Inside the ISDAfix manipulation case

The ISDAfix manipulation case may not have been as headline grabbing as Libor and FX scandals but the rate is just as important to derivatives end-users active in swaps trading.

Last May, the Commodity Futures Trading Commission (CFTC) hit Barclays with a $115m fine to settle claims of ISDAfix manipulation. It was the first fine handed out to the banking industry since the CFTC started investigating alleged ISDAfix market abuses in 2012. Yet, unlike the furore accompanying the London Interbank Offered Rate (Libor) and WM/Reuters FX rate rigging claims, ISDAfix has not gathered the same amount of attention from the market. This is partly down to the esoteric nature of the contracts using the ISDAfix reference. The rate, which represents the mid-market price for swap contracts with maturities from one to 30 years, is essentially the long-term equivalent of Libor, which goes out to a maximum one year. It is most commonly used to settle payments on over-the-counter (OTC) contracts including long-dated swaps, swaptions, steepeners and constant maturity swaps, amongst others, as well as some deliverable swap futures.

“It is less generic than Libor which is used everywhere – including Main Street – mortgages and funding and so on,” says Ben Larah, manager, Sapient Global Markets.

While it may not be as well known as Libor, for pension funds, insurers and other institutional derivative users hedging their interest rate exposures, ISDAfix is of massive significance. According to a report released in 2014 by the International Swaps and Derivatives Association (ISDA), the swaptions market alone currently stands at $30 trillion in notional outstanding contracts.

Mustering evidence

The ramifications for derivatives users, and the banks manipulating the rate, are huge, with losses potentially running into the billions. Lawyers have been mustering evidence to seek reimbursement for losses but it has been a slow process. So far, only one case has made it to court – last year’s claim brought by the Alaska Electrical Pension Fund against 13 banks who, it says, set ISDAfix at artificially low levels to manipulate the payments to investors in the derivatives.

Given the esoteric nature of the instruments – which are not centrally cleared, due to their lack of standardisation and are less frequently traded than other types of OTC derivatives – getting a handle on who has suffered what is tricky. At the same time, the legal complications of instigating a case, particularly in Europe, complicate matters further. The class action rule in the US – which allows lawyers to file a general complaint on behalf of a larger group of persons, through a single complaint – means that it is much easier to bring cases of market manipulation over there. European courts demand that all complainants are represented.

“You need to find sufficient number of aggrieved parties to do it in Europe,” says Alberto Thomas, partner at consultancy Fideres. “You need to find $10bn in transactions to make it viable so you need to actively approach institutional investors. It is a lot of work to get critical mass.”

At the same time, however, participants argue that there is a significant amount of evidence to implicate banks in the affair. Thomas says that unlike Libor, where most of the post-2008 manipulation was carried out by banks seeking to artificially lower their borrowing costs and ths presenting a better picture of their corporate health, ISDAfix manipulation was carried out opportunistically, with the intention of getting better prices on trading books filled with swaptions and other interest rate products through activities like “banging the close”.

 End-users backing off

“For years banks submitted almost identical ISDAfix rates down to five decimal places – this stopped in 2012,” says Thomas. “Once you go and analyse the behaviour of the market around the time they need to submit the rate you see the market moves sharply then goes back to normal. So anyone trading around that time will have suffered collateral damage by what the bank is doing.”

The CFTC’s recent fine against Barclays should give more fuel for others to mount their own cases. And regulators, such as the Financial Conduct Authority in the UK and Germany’s financial regulator, BaFin, have launched parallel probes into the manipulation which could encourage claims.

In any respect, ISDAfix, along with other benchmark scandals, has encouraged a shake-up of the rate setting market conventions. Investors are now under much greater pressure to follow best practices and good governance on behalf of their clients, which means making sure they are getting the best rate on products, rather than relying on benchmarks.

“If this has left us with anything it is that no matter how well you calculate the benchmark asset managers cannot accept the dealers’ rate without additional justification through transaction cost analysis,” says John Adam, head of product development at Portware. “As the market gets more liquid and swap execution facilities gain liquidity, you are going to have to look at more than one price. Now investors must explain how and why the trade was executed at a particular price. It isn’t enough to use benchmark rate and leave it at that.”

Adam says that buy-side companies are increasingly drawing on their own resources or implementing new transaction models to subvert ISDAfix manipulation – for example, moving from a voice to a request-for-quote (RFQ) model – or “going shopping” on best prices or rates between venues. Still, the damage caused by ISDAfix has not yet properly addressed the systematic problems of accountability in the industry.

“The biggest conflict of interest of all is within the financial community where end-users of financial products do not want to take action, and hence keep accountable, the dealers because they are worried of damaging their relationships,” says Thomas. “Therefore it’s the culture in the banking world that needs to be fixed: until we recognise that these are not failures by a few individuals but systematic failures, we are not going to be ready to move on from these scandals.”

It may indeed take a benchmark court case to really shake up things. Participants will be watching the Alaskan pension fund outcome with close interest. 

Reforming the ISDAfix world remains a huge task

As with Libor, banks are alleged to have used a number of different techniques to rig the ISDAfix rate. These include “banging the close” – trading large amounts of the instruments referencing the rate before the 11am fix time before unwinding – and spoofing, where a dealer will send out a quote which it has no intention to act on, simply to move the market in its favour. In August, Intercontinental Exchange (ICE) Benchmark Administration (IBA) took over ISDAfix management from ISDA, changing the rate name to ICE Swap Rate and revising the calculation methodology from the old style bank submission model to gathering tradeable quotes sourced from exchanges and regulated electronic trading venues. The idea is to change the rate setting to a more objective market model. But whether this will really fix the market from being manipulated in the future is doubtful.

“The change is important because it binds the fixing rate close to the market but this is not a guarantee that this can never be manipulated,” says Ben Larah, manager, Sapient Global Markets. “Banging the close is about making orders in a very large market – so the fact you have to send tradeable quotes is not itself sufficient to guard against the quotation being manipulated. You can manipulate the quote by trading it.”

In recent times, several central clearing counterparties (CCPs) – including the Chicago Mercantile Exchange (CME) and LCH.Clearnet’s Swapclear – have been working to develop a framework for clearing swaptions, and other currently bilaterally cleared OTC products to foster greater transparency in the market. As yet they continue to struggle with the extra complexity in clearing these products due to their customisation and lack of liquidity compared to interest rate swaps. It remains to be seen if things will change in the future and if the market can become truly fix-free.