Interest Rate Derivatives – the banker’s point of view

Jeff Slade, JBE (Associates) Ltd, Foreign Exchange Consultancy

Interest rate derivatives are a form of financial engineering that was devised by professionals for use by professionals; in this case the professionals are banks and bank traders.

Throughout history there have been financial innovations to cover various needs in the financial system. So coinage, banknotes, Gold standards, were all devised to cover commercial and financial needs.

Foreign exchange and the readily available ability to buy and sell currencies are a case in point. They really took off as countries relaxed Exchange Controls in the aftermath of the Second World War and the period, certainly in Europe, of great austerity and rebuilding.

The first real derivative could easily be considered the development of the Eurodollar market in London and Europe in the mid to late sixties. This was caused by the tidal wave of US dollars created by the Marshall Plan.

Banks (led by merchant banks in the City of London) realised that many of the US$ were not necessarily ready for repatriation or immediate use and could therefore be lent for short periods to other banks who had short term use for them. It was soon realised that any currency where the country had a major imbalance of payments, could be used in the same fashion. It is true to say that these Euro markets helped develop international trade in the post-war years.

These markets grew very rapidly in the late 60’s and early 70’s and led to the first problems of banks trading beyond the size of their balance sheets. In order to overcome the balance sheet problems, a Swiss company, Tradition, developed the first Interest Rate Derivative, called an FRA: A very simple instrument that was considered an ‘Off Balance sheet item’ and allowed the banks to continue trading without the restrictions of being within balance sheet limitations. (One can see immediately the dangers being created here for the future unsupervised overtrading that has occurred in recent years by ‘rogue traders’. Barings and the recent UBS rogue trader come to mind)

Other financial instruments were soon devised to cover various perceived requirements.

Interest Rate Swaps, Foreign Exchange Options, both vanilla and exotic. Financial futures (these were devised from long standing commodity futures markets such as the copper futures market) that started with open outcry markets. Repos, and ultimately some very complex instruments that were devised in the American investment houses. The junk bond market led by Drexel and Michael Milken, in the late 80’s and so on, until we came to the Subprime Mortgage debacle that led to the banking crisis and the fall of Lehman Brothers, Northern Rock, HBOS and various other banks. Many banks and hedge funds employed mathematicians to devise new and more complex derivatives to enhance their profit streams. Many of these instruments were too complex to verify and therefore, in my opinion, were very dangerous.

I reiterate my statement that these Interest Rate derivatives were created by professionals for professionals.

Should they have been used for ordinary banking purposes? That is not for me to decide but I would make it very clear that as a banker of some longstanding, I believe that there has been in place a tried and tested system for lending money to customers without the need for these added products.

The banks have lent to customers on a secured and unsecured basis for many decades. Whilst it is understandable to want to protect oneself from interest rate rises, it is probably true to say that economic history would indicate that unless there is high inflation causing violent upward movement of interest rates, this protection is not strictly necessary.

The period from about 2000, was vaunted by the previous Government as a period of growth, low inflation and low interest rates, and the present Government of historically low rates, so therefore were these instruments necessary?

Personally I do not think so, but you could argue a case for Interest rate Derivatives to protect on the upside with a ‘cap’ but I am not sure you could argue so successfully for a ‘collar’

Jeff Slade

Jeff Slade and Brian Hogg are the directors of JBE (Associates) Ltd, an established foreign exchange consultancy.

Between them they have over 80 years of experience of trading in the international foreign exchange markets for major banks and brokers .

Jeff Slade first traded in 1969 and worked in London both as dealer and broker, becoming Global Head of Central Banks and Middle East Region for a major European bank, culminating in becoming Vice President in charge of merging that bank with another major bank.

Brian Hogg started in 1967 and traded in various major banks throughout the world. Brian retired as UK Treasurer of a  foremost engineering company overseeing the Foreign Exchange and Cash Management of over 50 UK companies. Brian is an acknowledged expert in trading markets and banking practice, particularly in derivatives.

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