Rigging LIBOR or EURIBOR Macroeconomic Implications / asymptotix
In the midst of this LIBOR / EURIBOR scandal I thought I would share some references to LIBOR & its role in world capital markets from asymptotix. One would not generally reference LIBOR or EURIBOR explicitly since that would be far too arcane even for us!! Most of my references to LIBOR are in “asymptotix papers” which are long pdf documents; developed with the sole purpose of boring you to death!
About this running LIBOR rigging story, unravelling this weekend; a ‘friend’ said
“What they've caught onto is barely the tip of the iceberg. Eventually, the part below the surface might be revealed...”
Why are LIBOR & EURIBOR so important? They are the foundations, the technical-basis of the TERM STRUCTURE of interest rates; a crucial concept in Macroeconomics (& in banking risk management); in summary the 'term structure' is the PIVOT between MONEY & (real economic) ACTIVITY. LIBOR (or EURIBOR for Euro demoninated transactions) is the base, the lowest value of the 'term structure' vector (what is sometimes called the 'ratchet'). The technical phrase ‘Yield Curve’ can be used interchangeably with ‘Term Structure’. I give some colorful articulation of that relationship between Monetary conditions and the real economy in the references here on this page (but particularly in the paper below);-
If you think about the game theories of the Capital Markets for any length of time you realise that its all about optimizing several equations; all variants of the yield curve. The (yield curve) equation has an expectational and an idiosyncratic factor, the rest of it is your orthogonal estimation of risk appetite; it is a 'Factor Model'. This is Principal Components Analysis or "Peering into theTail" of risk. The Supervisor / Banker debate is about the Principal Components in the Extreme of the risk of an institution. The term structure guides the banker is pricing the risk of the client. It all pivots off the Yield on the Securities of the Monetary Authorities of your (DOMESTIC) currency (Government Securities, the base rate); from that value in the end LIBOR is arrived at; the idea of the unbreakable link between the Sovereign and the Bank. Risk is priced off the schedule of rates at increasing terms from instantaneous LIBOR to 10 year 'duration' & beyond. Thus any institution-specific risk appetite or operating risk profile (or any type of 'Reaction Function') can be cloned from the Yield Curve (i.e. the Term Structure) since that vector expresses the markets' perception of Risk. LIBOR or EURIBOR are the lowest common denominator of that vector for the banking institution.
LIBOR rigging is in effect ripping-off the government or the client by the bank. Ripping off the government becasue central Bank strategies like QE (or LTRO) [now, so familiar but historically very unusual] are expedited through financial markets by a process called “Round Tripping”; which incentivises financial institutions to expedite the policy since the margin (to the bank) on participating in 'Round Tripping' is essentially an interest rate-differential between the short and the long end of the ‘term structure’ of which LIBOR and EURIBOR are the short basis. I give a reasonable account of that process here;-
My initial exposition of ‘Round Tripping’ as it relates to ‘Crowding Out’ is given in the reference below. This is pre-QE or LTRO & illustrates the ‘carry trade’ or ‘circular trading’ [of Round Tripping] in a low-yield environment where issuance of government securities is dominant (i.e. more normal economic circumstances than the total economic sclerosis of now);-
.. so the logic above is applicable in a pre-QE / pre-LTRO context & is revealed by the arrival of ‘Crowding out’ (driven by the volume of government securities issuance to mitigate crisis); which I describe here;-
In my description of the trigger point of this Crisis which is in the winter of 2007; I describe how LIBOR and EURIBOR spreads indicated crisis arrival;
"The key measure of risk in the banking system (is) the spread of LIBOR and EURIBOR over the comparable index swap rate”
In this essay (link below) I set out the sequential dynamics of how financial market crisis reveals itself and what the authorities do to manage that (& indeed what impact authorities’ Reaction Functions’ actually have); this is the winter 2007 period of the arrival of the current crisis. You can see in this exposition, the Central Banks 'reacting' to market crisis with 'Open Market Operations' to impact LIBOR. OMO-style reactions by Central Authorities can be regarded in a context such as winter 2007 as QE-lite or LTRO-lite, almost 'normal' Central Authorities' Reaction Functions targetted upon key policy variables such as LIBOR;-
So, returning to the present (but attempting to use the past as a model!) we can see that LIBOR rigging is in effect ripping-off QE since the margin on 'Round Tripping' is a rate-differential! Rigging EURIBOR in London means that banks were also screwing with LTRO thus there is an EU dimension and the ECB will not be happy alongside ‘Spanker’ Mervyn . That is borne out by an announcement from Commissioner Almunia. EURIBOR rigging in London would mess up the ECB SMP (Securities Markets Programme [a variant of OMO]) which works in the same way as QE or LTRO through the rate differential & the money stock rebalance which that differential is intended to incentivise. To understand that mechanism see the refs above or papers below; as I have said before;-
“One has to take some regard of the challenges of "Kapital"; its function in society, its inherent drivers, the subtle differences in how it morphs along the liquidity spectrum and the complex interlinked signals which it sends through that wireless network [ REFERENCE ]. “
The Bottom Line is ripping off QE by LIBOR-rigging is sheer greed since QE (or LTRO) is free money (as an incentive) to Capital Market participants to expedite a Government Policy target to benefit all citizens i.e. rescue the Monetary Transmission Mechanism (ibid); in that context LIBOR rigging is grabbing MORE when you are already being “handed it on a plate”! But QE or LTRO is Central authorities' money; i.e. your and mine! This single page on asymptotix gives a brief overview of where LIBOR gaming may have impacted the crisis process in general; what the touch-points are;-
My (more formal, published, presented etc) discussions of LIBOR / EURIBOR, the transmission mechanism (of monetary policy) & detailed discussions of impacts of LIBOR or EURIBOR on credit pricing and securities pricing in general are here ( I am referencing, now only those papers not referenced above);-
In Conclusion ....
... everything is priced off LIBOR in the UK and EURIBOR in Europe. This rigging scandal has implications throughout the whole economic system. Maybe the crisis incentivised gaming LIBOR since it seems to have occurred during the OMO response to the first crisis signs of the winter of 2007 but it continued during QE at least & possibly during LTRO. Maybe these emergency measures just laid this kind of activity bare, who knows? I am sure over the months we are going to find out. Either way this LIBOR / EURIBOR rigging thing is going to loose London one helluva lot of money medium term - so much as to make any fine seem tiny! London FICC desks can ill-afford to loose fixed income business right now even though it wasn't profitable without the LIBOR rigging!! But in that tail lies an issue worth peering into; even when they could rig LIBOR, London Fixed Income desks have been loosing money 'hand over fist'; what kind of Risk Management and Trading Strategy 'thinking' has really been going on in those Canary Wharf towers?