The alleged London Interbank Offered Rate (Libor) conspiracy and manipulation was initially flagged by two articles published in the Wall Street Journal in April and May of 2008. Shortly after, in August 2008, I released a paper, co-authored with Michael Kraten, Albert Metz, and Gim Seow, in which we applied empirical screens to identify several unexpected patterns of Libor and the underlying banks’ quotes for the period January 2007 through May 2008. This analysis indicated the possibility of a conspiracy to manipulate Libor.
Following these initial screens we have been learning of large-scale investigations around the world of Libor denominated in multiple currencies. We have also learned of confessions by bank employees to manipulating Libor. The Libor case represents the most recent and significant application of screens, and establishes the power of these empirical tools to flag potentially illegal behavior.
The implications of such a manipulation, if proven true, would be enormous. The Libor rate impacts capital allocation around the world. The seriousness of the alleged conduct may have already inspired some of the new regulations on financial and commodities markets, namely those by the Commodities Futures Trading Commission (CFTC) related to price manipulation and fraud.Â In this short notice I briefly explain how several aspects of the new CFTC regulations may have been based, at least to some extent, on features of the alleged Libor conspiracy and manipulation.
In commodities markets, there is no generally accepted definition of manipulation, though legal definitions of manipulation have been developed over the last decades through specific cases involving many different types of manipulation. In general, we may say that there are 3 large categories of manipulation:Â delivery impairment, false information, and market-rigging.
Under the pre Dodd-Frank rules, manipulation referred to price manipulation, and it involved establishing the following four-part test: (1) the alleged manipulator had the ability to influence market prices, (2) he also had the intent, (3) artificial prices existed, and (4) these prices were caused by the alleged manipulator.
The post Dodd-Frank rules represent a significant expansion of the CFTC’s authority and lower the burden of proof in manipulation and fraud cases. The new regulations related to manipulation and fraud are composed of two rules, Rule 180.1 and Rule 180.2, which took effect last summer.
Rule 180.1 represents the new liability, and it relates to the prohibition on employment, or attempted employment, of manipulative and deceptive devices. It is similar in nature to the SEC’s 10(b)-5 rules, though substantially broader, as it applies to attempted fraud, and it does not require an actual transaction of the security, but just a violation in connection with the purchase or sale of swaps, cash, and futures markets. Additionally, this rule imposes prohibitions to those adopted by the Federal Energy Regulatory Commission and the Federal Trade Commission when dealing with physical energy markets.
This rule significantly expands the CFTC’s enforcement authority, as it extends to swaps (a U.S. $400 trillion dollar interest rate market), and it applies to reckless behavior.
Rule 180.2 represents the old liability, and it relates to the prohibition on price manipulation or attempted price manipulation. This rule reflects mostly the pre Dodd-Frank rules, but now it also applies to indirect manipulation or attempted manipulation. The four-part test should continue to apply to manipulation cases, but the CFTC has stated that it expects to exercise its authority where the fraud or manipulation has the potential to affect cash commodities, futures or swaps markets, or participants in those markets. Given this, Rule 180.2 may not always require a market or price effect.
What is interesting is that the features of the alleged Libor manipulation may lack many of the indicia of traditional financial manipulation, but meet the new criteria, and one may wonder whether they contributed to these changes. Notice the following features of the alleged Libor manipulation underlining the changes in the regulation:
Â Â Â Â Â Â Â Â Â Â Â Â (i)Â Â Â Â Â Â Â Â It does not require an actual transaction of a security”
The Libor is a quote; it is not based on an actual transaction of any security, but it is connected with the purchase or sale of swaps, cash, and futures markets.
Â Â Â Â Â Â Â Â Â Â (ii)Â Â Â Â Â Â Â Â It would have been an indirect manipulation”
A Libor manipulation would have indirectly caused distorted prices across multiple markets around the world.
Â Â Â Â Â Â Â Â Â (iii)Â Â Â Â Â Â Â Â It relates to swaps”
In particular, the effect of a Libor manipulation would have been the greatest in the newly covered swaps market.
Â Â Â Â Â Â Â Â Â (iv)Â Â Â Â Â Â Â Â It may have involved reckless behavior”
There may not have existed intent by many of the alleged participants, but only reckless use of the index’s internal machinery. The submission of a quote by a bank on a date when it has received no loan offers and expects no offers in the next few days, may not be false in any obvious way, given that there is no contrary input. It may be seen as reckless, given that the bad faith quote is not the fruit of a diligent information gathering process.
Â Â Â Â Â Â Â Â Â Â (v)Â Â Â Â Â Â Â Â There may not have been a material price effect”
If any effects existed, they may have been small and not material given common court standards for materiality. The actual redistributional effects could nevertheless have been enormous given the extensive use of the Libor as a primary benchmark of worldwide transactions.
For further analysis on this topic, please refer to the attached copy of R. Abrantes-Metz, A. Verstein, & G. Rauterberg, Revolution in Manipulation Law: The New CFTC Rules and the Urgent Need for Economic and Empirical Analyses,, Univ. of PA. J. Business Law, forthcoming.