Libor and Bitcoin

One is a venerable industry benchmark that was first introduced by the world’s leading global banks several decades ago. The other is a virtual currency that only exists on the internet and that was first proposed by a software developer a mere six years ago.

What could these two financial mechanisms possibly share in common? Regrettably, they have both emerged as instruments of illegal manipulation on a mammoth scale. In addition, they have both raised existential questions about the limits of regulatory authority in a complex and evolving global economy.

Libor, of course, is the variable interest rate that is established by a daily opinion survey of a group of global banks in London. It has become the preferred benchmark for $350 trillion of variable rate loans, swaps, and other securities with valuations that depend on prevailing market rates.

Bitcoin, on the other hand, is the $7.7 billion virtual currency unit that has begun to be accepted as legal tender by a variety of global organizations. Many commentators have praised the Bitcoin as the internet era’s version of an ounce of gold, i.e. as a storage unit of monetary value that is not subject to revaluation by any individual government entity.

Both mechanisms, however, have been targets of manipulation and scandal during the past two years. Regulatory investigations and lawsuits are continuing to plague the global banks that contribute to the Libor rate, while similar controversies and investigations have just begun to stain the Bitcoin market.

Both sets of controversies have also raised existential questions about the limits of governmental oversight. Do banking regulatory officials possess the authority to regulate opinion surveys like the Libor mechanism? Or internet activities that produce virtual commodities, like the Bitcoin system?

Although the British banking authorities have concluded that the Libor survey process is subject to regulation, they are permitting the survey itself to remain in private hands. And the Japanese authorities, responding to the collapse of a major Bitcoin operator in Tokyo last week, are insisting that the Bitcoin is not legal tender and cannot be regulated as such.

In the meantime, though, private investors are pressing ahead with litigation to recover damages for losses suffered in the Libor and Bitcoin markets. Will we reach a point when such lawsuits will force government regulators to focus on these financial mechanisms?

If you were Jaime Caruana, the General Manager of the Bank of International Settlements, the international organization of federal central banks, would you recommend that the global system of financial regulation establish authoritative oversight mechanisms for Libor and Bitcoin?

Behavioral Finance and Government Regulation

Are you familiar with a field of study called behavioral finance? It focuses on psychological explanations for market behavior. Researchers who specialize in the field believe that personal (and often irrational) attitudes, beliefs, and emotions drive judgments and decisions, which in turn determine how individuals act when responding to events.

So if attitudes determine actions, then conversely, actions should reflect attitudes … shouldn’t they? In other words, if we observe consistent trends in the choices and actions of individuals, we should be able to intuit the underlying beliefs and emotions that have inspired them.

With this relationship in mind, let’s ponder the recent choices and actions of traders in global finance. Last summer, the manipulations of the Libor interest rate exploded across the news headlines; they continue to be the focus of numerous regulatory and criminal investigations.

And within the past two weeks, other long term trends have emerged as well. For instance, several firms are now under investigation for manipulating prices in the energy industry through the use of decades-old tactics that were originally pioneered by Enron Corporation.

Furthermore, the London Metal Exchange is now under fire for enabling Goldman Sachs to manipulate commodity metals prices by purchasing and storing massive amounts of industrial aluminum. The strategy is reminiscent of the schemes that were employed by the Hunt Brothers to “corner” the metals market for silver three decades ago, a plot that ended disastrously on Silver Thursday.

Some banking executives have vigorously defended their actions, asserting that they have broken no laws. Indeed, regulations from the Affordable Care Act to the Dodd Frank Act to the Transfer Pricing Laws of the Internal Revenue Service have long been criticized for their bloated lengths and incomprehensible language.

Nevertheless, the longstanding practices of Wall Street traders appear to reveal an underlying belief that any manipulative strategy is acceptable as long as it is legal. Under such circumstances, what method is available to protect the public interest, other than government laws and regulations?

Global Banking: The Head Winds Of Regulation

It’s easy to argue that the global financial system is biased in favor of the banking industry. After all, the largest international financial entities have actually grown larger since the 2008 / 09 economic crisis, while benefiting from the now-institutionalized presumption that our governments consider them “too big to fail.”

But there are times when an entire industry finds itself facing the head winds of governmental oversight. Recently, for instance, a wide variety of news stories in the United States and across the globe addressed new proposals for the banking industry. And none of them – not a single one – proposed a policy in favor of deregulation.

Last week, for domestic banks that operate within the United States, three American financial regulators proposed doubling (yes, doubling) the capital reserve requirements of the financial institutions. Although the proposed standards would greatly surpass the reserve levels that are currently required under the global Basel system, the regulators asserted that they would provide reasonable protections against future fiscal crises.

Then another American financial regulator proposed that mysterious “dark pools” of trading activities, now operated by private organizations, should be required to disclose their activities. Finally, a trio of United States Senators announced an effort to reincarnate the Depression-era Glass Steagall prohibitions that separated traditional banking lines of business from speculative trading activities.

Meanwhile, on the global stage, Great Britain’s banking system stripped its own British Bankers Association (BBA) of authority over the deeply flawed London based Libor rate setting mechanism and handed it to NYSE Euronext. And the Swiss authorities agreed to move one step closer to the elimination of tax haven benefits within its once secretive banking industry.

Even the single news story that appeared to contain a glimmer of good news for the banking industry was, in fact, a story that pleased proponents of government oversight. The American financial regulator that sought to extend domestic bans on derivatives trading activity to foreign banking subsidiaries agreed to delay this extension for six months. Although lobbyists favored the outright cancellation of these extension plans, they were forced to accept a six month delay instead.

On the one hand, these news stories will likely fail to satisfy the Wall Street critics who continue to complain that very few financial professionals went to prison or were otherwise punished in the wake of the global economic crisis. On the other hand, though, the global financial industry is clearly tacking against the prevailing winds of regulation.

Globalization Risk: From Barclays To Benetton

One is a “too big to fail” financial institution that was founded in London during the late 1600s, an era when the monarchs William and Mary ruled over England. The other is a contemporary fashion brand that was launched in Italy during the 1960s.

At first glance, Barclays Bank and the Benetton Group appear to have nothing in common. They occupy different industries, compete in different markets, and function within different organizational structures; how can their interests possibly overlap?

Looking back over the past year, though, it is obvious that they have each grappled with the same existential challenge. Namely, they have each struggled with globalization risk.

Barclays and Libor

How difficult has this struggle been for Barclays? Well, former Chief Executive Bob Diamond was actually pressured into resigning his position last year because of the Libor manipulation controversy. Barclays then agreed to pay $450 million in penalties to U.S. regulators for its conduct during the scandal.

So what enabled the American authorities to impose such punitive measures on the bank? Barclays was betrayed, in fact, by its very breadth as a global organization. Although the Libor conspiracy was perpetrated by British employees, regulators in the U.S. maintain oversight authority over transactions in America. One of those American transactions was affected by the illicit British activity, hence exposing the bank to America’s legal system.

The bank’s internal controls should have been designed to address such cross-border risks. Regrettably, though, Barclays’ internal auditors were not up to the challenge of addressing them; as a result, the bank suffered an enormous blow.

Benetton and Bangladesh

The internal auditors at the Benetton Group have also recently failed to manage global risk. Last month, the factory of a Bangladeshi supplier collapsed because of shoddy construction standards. More than 1,000 workers died as a result of the tragedy.

Western firms are expected to require that their suppliers maintain humane working conditions for their employees. In reality, though, Benetton and other customers of the Bangladeshi factory did not do so.

This mismatch between expectations and reality is attributable to shifts of manufacturing operations from Europe and America to the least costly regions on earth. Such strategies have accelerated as a result of globalization; thus, Bangladeshi garment workers now work in unsafe facilities for wages as low as $38 per month.

Shell Games, Fashion Style

But why is it so difficult for internal auditors at organizations like Benetton to identify suppliers with unacceptable working conditions? Why is it such a challenge for these companies to refuse to do business with such suppliers?

Some firms do manage to develop blacklists; Walmart, for instance, has banned 250 suppliers from its supply chain. Industry experts, though, often complain that when a region loses manufacturing contracts, “the brunt of the pain falls on workers left jobless by the disruption in trade.”

Furthermore, the managers of blacklisted entities can often play “shell games” by shutting down banned corporate entities and facilities, shifting staff to different locations, and then resuming operations at any time. Conversely, managers who make good faith efforts to improve operating conditions may never be permitted to resume operations.

Shell Games, Banking Style

Similar shell games, of course, have been plaguing the efforts of government regulators to compel global financial institutions to disclose the interest rates of their borrowings. Although transaction based reporting requirements have been recommended by many regulatory bodies, none have yet been implemented by the financial markets.

Why not? Well, consider a hypothetical scenario in which Barclays needs to borrow $100 million from HSBC at an interest rate of 5%, but wishes to disclose to the public that the interest rate is only 3%. How can Barclays do so without breaking a law that mandates the truthful disclosure of direct interbank loan rates?

Barclays can easily achieve this objective by directly borrowing $1 from HSBC at 3%, and then by utilizing a third party intermediary institution to borrow $99,999,999 indirectly from HSBC at 5%. The direct loan rate of 3% would be reported to the authorities, but the overall effective interest rate would be approximately 5%.

Vertical Integration

So with these “shell games” generating such globalization risk, how can organizations manage the risk of failure throughout their networks of subsidiaries and affiliates? Indeed, how can firms maintain appropriate internal controls throughout all of their business functions?

A vertical integration strategy might help them achieve such goals. Such a strategy, for instance, recently compelled Delta Airlines to purchase and operate its own oil refinery. It is now also compelling Chinese automobile companies to acquire or establish fledgling operations within the United States.

Ironically, a decade ago, Dell became the largest personal computer manufacturer in the world by eschewing vertically integrated systems and by creating an extended enterprise instead. Boeing and others implemented this strategy as well, outsourcing many of their manufacturing and administrative activities to external suppliers.

But by doing so, they inevitably exacerbated the type of global risk that is now bedeviling Barclays and Benetton. Although globalization can bring immense benefits to multinational firms, it can generate tremendous risks as well.

Libor Scandal: A Win For The Banks!

It has been a rough year for the global banking industry, hasn’t it? From the revelation that HSBC provided money laundering services to drug kingpins and terrorist organizations, to JP Morgan Chase’s multi-billion dollar losses over a series of trades by the infamous London Whale, the institutions have struggled to win back the trust and good will of the global public.

The biggest scandal of them all, of course, has been the Libor manipulation brouhaha that was first reported in the business press nine months ago. First, the U.S. Commodity Futures Trading Commission successfully fined Barclay’s $200 million for interest rate manipulation in a debt market that is estimated at $300 trillion.

Subsequently, American and British government regulators won settlements from the Union Bank of Switzerland and the Royal Bank of Scotland as well. And many additional investigations are now reportedly proceeding on their paths through the regulatory system.

Last week, however, the banks won a temporary reprieve of sorts, when a New York based Federal District Court judge tossed out a set of multi-billion dollar lawsuits from investors and other parties who claimed to have been damaged by the interest rate manipulations. Does this mean that the banks have been vindicated in the court of law, if not in the court of public opinion?

Legal Technicalities

The plaintiffs of last week’s lawsuits had based their cases on the provisions of antitrust law, a set of regulations that prohibit banks and other parties from colluding with each other when they should be competing for new business and profits. These plaintiffs asserted that the banks engaged in collusive activities, and thus they claimed to have incurred losses as a result of the illegal actions.

The judge, however, decided that the banks had simply taken advantage of a system that permitted them to manipulate the Libor interest rate through the independent submission of rate quotations. In other words, although the judge acknowledged that the banks’ activities may have constituted illegal misrepresentations of interest rates, she asserted that their independent actions failed to meet the legal definition of collusion under antitrust law.

So why did the plaintiffs frame their cases as antitrust actions instead of as fraud actions? After all, it may have been possible for them to win fraud causes more easily than antitrust cases. It is quite likely, though, that the plaintiffs were enticed to do so by the prospect of receiving punitive awards with treble damages. Such awards are available under antitrust statutes, but not under fraud and other statutes.

Many other cases are still progressing through the legal system; furthermore, last week’s settlement may be appealed in a higher court. Thus, last week’s win may prove to be a fleeting one; nevertheless, it is a victory for which the global banks are undoubtedly grateful.

Explicit vs. Implicit Collusion

It’s important to keep in mind, though, that the Federal District Court judge was referring to the absence of explicit collusion. Such collusion often requires competitors to directly communicate with each other for purposes of fixing retail sales prices.

The classic Hollywood film version of such activities, featuring smoke-filled back rooms and dark alleys, is rarely ever replicated in the real world. Nevertheless, explicitly collusive conduct may occur during interactions as brief as limited telephone conversations. One such infamous conversation occurred between the Chairman of American Airlines and the President of Braniff Airways in 1983.

As noted in a Bloomberg Businessweek article last year, flaws in the Libor methodology allowed global banks to “rig” interest rates without explicitly conspiring to do so. Nevertheless, the institutions did indeed collaborate in an implicitly collusive scheme, as described by Michael Kraten in the Businessweek article:

“You have 16 banks employing people who are eating at the same restaurants, drinking at the same pubs. They look at each other as competitors, but also as friends. It’s easy to believe that whether or not they’re explicitly talking to each other, they understand each other well and they’re implicitly colluding.”

Implicit collusion. According to the Federal District Court judge, it isn’t an illegal activity, regardless of the level of damage that it inflicts on the public.

Fraud vs. Antitrust

But what of the other cases that are progressing through the legal system? Will they be dismissed on the basis of such legal technicalities as well?

Probably not, for many of these cases rely on legal claims that are unrelated to antitrust law. The federal government, for instance, is pursuing a case through the quasi-public mortgage finance giant Freddie Mac. This particular case relies on multiple charges of fraud and breach of contract, in addition to charges of collusion. Thus, even if the third charge is dismissed by the courts, the first two charges may indeed proceed to trial.

Considering these events, are you feeling impatient that the global banks have not yet incurred some type of significant punishment for their transgressions? Although they appear to have dodged one such punitive measure last week, they will likely face many more such challenges for years to come.

The Wheatley Report: A Libor Solution?

Each day seems to bring a fresh batch of troubling news about the global banking industry, doesn’t it? Last Monday, for instance, New York Attorney General Eric Schneiderman filed a lawsuit against JPMorgan Chase for deceptive practices involving mortgage backed securities loans. And later that same day, American Express agreed to pay a $112.5 million penalty for a wide array of deceptive and unethical practices.

On the other hand, most commentators have reacted favorably to the Wheatley Report, issued ten days ago by Martin Wheatley, managing director of Britain’s Financial Service Authority. Wheatley was asked to review the Libor system after a wave of devastating rate-fixing revelations led to a mammoth $450 million fine against Barclays and the forced resignation of its CEO.

The Wheatley Report recommends several critical modifications of the Libor system, enhancements that will undoubtedly protect the public interest. However, it also contains a trio of noteworthy provisions that may raise questions about whether Wheatley’s recommendations would fully restore confidence in the global banking system.

Government Oversight

Why has public reaction to the Report been so favorable? Generally speaking, it proposes a significant level of new government oversight over what has been a largely self-regulated system. Interestingly, the British Bankers Association (BBA) itself has welcomed these new proposals in light of its failure to prevent past manipulations of the Libor rates.

According to Wheatley, the process of collecting Libor quotations from individual banks should be taken away from the BBA and managed by the British government. Regulators should then subcontract the activity to a private sector organization, but should directly oversee its operations, conduct periodic reviews, and apply civil penalties and criminal sanctions to punish any wrongdoing.

All participating banks would be required to adhere to a Code of Conduct. They would also be required to appoint “Approved Persons” to manage the quotation submission process, and to submit to periodic audits by independent chartered accountants.

It is indeed difficult to find fault with any of these recommendations. Nevertheless, a trio of additional provisions in the Report may deserve critical scrutiny.

The Three Month Delay

The first noteworthy provision involves an unexpected proposal to abandon a longstanding practice of transparency. Namely, the Report suggests the imposition of a three month delay from the date of each individual bank’s rate submission to the date that it is revealed to the public.

Wheatley explains that this delay would prevent any bank from analyzing the recent quotations of its fellow banks to estimate how its own possible quotations would affect the Libor rates. In other words, he plans to force each bank to focus solely on its own internal data when developing its quotations, by denying it timely access to the contemporaneous quotations of its rivals.

Such a delay, regrettably, would deny the general public timely access to the quotation data as well. Journalists, academic researchers, and other guardians of the public interest would thus be unable to monitor the Libor system in “real time.”

Expansion and Compulsion

Another noteworthy provision involves the expansion of the roster of participant banks that submit rate quotations. Each participant, in the current small group, exerts a significant level of influence over the system itself. If participants are added to the Libor system, the influence of each bank would decrease in scope.

Thus, Wheatley recommends that British regulators be granted the authority to make participation compulsory for additional banks. In other words, he believes that the British government should be empowered to require banks to provide rate quotations to the Libor system, whether or not they wish to do so. But this proposal begs an important question: is this an appropriate application of government power?

An existential question can be posed, as well, about the fundamental nature of the Libor if it is transformed from a representative rate of the world’s largest banking institutions to one that incorporates a far larger number (and thus, inevitably, a broader array) of organizations. The current group is composed exclusively of banks that are considered relatively low risk institutions; would newly added banks, with smaller corporate footprints, change the very nature of the Libor group?

Transaction Data

The final noteworthy provision involves the definition of actual transaction data. Wheatley emphatically recommends that actual trade data provide support for all individual bank quotations.

But according to Box 4.B of page 28 of the Report, the Libor submission guidelines state that “in the absence of transaction data relating to a specific LIBOR benchmark, expert judgement should be used to determine a submission.” The guidelines also legitimize “techniques for interpolation or extrapolation from available data.”

What do these clauses mean? In short, according to Wheatley, the Libor participant banks will still remain able to rely on private judgement and estimation methodologies to determine their “actual” quotations. Such practices, of course, were what enabled Barclays (and, apparently, other banks as well) to manipulate the Libor rate in the first place.

Libor: Are There Any Winners?

You didn’t really think that supporters of the global banking industry would simply surrender to public condemnation regarding the Libor manipulation scandal … did you?

Two weeks ago, we described why the scandal posed a threat to the public interest. And last week, we discussed the difficulties that plaintiffs may face when filing lawsuits to recover their losses.

This week, we end our first-ever trilogy of blog columns by exploring a recent counter-argument that is gaining traction among supporters of the global banks. Namely, some industry veterans are asserting that the scandal did little to harm borrowers …

… and may have actually helped them!

Interest Payments

The essence of their argument appears to focus on the direction in which the bankers at Barclay’s appear to have manipulated the Libor interest rate. Namely, they appear to have understated their rate quotes, as other banks purportedly did as well during the depths of the financial crisis in order to maintain the impression that they were strong and stable institutions.

The Washington Post recently quoted several industry experts who asserted that, by understating interest rates, the banks actually assisted borrowers by minimizing their interest payments. And Bloomberg quoted a representative of British mortgage lenders who claimed that “it’s very unlikely that Libor-fixing will have had any material impact at all on consumers … if anything, a downward impact on Libor (was) advantageous overall to the wider influence on rates …”

From a narrow perspective, this argument is indeed true. Borrowers with fixed rate loans, for instance, would not be affected at all by Libor rate manipulations. And borrowers with variable Libor-based loans would indeed enjoy reduced payments when the rate is manipulated downwards.

But from a broader perspective, would these conclusions remain valid?

Interest Rate Swaps

Let’s consider an example of a debt arrangement that is far more complex than a single variable rate residential home mortgage. Let’s ponder the plight of a municipal government entity, for instance, that agrees to a primary fixed rate debt instrument with a secondary variable interest rate swap.

Huh? How would such a transaction work?

Well, the borrower would pay a fixed interest rate on its primary debt outstanding, and then would purchase an exotic secondary derivative that would provide varying levels of reimbursement in proportion to fluctuations in market interest rates. The two opposing cash flows, when netted together, would be designed to generate net interest payments that would reflect changes in the variable Libor rate.

Unfortunately, though, this strategy backfired for many government borrowers (as well as for investors in debt instruments) when Libor rates declined, purportedly as a result of understatement manipulations. Such declines minimized the variable cash inflows received on the derivative transactions, but did not affect the cash outflows paid on the primary fixed rate obligations. That is why the City of Baltimore, the New Britain Firefighters’ and Police Benefit Fund, the California Public Employees Retirement System, and others are now contemplating legal actions.

Macro-Economics

There is also a macro-economic perspective that should be considered when assessing whether any borrowers have benefitted from the Libor scandal. To consider this perspective, let’s assume that the global banks were indeed fixing variable rates at inappropriately low levels.

Because other lenders “peg” their variable rate loans to Libor as well, they would have also received lower interest payments from borrowers. In other words, the revenue streams of relatively small competitors would have been damaged as severely as those of the global banks by such manipulations.

But which institutions may have benefited from revenue declines that affected global banks and smaller competitors simultaneously? The global banks, by nature of their sheer market size, their implicit (or explicit) access to bailout programs like TARP, and their thicker capital cushions, undoubtedly would have been better positioned to survive such circumstances.

In other words, like any dominant industry player that launches a price war with the intention of driving smaller competitors out of business, the global banks may have enjoyed a macro-economic advantage by forcing market interest rates lower. In the long run, the elimination of competition cannot be beneficial for consumers.

The Public Trust

There is one final perspective, perhaps the broadest one of all, to consider when assessing whether any borrowers actually benefitted from the Libor manipulations. Namely, can any member of society ever benefit, in the long term, from scandals that fundamentally damage the public trust in our global financial system?

If public cynicism about the system permanently depresses demand for variable rate loans in the United States, for instance, can any one truly benefit? Likewise, if citizens in Greece and other struggling European nations rebel in disgust against the austerity measures that are needed to repay the government debts held by global banks, can the system ever heal?

In the broadest sense, it is difficult to argue that any deceitful manipulation scheme can create “winners” among borrowers. In the long run, if there is no public trust in the global financial system, we are all inevitably “losers.”

Libor Manipulation: Calculating Damages

Last week, in our blog posting entitled Libor and the Public Interest, we discussed what National Public Radio has called the biggest scandal in the world. Of course, NPR was referring to the Libor manipulation scandal, a scheme that dwarfs the other controversies that are now roiling the financial services industry.

And we don’t use the word “dwarfs” lightly. After all, within the past week, we learned that traders at JP Morgan Chase may have hidden losses from CEO Jamie Dimon that are now expected to exceed $7 billion. We also discovered that HSBC laundered several billion dollars for Mexican drug cartels. And we were told that the bankrupt Peregrine Financial Group misappropriated over $200 million in client investments.

Nevertheless, what of the news that over a dozen global banks have been manipulating the Libor rate that continues to be used around the world to establish interest charges on variable loans? It affects every citizen who holds a variable mortgage, credit card, line of credit, or small business loan. It also affects billions of dollars of corporate debt instruments, issued by global corporations, that utilize the Libor rate to calculate interest charges.

Extent of the Profits

By how much did the banks profit during this scandal? Well, a single bank with a $10 billion debt position (or portfolio) that successfully moves the daily interest rate 0.1% in a favorable direction could earn an incremental $10 million that day. If ten of the sixteen banks that define Libor earn similar profits on that day, the colluding group could earn a collective $100 million.

And what if the same group repeats the tactic one hundred times in a year? The annual collective profit of the group would equal $10 billion. And the counter parties on the “flip sides” of those transactions, i.e. individuals and organizations that are unfavorably influenced by such moves in the daily interest rate, would thus lose $10 billion per year.

As a point of comparison, the entire Centers for Disease Control and Prevention of the United States — the government entity that protects the American public against maladies from HIV / AIDS to influenza epidemics — received $10.6 billion in total funding last year (i.e. in fiscal 2011). It’s no wonder that Time Magazine has suggested that the Libor scandal may be considered the crime of the century because of its immense scale.

Proving Damages

With profits that are so significant, and with commensurate losses incurred by others, one would think that it should be easy for aggrieved parties to sue the banks and collect damages. Surprisingly, though, plaintiffs would be advised to proceed cautiously before filing lawsuits.

After all, the Libor mechanism serves to summarize the interest rates that each global bank estimates it would pay if it borrows funds from other banks in the City of London. Yes, Libor focuses on estimates that each bank would pay as opposed to the precise rate that each actually pays, and the hypothetical interest percentage if each bank chooses to borrow, as opposed to the real amount when each bank actually borrows.

In other words, each bank’s daily Libor quotation represents an educated guess, as opposed to an actual report. In order for a plaintiff to estimate damages, though, he would need to calculate the interest rate that each bank would have quoted if it had no incentive to manipulate the rate. But if the Libor quotations only represent rough estimates and educated guesses, how can any plaintiff establish what an unbiased “actual” rate would have been for a particular bank on a certain day?

The Trouble With Proxies

There are always “proxies” available for any statistic, including (perhaps) credit default swaps for unbiased Libor rate quotations. According to a Connecticut government report, “a CDS is a privately negotiated derivative through which a “buyer” pays an agreed-upon amount to a “seller” and, in return, receives a payment if a certain event occurs … the buyer does not need to own the underlying security and does not have to suffer a loss from the event in order to receive payment …”

When independent investors believe that a global bank is more likely to default on its borrowings, they bid up the market price of the CDS that is designed to pay off in the event of a bank default. And because such a bank might expect to pay a higher risk-adjusted interest rate on its borrowings, some commentators believe that plaintiff attorneys can use fluctuations in CDS values as proxies for appropriate Libor estimates.

What is worrisome about this belief? Simply put, the CDS market itself is prone to manipulation by wealthy investors. A single large investor can drive up the value of a single CDS, at least temporarily, by making a large strategically timed purchase. So by using CDS values as proxies for Libor values, a plaintiff’s attorney would simply be substituting one manipulable statistic for another.

Clearly, it will not be easy for plaintiff attorneys to calculate damages. And without such calculations, it will be difficult for courts to require banks to pay awards.

Libor and the Public Interest

Are you ready for yet another global banking scandal? Last week, the Chief Executive Officer of the British banking giant Barclays resigned in disgrace over the news that his organization had participated in a mammoth illegal scheme to fraudulently manipulate the Libor interest rate.

Libor? It’s the London Interbank Offered Rate, an interest rate that dominates the world’s variable debt markets. If you have a variable interest loan, there’s a good chance that your rate (and thus your payments) fluctuate on a daily, weekly, or monthly basis in accordance with the fluctuations of the Libor rate.

Any bank that possesses the power to manipulate the rate can make a fortune through a variety of methods. It could sell low interest loans to other banks shortly before a rate increase, for instance, or it could buy high interest loans from other banks shortly before a rate decrease.

Based on the preliminary findings of the unfolding investigation, many other global banks may be guilty of rate manipulation as well. And sadly, industry regulators have apparently been able to access evidence of the manipulations for several years, but either failed to notice the warning signs or failed to respond to them.

Hiding In Plain Sight

According to City A.M., a London newspaper and web site that covers financial and business news, four researchers (including Michael Kraten, one of the co-authors of this blog) raised questions about the possibility of manipulation in a study that was first presented in scientific circles four years ago.

Their manuscript was peer reviewed on two occasions, first prior to a presentation at a conference meeting of the Public Interest Section of the American Accounting Association in 2010, and then prior to its publication in the Journal of Banking and Finance in January of this year.

The study was also briefly mentioned in the Economist in April of this year, but did not receive widespread attention from business news organizations like CNBC and the Financial Times until this past week. City A.M. thus described the alleged perpetrators of the manipulation as “hiding in plain sight.”

Relying On The BBA

So how did the banks manipulate Libor? The institutions arranged for their trade association, the British Bankers’ Association (BBA), to collect their rate quotations each day. The BBA then ignored the highest and lowest quotations, computed simple averages of the remaining quotations, and announced the statistics as the Libor rates.

The banks claimed that their quotations reflected estimates of their own true borrowing costs. But no government regulator ever asked the banks to produce evidence that their quotations were actually based on real transactions. And their own trade association never challenged them to do so either.

Nevertheless, the BBA did make the banks’ original quotations available for public inspection, and thus the four researchers were able to build upon a previous Wall Street Journal analysis to identify statistical anomalies.

What anomalies? The quotations did not appear to move in synchronization with other measurements of bank borrowing costs that were available for analysis. And perhaps more disturbingly, normal patterns of random fluctuation were not evident in the trends of the quotations during certain noteworthy periods of time.

Some Critical Suggestions

Some critics have suggested that the Libor rate calculation process should be taken away from the BBA and given to an independent, objective entity. Others have suggested that the BBA (or another entity) should aggregate actual transaction information and not rely on “estimates” supplied by banks.

These are certainly reasonable suggestions. But if the banks were willing to submit fraudulent rate quotations to their own trade association, why would they not be willing to do so to some other entity as well?

And as JP Morgan Chase demonstrated with its own defense of a recent speculative transaction that was designed to meet the legal definition of a defensive hedge, the global banks are undoubtedly capable of engineering complex transactions that can produce “actual” data in accordance with any regulation.

The Public Interest

There is one suggestion, however, that could be implemented easily in order to protect the public interest. The Libor rate information could be subjected to audits by independent certified public accountants.

In the United States, such audits would fall under the jurisdiction of the Public Company Accounting Oversight Board (i.e. the PCAOB). The Board’s standards for attest engagements covers “historical … financial information (and) … analyses” in its AT Section 101, Paragraph .07.

Can the public trust the CPAs to audit the bankers? As well as the government regulators to oversee the CPAs? Although an audit requirement may not be sufficient to eliminate any possibility of a future scandal, it may be difficult to feel confident about any self-reported bank data until the statistics undergo professional audit activities.

In other words, even though an audit requirement for Libor may not represent the “last word” in developing a system of reporting that supports the public interest, it may nevertheless represent a perfectly reasonable place to start.

End Note:

On Friday, 13 July, Brian Mairs of the BBA provided the following comment to our publisher: British Bankers’ Association here. Regarding your story on LIBOR on 8 July, we need to make an important factual correction: the BBA does not set LIBOR. The LIBOR benchmarks are calculated daily from submissions made to Thomson Reuters: it publishes the benchmarks daily, along with all of the submissions from individual banks which are used to calculate it.

Although we never stated that the BBA “sets” Libor, we agree with the remainder of Brian’s comment. The Libor benchmarks are indeed derived from submissions that originate from the banks and not from the BBA itself. And Thomson Reuters does indeed provide a data compilation service.

We are allowing our column (above) to remain in its original form, and we ask our readers to decide for themselves whether Brian’s comment is a “factual correction” (as Brian refers to it) or an elaboration (as is our belief). Nevertheless, we do concur with his description of the process, and we stand by our suggestion.