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Rigging Interest Rates on $800 Trillion?

"LONDON—The scandal involving efforts to manipulate a key interest rate continued to tear through the top ranks of Barclays PLC, as its chief executive and chief operating officer resigned a day after its chairman stepped down.

CEO Robert Diamond resigned Tuesday amid intense political and investor pressure over the British bank's involvement in rigging the benchmark, used to set interest rates on an estimated $800 trillion of borrowings and derivatives. Jerry del Missier, who was named chief operating officer last month, also stepped down."

Pressure on Mr. Diamond increased after the bank agreed last week to pay $453 million to settle a U.K. and U.S. probe that showed traders had blatantly sought to manipulate the London interbank offered rate, or Libor, to disguise the high cost of the bank's own funding and to pad the profits of certain traders." (Source)

The LIBOR and Derivatives

"In 1984, it became apparent that an increasing number of banks were trading actively in a variety of relatively new market instruments, notably interest rate swaps, foreign currency options and forward rate agreements. While recognizing that such instruments brought more business and greater depth to the London Interbank market, bankers worried that future growth could be inhibited unless a measure of uniformity was introduced. In October 1984, the British Bankers' Association (BBA)—working with other parties, such as the Bank of England—established various working parties, which eventually culminated in the production of the BBA standard for interest rate swaps, or "BBAIRS" terms. Part of this standard included the fixing of BBA interest-settlement rates, the predecessor of BBA Libor. From 2 September 1985, the BBAIRS terms became standard market practice.

BBA Libor fixings did not commence officially before 1 January 1986. Before that date, however, some rates were fixed for a trial period commencing in December 1984.

Member banks are international in scope, with more than sixty nations represented among its 223 members and 37 associated professional firms (as of 2008).....

The LIBOR is widely used as a reference rate for many financial instruments, such as:

    forward rate agreements
    short-term-interest-rate futures contracts
    interest rate swaps
    inflation swaps
    floating rate notes
    syndicated loans
    variable rate mortgages
    currencies, especially the US dollar (see also Eurodollar).

They, thus, provide the basis for some of the world's most liquid and active interest-rate markets." (Source)

Implications of LIBOR manipulation

"Libor is calculated and published by Thomson Reuters on behalf of the British Bankers' Association (BBA) after 11:00 AM (and generally around 11:45 AM) each day (London time). It is a trimmed average of interbank deposit rates offered by designated contributor banks, for maturities ranging from overnight to one year. Libor is calculated for 10 currencies. There are eight, twelve, sixteen or twenty contributor banks on each currency panel, and the reported interest is the mean of the 50% middle values (the interquartile mean). The rates are a benchmark rather than a tradable rate; the actual rate at which banks will lend to one another continues to vary throughout the day."  (Source)
"Libor is often used as a rate of reference for pound sterling and other currencies, including US dollar, euro, Japanese yen, Swiss franc, Canadian dollar, Australian dollar, Swedish krona, Danish krone, and New Zealand dollar.

In the 1990s, the yen Libor was influenced by credit problems affecting some of the contributor banks.

Six-month USD Libor is used as an index for some US mortgages. In the UK, the three-month GBP Libor is used for some mortgages—especially for those with adverse credit history." (Ibid)

Follow the LIBOR Futures
"The Chicago Mercantile Exchange's Eurodollar contracts are based on three-month US dollar Libor rates. They are the world's most heavily traded short term interest rate futures contracts and extend up to ten years. Shorter maturities trade on the Singapore Exchange in Asian time. ...

Interest rate swaps based on short Libor rates currently trade on the interbank market for maturities up to 50 years. In the swap market a "five year Libor" rate refers to the 5 year swap rate where the floating leg of the swap references 3 or 6 month Libor (this can be expressed more precisely as for example "5 year rate vs 6 month Libor"). "Libor + x basis points", when talking about a bond, means that the bond's cash flows have to be discounted on the swaps' zero-coupon yield curve shifted by x basis points in order to equal the bond's actual market price. The day count convention for Libor rates in interest rate swaps is Actual/360, except for the GBP currency for which it is Actual/365. (Ibid)

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