A pattern is developing: In a given market—short-term borrowing rates, swaps rates, currency exchange rates, oil prices, you name it— a group of unsupervised banks setting basic benchmarks will rig them to their benefit.
Today news leaked that the European Union is about to fine six global banks, including perennial favorite JP Morgan but also Deutsche Bank and HSBC, for manipulating Euribor, a benchmark rate used to price everything from home loans to derivatives.
If the story sounds familiar, it’s because some of the same banks were dinged for fixing Libor, another benchmark rate set by the British Bankers’ Association. Both are “overnight bank rates,” which measure how much banks need to pay to borrow funds overnight. They are used to set floating-rate financial contracts used by consumers and sophisticated financial institutions alike. Because these benchmarks are not based on actual transactions (like the prices in the stock market), but instead are simply reported by banks to surveyors who compile a final average, opportunities for manipulation abound. Their investigations featured plenty of cringe-worthy transcripts of traders promising steak dinner and outright cash in exchange for favorable replies to surveyors, and resulted in the CEO and Chairman of Barclays bank resigning after a $450 million fine.
Lawsuits are still being filed against the banks involved in Libor, and European regulators are also investigating whether banks have been manipulating the Tibor, a benchmark rate linked to the yen.
Meanwhile, regulators are scrambling to come up with a replacement for Libor—potentially one based on actual data, rather than self-reporting. There’s no central marketplace for unsecured overnight bank lending, and the market is illiquid; it tends to dry up in times of trouble. Other, more transparent markets with more liquidity—such as the collateral repo market and overnight index swaps—have their own drawbacks. Global regulators are split on whether suitable data can be found or compiled, or whether a more accountable system of self-reporting will suffice to restore credibility.
The problems with rate-fixing don’t end with survey-based benchmarks. Even when benchmarks for opaque markets are set with real data using once-daily “fixes,” sufficiently organized traders can manipulate them. Other investigations are focused on whether traders have colluded to manipulate yet another opaque benchmark, the daily “London fix,” on currency exchange rates. And there are ongoing investigations into the daily ISDAfix, a frequently used benchmark for swaps rates; apparently, Wall Street traders were recorded instructing brokers for the ICAP (the world’s largest interdealer broker) who set the rate about where it should land. Other traders in Europe report using similar techniques to move oil price benchmarks.
Billions, if not trillions, of dollars hinge on these various rates. While the manipulation doesn’t harm everyone—indeed, some borrowers may have benefitted from misstated Libor benchmarks—there’s a loser in every trade. Markets are only useful when their users broadly trust the accuracy of their prices. When that trust is broken across that many contracts, the result is a broken financial system.