Management, a hedge fund specializing in interest-rate
trading.
Pabon voluntarily resigned from Barclays
in 2006; Barclays later found that he, too, had sent inappropriate emails. Dong
Kun Lee was terminated in July for "inappropriate communications," the records
show. That same month, Pal, the interest-rate trading boss, was "discharged."
Barclays found that he "engaged in a communication involving an inappropriate
request relating to Libor" and that he failed to "properly supervise" a trading
team making "inappropriate requests relating to Libor."
Pal declined to comment.
Merchant left Barclays in December 2009 to
run an interest-rate desk at UBS's trading operation in Stamford, Connecticut.
He left UBS in August, around the time Reuters reported that he was being
scrutinized by federal authorities for his work at Barclays.
Harrison and Bommensath remain at
Barclays. There is no indication of wrongdoing by the two executives.
People close to the U.S. and British
investigations say prosecutors are still deciding whether and against whom to
file charges related to alleged Libor manipulation. Traders who might find
themselves facing criminal liability are expected to claim they didn't
manipulate Libor because they weren't the employees who submitted the numbers
for calculating the rate, according to people familiar with the
situation.
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In federal court in Manhattan, the 19
banks that served on the panel in London that set dollar Libor are being sued by
a multitude of investors and borrowers for losses on investments or trades,
including Eurodollar futures, that they allege were caused by Libor
manipulation.
More about the Barclays desk is slowly
emerging in High Court in London, where nursing-homes operator Guardian Care
Homes is suing the bank for allegedly mis-selling it interest rate hedging
products based on Libor. The judge in the case ruled last week that Barclays
must hand over to Guardian Care's lawyers documents and emails of 42 staff
involved in setting Libor. It's not clear when that information might become
public. A trial is scheduled to start next October.
Trading in the CME's Eurodollar contract
has slowed since the Federal Reserve indicated it plans to keep interest rates
low until 2015. Daily volume averaged 1.8 million contracts in the first eight
months of this year, compared with the 2.5 million-contract peak in
2007.
As the trading continues, the way Libor is set has raised more questions. In a September speech, CFTC Chairman Gary Gensler said Libor remained oddly stable even in volatile markets. A Reuters review found that from January 2011 to mid-September this year, banks that submit borrowing costs to calculate three-month dollar Libor kept their submissions unchanged nearly 80 percent of the time.
As the trading continues, the way Libor is set has raised more questions. In a September speech, CFTC Chairman Gary Gensler said Libor remained oddly stable even in volatile markets. A Reuters review found that from January 2011 to mid-September this year, banks that submit borrowing costs to calculate three-month dollar Libor kept their submissions unchanged nearly 80 percent of the time.
On a call with analysts in July, CME
executives were quizzed about the impact of the Libor investigations on
Eurodollar futures trading. Executive Chairman Terry Duffy was clear: Libor, he
said, would "remain the pre-eminent benchmark."
(Additional reporting by Steve Slater in
London and Cezary Podkul in New York. Editing by John Blanton and Claudia
Parsons.)
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