Published on 10 April 2017

So apparently the Bank of England had some knowledge of the rate-rigging when it was going on, according to the UK newspapers today.

LIBOR as a reference rate was viewed for 30 years as the supreme neutral benchmark, the rate at which prime banks offer deposits to one another in the London interbank market – the banks all at the outset being AAA-rated.

3-month USD LIBOR was the most liquid contract in financial markets, underpinned by extensive exchange-traded and over-the-counter derivatives (futures, options, FRAs…) and securities markets (CP, FRNs…).

It assumed that banks were agnostic to building up their balance sheets with interbank deposits to/from one another and not netted. In effect it presupposed a market pre-Basel I where banks did not hold capital against their interbank book, that book being with undoubted, prime, AAA names.

The problems with LIBOR had been nascent before the financial crisis, but were revealed starkly by it. There was a huge shrinkage in the list of banks that other banks regarded as prime. Liquidity disappeared from interbank lending in terms of both amount limits and maturity limits. Banks’ cost-of-funds began to diverge from LIBOR, and then rigging was revealed to have taken place – in a market with no effective supervisor.

The surprise, surely, is not how many banks were involved in this but how few. Some are not ‘prime banks’ based on their credit rating, and are there only 8 or 9 prime market-makers in FX now?

When the UK crashed out of the ERM in September 1992, there were twenty or more American market-makers in “spot cable” (GBP vs USD exchange two days forward), including Manufacturers Hanover Trust, Security Pacific, Chemical Bank, Chase Manhattan Bank, Morgan Guaranty Trust Company, First National Bank of Chicago… and many more.

Now we have a thinner market, and one from which the central bank has withdrawn direct steerage.

The Bank of England used to be able to steer GBP interest rates itself, and not through the Base Rate, which has proven to be a very blunt instrument for transmitting a Monetary Policy Committee decision into a change in money supply and prevailing rates on the high street. Perhaps Charlotte Hogg would not have been so poor a choice for the MPC since, however erudite the deliberations in the MPC, they never alter the rate and it wouldn’t make any difference if they did.

In the 1980s the Bank of England would re-discount Bills of Exchange that been avalised by any one of a lengthy panel of London banks and which were offered to the Bank through a series of licenced bill brokers (like Tullets, Fultons and Butler Till).

While funds based on GBP LIBOR were available from any commercial bank, bill funding could only come from a panel member, and was based on a discount and not accrual. It was available in the same tenors as LIBOR (1, 2, 3, and 6 months), and could be approximately combined with OTC and exchange-traded derivatives, those being priced off LIBOR itself.

The point was that the re-discount rate offered at the Bank of England for eligible bills would work out to a discount-to-yield between 1/16% and 1/8% below LIBOR.

Customers who could get a bill line would issue bills instead of taking a loan on a LIBOR basis, the commercial spread added by their bank being the same on both drawing options. Indeed, it was normal to offer the two drawing options within the same credit line letter.

The Bank of England used the bill market to steer LIBOR, by keeping its Eligible Bill Discount Rate close to but below LIBOR. Borrowers wanting to generate GBP would draw bills as long as there was at least a 1/32% advantage. But if bills went down to 1/8% below LIBOR, there was an arbitrage opportunity for borrowers wanting to generate funds in other currencies (USD, DEM…). The FX swap and brokerage to do that cost around 1/16%, leaving a 1/16% benefit.

The carrying-out of those instruments would eliminate the arbitrage opportunity and bring LIBOR down within 1/32%-1/16% above the Eligible Bill Discount Rate.

In other words, by varying its Eligible Bill Discount Rate, the Bank of England could steer GBP LIBOR.

The great and (not) lamented Gordon Brown knew better – as he did with the UK’s gold reserves. He decided that the Bank of England would stop doing banking and that the market could be left to discipline itself.

The Bank of England sacrificed the tools to steer the market directly and was unable to police an electronic market indirectly. The British Bankers Association was then still ringing around 24 banks at 11:00am for quotations in the LIBOR currencies, dropping the highest and lowest quotations and averaging the rest, whilst there appears to have been a chatroom in which the traders giving their quotations to the BBA were agreeing what to say.

But the authorities never blame themselves for their lapses. Perhaps they have so little knowledge as to be unaware when they are knocking out a retaining wall, and then they blame the homeowner when the building collapses.