Allegations of interest rate swap market manipulation could spark wave of costly D&O claims and litigation

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Insurers could face a wave of directors & officers (D&O) insurance claims from the third big rate rigging scandal by banks – this time from alleged manipulation of the interest rate swap markets.

All the signs are that the cost of the ISDAFix scandal will dwarf the cost of either the Libor or the Forex scandals, especially for insurers. Early indications are that this will lead to large fines, litigation and huge claims for damages, according to Elborne Mitchell partner Edward Swan.

The issue surfaced in 2010 when concerned members of the interest rate swaps markets blew the whistle.

Members of 15 of the world’s largest banks allegedly conspired to rig the ISDAFix index, which is set by the International Swaps and Derivatives Association (ISDA) and gives benchmark rates for trading interest rate swaps.

There are two main areas of alleged wrongdoing, according to Swan.

The first is that traders were placing trades on information before it was made publically available, giving them an unfair advantage.

The second is that financial firms gave wrong information to the rate-setters of ICAP and Thomson Reuters, for their own benefit.

Swan says: “Whenever they made profits, of course, other people lost money. If people lose money due to genuine market movements, then that’s not a problem.

“But if it’s due to the conscious manipulation of certain institutions, well, that’s not the way that financial transactions are supposed to be conducted.”

The US Commodity Futures Trading Commission is already investigating, as is the UK’s Financial Conduct Authority.

If the allegations are true, then those affected include governments, municipalities, pension funds, institutional investors, other banks, buyers of interest rate derivatives hedging against rate changes – and insurers.

Swan says that the ISDAFix allegations could cause a wave of D&O claims for insurers to deal with.

“There may be significant damages assessed against banks and financial institutions, if the fines that were levelled for Libor and currency manipulation are any judge,” he says.

“In that case, financial institutions may turn to their insurers to collect on D&O policies, and insurers will have to think very carefully about whether or not these policies will cover this kind of activity, because the numbers could be very large indeed.”

The risk of D&O claims is one thing, but the scandal around rigging benchmark ISDAFix rates introduces a new cost for insurers, which relates to their status as major investors, reliant on interest rates.

Insurers could already have lost money from the way that some big banks apparently manipulated ISDAFix rates, according to Swan.

One of the uses of the ISDAFix rate is to set the value of financial instruments such as corporate bonds and asset portfolios, which are of huge importance to insurers. Also, interest rates can affect insurers in other ways, by influencing bonds, loans and trades in derivatives. If the rates were rigged, as alleged, then this could have caused insurers to lose money unfairly.

Swan says those affected can either apply to regulators to order redress, or else turn to private litigation. The problem will be working out what the damage is.

“That’s not an easy calculation,” Swan says. “That’s going to take a detailed regulatory investigation or, in private litigation, a detailed examination of the records of the defendants and the markets themselves.”

These problems aside, the intent to sue is there. Firms that provide outsourced electronic documents for law firms and financial institutions are already recruiting lawyers with ISDA experience.

“This can only mean one thing – they are expecting a lot of business,” Swan notes in a document on the ISDAFix scandal.

So where does the insurance industry go from here? The next steps depend on the outcomes of the open investigations. But if the allegations stick, then these investigations should unveil the true costs of the rigging and leave the door open for fines and litigation.