Is LIBOR, Benchmark for Trillions of Dollars in Transactions, a Lie?

Pretty much everything that has derivatives tied to it is manipulated. Option expiries, FX fixes as well. Or it was when I was looking at it.

The thing is there are derivatives that are sometimes non-linear, things with triggers and barriers. When some large enough fish has one of these (eg by taking the other side vs a customer) they have an incentive to move the rate in whatever way they can. Whether it's getting someone to submit a bad rate or sitting on an FX cross, it can be worth it.

Before I went full quant I was often looking at the screens manually. You'd often see at around the WM/Reuters fix that the price would move strangely. An unusually large move would happen with no apparent news. You'd get a rumour from a broker, but who knew how they knew? And quite often the move would fade after the window closed.

This would happen even in exchange traded options. If you knew the specifics of the settlement window, you would know when the price would go wonky. You wouldn't know who, but you knew that is wasn't a normal time in the market.

The LIBOR was a bit less obvious, only really clear to me in hindsight. Swaps don't have a common schedule like listed options, so there's a fixing every day that could be in someone's interest to influence. Same goes for FX, but since LIBOR is a bunch of opinions (as opposed to trades) it's not as obvious.

This article contains a rather poor explanation of what LIBOR is and the history around it. Matt Levine does a much better job: https://www.bloomberg.com/view/articles/2017-07-27/the-end-o...

Back in the 1960s, a Greek banker in London[1] wanted to find a way for banks to make syndicated floating-rate loans. He found a very simple answer: The banks would lend money to a company, charging their cost of funds plus a spread, and every three months, you'd go out and ask the banks what their cost of funds was, and you'd average their answers, and that (plus the fixed spread) would be the new interest rate on the loan. This was a simple product for the banks: They could pass their costs on directly to the customer, and make a fixed profit (the spread). And by surveying all the big banks and throwing out outlier submissions, you could get a pretty fair approximation of the overall funding cost for banks.

And so this -- Libor, the London interbank offered rate -- became the normal way that everyone did floating-rate loans, and then it became the normal way that everyone did interest-rate derivatives, and then it became the normal way that everyone did ... sort of ... everything? Libor just sort of became The Interest Rate, used for discounting cash flows in all sorts of transactions, "the most important number in the world." But it was always based on a survey of banks' funding costs, and so it was always a little hazy. One problem was that the banks could lie. But a second problem is that the banks might not even know. Libor surveys asked banks each day what they would have to pay to borrow money unsecured from other big banks, but over time the banks sort of stopped doing that, particularly in some of the more obscure combinations of tenors and currencies that nonetheless reported Libor rates. So the banks' Libor submitters would guesstimate their submissions based on deposit rates and commercial-paper rates and secured-borrowing rates and other tenors and what brokers and their buddies were telling them. It was all more or less good enough as a casual system for resetting the rates on a few billion dollars worth of syndicated loans, but it was not accurate down to the hundredth of a basis point as a foundation for the financial system, or as the source for pricing hundreds of trillions of dollars of derivatives.

[1] Minos Zombanakis: https://www.bloomberg.com/news/features/2016-11-29/the-man-w...

This is old news for large portions of the interest rate derivatives market, which is quickly moving towards OIS[1] rates instead, based on widely traded liquid instruments.

Also, the implication that LIBOR is purposefully a scam is basically untrue.

When LIBOR was first developed, it was an improvement on other interest rate benchmarks, and it also reflected current market conditions at the time, as banks actually did regularly make bilateral interbank (the 'IB' in LIBOR) loans to one another.

There are checks built into LIBOR to discourage fraud: for example, the actual calculation discards the high and low outliers, so individual banks cannot manipulate the benchmark easily[2].

But as the interest rate market continued developing, much of the actual lending transaction volume moved towards other markets; the financial crisis just accelerated that trend.

So now we have a lot of contracts written against a benchmark that slowly stopped reflecting an actual interest rate market. The right path forward would probably be to renegotiate these contracts so that going foward, they're against OIS instead.

[1] https://en.wikipedia.org/wiki/Overnight_indexed_swap [2] https://en.wikipedia.org/wiki/Libor#Calculation

On the one hand, LIBOR is a completely made-up number. On the other hand, so are central bank rates.

If you're going to peg transactions to a made-up number, is LIBOR really any worse than anything else?

> there is no market that LIBOR measures

Except that's not true. Interbank lending is still a $70 billion market in the United States alone [1]. Small compared to banks' balance sheets and less than the $500 billion from as recently as February 2008, but material nonetheless.

Good rule of thumb in finance is to ignore Matt Taibbi.

[1] https://fred.stlouisfed.org/series/IBLACBM027NBOG