LIBOR rigging: Difference between revisions
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{{a|casenote|{{image|Dramatic look|jpg|''[[Dramatic look gopher]] goes to the [[British Bankers’ Association]]'' {{vsr|2024}}}}}}{{quote| | {{a|casenote|{{image|Dramatic look|jpg|''[[Dramatic look gopher]] goes to the [[British Bankers’ Association]]'' {{vsr|2024}}}}}}{{quote| | ||
{{drop|“I|f the law}} supposes that,” said Mr. Bumble, squeezing his hat emphatically in both hands, “the law is a ass—a idiot. If that’s the eye of the law, the law is a bachelor; and the worst I wish the law is that his eye may be opened by experience—by experience.” | |||
{{drop|“I|f the law}} supposes that,” said Mr. Bumble, | |||
:— Charles Dickens, ''Oliver Twist''}} | :— Charles Dickens, ''Oliver Twist''}} | ||
== LIBOR: deep background == | |||
==== Banks have structural interest rate risk ==== | ==== Banks have structural interest rate risk ==== | ||
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In the early nineteen eighties, some [[First Men|bright sparks]] at [[Salomon Brothers]] figured out how to make interest rates into a tradable instrument. To standardise that instrument, the banks realised they would need a common way of describing how their interest rates change through time. A “benchmark”. | In the early nineteen eighties, some [[First Men|bright sparks]] at [[Salomon Brothers]] figured out how to make interest rates into a tradable instrument. To standardise that instrument, the banks realised they would need a common way of describing how their interest rates change through time. A “benchmark”. | ||
==== Chess club | ==== Chess club ==== | ||
{{Drop|E|nter the}} the [[British Bankers’ Association]]. This was just the sleepy, city-grandees-in-a-smoke-filled-gentlemen’s-club-in-Threadneedle-Street of your imagination. It began to compile what it called the “London Interbank Offered Rate” — “[[LIBOR]]”. This was to be an objective distillation of all the major banks’ borrowing rates. | {{Drop|E|nter the}} the [[British Bankers’ Association]]. This was just the sleepy, city-grandees-in-a-smoke-filled-gentlemen’s-club-in-Threadneedle-Street of your imagination. It began to compile what it called the “London Interbank Offered Rate” — “[[LIBOR]]”. This was to be an objective distillation of all the major banks’ borrowing rates. | ||
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Now. It is one of JC’s [[Financial disasters roll of honour|axioms of financial scandal]] that [[Air crashes v financial crashes|''calumny happens where you least expect it'']]. This is because success in financial services is in large part about “[[edge]]”, and you generally only find an [[edge]] where no-one else is looking for it. | Now. It is one of JC’s [[Financial disasters roll of honour|axioms of financial scandal]] that [[Air crashes v financial crashes|''calumny happens where you least expect it'']]. This is because success in financial services is in large part about “[[edge]]”, and you generally only find an [[edge]] where no-one else is looking for it. | ||
==== The cool kids ==== | |||
{{Drop|T|om Hayes was}} a cool kid (''metaphorically'': literally he has been described as “socially awkward”) but he hung out in the chess club. He, and a bunch of other groovers, found some [[edge]] there, where no one was looking for it. No one bothered them and they didn’t do a lot of harm — not, at least, that anyone has been since able to point to. But they sent each other lots of [[embarrassing emails]]. | |||
In any case, they made an effort to submit LIBOR rates that suited their derivatives trading positions and not, necessarily, their banks’ structural interest rate positions. | In any case, they made an effort to submit LIBOR rates that suited their derivatives trading positions and not, necessarily, their banks’ structural interest rate positions. | ||
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Another one of JC’s axioms: [[If you like sausages, don’t work in a smallgoods factory|''if you like sausages, don’t work in a smallgoods factory'']]. | Another one of JC’s axioms: [[If you like sausages, don’t work in a smallgoods factory|''if you like sausages, don’t work in a smallgoods factory'']]. | ||
As per the “basic banking model”, to manage its structural interest rate risk, a bank ''generally'' would want LIBOR to be low. But deposits are not the only show in town — there are other exposures to the interest rate market: notably, the new tradable instruments: [[interest rate swap]]s. | |||
==== Interest rate swaps ==== | |||
{{Drop|I|n an interest}} rate swap, the bank “swaps” interest rates with individual counterparties: it might, for an agreed period, pay one counterparty a fixed rate and receive from it a floating rate; with another it might pay floating and receive fixed. | |||
Before the advent of swaps, the only way of getting exposure to interest rates was by borrowing and lending principal. This required a lot of money down.<ref>It is a [[a swap as a loan|misconception]] that interest rate swaps do not involve principal borrowing and lending, but that is a story for another day</ref> Interest rate swaps got popular, fast. There are now trillions of dollars in notional interest rate swaps outstanding on any day. | |||
Unlike basic banking, there is no structural bias to swap trading. If a bank swaps a five-year fixed rate for a five-year floating rate, and LIBOR then goes up, by definition the bank profits: the “[[present value]]” of its incoming floating rate will increase while the [[present value]] of its outgoing fixed rate stays the same. The dealer is therefore “[[in-the-money]]”. If it swapped floating for fixed in the same case, it would book a corresponding loss. | Unlike basic banking, there is no structural bias to swap trading. If a bank swaps a five-year fixed rate for a five-year floating rate, and LIBOR then goes up, by definition the bank profits: the “[[present value]]” of its incoming floating rate will increase while the [[present value]] of its outgoing fixed rate stays the same. The dealer is therefore “[[in-the-money]]”. If it swapped floating for fixed in the same case, it would book a corresponding loss. |