One kind of obvious thing about financial markets is that you can't just call everyone into a room and tell them, "look, guys, just be honest about the price that you would pay / receive for Thing X." This is because financial industry traders are degenerate lying scumbags. No, wait, that's not right. This is because if everyone just told each other their reserve prices then it would be really hard for them to make any money trading and so we, like, wouldn't have a financial system. So you have things like anonymous execution on stock exchanges and dark pools and, um, lying scumbag traders. And that allows you to have profitable trading.
Of course you have to put some limits on the lying scumbaggery: you can't tell people you're investing their money while really blowing it on hookers, and I guess now you can't sell someone synthetic CDOs without telling them who was on the other side. But a little fudging around the edges about the price you're willing to pay or receive - or the price you could pay or receive elsewhere - is kind of at the heart of what trading is.
So in a sense the amazing thing about the Libor scandal is that people are amazed by it. A quick recap:
1. There's a thing called Libor that you can't avoid hearing is the basis for $350 trillion in interest rate swaps and $10 trillion in loans.*
2. That thing is set by Reuters calling up some banks and being like "hey, what rate can you borrow at today?," and them saying "0.49%" or whatever and then Reuters basically writes that down and takes a trimmed average of all the banks.
3. If you're a bank and you have some of those $350 trillion in interest rate swaps and you are net receiving floating then you want Libor to be higher, because then you'll receive more money. So it might occur to you, when Reuters calls, to say "oh, today I can't borrow for 3 months for less than 6.0%. I know, weird, right?" Similarly if you're net paying floating on your derivatives book then you could say "0%, actually, people are just asking to give us free money, someone call Paul Krugman."
4. That happened.
Now that sort of looks like a huge scandal, because three hundred and fifty trillion dollars in derivatives! Which to put it in useful context for you is roughly 4% of the cost of building the Death Star. And, given that somewhat silly process, you might say "I would have thought that building a multi-hundred-trillion dollar industry on prices that may be the average of guesses might create some issues, such as the risk of manipulation…"
You might also say: the British Bankers Association, which sets Libor, may or may not be smart, but the broad set of users of Libor is kind of ... everyone ... so they'd better be smart, and if Libor sucks so much they'd use something else for their swaps. So maybe those guys have figured out a way to make Libor kind-of reliable. For instance, while Libor quotes aren't transactable - it's just "where do you think you could have borrowed this morning?" - they are public, and a bank that regularly submits, say, a too-high Libor quote is going to get a lot of puzzled calls from competitors saying "hey, we'll lend to you cheaper than that, what's up?" That's not exactly a formal penalty, but it can make life awkward for the Libor submitter - who is at least supposed to be the person in charge of cash management for the bank, not the person in charge of interest rate derivatives.
In the earlier days of Libor scandal, the BIS looked into this question and said some sensible things in its March 2008 quarterly report (relevant discussion here, less relevant but interesting Libor stuff here). The whole thing is worth reading, and touches on why people use Libor rather than other floating rates like Treasury bills or whatever. It also asks about how manipulable Libor is:
One way in which fixings seek to be incentive compatible is by publishing individual banks’ contributed interest rates. Transparency exposes the banks to reputational risk because their customers will penalise them for transacting at rates significantly different from their submitted rates. However, transparency raises questions about the information signalled by contributing banks through their quotes. There may be circumstances in which contributing banks deliberately choose to disclose biased quotes. If there is uncertainty about the liquidity position of a contributing bank, the bank will be
wary of revealing any information that might add to this uncertainty for fear of increasing its borrowing costs. Therefore, for the purposes of the fixing, the bank has an incentive to quote a lower interest rate publicly than it might be prepared to pay in a private transaction.
The widespread use of fixings as reference rates also gives contributing banks an incentive to misquote. The costs of manipulating a given rate might be outweighed by the potential profit from positions based on those rates. For example, market participants with large positions in derivative contracts referencing a rate fixing might seek to move the fixing higher or lower by contributing biased quotes.
But they did some digging and found not much statistical evidence of that. Now, of course, we have some pretty direct evidence of that, with UBS apparently cooperating with investigations into possible abuses and with agreements between traders at multiple banks to manipulate yen Libor.
Elsewhere in the financial universe, the rule is often that conflicts are dealt with by disclosing them. That's useful if you're deciding whether to buy a security or vote on a merger; possibly less useful when you're dealing with one price set by a poll that lots of people are locked in to. But it's not useless: someone who benefits from a high Libor and who regularly comes in with quotes at the top of the range should maybe be booted off the Libor panel.
As it happens the BIS, who would know this data if anyone would, looked into this in 2008 and came up with:
[A]vailable data do not support the hypothesis that contributor banks manipulated their quotes to profit from positions based on fixings. Eurodollar futures contracts traded on the Chicago Mercantile Exchange indicate that commercial traders – a category which includes banks and other market participants that might seek to hedge their business activities in the futures market – had a larger than normal net open short position in the third quarter of 2007. To the extent that futures positions are representative of their overall exposure, banks would have gained by submitting low quotes to move Libor below the true market rate. In fact, Libor moved in the opposite direction: it rose in early August.
That is ... surprisingly weak available data! Total CME Eurodollar futures notional is in the single digit trillions, so nothing like the full interest rate exposure. And they're as likely to be hedging an opposite-way OTC exposure as to actually be "representative" of overall exposure. And the fact that Libor went up doesn't mean it wasn't biased down: maybe it would have gone up more but for banks' interest in keeping it down.
There's a strangely large amount of discussion about whether low interest rates are good for banks or bad for banks or bad, then good or other. And banks disclose various duration-y measures of interest rate risk, though more typically on their loan portfolios than on their derivatives. What they don't typically disclose, though, is DV01 of their entire loans + derivatives portfolio to each tenor of Libor. Perhaps if they did calculate and disclose that it would be easier for the BBA to monitor their quotes for shadiness.
Or maybe not. One thing that is interesting about the Libor reports is that bank senior executives weren't telling their Libor-reporter "we are net long Libor so push it up." Rather, it was individual traders telling the Libor-reporter "hey, I could use a higher Libor on my book, could you help me out?" For all we know the banks were actually acting against their overall interests, just to help out individual unscrupulous and pushy traders. Perhaps if they went to the trouble to calculate and disclose their overall exposures, they might be more able to resist those pushy traders before they have a chance to influence Libor.
* Like, you know what Libor is, right? It's the London Interbank Offered Rate, it is meant to represent the rate (rates, really) at which large banks can borrow unsecured in tenors from overnight through one year in ten currencies. In many of those currencies - notably US dollars - it's the basic short-term benchmark rate to which floating payments are indexed on things like bank loans, interest rate swaps, etc. Here's an official explanation that has those $350tn/$10tn figures.