Barclays Scandal Was Born of Diamond's Derivatives Bet

Updated to reflect Barclays emails, testimony and U.K. chancellor statement

NEW YORK ( TheStreet) -- In the casino-like world of the over the counter (OTC) derivatives trading market, Barclays ( BCS) and its former chief executive Bob Diamond played a winning hand.

Until they lost it all this week.

Diamond said Tuesday that he plans to step down from Barclays' top spot and is preparing to face a U.K. Treasury panel over a market manipulation probe at the bank's interest rate swap trading unit. The scandal prompted a $450 million fine paid to regulators in the U.S. and U.K last week.

The ascension of Barclays Capital and its leader Diamond in the world of high finance, highlighted by its scrappy growth through the 2000s and a crisis-time acquisition of Lehman Brothers' U.S. investment bank, and their recent turmoil underscores the risks that banks run by relying on opaque earnings sources like derivatives trading.

For those who are mystified by Diamond's sudden resignation and that of a top lieutenant Jerry Del Missier, it's key to understand how Barclays Capital transformed from a fringe investment banking player, to one that is challenging mainstays like Goldman Sachs ( GS), Morgan Stanley ( MS) and JPMorgan ( JPM).

Prior to acquiring Lehman Brothers' U.S business in 2008, Diamond ran Barclays Capital with a mission for it to be the "leading European investment bank for financing and risk management," and largely succeeded. By risk management -- which are Diamond's words taken from annual reports -- he mostly means providing hedging products for credit and interest rate risks that other financial institutions and corporations face.

By the onset of the financial crisis, Barclays Capital was recognized as a top derivatives player and had the market share to prove it; however, few of its other investment banking businesses were prominent outside of Europe.

In 2008, Barclays was anointed interest rate derivatives "house of the year" by industry trade publications International Financial Review and Risk Magazine as its unit grew into a top five global player in most key markets. Those accolades came on the heels of trading growth that was largely done before Diamond acquired Lehman Brothers traders and bankers at the nadir of the credit crunch. With Lehman onboard, Barclays Capital moved to the top of most interest rate and credit derivative trading markets.

But, after taking on nearly 10,000 Lehman Brothers employees, Diamond's mission for Barclays Capital changed. No longer interested in just dominating "risk management" - a Wall Street euphemism for derivatives - Diamond wanted Barclays Capital to become the "top global investment bank," meaning it would grow its debt and equity underwriting and investment banking advisory businesses to take on more white-glove operations like Goldman Sachs.

For instance, Barclays Capital provided most of the financing for Kinder Morgan's ( KMI) takeover of El Paso ( EP), in a front-page deal that it would not have won without former Lehman Brothers investment bankers.

It's those two phases of Barclays Capital, which may underscore the importance of Diamond and Del Missier's resignations. While they've successfully transformed Barclays Capital into a leading investment banking presence, it was their early reliance on hard-to-manage and opaque derivatives trading based earnings that may be their downfall and a cautionary tale.

Testimony prepared for the U.K.'s Treasury's Treasury Select Committee may signal that Diamond was adjacently involved with Barclays manipulation of Libor, a benchmark interest rate that is used for most variable rate debt and is the staple of the $350 trillion swaps market. According to the testimony and revelations from regulatory settlements, Diamond and top Barclays Capital executives like Del Missier may have inadvertently signaled for traders to underreport their borrowing costs after communications with the Bank of England in October 2008.

The resignations appear to center on a correspondence between Diamond and a Bank of England deputy Paul Tucker, where the official signaled 'senior' officials at the Central Bank felt that Barclays was reporting borrowing costs that were too high relative to peers and that the bank could lower them. "Tucker stated that the levels of calls he was receiving from Whitehall were 'senior' and that while he was certain we did not need advice, that it did not always need to be the case that we appeared as high as we have recently," wrote Diamond in an Oct. 30 email to former CEO John Varley that Barclays released on Tuesday.

While the bank stated that Diamond didn't think the correspondence was an explicit instruction to report artificially low short-term borrowing costs, Barclays said on Tuesday that "Jerry del Missier concluded that an instruction had been passed down from the Bank of England not to keep LIBORs so high. He passed down an instruction to that effect to the submitters."

Even if the ongoing inquiry into Barclays' Libor manipulation doesn't draw Diamond or Del Missier into the fray of allegations or prospective criminal probes, revelations from its settlement with regulators in the U.S. and the U.K. definitively show that some of the bank's traders were involved in repeated attempts at market manipulation over a span of years.

The fines also show that traders acting in OTC markets with limited oversight can cripple a banks reputation. JPMorgan's 'London Whale' trading loss also stands as another cautionary tale of derivatives trading run amuck.

Just days ago, in an internal memo obtained by Bloomberg, Diamond said that the banks' $450 million settlement with regulators was the making of "the action of a few people" within its interest rate swap trading units, mostly between 2005 and 2007. A week ago, the fine and Barclays' statements underscored how hard it is for bank CEO's to manage traders in opaque markets like derivatives.

Now, the resignations of Diamond and Del Missier and widespread uncertainty over who will lead Barclays show that risks can be even greater.

"The external pressure has reached a level that risks damaging the franchise - I cannot let that happen," said Diamond in his resignation statement on Tuesday. To be seen is what Barclays' reputational damage will be. Chairman Marcus Agius, who temporarily took back a Monday resignation, will lead a search process for a new CEO.

In a Tuesday statement to the BBC, U.K. Chancellor of the Exchequer George Osborne called Bob Diamond's resignation the "right decision."

Financial sector investors should be weary that Barclays problems are just a tipping point of widespread industry malfeasance. "The credit crisis has already claimed the jobs of many CEOs and post the revelations from Barclays of the Libor issues, may yet claim more," wrote Bank of America Merrill Lynch analyst Michael Helsby in a Tuesday note. Agius of Barclays also underscored concerns of the impact of a widespread Libor probe, in a Tuesday conference call.

Other large banks that set short-term rates such as Citigroup ( C), Bank of America ( BAC), RBS ( RBS), Lloyds Banking Group ( LBG), Credit Suisse ( CS) and UBS ( UBS) may also be brought into an ongoing manipulation probe by regulators around the world.

Still, Diamond's departure is particularly tragic because of his contribution to Barclays and his instrumental role in pulling the bank through the crisis and transforming it to a leading global player.

When Diamond took the helm of Barclays Capital in the late 1990s, the unit was a small investment banking operation within Barclays - Britain's second largest bank by assets - and an even smaller piece of the global capital markets and underwriting community, where the likes of Goldman Sachs ( GS), Morgan Stanley ( MS), JPMorgan ( JPM), Deutsche Bank ( DB) and Citigroup ( C) have long held top positions. Impressively, Diamond spearheaded growth at the investment bank and a separate unit called Barclays Global Investors, taking on Wall Street's largest players.

In fact, it was the investment banking and investment management businesses that Diamond grew and oversaw, which helped Barclays weather the 2008 financial crisis as peers like Royal Bank of Scotland ( RBS) were forced to take bailouts from the British government.

In 2008, Diamond made what may be the boldest bet of the financial crisis, buying Lehman Brothers U.S. investment bank, in a move that transformed Barclays Capital into one of the key players in global finance. Shortly thereafter, Diamond sold the Barclays Global Investors investment management and ETF unit he helped build to Blackrock ( BLK) for $13.5 billion, in a capital raise that averted a government bailout.

Diamond was rewarded for molding of Barclays Capital into a key part of Barclays overall earnings, and at the start of 2011, he took over as chief executive of the entire bank. In 2012, Diamond rebranded Barclays Capital so that it wouldn't stand separately from the larger retail banking operation centered in Britain, shaving off the "Capital" moniker from Barclays U.S. headquarters.

Now, Diamond's Tuesday resignation puts the bank potentially adrift. For other banks, risks may be equally large if regulatory inquiries lead to upper management departures.

The revelations of Barclays' manipulation of key benchmark rates known as Libor and Euribor may have an even broader market importance, notes Richard Bove, a banking analyst with Rochdale Securities. "Today, there is no base rate to set loans," he says, pointing to the doubts that the Barclays probe casts on the process of setting of short term interest rates. Still, Bove sees the interest rate swap market's continued growth as proof that it has a utility in finance.

According to a $450 million regulatory settlement with the Commodity Futures Trading Commission, the U.S. Department of Justice and the U.K.'s Financial Service Authority agreed last week, Barclays traders and employees responsible for determining the bank's LIBOR and Euribor funding costs attempted to manipulate and falsely report benchmark interest rates to bolster profits or minimize losses on derivatives trades. Starting in 2005 Barclays's manipulation "occurred regularly and was pervasive," said the CFTC in its settlement order.

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.

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

Regulators around the world, including the Department of Justice, Financial Services Authority and other Japanese and European agencies are investigating other allegations manipulation of the setting of the benchmark rates, which are a key part of opaque derivative markets that have roughly $350 trillion in outstanding market value.

-- Written by Antoine Gara in New York

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