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Dissertation Declaration

Title of Award

___Undergraduate Major Project____

Date December 11th 2015

____________________________________

SID Number

1008030 _____________________________________

Name of Supervisor Dr Swetketu Patnaik

_____________________________________

Title of Dissertation The effect of the LIBOR Rate fixing

_____________________________________ Scandal on the regulation of the rate

_____________________________________

_____________________________________

_____________________________________

_____________________________________

Word Count 10,000

_____________________________________ DECLARATION: I declare that the above work is my own and that the material contained herein has not been substantially used in any other submission for an academic award. Signed: Jamie Patton Date: 11/12/2015

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The effect of the Libor Rate fixing scandal on the Regulation of the rate Undergraduate Major Project Jamie Patton

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Abstract

The purpose of this report is to gain a better insight into the Libor Rate fixing scandal that

came to light in 2012. This was the biggest case of conspiracy and fraud the financial world

has ever seen. The report will begin by looking at the history behind Libor, its formation,

calculation, and how its purpose today as a global benchmark rate for banks borrowing and

lending in the money markets. It will then look into the size of the market and the types of

trading used to give a better idea of how the rate could have been manipulated and why.

Chapter 5 will focus upon the scandal as a whole beginning with the regulators of financial

markets and identifying who, if anyone, regulates the Libor market. It will then move on and

examine the initial allegations of rate manipulation, who was making the allegations and who

they were aimed at. Once this has been established the report will examine the rate

manipulation itself, looking how the rate was being manipulated and who was guilty of it. The

chapter will end by looking at the consequences for the banks who were guilty of manipulation

as well as the focusing upon the first ever criminal conviction of someone guilty of financial

crime.

The final chapter will bring together the information outlined and summarise the need for

reform of Libor. It will focus upon the Wheatley review commissioned by the UK Government

in the aftermath of the scandal. This report will look into the recommendations for reforming

Libor and examine any issues or barriers that these may have to overcome in order to be

implemented.

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Acknowledgements

Anglia Ruskin University: I would like to thank Anglia Ruskin University for giving me

the opportunity to do this project. It has been my home for the past few years and in

that time I have been able to further my education in a great learning environment

and have made some very good friends with students and lecturers alike who have

all supported me throughout my studies.

Dr Patnaik: I would also like to thank my project supervisor Dr Swetketu Patnaik. He

has shown interest in this topic and has given me some invaluable advice not only on

this project but also about pursuing my career after my studies.

Family and Friends: Finally I would like to thank my family and girlfriend who have

believed in me without doubt throughout my entire university experience. They have

helped to motivate me and support me during the good and bad times and I wish to

repay them by completing my studies by June 2016.

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Table of Contents Dissertation Declaration ............................................................................................ 1 Abstract ..................................................................................................................... 3 Acknowledgements ................................................................................................... 4 Key Terms and Abbreviations ................................................................................... 6

Chapter 1 ................................................................................................................. 7 Literature Review ...................................................................................................... 7

Chapter 2 ................................................................................................................. 8 Methodology.............................................................................................................. 8

Chapter 3 ................................................................................................................. 9 Introduction ............................................................................................................... 9

Chapter 4 ............................................................................................................... 10 Overview – A wider perspective of Libor and global currency markets .................... 10

4.1 History ........................................................................................................... 10 4.2 Calculation ..................................................................................................... 11 4.3 Market and Contributors ................................................................................ 14 4.4 Foreign Exchange Market .............................................................................. 14 4.5 Currencies ..................................................................................................... 17

Chapter 5 ............................................................................................................... 18 The Libor Scandal - Market Regulators and Allegations of Rate Manipulation ......... 18

5.1 Regulators ..................................................................................................... 18 5.2 Allegations ..................................................................................................... 21 5.3 Rate Manipulation .......................................................................................... 24 5.4 Conviction...................................................................................................... 27

Chapter 6 ............................................................................................................... 31 Libor; The Reformation – An Overhaul and New Benchmark? ................................ 31

6.1 Reasons for reform ........................................................................................ 31 6.2 Recommendations for Reform ....................................................................... 33

Conclusion............................................................................................................. 37

Bibliography .......................................................................................................... 39

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Key Terms and Abbreviations

Libor – The London Interbank Offered Rate

EURIBOR – The Euro Interbank Offered Rate

BBA – British Bankers Association

LPBAUG – Libor Panel Banks and Users Group

FSA – Financial Services Authority

FCA – Financial Conduct Authority

PRA – Prudential Regulation Authority

CDS – Credit Default Swap

CFTC – Commodity Futures Trading Commission

SEC – Securities and Exchange Commission

CME – Chicago Mercantile Exchange

NYSE – New York Stock Exchange

Forex – Foreign Exchange

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Chapter 1

Literature Review

The literature used mainly throughout this report will mainly be journal and

newspaper articles that were written before during and after the scandal. These

articles have been chosen due to their more up-to-date nature over textbooks.

However textbooks have also been used in order to gain further working knowledge

of the market as this information is rarely found in articles as they tend to focus more

upon the data during the scandal rather than the intricate details of the trading.

One of the most valuable report used in this piece is entitled LIBOR: Origins,

Economics, Crisis, Scandal and Reform. David Hou and David Skeie wrote this in

2014 for the Federal Reserve Bank of New York. This has proved invaluable for

details about exactly how the Libor rate is calculated and the many factors that must

be considered in the rate.

Another report that gave exceptional insight is The Wheatley Review. This was the

review that was commissioned by the Chancellor of the Exchequer, George Osborne,

in the immediate aftermath of the scandal as he called for reform to be made.

All of the literature reviewed for this project has all added worth to the overall topic

and have aided in this project being very in-depth.

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Chapter 2

Methodology

The purpose of this research is to look at the regulations of Libor before, during and

after the rate manipulation which came to light in 2012. This analysis will be carried

out by conducting a case study on the events surrounding the rate fixing scandal

using only secondary sources. In this project information will be gathered from

various journals and newspaper articles as well as reports and books. The

aforementioned literatures will be used to gain information about the people and

organisations involved and how this affected the market as a whole.

For the more intricate details of what happened there will be an analysis of

publications that were written in the aftermath of the scandal. This will include reports

from the regulators and impartial financial institutions, such as the Bank of England

and The Federal Reserve Bank of New York. There will also be an analysis of reports

that were written from the perspective of other financial institutions who were

affected.

The first summary will be regarding the regulations as they were at the time of the

scandal, and once this is clear, there will be an analysis of the market’s regulators.

The purpose of this analysis is to give a good idea of what their powers are in terms

of investigating and enforcing the rules and regulations the market users must abide

by. This analysis will then be linked to the rate fixing scandal to hopefully determine

whether or not the authorities were aware of what was happening. An investigation

into when they took action will then be carried out, which will help to establish their

position on the scandal. This should give a clearer view of their role, in terms of

whether they let it happen in order to force the Government to conduct a review of

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the process, or if in fact they were oblivious to what was happening within the market

they regulate.

Following the summary of the regulators and regulations the focus will be getting a

better idea of the market as a whole. This will focus on what the market was like at

the time the rates were being manipulated, how this manipulation affected the market

in the aftermath and ultimately how it affected the consumers.

All of the above will then be brought together in order to reach a comprehensive

conclusion on the matter. This will take into consideration the effect of the scandal on

the integrity of the Libor rate as a benchmark, as its purpose is to give a true

reflection of the banks borrowing and lending rates.

Chapter 3

Introduction

This project will focus upon the Libor rate fixing scandal of 2012. This was seen

as the worst financial conspiracy in history as it involved many of the world’s

biggest banks and spanned from London to Tokyo to New York and possibly

further as more and more details are being brought to light daily.

This project examine all factors that played a part in the scandal I order to give a

more detailed understanding of the rate manipulation that took place. It will

examine the rate, the market as a whole and identify the main players in the

market to better understand why they were manipulated

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The report will then attempt to offer motives for the rate manipulation as well as

looking at who was responsible. It will also give a detailed account of how the

rate was being manipulated so easily and almost without consequence.

Chapter 4

Overview – A wider perspective of Libor and global currency markets

4.1 History

The London Interbank Offered Rate (Libor) is a benchmark rate, which the largest

banks use to trade many different currencies with one another. It was originally an

idea by a Greek banker named Minos Zombanakis. He organised a loan from

Manufacturer’s Hanover to the Shah of Iran based upon the reported funding costs of

a set of reference banks (Ridley & Huw, 2012 as cited in Hou & David, 2014). During

the 1980’s banks began to both provide loans and borrow funds using the Libor

based rate. This lead to the creation of an incentive to underreport funding costs,

this then prompted the British Bankers Assosciation (BBA) to take control of the rate

in 1986 to formalise the data collection and governance process (Hou & David,

2014). This was turned into a uniform rate which had the ability to facilitate the

operation of markets and allow transparent and objective benchmarking. As of

January 1986, Libor became the market’s standard (Goldstein, 2012).

The Libor rates pupose is to give a true reflection of banks’ borriwing and lending

rates. It was intially alleged that banks were manipulating the in order to look in a

stronger financial state than they were. They did this becaue having a lower

borrowing rate shows a strong financial standing where as a high rate gives an

indication of a weak standing (Finch and Vaughan, 2012).

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Libor is not the only rate of its kind, it just happens to be the most widely known.

There are several others which are not widely known. Euribor is the European

internbank offered rate set by the European Banking Federation. It works in much the

same as Libor but its European banks the mainly use it. There is also an interbank

rate for many other financial centres like Tokyo, Mumbai, Singapore and Hong Kong.

These are known as Tibor, Mibor, Sibor and Hibor respectively ans they are all

conducted in the same way as Libor and Euribor (Hou and Skeie, 2014).

4.2 Calculation

The Libor rate is calculated each day; it used be that the BBA were advised by the

Libor Panel Banks and Users Group (LPBAUG) to use a reference panel of between

6 and 18 banks to submit 15 maturities for 10 currencies. This helps get a true

balance of the market (Goldstein, 2012). The currencies include the U.S. Dollar,

British Pound, Japanese Yen, Swiss Franc and Euro. However, previous to the

integration of the European currencies into the Euro, the Libor rate would have up to

16 different currencies . The maturities range from overnight to 12 months, although

not all of the currencies and maturities are active, (see fig. 1) (Hou & David, 2014).

The way the banks calculate their rate is by using the question “At what rate 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 11am?” (Hou & David, 2014),

(Goldstein, 2012). This basically means if a trader as were to ask a someone from a

different bank for a loan, what rate could they get?

Once these rates have been calculated for each currency and maturity, they are

submitted confidentially to Thomson Reuters, via an application where the other

banks are unable to see the rates which other banks have submitted (Goldstein,

2012). Once Thomson Reuters have received all fo the submissions from the banks,

they take away the upper quartile and lower qaurtile from each maturity pair and find

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the average of the rest. This average is released at 12 noon GMT and is used as the

Libor rate for that day (Hou & David, 2014).

Figure 1.

Libor Currencies Libor Maturities

Active Inactive Active Inactive

Euro Australian Dollar Overnight 2 weeks

U.S. Dollar New Zealand

Dollar

1 Week 4 Months

Brtish Pound Canadian Dollar 1 Month 5 Months

Japanese Yen Swedish Krone 2 Months 7 Months

Swiss Franc Danish Krone 3 Months 8 Months

6 Months 9 Months

12 Months 10 Months

11 Months

(Hou & David, 2014)

NB. All of the above currencies and maturities are were checked and are correct as

of 6th November 2015.

In order to fully undertand Libor all of it theoretical components must be looked at. It

is thought of as a combination of term and risk spreads. Below is formula which is

used to take the terms and risks into consideration.

LIBOR = Overnight risk free rate over the term + term premium + bank

term credit risk + term liquidity risk + term risk premium

(Hou and Skeie, 2014)

The overnight risk free rate over the term refers to the rate that a buyer could get

over night if the buyer is risk free. The term premium is the ‘intertemporal rate of

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substitution for the term of the loan’ (Hou and Skeie, 2014 pp. 4) this is referring to

the maturities available on Libor i.e. buying a six-month US Dollar maturity means

you have US Dollars but not until six months down the line. This then makes these

US Dollars available for shorter term trading. As the banks that use Libor are not risk

free borrowers the bank term credit risk refers to the counterparty and the amount

of risk the buyer is undertaking which rises in line the term of the loan i.e. the longer

the loan he higher the risk. The term liquidity risk refers to bank lending the funds

as they may be tied up in a long-term loan that will affect the banks ability to liquidate

the asset quickly should they need to. Finally the term risk premium is in the

equation to compensate should any of the other terms not return what they were

expected to.

There have been many attempts to break down each of the terms above in order to

show what percentage of the rate each term makes up. These theories are all very

different to one another. The first theory is that most of the risk is down to the

liquidity. It is thought that hoarding money during periods of stress is what drives

rates up. During 2007 in the financial crisis this is exactly what banks were doing.

(Acharya and Skeie, 2011, McAndrews, Sakar and Wang, 2008, Michaud and Upper,

2008 and Schwarz, 2010 all as cited in Hou and Skeie, 2014).

The next theory is that the counterparty credit risk is proxied by Credit default swap

(CDS) spreads and this is what drives the interbank rates (Taylor and Williams,

2008a, 2008b as cited in Hou and Skeie, 2014). This theory is saying that bank term

credit risk part of the equation is actually valued by the CDS spreads that the

borrower has.

Lastly Josephine Smith (2012) was able to find that up to 50% of the variation in

money market spreads is explainable by the term risk premium (Smith, 2012 as cited

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in Hou and Skeie 2014). This theory is basically saying that almost half of the

differences between rates is down to the extra compensation included in the rate.

4.3 Market and Contributors

The purpose of the Libor rate is to be a true reflection of banks borrowing and lending

rate. As a result of this the banks that contribute to the rate submissions must show

that they can be trusted to be send in honest rates. However this was all thrown into

disarray when allegations were made of manipulation by certain banks and traders.

This tarnished the reputation of Libor and further depleted customers’ confidence in

the banks and the financial services industry (Finch and Vaughan, 2012).

4.4 Foreign Exchange Market

The Forex market is worth $560tn with daily trades averaging about $5.3tn (Foster,

2012) (Daily FX, 2014). To put that in to some perspective the New York Stock

Exchange (NYSE) deals with roughly $28bn daily, some 30 times less than the Forex

market. It is widely accepted as the biggest market in the world due to its high

liquidity. This not only makes it an attractive prospect for traders as they are able to

enter and exit the market very quickly but they can also make trades of huge value

without the massive price fluctuations that would happen on a market of less liquidity

such as the NYSE (Daily FX, 2014).

The currency market is so big because there is more than one way to trade currency.

The main way is between banks however there are four types of trading that make up

the Forex market (Levinson, 2009).

4.4.1 Spot Trading

This is called the spot market because a majority of the trades are completed on the

spot. The best example of this is when buying currency to go on holiday. The buyer

goes into a local currency exchange hands over Euros and receives US Dollars at

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the day’s rate. Once the buyer receives the Dollars the transaction is finished.

Another form of spot trading is when a firm decides to convert export receipts in to

their own currency. These types of large spot trades were once arranged mainly via

the telephone however given the rise of the Internet and technological age the main

method for these transactions is by using electronic currency brokering systems

(Levinson, 2009). These are mainly done online and can be seen to have contributed

to size of the overall market, as banks are able to trade currency with other banks

based overseas. The actual trading of the currency in this instance however is not as

immediate as the face-to-face deals discussed above. These trades are agreed on

the spot but the exchange of currency must go through the banking system and

usually takes two days for the transactions to be completed and both parties to

receive their currency (Levinson, 2009).

4.4.3 Futures Trading

The basis of this type of trading is given away in the title. Futures’ trading is were a

company is expecting to receive currency at a certain maturity but they wish to

protect the currency they are receiving against their own currency. In this case the

firm would buy futures contract on the Chicago Mercantile Exchange. By purchasing

the futures contract the firm receiving the currency locks in the rate of that day

however this then means that the trade must go through on the day the contract

expires or else they will run the risk of exchange rates changing in the time between

receiving the currency and the day the contracts expire (Levinson, 2009). This means

that if you have a futures contract then it is in your best interests to complete the

trade on the date of the expiry or else you may see the currency devalue against

your own currency.

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4.4.5 Options Trading

This form of trading is very small in the market compared to other types. Option

trading is where a holder has a right but no obligation to buy or sell currency at a set

rate for certain period of time (Levinson, 2009). This type of trading is mainly used to

benefit the holder as sellers may not want to trade with them as the rate may be too

high and they may be inundated with buyers however he is under no obligation to

sell.

4.4.2 Derivatives Trading

This is how a majority of the trades are done on the Forex Market. Typically

derivatives are made up of different financial instruments such as futures and options

(Levinson, 2009). A derivative is something that gets it value from different contracts

it is made up of. This is the standard way of trading them however in Forex they are

commonly made up of different contracts.

The first type of contract that is used is a forward contract, this type of contract is

similar to a futures contract with a difference being that in a forward contract the two

parties not only agree upon a rate at which to trade in the future but they also agree

upon a date on which to complete the trade. The main difference between a future

contract and forward contract is that they are carried out directly between the dealer

and the customer. They also have more flexibility in terms of being arranged for a

precise date and amount of time that best suits the customer (Levinson, 2009).

The second type is foreign exchange swaps. These involve buying or selling

currency on one date and offsetting the buying or selling of the currency of the same

amount on a future date, with both parties agreeing upon these dates when the trade

is initiated (Levinson, 2009). An example of this would be if two parties agreed to

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trade Euros for US Dollars. If they are trading 100,000 Euros today they will also

agree to trade 100,000 Euros in 5 days time.

The next type of trading derivatives are based on is forward rate agreements. This is

where two firms agree to trade interest-payment obligations, if the obligations are in

different currencies there is also an exchange rate component to the agreement

(Levinson, 2009). This basically means that two firms can agree to pay the other

parties interest on a future obligation, so if the interest rate on it falls one party may

pay less and if it rises a party may have to pay more.

The final type of contract that makes up a derivative is the barrier option. This allows

the trader to limit their risk (Levinson, 2009). Basically this is where a trader puts a

barrier on a trade to automatically take the profit once the positions hits a certain rate

or the trader can put a barrier on the trade so if it drops the position will be closed

once it drops a certain amount.

4.5 Currencies

Although the market is made up of several currencies there are four major currencies

that take up a majority of the trading. The most dominant of the four is by far the US

Dollar (USD), this accounts for 87% of all market trading. The USD is followed by the

Euro, albeit not very closely, with 33% of all trading. The Japanese Yen comes in

third with 23% and finally fourth in the list is the Pound Sterling with 11% (BIS, 2013).

The remaining currencies are still traded on the market but the most popular of those,

the Swiss Franc, only accounts for 5% of all trading with the other minor currencies

having much less market share (BIS, 2013).

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Figure 2.

Libor Currencies by Percentage

Country Currency Market Percentage

US Dollar 87.0

Euro* 33.4

Japanese Yen 23.0

Pound Sterling 11.8

Australia Dollar 8.6

Swiss Franc 5.2

Canadian Dollar 4.6

New Zealand Dollar 2.0

Swedish Krone 1.8

Danish Krone 0.8

*The Euro is not tied to one specific currency rather it the main currency of the

European Union.

The above table is a breakdown of the main currencies traded using Libor and the

percentage of the market trades that they are involved in. These are taken from the

Bank for International Settlements 2013 Survey (BIS, 2013 pp. 10)

Chapter 5

The Libor Scandal - Market Regulators and Allegations of Rate Manipulation

5.1 Regulators

Since the BBA took over the governing of Libor in 1986 the market has been largely

unregulated. This is apparent because there was no direct regulatory body

overseeing its calculation, because as we know the rate is calculated by the banks

submitting their own rates (Ojo, 2012). However as financial crisis ended an act was

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passed into law and this was changed. The Financial Conduct Authority (FCA) is the

current regulator of the Libor market and all of the rate’s users. However, this was not

always the case as it was, until very recently, the Financial Services Authority; on

December 19th 2012 an act was given royal assent, this Act was the Financial

Services Act 2012 (UK Parliament, 2012), the royal assent passed the act into law

and started in motion the abolition of the FSA. This was then split into the FCA and

another governing body known as the Prudential Regulation Authority (PRA).

The FCA has three main objectives, which are clearly laid out in detail in the

Financial Services Act 2012. The first objective is the protection of consumers; in

order to fulfil this objective they must look at various points, for example, the risk of

entering into the investment, the experience or expertise the consumer may have

and whether the consumer has been given accurate information on which to base a

decision. The most important part of this objective, however, is laid out in Section 1C

2 (e) where they state “The FCA must have regard to; the general principal that those

providing regulated financial services should be expected to provide consumers with

a level of care that is appropriate having regard to the degree of risk involved in

relation to the investment or other transaction and the capabilities of the consumers

in question;” (Financial Services Act, 2012, 1C 2 (e)). This can be related back to the

trigger of the financial crisis, in which banks were wilfully selling mortgages to

consumers that they were not able to sustain. Consumers were not given a full

breakdown of the risks that would be involved in taking on such a huge investment,

the result of which caused many homes to be repossessed, and subsequently lead to

the financial crash in 2007.

The Second objective is The Integrity objective. The purpose of this objective is to

maintain the UK Financial System’s integrity as a trustworthy and unbiased system

that promotes a fair market place for both consumers and businesses alike. To do

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this they must maintain the soundness, stability and resilience of the UK Financial

System, ensure it is not used for anything related to financial crime i.e. rate

manipulation, it is not affected by behaviour that amounts to market abuse, the

financial markets are operated in an orderly fashion and that there is price

transparency from the markets (Financial Services Act 2012 s1D). This objective will

help rebuild consumers’ trust in their banks and those in charge of the UK Financial

system, given the loss of this trust after the recent failings of the banks with regards

to the financial crisis and the even more recent rate manipulation scandal.

The Third objective of the FCA is The Competition Objective. This objective is to

encourage competition in the market place. It does this by ensuring the consumers

have enough information about the financial services available to them and also

providing them with enough information about the products or services which they

might intend to use in the future, e.g. if a consumer would like to switch insurance

providers for a car or a home, the FCA will make sure there is enough information

readily available for them in order to make the decision on which is best for their

needs. The FCA also make sure that the financial services of any kind are easily

accessible not just in areas of high demand but also in areas which have low demand

as they may be viewed as economically deprived. This objective also helps with the

ease of obtaining the same kind of financial product or service but from a different

provider, for example if a consumer decides they can get a better current account to

fit their needs from a different bank, it the FCA’s responsibility to make sure that the

banks do not make it extremely difficult for customers to switch to one of their

competitor’s.

Finally, to maintain the competition objective the FCA must ensure the ease of

access for new competitors to enter the market and that the competition within the

market is encouraging innovation. So, in this instance, the FCA must see that all the

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competitors in the market are continuously changing how they operate in order to

make their services easier to access for consumers and that their new ideas are

actually driving industry forward and not just coming to standstill once they are

making profit (Financial Services Act 2012 s 1E).

5.2 Allegations

It is not know exactly when the Libor rate manipulation began, Professor Sharon E.

Foster speculates that it may have started as early as 2005 (Foster, 2012). However,

many media outlets, including Bloomberg, are of the opinion that it started two years

later, in 2007 (Finch and Vaughan, 2012). Although, none of these show that there is

any indication to support exactly when it began. Despite the lack of early evidence,

as the scandal came to light, more and more facts emerged to prove that the banks

involved in setting the Libor rate were actually influencing it to their own advantage.

According to an article on Bloomberg online, it was in 2007 when the financial crisis

hit, that the Libor rate was most at risk of being manipulated, this was due to the

banks not wanting to lend to one another instead opting to hoard cash. This made

the job of an analyst extremely difficult, as they had little or no trades to base their

rate submissions upon. They then turned to interdealer brokers, colleagues and

acquaintances for advice on what they should submit, however, this caused a

problem as any of these people could give advice on rates which would most benefit

them, rather than a rate which gave a true reflection of the market. This was

described as “legitimate information sharing in the absence of trading” (Finch and

Vaughan, 2012).

Manipulating the rate was simple, as discussed above, participating banks send in

their submissions for the 15 maturities, for 10 currencies with the upper and lower

quartiles removed, and the rest averaged in order to get the rate for that day. The

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way it was being manipulated, however, was that the bank’s submitters would send

in submissions which would be much higher than the market would expect, this

submission would then be eliminated in the upper quartile. However, with this

submission being removed, it would push another bank’s rate, which should have

been excluded, down into the group to be averaged, this would the push the average

up and that day’s Libor rate would be higher than expected (Finch and Vaughan,

2012).

Initially, it was thought that the banks were manipulating the Libor rate on purpose,

so they could deceive consumers in terms of their financial position during the crisis.

An article in the Wall Street Journal was the first to state these allegations, giving the

reasoning behind it as the banks wanting to portray a position of financial strength

during very hard times, and to do this they instructed their submitters to send in

fixings that were higher than they should have been, proving that they were not in a

position to fail (Finch and Vaughan, 2012) (Foster, 2012). It then came to light that

the banks could have been manipulating the rate in order to gain advantage over

other banks trading in the market (Foster, 2012). To put that in monetary terms, as

mentioned above, the Libor market overall is worth $560 trillion. So the movement of

one basis point, which is the equivalent of one one-hundredth of a percentage point,

could cost the market $56 billion (Foster, 2012).

As many banks have positions in the regions of $100 billion plus, the movement of 1

basis point can mean huge monetary gain in their favour. When this motive was first

offered, it was again, an article in the Wall Street Journal that made it public. The

author of the article, Carrick Mollenkamp, stated in the article that in the minutes from

a November 2007 meeting of the Monetary Policy Committee (MPC), several

members thought that the rates were lower than actual traded interbank rates

through the period of stress. The article also states that some banks and members

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had expressed concerns to the BBA as to whether the banks were reporting rates

true to the actual borrowing costs (Mollenkamp, 2008). Bloomberg later revealed in

an article in 2012, that a Barclays employee in London sent an email to the Federal

Reserve Bank of New York in August 2007 questioning the rates that banks were

submitting (Finch and Vaughan, 2012).

All of the above motives, although they were just speculations about the reasoning

for the low rates, show that the regulators had been warned almost immediately that

there was some manipulation happening. There is very little evidence to say why

these warnings were ignored. However, The Bank of England and The Federal

Reserve Bank of New York were happy to say they failed to act because at the time

of the warnings, and the subsequent manipulation in the years that followed, neither

of these institutions had any responsibility for the oversight of Libor (Finch and

Vaughan, 2012).

These were not the only institutions to have been warned of the manipulation going

on. In 2008 the BBA ignored recommendations from banks to change the way the

rate was computed. The reasons for not making any changes may have been due to

the fact that the regulators, both the BBA and the FSA, were preoccupied with

dealing with the biggest financial crash since the great depression, and forcing the

banks to be submit truthful rates would have shown that they were paying penalty

rates to borrow (Finch and Vaughan, 2012). This would have shown the market and

consumers just how much trouble the banks were in given the financial crisis that hit.

Had they been forced to submit truthful submissions, this would have meant even

more trouble for the banks as, consumers would have lost faith in them knowing just

how bad the situation really was. This begs the question; even though the regulators

were warned, did they let the manipulation happen on purpose?

24

The reasons behind this could ultimately come down to one of two options. The first

option could be that the regulators at the time, the FSA and the BBA, may have seen

that forcing the banks to be truthful with their submissions would have worsened the

situation during the financial crisis. As a result of this foresight, they could have

decided to wait until the banks were in stronger positions financially before taking

action. Even though the regulators knew what was going on and failed to act, it

doesn’t take away from the fact that manipulating the rates and not giving a truthful

reflection still damaged the reputation and integrity of Libor, but is also against

criminal law, as it is deceitful and fraudulent (R v Hayes, 2015).

5.3 Rate Manipulation

As mentioned above there were several different allegations about manipulation and

these lead to many media outlets coming to their own conclusions. However there

has not been any real evidence to support any motives that have been speculated.

One thing that was correct though is that this involved more banks than anyone could

have thought. The banks involved in the manipulation were some of the biggest

banks in the world this included UBS, Barclays, JP Morgan Chase & Co, RBS and

Citigroup (Freifeld, Henry and Slater, 2015). These banks were the main offenders

during the whole period of manipulation. It was uncovered that they were using an

invite only online chat system where they could discuss their submissions and trades

((Freifeld, Henry and Slater, 2015).

The earliest evidence of the rate being manipulated can be dated back to March 28th

2008 when the three-month yen rate at RBS rose from 0.94 on the 27th to 0.97 on the

28th; on this date they were the only bank to raise their rate out of the 16 contributing

banks (Finch and Vaughan, 2012). It was also revealed that this was not one

individual looking to make a gain for themselves, this was actually arranged through

a small network of people at RBS. Neil Danziger, a derivatives trader at RBS at the

25

time, was instructed by his boss in Tokyo, Tan Chi Min, in an instant message to

“bump it way up high, highest among all if possible” (Finch and Vaughan, 2012) As

Neil Danziger was a derivatives trader and was not responsible for the submissions

he would usually pass this message on to Paul White, however Paul was absent that

day so Neil Danziger simply put the rate in himself (Finch and Vaughan, 2012). The

fact that a derivatives trader was able to have such easy access to the rate

submission shows a serious lack of security in the rate. RBS were accused of

cheating their clients and pleaded guilty, for their part in the manipulation they had to

pay a fine of £395 million as well as £274 million to the Federal Reserve Bank of New

York (Freifeld, Henry and Slater, 2015).

Citigroup were involved in the scandal however it was their main banking unit Citicorp

who were actually guilty of the manipulation. They were eventually caught

manipulating the rate and pleaded guilty to cheating clients to boost their own profits.

The CEO of Citigroup, Mike Corbat, described the behaviour of the bank and thosde

involved as “an embarrassment” and has set in motion an internal investigation. As of

May 20th 2015 nine people had been sacked from Citicorp (Freifeld, Henry and

Slater, 2015). They were fined the most of all the banks, a staggering $925 million

criminal fine as well as $342 million to be paid to the Federal Reserve Bank of New

York (The Federal Reserve) (Freifeld, Henry and Slater, 2015).

JP Morgan Chase & Co was accused of the same charges as both Citigroup and

RBS. They also pleaded guilty to the accusations and were fined $550 million

criminal fine and $342 million to The Federal Reserve. However what makes JP

Morgan different and if anything worse, than the other banks involved was that is was

the first time a bank had plead guilty to criminal charges Since Drexel Burnham

Lambert, which plead guilty to 6 counts of securities fraud in 1989 (Freifeld, Henry

and Slater, 2015) (Eichenwald, 1989).

26

The most high profile case of pleading guilty to the accusations is that of Barclays

Plc. This banks role in the scandal was widely covered across all media outlets both

in the UK and in the US. Barclays were actually first to bring the entire manipulation

allegations to light as the then head of asset allocation, Tim Bond, publicly disclosed

the banks Libor figures in May 2008, stating that all banks were misstating their

figures (Finch and Vaughan, 2012) however these allegations were ignored.

As these allegations were ignored this could have almost given Barclays the ‘green

light’ to start manipulating the rate in their favour. The reason this case drew so much

media coverage could be due to the fact that even after they had pleaded guilty to

manipulating the Libor rate their employees continued to engage customers in

misleading sales practices (Freifeld, Henry and Slater, 2015). The staff at Barclays

would offer different rates to the ones offered by the traders, these were known as

‘mark-ups’ and were generally used to boost profits (Freifeld, Henry and Slater,

2015).

So basically even after Barclays had admitted to manipulating the Libor rate in order

to boost their profits, they thought it okay to continue manipulating rates to higher

ones, that again would help boost their profits. As punishment for this four traders

were sacked with an order to sack another four coming from Benjamin Lawsky, the

New York states banking regulator (Freifeld, Henry and Slater, 2015). They were also

fined $2.4 billion in total for all of their offences. Although Barclays had put aside $3.2

billion to pay for the fines, their share prices jumped to an 18 month record high after

the sackings as customers saw this as the bank getting rid of the uncertainty after the

rate rigging (Freifeld, Henry and Slater, 2015).

27

The Final substantial bank to be fined for Libor rate manipulation was United Bank of

Switzerland (UBS). This was the first bank to report the misconduct to the U.S.

Officials (Freifeld, Henry and Slater, 2015) this got the whole investigation started

into the previous allegations that had been made by other banks and employees as

mentioned above. However this ‘whistleblowing’ did not exempt UBS in any way as

they still plead guilty and paid a fine of $203 million for breaching a non-prosecution

agreement and for their part in the Libor manipulation they also had to pay $342

million to The Federal Reserve. (Freifeld, Henry and Slater, 2015).

5.4 Conviction

Out of all of the regulatory bodies that could have acted upon any of the warning

signs or accusations it was the Commodity Futures Trading Commission (CFTC) who

was the first to act. Vince McGonagle, a Senior Manager of the CFTC’s enforcement

team, decided to investigate the allegations surrounding Libor. At the time there was

a lot of discussion around whether or not they should investigate as cases of this

nature usually fell to the Securities and Exchange Commission (SEC) or the Federal

Reserve (Vaughan and Finch 2015). This was not the only barrier that needed to be

overcome however as Libor is a UK rate, the CFTC has no jurisdiction for it.

After being told by the FSA that they were not interested in such investigations it

came light that Libor was used on The Chicago Mercantile Exchange (CME), which

was under the CFTC’s jurisdiction, and the investigation was able to begin. The

CFTC requested information on how Libor was set from British banks with a few

responding to the request but many ignored them. Not having any UK regulators

willing to help almost ground the investigation to halt until the CFTC received a CD

that was a recording of two middle managers at Barclays openly discussing

manipulating the rate and how it had come from the Bank of England (Vaughan and

Finch, 2015). This prompted the CFTC to get the US Department of Justice involved

28

and when they did the banks were ordered to hand over evidence relating to the

case. It was when the UBS evidence was being reviewed that Tom Hayes was found

to be a frequent offender.

Tom Hayes was seen as the common denominator in the scandal. He had worked at

UBS and made over £200 million for the bank by fixing the Libor rate. It was then

uncovered that he had been sacked from Citigroup once they discovered what he

was doing (Spillett and Smith, 2015). However he wasn’t manipulating the rate

himself, he had built up a big network of brokers throughout The City that he would

regularly call or email and instruct them to tell their submitters what to do with the

rate. It can be argued that Tom Hayes was the ringmaster for a majority of the

manipulation however he disputed this claim stating in court that all of his managers

were aware of his actions and that in some instances had even condoned his actions

(R v Hayes, 2015).

As mentioned above when the financial crisis first hit and the trading began to slow

down the submitters would ask the brokers for advice on what the rate should be set

at, however what the submitters were unaware of at that time, is that the brokers

were in regular contact with Tom Hayes and he would tell them what he needed the

rate set at (Vaughan and Finch, 2015). The brokers would then give this information

to the submitters and they would simply take it at face value and input the rate. Little

did they know that they were actually pawns in the biggest financial conspiracy ever.

It was back in 2007, prompted by the collapse of the Lehman Brothers, that Hayes

was working at UBS in Tokyo, when Tom Hayes had the idea of influencing the rate.

He had a position of 400 billion yen about to mature when he really started contacting

everyone in his network to push the rate up. The brokers delivered and yen Libor

rose 3 basis points (Vaughan and Finch, 2014).

29

However, his network was not restricted to just who he personally knew. If he didn’t

know any submitters at certain banks he would use people he did know to befriend

them and then once they were onside, they too would receive “advice” on what their

Libor rate should be. The best example of how Tom Hayes would manipulate the rate

through a ‘friend of a friend’ was when he contacted his Brother-in-Law Peter O’Leary

at HSBC. Tom Hayes manipulated Peter O’Leary as he had done to so many others,

and advised his Brother-in-Law to befriend the person who set the yen Libor at

HSBC, Chris Porter. Hayes Advised O’Leary to befriend Porter “over a few pints” and

ask him to set the rate for the three-month yen lower as he had a position of $1

million on the line.

However this was not the end for Tom Hayes as in December 2012, the Serious

Fraud Office in London arrested him (Vaughan and Finch, 2015). At first he opted to

give evidence against his co conspirators in order to be accepted onto a Serious

Organised Crime and Police Act programme under s71 to protect himself from

extradition to the U.S. and signed the agreement on March 23rd 2013 (R v Hayes,

2015). This agreement would have given him immunity not only from extradition but

also may have had an effect on his punishment for his part in the scandal. However

once the immunity from extradition was granted Tom Hayes decided to change not

only his legal but also his plea from guilty to not guilty (R v Hayes, 2015). This

basically started the beginning of the end.

Tom Hayes had put forward his defence claiming that all banks were manipulating

the rate to help themselves however this was rejected as he was manipulating the

rate for personal gain (R v Hayes, 2015). He also tried to claim that what he was

doing by manipulating the rate was commonplace in the market and that his

managers condoned and encouraged his methods. This again was rejected as

regardless of who else was doing it or who was encouraging him to do it, does not

30

take away from the fact that what he was doing was deceitful and fraudulent (R v

Hayes, 2015).

At this point due to the change of legal team and the plea any legal argument that

could be made had been made (R v Hayes, 2015). Taking everything into

consideration Tom Hayes was sentenced to 14 years in jail due the amount of money

involved that fraudulently gained (R v Hayes, 2015).

This case in particular best shows how easy it was for one dishonest person to cause

so much damage. This relates back to the previous point that there needed to be

some form of security or regulation in place for the Libor rate. Had this been the case

this entire scandal could have been avoided. Given how high profile this was it has

helped clear the way for other cases and countries to take legal action against banks

and traders who were also involved.

As of November 13th UK prosecutors had charged 10 former traders from Barclays

and Deutsche Bank with fixing the Euribor rate. This is on top of the six interdealer

brokers from ICAP, Tullet Prebon and RP Martin who are on trial accused on

assisting Tom Hayes (Fortado, 2015).

In the first U.S. trial for Libor rate fixing, two former Rabobank traders, Anthony Allen

and Anthony Conti have been found guilty of rigging the yen and US Dollar Rate

(Fortado, 2015).

31

Chapter 6

Libor; The Reformation – An Overhaul and New Benchmark?

The need for reform is considered as critical in helping to regain the integrity and

restoring faith in the Libor rate. This part of the report will focus upon the ideas and

recommendations of rate as well as detailing any issues that may hinder any

recommendations proposed.

6.1 Reasons for reform

As discussed throughout this report there are several reasons that all point to the

need for reform in Libor. As the scandal gathered so much media attention this

prompted the UK Government to step in.

After the discovery of hard evidence that manipulation was going on, the Chancellor

of the Exchequer, George Osborne ordered the Managing Director of the FCA,

Martin Wheatley to conduct a review into Libor. This tasked him with looking at the

issues with Libor and all of its practices and then making recommendations for it.

This was agreed in 2012, however as mentioned above the banks themselves asked

the BBA to do this in 2008 (Finch and Vaughan, 2012). The main issues with Libor

are summarised below;

The first reason to reform Libor is because it is used as a benchmark for a true

reflection of banks borrowing and lending rates. However over time this type of

trading has slowed given the recent financial crisis. This means that the rate setters

in the banks have been basing their submissions on expert advice rather than actual

transactional data (Wheatley, 2012).

32

The second reason as outlined in the Wheatley review and mentioned above is that

the banks and the people who work for the banks have an incentive to try and

manipulate the rate to either boost perception of their creditworthiness or to support

their trading positions (Wheatley, 2012).

The third reason is that because the process of submitting Libor rates is self-policing.

This leaves it open to manipulation in line with the incentives (Wheatley, 2012). This

basically means that if all of the rate submitters are manipulating the rates it does not

seem as if anyone is doing anything wrong. Something Tom Hayes implied as his

defence during trial.

The final reason is that there are weaknesses within governing arrangements for the

compilation processes and within contributing banks. This is basically in reference to

people such as Tom Hayes, Tan Chi Min, Anthony Allen and many others who have

not yet been publicly revealed, this is basically saying that there are still people

involved in the banks and quite possibly the governing bodies such as the BBA who

are willing to manipulate the rate for substantial financial gain with blatant disregard

for the integrity of the rate or themselves.

Taking all of this into consideration in line with a recommendation form Martin

Wheatley, it is very clear that Libor cannot and must not continue to operate as it

currently is. Even though some of the worst offenders have been caught and have

either been or are currently being dealt with by the authorities, there needs to be

changes made to Libor that will prevent this sort of conspiracy happening again.

Similar to how the Regulators dealt with the fallout from the financial crisis, with

things such as stress tests for banks, Libor needs an overhaul in order to be

financially trusted again.

33

6.2 Recommendations for Reform

In the Wheatley report there are two main areas that have been identified with

regards to reform. The first area is the strengthening of Libor (Wheatley, 2015). This

would entail changing the way that the rate is calculated and finding a formula that

would prevent any outside parties having an influence on the rate. Something similar

to the how the Bank Of England sets interest rates could be an option in that an

impartial body sets the rates and the banks use that rate. However this would need to

be based upon transactional data and as mentioned above, there has been a huge

decline in the trading on the Forex market. This would still not the make the rate

immune to manipulation. Due to the low numbers of transaction being doing a small

number of off-market rates would be able to skew the rate (Wheatley, 2012).

Another option for strengthening Libor could be to publish each banks submission for

each currency daily (Wheatley, 2012). This would create transparency throughout the

rate with everyone being able to see what each bank thinks the rate would be. Ideally

the submissions should all be similar as many of the banks are in similar financial

positions. However by publishing the rates it would make it much easier to spot if any

banks were trying to influence the overall rate. The threat of regulators and

authorities being able to spot the manipulation, with either a very high or very low

rate, could be enough of a deterrent to force the banks to be completely truthful. This

is simply a suggestion and may not be a viable option on its own, as it may need to

be coupled with the previous option of real consequences for manipulation.

A final way the Libor rate could be strengthened is by increasing the amount of

regulation or security surrounding the rate. As discussed rate setters, traders and

brokers were all able to influence the rate though the submitters at banks. They were

able to do this because the treat of any repercussions was almost non-existent. By

34

increasing security surrounding the setting of the rate and having a real threat of

serious consequences for any manipulation would deter individuals from trying to

skew influence the rate in their favour. The recent conviction of Tom Hayes for his

crimes has done a lot in terms of forcing people to realise they will not get away with

manipulation and prompting banks to intensify their compliance policies, however this

is not enough. There needs be a specific legislation or regulation brought in to clearly

set out that if anyone is found to be influencing the rate there will be severe

punishments as they are not only tarnishing their own reputation but also harming the

integrity of the financial sector as a whole.

The second area identified for reform is to find an alternative to Libor (Wheatley,

2012). This would mean abolishing Libor completely and using a different rate. By

doing this, the regulators would need to come up with a new rate which would be

suitable, they would need to propose a new calculation methodology and they would

also need to take into consideration the cost of moving any existing contracts on

Libor on to the new rate. The specific issues that each point would need to address

are summarised below:

When finding a new rate the main thing to consider is, will it be able to perform in the

market in the same way as Libor? This is not meant in terms of will the rate be able

to handle the transactions it is more about will the rate appropriately incorporate

some of the main characteristics that make up Libor. These characteristics, as

mentioned in Chapter 3, are the types of risk that Libor incorporates when setting the

rate. The first is the bank term credit risk, this as discussed, incorporates the amount

of risk the counterparty is undertaking when agreeing to the loan. A new rate would

need to be able to add this to the equation however, it may prove difficult if the rate is

set independently as the rate setter may not know how much risk the party is

undertaking.

35

The second characteristic to be considered is the liquidity risk. An independent rate

setter would need to be sure that a bank is not going to need to liquidate the funds

quickly during the loan period an if there was possibility, would need to compensate

the bank accordingly until the end of the loan term. A possible solution to this could

be the rate setter assuming the risk from banks. For example if the Bank of England

were to set the rate they could absorb the risk by agreeing with the banks that if they

needed to liquidate the cash quickly the Bank of England would give the cash to the

bank and when the loan term ended the cash would be paid back to the Bank of

England rather than the bank. However this would not be feasible as the Bank of

England may not have the funds to lend out if this were to happen to multiple banks

at once.

The characteristics mentioned above would need to be included the method of

calculation. This could again prove problematic, as even with the current formula

there is no exact percentage that these types of risk take up in the overall figure. Due

to the nature of the risk involved they tend to be variable rates differing between

banks as they all trade different volumes of the available maturities and currencies.

This would then mean that some banks might have to deal with higher amounts of

risk than they need to, possibly costing them money.

Another barrier to creating an alternative rate to Libor is the cost of transferring

contracts from the existing rate to the new one. This could not just be an overnight

process due to the length of some maturities that are used on Libor. As mentioned in

Chapter 3 there are maturities, which can be very long term, ranging from 6 months

up to 12 months. If a new rate was introduced the authorities would need to consider

two options. The first option would be to decide a date on which all banks would have

to stop using certain maturities so that they would have time to run for the full term of

36

the loan without being changed and possibly changing the return to either party

involved in the loan. This is because changing the rate may mean that that either the

borrower or lender could see less of a return with a new rate than they would receive

from the rate used when the contract was agreed.

If the regulators were to consider when the longest-term loans would finish they could

set the date after this as being the start of using the new rate and then put

restrictions on other trading according to the length of those terms. For example if the

12 month maturities ran out December 31st 2016, they could stop any trading of 12

month rates in the old benchmark after the 31st December 2015, and then for each of

the maturities less than this adjust the final trading rate i.e. no 11 month maturities

after January 31st 2016. The regulators could then say that the trading of 12-month

maturities could begin on January 1st 2016 using the new rate and continue this way

with each of the maturities until all of them were using the new rate. This would then

mean that banks with open positions in all their maturities would be able to keep

them in place for their duration and continue trading. This would also eliminate the

possibility of reform coming in too quickly which feared as it may cause chaos to the

$300tn worth of contracts open in the market (Masters, 2012).

In conclusion to all of the facts presented here it is very clear that there is a definite

need for reform as the Libor rate cannot go on operating as it is now. It seems to be

that the manipulation of Libor had become somewhat of an age old practice that is

simply no longer accepted. The situation was left to get out of control before

something was done about it, however as mentioned throughout the report many

warnings and doubts had been ignored. It can be argued that if these warnings were

not ignored the whole scandal could have been avoided, however if this had been the

case there is no evidence to say that the rate would have been reformed and the

37

manipulation could have happened regardless. So in a way it can be seen as good

thing that the rate got to a point to force the reform.

To answer a question offered in Chapter 5 ‘did the regulators let the manipulation

happen on purpose to force reform?’ The evidence points to the conclusion that the

regulators were not letting it happen on purpose, rather they just didn’t care that it

was happening, shown by the fact that the CFTC contacted the FSA and the FSA

decided not to act upon their suspicions.

In the time after the Wheatley review there have been movements towards the

reformation of Libor albeit little ones. As a result of the review the BBA has been

removed as the governing body of Libor and were replaced by the Intercontinental

Exchange (ICE) Libor. This could hint at the regulators are moving towards a new

benchmark that doesn’t just serve London but is used worldwide.

It will be sometime before any real significant changes are made to Libor as due it’s

size and complexity it is no little task to perform an overhaul of that magnitude

however one thing is for sure, there is definitely reform coming and this will surely be

welcomed by the market.

Conclusion

In conclusion to all of the facts presented here it is very clear that there is a definite

need for reform as the Libor rate cannot go on operating as it is now. It seems to be

that the manipulation of Libor had become somewhat of an age old practice that is

simply no longer accepted. The situation was left to get out of control before

something was done about it, however as mentioned throughout the report many

warnings and doubts had been ignored. It can be argued that if these warnings were

38

not ignored the whole scandal could have been avoided, however if this had been the

case there is no evidence to say that the rate would have been reformed and the

manipulation could have happened regardless. So in a way it can be seen as good

thing that the rate got to a point to force the reform.

To answer a question offered in Chapter 5 ‘did the regulators let the manipulation

happen on purpose to force reform?’ The evidence points to the conclusion that the

regulators were not letting it happen on purpose, rather they just didn’t care that it

was happening, shown by the fact that the CFTC contacted the FSA and the FSA

decided not to act upon their suspicions.

In the time after the Wheatley review there have been movements towards the

reformation of Libor albeit little ones. As a result of the review the BBA has been

removed as the governing body of Libor and were replaced by the Intercontinental

Exchange (ICE) Libor. This could hint at the regulators are moving towards a new

benchmark that doesn’t just serve London but is used worldwide.

It will be sometime before any real significant changes are made to Libor as due it’s

size and complexity it is no little task to perform an overhaul of that magnitude

however one thing is for sure, there is definitely reform coming and this will surely be

welcomed by the market.

39

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