Here is an amazing primer by Donald Mackenzie on how Libor is fixed in London markets (HT: superb post in JRV blog) .
He explains all the mechanics of money markets in London and how this Libor process is done. It is like those Michael Lewis type articles. He wrote this article in 2008 and is quite prophetic as well. He does point to issues with Libor fixing as well way back in 2008. So the Libor scam was pretty much in making. This is what led Dr. Reddy to say in this lecture:
…In the discharge of semi-fiduciary functions that are critical to the integrity of financial markets, such as fixation of Libor and credit rating, the major global players in financial markets discredited themselves by resorting to questionable practices.”
Asked how he knew such market-sensitive information about the Libor scandal several days before the FSA announced its decision, Reddy says: “The moment investigation started, I knew that the well-known secret about manipulation of Libor will be out.” Note the phrasing about the “well-known secret” and the reference to the “major global players” in plural.
First why Libor is fixed in London when NY has been the centre of finance?
In a financial world dominated since 1945 by the US, it’s striking that the global benchmark is a set of London rates. Paradoxically, the reason for this is Britain’s failure – crystallised in the 1957 sterling crisis – to re-establish the pound as a major international currency after the war. That prompted the leading British banks increasingly to lend, borrow and accept deposits in US dollars (‘eurodollars’, as they came to be called). The Bank of England overcame its initial anxieties and came tacitly to support the eurodollar market, and the Johnson administration inadvertently encouraged it by trying to stem the flow of dollars overseas. Eurodollar operations conducted in London allowed US banks to circumvent the new controls.
The result was that London became – and in many ways remains – the centre of the international money markets. ‘Money’ here does not mean cash, but short-term loans between banks and other major institutions; more than a fifth of international lending of this kind still takes place in London.
Hmmm. To price Eurodollars, we got LIBOR.
How is it calculated? This is pretty well-known thanks to Barclays scam:
The calculation of Libor is co-ordinated by just two people, who work in an unremarkable open-plan office in London’s Docklands. I watched the process, which seemed utterly routine, a couple of years ago. Just after 11 a.m. on every weekday that’s not a bank holiday, traders at leading banks send in their estimates of the interest rates at which their banks could borrow money. They do this electronically, but sometimes the co-ordinators make a phone call to a bank that hasn’t sent in its estimates, and if the latter seem implausible – typos, for example, are fairly common – they’re checked, also with a quick call: ‘Hi there, is the Kiwi chap [provider of the estimates for borrowing New Zealand dollars] about? … Bit of a spread on the two month. Everyone else is coming in a good bit under that.’
A simple computer program discards the lowest quarter and highest quarter of the estimates, and calculates the average of the remainder. The result is that day’s Libor. The calculation is repeated for each of ten currencies and 15 loan durations (from overnight to 12 months), so 150 Libors are published daily: overnight sterling Libor, one-week euro Libor, one-month yen Libor, three-month US dollar Libor and so on.
The author explains brokers played a major role in making Libor popular:
Crucial to facilitating this market – and to enabling Libor to be calculated – were, and are, London’s money brokers. They emerged in the 1960s as a challenge to the traditionally staid, gentlemanly, top-hatted sterling money markets, in which lending took place via designated ‘discount houses’ backed by the Bank of England. Money brokers put lenders and borrowers directly in touch with each other, charging a fee for doing so. The business is fast-moving, and competition fierce and sometimes not at all gentlemanly. If you listen to brokers’ voices, you hear the tones of the East End and Essex more often than those of Eton or Harrow. Open-necked shirts are more common than suits and ties. While banks’ dealing rooms are now often disappointingly quiet and orderly places – in reality there’s far less shouting and swearing than in film portrayals – brokers’ offices are more tightly packed (there’s less space between desks) and more raucous.
Suppose a bank wants to borrow or lend in the interbank market. (It might want to lend because no bank likes to leave cash idle, even for the shortest period. Indeed, overnight lending is the busiest sector of the interbank market, with banks that have excess cash at the end of the working day lending to those that need it.) A bank’s money-market traders could directly contact their counterparts in other banks, but it’s usually quicker and easier to work through the brokers. This can now be done on-screen, but – especially if large sums are involved or market conditions are tricky and changing rapidly – it’s often better to use the ‘voicebox’. This is a combination of microphone, speaker and switches that instantly connects each broker by a dedicated phone line to each of his clients in banks’ dealing rooms.
It talks about how judgement matters in fixing the most important rate in the world:
Note the conditional: a Libor input is what a bank could do, not what it has done. So judgment is involved. A bank might not have borrowed anything in the minutes before 11 a.m. Deals for longer than overnight are intermittent, and there is little borrowing at some of the time periods involved, such as 11 months. ‘Reasonable market size’ is deliberately not defined exactly: it will vary from currency to currency and according to time period and market conditions. The need for judgment is why the information provided by brokers is important to the calculation of Libor. It helps a bank’s traders to estimate the rate at which they could borrow money, even if they’re not trying to do so.
They get some of the information they need from the screens provided by their various brokers: all serious traders employ several. The screens indicate the lowest rate at which banks are currently offering to lend and the highest rate at which they are prepared to borrow. Only the naive, however, would give the former rate as their Libor input. The screens don’t reveal the amount actually available for borrowing at the lowest quoted rate, and it may fall short of ‘reasonable market size’. It could range from a mere $50 million or so to a yard or more (‘yard’ – originally an abbreviation of ‘milliard’ – is the money-market term for billion, a word that in a noisy environment is all too easy to confuse with ‘million’).
What about the criticism? The criticism for Libor ahs been there for a while from US:
Much of the most vocal criticism of Libor has come from the US, and has focused on dollar Libor – especially three-month dollar Libor, the rate used more than any other in the swaps market. Some seem unhappy that the benchmark dollar interest rates are set in London just after 6 a.m. New York time, when traders are only starting to arrive at their desks, and that the US dollar Libor panel contains only three recognisably ‘American’ banks. The British Bankers’ Association – membership of which is open to any bank operating in the UK, wherever it is domiciled – counters by pointing out that all the banks on the panel are global institutions, some with a major presence on the ground in the US, and that collectively they are responsible for most London interbank dollar lending and borrowing.
The most prominent critic has been the Wall Street Journal. It has suggested that the public dissemination of banks’ inputs – which is intended to make the process more transparent – has the effect of biasing inputs downwards, because banks fear that reporting publicly that they can borrow only at high rates would spark rumours about their creditworthiness. On 16 April, under the headline ‘Finance markets on edge as trust in Libor wanes,’ the WSJ reported a claim by Scott Peng, an analyst at Citigroup, that although, because of the credit crunch, Libor was already high relative to the rates set by central banks, it should be even higher. Three-month US dollar Libor, Peng suggested, should actually be 30 basis points higher than it was – a difference that represents huge amounts of money, given the trillions of dollars indexed to it.
Once again despite criticism, issues pertaining to financial sector were sweeped beneath the carpet. It is amazing how things were known in advance in financial sector but so little was done…
