Barometer of Fear

by Alexis; Stenfors

  A key element of the problem, as I saw it, had to do with the design of the LIBOR fixing mechanism itself. This mechanism was quite simple, and was almost precisely the same as it had been three decades ago. Other financial centres had copied the methodology, so CIBOR, TIBOR, EURIBOR and all the others looked very similar. It worked like this. A LIBOR ‘submitter’ (a trader or other bank person at the cash desk or treasury) submitted their LIBOR quotes from a bank terminal, and the other panel banks did the same without being able to see the other banks’ quotes. The LIBOR rule book stated that each bank should submit a quote according to the following 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 11 a.m.?’ A designated calculation agent (such as Reuters) then collected the quotes from the individual LIBOR panel banks. During a short period, the calculation agent audited and checked the quotes for obvious errors and then conducted the ‘trimming’ – the omission of the highest and lowest quotes (the number of which depended on the panel size). Thereafter, the arithmetic mean was calculated, rounded to a specified number of decimals and finally published at a certain time midday.2

  One of the problems was that the rule book was not binding. The LIBOR panel banks did not have to commit to their quotes in any way, nor was there a way of checking whether they had actually traded at a specific price just before 11 a.m., or whether they had traded at all. Trades were kept secret. Instead, the banks were supposed to submit their perceptions about the rate at which they could borrow, and the other benchmarks were phrased similarly. For instance, STIBOR banks were supposed to submit quotes at a rate they ‘claimed’ they could lend to each other. CIBOR banks submitted rates according to the rate at which banks were ‘prepared to’ lend, and TIBOR banks3 what they ‘deemed to be’ prevailing market rates, ‘assuming’ transactions between banks. The integrity of the whole process therefore rested upon the assumption (and trust) that the banks were revealing the truth, or at least what they believed to be the truth. The rule book and the lack of transparency gave the banks a tremendous opportunity to deceive right from the start.

  While the LIBOR fixing mechanism gave the banks an opportunity to deceive, the seemingly ever-growing derivatives market provided them with an extremely strong incentive to do so. Every single derivatives contract remained in the trading book until the final LIBOR fixing had taken place, after which payments were made and the deals disappeared. Banks, being profit maximising and by far the most frequent users of financial instruments indexed to LIBOR, naturally had an interest in the outcome of the LIBOR fixing being favourable to them. The bigger the stakes, the stronger the incentive to be right. Or to get it right.

  To illustrate this, let us assume that each panel bank submits a quote according to the LIBOR rule book above. The highest and the lowest are omitted, and the average of the remaining quotes becomes the LIBOR fixing. If there is nothing stopping the banks from lying, all of them could submit quotes that would favour their respective LIBOR-indexed derivatives portfolios. If a bank prefers a high fixing, the bank would submit a relatively high quote. If another bank prefers a low fixing, that bank would submit a relatively low quote. The only banks not submitting deceptive quotes would be those without any derivatives whatsoever. This, however, is highly unlikely given that all banks (and especially LIBOR banks, as it turns out) have enormous amounts of LIBOR-indexed derivatives in their portfolios.

  Think about match fixing in sports. All players have the opportunity to influence the outcome of the game. All players also have an incentive to win the game (because of prestige, money or whatever). The crucial difference between the final score of the game and the LIBOR fixing was the following. The former normally has a referee determining what can be regarded as a fair and objective result. In the latter, some of the players acted as referees.

  ***

  Before the LIBOR scandal broke, the trimming process was widely regarded as an effective prevention method against systematic manipulation.4 The logic went like this. Since banks did not know whether the other banks wanted high or low LIBORs, it was not rational for a bank to submit, say, an unreasonably high quote because it knew that this quote would end up as an outlier and therefore would not count towards the LIBOR fixing. A manipulative strategy was doomed to fail. Paradoxically, the Japanese banking crisis of the late 1990s showed that this trimming mechanism worked properly as a deterrent even under ‘stress’. At the time, Japanese banks had to face a premium on their borrowing costs in Japanese yen. As the yen LIBOR and the yen TIBOR were interbank money market benchmarks for yen deposits, they not only should have reflected the current and expected future official rate of the Bank of Japan, but also should have incorporated credit and liquidity risk. However, the TIBOR was set in Tokyo and its panel largely consisted of Japanese banks, whereas the London-based LIBOR panel included mainly European and American banks. During the crisis, the quotes by the few large Japanese banks that were part of the LIBOR panel in London were consistently higher than the others, and therefore they were omitted from the calculation of the LIBOR average. This left the London-based yen LIBOR fixing largely in the hands of non-Japanese banks without funding issues. The Tokyo-based yen TIBOR, however, had more Japanese than foreign banks. The outcome was that the difference between TIBOR and LIBOR for Japanese yen, or the TIBOR–LIBOR spread, widened sharply during this period – exactly as it ‘should’ have done.

  It was thought that no bank wanted to be an outlier. But if a bank ended up as one, there would be a scientific reason for it. Likewise, if a group of banks ended up as outliers, something must be structurally different with these banks. Other explanations, for instance that they simply agreed to rig the result, were not seen as plausible. Moreover, the larger the panel, the larger the number of quotes that were omitted. The US dollar LIBOR, for instance, had 16 banks and the highest four and lowest four were omitted. This meant that you needed at least five outliers in the same direction in order to influence the fixing. Why would five banks competing fiercely with each other in the financial markets suddenly decide to become collaborators?

  Well, it turned out that one way to get around the trimming process was simply to make a phone call to a friend at one of the other LIBOR banks. For instance, on 26 October 2006, a Barclays trader received an email from a trader at another bank who wanted a low three-month US dollar LIBOR: ‘If it comes in unchanged I’m a dead man.’

  The Barclays trader then replied that he would ‘have a chat’.

  Later that day, after the LIBOR fixing, the other trader thanked the Barclays trader: ‘Dude. I owe you big time! Come over one day after work and I’m opening a bottle of Bollinger.’5

  When UBS, on 19 December 2012, agreed to pay the UK, US and Swiss authorities £940 million for its involvement,6 the LIBOR scandal reached a whole new dimension. According to the FSA, a least 2,000 requests to manipulate LIBOR had been documented, and at least 45 individuals (including traders, managers and senior managers) were involved in, or aware of, these manipulative practices.7

  When the press release came out, I was standing outside the Hertz car rental at Nyköping airport in Sweden. I downloaded the 40-page Final Notice from the FSA website, sat down in the passenger seat and read it during the 90-minute trip to our cottage. For me, this was a tipping point. I was furious. Not in a million years had I imagined how widespread the manipulation had been. And the worst thing was that it had all been played out in front of my eyes. It involved people I knew: traders I had dealt with on a daily basis and brokers I had chatted with dozens of times every day for years. If I had been able to get hold of a database of my old trades, I could literally have used the regulator’s transcripts to trace when, where and by how much I had been deceived. Even though I was no longer a trader and should not care, I was still bitterly disappointed with what they had done to the game. When we finally arrived, the snow was unusually deep for December.

  ‘I�
��ll go and chop some wood,’ I said to Maria.

  ***

  The next bank in line was RBS, which had been rescued during the height of the financial crisis and which was now largely owned by UK taxpayers. On 6 February 2013, the bank was fined £390 million by regulators for its involvement in the LIBOR scandal.8 Others followed: Rabobank on 29 October 2013 (£660 million), Lloyds Bank on 28 July 2014 (£226 million) and Deutsche Bank on 23 April 2015 ($2.5 billion). The following conversation had taken place on 26 June 2009,9 showing that this was not a matter of just one or two banks:

  Broker A: Alright okay, alright listen, we’ve had a couple of words with them. You want them lower, right?

  Trader B [LIBOR Bank 1]: Yeah.

  Broker A: Alright okay, alright, no we’ve okay just confirming it. We’ve, so far we’ve spoke to [LIBOR Bank 2], [LIBOR Bank 3], [LIBOR Bank 4], who else did I speak to? [LIBOR Bank 5]. There’s a couple of other people that the boys have a spoke to but as team we’ve basically said we want a bit lower [Japanese yen LIBOR] so we’ll see where they come in alright?

  Trader B: Cheers.

  Broker A: No worries mate.

  The conversation above reveals the level of complicity. This was not about a few traders, submitters or brokers. It was much more systematic. At the same time, however, the dialogue illustrates the almost casual approach to skewing numbers that ultimately would have an impact on contracts amounting to billions – whichever currency it involved. The laid-back attitude in other transcripts, where sushi lunches or steak sandwiches were mentioned as favours in return for helping to tweak these numbers, understandably caused public outrage. Manipulation seemed to be like a daily habit, akin to going to the supermarket to buy groceries.

  When a manager at Lloyds Bank was told by a trader about a request made to another trader at the bank regarding a low LIBOR, he was told that ‘every little helps … It’s like Tesco’s.’ ‘Absolutely,’ the manager replied, ‘every little helps.’10

  Large LIBOR panels would require at least a handful of banks to come to some kind of arrangement over the phone or on an electronic platform to have any chance of skewing the fixing. Even so, the impact might be minuscule. Realistically, you would need half the panel on your side to guarantee a favourable outcome. This might be very complicated. There are many different LIBORs. You might want a high six-month LIBOR and a low three-month LIBOR. A high one-month US dollar LIBOR and a low three-month yen TIBOR. And the next day would be different. Your mates could be your friends one day, but your foes the next.

  In such cases, interdealer brokers might be used to help out. This is why, on 25 September 2013, the interdealer broker firm ICAP was fined £55 million for its involvement in the LIBOR scandal. On 15 May 2014, Martin Brokers was fined £630,000.

  To illustrate how this could take place, consider this exchange between ‘Trader A’ and ‘Broker F’:11

  Trader A: HIGH 6M SUPERMAN … BE A HERO TODAY.

  Broker F: I’ll try mate … as always.

  From this quote, it is clear that the derivatives trader in question would prefer a high six-month LIBOR on that day, and is encouraging the broker to help him achieve that goal.

  Brokers do not trade themselves but act as intermediaries between traders at different banks by matching buyers and sellers. For every trade, they receive a commission, and the size of the commission depends on the size of the trade. In other words, brokers have an incentive to get many (and preferably big) deals done.

  The first time I heard a broker shouting down the box (the squawk box, the dealer board, the speakerbus, or whatever else we called the telecommunication system used to communicate with each other), I thought it sounded comical. I had never been to a horse race and could not comprehend how someone could pepper the air with so many numbers in such a short time. It almost sounded like a machine gun, ‘80–83, 80–83, 80–83, 80–83’, until the broker said ‘Given!’, ‘Taken!’, ‘Off!’ or changed the ammunition to ‘80–82, 80–82, 80–82, 80–82’.

  ‘The old image is of East End barrow boys paid to give prices and be entertaining,’ a former ICAP broker said during a LIBOR trial.12 The stereotypical broker came from the East End of London or Essex, leaving school at 16 to work in the City of London. Several of my brokers ticked every single box in that respect, whereas others had joined the broking business after having had a go at trading in one of the large banks. Either way, brokers who survived the cutthroat business of competing against each other to win business from traders were generally good at two things. First, they might not have been mathematicians, but they tended to have a natural flair with numbers. Second, they often had extraordinarily good social skills. No matter how little respect they were shown by traders, who could be angry, ruthless, arrogant or short-sighted, they always managed to make the traders feel on top of the world. Like superheroes.

  Brokers communicate with traders all the time via speaker boxes, phones, texts, emails, Bloomberg and other electronic systems. Given the amount of interaction, the personal chemistry between a trader and a broker is therefore tremendously important. Nonetheless, brokers compete with other brokers on price and price information, and, as a trader, you would naturally rather go to a broker showing the best price rather than the second-best price. Likewise, if you were uncertain about where the market was trading at a particular moment in time, you would generally ask brokers. As the brokers speak to other banks as well, they will invariably be able to provide either a firm and tradeable price, or a very good indication of where such a price ought to be. If they are unable find an indication, they can make it up. Like the best London black cab drivers, they tend to be good at working out where the grid might be congested and the route commuters are likely to take. Brokers, therefore, are a great source of information.

  In a volatile or illiquid market, traders constantly ask brokers for prices or price indications, and brokers ask traders for prices or price indications in return. If you are not particularly active in a specific market, or have simply left the trading desk for five minutes to get a coffee, brokers are the first point of contact when trying to take the pulse of the market – without having the obligation to trade. Active and experienced traders know the important role brokers play in broadcasting prices and price indications to the market. In that respect, the broker can act as a key ‘signalling device’. This could be seen as a good thing, as price transparency is supposed to make markets more efficient. If, however, the signalling device is used to broadcast half-truths or outright lies, it is potentially a vehicle for market manipulation.

  A common way for brokers to broadcast prices was to send out ‘run-throughs’. These were simply series of two-way prices for, say, yen interest rate swaps or euro/dollar FX swaps. Sometimes, these did not consist of firm and tradeable prices, but instead were the broker’s best guess at that moment in time. The best guess, or price indication, ought to have been a blend of other banks’ prices or price indications given to the broker – coupled with the broker’s own judgement.

  I used to be given run-throughs over the speaker box many times a day, in different instruments, in different currencies and by different brokers. Increasingly, these were also sent out as emails or messages via terminals provided by Bloomberg, the news and market data provider. In addition, because I was active in the Japanese market, I was also sent run-throughs via text messages. The run-throughs increasingly tended to contain indications of where the brokers thought US dollar and Japanese yen LIBORs would fix during the day. Brokers knew the increased attention LIBOR numbers were receiving, and LIBOR indications became part of the overall package of price information and market ‘colour’. It was irritating to be woken up at 1.30 a.m. by a string of prices indicating where the Tokyo market had opened, but it became part of the daily routine. I always tended to scroll through the run-throughs on my mobile phone while I was waiting for the espresso machine to do its job first thing in the morning. If I wanted to get into work early, or simply needed a moment
to reflect, I would call for a minicab to take me to the City. To get myself in the right mood, I had got into the habit of listening to The Smashing Pumpkins while analysing the prices and indications the brokers had sent me. They became ingredients in the trading strategies I formed in my head on the way to the dealing room.

  Should such run-throughs be taken seriously – and I certainly took them very seriously at the time – while containing deceptive indications from a trader at the other end, the broker would in effect be spreading false information. Brokers might do so consciously or unconsciously, but the information would nonetheless influence traders at other banks (like myself) and also LIBOR submitters who were keen to get an idea of where the money market was trading (or at least ought to be trading). In other words, a trader might achieve a manipulated LIBOR quote by colluding not only with other banks, but also with a broker who was trusted by others.

  The question is: how could you get brokers to spread false information? As they do not trade derivatives, LIBOR is of no direct relevance to their profit or loss. Why would they play along? This might sound cynical, but they could be threatened to help influence it. A trader could simply cease – or threaten to cease – doing business with a broker and go to a competitor instead, should the broker not comply with their demands. Traders regularly penalised brokers by switching to a competitor, even if it were just for a day or two. This could also take place at a higher level, should the trader be very senior. During my career, I was ‘banned’ numerous times from speaking to my preferred brokers, simply because they happened to be working for the same firm where another broker had disappointed one of the senior traders in my bank. It was a kind of collective punishment.