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Dissertation Declaration
Title of Award
___Undergraduate Major Project____
Date December 11th 2015
____________________________________
SID Number
1008030 _____________________________________
Name of Supervisor Dr Swetketu Patnaik
_____________________________________
Title of Dissertation The effect of the LIBOR Rate fixing
_____________________________________ Scandal on the regulation of the rate
_____________________________________
_____________________________________
_____________________________________
_____________________________________
Word Count 10,000
_____________________________________ DECLARATION: I declare that the above work is my own and that the material contained herein has not been substantially used in any other submission for an academic award. Signed: Jamie Patton Date: 11/12/2015
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The effect of the Libor Rate fixing scandal on the Regulation of the rate Undergraduate Major Project Jamie Patton
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Abstract
The purpose of this report is to gain a better insight into the Libor Rate fixing scandal that
came to light in 2012. This was the biggest case of conspiracy and fraud the financial world
has ever seen. The report will begin by looking at the history behind Libor, its formation,
calculation, and how its purpose today as a global benchmark rate for banks borrowing and
lending in the money markets. It will then look into the size of the market and the types of
trading used to give a better idea of how the rate could have been manipulated and why.
Chapter 5 will focus upon the scandal as a whole beginning with the regulators of financial
markets and identifying who, if anyone, regulates the Libor market. It will then move on and
examine the initial allegations of rate manipulation, who was making the allegations and who
they were aimed at. Once this has been established the report will examine the rate
manipulation itself, looking how the rate was being manipulated and who was guilty of it. The
chapter will end by looking at the consequences for the banks who were guilty of manipulation
as well as the focusing upon the first ever criminal conviction of someone guilty of financial
crime.
The final chapter will bring together the information outlined and summarise the need for
reform of Libor. It will focus upon the Wheatley review commissioned by the UK Government
in the aftermath of the scandal. This report will look into the recommendations for reforming
Libor and examine any issues or barriers that these may have to overcome in order to be
implemented.
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Acknowledgements
Anglia Ruskin University: I would like to thank Anglia Ruskin University for giving me
the opportunity to do this project. It has been my home for the past few years and in
that time I have been able to further my education in a great learning environment
and have made some very good friends with students and lecturers alike who have
all supported me throughout my studies.
Dr Patnaik: I would also like to thank my project supervisor Dr Swetketu Patnaik. He
has shown interest in this topic and has given me some invaluable advice not only on
this project but also about pursuing my career after my studies.
Family and Friends: Finally I would like to thank my family and girlfriend who have
believed in me without doubt throughout my entire university experience. They have
helped to motivate me and support me during the good and bad times and I wish to
repay them by completing my studies by June 2016.
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Table of Contents Dissertation Declaration ............................................................................................ 1 Abstract ..................................................................................................................... 3 Acknowledgements ................................................................................................... 4 Key Terms and Abbreviations ................................................................................... 6
Chapter 1 ................................................................................................................. 7 Literature Review ...................................................................................................... 7
Chapter 2 ................................................................................................................. 8 Methodology.............................................................................................................. 8
Chapter 3 ................................................................................................................. 9 Introduction ............................................................................................................... 9
Chapter 4 ............................................................................................................... 10 Overview – A wider perspective of Libor and global currency markets .................... 10
4.1 History ........................................................................................................... 10 4.2 Calculation ..................................................................................................... 11 4.3 Market and Contributors ................................................................................ 14 4.4 Foreign Exchange Market .............................................................................. 14 4.5 Currencies ..................................................................................................... 17
Chapter 5 ............................................................................................................... 18 The Libor Scandal - Market Regulators and Allegations of Rate Manipulation ......... 18
5.1 Regulators ..................................................................................................... 18 5.2 Allegations ..................................................................................................... 21 5.3 Rate Manipulation .......................................................................................... 24 5.4 Conviction...................................................................................................... 27
Chapter 6 ............................................................................................................... 31 Libor; The Reformation – An Overhaul and New Benchmark? ................................ 31
6.1 Reasons for reform ........................................................................................ 31 6.2 Recommendations for Reform ....................................................................... 33
Conclusion............................................................................................................. 37
Bibliography .......................................................................................................... 39
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Key Terms and Abbreviations
Libor – The London Interbank Offered Rate
EURIBOR – The Euro Interbank Offered Rate
BBA – British Bankers Association
LPBAUG – Libor Panel Banks and Users Group
FSA – Financial Services Authority
FCA – Financial Conduct Authority
PRA – Prudential Regulation Authority
CDS – Credit Default Swap
CFTC – Commodity Futures Trading Commission
SEC – Securities and Exchange Commission
CME – Chicago Mercantile Exchange
NYSE – New York Stock Exchange
Forex – Foreign Exchange
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Chapter 1
Literature Review
The literature used mainly throughout this report will mainly be journal and
newspaper articles that were written before during and after the scandal. These
articles have been chosen due to their more up-to-date nature over textbooks.
However textbooks have also been used in order to gain further working knowledge
of the market as this information is rarely found in articles as they tend to focus more
upon the data during the scandal rather than the intricate details of the trading.
One of the most valuable report used in this piece is entitled LIBOR: Origins,
Economics, Crisis, Scandal and Reform. David Hou and David Skeie wrote this in
2014 for the Federal Reserve Bank of New York. This has proved invaluable for
details about exactly how the Libor rate is calculated and the many factors that must
be considered in the rate.
Another report that gave exceptional insight is The Wheatley Review. This was the
review that was commissioned by the Chancellor of the Exchequer, George Osborne,
in the immediate aftermath of the scandal as he called for reform to be made.
All of the literature reviewed for this project has all added worth to the overall topic
and have aided in this project being very in-depth.
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Chapter 2
Methodology
The purpose of this research is to look at the regulations of Libor before, during and
after the rate manipulation which came to light in 2012. This analysis will be carried
out by conducting a case study on the events surrounding the rate fixing scandal
using only secondary sources. In this project information will be gathered from
various journals and newspaper articles as well as reports and books. The
aforementioned literatures will be used to gain information about the people and
organisations involved and how this affected the market as a whole.
For the more intricate details of what happened there will be an analysis of
publications that were written in the aftermath of the scandal. This will include reports
from the regulators and impartial financial institutions, such as the Bank of England
and The Federal Reserve Bank of New York. There will also be an analysis of reports
that were written from the perspective of other financial institutions who were
affected.
The first summary will be regarding the regulations as they were at the time of the
scandal, and once this is clear, there will be an analysis of the market’s regulators.
The purpose of this analysis is to give a good idea of what their powers are in terms
of investigating and enforcing the rules and regulations the market users must abide
by. This analysis will then be linked to the rate fixing scandal to hopefully determine
whether or not the authorities were aware of what was happening. An investigation
into when they took action will then be carried out, which will help to establish their
position on the scandal. This should give a clearer view of their role, in terms of
whether they let it happen in order to force the Government to conduct a review of
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the process, or if in fact they were oblivious to what was happening within the market
they regulate.
Following the summary of the regulators and regulations the focus will be getting a
better idea of the market as a whole. This will focus on what the market was like at
the time the rates were being manipulated, how this manipulation affected the market
in the aftermath and ultimately how it affected the consumers.
All of the above will then be brought together in order to reach a comprehensive
conclusion on the matter. This will take into consideration the effect of the scandal on
the integrity of the Libor rate as a benchmark, as its purpose is to give a true
reflection of the banks borrowing and lending rates.
Chapter 3
Introduction
This project will focus upon the Libor rate fixing scandal of 2012. This was seen
as the worst financial conspiracy in history as it involved many of the world’s
biggest banks and spanned from London to Tokyo to New York and possibly
further as more and more details are being brought to light daily.
This project examine all factors that played a part in the scandal I order to give a
more detailed understanding of the rate manipulation that took place. It will
examine the rate, the market as a whole and identify the main players in the
market to better understand why they were manipulated
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The report will then attempt to offer motives for the rate manipulation as well as
looking at who was responsible. It will also give a detailed account of how the
rate was being manipulated so easily and almost without consequence.
Chapter 4
Overview – A wider perspective of Libor and global currency markets
4.1 History
The London Interbank Offered Rate (Libor) is a benchmark rate, which the largest
banks use to trade many different currencies with one another. It was originally an
idea by a Greek banker named Minos Zombanakis. He organised a loan from
Manufacturer’s Hanover to the Shah of Iran based upon the reported funding costs of
a set of reference banks (Ridley & Huw, 2012 as cited in Hou & David, 2014). During
the 1980’s banks began to both provide loans and borrow funds using the Libor
based rate. This lead to the creation of an incentive to underreport funding costs,
this then prompted the British Bankers Assosciation (BBA) to take control of the rate
in 1986 to formalise the data collection and governance process (Hou & David,
2014). This was turned into a uniform rate which had the ability to facilitate the
operation of markets and allow transparent and objective benchmarking. As of
January 1986, Libor became the market’s standard (Goldstein, 2012).
The Libor rates pupose is to give a true reflection of banks’ borriwing and lending
rates. It was intially alleged that banks were manipulating the in order to look in a
stronger financial state than they were. They did this becaue having a lower
borrowing rate shows a strong financial standing where as a high rate gives an
indication of a weak standing (Finch and Vaughan, 2012).
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Libor is not the only rate of its kind, it just happens to be the most widely known.
There are several others which are not widely known. Euribor is the European
internbank offered rate set by the European Banking Federation. It works in much the
same as Libor but its European banks the mainly use it. There is also an interbank
rate for many other financial centres like Tokyo, Mumbai, Singapore and Hong Kong.
These are known as Tibor, Mibor, Sibor and Hibor respectively ans they are all
conducted in the same way as Libor and Euribor (Hou and Skeie, 2014).
4.2 Calculation
The Libor rate is calculated each day; it used be that the BBA were advised by the
Libor Panel Banks and Users Group (LPBAUG) to use a reference panel of between
6 and 18 banks to submit 15 maturities for 10 currencies. This helps get a true
balance of the market (Goldstein, 2012). The currencies include the U.S. Dollar,
British Pound, Japanese Yen, Swiss Franc and Euro. However, previous to the
integration of the European currencies into the Euro, the Libor rate would have up to
16 different currencies . The maturities range from overnight to 12 months, although
not all of the currencies and maturities are active, (see fig. 1) (Hou & David, 2014).
The way the banks calculate their rate is by using the question “At what rate could
you borrow funds, were you to do so by asking for and then accepting inter-bank
offers in a reasonable market size just prior to 11am?” (Hou & David, 2014),
(Goldstein, 2012). This basically means if a trader as were to ask a someone from a
different bank for a loan, what rate could they get?
Once these rates have been calculated for each currency and maturity, they are
submitted confidentially to Thomson Reuters, via an application where the other
banks are unable to see the rates which other banks have submitted (Goldstein,
2012). Once Thomson Reuters have received all fo the submissions from the banks,
they take away the upper quartile and lower qaurtile from each maturity pair and find
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the average of the rest. This average is released at 12 noon GMT and is used as the
Libor rate for that day (Hou & David, 2014).
Figure 1.
Libor Currencies Libor Maturities
Active Inactive Active Inactive
Euro Australian Dollar Overnight 2 weeks
U.S. Dollar New Zealand
Dollar
1 Week 4 Months
Brtish Pound Canadian Dollar 1 Month 5 Months
Japanese Yen Swedish Krone 2 Months 7 Months
Swiss Franc Danish Krone 3 Months 8 Months
6 Months 9 Months
12 Months 10 Months
11 Months
(Hou & David, 2014)
NB. All of the above currencies and maturities are were checked and are correct as
of 6th November 2015.
In order to fully undertand Libor all of it theoretical components must be looked at. It
is thought of as a combination of term and risk spreads. Below is formula which is
used to take the terms and risks into consideration.
LIBOR = Overnight risk free rate over the term + term premium + bank
term credit risk + term liquidity risk + term risk premium
(Hou and Skeie, 2014)
The overnight risk free rate over the term refers to the rate that a buyer could get
over night if the buyer is risk free. The term premium is the ‘intertemporal rate of
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substitution for the term of the loan’ (Hou and Skeie, 2014 pp. 4) this is referring to
the maturities available on Libor i.e. buying a six-month US Dollar maturity means
you have US Dollars but not until six months down the line. This then makes these
US Dollars available for shorter term trading. As the banks that use Libor are not risk
free borrowers the bank term credit risk refers to the counterparty and the amount
of risk the buyer is undertaking which rises in line the term of the loan i.e. the longer
the loan he higher the risk. The term liquidity risk refers to bank lending the funds
as they may be tied up in a long-term loan that will affect the banks ability to liquidate
the asset quickly should they need to. Finally the term risk premium is in the
equation to compensate should any of the other terms not return what they were
expected to.
There have been many attempts to break down each of the terms above in order to
show what percentage of the rate each term makes up. These theories are all very
different to one another. The first theory is that most of the risk is down to the
liquidity. It is thought that hoarding money during periods of stress is what drives
rates up. During 2007 in the financial crisis this is exactly what banks were doing.
(Acharya and Skeie, 2011, McAndrews, Sakar and Wang, 2008, Michaud and Upper,
2008 and Schwarz, 2010 all as cited in Hou and Skeie, 2014).
The next theory is that the counterparty credit risk is proxied by Credit default swap
(CDS) spreads and this is what drives the interbank rates (Taylor and Williams,
2008a, 2008b as cited in Hou and Skeie, 2014). This theory is saying that bank term
credit risk part of the equation is actually valued by the CDS spreads that the
borrower has.
Lastly Josephine Smith (2012) was able to find that up to 50% of the variation in
money market spreads is explainable by the term risk premium (Smith, 2012 as cited
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in Hou and Skeie 2014). This theory is basically saying that almost half of the
differences between rates is down to the extra compensation included in the rate.
4.3 Market and Contributors
The purpose of the Libor rate is to be a true reflection of banks borrowing and lending
rate. As a result of this the banks that contribute to the rate submissions must show
that they can be trusted to be send in honest rates. However this was all thrown into
disarray when allegations were made of manipulation by certain banks and traders.
This tarnished the reputation of Libor and further depleted customers’ confidence in
the banks and the financial services industry (Finch and Vaughan, 2012).
4.4 Foreign Exchange Market
The Forex market is worth $560tn with daily trades averaging about $5.3tn (Foster,
2012) (Daily FX, 2014). To put that in to some perspective the New York Stock
Exchange (NYSE) deals with roughly $28bn daily, some 30 times less than the Forex
market. It is widely accepted as the biggest market in the world due to its high
liquidity. This not only makes it an attractive prospect for traders as they are able to
enter and exit the market very quickly but they can also make trades of huge value
without the massive price fluctuations that would happen on a market of less liquidity
such as the NYSE (Daily FX, 2014).
The currency market is so big because there is more than one way to trade currency.
The main way is between banks however there are four types of trading that make up
the Forex market (Levinson, 2009).
4.4.1 Spot Trading
This is called the spot market because a majority of the trades are completed on the
spot. The best example of this is when buying currency to go on holiday. The buyer
goes into a local currency exchange hands over Euros and receives US Dollars at
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the day’s rate. Once the buyer receives the Dollars the transaction is finished.
Another form of spot trading is when a firm decides to convert export receipts in to
their own currency. These types of large spot trades were once arranged mainly via
the telephone however given the rise of the Internet and technological age the main
method for these transactions is by using electronic currency brokering systems
(Levinson, 2009). These are mainly done online and can be seen to have contributed
to size of the overall market, as banks are able to trade currency with other banks
based overseas. The actual trading of the currency in this instance however is not as
immediate as the face-to-face deals discussed above. These trades are agreed on
the spot but the exchange of currency must go through the banking system and
usually takes two days for the transactions to be completed and both parties to
receive their currency (Levinson, 2009).
4.4.3 Futures Trading
The basis of this type of trading is given away in the title. Futures’ trading is were a
company is expecting to receive currency at a certain maturity but they wish to
protect the currency they are receiving against their own currency. In this case the
firm would buy futures contract on the Chicago Mercantile Exchange. By purchasing
the futures contract the firm receiving the currency locks in the rate of that day
however this then means that the trade must go through on the day the contract
expires or else they will run the risk of exchange rates changing in the time between
receiving the currency and the day the contracts expire (Levinson, 2009). This means
that if you have a futures contract then it is in your best interests to complete the
trade on the date of the expiry or else you may see the currency devalue against
your own currency.
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4.4.5 Options Trading
This form of trading is very small in the market compared to other types. Option
trading is where a holder has a right but no obligation to buy or sell currency at a set
rate for certain period of time (Levinson, 2009). This type of trading is mainly used to
benefit the holder as sellers may not want to trade with them as the rate may be too
high and they may be inundated with buyers however he is under no obligation to
sell.
4.4.2 Derivatives Trading
This is how a majority of the trades are done on the Forex Market. Typically
derivatives are made up of different financial instruments such as futures and options
(Levinson, 2009). A derivative is something that gets it value from different contracts
it is made up of. This is the standard way of trading them however in Forex they are
commonly made up of different contracts.
The first type of contract that is used is a forward contract, this type of contract is
similar to a futures contract with a difference being that in a forward contract the two
parties not only agree upon a rate at which to trade in the future but they also agree
upon a date on which to complete the trade. The main difference between a future
contract and forward contract is that they are carried out directly between the dealer
and the customer. They also have more flexibility in terms of being arranged for a
precise date and amount of time that best suits the customer (Levinson, 2009).
The second type is foreign exchange swaps. These involve buying or selling
currency on one date and offsetting the buying or selling of the currency of the same
amount on a future date, with both parties agreeing upon these dates when the trade
is initiated (Levinson, 2009). An example of this would be if two parties agreed to
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trade Euros for US Dollars. If they are trading 100,000 Euros today they will also
agree to trade 100,000 Euros in 5 days time.
The next type of trading derivatives are based on is forward rate agreements. This is
where two firms agree to trade interest-payment obligations, if the obligations are in
different currencies there is also an exchange rate component to the agreement
(Levinson, 2009). This basically means that two firms can agree to pay the other
parties interest on a future obligation, so if the interest rate on it falls one party may
pay less and if it rises a party may have to pay more.
The final type of contract that makes up a derivative is the barrier option. This allows
the trader to limit their risk (Levinson, 2009). Basically this is where a trader puts a
barrier on a trade to automatically take the profit once the positions hits a certain rate
or the trader can put a barrier on the trade so if it drops the position will be closed
once it drops a certain amount.
4.5 Currencies
Although the market is made up of several currencies there are four major currencies
that take up a majority of the trading. The most dominant of the four is by far the US
Dollar (USD), this accounts for 87% of all market trading. The USD is followed by the
Euro, albeit not very closely, with 33% of all trading. The Japanese Yen comes in
third with 23% and finally fourth in the list is the Pound Sterling with 11% (BIS, 2013).
The remaining currencies are still traded on the market but the most popular of those,
the Swiss Franc, only accounts for 5% of all trading with the other minor currencies
having much less market share (BIS, 2013).
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Figure 2.
Libor Currencies by Percentage
Country Currency Market Percentage
US Dollar 87.0
Euro* 33.4
Japanese Yen 23.0
Pound Sterling 11.8
Australia Dollar 8.6
Swiss Franc 5.2
Canadian Dollar 4.6
New Zealand Dollar 2.0
Swedish Krone 1.8
Danish Krone 0.8
*The Euro is not tied to one specific currency rather it the main currency of the
European Union.
The above table is a breakdown of the main currencies traded using Libor and the
percentage of the market trades that they are involved in. These are taken from the
Bank for International Settlements 2013 Survey (BIS, 2013 pp. 10)
Chapter 5
The Libor Scandal - Market Regulators and Allegations of Rate Manipulation
5.1 Regulators
Since the BBA took over the governing of Libor in 1986 the market has been largely
unregulated. This is apparent because there was no direct regulatory body
overseeing its calculation, because as we know the rate is calculated by the banks
submitting their own rates (Ojo, 2012). However as financial crisis ended an act was
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passed into law and this was changed. The Financial Conduct Authority (FCA) is the
current regulator of the Libor market and all of the rate’s users. However, this was not
always the case as it was, until very recently, the Financial Services Authority; on
December 19th 2012 an act was given royal assent, this Act was the Financial
Services Act 2012 (UK Parliament, 2012), the royal assent passed the act into law
and started in motion the abolition of the FSA. This was then split into the FCA and
another governing body known as the Prudential Regulation Authority (PRA).
The FCA has three main objectives, which are clearly laid out in detail in the
Financial Services Act 2012. The first objective is the protection of consumers; in
order to fulfil this objective they must look at various points, for example, the risk of
entering into the investment, the experience or expertise the consumer may have
and whether the consumer has been given accurate information on which to base a
decision. The most important part of this objective, however, is laid out in Section 1C
2 (e) where they state “The FCA must have regard to; the general principal that those
providing regulated financial services should be expected to provide consumers with
a level of care that is appropriate having regard to the degree of risk involved in
relation to the investment or other transaction and the capabilities of the consumers
in question;” (Financial Services Act, 2012, 1C 2 (e)). This can be related back to the
trigger of the financial crisis, in which banks were wilfully selling mortgages to
consumers that they were not able to sustain. Consumers were not given a full
breakdown of the risks that would be involved in taking on such a huge investment,
the result of which caused many homes to be repossessed, and subsequently lead to
the financial crash in 2007.
The Second objective is The Integrity objective. The purpose of this objective is to
maintain the UK Financial System’s integrity as a trustworthy and unbiased system
that promotes a fair market place for both consumers and businesses alike. To do
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this they must maintain the soundness, stability and resilience of the UK Financial
System, ensure it is not used for anything related to financial crime i.e. rate
manipulation, it is not affected by behaviour that amounts to market abuse, the
financial markets are operated in an orderly fashion and that there is price
transparency from the markets (Financial Services Act 2012 s1D). This objective will
help rebuild consumers’ trust in their banks and those in charge of the UK Financial
system, given the loss of this trust after the recent failings of the banks with regards
to the financial crisis and the even more recent rate manipulation scandal.
The Third objective of the FCA is The Competition Objective. This objective is to
encourage competition in the market place. It does this by ensuring the consumers
have enough information about the financial services available to them and also
providing them with enough information about the products or services which they
might intend to use in the future, e.g. if a consumer would like to switch insurance
providers for a car or a home, the FCA will make sure there is enough information
readily available for them in order to make the decision on which is best for their
needs. The FCA also make sure that the financial services of any kind are easily
accessible not just in areas of high demand but also in areas which have low demand
as they may be viewed as economically deprived. This objective also helps with the
ease of obtaining the same kind of financial product or service but from a different
provider, for example if a consumer decides they can get a better current account to
fit their needs from a different bank, it the FCA’s responsibility to make sure that the
banks do not make it extremely difficult for customers to switch to one of their
competitor’s.
Finally, to maintain the competition objective the FCA must ensure the ease of
access for new competitors to enter the market and that the competition within the
market is encouraging innovation. So, in this instance, the FCA must see that all the
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competitors in the market are continuously changing how they operate in order to
make their services easier to access for consumers and that their new ideas are
actually driving industry forward and not just coming to standstill once they are
making profit (Financial Services Act 2012 s 1E).
5.2 Allegations
It is not know exactly when the Libor rate manipulation began, Professor Sharon E.
Foster speculates that it may have started as early as 2005 (Foster, 2012). However,
many media outlets, including Bloomberg, are of the opinion that it started two years
later, in 2007 (Finch and Vaughan, 2012). Although, none of these show that there is
any indication to support exactly when it began. Despite the lack of early evidence,
as the scandal came to light, more and more facts emerged to prove that the banks
involved in setting the Libor rate were actually influencing it to their own advantage.
According to an article on Bloomberg online, it was in 2007 when the financial crisis
hit, that the Libor rate was most at risk of being manipulated, this was due to the
banks not wanting to lend to one another instead opting to hoard cash. This made
the job of an analyst extremely difficult, as they had little or no trades to base their
rate submissions upon. They then turned to interdealer brokers, colleagues and
acquaintances for advice on what they should submit, however, this caused a
problem as any of these people could give advice on rates which would most benefit
them, rather than a rate which gave a true reflection of the market. This was
described as “legitimate information sharing in the absence of trading” (Finch and
Vaughan, 2012).
Manipulating the rate was simple, as discussed above, participating banks send in
their submissions for the 15 maturities, for 10 currencies with the upper and lower
quartiles removed, and the rest averaged in order to get the rate for that day. The
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way it was being manipulated, however, was that the bank’s submitters would send
in submissions which would be much higher than the market would expect, this
submission would then be eliminated in the upper quartile. However, with this
submission being removed, it would push another bank’s rate, which should have
been excluded, down into the group to be averaged, this would the push the average
up and that day’s Libor rate would be higher than expected (Finch and Vaughan,
2012).
Initially, it was thought that the banks were manipulating the Libor rate on purpose,
so they could deceive consumers in terms of their financial position during the crisis.
An article in the Wall Street Journal was the first to state these allegations, giving the
reasoning behind it as the banks wanting to portray a position of financial strength
during very hard times, and to do this they instructed their submitters to send in
fixings that were higher than they should have been, proving that they were not in a
position to fail (Finch and Vaughan, 2012) (Foster, 2012). It then came to light that
the banks could have been manipulating the rate in order to gain advantage over
other banks trading in the market (Foster, 2012). To put that in monetary terms, as
mentioned above, the Libor market overall is worth $560 trillion. So the movement of
one basis point, which is the equivalent of one one-hundredth of a percentage point,
could cost the market $56 billion (Foster, 2012).
As many banks have positions in the regions of $100 billion plus, the movement of 1
basis point can mean huge monetary gain in their favour. When this motive was first
offered, it was again, an article in the Wall Street Journal that made it public. The
author of the article, Carrick Mollenkamp, stated in the article that in the minutes from
a November 2007 meeting of the Monetary Policy Committee (MPC), several
members thought that the rates were lower than actual traded interbank rates
through the period of stress. The article also states that some banks and members
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had expressed concerns to the BBA as to whether the banks were reporting rates
true to the actual borrowing costs (Mollenkamp, 2008). Bloomberg later revealed in
an article in 2012, that a Barclays employee in London sent an email to the Federal
Reserve Bank of New York in August 2007 questioning the rates that banks were
submitting (Finch and Vaughan, 2012).
All of the above motives, although they were just speculations about the reasoning
for the low rates, show that the regulators had been warned almost immediately that
there was some manipulation happening. There is very little evidence to say why
these warnings were ignored. However, The Bank of England and The Federal
Reserve Bank of New York were happy to say they failed to act because at the time
of the warnings, and the subsequent manipulation in the years that followed, neither
of these institutions had any responsibility for the oversight of Libor (Finch and
Vaughan, 2012).
These were not the only institutions to have been warned of the manipulation going
on. In 2008 the BBA ignored recommendations from banks to change the way the
rate was computed. The reasons for not making any changes may have been due to
the fact that the regulators, both the BBA and the FSA, were preoccupied with
dealing with the biggest financial crash since the great depression, and forcing the
banks to be submit truthful rates would have shown that they were paying penalty
rates to borrow (Finch and Vaughan, 2012). This would have shown the market and
consumers just how much trouble the banks were in given the financial crisis that hit.
Had they been forced to submit truthful submissions, this would have meant even
more trouble for the banks as, consumers would have lost faith in them knowing just
how bad the situation really was. This begs the question; even though the regulators
were warned, did they let the manipulation happen on purpose?
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The reasons behind this could ultimately come down to one of two options. The first
option could be that the regulators at the time, the FSA and the BBA, may have seen
that forcing the banks to be truthful with their submissions would have worsened the
situation during the financial crisis. As a result of this foresight, they could have
decided to wait until the banks were in stronger positions financially before taking
action. Even though the regulators knew what was going on and failed to act, it
doesn’t take away from the fact that manipulating the rates and not giving a truthful
reflection still damaged the reputation and integrity of Libor, but is also against
criminal law, as it is deceitful and fraudulent (R v Hayes, 2015).
5.3 Rate Manipulation
As mentioned above there were several different allegations about manipulation and
these lead to many media outlets coming to their own conclusions. However there
has not been any real evidence to support any motives that have been speculated.
One thing that was correct though is that this involved more banks than anyone could
have thought. The banks involved in the manipulation were some of the biggest
banks in the world this included UBS, Barclays, JP Morgan Chase & Co, RBS and
Citigroup (Freifeld, Henry and Slater, 2015). These banks were the main offenders
during the whole period of manipulation. It was uncovered that they were using an
invite only online chat system where they could discuss their submissions and trades
((Freifeld, Henry and Slater, 2015).
The earliest evidence of the rate being manipulated can be dated back to March 28th
2008 when the three-month yen rate at RBS rose from 0.94 on the 27th to 0.97 on the
28th; on this date they were the only bank to raise their rate out of the 16 contributing
banks (Finch and Vaughan, 2012). It was also revealed that this was not one
individual looking to make a gain for themselves, this was actually arranged through
a small network of people at RBS. Neil Danziger, a derivatives trader at RBS at the
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time, was instructed by his boss in Tokyo, Tan Chi Min, in an instant message to
“bump it way up high, highest among all if possible” (Finch and Vaughan, 2012) As
Neil Danziger was a derivatives trader and was not responsible for the submissions
he would usually pass this message on to Paul White, however Paul was absent that
day so Neil Danziger simply put the rate in himself (Finch and Vaughan, 2012). The
fact that a derivatives trader was able to have such easy access to the rate
submission shows a serious lack of security in the rate. RBS were accused of
cheating their clients and pleaded guilty, for their part in the manipulation they had to
pay a fine of £395 million as well as £274 million to the Federal Reserve Bank of New
York (Freifeld, Henry and Slater, 2015).
Citigroup were involved in the scandal however it was their main banking unit Citicorp
who were actually guilty of the manipulation. They were eventually caught
manipulating the rate and pleaded guilty to cheating clients to boost their own profits.
The CEO of Citigroup, Mike Corbat, described the behaviour of the bank and thosde
involved as “an embarrassment” and has set in motion an internal investigation. As of
May 20th 2015 nine people had been sacked from Citicorp (Freifeld, Henry and
Slater, 2015). They were fined the most of all the banks, a staggering $925 million
criminal fine as well as $342 million to be paid to the Federal Reserve Bank of New
York (The Federal Reserve) (Freifeld, Henry and Slater, 2015).
JP Morgan Chase & Co was accused of the same charges as both Citigroup and
RBS. They also pleaded guilty to the accusations and were fined $550 million
criminal fine and $342 million to The Federal Reserve. However what makes JP
Morgan different and if anything worse, than the other banks involved was that is was
the first time a bank had plead guilty to criminal charges Since Drexel Burnham
Lambert, which plead guilty to 6 counts of securities fraud in 1989 (Freifeld, Henry
and Slater, 2015) (Eichenwald, 1989).
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The most high profile case of pleading guilty to the accusations is that of Barclays
Plc. This banks role in the scandal was widely covered across all media outlets both
in the UK and in the US. Barclays were actually first to bring the entire manipulation
allegations to light as the then head of asset allocation, Tim Bond, publicly disclosed
the banks Libor figures in May 2008, stating that all banks were misstating their
figures (Finch and Vaughan, 2012) however these allegations were ignored.
As these allegations were ignored this could have almost given Barclays the ‘green
light’ to start manipulating the rate in their favour. The reason this case drew so much
media coverage could be due to the fact that even after they had pleaded guilty to
manipulating the Libor rate their employees continued to engage customers in
misleading sales practices (Freifeld, Henry and Slater, 2015). The staff at Barclays
would offer different rates to the ones offered by the traders, these were known as
‘mark-ups’ and were generally used to boost profits (Freifeld, Henry and Slater,
2015).
So basically even after Barclays had admitted to manipulating the Libor rate in order
to boost their profits, they thought it okay to continue manipulating rates to higher
ones, that again would help boost their profits. As punishment for this four traders
were sacked with an order to sack another four coming from Benjamin Lawsky, the
New York states banking regulator (Freifeld, Henry and Slater, 2015). They were also
fined $2.4 billion in total for all of their offences. Although Barclays had put aside $3.2
billion to pay for the fines, their share prices jumped to an 18 month record high after
the sackings as customers saw this as the bank getting rid of the uncertainty after the
rate rigging (Freifeld, Henry and Slater, 2015).
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The Final substantial bank to be fined for Libor rate manipulation was United Bank of
Switzerland (UBS). This was the first bank to report the misconduct to the U.S.
Officials (Freifeld, Henry and Slater, 2015) this got the whole investigation started
into the previous allegations that had been made by other banks and employees as
mentioned above. However this ‘whistleblowing’ did not exempt UBS in any way as
they still plead guilty and paid a fine of $203 million for breaching a non-prosecution
agreement and for their part in the Libor manipulation they also had to pay $342
million to The Federal Reserve. (Freifeld, Henry and Slater, 2015).
5.4 Conviction
Out of all of the regulatory bodies that could have acted upon any of the warning
signs or accusations it was the Commodity Futures Trading Commission (CFTC) who
was the first to act. Vince McGonagle, a Senior Manager of the CFTC’s enforcement
team, decided to investigate the allegations surrounding Libor. At the time there was
a lot of discussion around whether or not they should investigate as cases of this
nature usually fell to the Securities and Exchange Commission (SEC) or the Federal
Reserve (Vaughan and Finch 2015). This was not the only barrier that needed to be
overcome however as Libor is a UK rate, the CFTC has no jurisdiction for it.
After being told by the FSA that they were not interested in such investigations it
came light that Libor was used on The Chicago Mercantile Exchange (CME), which
was under the CFTC’s jurisdiction, and the investigation was able to begin. The
CFTC requested information on how Libor was set from British banks with a few
responding to the request but many ignored them. Not having any UK regulators
willing to help almost ground the investigation to halt until the CFTC received a CD
that was a recording of two middle managers at Barclays openly discussing
manipulating the rate and how it had come from the Bank of England (Vaughan and
Finch, 2015). This prompted the CFTC to get the US Department of Justice involved
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and when they did the banks were ordered to hand over evidence relating to the
case. It was when the UBS evidence was being reviewed that Tom Hayes was found
to be a frequent offender.
Tom Hayes was seen as the common denominator in the scandal. He had worked at
UBS and made over £200 million for the bank by fixing the Libor rate. It was then
uncovered that he had been sacked from Citigroup once they discovered what he
was doing (Spillett and Smith, 2015). However he wasn’t manipulating the rate
himself, he had built up a big network of brokers throughout The City that he would
regularly call or email and instruct them to tell their submitters what to do with the
rate. It can be argued that Tom Hayes was the ringmaster for a majority of the
manipulation however he disputed this claim stating in court that all of his managers
were aware of his actions and that in some instances had even condoned his actions
(R v Hayes, 2015).
As mentioned above when the financial crisis first hit and the trading began to slow
down the submitters would ask the brokers for advice on what the rate should be set
at, however what the submitters were unaware of at that time, is that the brokers
were in regular contact with Tom Hayes and he would tell them what he needed the
rate set at (Vaughan and Finch, 2015). The brokers would then give this information
to the submitters and they would simply take it at face value and input the rate. Little
did they know that they were actually pawns in the biggest financial conspiracy ever.
It was back in 2007, prompted by the collapse of the Lehman Brothers, that Hayes
was working at UBS in Tokyo, when Tom Hayes had the idea of influencing the rate.
He had a position of 400 billion yen about to mature when he really started contacting
everyone in his network to push the rate up. The brokers delivered and yen Libor
rose 3 basis points (Vaughan and Finch, 2014).
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However, his network was not restricted to just who he personally knew. If he didn’t
know any submitters at certain banks he would use people he did know to befriend
them and then once they were onside, they too would receive “advice” on what their
Libor rate should be. The best example of how Tom Hayes would manipulate the rate
through a ‘friend of a friend’ was when he contacted his Brother-in-Law Peter O’Leary
at HSBC. Tom Hayes manipulated Peter O’Leary as he had done to so many others,
and advised his Brother-in-Law to befriend the person who set the yen Libor at
HSBC, Chris Porter. Hayes Advised O’Leary to befriend Porter “over a few pints” and
ask him to set the rate for the three-month yen lower as he had a position of $1
million on the line.
However this was not the end for Tom Hayes as in December 2012, the Serious
Fraud Office in London arrested him (Vaughan and Finch, 2015). At first he opted to
give evidence against his co conspirators in order to be accepted onto a Serious
Organised Crime and Police Act programme under s71 to protect himself from
extradition to the U.S. and signed the agreement on March 23rd 2013 (R v Hayes,
2015). This agreement would have given him immunity not only from extradition but
also may have had an effect on his punishment for his part in the scandal. However
once the immunity from extradition was granted Tom Hayes decided to change not
only his legal but also his plea from guilty to not guilty (R v Hayes, 2015). This
basically started the beginning of the end.
Tom Hayes had put forward his defence claiming that all banks were manipulating
the rate to help themselves however this was rejected as he was manipulating the
rate for personal gain (R v Hayes, 2015). He also tried to claim that what he was
doing by manipulating the rate was commonplace in the market and that his
managers condoned and encouraged his methods. This again was rejected as
regardless of who else was doing it or who was encouraging him to do it, does not
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take away from the fact that what he was doing was deceitful and fraudulent (R v
Hayes, 2015).
At this point due to the change of legal team and the plea any legal argument that
could be made had been made (R v Hayes, 2015). Taking everything into
consideration Tom Hayes was sentenced to 14 years in jail due the amount of money
involved that fraudulently gained (R v Hayes, 2015).
This case in particular best shows how easy it was for one dishonest person to cause
so much damage. This relates back to the previous point that there needed to be
some form of security or regulation in place for the Libor rate. Had this been the case
this entire scandal could have been avoided. Given how high profile this was it has
helped clear the way for other cases and countries to take legal action against banks
and traders who were also involved.
As of November 13th UK prosecutors had charged 10 former traders from Barclays
and Deutsche Bank with fixing the Euribor rate. This is on top of the six interdealer
brokers from ICAP, Tullet Prebon and RP Martin who are on trial accused on
assisting Tom Hayes (Fortado, 2015).
In the first U.S. trial for Libor rate fixing, two former Rabobank traders, Anthony Allen
and Anthony Conti have been found guilty of rigging the yen and US Dollar Rate
(Fortado, 2015).
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Chapter 6
Libor; The Reformation – An Overhaul and New Benchmark?
The need for reform is considered as critical in helping to regain the integrity and
restoring faith in the Libor rate. This part of the report will focus upon the ideas and
recommendations of rate as well as detailing any issues that may hinder any
recommendations proposed.
6.1 Reasons for reform
As discussed throughout this report there are several reasons that all point to the
need for reform in Libor. As the scandal gathered so much media attention this
prompted the UK Government to step in.
After the discovery of hard evidence that manipulation was going on, the Chancellor
of the Exchequer, George Osborne ordered the Managing Director of the FCA,
Martin Wheatley to conduct a review into Libor. This tasked him with looking at the
issues with Libor and all of its practices and then making recommendations for it.
This was agreed in 2012, however as mentioned above the banks themselves asked
the BBA to do this in 2008 (Finch and Vaughan, 2012). The main issues with Libor
are summarised below;
The first reason to reform Libor is because it is used as a benchmark for a true
reflection of banks borrowing and lending rates. However over time this type of
trading has slowed given the recent financial crisis. This means that the rate setters
in the banks have been basing their submissions on expert advice rather than actual
transactional data (Wheatley, 2012).
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The second reason as outlined in the Wheatley review and mentioned above is that
the banks and the people who work for the banks have an incentive to try and
manipulate the rate to either boost perception of their creditworthiness or to support
their trading positions (Wheatley, 2012).
The third reason is that because the process of submitting Libor rates is self-policing.
This leaves it open to manipulation in line with the incentives (Wheatley, 2012). This
basically means that if all of the rate submitters are manipulating the rates it does not
seem as if anyone is doing anything wrong. Something Tom Hayes implied as his
defence during trial.
The final reason is that there are weaknesses within governing arrangements for the
compilation processes and within contributing banks. This is basically in reference to
people such as Tom Hayes, Tan Chi Min, Anthony Allen and many others who have
not yet been publicly revealed, this is basically saying that there are still people
involved in the banks and quite possibly the governing bodies such as the BBA who
are willing to manipulate the rate for substantial financial gain with blatant disregard
for the integrity of the rate or themselves.
Taking all of this into consideration in line with a recommendation form Martin
Wheatley, it is very clear that Libor cannot and must not continue to operate as it
currently is. Even though some of the worst offenders have been caught and have
either been or are currently being dealt with by the authorities, there needs to be
changes made to Libor that will prevent this sort of conspiracy happening again.
Similar to how the Regulators dealt with the fallout from the financial crisis, with
things such as stress tests for banks, Libor needs an overhaul in order to be
financially trusted again.
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6.2 Recommendations for Reform
In the Wheatley report there are two main areas that have been identified with
regards to reform. The first area is the strengthening of Libor (Wheatley, 2015). This
would entail changing the way that the rate is calculated and finding a formula that
would prevent any outside parties having an influence on the rate. Something similar
to the how the Bank Of England sets interest rates could be an option in that an
impartial body sets the rates and the banks use that rate. However this would need to
be based upon transactional data and as mentioned above, there has been a huge
decline in the trading on the Forex market. This would still not the make the rate
immune to manipulation. Due to the low numbers of transaction being doing a small
number of off-market rates would be able to skew the rate (Wheatley, 2012).
Another option for strengthening Libor could be to publish each banks submission for
each currency daily (Wheatley, 2012). This would create transparency throughout the
rate with everyone being able to see what each bank thinks the rate would be. Ideally
the submissions should all be similar as many of the banks are in similar financial
positions. However by publishing the rates it would make it much easier to spot if any
banks were trying to influence the overall rate. The threat of regulators and
authorities being able to spot the manipulation, with either a very high or very low
rate, could be enough of a deterrent to force the banks to be completely truthful. This
is simply a suggestion and may not be a viable option on its own, as it may need to
be coupled with the previous option of real consequences for manipulation.
A final way the Libor rate could be strengthened is by increasing the amount of
regulation or security surrounding the rate. As discussed rate setters, traders and
brokers were all able to influence the rate though the submitters at banks. They were
able to do this because the treat of any repercussions was almost non-existent. By
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increasing security surrounding the setting of the rate and having a real threat of
serious consequences for any manipulation would deter individuals from trying to
skew influence the rate in their favour. The recent conviction of Tom Hayes for his
crimes has done a lot in terms of forcing people to realise they will not get away with
manipulation and prompting banks to intensify their compliance policies, however this
is not enough. There needs be a specific legislation or regulation brought in to clearly
set out that if anyone is found to be influencing the rate there will be severe
punishments as they are not only tarnishing their own reputation but also harming the
integrity of the financial sector as a whole.
The second area identified for reform is to find an alternative to Libor (Wheatley,
2012). This would mean abolishing Libor completely and using a different rate. By
doing this, the regulators would need to come up with a new rate which would be
suitable, they would need to propose a new calculation methodology and they would
also need to take into consideration the cost of moving any existing contracts on
Libor on to the new rate. The specific issues that each point would need to address
are summarised below:
When finding a new rate the main thing to consider is, will it be able to perform in the
market in the same way as Libor? This is not meant in terms of will the rate be able
to handle the transactions it is more about will the rate appropriately incorporate
some of the main characteristics that make up Libor. These characteristics, as
mentioned in Chapter 3, are the types of risk that Libor incorporates when setting the
rate. The first is the bank term credit risk, this as discussed, incorporates the amount
of risk the counterparty is undertaking when agreeing to the loan. A new rate would
need to be able to add this to the equation however, it may prove difficult if the rate is
set independently as the rate setter may not know how much risk the party is
undertaking.
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The second characteristic to be considered is the liquidity risk. An independent rate
setter would need to be sure that a bank is not going to need to liquidate the funds
quickly during the loan period an if there was possibility, would need to compensate
the bank accordingly until the end of the loan term. A possible solution to this could
be the rate setter assuming the risk from banks. For example if the Bank of England
were to set the rate they could absorb the risk by agreeing with the banks that if they
needed to liquidate the cash quickly the Bank of England would give the cash to the
bank and when the loan term ended the cash would be paid back to the Bank of
England rather than the bank. However this would not be feasible as the Bank of
England may not have the funds to lend out if this were to happen to multiple banks
at once.
The characteristics mentioned above would need to be included the method of
calculation. This could again prove problematic, as even with the current formula
there is no exact percentage that these types of risk take up in the overall figure. Due
to the nature of the risk involved they tend to be variable rates differing between
banks as they all trade different volumes of the available maturities and currencies.
This would then mean that some banks might have to deal with higher amounts of
risk than they need to, possibly costing them money.
Another barrier to creating an alternative rate to Libor is the cost of transferring
contracts from the existing rate to the new one. This could not just be an overnight
process due to the length of some maturities that are used on Libor. As mentioned in
Chapter 3 there are maturities, which can be very long term, ranging from 6 months
up to 12 months. If a new rate was introduced the authorities would need to consider
two options. The first option would be to decide a date on which all banks would have
to stop using certain maturities so that they would have time to run for the full term of
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the loan without being changed and possibly changing the return to either party
involved in the loan. This is because changing the rate may mean that that either the
borrower or lender could see less of a return with a new rate than they would receive
from the rate used when the contract was agreed.
If the regulators were to consider when the longest-term loans would finish they could
set the date after this as being the start of using the new rate and then put
restrictions on other trading according to the length of those terms. For example if the
12 month maturities ran out December 31st 2016, they could stop any trading of 12
month rates in the old benchmark after the 31st December 2015, and then for each of
the maturities less than this adjust the final trading rate i.e. no 11 month maturities
after January 31st 2016. The regulators could then say that the trading of 12-month
maturities could begin on January 1st 2016 using the new rate and continue this way
with each of the maturities until all of them were using the new rate. This would then
mean that banks with open positions in all their maturities would be able to keep
them in place for their duration and continue trading. This would also eliminate the
possibility of reform coming in too quickly which feared as it may cause chaos to the
$300tn worth of contracts open in the market (Masters, 2012).
In conclusion to all of the facts presented here it is very clear that there is a definite
need for reform as the Libor rate cannot go on operating as it is now. It seems to be
that the manipulation of Libor had become somewhat of an age old practice that is
simply no longer accepted. The situation was left to get out of control before
something was done about it, however as mentioned throughout the report many
warnings and doubts had been ignored. It can be argued that if these warnings were
not ignored the whole scandal could have been avoided, however if this had been the
case there is no evidence to say that the rate would have been reformed and the
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manipulation could have happened regardless. So in a way it can be seen as good
thing that the rate got to a point to force the reform.
To answer a question offered in Chapter 5 ‘did the regulators let the manipulation
happen on purpose to force reform?’ The evidence points to the conclusion that the
regulators were not letting it happen on purpose, rather they just didn’t care that it
was happening, shown by the fact that the CFTC contacted the FSA and the FSA
decided not to act upon their suspicions.
In the time after the Wheatley review there have been movements towards the
reformation of Libor albeit little ones. As a result of the review the BBA has been
removed as the governing body of Libor and were replaced by the Intercontinental
Exchange (ICE) Libor. This could hint at the regulators are moving towards a new
benchmark that doesn’t just serve London but is used worldwide.
It will be sometime before any real significant changes are made to Libor as due it’s
size and complexity it is no little task to perform an overhaul of that magnitude
however one thing is for sure, there is definitely reform coming and this will surely be
welcomed by the market.
Conclusion
In conclusion to all of the facts presented here it is very clear that there is a definite
need for reform as the Libor rate cannot go on operating as it is now. It seems to be
that the manipulation of Libor had become somewhat of an age old practice that is
simply no longer accepted. The situation was left to get out of control before
something was done about it, however as mentioned throughout the report many
warnings and doubts had been ignored. It can be argued that if these warnings were
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not ignored the whole scandal could have been avoided, however if this had been the
case there is no evidence to say that the rate would have been reformed and the
manipulation could have happened regardless. So in a way it can be seen as good
thing that the rate got to a point to force the reform.
To answer a question offered in Chapter 5 ‘did the regulators let the manipulation
happen on purpose to force reform?’ The evidence points to the conclusion that the
regulators were not letting it happen on purpose, rather they just didn’t care that it
was happening, shown by the fact that the CFTC contacted the FSA and the FSA
decided not to act upon their suspicions.
In the time after the Wheatley review there have been movements towards the
reformation of Libor albeit little ones. As a result of the review the BBA has been
removed as the governing body of Libor and were replaced by the Intercontinental
Exchange (ICE) Libor. This could hint at the regulators are moving towards a new
benchmark that doesn’t just serve London but is used worldwide.
It will be sometime before any real significant changes are made to Libor as due it’s
size and complexity it is no little task to perform an overhaul of that magnitude
however one thing is for sure, there is definitely reform coming and this will surely be
welcomed by the market.
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