The Bullpen

Experts Warned CFTC About Potential Libor Rigging 15 Years Ago

The Commodity Futures Trading Commission has led the investigation into the Libor rate-rigging scandal. They have pursued civil charges, and worked with the Justice Department on criminal ones. But when the CFTC first learned about how banks could easily implement rate-rigging, they ignored it – when the agency was under the executive branch of President Bill Clinton, all the way back in 1997.

Richard Robb, a professor at Columbia University, understood that the calculation of the Libor was the core problem that needed to be addressed. Under the current standard, 16 banks write in to the British Banker’s Association with the interest rate at which they are charged to secure funding, and the organization posts a range of those, throwing out the high and the low numbers, to determine the rate. There was a better way, devised by the Chicago Mercantile Exchange (CME) back in 1981, which engaged a much larger pool of banks, and picked 20 blindly and at random to determine the rate, on two separate occasions. Eventually they would get a result that would better reflect the actual interbank lending rate. This worked well for 16 years.

In September 1996, the CME applied to the U.S. Commodity Futures Trading Commission for permission to switch from its own, sensible Libor calculation to the BBA’s. Presumably, the CME worried that a rival exchange would steal market share by starting a contract tied to BBA Libor, which was and is the standard floating rate index for swaps, loans and notes.

On Nov. 18, 1996, I filed a public comment letter with the CFTC objecting to the CME’s plan. Here are some excerpts from that letter:

“In a severe funding crisis … banks might respond to the BBA survey with a rate substantially below their true lending rate. Since the BBA survey results appear on Telerate [a Bloomberg-like information service widely used at the time], the banks may want to hide the extent of their troubles…The CME randomly draws a limited number of reference banks from a larger pool on the futures settlement date. This ensures that banks will not know ahead of time whether they will be able to participate in the survey. The BBA, on the other hand, surveys the same sixteen banks every day. To see how a bank could exploit this feature of the BBA survey to manipulate the index, suppose that the four high quotes are expected to be the three Japanese banks (Bank of Tokyo/Mitsubishi, Fuji, and Sumitomo Trust) and the Bank of China. Then, any of the remaining banks can raise their quote, and the effect will flow directly to the final index. A British bank, for example, might raise its quote by 12.5 basis points. Since eight banks make up the average, the average will rise by 12.5/8 = 1.5626 basis points. If two banks worked together, they could raise the average by 3 basis points […]

That was more than 15 years ago. No one should be surprised that banks would suppress their posted rates in a funding crisis or that they might manipulate the survey for gain. It was easy to see this coming.

Robb adds that CFTC ignored the letter. And then every single consequence that he described came to pass. Robb writes, “While the CFTC is dishing out nine-figure fines to banks caught up in the scandal, it might want to consider another possible culprit: itself.”

There are actually simple solutions to the various banking crises that regulators and bankers in concert do not want to fix.

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David Dayen

David Dayen