The demise of over-the-counter trading

As the US Department of Justice opens a criminal probe into the setting of Libor rates, is this the beginning of the end of shady, illiquid and highly profitable trades that banks make between themselves?
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Trading is set to move on to exchanges — sooner or later
<div style="text-align: left;"> Trading is set to move on to exchanges — sooner or later </div>

It is not really surprising that the US Department of Justice has opened a criminal probe into the setting of Libor rates by banks around the world. It is not really surprising that regulators have shown a remarkable level of collaboration when investigating this, with gumshoes from Japan, the UK and Canada teaming up with their US counterparts to get to the bottom of what has happened. It is not even that surprising that the scandal came to light because of a whistleblower at one of the most beleaguered of the big banks — UBS.

What is most surprising is that in today’s world, an interest rate — on which by some estimates $350 trillion worth of securities are priced — is still set by a handpicked committee of the self-interested.

The way that Libor is set is not just antediluvian — it is prelapsarian. The distinction in Christian thought is that antediluvian came before Noah’s flood, but the prelapsarian came before man’s fall from the Garden of Eden. The distinction is key. That regulators and the markets should think that 16 banks could come together each day and set the main global interest rates without any kind of self-serving shenanigans is wilfully blind. It stems from a time when perhaps we assumed that such things could be clear, above board and not held hostage to the imperatives of a trading desk. An Eden perhaps; a nirvana certainly.

One of the certainties of the three-and-a-half-year-old global financial crisis is that such dark and shady corners of the global financial system will be brought blinking into the light, like so many bugs scurrying beneath an up-turned stone. It may not be pretty.

This is not to say that over-the-counter (OTC) trading necessarily caused the crisis, but, in terms of working out who would be affected, it has certainly made it worse. For instance, between now and March 8, the Isda committee is meeting in conclave to decide whether or not Greece has defaulted and therefore whether or not Greek credit default swaps (CDS) will be triggered. This decision is made more difficult than it need be because we have no way of actually knowing who owns what by way of Greek CDS — or more importantly who has written them.

OTC derivatives and securities trading have always served a purpose — mainly to enrich the desk writing the contracts. Jes Staley, J.P. Morgan’s global head of investment banking, let slip yesterday at the bank’s annual investor day that it makes about $30,000 a trade on equity options and swaps, and $12,000 a trade on OTC interest-rate swaps. It is the bank’s most profitable business.

Almost all of these instruments can and will find their way onto exchanges sooner or later. The fact that they haven’t already is purely due to naked self-interest. It has long been a source of mild amusement in Hong Kong, Singapore, Tokyo and London how much money the interdealer broker community make by linking up buyers and sellers of illiquid bonds. Why do traders still use them rather than migrate their business to the screen-based products that have come and gone over the years, such as bondsinasia. The answer is very simple: computers don’t have expense accounts and don’t keep Wanchai/Boat Quay/Roppongi/Mayfair rocking into the small hours every Thursday night.

But the days of OTC markets are coming to an end. The market simply cannot allow it to continue and the regulators — for once — appear to be acting in the interests of the greater good. Getting Libor to become a properly market-derived interest rate will be a very good start. The rest will follow. And the logical conclusion to all this? Ten years from now, perhaps newly minted MBA grads will be applying for jobs in clearing rather than trading. Although I suspect that that is very prelapsarian thinking.

¬ Haymarket Media Limited. All rights reserved.
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