Tuesday, 10 July 2012

Lies, Damn Lies and LIBOR

I've been hesitant to write about the LIBOR scandal because what I want to say goes so much further. We now know that Barclays and other major global banks have been manipulating the calculation of LIBOR through the quotation data they provided to the British Bankers Association. What I suspect is that this is not a flaw but a feature of modern financial markets. And if it was happening in LIBOR for between 5 and 15 years, then the business model has been profitably replicated to many other quotation-based reference prices.

Price discovery is not a sexy function of markets, but it is critical to the efficient allocation of scarce capital and resources, and to the preservation of the long term wealth of investors and the economy as a whole. If price discovery is compromised by manipulation, then we will all be gradually impoverished and the economy will be imbalanced and unstable.

Over the past 25 years the forces of regulatory liberalisation and demutualisation of markets have allowed the largest global banks to set the rules, processes and infrastructure of global markets to their own self-interested requirements. Regulatory complexity and harmonisation benefit the biggest banks disproportionately, eroding the competitive stance of smaller, local banks and market participants. This has led to a very high degree of concentration in a very few banks in most markets that determine global reference rates for interest rates, currencies, commodities and investments. If those few collude with each other - as Adam Smith warned was always the result - then they impoverish us all.

We have allowed markets to evolve in ways that make supervision of markets almost impossible. Many instruments trade off-exchange or in multiple venues, making it nearly impossible for any single investor or regulator to supervise trading to prevent or detect manipulation or abuse. Many financial instruments are now synthetic compilations of underlying assets and derivatives, with multiple pricing components determined by reference to other prices or rates. Demutualisation and regualtory reforms stripped exchanges of the self-regulating interest in preventing manipulation and abuse by their members as mergers, profits and market share came to dominate governance objectives.

Off-exchange trading has been allowed to proliferate, creating massive ill-transparent and largely illiquid markets in almost every sector of finance. Pricing in these markets is based around calculated reference rates which, like LIBOR, are open to abusive quotation and data input practices. Many OTC derivatives are priced and margined using reference rates calculated against quotations unrelated to actual reported transactions. Synthetic securities such as ETFs are another example of an instrument that prices off a reference rate rather than the actual contents of an underlying asset portfolio. These instruments are open to consistent abusive pricing as a means of incrementally impoverishing those market participants who are the krill on which the global banks thrive.

How has it been possible for banks to grow from less than 4 per cent of the global economy to more than 12 per cent of the global economy without impoverishing others? How has it been possible for profits in the financial sector to be consistently higher than profits from other human endeavors with more tangible products or impacts on our daily lives - such as agriculture, transport, health care or utilities? How has it been possible that banks derive their profits not from the protected and regulated activities of deposit-taking and lending, but from the unsupervised and often unknowable escalation of off-balance sheet assets and liabilities? How has it been possible that pension savings have increased while pension returns have declined to the point where only bankers can expect a comfortable old age? Global banks have built the casinos and tilted the odds in the house's favour by rigging the data that determines the outcomes of most of the bets on the table. Every one of us that sits at the table long enough - whether saver, investor, borrower, taxpayer or pensioner - will be a loser. It is not a flaw; it is a feature.

There is a reason that financial infrastructure used to be dominated by mutuals. Mutual gain and mutual liability created a natural discipline on excess and on rogue elements that would impoverish their peers.

There is a reason why trading was restricted to exchanges, and exchanges and clearing houses used to be self-regulating, and even had responsibility for resolution and liquidation of their members. Direct responsibility, authority and financial control meant that they could exert very powerful and immediate consequences on those members identified as abusing the market or investors.

The investigations into market rigging are just beginning. Paul Tucker opened the box yesterday when he admitted that he could not know whether the abuses discovered in setting LIBOR had spread to other synthetically calculated reference rates. As events unfold, it may be that we begin to appreciate just how deeply vulnerable we have become to predation by bankers with no stake in a local economy or in the local quality of life of the people they impoverish. A reckoning is needed, and then a rebalancing toward more local and mutual provision of essential services and market infrastructure that serves markets rather than those few bankers on the board.

As a start, regulators should consider punitive restrictions on the sale of instruments which price on reference rates unrelated to reported market transactions or underlying asset portfolios. Pricing should reflect real market transactions rather than guesstimates talking the banker's book.

We need to rethink as a society what banks are for, what exchanges are for, and what clearing houses are for. If they are for the profit of the few at the expense of the many now, that is because it is the business model we have permitted. If banks, markets and clearing are protected because they have a social function, we should make certain that social function is adding value. If it isn't, then we need some new models and some new rules.

34 comments:

Anonymous said...

LB - you've been duped by the new Blogger interface. If you use HTML edit, you now have to put in the

tag every time you want a new paragraph to appear.

Charles Butler said...

Of course, comments won't accept the tag. It is (br/)(br/) with angle brackets.

London Banker said...

Cheers, Charles. I noted the absence of paragraph breaks on review and have now manually put these in.

Anonymous said...

the issues and solutions don't align; one would question from the content that your blog is sponsored by the exchange business; i.e. 'members only' as opposed to the open access and free competition OTC markets.

WRT "real transactions" - You also utterly miss the key point which was reiterated by Tucker yesterday that Libor doesn't trade and hasn't traded since the crisis much beyond 1w, yet the market requires a benchmark.

PeterJB said...

@LB

Glad to see that you are finally coming around to the reality of the Recursive Scamming of the Banking System; nothing new here, mais oui, for the past ~5,000 years or so.

Try: http://verbewarp.blogspot.com.au/2011/02/recursive-game-is-policy.html

So I see "Oh Gee Whiz, the Libor is manipulated, Oh, the Bullion markets and Gold and Silver are manipulated, the Bond markets are manipulated as the Munis, the OTC, the Housing", etc., gee whiz Old Boy, no corporation is running at a profit unless Fraud, Theft, Manipulation, Mark to Fantasy Accounting, MSM Lies, and er, secrecy, ie, "national security" and assassination is not employed as elite "innovation".

Our old friends like Roubini and Stiglizt are now calling for hanging Bankers as well as a few others (except Krugman)

Can you see the dynamic yet @LB?

Manchester Capitalism said...

That's a fantastic post. We were writing about this precise point in our own blog post yesterday on the signalling effect of accounting numbers. http://manchestercapitalism.blogspot.co.uk/2012/07/on-banking-culture.html

BrianSJ said...

Also need to re-think how regulation works. There aren't enough William K Blacks to go around.

RichL said...

All transactions involve two parties. If a transaction is private (off-exchange) why does it follow that one party to the trade is disadvantaged?

The world has a demographic imbalance, with more boomers about to retire than most other population cohorts. The greatest accumulation of assets should occur at the time when people are about to retire. These people have either saved for retirement on their own, or are the beneficiaries of pension schemes. The financial markets are the vehicle by which saving is translated into investment. This savings pool is large, occurs naturally, and has to be managed.

As an example, Alcoa had 1Q12 sales of $6 billion, equity of $17.6 billion, and income of $99 million. In AOCI, the firm had a loss from pensions of $56 million that flows through the balance sheet rather than the income statement. Foreign currency translation adjustments were $244 million in that quarter. There are many pages in the 10-Q describing their derivative exposures. Turning to Alcoa’s 10-K, starting on page 136- footnote W- the firm has pension obligations of $13.5 billion, and assets of $10.3 billion to fund the liability, and a balance sheet liability of $3.1 billion to reflect the shortfall. The point of all this is that Alcoa is not considered to be a financial, but the financial exposures that they have to manage aren’t greatly different in size from their core aluminum business.

To turn your question around, how is it possible for the financial sector to be as small as 12% of the global economy given the massive asset and liability exposures that have to be managed in a modern economy with so many people about to retire?

Perhaps the London Banker does not own bank shares? If he did he may have noticed that that investment has not been remunerative for the past 5 years. I see a financial market that is highly competitive, with MUCH lower spreads than prevailed a decade ago, much higher volume, and lower bank profitability. The collusion alleged has not been successful if judged on the more conventional measure of profitability.

PeterJB said...

@RichL Your assumption that all transactions involves only two Parties is incorrect and invalid.

You overlook the State and its diverse bureaucracies as well as the Banks as well as their widespread tentacles of intermediaries and Fiduciary Agents du finesse.

@RichL - there is nothing new here - saturated corruption by those with the opportunity and trust is pervasively notorious. And it always ends with genocide. It is called fascism.

creditplumber said...

Thoughtful piece, LB.
Universal Banking built itself on the virtues of trust, confidence and expertise. However, it ignored the abundant epistemic arrogance across the broader (shadow) Financial sector. It is therefore unsurprising the System has collapsed. What is more, it is also clear by now that when it comes to re-regulation, proctologists aren't necessarily best to fix teeth.
The (buy-side) professionals and amateurs fueling the bubble have now realized risk outcomes cannot be dictated by clever financial analysis. Soros has discussed this well in his theory of Reflexivity. And with regulators, we can be assured that they will apply the same weak standards that enabled them to repeat similar mistakes made with the Lloyds of London fiasco of the '80's and '90's writ large. Deja vu all over again.
When only one party (sell-side) has access -in a timely manner- to observable event data and has gouged significant value for themselves from this asymmetry, trust cannot be "restored". Nor can culture simply be changed.
The relationship between credit creation and M3 has collapsed thanks to what is popularly called "shadow banking". Limiting access to Central Banks LOLR liquidity to Bank Holding Companies is an anachronism. Rectifying this anomaly is one act that can reduce banks monopolistic position in the credit intermediation process. It can also offer a focus for re-regulation. Levelling the playing field for defined participants is a start. "Cross sector Risk Transfer" was addressed by the FSA in 2002 in a paper, yet ignored subsequently. In the broader financial system,Financial Law has essentially converged Structured Finance at a faster pace than regulation of cross-sector credit intermediation.
Nothing changes overnight but the Real World continues to turn. Addressing the issues of LOLR & information may begin to re-balance Financial Markets. It will certainly enable regulators and some participants to ringfence the socially useful application of investor capital to Real Economic activity from the capital of those dying in the cesspit.

BRM said...

Always appreciate your writing. I do have to say though that I find the idea that clearinghouses are the cure-all (or even the cure-most) solution to be a little naive.

The abuse of customers that existed at every single clearinghouse-based exchange until side-by-side electronic markets nullified that abuse's tactics was widely acknowledged and accepted by all "members".

I agree with the trust of the post though -- regulation must have effective enforcement measures and markets should quote actual transactions in some audit-able kind of way.

Coldtype said...

All transactions involve two parties. If a transaction is private (off-exchange) why does it follow that one party to the trade is disadvantaged? Rich L

Here's a better question RL, how is it the taxpayer's job to backstop the speculators involved when these "private" instruments blowup in their faces?

It's a simple deal here, if you want to privatize the gains then you damn well better be prepared to privatize the losses.

Richard Field said...

LB,

As always, excellent post.

What you described is how the banks have inserted opacity into the financial system over the last 30 years. Opacity that the financial regulators permitted.

The results have been predictable as opacity hides bad behavior.

The solution as you correctly point out is transparency. (I have discussed this extensively on my blog: www.tyillc.blogspot.com)

It is well recognized that sunlight is the best disinfectant for the behavior the banks are engaging in and stopping their extraction of rent from the real economy.

I agree that Libor should be based on real transactions.

As for the concern that the market froze and there were no transactions, the response is the freezing of the market occurred in all the opaque areas of the market (banks and structured finance securities for example). If transparency were brought to these areas, then the market would not have frozen and prices would have been available.

Unknown said...
This comment has been removed by the author.
Unknown said...

How much different is this to make conterfeit money ?
Why is sentencing shockingly light for them, if they get any ?
See Money Conterfeit Sentencing

Guidoamm said...

Just a minor correction. You say:
"Global banks have built the casinos and tilted the odds in the house's favour by rigging the data that determines the outcomes of most of the bets on the table."

This is not a matter of odds. Fractional Reserve Banking ensures that money is injected into the economy through specific and exclusive gates. In a monetary system predicated on the deliberate and artificial inducement of inflation, the diminishing marginal utility of the currency ensures that ALL profits eventually concentrate in the financial industry and, finally, concentrate in the hands of the Primary Dealers. Granted the time line is rather extended but the ultimate result is an arithmetical certainty.

Anonymous said...

Great post.

"In a monetary system predicated on the deliberate and artificial inducement of inflation, the diminishing marginal utility of the currency ensures that ALL profits eventually concentrate in the financial industry and, finally, concentrate in the hands of the Primary Dealers. Granted the time line is rather extended but the ultimate result is an arithmetical certainty."

+1 on this one

Is'nt our great "London banker" joining the lunatic fringe:)

TomTom said...

Not only has risk been mis-priced but synthetic collateral has been pyramided to the point that global GDP exceeds global Output. The constant drive for cheap labour in China to support the Credit Pyramid through increased output of physical goods has run up against constraints.

When Marks & Spencer built a financial services division it destroyed its retail operation by driving for FIRE returns from Clothing and cheapened product and presentation by skimping on textile quality and fabric sizing.

The Capitalist System is hollowed out by the FIRE Sector which distorts measurement to favour money scales of attainment only.

The FIRE Sector is a coaling station reducing all physical products to combustible carbon

MarcoPolo said...

London Whale, meet Krill. Love the analogy.

Sean said...
This comment has been removed by the author.
Sean said...

Nice post.

Mutual's did not work too well in Spains cajas did they? they too were well and truly corrupted.

Now we all know how the Reed warbler feels when it discovers it has a Cuckoo in its nest. And just like the Cuckoo chick "banks" makes the sound of 6 hungry Reed warbler chicks to get the parent to feed it. The same chick that killed the Warblers natural young.

I propose a new term "Cuckoo banking" it tells the story.

London Banker said...

Cheers to all of you for reading and commenting! I'm rather surprised at the interest in this piece, as price discovery functions of markets and reference data methodologies aren't compelling topics in normal times. But these are not normal times.

Special hat tip to MarcoPolo as I had not drawn the London Whale/krill connection until he pointed it out. If only I was that clever!

jo6pac said...

Wondering what the London Bookies have odds on anyone going to jail?
This is just business as usual for the criminal class running the planet for their own greed. Only Main Street will lose.

ionotter said...

Now we know why local police departments have been militarized.

Now we know why there are cameras all over the place, watching our every move.

Now we know why all of our governments have been spying on us for the last 10-15 years, if not longer.

Oceania and Air Strip One were not built in a day.

Knute Rife said...

As I've chimed in with Black and others on several occasions, high-speed trading alone has rendered the transparency model of regulation a farce. It is physically impossible for anyone but insiders to receive, process, and act on investment information in a meaningful timeframe. Add neoliberal policies that have left regulators asleep at the switch, and the markets have turned into gunfights with everyone but the big houses armed with popsicle sticks.

@PeterJB: In fact, there is effectively no such thing as a two-party financial contract anymore. The only laughably regulated derivatives market and the openly unregulated CDS market created daisy chains made of cotton candy that were leveraged up and down the line. We haven't even begun to wring this out yet.

@Guidoamm: You would perhaps prefer the good old days when everyone could issue scrip and no one was obligated to accept it? Talk about a boom and bust currency. Or perhaps a hard money policy? There isn't enough gold and silver on Earth to back the currency needed for a sane global economy, let alone what we have now.

@LB: Yes, price discovery is an archaic alchemy, but it's fundamental to the point of being taken for granted. People are now noticing because the comforting axioms we based our price discovery models on are proving, shall we say "weak"; what we thought was Chanel No. 5 is in fact Eau de Crappe. It's rather like waking up one morning to discover your house's foundation is just a figment of your imagination.

guidoamm said...

@ Knute - "You would perhaps prefer the good old days when everyone could issue scrip and no one was obligated to accept it? Talk about a boom and bust currency. Or perhaps a hard money policy? There isn't enough gold and silver on Earth to back the currency needed for a sane global economy, let alone what we have now."

The argument that "there is not enough gold or silver on earth to back the currency" is patently not true. All that happens is that the underlying is revalued or devalued with the ebb and flow of the economy; the old time preference trick. But without necessarily going to gold and silver, all that is needed is to eliminate the privilege to create unlimited currency from an entity that stands outside of society. In the current set up, the diminishing marginal utility of debt guarantees an asymmetric advantage to the creator of the currency whom ends up concentrating all profits.

Knute Rife said...

@guidoamm
1. No, it is patently true there isn't enough metal to go around. How much outstanding gold and silver do you think there is? It doesn't match outstanding cash flow, let alone adding in commercial and industrial uses for the metals. I have yet to see one of you bullion bugs show evidence to the contrary, unless you include exchange-traded bullion, which is bogus.

2. All banks used to be able to issue currency. It was a mess. Now the sovereigns have pulled that power in. However Randbots may wish to misinterpret the monetary system, banks don't create money, sovereigns do, then they book it into the private system using the budget and banks and bring it back in through the revenue code. It's why having a sovereign currency matters.ivestsp 1

Richard Field said...

Knute,

High speed trading has not rendered the transparency model of regulation a farce.

First, the model is not just limited to trading. It extends to when and what banks/structured finance securities should have to disclose to all market participants.

Second, the fact that high speed trading distorts the market is a positive finding from the transparency model of regulation. It is positive in that it suggests high speed trading should be banned.

Charles Butler said...

Sean - I'm a tad late here. but the cajas, at least the ones in the headlines, were never mutuals. They were/are not-for-profit charities. There's a very small and totally distinct sector (maybe 2% of total banking assets) known as 'cajas rurales', which sprung from agricultural and fishing co-ops. which are depositor owned. Hands down, they are the ones that have had the fewest problems arising from the real estate bubble - even including normal banks in the comparison.

S Roche said...

LB,

Thank you, could you please comment on the likelihood and the consequences of gold being accepted as a Tier 1 asset with zero risk rating, as is presently being contemplated on both sides of The Pond.

Supplemental question: "gold" would be gold & gold receivables presumably?

All the best,

SR

guidoamm said...

@ Knute Rife

I reiterate; there is no need to go to a gold standard.

That said, the scarcity of gold is exactly what constrains government from devaluing the currency for expedient political ends.

There is absolutely no need to expand the monetary base other than some modest amount occasionally. Under a gold standard, if the sovereign wished to expand the money supply for whatever reason (and the reason should be submitted to the people for ratification) then said sovereign either employs people and machinery in order to locate, extract, convey, refine and distribute gold or it would have to produce goods to trade in order to accumulate gold. Either way, expanding the money supply would foster economic activity and capital formation.

There cannot be a situation where there is not enough physical gold to satisfy monetary demand. If gold should be in great demand (i.e. if money should be in great demand according to the time preference of economic actors) then an ounce of gold would increase in price. Also, industrial use destroys only a fraction of mined gold. Most of the gold ever mined is still in existence.

Regarding banks, I stand corrected. It is not "banks" that create money. It is the commercial banks and the Primary Dealers that do so.

Fractional Reserve banking most certainly creates money supply. The crucial difference is that at 10% reserve requirement, 90% of the created money supply is "fiduciary media" - i.e. it is money that has not been requested by the sovereign.

By extension, the newly created fiduciary media does not enter the economy evenly and simultaneously. Thus, as this process is carried out permanently and aggressively, the farther away you are from the creator of the currency, the weaker is the purchasing power of the currency when it finally reaches you.

No need to call people names mate. We are here to debate. Keep it civil and we'll all get along just fine.

Anonymous said...

It might seem over simplistic but if existing regulations are not adhered to and no one is brought to book, why would further legislation stem the tide of greed? Legislation without enforcement is pointless.

What is worse is that our bankers have now learnt that they can operate illegaly with little more than a slap on the wrist. A little public humiliation is nothing and soon forgotten in the glittery face of mega wealth.

While we look for govenrments to enforce laws, what are we doing to motivate them. To let them see that as the voting public we demand they enforce our legislated ethics.

How many domestic Barclays clients closed their accounts, how many small businesses transferred their accounts to other banks, how many big companies severed thier ties with the lies?

The truth is, no one wants the bank to fail. It is one of our foundations and rattling it appears sucidial.

We need to sharpen the stick of justice and bring to book people, people responsible for committing the infringements, as well as those who have stood by and allowed what amounts to crimes against humanity.

The collapse of our economic system is not being perpetuated by institutions it is being perpetuated by extremely greedy people with no guiding ethics!

The system undoubtably needs a complete overhaul but in the meantime we need to lobby for personal accountability.

Anonymous said...

It might seem over simplistic but if existing regulations are not adhered to and no one is brought to book, why would further legislation stem the tide of greed? Legislation without enforcement is pointless.

What is worse is that our bankers have now learnt that they can operate illegaly with little more than a slap on the wrist. A little public humiliation is nothing and soon forgotten in the glittery face of mega wealth.

While we look for govenrments to enforce laws, what are we doing to motivate them. To let them see that as the voting public we demand they enforce our legislated ethics.

How many domestic Barclays clients closed their accounts, how many small businesses transferred their accounts to other banks, how many big companies severed thier ties with the lies?

The truth is, no one wants the bank to fail. It is one of our foundations and rattling it appears sucidial.

We need to sharpen the stick of justice and bring to book people, people responsible for committing the infringements, as well as those who have stood by and allowed what amounts to crimes against humanity.

The collapse of our economic system is not being perpetuated by institutions it is being perpetuated by extremely greedy people with no guiding ethics!

The system undoubtably needs a complete overhaul but in the meantime we need to lobby for personal accountability.

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