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:— Charles Dickens, ''Oliver Twist''}} | :— Charles Dickens, ''Oliver Twist''}} | ||
{{drop|T|he basic model}} of a bank is to borrow, short-term, at a low rate, and lend, long-term, at a high rate. ''Generally'' banks calculate interest on | {{drop|T|he basic model}} of a bank is to borrow, short-term, at a low rate, and lend, long-term, at a high rate. ''Generally'' banks calculate interest on deposits, by which they borrow, at a [[Floating rate|floating]] rate and on term loans, by which they lend, at [[Fixed rate|fixed]] rates. | ||
Since banks ''borrow'' in floating and ''lend'' in fixed. they have “structural interest rate risk”. They want floating rates to be low, and to move lower. If they don’t manage this risk, things can get funky fast. Just ask [[Silicon Valley Bank]]. | |||
So, a foundational question: How to determine the floating rate, day to day? | |||
Enter, lifetimes ago, the [[British Bankers’ Association]]. This was just the sleepy, city-grandees-in-a-smoke-filled-gentlemen’s-club-in-Threadneedle-Street of your imagination. Inasmuch as it ever did anything useful, the BBA compiled the London Interbank Offered Rate — “[[LIBOR]]” — sleepily, by inviting 18 major banks to, literally, ''phone in'' the rate at which they believed they could borrow in various currencies and maturities in the market each day. | |||
The BBA would then “trim” — ignore — the top four and bottom four submissions and average the rest, producing daily LIBOR rates for each currency and maturity, then toddle off for a liquid lunch at the Garrick before their regular three o’clock tee time. You get the picture. | |||
With LIBOR the banks could then set the rates for their deposits and calculate a suitable fixed rate for new term loans . Happy, dull stuff, carried out by happy, dull people: We din’t want to run the LIBOR people down, but pre 1997 this was the after-school chess club: all the cool kids were out shagging, smoking weed and shorting structured credit. | |||
It is one of JC’s axioms that market catastrophe will find where you least expect it. This is because success in financial services is in large part about [[edge]], and you find the most edge where no-one else is looking for it. | |||
Tom Hayes was a cool kid. He hung out in chess club. And shagged and smoked weed. ''Metaphorically''. He found some edge. So did a bunch of other groovers. No-one bothered them and they didn’t do any harm — at least, not that anyone has been since able to point to. | |||
As per the basic model, to manage their structural interest rate risk, banks ''generally'' would want LIBOR low — but deposits are not the only show in town. Some banks — principally those that were swap dealers — had exposure to the interest rate market through swaps. | As per the basic model, to manage their structural interest rate risk, banks ''generally'' would want LIBOR low — but deposits are not the only show in town. Some banks — principally those that were swap dealers — had exposure to the interest rate market through swaps. | ||
Here, the bank “swaps” interest rates with its customers: one customer | Here, the bank “swaps” interest rates with its customers: it might pay one customer a fixed rate and receive from it a floating rate; with another it might swap floating for fixed. | ||
If a dealer swaps | If a dealer swaps five year fixed for five year floating, and LIBOR goes up, by definition the dealer has profited: 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“ [[in-the-money]]”. | ||
While dealers try to balance their customer swaps | While dealers try to balance their books so their customer swaps offset each other as far as possible, they may be asked to help manage their bank’s structural interest rate risk arising from its normal banking activities. They might also have an outright “prop” position on interest rates. Less likely now, but this was back then | ||
We can see in any case that, nothwithstanding the bank’s structural interest rate risk, an interest rate derivatives trader who is net long floating rate — and indeed the whole organisation — might well have a financial interest in floating rates going higher. | |||
What with all the frenetic customer activity and market conditions constantly changing it is quite conceivable that, though simplistically a bank should always want the LIBOR rate to be low to improve its spread on deposits against loans, the positioning of its interest rate derivatives book might offset or even reverse that such that it might suit the bank for LIBOR to be ''high''. | What with all the frenetic customer activity and market conditions constantly changing it is quite conceivable that, though simplistically a bank should always want the LIBOR rate to be low to improve its spread on deposits against loans, the positioning of its interest rate derivatives book might offset or even reverse that such that it might suit the bank for LIBOR to be ''high''. |