LIBOR Rate Manipulation

Jeff  Carter
Posted: Feb 18, 2012 12:01 AM

Bankers manipulated the LIBOR rate.

These are the kinds of things that disgust people about Wall Street. Manipulation makes credible marketplaces look like a sham. For those that don’t know, the LIBOR market is the largest most liquid credit market in the world. The Eurodollar ($GE_F) contract at the CME ($CME) is the most liquid, most actively traded contract.

Why does it exist? To help banks manage short term interest rate borrowing risks. If Eurodollars weren’t traded, it would be very difficult for anyone to refinance a home or business loan.

The LIBOR rate is the London Interbank Rate, and is the rate of interest banks charge each other for short term loans. It is calculated each day based on a survey of designated banks. The market isn’t billions of dollars large. It’s trillions of dollars. Soon it will be quadrillions. The LIBOR market isn’t small potatoes, and most people haven’t heard of it.

The bankers artificially colluded to try and move the rate to best suit their positions in the market from 2007 to 2010. They used text and instant messaging to submit quotes. You Ksee, while there is a cash and futures market that provides a lot of transparency, it is heavily influenced by the cash rate which is fixed each day by a survey of banks.

In the financial crisis, short term rates skyrocketed as the risk of borrowing overnight escalated. There was massive uncertainty and counter party risk was driving prices higher. However, the LIBOR rate didn’t go as high as it might have because bankers manipulated the quotes they were sending in-understating their true borrowing costs.

Right now, the bankers in all countries have an incentive to understate borrowing costs. In Japan, they have been pushing on a string for two decades. How long can rates continue to be so low? Europe has massive government credit problems-again, how can borrowing costs not be soaring even more? Isn’t counter party risk there at all time highs. Who knows which bank is most susceptible to default? In the US, the interbank market froze during the crash of 2008. Bankers here were bailed out, and their borrowing costs from each other seemed low at the time.

This is why things like dark pools and private markets are so pernicious. True transparency wouldn’t allow it because someone would have the ability to look at the numbers and cry “wolf”. It is critically important to the capitalistic system of free markets to have a market that isn’t rigged. Price is the most important information in a market. Prices coordinate everything. They help people make decisions on where to allocate capital.

When a small group colludes to misinform the broader market about the true price, it leads to imbalances and poor decisions being made in other places. That’s why independent and government regulators come down so hard on people that try to corner commodity markets, and that’s why these colluding bankers should never be allowed to work in the marketplace again.

It’s also why centrally planned pricing policies never work. This is ultimately why Obamacare will fail, and wind up costing American taxpayers trillions of dollars. A free, transparent market always works better in than a centrally planned one.

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For a different illustration on a similar theme, here is the master himself, Milton Friedman on the price of a pencil.