Regulators probing the alleged manipulation of global interestrates are focusing on what traders involved in setting thebenchmark say were routine discussions condoned by theirsuperiors.

Staff responsible for submissions to the London interbankoffered rate regularly discussed where to set the measure withtraders sitting near them, interdealer brokers and counterparts atrival banks, according to money-market traders with directknowledge of procedures at three firms. The talks became commonpractice after money markets froze in 2007, making it difficult forindividual bankers to gauge the cost of borrowing from otherlenders, said the traders, who asked not to be identified becausethey weren't authorized to speak about the subject.

“A few hundred people, mostly based in one city and sitting inclose proximity to each other, set an index rate for trillions ofdollars of securities with little or no oversight,” said MarkSunshine, chief executive officer and chairman of Veritas FinancialPartners, a Florida-based firm that provides loans to businessesand real estate companies. “That cannot continue. The mechanismitself, the oversight and the penalties if violated, are woefullyinadequate.”

The investigation by regulators in the U.K., U.S. Canada, Japanand the European Union, is the latest black eye for an industrysmarting from criticism that it caused a global financial crisis in2008. The probes have called into question whether firms can betrusted to set with no regulatory oversight a rate that is thebasis for about $360 trillion of securities from floating-ratemortgages to commercial loans.

“Given the number and the value of transactions in interest-ratederivatives, and the crucial role these products play in themanagement of risk, any confirmed manipulation of these interestrates would probably imply a very significant cost to the Europeaneconomy,” EU Competition Commissioner Joaquin Almunia said in aspeech last week.

Traders interviewed said there were no rules stopping talksbetween employees, or guidelines on how the rate should be set. TheBritish Bankers' Association, the London-based lobby group thatpublishes the rate, said it has never required banks to erectChinese walls between those setting the rate and traders makingbets on the future direction of the measure, leaving it up to thefirms themselves and their regulators.

Spokesmen at lenders that contribute to Libor — Credit SuisseAG, Societe Generale SA, Bank of America Corp., Royal Bank ofScotland Group Plc (RBS), JPMorgan Chase & Co. (JPM), CitigroupInc. (C), Lloyds Banking Group Plc, HSBC Holdings Plc and UBS AG(UBSN) — declined to comment on what internal controls they havefor their submissions.

Employees interviewed by Bloomberg said the interbank lendingmarket had been broken since before Lehman Brothers Holdings Inc.filed for bankruptcy in September 2008.

Reluctance to Lend

The difference between three-month dollar Libor and theovernight indexed swap rate, an indicator of banks' reluctance tolend to each other, peaked at a record 364 basis points on Oct. 10,2008. The spread averaged about 10 basis points in the five yearsup to the collapse of Lehman Brothers Holdings Inc. and hasaveraged 45 basis points since.

Traders say the lack of interbank activity made it impossible tocalculate accurately where borrowing costs should be fixed.Instead, rate-setters resorted to talking with other marketparticipants, checking previous submissions from competitors andscanning the news to come up with a best guess of what they mighthave to pay for short-term cash if a market existed, according tothe traders.

During the crisis, banks routinely misstated borrowing costs inthe BBA process to avoid the perception they faced difficultyraising funds, Tim Bond, then head of asset allocation at BarclaysCapital, said in a Bloomberg Television interview in May 2008. In areport the same year, the Bank for International Settlements, thecentral bank for central bankers, questioned the accuracy of Liborquotes, saying they could be influenced by “strategic behavior.”The BIS said firms would be “wary of revealing” information thatcould signal stress.

“Libor is not a market interest rate,” said Christoph Rieger,head of fixed-income strategy at Commerzbank AG in Frankfurt. “Thespot fixings are at best bank guesses of a hypothetical interbank”borrowing rate. “For that reason, this will always be subject tocontroversy.”

The benchmark is generated through a daily survey of firmsconducted on behalf of the BBA in which lenders are asked how muchit would cost them to borrow from one another for 15 different timeperiods, from overnight to one year, in currencies includingdollars, euro, yen and Swiss francs. After a predetermined numberof quotes are excluded, those left are averaged and published foreach currency by the BBA before noon.

While the BBA says typically only a bank's Treasurer or othernominated individual can make a submission, a trader at one firmsaid a large number of employees had access to the software used tomake a bank's submission and could overwrite others' figures. Onany given week, several different traders might input the rate andon at least one occasion a graduate trainee was deputized to do so,according to the trader who had direct knowledge of that firm'spractices.

Trader Dismissed

Tan Chi Min, a trader dismissed by RBS, said in a lawsuit filedin Singapore in December that he and at least seven of hiscolleagues at the Edinburgh-based lender were regularly consultedon the bank's yen Libor submissions by rate-setters and seniormanagers.

There was no “regulation, policy, guideline or law” in place,Tan said in the filing. A person familiar with RBS's rate settingprocedures corroborated Tan's account.

RBS responded in January, saying in court filings that it firedTan because he tried to improperly influence the bank's ratesetters from 2007 to 2011 to persuade them to offer Liborsubmissions that would benefit his trading positions. Tan wasn'treachable for comment.

Traders at two more firms said they also discussed where Liborwould be set with managers and rate-setters because that is how theindustry operated.

“As all contributor banks are regulated, they are responsible totheir regulators, rather than us, for maintaining appropriateChinese walls,” the BBA said in a statement.

The U.K.'s Financial Services Authority imposes no specificrestrictions on banks to prevent communications between traders andrate-setters over Libor beyond a broad requirement for them toidentify and prevent conflicts of interest, according to guidelinesposted on its website. A spokesman for the London-based watchdogdeclined to comment beyond the guidelines.

Investigators are now scrutinizing e-mails and instant messagesbetween traders and rate-setters for evidence that traders not onlydiscussed Libor, but collaborated to rig the rate to profit fromwagers on future interest rates.

Canada's Competition Bureau said in court filings that one bankhad confessed to participating in a conspiracy among employees atHSBC Holdings Plc (HSBA), Deutsche Bank AG, ICAP Plc (IAP),JPMorgan, RBS and Citigroup Inc. to rig the price of derivativesglobally by manipulating Libor.

UBS was the bank that alerted Canadian regulators to the allegedconspiracy in return for immunity from regulatory penalties for thefirm, three people with knowledge of the inquiry said lastmonth.

A UBS employee, identified only as Trader A in the Canadiancourt documents, began in 2007 to contact employees at other banksto discuss his market positions and a desire for a “certainmovement” in yen Libor, according to the filings. Some of thosecontacted said they would try and facilitate his requests byinfluencing their own banks submissions, according to thedocuments, filed at the Ontario Superior Court in May.

Traders involved say the existence of such correspondence showsthey weren't trying to hide their acts from superiors. They didn'tknow they were in breach of any rules, they said.

Individuals and firms found to have engaged in wrongdoing wouldlikely face demands from regulators to return any illicit profits,said Jordan Thomas, a former enforcement attorney at the U.S.Securities and Exchange Commission who now advises whistle-blowersat Labaton Sucharow LLP in New York. They may also be fined andwould be forced to improve their business practices to prevent asimilar situation arising again, he said.

“These cases have put the spotlight on the failings of Libor andwill hopefully spur demand on regulators to assess this,” saidRichard Werner, a professor at University of Southampton, England.“The danger is that the focus is too much on individual cases. Thisis a systemic problem.”

Bloomberg News

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