Barometer of Fear

by Alexis; Stenfors

  ***

  In 2002, when I was working for the French bank Crédit Agricole Indosuez, I found myself at an award ceremony in a hotel near Sloane Square in Chelsea. Traders, sales people, brokers and clients were regularly sent surveys and questionnaires to determine which banks and traders were perceived to be the ‘best’ in various categories. Surveys were conducted by industry journals such as Euromoney or Risk. Ranking lists were then published, and prizes were handed out to the winners. This particular evening it was time to find out who had won the awards in derivatives ranging from synthetic CDOs and FTSE 100 equity index options to South African FRAs and Polish zloty interest rate options. Risk, which conducted the survey and organised the event, had put on a lavish do in the banqueting hall. Around ten traders and managers sat around each table – this was not a night when you sat down next to your competitor or your friend from Deutsche Bank, Goldman Sachs or Credit Suisse. Traders wore dark suits and ties, even though the formal dress code in the dealing rooms had long since been consigned to the history books. During the height of the dot-com bubble, banks had decided it was time to catch up with the times and began to introduce a Friday dress policy. Dark suits and ties gave a boring image of investment banking and discouraged talented graduates with IT skills from applying. Deemed a success, ‘business casual’ quickly became the accepted norm among traders and sales people Monday to Friday, as long as clients did not get a glimpse of you. From then on, coming to work wearing a tie always prompted one of these two questions: ‘Which client are you meeting?’ or ‘Which bank are you interviewing with?’

  With the ties loosened, and a more relaxed atmosphere enabled by generous amounts of champagne, wine and cognac, it was time for the results. When our bank was announced as the winner in the one-month NIBOR IRS category, I could not help feeling both flattered and proud. However, this feeling turned out to be short-lived. Before I had the chance to put down my cutlery, my manager, ignoring me, stepped up to the podium and accepted the prize on behalf of the bank. He nodded gracefully to the audience, half of which applauded politely and half of which was now more interested in ordering another round of drinks. For a while, I expected my manager would hand the trophy over to me. As the evening progressed, however, I began to realise that this was not going to happen. I never found out where my engraved glass trophy ended up. Looking back, however, perhaps some achievements are better forgotten. Was there ever a need to make that market?

  The last big trade I remember doing in the one-month NIBOR IRS market was for exactly 80 billion Norwegian kroner (around $10 billion). To put this into perspective, Norwegian exports of military equipment amounted to 2.4 billion in 2015.24 But then Norway is not exactly famous for its military exports. How about culture? According to the Norwegian Ministry of Culture, the total expenditure on culture by the government, county authorities and local authorities amounted to 23.6 billion kroner in 2014.25 Still only a fraction of that single derivatives trade. Of course, nobody would, in all seriousness, call a bank manager to ask whether it would be possible to borrow $10 billion. To enter into a derivatives contract as if you were borrowing $10 billion is, however, something completely different.

  ***

  The third phase that made LIBOR appear market-determined involved a gradual reduction – and at some points even the disappearance – of the underlying Eurodollar market. Just as the FX swap market had outgrown the actual market for borrowing and lending money, so too did the LIBOR derivatives market. Paradoxically perhaps, new regulatory requirements promoted the use of financial derivatives.

  An important development in banking during the 1990s, and particularly towards the end of the decade, was the increased attention to credit risk. New regulations were being implemented and banks had to follow the new rules. According to the 1988 Basel Accord, different kinds of bank assets were to be classified according to pre-set brackets. The brackets ranged from 0 per cent (no risk) to 100 per cent (everything at risk), and banks were required to hold capital equal to 8 per cent of the risk-weighted assets. If you lent $1 million to another bank or to a corporation for one year, there was always a risk that they might default before it was time for them to pay back the loan. In a worst-case scenario, nothing would be paid back. This was an example of an asset that would attract a high risk percentage. If you did a one-year FX swap in $1 million, however, the risk was much smaller as the other side of the trade (in another currency) would offer protection. The exchange rate might swing – say, 10 or 20 per cent during the course of the year – but you would not lose everything. FX swaps therefore received a lower risk percentage. Interest rate derivatives were even better because you never physically lent any money. The only thing that was exchanged was the profit or loss as if you had done so.

  Although the Basel rules put new constraints on banks, they simultaneously opened doors. Excessive ‘on-balance-sheet’ asset usage (Eurodollars belonged to the risky type) was ‘penalised’, while ‘off-balance-sheet’ product trading – which was perceived as low risk (LIBOR derivatives, for instance) – was, relatively speaking, ‘rewarded’. From a traders’ perspective, this meant two things. Firstly, excessive usage of the bank’s balance sheet was seen as a bad thing. Old-fashioned borrowing and lending was to be avoided whenever an alternative could be found. I remember watching a PowerPoint presentation where the word ‘assets’ had been crossed out and a symbol of two syringes and a skull inserted. Assets were seen as deadly. Secondly, according to the new rules, off-balance-sheet trading was to be rewarded. In other words: ‘Trade derivatives, because they were off balance sheet!’ Although the Basel rules were designed as a deterrent to excess risk taking (lending is a risky activity because the borrower might default), they also came to have a perverse effect by acting as an incentive for increased derivatives trading by banks. The fear of risky assets, combined with the generous treatment of derivatives by regulators, led to a kind of ‘regulatory arbitrage’. Financial derivatives increasingly became part of the daily trading and funding routines. And as the banks’ risk appetite grew, their speculative activity increasingly took place via derivatives that replicated the idea of borrowing and lending. Instruments were created that looked like old-fashioned borrowing and lending but were not treated as such – because that was not what they were. At the centre of this transformation were LIBOR derivatives. They acted as a natural bridge between what banks used to be and what they would become. The derivatives market grew, with trade amounts now often in billions, not millions, of dollars. And along with it, the importance of LIBOR itself also increased.

  This did not happen overnight but was introduced gradually into the psyche of traders. Credit officers would increasingly complain when traders traded ‘real’ cash, whereas derivative traders were left to their own devices. Bid–offer spreads narrowed in the derivatives market but were left largely unchanged in the ‘real’ market. This gradual change was also reflected in the various pricing spreadsheets and systems used by traders and banks. Like all traders, I also used spreadsheets to help with the pricing of the financial instruments I traded. As the spreadsheets were fed with live market data, they were key tools in spotting new trading opportunities. During the hour or so before I left the dealing room to go home, or when the market was quiet, I would spend time fine-tuning my spreadsheets, adding new mathematical formulae to make them more sophisticated, removing parts to make them faster, or simply changing some colours if I got bored. Over the years, more and more live feeds from the cash markets were removed because there was little or no trading going on in them. The indicative bid–offer spreads were too wide or too sticky to provide much meaningful information about what was going on in the markets ‘here and now’. Increasingly, such feeds were replaced by derivatives prices that seemed to provide a more accurate picture of the market.

  Traders in the derivatives market also seemed to be rewarded with bigger bonuses than those in the real market, and they came to be seen as more glamorous. During the trial of
five former Barclays employees accused of conspiring to rig the US dollar LIBOR, the prosecutor claimed that the IRS desk was where the ‘glamour boys’ and ‘big dogs’ worked.26 On 17 May 2016, he said that one of the defendants, Jonathan Mathew, a LIBOR submitter on the money market desk, had attempted to boost his career by giving derivatives traders certain favours. Mathew denied the allegations, but also testified that the IRS desk was ‘the desk that people wanted to get onto. All the graduates wanted to become swaps traders, they didn’t want to be on the money markets desk.’27

  The STIRT desk, where I used to work, tended to rank somewhere in the middle on the glamour scale. We traded FX and money market instruments, which were rather old-fashioned. On the other hand, we also traded short-term IRSs and other derivatives, giving the desk a more exotic feel. There was no doubt, however, that the long-end IRS desk (trading derivatives maturing far beyond the two- or three-year horizon we were focused on) was perceived to be more sophisticated and attractive.

  Half a year after joining Merrill Lynch I was approached by Goldman Sachs, who asked whether I would be interested in a position on their long-end IRS desk. I felt honoured, of course, given not only the status of the investment bank but also the prestige of the role that potentially was on offer. However, having agreed to meet them in a quiet café near Blackfriars Bridge, I was unable to show much passion for the opportunity and, instead, ended up recommending one or two of my competitors for the job. It didn’t feel right to leave Merrill Lynch after just six months. That would have been rude. More than this, though, the idea of turning my back on the STIRT desk made me very uncomfortable. Over the years, it had almost started to feel like a second home, and I knew how much I would miss it.

  ***

  The budgets for traders in the derivatives markets also increased. To meet those targets, there was a need (but also a desire) to take more risk. The trade tickets got bigger – much bigger. Standard and conventional amounts, be they $10 million or £25 million, came to be regarded as peanuts. Market conventions still dictated what should be considered a ‘reasonable’ or ‘standard’ market amount when one market maker called another for a two-way price. Gradually, larger amounts became the accepted norm, rather than rare exceptions.

  Gentlemen’s agreements regarding the amounts market makers were supposed to quote each other did not apply in cases where a trade was done through a broker. And since brokers often acted as intermediaries between two banks, even larger trade tickets could be printed. The negotiations regarding not only the price but also the size of the derivatives trade could turn into a game of arm wrestling, much to the delight of the interdealer broker standing in the middle of it all. If one bank indicated an amount of, say, ¥100 billion, the trader at the other bank might reply ‘Can do more!’ ‘Can do more!’ meant precisely that: the other trader was willing to do more, say ¥200 billion at that price, perhaps even up to ¥500 billion. Depending on your conviction about the direction of the market and your assessment of the other trader’s (and, of course, your own) ability and skill to predict the future, you might counter with ‘What’s your full amount?’ If it got to the stage where the full amount was disclosed, this generally ended with a mutual understanding that one trader would clear their total amount – ¥450 billion, say – with the trader at the other bank at that price and at that moment in time. The selling trader would not return a few minutes later, spraying the market with another hundred billion Japanese yen. That would have been seen as unethical, and strictly against the prevailing gentlemen’s agreement. ‘Full amount!’ was therefore synonymous with a firm handshake, where one trader got rid of everything they needed or wanted to get rid of, and the other trader swallowed the whole lot, even though it might have been somewhat more than their normal risk appetite would allow. The accepted norm was that the deal price was favourable to the trader who accepted to carry and gradually offload the heavy luggage. It might take some time to do so, and the process could be extremely nerve-racking if the market was volatile, but if the other trader behaved fairly, such trades were generally quite lucrative.

  But not always. I remember when a large hedge fund contacted me wondering if I would be willing to quote a two-way price on a gigantic interest rate swap in their ‘full amount’. The owner of the fund had almost celebrity status and the traders always featured prominently on the lists of the highest-paid hedge fund managers in the world. I had never dealt with them before, and was surprised by their approach. Normally, sales people would make the first introduction to a new client.

  Quoting a price would have had huge PR value for the bank, for my boss, for me. I should have been alarmed by the fact that the amount was 40 times the normal market size, but at the time I was extremely confident in my risk-taking abilities. It turned out that the banks the hedge fund normally dealt with had declined to quote a price, and that they had contacted me because of my reputation. Incredibly flattered by hearing this, it made me even more amenable to accommodating their polite, but sizeable, request.

  The market was very thin, however, and soon my competitors figured out that I was holding bad cards. Whenever I called a bank requesting a price quote, in a fraction of the amount needed to reduce my risk, they had already read my intentions and adjusted their quotes accordingly. The position took weeks to get out of. Drained of energy, it was like slowly being run over by a bulldozer. I lost a fortune on the trade.

  As the market grew even larger, the meaning of a ‘Full amount!’ began to change somewhat. It signalled that there might be a client trade that had triggered the desire or need to trade in an amount that, no matter how large, was limited. On the other hand, everyone knew that such client trades had become minuscule in relation to the speculative activity expertly undertaken by traders at banks and hedge funds. ‘Full amount!’ began to signal a kind of weakness, because it involved a limitation in the trader’s conviction or ability to take risk. Being a flow trader, whose only job was to execute trades on behalf of clients, was more glamorous than being a broker, but not by much. This led to a new phrase gaining popularity: ‘Your amount!’ ‘Your amount!’ was a double-edged sword. One the one hand, it meant a trader generously offered to accommodate whatever amount another trader required at an agreed price at that particular moment in time. However, it also planted a seed of doubt in the brain of the other trader. What does the trader know that I don’t? How can the trader be so convinced about selling that they are willing to buy any amount at that price? Have I missed something? This could happen after an important macroeconomic data release or, more frequently, a central bank monetary policy committee meeting – something that might cause traders to suddenly change their view about where interest rates would be at some point in the future, and where certain derivatives should therefore be priced. The psychological warfare was now in full swing. Once a trader had said ‘Your amount!’, there was no way out. The trader had to accept ¥900 billion or ¥2 trillion if that was the amount you suggested. A gentlemen’s agreement stipulated that. It goes without saying that some of these poker games, sometimes cleverly orchestrated by brokers to boost their commissions (and the egos of everybody involved), would become legendary in the financial markets. Whereas ‘Can do more!’ was a statement by a rather self-confident trader, ‘Your amount!’ was the joker in the pack that bordered on hubris. Admittedly, it was one of my favourite cards.

  The FX swap market was much more liquid than the money market. It was cheaper to put bets on interest rates via the FX swap market than the money market, and cheaper to take the bets off. The FX swap market also involved considerably less credit risk, which meant that more trading could be done with other banks (and also with clients) before the credit department became worried. Larger bets could be put on. The LIBOR derivatives market became, in most currencies, even more liquid than the FX swap market. What is more, it worried credit departments even less. This development, coupled with innovative sources of funding (often through so-called securitisation), made the o
ld-fashioned international money market all but unnecessary. After all, borrowing and lending was expensive, risky and ultimately detrimental to the share price. It was an activity that should be avoided rather than embraced, and it was therefore transformed into a platform for rather boring and routine bank operations. Maturities became much shorter, as trading in and out was a highly capital-intensive activity. LIBOR, as a reflection of the term money market, therefore became even less linked to a market that was actually trading. For instance, according to the ECB, 99 per cent of turnover in the unsecured euro money market in 2015 involved transactions with up to one-month maturities. Hardly any trading took place in three-month or six-month maturities, to which most EURIBOR derivatives were indexed.28 A similar pattern could be seen in other money markets around the world. And, contrary to what many people seem to believe, the market had shown signs of disappearing long before the outbreak of the 2007–08 financial crisis.

  However, trading in very short-term maturities (such as overnight or for one week) had little to do with interest rate expectations and credit provision and more to do with daily funding and liquidity requirements to square up bank balances before going home for the day. There was no derivative that could replace this daily bank routine, which is why it was predominantly done in the FX swap market. Invariably, these tasks were left to the treasury desk, to junior traders, or to the FX swap traders themselves who were most active in the respective currency pairs. I remember often hating doing that job, day in and day out. I would try to square up the accounts using the help of brokers before the ‘proper’ market opened at 8 o’clock, but if the balance was large this was not possible. I could occasionally be stuck for hours trading ‘tomnext’ (contracts with a start date tomorrow and an end date the day after tomorrow) – losing focus on what I believed was a more important market. But I have to confess that I would not have liked giving it up either. The activity reminded me of how things used to be when I was a junior trader. For brokers, it was a way of getting my attention, and I found the morning habit quite pleasant. Naturally, it also gave me an insight into which banks regularly borrowed and which banks regularly lent US dollars, for example, via the FX swap market. There was generally a logical reason behind such patterns in their trading behaviour, and often it could provide useful clues as to how the other banks were positioned – or how they wanted to be positioned. It was the true barometer of fear.