Sara Teasdale, Partner, Byrne and Partners explains the background to the LIBOR scandal and its impact for investors. She writes that in 1984 concerns emerged that with banks increasingly trading a variety of options based on loans there developed a need to standardise the pricing of those loans. The British Bankers’ Association (BBA) established various working parties and in October 1984 the production of the BBA standards for interest swap rates (BBAIRS) was born.
Part of those standards included the LIBOR predecessor, and in 1986 the BBA published the first LIBOR interest rate in three currencies: US dollar, Japanese yen and British sterling.
In short, the LIBOR rate reflects the average rate that banks have to pay to borrow cash from rival banks, across a range of currencies and time periods.
Fast forward 30 years and today LIBOR is used as a benchmark for financial products worth approximately USD450 trillion. With more than 20 per cent of all international bank lending and more than 30 per cent of all foreign exchange transactions taking place in London, the integrity of the benchmark has understandably become a matter of global interest (no pun intended).
In practice LIBOR was not only used globally as a benchmark rate to price trillions of pounds worth of transactions, but crucially it served as a barometer of the financial health, or otherwise, of the panel banks that formed part of the submission process.
The findings of wrongdoing have been widely reported but in essence the egregious conduct falls into two categories:
• Firstly, attempts were made to manipulate LIBOR in order to financially benefit particular trading positions.
• Secondly, as the financial markets became increasingly volatile during the financial crisis, banks started to deliberately “low ball” their submissions in an attempt to avoid media speculation as to the bank’s creditworthiness. Indeed, in as early as April 2008 the Wall Street Journal published an article questioning the veracity of the LIBOR rate setting process.
LIBOR (the London Interbank Offered Rate) is defined as “the rate at which an individual Contributor Panel bank could borrow funds, were it to do so by asking for and then accepting inter-bank offers in a reasonable market size, just prior to 11am London time”.
The rates submitted were estimates based on where the banks could borrow funds, not where they actually had borrowed funds. The potential issue was succinctly alluded to in September 2008 by a former member of the Bank of England’s monetary Policy Committee, Willem Buiter, when he described LIBOR as “the rate at which banks don’t lend to each other”. The hypothetical nature of the definition; the historical absence of any requirement for trading data and the unregulated nature of all aspects of the LIBOR submission process, no doubt left it vulnerable to abuse.
In April 2008 the first of many investigations began, with the CFTC opening an investigation in response to growing media speculation about the accuracy of LIBOR. Thereafter investigations were commenced by regulators and prosecutors across a spectrum of jurisdictions, including the UK, resulting in the imposition of hundreds of millions of pounds worth of fines across the banking industry. Additionally, the EU Competition Commission has imposed record levels of fines further to its investigation into alleged cartel activity relating to the manipulation of benchmark interest rates, including LIBOR.
In addition to the several billion pounds worth of fines levied against financial institutions, regulatory and criminal action has also been taken against individuals for misconduct arising out of LIBOR manipulation. Last month heralded the start of the high profile trial of Tom Hayes, the former UBS and Citibank trader who is the first person to face a criminal trial arising out of the LIBOR scandal. Hayes is being prosecuted by the SFO for conspiracy to defraud in relation to his alleged attempts to manipulate the LIBOR rate.
In September 2012 the BBA surrendered its role as LIBOR’s administrator, and the benchmark is now overseen by IntercontinentalExchange (“ICE”). The benchmark has been pared down considerably, and LIBOR is now only produced for five currencies in seven maturities, ranging from overnight to 12 months.
At the same time a “complete overhaul” was announced by the FCA and the resulting changes have been considerable, including:
- The setting of LIBOR has become a regulated activity with the creation of two new SIF Controlled Functions for individuals who administer LIBOR (CF50 – benchmark administration function) and individuals who submit LIBOR (CF40 – benchmark submission function).
- Knowingly or deliberately making false or misleading statements in relation to benchmark-setting has been made a criminal offence.
- The FCA introduced a Code of Conduct which sets out practice standards for contributing banks.
- In an attempt to preserve the integrity of the rate and reduce the risk of future incidents of “low balling”, individual submissions are no longer published until three months after the submission date.
Fair and Effective Markets Review
Whilst the first public wave of concern about LIBOR emerged as long ago as 2008, the fallout continues to stay at the forefront of global headlines. Only this week, the Fair and Effective Markets Review published its Final Report setting out 21 recommendations in an attempt to restore trust in the UK as a leading centre for global capital markets. The Review, established by the Chancellor of the Exchequer and the Governor of the Bank of England in June 2014, came in response to the LIBOR and FOREX scandals, and focussed on four core principles. First, seek to raise standards and accountability of individuals. Second, impose greater responsibility upon firms. Third, strengthen the regulation of financial markets. Fourth enhance and encourage co-ordinated international action in light of the global nature of financial markets.
The key recommendations aimed at stamping out future misconduct, include the extension of the FCA’s senior managers regime (imposing criminal liability for misconduct and neglect) to a wider range of regulated firms; lengthening the maximum sentence for market abuse from seven to ten years imprisonment and the creation of a new statutory civil and criminal market abuse regime for spot foreign exchange.