Systemic operational risk: the LIBOR manipulation scandal
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Journal of Operational Risk 8(3), 59–99
Systemic operational risk:
the LIBOR manipulation scandal
Patrick McConnell
Macquarie University Applied Finance Centre, Level 3, 10 Spring Street,
Sydney, NSW 2000, Australia; email: pjmcconnell@computer.org
(Received March 13, 2013; revised April 8, 2013; accepted April 10, 2013)
The manipulation of the London Interbank Offered Rate (LIBOR) was not a local-
ized event. Unscrupulous traders and managers in some of the largest banks
around the world deliberately and systematically manipulated borrowing rates.
It was not the work of isolated “rogue traders” but part of business-as-usual in
the international money markets. This paper describes the LIBOR scandal and
argues that it is an example of systemic operational risk, in particular people risk.
The paper first describes the LIBOR setting process. The explosive growth over
the past twenty-five years in the use of interest rate swaps (IRSs) and the process
of resetting rates on IRSs, which ultimately led to the unethical manipulation of
the underlying LIBOR rates, is then described. The paper then looks at official
inquiries into manipulation of LIBOR at three banks, Barclays, UBS and Royal
Bank of Scotland, to identify examples of operational risk. The transcripts of con-
versations unearthed by these investigations show rampant illicit activities that
were apparently a normal part of doing business, as traders, LIBOR submitters
and brokers colluded to manipulate LIBOR for their own interests. Finally, the
paper makes some suggestions as to how the management of systemic operational
risks may be addressed by banks and regulators.
1 INTRODUCTION
The manipulation of the process of “fixing” the London Interbank Offered Rate
(LIBOR) is truly scandalous, involving blatantly unethical, and sometimes illegal,
activities by a small number of people in trusted financial institutions. Unfortunately,
this scandal is just the latest in a series of unsavory practices that have surfaced
following the global financial crisis (GFC).
It should be noted that the LIBOR scandal did not cause, nor was it caused by, the
GFC but it was brought to light by the events of the GFC, in particular, attempts by
a leading bank, Barclays, to maintain the market’s perception of its creditworthiness
(CFTC Barclays 2012). Once that rock had been lifted up, investigations by regulators,
in particular the Commodity Futures Trading Commission (CFTC) and the Financial
5960 P. McConnell
Services Authority (FSA), found that manipulation was not limited to just managers
and traders in Barclays, but had occurred many times over many years in other banks.
The process of fixing LIBOR rates is systemic. It is a truly global process, involving
dozens of individuals in international banks estimating, each day, what they believe
interest rates will be over a variety of periods in several currencies. It is a relatively
simple process that relies on nominated experts (the “submitters”) making what is
essentially a well-informed estimate on what borrowing rates will be in the market
today. Estimates provided by these experts are averaged (according to a none too
complicated formula) and then average “official rates” published to the financial
markets.
The resulting LIBOR rates are then used by banks around the world (not only those
providing the estimates) as a “benchmark” for setting rates for lending to corpora-
tions, investment firms, insurance companies and other banks. LIBOR has become
an indispensable component of the global financial system, embedded in millions of
financial contracts. In its current form, the daily process of fixing LIBOR has been in
place since 1986, and despite the scandal described in this paper it is still working,
essentially unchanged, although additional accountability and legal sanctions have
been introduced as a result of the Wheatley (2012b) inquiry.
As we describe in Section 2, the LIBOR process was originally developed, as
the name suggests, to settle contracts in the “interbank” lending market. However,
the market has changed, as a result of the innovation and spectacular success of
interest rate swaps (IRSs), such that pure lending became replaced over time by
firms “swapping” interest rate payments on “notional” loans. The IRS market is, as
described in Section 3, less transparent than the lending market, and, especially in
some currencies, there are fewer transactions that can be observed against which rates
can be fixed. This lack of transparency in the IRS market in turn made it easier to
manipulate the LIBOR rates against which many contracts were reset.
Slowly and imperceptibly the nature of the interbank lending market changed, as
IRSs grew in popularity, but the mechanism for setting rates did not keep pace. In many
respects, the LIBOR fixing process had become obsolete, but continued nonetheless
because it was so widely used and hence would cause too much disruption to change.
There is a lesson here for the operational risk community: to always question basic
assumptions and processes as to their continued relevance.
The LIBOR fixing process is subjective and qualitative, relying on submitters in
selected “contributor banks” providing an unbiased opinion on what they estimate
today’s rates should be, based on their intimate knowledge of the market. It relies on
“trust” that the experts will not be swayed by personal conflicts of interest and will
not be pressurized by management to manipulate their estimates of rates. But, as this
paper describes, this trust broke down, resulting in manipulation of rates to the benefit
of individuals and firms and to the detriment of borrowers around the world.
Journal of Operational Risk 8(3), Fall 2013Systemic operational risk 61
The systemic nature of the LIBOR scandal is illustrated by the summary of the
findings against UBS that stated:
This profit-driven conduct spanned from at least January 2005 through June 2010
and, at times, occurred on an almost daily basis. It involved more than three dozen
traders and submitters located in multiple offices, from London to Zurich to Tokyo,
and elsewhere.
The misconduct included several UBS managers, who made requests to benefit
their trading positions, facilitated the requests of their staff for submissions that
benefited their trading positions, or knew that this was a routine practice of the
traders and did nothing to stop it.
UBS traders inappropriately viewed their benchmark interest rate submissions,
such as UBS’s LIBOR submissions, as mere tools to help the traders increase the
profits or minimize losses on their trading positions.
To be sure, UBS’s benchmark interest rate submissions frequently were not a reflec-
tion of UBS’s assessment of the costs of borrowing funds in the relevant interbank
markets, as each of the benchmark definitions required. [Emphasis added.]
CFTC UBS (2012)
As two other inquiries1 into the manipulation of LIBOR show, one could eas-
ily substitute the name Barclays (CFTC Barclays 2012) or Royal Bank of Scotland
(CFTC RBS 2013) for “UBS” in the quote above and it would still be appropriate.
Manipulation of LIBOR rates was systematic and widespread.
Section 2 of this paper first describes LIBOR and its use in the global financial
markets. Section 3 then describes the interest rate markets for which LIBOR has
become the predominant benchmark. It was the growth of markets in products such as
IRSs that created the environment that made manipulation of LIBOR very profitable.
Section 4 describes the findings of various regulatory investigations that laid bare
the illicit market manipulation. Section 5 then describes examples of people-related
risks that were apparent in the LIBOR scandal. Finally, Section 6 argues that the
manipulation of LIBOR is an example of systemic operational risk, in particular
people risk, and makes recommendations as to how banks and regulators may improve
management of people risk at both the firm and systemic levels.
2 LIBOR
2.1 The history of LIBOR
The importance of the London Interbank Offered Rate came about as a result of the
expansion of the Eurodollar market, in London, in the 1950s and 1960s (Kawaller
1 Atthe time of writing, similar inquiries are in progress as regards other large international banks
(Vaughan and Finch 2012).
Forum Paper www.risk.net/journal62 P. McConnell
1994; Schenk 1998). Eurodollars are term deposits denominated in US dollars (USD)
but held by banks outside of the United States and, importantly, not regulated by
the US Federal Reserve (Corb 2012). Because offshore Eurodollars deposits did not
have regulatory reserve and deposit insurance requirements, they were a cheaper
source of funds for international banks. By the 1970s, banks were actively on-lending
these deposits to governments and corporations that wished to borrow in Eurodollars,
including corporations in the United States. Schenk (1998) argues that the growth
of the Eurodollar market was not only a result of cheaper available funds but also
“innovation” by banks:
The Eurodollar should not be viewed exclusively as a “defensive” innovation but
also as an aggressive one as banks took advantage of opportunities for profit through
domestic currency swaps and third party lending, and also sought to meet the needs
of new customers.
During the 1970s, the market grew considerably as governments and corporations
also began to issue securities in Eurodollars at rates lower than they could borrow
locally (Schenk 1998). Though attractive, borrowing or issuing securities in Eurodol-
lars was not without risk as there was often a mismatch between the borrowers’sources
of income and their funding. This, in turn, gave rise to one of the most innovative
financial products of the late twentieth century, the IRS, which allowed borrowers
to eliminate such risks while still retaining many of the benefits of borrowing in
Eurodollars (Corb 2012).
The spectacular growth of the IRS market in the last twenty-five years is central
to understanding the LIBOR scandal and is described in the next section, but it is
sufficient to note at this point that by the mid 1980s the market had reached a critical
mass and some standardization was needed for the market to continue to grow. In 1984
(in line with the opening and deregulation of the UK financial markets, the so-called
“Big Bang”), the British Bankers’ Association (BBA) took the lead in developing
a set of standard terms and conditions for IRS contracts. One of the standard terms
developed by the BBA was a mechanism for “fixing” contract settlement rates, termed
LIBOR – the London Interbank Offered Rate.
2.2 What is LIBOR?
LIBOR (technically BBA LIBOR) is not a single rate but a set of rates that cover rep-
resentative borrowing rates in ten different currencies (see Table 1 on page 66) and
over fifteen different borrowing periods, also called tenors2 or maturities (Wheatley
2012a). For each LIBOR currency, there is a “panel” of “contributor banks”, which
2In 2012, the tenors were one day, one week, two weeks, one month, two months and each month
up to twelve months.
Journal of Operational Risk 8(3), Fall 2013Systemic operational risk 63 provides the expertise of “submitters” to estimate borrowing rates for each matu- rity/tenor for each currency. The 150 rates (for fifteen tenors in ten currencies) are published through the BBA and used as “benchmarks” or reference rates for corporate and retail borrowing for the currencies and borrowing periods covered. For example, USD 3M LIBOR C0.5% represents a borrowing rate of 0.5% over the current three- month LIBOR rate for US dollars. LIBOR has become the most heavily referenced benchmark in global finance, being used as the basis of over US$300 trillion of derivatives contracts, especially the IRSs described later (Wheatley 2012a). LIBOR is widely used but is not unique. For example, since the introduction of the single European currency in 1999, a similar mechanism, called EURIBOR, has been operated by the European Banking Federa- tion and there are other benchmarks, such as TIBOR (for Tokyo). However, for this paper, the emphasis will be on LIBOR, because of its dominant position in the inter- national money markets. Before discussing how manipulation of LIBOR became, if not commonplace, an acceptable business practice throughout the global financial system, the LIBOR process is summarized. 2.3 The process of fixing LIBOR The process of “fixing”, or setting, the 150 LIBOR rates is deceptively simple and transparent (BBA LIBOR 2013). Each morning on which business is to be conducted, nominated specialist “submitters” in each contributor bank within a particular panel answer the same question: “at what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11am?” (BBA LIBOR 2013). The contributing banks’ estimates are then “submitted” electronically to the “des- ignated calculation agent”, Thomson Reuters (BBA LIBOR 2013). The estimates of the contributing banks for each currency and tenor are aggregated and first of all “trimmed”, removing the top and bottom (also called “topping” and “tailing’) 25% of estimates (the “outliers”), and then averaged to produce the “final” LIBOR rate for each tenor within each currency. Thomson Reuters, as the “designated distribu- tor”, then publishes these final rates as the official LIBOR rates for the day, making them available to thousands of banks around the world just after midday London time (Wheatley 2012a). These official LIBOR rates are then used by banks as benchmarks not only for lending to customers and each other but also for settlement of contracts, such as maturing interest rate contracts on derivatives exchanges, and, importantly in this context, for setting rates for IRSs (Corb 2012). This LIBOR process has, because it is used so widely, become an integral and critical component of the international financial system. Forum Paper www.risk.net/journal
64 P. McConnell
The process of contributing rates is monitored and overseen by the Foreign
Exchange and Money Market Committee (FX&MMC) of BBA LIBOR Ltd, a sub-
sidiary of the BBA (Wheatley 2012a). Subcommittees of FX&MMC are respon-
sible for identifying and resolving any issues with the LIBOR submission pro-
cess and taking disciplinary actions when necessary. It is interesting to note at this
point that the individual submissions by contributing banks are made available to
the public on the same day (Wheatley 2012a). Paradoxically, this level of trans-
parency, normally laudable, was integral to some of the manipulation described in
this paper.
So why did such a well-established and seemingly transparent process become the
subject of widespread manipulation that went undetected for so long? To answer that
question, we must look first at the weaknesses in the process and second at the people
involved in the process, especially those who were able and willing to take advantage
of those weaknesses.
2.4 The LIBOR process: strengths and weaknesses
As might be expected, the BBA promoted the strengths of the LIBOR process, and
with some justification, pointing out that LIBOR: “is long established; reflects the
largest range of international rates; has a wide commercial use; has wide interna-
tional dissemination; and has a transparent calculation mechanism” (BBA LIBOR
2013). These are not inconsiderable strengths, especially where many markets, such
as for over-the-counter (OTC) derivatives, lack transparency. For good reason, LIBOR
became part of the very fabric of international financial markets, a (seemingly) stable
cornerstone of day-to-day business.
But, because the process was so embedded in normal business, and rarely ques-
tioned, the inherent weaknesses were more difficult to identify. With admitted hind-
sight, some critical deficiencies can be perceived.
The first weakness relates to the question asked of individual submitters at con-
tributing banks, “at what rate could you borrow funds, were you to do so by asking for
and then accepting interbank offers in a reasonable market size just prior to 11am?”
This is a hypothetical question, in effect asking contributors for their expert opinion
as to what they believe interbank borrowing rates will be. It is not an unreasonable
question to ask an expert, provided that one believes that the answers given would be
objective and unbiased. The question is, however, open to abuse were an unethical
person to answer it.
The second weakness is related to the first one in that, in many cases, it is difficult
to “corroborate” the answers given in LIBOR submissions. As the official Wheatley
review into LIBOR pointed out:
Journal of Operational Risk 8(3), Fall 2013Systemic operational risk 65
It is difficult to corroborate individual submissions as the market that LIBOR is
intended to provide an assessment of is illiquid and the types of transactions are
becoming increasingly less relevant for bank funding. This is particularly the case
for less well-used currencies and maturities. [Emphasis added.]
Wheatley (2012a)
In other words, the original assumption that the rates quoted by contributors
reflected rates actually transacted in the market was overtaken by the reality that
the main use of LIBOR had become setting rates for the burgeoning nontransparent
OTC derivatives markets. By its very success, LIBOR may have outlived its use-
fulness and was overdue a reassessment. But success is infectious; who questions a
winner?3
Despite its detachment from the realities of the market, there is no reason why
experts, who after all have an interest in ensuring the integrity of their markets,
should not continue to give their objective, unbiased opinions as to borrowing rates in
the daily LIBOR question. There were, however, multiple “conflicts of interest”, not
addressed in the LIBOR process over several years, which together helped to create
the conditions for the emerging scandal.
2.5 Conflicts of interest in the LIBOR process
There are three main areas of “conflicts of interest” apparent in the LIBOR process.
Structural: related to the organization of the process itself.
Bank level: related to the contributing banks.
Individual: related to the individuals responsible for submitting rates.
2.5.1 LIBOR panels
Before discussing these conflicts of interest, it is worth considering the composition
of the LIBOR panels and the contributor banks. As noted above, there is one panel for
each LIBOR currency and the number of contributor banks on each panel reflects the
currency’s relative importance in terms of market activity. There are three (essentially
qualitative) criteria used to assesses the suitability to become a member of a particular
panel: “the scale of market activity of the bank; the bank’s reputation; and the bank’s
perceived expertise in the particular currency” (Wheatley 2012a).
Table 1 on the next page shows the contributing banks in each LIBOR panel by
currency as at January 1, 2013. In the table, where a bank is considered a globally sys-
temically important bank (GSIB) by the Financial Stability Board (FSB), the “bucket
3 But as various rogue trader incidents show (Jobst 2007), winners should be questioned as to where
their winnings are coming from.
Forum Paper www.risk.net/journal66
TABLE 1 LIBOR panels: January 2013 (BBA LIBOR 2013).
Contributor bank GSIB G14 USD EUR GBP JPY CHF CAD AUD NZD DKK SEK
P. McConnell
Abbey National — — — Yes Yes — — — — — — —
Bank of America 2 Yes Yes — — — — — — — — —
Bank of Nova Scotia — — — — — — — Yes — — — —
Bank of Tokyo-Mitsubishi UFJ 2 — Yes Yes Yes Yes Yes — — — — —
Barclays Bank 3 Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
BNP Paribas 3 Yes Yes — Yes — — — — — — —
CIBC — — — — — — — Yes — — — —
Citibank NA 4 Yes Yes Yes Yes — Yes — — — — —
Journal of Operational Risk 8(3), Fall 2013
Commonwealth — — — — — — — — Yes Yes — —
Credit Agricole 1 — Yes — Yes Yes — — — — — —
Credit Suisse 2 Yes Yes Yes — — Yes — — — — —
Deutsche Bank 4 Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
HSBC 4 Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
JP Morgan Chase 4 Yes Yes Yes Yes Yes Yes — Yes Yes Yes Yes
Lloyds Banking Group — — Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Mizuho Bank 1 — — Yes Yes Yes — — — — — —
Rabobank — — Yes Yes Yes — — — — — — —
Royal Bank of Canada — — Yes Yes Yes — — Yes — — — —
Société Générale 1 Yes Yes Yes Yes Yes Yes Yes — — — —
Sumitomo Mitsui Banking Corporation 1 — Yes — — Yes — — — — — —
Norinchukin Bank — — Yes — — Yes — — — — — —
Royal Bank of Scotland 2 Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
UBS 2 Yes Yes Yes Yes Yes Yes — — — — —
Panel Size — 11 18 15 16 13 11 9 7 7 6 6Systemic operational risk 67 number”, which is a measure of the systemic significance of a bank from 1 (low- est) to 5 (highest), is shown (FSB 2009; BCBS 2011b). As can be seen, most of the contributor banks are GSIBs and those that are not are almost certainly likely to be designated as local-SIBs (LSIBs) by their local prudential regulators. In other words, LIBOR contributors are very large, systemically important banks, many of which are considered “too big to fail”. 2.5.2 Structural conflicts of interest Table 1 on the facing page shows that a number of banks are contributors in all, or almost all, panels (Barclays, Deutsche Bank, HSBC, JP Morgan, Lloyds and RBS). This dominance of UK banks may reflect the fact that LIBOR was originally a UK initiative and, as banks headquartered in London, these banks would have a vested interest in promoting the City as a financial hub. Table 1 also shows the importance, as measured by number of contributors in a panel, of the four major currencies (USD, EUR, GBP and JPY), which coincides with the distribution of outstanding derivatives as at the end of 2012 (BIS 2012). Table 1 on the facing page also shows the banks that are part of the Group of Fourteen (G14),4 are the most active derivative traders in the world, together accounting for some 70% by value of basic (or “vanilla”) IRSs and over 80% of all outstanding interest rate derivatives (Sidanius and Wetherilt 2012). In other words, the banks that are most involved in fixing LIBOR rates are also those most involved in trading the derivatives for which LIBOR is most often used. While this does not cause a conflict of interest per se, in such a situation there would be a tendency “not to rock the boat”. As noted above, oversight of the LIBOR process is conducted by the FX&MM Committee of BBA LIBOR Ltd. While the board of LIBOR Ltd is independent of the panel banks, the committee is selected from the LIBOR panel banks and users group (LPBUG), which is chaired by members of contributing banks and has members from those banks and interested parties, such as derivatives exchanges (Wheatley 2012a). In other words, despite the fact that an independent secretariat in BBA LIBOR can raise issues, oversight and sanctions are controlled by the contributing banks. In short, the contributing banks were overseeing themselves. Nor were prudential regulators overseeing LIBOR as well as they maybe should have been. As documented in its internal inquiry, the FSA believed both that LIBOR was adequately regulated by the BBA and that LIBOR was not a defined “regulated activity” and therefore fell outside the FSA’s normal terms of reference. In addition, the FSA was obsessed by the “market dislocation” of the GFC rather than what appeared at the time to be a relatively minor matter of market pricing (FSA Audit 2013). 4Note that the members of the G14 that are not LIBOR contributors are the US-based banks Goldman Sachs, Morgan Stanley and Wells Fargo. Forum Paper www.risk.net/journal
68 P. McConnell
The clear conflict of interest and lack of transparency in the oversight (or nonover-
sight) of the LIBOR process was recognized by the regulatory report into LIBOR
(Wheatley 2012b), which recommended transferring responsibility for the LIBOR
process from the BBA to a new “administrator” that would have “specific obliga-
tions” for creating new oversight arrangements. Notwithstanding the fact that, in the
wake of the LIBOR scandal, new arrangements have been recommended, it raises
the question of why such “structural” conflicts of interest were not recognized and
addressed earlier.
2.5.3 Banks’ conflicts of interest
As described above, the banks that contributed most to the LIBOR process were also
the banks that traded most heavily in derivatives linked to LIBOR. This at least raises
the possibility that, in the absence of corroborating transactions (Wheatley 2012a),
the submission of rates could be influenced by trading activity. In fact, as Section 4.5
illustrates, this is exactly what did happen.
International banks are faced with many potential conflicts of interest, such as
“insider trading”. They generally handle such conflicts through internal policies,
such as so-called “Chinese walls”, often involving the organizational and physical
separation of employees who may be put in conflict situations. The subjective nature
of the LIBOR process, which required submitters to be experts in, and close to,
the markets for which they were submitting rates, inevitably meant that submitters
would come into contact with traders. However, as testimony to the UK Parliamen-
tary Committee that investigated Barclays’ involvement in the LIBOR scandal found,
the Chinese walls were paper-thin (Treasury Committee 2012, p. EV.18). In practice,
modern communication mechanisms, such as emails, instant messaging and “open”
telephone conversations, eliminated the Chinese walls, as submitters were constantly
bombarded with information about their bank’s positions in the market and it would
be difficult to remove that knowledge from their analysis.
In a number of situations, detailed later, the conflicts of interest were even more
apparent, as some submitters also held active roles as traders (so-called “trader-
submitters”), and sometimes when submitters were on vacation traders were drafted
in to cover for them (see, for example, CFTC RBS 2013). The banks concerned were
well aware that conflicts of interest were possible but appeared to take no action to
reduce these particular conflict situations.
The LIBOR scandal illustrates that banks are placed in situations where there
are natural conflicts of interest and are required, usually through their compliance
functions, to proactively address such issues. It is apparent that some banks did not
fulfill this quite basic fiduciary duty (CFTC RBS 2013).
Journal of Operational Risk 8(3), Fall 2013Systemic operational risk 69 2.5.4 Individuals’ conflicts of interest The subjective nature of the LIBOR submission process and the difficulty of corrob- orating any particular submission raises the obvious question “is it possible for an individual to benefit from a knowledge of future submissions?”. If, for example, a trader were able to influence the direction of the final LIBOR rate for a particular currency and maturity, then they could set rates to the advantage of their existing market positions or take new advantageous positions. This would, of course, require collusion between submitters and traders to effect such a change. This is precisely what happened in a number of situations, as described later. The LIBOR calculation process of trimming outliers and then averaging mid-range submissions meant that without wholesale collusion it would be extremely difficult to engineer a precise rate but not overly difficult to “nudge” a rate in a desired direction. For example, submission of a “high” rate, even if excluded, would drag the average up and likewise submission of a “low” rate would drag it down, by an amount dictated by other submissions. Such actions, of course, would be, at least, unethical and risk internal sanctions, so the obvious question raised is whether the reward would be worth the risk. Changes to LIBOR rates are typically in the range of fractions of a basis point, often ˙0:001%, and clearly insignificant for small positions (BBA LIBOR 2013). However, as the next section illustrates, the markets supported by LIBOR, in particular IRSs, have expanded enormously in the past twenty-five years (BIS 2012) and the reality is that large banks, such as those listed in Table 1 on page 66, will be holding IRS positions in the hundreds of billions of dollars of “notional” value at any point in time. Therefore, even a small change in LIBOR for such enormous positions could produce substantial profits. This conflict of interest for the individual trader was recognized too late, as it was assumed that the LIBOR calculation process, by its very transparency, made such actions unlikely. Unfortunately, that assumption proved to be naive. Before discussing the details of how the LIBOR scandal unfolded, it is worth describing the explosive growth in international interest rate markets that made manip- ulation feasible and, because of the sheer size of the market, also very profitable. 3 THE GROWTH OF INTEREST RATE SWAPS 3.1 What is an IRS? Since the first “interest rate swap” was agreed between IBM and the World Bank in 1981 (Jorion 1997; Corb 2012), the market for similar contracts has exploded, as illustrated by the annual outstanding volume figures published by the Bank for International Settlements, which show growth from some US$65 trillion of “notional value” to over US$300 trillion by 2011 (BIS 2012). Forum Paper www.risk.net/journal
70 P. McConnell
In the early 1980s, each swap was bespoke, specially tailored, usually by an invest-
ment bank, to meet the specific borrowing needs of two corporations or government
bodies. However, after a time, it became increasingly difficult to find two parties
with requirements that exactly corresponded and, as a result, it became practice for
so-called “swap dealers”, usually commercial and investment banks, to act as interme-
diaries taking short-term positions to facilitate market expansion (Whittaker 1987).
Originally, the economic rationale for such swaps was the reality that different
borrowers had different comparative advantages in different markets. For example,
a highly regarded US company could borrow more cheaply at home in the United
States than in the United Kingdom. However, a US corporation often needed to borrow
overseas to expand business, as would an overseas borrower to fund expansion in the
United States. If such borrowers could be put in touch and each bank could borrow at
the most attractive local rate and then somehow “swap” the payment obligations, then
each borrower would be able to borrow at a lower overall rate. In other words, swaps
could take advantage of the arbitrage in different credit markets (Whittaker 1987;
Corb 2012). And the investment banks that arranged the deals between the borrowers
would also benefit from the fees earned. This appears to be a true win–win–win
situation.
A contract such as the original IBM/World Bank swap is called a “currency swap”,
as it involves borrowing in two currencies (Corb 2012). But there are other arbitrage
opportunities, in particular where a borrower (such as a mortgage bank) prefers to
borrow at a fixed rate but has income that is tied to a floating rate. To cater for such
borrowers, the “fixed–floating” IRS was developed (Whittaker 1987). In a fixed–
floating IRS contract, one party agrees to pay interest on a “notional amount” at a
fixed rate at an agreed frequency (usually quarterly or semiannually), while the other
party agrees to pay interest at a floating rate (often tied to LIBOR) at the same or a
different frequency (Corb 2012).
As noted above, fairly soon after the first bilateral contracts were created, it became
standard practice for swap dealers to act as intermediaries to contracts (Crouhy et al
2006). Over time, the often complex IRS contracts became standardized through
the industry body, the International Swaps and Derivatives Association (ISDA), and
innovation in the industry created flexibility in the terms of contracts. As a result,
IRSs became one of the main tools for asset-liability management (ALM) in corporate
treasuries across the world (Corb 2012).
Reasons for the popularity of IRSs include the following (Crouhy et al 2006; Corb
2012).
Flexibility: contracts can be tailored to the specific requirements of a client, thereby
allowing them to better hedge their exposures.
Journal of Operational Risk 8(3), Fall 2013Systemic operational risk 71 Extended maturity: unlike other interest rate instruments, such as Forward Rate Agreements (FRAs), IRSs can specify maturities that can extend over several years, locking in long-term rates. Transactional efficiency: unlike other instruments, such as FRAs, a number of bor- rowing periods can be covered by a single transaction. Costs: as contracts became standardized and the number of swaps dealers expanded, the costs of IRS contracts fell for clients. In addition, IRS costs tend to be lower than other contracts, such as options. Larger markets: for borrowers, the use of currency swaps increases the number of markets where credit is available. Minimal outlay: unlike traditional borrowing, where the “notional amount” is exchanged at inception and maturity, only the much smaller interest payments are exchanged. This, of course, increases leverage for speculators in this market (Whittaker 1987). Netting: outlays can be reduced even further if parties, especially swaps dealers, agree to exchange only the differences in (or “net”) interest payments rather than the full payments. This, of course, further increases possible leverage. Capital usage: tied in with leverage and netting, the regulatory capital needed to cover an interest rate swap under Basel II regulations is much less than an equivalent loan (Basel Committee on Banking Supervision (BCBS) 2004). But IRS contracts are not without risks, in particular: credit risk, such as the default of one of the parties to an IRS contract; market risk changes to market rates, which may make an IRS contract unprofitable for one of the parties; and operational risks, which are described in more detail later. Although IRSs are the most heavily traded interest rates contracts, there are a number of other related interest rate derivatives, such as swaptions and FRAs, and interest rate options, such as caps, floors and collars. These derivatives, in combination with IRSs, provide highly tailored, but also potentially very risky, interest rate hedging strategies for corporations and banks (Corb 2012). The uses, valuation of and risks in IRSs and related derivatives are well documented (see, for example, Dubofsky 1992; Fabozzi 1993; Mangiero 1994; Jorion 1997; Saunders and Allen 2002; Crouhy et al 2006; Corb 2012). It is beyond the scope of this paper to discuss the immense increase in leverage within the IRS market before the GFC and whether the IRS market was in any way the cause of the crisis, but it is worth noting that regulators were worried as far back as 1987 about the systemic risks due to the potential for “excessive risk-taking and under-pricing of this highly leveraged instrument” (Whittaker 1987). Forum Paper www.risk.net/journal
72 P. McConnell
3.2 The key role of brokers in the IRS market
The majority of IRS trades are agreed, usually by telephone, between traders, in the
so-called interbank market (Corb 2012). However, brokers still play a major role in
providing electronic “venues where dealers may exchange pretrade information and
increase the efficiency of [their] search” (Avellaneda and Cont 2010). Corb (2012)
notes that brokers provide valuable liquidity in the market by “loosely” connecting
dealers “by helping to match offsetting dealer positions (on an anonymous basis)”.
Brokerage volume statistics are not generally provided but Avellaneda and Cont
(2010) estimate that one of the leading brokers, ICAP, was an intermediary in 30% of
IRS trades (by volume) in 2010. IRS brokers, like brokers in all markets, make money
by charging a fee/commission for each introduction that results in a trade, so volume
is an important indicator of their profitability. Broker fees in the swaps market are
not disclosed but are typically in the range of one basis point (or 0.01%) of “notional
value” (Coyle 2001). Osborn (2013) notes a fierce battle among brokers to maintain
their share of the market in the face of increasing regulation, and the increasing use
of “electronic swaps markets”.
Such a business model, relying on volume for profitability, raises the possibility
that a broker may act unethically to get a trade done for a valuable customer, and this
is exactly what occurred, as Section 4 describes.
3.3 IRSs: resetting floating rates
The key to understanding why LIBOR manipulation became so profitable is to be
aware of the process for resetting floating rates, on fixed–floating swaps, especially
those based on LIBOR. Typical IRS contracts will specify the frequency (often, but
not always quarterly) on which floating and fixed interest will be paid. On a designated
payment date, the party in the “floating leg” will pay an amount of interest based on
the floating rate in effect for the prior period and will be notified of the rate in effect
for the next period. Likewise, for the “fixed leg”, a fixed amount will be paid on the
same date or a different date depending on the specifics of the IRS contract.
In a typical contract, the floating rate in effect for a particular period is “deter-
mined”, or “reset” a number of “business days” before the start of the period.5 On the
determination date, the rate that will apply for the forthcoming period and the interest
due at payment will be communicated to the party that is paying the floating rate of
interest. Since the profitability of a fixed–floating IRS contract for any period depends
5Note that ISDA rules clearly specify the precise timing should a payment or determination day
fall on a nonworking day.
Journal of Operational Risk 8(3), Fall 2013Systemic operational risk 73 on the value of the floating rate, obviously any ability to influence the direction of rates on or just before the determination date6 could be advantageous. Although manipulation would yield little for a single IRS contract over a single payment period, there is the potential for substantial profits (or losses) whenever many contracts have the same, or close, determination dates. In cases where there are a large number of IRSs, with a total notional value in the hundreds of billions, even a small change to a floating rate (fractions of a basis point) could have a substantial impact on profitability. So, unlike, for example, manipulation of a stock price, it is the net position on a particular day, or over a number of days, that will determine the direction and impact of any manipulation. In contrast to equity trading, for example, it could benefit a trader to nudge a particular rate up one day and down the next, depending on whether they were paying floating or fixed interest on their positions on a particular day. Furthermore, because LIBOR covers multiple periods, a trader could, in an arbitrage strategy, be trying to move a rate one way on one tenor (say USD 3M), yet a different way on another (eg, USD 6M). Without a detailed understanding of the underlying positions, it is very difficult to detect manipulation of LIBOR rates. In light of events described below, it should be noted that if a contract agreed to pay interest on March 15, June 15, September 15 or December 15, it would be called an “International Money Market (IMM) swap”, or one that coincides with so-called IMM dates, when Eurodollar derivatives contracts expire on futures exchanges (Crouhy et al 2006). For hedging purposes, many IRS contracts are deliberately created to reset on those IMM dates. The potential for increasing profits, or alternatively reducing losses, by manipulating LIBOR around IMM dates would make manipulation attractive to unscrupulous traders. 3.4 Interest rate swaps: operational risk Basel II provides a general definition of operational risk, specifically “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk but not strategic or reputational risk” (BCBS 2004). The risks described in this paper are predominately people-related, but other risks have become apparent over the emergence of the IRS market. One of the first instances of large-scale operational risk in the emerging IRS market was the 1991 case of Hazell v. Hammersmith and Fulham Borough Council, in which the UK House of Lords held that the (somewhat speculative) swap contracts entered into by the council were in fact ultra vires, or beyond the legal capacity of the council, and hence the contracts were null and void (Sharma and Shukla 2008). Following this 6It should be noted that such manipulation would have no effect on days when there was no reset activity. Forum Paper www.risk.net/journal
74 P. McConnell
famous case, the ISDA7 was formed, acting as a trade organization that develops
standards for legal documentation for over-the-counter (OTC) swaps and derivatives.
The next major crisis in the developing IRS market was people-related, in particular
the mis-selling scandals that hit Bankers Trust (BT) in the early 1990s (Crouhy et al
2006). BT, a leading investment bank at the time, had entered into a number of
fixed–floating swap contracts with two large corporations, Proctor & Gamble and
Gibson Greeting, which lowered the cost of funding for these companies. But the
lower cost was achieved though the use of leverage, which would markedly increase
the corporations’ costs if US interest rates were to rise. Following the bond market
crisis of 1994, rates rose by over 250 basis points, incurring immense loses for the
two corporations (Crouhy et al 2006). Both companies successfully sued BT for
misrepresenting the risks and potential losses of these new products. As the Gibson
settlement noted,
over time, the derivatives BT Securities sold to Gibson became increasingly complex,
risky and intertwined.... Gibson, however, did not have the expertise or computer
models needed to value the derivatives it purchased from BT Securities.
In short, interest rate swaps had become so complex that only experts understood them,
and it should be noted that IRSs and related derivatives have become immeasurably
more complex since 1994.
As an illustration that history is quickly forgotten, at the time of writing the UK
Financial Conduct Authority (FCA), one of the successors to the FSA„ is in the
process of negotiating with the largest banks in the United Kingdom for restitution to
small and medium-sized companies who were mis-sold complex interest rate hedging
products (IRHPs) comprising complex “structured” products involving interest rate
swaps, caps and collars (FSA 2012, 2013). The full costs to the major banks have not
yet been calculated but will be substantial and potentially as large as the costs of the
payment protection insurance (PPI) scandal (McConnell and Blacker 2012; Wilson
2013).
Over 50% of IRS trades are between financial institutions rather than between a
bank and a customer, and within these, trading is concentrated in a small number of
large banks (Fleming et al 2012). This means that the major swaps banks are “highly
interconnected” and hence contribute to a higher level of systemic risk (Haldane
2009). The failure of one of the largest swaps dealers could have a devastating impact
on bank funding worldwide. Before considering the operational risks involved in more
detail, the next section discusses the emergence of the LIBOR scandal.
7 The original name was the International Swaps Dealers Association, reflecting its industry focus.
Journal of Operational Risk 8(3), Fall 2013Systemic operational risk 75 4 THE LIBOR MANIPULATION SCANDAL 4.1 Who would be tempted to manipulate LIBOR? We are unlikely to ever discover who was the first person to successfully manipulate LIBOR. However, the history of so-called rogue traders (Jobst 2007), such as the most recent at UBS, Kweku Adoboli (FINMA 2012), shows how such misconduct starts small, goes undetected, then is repeated more frequently and on a bigger scale until it gets too big to ignore (Fenton-O’Creevy et al 2007). The most likely scenario for the first attempt to manipulate LIBOR is one where a trader, somewhere, was holding a losing position and, to reverse the losses, persuaded a compliant submitter, probably a junior, to “nudge” the bank’s LIBOR submissions higher or lower. Having got away with that deception, an unscrupulous trader would be tempted to turn their mind to how profits could be made, repeating the deception, getting away with it, enhancing their reputation as a successful trader and doing it again and again. After a time, manipulation would become standard practice. Regulatory inquiries report that manipulation was already widespread in 2005/6 (see, for example, CFTC Barclays 2012; FSA Audit 2013) but how long the manipu- lation had been going on before that is unknown. Keenan (2012), an ex-trader, reports that as far back as 1991 he had reported to his managers at Barclays that LIBOR rates were being manipulated. He noted that as a junior trader his “naivety seemed to be humorous to my colleagues” (Keenan 2012). We might ask how the manipulation became so widespread. That too is unknown, but the inquiry into UBS gives a clue (CFTC UBS 2012). Although the market is enormous in economic terms, the number of people involved at any one time is small, in the hundreds rather than the thousands. These people are acknowledged experts in a very narrow field – the movement of interest rates in a handful of currencies. They are also well paid and highly mobile. Some traders regularly move jobs between a small number of large investment banks and brokerage firms, which are located in the same financial hubs. When a trader moves jobs, they invariably maintain contacts with ex-colleagues, subordinates and managers, as there may be a need to use this network in future. 4.2 Who suffered as a result of the manipulation of LIBOR? The manipulation of LIBOR is not a victimless crime, it is just very difficult to iden- tify precisely who the victims are, and how much financial loss they have suffered. Corporations and other banks that are paying floating rate interest based on LIBOR will lose when LIBOR rates rise, or are forced up by illicit means. Likewise, corpora- tions and other banks that are paying fixed rate interest will lose when floating rates are forced down, as they will receive less interest. We will never know with certainty all of the victims of the LIBOR scandal but some are beginning to come forward. Forum Paper www.risk.net/journal
76 P. McConnell
Though details have yet to be published officially, Benson (2012) reported that an
audit by the Federal Housing Finance Agency (FHFA) has estimated that Freddie
Mac and Fannie Mae, two large US housing agencies that failed in the GFC, had
lost some US$3 billion due to LIBOR manipulation. In March 2013, Freddie Mac
sued not only a dozen banks, but also the BBA, for undisclosed damages in respect
of losses incurred as a result of alleged “unlawful conduct” in manipulating LIBOR
(FHLMC 2013). Other financial parties have already filed legal suits against LIBOR
banks (Hals 2012). But it was not only financial corporations that suffered; individuals
whose mortgage payments were linked to LIBOR were impacted, as the first of the
potentially many class-action lawsuits alleges (Touryalai 2012).
4.3 Investigations into the possible manipulation of LIBOR
One of the problems with analyzing LIBOR submissions is that, in the absence of other
information, such as market prices or positions, it is very difficult to detect anomalies,
unless we know what we are looking for. LIBOR rates are meant to fluctuate, but it
is difficult to detect precisely what is causing the fluctuations, whether it is market
factors or something more sinister. It is like searching for a needle in a haystack.
In March 2008, in reaction to rumors in the market, the Bank for International
Settlements (BIS) published a paper on LIBOR rates that concluded that there was
little evidence of manipulation [and that] available data do not support the hypothesis
that contributor banks manipulated their quotes to profit from positions based on
fixings.
Gyntelberg and Wooldridge (2008)
However, the analysts’ conclusion was tempered with the warning that there were
“discrepancies”. Abrantes-Metz et al (2008) analyzed LIBOR submissions by con-
tributing banks between January 2007 and May 2008 (ie, in the midst of the GFC) and
concluded that the “evidence found is inconsistent with an effective manipulation of
the level of the LIBOR”. A similar conclusion was reached by a study reported in the
International Monetary Fund’s Global Financial Stability Review in October 2008,
which concluded that anomalies were probably a consequence of “elevated volatility”
in lending markets (González-Hermosillo and Stone 2008).
A tipping point in the LIBOR scandal was the publication of an article in the Wall
Street Journal in May 2008, as the worst of the subprime crisis was unfolding (Mol-
lenkamp and Whitehouse 2008). This article conjectured that major banks, such as
Citigroup, JP Morgan and UBS were “contributing to the erratic behavior of a crucial
global lending benchmark”, and in particular were “reporting significantly lower bor-
rowing costs for the [LIBOR] rate than what another market measure suggests they
should be”. The Wall Street Journal analysts had compared changes in LIBOR rates
Journal of Operational Risk 8(3), Fall 2013Systemic operational risk 77 with another measure of bank creditworthiness, credit default swap rates,8 which they argue should, but did not, correlate with LIBOR (Mollenkamp and Whitehouse 2008). Considering the claims made by Mollenkamp and Whitehouse, Snider and Youle (2010) surveyed LIBOR submissions, just prior to and over the GFC, and found “bunching of quotes around particular points” that were consistent with “incentives to affect the rate (as opposed to simply reporting costs)”. In other words, those banks with the greatest exposures had the greatest incentives to push LIBOR in a certain direction and appeared to be trying to do so (Snider andYoule 2010). But, all in all, the evidence of LIBOR manipulation derived from statistical analysis was inconclusive. 4.4 Manipulation of LIBOR for reputational reasons Manipulation of LIBOR falls into two very distinct categories with different staff involved, although the role of the “submitter” was common. Manipulation for reputational reasons: where senior management ordered LIBOR rates to be manipulated to protect the reputation of their firms, in particular, per- ceptions of their creditworthiness. Manipulation for profit: where employees manipulated LIBOR to benefit their own market positions and overall profitability for the banks. Paradoxically, although manipulation for profit was much more widespread, had been going on for longer and involved many more people, it was the manipulation for reputational reasons that was brought to light first. Like many problems that were unearthed by the GFC, such as misrepresentation of credit ratings (McConnell and Blacker 2011), it was the turmoil in the global credit markets that first raised questions which then eventually led to the exposure of the LIBOR scandal. In an article on Bloomberg in September 2007, provocatively titled “Barclays takes a money market beating”, Gilbert (2007) posed the equally provocative question, “So what the hell is happening at Barclays and its Barclays Capital securities unit that is prompting its peers to charge it premium interest rates in the money market?” The question was prompted by the journalist’s observation that Barclays was submitting USD LIBOR rates consistently higher than all other banks, coupled with the observa- tion that Barclays had approached the Bank of England for overnight funds a number of times in the previous month. Could it be that other banks considered Barclays uncreditworthy? A strict reading of the LIBOR question might lead us to believe that interpretation. Barclays, as would be expected, denied the article’s implications, pointing to lack of liquidity in the markets making prices unreliable. But, inside Barclays, alarm bells 8 Credit default swap rates are a measure of the cost of default insurance. Forum Paper www.risk.net/journal
78 P. McConnell
went off. The inquiry into LIBOR manipulation at Barclays (CFTC Barclays 2012)
noted that, after senior management discussions,
Senior Barclays Treasury managers instructed the US dollar LIBOR submitters and
their supervisor to lower Barclays’ LIBOR submissions, so that they were closer
in range to the submitted rates by other banks but not so high as to attract media
attention. [Emphasis added.]
CFTC Barclays (2012)
Such an order, of course, would not comply with BBA rules for submitting LIBOR
rates, as would have been well-known at Barclays because one of its senior managers
sat on the BBA FX&MMC committee at the time. Over the next few months Bar-
clays lowered its LIBOR submissions, not only in USD but also other currencies, and
kept them low in a strategy called “no head above the parapet”, also known as “low-
balling” (FSA Audit 2013). This was despite the fact that the senior USD LIBOR
submitter warned his supervisor that Barclays was being “dishonest” and “the super-
visor directed these concerns to a senior compliance officer and a member of senior
management of Barclays” (CFTC Barclays 2012). In turn, the senior compliance offi-
cer had discussions with the bank’s regulator (the FSA) about LIBOR rates in general
(but without discussing Barclays’ “parapet” strategy).
Around the same time, a senior treasury manager at Barclays informed the BBA
in a telephone call that “it had not been reporting [LIBOR] accurately”, although he
noted that Barclays was not the worst offender of the panel bank members. “We’re
clean, but we’re dirty-clean, rather than clean-clean” (CFTC Barclays 2012). The
BBA representative responded, “no one’s clean-clean”. So it is apparent that many
senior managers in Barclays and even the BBA were aware that all was not well
with the LIBOR process, at least at Barclays, but did not investigate further or take
appropriate actions. With hindsight, the rationale was obvious; in the middle of the
banking crisis everyone was trying to keep Barclays (and LIBOR) alive. But this was
achieved partly because Barclays “knowingly delivered, or caused to be delivered,
false, misleading or knowingly inaccurate reports concerning US dollar LIBOR”
[emphasis added] (CFTC Barclays 2012).
Barclays weathered the GFC storm, but in doing so caused the lid to be lifted on the
LIBOR process and investigations to be initiated at several levels. One question that
was raised was how high within Barclays’ management team was the manipulation
known and sanctioned? The answer to this question was to eventually lead to the forced
resignation of Barclays’CEO and several senior managers (Treasury Committee 2012)
and substantial fines for fraudulent activities totaling some US$550 million (CFTC
Barclays 2012; DOJ 2012). Detailed discussions of these events are beyond this paper,
but we note that the fines for misconduct by Barclay’s management and staff fall under
the Basel II definition of operational risk, specifically people risk.
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