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The Genesis of Over The Counter Interest Rate Derivatives

InvestorEducation / Derivatives Sep 25, 2007 - 06:43 PM GMT

By: Rob_Kirby

InvestorEducation

Best Financial Markets Analysis ArticleMisinformation regarding the origin and genesis of the OTC Interest Rate Derivatives complex abound in the market. 

During the 1970's – after President Nixon took the world off the gold standard - the dramatic increase in the price of crude oil led to burgeoning balances of petro dollars [Euro-dollars] in the treasuries of banks involved in international trade. This immediately led to banks bolstering their treasury operations to deal with the influx of ‘inflated dollars'.


In the beginning these petro-dollar balances were strictly lent or borrowed in the inter-bank market.

Interest Rate Derivatives were initiated by the establishment [around 1980] of the four 3-month IMM Eurodollar Futures Contracts [Dec, Mar, Jun, Sept] on the Chicago Mercantile Exchange [CME]. These contracts settled against 3 month libor [London Interbank Offered Rate] for Eurodollar Time Deposits on the third Wednesday of the contract month. The 3 month libor rate is ‘set' daily by a group of banks selected by the British Bankers Association and represents where these ‘reference banks' are willing to ‘loan' their mostly recycled Euro Dollar [petro-dollar] as 3 month time deposits. 

The advent of these 3 month Euro-dollar futures gave banks the ability to ‘hedge' or book profits on sizable amounts of predictable future cash flows emanating from ongoing business. But the business remained – while burgeoning – largely a cash trade.

In 1980, Canada revised it's Bank Act. In the ensuing few months, with the influx of foreign banks [dubbed schedule B banks] – Canada went from having 5 domestic banks to having roughly 65 banks. To protect their home turf, the existing domestic banking industry successfully lobbied the politicos to limit the amount of capital new ‘schedule B' banks could have [initially to 5 or 10 million]. This placed a straight jacket on foreign banks now operating in Canada; capital ceilings implied severe balance sheet restrictions. So a situation had developed where 60 new banks had just opened their doors – but were effectively frozen out [balance sheet limitations] of participating in ‘main stream' bank treasury operations [lending long – borrowing short - in the inter-bank market].

These treasury operations needed to find a raison d'etre [a road to profitability] in a hurry or their parent banks would shut them down.

Competition Breeds Innovation

To differentiate themselves from the rest of the crowd back in the early 1980's, institutions like Citibank, Toronto and Chemical Bank, Toronto went on a hiring binge of Ph D mathematician types and immersed themselves in ‘financial engineering' utilizing then emerging exchange traded futures [cited above].

It was Citibank, Toronto or Chemical Bank, Toronto who did the very first Inter-bank U.S. Dollar Interest Rate Derivative – known as an FRA [Future Rate Agreement] which, at its core – is nothing more than a glorified ‘bet' on what 3, 6 or 12 month libor will be at a future date. I know this because I was an institutional broker and Citibank, Toronto was my client. Soon after [or simultaneously] the first FRA's were done – Citibank Toronto had engineered a model to successfully book profits from interest rate swaps.

In the very beginning – these trades were ENORMOUSLY profitable – so much so that Citbank Toronto very quickly became – hands-down -the world's biggest OTC interest rate derivatives house and was, in fact, the clearing house for OTC interest rate derivatives for Citibank worldwide.

What this innovation allowed banks to do – was make the same bets on the interest rate curve as the cash players – without ever risking the principal AND it was all off balance sheet – therefore avoiding the balance sheet restrictions.

This business absolutely mushroomed!

Somewhere along the line – like the late 1980's – folks in New York took notice that they were losing their grip on the pulse of the money market and institutions like Citibank Toronto had their ‘books' repatriated back to New York. I watched all of this happen – first hand.

By this time, folks at institutions like J.P. Morgan and Bankers Trust [later merged/bailed out by Deutshe Bk.] realized that these products – utilized in sufficient size – could effectively give an institution control of interest rates.

And that where we are now.

You see folks – this is why J.P. Morgan Chase now sports an OTC derivatives book of over 70 TRILLION in notional. It's all about control.

By Rob Kirby
http://www.kirbya nalytics.com/

Rob Kirby is the editor of the Kirby Analytics Bi-weekly Online Newsletter, which provides proprietry Macroeconomic Research.

Many of Rob's published articles are archived at http://www.financialsense.com/fsu/editorials/kirby/archive.html , and edited by Mary Puplava of http://www.financialsense.com

Rob Kirby Archive

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