Leaving: Robert Diamond resigned after Barclays admitted to attempted manipulation of LIBOR.

Barclays turmoil tip of iceberg

LIBOR scandal's effect on investors hard to pin down

Updated with clarification

Barclays PLC's record $451 million in fines for interest rate manipulation could be the turning point in a global investigation into critical interest rate benchmarks used by institutional investors.

One money manager who asked not to be named said if global investigations confirm that banks had colluded to manipulate the London interbank offered rate and the euro interbank offered rate, “it's the financial equivalent of poisoning the water supply.”

Barclays' admission that employees attempted to manipulate LIBOR and EURIBOR directly led to the July 3 resignations of Robert Diamond, the bank's CEO, and Jerry del Missier, chief operating officer. Barclays' Chairman Marcus Agius had resigned July 2.

David Paterson, head of corporate governance at the National Association of Pension Funds in London, said in an e-mailed statement: “The impact of LIBOR manipulation on pension funds is hard to pin down, and could have happened through a range of financial instruments. Pension fund trustees should ask their fund managers to tell them if and how their assets have been affected.

“This issue raises doubts about previous remuneration, which need to be answered,” Mr. Paterson added.

The fines and the related case documents represent “a smoking gun” that false submissions were made for the LIBOR and EURIBOR, said Lianne Craig, partner at the law firm Hausfeld LLP in London. Hausfeld is representing institutional clients in the on legal proceedings in connection with LIBOR manipulation.

“It's clear that Barclays was not acting in isolation,” Ms. Craig said.

The investigation was conducted by the U.S. Department of Justice, the Commodity Futures Trading Commission and the U.K.'s Financial Services Authority. It is part of a much broader probe into misconduct by banks in setting LIBOR and related rates; the investigations involve regulators in the U.S., U.K., European Union, Switzerland, Canada and Japan.

LDI use

Pension funds, money managers and insurers often use derivatives based on LIBOR and EURIBOR to hedge interest rate risks, for example, within liability-driven investing strategies. In the first half of 2011, the notional amount outstanding of over-the-counter interest rate derivatives contracts was about $554 trillion globally, according to the FSA.

Securities and loan products also rely on LIBOR and EURIBOR, as do mortgages, credit-card payments and student loans. Some performance fees paid by investors in absolute-return and hedge fund strategies also rely on LIBOR, consultants said.

“What is not clear is whether attempts to manipulate LIBOR had an impact on the actual rate,” said Boris Mikhailov, principal within Mercer's financial strategy group, London. “If that was actually the case and LIBOR is restated, investors would need to determine which side of the fence they were on and what actually happened to LIBOR. There will be winners and losers,” depending on the type of assets and derivatives they hold, as well as timing of investing.

However, Justice Department documents on the case state: “On some occasions, Barclays' submissions affected the fixed rates.”

If LIBOR was lower than it should have been, then pension funds that have entered into interest rate swaps to pay LIBOR and receive a fixed rate potentially would have benefited, Mr. Mikhailov said. On the other hand, investors in other products such as asset-backed securities, floating-rate notes and asset swaps could potentially be worse off because the LIBOR-based payments received would be lower. In the case of floating rate notes, for example, LIBOR is used as the basis for pricing and a lower LIBOR rate would result in lower coupon payments.

Since 2005

Beginning as early as 2005, traders at London-based Barclays — the U.K.'s second-biggest bank by assets — “communicated with traders at other financial institutions ... to request LIBOR and EURIBOR submissions that would be favorable to their or their counterparts' trading positions,” according to documents released July 4 by the Justice Department. Barclays' goal was to either increase profits or minimize losses on derivatives held by the banks, according to the documents.

Citigroup, Bank of America, Royal Bank of Scotland Group, UBS AG, Credit Suisse Group AG, Deutsche Bank AG and Lloyds Banking Group are among the institutions regulators are investigating.

“This is a major regulatory issue for the LIBOR banks that will likely generate significant civil claims over the next four to five years,” according to a June 29 research note published by Sanford C. Bernstein & Co., New York. “Investors should not minimize the importance of this matter.”

Barclays was the first to provide “extensive and meaningful cooperation in a meaningful way in disclosing its conduct,” according to documents from the Justice Department. UBS last year disclosed it had opened its doors to U.S. antitrust investigators in exchange for immunity.

“There's no doubt that the scope of this action is very broad,” said William Butterfield, Washington-based partner and chair of the financial services practice group at Hausfeld, which is co-lead counsel for “In re: LIBOR-Based Financial Instruments Antitrust Litigation” filed last year in U.S. District Court for the Southern District of New York.

“All types of financial transactions are indexed to LIBOR,” he added. “This (case) will be very complicated, with different plaintiff groups involved.”

Hausfeld is representing the mayor and City Council of Baltimore and the City of New Britain (Mass.) Firefighters' and Police Benefit Fund.

LIBOR first became prominent in the mid-1980s and has become the most widely used short-term interest-rate benchmark globally. According to Justice Department documents, the rates are meant to reflect each bank's assessment of the rates at which it could borrow unsecured interbank funds. For LIBOR, the highest and lowest 25% of the contributed rates are excluded from the calculation, and the remaining rates are averaged to calculate the daily rates, published on behalf of the British Bankers' Association.

For EURIBOR, the highest and lowest 15% are excluded, and the remaining averaged.

Even before revelations about Barclays' attempted manipulation surfaced, investors were questioning the stability of LIBOR as a benchmark rate, Mr. Mikhailov said.

Survey drawback

LIBOR's main flaw is that it's a rate based on a survey from banks' own estimates of borrowing rates and therefore can be manipulated, sources said. Although the Barclays case has bolstered calls to find an alternative to LIBOR, that could take years.

However, some institutional investors already are finding ways around LIBOR. For example, some investors in LDI increasingly are using government bond repurchase agreements to hedge interest rate exposure, rather than LIBOR-linked swaps. Separately, some banks including UBS are attempting to test a benchmark interest rate based on the actual rates paid for repos.

Others in the U.K. are basing transactions on the sterling overnight interbank average rate, which is also based on actual trades, rather than estimates, Mr. Mikhailov said. “During the financial crisis, LIBOR was very volatile, whereas SONIA was fairly constant,” Mr. Mikhailov said. “By far, SONIA was more stable and more objective.”