The system by which benchmark rates are fixed for interest rates, currencies and gold is an arcane and archaic one. There are two common elements when it comes to fixing such rates: One, the fixing is done in London, and two, the fix is implemented by a very select group.
Consider the fix for the London Interbank Offered Rate (LIBOR), the benchmark rate that is used as a reference for trillions of dollars in loans and swaps. LIBOR reflects the short-term cost of funds for major banks active in London. Prior to Feb. 1, 2014, LIBOR was administered by the British Bankers’ Association (BBA). Each day, the BBA would survey a panel of more than a dozen banks, and ask each contributor bank to base its LIBOR submissions in response to the following question – “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 a.m. London time?” The submissions received were then ranked in descending order, with the submissions in the top and bottom quartiles excluded as outliers and the arithmetic average of the remaining contributions used to arrive at the LIBOR rate. Separate LIBOR rates for 15 different maturities of 10 major currencies were then reported at 11:30 a.m. (See also "What is the ICE LIBOR and What is it Used for?")
In the foreign-exchange market, the closing currency “fix” refers to benchmark forex rates that are set in London at 4 p.m. daily. Known as the WM/Reuters benchmark rates, these rates are determined based on actual buy and sell transactions conducted by forex traders in the interbank market during a 60-second window (30 seconds either side of 4 p.m.). The benchmark rates for 21 major currencies are based on the median level of all trades that are executed in this one-minute period.
The price of gold is fixed using a century-old ritual that dates back to 1919. As of 2014, there were five banks involved in the gold fix - Barclays, Deutsche Bank AG, Bank of Nova Scotia, HSBC Holdings and Societe Generale. The gold price is fixed twice a day at 10:30 a.m. and 3 p.m. London time. The fixing is done through teleconference between the five banks, with the current chairman (chairmanship rotates annually) announcing an opening price to the other four members, who then convey this price to their customers. Based on customer orders and their own trades, the banks then declare how many gold bars they want to buy or sell at the current price. The gold price is then adjusted upward or downward until demand and supply are approximately matched, i.e. the imbalance is 50 bars or less, at which point the gold price is declared fixed.
The archaic practices used to set these benchmarks were significant contributors to recently-unearthed rate-fixing abuse. These benchmarks are used to value trillions of dollars in contracts and trades, and collusion among a few players to set them at artificial levels distorts market efficiency, destroys investors’ confidence in fair markets, and enriches a handful at the expense of millions.
How Suspicion Arose
The LIBOR and gold rates came under special scrutiny in the wake of the two major bear markets in the first decade of this Millennium. The end of each “bear” was marked by renewed zeal among regulators and market players to usher in policies that would prevent a repetition of the previous boom-and-bust cycle. Thus, in the aftermath of the 2000-02 bear market – whose casualties included Enron, WorldCom and a number of other companies enmeshed in accounting irregularities – Sarbanes-Oxley legislation was enacted to improve corporate governance, while regulations aimed at preserving the independence of investment research were also introduced.
In the wake of the 2008-09 global bear market, excessive risk-taking by financial institutions came under the regulatory spotlight. One effect of this heightened scrutiny was to expose the manipulative practices used by influential banks and institutions to fix benchmark rates for interest rates, currencies, and perhaps even gold.
The primary motivation for manipulating benchmark rates is to boost profits. A secondary motivation, specifically with regard to LIBOR, was to downplay the level of financial stress that certain banks were under at the height of the 2007-2009 global credit crisis. These banks deliberately lowered their LIBOR submissions during this time to convey the impression that their counterparties had a higher degree of confidence in them than they actually did.
These issues may be avoided in the future, through measures such as benchmark administration by independent bodies and more effective regulation.
- Administration by independent bodies: New York University’s Stern School of Business Professor Rosa Abrantes-Metz and her husband, Albert Metz, have published leading-edge research highlighting the problems with LIBOR and with the gold fix. Abrantes-Metz has expressed concern that a few individuals with apparently no oversight whatsoever have the power to set benchmark prices (for financial assets or instruments) in which they have multiple other interests. In a January 2014 article in the Financial Times, she suggested that benchmarks of the future should be based on actual trades whenever possible, and be administered by independent bodies without direct financial interests in the benchmark values. The setting of LIBOR has already followed this path, as it is being administered by the Intercontinental Exchange Benchmark Administration (IBA) unit from Feb. 1, 2014, and is now known as ICE LIBOR (formerly known as BBA LIBOR). While the methodology is little changed, some changes have been made to help ensure the integrity of the LIBOR rates, such as individual submissions not being published until three months after the submission date.
- More effective regulation: In the LIBOR-fix and forex-fix scandals, there were concerns about collusion and manipulation for years before they were finally exposed. In both cases, regulators moved in only after journalists (and researchers like the Metzes) had already done the initial spadework. For instance, the LIBOR-fixing scandal was unearthed after some journalists detected unusual similarities in the rates supplied by banks during the 2008 financial crisis. As for the forex benchmark rates issue, it first came into the spotlight in June 2013 after Bloomberg News reported suspicious price surges around the 4 p.m. fix. A similar pattern is evolving with regard to the gold fix, with Abrantes-Metz and Albert Metz writing in a draft research paper released in February 2014 that unusual trading patterns around the time of the afternoon fix smacked of collusive behavior and warranted further investigation. More effective regulation is required to detect such trading anomalies. The mammoth forex market may also need better regulation to prevent blatant abuses like front running and colluding to drive exchange rates in one direction or to a specific level. (For more on this controversy, see "How The Forex Fix May Be Rigged.")
Regulatory authorities have been quick to take action in the LIBOR-fix and forex-fix scandals. A number of prominent heads have already rolled in connection with the LIBOR-fix debacle, specifically at Barclays, where three top executives resigned in 2012. In December 2013, the European Union penalized six leading banks and financial institutions with a record EUR 1.71 billion fine for their role in the LIBOR scandal. In the forex-fix fiasco, at least a dozen regulators on both sides of the Atlantic are investigating allegations of forex traders’ collusion and rate manipulation, and more than 20 traders have already been suspended or fired as a result of internal inquiries.
The Bottom Line
At the end of the day, the antiquated processes of yesteryear that have been used to set benchmark rates for decades may need a complete overhaul to promote greater transparency and prevent future abuses. Abandoning the use of the term “fix,” with its distinctly negative connotation in financial markets, would be a good place to start.