EU Is Shocked That Banks Colluded on Libor

A long time ago some big banks decided that it would be good to sell interest-rate derivatives.1 To do that they needed an interest rate on which to sell derivatives. Various possibilities presented themselves -- Treasury rates or whatever -- but the interest rates that the banks themselves paid on short-term borrowing had an especially obvious appeal as an index. If you're a bank, that data is readily available to you, you don't have to worry about government-market idiosyncrasies, and it's easier to be hedged if your derivatives (and the floating-rate loans you write to clients) are indexed to your own borrowing costs.

But being like, "we'll exchange you a fixed rate of 7 percent for a floating rate of 3 percent over our cost of three-month borrowing" is kind of weird. For one thing, it makes the client nervous: What if the bank has an accident and its cost of borrowing goes way up? (What if the bank lies about its cost of borrowing?) For another thing, it makes interest-rate swaps less fungible and liquid: A swap of JPMorgan-plus-300-basis-points is not easily comparable to a swap of Citi-plus-325, so you can't really close out a position in one by selling the other.