Is LIBOR, Benchmark for Trillions of Dollars in Transactions, a Lie?

http://www.rollingstone.com/politics/news/taibbi-is-libor-crucial-financial-benchmark-a-lie-w497305

by signor_bosco • 9 years ago

276 85 9 years ago

lordnacho3• 9 years ago

Pretty much everything that has derivatives tied to it is manipulated. Option expiries, FX fixes as well. Or it was when I was looking at it.

The thing is there are derivatives that are sometimes non-linear, things with triggers and barriers. When some large enough fish has one of these (eg by taking the other side vs a customer) they have an incentive to move the rate in whatever way they can. Whether it's getting someone to submit a bad rate or sitting on an FX cross, it can be worth it.

Before I went full quant I was often looking at the screens manually. You'd often see at around the WM/Reuters fix that the price would move strangely. An unusually large move would happen with no apparent news. You'd get a rumour from a broker, but who knew how they knew? And quite often the move would fade after the window closed.

This would happen even in exchange traded options. If you knew the specifics of the settlement window, you would know when the price would go wonky. You wouldn't know who, but you knew that is wasn't a normal time in the market.

The LIBOR was a bit less obvious, only really clear to me in hindsight. Swaps don't have a common schedule like listed options, so there's a fixing every day that could be in someone's interest to influence. Same goes for FX, but since LIBOR is a bunch of opinions (as opposed to trades) it's not as obvious.

JumpCrisscross11• 9 years ago

This would happen even in exchange traded options. If you knew the specifics of the settlement window, you would know when the price would go wonky.

Exchange-traded options settle on a predictable window; there's no "if you knew" to it [1]. Also, the price goes wonky near expiries because that's when delta approaches one. Market makers switch from hedging with derivatives to hedging with spot; that means jitters.

Not saying there's no fraud. But pricing going wonky around a settlement event makes sense as everyone prepares for it.

[1] http://www.dtcc.com/~/media/Files/Downloads/legal/service-gu...

lordnacho3• 9 years ago

Yes, I used to work in this. "If you knew" should say "Because you knew"...

Might actually be a reason for the exchange to fuzz the expiry (eg random time) but that has its own problems. People do have to look at the options as they expire for legitimate hedging reasons.

coliveira4• 9 years ago

Your understanding of the market doesn't consider that there are big players who overshadow everyone else. Yes, everybody prepares for the expiration of an option, but very few players can do anything to influence prices. Only a handful of institutions can successfully trade around these expiries, which is what the commenter above is mentioning.

wahern• 9 years ago

Retail and transactional banking have built-in incentives for honesty, at least with other banks. Banks are repeat players in a millennia old game. The banks primarily profit by charging their clients for their services. There's little upside and tremendous downside for being dishonest.

But when investment and retail banking merged, the stable system of incentives disintegrated. Before the merger, retail banking was more expensive, but it was incredibly stable; that premium was more than worth the cost. I don't see why investment banking needs to merge with retailing banking anymore than VC firms need to merge with retail banking. It just results in a chaotic system.

In an increasingly electronic age where the technical transactional costs are quickly eroding to nothing, you don't gain much efficiency by merging these roles. The remaining transactional costs are functional and specifically serve to ensure that incentives are well-aligned internally and externally. Removing those barriers merely permits people to extract all that value, diminishing the overall value of the systems and the economy in general.

Likewise, the global value of assets is so tremendous that investment firms don't need direct access to the capital within the retail banking sector. We're quickly approaching something like $100 trillion in highly liquid investments globally.

justincormack• 9 years ago

Even the retail banking behaviours broke down, eg look at RBS being sued now for bankrupting its own customers for gain https://www.theguardian.com/business/2016/apr/25/rbs-royal-b...

ThrustVectoring2• 9 years ago

Doesn't this work as an argument against cash-settling options and futures? Owning a giant pile of call options and driving the price up during the settlement window doesn't help you any if you have to unload a massive quantity of the underlying stock.

lordnacho3• 9 years ago

Forgot to mention it was mainly indexes I was talking about, and they are cash settled.

Single stock options tend to be settled with actual stock, and at least in Europe tend to be a lot less liquid. And there's other problems with trading them, like other people knowing a lot more than the market maker about what's happening. You also have pin risk which seems to be like a magnet.

cm21876• 9 years ago

There were two kinds of libor manipulations. Those instructed by the management of the banks to reduce the perception of the bank struggling to fund during the crisis, and the manipulations requested by the swap traders before the crisis.

I suspect the swap traders were mostly targeting future delivery dates (4 fixings a year). That's the only way the fraction of basis points they were asking the submitters to move the fixing by would have any material P&L impact. So it's kind of like other markets with strandardised contracts.

The former manipulation would have affected every days fixings.

rbcgerard• 9 years ago

yeah - imagine what physical commodities traders can do in the physical market that can have huge financial derivative impacts for them...

totalZero• 9 years ago

How were option expiries manipulated when you were looking at them? Or do you just mean that stocks tend to trade differently when a large position is expiring? Sometimes it's just innocuous things like a market maker trading out of his delta from gamma.

zzalpha3• 9 years ago

For folks who feel like they knew about this story already: read the article.

LIBOR fixing is one thing. But the realization that there is no market that LIBOR measures is truly astonishing!

2021 will be an interesting year...

JumpCrisscross11• 9 years ago

there is no market that LIBOR measures

Except that's not true. Interbank lending is still a $70 billion market in the United States alone [1]. Small compared to banks' balance sheets and less than the $500 billion from as recently as February 2008, but material nonetheless.

Good rule of thumb in finance is to ignore Matt Taibbi.

[1] https://fred.stlouisfed.org/series/IBLACBM027NBOG

rcarrigan87• 9 years ago

I agree, his reporting is terribly one-sided.

zzalpha3• 9 years ago

And Matt Levine, who said the exact same thing in an article posted in this comment thread?

But a second problem is that the banks might not even know. Libor surveys asked banks each day what they would have to pay to borrow money unsecured from other big banks, but over time the banks sort of stopped doing that, particularly in some of the more obscure combinations of tenors and currencies that nonetheless reported Libor rates. So the banks' Libor submitters would guesstimate their submissions based on deposit rates and commercial-paper rates and secured-borrowing rates and other tenors and what brokers and their buddies were telling them.

Last I'd checked Mr. Levine was pretty well regarded.

Not that it matters... We're well into ad hominem and argument from authority territory here.

c3534l2• 9 years ago

Yeah, the article flips between somewhat sensationalist black-and-white statements that imply to the less savvy reader that LIBOR is an arbitrary number decided by a secret cabal of bankers to more reasonable statements like interbank lending is falling and LIBOR is an increasingly poor choice to measure interest rates.

throw20163• 9 years ago

On the contrary Matt Taibbi has done some incredible work exposing the out of control culture of fraud and greed in the financial markets and the litany of fixing scandals.

Please read his work and make up your own mind.

The Libor fixing is real as is the FX rate fixing. Apologists for the banking system and governments often demand the the smoking gun in fraud and conspiracy even when its not always possible, unless at great personal cost like in Snowden, but here the smoking gun and entire armory is out in the open. Attempting now to discredit the messenger is disingenuous.

jkaptur• 9 years ago

I'm not a domain expert, but both could be right - isn't the point that some currencies and tenors are very illiquid, not that the entire market doesn't exist?

twic• 9 years ago

AIUI, most of that lending is overnight. LIBOR ostensibly measures three-month deposits, which don't see much volume these days.

Afforess• 9 years ago

This article contains a rather poor explanation of what LIBOR is and the history around it. Matt Levine does a much better job: https://www.bloomberg.com/view/articles/2017-07-27/the-end-o...

Back in the 1960s, a Greek banker in London[1] wanted to find a way for banks to make syndicated floating-rate loans. He found a very simple answer: The banks would lend money to a company, charging their cost of funds plus a spread, and every three months, you'd go out and ask the banks what their cost of funds was, and you'd average their answers, and that (plus the fixed spread) would be the new interest rate on the loan. This was a simple product for the banks: They could pass their costs on directly to the customer, and make a fixed profit (the spread). And by surveying all the big banks and throwing out outlier submissions, you could get a pretty fair approximation of the overall funding cost for banks.

And so this -- Libor, the London interbank offered rate -- became the normal way that everyone did floating-rate loans, and then it became the normal way that everyone did interest-rate derivatives, and then it became the normal way that everyone did ... sort of ... everything? Libor just sort of became The Interest Rate, used for discounting cash flows in all sorts of transactions, "the most important number in the world." But it was always based on a survey of banks' funding costs, and so it was always a little hazy. One problem was that the banks could lie. But a second problem is that the banks might not even know. Libor surveys asked banks each day what they would have to pay to borrow money unsecured from other big banks, but over time the banks sort of stopped doing that, particularly in some of the more obscure combinations of tenors and currencies that nonetheless reported Libor rates. So the banks' Libor submitters would guesstimate their submissions based on deposit rates and commercial-paper rates and secured-borrowing rates and other tenors and what brokers and their buddies were telling them. It was all more or less good enough as a casual system for resetting the rates on a few billion dollars worth of syndicated loans, but it was not accurate down to the hundredth of a basis point as a foundation for the financial system, or as the source for pricing hundreds of trillions of dollars of derivatives.

[1] Minos Zombanakis: https://www.bloomberg.com/news/features/2016-11-29/the-man-w...

tptacek• 9 years ago

Matt Levine is so much better on these topics than Matt Taibbi that one might hope the site would switch URLs. But, of course, accuracy is not the reason people read Taibbi's financial reporting. They're both humorous writers (though in different ways; Taibbi is the better of the two as stylists), but Taibbi is also emotionally satisfying.

It would be helpful if people kept providing Levine pieces to accompany Taibbi pieces.

res0nat0r• 9 years ago

The Spider Network, about the banker in the center of the scandal from a ways back just came out earlier this year and was an entertaining read.

https://www.amazon.com/dp/0062452983/ref=cm_sw_su_dp

al452• 9 years ago

In some ways agree, except that I do not find Taibbi's rage-driven ignorance-fuelled style in any way "emotionally satisfying".

xefer• 9 years ago

There are so many bilateral derivative contracts tied to LIBOR what would it even mean for this benchmark to go away?

cm21876• 9 years ago

I don't think it will completely go away. It will be replaced by some other benchmark calculated differently. Derivatives won't be a problem as the ISDA association can make a decision that would automatically convert all contracts. Bonds and private contracts will be more of a problem as they don't necessarily have a language for what happens if the index stops being published.

smallnamespace2• 9 years ago

This is old news for large portions of the interest rate derivatives market, which is quickly moving towards OIS[1] rates instead, based on widely traded liquid instruments.

Also, the implication that LIBOR is purposefully a scam is basically untrue.

When LIBOR was first developed, it was an improvement on other interest rate benchmarks, and it also reflected current market conditions at the time, as banks actually did regularly make bilateral interbank (the 'IB' in LIBOR) loans to one another.

There are checks built into LIBOR to discourage fraud: for example, the actual calculation discards the high and low outliers, so individual banks cannot manipulate the benchmark easily[2].

But as the interest rate market continued developing, much of the actual lending transaction volume moved towards other markets; the financial crisis just accelerated that trend.

So now we have a lot of contracts written against a benchmark that slowly stopped reflecting an actual interest rate market. The right path forward would probably be to renegotiate these contracts so that going foward, they're against OIS instead.

[1] https://en.wikipedia.org/wiki/Overnight_indexed_swap [2] https://en.wikipedia.org/wiki/Libor#Calculation

eightysixfour• 9 years ago

That's what the article stated - that at one point it made sense but banks found cheaper ways to get capital and slowly stopped lending to each other as much.

cm21876• 9 years ago

Also most banks got badly burned with fines after the Libor scandal and introduced a pretty strict process to ensure that doesn't happen again.

The "fantasy" the article is referring to is the fact that large banks have to submit a number for every currency and every tenor every day, even if they didn't fund in that currency and that tenor that day. They will usually interpolate based on other tenors.

However this is only a problem for the lesser used tenors (like 2m, 8m), the most referenced tenors in private contracts (1m, 3m, 6m) tend to trade very frequently.

JumpCrisscross11• 9 years ago

The most substantial change was reducing the number of currencies and tenors Libor is quoted in. Gone are the Australian dollar, Canadian dollar, New Zealand dollar, Danish krone, Swedish krona, 2 week, 4 month, 5 month, 7 month, 8 month, 9 month, 10 month and 11 month Libors [1]. That's an 80% reduction in the number of currency-tenors Libor is quoted in.

[1] https://en.wikipedia.org/wiki/Libor#Currency

chinathrow• 9 years ago

There are checks built into LIBOR to discourage fraud

https://en.wikipedia.org/wiki/Libor_scandal

jwfxpr• 9 years ago

'Discourage', obviously, is distinct from 'prevent'. But those checks were enhanced in the wake of the scandal, and it is based in large part on the strength of those enhanced checks that this conclusion about the underpinning validity of LIBOR has been drawn.

We can all agree, though, that the next iteration could do more to stop manipulation and fraud.

JumpCrisscross11• 9 years ago

they're against OIS instead

OIS stands for overnight indexed swap [1]. Like the fed funds rate [2], it's only quoted for one tenor: overnight.

In the United States we're somewhat spoiled with having a deep, reliable, market-based yield curve calculated every business day: the Treasury yield curve [3]. But if you want to approximate the cost of a bank borrowing for a given term on the wholesale unsecured market, Libor is still the default reference.

[1] https://en.wikipedia.org/wiki/Overnight_indexed_swap

[2] https://en.wikipedia.org/wiki/Federal_funds_rate

[3] https://www.treasury.gov/resource-center/data-chart-center/i...

smallnamespace2• 9 years ago

Like the fed funds rate [2], it's only quoted for one tenor: overnight.

That's not quite true -- for example, 3m OIS swaps have fixings that are essentially the 3m average of FF over the period in question.

In fact, this is mathematically a bit cleaner. If you construct an interest yield curve off of compounded 1m LIBOR vs. 3M LIBOR, you get rather different answers, whereas OIS yield curves constructed from different tenors are much closer.

The argument for using OIS instead of Treasury yields is pretty simple: Treasuries reflect the cost of borrowing for the government and are implicitly affected by the government's creditworthiness (e.g. not raising the debt ceiling), while banks can actually borrow from the Fed at FF. While the US gov't funds at pretty close to 'risk free', in other markets the credit component would be significant.

OIS is generally closer to LIBOR than a Treasury yield curve is.

cm21876• 9 years ago

I think you are mixing overnight index and overnight index swap. Derivative discounting is based on the index referenced in the CSA, which is typically an overnight index (Fed Fund in USD). To build a forecast curve for this index (and therefore a discount curve) you need to use swaps paying that index, ie OIS, hence the term OIS discounting. You can have any tenor you want for an OIS. When people refer to an OIS and don't specify the tenor, they usually mean a 3m swap, but you can 10y OIS.

You could document a loan paying quarterly with an interest calculated as the average o/n index for these 3 months. In fact that's how weekly CSA work. But that's not very practical for smaller non financial clients. It would be better if there was an index they can observe directly.

lomnakkus• 9 years ago

Just by your terminology, I trust that you know (at least somewhat) what you're talking about, so... is there an ELI5 for this stuff? I'm completely lost in these types of discussions. They seem absurdly complicated for (good|bad) reasons? Are we looking at another complexity bubble that's going to burst in 5-10 years... to the detriment of everyone but the "top execs" who'll be bailed out?

My impression after reading "Too Big To Fail" -- which, BTW is an amazingly well-written book[1] -- is that "they" will probably get away with all this confusion and obfuscation... right?

I really do want to learn at least a little bit, but it seems like such an impenetrable world of concepts, and I really do want to avoid the "news-based" or even "journalist-based" approach to learning about this subculture. (When a Dartboard fares better that your average journalist/investor-proxy, you know you have a gambling problem.)

[1] Not sure how accurate it is, but it's really well-written and exciting. Unfortunately, it doesn't delve that much into the technical concepts in Finance :(, though it does mention LIBOR at least once.

tanderson92• 9 years ago

Regularly read Matt Levine's Bloomberg column and the articles he links to and you'll pick up more than you ever thought you would know about finance. It is also fun, how he explains things.

Note: not a substitute for formal study of these things.

cm21876• 9 years ago

If you read the market section of the FT every day for a year, you will probably read enough articles with an introduction to all of these concepts to have a good enough understanding. But like any other profession, if you dive into the details, it can get quite complicated very quickly. There are lots of introductary books to each area of finance. For interest rates, the best book I have read is Interest Rate Swaps and Their Derivatives: A Practitioner's Guide by Amir Sadr. It's been written a few years ago and some things have moved on since but that's still an excellent, very practical, not too mathematical introduction to interest rate products.

jpttsn2• 9 years ago

Good reasons, imho. The complexity is not (purely) a smoke screen thrown by conspiratorial insiders.

Most of the harder tech HN articles would seem just as impenetrable to regular Bloomberg Terminal users.

Spooky23• 9 years ago

Markets need transparency and trust to be effective.

cperciva• 9 years ago

On the one hand, LIBOR is a completely made-up number. On the other hand, so are central bank rates.

If you're going to peg transactions to a made-up number, is LIBOR really any worse than anything else?

bboreham4• 9 years ago

Central banks actually will lend (or take deposits) at their rate. So in that sense it's not made-up.

coliveira4• 9 years ago

Does it matter? Central banks are creating money, so of course they can pay the interest rates they made up from whole cloth.

Torai• 9 years ago

It later came out that banks had not only lied about their numbers during the crisis to make the financial system look safer, but had been doing it generally just to rip people off, pushing the number to and fro to help their other bets pay off.

Written exchanges between bank employees revealed hilariously monstrous activity, with traders promising champagne and sushi and even sex to LIBOR submitters if they fudged numbers.

"It's just amazing how LIBOR fixing can make you that much money!" one trader gushed. In writing.

Maybe this is old news, but they should be imprisoned for it.

bboreham4• 9 years ago

Some have been jailed. Jay Merchant, Tom Hayes, etc.

dogruck3• 9 years ago

Ah, Rolling Stone -- great source for solid info on LIBOR.

65827• 9 years ago

Are you dense? Matt Taibbi is possibly the most informed and important financial journalist of the last several decades.

dogruck3• 9 years ago

Thanks for the insult.

Matt Taibbi has an unabashed, heavily liberal bias. He sells by appealing to readers like you.

I would argue that Michael Lewis is a superior popular finance writer.

NelsonMinar• 9 years ago

Taibbi's gonzo style is amusing shtick, but frequently exaggerates. If you'd rather read a boring but reliable Economist take on the same story: https://www.economist.com/news/finance-and-economics/2172581...

The facts are more or less the same in both stories.

ojosilva• 9 years ago

The Euribor, which governs my mortgage, uses the same interbank lending sources as the LIBOR.

http://www.euribor-rates.eu/what-is-euribor.asp

But I can't say I'm unhappy with it: never have I paid so little interest on anything I've ever owed, Euribor is negative right now and I'm loving it.

Whatever means of calculation or manipulation are being used, they are working out in my favor today. Maybe a stricter regulation would limit the banks abilities to lend competitively, which may not be in neither their, mine nor the government's favor.

heisenbit• 9 years ago

But beginning in the mid-nineties, banks began to discover that other markets provided easier and cheaper sources of funding, like the commercial paper or treasury repurchase markets. Trading between banks fell off.

The continuous easy money policies have prevented the markets to price credit risks for a long time. This has manifested itself in a series of bubbles. Weaning off will be difficult. Not weaning off will ensure collision with a brick wall eventually.

veritas213• 9 years ago

it wasn't till it became.

There was clear evidence of fraud and broken fiduciary responsibilities which i belive are unforgivable.

LIBOR will still be around but its importance will diminish in perpetuity.

pjdorrell• 9 years ago

Surely some borrowers and lenders make decisions about making and taking loans based on the actual interest rates on the actual loans? In which case it doesn't matter so much if the rates are calculated based on a fictional assumption about something. At the end of the day every borrower or lender in the market makes their own decision about which lending contracts they take part in.

rbanffy• 9 years ago

Isn't the value of money a lie we all agree is true?

osrec• 9 years ago

Libor is clearly out of date and open to manipulation (as are a lot of measures in finance). It's funny how so much of finance is quite literally opinion, presented as a number attempting to masquerade as fact. Every stock price, every swap rate, every credit rating. They're just herded opinions, often churned out of poor quality models or unstable, easily manipulated processes! As for making libor up, in my opinion, it was pretty made up, even if it's original processes worked as expected. You see, it assumes integrity on behalf of it's contributors, and that assumption is utterly false; every bank has an ulterior motive to optimise in favour of its portfolio. Finance in general needs a rethink; it's full of obvious moral hazard, which has somehow been considered acceptable through the times. The interest rate markets are probably a good place to start shaking things up, as they are likely full of the biggest manipulations.

Is LIBOR, Benchmark for Trillions of Dollars in Transactions, a Lie?

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