The Spider Network

by David Enrich

  Derivatives had been around, in various forms, for a very long time. In the twelfth century, English merchants at medieval fairs signed contracts guaranteeing to deliver their wares at a set price at a future date—a primitive type of futures contract. Five hundred years later, Japanese feudal lords used a similar practice to lock in rice prices to protect themselves from bad weather or war. The famous Dutch tulip bubble largely involved the frenzied trading of options to buy or sell the bulbs—a precursor to modern-day stock options—rather than transactions involving the actual flowers.

  Derivatives really exploded in popularity in the 1970s, in large part due to unprecedented volatility that hit financial markets. Oil prices ricocheted up and down. Governments delinked their currencies from the gold standard, causing exchange rates to swing wildly. Rapid inflation spurred central banks to jack up interest rates. Companies and individuals needed ways to protect their fortunes from these new risks—and banks and brokerages were there to help, peddling a growing array of derivatives. A company that offered hot-air-balloon rides might purchase derivatives whose value rose the more rainy days there were in a season, thereby shielding the company from the adverse effects of bad weather. The banks or other companies that sold those instruments would charge a fee and then would try to balance out their positions by offering the opposite positions—say, a derivative whose value climbed based on the number of sunny days—to other customers, such as umbrella manufacturers. Boiled down to their essence, derivatives were designed to help people or institutions protect themselves from future circumstances. And no matter the sunshine or the clouds, one party in the transaction always came out ahead—that was the bank that, for a fee, engineered the derivative.

  Derivatives were uniquely suited for speculation, because traders could dabble without actually having to own a product. Someone who bought or sold pork belly futures, for example, was unlikely to actually own, now or ever, any actual pig parts. But future swings in the price of pork bellies might be a good gauge of expectations about the weather or a harvest or a disease’s severity or just basic macroeconomic trends. And so investors might buy or sell pork belly futures to get a piece of that action.

  The increasing popularity of derivatives as a speculative vehicle unnerved many experts. After the 1987 market crash, a White House report blamed derivatives for worsening the crisis by intensifying the snowball-like nature of panicked selling. In April 1994, derivatives landed on the cover of Time under the headline “Risky Business on Wall Street.” (The magazine’s cover illustration was of an evil-looking nerd staring at a computer screen.) And in 1998, the chaotic collapse of the giant, derivatives-investing hedge fund Long-Term Capital Management, run by mathematicians and Nobel Prize–winning economists, further underscored the instruments’ risks. “Every time there’s been a fire, these guys [derivative traders] have been around it,” the former U.S. Treasury secretary Nicholas Brady noted in response. But derivatives were not going anywhere.

  * * *

  IBM had a problem. The company, with operations all over the world, had issued debt to finance its European businesses in Swiss francs and German marks. But IBM preferred to have all its debts denominated in American dollars—otherwise its finances were tethered to volatile and unpredictable international exchange rates. In 1981, IBM turned to Salomon Brothers for help. The Wall Street firm approached the World Bank—one of the leading issuers of debt anywhere, and an entity with a tolerance for bonds denominated in a variety of currencies—and convinced it to sell a slug of bonds that were identical to the IBM debt except for one crucial difference: They were in dollars. Then IBM and the World Bank simply swapped responsibility for making interest payments and eventually repaying the principal on their respective bonds. It was the birth of a new financial derivative: the swap.

  Derivatives tied specifically to interest rates became common as Hayes came of age in the banking industry. Say that ABC Corp. borrowed $100 from First National Bank. The loan had a floating interest rate tethered to the Federal Reserve’s base rate,* which currently stood at 2 percent. That carried risks. If the Fed subsequently hiked rates, ABC Corp. would see its interest payments shoot higher. So investment banks concocted a derivative product, known as an interest-rate swap, that would help protect ABC Corp. from the possibility of being burned. ABC Corp. and Giantbank would enter into a derivative contract that simulated a pair of similar $100 loan transactions. First, ABC Corp. would agree to borrow $100 from Giantbank with a fixed 2 percent rate. Then Giantbank would agree to borrow $100 from ABC Corp. with a floating rate tied to the Fed’s base rate or another metric. At the end of the loan period, whichever party—ABC Corp. or Giantbank—owed more money on their side of the contract would pay the other party. (The $100, called the derivative’s notional amount, wouldn’t change hands.) Under this construction, ABC Corp. would stand to make money on the swap if the floating rates jumped above 2 percent, which would make up for the higher interest rates it would owe First National on the original loan. If floating rates declined, ABC Corp. would owe money to Giantbank, but that would be offset by its savings from the declining rates on the First National loan. In other words, the derivative neutralized the interest-rate risks ABC Corp. faced in its original loan. (Got it?) Providing interest-rate swaps was a valuable service, involving not only complex calculations but also the assumption of large risks, and banks charged their clients handsomely.

  If that setup sounds terrifyingly complicated, keep in mind that like so many instruments in the hall of mirrors that is modern finance, there might not even be an “ABC Corp.” The swaps were simply another vehicle with which banks could bet on the future direction of interest rates. That meant a particular interest rate—and this is where Libor would eventually come into the equation—could have massive effects when it came to a bank’s bottom line: If it moved in an advantageous direction, a particular swap could become extremely lucrative. By 2010, some $1.28 trillion of these interest-rate swaps would change hands on a daily basis, up from $63 billion fifteen years earlier. As always, the advantage went to the trader who found an edge—whether that edge was a gullible client, a superior product, a more sophisticated computer model, whatever. Sometimes the edge was simply pushing the envelope just a little bit further than anyone else.

  Hayes landed in a subgroup of the interest-rate team that specialized in products derived from Japanese rates. At first, one of his main tasks was to rewrite the computer models that RBS used to figure out how much its derivatives were worth. It was a monstrously complex task. Hayes needed to come up with intricate models to predict not only the future direction of Japanese interest rates, but also the prices of a variety of instruments that were underpinned by those interest rates, as well as their likely interactions with interest rates elsewhere in the world. The process was made all the more grueling by the archaic state of RBS’s computer and software systems.

  In 2002, Hayes was handed partial responsibility for a small segment of his team’s trading. Under his boss’s supervision, he was allowed to start buying and selling limited quantities of low-risk derivatives tied to Japanese rates. Hayes had arrived; he was a trader, near the top of the Wall Street food chain. But it was an unglamorous assignment. He was squeezed on RBS’s teeming trading floor, surrounded by row after row of loud, cocky colleagues, with only a stack of computer monitors to act as a buffer between the awkward young man and his rowdy deskmates. The real problem, though, was that the Bank of Japan had kept interest rates at zero for nearly ten years, trying in vain to resuscitate the country’s moribund economy, a period that would come to be known as Japan’s “Lost Decade.” With interest rates flatlined, the derivatives Hayes was responsible for were pretty dull. Another downside: He needed to be at his desk for a large portion of the period each day that Japanese financial markets were open. That meant arriving at RBS’s offices as early as 4 a.m., which in turn meant going to bed by 7:30 p.m. Unlike most traders, Hayes was far from social, and so he didn’t mind t
he early bedtime. In the summer, he loved strolling through the City’s ancient, deserted streets as predawn daylight emerged over seventeenth-century church steeples and twentieth-century skyscrapers. But during the winter, the sun didn’t rise until after 8 a.m. Then, having to drag himself out of bed at 3 a.m. was torture.

  Because many of the clients looking to buy or sell Japanese derivatives were based in Japan, Hayes got to travel to Tokyo. One trip happened to overlap with a visit by Fred Goodwin, RBS’s hard-charging CEO. Goodwin was staying at the luxurious Four Seasons; Hayes was in a crummy hotel down the street from RBS’s offices. Misreading the cues, Hayes ribbed the CEO about his posh digs and jokingly complained that he wasn’t permitted to stay there. The attempt at humor fell flat with the ill-tempered Goodwin.

  RBS had a small office in Tokyo, and most of its trading business involved proprietary trading, in which traders made large bets simply using the bank’s money; there was no ancillary business of making markets for or otherwise helping clients. Goodwin was introduced to a group of traders. He looked at each of them, asking what they did for the bank. “Prop trading,” came the proud response. The CEO looked queasy. After all, what business did a Scottish bank really have employing high-stakes gamblers on the opposite side of the globe? Years later, Hayes would recall that Goodwin appeared to be “a bit nervous that there was some Nick Leeson waiting in the wings in Tokyo.” Leeson was the Singapore-based trader whose unauthorized, money-losing gambles caused the 1995 collapse of Barings Bank, what had been the United Kingdom’s oldest investment house. But Goodwin wanted growth. That meant taking risks—by the company and by its legions of ambitious young traders. And Goodwin would get what he wanted.

  Chapter 3

  Classy People

  The eight-year-old boy left Ethiopia in search of a better education and a brighter future.

  It was 1963, a time of considerable change in the country where the boy had lived with his parents. Thousands of Western tourists were venturing there, hoping to enjoy Ethiopia’s sunny weather and its ancient history. In the capital, Addis Ababa, new buildings designed by prominent European architects were sprouting up as a gusher of foreign aid—and a boom in the export of Ethiopian coffee—lifted the economy. And the city was the home of the new Organisation of African Unity, a confederation of dozens of African countries. At its inaugural summit that May, the two-thousand-plus delegates—which included thirty-one heads of state—pledged to devote themselves to decolonizing the rest of the continent. Ethiopia’s autocratic emperor, Haile Selassie, tried to refashion himself as a beacon for independence and self-determination. “May this convention of union last 1,000 years,” the seventy-one-year-old emperor declared at the summit, before inviting the delegates to a sumptuous banquet.

  The optimistic mood didn’t temper the reality on the ground. Selassie was a brutal, absolutist ruler. Most Ethiopians were impoverished peasants. Even the affluent couldn’t avoid the sight of things like leprosy and widespread destitution. While the Western world had grown accustomed to viewing coronations and other events on live TV, very few people in Ethiopia could afford to buy a television set and, even if they could, there were no broadcasts to actually watch.

  And so the eight-year-old, named Michael Spencer, decamped to England. His parents, diplomats in the British civil service, had enrolled him in a Catholic boarding school in the rolling green hills and farmland south of London. The young Spencer was a strong student and was later admitted to Oxford University, where he studied astrophysics. But his goal, ever since he’d been fifteen, was to work in finance. He was fascinated by the Rockefeller and Morgan dynasties in the United States. Most important, he craved money. His father, back in Addis Ababa, didn’t discourage the obsession. “Money can’t make you happy, but it does allow you to be miserable in comfort,” he counseled his son.

  After graduating from Oxford, the twenty-one-year-old Spencer, with a hippie haircut and beard, landed his first job in the City of London in 1976 at stockbroker Simon & Coates. He was fired in 1979 after losing gobs of money on a bet that the price of gold would go down; instead, the price had soared after the Soviet Union invaded Afghanistan. Spencer seemed to blame the mishap on his absorption of the industry’s prevailing culture. “I rather naively believed one could get rich quick, and the whole idea of working in the City was to get rich quick,” he would tell an interviewer in 2005. Spencer soon bounced back and secured a new gig in London at the American bond-trading firm Drexel Burnham Lambert. Once again, he was fired after three years, this time not only for making bad trades but also for trying to conceal them.

  In many industries, that would have been the final straw, but London’s financial arena in the 1980s was a wild, reckless place. The City was about to undergo the violent tremors of Margaret Thatcher’s deregulatory revolution, and hungry young traders and brokers were in high demand. Spencer resurfaced at a smaller brokerage firm called Charles Fulton. By now, despite his money-losing ways, he was developing an expertise in a fast-growing corner of the markets called interest-rate derivatives. When Charles Fulton converted into a publicly traded company in 1985, Spencer took his earnings—about $200,000—and with a few colleagues decided to create a new brokerage firm that would specialize in matching up buyers and sellers of interest-rate swaps and other derivatives. They launched Intercapital in May 1986. Its name would later be shortened to ICAP.

  * * *

  One of the pieces of sage counsel that Brent Davies pounded into his impressionable mentee’s head, over and over again, was the following: “Never trust a broker.” Brokers, he explained to Tom Hayes, were like the hyenas of the investment banking world, wild, clownish figures who feasted on the carcasses left behind by stronger, more cunning predators—namely, traders. These weren’t run-of-the-mill stockbrokers, the types who handled many grandparents’ portfolios of blue-chip stocks. These particular middlemen—known in the industry as “interdealer brokers”—solely interacted with people at big banks and other financial institutions. Say that a trader at RBS wanted to buy a bundle of interest-rate derivatives. To avoid tipping his hand to rivals, the trader would tell one of his favorite brokers that he wanted the derivatives and was willing to pay a certain price, say $1,000 per contract. The broker would tell his colleagues. Then those brokers—generally keeping the identity of their client secret—would fan out to their trader contacts at other banks and see if there was anyone willing to sell that product at something resembling the price the RBS trader was willing to pay. If so, the match was made and the trade got done. For his efforts, the broker’s firm was rewarded with a tiny percentage of the transaction’s value as a commission. Because the trades regularly ran into the millions of dollars, and lots of them occurred every day, such commissions quickly stacked up. The brokers personally received a big chunk of their commissions.

  But the brokers also played another, less tangible role in the shadows of London’s financial markets, as purveyors of gossip and other often-questionable information. When a trader wanted to get a sense of where a market was heading, he might call a broker to get a feel for where rival traders were putting their money. The brokers—few of them university educated, but most of them with street smarts—also were infamous for spoon-feeding traders bogus information that had no purpose other than tricking them into doing trades that weren’t really worthwhile to anyone but the brokers themselves. Similarly, if a trader wanted to spread misinformation in the market—for example, nudging the price of a thinly traded instrument higher based on a hazy rumor about pent-up demand for that particular product—a broker could be an ideal conduit. One illustration of the industry’s culture was that brokers used the word broking to mean “tricking” or “misleading”—as in, I was broking him to believe something that wasn’t true.

  For a good trader, however, brokers were indispensable as sources of trading opportunities and information. As a result, when Hayes gained responsibility for a small amount of trading, his colleagues started introd
ucing him to brokers—and warning him about the hazards they posed, especially to someone who was gullible and prone to social confusion. One of the first brokers Hayes met was Noel Cryan, an amateur boxer who worked at one of London’s biggest brokerages, Tullett Prebon. The son of Irish immigrants—his dad was a construction worker, his mother a nurse—Cryan attended Catholic school, where he struggled with disciplinary issues. He dropped out at age seventeen and spent the next couple of years working odd construction jobs. One miserably cold winter morning, Cryan stood outside at a construction site and decided that perhaps it was time to start a career. Despite his lack of interest in school, he was good at math, and he found an apprenticeship at a local gambling company. He enjoyed the job and figured he could earn a better living putting his skills to work in finance. A broker he knew said he’d be a good fit in that industry, and so, at age twenty-one, Cryan joined the profession in which he would spend the next quarter century.

  Cryan—with a bulbous nose and hangdog cheeks, he had a slight resemblance to Kevin Spacey—was married with two sons. An avid sports fan, he’d taken a liking to the New England Patriots, but his biggest passion was soccer; he supported a third-rate London club called Millwall, whose fans were renowned, even in England’s bare-knuckled hooligan culture, for their pugilistic tendencies.

  Hayes regarded Cryan as bright and likable, especially because he, like Hayes, was loyal to a mediocre soccer team. (In Hayes’s linear mind, fidelity to a downtrodden squad was a sign of strong moral fiber and therefore meant the person could be trusted under virtually all circumstances.) The feeling wasn’t mutual. Cryan, a bit of a party animal, thought Hayes was basically a loser, shy and antisocial, and seemed to suffer from some sort of obsessive-compulsive disorder. (That Cryan’s wife was a special-needs teacher probably made him more attuned to this sort of thing than the average broker.) When they went out for a drink, it was hard to get Hayes to talk about anything other than financial markets or soccer, and he still refused to make eye contact. Hanging out with him was exhausting.