Barclays Fine Signals Fraud In $350 Trillion Lending Market (Update 1)

Updated with British Bankers Association comments, trader correspondance.

NEW YORK ( TheStreet) -- Barclays ( BCS) has agreed to pay regulators in the U.S. and Europe almost $500 million to settle a probe of its manipulation of key benchmark rates known as Libor and Euribor that appear to stretch from the banks trading desks to senior management.

A manipulation of the rates may have unfairly impacted the borrowing costs of homeowners, governments and corporations around the world, as the bank allegedly tried to profit or curb losses tied to floating interest rates at the height of the financial crisis.

In three separate penalties, Barclays will pay the Commodity Futures Trading Commission, the U.S. Department of Justice and the U.K.'s Financial Service Authority a total of $454 million. In the CFTC's settlement, Barclays traders - with the assistance of senior management -- are accused of attempting to manipulate the bank's true funding costs, which are key to setting short-term interest rates that are used in roughly $350 trillion of financial market contracts.

According to the CFTC, Barclays traders and employees responsible for determining the bank's LIBOR and Euribor funding costs attempted to manipulate and falsely reported the benchmark interest rates to bolster profits or minimize losses on derivatives trades. Starting in 2005 Barclays's manipulation "occurred regularly and was pervasive" and involved the bank's traders in New York, London and Tokyo, in addition to "high levels of management within Barclays Bank," said the CFTC in its settlement order.

During the financial crisis between August 2007 and early 2009, Barclays is accused of making artificially low Libor submissions to protect the bank from negative market and media perceptions concerning its funding costs, with instructions coming from Barclays' senior management, the CFTC said. In addition, they accuse Barclays' European traders of aiding and abetting traders at other banks in each other's attempts to manipulate Euribor.

Already, the process of setting the rates, which is governed by the British Banking Association, has been criticized as being too opaque and giving far too much power to the world's largest banks. Banks are polled on the costs to borrow from each other in different currencies like the dollar, yen, euro and Swiss franc for 15 different periods, from overnight to one year. Some high and low quotes are excluded, with remaining bids averaged and set by the BBA.

In the Department of Justice's settlement, it said on Wednesday that, "Barclays has admitted and accepted responsibility for its misconduct." The agency also added that a criminal investigation into the manipulation of Libor and Euribor by other financial institutions and individuals is ongoing and that its settlement with Barclays compels the bank to continue its cooperation on that investigation.

Barclays settlement may be the first in a series of regulatory penalties that may be handed out to banking giants like HSBC ( HBC), Citigroup ( C), The Royal Bank of Scotland ( RBS) and JPMorgan ( JPM).

"Because mortgages, student loans, financial derivatives, and other financial products rely on LIBOR and EURIBOR as reference rates, the manipulation of submissions used to calculate those rates can have significant negative effects on consumers and financial markets worldwide," said Assistant Attorney General Lanny Breuer, in a statement.

Libor, or the London Interbank Offered Rate is a key reference rate for short-term bank funding, interest rate swaps, corporate bonds and even consumer financial products like adjustable rate mortgages.

The DoJ's investigations have ties to a financial crimes task force launched by President Barack Obama in January.

In addition to masking true crisis-time borrowing costs, keeping overnight interest rates artificially low or unfairly high could have also helped banks keep payments on derivatives like interest rate swaps from spiking, while also stopping consumer financial products like adjustable rate mortgage rates from rising.

Meanwhile, the manipulation of the rate may have minimized the banks payments due to corporations and municipalities who swapped fixed rate debt payments for floating rate contracts.

Breuer credited Barclays with its efforts in assisting the DoJ's Criminal Division in an ongoing investigation of "individuals and other financial institutions," related to market manipulation.

"The events which gave rise to today's resolutions relate to past actions which fell well short of the standards to which Barclays aspires in the conduct of its business," said Barclays chief executive Bob Diamond in a statement. "I am sorry that some people acted in a manner not consistent with our culture and values," Diamond added. He and top executives Chris Lucas, Jerry del Missier, Rich Ricci said they will forgo any annual bonus as a result of the violations.

"The American public and our markets rely upon the integrity of benchmark interest rates like LIBOR and Euribor because they form the basis for hundreds of trillions of dollars of transactions and affect nearly every corner of the global economy," said David Meister, the CFTC's Director of Enforcement.

The New York Times reports that regulators are looking into whether banks violated so-called 'Chinese Walls' between their trading desks and treasury units to collude in manipulating lending rates. In the process of setting short-term rates, trading desks and treasury departments are supposed to interact at an arms length; however, emails uncovered by regulators in Barclays settlement cast doubt on that process.

For instance, in a 2007 interaction that regulators uncovered, a Barclays trader asked a treasury employee tasked with submitting BBA rates to manipulate that process. "Pls set 3 month libor as high as possible today," the trader asked. "Sure 5.37 okay?" replied the submitter. "5.36 is fine."

A manipulation probe into the $350 trillion financial market tied to short term interest rates began to grow in early 2012, with banks Credit Suisse ( CS) and UBS ( UBS) coming under increasing scrutiny by Swiss competition watchdogs in February, according to a Bloomberg report.

Regulators around the world, including the DoJ, FSA and Japanese and European agencies are investigating manipulation of the setting of the benchmark rates, which are a key part of opaque credit and interest rate derivative markets that are subject to recent regulatory reforms like the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act.

Barclays $200 million fine is the largest CFTC settlement ever. For the Department of Justice, the settlement is the first after it launched a probe on 16 of the world's largest banks including Barclays, Bank of America ( BAC) and Citigroup, last July. In July 2011, the DoJ granted immunity to UBS in its Libor probe.

At the onset of the financial crisis in the summer of 2007, overnight rates like Libor spiked as banks faced a cash squeeze, prompting the Federal Reserve and other central banks around the world to launch emergency liquidity facilities. The question now is whether there was pervasive collusion by banks to lower their borrowing costs during the crisis, keeping Libor and short term borrowing from rising substantially.

Libor is set every day in London at 11 a.m., using submissions by a consortium of banks that report the rate they are paying to borrow. Roughly $10 trillion in loans and $350 trillion in derivatives are tied to Libor, according to The Wall Street Journal calculations.

In a statement, the BBA, which is investigating its rate setting process, said, "This is an announcement with extremely serious implications which need to be carefully considered and the investigation findings will be fully included in the current review of Libor."

-- Written by Antoine Gara in New York