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The world’s most influential global banks have been rocked by scandal recently after revelations that traders were manipulating one of the world’s most important financial benchmarks, LIBOR.Hundreds of trillions of dollars in financial contracts are tied to the London Interbank Offered Rate, which is supposed to capture the price at which major, creditworthy banks lend to one another.

The most nefarious of these incidents seem to have occurred before the financial crisis, when traders (specifically at Barclays) asked one another to submit rates somewhat higher or lower than those it would otherwise report for their own personal gain. This behaviour appears to have been widespread, and investigators are only now figuring out the full extent of the rate distortions.

A former derivatives trader for Citigroup shed light on the scandal in an article published today in the Boston Review. While he was not involved in the LIBOR scandal proper, Omer Rosen’s recollections of his own trades nonetheless reflect the ways in which bankers can distort complex financial predictions in order to make big money for their clients.

Rosen describes a scenario in which a big bank approached him, looking for a way to diminish tax payments based on future interest rates. Essentially, Rosen had to create a scenario in which LIBOR would be higher in the future than a given fixed rate. This would save a bank money in taxes.

The scheme, Rosen admits, was not illegal. But the point of his article is that it’s incredibly easy for bankers to make their clients money—and cheat the U.S. taxpayer—through interest rate manipulations, real or imagined.

Rosen describes how he “rigged” LIBOR in his scheme:

So as I set about figuring out how the bank could structure the transaction in a way that satisfied both the client’s criteria and our internal bank policies, I also began making up future LIBORs. I say “making up,” rather than “forecasting,” because I was not really trying to forecast anything. Every few days or weeks I’d look at interest rates, figure out what the fixed rate in the transaction would end up being, and then see if, without being completely outlandish, I could come up with different combinations of future LIBORs that would make it possible for the fixed rate to theoretically save the client money over the course of several years. These future LIBORs were not based on what anyone thought LIBOR would be or could be or should be, nor on any simulations. Rather, they were based just on what we needed them to be (sound familiar?) in order for the company to be able to pretend to justify the transaction to themselves and their tax people from a financial point of view (and not from a taxation point of view, since that, you know, might be illegal—or perhaps just tax-abusive, to use proper IRS jargon)...

I messed around with different LIBORs until I came up with something that struck the right balance and looked kosher, updated the “Alternative Financing Discussion” presentation with the newly minted future-LIBOR scenarios, and sent it off to the client as if I had just conducted a new analysis on their behalf. After many months of playing with LIBORs (and overcoming the other numerous structuring obstacles that involved myriad bank departments) the transaction was executed.

In the continuing debate over ethics at the world’s most important financial institutions, this account confirms that bankers do shady things to manipulate interest rate derivatives for their own personal benefit.

Another former derivatives trader told Business Insider that his team at a major Wall Street investment bank spent an entire year utilising other banks’ misunderstandings of the way in which LIBOR transactions were settled in the mid-1990s to net big profits. (In many contracts based on LIBOR, basis points are measured in denominations of $25. When banks don’t know that, they lose money.)

As more and more revelations surface about deliberate rigging of LIBOR and other financial benchmarks, we’re likely to hear much more about shady derivatives transactions like the one Rosen describes in his column.

Read Rosen’s full account of his interactions with LIBOR on Boston Review >


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