The Inherent Conflict of Interest in Interest Rates Determination

The global financial system is not perfect by any means. However, most of the imperfections seem to be minor. As a whole, individuals and corporations feel safe transacting and investing based on the rules defined in the current system.

This is possible because the stalwarts of modern day finance have been ignoring the elephant in the room, which is the conflict of interest inherent in the way in which interest rates are set. There are some major problems with the manner in which these interest rates are set. In this article, we will understand the conflict of interest related to the determination of interest rates.

Conflict of Interest in Interest Rate Determination

LIBOR is one of the most significant interest rates in the world. LIBOR is short for the London Interbank Offered Rate. This means that LIBOR is nothing but an average of the interest rates, which is quoted by major banks in London. LIBOR is not the only interest rate which is derived in this manner. All major interest rates in different parts of the world are derived in the same way.

The problem with this approach is that it allows banks to become both the price taker as well as the price maker at the same time. The banks which quote the rates required to determine the interest rate are also the banks who hold positions that gain or lose value depending on the interest rate being quoted. It is therefore obvious that if banks can control the interest rate that they quote, they can control the profit or loss that they incur on a trade. The ability to set interest rates gives banks the upper hand over other traders in the market.

The manipulation of interest rates by participating banks is not a theoretical construct. This is a very real risk which different banks in the world have exploited to their advantage several times. The Barclays bank in the United Kingdom, as well as the ANZ bank in Australia, are famously known to have rigged the interest rate with the sole purpose of raking in huge profits.

How do Banks Make Profits by Rigging Interest Rates?

The market value of a lot of derivative securities is based on interest rate fluctuations. For instance, most of the derivative securities which are traded in the United States are based on the LIBOR. As already mentioned above, banks like Barclays bank have a say in what the LIBOR rate will be. At the same time, banks like Barclays bank are also allowed to take positions in securities that are affected by a movement in LIBOR. Banks can take advantage if they are able to predict the movement of interest rates in either direction.

• For instance, banks like Barclays form a cartel and take similar positions. In many cases, as a group, they are betting that the value of the security will go down. Then they covertly form a group and raise the interest rates higher. By doing so, they are able to actually reduce the value of the underlying security and secure handsome gains in the process
• In many cases, the banks also form a cartel to artificially lower the interest rates. This is usually done in order to project a stronger image of the bank. Taking advantage of the artificially lower interest rates banks are able to raise financing at lower rates when they need the money.

A study of the process makes the glaring inconsistencies obvious. The process is not unbiased for all the members of the market. There are some players who will always have an upper hand because of the information asymmetry which works in their favour.

Why does Interest Rate Manipulation Continue?

Interest rate manipulation is not really a new idea. It has been taking place for a long time. Many top banks have been penalised for manipulating interest rates. The total amount of fines and penalties collected have been upward of $9 billion. Hundreds of traders have been suspended or terminated from their jobs for trying to manipulate interest rates. More than twenty traders have been sent to prison, some for as long as eleven years! However, the interest rate manipulation just doesn’t seem to stop.

After every few months, a new bunch of traders starts colluding in order to manipulate the interest rates. This happens so often because the collusion is difficult to prove. Until and unless there is clear cut evidence of collusion such as e-mail or recorded telephone conversations, collusion is almost impossible to prove. This is because judges and juries all over the world assume that the traders were working in good faith, and the interest rates quoted by them did reflect the true risk at that time.

At the present moment, investors all over the world are in turmoil. This is because they do not yet have a system which can be considered to be an alternative to LIBOR based system. There is very little trust that investors place on the banks as well as this entire system. However, the system continues to be in place due to lack of options.