Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Corporate Hedging and Distorted Benchmarks

I wrote the following short piece on the subject of “Corporate Hedging and Distorted Benchmarks” for the magazine CFO Connect.

Background

The ongoing investigations into the manipulation of Libor fixing have highlighted the possibility that important benchmarks underlying corporate hedges may be manipulated by large players with the possible tacit acquiescence of the global regulators. Similarly, recent developments in key crude oil benchmarks (Brent and WTI) have demonstrated that these benchmarks can be distorted by factors that could not have been anticipated a few years ago. How does this affect corporate risk management? What can corporate risk managers do to make their hedging programmes more resilient?

There are some corporate hedges that are completely unaffected by the distortion or manipulation of benchmarks. This comfortable situation arises when the hedge is designed in such a way that the benchmark in question is completely eliminated from the all-in hedged cost. For example, consider the following:

  • A company borrows under a floating rate instrument where it is required to pay Libor + 3%
  • It enters into an interest rate swap under which it pays 5% fixed and receives Libor.
  • Clearly, the hedged cost is Libor + 3% + 5% Libor = 8%. Whatever happens to Libor, the company’s borrowing cost is guaranteed to be 8% fixed and the company does not care whether Libor is manipulated upward or downward.

The crucial feature of the above example is that the hedge has no “basis risk” at all because the hedging instruments exactly matches the risk exposure and the risk is neatly cancelled out (Libor Libor = 0). Not all real life hedges are so neat and simple – “basis risk” is quite common.

Consider another example which illustrates the problem:

  • A company (for example, an oil refinery) is exposed to crude oil price risk.
  • It hedges this risk using Brent crude futures
  • In reality, it sources its crude from say Saudi Arabia and not from the Brent oil fields.
  • Now the crude oil price does not cancel out completely. Instead, there is a “basis risk” where: basis = Saudi crude price Brent crude price.
  • The company might believe that the “basis risk” is negligible or at least much lower than the original crude oil price risk. While crude prices can move from $50 to $150 within a few months, the price basis between Saudi crude and Brent crude might be expected to change by only $3 or $5.
  • Now the company has to worry about whether somebody is manipulating the Brent price or whether other distortions are creeping in which were not anticipated when the hedge was set up.

Libor manipulation

Libor fixing methodology

Libor stands for the London Inter Bank Offer Rate – the rate at which the large banks are able to borrow on an unsecured basis for short maturities. The official definition is that Libor* is: “The rate at which an individual contributor panel bank could borrow funds, were it to do so by asking for and then accepting interbank offers in reasonable market size, just prior to 11.00am London time.”

There are two problems with this benchmark. First, as the definition makes very clear, Libor is not the rate at which a bank has actually borrowed – it is the rate at which it could borrow funds. Second, unlike say a stock market, where all trades take place in public and transaction prices are known to all, the interbank borrowing is a bilateral market about which there is very little transparency. Therefore, if a bank says that it could borrow at 2.45%, it is not easy for anybody to verify whether this is a reasonable estimate at all.

The Libor computation tries to ameliorate this problem by polling several banks, dropping the bottom 25% and the top 25% of all quotes and averaging the central 50%. If one rogue bank submits an unreasonable quote, it is likely to fall in the top or bottom 25% which are dropped and therefore the final average may not be contaminated by this rogue quote.

The Libor computation has one final problem which people did not worry about in the good old days, but is probably very important in retrospect. The entire Libor computation methodology and process are managed by the British Bankers Association and not by an official body independent of the banks who are being polled.

Pre-crisis manipulation

Evidence that has become available in recent weeks indicates that prior to the global financial crisis, some banks were trying to manipulate Libor to suit their own exposures. Banks are large players in interest rate swaps and other derivative markets based on Libor. The British Bankers Association was of course aware of this possibility and they stipulated that “The rates must be submitted by members of staff at a bank with primary responsibility for management of a bank’s cash, rather than a bank’s derivative book.”

When regulators in the US and the UK examined all the internal emails as part of their investigation, they found that the derivative traders were routinely requesting the “submitters” to submit false quotes designed to suit the positions of those traders. The submitters were routinely complying with these requests.

In a few cases, requests were coming from traders at other banks and these were also being accommodated. Such collusion between banks would of course imply that the simple expedient of dropping the top and bottom quartiles of quotes would no longer be sufficient to prevent the average itself from being manipulated.

Manipulation during the crisis

The other evidence that has become available is about the period during the global financial crisis, when people were scared about the solvency of banks and were unwilling to lend to weak banks. During this period, it appears that most banks were systematically under reporting the rates at which they could borrow.

Comparison with the Credit Default Swap (CDS) market which measures the credit worthiness of banks suggests that Libor might have been understated by several percentage points.

It also appears that the Bank of England and the Federal Reserve Board in the US were aware of this and it is suggested that they tacitly approved of this practice. Regulators apparently feared that if the true borrowing cost of banks were widely known, that could add to the panic in the markets.

Example of Failed Libor Hedges

The case of US municipalities provides a very interesting example of how hedges based on Libor can go very badly wrong when the underlying benchmark is distorted or manipulated.

US municipalities traditionally borrowed using auction rate securities. The interest rate was a floating rate, but instead of being set as a spread over Libor, it was determined by periodic auctions. Historically, these auction rates (adjusted for the tax free status of municipal bonds) tended to be very close to Libor. It was common for them to hedge their interest rate risk by using interest rate swaps based on Libor. In normal times, this hedge worked quite well.

During the crisis however, the municipalities faced very steep borrowing rates in their auction rate securities (some auctions actually failed). This was partly driven by the general lack of liquidity in the market and partly by perceived risk of insolvency of some municipalities. Of course, the banks also faced similar perceived risk of insolvency, but because of the manipulation, the reported Libor did not reflect the same degree of stress.

As a result, the floating rate (Libor) that the municipalities received on their swaps was much lower than the floating rate (auction rates) that they paid on their borrowings. The actual borrowing cost turned out to be far in excess of the fixed rate that they thought they had locked in through the hedges.

This is a dramatic example of how a “basis risk” which was regarded as modest and manageable during normal times can become life threatening when the underlying benchmarks are distorted.

Crude oil benchmark distortion

Almost all crude oil trading in the world (both the physical market and the derivative markets) is based on a handful of benchmarks of which the two most prominent are Brent and WTI (West Texas Intermediate). As is to be expected, WTI used to be the dominant benchmark in the US while Brent was the benchmark of choice elsewhere in the world. Based on the quality of the crude (for example, the sulphur content), the crude from a specific oilfield might trade at a premium or discount to Brent or WTI. A long term supply contract between an oil producer and an importer might therefore specify the price as simply Brent + 3$ or Brent 1$.

In recent years, the emergence of shale oil has drastically altered the supply-demand imbalances within the US. The Cushing region on which the WTI benchmark is based has become an oil surplus region and WTI prices have become artificially depressed. This position is expected to be solved as new pipelines are built and existing pipelines are modified to run in the opposite direction. In the meantime, retail gasoline prices in the US appear to have completely decoupled from WTI prices and seem to be much more closely aligned to Brent prices.

At the same time, Brent has been affected by declining production in the North Sea oilfields on which this benchmark is based. The short supply of Brent has led to a rise in prices to the extent that Brent now trades at a premium to WTI though historically, WTI was more expensive because of its superior quality.

A lot of oil price hedgers have struggled to cope with the unexpected blow out of “basis risk” due to the historically unprecedented distortion of the two principal benchmarks. To make matters worse, the methodology underlying crude oil benchmarks suffers from the same infirmities as Libor possibly on a larger scale. The markets depend on prices reported by some private agencies like Platt who are completely unregulated.

Broader lessons for corporate hedging

Some of us are fond of joking that much of what passes for hedging is actually speculating on the “basis”. Like all good jokes, this joke too has some grain of truth in it. For example, US municipalities were to some extent taking a speculative position that their borrowing cost would not materially exceed Libor on a tax adjusted basis. Their only real cause for complaint is that Libor was manipulated and did not reflect free market outcomes.

In reality, however, “basis risk” is impossible to eliminate completely. Liquid derivative markets must perforce be based on liquid benchmarks, and a specific company’s costs are unlikely to exactly mirror these benchmarks. Moreover, a hedge with significant “basis risk” is likely to be much less risky than a completely unhedged position. Thus even an imperfect hedge is risk reducing and can not fairly be described as speculative risk taking.

The exception is when hedging is used to justify high levels of leverage. Many of the problems that banks have faced during and after the crisis were due to this. A mistaken belief that “basis risk” is negligible leads to the assumption that the hedged position is practically risk free and can be supported by astronomical levels of leverage. Even modest movements in the “basis” can then wipe out the capital and expose the bank to risk of insolvency.

Outside of finance, some manufacturing companies might be making similar mistakes. By underestimating the basis risk, they may be emboldened to adopt risky financial and operating policies that they might not have chosen if they were fully aware of the “basis risk”. These are the companies that can be truly described as speculating on the “basis”.

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