The Hidden War That Could Change Everything

Sometimes it takes zooming out on the big picture to start connecting the dots. But that doesn’t always happen when it comes to the financial world. Today it seems to be more about the next quick soundbite, even if it turns out to be wrong.

But what if, when you take a step back, look at the playing field and truly see the big picture, things seem to be far different than that 30 second clip on Instagram? What if everything we think we know is wrong?

It’s the type of thinking beyond what’s on the surface that can lead us to a better answer. An exercise that can lead us to seeing how the game may play out in the coming years. And eventually to uncovering asymmetric investment opportunities with the potential for outsized gains.

Recently, I’ve thought about several things that need a deeper understanding. Including the battle for control of the flow of money.

In order to understand where I’m going with this, we need to go back in time. More specifically, looking look more closely at interest rates. Especially when it comes to pricing loans in the private market and how that worked historically.

For decades, the world depended on the London InterBank Offer Rate (LIBOR). It was an offshoot of the Eurodollar system created in London in the 1950’s.

The Eurodollar market is just a system to trade dollars outside of the U.S. and isn’t subject to U.S. banking regulations.

When the British government faced high inflation in the 1950’s, it restricted using sterling for financing international transactions. It was a form of capital controls. London banks saw an opportunity and started taking U.S. dollar deposits and then making offshore dollar loans.

It was the dawn of a new, unregulated market for short-term dollar funding outside the U.S. And it turned into a multi-trillion-dollar market in no time.

As the popularity of Eurodollars grew, so did the mechanics of charging interest on loans using them. The idea behind LIBOR kicked off when a bank syndicate led by Manufacturers Trust needed a rate for an $80 million floating-rate loan to the Shah of Iran in 1969.

Not long after, the British Banker’s Association (BBA) and the Bank of England officially launched LIBOR as a standardized benchmark rate for lenders and borrowers to use for these types of loans.

The way it worked was every day, major banks in London submitted the rate they believed they could borrow money. LIBOR was an average of these rates. It was a survey system. One dependent on trust.

Over time, LIBOR became the global benchmark for short-term interest rates. That influenced not just loans outside the U.S. But loans within the U.S. like mortgages, corporate debt and more.

The system worked…so long as the banks were honest.

In the mid-2000’s, however, a scandal rocked the global financial world.

Traders at major British bank Barclay’s, along with others, started coordinating how they would submit the LIBOR survey every day. The goal was to increase or decrease the rate to benefit their trading books.

If they could manipulate LIBOR, it would mean billions in profit. It also meant that banks trading in Eurodollars could export any stress back onto U.S. banks.

Since millions of people in the U.S. had loans tied directly to LIBOR, every time the rate increased in London, it would automatically increase interest rates in the U.S. Even if there was no real stress in the U.S. economy.

As rates went higher, so did defaults. More and more loans went bad. So the banks controlling LIBOR would keep sending rates higher to try to contain the damage from those now “bad” loans.

It created its own sort of feedback loop. The higher LIBOR went, the more borrowers would default on their loans. The more bad loans, the higher likelihood LIBOR increased…at least so the banks controlling it could still show a profit.

The 2008 financial crisis exposed it all. The fallout was swift. Barclay’s paid about $450 million in fines. CEO Bob Diamond resigned. And the bank fired more than 100 traders and brokers were.

UBS paid about $1.5 billion in fines. Deutsche Bank paid $2.5 billion. 

In total, the banks responsible paid over $15 billion in fines.

In the aftermath, the outrage over the manipulation of LIBOR led to the realization that almost the entire global market for debt was in the hands of a few elite banks.

Control the market for money, control the global financial system.

Fast forward to 2014. LIBOR was sputtering along, on its last legs.

The UK government’s own investigation – the Wheatley Review – showed the entire structure of LIBOR needed reform. There was no oversight. And no consequences for manipulation.

Borrowers paid for it all. All because a few powerful hands controlled it thinking no one would catch them.

But something needed to replace it. Regulators around the world knew a system like LIBOR wasn’t the answer. They couldn’t just patch it up and put it back to work.

Instead, they realized they needed something different. A more market-based alternative. A lending rate set by the market forces of supply and demand. Not a rate set by a few banks submitting a survey.

So in 2014, the U.S. Federal Reserve established the Alternative Reference Rates Committee (ARRC) to help find a replacement. Three years later, it recommended the Secured Overnight Financing Rate (SOFR).

SOFR is different from LIBOR. It doesn’t come form an arbitrary survey of bankers. It comes from actual data from overnight lending transactions.

The New York Fed collects all data from the overnight lending market. (Basically, a borrower pledges treasury bonds for some quick cash and agrees to buy them back the next day at a slightly higher value.)

It takes the volume-weighted median of all eligible overnight lending rates and publishes SOFR at 8 AM EDT for the next business day.

Because of its tie to U.S. Treasuries, it’s considered nearly risk-free. It’s a true, free-market rate in that sense.

And it’s far larger than LIBOR ever was. Daily volume underlying LIBOR transactions was around $500 billion. Daily volumes underlying SOFR is typically over $1 trillion.

Within a month of the Fed zeroing in on SOFR to replace LIBOR, the UK announced it would phase out publishing LIBOR rates by 2023.

The game was over. The power to control the flow of money through lending rates shifted from London to New York. Meaning the Fed severed the tie that would import financial stress from Eurodollars back to the U.S.

The U.S. wrested back control of its global debt pricing making it far harder to manipulate rates. It also meant that if foreign borrowers want to borrow U.S. dollars, they may be better off going straight to U.S. banks…or the U.S. Treasury itself.

That in turn may just increase the interest for dollars around the world in the coming years. And it may make the overall U.S. economy more resistant to external pressure in the long run.

Control the flow of money, control the global financial system.

But that’s only part of the story. Next week, I’ll talk about another thing happening in the world of money that will only add fuel to the fire. Something almost no one saw coming. Stay tuned…

Editor, Strategic Trader