You cannot protect yourself against Mother Nature through derivatives. However, by trading derivatives on Mother Nature, you can protect yourself against (and speculate on) movements in the benchmark used to measure the force of Mother Nature. The temperature, measured at specific times and in specific locations in London, Amsterdam, Cincinnati or Kansas City, is of interest not only to farmers and residents in and around these cities, but also to futures and options traders around the world who are active on the Chicago Mercantile Exchange (CME), where weather derivatives contracts can be traded. Using a weather benchmark, a derivative could also, for instance, be constructed that would pay out if global warming intensified. Weather derivatives are an extreme example, because there is obviously no market for temperature. You cannot buy or sell Fahrenheit or Celsius. However, it serves as a good illustration as to why, once a benchmark has been agreed upon, derivatives on Fahrenheit or Celsius can be constructed, traded and then have a life of their own. It enables the cash-settled derivatives market to expand beyond the limits of the underlying market, whether or not such a market exists in reality. The point is that the outstanding amount of weather derivatives does not need to be directly related to the number of sunny days in a year, nor does the amount of LIBOR derivatives need to be directly related to the size of the global banking system, for example, or to how much banks lend to each other. Retrospectively, it is easy to come up with reasons why there is a need for each new derivative instrument that is made. A snow derivative, whose value would depend on, say, the number of millimetres of snow falling in a Swiss city over a certain period of time, might make sense. If you operate a ski lift, work as a snowboard instructor or sell hot chocolate up on a mountain, your future revenue would depend on the existence of snow during the winter season. How could you ‘protect’ yourself against disappointing weather? A snow derivative could be a solution, if constructed so that it would pay out in cases when the slopes remained green. Even a winter without any snow whatsoever might involve the buying and selling of snow derivatives, as you never know when the clouds might roll in and a few snowflakes begin to fall.
In September 2009, Adair Turner, the chairman of the FSA at the time, delivered a speech in London that went on to be cited frequently in the British media.16 He was critical towards the City and the role banks had played in the run-up to the financial crisis.
‘Not all financial innovation is valuable, not all trading plays a useful role, and a bigger financial system is not necessarily a better one,’ he said.
‘There are good reasons for believing that the financial industry, more than any other sector of the economy, has an ability to generate unnecessary demand for its own services – that more trading and more financial innovation can under some circumstances create harmful volatility against which customers have to hedge, creating more demand for trading liquidity and innovative products.’
Banks had been at the forefront in creating all these new derivatives, and no matter how useful they might seem, he questioned whether they brought any benefits to society as a whole. In reality, farmers or snowboard instructors did not trade derivatives. The main players were banks, which traded them to make money.
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Banks made the Eurodollar market and subsequently made LIBOR. It is no surprise then that banks also made LIBOR derivatives. As I said, it is impossible to actually trade LIBOR. It is only possible to trade derivatives based on LIBOR. However, the derivatives market increased the importance of LIBOR. At the same time, it reduced the attention paid to the ‘real’ underlying market: namely the interbank money market that was supposed to form the basis for LIBOR. This process can be seen as having taken place in four different phases – each overlapping, each strengthening the appearance that LIBOR was a ‘market’, even though it never was such a thing.
The first phase started with the invention of the world’s first cash-settled futures contract, the Eurodollar future, which was launched by the CME in 1981. It quickly became the world’s most actively traded short-term interest rate contract.17 In a Eurodollar futures contract, the underlying ‘asset’ is a three-month deposit of precisely $1 million. This means that the underlying benchmark is an interest rate corresponding to such a deposit. The counterparties involved exchange the equivalent of the change in the interest rate on a three-month deposit of $1 million. Although no actual deposit is made or required, for each contract they exchange as if they had borrowed or lent $1 million. To ensure that the market is liquid, the maturity dates of Eurodollar contracts are standardised according to the IMM convention, using four quarterly dates per year; these dates are the third Wednesday of March, June, September and December. If, for instance, I sold 1,000 June Eurodollar futures contracts, it meant that I was putting on a trade that replicated a deal whereby I borrowed $1 billion for three months starting in June. If interest rates went up by June, I would hypothetically be able to lend those $1 billion to someone else at a higher rate and therefore make a profit. In reality, though, I never borrowed or lent any money. I only entered into contracts that would pay out the same amount as if I had done so.
Up until 1996, the CME used a benchmark based on a survey of which randomly selected banks had been willing to lend to ‘prime banks’.18 In January 1997, however, the contract began to be fixed and settled against LIBOR, although it still bore the name ‘Eurodollar futures’ (reminding us of its link to the Eurodollar market). Between 1981 and 2006, more than 2.7 trillion CME Eurodollar futures contracts had been traded, and in 2011 the value of Eurodollar futures contracts traded on the exchange reached $564 trillion. To put this into some kind of perspective, the total market value of all goods and services produced in the world in 2015 was ‘only’ $73 trillion. The corresponding figure for the EURIBOR futures contracts traded on the London International Financial Futures and Options Exchange (LIFFE) was not far off: €241 trillion. For short sterling (the equivalent future on British pounds) LIBOR futures, the turnover was £58 trillion.19
The success of Eurodollar futures also prompted competing exchanges, such as the LIFFE, the Singapore International Monetary Exchange (SIMEX) and the Tokyo International Financial Futures Exchange (TIFFE), to offer similar instruments. Euroswiss, Euromarks and Euroyen all became more closely associated with their respective LIBOR than the Eurocurrencies themselves. The name of the benchmark also ended up being copied in a range of other international financial centres: FIBOR in Frankfurt, PIBOR in Paris, TIBOR in Tokyo, STIBOR, NIBOR and so on. A whole new landscape opened up for derivatives exchanges, futures brokers and banks. I remember when SIMEX tried to launch its new Euroyen LIBOR futures contract. It must have been around 1999, in the aftermath of the Japanese banking crisis and the subsequent swings in the TIBOR–LIBOR spread. SIMEX already had control over the Euroyen TIBOR futures market and presumably wanted to capitalise on the fact that the yen market had two frequently used benchmarks. A futures broker from Credit Suisse First Boston, trustworthy and sharp as a sushi knife, asked if he could come into the dealing room and explain all the benefits of this new product. I still have the pamphlet from the marketing campaign, which opens with a quote by Rudyard Kipling: ‘Oh, East is East, and West is West, and never the twain shall meet.’ Then, above a British and Japanese tea set, it says: ‘At SIMEX, we beg to differ.’ The derivatives exchange in Singapore proudly proclaimed that it did not subscribe to the view held by the writer from the British colonial period. By being able to offer financial instruments indexed to both TIBOR and LIBOR, they could bring Asia and Europe together.
Marking the twenty-fifth birthday of the Eurodollar futures contract, CME Executive Chairman Terry Duffy said:20
Perhaps no other contract exemplifies our spirit of innovation better than the CME Eurodollar contract. As the world’s first cash-settled contract, CME Eurodollar futures transformed financial markets and paved the way for future contracts, such as stock indexes and weather, which cannot be physically delivered.
As Duffy stated, this was t
ruly a remarkable innovation – just like the Eurodollar market had been during the 1950s. The conviction that this innovation had brought, and would continue to bring, benefits to society as a whole was echoed by comments made by CME’s Chief Executive Officer Craig Donohue:
The ability to hedge interest rate risk has had a tremendous impact on the global economy, as it has allowed banks and other financial institutions around the world to manage their interest rate risk in ways that otherwise would not be possible.
He continued: ‘In addition to lowering the risk of lending, the ability to hedge interest rates lowers the cost of lending, which ultimately benefits both corporate and consumer borrowers.’ The logic is exactly the same as in the example of the farmer. A farmer benefits from being able to trade wheat derivatives, because it makes farming less risky. This lowers the cost of wheat, much to Weetabix Limited’s delight. The company can lower the price of its breakfast cereal, which is made of 95 per cent wholegrain wheat. Consumers who like Weetabix gain. The lower price of Weetabix might even push down the price of cornflakes, as Kellogg’s might want to remain competitive in the cereal business. So consumers gain even more. The same logic applies to LIBOR-indexed Eurodollar futures. A bank benefits from being able to trade Eurodollar futures, because it makes lending less risky. This lowers the cost of lending, much to the delight of the bank. The bank can lower the interest rate it charges on its loans, which is linked to LIBOR. Households with mortgages gain. Companies can borrow at lower interest rates, invest more and create more jobs. And so on.
Despite the success story of the exchange-traded LIBOR-based derivatives, such as Eurodollar futures, it was the OTC derivatives market that truly changed the market place. This was the largely unregulated market for interest rate and foreign exchange derivatives that always involved two counterparties: a bank and a client, or, more frequently, a bank and another bank. OTC derivatives, such as IRSs, CRSs, FRAs, caps and floors differed from exchange-traded derivatives in the sense that they were much less standardised and could be tailor-made to suit the needs and wants of those involved in the transaction. They offered much greater flexibility in terms of amounts, maturities, currencies and benchmarks, and they stimulated further financial innovation. A US dollar forward rate agreement (FRA) is, for instance, very similar to a Eurodollar future. However, rather than always being $1 million, it can be any amount. Any business day in the future can be chosen as the start date. Rather than having to resort to three months, any LIBOR maturity could be chosen. If I bought a $1 billion three-month FRA starting in June, the idea would be the same as selling those futures contracts in the example above. I would be putting on a trade that replicated a deal in which I borrowed $1 billion for three months starting in June. The contract would pay out as if I had borrowed the money for real. An interest rate swap (IRS) could be explained non-technically in several ways. The easiest way is to think about it as a string of many FRAs in a row. If I bought a $1 billion two-year IRS starting in June, it would be as if I had bought eight consecutive three-month $1 billion FRAs: the first starting in June, the second in September, the third in December, and so on. Again, I do not borrow or lend any money; I only enter into a contract that pays out the same amount as if I actually did.
The Bank for International Settlements (BIS) estimates that the IRS market grew from just $3 billion in 1982 to around $100 billion to $150 billion in 1985. Since then, growth has been phenomenal, with daily turnover in 2013 reaching $1,415 billion.21 In June 2014, the notional amount of outstanding OTC interest rate derivatives contracts amounted to $691 trillion.22 Of these, it is estimated that between 60 per cent and 90 per cent are linked to LIBOR, EURIBOR or TIBOR. LIBOR and its equivalents are by far the most frequently used benchmarks for IRSs, FRAs and OTC interest rate options.
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When I was working for Citibank in London during the late 1990s, I became involved in making a derivatives market for IRSs indexed to the one-month Norwegian interest rate benchmark, NIBOR. Back then, IRSs had been around for 15 years, and they also existed in Norway. However, no derivatives market existed using the one-month NIBOR as a benchmark. The relatively short maturity of the benchmark made the price of the swap more sensitive to swings in the interest rates at which banks funded themselves in the very short term, and also to potential central bank rate changes in the near future. As with any derivative, the ‘usefulness’ of it could be explained by what kind of benefits it offered to the potential buyer and the potential seller: the buyer would profit from central bank rate hikes and/or funding squeezes in the Norwegian banking system. The seller would profit from the opposite scenarios.
A market does not exist unless it has at least one buyer and one seller. To begin with, the market had this bare minimum requirement: a trader at Chase Manhattan and myself. As in any derivative market, traders often disagree upon whether the current market price is justifiable or correct given all the information that exists out there in the universe. Consequently, prices went up and down and the actual trading activity was a bit like a snowball fight. I threw first, and sold him around 250 million Norwegian kroner worth of swaps (I cannot recall the precise amounts). He threw one back the next day, selling 250 million back to me. Then he threw another, and sold me 100 million, and perhaps 50 million more. I went on the defence, and was hit by another 100 million, then attacked and sold 250 million. At some point, a few other banks also began to play. Interdealer brokers got involved to match trades at better prices than we could have achieved by simply calling each other directly. I was rather excited by this development, and happy that others had come on board. Looking back, I don’t think I ever reflected on the fact that the market, as a result, got bigger and bigger. I had already become immune to large numbers, and being so involved in the process of constructing the market only served to make me less aware of what it might look like from the outside.
It was often cheaper to enter into price negotiations through brokers and pay them a commission, rather than having to trade directly on the relatively wide bid–offer spreads we quoted each other at the time. The audience grew, and after a while more onlookers were keen to have a go at the new game in town. More interdealer brokers entered the market. Soon, at least half a dozen banks could proudly claim that they were market makers in one-month NIBOR IRSs. The sales people on the trading floors loved it. They now had a new product they could sell to clients. It offered something slightly different that other products could not. If you wanted to protect yourself against higher (or lower) Norwegian interest rates in the near future, the one-month NIBOR IRS market was the right place for you. If you wanted to speculate on a surprise rate hike (or cut) by the Norwegian central bank, the one-month NIBOR IRS market was the right place for you. By being able to offer a solution to a potential future problem, or an opportunity to profit from such a problem, the banks could portray themselves as smart, sophisticated and customer-oriented, all in one go. Something that might be of genuine interest from the trading desk gave sales people a reason to pick up the phone and talk to clients. It might not necessarily result in an actual trade, but the customer might, while on the line, express an interest in something completely different – perhaps a different derivative in a different currency. Years later, it got to the stage that you had to be a market maker in one-month swaps if you wanted to be taken seriously in the Norwegian krone market.
So, the cash-settled derivatives market did not simply ‘evolve’ from the 1980s onwards. Banks and traders made derivatives and derivatives markets, in the same way as Apple made the iPhone. The iPad did not evolve from the iPhone or from the typewriter. Apple made the iPad.
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The second phase began during the 1980s, when the global economic situation and accompanying financial market regulatory changes transformed the character of the financial markets. Despite the fact that the Eurodollar market was still growing, these changes led to a reduction in its relative importance as a funding source or investment outlet for the b
anks. Instead, Eurodollars gradually turned into the prime tool with which to speculate on short-term interest rates in an increasing range of currencies. This was an area where banks had a superior competitive, informational and economic advantage. Further, the abolishment of capital controls made it possible for any bank to become involved in the Eurodollar market by constructing ‘synthetic’ Eurodollars. According to the so-called ‘covered interest parity’, an FX swap could theoretically be seen as the difference in interest rates in two currencies. By entering into an FX swap, you effectively borrowed in one currency and lent in another. Therefore, if you believed that the interest rate would increase (or decrease) more in one currency than in another, the FX swap market presented itself as a perfect outlet for such speculation. Moreover, because you actually borrowed from and lent to the same counterparty at the same time (in different currencies, though), there was considerably less credit risk involved. If the counterparty defaulted halfway through and therefore was unable to pay back what you, in effect, had lent them in one currency, you, on the other hand, were sitting with the other side of the trade: the money they had lent to you in the other currency. The lower credit risk boosted the FX swap market, which ultimately made it much more liquid than the deposit market in the underlying Eurocurrencies.
Eurocurrencies as a proportion of total credit creation had already begun to slow down and diminish in the 1980s.23 However, LIBOR derivatives, as a proportion of banks’ total exposure to LIBOR, increased and began to all but completely replace the Eurocurrency market as a vehicle for hedging and speculating. Derivatives enabled banks to expose themselves to LIBOR in very large notional terms with little real or physical exposure to the underlying money market. It did not matter if you believed in higher or lower interest rates, trading derivatives as if you borrowed or lent money was much cheaper, safer and easier than actually borrowing or lending money. An important reason why the outstanding amount of derivatives grew so fast was that they were traded as if they could be bought or sold again and again – although in reality they could not. Because, like loans, they were contracts between two counterparties, and until the trades matured (which could take a day, a month or 30 years), OTC derivatives were kept on the banks’ books. Although they often netted each other out, new trades were put on faster than the old ones expired. As a result, the outstanding notional amount of the derivatives market ballooned.
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