LIBOR rigging: Difference between revisions

LIBOR rigging (view source)

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 In the good old days, each bank worked out its own floating rates based on its own models, funding costs and market positioning. This process was neither transparent nor standardised. Rates could vary significantly between similar banks. As long as interest rates were not tradable instruments, this did not much matter to banks: they just told their customers what the floating rate was each day, and that was that.
-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 standard 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 and the cool kids ====
-{{Drop|E|nter, in 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. The method the BBA chose to compile it was simple: it invited 18 major banks to
+{{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.
-literally, ''phone in'' what they believed they could borrow in various currencies and maturities in the market each day.
-The BBA would compile the submissions, “trim” off the top and bottom four, average the rest and publish the result as a set of daily LIBOR rates for each currency and maturity, before toddling off for a liquid lunch at the Garrick and a regular three o’clock tee time.
+The method the BBA chose to compile it was simple: it invited 18 major banks to
+literally, ''phone in'' what they believed they could borrow in various currencies and maturities in the market each day. The BBA would then compile the submissions, “trim” off the top and bottom four, average the rest and publish a set of daily LIBOR rates for each currency and maturity, before toddling off for a liquid lunch at the Garrick and their regular three o’clock tee time at Wentworth.
 You get the picture.
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 Happy, unadventurous stuff, carried out by happy, unadventurous people. Look: we don’t want to run the interest rate-setting crowd down, but before 2007, the LIBOR rate setting process was like the after-school chess club: snoresville. All the cool kids were out shagging, smoking weed and shorting structured credit. None of the hepcats paid much attention to LIBOR.
-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 a. [[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.
 Tom Hayes was a cool kid (''metaphorically'': he wasn’t ''literally'' very cool at all). 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 any harm — at least, not that anyone has been since able to point to. But they sent each other lots of [[embarrassing emails]].
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 ==== Interest rate derivatives ====
-{{drop|A|s 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, [[Interest rate swap mis-selling scandal|interest rate swap]]s. Swaps [[Swap history|emerged as an asset class in the early 1980s]], and there is a good argument that LIBOR — instituted in 1986 — emerged in response to demand in the burgeoning interest rate swaps market for a more standardised measure of floating rates.
+{{drop|A|s 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.
-In an interest rate swap, the bank exchanges — “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.
+In 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 [[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>
 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.