Barometer of Fear

by Alexis; Stenfors

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  The fourth, and perhaps most abstract, phase took place when the benchmark needed to become anchored to something else. However, if the original market had all but disappeared, what could be the next-best thing? It turned out to be its own derivative, rather than the underlying market it was supposed to reflect. The liquidity of LIBOR derivatives increased as they became more suitable for trading ‘needs’ than the underlying Eurocurrencies were. Importantly, superior liquidity as reflected in bid–offer spreads gave them an advantage over the underlying asset (the money market) in the price determination process. Money market traders began to look more towards the LIBOR derivatives markets rather than the money market itself, both in terms of risk taking and for indications of the future direction of LIBOR. It was many times cheaper to put bets on three-month Eurodollar futures, for instance, than to actually borrow or lend US dollars for a period of three months. If you wanted to know where the market thought LIBOR would be in a few weeks’ time, you could simply look at the Eurodollar futures contract expiring next month. There was even a FRA market for tomorrow’s LIBOR, which gave an even better indication of where LIBOR should be today. If one bank was prepared to bet that LIBOR would be higher than 3.00 per cent tomorrow, and another bank was prepared to bet that it would be lower than 3.01 per cent tomorrow, surely today’s LIBOR could not be vastly different from a 3.00 to 3.01 per cent range – unless a special event was supposed to happen sometime during the next 24 hours.

  The LIBOR rate for longer maturities, such as six months, became less driven by actual money market trading in those maturities and instead reflected interest rates implied by the prices of a range of LIBOR derivatives. There was hardly any activity in interbank borrowing and lending for such maturities. However, plenty of derivatives made it possible to imagine and mathematically calculate the interest rate at which borrowing and lending ought to have been taking place – if such a market had existed in reality. LIBOR, as a ‘thing’, became more and more imaginary. Imagine a referee uncertain as to how many yellow cards ‘reasonably’ to hand out during a football match. Way too many, and players, coaches, fans and commentators will blame the referee for interrupting the play too much. Too few, and players, coaches, fans and commentators will blame the referee for losing control of the game. A way to avoid being blamed for poor judgement would be to glance at the football betting market, which provides a reasonable assessment of how many yellow cards others expect during the 90 minutes of play. This, in effect, is what happened to LIBOR. It became dependent on the betting market, which was betting on it, in a continuous feedback loop.

  Given that the money market dried up during the financial crisis, it would be logical to think that LIBOR derivatives also all but disappeared in 2009. However, LIBOR continued to be used not only when the interbank money market ceased to exist; it continued to be used even though everyone knew that the interbank money market no longer functioned. In fact, the absence of an underlying market did nothing to halt the growth of the derivatives market relating to it. The daily global turnover of the LIBOR-indexed FRA market, which is a kind of bespoke OTC Eurodollar futures market, gradually grew from $74 billion in 1998, to $129 billion in 2001, to $233 billion in 2004, and to $258 billion in 2007. Rather than eliminating it because of the lack of an underlying market, the financial crisis injected the market with steroids. By 2010, the turnover had more than doubled to $601 billion.29

  This statistic highlights how illogical the cash-settled derivatives market can seem to be. However, it is something that is very fundamental to it. Just as the weather derivatives market is built on imaginary ‘prices’ in temperature, raindrops or snowfall, the LIBOR derivatives market was built on imaginary prices in the money market. As long as we can treat the temperature or LIBOR as ‘prices’, and as long as it is possible to trade and profit from changes in these imaginary prices, the derivatives market can grow. Although the underlying LIBOR was never a market per se, its relative significance gradually increased. The astonishingly large turnover of derivatives referencing LIBOR sustained the illusion that the underlying index reflected a large, liquid and efficient money market. More specifically, it served as ‘evidence’ that LIBOR was indeed an outcome of a market-determined and objective process. Perhaps no better illustration of the faith in LIBOR-equivalent benchmarks can be found than in the fact that EURIBOR was first published on 30 December 1998, two days prior to the euro becoming an accounting currency on 1 January 1999. This enabled a EURIBOR derivatives market to emerge before physical transactions could possibly be made, as the currency did not yet exist.

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  We can see how these four phases led to a perception that LIBOR was a market-determined benchmark, even though the mechanism was no such thing. We can also see how, propelled by the extremely large volume of derivatives trading, LIBOR gradually took on an objectivity that enabled the derivatives market to eclipse the Eurodollar market. This, in turn, enabled LIBOR to replace the money market as an objective ‘fact’. This did not happen only in dealing rooms. Because LIBOR had turned into something so important, it came to be used – or misused – in other areas as well.

  For instance, given its importance in finance and economics, LIBOR became frequently quoted (and misquoted) in scholarly and professional literature. Before the LIBOR scandal erupted, benchmarks in financial markets were rarely mentioned as more than footnotes in the academic literature – or by the financial press or regulators, for that matter. In many ways, this is not surprising, as benchmarks are used like yardsticks. They are simply standardised indicators measuring and analysing performance and predictions for the future of something else. Take inflation, for example. Inflation refers to an increase in the general price level of a country. However, a benchmark such as the CPI is used to measure it. Very few people know (or are interested in) precisely which products count towards the basket that makes up the index. The same goes for stock market indices such as the FTSE 100 or the S&P 500. Many people know that they are useful benchmarks for measuring the performance of the UK and US stock markets, but few would be able to recite the names of the 100 or 500 companies whose share prices make up the benchmarks. Most people simply trust that the benchmarks are correct in measuring whatever they are supposed to measure.

  A Eurodollar future or interest rate swap cannot be properly explained without mentioning the underlying benchmark. Take the following from the classic academic textbook Introduction to Futures and Options Markets by John Hull (the 1991 edition):30 ‘The variable underlying contract … is the 90-day Eurodollar interest rate. A Eurodollar is a dollar deposited in a U.S. or foreign bank outside the United States.’ Whereas the definition is correct, the following quote (from the same book) highlights how the underlying benchmark becomes known as the underlying market: ‘The Eurodollar interest rate is the inter-bank interest rate earned on Eurodollars and is also known as the 3-month London Interbank Offer [sic] Rate (LIBOR).’ Finally, trading in the Eurocurrency market is described as almost synonymous with trading LIBOR itself – which, of course, is impossible: ‘LIBOR … is a floating reference rate of interest. LIBOR is determined by the trading of deposits between banks on the Eurocurrency market.’ This widely translated classic textbook by Hull is not only to be found in all prominent dealing rooms around the world; it also belongs to the core derivatives literature at business schools and universities. The use of the derivatives benchmark, rather than the underlying market, in academic textbooks, journal articles and the financial press further cements the facticity that had been developed through banks’ trading practices. ‘Facts’ in important textbooks should not be underestimated. Even when I am writing this today, on 21 April 2016, LIBOR is described with the heading ‘Interest rates: market’ in The Financial Times, to distinguish it from central bank interest rates, which are coined ‘Interest rates: official’. LIBOR is not, and cannot be, a market interest rate. Like Celsius or Fahrenheit, it is a measurement, and therefore it cannot be bought o
r sold.

  Another example, and arguably the most powerful justification for the use of LIBOR, occurred when it became accepted and adopted by the state. As mentioned previously, the interbank money market rate is important in central banking as it acts as the first step of the monetary transmission mechanism, measuring how policy rate changes ultimately affect lending and borrowing in the real economy. Central banks around the world need a measurement for this interbank money market rate, and this turns out to be LIBOR. It is easily observable on Bloomberg and Reuters screens or in the daily press.

  The importance of this is considerable. For instance, when the ‘barometers of fear’ surged in virtually all developed countries during the height of the financial crisis, central banks introduced a wide range of extraordinary measures to alleviate the stress in their banking systems. The common measure for this was the LIBOR–OIS spread, which was widely perceived as being based on actual market transactions. In other words, LIBOR had become a key variable that was used in assessing the effectiveness of central bank policy in dealing with the financial crisis.31 If LIBOR reacted promptly to what central banks did, the policy measure was deemed successful. If it didn’t, the measure was seen as misplaced or insufficient.

  Some central banks went even further, making LIBOR a strategic policy tool in itself. Since January 2000, the monetary policy strategy of the Swiss National Bank has consisted of three elements: ‘a definition of price stability, a medium-term inflation forecast and – at operational level – a target range for a reference interest rate, the three-month Swiss franc LIBOR’.32 Norges Bank, the central bank of Norway, publicly announces its projected monetary policy rate and also the future three-month Norwegian krone risk premiums, based on the three-month NIBOR.33 All of this might seem like a paradox, considering that the Eurodollar market was created in order to avoid the jurisdiction of the central banks. If central banks, as part of the state, accept LIBOR as a fact, surely it can be trusted?

  LIBOR was, however, of importance not only to derivatives traders, academics and central bankers. Cemented as ‘the world’s most important number’, banks could put LIBOR into use in other areas of the economy as well. LIBOR became not only the benchmark of choice for a variety of derivatives contracts, but the underlying benchmark for seemingly unrelated agreements such as residential mortgages, credit card debt and student loans. The Eurodollar market was never intended to be an investment outlet or a place to raise funds for households, university students or pensioners. However, as a vast number of people and organisations became directly exposed to the movement of the LIBOR rate through these agreements, it became a focal point that was easily followed in the daily press, which opted to publish the LIBOR rate as it would any other important number, such as the local weather or the closing level of the stock market index. Companies and households entered into LIBOR-indexed financial contacts falsely believing that the money market was the underlying benchmark.34

  The LIBOR scandal turned this upside down. On 30 April 2012, a lawsuit35 was filed in New York (and many others followed) alleging that a group of defendants had conspired to manipulate LIBOR. The list of defendants read like a Who’s Who of global banking: Credit Suisse, Bank of America, JPMorgan Chase, HSBC, Barclays, Lloyds, WestLB, UBS, RBS, Deutsche Bank, Citi, Rabobank, Norinchukin Bank, Bank of Tokyo-Mitsubishi, Royal Bank of Canada. The plaintiffs who initiated the lawsuit were two ordinary citizens, Ellen Gelboim and Linda Zacher, who had exposure to LIBOR. Gelboim, from New York, had a retirement account that owned a debt security that was issued by General Electric. Linda Zacher, from a small town in Pennsylvania, was the sole beneficiary of her late husband’s retirement account that owned a debt security that was issued by the State of Israel. Both of these financial instruments were indexed to the US dollar LIBOR. The plaintiffs alleged that the banks ‘collusively and systematically suppressed LIBOR’ so that the interest rates paid were lower than they otherwise should have been.

  They also argued that they ‘did not know, nor could they reasonably have known, about defendants’ unlawful conduct until at least March 2011’. Indeed, the exclusive privilege to determine LIBOR was always in the hands of a few banks. This naturally benefited the banks as long as the illusion was maintained that LIBOR was not susceptible to manipulation and represented a tradeable market.

  In February 2009, during my final days at Merrill Lynch, a UBS trader asked a broker at RP Martins to help manipulate LIBOR because he had ‘heard [he] knew magic’.

  ‘Yes I’ve got my wizard’s hat on today,’ the broker replied, having agreed to assist.36

  LIBOR, however, was always much more than just an extremely elaborate magic trick.

  CHAPTER 5

  THE VALUE OF SECRETS

  ‘What does the industry do to people working in it? Do you recognise yourself in characters that feature in Wall Street, American Psycho or Cosmopolis?’

  I have never stopped thinking about the question I got from a journalist in 2012. It would be logical to think that the financial ‘industry’ has a tendency to change individuals. Money often has a strong influence on people, and the activities taking place in dealing rooms are closely connected to money. Therefore, a person who has spent 15 years in a dealing room ought to have gone through a fundamental life transformation. Moreover, because of my past and my turbulent exit from this industry, it was automatically assumed I would identify myself with characters in books and films set in or around such dealing rooms.

  I will come back to my response in a later chapter, but in many ways I think the question is much more interesting than the answer. To me, it captures two of the most widespread and important perceptions – or perhaps misperceptions – about the ‘industry’. From different perspectives, both of them illustrate how powerful banks are, and how much of this power is linked to various forms of secrecy.

  The use of the word ‘industry’ in the question by the journalist highlights the fact that the distinction between the ‘market’ and the firms operating in these markets (mainly banks) can be blurry. As a trader, however, you are never employed by the ‘market’ – the system or the place where the financial instruments are bought and sold. You are not hired by the ‘industry’ either – ‘industry’ referring to the collective of all the institutions and organisations providing services that relate to these financial instruments. I have been employed by Dresdner Bank, HSBC, Citi, Crédit Agricole Indosuez and Merrill Lynch, but never by the industry or by the market. It is an important difference, because when elaborating on what is going on in this industry and how it affects you, you must, in effect, reveal what is going on inside the bank.

  Problematically, it is extremely difficult to talk about what the bank looks like from the inside without almost immediately breaking a string of rules. When you enter a dealing room as an employee for the first time, you have already signed an agreement to keep secrets. And these secrets are supposed to last forever. One of the first agreements regarding secrecy and confidentiality I signed read like this:

  Stenfors may not without authorization disclose what he, during his activity at the Bank, has gotten to know about others’ business or personal relationships. This duty remains even after the termination of your employment.

  This sounds fair enough. It would not be pleasant if you had a colleague who kept on gossiping about your private life.

  Another deal with my signature on it was somewhat more detailed when it came to protecting clients (and the bank, of course):

  You will keep secret all trade secrets or other confidential, technical or commercial information which you may use, see or obtain regarding the affairs of the Bank or its clients. This includes, in particular, intellectual property, software packages, specialist know-how, names of clients and customers and any information concerning its or their dealings or affairs.

  How about scribbling some interesting stories or revelations in a diary kept in the dealing room, so you have some anecdotes to share in the future? This,
too, is impossible without breaking secrecy rules. I have signed this agreement as well:

  You may not make, other than as necessary for your duties, any notes or memoranda relating to any matter concerning the dealings or affairs of the Bank. Nor shall you during your employment or at any time after you have left the employment of the Bank, use or permit the use of any such notes or memoranda.

  However, of all the secrecy clauses I have signed, this paragraph remains my favourite:

  You agree to keep confidential and not divulge to others, during the course of your employment, secret and confidential information and data regarding the business of the Bank, its customers, products and services, methods, systems, business plans or marketing methods and strategies, costs or other confidential, secret or proprietary information. Further, you agree to keep confidential the secret and proprietary information of the Bank’s customers, clients and vendors. In the event that your employment with the Bank terminates, you agree not to divulge or use such confidential information, and to return promptly to the bank all documents and other materials owned by the Bank.