By Preslav Raykov
Five and half years! That’s exactly how long the former trader of the Swiss bank UBS (UBS) - Tom Hayes has been in prison of his eleven-year sentence.
He was one of the first effectively sentenced people for manipulation of the LIBOR index at which base are formed the prices of the financial instruments and derivatives for more than 350 trillion dollars. For comparison: the amount of the world GDP for 2020 is 85 trillion dollars.
Whether because of financial reverence or due to deep disappointment, the era of one of the main referent indexes on the financial markets ended on December 31 with champagne, fireworks and New Year resolutions. On first day of 2022 the world woke up with fully suspended LIBOR quotes for the Britain lira, Euro, Swiss frank and yen, as also for some dollar urgency. Until the middle of 2023 all quotes of the tainted financial index will be in the history of the financial markets.
From the island of Crete to the Shah of Iran and the City of London
LIBOR, or the "London Interbank Offered Rate", was one of the main indices used to determine a large part of the prices of international financial and credit instruments over the past 36 years.
LIBOR was an era in finance. It reflected the average value of interest paid by banks when issuing short-term unsecured loans in different currencies and with different maturities, from one day to one year. The concept and prototype of the index are attributed to Minos Zombanakis, a Greek banker born in 1926 in a small village on the island of Crete. Zombanakis, who while working in the London office of an American investment bank (Manufacturers Hanover), in 1969 negotiated and priced the first syndicated loan of $ 80 million for Iranian Shah Mohammed Reza Pahlavi. The Greek financier skillfully found and used data on the cost of unsecured financing between a group of leading banks at the time to determine the interest rates on the deal. Zombanakis's achievement can be compared to a man stepping on the moon - only in the financial world. It was he who started the giant wave in the syndicated credit market, which subsequently finance spectacular projects that have contributed greatly to the development of mankind.
To this day, Zombanakis is referred to in the financial world as the "Greek Banker". A number of attempts by large international banks are following to use a common index on which to price most of the financial instruments they trade. Thus, in 1986, LIBOR was officially launched as a market index and was administered by the British Banking Association until 2014, when a division of the Intercontinental Exchange (ICE) took over the management and publication of the index. The rest is history.
For 36 years of existence LIBOR has become one of the main pillars of financial models for valuing assets worldwide: mortgage lending, leasing contracts, credit cards and student loans, stocks, currencies, raw materials, debt markets, the fate of international corporations, countries and finance ministers. All this is directly related to the index.
LIBOR is invariably integrated into the major financial models, accounting and administrative systems of the modern financial world: central, investment and commercial banks, pension and hedge funds, stock exchange operators, commodity conglomerates and finance ministries. They all danced together with LIBOR at their commercial terminals - until the beginning of the mortgage crisis in 2008, when a number of scandalous violations in the data provided by banks were identified. And the ongoing financial chaos put the index under regulatory pressure and left a lasting mark on its long-standing reputation.
Behavioral finances and the $ trillion issue
After the financial and economic storm of 2008, most banks stopped lending to each other due to the uncertainty in the financial system. The market for unsecured interbank loans, which should be the basis of the index, has dried up. But not the publication of LIBOR quotes, which were determined solely on the basis of data sent by banks and their subjective perception of risk. And these data are sent daily by human beings, subject to emotions - optimism, greed, fear. The trading desks of the big banks have their rituals. After drinking their second coffee and long since the morning operations to review the markets, traders are ready to take risks. That's when the intercontinental exchange comes the question sent every morning before 11:00 GMT: ‘At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?’
The answer to this question is measured in trillions of financial markets. Of course, we cannot directly claim that traders have been influenced by the time period for sending LIBOR quotes, but a detailed study of the manipulation case shows that the behavioral and psychological preconditions of traders, brokers and bank management have played an essential role in the data manipulation process. However, there is no denying that the lack of an adequate corporate culture, as well as well-established and controlled internal control procedures in banks, is the other main reason for this.
The scandal and the predestined crisis of LIBOR
For many of the banks participating in the calculation of the index, the manipulation of LIBOR was partly predetermined - due to the methodology and rules for its calculation. According to the instructions for its calculation, the quotations sent by the banks are recommended, but not obligatory, to be based on actually concluded transactions on the interbank market. The formation of the index gives banks the freedom to send data that they fully subjectively perceive as adequate, taking into account their short-term liquidity, credit and market position, as well as their overall assessment of market processes and risk factors. This naturally creates a precondition for all participants to want to present themselves as stable banks, without liquidity and credit problems and to position the values of the index in their favor in the best possible way in relation to their concluded transactions. This was reflected in the unnaturally low quotations of LIBOR during the worst days of the financial crisis, which became the main indicator that something was wrong with the index.
It turned out that many regulators around the world were fully aware of the weaknesses and potential opportunities for manipulation of the index. A number of reports on the case state that the Federal Reserve, the Bank of England, the Bank for International Settlements and the European Central Bank have repeatedly addressed the issue to participating banks before breaking out the scandalous revelations and subsequent billions of cases. So far, the total fines imposed on all banks involved in the manipulation by all regulators amount to more than $ 9 billion. Morgan and Citigroup. It also proves that LIBOR manipulation significantly exacerbated and accelerated the negative development of the global financial crisis in 2008. The distorted calculation of many credit products, in particular credit default swaps (CDS), which serve as insurance against bankruptcy, was one of the main factors that started the crisis were strongly affected by the manipulated quotes of LIBOR.
Unprepared for retirement
After the global scandals with LIBOR, since 2012 there has been talk of terminating and decommissioning the index. In the course of manipulation investigations, much of the financial world has confirmed that the index does not reflect real credit conditions and should be retired. The task turned out to be more difficult than expected. Everyone who has ever worked in a bank knows that accounting systems have a life of their own and often come close to thinking for themselves. Of course, this is part of the joke. But when LIBOR's quotes became negative for the first time in 2011, everyone wondered how that fact would affect banking systems and transactions around the world. Questions began to arise, such as "is it possible to introduce a negative interest rate, and will there be a breakdown in the banking system?" Or: Will billions of dollars be lost in interest payments?
All these problems remained in the past, when most of the banks fixed the value of LIBOR as zero, even if it was negative.
Today, 11 years later, LIBOR's retirement may seem boring, administrative and insignificant to the general public, but its decommissioning at the end of 2021 is a significant event that will remain in the history of financial markets.
The process again raises many of the institutions with the same issues as in 2011, but also introduces a number of new challenges - operational, technical and, above all, commercial. Although many financial institutions already have well-developed transition plans, many still face a number of obstacles in preparing for the decommissioning of the index. Many businesses using LIBOR, such as reference rate for pricing, say they are working hard to implement technology solutions to locate all their business relationships and contracts based on LIBOR in a timely manner to facilitate the transition to new indices without creating risks to systemically important systems. However, there is no doubt that the transition will be associated with increased volatility in the main derivatives.
What’s next. SOFR, ESTER, SONIA, TONAR, SARON
LIBOR is not just luminous quotes at commercial terminals. The index was also a measure of dominance in the financial world. So far, LIBOR's dollar quotes have been considered the most important of the main - and this was normal, given the status of the dollar in the world economy. Once it became clear that the index would be phased out, a global competition began to develop a suitable substitute that could be successfully implemented in the new financial contracts and be truly reflective of the market environment. Working groups have been set up on both sides of the ocean at major central banks to try to generate and enforce an index to be used globally. This competition could not determine a clear winner and the indices that will be implemented, as substitutes will be based on local reference indices, which existed before the abolition of LIBOR. What is new about them is that they are based mainly on actually concluded market transactions, and have much shorter maturities, but better reflect the market situation.
The SOFR (Secured Overnight Financing Rate) index, developed and maintained by the US Federal Reserve, is currently the main substitute for LIBOR dollar quotations. It is based on real transactions secured by government securities and measures interest rates on overnight transactions in these instruments.
Unlike LIBOR, the new index is considered risk-free due to the fact that it is secured by government securities and mainly takes into account data from repo market transactions, clearing them from those that are considered specific and unformed on a market basis. The index is volumetrically measured and takes the median value of the information collected, and its use is progressing significantly and everywhere.
According to the International Bank for Payments, by the end of 2020 $ 80 trillion. Derivative products quoted in dollars have switched to using the index. Compared to LIBOR and the interbank market for unsecured deposits, SOFR has more than 1,500 times the volume of actually concluded transactions to be used. The Federal Reserve wanted the index to be a complete substitute for LIBOR for all currencies, but a number of countries preferred to use their benchmarks.
SOFR was developed in 2017, when a specialized working group formed by the Federal Reserve in partnership with leading banks had to decide which index to use as a substitute for LIBOR. The transition to the index will be difficult due to the fact that there are still over $ 200 trillion debt instruments at the moment whose maturity does not expire before the date of decommissioning of LIBOR. This requires recalculation and equating of these derivatives, and this creates a number of opportunities for errors and systemic risks.
Overall, the SOFR is expected to bring significant short-term volatility to derivatives markets during the transition period, but also to have a favorable and stabilizing effect over the longer term. The competition for the implementation of the new indices replacing LIBOR is also quite fierce. US bank JP Morgan was the first to successfully use the new SOFR index in one of its deals to finance $ 600 million to one of the US mortgage giants, Walker & Dunlop. The index was extremely appropriate because Walker & Dunlop had already begun basing mortgage payments on the new index.
Currently, JP Morgan leads in the volume of new transactions based on SOFR, which may give it a leading role in creating the model in which the index will be implemented in the financial world.
However, the even wider use of the index is hampered by the fact that it is only available for the overnight period, while LIBOR had quotes within a year. This is expected to be resolved soon, and monthly, quarterly and six-month quotes will be adopted. Another drawback is that anyone who wants to base their product on SOFR with a maturity of more than one day must obtain explicit permission from the index administrator. There is still a lack of full consensus on how the index will be implemented in financial products.
The other substitutes for LIBOR for the British pound, the euro and the yen will be SONIA (Sterling Overnight Index Average), ESTER (Euro Short Term Rate) and TONAR (Tokyo Overnight Average Rate) respectively. All three are developed and administered by the respective central banks, and are mainly based on unsecured overnight money market transactions in the respective currencies.
The main characteristics sought were the indices to be as risk-free as possible, to have real depth and volume of transactions on which they are based, and to be relatively easy to implement and apply in financial products, and especially in derivative transactions. The only European index that, like SOFR, will be secured is the Swiss Average Rate Overnight (SARON). The index will be based and secured on the basis of repo transactions concluded in Swiss francs.
THE BOTTOM LINE On the first day of 2022, the world woke up with completely suspended LIBOR quotes for the British pound, the euro, the Swiss franc and the yen, as well as for some of the dollar maturities
