5  CFTC UBS, 2012, page 12. 6  CFTC UBS, 2012, page 13. 7  CFTC Barclays, 2012, page 13. 4  BIS central bankers’ speeches  We have learned as well that compensation and hiring practices also helped to undermine the integrity of the reporting regime. For example, we have seen that compensation and promotion within a bank are often tied to a trader’s market share and profitability. In addition, traders often move between firms so having a network of external contacts and being viewed as a team player could help to support job mobility. Consequently, one can conclude that even the loss of a job is not necessarily a permanent setback, and that market participants with allegations of improper behavior could potentially move on to other firms with the expectation that they would generate revenue and profits for their new employer. These incentives were amplified by the structure of the markets that underlie the setting of LIBOR and those that use LIBOR. The interbank cash borrowing market that LIBOR references is very small relative to the enormous markets that use LIBOR, for example interest rate derivatives. The standardization of settlement dates further concentrated trading activity. In this type of environment, relatively small changes in LIBOR submissions – either because the actual borrowing costs fluctuate or a submitting bank intentionally misreports its submissions – can have substantive effects on a trader’s profitability because the trader can hold large derivatives or futures positions that reference the cash LIBOR rate at the time these contracts settle.
For each currency, there is a designated panel of contributing banks that each submit an estimate of its own borrowing costs for each maturity. For each panel, these estimates are aggregated to form LIBOR. The LIBOR rates are then used as a basis for financial contracts ranging from adjustable rate mortgages to interest rate swaps and futures. To make sure that the submitting banks have sufficient expertise in the funding trends in a particular currency, it is important that they be actively involved in that market. For this reason, the contributing banks are the large banks that have been active in the London market and the panel of submitting banks varies across currencies. The LIBOR reference rates were intended to capture on a daily basis borrowing costs along each currency-maturity combination based on the experience of the submitting banks. The actual process for fixing LIBOR each day is quite straightforward. Each morning the submitters from each contributing bank answer the following hypothetical question: “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers at a reasonable market size just prior to 11 a.m.?” The transmitted submissions are ordered by rate for each currency and maturity pair. The ordered rates for U.S. dollar LIBOR, for example, are then trimmed by generally dropping the top and bottom 25 percent of submissions to remove any influence of outliers. The average of the remaining individual submissions is calculated and then posted.