[Transcript Follows]
When people angrily shout about the finance industry; “It’s not real! They’re just moving numbers around on paper!” Probably the best example that comes to mind is the derivatives market. Warren Buffet famously called them “a financial weapon of mass destruction”, and a bunch of angry autistic men in suits use them to steal a little bit of money from just about everyone on Earth.
There are two types of derivatives, but the one we’re concerned with right now is the over-the-counter derivatives market. It’s the one associated with what you’re familiar about on the news for the 2008 financial crisis; credit default swaps are an over-the-counter derivative.
Derivatives are pretty important. They’re usually a form of insurance or price guarantee. A shipping company might buy an oil prices derivative whose value goes up with the price of oil, to offset their increased costs. Likewise, an oil company would take one in case the price went down, to offset their lost revenue. It’s part insurance, part gambling, where the banks that offer the derivatives play the role of the house, taking fees for setting the derivatives up.
Except a lot of derivatives sound more like: I bet you ten thousand dollars the difference between the Australian and American dollar is going to be worth three times the difference between the Australian and Canadian dollar in six months.
In the oil example, your shipping company didn’t bet on the price of oil. It bet on the price difference between the price of oil and their main currency, the Australian dollar. So maybe the price of oil went down, but not as much as the Australian dollar crashed. That protects them more specifically, because oil is import-only in Australia, so it’s more important than just betting directly on the price of oil itself.
I’m going to give you a number, first. 65 trillion, with twelve zeroes. 65 million millions. NASA helpfully suggests that to count that high would take 1 million, nine hundred and eighty seven thousand years.
It’s one of those numbers too big to comprehend. The human brain just starts breaking down at these numbers. But 65 trillion is about the GDP of the entire planet for a calendar year.
The over-the counter derivatives market was estimated at $700 trillion in 2011, around the time the LIBOR scandal took place. Over ten times the world’s entire annual gross domestic product.
And LIBOR? The London Interbank Offered Rate? It set the rates on half of it, or five times the world’s annual GDP.
The London Interbank Offered Rate was the lending rate banks set to lending money to each other, which is an important practice. Fractional Reserve Banking means that banks can lend out more money than they actually have, but only as a proportion of the money they do have. Say they have $10 in the vaults, they can give out $100 in loans – Around a 10% reserve being fairly common. As long as too many people don’t all try to collect their money at once — what’s called a ‘bank run’ — the bank stays solvent and can collect a lot more on loans than it actually has, but it’s got to stay within that limit for safety reasons. If that $10 disappears at once and the bank goes under, it takes that $100 worth of assets it was funding with it, as that value was basically founded on trust and happy thoughts.
So what happens when, say, an oil sheik tries to get a loan for $1,000 in this scenario? It’s more money than any bank is allowed to loan out, but the risk for it is very low. The banks can make a joint loan. But how do they work out what the interest rate should be, for lending the money to each other? You’d have to make some kind of meta interest rate.
This wasn’t a hypothetical, and was actually the origins of the LIBOR rate. Knockoffs soon formed, like HIBOR for Hong Kong Interbank Offered Rate, or TIBOR for the Tokyo Interbank Offered Rate, but the underlying principle in the same. It was an extremely useful metric, and its inception resulted in the explosion of the derivatives market in the 1970s.
See, a lot of financial derivatives are about loans, the cost of money and the perceived risk of lending. The reason so much of the derivatives market came under LIBOR was because it was a good meta-rate on a lot of these things. As a result, banks became the heaviest investors in the derivatives market, now that they had an effective tool to measure and bet on it. While initially as a tool for risk management — like the example above of the shipping company and the oil company — banks began to take on a lot of risk — that is, they were gambles.
The derivatives market is, in a sense, kind of like playing on a non-euclidean roulette wheel, where up and down is red and black. It doesn’t matter which way it goes, as long as you bet correctly. And for everyone who wins, the money has to come from someone who loses.
That also means that if someone knew ahead of time whether LIBOR was going to go up or down, they could place bets on the value of that $350 trillion dollar market.
To understand just how staggering the numbers we’re talking about here, if you could adjust the LIBOR rate just a tenth of a percent in either direction, which might be daily, you’d shifted the market some three hundred and fifty million in value.
So, who set the various IBORs?
The banks, actually.
Yes, really. The banks, the heaviest investors in the derivatives market, also set the interest rate which underpinned most of it.
LIBOR was set when each person at a major contributing bank that was approved for the group sent in their rates, daily. The highest value and lowest value was removed, and the rest were averaged out. Whatever the average was, was the rate.
Only it wasn’t actually checked. The submission process was unpoliced, unmonitored, worked on the trust system, was mostly given to some low-level schmuck as part of crossing-the-I’s and dotting-the-t’s. Meaning that, as long as the banks were friendly enough with each other, they could shift the entire market into more favourable positions and have plausible deniability. Usually we’re talking fractions of a percent… but tiny changes in impossibly large numbers are still large numbers.
In the non-euclidean roulette example, they’d figured out how to bump the table.
It is impossible to know how much they skimmed off the top of the global economy, but it is reasonable to put low estimates in the hundreds of millions, largely taken from insurance groups and pension funds, as well as small-time investors.
Traders fought for the right to have access to pension fund and small investors money, so-called “dumb money”.
So how did it happen? Well, a lot of it was centered in the City of London, which isn’t London. it’s a small city inside London. Essentially the City of London was an independent walled city that never got conquered, so the English monarchy made a non-aggression pact with it and operated around it. Eventually Westminster was built next to it, which became the London we know as London today, with the City of London being a sort of micronation within England’s borders, sort of similar to the Vatican in Italy.
The City of London is largely free to pick and choose many of the financial laws and regulations it wants to follow within its borders. As a result, it’s become the most wretched hive of suits and daiquiris this side of the galaxy. David Cameron praised it in a speech in 2006:
“The City is a great example of using our advantages.The City of London is a great UK success story. It’s the biggest international financial centre on earth.
The London foreign exchange market is the largest in the world, with an average daily turnover of $504 billion. That’s more than New York and Tokyo combined.”
Now, I’m going to read the rest of it, because I think it’s hilarious.
It is supremely meritocratic. It is also highly innovative. You cannot simply set in stone a tax or regulatory regime for the City as it is today because it’s always changing, adapting and mutating.
The lessons from the City are clear. Low tax. Low regulation. Meritocracy. Openness. Innovation. These are the keys to success.
The government is wedded to the impulse to over-regulate…While I see a much greater role for exhortation and leadership.
Many on the left-of-centre still seek to solve problems through more taxes, more laws and more regulations…But we, on the centre-right, prefer to step out of the way of business.
Gordon Brown, on the left, meanwhile in 2005:
“A risk based approach helps move us a million miles away from the old assumption – the assumption since the first legislation of Victorian times – that business, unregulated, will invariably act irresponsibly. The better view is that businesses want to act responsibly. Reputation with customers and investors is more important to behaviour than regulation, and transparency – backed up by the light touch – can be more effective than the heavy hand.”
The LIBOR fixing was occurring as these speeches occurred. It just hadn’t been caught yet, because there weren’t _effective _regulatory agencies capable of catching it. The light touch meant a blind eye.
So long as the banks were making more money in the City than anywhere else in the world, it didn’t matter how, or why.
The story of that collusion, though, is more stupid than anything else. We know from the investigations, from the emails and instant messages between traders, that the collusion was both rampant and often informal. A bunch of you-scratch-my-back favours between traders and bankers.
Sometimes this meant a banker telling a friend of theirs what the rate was likely to be in advance, and sometimes this meant a trader asking a banker to push it higher or lower.
Some messages:
‘It’s just amazing how Libor fixing can make you that much money or lose if opposite … It’s a cartel now in London’.
‘Yes, deffinite manipulation – always is tho to be honest mate . . . i always used to ask if anyone needed a favour and vice versa . . . a little unethical but always helps to have friends in mrkt’.
‘its just amazing how libor fixing can make you that much money’.
So I’m going to have to explain this one a little bit. The 6m refers to ‘6 months’, since there are different time frames interest rates can be set for. So this is the Swiss 6 month variable.
Swiss Franc Trader: ‘can u put 6m swiss libor in low pls?’
Primary Submitter: ‘NO’
Swiss Franc Trader: ‘should have pushed the door harder’
Primary Submitter: ‘Whats it worth’
Swiss Franc Trader: ‘ive got some sushi rolls from yesterday?’
Primary Submitter: ‘ok low 6m , just for u’.
Swiss Franc Trader: ‘if u did that i would come over there and make love to you your choice’
You just witnessed someone interfere with a market worth trillions of dollars for a pack of yesterday’s sushi. Be in awe.
A man named Colin Goodman would send out a routine email to many traders and brokers which had a LIBOR forecast, tables predicting what the LIBOR rates would be for the day. But because LIBOR setting was a task assigned to lower staffers of banks, he found that he had immense power to set the rate; Many bankers used his predictions to set what their rates were. Goodman could move a 350 trillion dollar market because of laziness.
Another important thing is to emphasize that it’s a swiss currency being altered, there, through the multinational banks that largely operated out of the City. International finance, the world economy, was mostly being subjected to national law enforcement and speculation.
The entire world hinged on England paying attention, but they were too busy being proud of their wilful ignorance because it was profitable to do so. Parr for the course, really.
With the stage set, and all the background information provided, we can finally get to our protagonist of the piece, Tom Hayes. Tom Hayes is the only man who would see jail time for the LIBOR fixing. Nobody who sent any of the emails or instant messages from before would personally catch a fine.
Tom Hayes was an angry autistic man in a suit who happened to steal a little bit of money from everyone on Earth. That is to say, he was a trader in the derivatives market, working with the Royal Bank of Scotland, then with the Royal Bank of Canada, then to UBS — a Swiss bank — where he moved to Tokyo, rejected a job offer at Goldman Sachs in 2008 and finally ended up at Citigroup in 2009 with a $3,000,000 dollar signing bonus, but he was dropped like a hot potato in 2010 when LIBOR started making news, and sent back home to England to face trial.
All of this is to say, while personally most everyone who knew him agreed he was an antisocial asshole — including Hayes himself — he was a very professionally popular one. Those were all headhunting promotions over 8 years, meaning all those banks were fighting over who got to have the legendary trader Tom Hayes at their desks.
Most notable is his time with UBS, which is when he started trading in Tokyo. Hayes was an expert in basis trading, one of the best in the world, and basis trading was specializing in derivatives regarding interest rates, like the difference between the Japanese and LIBOR rates. This is interesting because when he was sent to Tokyo to be their expert, the Tokyo rate was set to zero. There was very little reason to have a basis trader study the Japanese market…
So, while Hayes was stationed there, of course Japan reinstated interest rates. And because there hadn’t been a reason to have basis traders learn the nuances of the Japanese market before, suddenly Hayes was a very valuable individual.
In his rise, as in his fall, Hayes was found by the banks to be the right man, in the right place, at the right time for their needs.
He wasn’t the first. Much of Hayes behaviour and attitude was learned at UBS where another man, Kweku Abdoli, lost $2.3 billion dollars in what’s now known as the 2011 UBS rogue trader scandal. He had been using methods taught to him by management to hide just how much money his team had been losing, and to buy them some more time. He just dug his hole deeper, however, and he was sentenced to seven years in prison for fraud. UBS would also be hit with $47 million dollars in fines.
The prosecution painted Abdoli as a lone wolf and a singular bad actor, but his defense pleaded that Abdoli’s behaviour was a systemic problem. They pointed to emails where colleagues openly referred to what was going on. The jury didn’t believe he was just a scapegoat for the banks risk-heavy practices, it seems.
Two years later, Tom Hayes would be in court with his defense making the same pleas for his participation in LIBOR fixing: That he was a scapegoat for an industry-wide practice, so ubiquitous it would be performed as a favour for day-old sushi.
It had taken years for outside investigators to pay attention to LIBOR pricing and to lean on the big banks, forcing them to commit to internal investigations to see if they were criminally culpable, should they be caught. These internal investigations had been following Hayes from his years at UBS, and they finally caught up to him while working at Citi. He made them millions in the few months that he worked there, but still found himself in a meeting with senior management presenting him with a letter of termination. He had not fully co-operated with their investigations into the matter, so the termination was punitive. It was to be without severance, but he could keep his $3 million signing bonus. They also wouldn’t tell his next employers about the circumstances of the dismissal.
And this is the moment that Hayes becomes the protagonist of this story. He told management that he had never been told that he was breaking any rules. That they were informed over daily meetings exactly what he was doing. He was using the whistle-blower’s clause in his contract to point the finger at two such managers.
When he had asked Citi’s higher ups about the investigations, they had repeatedly assured him not to worry. One of its executives, Hayes’ senior Chris Cecere, had openly condoned the activity, but when Hayes and his colleague Hosino had asked about its legal nature, Cecere told them both to talk about it in person or over mobile, instead of through the messaging systems, “so nothing is lost in translation over e-mail.”
Hoshino quickly realized that was because the company emails were saved and monitored, but the calls were not, and took that as a condemnation of the practice. Hayes, who was more literal-minded, had not. If it was wrong, his boss would have told him in as many words, surely?
So, when these same executives fired him for practices they’d reassured him on, Hayes took it… poorly.
Cecere was asked by the bank to resign, and _he _was pissed as well. He contacted UBS, having found out that it was one of Hayes previous managers that was digging dirt at him, and informed the bank that by-the-by, Hayes had been doing the same thing under that manager’s supervision, as much as he was trying to hang the millstone around Tom Hayes neck. UBS was complicit in these same crimes that the US and British governments were now investigating.
UBS reacted immediately. It had been forced by the US Commodity Futures Trading Commission, the CFTC, to hire an outside law firm, Allen & Overy, to look into LIBOR fixing. Instead, UBS put senior manager Michael Pieri in charge of the investigation… the senior manager that Cecere was implicating.
The US government was eager to charge bankers with some crime, any crime at this point. The 2008 crisis was fresh in the public’s mind and faith in their regulators at an all time low. A man named Harry Markopolos had just testified that the SEC “roared like a mouse, and bit like a flea” — we’ll talk about him next week. The LIBOR fixing was becoming more and more evident on the world stage.
The British were failing to regulate their City, that much was obvious. The US had made UBS at least pretend to co-operate by now, and Tom Hayes’ name had come up in their searches. He hadn’t been a major figure, though, until Cecere’s tipoff had brought him to the fore again. Now the CFTC saw his aspergers as making him vulnerable to being flipped to turn informant.
The US investigations had implications that the banks couldn’t ignore. Their own investigations to their liability would see them suspending and cutting ties with many of the people who would also see trial, but not be charged, for fraud.
In 2012, after the first reports of Hayes had been making newspaper headlines, he got himself a lawyer. His one biggest fear was being extradited to the United States. It meant US courts, US sentencing and a US prison if that were to occur.
But the focus on Hayes meant that all his old colleagues, even Cecere, were perfectly happy to downplay their own roles in the fixing by pinning it on Hayes, painting him as a criminal mastermind, Cecere referring to the whole thing as his ‘spiders network’.
The banks themselves were also happy to pin it on Tom Hayes. They could blame the criminal activity as the result of a few bad actors, and absolve themselves of any liability at a systemic level, at a managerial level. As a result of all this testimony from his many colleagues refusing to admit responsibility for anything, and a financial crime that was so hard to understand — let alone prove — Hayes was charged by the US along with Roger Darin, his old colleague at UBS.
UBS is a Swiss bank, and Roger Darin a Swiss resident. Switzerland is not an extradition country. Darin would be charged and sentenced in US courts, but his only punishment is that he cannot leave Switzerland’s borders. Tom Hayes, in the UK, did not have that luxury, did not have that out.
Hayes sought out David Bermingham, an investment banker who had been extradited to the US for his role in Enron, for advice. Bermingham encouraged Hayes to throw himself at the comparative mercy of the British courts. Bermingham had even tried to sue the British courts to charge him, unsuccessfully.
Tom Hayes would turn whistleblower, then, in exchange for a twenty month sentence. The Serious Fraud Office took him in, interviewed him, saw the potential of him as an insider to break the case. Hayes provided hours of testimony, admitting to his part in the broad, system-wide issue. He emphasized that he truly believed that, while he personally acted dishonestly, he wasn’t doing anything wrong. There was no hard and fast rule to what the exact basis point had to be, so why not ask for it to be ‘close enough’ where you wanted it?
At this point, Hayes was informed by the SFO that the banks were giving instructions to their LIBOR submitters. One of the reasons Hayes was singled out was because he had to work through Roger Darin to get his LIBOR shifts, creating a documentation chain from emails and messages. Other banks bypassed this entirely. In Hayes words, it was blatant.
After a few days of these interrogations, Hayes was formally charged by the SFO with eight counts of conspiracy to defraud. Unlike the original draft documents shown to him, which listed many of the people he was implicating, the charges had been laid against only him. But this meant that he would not be extradited to the US: The important win.
But these charges against him, his treatment by the SFO, his emotional state… Hayes committed to pleading not guilty. The SFO now had 82 hours worth of recorded interviews with him, but Hayes knew that at UBS he had received countless emails with instructions from higher-ups to push LIBOR up and down. He couldn’t have known he was doing anything wrong, he’d been told and even ordered otherwise.
The SFO had never asked UBS to hand over its documentation. UBS withheld the material. If Hayes hadn’t co-operated with the SFO so completely, they might have had to follow through. In fact, so sure were the SFO with Hayes co-operation, they’d rather failed to do any further investigation. They’d even turned down other requests to co-operate from people who were also desperate to be tried in the UK, and not the US.
Tom Hayes plead not guilty, because he felt the weight of too many knives hanging from his back, and he wanted to have his day in court. He had been manipulated, and he had now been given proof of that manipulation. His Defense also hired a pscyhologist to provide a diagnosis of his Asperger’s syndrome:
Mr Hayes does not perceive the world as people without Asperger’s Syndrome do…. It is consistent with a diagnosis of AS that if manipulation of Libor existed both before and after Mr Hayes’ employment in the market, then he is likely to have simply regarded it as acceptable practice…. People without AS might recognise the moral grey area of this line of work and might appreciate that excelling in this area would make them vulnerable…. In order to function he appears to have needed to believe that his bosses are right because they set the rules. This is a feature of AS. It is also likely to have made him vulnerable to exploitation.
I just want to repeat that: It is also likely to have made him vulnerable to exploitation. That hadn’t just been true of LIBOR fixing, it was true of his trial.
There were too many people that needed Thomas Hayes arrested, not just the SFO. The governments of the world needed to look like they were doing something to keep the finance industry in check, and the finance industry really needed to show that wasn’t necessary. Tom Hayes trial filled both those needs. Proof that bad actors could be arrested while still denying any broad, systemic problems.
But for all the damage that LIBOR manipulation did to the economy — again, the numbers I can find on it suppose $172 billion — of Hayes 45,407 transactions between 2006 and 2010, all but 47 had been with other major banks, who were also in the LIBOR fixing racket. Irreparable damage to pension funds and small investors had been done globally, but the only man who went to prison had not been the one to collect on them.
He was assigned Sir Jeremy Cooke to judge his case, a man famous for sentencing a woman to eight years in prison for performing her own late-term abortion, a man who openly referred to the case as ‘open and shut’ before the trial. He made it clear that, should Hayes be convicted, he would give the harshest sentence possible, to set a warning to those in the financial industry. Appeals by the defense for Cooke to be refused would be overturned.
Tom Hayes was sentenced to fourteen years of prison, the longest ever given to a white collar criminal in the UK, longer than many murderers. His appeals would only succeed in getting three years removed from his sentence, deemed ‘too harsh’.
Everyone else in his ‘spider network’ would go free. While six would stand trial, many more would still be employed, pulling six-or-seven figure salaries at hedge funds. Many of the executives of UBS, of Citigroup, who had encouraged and guided Hayes actions would remain in their positions. Many would be promoted.
These crimes continue mostly uninvestigated and unimpeded, and we are sleepwalking to the next disaster, barely able to keep our eyes open no matter how many times we are sent tumbling down a flight of stairs for our societal inattention.
To be blunt, the SFO was wholly incompetent. Many of their interviews and interrogations would only be held after trials were already underway. They had failed to prevent the threat, and they had failed to follow through on prosecuting the aftermath.
This is because they did not and do not exist to regulate these kinds of white collar crimes. They exist to show the public that something is being done while being denied the resources, staffing or legislature that would allow them to perform their role. This has been by design.
The United States, which Hayes feared so much, is similarly afflicted by this intentional gutting of any safeguards preventing high finance from doing what they will.
The final part of this trilogy, “Why Wouldn’t They Listen?”, focuses on Quant. Harry Markopolos decade long struggle to get somebody, anybody, to intervene in a $65 billion dollar Ponzi scheme. How even a brilliant, honest, ruthlessly determined man with all the evidence is still unable to get our regulators to act.