Barometer of Fear
Page 11
The new market was also boosted by a range of structural economic factors, such as a growing pool of US dollars abroad as central banks had begun to accumulate large currency reserves. Overall, however, the Eurodollar market proved to be a special financial invention. It became systematic. It had a clear purpose. After some initial resistance, it was also approved by authorities. Ultimately, the Eurodollar market resulted in what today we simply refer to as the ‘international money market’.
The first ever Eurodollar trade, however, seems to have been triggered by fears of sovereign and political risk, rather than by the economic and regulatory factors mentioned above. The international political climate that existed during the Cold War began to intensify towards the late 1950s. The mounting supply of dollars on ‘the other side’ of the Iron Curtain needed to be invested, but preferably not in the US. The first to exploit this opportunity was, perhaps paradoxically, the Soviet Union, when it transferred deposits to its bank in Paris, the Banque pour l’Europe du Nord (more commonly known by the telex address ‘Eurobank’). US dollars deposited at Eurobank became known as Eurodollars.7 Investors in the Middle East also began to place US dollars in Europe, quite possibly influenced by the resulting instability after the outbreak of the Suez War in 1956, when the US reacted by freezing some US assets held by foreigners. Later, with the oil shocks of 1973 and 1979, OPEC countries began accumulating large US dollar surpluses that they preferred to invest in European countries with large funding requirements.
However, the key driver of the Eurodollar market was financial regulation – or, more specifically, the banks’ determination to avoid it. Money markets were heavily regulated at the time, particularly in the US, making a strong case for setting up a US dollar money market outside the jurisdiction and scrutiny of the Federal Reserve and other US authorities.8 This also coincided with the end of the foreign exchange controls that had existed in Western Europe. With the Eurocurrency market, a free, competitive and global money market was beginning to take shape for the first time.
A platform for engaging in regulatory arbitrage was formed, and European banks jumped at the opportunity to exploit loopholes in different jurisdictions. As policy makers began to realise that this market was impossible to curb (there was no global regulator, no global central bank nor any global state), they began to embrace and even encourage it. As such, this marked the beginning of a process of competitive deregulation on both sides of the Atlantic. Seen from a different perspective, if the Eurocurrency market was the banks’ response to regulation, the subsequent deregulation phase was individual states’ response to the regulation of other states.
The deregulation process did not, however, happen overnight or completely without friction. Opponents raised concerns surrounding the possible inflationary effects caused by excessive lending by banks, the weakening role of the central bank in controlling the monetary system,9 the difficulties for smaller banks of competing with the new ‘universal’ banks, and the Eurocurrency market’s destabilising impact on exchange rates. Some argued that the market had created a set of semi-independent international interest rates over which no single country or institution had control.10 Questions were also asked about the vulnerability of domestic banks as a result of the opaqueness of the new financial innovations and whether and how they should be regulated.
In fact, the arguments used back then were surprisingly similar to some of those used during and after the financial crisis of 2007–08. Banks were seen as having lent recklessly. Banks had created financial instruments that hardly anybody understood. The deregulation process had gone too far. Many banks had become too big to fail. Central banks had to resort to extraordinary measures to save the global financial system from collapse. And so on …
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On 12 December 2012, the United States of America charged two of my former trading counterparties, Tom Hayes and Roger Darin, with conspiracy, wire fraud and price fixing in relation to LIBOR.11 In a bid to dismiss the charges (which he lost), Roger and his lawyer argued that the US authorities had no jurisdiction over his actions. Not only was he a foreign citizen but he had also been charged with ‘conspiring to manipulate a foreign financial benchmark, for a foreign currency, while working for a foreign bank, in a foreign country’. Considering that the Eurodollar market was invented in 1957 to avoid US authorities, it is striking how LIBOR (which is based upon the Eurodollar market) returned to the issue of jurisdiction more than half a century later.
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It is possible to explain the birth and rapid growth of the Eurodollar market by relying on a range of macroeconomic and political factors. However, these factors cannot explain why the Eurodollar market continued to grow so fast even after the international political climate had stabilised. Demand by multinational corporations definitely played a crucial role in justifying the market, but obvious causality becomes difficult to establish as the growth rate of the Eurodollar market overtook that of international trade and investment.
The rapid deregulation of the financial markets around the globe during the 1980s was also crucial. The City of London changed remarkably after Margaret Thatcher launched the ‘Big Bang’ in 1986, and similar fireworks took place in a number of financial centres around the same time. In fact, since then, the Eurodollar market has often been downplayed as a historic ‘event’. Rather, focus is placed on the processes of liberalisation, globalisation, privatisation and financialisation that appear to have started in conjunction with the financial deregulation that took place in the 1980s. Whereas this might be logical, the approach can also be misleading.
Financial deregulation did not prompt Eurodollar trading. It was the other way round: Eurodollar trading was pivotal in prompting financial deregulation. If we see it this way, as a key innovation that led to change, we need to look closer at the ‘innovators’ – the banks.
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In the summer of 2009, I had lunch with a former competitor at Roka, a Japanese restaurant on Charlotte Street in London. He clearly felt sympathy for what I had been through, following my turbulent exit from the market. But it was also as if he wanted to justify why he was still there, doing the same job he had always done. What was his actual contribution? What had our contribution been?
‘We make the interest rate,’ he proudly proclaimed, suggesting that market making was a craft that came with a great degree of responsibility and importance.
It reminded me of an evening back in the 1990s. It had been a volatile day in the financial markets and the whole FX trading desk at HSBC needed a drink or two. When we strolled past the Swedish central bank, which was located just around the corner from our new office, the chief dealer suddenly burst out: ‘The Governor has never made a two-way price in his life!’
Everybody laughed.
The joke referred to the fact that not even the Swedish central bank governor Urban Bäckström knew what it felt like being a market maker. He was an economist and ex-politician, not a trader, and now he was the most influential person in the Swedish foreign exchange market. He was not ‘one of us’ and therefore could not hope to understand how difficult it was to quote a bid price and an offer price at exactly the same time in a volatile market.
Both of the remarks above might sound out of touch, perhaps even arrogant. However, they highlight an important aspect of the financial markets that is often overlooked or simply misunderstood. Markets do not evolve automatically. Markets are made.12 The cassette tape did not evolve into a CD and then into an MP3 file. Each format drew lessons and inspiration from the former, but ultimately they were made separately. The same goes for the Eurodollar market. It did not emerge automatically and autonomously within an already existing money market. The Eurodollar market was made by the banks.
And just as the banks made the Eurodollar market, so they went on to make LIBOR. The interest rate at which Eurodollars were trading became known as the Eurodollar rate. These Eurodollar rates were not ‘official’ in any way. They were simply p
rices at which trading had taken place. Although LIBOR soon came to be associated with the derivatives market, it was the syndicated loan market that had begun to develop during the 1980s that created a need for it. This referred to large loans to corporates and institutions that were put together by a group of banks to spread the risk, rather than being arranged by one single bank. Thus, an appropriate interest rate for these loans had to be agreed upon. Initially, an average interest rate was taken from three reference banks at 11 a.m. two days before a loan was due to roll over. Sometimes, the bank syndicates tried to retain the right to name substitute banks if the majority of syndicate members felt that the original reference bank had lower borrowing costs than would be representative for the syndicate as a whole.13 With time, however, members of large loan syndicates became insistent that the reference banks used should be representative of the various bank syndicate members. In 1984, UK banks asked the BBA to develop a calculation method (or fixing mechanism) that could be used as an impartial basis for calculating the interest rate on syndicated loans. This led to the creation in 1985 of BBAIRS, the BBA Interest Rate Settlement, which in 1986 became LIBOR.
Originally designed using the tradeable Eurodollar market as a template, LIBOR came to bear – and still bears – a close resemblance to a market. In effect, the LIBOR panel banks are the largest banks in the world, which are competing fiercely against each other. However, LIBOR was never an outcome of a market-determined process. As mentioned previously, the submitted quotes are not binding, tradeable prices. Instead, LIBOR (and its equivalents elsewhere) can be seen as a benchmark for where the selected panel banks argue that the money market is.
The Eurodollar market prompted regulatory arbitrage between different jurisdictions, which resulted in a competitive deregulation process among states. Likewise, LIBOR (with its roots in the Eurodollar market) managed to escape the confines of particular regulatory jurisdictions. The benchmark remained unregulated up until 2013.14 The definition, the fixing mechanism and the panel bank compositions of the LIBOR benchmarks managed to remain remarkably unchanged, despite far-reaching changes in financial markets more generally from the 1980s onwards.
Leaving the susceptibility to manipulation aside, a fundamental issue is the discrepancy between what LIBOR is and what it has been perceived to be. It is a benchmark, but it has been perceived to be the Eurodollar market, the international money market, the short-term interbank money market or an objective reflection of all these. Financial derivatives offer an insight into why LIBOR cannot be synonymous with the underlying interbank money market. Whereas syndicated loans justified the need for some kind of objective reflection of the Eurodollar market, the derivatives market required a benchmark.
A derivative can broadly be seen as an instrument whose value depends on the value of an underlying asset, index or measurement. Prior to the 1980s, the best known and most traded derivatives markets were the agricultural commodities markets of North America: derivatives on wheat, corn, soya beans, coffee and so on. Academic textbooks often look back to these as typical, perhaps because they help to illustrate the ‘need’ for derivatives. The theoretical approach has its roots in neoclassical economics,15 and goes something like this: we do not know what the future will look like, and some people do not like uncertainty. Derivatives enable people to transact in the future. Being able to transact in the future right now reduces uncertainty. Therefore, because some people do not like uncertainty, derivatives increase overall economic well-being in society.
A classic textbook illustration of how this works in practice would involve a farmer. Imagine a wheat farmer. Nobody knows what the price of wheat will be next year. The price could fall, for instance because of oversupply in the market for wheat. Or perhaps consumers switch from eating Weetabix to cornflakes for breakfast. In both cases, the wheat farmer will be paid less for his harvest. To protect against a fall in the price of wheat, the farmer could enter into a derivative whose value depends on the price of wheat, such as a wheat futures contract.
Assume that John Wheatley has a farm outside St. Louis, Missouri. He knows he will have 5,000 bushels of wheat to sell in September next year. The current price of wheat is $3 per bushel and the September futures price is $4. By selling one September wheat futures contract (which is based on 5,000 bushels) at $4 now, he can ‘lock in’ that price. He can make sure that a potential loss from the price of wheat will be offset by a gain from the position in the wheat futures contract. Should the wheat price end up being $2 next September, the futures price will also settle at $2. In comparison to today’s price, he will lose $1 per bushel on the crop (the price having fallen from $3 to $2), but will make $2 per bushel on the futures contract (the price having fallen from $4 to $2). Likewise, should the wheat price end up being $5 next September, the futures price will also settle at $5. In comparison to today’s price, he will make $2 per bushel on the crop (the price having risen from $3 to $5), but he will lose $1 per bushel on the futures contract (the price having risen from $4 to $5). By entering into the derivatives market, he can rest assured that $4 is what he will be paid for his efforts come September.
The theory is almost beautiful in its simplicity. However, there are two problems with it. First, my father-in-law is a wheat farmer. He is also a civil engineer and a retired maths teacher. He would not have any trouble in understanding the pricing and valuation of rather complex derivatives instruments, including wheat futures contracts. But he has never traded wheat derivatives. In fact, I have met numerous farmers in my life and all of them, it seems, have yet to set up derivatives trading accounts. Academics do not seem to pay attention to the fact that farmers rarely trade derivatives. Instead, it appears that they are mostly occupied doing something else, such as farming. The main users of derivatives are banks. And banks, as we know, do not belong to the agricultural sector. Second, the theory does not explain the phenomenal growth in derivatives in recent decades. Why is the market so phenomenally large, and why do speculators, rather than hedgers (such as farmers), seem to drive the market forward?
One of the main issues lies in how derivatives are taught and explained. This can lead to confusion, misunderstanding or even fear of derivatives as ‘weapons of mass financial destruction’. Some of the confusion can be cleared up by dividing derivatives into two groups: an old-fashioned, concrete type and a modern, abstract version. The concrete type is the one that normally appears in textbooks or in basic explanations of derivatives as useful tools to make markets more efficient and societies better off. The concrete type is like the cassette tape: visible, physical, easy to grasp, but increasingly rare. The abstract type is the opposite: almost invisible, virtual, difficult to understand – but hugely popular.
Before the 1980s, derivatives were always settled physically (100 per cent were of the concrete type). When the wheat futures contract expired, the farmer had to deliver the wheat in return for cash. Whoever was on the other side of the contract did the opposite. Since the expansion of derivatives trading in the 1980s, however, the vast majority of derivatives are no longer settled physically. Instead, they are settled purely in cash. Cash-settled derivatives function as if an underlying commodity-like exchange occurs. But the exchange of whatever the underlying ‘thing’ is – be it coffee, gold, the FTSE 100 stock market index or LIBOR – never actually takes place.
The revolutionary aspect of cash-settled derivatives is that the only thing that is delivered is cash – not an asset, commodity, security or anything else that could be seen as tangible. When you buy a bottle of water, cash is exchanged for a bottle of water. We could also imagine a bottle of water being exchanged for cash at some point in the future (some kind of physically settled derivative). In a cash-settled derivative, however, the amount of cash that needs to change hands in the future would depend on where people argued the price for a bottle of water was. This would then require some kind of bottle-of-water benchmark, so that the buyer and the seller would be in complete agreement with regar
d to how much one party owed the other in cash.
The benchmark itself cannot be bought or sold, nor can it be delivered in exchange for cash. A benchmark can, however, determine the amount of cash due in other financial instruments. This has two important consequences. First, it makes derivatives less useful for those who want to exchange the underlying asset, but perfect for those who want to capture price changes in the underlying benchmark through buying and selling. Banks, of course, have no real interest in storing wheat. Second, it enables a vast expansion of the quantities that can be traded by removing the need to source and deliver the underlying asset. It can be complicated or expensive to source, store and deliver gold, oil, equities, bonds and so on. Money, however, is incredibly easy to exchange. This is clearest in the most ‘developed’ forms of derivatives, such as volatility, inflation or weather derivatives, for which delivery of an underlying asset is simply impossible. You cannot source and deliver a unit of market turbulence, an item of inflation or a specific type of weather. Consequently, it is not possible to create physically settled derivatives that are indexed to, say, the inflation rate or the temperature. Cash-settled derivatives, however, are possible as long as you can agree upon a benchmark. The benchmark could be the UK Consumer Price Index (CPI) as reported by the Office for National Statistics, or the outside temperature in Fahrenheit or Celsius measured by the Met Office.