Shhh... Don't Tell Anyone; Central Banks Manipulate Rates

David Zervos, Jefferies: Shhh... Don't Tell Anyone; Central Banks Manipulate Rates

It should come as no surprise to anyone that major commercial banks manipulate Libor submissions for their own benefit. The OTC derivatives markets was designed by the big banks, for the big banks, to ensure that as they set up their own private securities exchanges - away from regulatory scrutiny - they could control the interest rate settings. Money center commercial banks did not want the “truth” of market prices to determine their loan rates. Rather, they wanted an oligopolistically controlled subjective survey rate to be the basis for their lending businesses.

To that end, if there was a big reset for a specific bank on a given trading day, and a lower rate suited, said bank would surely shade its Libor submission lower. And then of course there were the far more unscrupulous submitters who tried to influence where other banks might post rates on a given day (for a bottle of Bolly or for a quid pro quo at a future date). When there are only 16 players – a “gentlemen’s agreement” is relatively easy to formulate. That is the way business has been transacted in the broader OTC lending markets for nearly 30 years. It is impressive that it took this long for the regulators to actually realize what a complete shame the entire structure really is.

In a way, the evolution of a corrupted Libor market is par for the course when it comes to the commercial bank tear down of the Glass-Steagall act. The biggest banks in the US and Europe spent decades trying regain control of the securities markets. In the US, Gramm-Leach-Bliley was the final nail in the Glass-Steagall coffin after the tireless work of folks like Sandy Weill and Hugh McCall (and their public sector lackeys Bob Rubin, Larry Summers and Alan Greenspan). One of the best analyses of the post Glass-Steagall world was done by Luigi Zingales at the University of Chicago. His recent FT article is attached below – and it is a MUST read. From the perspective of the evolution of the OTC derivative market, and Libor misrepresentations, this paragraph from Luigi says it all –

“The third reason why I came to support Glass-Steagall was because I realized it was not simply a coincidence that we witnessed a prospering of securities markets and the blossoming of new ones (options and futures markets) while Glass-Steagall was in place, but since its repeal have seen a demise of public equity markets and an explosion of opaque over-the-counter ones.”

The money center banks have successfully created their own private marketplaces, where everyone from money managers to hedge funds to homeowners MUST trade upon rates that are set in an opaque fashion by the owners of said marketplace. It’s a travesty, but it’s our reality. Maybe that will change, but somehow I doubt it. Even going back to Jefferson and Madison, the debates on bank influence were fierce. Sadly, one of the negative by-products of our wonderful system of capitalism is that banks end up with too much political control. And, of course, they use it to create oligopolistic rents. We can all hope to set up rules that do not allow this, but it’s most likely impossible.

To reiterate, it should come as no surprise that Barclays, or any number of commercial banking institutions, used their influence to drive Libor rates towards levels that suited their positions. The rate setting structure was designed to be manipulated. To that end let’s review what Libor is – it is a rate that is not derived from any traded market, it is a survey rate. When a bank submits Libor rates at 7:29am each day, they need not have any paperwork suggesting that is where they actually borrowed funds. In fact, back in 2008, all interbank lending ceased to exist. Yes, we had a $500 trillion OTC derivatives market based off an index that couldn’t even be traded - amazing. And as the attached chart shows, the interbank lending market has never come back. Libor was designed to be an opaque and non-transparent rate. So when a bank submits a rate which may not represent its true borrowing costs, it really has done nothing wrong. The system was set up to be divorced from reality. But where banks get into trouble is when they work ologopolistically to collude on where these rates are set. That is where Barclays fell down, and that is why senior management has been wiped out.

While we can point to the ridiculousness of 16 banks in London colluding on where mom and pop’s trailer park mortgage rate is set, or where a small business loan rate is set, or where a student loan rate is set; the reality is we have no choice. I wish the bulk of our lending rates were set as a spread off Treasury yields, or COFI, or better yet the Fed funds rate/OIS. But they are not. The banks tore down Glass-Steagall, became too big to fail, and set up a $500 trillion derivatives market that is too big to close. We are stuck trading whites, reds, greens, blues, golds for a good while longer!

I once proclaimed, back in the summer of 2007, that I would not trade Libor based products ever again. In the last 12 months however I had to give in, as there were no viable hedges left for spoos. You couldn’t lever a long 2yr Treasury or Schatz position any longer because rates were 20bps - all that was left were the short end forward rates. Of course I would NEVER go long 10yr or 30yr Treasuries or Bunds because of the long term inflation risks, but I would happily trade a 3 year forward 1 year rate, thereby betting that the Fed and ECB stay too low for too long. If there was a way to liquidly trade 3 year forward 1 year OIS rate I would do it in a second – but it doesn’t exist. Unfortunately, the ONLY way to trade forwards liquidly is in LIBOR, so I had to go back on my pledge. It pains me every day, and I long for the day when Libor is replaced with something tradable and objective – until then, I like many are forced to transact in a rigged market.

So what will be the fallout from this grand realization that Libor is rigged, and money center banks collude to set rates. Like I said, my hope is that we move to an OIS based market. The overnight effective fed funds rate, or EONIA, SONIA, TONIA etc etc are TRADED rates. They represent where actual transactions took place for unsecured lending between banks. There is no subjectivity, and more importantly the central banks DIRECTLY affect the rate. The submitting banks will resist, and sadly will likely win. So I can hope we move to an OIS world, but I’m not holding my breath...I’m still trading blues.

In the end, I fully expect there will be many investigations, fines and job losses associated with the collusion activities in Libor markets. But there will be little impact on markets. Furthermore, anyone who believes (as the senior management of Barclays seemed to) that central bankers will have some accountability in this scandal is mistaken. The most bizarre thing to come out of the Barclays scandal is the attack on the Bank of England and Paul Tucker. Is it really a scandal that central bank officials tried to affect interest rates? Absolutely NOT! Central bankers try to influence rates directly and indirectly EVERY day. That is their job. From the NYFED website this is description of the monetary policy objective –

“the directive for implementation of U.S. monetary policy from the FOMC to the Federal Reserve Bank of New York states that the trading desk should “create conditions in reserve markets” that will encourage fed funds to trade at a particular level. Fed open market operations change the supply of reserve balances in the system, and by affecting the supply of balances, the Fed can create upward or downward pressure on the fed funds rate.”

All central banks, and central bankers, are in the business of setting rates. That’s what they do for a living. That’s why we spend so much time watching them. Surely, the Fed and BoE were unhappy that Libor rates, commercial lending rates, residential mortgage rates and the like were not cooperating with their traditional rate manipulation techniques in the overnight market for unsecured funds. That is why they created a myriad of unusual and exigent programs during the 2008/2009 crisis. But for the senior management of Barclays to come out and claim the Bank of England, or any central banker, was at fault for trying to “manipulate” interest rates is absurd. Congresses and Parliaments have given central banks monopoly power in the printing of money and the management of interest rate policy. These same law makers did not endow 16 commercial banks with oligopoly power to collude on the rate setting process in their privately created, over the counter, publically backstopped marketplaces. Good luck trading.


Why I was won over by Glass-Steagall
By Luigi Zingales

I have to admit that I was not a big fan of the forced separation between investment banking and commercial banking along the lines of the Glass-Steagall Act in the US. I do not like restrictions to contractual freedom, unless I see a compelling argument that the free market gets it wrong. Nor did I buy the argument that the removal of Glass-Steagall contributed to the 2008 financial crisis. The banks that were at the forefront of the crisis – Bear Stearns, Lehman Brothers, Washington Mutual, Countrywide – were either pure investment banks or pure commercial banks. The ability to merge the two types was crucial in mounting swift rescues to stabilise the system – such as the acquisition of Bear Stearns by JP Morgan and of Merrill Lynch by Bank of America.


Over the last couple of years, however, I have revised my views and I have become convinced of the case for a mandatory separation.


There are certainly better ways to deal with excessive risk-taking behaviour by banks, but we must not allow the perfect to become the enemy of the good. In the absence of these better mechanisms, it makes perfect economic sense to restrict commercial banks’ investments in very risky activities, because their deposits are insured. Short of removing that insurance – and I doubt commercial banks are ready for that – restricting the set of activities they undertake is the simplest way to cope with the burden that banks can impose on taxpayers.


The Volcker rule, which prohibits banks from engaging in proprietary trading but allows them to put their principal at risk, is not a good substitute. Proprietary trading is when a bank invests in stock hoping that its price will go up. A bank engages in principal trading when it buys a stock from a client as a service to that client, who wants to unload his position quickly. The difference is therefore one only of intentions, which are impossible to detect, since any transaction involves two consenting parties.


The second reason why Glass- Steagall won me over was its simplicity. The Glass-Steagall Act was just 37 pages long. The so-called Volcker rule has been transformed into 298 pages of mumbo jumbo, which will require armies of lawyers to interpret. The simpler a rule is, the fewer provisions there are and the less it costs to enforce them. The simpler it is, the easier it is for voters to understand and voice their opinions accordingly. Finally, the simpler it is, the more difficult it is for someone with vested interests to get away with distorting some obscure facet.


The third reason why I came to support Glass-Steagall was because I realised it was not simply a coincidence that we witnessed a prospering of securities markets and the blossoming of new ones (options and futures markets) while Glass-Steagall was in place, but since its repeal have seen a demise of public equity markets and an explosion of opaque over-the-counter ones.


To function properly markets need a large number of independent traders. The separation between commercial and investment banking deprived investment banks of access to cheap funds (in the form of deposits), forcing them to limit their size and the size of their bets. These limitations increased the number of market participants, making markets more liquid. With the repeal of Glass-Steagall, investment banks exploded in size and so did their market power. As a result, the new financial instruments (such as credit default swaps) developed in an opaque over-the-counter market populated by a few powerful dealers, rather than in a well regulated and transparent public market.


The separation between investment and commercial banking also helps make the financial system more resilient. After the 1987 stock market crash, the economy was unaffected because commercial banks were untouched by plummeting equity prices. During the 1990-91 banking crisis, securities markets helped alleviate the credit crunch because they were unaffected by the banking crisis. By contrast, in 2008 the banking crisis and the stock market crisis infected each other, pulling down the entire economy.


Last but not least, Glass-Steagall helped restrain the political power of banks. Under the old regime, commercial banks, investment banks and insurance companies had different agendas, so their lobbying efforts tended to offset one another. But after the restrictions ended, the interests of all the major players were aligned. This gave the industry disproportionate power in shaping the political agenda. This excessive power has damaged not only the economy but the financial sector itself. One way to combat this excessive power, if only partially, is to bring Glass-Steagall back.