Friday, February 24, 2012

EURIBOR – Calculation Process and Legal Structure

Last week, I wrote about the ongoing probe into whether investment banks manipulated global lending rates such as EURIBOR, LIBOR and TIBOR. Today, I would like to expand on this discussion and present some general guidelines to understand how EURIBOR rates are set.

A. Introduction

EURIBOR stands for Euro Interbank Offered Rate. By definition, it only applies to one currency, the Euro. EURIBOR rates are calculated for 14 maturities, e.g. 1 week, 2 weeks as well as 1 to 12 months.

B. Calculation Process

The process of defining the above described EURIBOR rates is set out in the EURIBOR Code of Conduct.

The Code of Conduct first sets the conditions that financial institutions must meet to qualify as EURIBOR panel banks: They must not only be active in the Euro money markets but also handle good volumes in Euro interest rate related financial instruments. Additional criteria include a first class credit standing, high ethical standards and an excellent reputation.

As of today, the EURIBOR panel includes the following financial institutions:

EURIBOR's Steering Committee is in charge of choosing and regularly reviewing the constitution of the EURIBOR panel.

According to Article 6 of the Code of Conduct, panel banks communicate “the rates at which Euro interbank term deposits are being offered within the EMU zone by one prime bank to another at 11.00 a.m. Brussels time”. In addition, panel banks must also submit their aggregate loan volume and the weighted average interest rate applied.

EURIBOR rates are trimmed averages of the submitted data and calculated by Thomson Reuters in a two step process:

  • First, the highest and lowest 15% of all the quotes collected are eliminated.
  • Second, the remaining rates are averaged and rounded to three decimal places.

Finally, Thomson Reuters not only publishes the calculated EURIBOR rates. In addition, it also makes all underlying quotes available to the general public.

C. Parties and Institutions


EURIBOR-EBF is an international non-profit making association under Belgian law. It was founded in 1999.

Its members are national banking associations of the European Union who participate in the European Banking Federation. A member can be excluded from the association if he violates the association's legal framework.

According to its statutes, EURIBOR-EBF is in charge of

  • developing and supporting EURIBOR;
  • providing information about EURIBOR to its members and other stakeholders;
  • enhance the integration of the European financial market.

EURIBOR-EBF's internal legal structure consists of the General Assembly, the Board of Directors, the President of the Board of Directors, the association's Secretary General, the EURIBOR Steering Committee, and the STEP Market Committee.

1. General Assembly

The General Assembly is the central organ that is responsible for attaining the association's purpose; it is namely in charge of changing the statutes, appointing directors, and defining the strategy. The General Assembly consists of the association's full members and each of them has one voting right.

2. Board of Directors / President of the Board of Directors

The Board of Directors is the association's executive body and consists of at least 3 members who are appointed for 2 years. It elects its President for a duration of 2 years. Both the President and the Secretary General are the spokespersons of EURIBOR-EBF.

3. EURIBOR Steering Committee

The EURIBOR Steering Committee has been created jointly by EURIBOR-EBF and EURIBOR ACI, both associations under Belgian Law. It controls, supervises, and reprimands the application of the EURIBOR Code of Conduct. Its members are 10 independent and experienced market experts whose names are published on the EURIBOR dedicated website.

4. STEP Market Committee

Finally, the STEP Market Committee monitors market developments and establishes and reviews market standards. A specific code of conduct applies to its operations. It consists of 10 voting members of the association. The committee is assisted by a STEP Secretariat.

II. Thomson Reuters

Thomson Reuters calculates and publishes EURIBOR rates.

D. Comment

In my last week's comment on the LIBOR rate fixing, I criticized the unclear legal structure that surrounds the LIBOR fixing. However, this critic does not apply to the EURIBOR fixing process: Not only does EURIBOR-EBF dispose a clearly defined legal status as it is an association under Belgian Law. In addition, the relevant constitutional documents of this association are published on the below mentioned website leaving no doubt as to how EURIBOR-EBF's internal structure looks like and how it might be modified, if required.


  • EURIBOR-EBF statutes and other constitutional documents

Thursday, February 16, 2012

LIBOR Manipulation?

On February 9, 2012, the Financial Times reported that regulators worldwide currently investigate into whether banks had colluded on their LIBOR submissions. In addition, on February 10 and 15, 2012, the FT reported possible implications of Citigroup and UBS in this probe.

To understand the ongoing discussion and investigations, I would like to clarify the calculation process as well as the legal status of LIBOR rate.

A. Introduction

LIBOR refers to the London Inter Bank Offered Rate. It is defined as

The rate at which an individual contributor panel bank could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size, just prior to 11.00 London time.”

In addition to this general definition, the following characteristics apply to LIBOR:

  • First, LIBOR refers to a bank’s perception of its cost of unsecured funds.
  • Second, LIBOR’s pricing only integrates the interbank market as opposed to other refinancing sources such as deposits or central bank lending.
  • Third, as its name states, LIBOR refers to the London money market.
  • Finally, LIBOR rates represent deposits governed by the laws of England and Wales and whose parties are subject to the jurisdiction of the courts of England and Wales.

B. Currencies and Maturities

LIBOR bans foreign currency exchanges. In other words, the rate represents the cost of refinancing in a specific currency, excluding a bank’s possibility to access foreign currency refinancing and convert such foreign currency funds subsequently.

LIBOR rates exist for the following currencies and maturities:

C. Contributor panels

At the heart of the calculation process is the constitution of a contributor panel of banks for each currency.

The above panels are compiled by the British Bankers' Association (BBA), advised by the Foreign Exchange and Money Markets Committee (FX&MMC), and after discussions with the BBA LIBOR Steering Group. The choice of banks is guided by the bank’s scale of market activity, its credit rating, and its perceived expertise in the currency concerned. The contributor panels are revised twice a year.

D. Calculation process

The process starts off with the contributor panel banks being asked the following question:

At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?”

As regards the submission of these rates, the BBA specifies that the rates must be submitted by members of staff with primary responsibility for management of a bank’s cash, rather than a bank’s derivative book. In addition, Contributor Banks must submit their rates independently from each-other.

If any bank submission falls outside a defined set of parameters, Thomson Reuters, BBA's calculation agent, will consult the contributor and request confirmation that the rate formulated is correct. The intention of this process is to avoid typing errors. The parameters are set by the FX&MMC and they are regularly reviewed to ensure they reflect prevailing market conditions and maintain the highest level of scrutiny over the rates. Currently, Thomson Reuters will coordinate with a contributor bank if

  • submissions more than 2 standard deviations from the fix for that maturity;
  • compared to the prior submission, submissions move the contributor from above to below the fix, or vice versa;
  • submissions are more than 5bp higher or lower than the previous submission, unless the majority of the rest of the panel have also moved more than 5bp in the same direction.

The above rates are directly communicated to the calculation agent Thomson Reuters. The latter then calculates a trimmed average of the submitted rates, eliminating a predetermined number of outliers that depends on the extent of the contributor panel in question.

Thomson Reuters not only publishes the LIBOR rates themselves but also all data contributed by each individual bank.

E. LIBOR legal status

The participants

  • British Banker’s Association (BBA)

The BBA is a trade association for the UK banking and financial services sector. Its major tasks are influencing decision makers by promoting a legislative and regulatory system for banking and financial services in the UK, Europe and internationally, and promoting and defending the industry.

The BBA reserves its right to review the LIBOR fixing process from time to time. However, it promises to duly consider and notify planned changes in advance.

  • Foreign Exchange and Money Markets Committee (FX&MMC)

According to the BBA, the FX&MMC is independent of the BBA and any other organization. It has the sole responsibility for all aspects of the functioning and development of the LIBOR rate. Its internal organization comprises a chairman and 2 deputy chairmen.

The FX&MMC has three sub-committees: The fixings sub-committee is in charge of considering any information relevant to the LIBOR rate and its fixing in general. The oversight sub-committee exercises control over the contributing banks. It can issue (non-published) written guidance, consider a re-statement of contributor protocols; require an up-to-date audit of a panel bank’s contribution processes and recommend to the FX&MMC to remove a contributor bank. Finally, the steering group is in charge of reviewing the LIBOR process and, as the case may be, can make appropriate recommendations to the FX&MMC.

  • BBA LIBOR Ltd.

BBA LIBOR Ltd. is in charge of running the daily operations of the LIBOR benchmark. The company operates under the supervision of the FX&MMC.

  • Thomson Reuters

Thomson Reuters is BBA's calculation agent. I understand that Thomson Reuters is contractually bound to BBA LIBOR Ltd. and, thus, remains contractually liable towards this company.

  • Contributor Banks

Contributors undertake to have their internal processes for submitting rates audited as part of their firm’s annual compliance procedures and provide written confirmation to the FX&MMC that this audit has been completed.

F. Comment

Reading the LIBOR dedicated website, the detailed legal structure of the LIBOR fixing process in general and the FX&MMC in particular remain unclear to me.

For example, the composition of the FX&MMC remains loose. On the above mentioned website one can only read that “the committee consists of highly experienced market participants […] along with other concerned parties and associations who do not submit to bbalibor”.

In addition, reading BBA’s web page, the relationship between the FX&MMC on the one hand and BBA and the other parties described above remains ambiguous.

Finally, and perhaps most importantly, it seems that the whole fixing process is at the exclusive discretion of the BBA. Admittedly so, the information that BBA provides on its LIBOR dedicated website is very detailed. However, as an outsider to the whole process, you cannot really understand the entire legal framework of the fixing process.

My critic as to the vague legal structure does, however, not apply to the disclosure of data. Namely, the publication of outliers in the calculation process should ensure that the overall calculation process is carried out with the appropriate diligence by the parties.

G. LIBOR Manipulation?

Finally, as regards the ongoing investigation over LIBOR manipulation, I came across an interesting article (“Libor Manipulation?” by Abrantes-Metz, Kraten, Metz, and Seow) published recently in the Journal of Banking & Finance.

In the beginning, the authors remind the incentives that contributing banks might have to manipulate their submissions:

  • Manage public business reputation – Signal the market that their funding costs are lower than they are in reality.
  • Communicate pricing intentions among banks.
  • Influence LIBOR to hedge against interest rate fluctuations.

The authors then go on explaining the general rationale of statistical screening tests and, in particular, explaining their screening approach used to investigate any possible manipulation of LIBOR rates.

The major finding of the cited analysis is that, while some anomalies within individual quotes exist, this is not consistent with a material manipulation of the LIBOR rate.


  • Abrantes-Metz, Kraten, Metz, Seow – Libor Manipulation?, Journal of Banking & Finance 2012, p. 136 et seq.

Thursday, February 9, 2012

Expansion vs. Prior Financing Structure

What is the optimal combination of debt and equity for financing an expansion project? How does this decision relate to the initial financing structure of the firm, prior to implementing the expansion project?

This topic has been explored by Sudipto Sarkar in a recent article in the International Review of Finance.

The author describes first the arguments that guide the decision to finance through debt or equity:

Tax advantage vs. bankruptcy risk trade-off

From a shareholder perspective, the advantage of a high portion of debt financing is twofold. First, deducting interest from the firm's taxable income, debt provides an important tax shield. Second, a high portion of debt financing leads to a wealth transfer from debt-holders to shareholders.

On the other hand, the main backdrop of debt financing is that the post-expansion default trigger will be higher, resulting in a higher probability of default or earlier default and, thus, to higher expected bankruptcy costs.

As a consequence, shareholders must make a trade-off between tax benefit and increased bankruptcy risk and cost linked to debt financing.

Agency problem of debt

Debt allows the transfer of wealth from debt-holders to shareholders. Therefore, the agency incentive to use more debt to finance the expansion increases with the initial debt level.

Thus, the agency effect works in the opposite direction to the traditional trade-off theory, in which higher debt levels lead to reduced debt usage for the expansion.

Sarkar’s major findings

The major findings of Sarkar’s quantitative analysis are fourfold:

  • A high equity portion in the expansion financing package leads to under-investment whereas a high portion of debt in the package leads to over-investment.
  • The higher the initial leverage ratio is, the lower is the debt component in the expansion financing package.
  • The higher the project's volatility and the cost of implementing the project are, the higher is the debt component in the expansion financing package.
  • Companies with large growth opportunities tend to use less debt and more equity to finance expansions.

The importance of contractual covenants

In this context, Sarkar refers to the importance of contractual covenants that (partially) rule out future debt issues and, therefore, imply that the expansion has to be financed predominantly with equity.

Contractual covenants under LMA standard

I would like to take this opportunity to briefly outline the major contractual covenants that the standard leveraged finance facility agreement, as recommended by the loan market association (LMA), provides for.

Obviously, only yearly capital expenditure limits have a direct influence on the borrower’s possibility to carry out expansion projects. However, a distinction between debt and equity financing of such expansion project is only relevant in case the firm has negotiated the optional carve out related to Capex funded by new shareholder injections. Otherwise, capital expenditure will be limited altogether, irrespective of the nature of its underlying financing.

As regards financial ratios, the minimum cash flow cover will be mostly concerned: Not only will the cash flow numerator be adjusted for the total amount of capital expenditure, business acquisition, and joint venture investment, but also the debt service denominator will increase depending on the extent of debt in the expansion financing mix.

The other financial ratios are also affected, but a a lower extend:

First, maximum senior leverage and maximum leverage ratios will be affected by the debt / equity mix for expansion projects because the ratios’ numerator will consider the total amount of debt whereas their EBITDA denominator will not take capital expenditure into account.

Second, minimum senior interest cover and minimum interest cover ratios will be altered as well. As a matter of fact, the ratios’ numerator will remain unaffected as opposed to its denominator that will increase, corresponding to an increasing portion of debt in the expansion financing structure.


  • Sarkar in International Review of Finance 2011, 57 et seq.
  • LMA Leveraged Finance Facility Agreement dated January, 20, 2012

Thursday, February 2, 2012

Why the European Commission blocks Deutsche Börse / NYSE Merger

On February 1, 2012, the European Commission has declared the intended merger of Deutsche Börse and NYSE incompatible with the common market and, therefore, blocked the intended concentration.

Under the applicable EU legislation, the decision-making process is as follows:

Prior Debate

Prior to yesterday's decision, Deutsche Börse and NYSE on the one hand and the European Commission on the other hand, had vividly exchanged arguments in favor and against the agreed merger.

Contra Merger

  • The merger would create a dominant player in European exchange-traded derivatives markets, stifling competition from potential new entrants.
  • The merger would unite the 2 main European futures exchanges, Eurex and Liffe, and confer 95 per cent of trading in benchmark short-term interest rate and German government bond futures to NewCo.

Pro Merger

  • The market for exchange-traded derivatives is global, not regional, and the merged group would still face competition from CME Group in the US.
  • Even after the merger, NewCo would still face competition from over-the-counter derivatives markets.
  • Merging Deutsche Börse and NYSE would free collateral posted by clients and, therefore, bring market benefits.
  • Eurex (part of Deutsche Börse group) and Liffe (part of NYSE group) do compete on equity options. However, they do not compete on their main product, e.g. interest rate and government bond futures. This is because Liffe's main offer includes (short-term) Euribor interest rate futures while Eurex's main offer includes (long-term) German bond futures.

Decision of the European Commission

Yesterday's press releases announce the blocking of the intended merger and outline the basic reasoning of the European Commission. However, it must be noted that an extensively motivated decision has not been published yet. The exact reasoning of the European Commission will, therefore, only be known at a later stage.

European vs. global market

In the last months, the debate was mainly about the question whether the European Commission had correctly appreciated the global nature of the market for exchange-traded derivatives.

First of all, from an economic perspective, it makes no sense to talk about a European vs. a global market: The market is a pure process by which buyers and sellers determine what they are willing to buy and sell and on what terms, e.g. quantities and prices of goods and services.

Therefore, what counts is to fix the product scope clearly and then to appreciate the process how supply and demand for this specific product match.

From a legal perspective, European law introduces a local component. However, it does so to distinguish between the competency of member state authorities and EU authorities and not to appreciate the market structure itself.

In its decision, the European Commission defines the market as financial derivatives whose underlying are European interest rates, European stocks, or European equity indexes. As a matter of fact, we should avoid any confusion about European underlying and European market.

The European Commission holds that there is no significant offer for derivatives on the above cited European underlying from CME or other exchanges in the world and, therefore, concludes that the merger would lead to a quasi monopoly.

Exchange-traded vs. OTC derivatives

The European Commission refutes the argument that OTC derivatives markets would still provide a significant level of competition to the merged exchange-traded derivatives market. This is because exchange-traded derivatives are, as opposed to OTC derivatives, fully standardized and their cost structure and trading partners differ substantially.

Reduction of collateral postings

The European Commission recognizes that a merger would lead to clients posting less collateral, even though it holds that such gains would be significantly lower than argued by Deutsche Börse and NYSE. Nevertheless, it considers that such efficiencies cannot offset the downsides of the merger.

Looking at the above schema, this seems reasonable: The merger is certainly not indispensable to obtain a reduction of collateral.

Short-term vs. long term underlying

The European Commission does, subject of its more detailed decision to be issued, not discuss this argument. It only states that “Eurex and Liffe are of comparable size in terms of their membership base and portfolio of contracts they offer for trading and clearing, and they both focus on European financial derivatives, namely European interest rate and equity derivatives”.


  • Art. 101 et seq. Treaty on the Functioning of the European Union
  • EC Council Regulation No. 139/2004
  • European Commission Press Releases dated February 1, 2012