Imagine a “benchmark” as a notch on a carpenter’s bench used to measure. Simple enough. But what if the carpenter cheated, moving his marks to be able to charge a little more for a piece of lumber? In their role in modern financial markets, benchmarks set by traders help establish costs for mortgages, gasoline and money itself. They’re hard to understand and easy to manipulate. At the heart of the problem lies an inherent conflict: The figures are determined by the very firms that have the most to gain from where they’re set. Regulators agree that the main financial benchmarks are broken.
Recent scandals have revealed traders manipulating the numbers to boost their own profits. Fiddling in the London interbank offered rate, or Libor, came to light in 2008, culminating in record fines for collusion by banks including Royal Bank of Scotland and UBS. E-mails and instant messages showed that dealers contributing to the rate-setting pool agreed to make submissions that suited their trading positions. Benchmarks used in oil, gold and derivatives have also been shown to be vulnerable to abuse, and are being investigated for evidence of wrongdoing. Now regulators are examining potentially the biggest rate-rigging scandal of them all. The U.S. Justice Department, the European Union and the Swiss Competition Commission are looking into whether foreign-exchange rates — long considered immune from tampering because of the sheer size of the $5.3 trillion-a-day currency market — were compromised. So far a dozen traders have been placed on leave or fired from banks including Citigroup, JPMorgan Chase, and Barclays. As the probes came to light, several banks banned multidealer chat rooms, the electronic forums used by traders to talk business and exchange wisecracks with their colleagues, customers and counterparts at other firms.
Benchmarks were developed to underpin rates in contracts or to assign standard end-of-day values to particular holdings, and are set by a variety of methods. Libor is based on a daily survey of about a dozen big banks that estimate their short-term borrowing costs; the London Gold Fix is set on a private telephone call of five people; currency benchmarks, known as WM/Reuters rates, are calculated from the median of all trades in a 60-second period. Yet they share fundamental characteristics that have left them prone to manipulation: a system of self-regulation, tradition-bound and often unchanged for decades with little or no oversight. With the reputation of bankers tarnished by the financial crisis, regulators and politicians agree that it’s no longer acceptable for control of key benchmarks to stay in the hands of a few. In July, officials from more than 50 countries published a set of principles to make the rates more transparent, including using data from real trades wherever possible, minimizing conflicts of interest and making specific individuals responsible for rate-setting at each firm. The U.K. introduced criminal sanctions for anyone knowingly making false or misleading statements relating to benchmark-setting.
Traders caught up in the rate-rigging probes argue that they were following long-standing banking practices passed down to them, and that they shouldn’t be judged through the prism of today’s more rigorous standards. For their part, banks have tried to paint the problem as the behavior of a few rogue traders. That line rings hollow, as senior managers are alleged to have been involved in rigging both Libor and foreign-exchange rates. While regulators are introducing more safeguards, the benchmarks are so widely used in financial markets that they can’t be changed in ways that could invalidate existing contracts or introduce greater volatility. Until the conflicts are cleared completely, traders will still have an incentive to game the system. It took a Bloomberg News investigation in June to uncover the potential problems in currencies, where spikes in rates before the 4 p.m. London fixing are under scrutiny.
The Reference Shelf
- Bloomberg Markets article on the Libor scandal and its ramifications.
- Principles for financial benchmarks published by global regulators in July 2013, and the U.K.’s Wheatley Review of Libor.
- A history of the London Gold Fix, which traces its origins to 1671.
- Bloomberg data visualization of spikes in currency rates at the time of the 4 p.m. London fix.
- The methodology for setting WM/Reuters currency rates.