Sunday, July 1, 2012

LIBOR Cyborg - I

So, as I'd said earlier this week, I spent some time educating myself about LIBOR beyond the perfunctory nod given to it in our MBA classes; not that I blame them, it is a rather mundane, even arcane thing to look at. Anachronistic even. LIBOR just is, why would anyone want to go into that? 

But now that this shit's blowing in our faces that LIBOR might not be what we think it to be (and the more I read, the more I wonder how we decided to go along with it in the first place), I think I should put together my thoughts on who, what and why the LIBOR is, and some thoughts on the scandal. What I am trying to do is put together a small guide to educate myself in rather simple words. So bear with me, yes? 

LIBOR - London InterBank Offered Rate - is the rate at which a select panel of banks thinks that they can borrow from another bank for a period of time. 

If this confuses you, we'll come back to it later. Let's go through the process of how LIBOR is determined and by the end of it, you'll understand what the line above means, alright? 

First things first, the LIBOR is not just one rate. The LIBOR is produced for 10 currencies for 15 maturities, giving a total of 150 LIBORs running around at any point of time. 

This is how it would look like - everyday.
      s/n - spot/next; o/n - overnight

Right, so we need 150 rates a day. How do we get them? 

Every day, between 11.00 and 11.10 am (London Time), one person each from a panel of 6-18 banks inputs each of these rates into a Thomson Reuters terminal, where it is collated, after removing the top 25% highest rates and bottom 25% lowest rates. The middle 50% rates are then averaged and voila, you get the LIBOR rates.

So what does the person input? He puts in answers to the following question:
"At what rates could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 a.m.?"

i.e. If someone wants to lend you unsecured money for a certain amount of time in a certain currency, how much interest would they charge you? 
The 'unsecured' part is important. Remember, the more credit-worthy the market thinks you are, the lower the rate that you are able to borrow at. Therefore, the implication is, if you can borrow at a lower rate, the stronger you are. 

To give an example: 

Every morning, a person from Barclays (from their cash management team, I suppose) sits at his Thomson Reuters terminal and keys in the answer to the following questions:

1. At what rates could you borrow GBP overnight, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 a.m.?

2. At what rates could you borrow GBP for one week, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 a.m.?

16. At what rates could you borrow USD overnight, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 a.m.?
17. At what rates could you borrow USD for one week, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 a.m.?

Note: All banks are not on all the panels. So, Barclays might be on the panel for 7 currencies, JP Morgan for 8, Lloyd's for 6 and so on. They give the inputs for the currencies they are on the panel for.

Not "at what rates are you able to borrow funds", but "at what rate could you borrow funds".

Not for a specified amount, but for "reasonable size".

All subjective, nothing objective. It is rather surprising, isn't it? That such a fundamental unit is calculated in such a rather whimsical way?

Why is LIBOR important?

From the CFTC order on the Barclays fine -  
The BBA represents that LIBOR is intended to be a barometer to measure strain in money markets, that it often is a gauge of  the market's expectation of  future central banle interest rates, and that approximately $350 trillion of  notional swaps and $10 trillion of  loans are indexed to LIBOR.  LIBOR also is the basis for settlement of  interest rate futures and options contracts on many of  the world' s  major futures and options exchanges, including the three-month and onemonth Eurodollar contracts on the Chicago Mercantile Exchange ("CME").  Measured by the notional value of  open interest, the CME Eurodollar contract is the most  liquid and largest notional futures contract traded on the CME and in the world.  The total traded volume of  the CME Eurodollar contract had a notional value of over $437 trillion in 2009 and $564 trillion in 2011. It settles based on the three-month U.S. Dollar LIBOR published on the Monday before the last trading day of  the contract month. Moreover, LIBOR is fundamentally critical to financial markets and has an enormously widespread impact on global markets and consumers. LIBOR also affects businesses seeking credit, consumers obtaining mortgages or personal loans, and market participants transacting in numerous other financial contracts in the U.S. and abroad that are based on the benchmark interest rates. 
Central Banks around the world look at LIBOR for setting policy rates. Monetary policy is often set around achieving certain LIBOR rates or at managing spreads between LIBOR and other rates (two central banks I know of that are/were using LIBOR are ECB and Swiss Central Bank). These rates influence policy decisions. 

Yeah, so they're pretty important.

So, What's the problem here?

There are two accusations that I've been able to work out till now. 

1. During the GFC (we've all settled on this acronym, right?), regulators allege that some of the banks quoted artificially low rates for LIBOR, in order to give the impression that they were in better financial health than they actually were. Remember, the lower your rate, the stronger you're supposed to be. While banks internally might know that the other banks were bullshitting (they were, after all, the people who lent to each other in the first place, although I assume there would be some kind of Chinese Wall in place), outside of the banks, regulators, money market funds and other market participants might see them in a different light and think that the situation is better than it actually is.

2. The obvious one, that manipulated rates submitted (and accepted) might lead to lower or higher final LIBOR rates and lead to profits for the trading desks of the investment banks as per their outstanding trades. 

The accusation on Barclays is not that it manipulated LIBOR, but attempted to do so i.e. it gave falsified rates during its daily submissions. And not only did it do so for its own benefit, but also accepted requests from other bank's trading/investment desks to do the same. Of course, you couldn't manipulate LIBOR alone even if you wanted to, unless there is collusion between the bankers.  The probe's still ongoing, Barclays is simply the first bank who settled (and with a 30% discount for co-operating, yay!), so there's a lot more stuff to come out.  We'll keep watching. Citi, UBS, Lloyds, ICAP, RBS and Deutsche are being investigated, but I expect them to settle sooner rater than later.

The Evidence

This is perhaps some of the juiciest stuff I've ever read (in financial terms, obviously). A sampling follows:




From here:
Regulators say they found dozens of communications from 2005 to 2009 in which derivatives traders pressed another group of Barclays employees to try to influence Libor. The British Bankers’ Association, which oversees the standards for calculating Libor, does not allow banks to use interest rates linked to derivatives to determine their Libor submissions.
From here
“A member of senior management” instructed Barclays’ Libor staff to lower their submissions to make them match other banks and dispel concern about the lender’s health.
The breaches included "included a significant number of employees and occurred over a number of years".
At least 14 derivatives traders, including senior traders, made requests to rate submitters at the bank. From January 2005 through May 2009, at least 173 requests for U.S. dollar Libor submissions were made to Barclays’ submitters. That includes 11 requests based on talks with traders at other banks, the FSA said. There were at least 58 requests for Euribor submissions from September 2005 through May 2009, and at least 26 for yen Libor submissions from August 2006 through June 2009.
“The derivatives traders discussed the requests openly at their desks. At least one derivatives trader at Barclays would shout across the euro swaps desk to confirm that other traders had no conflicting preference prior to making a request to the submitters.”
“The senior U.S. dollar submitter emailed his supervisor, ‘following on from my conversation with you I will reluctantly, gradually and artificially get my libors in line with the rest of the contributors as requested. I disagree with this approach as you are well aware. I will be contributing rates which are nowhere near the clearing rates for unsecured cash and therefore will not be posting honest prices.’’
Fun. Read the two reports at your leisure. It really is fun.
The Result

From here:
While it might be hard for one bank among many to influence Libor, regulators felt Barclays was sometimes able to do so. In the findings for the Barclays settlement, the Justice Department said, “the manipulation of the submissions affected the fixed rates on some occasions.”
Wow, that plus the evidence pretty explicit. So, who's going to jail? No one, that's who, as of now. So they found the bank guilty, and let them go with a simple slap of the wrist. Barclays shareholders might not agree with me that $453 million in fines ($ 200 mn to CFTC, $160 mn to U.S. Dept. of Justice and $93 mn to Britain's FSA) is a small amount, but I think it is. And no criminal prosecutions till now? Well, its still a developing matter so we'll see where it goes. Especially the civil suits which are sure to be forthcoming since LIBOR basically affects everything. There's a reason Barclays and RBS's stock tanked.

In defense of the settlement

Dealbreaker puts it pretty well and I quote it extensively here:
Sometimes Barclays convinced other banks to go along with its plans, but clearly sometimes it was shooting against other banks. One reason not to get over-excited about the Libor scandals is that there seems to have been, roughly speaking, a two-sided market: some banks wanted Libor too low, some wanted it too high, so maybe it ended up just about right. Maybe. With notable exceptions for the depths of the financial crisis, when everyone wanted to look like they could borrow cheaply (or at all), at which point Libor manipulation served as back-door monetary easing? I guess? They should be rewarded, not fined? Meh.
Besides the two-sidedness of the fraud partially cancelling out, there’s perhaps another reason that the CFTC and FSA settled. What the heck is Libor anyway? Look at those criteria that the CFTC half-endorsed: the submitter was supposed to consider things like central bank decisions and “prior LIBOR submissions by Barclays and other panel banks” in making its submission, rather than just looking for objective measures of where Barclays could borrow money that day. That makes sense, of course, since Barclays wasn’t in the habit of borrowing in all of the currencies and tenors of Libor every day and so had to do a certain amount of guessing – but I submit to you there were a whole lot of days where expectations about future FOMC decisions (or prior JPMorgan borrowing rates) were not uppermost in the minds of those considering lending money to Barclays. But once you’re on board with the fact that Barclays’ submitted was guessing in the best of circumstances, it’s harder to argue that biased guessing is “manipulating a commodity” as opposed to just picking a different number out of thin air. That might be a stumbling block for regulators taking this case to court, making them willing to settle. And it’s easy to see why Barclays wanted to settle – getting all those emails quoted in a settlement is embarrassing, but nothing like as bad as getting them read in court.
While I don't agree with the first point - If everyone was lying, get everyone to jail - but we know that's not going to happen; the second one makes more sense. Taking Barclays or any other bank to court would not guarantee convictions, so the regulators took a call of slapping them on the wrist. Doesn't make me feel any better about it, though.

So what's being done now?

The investigation is ongoing. Let's see who all come to settle now. 

Here's a graphic I found about possible changes to LIBOR setting. Couldn't find the Credit Suisse report in its entirety. If anyone does, let me know. None of them seem particularly effective in the face of human greed and/or fear though.

(Click for a better look)

Is LIBOR really relevant?

Look at a bank's LIBOR submissions. Look at its floating paper rate in the market. During bad times, they certainly won't match. So what's the point of using it? Its the stickiness of standards. Once a thing, any thing has been accepted as a standard, it would take years, even decades to replace or to phase out. For example, if you decided to replace the LIBOR, what about the 10-year, 20-year, even 50-year papers denominated in LIBOR? If you change the definition of LIBOR, what would stop your counter-party from going to court and calling it a 'force majeure' event? It'd all be very brilliant for the lawyers, who seem to make out like crazy when shit blows up. Someone should be seriously looking at the role of lawyers in the GFC, you know for writing such impenetrable stuff that no one can make head or tails out of it, and allowing people to get away with illegal or at least quasi-legal stuff.

One more important point is that some of these figures are outright guesses; if I had to pick one, it would be the NZD-11m rate. Such transactions just don't exist. Its difficult enough to get Euro or USD unssecured funding for anything more than three months, for other currencies there's just no market. So why bother having them in the first place? This also negates the possibility of replacing the 'could you fund' part of the LIBOR question with 'do you fund' because then you won't get any rate at all, because these transactions don't exist! 

There is some good stuff (with charts) on Sober Look blog here and here about how LIBOR is becoming less relevant, especially in Europe because banks simply aren't picking up from each other as much as they used to. First, because they know this is not a reliable source of funding and that it will dry up at the first instance of any trouble; Second, because they've all shifted to repo or secured transactions and third, because they deal with the ECB directly rather than with each other.  

His/her suggestions for alternatives include the Overnight Index Swaps (OIS) or the actual Swaps/Repo rates. But the problem here is the same because swaps for longer than 3 months hardly exist. 

Another rate could be at what rate the banks CP is placed in the money markets. 

The Conclusion
All this LIBOR business is, at its heart, a damning indiction of the utter and total moral failure at most (all) major banks, who justifiably have concluded that they can do anything they want and get away with it because there is nothing and no one to stop them. Plus they get to make shit-tons of money while they do it. Would you not do it if you were in their place? Don't answer, because you're not in their place.

So that's that, in a nutshell, I suppose. This should be about it for now. Might do one more on what changes are being thought of to improve/fix the LIBOR setting mechanism. Hit me up if you want to talk.

Links/Further Reading:
(Don't ask me about the title. I had to make something rhyme with LIBOR. Again, don't ask.)
Songs listened to while writing this: Entire OST of Cocktail, Ishaqzaade, Gangs of Wasseypur and Agneepath
At the end, a splitting headache.