Systemic operational risk: the LIBOR manipulation scandal

Transcription

1 Journal of Operational Risk 8(3), Systemic operational risk: the LIBOR manipulation scandal Patrick McConnell Macquarie University Applied Finance Centre, Level 3, 10 Spring Street, Sydney, NSW 2000, Australia; (Received March 13, 2013; revised April 8, 2013; accepted April 10, 2013) The manipulation of the London Interbank Offered Rate (LIBOR) was not a localized event. Unscrupulous traders and managers in some of the largest banks around the world deliberately and systematically manipulated borrowing rates. It was not the work of isolated rogue traders but part of business-as-usual in the international money markets. This paper describes the LIBOR scandal and argues that it is an example of systemic operational risk, in particular people risk. The paper first describes the LIBOR setting process. The explosive growth over the past twenty-five years in the use of interest rate swaps (IRSs) and the process of resetting rates on IRSs, which ultimately led to the unethical manipulation of the underlying LIBOR rates, is then described. The paper then looks at official inquiries into manipulation of LIBOR at three banks, Barclays, UBS and Royal Bank of Scotland, to identify examples of operational risk. The transcripts of conversations unearthed by these investigations show rampant illicit activities that were apparently a normal part of doing business, as traders, LIBOR submitters and brokers colluded to manipulate LIBOR for their own interests. Finally, the paper makes some suggestions as to how the management of systemic operational risks may be addressed by banks and regulators. 1 INTRODUCTION The manipulation of the process of fixing the London Interbank Offered Rate (LIBOR) is truly scandalous, involving blatantly unethical, and sometimes illegal, activities by a small number of people in trusted financial institutions. Unfortunately, this scandal is just the latest in a series of unsavory practices that have surfaced following the global financial crisis (GFC). It should be noted that the LIBOR scandal did not cause, nor was it caused by, the GFC but it was brought to light by the events of the GFC, in particular, attempts by a leading bank, Barclays, to maintain the market s perception of its creditworthiness (CFTC Barclays 2012). Once that rock had been lifted up, investigations by regulators, in particular the Commodity Futures Trading Commission (CFTC) and the Financial 59

2 60 P. McConnell Services Authority (FSA), found that manipulation was not limited to just managers and traders in Barclays, but had occurred many times over many years in other banks. The process of fixing LIBOR rates is systemic. It is a truly global process, involving dozens of individuals in international banks estimating, each day, what they believe interest rates will be over a variety of periods in several currencies. It is a relatively simple process that relies on nominated experts (the submitters ) making what is essentially a well-informed estimate on what borrowing rates will be in the market today. Estimates provided by these experts are averaged (according to a none too complicated formula) and then average official rates published to the financial markets. The resulting LIBOR rates are then used by banks around the world (not only those providing the estimates) as a benchmark for setting rates for lending to corporations, investment firms, insurance companies and other banks. LIBOR has become an indispensable component of the global financial system, embedded in millions of financial contracts. In its current form, the daily process of fixing LIBOR has been in place since 1986, and despite the scandal described in this paper it is still working, essentially unchanged, although additional accountability and legal sanctions have been introduced as a result of the Wheatley (2012b) inquiry. As we describe in Section 2, the LIBOR process was originally developed, as the name suggests, to settle contracts in the interbank lending market. However, the market has changed, as a result of the innovation and spectacular success of interest rate swaps (IRSs), such that pure lending became replaced over time by firms swapping interest rate payments on notional loans. The IRS market is, as described in Section 3, less transparent than the lending market, and, especially in some currencies, there are fewer transactions that can be observed against which rates can be fixed. This lack of transparency in the IRS market in turn made it easier to manipulate the LIBOR rates against which many contracts were reset. Slowly and imperceptibly the nature of the interbank lending market changed, as IRSs grew in popularity, but the mechanism for setting rates did not keep pace. In many respects, the LIBOR fixing process had become obsolete, but continued nonetheless because it was so widely used and hence would cause too much disruption to change. There is a lesson here for the operational risk community: to always question basic assumptions and processes as to their continued relevance. The LIBOR fixing process is subjective and qualitative, relying on submitters in selected contributor banks providing an unbiased opinion on what they estimate today s rates should be, based on their intimate knowledge of the market. It relies on trust that the experts will not be swayed by personal conflicts of interest and will not be pressurized by management to manipulate their estimates of rates. But, as this paper describes, this trust broke down, resulting in manipulation of rates to the benefit of individuals and firms and to the detriment of borrowers around the world. Journal of Operational Risk 8(3), Fall 2013

3 Systemic operational risk 61 The systemic nature of the LIBOR scandal is illustrated by the summary of the findings against UBS that stated: This profit-driven conduct spanned from at least January 2005 through June 2010 and, at times, occurred on an almost daily basis. It involved more than three dozen traders and submitters located in multiple offices, from London to Zurich to Tokyo, and elsewhere. The misconduct included several UBS managers, who made requests to benefit their trading positions, facilitated the requests of their staff for submissions that benefited their trading positions, or knew that this was a routine practice of the traders and did nothing to stop it. UBS traders inappropriately viewed their benchmark interest rate submissions, such as UBS s LIBOR submissions, as mere tools to help the traders increase the profits or minimize losses on their trading positions. To be sure, UBS s benchmark interest rate submissions frequently were not a reflection of UBS s assessment of the costs of borrowing funds in the relevant interbank markets, as each of the benchmark definitions required. [Emphasis added.] CFTC UBS (2012) As two other inquiries 1 into the manipulation of LIBOR show, one could easily substitute the name Barclays (CFTC Barclays 2012) or Royal Bank of Scotland (CFTC RBS 2013) for UBS in the quote above and it would still be appropriate. Manipulation of LIBOR rates was systematic and widespread. Section 2 of this paper first describes LIBOR and its use in the global financial markets. Section 3 then describes the interest rate markets for which LIBOR has become the predominant benchmark. It was the growth of markets in products such as IRSs that created the environment that made manipulation of LIBOR very profitable. Section 4 describes the findings of various regulatory investigations that laid bare the illicit market manipulation. Section 5 then describes examples of people-related risks that were apparent in the LIBOR scandal. Finally, Section 6 argues that the manipulation of LIBOR is an example of systemic operational risk, in particular people risk, and makes recommendations as to how banks and regulators may improve management of people risk at both the firm and systemic levels. 2 LIBOR 2.1 The history of LIBOR The importance of the London Interbank Offered Rate came about as a result of the expansion of the Eurodollar market, in London, in the 1950s and 1960s (Kawaller 1 At the time of writing, similar inquiries are in progress as regards other large international banks (Vaughan and Finch 2012). Forum Paper

4 62 P. McConnell 1994; Schenk 1998). Eurodollars are term deposits denominated in US dollars (USD) but held by banks outside of the United States and, importantly, not regulated by the US Federal Reserve (Corb 2012). Because offshore Eurodollars deposits did not have regulatory reserve and deposit insurance requirements, they were a cheaper source of funds for international banks. By the 1970s, banks were actively on-lending these deposits to governments and corporations that wished to borrow in Eurodollars, including corporations in the United States. Schenk (1998) argues that the growth of the Eurodollar market was not only a result of cheaper available funds but also innovation by banks: The Eurodollar should not be viewed exclusively as a defensive innovation but also as an aggressive one as banks took advantage of opportunities for profit through domestic currency swaps and third party lending, and also sought to meet the needs of new customers. During the 1970s, the market grew considerably as governments and corporations also began to issue securities in Eurodollars at rates lower than they could borrow locally (Schenk 1998). Though attractive, borrowing or issuing securities in Eurodollars was not without risk as there was often a mismatch between the borrowers sources of income and their funding. This, in turn, gave rise to one of the most innovative financial products of the late twentieth century, the IRS, which allowed borrowers to eliminate such risks while still retaining many of the benefits of borrowing in Eurodollars (Corb 2012). The spectacular growth of the IRS market in the last twenty-five years is central to understanding the LIBOR scandal and is described in the next section, but it is sufficient to note at this point that by the mid 1980s the market had reached a critical mass and some standardization was needed for the market to continue to grow. In 1984 (in line with the opening and deregulation of the UK financial markets, the so-called Big Bang ), the British Bankers Association (BBA) took the lead in developing a set of standard terms and conditions for IRS contracts. One of the standard terms developed by the BBA was a mechanism for fixing contract settlement rates, termed LIBOR the London Interbank Offered Rate. 2.2 What is LIBOR? LIBOR (technically BBA LIBOR) is not a single rate but a set of rates that cover representative borrowing rates in ten different currencies (see Table 1 on page 66) and over fifteen different borrowing periods, also called tenors 2 or maturities (Wheatley 2012a). For each LIBOR currency, there is a panel of contributor banks, which 2 In 2012, the tenors were one day, one week, two weeks, one month, two months and each month up to twelve months. Journal of Operational Risk 8(3), Fall 2013

5 Systemic operational risk 63 provides the expertise of submitters to estimate borrowing rates for each maturity/tenor for each currency. The 150 rates (for fifteen tenors in ten currencies) are published through the BBA and used as benchmarks or reference rates for corporate and retail borrowing for the currencies and borrowing periods covered. For example, USD 3M LIBOR C0.5% represents a borrowing rate of 0.5% over the current threemonth LIBOR rate for US dollars. LIBOR has become the most heavily referenced benchmark in global finance, being used as the basis of over US$300 trillion of derivatives contracts, especially the IRSs described later (Wheatley 2012a). LIBOR is widely used but is not unique. For example, since the introduction of the single European currency in 1999, a similar mechanism, called EURIBOR, has been operated by the European Banking Federation and there are other benchmarks, such as TIBOR (for Tokyo). However, for this paper, the emphasis will be on LIBOR, because of its dominant position in the international money markets. Before discussing how manipulation of LIBOR became, if not commonplace, an acceptable business practice throughout the global financial system, the LIBOR process is summarized. 2.3 The process of fixing LIBOR The process of fixing, or setting, the 150 LIBOR rates is deceptively simple and transparent (BBA LIBOR 2013). Each morning on which business is to be conducted, nominated specialist submitters in each contributor bank within a particular panel answer the same 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? (BBA LIBOR 2013). The contributing banks estimates are then submitted electronically to the designated calculation agent, Thomson Reuters (BBA LIBOR 2013). The estimates of the contributing banks for each currency and tenor are aggregated and first of all trimmed, removing the top and bottom (also called topping and tailing ) 25% of estimates (the outliers ), and then averaged to produce the final LIBOR rate for each tenor within each currency. Thomson Reuters, as the designated distributor, then publishes these final rates as the official LIBOR rates for the day, making them available to thousands of banks around the world just after midday London time (Wheatley 2012a). These official LIBOR rates are then used by banks as benchmarks not only for lending to customers and each other but also for settlement of contracts, such as maturing interest rate contracts on derivatives exchanges, and, importantly in this context, for setting rates for IRSs (Corb 2012). This LIBOR process has, because it is used so widely, become an integral and critical component of the international financial system. Forum Paper

6 64 P. McConnell The process of contributing rates is monitored and overseen by the Foreign Exchange and Money Market Committee (FX&MMC) of BBA LIBOR Ltd, a subsidiary of the BBA (Wheatley 2012a). Subcommittees of FX&MMC are responsible for identifying and resolving any issues with the LIBOR submission process and taking disciplinary actions when necessary. It is interesting to note at this point that the individual submissions by contributing banks are made available to the public on the same day (Wheatley 2012a). Paradoxically, this level of transparency, normally laudable, was integral to some of the manipulation described in this paper. So why did such a well-established and seemingly transparent process become the subject of widespread manipulation that went undetected for so long? To answer that question, we must look first at the weaknesses in the process and second at the people involved in the process, especially those who were able and willing to take advantage of those weaknesses. 2.4 The LIBOR process: strengths and weaknesses As might be expected, the BBA promoted the strengths of the LIBOR process, and with some justification, pointing out that LIBOR: is long established; reflects the largest range of international rates; has a wide commercial use; has wide international dissemination; and has a transparent calculation mechanism (BBA LIBOR 2013). These are not inconsiderable strengths, especially where many markets, such as for over-the-counter (OTC) derivatives, lack transparency. For good reason, LIBOR became part of the very fabric of international financial markets, a (seemingly) stable cornerstone of day-to-day business. But, because the process was so embedded in normal business, and rarely questioned, the inherent weaknesses were more difficult to identify. With admitted hindsight, some critical deficiencies can be perceived. The first weakness relates to the question asked of individual submitters at contributing banks, 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 a hypothetical question, in effect asking contributors for their expert opinion as to what they believe interbank borrowing rates will be. It is not an unreasonable question to ask an expert, provided that one believes that the answers given would be objective and unbiased. The question is, however, open to abuse were an unethical person to answer it. The second weakness is related to the first one in that, in many cases, it is difficult to corroborate the answers given in LIBOR submissions. As the official Wheatley review into LIBOR pointed out: Journal of Operational Risk 8(3), Fall 2013

7 Systemic operational risk 65 It is difficult to corroborate individual submissions as the market that LIBOR is intended to provide an assessment of is illiquid and the types of transactions are becoming increasingly less relevant for bank funding. This is particularly the case for less well-used currencies and maturities. [Emphasis added.] Wheatley (2012a) In other words, the original assumption that the rates quoted by contributors reflected rates actually transacted in the market was overtaken by the reality that the main use of LIBOR had become setting rates for the burgeoning nontransparent OTC derivatives markets. By its very success, LIBOR may have outlived its usefulness and was overdue a reassessment. But success is infectious; who questions a winner? 3 Despite its detachment from the realities of the market, there is no reason why experts, who after all have an interest in ensuring the integrity of their markets, should not continue to give their objective, unbiased opinions as to borrowing rates in the daily LIBOR question. There were, however, multiple conflicts of interest, not addressed in the LIBOR process over several years, which together helped to create the conditions for the emerging scandal. 2.5 Conflicts of interest in the LIBOR process There are three main areas of conflicts of interest apparent in the LIBOR process. Structural: related to the organization of the process itself. Bank level: related to the contributing banks. Individual: related to the individuals responsible for submitting rates LIBOR panels Before discussing these conflicts of interest, it is worth considering the composition of the LIBOR panels and the contributor banks. As noted above, there is one panel for each LIBOR currency and the number of contributor banks on each panel reflects the currency s relative importance in terms of market activity. There are three (essentially qualitative) criteria used to assesses the suitability to become a member of a particular panel: the scale of market activity of the bank; the bank s reputation; and the bank s perceived expertise in the particular currency (Wheatley 2012a). Table 1 on the next page shows the contributing banks in each LIBOR panel by currency as at January 1, In the table, where a bank is considered a globally systemically important bank (GSIB) by the Financial Stability Board (FSB), the bucket 3 But as various rogue trader incidents show (Jobst 2007), winners should be questioned as to where their winnings are coming from. Forum Paper

8 66 P. McConnell TABLE 1 LIBOR panels: January 2013 (BBA LIBOR 2013). Contributor bank GSIB G14 USD EUR GBP JPY CHF CAD AUD NZD DKK SEK Abbey National Yes Yes Bank of America 2 Yes Yes Bank of Nova Scotia Yes Bank of Tokyo-Mitsubishi UFJ 2 Yes Yes Yes Yes Yes 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 Chase 4 Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Lloyds Banking Group Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Mizuho Bank 1 Yes Yes Yes Rabobank Yes Yes Yes Royal Bank of Canada Yes Yes Yes Yes Société Générale 1 Yes Yes Yes Yes Yes Yes Yes Sumitomo Mitsui Banking Corporation 1 Yes Yes Norinchukin Bank Yes Yes Royal Bank of Scotland 2 Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes UBS 2 Yes Yes Yes Yes Yes Yes Panel Size Journal of Operational Risk 8(3), Fall 2013

9 Systemic operational risk 67 number, which is a measure of the systemic significance of a bank from 1 (lowest) to 5 (highest), is shown (FSB 2009; BCBS 2011b). As can be seen, most of the contributor banks are GSIBs and those that are not are almost certainly likely to be designated as local-sibs (LSIBs) by their local prudential regulators. In other words, LIBOR contributors are very large, systemically important banks, many of which are considered too big to fail Structural conflicts of interest Table 1 on the facing page shows that a number of banks are contributors in all, or almost all, panels (Barclays, Deutsche Bank, HSBC, JP Morgan, Lloyds and RBS). This dominance of UK banks may reflect the fact that LIBOR was originally a UK initiative and, as banks headquartered in London, these banks would have a vested interest in promoting the City as a financial hub. Table 1 also shows the importance, as measured by number of contributors in a panel, of the four major currencies (USD, EUR, GBP and JPY), which coincides with the distribution of outstanding derivatives as at the end of 2012 (BIS 2012). Table 1 on the facing page also shows the banks that are part of the Group of Fourteen (G14), 4 are the most active derivative traders in the world, together accounting for some 70% by value of basic (or vanilla ) IRSs and over 80% of all outstanding interest rate derivatives (Sidanius and Wetherilt 2012). In other words, the banks that are most involved in fixing LIBOR rates are also those most involved in trading the derivatives for which LIBOR is most often used. While this does not cause a conflict of interest per se, in such a situation there would be a tendency not to rock the boat. As noted above, oversight of the LIBOR process is conducted by the FX&MM Committee of BBA LIBOR Ltd. While the board of LIBOR Ltd is independent of the panel banks, the committee is selected from the LIBOR panel banks and users group (LPBUG), which is chaired by members of contributing banks and has members from those banks and interested parties, such as derivatives exchanges (Wheatley 2012a). In other words, despite the fact that an independent secretariat in BBA LIBOR can raise issues, oversight and sanctions are controlled by the contributing banks. In short, the contributing banks were overseeing themselves. Nor were prudential regulators overseeing LIBOR as well as they maybe should have been. As documented in its internal inquiry, the FSA believed both that LIBOR was adequately regulated by the BBA and that LIBOR was not a defined regulated activity and therefore fell outside the FSA s normal terms of reference. In addition, the FSA was obsessed by the market dislocation of the GFC rather than what appeared at the time to be a relatively minor matter of market pricing (FSA Audit 2013). 4 Note that the members of the G14 that are not LIBOR contributors are the US-based banks Goldman Sachs, Morgan Stanley and Wells Fargo. Forum Paper

10 68 P. McConnell The clear conflict of interest and lack of transparency in the oversight (or nonoversight) of the LIBOR process was recognized by the regulatory report into LIBOR (Wheatley 2012b), which recommended transferring responsibility for the LIBOR process from the BBA to a new administrator that would have specific obligations for creating new oversight arrangements. Notwithstanding the fact that, in the wake of the LIBOR scandal, new arrangements have been recommended, it raises the question of why such structural conflicts of interest were not recognized and addressed earlier Banks conflicts of interest As described above, the banks that contributed most to the LIBOR process were also the banks that traded most heavily in derivatives linked to LIBOR. This at least raises the possibility that, in the absence of corroborating transactions (Wheatley 2012a), the submission of rates could be influenced by trading activity. In fact, as Section 4.5 illustrates, this is exactly what did happen. International banks are faced with many potential conflicts of interest, such as insider trading. They generally handle such conflicts through internal policies, such as so-called Chinese walls, often involving the organizational and physical separation of employees who may be put in conflict situations. The subjective nature of the LIBOR process, which required submitters to be experts in, and close to, the markets for which they were submitting rates, inevitably meant that submitters would come into contact with traders. However, as testimony to the UK Parliamentary Committee that investigated Barclays involvement in the LIBOR scandal found, the Chinese walls were paper-thin (Treasury Committee 2012, p. EV.18). In practice, modern communication mechanisms, such as s, instant messaging and open telephone conversations, eliminated the Chinese walls, as submitters were constantly bombarded with information about their bank s positions in the market and it would be difficult to remove that knowledge from their analysis. In a number of situations, detailed later, the conflicts of interest were even more apparent, as some submitters also held active roles as traders (so-called tradersubmitters ), and sometimes when submitters were on vacation traders were drafted in to cover for them (see, for example, CFTC RBS 2013). The banks concerned were well aware that conflicts of interest were possible but appeared to take no action to reduce these particular conflict situations. The LIBOR scandal illustrates that banks are placed in situations where there are natural conflicts of interest and are required, usually through their compliance functions, to proactively address such issues. It is apparent that some banks did not fulfill this quite basic fiduciary duty (CFTC RBS 2013). Journal of Operational Risk 8(3), Fall 2013

11 2.5.4 Individuals conflicts of interest Systemic operational risk 69 The subjective nature of the LIBOR submission process and the difficulty of corroborating any particular submission raises the obvious question is it possible for an individual to benefit from a knowledge of future submissions?. If, for example, a trader were able to influence the direction of the final LIBOR rate for a particular currency and maturity, then they could set rates to the advantage of their existing market positions or take new advantageous positions. This would, of course, require collusion between submitters and traders to effect such a change. This is precisely what happened in a number of situations, as described later. The LIBOR calculation process of trimming outliers and then averaging mid-range submissions meant that without wholesale collusion it would be extremely difficult to engineer a precise rate but not overly difficult to nudge a rate in a desired direction. For example, submission of a high rate, even if excluded, would drag the average up and likewise submission of a low rate would drag it down, by an amount dictated by other submissions. Such actions, of course, would be, at least, unethical and risk internal sanctions, so the obvious question raised is whether the reward would be worth the risk. Changes to LIBOR rates are typically in the range of fractions of a basis point, often 0:001%, and clearly insignificant for small positions (BBA LIBOR 2013). However, as the next section illustrates, the markets supported by LIBOR, in particular IRSs, have expanded enormously in the past twenty-five years (BIS 2012) and the reality is that large banks, such as those listed in Table 1 on page 66, will be holding IRS positions in the hundreds of billions of dollars of notional value at any point in time. Therefore, even a small change in LIBOR for such enormous positions could produce substantial profits. This conflict of interest for the individual trader was recognized too late, as it was assumed that the LIBOR calculation process, by its very transparency, made such actions unlikely. Unfortunately, that assumption proved to be naive. Before discussing the details of how the LIBOR scandal unfolded, it is worth describing the explosive growth in international interest rate markets that made manipulation feasible and, because of the sheer size of the market, also very profitable. 3 THE GROWTH OF INTEREST RATE SWAPS 3.1 What is an IRS? Since the first interest rate swap was agreed between IBM and the World Bank in 1981 (Jorion 1997; Corb 2012), the market for similar contracts has exploded, as illustrated by the annual outstanding volume figures published by the Bank for International Settlements, which show growth from some US$65 trillion of notional value to over US$300 trillion by 2011 (BIS 2012). Forum Paper

12 70 P. McConnell In the early 1980s, each swap was bespoke, specially tailored, usually by an investment bank, to meet the specific borrowing needs of two corporations or government bodies. However, after a time, it became increasingly difficult to find two parties with requirements that exactly corresponded and, as a result, it became practice for so-called swap dealers, usually commercial and investment banks, to act as intermediaries taking short-term positions to facilitate market expansion (Whittaker 1987). Originally, the economic rationale for such swaps was the reality that different borrowers had different comparative advantages in different markets. For example, a highly regarded US company could borrow more cheaply at home in the United States than in the United Kingdom. However, a US corporation often needed to borrow overseas to expand business, as would an overseas borrower to fund expansion in the United States. If such borrowers could be put in touch and each bank could borrow at the most attractive local rate and then somehow swap the payment obligations, then each borrower would be able to borrow at a lower overall rate. In other words, swaps could take advantage of the arbitrage in different credit markets (Whittaker 1987; Corb 2012). And the investment banks that arranged the deals between the borrowers would also benefit from the fees earned. This appears to be a true win win win situation. A contract such as the original IBM/World Bank swap is called a currency swap, as it involves borrowing in two currencies (Corb 2012). But there are other arbitrage opportunities, in particular where a borrower (such as a mortgage bank) prefers to borrow at a fixed rate but has income that is tied to a floating rate. To cater for such borrowers, the fixed floating IRS was developed (Whittaker 1987). In a fixed floating IRS contract, one party agrees to pay interest on a notional amount at a fixed rate at an agreed frequency (usually quarterly or semiannually), while the other party agrees to pay interest at a floating rate (often tied to LIBOR) at the same or a different frequency (Corb 2012). As noted above, fairly soon after the first bilateral contracts were created, it became standard practice for swap dealers to act as intermediaries to contracts (Crouhy et al 2006). Over time, the often complex IRS contracts became standardized through the industry body, the International Swaps and Derivatives Association (ISDA), and innovation in the industry created flexibility in the terms of contracts. As a result, IRSs became one of the main tools for asset-liability management (ALM) in corporate treasuries across the world (Corb 2012). Reasons for the popularity of IRSs include the following (Crouhy et al 2006; Corb 2012). Flexibility: contracts can be tailored to the specific requirements of a client, thereby allowing them to better hedge their exposures. Journal of Operational Risk 8(3), Fall 2013

13 Systemic operational risk 71 Extended maturity: unlike other interest rate instruments, such as Forward Rate Agreements (FRAs), IRSs can specify maturities that can extend over several years, locking in long-term rates. Transactional efficiency: unlike other instruments, such as FRAs, a number of borrowing periods can be covered by a single transaction. Costs: as contracts became standardized and the number of swaps dealers expanded, the costs of IRS contracts fell for clients. In addition, IRS costs tend to be lower than other contracts, such as options. Larger markets: for borrowers, the use of currency swaps increases the number of markets where credit is available. Minimal outlay: unlike traditional borrowing, where the notional amount is exchanged at inception and maturity, only the much smaller interest payments are exchanged. This, of course, increases leverage for speculators in this market (Whittaker 1987). Netting: outlays can be reduced even further if parties, especially swaps dealers, agree to exchange only the differences in (or net ) interest payments rather than the full payments. This, of course, further increases possible leverage. Capital usage: tied in with leverage and netting, the regulatory capital needed to cover an interest rate swap under Basel II regulations is much less than an equivalent loan (Basel Committee on Banking Supervision (BCBS) 2004). But IRS contracts are not without risks, in particular: credit risk, such as the default of one of the parties to an IRS contract; market risk changes to market rates, which may make an IRS contract unprofitable for one of the parties; and operational risks, which are described in more detail later. Although IRSs are the most heavily traded interest rates contracts, there are a number of other related interest rate derivatives, such as swaptions and FRAs, and interest rate options, such as caps, floors and collars. These derivatives, in combination with IRSs, provide highly tailored, but also potentially very risky, interest rate hedging strategies for corporations and banks (Corb 2012). The uses, valuation of and risks in IRSs and related derivatives are well documented (see, for example, Dubofsky 1992; Fabozzi 1993; Mangiero 1994; Jorion 1997; Saunders and Allen 2002; Crouhy et al 2006; Corb 2012). It is beyond the scope of this paper to discuss the immense increase in leverage within the IRS market before the GFC and whether the IRS market was in any way the cause of the crisis, but it is worth noting that regulators were worried as far back as 1987 about the systemic risks due to the potential for excessive risk-taking and under-pricing of this highly leveraged instrument (Whittaker 1987). Forum Paper

14 72 P. McConnell 3.2 The key role of brokers in the IRS market The majority of IRS trades are agreed, usually by telephone, between traders, in the so-called interbank market (Corb 2012). However, brokers still play a major role in providing electronic venues where dealers may exchange pretrade information and increase the efficiency of [their] search (Avellaneda and Cont 2010). Corb (2012) notes that brokers provide valuable liquidity in the market by loosely connecting dealers by helping to match offsetting dealer positions (on an anonymous basis). Brokerage volume statistics are not generally provided but Avellaneda and Cont (2010) estimate that one of the leading brokers, ICAP, was an intermediary in 30% of IRS trades (by volume) in IRS brokers, like brokers in all markets, make money by charging a fee/commission for each introduction that results in a trade, so volume is an important indicator of their profitability. Broker fees in the swaps market are not disclosed but are typically in the range of one basis point (or 0.01%) of notional value (Coyle 2001). Osborn (2013) notes a fierce battle among brokers to maintain their share of the market in the face of increasing regulation, and the increasing use of electronic swaps markets. Such a business model, relying on volume for profitability, raises the possibility that a broker may act unethically to get a trade done for a valuable customer, and this is exactly what occurred, as Section 4 describes. 3.3 IRSs: resetting floating rates The key to understanding why LIBOR manipulation became so profitable is to be aware of the process for resetting floating rates, on fixed floating swaps, especially those based on LIBOR. Typical IRS contracts will specify the frequency (often, but not always quarterly) on which floating and fixed interest will be paid. On a designated payment date, the party in the floating leg will pay an amount of interest based on the floating rate in effect for the prior period and will be notified of the rate in effect for the next period. Likewise, for the fixed leg, a fixed amount will be paid on the same date or a different date depending on the specifics of the IRS contract. In a typical contract, the floating rate in effect for a particular period is determined, or reset a number of business days before the start of the period. 5 On the determination date, the rate that will apply for the forthcoming period and the interest due at payment will be communicated to the party that is paying the floating rate of interest. Since the profitability of a fixed floating IRS contract for any period depends 5 Note that ISDA rules clearly specify the precise timing should a payment or determination day fall on a nonworking day. Journal of Operational Risk 8(3), Fall 2013

15 Systemic operational risk 73 on the value of the floating rate, obviously any ability to influence the direction of rates on or just before the determination date 6 could be advantageous. Although manipulation would yield little for a single IRS contract over a single payment period, there is the potential for substantial profits (or losses) whenever many contracts have the same, or close, determination dates. In cases where there are a large number of IRSs, with a total notional value in the hundreds of billions, even a small change to a floating rate (fractions of a basis point) could have a substantial impact on profitability. So, unlike, for example, manipulation of a stock price, it is the net position on a particular day, or over a number of days, that will determine the direction and impact of any manipulation. In contrast to equity trading, for example, it could benefit a trader to nudge a particular rate up one day and down the next, depending on whether they were paying floating or fixed interest on their positions on a particular day. Furthermore, because LIBOR covers multiple periods, a trader could, in an arbitrage strategy, be trying to move a rate one way on one tenor (say USD 3M), yet a different way on another (eg, USD 6M). Without a detailed understanding of the underlying positions, it is very difficult to detect manipulation of LIBOR rates. In light of events described below, it should be noted that if a contract agreed to pay interest on March 15, June 15, September 15 or December 15, it would be called an International Money Market (IMM) swap, or one that coincides with so-called IMM dates, when Eurodollar derivatives contracts expire on futures exchanges (Crouhy et al 2006). For hedging purposes, many IRS contracts are deliberately created to reset on those IMM dates. The potential for increasing profits, or alternatively reducing losses, by manipulating LIBOR around IMM dates would make manipulation attractive to unscrupulous traders. 3.4 Interest rate swaps: operational risk Basel II provides a general definition of operational risk, specifically 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 (BCBS 2004). The risks described in this paper are predominately people-related, but other risks have become apparent over the emergence of the IRS market. One of the first instances of large-scale operational risk in the emerging IRS market was the 1991 case of Hazell v. Hammersmith and Fulham Borough Council, in which the UK House of Lords held that the (somewhat speculative) swap contracts entered into by the council were in fact ultra vires, or beyond the legal capacity of the council, and hence the contracts were null and void (Sharma and Shukla 2008). Following this 6 It should be noted that such manipulation would have no effect on days when there was no reset activity. Forum Paper

16 74 P. McConnell famous case, the ISDA 7 was formed, acting as a trade organization that develops standards for legal documentation for over-the-counter (OTC) swaps and derivatives. The next major crisis in the developing IRS market was people-related, in particular the mis-selling scandals that hit Bankers Trust (BT) in the early 1990s (Crouhy et al 2006). BT, a leading investment bank at the time, had entered into a number of fixed floating swap contracts with two large corporations, Proctor & Gamble and Gibson Greeting, which lowered the cost of funding for these companies. But the lower cost was achieved though the use of leverage, which would markedly increase the corporations costs if US interest rates were to rise. Following the bond market crisis of 1994, rates rose by over 250 basis points, incurring immense loses for the two corporations (Crouhy et al 2006). Both companies successfully sued BT for misrepresenting the risks and potential losses of these new products. As the Gibson settlement noted, over time, the derivatives BT Securities sold to Gibson became increasingly complex, risky and intertwined... Gibson, however, did not have the expertise or computer models needed to value the derivatives it purchased from BT Securities. In short, interest rate swaps had become so complex that only experts understood them, and it should be noted that IRSs and related derivatives have become immeasurably more complex since As an illustration that history is quickly forgotten, at the time of writing the UK Financial Conduct Authority (FCA), one of the successors to the FSA is in the process of negotiating with the largest banks in the United Kingdom for restitution to small and medium-sized companies who were mis-sold complex interest rate hedging products (IRHPs) comprising complex structured products involving interest rate swaps, caps and collars (FSA 2012, 2013). The full costs to the major banks have not yet been calculated but will be substantial and potentially as large as the costs of the payment protection insurance (PPI) scandal (McConnell and Blacker 2012; Wilson 2013). Over 50% of IRS trades are between financial institutions rather than between a bank and a customer, and within these, trading is concentrated in a small number of large banks (Fleming et al 2012). This means that the major swaps banks are highly interconnected and hence contribute to a higher level of systemic risk (Haldane 2009). The failure of one of the largest swaps dealers could have a devastating impact on bank funding worldwide. Before considering the operational risks involved in more detail, the next section discusses the emergence of the LIBOR scandal. 7 The original name was the International Swaps Dealers Association, reflecting its industry focus. Journal of Operational Risk 8(3), Fall 2013

17 Systemic operational risk 75 4 THE LIBOR MANIPULATION SCANDAL 4.1 Who would be tempted to manipulate LIBOR? We are unlikely to ever discover who was the first person to successfully manipulate LIBOR. However, the history of so-called rogue traders (Jobst 2007), such as the most recent at UBS, Kweku Adoboli (FINMA 2012), shows how such misconduct starts small, goes undetected, then is repeated more frequently and on a bigger scale until it gets too big to ignore (Fenton-O Creevy et al 2007). The most likely scenario for the first attempt to manipulate LIBOR is one where a trader, somewhere, was holding a losing position and, to reverse the losses, persuaded a compliant submitter, probably a junior, to nudge the bank s LIBOR submissions higher or lower. Having got away with that deception, an unscrupulous trader would be tempted to turn their mind to how profits could be made, repeating the deception, getting away with it, enhancing their reputation as a successful trader and doing it again and again. After a time, manipulation would become standard practice. Regulatory inquiries report that manipulation was already widespread in 2005/6 (see, for example, CFTC Barclays 2012; FSA Audit 2013) but how long the manipulation had been going on before that is unknown. Keenan (2012), an ex-trader, reports that as far back as 1991 he had reported to his managers at Barclays that LIBOR rates were being manipulated. He noted that as a junior trader his naivety seemed to be humorous to my colleagues (Keenan 2012). We might ask how the manipulation became so widespread. That too is unknown, but the inquiry into UBS gives a clue (CFTC UBS 2012). Although the market is enormous in economic terms, the number of people involved at any one time is small, in the hundreds rather than the thousands. These people are acknowledged experts in a very narrow field the movement of interest rates in a handful of currencies. They are also well paid and highly mobile. Some traders regularly move jobs between a small number of large investment banks and brokerage firms, which are located in the same financial hubs. When a trader moves jobs, they invariably maintain contacts with ex-colleagues, subordinates and managers, as there may be a need to use this network in future. 4.2 Who suffered as a result of the manipulation of LIBOR? The manipulation of LIBOR is not a victimless crime, it is just very difficult to identify precisely who the victims are, and how much financial loss they have suffered. Corporations and other banks that are paying floating rate interest based on LIBOR will lose when LIBOR rates rise, or are forced up by illicit means. Likewise, corporations and other banks that are paying fixed rate interest will lose when floating rates are forced down, as they will receive less interest. We will never know with certainty all of the victims of the LIBOR scandal but some are beginning to come forward. Forum Paper

18 76 P. McConnell Though details have yet to be published officially, Benson (2012) reported that an audit by the Federal Housing Finance Agency (FHFA) has estimated that Freddie Mac and Fannie Mae, two large US housing agencies that failed in the GFC, had lost some US$3 billion due to LIBOR manipulation. In March 2013, Freddie Mac 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 LIBOR (FHLMC 2013). Other financial parties have already filed legal suits against LIBOR banks (Hals 2012). But it was not only financial corporations that suffered; individuals whose mortgage payments were linked to LIBOR were impacted, as the first of the potentially many class-action lawsuits alleges (Touryalai 2012). 4.3 Investigations into the possible manipulation of LIBOR One of the problems with analyzing LIBOR submissions is that, in the absence of other information, such as market prices or positions, it is very difficult to detect anomalies, unless we know what we are looking for. LIBOR rates are meant to fluctuate, but it is difficult to detect precisely what is causing the fluctuations, whether it is market factors or something more sinister. It is like searching for a needle in a haystack. In March 2008, in reaction to rumors in the market, the Bank for International Settlements (BIS) published a paper on LIBOR rates that concluded that there was little evidence of manipulation [and that] available data do not support the hypothesis that contributor banks manipulated their quotes to profit from positions based on fixings. Gyntelberg and Wooldridge (2008) However, the analysts conclusion was tempered with the warning that there were discrepancies. Abrantes-Metz et al (2008) analyzed LIBOR submissions by contributing banks between January 2007 and May 2008 (ie, in the midst of the GFC) and concluded that the evidence found is inconsistent with an effective manipulation of the level of the LIBOR. A similar conclusion was reached by a study reported in the International Monetary Fund s Global Financial Stability Review in October 2008, which concluded that anomalies were probably a consequence of elevated volatility in lending markets (González-Hermosillo and Stone 2008). A tipping point in the LIBOR scandal was the publication of an article in the Wall Street Journal in May 2008, as the worst of the subprime crisis was unfolding (Mollenkamp and Whitehouse 2008). This article conjectured that major banks, such as Citigroup, JP Morgan and UBS were contributing to the erratic behavior of a crucial global lending benchmark, and in particular were reporting significantly lower borrowing costs for the [LIBOR] rate than what another market measure suggests they should be. The Wall Street Journal analysts had compared changes in LIBOR rates Journal of Operational Risk 8(3), Fall 2013

19 Systemic operational risk 77 with another measure of bank creditworthiness, credit default swap rates, 8 which they argue should, but did not, correlate with LIBOR (Mollenkamp and Whitehouse 2008). Considering the claims made by Mollenkamp and Whitehouse, Snider and Youle (2010) surveyed LIBOR submissions, just prior to and over the GFC, and found bunching of quotes around particular points that were consistent with incentives to affect the rate (as opposed to simply reporting costs). In other words, those banks with the greatest exposures had the greatest incentives to push LIBOR in a certain direction and appeared to be trying to do so (Snider andyoule 2010). But, all in all, the evidence of LIBOR manipulation derived from statistical analysis was inconclusive. 4.4 Manipulation of LIBOR for reputational reasons Manipulation of LIBOR falls into two very distinct categories with different staff involved, although the role of the submitter was common. Manipulation for reputational reasons: where senior management ordered LIBOR rates to be manipulated to protect the reputation of their firms, in particular, perceptions of their creditworthiness. Manipulation for profit: where employees manipulated LIBOR to benefit their own market positions and overall profitability for the banks. Paradoxically, although manipulation for profit was much more widespread, had been going on for longer and involved many more people, it was the manipulation for reputational reasons that was brought to light first. Like many problems that were unearthed by the GFC, such as misrepresentation of credit ratings (McConnell and Blacker 2011), it was the turmoil in the global credit markets that first raised questions which then eventually led to the exposure of the LIBOR scandal. In an article on Bloomberg in September 2007, provocatively titled Barclays takes a money market beating, Gilbert (2007) posed the equally provocative question, So what the hell is happening at Barclays and its Barclays Capital securities unit that is prompting its peers to charge it premium interest rates in the money market? The question was prompted by the journalist s observation that Barclays was submitting USD LIBOR rates consistently higher than all other banks, coupled with the observation that Barclays had approached the Bank of England for overnight funds a number of times in the previous month. Could it be that other banks considered Barclays uncreditworthy? A strict reading of the LIBOR question might lead us to believe that interpretation. Barclays, as would be expected, denied the article s implications, pointing to lack of liquidity in the markets making prices unreliable. But, inside Barclays, alarm bells 8 Credit default swap rates are a measure of the cost of default insurance. Forum Paper

20 78 P. McConnell went off. The inquiry into LIBOR manipulation at Barclays (CFTC Barclays 2012) noted that, after senior management discussions, Senior Barclays Treasury managers instructed the US dollar LIBOR submitters and their supervisor to lower Barclays LIBOR submissions, so that they were closer in range to the submitted rates by other banks but not so high as to attract media attention. [Emphasis added.] CFTC Barclays (2012) Such an order, of course, would not comply with BBA rules for submitting LIBOR rates, as would have been well-known at Barclays because one of its senior managers sat on the BBA FX&MMC committee at the time. Over the next few months Barclays lowered its LIBOR submissions, not only in USD but also other currencies, and kept them low in a strategy called no head above the parapet, also known as lowballing (FSA Audit 2013). This was despite the fact that the senior USD LIBOR submitter warned his supervisor that Barclays was being dishonest and the supervisor directed these concerns to a senior compliance officer and a member of senior management of Barclays (CFTC Barclays 2012). In turn, the senior compliance officer had discussions with the bank s regulator (the FSA) about LIBOR rates in general (but without discussing Barclays parapet strategy). Around the same time, a senior treasury manager at Barclays informed the BBA in a telephone call that it had not been reporting [LIBOR] accurately, although he noted that Barclays was not the worst offender of the panel bank members. We re clean, but we re dirty-clean, rather than clean-clean (CFTC Barclays 2012). The BBA representative responded, no one s clean-clean. So it is apparent that many senior managers in Barclays and even the BBA were aware that all was not well with the LIBOR process, at least at Barclays, but did not investigate further or take appropriate actions. With hindsight, the rationale was obvious; in the middle of the banking crisis everyone was trying to keep Barclays (and LIBOR) alive. But this was achieved partly because Barclays knowingly delivered, or caused to be delivered, false, misleading or knowingly inaccurate reports concerning US dollar LIBOR [emphasis added] (CFTC Barclays 2012). Barclays weathered the GFC storm, but in doing so caused the lid to be lifted on the LIBOR process and investigations to be initiated at several levels. One question that was raised was how high within Barclays management team was the manipulation known and sanctioned? The answer to this question was to eventually lead to the forced resignation of Barclays CEO and several senior managers (Treasury Committee 2012) and substantial fines for fraudulent activities totaling some US$550 million (CFTC Barclays 2012; DOJ 2012). Detailed discussions of these events are beyond this paper, but we note that the fines for misconduct by Barclay s management and staff fall under the Basel II definition of operational risk, specifically people risk. Journal of Operational Risk 8(3), Fall 2013