The LIBOR scandal explained

Former trader Aidan Neill details what LIBOR is, why it's important and how the scandal erupted

Loans come in a variety of different shapes and complexities, but can be broadly characterised as either fixed rate or floating rate - that is, they pay a set or variable rate of interest. Anyone who has or has considered getting a mortgage will be aware of this distinction. If you take out a fixed rate mortgage you may sometimes pay more than the best rate in the market each month in interest payments, but will have certainty of always knowing exactly what that payment figure will be. On the other hand, a variable rate or, in banking terminology, a floating rate, will be determined by reference to a set rate of interest - in the case of mortgages, one that's periodically reset by the Bank of England. Floating rate debt pegged to a market rate was first issued in 1970s America, where it developed out of a need to help both borrowers and lenders manage their exposure to heavily fluctuating market interest rates.

The importance of LIBOR

This is where the London Interbank Offered Rate (LIBOR) comes in. LIBOR is an average interest rate calculated by leading banks in London based on the rates they charge to lend to each other. In the financial markets, most debt products come with a floating interest rate set a certain number of percentage points above LIBOR, with the British Bankers Association stating that $800 trillion (almost £500 trillion) worth of securities are pegged against it - from mortgage loans to credit cards to corporate bonds and derivatives. Given that $800 trillion is roughly 12 times the entire global annual economic output, the choice and mechanics of LIBOR's calculation is of considerable importance.

Every day at 11am GMT the banks which contribute to the LIBOR-setting process send their estimations of their interbank borrowing rates to Thomson Reuters. The highest and lowest contributions are discarded and an average is calculated using the remaining estimates. The number of banks contributing to the process varies according to the currency being borrowed. The euro panel has 15 banks, the sterling panel has 16 and the US dollar panel 18. The key issue with this process is that the inputs from participating banks are not based on actual trades, but on estimates, which means they are open to interpretation or worse, manipulation.

How LIBOR was rigged

There are two main aspects to the "rigging" that's currently being investigated. First, were traders colluding within or between banks to input figures that would benefit their trading positions? Suppose, for example, that a derivatives trader in a bank has taken a view that LIBOR rates will increase in the future. He might decide to buy a futures contract carrying the right to pay a 1 per cent interest rate for the next three months. If, thanks to rises in LIBOR, the rate he would otherwise be paying in December is actually 2 per cent, then his contract will ensure that he can still borrow at 1 per cent - and will therefore be valuable.

But if the trader could somehow push the actual December rate even higher, the value of his contract will increase even more. The emails exchanged between the "VIP club of rate riggers", then, make for interesting reading. On 26 October 2006, an external trader made a request to a Barclays trader for a lower three-month US dollar LIBOR submission: "If it comes in unchanged I'm a dead man." The Barclays trader responded via email, saying that "he would have a chat", implying that he would talk to the person at Barclays responsible for the LIBOR submission. Lo and behold, the actual Barclays submission on the day was lower than the day before. The external trader thanked the Barclays trader: "Dude. I owe you big time! Come over one day after work and I'm opening a bottle of Bollinger."

The second aspect of the manipulation relates to LIBOR rates at the beginning of the financial crisis in late 2007. Banks had virtually stopped lending to each other, so there was no clear interbank lending market. During this time Barclays had been submitting LIBOR rates that it believed reflected the difficulty of the market, so their rates were therefore relatively high. These high submissions sparked media speculation that Barclays was in trouble. Following much internal debate and a controversial conversation between Bob Diamond and Paul Tucker at the Bank of England, Barclays magically began to submit much lower rates.

The fallout from the LIBOR fixing scandal continues. In June, Barclays was fined £290 million and chief executive Bob Diamond was forced to resign. Other banks are set to be implicated too, with RBS for one currently under investigation by the Financial Services Authority (FSA). Investigations are ongoing in Canada, the US, Japan and Switzerland too. The most recent developments (see box) could be just the tip of the iceberg, with further findings and recommendations to follow.