Must read for those who have had LIBOR-based adjustable rate notes.
It has recently become public knowledge that the London Interbank Offered Rate (Libor) has been misreported by banks. Such misreporting is generally thought to have begun in about 2005. In fact, such misreporting has been common since at least 1991. Moreover, corruption in the interest-rate markets has been aided and abetted by official institutions.
In 1991, I began trading for an investment bank, Morgan Stanley, in London. I was trading bonds, derivatives, and related securities. One of those securities was based on the 3-month Libor rate, i.e. the interest rate at which banks can borrow money for 3 months, on the interbank market. Morgan Stanley does not trade on the interbank market; so I could not directly borrow or loan money at Libor rates. What I could do, however, was trade a “futures contract” on the 3-month Libor rate.
As an example of how a futures contract works, consider the following. Suppose that we are concerned about 3-month Libor rates increasing in the future; in particular, we are concerned about what the 3-month rate will be in September. If that 3-month rate is currently, say, 1%, we can contract today to effectively lock in that rate. If, come September, the actual 3-month rate is 2%, then our contract will ensure that we can still borrow at 1%. Such a contract is a futures contract.
Trading the futures contract
Futures contracts on 3-month Libor were, and are, heavily traded on the London International Financial Futures Exchange (Liffe, now part of NYSE Euronext). There was a standard contract for the month of September. That contract had its rate settled on the third Wednesday of the month, at 11 AM.
In 1991, I had live trading screens that showed the Libor rates. In September of that year, on the third Wednesday, at 11 AM, I watched those screens, to see where the futures contract would settle. Shortly afterwards, Liffe announced the settlement rate. The announced rate was different from what had been shown on my screens, by a few hundredths of a percent.
As a result, I lost money. The amount was insignificant for me, but I believed that I had been defrauded, and I complained to Liffe. Liffe explained that the settlement rate was not determined by what rates actually were in the market. Instead, the British Bankers’ Association polled selected banks, asking them what the rates were. The highest and lowest reported rates were discarded, and the rest were averaged, giving the settlement rate. Liffe explained that, in doing this, they were adhering to the terms of the contract.
I talked with some of my more experienced colleagues about this. My colleagues told me that the banks misreported the Libor rates in a way that would generally bring them profits. I had been unaware of that, as I was relatively new to financial trading. My naivety seemed to be humorous to my colleagues.
Simply put, then, misreporting of Libor rates has been common practice since at least 1991. Although the difference between the reported rate and the actual rate might seem small, the total amount of money involved is material, given that Libor rates affect contracts worth hundreds of trillions. Also important is what such misreporting says about the culture.