The Fix. Vaughan Liam

onto apostgraduate course despite not having the necessary qualifications. From Harvard he moved to Rome and entered the world of banking as “Manny Hanny's” representative for the Middle East.

      The real action, though, was happening elsewhere. By now London was growing as a global financial hub. Russia, China and many Arab states wanted to keep their dollars out of the U.S. for political reasons, or out of fear they might be confiscated, and they chose to bank their money in the U.K. instead. The City of London was also benefiting from stringent U.S. regulations that capped how much American banks could pay for dollar deposits and cut the amount of interest they could charge on bonds sold to foreigners. Many firms set up offshore offices in swinging London, where they could ply their international trade unhindered. After 10 years in Rome, Zombanakis was bored and scented an opportunity to further his career.

      The eurodollar market, as the vast pool of U.S. dollars held by banks outside the U.S. is known, was already well developed, but Zombanakis had spotted a gap – the supply of large loans to borrowers looking for an alternate source of capital to the bond markets. In 1968, he persuaded his bosses in New York to give him £5 million to set up a new branch in London. Six-foot-three and impeccably turned out, Zombanakis made a striking impression, and before long he became known in clubby British financial circles as simply the “Greek Banker”. He was one of a small band of international financiers who were opening up the world's markets to cross-border lending for the first time since the Wall Street crash of 1929.

      Zombanakis first met Farmanfarmaian in Beirut in 1956, and the two had hit it off. So when the Iranians needed money, they headed straight to Manufacturers Hanover's office on Upper Brook Street in London's exclusive Mayfair district.12

      Zombanakis knew that no single firm would loan $80 million to a developing country that didn't have enough foreign-currency reserves to cover the debt. So he set about marketing the deal to a variety of foreign and domestic banks that could each take a slice of the risk. But with U.K. interest rates at 8 percent and inflation on the rise, banks were wary of committing to lending at a fixed rate for long periods – borrowing costs could increase in the interim and leave them out of pocket.

      Zombanakis and his team came up with a solution: charging borrowers an interest rate recalculated every few months and funding the loan with a series of rolling deposits. The formula was simple. The banks in the syndicate would report their funding costs just before a loan-rollover date. The weighted average, rounded to the nearest 1/8th of a percentage point plus a spread for profit, became the price of the loan for the next period. Zombanakis called it the London interbank offered rate.

      Other financiers cottoned on, and by 1982 the syndicated-loan market had ballooned to about $46 billion.13 Virtually all those loans used Libor to calculate the interest charged. Soon, the rate was adopted by bankers outside the loan market who were looking for an elegant proxy for bank borrowing costs that was simple, fair and appeared to be independent. In 1970, the financier Evan Galbraith, who would go on to be U.S. ambassador to France under President Ronald Reagan, is said to have come up with the idea of pegging the first bond to Libor – known as a floating-rate note.

      As London's financial markets took off, they became increasingly complex. Within a few years, Libor had morphed from being a tool to price individual loans and bonds to being a benchmark for derivatives deals worth hundreds of billions of dollars. Chief among these new derivatives was the interest-rate swap, which allowed companies to mitigate the risk of fluctuating interest rates. The swap was invented during a period of extreme volatility in global rates in the 1970s and early 1980s.14 The concept is simple: Two parties agree to exchange interest payments on a set amount for a fixed period. In its most basic and common form, one pays a fixed rate, in the belief that interest rates will rise, while the other pays a floating rate, betting they will fall. The floating leg of the contract is pegged, more often than not, to Libor. It wasn't just company treasurers who bought them. Because swaps require little capital up front, they gave traders a much cheaper way to speculate on interest-rate moves than government bonds. Before long, banks had built up huge residual positions in the instruments.

      As Libor became more central to the global financial system, pressure grew to codify the setting of the rate, which was still hashed out on an ad hoc basis by the various banks involved with individual deals. In October 1984, the British Bankers’ Association, a lobbying group set up in 1919 to champion the interests of U.K. financial firms, began consulting with the Bank of England and others on how such a benchmark might work.

      Several early versions of the rate evolved into BBA Libor, set in pounds, dollars and yen, in 1986. The BBA established a panel of banks that would be polled each day and tweaked the original formula to strip out the bottom and top quartile of quotes to discourage cheating. Otherwise the rate looked similar to the one first conceived by Zombanakis. In the quarter-century between then and Hayes's time at UBS, the suite of currencies was expanded to 10 and the process became electronic, but not much else changed.

      The same could not be said of the U.K. banking industry, which was transformed by Prime Minister Margaret Thatcher's “Big Bang” financial deregulation program of 1986. Overnight, Thatcher cleared the way for retail banks to set up integrated investment banks that could make markets, advise clients, sell them securities and place their own side bets, all under one roof. She also removed obstacles to foreign banks taking over U.K. firms, leading to an influx of big U.S. and international lenders that brought with them a more aggressive, cutthroat ethos. The advent of light-touch regulation, with markets more or less left to police themselves, made London a highly attractive place to do business. The market for derivatives, bonds and syndicated loans exploded.

      By the 1990s, Libor was baked into the system as the benchmark for everything from mortgages and student loans to swaps. However, it was its adoption by the Chicago Mercantile Exchange (CME) as the reference rate for eurodollar futures contracts that cemented its position at the heart of the financial markets.

      Eurodollar futures are standardized, exchange-traded derivatives that let traders bet on the direction of short-term interest rates. For years, the value of the contracts was determined by a benchmark calculated by the CME, but in January 1997 the exchange ditched its own rate in favor of the now ubiquitous Libor.15 The eurodollar futures market had been around since 1981, and the CME's highly liquid contract was particularly popular among traders looking to hedge their exposure to over-the-counter swaps. As swaps, and much else besides, referenced Libor, the CME believed its product would be more appealing if it used the same rate. Average daily trading volume at the time of the switch in 1996 was about 400,000 contracts. That rose to 2.8 million by March 2014.16

      1

      BBA LIBOR: the world's most important number now tweets daily, British Bankers’ Association, May 21, 2009, http://www.easier.com/25225-bba- libor-the-world-s-most-important-number-now-tweets-daily.html.

12

Ibid.

13

BIS Quarterly Review, December 2004.

14

The Bank of England raised its key interest rate 10 percentage points between November 1977 and November 1979. Bank of England, http://www. bankofengland.co.uk/boeapps/iadb/Repo.asp.

15

The CME's method for calculating the interbank rate was actually harder to game than Libor. It involved a random survey of banks, which were asked at what rate they were willing to lend to prime banks. No bank knew whether it was going to be included in the pool.

16

Carrick Mollenkamp, Jennifer Ablan and Matthew Goldstein, “How gaming Libor became business as usual”, Reuters, Nov. 20, 2012, http://uk.reuters.com/article/us-libor-fixing-origins-idUSBRE8AJ0MH20121120 and CME data.