Libor scandal: Explained

BY TIO Staff

|July 30, 2024

The Libor scandal, a financial debacle that came to light in 2012, shook the world of trading to its core. It was a revelation that exposed the manipulation of a key interest rate, the London Interbank Offered Rate (Libor), by some of the world's leading banks. This scandal had far-reaching implications, affecting millions of contracts worldwide and leading to billions in fines for the banks involved. This article aims to provide a comprehensive understanding of the Libor scandal, its origins, implications, and its impact on the world of trading.

The Libor rate is a benchmark interest rate used globally, affecting trillions of dollars of loans and financial contracts. It is set daily by a panel of banks and reflects the rate at which they are willing to lend to each other. The scandal emerged when it was discovered that some of these banks were falsely inflating or deflating their rates to profit from trades, or to give the illusion that they were more creditworthy than they actually were.

Origins of the Libor Rate

The London Interbank Offered Rate, or Libor, was first developed in the 1980s as a standardized benchmark for short-term interest rates around the world. It was designed to reflect the average rate that banks are willing to lend to each other in the international interbank market. The rate is calculated and published daily by the British Bankers' Association (BBA).

Libor rates are calculated for five currencies (US Dollar, Euro, British Pound, Japanese Yen, and Swiss Franc) and seven borrowing periods ranging from overnight to one year. The rate is used as a reference for various financial products such as derivatives, loans, and bonds. The importance of Libor in the global financial system cannot be overstated, with an estimated $350 trillion in derivatives and other financial products tied to it.

How is the Libor Rate Set?

The Libor rate is set through a daily survey carried out by the BBA. The panel consists of the world's most prominent banks, each of which submits the interest rate at which it could borrow funds, were it to do so by asking for and then accepting interbank offers in reasonable market size, just prior to 11:00 am London time.

The submitted rates are then arranged in descending order, and the highest and lowest quartiles are discarded. The remaining rates are averaged to arrive at the Libor rate for that day. This process was designed to prevent any one bank from manipulating the rate, but as the scandal revealed, this was not foolproof.

The Unfolding of the Libor Scandal

The Libor scandal began to unfold in the wake of the 2008 financial crisis when it was discovered that banks were artificially manipulating the Libor rates. At the heart of the scandal was the revelation that banks were submitting false rates in order to profit from trades or to portray a more robust image of their creditworthiness.

The manipulation of the Libor rate was carried out by traders who would request specific Libor submissions to benefit their trading positions. This collusion between traders was often carried out openly, with little regard for the legality or the potential impact on the global financial system.

Discovery and Investigation

The first signs of the Libor scandal came to light in 2008 when the Wall Street Journal published an article questioning the accuracy of the Libor rates. The article suggested that banks may have been understating their borrowing costs to avoid appearing financially weak.

Following this, several regulatory authorities around the world, including the Financial Services Authority (FSA) in the UK, the Swiss Financial Market Supervisory Authority (FINMA), and the U.S. Commodity Futures Trading Commission (CFTC), launched investigations into the alleged manipulation of the Libor rates. The investigations revealed widespread manipulation by several banks, leading to hefty fines and a complete overhaul of the Libor setting process.

Impact on the Trading World

The Libor scandal had a profound impact on the trading world. The revelation that the Libor rate could be manipulated undermined trust in the financial system. The scandal also led to significant losses for many investors who had financial contracts tied to the Libor rate.

Furthermore, the scandal led to a tightening of regulations in the financial sector. Regulatory authorities around the world took steps to prevent such manipulation in the future, leading to increased scrutiny and higher compliance costs for banks. This has had a significant impact on the trading landscape, with many banks and financial institutions having to adjust their trading strategies and operations to comply with the new regulations.

Regulatory Changes

In the wake of the Libor scandal, regulatory authorities around the world implemented a series of reforms to prevent such manipulation in the future. These reforms included increased oversight of the rate-setting process, stricter penalties for manipulation, and the introduction of new benchmark rates to replace Libor.

For example, in the UK, the Financial Conduct Authority (FCA) took over the administration of the Libor rate from the BBA and introduced new regulations to ensure the integrity of the rate-setting process. Similarly, in the U.S., the Alternative Reference Rates Committee (ARRC) was established to identify a set of alternative reference rates that are more transparent and reliable than Libor.

Conclusion

The Libor scandal was a stark reminder of the potential for manipulation in the financial markets. It exposed the flaws in the Libor rate-setting process and led to significant changes in the global financial system. While the scandal had a negative impact on the trading world, it also led to important reforms that have made the financial system more transparent and robust.

As traders, it is crucial to understand the implications of the Libor scandal and the changes it has brought about. The scandal has highlighted the importance of transparency and integrity in the financial markets, values that are fundamental to the practice of trading.

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TIO Staff

Behind every blog post lies the combined experience of the people working at TIOmarkets. We are a team of dedicated industry professionals and financial markets enthusiasts committed to providing you with trading education and financial markets commentary. Our goal is to help empower you with the knowledge you need to trade in the markets effectively.