How Barclays Made Money On LIBOR Manipulation
The scandal over manipulation of the LIBOR and EURIBOR rates—benchmark lending rates for global banks—is complex, as it involves derivatives that most people have never even heard of.
On June 27, the U.K.'s Financial Services Authority published detailing some of Barclays' infractions in manipulating LIBOR.
So far, the company has agreed to shell out ￡290 million ($455 million) in fines due to the scandal. Not to mention various resignations and suspensions, and conspirators could even face the prospect of criminal charges.
So why lie about LIBOR? Here's a brief explanation.
LIBOR is used to settle contracts on money market derivatives. Every day, 18 banks are polled by the British Bankers Association and asked 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 11 am?"
The 18 banks all submit responses, telling the Thomson Reuters data collection service that handles LIBOR submissions the price they would offer to loan money (LIBOR) on a variety of different timetables. The service throws out the top and bottom four submissions, then takes the average of those submissions to determine these official BBA rates.
Bets involving Eurodollar futures—which allow traders to take bets on how interest rates will move over certain time periods—caused Barclay's submitters to alter the lending rates they reported to the BBA that would make up LIBOR. Eurodollar futures (and the derivatives related to them) accounts for some $360 trillion in global trade, and typical contracts involve at least $1 million.
It's no surprise, then, that Barclays stood to gain a lot of money off of even small changes in the LIBOR rate—generally just a few basis points.
One example, from page 12 of that report:
On Friday, 10 March 2006, two US dollar Derivatives Traders made email requests for a low three month US dollar LIBOR submission for the coming Monday:
i. Trader C stated “We have an unbelievably large set on Monday (the IMM). We need a really low 3m fix, it could potentially cost a fortune. Would really appreciate any help”;
ii. Trader B explained “I really need a very very low 3m fixing on Monday – preferably we get kicked out. We have about 80 yards [billion] fixing for the desk and each 0.1 [one basis point] lower in the fix is a huge help for us. So 4.90 or lower would be fantastic”. Trader B also indicated his preference that Barclays would be kicked out of the average calculation; and
iii. On Monday, 13 March 2006, the following email exchange took place:
Trader C: “The big day [has] arrived… My NYK are screaming at me about an unchanged 3m libor. As always, any help wd be greatly appreciated. What do you think you’ll go for 3m?
Submitter: “I am going 90 altho 91 is what I should be posting”.
Trader C: “[…] when I retire and write a book about this business your name will be written in golden letters […]”.
Submitter: “I would prefer this [to] not be in any book!”
Essentially, Traders B and C begged the person responsible for submitting Barclays's LIBOR number to lower the rate they submitted for that day on three-month lending. [Even if Barclays's submission had gotten thrown out because it was unnaturally low, during the period before the crisis, the bank was generally submitting high rates, so a thrown out submission would have pulled the final LIBOR down.]
That was because they had $80 billion in three-month forward interest rate swaps (IMMs) "fixing" on March 13. We won't go into the details of how this swap is constructed. But in essence, traders enter into these swap agreements, betting that interest rates will go down versus some fixed rate set forward in the contract. Thus, the larger the difference between the fixed rate and LIBOR (a floating rate that changes daily), the more money they make.
A complete explanation of how this works is available in Dr. Galen Burghardt's "The Eurodollar Futures and Options Handbook." For now, we'll just use an equation from that volume to determine how much Barclays would have made off of a 3-month LIBOR rate (here, floating rate) that was just one basis point lower:
Had Barclays traders actually affected the rate by one basis point, they would have made more than $2 million. This is just one trade, and these contracts settle quite frequently. Further, it's likely that Barclays was not the only bank fiddling with these numbers.
In this situation, a counterparty that sold them the IMM swap would have taken the trading loss. To some extent, the fact that financial firms, and not the common man, appear to have taken the losses here means that manipulation of LIBOR rates has not become a matter of public outcry. Even so, such distortions in the market demonstrate a fundamental flaw in the system by which much of the world's lending is organized.
If you have any tips or insight to contribute—or if you see an error with our math—please contact Simone Foxman at [email protected] or call U.S. number 646-376-6016.
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