The oil crisis of 1973, when crude oil prices soared creating massive surpluses for OPEC, Norway and Russia, and dollar shortages elsewhere, gave rise to the ‘petrodollar’ and then the eurodollar. The latter – US dollars held outside the US – gravitated to Europe’s lightly regulated money market. This vast pool of new cash lured US investment banks, then European and Japanese ones, finally Russian and Chinese institutions to the City of London. A cheap and less onerous way of setting up a bank without retail deposits.
Futures contracts on eurodollars were introduced by the Chicago Mercantile Exchange in January 1982, joining the Chicago Board of Trade’s futures on US Treasury Bonds, which were a roaring success from introduction in 1977 – as Paul Volker took drastic action to tame rampant inflation starting in 1979. Options on these futures were added later so that these hedging tools meant ever more sophisticated and aggressive trading strategies were possible. The London International Financial Futures Exchange introduced similar instruments on UK gilts and short sterling money market rates later in 1982. Similar products were listed all over the world, and eventually on the euro interest rate, with London ironically dominating volume – and billions traded daily.
Hybrids between cash and derivatives grew and grew, including floating rate notes, interest rate swaps, caps, floors and collars, fixed-rate mortgages and conventional corporate loans – and billions traded daily. Recent data from the CME show that daily interest rate volume on its platform is running at 5,460,461 contracts (where most contracts are worth $1 million apiece); open interest at 70,827,414 are the number of positions open at the close of business. Estimates for the global outstanding is $350 trillion.
Central to the settlement of all these products is the London Interbank Offered Rate (Libor) and its lesser-known sidekick Libid – the rate at which a bank will bid for wholesale funds. Overseen by the British Bankers' Association, it has come into disrepute because many believe some bankers on the panels of rate-setters were shading their submissions, either to suit trading positions or to make others believe their organisation was in rude health. What to replace it with is problematic and as bond fund giant Pimco recently noted: "Forcing a Libor transition date before the market is prepared will probably cause a mass scramble to migrate positions, which will impose a cost to investors."
Money market futures contracts are priced as 100 minus the rate at which a bank will lend wholesale funds for three months – because hurly burly pit traders need to buy low and sell high to make money, finding the nuances of being both a borrower and a lender tricky.
For those who long for simpler times when banking was straightforward, we caution that a lack of hedging tools meant interest rate gyrations were bigger and more sudden. The eurodollar contract swung between interest rate equivalents of 11 per cent to less than 8 per cent several times in a two-year period from July 1987. The short sterling contract from 11 per cent in June 1991 after which rates tumbled to just 5 per cent. The euribor future saw rates tumble from an already super-low of 2.5 per cent in July 2013 to an eye-watering minus 0.3 per cent three years later. As for Japan, rates have been at next to nothing for a very long time – and continue to be thus.
