Who’s Manipulating Derivative Indexes and Why; How to think about the Libor scandal and its astonishingly proliferating offspring

June 21, 2013, 6:31 p.m. ET

Who’s Manipulating Derivative Indexes and Why

How to think about the Libor scandal and its astonishingly proliferating offspring.

By HOLMAN W. JENKINS, JR.

Is Ewan McGregor, who played Nick Leeson in the movie about the Barings bank bust, available for a sequel? He would find an oddly similar character in Tom Hayes, the former UBS UBSN.VX -1.93% and Citibank employee charged in this week’s latest financial scandal of the century.Let’s try to sort it out. As with Libor, or the London interbank offered rate, a benchmark for loans world-wide, allegations are floating that traders manipulated other widely used benchmarks. Three big banks—Barclays, BARC.LN -2.26% UBS and Royal Bank of Scotland RBS.LN -7.24% —have already paid $2.5 billion in fines and penalties in the Libor caper. Now the focus has turned to suspected manipulation of fuel-market indexes, loan-market indexes in Japan and Singapore, and indexes used in pricing interest-rate swaps.

Said Europe’s Competition Commissioner Joaquin Almunia last month: “Huge damages for consumers and users would have been originated by this.”

Well, maybe. A basic schematic would go like this: Some enterprising soul decides it would be useful to publish a daily price benchmark by surveying market participants about certain transactions that don’t take place on a central exchange. Somebody else decides it would be useful to create tradable derivatives whose price would vary based on changes in these benchmarks—that is, would let participants bet on how a survey of themselves in the future will come out.

Libor involved questioning bank traders about the pricing of loans—and Libor derivatives let these same traders bet on the answers they would give in the future. The invitation here now seems rather obvious. Mr. Hayes, a baby-faced yen-derivatives trader in Tokyo at the time, is charged with orchestrating attempts to rig a similar Tokyo-based benchmark called Tibor.

All this proves one thing: Financial professionals can’t be counted on to do the right thing when self-interest beckons so we must turn power over to government officials who always do the right thing regardless of self-interest.

Or maybe not. The Libor scandal broke only because London banks, in cahoots with regulators, put out transparently fake reports about their borrowing costs during the 2008 panic. That led to the discovery of a long history of everyday manipulation of their Libor borrowing costs. Traders now fessing up say they learned the practice from their predecessors who learned it from their predecessors, and so on.

As they drain this swamp, investigators like to allege enormous damage to the public by multiplying small discrepancies by the number of transactions in the market. Treat these claims with skepticism. Whatever the extent of mispricing in downstream transactions, it is a smidgeon compared to the rake-off brokers used to earn in pre-electronic days. It is a smidgeon compared to the margins that middlemen could extract before published surveys were available to shed light on transactions previously invisible to most market participants.

It is also a smidgeon compared to the margins that would have to be built into prices if not for Libor hedges and other risk-sharing inventions.

A kick in the pants has been delivered to publishers of price indexes. They need to make their products more manipulation-proof. Where markets are thin and surveys are the only way to glean market intelligence, publishers already exercise a visible hand to expel questionable or anomalous data. A further solution might be to poll a larger number of traders and randomly exclude most of their answers so no trader would have any certainty of influencing the index.

To understand why such opportunities exist in the first place is to understand something about a generic condition of our world, in which technology has drastically reduced transaction costs and cheap money has vastly increased leverage available even to low-ranking bank employees, magnifying the return to small bits of illicit or licit information, including insider information.

The resulting teensy deviations are usually not material to downstream buyers and sellers (no matter what Mr. Almunia says). They would also tend, as a matter of logic, to net out over time. But the deviations can be quite material to an individual trader’s bonus (Mr. Hayes made $5 million a year) or a five-man trading desk’s profit-and-loss statement. Nor does a cure-all suggest itself, though a blanket way to disincentivize excessive pursuit of small arbitrage opportunities would be to return to the normal (i.e., higher) interest rates that prevailed before the Greenspan-Bernanke era of too-big-to-fail monetary policy.

Normalizing the cost of money would render such pursuits less profitable at the margin. By happy coincidence, this week Ben Bernanke seems to be working on exactly that.