The scandal around Barclays’ misconduct relating to the London Interbank Offered Rate (Libor) and the Euro Interbank Offered Rate (Euribor) is far reaching, but proving lost revenue due to any manipulation of the interbank rate could be challenging.
Libor is a benchmark set by the British Bankers Association (BBA) and covers a range of rates depending on the lending period. It is the average of all the interest rates charged by London’s big banks. Its three-month dollar rates are used to price the Eurodollar contracts offered by the Chicago Mercantile Exchange and interbank interest rate swaps are based on LIBOR. In total some US$350 trillion of derivatives are estimated to be based on the London rate.
The rate of Libor is used to settle options at the time of contract expiration, and therefore can determine if a contract is worthless or in the money, and whether or not a writer, in the case of a call option for example, will have to compensate the buyers.
According to UK regulator the Financial Services Authority (FSA), the notional amount outstanding of OTC interest rate derivatives contracts in the first half of 2011 was estimated at US$554 trillion dollars.
The total value of volume of short-term interest rate contracts traded on Liffe in London in 2011 was €477 trillion, including over €241 trillion euro relating to the three month Euribor futures contract, which is the fourth largest interest rate futures contract by volume in the world.
Until February 2011 the US dollar Libor panel consisted of 16 banks and the rate calculation for each maturity excluded the highest four and lowest four submissions.
An average of the remaining eight submissions was taken to produce the final published Libor. The Euribor panel consisted of at least 40 banks throughout the relevant period, and in each maturity the rate calculation excluded the highest 15% and lowest 15% of all the submissions collated. A rounded average of the remaining submissions was taken to produce the final published Euribor.
Any manipulation of Libor may have had serious consequences for derivatives traders and their returns. The FSA details Barclays’ misconduct as: making submissions which formed part of the Libor and Euribor setting process that took into account requests from Barclays’ interest rate derivatives traders, noting that the traders were motivated by profit and sought to benefit Barclays’ trading positions; trying to influence the Euribor submissions of other banks contributing to the rate setting process; and reducing its Libor submissions during the financial crisis as a result of senior management’s concerns over negative media comment.
It also said that Barclays failed to have adequate systems and controls in place relating to its Libor and Euribor submissions processes until June 2010 and failed to review its systems and controls at a number of appropriate points.
It will be difficult for regulators or any other party to prove whether or not Libor levels were correct compared to levels within the interbank market. For an entity such as the FSA to work out the potential losses to parties, it would need to reconstruct the Libor fixings for a significant period of time.
To do that for one day the regulator would have to: look at the transactions taking place for that particular day; listen to all of the telephone conversations involving traders; work out the Libor levels the individual banks put in to the BBA; work out the extent to which they had an effect on the average which drove the Libor fixing; then decide if that was a genuine rate that the bank put in or if it was put in at the request of someone else in the organisation.
Anyone with a futures or options contract that settled against Libor during the period of manipulation will find it difficult to prove they were disadvantaged. In the case of a group litigation action, for that data to be gathered they would need the interbank data from transaction reports, which the FSA may be able to provide.
One source suggested the regulator would have to put a team in to the banks involved for up to two years to listen to all of the telephone conversations and all of the data.
“If the data were available today the process would be fairly straightforward,” said a market participant. “There are hundreds of billions of dollars that settle off Libor and including OTC contracts it is in the trillions. So there are many people out there who may think they have a case.”
With Libor’s credibility struck down, authorities may have to find an alternative benchmark quickly. A number of banks including Barclays recently began offering an alternative to Libor, called the Repurchase Overnight Index Average (Ronia), an index of the weighted average interest rate on all secured sterling overnight delivery-by-value transactions brokered in London by firms in the Wholesale Market Brokers Association.
Sir Mervyn King, Governor of the Bank of England has called for Libor’s rate to be based upon the value of transactions in future, rather than estimates.