A Barclays specialist at the New York Stock Exchange

Imagine working in a large office that runs a daily lottery. Every day, the receptionist collects a dollar from the several hundred employees who work there, and asks them to pick a number between 1 and 500. Sometime that afternoon, she reminds everyone, that day's winning number will be announced, and the collected pot will be divided between perhaps a dozen of the employees with the closest guesses.

Now imagine if, instead of just drawing the winning number out of a rotating drum full of tiny balls, the receptionist actually called some employees participating in the lottery to have them determine the day's winning number.  After asking something like, What do you think today's winning number is likely to be? she would tabulate the average of the responses and post that figure as the jackpot winner.

As conflict-ridden as such a system would seem, that, on a dollar scale several billion times larger, is pretty much how the world's market for interest rate swaps works. With a notable difference: While the 'winning number' in the workplace pool example would be inconsequential to anyone outside that office, the number underlying the interest rate swap market matters a great deal.

That's because the numerical figure -- known as the London Interbank Offered Rate, or Libor for short -- just happens to be one of the most important figures in global finance, underlying not only the interest rate swap market, but some $360 trillion in securities, like preferred shares and municipal bonds. Not to mention the hundreds of billions in interest tied to Libor-rate clauses in everything from complex structured financing arrangements, to low-mileage vehicle leases, to student credit cards.

If you've never heard of Libor or have only encountered the term in the back of the financial pages, you're likely not alone. The figure, or the process by which it is arrived at on a daily basis, is barely discussed outside of financial circles. Until now.

Following the revelation last week that British banking giant Barclays was engaging in massive fraud meant to distort the rate, for which Barclays was fined $450 million, politicians and regulators the world over are taking a sober look at LIBOR.

It's very important [the review] takes all of the actions necessary, holding bankers accountable ... making sure there's proper transparency, making sure the criminal law can go wherever it needs to uncover wrongdoing, Prime Minister David Cameron told BBC on Saturday.

Fraud is a crime in normal business, why is it not so in banking? Chancellor of the Exchequer George Osborne said in a statement to Parliament on Monday.


British Chancellor of the Exchequer George Osborne slamming Barclays during a Parliament session

Beyond tossing a few fraudsters in jail, the investigation may end up exposing just how rigged rate-fixing has been in the past, experts say, and perhaps lead to a wider philosophical discussion of why the global financial system relies on Libor at all.

This judgment, about what the rate of interest should be for the economy, is incredibly important for the future of the economy, said Ann Pettifor, the director of London-based macroeconomics research group PRIME Economics, and if we leave it to the bankers to decide that rate, they're going to screw us all.

Done ... for you big boy.

Libor is a rate calculated every day by Thomson Reuters, a publicly traded financial information company, and is supposed to reflect the interest banks are currently paying to borrow dollars from each other. That calculation is done on behalf of the British Bankers' Association, an industry trade group for UK-based banks. Yet instead of calculating the rate from, say, electronic records of transactions that reflect interbank lending, the figure is tabulated in the same quaint manner it has been for 26 years: Someone from Reuters calls someone at a group of specific banks to ask for a number, ignores certain outliers, then calculates the average.

Before 1986, when standardized daily fixings began, that same function was done by regional banking groups or individual banks calling their peers and tabulating rates privately.

Banks are expected to answer truthfully to the daily query, but given the process is self-policed, many insiders have always wondered just how truthful those responses really are. For one, there's the roundabout way in which the question is posed to the banks: 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 a.m.?

That wording, particularly the reasonable market part, seemingly invites bankers to pull a number out of thin air, rather than reporting the one being shown on their trading terminals. Worse, if a bank has made a bet on interest rate instruments one way or the other, tens of millions of dollars might be made or lost depending on how they answer the question.

That's exactly what was happening at Barclays.


Barclays headquarters in East London

In announcing a settlement last week for its rate-fixing activities, U.S. and UK regulators showed traders emails or instant-messages from officers at the bank who were in charge of responding to the Libor poll, pleading with them to move the figure one way or the other (usually lower).

An example of how the interaction happened, according to records released by the U.S. Commodities and Futures Trading Commission, the federal Department on Justice and the British Financial Services Authority:

In an early March 2006 email, a trader at Barclays told a person in charge of the Libor poll submissions: I really need a very very low 3m fixing on Monday -- preferably we get kicked out. We have about 80 yards [billion dollars] fixing for the desk and each 0.1 [one basis point, or one-hundredth of a percent] lower in the fix is a huge help for us. So 4.90 or lower would be fantastic.

A few days later, the submitter emailed the trader saying I am going 90 altho [sic] 91 is what I should be posting.

The trader was grateful, telling the submitter that when I retire and write a book about this business, your name will be written in golden letters.

I would prefer this not be in any book!, the submitter replied.

In another interaction about a month later, the same trader made it clear that there was a quid pro quo with the submitter to whom the note was addressed.

If it's not too late low 1m and 3m would be nice, but please feel free to say no...  Coffees will be coming your way either way, just to say thank you for your help in the past few weeks, the trader emailed the person in charge of the Libor submission.

The response, a few minutes later: Done...for you big boy.

An authoritative benchmark

As regulators continue prodding other banks, rates analysts suspect they may find evidence of fraud.

Particularly noted by Libor skeptics have been periods in 2008 and late 2011 when the European money markets underwent significant credit crunches. Anecdotal evidence and other indicators of the rates at which banks could borrow short-term dollars - - like the interest-rate for repo agreements -- suggested that they were having trouble getting that financing, and that volatility in the market was off the charts. Yet, amid the fear and uncertainty, the daily published Libor moved in an eerily calm fashion.  

According to the British Bankers' Association, Libor continues to be the authoritative benchmark of the wholesale money market. In an early March statement, the association said it was committed to retaining the reputation and integrity of BBA Libor.

When news of the Barclays fraud came out, the BBA said it was shocked by the revelations.


A man walks in the Square Mile, the financial center of the city of London. The British banking association said it was shocked by the banking fraud.

Peter Went, a senior vice-president at the Global Association of Risk Professionals in New York, suggested that claim is absurd: There is a bias in Libor that has been very well known and has been very well known for a long time. This is an inherent problem in self-reported data

Went noted that, for example, in 2008, the relationship between Libor rates and the rates reflected in certain instruments that also have to do with how willing banks are to lend to each other, like repurchase agreement rates, broke down.

When you look at the Libor, what's really surprising given the volatility of the rates, what you see is that the Libor is essentially very smooth. This is why this is odd. If you look at the volatility in the Libor, compared to the volatility in other markets, it's essentially two different worlds.

Others involved directly in operations using bank rates say the same.

Indrajit Roy Choudhoury, a banking systems and treasury operations consultant for the Trade Bank of Iraq in Baghdad says it is known throughout the business that dealers call each other and send SMS, as text messages are known outside the U.S., to coordinate the reporting on rates among themselves.

That lack of reality reflected in the rates has led certain corners of finance to look for alternatives.

Wholesale market dealers associations are using SONIA, the Sterling Overnight Index Average, a rate calculated from actual transaction records and not based on a banker's response to a poll, said Choudhoury. However, Libor is still the main benchmark rate. It is likely to continue despite such aberrations.

The reason is that Libor is accepted globally and a corner or country cannot change the Libor for its own domain, as it is linked to borrowing or lending in international markets based on Libor.


Barclays trading station at the New York Stock Exchange

The Regulator's Role

Those outside of the world of high finance might wonder how it was possible for such an important rate-setting process to go awry without provoking regulator interference earlier. Were regulators really completely asleep at the switch?

The short answer is, No, they just had bigger issues to worry about.

Rhodi Preece, director of capital markets policy for the CFA Institute, which sets ethics guidelines for chartered financial analysts, agreed. The market was suggesting that something wasn't quite right since at least 2008. I suspect [regulators] have been preoccupied. It's sort of appeared now, but this problem has been going on for some time.

There's also the fact, as several experts interviewed noted, that if banks were artificially reporting a low rate there's a positive externality that could have resulted: Lower interest on loans set using the manipulated Libor would have a stimulative effect on the economy.

In an article on Sunday, Robert Peston, the business editor of BBC News, suggested that might have been part of the whole manipulation from 2008 on. Specifically, Peston asserted that the deputy governor of the Bank of England, Paul Tucker, suggested to executives at Barclays they should try to keep Libor submissions on the lower end of the spectrum. Or at least that's what the bankers understood.

The fact that a conversation between the bank and Tucker occurred is noted in the report by the British Financial Services Authority that accompanied the announcement of the fine last week.

As the substance of the telephone conversation was relayed down the chain of command at Barclays, a misunderstanding or miscommunication occurred. This meant that Barclays' submitters believed mistakenly that they were operating under an instruction from the Bank of England (as conveyed by senior management) to reduce Barclays' Libor submissions.

Perhaps most striking, however, is the fact that, during the period in which Barclays was lowering rate submissions, its quotes were still higher than those from other banks.

In other words, Barclays might have, under presumed or real regulatory guidance, been stealing an inch. But other banks we have yet to hear about may have been stealing a mile.


A sign near the New York Stock Exchange. The LIBOR scandal may affect other banks besides Barclays

Now What?

No one knows exactly who the next bank to be involved in the Libor imbroglio may be, although markets seem to be suggesting it could be the Royal Bank of Scotland, in Britain, or JPMorgan Chase and Co., in New York.

Once the dust settles, there will be calls to fine the banks, and then reform the system. One option is to base the rates on calculations of actual electronic transactions. Another is to have public entities, not the banks, set the rates. Yet another might be to reform the Libor system, perhaps by changing the question asked every day to bankers to make it more explicit or increasing the number of reporting banks.

But Ann Pettifor, the macroeconomic policy research director, suggests this could also be a good time to fundamentally rethink why and how we set interest rates that control the price of everything from hundreds of thousands of sub-prime mortgages to yacht-financing leases.

Credit is not like other products and services. It's not like farming. You don't have to wait for the seeds to grow and whatnot. You just put a number in a computer and figure out if Mrs. Smith in Michigan will be able to pay her loan.

The presumption is that the going rate is set by the supply and demand for credit. It's not ... it's a judgment made by a banker. Interest rates are a social construct.

Pettifor advocates going back to a variation on the system that existed previously, which was handled by the central bank.

I would want a sort of Electoral College in the Bank of England where finance is represented, industry is represented and labor is represented.

But getting there will take an immense amount of political will.

What is happening is bankers are trying to hold the rest of us for ransom. They tell us, 'We might have colluded. We have bankrupted millions of Americans. But there's no other option.' We had a similar dynamic in the 1930s. In the 1930s Roosevelt told them, 'Sorry guys. But there is an alternative. There is an alternative. And I'm going to introduce it.' And he began to regulate the process. And the banking system stabilized. And there was never a shortage of money ... even to fund a world war. Those are all the consequences of a political decision to stand up to the banks.

Without that, nothing much may change: As long as they allow them, the bankers will manipulate the system, Pettifor said. Wouldn't you?