Barometer of Fear

by Alexis; Stenfors

  Since the financial crisis of 2007–08, a number of reforms have been introduced with the aim of not only preventing future crises, but also steering bankers and traders away from risky behaviour and a culture of short-term thinking. ‘Remuneration policies which lead to risk–reward imbalances, short-termism and excessive risk-taking undermine confidence in the financial sector,’ the CEO of the UK’s Prudential Regulation Authority (PRA), Andrew Bailey, said in 2016. Stricter rules on the form in which bonuses are paid out, and even clauses allowing banks to claw back bonuses should things go wrong, are thought to align the interests of traders more closely with those of the shareholders of the bank. The logic is familiar, the idea being that traders think short term and take excessive risk almost by default if a potential reward is offered to them personally. Change the reward structure, and traders will behave differently.

  While this certainly might trigger some traders to leave trading (many already have) and discourage new generations from entering the banking sector in search of easy money, I am less convinced about its effectiveness in preventing risk taking more generally. Bonuses had no direct influence on my mismarking episode at Merrill Lynch during those six weeks in early 2009. The next potential bonus payment was at least ten months away, and I couldn’t see that far ahead. In fact, in late 2008 I felt that there was nothing the bank could do to compensate me for what I was going through. However, being paid well for what I did probably made me believe that I was very good at it, and that what I was doing was of some greater importance, whatever that might be. Bonuses, whether small or large, tend to be paid once a year. This might be considered as short term to shareholders or to society as a whole. However, 365 days is an eternity in the foreign exchange and money markets. A minute or a day can be long. Curbing bonuses is not, in itself, going to solve all the problems. Irrespective of potential monetary rewards, some people will always be attracted to unpredictable and dangerous seas.

  Trading and risk taking go hand in hand. Even by the standards of Merrill Lynch, I was a very aggressive risk taker. When the Irish Financial Regulator fined the bank after my scandal, it argued that Merrill had failed to ‘manage effectively market risk limits in respect of the trader’s activities’. Strangely, to date, I cannot recall a single moment when I was emailed or told formally, or even informally, what, if any, my risk limits were. All other banks I had worked for, or heard of, set clear limits on how much risk a trader was allowed to take. Sometimes, traders (myself included) would argue for bigger limits, in which case they might be increased. Merrill Lynch was different. Nowhere else, I thought, were traders given so much trust and power at the outset – and were then encouraged and motivated to maximise a seemingly limitless potential. For me, it was like being in heaven. It was an environment I thrived in, like giving Viagra to a sex addict or inviting an alcoholic to a free bar. The flipside, of course, was that it was also like driving a Formula One car without a helmet or skydiving without a back-up parachute.

  In the run-up to the financial crisis, many banks took a great deal of risk. Because of the chaos that followed, regulators have since made it much more difficult for banks to speculate as freely as they did before. This ought to not only make banks safer for the public again, but also make banks safer from potential rogue trading scandals in the future. Risk taking, however, is inherent in banking, and banks will continue to take risks in the financial markets regardless of what any future regulation looks like. I think it is important to remember that the risk-taking activity itself is delegated to relatively few individuals within the banks. In order to understand what banks do, how markets work or what risk is about, it is not enough to have a thorough knowledge of ‘banks’, ‘markets’ and ‘risk’. It is also necessary to understand how traders think, talk, behave and interact.

  Another set of reforms, or reform proposals, have aimed to achieve greater ‘formalisation and professionalism’.6 For instance, from having been an unregulated activity (or, to be more precise, a self-regulated activity among the panel banks themselves in conjunction with the BBA), LIBOR is now regulated by the FCA. A similar shift has taken place with IBORs in other jurisdictions. A specific code of conduct (‘the LIBOR Code’) sets out standards that LIBOR panel banks are expected to follow. These changes are logical given the string of fines imposed on banks for having manipulated, or having attempted to manipulate, the benchmark.

  ‘Rabobank’s misconduct is among the most serious we have identified on LIBOR. Traders and submitters treated LIBOR submissions as a potential way to make money, with no regard for the integrity of the market. This is unacceptable,’ said Tracey McDermott, the FCA’s Director of Enforcement and Financial Crime, after the UK regulator had fined the Dutch bank £105 million in October 2013.7

  Benchmark manipulation has also been made a criminal offence, and, following the first guilty verdict of an individual involved, the Hon. Mr Justice Cooke said: ‘The conduct involved here is to be marked out as dishonest and wrong, and a message sent to the world of banking accordingly. The reputation of Libor is important to the City, as a financial sector, and the banking institutions of this City.’8 All in all, the reforms following the scandals have strived to eliminate – or at least greatly reduce – the incentives for manipulation, abuse or collusive practices. Considering the threatened punishments, neither banks nor individual traders would likely see them as activities worth doing.

  Revelations about how some traders have thought, talked, behaved and interacted have made spectacular headlines in recent years. No matter how awful some of these conversations might seem, however, it is important not to see them in isolation when shaping new theories, rules or laws.

  ***

  Banks themselves have also attempted to change, introducing stricter rules, controls and training requirements. For reputational, regulatory or legal reasons, no bank would want to find such behaviour going on inside their dealing room. Furthermore, no bank would be willing to defend dealing room behaviour on the basis that it was following conventions that were based on ‘what everyone else in the market had been doing for years’.

  Banks have also substantially increased the number of compliance officers scrutinising what the traders are up to. Numerous dealing room conventions have been banned, or have become subject to internal monitoring and oversight (such as the use of mobile phones and multi-bank electronic chatrooms), in order to limit the possibilities for improper communication between traders and their competitors, interdealer brokers and clients. However, as two Bloomberg journalists pointed out, ‘while banks can limit access to details about client orders on their computer systems, they can’t keep employees from talking to one another’.9 Communication via Snapchat, in the restroom or in the smokers’ corner is difficult to monitor. Reportedly, some banks have even gone as far as hiring experts from the military or the CIA to study the behavioural patterns of traders, and so to identify the next possible market manipulator or rogue trader.10 An underlying assumption here is that traders in these markets have often manipulated, colluded or gone rogue as a result of having the means and opportunities to do so. By reducing and monitoring human communication, society (and the banks themselves) can thus be reassured that the markets are fair. Everyone, in theory, should feel safer.

  Whereas boosting the support functions within banks and allowing compliance officers and risk managers to do their jobs more independently of traders are a good thing, this also poses new questions about trading and banking more generally. Trust and reciprocity remain central to banking, as well as to trading in the FX, money and derivatives markets. If informal norms and conventions in the market are deliberately broken down, how will this affect liquidity, what kind of rules will follow, and how will the enforcement mechanism work?

  Senior bankers have been vocal too. ‘Banks must undergo a wholesale change in their culture and refocus their behaviour on meeting the needs of customers to restore trust in the industry,’ Stephen Hester, then CEO of RBS, said in 2012. Ma
rcus Agius, then Chairman of Barclays, argued in 2010 that: ‘The leaders of industry must collectively procure a visible and substantive change in the culture of our institutions, so as fundamentally to convince the world once again that they are businesses which can be relied on.’ Banks, so they claim, want to change their culture in order to gain the public’s trust again. Regulators and policy makers, meanwhile, want the moral code of banking to be more in line with the morality of society as a whole. Traders and bankers, it is argued, need to know the difference between right and wrong and start behaving accordingly. And banks, therefore, need to have clear principles with regard to what is ‘right’ and ‘wrong’ trading and banking.

  These might just be nice words. Regardless of the political view one might have, however, they are also the core of the issue. Banks need to change, and they need to do so voluntarily. What is clear is that the structure should not be seen as one in which ‘a small number of employees’ have been able to cheat the system. Rather, banks created this system – and then took advantage of having contributed to, and sustained, a great illusion of what the world truly looked like.

  ***

  On 16 March 2015, I was watching the FCA website like a hawk. I kept on reloading the page, checking whether they had removed me from their list of ‘prohibited individuals’. It was five years to the day since I had received my five-year ban, and more than six years since I had last set foot in the Merrill Lynch dealing room. I wasn’t desperate to go out to sea again. I was desperate for some kind of closure.

  Nothing happened. I was still a prohibited individual. Nothing happened the next day either, or the day after that.

  I contacted the FCA, but nobody I spoke to knew how the process worked. There seemed to be a process in place for adding rotten apples to the prohibited individuals list, but not for removing them.

  After a couple of weeks, I finally got hold of the right person, who told me I had to make an application to get the prohibition order revoked – effectively demonstrating that I had rehabilitated myself. I wrote a long letter, and waited.

  Then, more than a month later, I finally got the reply. My ban had been revoked. Although I hadn’t been given a licence to trade, I was no longer prohibited from applying, should I wish to do so.

  Should I ever wish to go through it all again.

  Should I ever wish to put myself in a position where I had to go through it again …

  GLOSSARY

  Arbitrage: A trading strategy that takes advantage of two or more financial instruments being mispriced relative to each other.

  Banging the close: Aggressively buying or selling a financial instrument in order to influence the price level at a specific time during the day.

  Base rate: The interest rate that the Bank of England charges banks for secured overnight lending.

  Behavioural finance: The study of the influence of psychology on the behaviour of participants in the financial markets.

  Bid: The price that a market maker is prepared to pay for an asset or a financial instrument.

  Bid–offer spread: The difference between the price at which a market maker is willing to buy an asset or a financial instrument and the price at which it is willing to sell.

  Book: The portfolio of financial instruments held by a trader.

  Brokerage firm: A financial institution that facilitates the buying and selling of financial instruments between a buyer and a seller.

  Call-out: A co-ordinated action to simultaneously request prices in a particular financial instrument from multiple market makers.

  Cap: An interest rate cap, or simply a ‘cap’, is a derivative that pays out when a specified interest rate benchmark (such as LIBOR) is above a certain level.

  Collateralised debt obligation (CDO): A derivative whose income payments and principal repayments are dependent on a pool of different financial instruments which themselves are loans and are due to pay interest and ultimately be repaid.1

  Covered interest parity: The covered interest parity states that the interest rate differential between two currencies in the money markets should equal the differential between the FX forward and FX spot rates. If this is not the case, arbitrage would be possible.

  Credit default swap (CDS): A derivative designed to provide protection against the risk of a credit event (e.g. bankruptcy) relating to a particular company or country.

  Cross-currency basis swap (CRS): A derivative where two counterparties effectively borrow from each other in two different currencies. The counterparties exchange principals at both the start and the maturity of the swap, as well as regular floating interest rate payments, which generally are indexed to LIBOR or equivalent benchmarks.

  Derivative: A financial contract whose value is dependent on (i.e. derived from) the value of an underlying asset, index or measurement.

  Discount window: A credit facility in which eligible financial institutions can borrow from the central bank.

  Eurodollar market: The birth of the Eurodollar market occurred in 1957, when banks created a market in Europe in which US dollar deposits were re-lent to European institutions instead of being reinvested in the United States. Eurodollars thereby came to be defined as deposits denominated in US dollars in banks outside the US. These kinds of deposits were later denominated in other currencies, and these ‘Eurocurrencies’ in general (Eurodeutschmarks, Euroyen, Eurosterling and so on) came to represent borrowing and lending outside the jurisdiction of the central bank issuing the currency in question.

  Federal Reserve: The central bank of the United States.

  Floor: An interest rate floor, or simply a ‘floor’, is a derivative that pays out when a specified interest rate benchmark (such as LIBOR) is below a certain level.

  Forward rate agreement (FRA): An OTC derivatives contract on the future level of interest rates (typically LIBOR).

  FX forward: An agreement to exchange sums of currency at an agreed exchange rate on a value date that is in more than two bank business days’ time.

  FX spot: An agreement to exchange sums of currency at an agreed exchange rate on a value date that is usually in two bank business days’ time.

  FX swap: A combination of an FX spot transaction plus an FX forward done simultaneously, but in the opposite direction.

  Government bond: A debt security issued by a government, typically with a term of one year or more.

  Hedge: A trade, often involving the use of derivatives, designed to reduce risk.

  Interbank money market: The market where banks borrow from and lend to each other.

  Interdealer broker: A brokerage firm that acts as an intermediary between major dealers (typically banks) to facilitate trades.

  Interest rate swap (IRS): A derivative where two counterparties agree to exchange periodic interest payments based on a specified notional amount. Typically, interest rate swaps involve the exchange a fixed interest rate for a floating rate (e.g. LIBOR), or vice versa.

  Layering: Submitting a series of manipulative buy (or sell) orders with the intention of selling rather than buying (or buying rather than selling). The manipulative orders are intended to trick other market participants by creating the false impression of heavy buying or selling pressure.

  LIBOR fixing: The LIBOR fixing is calculated using a trimmed arithmetic mean of the individually submitted rates from the LIBOR panel banks.

  LIBOR panel bank: A bank participating in the LIBOR fixing mechanism.

  Liquidity: A term used to describe the ease and speed with which an asset can be turned into cash.

  Low-balling: Reducing a LIBOR submission in order to avoid the stigma of being perceived by others (market participants, media, etc.) as having a high cost of borrowing.

  Mark to market: To adjust the value of a financial instrument or portfolio to reflect its current market value (usually the daily closing price).

  Market maker: A market participant who facilitates trading in a financial instrument by supplying (tradeable) buy and sell quotes.


  Mismark: To wrongly adjust the value of a financial instrument or portfolio to reflect its current market value.

  Monetary transmission mechanism: The process by which monetary policy decisions taken by a central bank affect prices, interest rates, credit and ultimately agents’ behaviour and decision making in the wider economy.

  Money market risk premium: The difference between the interest rate at which banks borrow from each other for a specific maturity and the ‘risk-free’ interest rate for the same maturity.

  Mortgage bond: A debt security issued by a financial institution that is collateralised by one or several mortgaged properties.

  Offer: The price at which a market maker offers to sell an asset or a financial instrument.

  Option: A financial contract that gives the buyer the right, but not the obligation, to buy or sell an underlying instrument at a predetermined price in the future.

  Over the counter (OTC): Used to describe transactions that are bilaterally negotiated between two market participants.

  Overnight index swap (OIS): An interest rate swap where the floating rate is an overnight rate (or overnight index rate), compounded over a specified term.

  Position: The amount of a financial instrument held by a trader and generally a term for how sensitive the trader’s book is to different price movements in the market. The holder of a long position will profit if the price of the financial instrument goes up, whereas the holder of a short position will profit if the price goes down.

  Repo: A repurchase agreement, or ‘repo’, is a form of asset-backed borrowing, usually for the short term. The borrower sells securities (such as bonds) and simultaneously agrees to buy them back at a predetermined price at a later date.