Flaws in the way Libor is set allowed individual banks tomanipulate the key global interest rate for profit for years,according to traders.

While employees allegedly tried to rig the benchmark for $500trillion of securities worldwide, they didn't need to conspire withcounterparts at other firms to affect where the rate was set eachday, as some regulators concluded, said the people, one of whomlost his job for trying to distort the rate. By nudging their ownfirms' submissions up or down in small increments they could boostthe value of their trading books or cut their losses, said thepeople, who asked not to be identified because regulators are stillinvestigating the Libor-setting process.

The ability of a single bank to rig the London interbank offeredrate also is highlighted by e-mails disclosed when Barclays Plcpaid a 290 million-pound ($452 million) fine to U.S. and U.K.regulators for manipulating the benchmark, and by academic studies.The settlement forced the resignations of the top three executivesat Britain's second-biggest bank by assets, including ChiefExecutive Officer Robert Diamond, 60.

“It is far easier to manipulate Libor than it may appear,”Andrew Verstein, a lecturer at Yale Law School, said in a paper tobe published in the Winter 2013 issue of the Yale Journal onRegulation. “No conspiracy is required.”

Regulators in the U.S. and Europe are probing more than a dozenbanks worldwide over alleged rate-fixing, with British prosecutorsopening a criminal investigation on July 6. Barclays paid a recordfine to settle the claims, and others are poised to follow.Deutsche Bank AG, Germany's largest lender, may pay as much as$1.57 billion in penalties and legal costs and Edinburgh-basedRoyal Bank of Scotland Group Plc $1.48 billion, according toestimates published last week by Morgan Stanley analysts BetsyGraseck and Huw van Steenis.

Barclays fell 3.4 percent to 156.70 pence, the lowest in almosteight months, as of 10.40 a.m. in London trading today. The stockis down 11 percent so far this year.

Regulators may be especially interested in cases where tradersat several banks conspired to rig Libor, since this could subjectthe firms and traders to criminal antitrust charges and higherpenalties. That banks could and did manipulate Libor on their ownmay also prompt regulators to target individual firms beyondBarclays for unilaterally distorting the rate.

Chinese Walls

Libor is determined by a daily poll carried out on behalf of theBritish Bankers' Association that asks banks to estimate how muchit would cost to borrow from each other for different periods andin different currencies. The rate, an indicator of the cost ofmoney, is used to set prices for securities from mortgages to carloans. Similarly, Euribor, the euro-equivalent, is overseen by theEuropean Banking Federation in Brussels.

The so-called Chinese walls between traders and employees makinginterest-rate submissions on behalf of their banks were regularlybreached, leaving the rate vulnerable to manipulation, BloombergNews reported in February.

Of the daily submissions by 16 banks for U.S. dollar Libor, thetop and bottom four, known as the first and last quartiles, wereexcluded and an average of the remaining eight entries calculated.For Euribor, 43 banks sit on the panel and the top and bottom 15percent are excluded. Three-month dollar Libor was unchanged at0.455 percent on July 13.

By making a submission too high to be included in the average, asingle lender can push a previously excluded rate back into thepack to send the average higher. By submitting a rate that fallstoo low to be included, the average can be nudged down as apreviously excluded rate re-enters the pack.

One former trader interviewed by Bloomberg News, who asked notto be identified as he's being investigated by regulators, said heand his colleagues tried to influence his bank's rate-setters overa period of years because it was easy and even small movementshelped their profit and loss accounts.

Barclays's derivatives traders tried to profit by gettingcolleagues to alter their firm's Libor submissions on “numerous”occasions between January 2005 and June 2008, Britain's FinancialServices Authority said in its settlement with the bank last month.Out of the 173 e-mails asking rate-setters at Barclays to altertheir U.S. dollar Libor entries, only 11 came from outside thefirm, according to the FSA.

On Feb. 7, 2006, a U.S. dollar derivatives trader asked for“high” one- and three-month submissions, the FSA said, citinginternal e-mails. The employee also expressed his preference thatBarclays would be “kicked out” of the average calculation, the FSAsaid.

Final Average

“Trader C's aim was therefore that Barclays's submissions wouldbe high enough to be excluded from the final average calculation,which could have affected the final benchmark,” the FSA said.

On March 10, 2006, another trader sought a “very low”three-month fixing, saying “preferably we get kicked out.”

“We have about 80 yards fixing for the desk and each 0.1 lowerin the fix is a huge help for us,” he said, indicating the bank hadan $80 billion position, according to the FSA.

Most of the time, the firm's rate-setters complied with therequests, adjusting Barclays's submissions of its borrowing ratesone or two basis points up or down, according to the FSA. A basispoint is 0.01 percentage point. Between January 2006 and August2007, the bank's Libor quotes reflected traders' requests more thantwo-thirds of the time, the FSA said. In the case of Euribor, itwas 86 percent of the time.

“We're talking about huge sums of money, so a small nudge of thebenchmark is worth quite a bit potentially on the individualtrader's profit and loss account,” said Roger Francis, aLondon-based analyst at Mizuho International Plc.

In an interview, Yale's Verstein gave the example of eighthypothetical banks polled to create a Libor-like rate, where thetwo highest and lowest submissions are excluded. If the bankssubmit one-month rates ranging from 0.18 percent to 0.27 percent,they produce a setting of 0.2325 percent. By cutting thethird-highest submission 3 basis points, a bank can manipulate theoutcome to drive Libor down by 0.5 basis point, Verstein's analysisshows.

Adding 5 basis points to the lowest submitted rate can changethe range of included and excluded entries by enough to push Liborup by 0.75 basis point in this example.

That indicates the BBA, a lobbying group that oversees the rate,and the Bank for International Settlements were wrong when theysaid eliminating outliers would protect Libor from abuse.

Rate Vulnerability

“The decision to trim the bottom and top quartiles in thecalculation was taken to exclude outliers from the finalcalculation,” according to the BBA Libor website. “By doing this,it is out of the control of any individual panel contributor toinfluence the calculation.”

Jacob Gyntelberg and Philip Wooldridge, BIS economists,concluded in a March 2008 report that rates like Libor could onlybe rigged “if contributor banks collude or if a sufficient numberchange their behavior.”

“It is false to say, as many do, that it would have requiredcoordination,” Yale's Verstein wrote in his journal article. “Atleast 75 percent of the panel banks may unilaterally affect theaverage by moving the quote in their preferred direction.”

According to some estimates, the figure may be even higher.Between Jan. 2, 2007, and Aug. 8, 2007, 95 percent of submissionshad an impact on where the rate was set, according to “LiborManipulation?” a 2008 paper by academics including RosaAbrantes-Metz, an economist with consulting firm Global EconomicsGroup and an associate professor at New York University's SternSchool of Business.

If the Barclays e-mails are any indication, the right submissioncould at least earn an employee a cup of coffee from gratefultraders.

“If it's not too late, low 1m and 3m would be nice,” a Barclaystrader wrote to a Libor submitter in an April 7, 2006, e-mailreleased by the FSA. “Coffees will be coming your way either way,just to say thank you for your help in the past few weeks.”

On an $80 billion portfolio of swaps, a 1-basis-point move onone-month, U.S. dollar Libor could benefit a trader by about$667,000, according to data compiled by Bloomberg.

Consider a swaps trader at a bank that helps set U.S. dollarLibor, as Barclays did. The e-mails released by regulators focusedon the London-based bank's swaps desk.

Traders' Duties

The trader's principal duty is to help clients offsetinterest-rate risks or take bets on the direction of rates viaswaps or futures. A company taking out a loan, for example, maywish to protect itself from an increase in rates by buying aso-called plain-vanilla swap, whereby it exchanges its variableinterest payments for fixed ones.

After entering a swap with a client, the trader either can finda counterparty, hedge his position to mitigate potential lossesusing derivatives, or look to profit by leaving all or part of thetrade on his book un-hedged.

Over hundreds of trades, a desk will build a position that risesor falls depending on where Libor is set in different currenciesand maturities each day. A trading book with more contracts payingvariable payments than fixed payments would benefit if Libor islower, for example. The interests of different desks within thebank won't always be aligned.

“Barclays derivatives traders knew on any particular day whattheir book's exposure to a 1-basis-point movement in Libor orEuribor was,” the FSA said in the settlement.

To be sure, profits may be more pronounced if traders at otherbanks are willing to conspire. In February 2007, a Barclays traderwrote to a trader at another bank:

“If you know how to keep a secret I'll bring you in on it, we'regoing to push the cash downwards,” and “if you breathe a word ofthis I'm not telling you anything else.”

Barclays's settlement document says that from January 2005 toMay 2009, other firms' traders made requests to the British bankregarding U.S. dollar Libor 11 times and Euribor 20 times.

“You have 16 banks employing people who are eating at the samerestaurants, drinking at the same pubs,” said Michael Kraten, anaccounting professor at Providence College in Rhode Island and aco-author of the “Libor Manipulation?” paper. “They look at eachother as competitors, but also as friends. It's easy to believethat whether or not they're explicitly talking to each other, theyunderstand each other well and they're implicitly colluding.”

Verstein Analysis

Here's how one bank could manipulate Libor, based on Verstein'sanalysis:

Assume a panel of eight banks — A, B, C, D, E, F, G and H — seta benchmark like Libor. On day 1, their costs of borrowing U.S.dollars for a month are 0.18, 0.20, 0.22, 0.23, 0.23, 0.25, 0.26and 0.27, respectively. Excluding the top and bottom quartiles, thebenchmark on day 1 is (0.22+0.23+0.23+0.25/4) = 0.2325 percent.

On day two, the rate-setter at bank C follows a trader's requestto submit an artificially low rate of 0.19. That is then excluded,while the other banks submit the same numbers as the day before,meaning the 0.20 figure from bank B is pushed in. The benchmarkfigure on day 2 is (0.20+0.23+0.23+0.25/4) = 0.2275 percent — areduction of 0.5 basis point.

On day three, the rate-setter at bank A is asked to increase hisrate and submits 0.23, getting back into the four averagesubmissions and pushing bank B out again. If all other banks filethe same rate as the day before, the average of the four middlesubmissions would increase: (0.23+0.23+0.23+0.25/4) = 0.2350percent — a movement of 0.75 basis point.

If bank A inputs a rate of 0.27 the average would be pushed upmore, even though bank A would now get excluded from the averagefor being too high. In that instance, the benchmark would be(0.23+0.23+0.25+0.26/4) = 0.2425 percent — a jump of 1.5 basispoints from the previous day.

Bloomberg News

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