Hello, and welcome to another edition of the ad Thoughts Podcast.

I'm Tracy Alloway and I'm Joe Wisenthal.

Joe, do you remember Libor?

I think I remember that, Yes I do.

That's totally a loaded question.

Libor the London Interbank offered rate, basically the rate at which banks lend money to each other.

It was a big librar scandal, right, yeah, I mean there there's so much you could say about libor.

So it became a big deal during the Financial crisis because the rate blew out because basically all these banks didn't want to lend money to each other, so they had to offer a higher rate in order to do it.

And then after the financial crisis we found out that libor had been rigged in various ways.

And that's because the way libor actually works is it was done by hervey.

So someone would actually go to the banks and collect there are estimates of libor each day, and then they would come up with a sort of aggregate.

So it was a self reported rate that ended up being manipulated by some of the people that were reporting it.

I was so shocked when it turned out that it was manipulated.

Isn't the thing where they do the price literally called a fix.

Yeah, that's right, in retrose.

I can't believe that.

I can't believe that in retrospect something called the fix turned out to be manipulated.

I was.

I was totally stunned by that.

All right, we are all shocked, But I will tell you something that is actually shocking now.

Sort of.

We are all expecting Libor to be phased out at one point or another, um relatively soon actually, given what happened with the self reporting scheme, it's supposed to be replaced by something that hopefully won't be as subject to manipulation.

But just as Libor was about to be consigned to financial market history, it was about to die, right, it has come back from the dead effectively to haunt financial markets.

Oh I'm I'm intrigued.

Yes, So we are going to call this episode Revenge of the Libor, And we have the perfect person to talk about all this, not just what happened in two thousand eight and then during the Libor manipulation scandal, but also to discuss what's happening now and why people are once again discussing Libor.

Let's do it so, our guest for this episode is Scott Pyng.

He is the CEO of Advocate Capital Management, and he also used to be head of US interest rate strategy at City Group of Fact.

That will be relevant in just a few minutes.

Scott, thanks so much for coming on.

Thanks for having me guys.

So I'm so glad we could have you do this because you truly are the perfect person to talk about libor, because you were one of the first people, if not the first person, to actually point out that it looked like libor potentially was being manipulated in some ways.

That right, Yeah, And it's been a long and strange journey since that point.

And I would sort of contend with the statement that libor is dead because rumors of its death as well discuss are somewhat greatly exaggerated.

So, just to back up Tracy mentioned in the intro, libor being the rate that banks used to price short term lending to one another.

Just give us the sort of quick history of how this rate became a thing.

Sure, before I started the business in the eighties, the key short term rate was actually not liebor, was actually three month treasury bills.

Libel came along the mid eighties as a way to for a non US tom ossalled banks to obtain financing in the your dollar market UM and over time, with increased usage within with its center status in the middle of interest rate swaps, it took over UM the benchmark status from three month T bills and it's been the benchmark UM since the late eighties early nineties.

So that was really the genesis of LIBL And at some point maybe we'll have some time to touch back on that because I think going back to three months T bills may actually be a very useful thing in terms of considering librar replacements.

Yeah, we're definitely going to talk about library replacements UM, but before we do, just to set the scene, remind us what library looked like, you know, in two thousand and eight in the depths of the financial crisis, because we not only saw a librar blowout, we also measured library against o I s UM overnight index swaps basically a risk free rate of lending PEG to typically fed funds futures.

Walk us through the dynamics there.

Why did we see that spread blowout?

Well, the basic mechanics of libor back then was there were sixteen submission banks and the library setters, which is the British Banks Association, would take the four highest, four lowest, throw them out and average the rest, and that process was supposed to eliminate any attempt at collusion.

During the global financial crisis, bank funding costs started to rise and library did begin to rise.

However, because at that point libor rates um submitted by each bank was published on sources like Bloomberg, people could see when the bank was vulnerable because they could see its library submission start to rise.

And people began looking very carefully at these library submissions, and that creates an incentive on the part of many banks to begin to under count the actual financing rate.

And that really was, you know, the issue that we pointed out when we did our analysis on libor in April of two tho eight.

Can you explain a little bit that mechanism The banks submit numbers based on what and then they throw some out.

It sounds kind of like an Olympic scoring system of lopping off the edges.

But just walk us through that process a little bit more sure.

Banks are supposed to submit libor based on where they are financed, and typically the submission entity is supposed to be squared away in the middle of a bank's funding area.

Over time, some of those supposedly walled off people and ward off entities began to be influenced by other parts of the trading desk.

Very frequently, these submission entities and people sat on the same trading floor as traders who are taking positions on where library or interest rate swaps are.

So over time you started getting some influence from the traders we were market making and taking market positions, influencing the people who are actually setting the rates.

So there were two reasons to manipulate library, right, Like, on the one hand, you could potentially help your portfolio, your colleagues at the bank, you know, help the positions depending on where you shifted library.

But on the other hand, during the financial crisis, people were much more concerned about reputational risks, so typically they started under reporting the library rate because they didn't want to make it look like there was a huge interbank lending crunch and that they were getting the worst of it.

Is that right, right?

And you know, the more noble goal, if you will, is to make a bank appear stronger than it would be, And the more mundane goal would be for the traders to trying to profit on ongoing basis from these rate sets.

Now, when I published my article, um, we're not able to get access to sort of the day to day manipulations that men have been going on.

But what we could see is using publicly available data, we can start to see the discrepancy between where people are staying libboard verses where banks are actually funding.

So that really was the genesis of my analysis that you can uh find um, this discrepancy from publicly available market data.

So you said, there's theoretically two different sort of strains of library manipulation.

One would be designed to conceal the degree of vulnerability in the system overall, which because of self fulfilling prophecies, may in theoretically have been beneficial in some way.

And then the other is the more cynical manipulating the number so as to profit off of trades that are tied to the number.

How big was or is the market for instruments that are in some way connected to library I mean, libralar is tied into pretty much everything around us.

We're talking about hundreds of trillions of notionals of interest rate swaps that directly refer to libor.

On top of that, you have ank loans, student loans, mortgages that are all indexed to a great variety of lieborars.

So library is really an intricate part of our everyday lives.

So, Scott In, I think it was April two thou eight, you publish your report is Libor Broken?

What happened after that?

Did you get a lot of backlash?

I can't imagine.

UM your colleagues, even at City Bank potentially were were that enthused about it?

Yeah?

I mean we wrote on analysis, UM got sent out to clients and there was kind of radial silence for about a five day period, and then the Wellster Journal picked it up and was on the front page, and then all of a sudden, all hell broke loose.

So let's just say that I got called into quite a few meetings that day as a result of that.

Who was the most upset about it?

When you say all hell broke loose?

Where were you hearing that the most?

Um?

We heard that bb A wasn't happy with us.

We heard that UM management was not happy with us.

UM the good was I signed off on the article with my boss, Michael Schumacher of the same name as a race car driver prior to publications, so I knew he had my back, but there was a lot of political blowback from that because if you think about it, you know, again library is so central to everything, and not just finance but in the whole world that you know, calling the question was really a big deal.

So I want to move on to what librar is actually doing now and why we're all talking about it, But before we do, maybe just to sum up, after the financial crisis, we have an actual investigation into libor and how it was said.

What was the outcome of that investigation.

I think the outcome was that a great many of the banks who involved in liborar sets were were tainted in this submission um, whether it's on an ongoing basis or whether it's um infrequently, because of the influence of market makers and risk takers on the library submission side.

So I think the key results is that now we have a new administrator for libralar, we have banks who who have much clear policies in terms of the wall around the library centers, and hopefully when a bit of a better place.

I have one more question about library history before we move on.

You touched on the important point, and one of the reasons the story resonated so much is because it touches all of our lives, and so many of us have financial instruments that are in some way tied to library costs.

But why did that happen?

I mean, you mentioned there was an earlier benchmark, the three month treasury.

When you think about things like student loans or credit cards, it's not intuitive why the industry would start to price those off of bank lending rates as opposed to something a little more industry neutral.

I think if you look at bank assets and liabilities, the coevolution of that through time is part of what drove liborar's popularity.

Again, some of the old floating rate indu cries that banks used to use where things like prime or our CD rates.

But as libel kind of gained primacy in the drumatist market in the futures market, more banks decided to adopt libel as both as assets and liability indices.

And when you do that, you basically set policies to say, have a fixed floating funding mix, and the floating part of it is going to be directed towards the standard benchmark, which is libor likewise on the assets side.

Then as libel kind of becomes stand on liability side, the asset side is going to take live or as well as its mentionmark.

So again, increasingly, over time you had more and more bank products beginning to index the fillion rates off of libor.

Alright, so let's fast forward to today.

We went through the financial crisis, We went through this big libraar scandal.

At the end of the scandal, most people agreed that we were going to try to find a replacement for this rate uh something else that we could peg trillions of dollars worth of financial assets too.

We're going to talk about that effort in a second, but before we do, let's talk about the recent rise in library because of course, the thing has not been doing much for years and years and years, and we all kind of forgot about it, and then suddenly it's in the headlines once again.

Scott walk us through what's happening with the rise in library short Tracy.

Since the end of two thousand seventeen, we have seen libar, especially three month libel, which is the benchmark in library space, rise more than half a percent.

And this is in the absence of any Federal Reserve rate hike over that period, So that has obviously been of major concern to the market because of because everything is basically index off of libor.

So to me, I what I wanted to do was to us to look through UM strategistal analyst research to say, okay, what has been a driver of this?

And I was really not able to find it, So I basically had to do my own UM analysis and that really drove UM.

You know what we found out, which is that if you look at how much Libel has risen and you really try to attribute it into different sources, what we find is that about half of the rise came from the market pricing in UH future FED hikes only half, So that means the other half has to come from some other sources.

UM about two thirds of that is coming in analysis from increases in short term treasury will supply as the government UM is in the process of funding the tax reform.

But there is a there is a small but recognizable component of the Libel rise that is due to UH shifts in the credit market, which we identified as well.

Breakdown that that second half.

So it's easy enough to understand how you could figure out how much is attributable to expectations for an increase in Fed funds that um the other parts where you said part of it is short term treasury supply I guess, competing with inter bank lending, and also the slight change in credit perceptions of borrowers.

How did you sort of disambiguate those two aspects right?

You can.

You can think of library as a bunch of stacked lego bricks.

So at the bottom of that stack is the ristless rate.

How much the market is expecting uh FED funds rate to move, And we can find that out by looking at market predictions of three months oh i s overnight index swap, which is where markets pricing average three month FED funds.

That's the bottom stack, and we find that that's really about fifty eight percent of the Libel rise.

The next set of lego bricks is really actual securities, and the least risky securities in the three months sector is three month treasury bills.

So we looked at how much three months treasury blow yields have changed since the end of the year.

We found that it rose thirty seven basis points.

From that thirty seven basis points, you subtract the twenty four basis points the bottom stack of lego bricks that's from the three month oh I s and the residual the thirteen basis points we attribute to increased strategy bill supply.

And then the final piece of the puzzle is a difference between three month treasury yield and the most comparable instrument to three month libr in a market, which is ninety day commercial financial commercial paper rate, and that that difference contributed to the final eight basis points of the puzzle.

So this is actually the only analysis that I've seen attempt to quantify each of those aspects and their impact on library UM.

It's really good, But talk to us about the tax component of it, because I think for most listeners when they think about tax reform, they're not necessarily going to start thinking about what the impact is going to be on money markets.

Sure, and the impact of tax reform visa VI.

What we're talking about today is that as tax reform was enacted, obviously the companies that had a significant chunk of their overseas earnings UM left in overseas markets had a rake in terms of repatriation.

Now, a lot of these were already invested in dollar assets dollar short term masses such as a CP market, so there was no significant asset allocations shift from that repatriation.

However, what has been noted by industry sources such as Credit Swiss is that since the passage of tax reform, the CP market has seen significant shortening of the maturity stack.

So what we've seen is that the percentage of the CP market that is six weeks or shorter in credits research has risen from low fifties to mid s over that same period.

Now that may not seem very much, but it's a pretty substantial shift in terms of the sponsorship.

And my interpretation of what that means is that the cash rich companies such as a snail Apple, who have had that cash overseas, when they bring it back, they tend to want to keep it in shorter maturity paper because they're not necessarily sure what they're gonna do with it.

Perhaps they're going to be announcing some um some bonuses for workers, perhaps they're gonna start building another another headquarters, whatever that may be.

There is some policy uncertainty on the part of the company, and as a result, that's reflected in the stance of the tragedy department who are managing this cash flow.

Their stands would be, let's keep it shorter until we figure out what to do with it.

But spending it great, we don't have to do very much with it.

So they shortening in the maturity profile in the CP market um has has really been the big driver of this increased credit component of LIEB or So is this worrisome?

The numbers don't seem very big, and we're certainly not talking about anywhere near the scale we saw during the crisis or anything like that.

But how much anxiety should the increase, particularly in the credit component cause people.

But now it is not worrisome if you again, if you sum up the tragic bill component and the credit component, that adds up to roughly about bases points or roughly one FED hike.

So it's not that worrisome right now, maybe to the majority of the world, but to the FED that is an issue that they need to keep an eye on because if that component of libor continues to rise, then it has the impact of additional and intended FED hikes that will reduce liquidity in the marketplace over and beyond what the FED is doing.

Well, I was going to ask the consensus is that we shouldn't all freak out just yet.

But what does this say about the feds exit from monetary policy?

At the very least, it seems like it's a good example of how tricky it might be to actually tighten monetary policy and the number of things that the Central Bank is going to have to take into account, you know, like fiscal stuff such as tax reform.

It seems like you're asking a lot of them.

Yes, right, dude, that's absolutely right.

And what we are seeing with what is going on at CP market is that as the Fed is withdrawing its unprecedented liquidity, any additional shifts in liquidity provision is probably going to have an amplified effect in this environment.

So it's revenge of the Library.

But we shouldn't all, you know, panic just yet.

Scott, you mentioned earlier about attempts to find a replacement for Library and maybe sort of going back to the future and looking at what we used to use.

What is up for discussion and what do you think the best reference rate would actually be.

Sure Currently, the government has put forth an overnight rate called s o f R SOFA, which represents basically an arrogant where securitized borrowing takes place.

So typically, if you hold treasury bonds, you can pledge those bonds and borrow cash against that.

That's basically what this rate will reflect.

Now, this is a very front rate and its nature from libra or.

Libra or is supposed to represent UM a couple of things.

One is unsecuritized landing and second thing is obviously for longer than overnight rates.

So this proposal is really a very very different animal than LIBOR.

It is not meant to replace library.

Cannot replace librar because to attempt to do so would invite many, many different lawsuits on the part of at least half the market who would be disadvantaged by this.

Now, the issues I have with using rates like sofar are multipold.

One is again you're you're using a securitized rate to replace a quote unquote replace and unsecuritized rate.

The second is that the reason they've only proposed this overnight rate is because of lack of volume in longer term rates UM.

If you look at sort of overnight repose, hundreds of billions trade, but once you push term repo to one month or three months, the percentage of the entire report transaction that occurs in the one month three month point relative to the overnight point drops to well lesson tempatent, so you can't This is why the government can't tell the market hey when we use a one month securitized rate, because the volumes they're just are not They're just like um, you know, their arguments for pushing out LIBORAD.

There's their arguments for not using lib words that there's insufficient volume there.

Well, there's insufficient volume in terms strong securitized financing as well.

So the current best pick by the government is this overnight securitized rate, which I disagree with.

I'm much more in favor of using a rate such as three month fee bill because one it's been out there for a long time, people know what it is to its weekly auction treasury bills.

So the rate determination is based on the very transparent auction process.

And if we need daily sets, we can certainly increase the frequency of these auctions and still get significant volume.

For example, the previous weekly three months or thirteen week treasury bill produced well over three times the fifty billion of treasury bills that was sold, So there's plenty of liquidity in the tragedy bill market, and I think the government in putting all of its weight behind SOFUR is really doing the wrong thing and doing wrong.

By doing the wrong thing, I mean that we didn't come up with libor as the benchmark rate by FIAT.

The market kind of gravitated towards that there was more and more usage.

It started off with tragedy bills, market usage kind of gravitated around librard as a benchmark, and so I think creating a benchmark by FIAT is something that is going to have difficulty working.

I think what the government and others should do is to promote a variety of different types of floating rate indicries and kind of let the market decide.

Now, it's harder for the market to decide right now in this market environment because in the past, derivative instruments are pretty much traded over the counter, so it's just there's no regulation, it's just by lateral agreements.

Now pretty much all the swaps that are done have to be cleared.

So to really have a new benchmark going, one needs the cooperation of regulators like the FED, of the OTC, clearing houses like CIME or l c H, and also in these such as fast by because fast by issues regulations governing hedge accounting, for example, So UM corporations are going to a new floating right index if fast by dozen't so bless this rate.

So it's harder, I think for people to come around a new benchmark.

But I think we do need to let the market decide what the appropriate benchmark is rather than just being told that so you know you have to use so for going forward.

Another interesting stat I had as I pulled derivative counterparties is that even now, many many years after the Libel crisis, well over nine of all the swaps has traded in a single day is based in Libel.

So that really tells you.

So the staying power library, which goes back to my statement that you know the rumors of his death are greatly exaggerated, Well, I was just going to say, you know, let's say, okay, the government or regulators settle on some new benchmark.

How difficult and wrenching of a process would it be, given the number of instruments that are that are currently based on Libra, or to say okay, everybody switch, Well, I think it's it's gonna be a long time coming.

The fed only started publishing, sof um only will start publishing so far in April.

Um The market is going to have to get its arms around how this index looks versus other industries they're familiar with FED funds in terms of overnight comparison.

It's going to have to be a basis swap market that develops around this index, and then over time people may start trading this index outright in futures form and derivatives form and swap form.

So it has to be a block by block process.

I think the timetable that regulators have put forth i e.

Libel is going to be basically outdated, outmoded, eliminated by I think that's pretty dawn ambitious.

Okay, that may be the spookiest part of this entire story.

Scott Paying, CEO of Advocate Capital Management, thank you so much.

Thank you very much, guys.

Thanks that was great.

So Joe, I love that conversation because, as ever, it sort of brings back the good old days of financial crisis history for me.

What a time to be a markets reporter.

Well, I think that was a great conversation because a it was right in your wheelhouse and you've covered this a lot, and you understand this stuff better than most people I know, and be I don't really understand any of this of and I've always been sort of a little shy around this topic.

Just kind of the the perfect conversation for both of our needs.

Your expertise in me this big hole in my knowledge that I really needed to fill.

Now, Joe, I'm sure that's not true.

I'm sure you understand it very well.

But I think if anyone wants a broad takeaway from this conversation, it's that there's this thing called libor that exists, and it's incredibly important for the financial system.

It's incredibly important for our system of credit, and it's the thing that trillions, literally trillions of dollars worth of assets are actually pegged to, and no one really knows how it works or what affects it.

Like we are here having this discussion.

We've been talking for about, let's say, twenty five minutes, and we can kind of figure out some of the things that might be causing it, but there's no exact certitude.

And in fact, if you talk to other analysts in the market, they'll have all these different opinions that kind of amazes me.

Yeah, I know there's been all these stories we've done and seen recently about this inexorable rise in Library, and everyone has their own theories, so the degree of non consensus about what's driving it has really been fascinating.

I'm also just really interested in the point that Scott made about the sort of organic, natural way that Library emerged.

It wasn't by Fiata, wasn't saying Okay, we're gonna price all this stuff towards Library is a sort of network effects thing.

We're more and more entities thought it made sense, and the sort of difficulty of replicating that process in an artificial manner and just saying okay, now we're doing something else very different from the environment through which Library originally emerged.

Yeah, it's going to be really interesting to watch and see how long it actually takes to come up with the replacement and then transition it in.

Yes, all right, this has been another episode of add Thoughts.

You can follow me on Twitter at Tracy Alloway, and you can follow me on Twitter at the Stalwarts, and you should follow our producer tofur Foreheads at Foreheads T, as well as the Bloomberg head of podcast, Francesca Levy at Francesca Today, Thanks for listening,