MAFC Strategic Risk Management Finance Professionals Seminar Finance Professionals Seminar 18th September 2013 The LIBOR Scandal It s not over yet!

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1 18 th September 2013 The Scandal It s not over yet! FP.1 Agenda The Scandal How did it Happen? What to do about it? FP.2 FP.1

2 London Interbank Borrowing Offering Rate is about setting Borrowing Rates WRONG! Well, only partly wrong did start out with the purpose of fixing inter bank borrowing rates But over time, became more about setting and resetting rates for Interest Rate Swaps (IRS)! That opened the door to manipulation which proved hard to detect FP.3 What is? FP.4 FP.2

3 History of The importance of the came about as a result of the expansion of the Eurodollar market, in London, in the 1960s and 1970s In 1984, as part of the Big Bang, the British Bankers Association (BBA) developed a a mechanism for fixing contract settlement rates, termed the London Interbank Offered Rate. is not one rate, it is 150. There are rates in 10 tenors/maturities in 15 currencies. Tenors range from 1 day, 1 week, 2 weeks, 1 month up to 12 months The 10 currencies are USD, EUR,GBP,JPY,CHF,CAD,AUD,NZD,DKK,SEK Of these the most heavily traded are USD, EUR, GBP, JPY, CHF Most trades based on are in the 1 day to 3 month tenor range FP.5 How is supposed to work? is operated by BBA Ltd (BBA = British Bankers Association) For each currency there is a panel of so-called contributor banks. For each currency in each panel bank, there is an official submitter who will, each working day, submit rates electronically to Thomson - Reuters (the designated calculation agent ) around 11am London time Thomson Reuters, then trims the rates it receives by removing the top 25% highest and lowest values ( topping and tailing ) and then averages the remainder to get the final rate for each tenor in each currency. This final rate is then published by Thomson Reuters ( designated distributor ) to screens around the world around midday London time Pretty simple? Pretty foolproof? Or so we thought! FP.6 FP.3

4 The Submission Process Midday Final Rates Final Rates Trim and Average ±11:10 am Submitted Rates Submitter A Contributor Bank A Submitter B Contributor Bank B. Submitter n Contributor Bank N FP.7 The Panel Banks Most Active Banks Systemically Important Banks G-14, Most Active Derivatives Brokers Contributor GSIB G14 USD EUR GBP JPY CHF CAD AUD NZD DKK SEK Bank Abbey National Yes Yes Bank of 2 Yes Yes America Bank of Nova Yes Scotia Bank of Tokyo- 2 Yes Yes Yes Yes Yes Mitsubishi UFJ Barclays Bank 3 Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes BNP Paribas 3 Yes Yes Yes CIBC Yes Citibank NA 4 Yes Yes Yes Yes Yes Commonwealth Yes Yes Credit Agricole 1 Yes Yes Yes Credit Suisse 2 Yes Yes Yes Yes Deutsche Bank 4 Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes HSBC 4 Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes JP Morgan 4 Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Chase Lloyds Banking Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Group Mizuho Bank 1 Yes Yes Yes Rabobank Yes Yes Yes Royal Bank of Yes Yes Yes Yes Canada Société 1 Yes Yes Yes Yes Yes Yes Yes Générale Sumitomo 1 Yes Yes Mitsui Banking Corporation Norinchukin Yes Yes Bank Royal Bank of 2 Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Scotland UBS 2 Yes Yes Yes Yes Yes Yes Panel Size Most Active Least Active Usual Suspects? FP.8 FP.4

5 Who determines rates? Each designated submitter is supposed to answer the question at what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11am? This is, of course, a hypothetical question at what rate could you borrow funds So provided that a submitter is honest, then the process should work well. But what if the submitter was dishonest? See later Note too that the question asks at what rate could you borrow funds This question harks back to the 1980s when was used in the short term money markets when banks were borrowing and lending to each other every day But the market had moved on with the growth of Interest Rate Swaps. FP.9 Interest Rate Swaps FP.10 FP.5

6 What is an Interest Rate Swap? An Interest Rate Swap (IRS) is a contract between two s who agree to swap interest payments on a hypothetical notional loan. So instead of exchanging principal amounts, the borrowers exchange interest payments at agreed rates. The most heavily traded type of IRS is called a Fixed-Floating swap where one party pays interest at an agreed Fixed rate and in return receives interest at an agreed Floating rate, on the agreed notional amount. Pay Fixed 5.3% A B Receive Floating 3 month +.7% Notional amount such as $100 million FP.11 A typical Term Sheet Corb (2012) Notional $100 million Swap Dealer Pays Fixed Semi Annually Client Pays Floating Quarterly Semi-Annual Payment approx. $803,500 Quarterly Payment Depends on! FP.12 FP.6

7 Typical Cash Flows Quarterly FLOATING Payments Examples Only Floating to Swap Dealer Nov- 10 Fe b- 11 May- 11 Aug- 11 Nov- 11 Fe b- 12 May- 12 Aug- 12 Nov- 12 Fe b- 13 May- 13 Aug- 13 Nov- 13 Fe b- 14 May- 14 Aug- 14 Nov- 14 Fe b- 15 May- 15 Aug- 15 $350,000 $150,000 ($50,000) ($250,000) ($450,000) ($650,000) Fixed to Client ($850,000) Semi-annual FIXED FP.13 Most IRS are organized by Banks Legal Contract Legal Contract Legal Contract A Fixed 1.607% Fixed 1.606% Fixed 1.605% Bank A Bank B B % +.01% +.02% Broker 1 Broker 2 Fee if Paid ~.01% *NP FP.14 FP.7

8 IRS Explosion From small beginnings in early 1980s, the market for IRS grew to about $50 Trillion of Notional value in In the next 13 years the market exploded 10-fold to $500 Trillion in 2011 Why are IRS so popular? Flexibility - extended maturities, multiple currencies Standardization (ISDA) Efficiencies, Cost Efficient Capital Usage especially if Netting One of the greatest Innovations in Modern Finance Source BIS 600 Notional Amounts ($Trillions) FP.15 Tail Wagging the Dog FP.16 FP.8

9 Swaps versus Swaps Portfolios Bank A Swaps Portfolio Bank B Swaps Portfolio Bank A Bank B Pay/ Receive Net Value Pay/ Receive Net Value FP.17 Change in Risk/Reward Because large Banks are in the middle of most swaps, they will have Swaps portfolios in the order of Trillions of notional value Banks will have both fixed and floating swaps in their portfolios. Profitability is determined by actively managing the floating portion of their portfolio against the fixed portion On any one determination day, a large bank will have multiple fixed and floating swaps being reset. So profit on the quarter after a determination day will be based on the NET fixed versus floating position NOT the ACTUAL value of! Swaps traders do not care about the actual rate, but they do care if it goes Up or Down (depending on the Net value of their portfolio on any one day) And they might want it to go up one day and down the next, depending on which particular swaps are being reset FP.18 FP.9

10 IRS Tail wagging Dog Over a decade or so, went from being a benchmark for Lending to being a benchmark for setting IRS rates! And no-one noticed! Interest Rate Swaps FP.19 Manipulating FP.20 FP.10

11 So could be manipulated? Many people believed that could NOT be manipulated because: There were too many contributor banks to allow collusion; With trimming and averaging it was not possible to engineer a specific rate; There was an independent committee of BBA that monitored transgressions. Submitters and the banks they worked for were honorable! Sort of Right but basically WRONG: Most banks were interested in only a subset of tenors, most illiquid; While difficult to engineer a specific rate, it was possible to engineer a nudge up/down; The industry was self-regulating, as banks effectively ran BBA ; Submitters and the banks they worked for were NOT honorable! Unscrupulous banks and traders found ways to nudge in directions that made their Swaps portfolio profitable! FP.21 was manipulated was manipulated in 2 different ways 1. By traders for profit; and 2. By senior managers to protect the market s perception of their firms. Paradoxically, even though the former (manipulation by traders) had been going on for many years, it was manipulation by senior managers, which was much less frequent, that came to light first. It was the Global Financial Crisis (GFC) that turned over the rock that exposed the wrongdoing. Interestingly, there were three investigations by regulators and economists that concluded that available data do not support the hypothesis that contributor banks manipulated their quotes to profit from positions based on fixings But the researchers were looking in the wrong place! FP.22 FP.11

12 Suspicions Raised It was noticed that, over the GFC, Barclays submissions were higher than other banks. Did that mean that Barclays were being charged more by other banks for borrowing? Was Barclays the next domino to fall? Then in October, Barclays came back into line! Suspicious? Barclays submitters were ordered to go low! No head above the parapet Economist Rotten Heart of Finance July 2012 FP.23 Aftermath of Barclays Manipulation In the aftermath of the GFC, various regulators and politicians began to look at the underlying reasons, including the role of Barclays CEO (Bob Diamond), Chairman (Marcus Agius) and various executives (incl. Jerry Del Missier) were hauled up in front of the Treasury Select Committee of the UK parliament and grilled. They confessed It s a fair cop, guv. We did it! But for the best of intentions Then the bonfire of the vanities! Diamond and Del Missier resigned, as did Agius but he relented and then resigned later But the cat was well and truly out of the bag! During inquiries into Barclays, a huge cache of recorded telephone calls and s was collected by regulators which uncovered wrongdoing all over the place! FP.24 FP.12

13 The incriminating phone calls In June 2012, the Commodity Futures Trading Commission (CFTC) published a report into manipulation of by Barclays, followed soon after by reports on UBS and on Royal Bank of Scotland. The reports were truly shocking, showing widespread, blatant, systematic and long-standing manipulation of for profit by Barclays, UBS and RBS traders What was most shocking was that manipulation was business as usual, no one questioned the ethics of such manipulation. Senior trading managers, traders, submitters and brokers were all involved and no one seemed to care. Where was Compliance and Risk Management? Missing in Action! FP.25 A Typical Conversation The following conversation, between a Barclays trader in New York and a Barclays submitter in London, is fairly typical Trader We have another big fixing tom[orrow] and with the market move I was hoping we could set the 1M and 3M Libors as high as possible Submitter NP (No Problem) This conversation is, of course, completely against rules as the Trader and Submitter both knew There are hundreds of such illicit conversations on open lines, s and Instant Messaging (IM) but no one was watching and, in fact, management were encouraging manipulation. This conversation took place between traders at two different banks in Tokyo Senior Yen Trader: "hello mate, real big favour to ask. could you try for low 6m fix today pis wid be most appreciated. thx mate" Yen Bank B Trader: "will try my best dude hows u??" Senior Yen Trader: "ok, trading like an idiot today, to be honest just want to take some risk off my book before i come back in dec, have had ok year but management still pushing me for more, have huge 6m fix so if you could help out today would really really really appreciate it! how are you?" FP.26 FP.13

14 Rampant Manipulation Final Rates Final Rates Submitted Rates Submitted Rates 1 4 Submitter A Do me a favour, Mate? Submitter B 3 Trader A Wash trade 6 Trader B Contributing Bank A Broker 1 5 Contributing Bank B FP.27 Illicit Communications We could discuss such communications for hours but not enough time In summary, there was illicit and corrupt communications between 1. Traders and Submitters can you do me a favour? 2. Traders and Brokers can you get another trader to go up/down? 3. Brokers and other banks what are you doing today, any chance of.? 4. Submitter and other Submitters what are you going to submit? 5. Trader and other traders you scratch my back (completely illegal)! 6. Traders and Brokers payment by use of wash trades, completely corrupt! These communications were collusion on a grand scale and clearly uncompetitive The Senior Yen Trader at RBS summed it up in a conversation with a Yen submitter The jpy libor is a cartel now [... ] its just amazing how libor fixing can make you that much money [... ] its a cartel now in london[.] they smack all the 1yr irs.. and fix it very high or low FP.28 FP.14

15 State of Play FP.29 Repercussions - So Far Barclays: Fined approx. $450 Million in USA and UK CEO, Chairman and Senior executives resigned CEO surprised he was forced out as they had confessed! Royal Bank of Scotland Fined approx $600 Million CEO, Chairman and Senior executives already gone after GFC UBS Fined approx $1.5 Billion CEO, Chairman and Senior executives already gone after GFC UK banking regulator Financial Services Authority (FSA) Broken up (not only because of ) New Financial Conduct Authority (FCA) to regulate banking behaviour New Prudential Regulatory Authority (PRA) new banking supervisor FP.30 FP.15

16 Legal Actions It has taken some time for legal actions to begin but they have now started. In July 2013, UBS Trader Tom Hayes (the Rain Man ) was the first to appear in court charged by the UK Serious Fraud Office (SFO) with working to manipulate with employees at JPMorgan Chase & Co., Royal Bank of Scotland, HSBC Holdings Plc, Rabobank, Deutsche Bank, And Brokers Tullett Prebon Plc, ICAP Plc and RP Martin More Shoes to Fall? Private Legal Actions In March 2013, Freddie Mac (the US Mortgage Agency) sued not only a dozen banks, but also the BBA, for undisclosed damages in respect of losses incurred as a result of alleged unlawful conduct in manipulating ; Various class action suits begun in the USA. FP.31 The Wheatley Report In September 2012, the UK government asked Martin Wheatley, the first head of the new UK Financial Conduct Authority (FCA), to recommend changes to the existing regime. In summary, Wheatley s recommendations are: be made a "regulated activity" under the Financial Services and Markets Act 2000 (FSMA), Its administration be taken away from the BBA and given to an independent administrator; and, manipulation of a benchmark, such as, be considered as a criminal offence But Wheatley does NOT address underlying causes: Conflicts of Interest - in and between firms (not just manipulation); Collusion - between market participants; Inappropriate Incentives, such as payment for volume not quality; Lack of Controls, total failure of Compliance and Risk Management; and Lack of Action, bank management turned a blind eye to wrongdoing FP.32 FP.16

17 Bank Manager Conflicts of Interest Trader Submitter Other Bank Chinese Wall (Supposed) Broker Other Client Internal External Other Clients FP.33 Regulators Wake Up In July, the International Organization of Securities Commissions (IOSCO) published its Principles for Financial Benchmarks which recommends (in summary): Each benchmark should have a designated Administrator, responsible for its integrity and with quality standards ; A benchmark should operate such that it is based on Bona Fide, observable transactions in active markets; The methodology should be transparent, including a Submitter's Code of Conduct; There must be accountability, with formal audits and a complaints procedure. Note it is likely that the BBA would have passed all of the above! Note IOSCO recommendations are optional! In the wake of the scandal and mutterings about other benchmarks, such as FX and commodities, the Financial Stability Board (FSB) has set up a high-level task force to discuss benchmarks. The task force includes a market participants group letting the fox in the chicken coop! Neither IOSCO or FSB address the broker issue! FP.34 FP.17

18 Monetary Authority of Singapore New Rules MAS has sanctioned 20 banks which were found to have deficiencies in the governance, risk management, internal controls, and surveillance systems for their involvement in benchmark submissions New proposals for more intrusive regulation of benchmark submitters MAS June 2013 FP.35 What to Do About it? FP.36 FP.18

19 Operational Risk Basel II defines Operational Risk as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk but not strategic or reputational risk Under Basel II, fines resulting from regulatory or civil actions are classified as Operational Risk events under Basel II, specifically in the categories of Clients, Products and Business Practices, Improper Business or Market Practices Market Manipulation ORX Classification EL0402 ( market manipulation ) is then a clear example of People-related risk Because manipulation occurred in many banks across the global financial system and the fact that the fines and disruption is so large, it is also an example of Systemic Risk The Manipulation of is an example of Systemic Operational Risk FP.37 People Risk Management is just the latest scandal in banking related to People Risk, such as, Rogue Traders, PPI (Payment Protection Insurance), GFC, and so on and so on Need a special focus on People Risk Management (PRM) in banks Operational Risk Frameworks, including 1. People Risk Governance: Assisting the Board and Executive in developing formal 'People Risk Policies'; a 'People Risk Appetite'; and a specific People Risk Framework (within the overall Risk Framework of the firm); Monitoring and reporting on compliance with People Risk policies. 2. People Risk Framework: Developing processes and systems for the formal Identification of People Risk within all departments of a bank; Establishing Key Risk Indicators for People Risks based on the firm's Risk Appetite; Developing education and induction programs for People Risk and ethical issues. 3. People Risk Partnerships: 1. Working with Systemic and Prudential regulators to develop and implement Systemic Key Risk Indicators for People Risks; 2. Establishing formal lines of communication with internal People related functions such as Human Resources, Compliance and Legal departments FP.38 FP.19

20 Questions Systemic operational risk: the manipulation scandal Journal of Operational Risk 8(3), Fall 2013 FP.39 FP.47 FP.20

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