Manipulation of Financial Markets

This week, a bank was fined two and a half billion US dollars for manipulating Libor. There was also an English man who had his bail set at five million for spoofing Futures markets. What do these terms mean? What did they actually do that was so bad?

Let’s go to Rabbit Town. They have a big fruit and vegetable market. Jim has a stall where he buys and sells carrots. The market has a big carrot section, there are about fifteen other carrot stalls. Every day, the town publishes the average price for carrots. People use the Town Price when they are doing their deals. For example, the Rabbit Town school buys 20 carrots every day from the farmer and they agree they will pay the farmer whatever the published price is.

The town calculates the Town Price very carefully. They ask all fifteen stall holders what their price is for that day. They then take off the top two (most expensive) and the bottom two (cheapest) and work out the average of all the others. That then becomes the Town Price for that day. People do not have to use it, but it’s a helpful guide.

Now, Jim has two brothers. One brother is a carrot farmer and he sells carrots. The other brother owns a soup factory, so once a month, he buys carrots. Both brothers have contracts with other people and they have agreed to buy and sell carrots at the Town Price. They know that the price that Jim gives in to the town hall, very slightly affects what the Town Price is set at. When they have carrots to buy or sell, they go to see Jim and ask him to slightly move the price on his stall. Not too much, because he doesn’t want to be in the top or bottom, but just enough that it alters the average a tiny bit, moving it to be in their favour. Jim likes to help his brothers, so he agrees. Sometimes he even persuades his friends to change their prices a little too.

If carrots are interest rates, then Libor is the Town Price. It stands for London Interbank Offer Rate. It is the interest rate that banks use when they lend to each other.

Jim was meant to give in the actual price that he thought he could buy and sell carrots at, not a price that would help his brothers. Even though, due to averaging, it doesn’t change the price much, it is still corrupt. The fines given to banks who do this have been huge. Now, as Jim’s false price sometimes went up and sometimes went down, it is unclear how other people were impacted. The big fine does not seem to really correspond to the financial damage that was caused. We’ll discuss this a bit more later.

Let’s take a look at ‘spoofing’ now. What is it? Well, imagine Jim has loads of carrots and he wants to sell them to other stalls. He wants the price to be as high as possible, so he makes up a rumour. The rumour says that a big carrot buyer is about to visit the market and he needs lots of carrots. Jim then sends anonymous notes to all the other stall holders, putting in orders for lots of carrots. All the stall holders quickly put up their prices, ready for when the big buyer comes to town. Jim then quickly cancels the false orders, sells his carrots to them at the higher price and makes a nice profit. This is called spoofing. It is against the law in financial markets.

Let’s look at one other thing that might affect prices. Jim has some special carrots. They are bigger and more orange than all his other carrots. He keeps them on a special shelf and they are not the same price as all the other carrots. That is allowed – he can have a special price for special carrots. What he is NOT allowed to do, is to wait until a customer arrives and then change the price for what he thinks he can get. He cannot look at Mrs Bunny and think, “Ah, nice watch, designer handbag, new shoes, I will charge her fifty quid a carrot for my special carrots.” This might be what your plumber does (“Big house, that’s a £70 call out fee” or “Small house, old lady, that’s a £30 call out fee.”) but banks are increasingly not allowed to. It is called ‘price discrimination.’

Now, we can see that banks are expected to behave differently to other institutions. If a car company does something bad, even something which is negligent and causes people to die, they will probably be given less big fines than the banks. Why? Is this fair? Personally, I think it is right. I think that the fine is not related to the injury caused financially, but the injury that has been caused to the bank’s reputation.

Our society relies on banks. We need them to be completely trustworthy and so the standard set for banks needs to be higher than the standard set for shops or manufacturers or plumbers. The financial stability of a country depends on the banks, so we need stringent rules set in place to keep them honest. They used to have similar rules to other companies but that has changed and they are now much more tightly regulated. If the laws are clearly set in place and applied to all banks equally, I think that is fair. I want to be able to trust my bank. In the same way as I want to be able to trust my legal system.

There are some politicians who like to bash banks, who think that if they impose big fines then they will be elected to a higher office, they will personally look good. Personally, I think this is cheap and they are stupid. Don’t vote for them.