Barometer of Fear

by Alexis; Stenfors

  The impact of losing a major client can be devastating for a broker. Brokers compete with each other to get the main players on board (these players are often just a handful of individuals) and to retain them. A threat would pose the broker with a dilemma, as their revenue – and that of the company – also depends on their long-term reputation for being fair and seemingly objective. Although brokers tend to have one, two or three key accounts, they cannot be seen to favour these ahead of their other clients. If so, the less active traders providing bread-and-butter business might switch to another broker who provides a fairer service.

  On 17 December 2015, a broker said in court that he would never have taken the risk of favouring one bank over another. If the news got out ‘it’d spread through like wildfire around the market,’ he said. ‘You’d go from hero to zero in no time.’13

  I think his statement is partially correct, but not completely. It would definitively spread like wildfire around the market. Everyone would know that he was favouring that particular bank or that particular trader. However, I am not so sure that the fall from grace would be that dramatic. Everyone knows that, in the end, the powerful banks and the powerful traders get better service from the brokers than less influential players. I think most traders would have been bitterly disappointed, but they would still have forgiven him for playing the game.

  Instead of resorting to blackmailing techniques, a trader could also do the opposite: ensnare a broker into a lucrative financial arrangement. The trader could, in theory, simply pay bribes to a broker for complying with certain demands. Bribes would not have to come in the form of brown envelopes discreetly handed over in a dark alleyway. Instead, a trader could put more business through a particular broker and reward them in that way. More business would mean more commission – which would mean a bigger bonus for the broker. There is, however, one problem. Doing more deals just to keep the broker happy would also mean that a trader would suddenly be taking more risk than they might want to at that particular moment. Therefore, bribes could be elaborately constructed in the form of so-called ‘wash trades’. In such a case, a trader would buy, say, $1 billion worth of FRAs from a trader at another bank, and simultaneously agree to sell it back at exactly the same rate. There would be no risk involved, as the trades would offset each other perfectly. Such a trade naturally sounds pointless. Why would a trader buy something and sell it back at the same time at the same price? Well, if a broker acts as an intermediary, the two trades would result in having to pay a commission to the broker. The bigger the amount, the bigger the commission (read: bribe) paid to the broker.

  Asked in court why he did not refuse to be rewarded with wash trades worth tens of thousands of pounds in commission from a trader, a broker told the prosecutors:14

  You’ve got to bear in mind who he [the derivatives trader] was at the time, like I said he was paying a million pounds a month brokerage to Tokyo. He was the biggest player out there by a country mile. And if I jeopardize the relationship I’m sacked. I’m gone.

  What he was saying was that his employer would not have forgiven him for not playing the game.

  The tricky element of a wash trade would be to get a trader on the other side to agree to such a pointless trade.

  ‘I will do a humongous trade with you … $50,000 trade. I need you to keep it low … I will pay you $50,000, $100,000, whatever you want. If you can just call in some favours … if you’ve got a mate who will do a flat switch,’ Tom Hayes told a broker in September 2008.15

  It did not matter how much money a broker was paid. At the end of the day, it was necessary to have a bank on the other side that was willing to do a pointless trade. A flat switch meant that the other bank agreed to do such a trade, but at least it did not have to pay commission for it.

  As it turned out, JPMorgan Chase agreed to do a switch for ¥50 billion, and RBS did a ¥150 billion wash trade. The broker netted trade commissions worth £32,012 from UBS and £10,244 from RBS. I have no idea why RBS agreed to pay ten grand for something they could have done for free. However, they did get a lunch delivery to the whole trading desk in return, according to the transcripts.

  It seemed almost everyone could be a winner in this game. The UBS trader could influence LIBOR, which would generate a profit both for the bank and for himself. The broker, likewise, netted a profit for the firm and himself. Traders at RBS got a nice but expensive lunch (paid for by RBS shareholders, though). JPMorgan Chase did not make any money out of it, unless they also wanted to skew LIBOR in the same direction.

  A trader at Merrill Lynch was also asked to help, but according to the transcripts published by a newspaper in 2015 he turned down the request. Although I was not mentioned by name, I had a strong feeling that the trader was in fact me, and this realisation caused me to cry for the first time in years. It was the only occasion since I had left my life as a trader that it had been mentioned in the public domain in a non-negative way. Even though it was just a tiny fraction, a few minutes extracted from 15 full years, it portrayed me neutrally – maybe even positively, considering that it was a criminal case. Insignificant as this might sound, I felt as if I was being seen for who I was.

  During the autumn, I was contacted by a couple of journalists who confirmed that the Merrill Lynch trader was indeed me. I asked one of them if he could email me the full transcript he had obtained during the Tom Hayes trial. Here is a conversation between a trader, a broker and myself, taking place on 19 September 2008:

  Trader: Any chance you could wash a trade through with rpms [RP Martin Brokers] for me pls?

  Me: [No response.]

  Later:

  Broker: It’s UBS both sides basically, you’ll be like – you’ll take two sides off him and give it back … at the same level. Don’t pay any bro, you’ve got no risk, no counterparty risk because it’s UBS the same, both sides of the deal …

  Me: Oh you mean. I see what you mean. I don’t know if I can do that.

  Broker: Yeah, if it’s a bit dodgy that’s fair enough, but I mean …

  Me: Yeah it is actually … yeah. In these tough times for bankers … let me think about it.

  Later:

  Me: I just don’t want to do the same thing in and out …

  I cannot remember this dialogue. But it obviously took place and those were the exact words I used. One of the problems with extracts from conversations over the phone, via email or in electronic chatrooms is that they don’t always give the whole picture. I don’t recall thinking that they were involved in something ‘dodgy’ related to LIBOR at the time, because I remember how much I respected the trader and liked the broker. My main problem with the deal, which was later defined as a ‘wash trade’ in court, had more to do with the fact that I had come to regard more and more aspects of trading and banking as ‘wrong’.

  Ironically, the original idea of a switch was rather noble. Flat switches had been common ever since I started as a trader and they probably existed long before that. Because of the sheer volume traded in the market, credit lines were often filled up temporarily. During a crisis, however, and depending on the perceived creditworthiness of the bank on the other side, it could take much longer for the credit department to come back and give a green light. Therefore, if two market makers were unable to trade with each other, a third market maker might step in as a go-between – ultimately to help the suffering bank access the financial markets as in normal times. Again, it was part of the game, an unwritten footnote in one of the many gentlemen’s agreements that existed. When a bank was struggling to find banks to trade with, or when its perceived creditworthiness fell dramatically, you would not just stand on the sidelines and watch the bank disappear from the market or face a slow and painful death. No, you would at least consider throwing a lifejacket to enable the trader at the other bank to catch their breath. You would offer to do a flat switch out of pure generosity – because you never knew when you might end up in the same situation, desperately trying to trade at prices in t
he market only to find that you were unable to grab onto those prices because banks were refusing to trade with you. This was a thing with trading. No matter how ruthless the environment might seem from the outside, there was also a warmth to be found for those on the inside and a great deal of forgiveness.

  Nevertheless, some traders would refuse to do a flat switch, and demanded something in return to compensate for the fact that credit lines were being used up. From the outside, this might seem like sound risk management being applied. However, this ‘fee’ always ended up on the trader’s book (and part of it, therefore, in the trader’s own pocket), not with the credit officers who were trying to work out the risks involved and how much exposure the bank was willing to have towards another bank. This was another thing about trading. Traders and sales people were ‘profit centres’, meaning that profits (or losses) on new trades were booked against their names. Credit officers, compliance managers, back office staff, risk managers, financial controllers and others, however, were treated as ‘cost centres’. It was very difficult for them to quantify the extent to which their work had paid off.

  I remember once being invited home to dinner with a credit officer who was responsible for deciding the bank’s credit lines to other banks and large corporations in a whole country.

  ‘Since I joined the bank ten years ago, the credit losses in our department have been zero,’ he proudly proclaimed while guiding me through his enormous art collection.

  ‘Hmm, that is not the view we hold of you on the trading floor,’ I thought. To us, he was impossible to deal with as he refused to show any kind of flexibility. He was more concerned about his loyalty to the bank than his reputation on the trading floor.

  When I told the broker that bankers were having a ‘tough time’, it wasn’t as if I was looking for sympathy. It was my way of expressing the fact that, in the aftermath of the Lehman Brothers collapse, I felt a stronger loyalty towards the credit department of Merrill Lynch than towards a trader at another bank. Technically, I could have accepted to do a wash trade of a few trillion yen. I would not have broken any limits. But it did not feel right.

  ***

  There was, however, another serious problem and it had to do with how the LIBOR fixing mechanism was linked to the barometer of fear. According to the rule book, individually submitted LIBOR quotes were supposed to reflect ‘where the bank can fund itself in the interbank market’. The LIBOR quotes from each individual bank became visible to the whole market at the same time as the LIBOR fixing was published. By comparing the different quotes, you could see which banks had to pay higher interest rates in order to be able to borrow (i.e. which banks were in trouble) and which banks had easy access to money. This signal to the market showing where each and every bank was able to borrow money was important, as the funding cost of the bank and its capital and reputation are closely linked. Downgrades by Moody’s or Standard & Poor’s were rare events. Likewise, earnings reports and other financial statements were not published frequently. The individual LIBOR quotes, by contrast, were announced daily and therefore served as snapshots of the perceived creditworthiness of the banks.

  A unique thing with banks is that they inherently always have a desire to appear ‘good and sound’. If depositors lose confidence in the ability of the bank to meet its obligations, there could be a bank run around the corner and the bank could face the risk of being wiped out altogether. Even the slightest of suspicions could cause a sharp decline in the stock price. The problem with the LIBOR fixing mechanism resulted from the individual LIBOR rates being public knowledge (i.e. fully transparent) at the same time as the actual funding rate was private knowledge (i.e. secret). LIBOR banks did not have to prove that the rates they were submitting were, in fact, rates at which they were able to borrow. This lack of transparency, coupled with the desire of banks to look ‘good and sound’, therefore worked as an incentive to conceal potential funding problems publicly through the LIBOR signalling process. An individual quote above the average of the others might be interpreted as a signal that the bank had funding issues. An individual quote below the others would indicate that the bank was in relatively decent shape. Consequently, there was a stigma attached to signalling a relatively high funding cost via the LIBOR mechanism, similar to the stigma of having to rely on emergency funding from the central bank. Everyone trading in the money markets knew that there was a severe financial crisis, but no bank wanted to look desperate for cash. That would have meant the end. The LIBOR fixing mechanism turned into a vast game of poker, where most of the players were holding terrible cards.

  Rumours about which banks needed life support were flying around like confetti. Some of the gossip also leaked out of the dealing rooms. On 3 September 2007, only three weeks after I had put down the axe and returned from the woodshed in Sweden, Bloomberg came out with the following headline: ‘Barclays takes a money market beating.’ The journalist pointed out that Barclays had submitted the highest quotes among the panel banks for the three-month LIBOR in British pounds, euros and US dollars. They asked: ‘What the hell is happening at Barclays and its Barclays Capital securities unit that is prompting its peers to charge it premium interest rates in the money market?’

  It was a good question. It was also very bad publicity for Barclays, and senior management at high levels became worried. According to the FSA, managers slightly lower in the hierarchy reacted by asking the LIBOR submitters in the bank to reduce their quotes to avoid bad publicity. The instructions were followed, and the following day Barclays submitted LIBOR rates below those at which they were able to fund themselves in the market. The demand for US dollars was particularly severe. However, all major currencies, to some degree, were affected by the crisis. A few weeks later, an email was sent out stating that Barclays should ‘try to get our JPY [Japanese yen] libors a little more in line with the rest of the contributors, or else the rumours will start flying about Barclays needing money because its libors are so high’.16 This issue was raised in the Wall Street Journal in May 2008.17 The journalists Carrick Mollenkamp and Mark Whitehouse argued that some LIBOR panel banks had deliberately quoted rates that were too low to be justified by their credit standing as reflected in the credit default swap (CDS) market. Although the article did not claim outright manipulation, it argued that banks ‘may have been low-balling their borrowing rates to avoid looking desperate for cash’. The contents of the article supported anecdotal evidence from some active market participants (myself included) who had become suspicious of LIBOR manipulation. Already in August 2007, when the LIBOR–OIS spread began to widen, I did not think that LIBOR rose enough. It was difficult to work out by how much it should have risen. But given that some large banks were practically shut off from the interbank market, I thought that the ‘actual’ LIBOR often should have been considerably higher.

  ***

  In 2011, I decided it was time to go back to Tokyo. I had not been back in ten years and missed the city. Moreover, the Japanese TIBOR–LIBOR spread was central to the PhD I was writing and Tokyo-based banks now seemed to be under scrutiny from financial regulators. I wanted to broaden my outlook on LIBOR. By now, I had become convinced that banks had misled the public through LIBOR manipulation. However, something else that had bothered me was the fact that not only did the final LIBOR fixing seem to be too low, but also that the individually submitted LIBOR quotes by each bank seemed too similar. Most LIBOR panels had many contributing banks, and I found it strange how well they managed to harmonise their misleading quotes. I did not find it plausible that all the banks had been talking to each other.

  Unfortunately, a meeting I was supposed to have with the Japanese financial regulator was cancelled at the very last minute. Even though I was now an academic, my rogue trader background apparently led them to change their mind about the propriety of me talking to them. I am not totally sure what swayed me to do it, but my instinct told me that it would be good to meet up instead with former traders and brokers in a market
where I had been very active. As of February 2009, I had disappeared from that market and was eager to check in again. Not as a trader, of course, but not as a PhD student either. I just wanted to meet people who had been part of my life for years and whom I genuinely liked.

  I was expecting to be met with a mixture of suspicion and distance, given that I had left a while ago under somewhat spectacular circumstances. I took it for granted that everybody had read about what had happened, and I was therefore nervous about what the reaction would be. To my surprise, I was welcomed with open arms. Invitations to lunches, drinks and dinners rolled in. The generosity was endless, as if I were still a ‘player’ in the market. My perspective, however, was now very different. I had returned to see what had gone wrong with the market, or perhaps what ultimately had led me to do something wrong. I was not there to claim any lost territory. But behind the façade, I could also sense a fundamental change in the people I met. Although this was still a group of people with immense confidence and optimism, there was a newly injected concern that I had not seen before. It was as if some traders and brokers were beginning to feel that they had been part of a game all along, but could not really work out its rules.