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CFTC Ignored Warnings of Libor-Gaming – 15 Years Ago

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When the Chicago Mercantile Exchange launched its Eurodollar futures contract in 1981, it devised a nearly foolproof way to calculate the London interbank offered rate. 

The CME would select 20 banks at random from a much larger pool and survey those banks for their perception of interest rates. It would discard a subset of the highest and lowest and average the responses that remained.  At a randomly selected time within the next 90 minutes, the CME would conduct a second survey with a fresh random set of banks. Finally, it would publish the average of the results of the two surveys without revealing the identities of the banks that participated.

This is in sharp contrast to the now-infamous procedure of the British Bankers' Association which uses a smaller sample of the same banks every day and displays their rates for the world to see.

In September 1996, the CME applied to the U.S. Commodity Futures Trading Commission for permission to switch from its own, sensible Libor calculation to the BBA's.  Presumably, the CME worried that a rival exchange would steal market share by starting a contract tied to BBA Libor, which was and is the standard floating rate index for swaps, loans and notes.   

On Nov. 18, 1996, I filed a public comment letter with the CFTC objecting to the CME's plan.  Here are some excerpts from that letter:

"In a severe funding crisis … banks might respond to the BBA survey with a rate substantially below their true lending rate.  Since the BBA survey results appear on Telerate [a Bloomberg-like information service widely used at the time], the banks may want to hide the extent of their troubles…The CME randomly draws a limited number of reference banks from a larger pool on the futures settlement date.  This ensures that banks will not know ahead of time whether they will be able to participate in the survey.  The BBA, on the other hand, surveys the same sixteen banks every day. To see how a bank could exploit this feature of the BBA survey to manipulate the index, suppose that the four high quotes are expected to be the three Japanese banks (Bank of Tokyo/Mitsubishi, Fuji, and Sumitomo Trust) and the Bank of China.  Then, any of the remaining banks can raise their quote, and the effect will flow directly to the final index.  A British bank, for example, might raise its quote by 12.5 basis points.  Since eight banks make up the average, the average will rise by 12.5/8 = 1.5626 basis points.  If two banks worked together, they could raise the average by 3 basis points.  

“The CME claims the BBA survey will self-correct if markets become more volatile.  They argue that ‘[t]he outstanding notional value of instruments tied to the BBA fixings is enormous…’  But enormous markets create enormous temptations.  The CME argument works only to the extent that we rely on BBA members to look beyond their self-interests.  Again, without impugning any of the BBA banks, we do not consider this to be a sound basis for predicting human behavior.”

That was more than 15 years ago.  No one should be surprised that banks would suppress their posted rates in a funding crisis or that they might manipulate the survey for gain. It was easy to see this coming. 

The CFTC ignored my letter, sent on the stationery of the derivatives subsidiary of Japan's largest bank, as well as a similar letter from Salomon Brothers. (They are available today on request from the CFTC.) The CME converted the gigantic Eurodollar futures market to BBA Libor starting in January 1997 and crystalized the dominance of the BBA.  So while the CFTC is dishing out nine-figure fines to banks caught up in the scandal, it might want to consider another possible culprit: itself. 

The recent suggestion that BBA improve the Libor calculation by deriving it from actual transactions is not practical.  How would nine-month U.S. dollar Libor be determined?  I doubt any bank has once lent to another in dollars or any other currency for a nine-month term since the crisis began.  Like it or not, Libor is a survey of opinions.

The Eurodollar contract was designed by my friend, the late Fred Arditti, who was the CME's chief economist at the time.  Let's throw in a posthumous "I told you so" for Fred. The CME could have adopted the BBA method in 1981 but did not because it recognized that the BBA method had flaws that the scandal has now exposed.

The problem, though, is not hard to fix. The BBA and the CME should switch to the old CME rules that Fred designed. What worked before will work again.

Richard Robb is chief executive of Christofferson, Robb & Co., an investment management firm, and professor of professional practice of international finance at Columbia University's School of International and Public Affairs.

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Comments (4)
Did the CFTC ignore Mr. Robb's prescient comment, or did the Commission focus on the problem that the CME would not be offering a true LIBOR-index product if it was using a formula that differed from LIBOR? To be a true hedge, which is the foundational purpose of a future's contract, you want the reference points to be as close as possible to the value from which the futures contract derives its value. The CME product was touted as a LIBOR derivative, requiring that it be as closely as possible tied to the genuine LIBOR definition and formula, however LIBOR was derived. The fear that some other firm in the 1990s (when the international market for futures business was fiercely competitive) might offer a competing contract more closely following genuine LIBOR was very real. The issue then was a true match of the LIBOR futures with the LIBOR rates. The issue today, a very different one, is how LIBOR identifies its rates. As those formulas change--and they surely will--no doubt that the CME contract will, too. The author's insightful comments on how LIBOR was vulnerable were likely more appropriately directed to the owners and operators of LIBOR rather than to the proposal by the CME, who was trying to create a derivitive that matched it.
Posted by WayneAbernathy | Wednesday, September 05 2012 at 3:51PM ET
The CME original system worked. It could be validated by transaction information.
Posted by parkerco | Wednesday, September 05 2012 at 4:09PM ET
Something didn't ring true about the CFTC being the intrepid enforcer. After all, it's the CFTC -- or any financial regulator.

Since then, there have been scandals involving the abuse of customer funds, and in the case of MF Global, the Chairman's finger prints were all over it before he "recused" himself.

At a recent House Ag hearing, several Members expressed skepticism and outrage over the behavior of CME and FIA as SROs and have begun to question the SRO model. The industry has taken the position that there doesn't need to be any regulation, because this industry is trouble-free.
Posted by bob-dc | Wednesday, September 05 2012 at 4:28PM ET
To aberw: As you say, the CME wanted to forestall competitors who might launch a BBA libor futures contract. But Eurodollar futures were not only used to hedge BBA-libor derivatives. Eurodollar futures had a life of their own. For example, consider a firm with fixed-rate debt that wanted to convert to floating. As an alternative to a swap, it could buy a strip of Eurodollar futures. There was no reason to touch BBA-libor; BBA libor was no more genuine than CME libor. The same comment applies to the "TED spread." Traders bought or sold T-bill futures vs. Eurodollars. The Eurodollar leg did not need to be BBA libor. Prior to 1997, the Eurodollar contract provided an effective hedge for derivatives dealers (who wanted a futures contract that was close enough to BBA libor) and all the other users (who wanted the best possible measure of banks' three-month funding cost, to the extent they gave it any thought). Derivatives dealers could live with the basis between CME and BBA, since they held futures hedges for relatively short periods of times, and they could use FRAs to eliminate any unwanted reset risk. If the CFTC had told the CME to stick with its original method, I believe the Eurodollar futures market would have continued to thrive, while traders and hedgers would have been spared the defects of BBA libor.
Posted by Brad Golding | Wednesday, September 05 2012 at 4:39PM ET
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