The Spider Network

by David Enrich

  After weeks of discussion within its legal and compliance departments, UBS decided to let Hayes start trading. The only condition: For three months, he would be on probation and would have to get his supervisor to sign off on his books at the end of each day. Most new employees were automatically subjected to similar trial periods. This barely amounted to a slap on the wrist, not even the “good bollocking” that RBC had recommended as it sought to minimize the problem.

  Based on Hayes’s experiences at the royal banks of both Scotland and Canada, this seemed to be the way banks dealt with mishaps: Rinse them away in the least disruptive manner possible. The lesson was hard not to internalize.

  Chapter 4

  Peak Performance

  John Ewan was born five years after Minos Zombanakis fathered his interest-rate mechanism. But by 2005, his professional life revolved around Zombanakis’s creation. Ewan didn’t have any particular interest in finance or banking. Raised in a family of quasi-socialists, he aspired to be a scientist, majoring in biology at the University of Bath in southwestern England. Tall and with muttonchop sideburns, Ewan played the guitar and loved the theater. But his real passion was traveling. While classmates and then colleagues hewed to the well-beaten path, Ewan trekked to Borneo and Costa Rica for vacations where he could hone his scuba-diving skills. But he had to find a way to pay the bills. His first job out of college was working in the call center of a large investment firm near his hometown, answering the phones as customers rang with questions and complaints. A year later, in 1998, he joined the Financial Times Stock Exchange group, a London provider of financial indices known in the finance industry as FTSE (pronounced FOOT-see). After five years there, working as an administrator, Ewan quit in 2003 to fulfill a lifelong dream of traveling around the world. When he reached Rio de Janeiro, he fell in love with the city and settled in. Then, after fourteen months of adventure, he ran out of money. It was time to return to reality.

  Back in England, the twenty-nine-year-old Ewan applied for a bunch of jobs. He eventually accepted one at the British Bankers’ Association and started working there in April 2005. Founded in 1919, the BBA was mainly devoted to lobbying for lax regulations on the banking sector. The group occupied the third floor and the basement of a modern stone building (complete with a waterfall splashing through its atrium) smack in the middle of the City. The Bank of England’s colonnaded headquarters was a short walk down the street. At the time Ewan joined, the group was representing more than two hundred banks, from sixty countries, and was enjoying remarkable success, thanks to the traditionally anti-bank Labour Party’s embrace of a staunchly pro-bank regulatory philosophy.

  The BBA wasn’t a bank. It wasn’t a government agency. It wasn’t even a company. It certainly wasn’t regulated. But it was probably one of the financial world’s most powerful institutions. And that was because the BBA controlled something called Libor.

  Zombanakis’s innovative method of calculating interest rates on large loans had quickly become popular, but for more than a decade, it had remained an informal mechanism. Whenever a group of banks teamed up on a loan, they essentially would arrange their own version of the benchmark. There was nothing etched in stone, no way to easily replicate the rate for day-to-day use.

  By the 1980s, this piecemeal setup was increasingly seen as problematic by some in the industry and regulatory community. Banks in London had begun dabbling in a wild array of derivatives and other financial instruments—things like interest-rate swaps—that were designed not only to meet customers’ needs but also to create new playgrounds for the growing teams of avaricious traders. But, to the consternation of British politicians and financiers, London was at risk of lagging behind. The era of bowler hats, starched collars, and my-word-is-my-bond gentlemen’s agreements among the City’s privileged caste refused to give way to the frenzied international competition that was taking place in rival financial centers like New York. At the same time, the armies of midlevel bank employees and brokers continued to relish their long, beer-soaked lunches of fish and chips, oblivious to the speed of change and dealmaking occurring around them.

  It wasn’t just restless traders who were scowling at established antiquity and lassitude. Even the tradition-bound Bank of England governor—whose office continued to be guarded by tailcoated attendants and whose wooden desk was adorned with crystal pots of red and black ink—wanted the City to remain in the game. One impediment to accommodating these nascent markets was the lack of uniformity in how banks calculated interest rates that fed into swaps and other instruments; negotiating interest rates on a contract-by-contract basis was hardly efficient. At the request of the Bank of England, in October 1984 the BBA set up a committee of commercial bankers and powerful central bank officials to contemplate the issue. After extensive deliberations, the group hatched an idea: Each day, the BBA would collect from a group of banks—not just British ones, but also American and European lenders—data about how much it cost each of them to borrow money from each other, on a percentage basis down to two decimal places. Around lunchtime, after knocking out the highest and lowest estimates, the BBA would disseminate the average to the banks and others for use in various financial instruments. The number was dubbed “the BBA standard for interest rate swaps.” That didn’t exactly roll off the tongue, so the group decided on a marginally catchier acronym: BBAIRS. That name didn’t last long. On New Year’s Day in 1986, the BBA for the first time published something called the London interbank offered rate—Libor, for short. Pronounced LIE-bore, it would soon be the basis for much of the modern financial world.

  That same year, Margaret Thatcher ignited what came to be known as the “Big Bang.” It was her attempt to make London a vital financial capital by loosening restrictive, antiforeigner rules that had long governed the London Stock Exchange, and freeing the country’s banks from curbs on their growth and consolidation. The reforms unleashed a frenzied period of expansion and consolidation in the financial industry. They also precipitated an invasion of American financiers, who appeared poised to stampede the City’s gentlemanly culture. Before long, more than five hundred foreign banks were operating there, and a new class of workers—those who saw an opportunity for riches and had, by dint of background and pedigree, been locked out of the elitist, insular institutions that historically dominated the City—began gravitating to the industry.

  While the Americans were exporting their bankers to London, the Brits were exporting their benchmark around the world. In the United States, the interest rates on most home mortgages historically had been based on the Federal Reserve’s rarely changing base rate. Libor, by contrast, had the potential to move daily, in tandem with market conditions, or at least in tandem with what banks reported market conditions to be. Now bankers could set interest rates on mortgages or credit cards or other loans at Libor plus a certain amount—and that certain amount was essentially the bank’s profit, which they would pocket regardless of where interest rates moved. That was enticing for customers—they’d no longer worry about missing out on savings if interest rates dropped in the future—and it was attractive for the banks—the variable rate would encourage customers to borrow more, while locking in profits for banks above what it cost them to borrow money. By the 1990s, the phrase “London interbank offered rate” was buried in the fine print of an increasing number of American loan agreements. Before long, the fortunes of just about anyone who borrowed money in the United States and, to a slightly lesser extent, elsewhere in the Western world hinged on Libor.

  Libor’s spread was part of a much broader trend: the globalization of finance. No longer were banks confined to specific regions or even individual countries. Increasingly, they spanned the planet, collecting deposits in one part of the world and loaning out the money in another. Similarly, a mortgage that got issued to a family in Michigan might be packaged into a complex financial instrument that would end up, after cycling through several intermediaries, being purchased by a German pension fund or
a Japanese bank. In the 1990s and early 2000s, the phenomenon made it easier for people and companies to borrow money at affordable rates. How? By better matching up would-be lenders—anyone who had deposits stashed in a bank account, or money they were looking to invest in a mortgage security, to name just two examples—with would-be borrowers—such as credit card customers, students who needed help paying their tuition, or governments that wanted to finance military spending or entitlement programs. For the first time in history, it seemed possible to distribute capital almost instantly and with perfect efficiency worldwide.

  Not surprisingly, things turned out to be considerably more complex. The trend enabled many borrowers—not just Americans who wanted to buy a house, but also acquisition-hungry corporations and free-spending governments—to gorge on levels of debt that would later become crippling. And, when markets inevitably turned, the increased interconnectedness meant that the resulting financial crisis would prove deeper, longer lasting, and further reaching than it otherwise would have been. But few people saw that coming. And for now, the fact that an interest rate set by banks in London and overseen by a British trade group was determining what a family in Kalamazoo was paying on its mortgage was hailed as a manifestation of a laudatory global trend.

  From the start, though, Libor was prone to problems. Chief among those was the potential for banks to manipulate it for their own benefit. Doing that was alarmingly easy. In the 1990s, junior bank employees would simply pick up the phone and call in their submissions to financial data company Thomson Reuters every morning around eleven o’clock. A low-level Reuters employee punched all the banks’ data into a computer and calculated the averages. Nobody of any seniority monitored the process. Virtually all it took for a bank to skew Libor was for it to skew its own submission. As long as the bank’s figures weren’t the very highest or the very lowest of all that day’s submissions, a change in its data would ripple through the average.

  In 1991, a young Morgan Stanley trader in London named Douglas Keenan was placing bets on interest-rate futures. Their value was calculated based on where Libor moved. After the market moved against him one day, Keenan came to suspect that someone—he wasn’t sure who—was somehow manipulating the instruments to suit his or her own trading positions. He shared his suspicions with his colleagues. They laughed at his naïveté. It was common knowledge that banks tweaked Libor to benefit their own trading positions. It seemed that everyone other than Keenan already knew it was happening.

  Banks had multiple incentives to push or pull Libor. One was that, because each bank’s submission was made public, investors scoured the data for indicators about the bank’s financial health. A bank that reported a spike in its borrowing costs might be in trouble—after all, why else would rival institutions suddenly be charging it more to borrow money? That gave banks a reason to keep their submissions low, especially during periods of market unease. Another enticement for banks to tinker with Libor was to increase the value of the vast portfolios of derivatives that the banks’ traders were sitting on at any given time. Those positions could incentivize a bank to move Libor higher or lower—or both, in the frequent event that different traders at the same bank had amassed different positions. It all depended on what their traders had recently bought or sold.

  The implications of this were potentially enormous. It meant that there was a possibility that the interest rates on everything from mortgages and credit card bills to enormous corporate loans could be based on flawed data. If banks pushed Libor higher, it meant that ordinary people all over the world collectively were getting ripped off to the tune of billions of dollars in excess interest payments. Even if Libor was moved artificially lower, there were losers aplenty. Many American cities and pension funds, for example, had purchased interest-rate swaps to protect themselves against the risk of rising rates. If Libor declined artificially, those municipalities and pensions would be stiffed out of money that was rightfully theirs. Normal people would be the victims.

  * * *

  Going back to the years leading up to the Civil War, the Chicago Mercantile Exchange had been the trading hub for contracts to buy and sell things like corn and livestock at a set price at a future date. The exchange bustled with traders who wore color-coded jackets to identify their roles. They communicated over the trading floor’s din using hand signals. (The system worked partly because trading was clustered around “pits,” where the floor was angled slightly downhill, like the seats of a stadium, to facilitate communication.) In the 1960s, the Merc (as it was fondly known by traders) diversified into futures contracts on things like pork bellies. Futures contracts allowed businesses and farmers to lock in future prices for essential products and thereby to make long-term investment and strategic decisions.

  By the 1980s, the Merc was branching into a growing menu of financial products that traders could buy and sell, among them instruments linked to U.S. dollars parked in European bank accounts. The Merc wasn’t offering to let traders buy or sell these so-called Eurodollars. Instead, it was offering contracts that essentially gave traders the theoretical right to buy or sell the Eurodollars elsewhere in the future at a set price. That future price was determined based on interest rates. (In essence, a Eurodollar’s future value was derived from how much someone could expect to earn by stashing it in an interest-bearing bank account.) As with the trader of pork belly futures who has no interest in owning any actual pork bellies, the entire purpose of these derivatives was to allow traders to roll the dice about future fluctuations in interest rates.

  To determine the value of the derivatives, the Merc had to build a benchmark interest rate into the contracts. For years, the Merc calculated that rate by conducting a random survey of what it cost an ever-changing group of banks to borrow from one another. But in 1996, the exchange wanted to simplify the process of calculating rates. Libor was by now widely accepted around the world as a trustworthy proxy for interest rates. Why not just incorporate Libor into the Merc’s increasingly popular derivatives?

  The decision wasn’t entirely up to the Merc. An obscure U.S. government agency, the Commodity Futures Trading Commission, had the power to approve or veto changes to the design of certain futures contracts. So the Merc applied to the CFTC for permission. Using Libor, the exchange argued in its application, “will make our Eurodollar futures an even more attractive risk management tool.”

  Not everyone agreed. When the CFTC invited the public to comment on the Merc’s proposal, Marcy Engel jumped at the opportunity. Engel was a lawyer for Salomon Brothers, then firmly established as one of Wall Street’s most aggressive bond-trading houses (it soon would become part of Citigroup). She worried that linking Libor to the Eurodollar futures would provide banks, which had huge businesses trading those contracts, “an opportunity for manipulation . . . to benefit its own positions.” Richard Robb, at the time a thirty-six-year-old trader at a small Japanese financial company, DKB Financial Products Inc., also wrote to the commission to caution that Libor was vulnerable to manipulation and therefore shouldn’t be embedded in the contracts. “If two banks worked together, they could raise the average” substantially, he warned.

  During Bill Clinton’s presidency, the CFTC had earned a reputation as a hands-off, probusiness regulator. In December 1996, staffers wrote a memo to the agency’s leaders saying that Libor “does not appear to be readily susceptible to manipulation.” The commission approved the Merc’s application. The next month, Libor officially became an integral component of the fast-growing derivatives market.

  * * *

  When Ewan arrived at the BBA, his job duties were largely administrative—befitting someone whose only professional experience was clerical and who seemed to have little interest in finance. He worked for Alex Merriman, a bedraggled-looking man with stringy blond hair and a droopy mustache. Merriman wasn’t the easiest guy to work for. He sometimes nodded off during meetings and, when awake, tended to have a short fuse. Merriman had a number of responsibiliti
es, one of which was running Libor. At the time, this was a pretty simple task. It consisted of making sure that the drones at Thomson Reuters did their job of compiling the data, and, once a year, embarking on a series of meetings around London to make sure that the banks contributing data to Libor were satisfied with the process. When Ewan came on board, Merriman immediately handed him responsibility for handling Libor-related paperwork. Before long, Merriman had delegated basically all of his Libor responsibilities to his underling.

  Ewan’s colleagues liked him. He seemed like a friendly, normal guy. He loved Formula 1 auto racing and made frequent trips to European cities to catch the action. Once, when the BBA was looking for a volunteer to go on a business trip to Mongolia, Ewan was the only one to raise his hand. Nobody else had any interest in flying halfway around the world to a barren country with few tourist attractions. Ewan saw it differently, noting Mongolia’s rich reserves of useful minerals. “That’s not a country,” the onetime aspiring scientist told bemused colleagues, “it’s a chemistry lab.” But Ewan found this to be a confusing period. Nobody actually explained to him how the markets worked. He was on his own to figure things out.

  To bankroll the organization, the BBA relied on annual dues paid by its members, as well as the occasional conference the group hosted. Those membership payments varied by the size of the bank, but generally they were several thousand pounds a year. The BBA also made money off Libor by selling licenses to companies that allowed them to incorporate the benchmark into their products. If the group was going to keep growing and gaining power, it was going to need new sources of money.

  One way for the BBA to wring more revenue out of Libor was to create new versions of the benchmark. The most prominent versions of Libor were the British pound and the U.S. dollar varieties, but by 2005 Libor came in ten flavors: The pound and dollar were joined by the Australian dollar, the Canadian dollar, the Swiss franc, the Danish krone, the euro, the Japanese yen, the New Zealand dollar, and the Swedish krona. And within each of those, there were fifteen subcategories, broken down by time periods. For example, a three-month U.S. dollar Libor was supposed to measure how much it would cost a bank to borrow dollars in London for a three-month period. Other time periods included one month, six months, one year, and so on.