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LIBOR – INTRODUCTION

The London interbank offered rate (LIBOR) is a primary benchmark for short term interest rates globally and is used as the basis for settlement of interest rate contracts on many futures and options exchanges. It is used in    Used in loan agreements throughout global markets Mortgage agreements Considered as a barometer to measure the health of financial money markets.

Although reference is often made to the LIBOR interest rate, there are actually 150 different LIBOR interest rates. LIBOR is calculated for 15 different maturities and for 10 different currencies. The official LIBOR interest rates (bbalibor) are announced once a day at around 11.45am London time by Thomas Reuters on behalf of the British Bankers association (BBA). American dollar - USD LIBOR Australian dollar- AUD LIBOR British pound sterling - GBP LIBOR Canadian dollar- CAD LIBOR Danish krone - DKK LIBOR European euro - EUR LIBOR Japanese yen - JPY LIBOR New Zealand dollar - NZD LIBOR Swedish krona - SEK LIBOR Swiss franc - CHF LIBOR

Each day, the BBA surveys a panel of banks, asking 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 11 am?”. The BBA throws out the highest and lowest portion of the responses, and averages the remaining middle. The average is reported at 11:30 a.m. LIBOR is actually a set of indexes. There are separate LIBOR rates reported for 15 different maturities (length of time to repay a debt) for each of 10 currencies. The shortest maturity is

Two unlikely circumstances would have to occur for a single misstated LIBOR submission to have a material impact on the calculation of the trimmed mean i) a substantial differential between the top and bottom quartiles. there would be no impact on the resulting LIBOR calculation. In most instances. The global credit crisis in 2007 and 2008 exemplified the limitation in deriving LIBOR based on estimated borrowing rates. many private contracts reference the three month dollar LIBOR. In addition. . It is a self-reporting process as each submitting bank provides to the BBA an estimate of the interest rate at which the bank believes it could borrow from other banks. During the peak of the crisis in which there was considerable dislocation in the credit markets. in instances where both the manipulated submission and correct submission were to fall into the same top or bottom quartile. An example is illustrated below to explain how a small variation in the submitted rate by a bank can alter the overall LIBOR rate. market-based price. by its very nature. LIBOR is determined based on a trimmed mean approach. a single misstated LIBOR submission would have very little or no impact on the calculated trimmed mean. In the United States. which is the index resulting from asking the panel what rate they would pay to borrow dollars for three months. LIBOR-submitting banks’ short-term financing composition shifted from interbank borrowings to government-issued financing. Trimmed mean averaging reduces the effects of outliers and can provide a more robust estimation of the average than an arithmetic mean of all data points. The decline in interbank borrowing may have made it more difficult for banks to accurately assess their interbank borrowing rates. For example. it is not a precise.overnight. and ii) a bank would have to submit a misstated rate that would cause the rate either to be included in the trimmed mean calculation as stated or to fall in a different quartile than it would have had it not been misstated. WHAT WENT WRONG AND HOW DID THEY MANIPULATE? The BBA’s rate-setting process has certain inherent subjectivities. the longest is one year. It is an estimate rather than an actual interbank borrowing cost.

The rate of 4. the financial press started writing about potential abuses. Bank 2 becomes the second lowest among the 18 submitted rates. and the rate of 3. In Panel B.15%.9%. which was correctly excluded under the Panel A calculation. is now included and part of the averaging process. but is submitted as 3.” The Wall Street Journal in April 2008 also ran the first of several articles about Libor’s reliability. using the trimmed mean approach.6% submitted by Bank 5.6% submitted by Bank 15. almost five years ago. is now excluded from the averaging process. Gillian Tett in the Financial Times appears to have been the first: On September 4 of that year she quoted a banker as calling Libor “a fiction. . including at meetings of bond trading associations and even in government publications. reflecting what their sources were telling them. Panel C demonstrates how this incorrect submission affects the ultimate computed rate. How so? Largely it has to do with the nature of Libor and Euribor themselves. based on the rates submitted by the 18 banks. rates for Banks 1 through 4 (top 4) and Banks 15 through 18 (bottom 4) would be excluded and the resulting average would be 4. on the other hand.As illustrated in Panel A of Exhibit 2. With the submission at 3.35%. At the same time. As a result. WHEN DID THEY START MANIPULATION? Starting in the fall of 2007. using data from the markets themselves. we assume that the correct rate for Bank 2 is 4.35%.05% (10 basis points lower than what it should be). suspicions started being aired in more official circles. the calculated LIBOR has dropped to 4.

Investors. the Libor and Euribor rates tracked quite accurately the rates that were actually transacted. He’s a French former swaps trader with a long record in the markets.3 basis points. the rates that the banks submit in these sessions are not the rates they are actually paying to borrow money.4%. cover 10 currencies. he gave a presentation to the annual meeting of the European Bond Commission. The top and bottom 25% of these submissions are eliminated. hedgers. there was a very significant divergence between the benchmark Libor and Euribor rates. But. In general. Jean-François Borgy spotted that at once. LIBOR levels have become a signal to the . and the periods range from overnight up to a year. As Borgy explained in his 2007 presentation.These rates are set by panels of banks who meet daily to disclose the average rate at which they can obtain unsecured funding for a given period. borrowers globally. but rather the rates that they estimate they would have to pay. and the rate is calculated using the average of the 50% that are left. But with the crisis it suddenly jumped to 40 basis points. the Eonia rate is drawn from the same 47 banks who are involved in the Euribor fixing. benefits the borrowers and hence it’s against banks interest to keep LIBOR low. Until the 2007 crisis. and which are noted by central banks. after Lehman. for example. mortgage borrowers etc. while Euribor simply reflects what the banks say they will do. almost without exception had been mirrored by the effective European overnight rate based on actual transactions. For a trader. in October 2007. he showed how the Euribor three-month rate had. that’s a huge and obvious change. lower LIBOR hurts banks as lenders. Banque Worms and Natixis. the difference is that Eonia reflects real transactions by the banks. or 0. and the actual transaction rates. The Libor fixings. He was so struck by the change that.063%. The spread or difference between this Eonia (Euro OverNight Index Average) rate and the Euribor rate had consistently been 6. Pensions funds. since the 1999 introduction of the euro as a currency. IMPLICATIONS ON GLOBAL FINANCIAL MARKETS Parties involved in LIBOR linked financial instruments are numerous banks. critically. But suddenly. However during the crisis. having worked for Credit Lyonnais. or 0. In a series of charts.

If included then they would have had only 2 bps impact on LIBOR. However when multiple banks gives data in such a way that it get included in that LIBOR will be higher. adverse movements in LIBOR. Calculating fair level itself s difficult. In many cases. At that time irrespective of the gains/losses on the lending. Complexity of Securitized Cash Flows Many special purpose vehicles (SPVs) that issue securitized debt (also described as securitized products). IMPACT OF SCANDAL    During the crisis period investors and lenders lost money for LIBOR being artificially low and borrower saved money In pre-crisis period. a number of submitting banks had interest in submitting a lower rate and keeping the LIBOR low. an institution that experienced losses on certain transactions as a result of an artificially low LIBOR could have also experienced gains on other transactions. many corporations and financial institutions that purchase floating-rate investments also issue floating rate debt. The universe of securitized products is vast and such vehicles often have complex waterfall structures and unique triggers that affect cash flows to the various investor classes. have both liabilities and underlying assets that pay coupons tied to LIBOR. it’s difficult to judge who gained and who lost since LIBOR fixing could be higher or lower than fair levels. If a bank underreported by 20 bps we have to see whether the banks submission was included or excluded. Net Impact In many instances. SPVs have also entered into LIBOR based derivative contracts to match the asset and liability cash flow characteristics and/or protect investors against the impact of large. If the latter applies. Gross vs. For example. Estimating the true extent of losses associated with LIBOR manipulation would in many cases require sophisticated financial modelling capabilities. . The key question in these instances surrounds whether the financial impact should be assessed on a gross or net basis. an analysis of the total LIBOR-indexed portfolio may need to be performed in order to estimate the net economic impact of any alleged LIBOR manipulation and to return the plaintiffs to the economic position they would have enjoyed “but for” the alleged manipulation.market. such as collateralized debt obligations.

This could affect the mark-to-market value of many over-the-counter derivative instruments and could have major implications for collateral and margin requirements. Artificially low spot LIBOR could have a spill over effect and lead to a depressed forward curve. For example. . many interest rate derivatives are valued based on projected future interest rates (usually referred to as a forward curve).Forward Interest Rate Curves There are other potential second order effects which are difficult to quantify or estimate.