Burning Question

The London Interbank Offered Rate (LIBOR) recently hit the UK headlines after Barclays admitted to manipulating the rate during the financial crisis, and it was subsequently fined around $460 million. At least 10 agencies across the UK, US, Canada, Europe and Japan are currently investigating rate-setting practices of at least a dozen banks and brokers. A recent forecast estimates the combined regulatory penalties and third-party damages claims from investors and counterparties will cost banks involved as much as $22 billion.

Determining the extent of, and the harm caused by, these activities will keep the Financial Services Authority, the Financial Conduct Authority and other agencies occupied for some time. But the central question for the European Commission in its investigation is whether certain banks formed a cartel to collaboratively fix the reference rate.

What is LIBOR?

LIBOR is intended to indicate the average rate of interest at which banks will lend to each other on any given day. The British Bankers' Association (BBA), which sponsors the rate, asks a representative 'panel' of banks for daily submissions in response to the following question: "At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size, just prior to 11:00am." The panel's submissions are collected by a third-party agency which calculates a 'trimmed average', whereby the highest and lowest daily submissions are excluded, and those which remain are averaged. The end result is published at 12:00pm daily. LIBOR is adopted worldwide as a benchmark rate in a variety of financial instruments, which have an estimated combined value of $350 trillion.

The consequences of a misrepresentation of LIBOR are clearly significant for parties to these instruments. When the rate is artificially high or low, those parties are likely to be over- or under-paying. The process of taking a 'trimmed average' is intended to restrict any one bank's ability to unilaterally sway the rate: if a bank's estimate is very high or low it will not be counted; if its submission is close enough to the median to be included in the calculation, its influence upon the average will be very small.

Collusion

But one way for a bank to increase its influence over the rate is to cooperate with other banks in forming rate submissions, since their combined submissions would have a much stronger effect on the average. The Commission's investigation is directed towards the existence and extent of any such collaborative arrangements.

As the EU's competition authority, the Commission can step in and conduct investigations where it has suspicions of harmful anti-competitive behaviour by businesses. One of the Commission's main objectives as an institution is to expose and punish cartels. It sees them as one of the most serious forms of anti-competitive behaviour, and the fines it levies on participant businesses are intended to be a powerful deterrent. It is able to set fines of up to 10% of a participant's worldwide turnover, and the largest fine it has imposed against a cartel member is almost €900 million.

The Commission's specific concern in relation to LIBOR is that banks may have violated competition rules prohibiting cartels and anti-competitive business practices in the trading of interest-rate derivatives. Interest-rate derivatives, or 'swaps', form the largest derivatives market in the world. At its simplest, this kind of instrument is an agreement between Company A and Company B, each of which agrees to finance a loan taken out by the other. The value of each company's loan will be the same, but Company A's loan may come with an obligation to pay interest at a fixed rate and Company B's at a floating rate. The companies may look at the market, or their own cashflow requirements, and decide to swap rates. If the floating interest rate is set to track LIBOR, it would be in the interests of Company A, which has adopted the floating rate, for LIBOR to be low. The Commission fears that derivatives traders at banks were cooperating to ensure that LIBOR outcomes suited their own trading positions.

The Commission said in February that "given the number and the value of transactions in interest-rate derivatives, and the crucial role these products play in the management of risk, any confirmed manipulation of these interest rates would probably imply a very significant cost to the European economy".

Article 101

Article 101 of the Treaty on the Functioning of the European Union prohibits agreements, decisions and concerted practices between undertakings which have as their object or effect the restriction, distortion or prevention of competition within the European Union, and which may affect trade between member states of the European Union. The Commission will be seeking to establish whether this provision has been infringed.

To establish a concerted practice, the Commission would not need to show any contractual agreements: evidence of collusion, however informal, would be sufficient. Where an arrangement imposes 'hard-core restrictions' on competition, such as price-fixing or bid-rigging, the Commission will generally presume that the arrangement has as its object the restriction of competition, and so it will not be necessary to demonstrate its anti-competitive effect. It is likely that, if the Commission finds a rate-rigging cartel was in operation, it will deem this arrangement to have had an anti-competitive object and it will be able to establish an infringement of Article 101.

Reform

One criticism of LIBOR can be traced to the wording of the BBA's question. It is hypothetical and elicits a subjective response from banks based on their perception of market conditions. Regulators, therefore, cannot easily verify the accuracy of submissions. This problem is compounded by the fact that unsecured interbank lending has been at very low levels for a number of years, with the result that LIBOR submissions have become an even more subjective process.

The problem is that ideas for new ways of setting LIBOR are thin on the ground. Calculating an average interest rate on actual interbank loans would be more objective, but there may not be a sufficient volume of suitable transactions in one day to form a reliable average, particularly in times of low liquidity. The value in a rate based on perception is that its reliability is not dependent on a statistically significant quantity of data. But, by their nature, such rates are difficult to audit and verify.

The Commission and other regulators will continue their investigations and will doubtless adopt a strategy of punishment and deterrence by imposing fines, if an infringement is established. The Commission has also proposed criminalising the conduct of the individuals involved. But this needs to be combined with a new approach to LIBOR itself. Reform of the way it is set and the way it is used has become a top priority for the newly formed Financial Conduct Authority, and its preliminary views may be presented as soon as this autumn.

Joel Marris is a first-year trainee at Edwards Wildman.