Global Benchmarks in the Spotlight: An Overview of Investigations into LIBOR and Foreign Exchange Market Manipulations

Worldwide investigations into manipulations of the London Interbank Offered Rate (LIBOR) have resulted in settlements between regulators and banks with fines so far exceeding USD 6 billion in total. After a number of banks have admitted in deals struck with regulators to manipulating LIBOR by misreporting borrowing rates, numerous private claimants have followed suit by pursuing individual and class actions. At the same time, evidence gathered by regulators has spurred further investigations into other financial benchmarks, in particular in the foreign exchange market where purported misconduct is expected to trigger further multibillion-dollar fines and civil litigation.

By Thomas Werlen/Jonas Hertner (Reference: CapLaw-2014-14)

1) Introduction

The London Interbank Offered Rate (LIBOR) is the reference rate at which banks indicate they can borrow funds, in marketable size, from other banks in the London interbank market. It is derived from a filtered average of submissions by a panel of banks and fixed daily. Used in financial markets globally, it is one of the main rates to determine the borrowing costs for trillions of dollars in loans. As such, LIBOR has been described as ‘the most important number in the world’.

Although regulators and market observers had doubts about whether banks were being honest in how they were calculating the LIBOR as early as in 2007, it was only in June 2012 that it became the subject of public controversy. Allegations arose that individual panel banks signify cantly underreported their borrowing costs in order (1) to project financial strength in the midst of market uncertainty, and (2) to realize gains on LIBOR-based contracts. In total, US, UK and EU regulators have fined banks more than USD 6 billion for participating in rigging benchmark interest rates, and ongoing investigations are expected to implicate further major financial institutions. In the meantime, both regulators and banks themselves have expanded the scope of their investigations into further allegations of benchmark rate and price manipulations. In the context of the foreign exchange (FX) market, in particular, allegations over benchmark rate and price fixing are at least as serious and substantial as the LIBOR manipulations have been.

The purpose of the present article is to provide a summary overview of investigations into both LIBOR and FX. The article will also, in brief, examine the basis that these investigations might provide for potential civil claims under US law.

2) LIBOR and other key interest rates

Hints by a Barclays insider at the end of 2007 and a subsequent Wall Street Journal study had cast grave doubts on the reliability of LIBOR. The Barclays employee is said to have contacted US regulators to complain that Barclays was not setting ‘honest’ rates. The April 2008 Wall Street Journal article then argued that a number of banks may have underreported interbank borrowing costs by signifi cant amounts and on numerous occasions. This first spurred investigations into the fixing of a number of key reference rates, including LIBOR.

a) Regulatory Investigations

In the United States, the investigations into manipulations of LIBOR and other benchmark rates have been led by the US Department of Justice Fraud Division (DOJ) and the US Commodity Futures Trading Commission (CFTC). Non-public investigations by the CFTC began in late 2008, but it was only in early 2011 that the expanding global scope of the investigations became apparent when major financial institutions were subpoenaed by either the DOJ or the CFTC or both.

The DOJ launched criminal investigations in the course of which several banks pleaded guilty and received criminal fines. As of today, four banks – Barclays, UBS, RBS and Rabobank – have settled regulatory actions with the DOJ in the context of LIBOR manipulations and entered into non-prosecution (NPA) or deferred prosecution agreements (DPA).

Barclays seems to have been the first institution to have entered into an agreement with the DOJ in June 2012 admitting that it provided LIBOR and EURIBOR (Euro Interbank Offered Rate) submissions that, at various times, were false because they improperly took into account the trading positions of its derivative traders or reputational concerns about negative media attention. Barclays admitted that by falsely representing that its USD LIBOR submissions were based on its perceived costs of borrowing while fraudulently and in collusion with other institutions submitting misleading rates, it improperly benefi ted at the expense of its counterparties. It agreed to pay a USD 160 million fine. Barclays also entered into a settlement with the CFTC that entailed a USD 200 million fine to resolve LIBOR-related charges that it violated the Commodity Exchange Act (CEA).

UBS entered into an NPA with the DOJ in December 2012 admitting and accepting responsibility for misconduct, acknowledging that UBS derivatives traders (whose compensation was directly connected to their success in trading financial products tied to LIBOR and other benchmarks) exercised improper infl uence over UBS’s submissions for LIBOR and other rates, i.e. that they requested and obtained submissions which benefi ted their trading positions. UBS further acknowledged that certain of its managers and senior managers were aware of the interest rate manipulations. Its subsidiary, UBS Securities Japan, signed a plea agreement in which it plead guilty to felony wire fraud and agreed to pay a USD 100 million fine. On the same day in December 2012, UBS and UBS Securities Japan entered into a settlement with the CFTC to resolve allegations that UBS violated the Commodity Exchange Act. According to the CFTC’s findings, from at least January 2005 through at least June 2010, UBS engaged in systematic misconduct that undermined the integrity of certain global benchmarks, including USD LIBOR. The DOJ further filed criminal charges against two former UBS traders.

Later, in February 2013, RBS Securities Japan agreed with the DOJ to plead guilty to fraud and admitted its role in manipulating the Japanese Yen LIBOR, paying a USD 50 million fine. In addition, its parent company, the Royal Bank of Scotland (RBS), was charged as part of a deferred prosecution agreement with fraud for its role in manipulating LIBOR rates and with participation in a price-fixing conspiracy in violation of the Sherman Antitrust Act by rigging the Yen LIBOR with other banks. The DPA further required RBS to pay a USD 100 million penalty beyond the fine imposed upon RBS Securities Japan. This marked the first time the DOJ has held a financial institution criminally liable under the Sherman Antitrust Act for a trader-based market manipulation.

In October 2013, Rabobank was the fourth major financial institution to admit to misconduct in the context of rigging interest rates in a deal with the DOJ. Rabobank agreed, as part of a DPA, to pay a USD 325 million fine. It also settled for a USD 475 million fine with the CFTC after it was found that, from at least mid-2005 through early 2011, Rabobank traders engaged in hundreds of manipulative acts undermining the integrity of the LIBOR and the EURIBOR. Then in January 2014, three former Rabobank traders were charged with manipulating the Japanese Yen LIBOR by deliberately submitting what the traders called ‘obscenely high’ or ‘silly low’ LIBOR rates in order to benefit their own trading positions.

A further target of the CFTC was ICAP Europe, an interdealer broker against whom CFTC brought charges over manipulation, attempted manipulation, false reporting, and aiding and abetting derivatives traders’ manipulations relating to the Yen LIBOR. The CFTC found that for more than four years, from at least October 2006 through at least January 2011, ICAP brokers on its Yen derivatives and cash desks knowingly disseminated false and misleading information concerning Yen borrowing rates to market participants in attempts to manipulate, at times successfully, the official fixing of the daily Yen LIBOR. ICAP was ordered to pay a USD 65 million civil monetary penalty.

In Europe, regulators have also been actively investigating banks’ misconduct and ordering fines. An extensive investigation that has led to substantial fines, criminal charges and regulatory action to improve the LIBOR setting methodology was conducted in the UK by the Financial Services Authority (FSA, which was replaced in 2013 by the Financial Conduct Authority [FCA]). These investigations have uncovered a range of systemic flaws in the LIBOR-setting methodology as identifi ed in the Wheatley Review and have led to calls for fundamental reform or even the replacement of LIBOR. Equally notable, the European Commission in December 2013 fined eight major financial institutions a total of EUR 1.7 billion for participating in illegal cartels in the financial derivatives markets. Four of these institutions – Barclays, Deutsche Bank, RBS and Société Générale – had participated in a cartel relating to Euro-denominated interest rate derivatives, while six institutions – UBS, RBS, Deutsche Bank, JPMorgan, Citigroup and RP Martin – had participated in one or more bilateral cartels relating to Japanese Yen-denominated interest rate derivatives. Of these, UBS received full immunity for revealing the existence of the cartels and thereby avoided a fine of EUR 2.5 billion for its participation in multiple infringements.

The cartel in Euro interest rate derivatives is said to have operated between September 2005 and May 2008. Traders are alleged to have discussed their bank’s submissions for the calculation of the EURIBOR as well as their trading and pricing strategies. While the abovementioned four institutions agreed to settle the case, thereby receiving a substantial reduction of fines, the European Commission has further opened proceedings against Crédit Agricole, HSBC, JPMorgan and the cash broker ICAP in the same context. Investigations are also being carried out into alleged manipulations of the Swiss Franc LIBOR. Besides regulatory investigations, authorities in a number of countries have brought criminal charges against individual traders.

b) Civil litigation

In the wake of the wide-ranging regulatory and criminal investigations into the LIBOR benchmark-setting process in the course of which a number of banks have admitted to misconduct, numerous private suits ensued in the US. Plaintiffs have based their claims most notably (1) on violations of antitrust laws and (2) on breach of contract and common-law fraud.

Many of the cases filed in a first round of litigation have been antitrust class actions brought on behalf of a diverse group of plaintiffs including municipalities, investment managers, lending institutions, derivatives users and brokerage firms. A number of these early suits filed in 2011 were consolidated and transferred to In re LIBOR (In re LIBOR-Based Financial Instruments Litigation [Southern District of New York 12 August, 2011). However, in March 2013, Judge Buchwald held that plaintiffs had not suffered any antitrust injury and dismissed class action antitrust claims. LIBOR, Judge Buchwald opined, was never intended to be a competitive rate-setting process. Competition in the market for LIBOR-based financial instruments could not have been restrained through the actions of the defendant banks since any alleged collusion would not have harmed competition between buyers and sellers of such instruments. Rather, the injury alleged would have been the same if each defendant had decided independently to misrepresent the institutions estimated borrowing costs.

Anticipating that antitrust claims would likely not be viable, other plaintiffs focused their claims on direct relations with benchmark-setting banks. One of these “second-generation” lawsuits – based on fraud claims – was brought by Salix Capital (Salix Capital US v. Banc of America Securities LLC et al. [13 Civ. 4018]) which owns claims belonging to a number of investment funds that entered into interest rate swaps with the defendants. In these arrangements, the investment funds would contract with one of the defendant banks to receive floating rate payments linked to LIBOR. The swaps were supposed to be a hedge against a banking crisis given that LIBOR should have increased as it became more expensive for banks to borrow from one another. Instead, the plaintiff argues, the benchmark-setting banks signifi cantly underreported their estimated borrowing costs, undermining the investment funds’ trading strategy. The plaintiff argues further that the funds “relied on the integrity of how Libor was set and the truthfulness of defendants’ representations about how Libor was set in entering into these transactions,” the complaint said. “By suppressing Libor, defendants artificially lowered the amount they were contractually obligated to pay to the funds under the interest rate swaps, while still demanding that the funds make the contracted-for (comparatively high) fixed-rate payments. In marketing the basis packages, defendants misrepresented Libor and omitted to disclose their manipulation of Libor.” In December 2013, the Salix Capital suit and other similar cases were transferred to Judge Buchwald in In re LIBOR.

Further second-generation lawsuits have been brought by mortgage financers Freddie Mac and Fannie Mae who filed largely identical suits against several LIBOR-setting banks alleging that the manipulations caused them to lose money on mortgages and other instruments. Most recently, the Federal Deposit Insurance Corporation (FDIC), who is acting as receiver for 38 failed banks, filed suits against 16 institutions claiming that these USD LIBOR panel banks ‘fraudulently and collusively suppressed’ the rate. The FDIC argues that the failed banks “reasonably expected that accurate representations of competitive market forces, and not fraudulent conduct or collusion” would determine the benchmark rate.

The only two cases brought so far in the UK involve Barclays against whom plaintiff Guardian Care Homes sought to rescind an interest-rate swap linked to LIBOR, pleading fraudulent misrepresentation or deceit (Graiseley Properties v. Barclays Bank [2012] EWHC 3093 [Comm]) and Deutsche Bank v. Unitech Global ([2013] EWHC 471 [Comm]). Unitech was allowed to amend its defense and counterclaim in respect of a claim brought by Deutsche Bank for payment under a credit facility and an interest rate swap so as to include similar allegations to those made by Graiseley. While the Graiseley case was settled in early April 2014, the latter is still pending.

3) Foreign exchange trading probes

Banks bound by cooperation agreements in LIBOR rigging investigations have provided regulators with extensive material that spurred further investigation into alleged manipulations of their foreign-exchange business. The potential scope of these manipulations are expected to exceed the magnitude of the LIBOR manipulations. It is reported that banks have found an array of apparent misconduct in internal reviews. Given that, at a trading volume of USD 5.3 trillion a day, the foreign exchange market is the largest market in the world, probes by regulators worldwide are excepted to trigger further multibillion-dollar fines and civil litigation.

a) Regulatory Investigations

Over the last few months, antitrust regulators in the US, Europe and Asia have focused investigations in particular into the possibility that major financial institutions have been manipulating the 4 pm ‘London Fix’ – the most widely used foreign-exchange benchmark rate – so as to profit off of their clients’ trades.

The currency exchange market is a USD 5.3 trillion a day market with a daily average turnover estimated at USD 2 trillion. Companies, investors, portfolio managers and stock index compilers, among others, use exchange-rate benchmarks – snapshots of traded currency rates calculated on a half-hourly basis using sample data from a minute-long period starting thirty seconds before the half-hour/hour mark – as a transparent and auditable way of buying and selling currencies. The most popular benchmark, called the WM/Reuters rate, or the ‘London fix’, runs at 4 pm London time on each trading day. Hence, the London fix is calculated based on the transactions conducted between 3:59:30 and 4:00:30 each day.

The foreign exchange market is largely opaque and almost entirely unregulated, with four banks dominating the market and trading around the London fix: Deutsche Bank (15.2%), Citigroup (14.9%), Barclays (10.2%) and UBS (10.1%). Collectively, these banks have a market share exceeding fifty percent.

In the US, the DOJ, in cooperation with the Federal Bureau of Investigation and the CFTC, has an active criminal investigation into possible collusion among banks and has required the production of banks’ documents as well as conducted raids of foreign exchange traders’ homes. (SCHOENBERG, ‘U.S. Said to Open Criminal Probe of FX Market Rigging’, Bloomberg 12 October 2013). Preliminary findings of the US investigation prompted US Attorney General Eric Holder to tell the New York Times that “the manipulation we’ve seen so far may just be the tip of the iceberg” and that the DOJ “recognized that this is potentially an extremely consequential investigation” (PROTESS et al., ‘U.S. Investigates Currency Trades by Major Banks’, New York Times DealBook 14 November 2013).

In Europe, the UK’s FCA, the Swiss Financial Market Supervisory Authority (FINMA) and the EU’s top antitrust regulator, Joaquin Almunía, have also opened investigations. Swiss Finance Minister Eveline Widmer-Schlumpf has already confi rmed that “it’s a fact that foreign exchange manipulation was committed” (TREANOR, ‘Foreign Exchange Rate Benchmarks Called into Question by Investigation’, The Guardian 12 June 2013). Banks including Deutsche Bank, UBS, RBS, JPMorgan, Barclays, Credit Suisse, HSBC, Goldman Sachs and Citigroup have all confi rmed they are the subject of investigations as well.

In April 2014, the Swiss Competition Commission became the first regulator to announce that it had uncovered signs of illegal activity in the context of price setting in the foreign exchange business. In addition, FINMA and Switzerland’s Office of the Attorney General have also launched investigations into possible violations of banks’ duties and banking secrecy provisions, respectively. To this date, regulators in more than a dozen countries on four continents are investigating possible manipulations. And while probes around the globe continue to identify hard evidence for misconduct and the number of banks that reach settlements with regulators increase, the number of civil lawsuits is equally on the rise.

b) The mechanics of FX manipulation

To profi t on foreign exchange transactions, traders at a number of major banks seem to have been conspiring to manipulate foreign exchange rates to artifi cially infl ate or suppress the value of certain currencies. This manipulation of currencies appears to be only possible through collusion between traders at various different institutions and information has emerged about how traders at major banks signaled each other.

First, foreign exchange traders would gather information about the direction of currency movement around the London fix by aggregating confi dential information about their clients’ trades and then sharing it with traders at other firms. According to multiple reports traders would rely on voice brokers and sales people to determine the amount and direction of currency exchanges that would take place at the [London] fix. Traders would then exchange that information with traders at other banks. As the Wall Street Journal reported based on evidence turned up in the global investigation:

“a trader at one bank would accumulate all of his institution’s ‘buy’ orders in a specific currency, so that he was responsible for all of the planned trades. Then he would share this information with his competitors and exchange information about their overall positions. If rival traders were planning similar batches of transactions, they would coordinate the timing of those deals in an attempt to boost everyone’s profits.” (MARTIN/ENRICH, ‘Forex Probe Uncovers Collusion Attempts’, WSJ 19 Dec 2013).

Traders would generally communicate this information through instant messaging and electronic chat rooms. The traders in these chat rooms were known by aliases such as ‘The Cartel’, ‘The Bandits’ Club’, and ‘The Dream Team’. By sharing information, traders were able to align their strategies, ensuring that they achieved the desired move in the benchmark and did not trade in a direction opposite to that in which the manipulation was occurring.

Second, traders would then preposition themselves or ‘front-run’ to take advantage of the information they acquired from their counterparts at other banks. One trader provided the following account which is illustrative of how this is executed:

“if [a trader] received an order at 3.30 pm to sell EUR 1bn in exchange for Swiss franc at the 4 pm fix, he would have two objectives: to sell his own Euros at the highest price and also to move the rate lower so that at 4pm he could buy the currency from his client at a lower price. He would profit from the difference between the reference rate and the higher price at which he sold his own Euros, he said. A move in the benchmark of 2 basis points, or 0.02 percent, would be worth CHF 200.000, he said.” (VAUGHAN/FINCH/CHOUDHURY, ‘Traders Said to Rig Currency Rates to Profit Off Clients’, Bloomberg 26 June 2013).

Third, once traders were prepositioned, they acted in concert to manipulate the benchmark rate. This manipulation was accomplished primarily by concentrating orders in the moments before and during the 60-second window for calculating the benchmark rate in order to push the rate up or down – a process known as ‘banging the close’. Through their concerted actions, the banks were able to amass enough trade volume to push an exchange rate in a direction contrary to their customers’ interests. Because the benchmark is based on the median of transactions during the period, traders would break their clients’ orders into small installments so as to have more trades, which would in turn maximize the pressure on the exchange rate.

Lastly, traders would further manipulate the benchmark by ‘painting the screen’, meaning traders would place orders with other traders to create the illusion of trading activity in a given direction in order to move the rates prior to the fixing, even though the activity is only between traders and will be reversed shortly after the benchmark. Collectively, through these acts, traders at major institutions have been able to cause inflation or suppression of exchange rates at the time of the London fix.

4) Summary and Outlook

While with regard to allegations of LIBOR manipulation, a first wave of regulatory activity has ended with heavy fines, it is now the turn of private claimants to use the financial institutions’ admissions and guilty pleas to bolster their claims. At the same time, regulators are widening the scope of investigations into alleged manipulative conduct in the foreign exchange market.

In the context of LIBOR litigation, antitrust claims have, until now, not been fruitful. As of today, plaintiffs seem to find it hard to show that they suffered injury resulting from banks’ alleged anticompetitive conduct given that US courts repeatedly have held that the process of setting LIBOR was not competitive and the alleged collusion occurred in an area in which the defendant banks never were intended to compete. As a result, focus has shifted to large investors who had direct contact with defendant banks and are in a position to bring individual actions alleging breach of contract, breach of the implied covenant of good faith, fraud etc. While such claims may succeed in some instances, many plaintiffs find, and will continue to find, it challenging to produce the necessary evidence in order to demonstrate damages and causality.

With regard to alleged manipulations of the foreign exchange market, plaintiffs in the US have already filed antitrust and breach of contract complaints against numerous financial institutions arguing that they conspired to manipulate FX benchmark rates by increasing trade volume at the time the rates are established. In Europe, potential plaintiffs have indicated interest in civil litigation over foreign exchange market manipulations, and, given the ongoing investigations by regulators and the possibility of obtaining further documentary evidence through these investigations as well the comparatively complex nature of the traders tricks and the necessary analysis of data, lawsuits are expected to follow later this year.

Whereas, in the matters relating to LIBOR manipulations, some potential plaintiffs still appear to remain hesitant to bring suits, given that manipulations generally occurred in both direction, i.e. not necessarily against a bank’s client or counterparty, and because judges so far have refused to consider the collusion by traders an antitrust issue, the position with regard to the rigging of FX benchmarks seems slightly more favorable towards plaintiffs. As far as it appears today, banks involved in FX rigging have sought and achieved to manipulate the London fix over a prolonged period of time specifically against and to the detriment of their clients.

Currently, with most of the banks accused of manipulating LIBOR having settled their cases with regulators and the future of LIBOR civil litigation not entirely certain, banks will likely seek to avoid another round of record penalties by fully collaborating with investigators and dismissing potential wrongdoers from their trading floors. At the same time, it is likely that regulators are discovering evidence that will lead to expand probes further into possible benchmark misreporting in other markets. This is destined to not only to result in a substantial increase of financial litigation in the medium term, but also put further (political) pressure to fundamentally change the way financial benchmarks are set.