What’s your Futures Market Marked to?

What do you get when three banks are fined over $2 billion for rigging the Libor rate to make money on derivatives? The British government practically gives it away to The NYSE for the cost of a small cup of coffee. Now, futures exchange ICE will own NYSE Euronext later this year in a $10 Billion deal, and here’s where things get interesting. You see, ICE is a direct competitor with the CME in interest rate futures tied to Libor, and the CME just happens to have their biggest product (Eurodollar futures) benchmarked to LIBOR. I don’t imagine they like the idea of their biggest product line now somewhat controlled by a rival.

For their part, NYSE Euronext is promising their intentions are noble, with Finbarr Hutcheson, chief executive officer of Liffe, saying in an interview with Bloomberg:

“Our primary focus is restoring the credibility and integrity of Libor, which we think will be an important benchmark for years to come,” Hutcheson said in an interview yesterday. “We’ll run it as a commercial business, but our role in restoring the market’s trust in Libor is our biggest concern.”

But this is still a little like Pepsi buying the safe that contains the Coca Cola secret recipe, promising not to look in it – but just keeping an eye on it to make sure nothing happens to it. The bigger problem here – is the sanctity of futures markets tied to LIBOR, in our opinion, and the CFTC echoed those comments:

“Benchmarks such as it [Libor] and Euribor that are based on banks’ estimates are “unsustainable” and should be replaced with alternatives based on real data.”

Gensler hit the head on the nail (for once.) The growth of futures markets has grown substantially over the years, moving beyond futures markets on ‘commodities’ like Milk, Swiss Francs, and Corn – to futures on indices like the S&P 500, German Dax – to futures on reported indices like Libor, housing, and more. It strikes us as a real issue if the banks controlling the benchmark which derivative prices are based on, can also trade and profit from changes in the price of those derivatives. There’s more than one reason we hear of banks having perfect trading record in a quarter.

We’ll see what the effect on CME volume for interest rate futures based on LIBOR are in the future, but we suspect it will be muted and this will all likely pass over soon with Libor and Libor futures returning to the back pages of the news. Or in the annual statement of those with adjustable rate mortgages tied to LIBOR,  which became a common benchmark, in America, it turns out, as a result of the banks packaging mortgages together and selling to unsuspecting German banks, according to the Guardian:

Less than ten years ago, if a Wall Street trader wanted to find a sucker to buy bad mortgages, he knew where to find him: often, sitting in an office in a German landesbank in a small city, looking for a risky bets that would make him a killing.

The German network of savings and loans – 2,000 state-backed banks, fattened over time by Germans saving around 12% of their income a year – were designed to make loans to local businesses. But starting around 2004, they started following the same dangerous path as the the tiny US savings and loans companies in the 1990s, which gorged on mortgage lending.

The investment managers at the German landesbanks, usually unsophisticated compared to their sharper cousins in London and New York, became reliable buyers for risky, complicated mortgage derivatives. In fact, the Germans landesbanks and other foreign investors wanted to gobble up so many mortgage-backed securities that the American banks bundling the mortgage mortgages started pandering to them: many adjustable-rate mortgages in the US, designed for overseas buyers, newly had their interest rates set to Libor, the European interest rate, as that made it easier for the European buyers of the bundled US mortgages.”


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