EURIBOR RIGGING: the context & incentive. “lack of understanding is absolutely no excuse”
In December 2008 financial market liquidity (in Europe) disappeared altogether, vanished according to the ECB FSR June 2010 . For monetarists like me this massive disappearance precedes & probably causes the massive GNP collapse of 3 quarters later; visually the 2 collapses have close to identical shapes. Thru 08,10 the ECB maintained the euro financial systeme on Life Support, no question, the EZ was in the ITU it was being kept alive by the ECB-machine; pumping LTRO-lite, MRO & OMO through the systeme!
Most of the write off decisions on impaired asset collections known as toxic debt (remember that?) were going on at the time (mandated by the European Commission) & state aid was being pumped into the banks (facilitated in Europe, with conditions, particularly in the UK; by the European Commission). Bank profits and particularly investment bank fixed income trading profits were not only in free fall they were rushing ‘like snow off a dyke’ into massive losses!
EURIBOR, like LIBOR, in and of itself is a meaningless price, it only becomes important in relation to something else or as the pivot of the ratchet of longer duration interest rates, as I have said before, I know ad nauseam! The Central banks monitor the spread of EURIBOR (interchangeable with LIBOR for the purposes of this discussion); with the OIS (the Overnight Index Swap); which is an index of the swap price of interbank short duration notes implicit in which is a price or interest rate. As that swap differential with EURIBOR (the spread) escalates Interbank stress is indicated since something is indicated being ‘out of whack’ about the way the banks view each others’ credit worthiness. In the interbank game each bank is using a mathematical reaction function of ach other bank to price the respective credit worthiness of the counterparty bank. This is paradigmatic Rational Expectations heuristics in an almost perfect game-theoretic context. If the EURIBOR/OIS spread increases (whatever the base values of either EURIBOR or OIS are) then that indicates that the banks themselves are paranoid about at least one of their member, one of the participants in their game. This makes the Central Bank really twitchy!
But there is another complex exogenous factor set which influences the EURIBOR/OIS spread to go completely haywire! Any liquidity provision by the Central Bank, any Open Market Operations; called MRO or QE or LTRO (at this point [in ’09, ‘10] they are being conducted in ‘.LITE’ variants) influences the LIBOR/OIS spread. You have to understand that any bank which either cannot acquire funds in the EURIBOR market or cannot afford the set EURIBOR is forced to go to the Central Bank and effectively triggers OMO on a demand pull basis (gettit?).
The root cause of the interbank paranoia in the EURIBOR market in ‘09/’10 was the sovereign bond market in Euroland going berserk! Sovereign Bonds constitute much of the asset side of the European banking systeme. During this period for the first time in modern history sovereign paper under attack from ‘bond vigilantes’ skeptical about government statistics and European Central Authorities comprehension of the scale of the crisis; became no longer risk free & sovereign yields were rocketing skyward indicating potential default of a euro-sovereign and turning European bank balance sheets to mush.
So you have it, the context to incentivise Fixed Income trading desks (most all of which are in London); making losses in the context of total Armageddon; to start to behave in a criminally disruptive manner; the environment was ‘all bets are off’; ‘this is the end of the world as we know it’ (sing along)! More seriously the opportunity to rig LIBOR or EURIBOR is a creature of OMO or QE or LTRO; it occurs in a context of crisis where Central Authorities have lost control of the capital market transmission mechanism! Rigging is not a feature of normal conditions.
Through ’09 & ’10 in parallel with the massive write down process in European banks; sovereign bond markets became completely illiquid. European Central authorities OTHER THAN THE ECB simply failed to grasp the significance of the context. Indeed Hermann van Rompuy (President of the European Council) opened the ECOFIN meeting of June 17th 2010 with the immortal line;
As we can see there is an absence of any sign of crisis at this moment, so I hope we can look forward to meeting in a relaxed and comfortable context
…or words to that effect [see ‘ANTCI’ for verbatim]. It is well known that this lack of sensibility at the apex of EU decision making was the subject of much heated banging of heads attempts by the ECB in Brussels; although I just cannot envisage Trichet shouting at all, can you? This sort of wider context for EURIBOR rigging reflects analytic thinking we have developed here on asymptotix in our series called LUNATIX Sovereign paper market failure began to erode the monetary transmission mechanism by spreading contagiously to interbank markets and senior European Political leaders did not see it. The ECB had seen it coming for months and warned in public as the Commission eroded its macroprudential role with the ESRB (but that is another story)!
The problem of this context for Rigging can be interpreted in the ‘baby language’ of Barosso and Van Rompuy as the Investment Bank or Hedge Fund ‘hounds of hell’ bond vigilantes wrecking the world or it can be interpreted as Political Leaders being so stupid or running an alternate political agenda but not Rationally; getting mugged simply because they left themselves wide open to it? Who behaved worse? Who had the political authority and the moral obligation, is the question I would ask; in my view, lack of understanding is absolutely no excuse.