This week’s Bloomberg Businessweek cover story is about Tom Hayes, a British trader convicted of manipulating Libor.
The London Interbank Offered Rate is a global benchmark for the cost of borrowing. Every day, a panel of banks says how much it might cost them to borrow money, in various currencies, for various lengths of time (or maturities). In each category, the highest quarter and lowest quarter of submitted figures are discarded, and the average of the remaining figures becomes that day’s Libor in that category.
For example, the yen 6-month Libor is shown below; it is at about a tenth of where it was during the late-2008 financial crisis, reflecting easier, safer borrowing.
Fig. 1 ICE Libor JPY 6 Month. Drag to see banks’ submitted rates over time
What if you want Libor higher, or lower, depending on your trades? The fact that Libor is computed as a “trimmed average” (with outliers discarded) means that submitting a wildly high or low guess doesn’t move the figure. Even if you had total control over how one bank sets its rates, you couldn’t necessarily move Libor at all.
Fig. 2 Hypothetical. Drag to change a hypothetical bank’s submitted rate
In 2006, Hayes figured out how to sway several submitters at once. In the hypothetical model below, banks’ rates follow a random walk, and moving one bank’s submissions has some random partial influence over other banks’ submitted rates. (This is only roughly instructive.)
Fig. 3 Hypothetical. Drag to change a hypothetical bank’s submitted rate
Many financial contracts are based on Libor in some way, so manipulating it can pay off. Imagine a simplified interest rate swap: Alice has agreed to pay Bob a fixed interest rate on some principal, and Bob has agreed to pay Alice a floating interest rate on that principal, which moves with Libor. Try maximizing what one pays the other.
Fig. 4 Hypothetical consequences of fluctuations in Fig. 3. Drag to change principal
If you could pull that off in real life, you might have the makings of a financial conspiracy for the ages — and a stay at Her Majesty’s Prison Wandsworth. Please don’t.