ICE LIBOR and the Slippery Road Ahead

The head of the Financial Conduct Authority (FCA) is somewhat of a superstar in the world of finance and regulation. Unsurprisingly, Martin Wheatley makes a lot of speeches. He famously authored the Wheatley Review (the review) – the blueprint as regards reforming the world’s “most important number”, i.e. the London Interbank Offered Rate (LIBOR). Aiming to impress the government and the public, Wheatley’s rhetoric revolves around buzzwords such as accountability, conduct and governance.

Only late last year, speaking on modelling integrity through culture, he reiterated that:

Our own emphasis on conduct and culture is heralded by our work to strengthen benchmarks. We’ve been at the vanguard of establishing a regime that is practical, but that nonetheless results in a shift in firm behaviour and individual accountability. As I prepared to take on the task of chief executive of the FCA, I was also asked to review whether the revelations surrounding LIBOR required a wider policy response. The policy recommendations resulting from this review – now known as the Wheatley Review – have delivered a LIBOR regime that provides for accountability, strengthened governance and robust systems and controls around the submission of rates.

Yet a robust system involving proper scrutiny of rates had been in the making for quite some time. For example, in 2008, the former Governor of the Bank of England, Sir Mervyn King told Parliament that “in many ways” LIBOR is “the rate at which banks do not lend to each other” and “it is not a rate at which anyone is actually borrowing”. It was common knowledge that the banks were cheating. However, not for the first time, by leaving things to “market forces” the regulators chose to keep their heads in the sand while fraud was occurring on a grand scale. Four years later, Sir Mervyn King admitted that he was not talking about LIBOR being fixed by a single basis point. Rather, the authorities “were worried about tens of basis points”. Given the value of a single basis point, the Treasury Committee was “surprised and disappointed by the Governor’s remarks”.

On the other hand, the review did introduce wholesale reforms. But a quick fix was required because the need to pacify the public was great. The issues raised by the ten-point programme for greater control involved enhanced regulation, institutional reform, fresh rules and guidance and international coordination.

The review plugged up legal lacunae by making the administration of and submissions to LIBOR regulated activities with an approved persons regime: both submitting to and administering LIBOR were made controlled functions. In practice, the changes meant that independent supervision, reinforced by criminal and civil sanctions, became a reality and began to fall more fully in the FCA’s remit.

The appointment of a new administrator was a key feature of the reform triggered by the review. On 9 July 2013, the Hogg Tendering Advisory Committee announced that NYSE Euronext would be the new LIBOR administrator. But in November 2013 Intercontinental Exchange (ICE) completed its acquisition of NYSE Euronext. Ultimately, on 1 February 2014, ICE Benchmark Administration Limited (IBA) replaced the British Bankers Association as the new LIBOR administrator and an improved new ICE LIBOR came onto the market. In line with the review, it is produced in five currencies (namely Swiss Franc, Euro, Pound Sterling, Japanese Yen and US Dollar) with seven maturities/tenors quoted for each (ranging from overnight to twelve months) producing 35 rates each business day.

The compilation, distribution, governance and oversight of LIBOR are now IBA’s responsibility. As the review emphasised, transparency and scrutiny of submissions will ensure LIBOR’s integrity and credibility. Accordingly, we are informed that:

• ICE intends to return credibility, trust and integrity to LIBOR, by bringing together a strong regulatory and governance framework and market-leading validation techniques

• ICE has implemented a new post-publication surveillance system and tests designed to assess the credibility of LIBOR submissions and rates

• New surveillance methodology has been designed to adjust to changing market conditions and employs sophisticated analytical tools to operate the benchmark price setting process with transparency
• Thomson Reuters continues to undertake the collection, some real-time surveillance and calculation services, under the oversight of ICE

• Upon transfer, ICE took over from Thomson Reuters as the primary publisher of the LIBOR rates, using a new Secure File Transfer Protocol (SFTP) service

• Data continues to be available via third party re-distributors

Under the review, an independent and separate external oversight committee responsible for details of LIBOR, requiring the input of stakeholders such as market participants was established. As regards rules and guidance, the LIBOR Code of Conduct for Contributing Banks – the industry-led code envisaged by the review – provides detailed guidance for LIBOR submissions. The code is accompanied by a whistleblowing procedure which maintains anonymity unless disclosure as regards the whistleblower is ordered by the FCA.

The code is arranged into eight parts: (1) governance arrangements (2) staff training and arrangements (3) submission methodology (4) managing conflicts of interest (5) suspicions (6) record keeping (7) compliance and internal audit and (8) auditor reporting. An annex about submission methodology supplements the foregoing. As one would expect, the code embeds into its corpus the requirements of part 7 – section 91 (Misleading statements in relation to benchmarks) and section 92 (Penalties) – of the Financial Services Act 2012 and the associated the Financial Services Act 2012 (Misleading Statements and Impressions) Order 2013, MAR 8 and other interlinked parts of the FCA’s Market Conduct Handbook. Equally, as one would expect, the post-review requirements of article 63O and schedule 5 of Financial Services and Markets Act (Regulated Activities) Order 2001 (as amended by the Financial Services and Markets Act 2000 (Regulated Activities) (Amendment) Order 2013) in relation to LIBOR submission and administration are also embedded into the code.

In his comprehensive/alerter article, Reforming LIBOR: Wheatley versus the Alternatives, Professor Bainbridge observed in January 2013 that the review was a good first step because it was “politically attractive” and “a viable starting point”. However, he nevertheless urged caution and advised us:

To be sure, the Wheatley regime is not perfect.

Among other things, Professor Bainbridge also expressed concern about the fact that with only two independent members, the committee may not meet best governance practice because under the UK Code of Corporate Governance at least half of the board of directors must consist of independent non-executive directors. (So the governance bit in Wheatley’s formula raises questions.)

Chaired by Joanna Perkins (who is also a non-executive director), the oversight committee is made up of eighteen members. It has four members – one each from UBS, Barclays, HSBC and Bank of Tokyo Mitsubishi – who are benchmark submitters. Paul Fisher from the Bank of England acts as observer of the oversight committee. The committee has five association representative members – one each from WMBA, LMA, ISDA and the Association of Corporate Treasurers. Three market infrastructure providers – one each from Intercontinental Exchange (Liffe), DTCC New York and CME Group – and two ex-officio members from the IBA are also part of the committee. And coupled with a calculation agent from Thompson Reuters, the second non-executive director, i.e. IBA Chairman André Villeneuve, beefs up the strength of the committee to a total of eighteen members.

But beneath the veneer of success some things are still unresolved. Although the review did explore alternative interest rate benchmarks, it only considered itself to be a starting point for further discussion as regards the use of other options. Overall, the review considered making conclusions or recommendations about alternatives to fall outside its scope. Not long after the UK Government accepted the review’s recommendations “in full”, while advocating the use of Alternatives to LIBOR on the one hand, Rebecca Tabb and Joseph Grundfest nonetheless made the case as regards its partial indispensability by arguing that:

• Evidence of extensive fraud in LIBOR submissions has fueled international calls for reform. A common theme is the current rate setting process, in addition to being subject to manipulation, relies on conjecture as to rates that might prevail in markets that can often be illiquid, and should be replaced with a process that relies more directly on actual transactions.

• There are no perfect substitutes for LIBOR. Overnight index swap rates and repo rates, the most attractive alternatives to LIBOR, do not incorporate the same counterparty credit risk or term premiums. Repo rates also reflect the risks of underlying collateral, which can be inappropriate for certain market participants. Liquidity in these alternatives is also concentrated in shorter maturities. These differences make it difficult for LIBOR alternatives to fully replace LIBOR in all instances.

• The challenge of finding a LIBOR substitute can be reframed along three dimensions. With regard to existing contracts, the challenge may be to reform the current version of LIBOR so it better reflects legitimate market expectations while being less susceptible to self-serving panel bank manipulation. With respect to new contracts, parties can look to a wide variety of LIBOR alternatives to select a substitute. Put another way, it makes little sense, on a prospective basis, to require a single substitute for LIBOR when the market may rationally prefer any of several viable alternatives. And, once new metrics have been established in the market for new contracts, renegotiating existing contracts to substitute a new metric for the current LIBOR, or improved version of LIBOR, may be easier.

• Identifying a single, best substitute for LIBOR may thus be a fool’s errand. Creating an environment in which many different alternatives can legitimately co-exist may be a preferred strategy.

So we are stuck with LIBOR because even to get rid of it we still need it. Since it is an imperfect benchmark and remains susceptible to cheating, it is unsurprising that writing earlier this year, Calvin Benedict expressed his reservations by saying that:

At its core, the scandal highlights a cultural and ethical malaise that made compliance effectively redundant. Sweeping legislation and other legal reforms designed to curb LIBOR manipulation will prove ineffective if they are not supported by a swift enforcement threat and a change of culture in the finance industry.

Such scepticism is well-founded because despite the review the image of the banking sector has been hugely tarnished: law reform alone is incapable of undoing the scandal. Interesting new things are happening all the time and despite Wheatley’s mantras about the efficacy of the new financial conduct regime, the LIBOR scandal remains very much in fashion on the world’s financial catwalk and it refuses to go away.

There is a staggering number of LIBOR related investigations/proceedings going on. Here are a few recent developments.

European Union

For example, in terms of EU competition law, because the banks were acting collusively  – behaviour prohibited by Article 101 of the Treaty on the Functioning of the European Union (TFEU) and Article 53 of the EEA Agreement – other problems as regards the operation of illegal cartels emerged. Thus, when the European Commission fined banks €1.71 billion for participating in cartels in the interest rate derivatives industry in December 2013, Joaquín Almunia (the Vice-President in charge of competition policy) said:

What is shocking about the LIBOR and EURIBOR scandals is not only the manipulation of benchmarks, which is being tackled by financial regulators worldwide, but also the collusion between banks who are supposed to be competing with each other. Today’s decision sends a clear message that the Commission is determined to fight and sanction these cartels in the financial sector. Healthy competition and transparency are crucial for financial markets to work properly, at the service of the real economy rather than the interests of a few.

United States

Last month the list of American cases expanded further when the Federal Deposit Insurance Corporation (FDIC) sued sixteen of the world’s largest banks including UBS and Barclays (both which have one member each on the oversight committee!).

The FDIC filed proceedings – Federal Deposit Insurance Corporation et al v. Bank of America Corporation et al, Case Number 1:14-cv-01757 – on behalf of thirty-eight banks that went into receivership because sixteen influential banks collaborated to:

… suppress LIBOR from 2007 to 2011 in order to pay lower interest rates to IndyMac Bank, Washington Mutual Bank and several other failed banks.

United Kingdom

But there is good news for Barclays which faced a showdown with Graiseley Properties in the English High Court later this month. The English cases have been covered on this blog here (Graiseley & Ors v Barclays Plc [2012] EWHC 3093), here (Graiseley & Ors v Barclays Plc & Ors [2013] EWHC 67), here (Deutsche Bank AG & Ors v Unitech Global Ltd & Anor [2013] EWHC 2793) and here (Graiseley & Ors v Barclays Plc & Ors [2013] EWCA Civ 1372). Barclays agreed to settle the £40 million claim brought by Guardian Care Homes (Graiseley is Guardian’s parent). The case, which was fixed for trial from 29 April 2014, has been withdrawn. Issuing identical statements both Barclays and Graiseley let it be known that:

In order to support the ongoing viability of Graiseley’s care home business, the parties have signed a restructuring of Graiseley’s debt. This reflects the impact of changes in conditions to the sector over the past few years. Graiseley has withdrawn the litigation.

The fact that senior executives in Barclays such as former CEO Bob Diamond were aware that LIBOR was being rigged meant that the court process would have dragged them out to give evidence. (As will be recalled, between 2005 – 2009, Barclays international traders made a total of 257 requests to LIBOR submitters to fix LIBOR and EURIBOR. Diamond said that reading the emails sent by dodgy traders made him “physically ill.”)

The compromise is somewhat disappointing because some of us, my friend Professor Roger McCormick (director of the LSE’s Conduct Costs Project) included, wanted to indulge in the nitty-gritty of the substantive case.

Ultimately, the bank has opted to save its present and former senior executives embarrassment. The outcome of the case is important to businesses which may have been mis-sold complex interest rate derivatives by their lenders and in light of the settlement between the parties in the Graiseley “test case”, compromises between mis-selling banks and their victims are likely because the banks have set aside £3 billion to settle potential cases involving interest swap mis-selling. But P. Gandhi et al (see Libor Manipulation: Cui Bono?) estimate that LIBOR manipulation “could have increased the market value of the panel banks by $22.76 billion.” So arguably, the gains have offset the losses.

However, the Serious Fraud Office (SFO) has been investigating the criminal face of the LIBOR scandal. So far, nine people have been charged by the SFO. Initially, charges against Tom Hayes were brought in June 2013. Then, Terry Farr and James Gilmour were similarly charged in July 2013. Similarly, Barclays’ employees Peter Charles Johnson, Jonathan James Mathew and Stylianos Contogoulas were also charged in February 2014. And in March 2014, Danny Martin Wilkinson, Darrell Paul Read and Colin John Goodman of ICAP plc joined the list. The SFO’s website explains that formal charges will be made later this month.

To say the very least, it will be interesting to see how things progress with LIBOR this year. The road ahead is slippery no doubt!