It’s tempting to think of today’s Wall Street as a technocracy with a thin human overlay. Brokers flashing hand signals on exchange floors were long ago replaced by humming server farms. The white-shoe deal-making of years past has given way to a global, diverse, hardwired marketplace that, in many ways, is more science than art. We think of threats to the system’s fairness and stability in terms of rogue algorithms and synthetic derivatives, not human frailty.
This summer’s LIBOR-rigging scandal shattered that image. The London Interbank Offered Rate—the critical benchmark used to set interest rates on trillions of dollars’ worth of financial products, including most people’s mortgages and student loans—was exposed as a moving target, all too manipulable by a small handful of opportunistic traders. E-mails revealed a clique of culprits passing around compliments (“When I retire and write a book about this business your name will be written in golden letters”) and trading favors (“Come over one day after work and I’m opening a bottle of Bollinger!”) in exchange for shifting the LIBOR in each other’s favor. What appeared to be just another dully named variable immaculately conceived by some mainframe turned out to be a product of good old-fashioned boys’-club culture, essentially run on the honor system. The roots of the scheme dated all the way back to 1969, when a banker named Minos A. Zombanakis created the first iteration of the rate by calling a group of his banker colleagues, inquiring about their borrowing costs, averaging the numbers they gave, and using that average to make syndicated loans. “The whole system was based on good faith,” Zombanakis, who worked at the now-defunct Manufacturers Hanover, recently told The Deal magazine. So all that is history and the problem is solved now, right? Not hardly.
According to a confidential International Organization of Securities Commissions paper, made public last week by Bloomberg News, more than half the world’s benchmark interest rates—the ones used to issue credit cards in China and mortgages in Mumbai—are set in much the same manner as LIBOR, with minimal transparency and plenty of opportunity for exploitation. Eighty percent of the world’s benchmark rates, the IOSCO found, are compiled by trade associations or private companies, and many are based on surveys of non-executed transactions, which submitters can fudge at will.
“There’s an obvious flaw in the setup of the market,” says Tim Loughran, a finance professor at Notre Dame’s Mendoza College of Business. “If there’s a number and you can work it to your advantage to make a profit, wouldn’t you be interested in doing it?”
Regulators attempting to fix today’s system agree that benchmarks tied to actual market transactions—as opposed to rates set by parties who stand to profit by artificially inflating or depressing their estimates—would be less subject to chicanery. But even Gary Gensler, the hard-driving chairman of the Commodity Futures Trading Commission, has conceded that the government can’t just impose a new rate regime overnight (virtually every derivative contract in the world would have to be rewritten, for one). “Ultimately, it’s going to be the markets—the borrowers and lenders and derivatives users—that might move to something else,” Gensler said at a recent Politico gathering.
Let’s hope they do. High-frequency trading is scary in its own way, but at least a computer can’t be swayed by LinkedIn connections and free Champagne.