Streetwise Professor

June 27, 2012

The Truth About LIEBOR is Coming Out

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,Regulation — The Professor @ 8:59 am

Barclays’ has copped to an attempted manipulation of LIBOR.  It has agreed to pay about $450 million to the UK’s FSA, the CFTC, and the USDOJ.  The CFTC filing states that Barclays had two motives for its actions.  First, when Barclays’ reports to LIBOR were high relative to other banks’ (which Barclays people referred to as having their head above the parapet) and thereby raising questions about the bank’s financial condition, it allegedly reduced reported rates in order to allay such fears.  Second, the bank’s traders allegedly influenced rate submissions, and conspired with traders at other banks to change their submissions, in order to advantage derivatives positions.

As I noted in 2008, when the story first broke, the second possibility created substantial legal liability for banks like Barclays that submitted the false reports.  Under the anti-manipulation law in effect in the US at the time, it was necessary to have specific intent to create an artificial price of something like the LIBOR-based Eurodollar futures contract.  The emails divulged today suggest such a specific intent.

Perhaps crucially, the Order only finds that Barclay’s attempted to manipulate, not that it had in fact succeeded.  This will be an important issue going forward.  To prove manipulation, and crucially, to collect damages, it will be necessary to show that Barclay and other submitters of LIBOR quotes indeed distorted the index, that is, they caused an artificial price in a futures contract based on LIBOR or some other interest rate like Euribor.

Proving this will be a very data intensive exercise.  Moreover, there are two distinct issues-the impact of manipulation on the final settlement price of the futures contract (which is based on LIBOR), and the impact of manipulation on futures prices prior to expiration.  The second issue will prove more challenging than the first because the connection is more direct in the final settlement price.  Even that will pose some issues, however, because of the necessity of identifying the “but for”, i.e., what interest rate should banks like Barclays have reported.   This will necessarily require looking at actual interbank transactions, raising the question of how many such transactions there will be during periods of time of money market stress starting in 2007.

These issues are not impossible.  Similar, and arguably even more challenging issues, were confronted in a class action lawsuit against those who misreported  natural gas prices to publishers like Platts.  (Full disclosure: I consulted with plaintiffs in that matter, and wrote a declaration in support of certain aspects of the plan of allocation of settlement monies.)

The whole fiasco does point out, yet again, the overriding importance of basing cash-settled indices on actual transactions, wherever possible.

This is becoming an important issue in oil markets as well, as “Price Reporting Agencies” like Platts and Argus are under great scrutiny.  But oftentimes the problem is not amenable to easy solution.  You can’t have a reliable transaction-based index that is not susceptible to manipulation if (a) there are few transactions, and/or (b) market participants have the option to report transactions.  Pharonic pronouncements from regulators that PRAs make bricks without straw are futile.

None of these issues are new.  I (and my colleagues at UH) dealt with them in 2003 in our efforts to create an “energy data hub” in the aftermath of the price reporting scandal post-Enron.  Voluntary reporting is extremely problematic.  Compulsory reporting (along the lines of one of the few salutary features of Frankendodd) is necessary (but not sufficient for some markets) to produce reliable price indices.  Arranging this on an international market like oil seems virtually impossible to implement, let alone enforce.

This is the longer explanation behind my rather cryptic quote from this WSJ article from last week.

Going back to LIEBOR, the Barclays $450mm coughed up is the first fine, but it won’t be the last one.   In the energy markets, the CFTC collected about $250 million: fines will be many multiples of that in LIBOR and Euribor and TIBOR and whatever.  And believe it or not, the really big money will likely be in civil litigation, and the battles will be much more intense there as well, IMO.

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  1. Hencethe use of the EDSF (Eurodollar sythetic or swap (I forget which) funds) for anything longer than a year or two – The hell this kind of thing can cause in the structured finance market should not be underestimated.

    Comment by Sam — June 27, 2012 @ 9:05 am

  2. Sam-interesting. Please elaborate-sounds very interesting.

    The ProfessorComment by The Professor — June 27, 2012 @ 9:06 am

  3. we have begun seeing a couple of deals based on an EDSF index – spreads a bit wider than the equivalent LIBOR spreads. Eurodollar deposits are traded and there is an active forward and future market in them, so swap rates and FRA’s can be priced over them. The advantage of LIBOR is that it is so universal, and so many deals haveethe index on boththe asset and liability side, taht it will be very difficult to get rid of it, at least on the short term floater side. If iI can figure out how to do it, I will try to e mail you some bloomberg pages that have EDSF incorporated in the Forward curve – you can see cash, futures and swap rates all intermingled in building the forward curve.

    Comment by Sotos — June 27, 2012 @ 11:13 am

  4. Let me expand on this: talking to a colleague who spent a lot of time in Euro auto receivables land, EDSF has been a standard for short term ( +- 1 year AL) amortizing paper for quite a while, being viewed as “more accurate” than LIBOR – he thinks this may go back as far as the late 90’s. What is different now is that some longer Al paper, not necessarily amortizing, has been issued floating of off the “new” index. Again it is hard to get away from this the LIBOR standard, and non-index ways of dealing with this, remarketed securities, Dutch auctions, etc., have proven themselves very vulnerable to lockouts during the last melt down.

    Comment by Sotos — June 27, 2012 @ 12:49 pm

  5. […] but did not say whether the bank did succeed – or could have succeeded – at it. Here’s Craig Pirrong… Proving this will be a very data intensive exercise. Moreover, there are two distinct […]

    Pingback by FT Alphaville » Transacting at Libor, bro — June 28, 2012 @ 7:48 am

  6. […] wasn’t the only bank fixing Libor rates I bet. This isn’t a small story. It has pretty big ramifications up and down a lot of […]

    Pingback by Friday Breakfast Links | Points and Figures — June 29, 2012 @ 5:14 am

  7. CME ought to sue for lost volume in Eurodollars!

    Comment by Jeff — June 29, 2012 @ 5:16 am

  8. I re-read your piece. Great point about cash settled markets being tied to actual transactions. In the Hog market, we find even cash transactions are being manipulated because the price reporting standards set forth by the government are less than robust.

    Comment by Jeff — June 29, 2012 @ 5:24 am

  9. Fines are one thing. Mostly to the megabucks financial organizations, small potatoes. Part of the cost of doing business. Where there is a situational financial incentive for wrongdoing, the penalties should be stronger. Firstly, personal fines for those that break or encourage subordinates to break the rules, for obvious financial advantage, (not for technical violations). Secondly, prison time for company officers and subordinates, again where the financial gain motive is evident, especially if it undermines faith in the financial system.

    Funny how a small robbery can get you incarcerated, whereas theft of vast sums via financial fraud gets a slap on the wrist.

    Comment by Hypnotherapy & Hypnosis Los Angeles — June 29, 2012 @ 9:21 pm

  10. […] link: ‘Proving [actual Libor manipulation] will be a very data intensive exercise’ – Streetwise […]

    Pingback by FT Alphaville » ‘The Libor matter,’ at the SFO — July 6, 2012 @ 7:47 am

  11. […] Professor, The Truth About LIEBOR is Coming Out, here.  Didn’t UST yields and USDLibor invert for bit in 2008-9? I think the “actually […]

    Pingback by if you don’t actually nail it down, they’ll steal it « Pink Iguana — July 8, 2012 @ 8:05 am

  12. […] the same time, it’s worth returning to the point made by the Streetwise Prof when the Barclays settlement first appeared. When you’re going from attempted manipulation […]

    Pingback by FT Alphaville » The Libor lawsuits defence — July 17, 2012 @ 11:33 am

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