The End of Libor and Non-Voting Stock

Also Martin Shkreli, Fed dividends, lottery scams, marine insurance fraud, safe assets and a bitcoin Moriarty.

So long Libor.

Back in the 1960s, a Greek banker in London wanted to find a way for banks to make syndicated floating-rate loans. He found a very simple answer: The banks would lend money to a company, charging their cost of funds plus a spread, and every three months, you'd go out and ask the banks what their cost of funds was, and you'd average their answers, and that (plus the fixed spread) would be the new interest rate on the loan. This was a simple product for the banks: They could pass their costs on directly to the customer, and make a fixed profit (the spread). And by surveying all the big banks and throwing out outlier submissions, you could get a pretty fair approximation of the overall funding cost for banks.

And so this -- Libor, the London interbank offered rate -- became the normal way that everyone did floating-rate loans, and then it became the normal way that everyone did interest-rate derivatives, and then it became the normal way that everyone did ... sort of ... everything? Libor just sort of became The Interest Rate, used for discounting cash flows in all sorts of transactions, "the most important number in the world." But it was always based on a survey of banks' funding costs, and so it was always a little hazy. One problem was that the banks could lie. But a second problem is that the banks might not even know. Libor surveys asked banks each day what they would have to pay to borrow money unsecured from other big banks, but over time the banks sort of stopped doing that, particularly in some of the more obscure combinations of tenors and currencies that nonetheless reported Libor rates. So the banks' Libor submitters would guesstimate their submissions based on deposit rates and commercial-paper rates and secured-borrowing rates and other tenors and what brokers and their buddies were telling them. It was all more or less good enough as a casual system for resetting the rates on a few billion dollars worth of syndicated loans, but it was not accurate down to the hundredth of a basis point as a foundation for the financial system, or as the source for pricing hundreds of trillions of dollars of derivatives.

Then there was a big scandal.

After the big scandal, regulators got a lot more interested in Libor. The first thing they did was decree that banks shouldn't lie about Libor any more. This solved the first problem: Banks stopped lying about Libor. (I mean, let's assume.) But it did not address the second problem, which is that banks had a hard time knowing the right answer to many of the Libor questions -- "how much would you have to pay to borrow Danish kroner for two months?," that sort of thing -- and so had to either fudge the answers (and risk liability) or leave them blank. The regulators did not want them to leave the answers blank, since that would kill Libor, and when the U.K. Financial Conduct Authority took over the administration of Libor, it "spent a lot of time persuading banks to continue submitting rates." The FCA wanted Libor to be honest, but not dead.

Now the FCA wants Libor to be dead, which really makes a lot more sense, and is going to phase it out by 2021:

Andrew Bailey, the head of the Financial Conduct Authority, said Thursday that the rate isn’t sustainable because of a lack of transactions providing data. Libor became a byword for corruption after traders were caught manipulating the benchmark, leading to about $9 billion in fines and the conviction of several bankers.

“We do not think we will complete the journey to transaction-based benchmarks if markets continue to rely on Libor in its current form," Bailey said in a speech at Bloomberg’s London headquarters. "Panel bank support for current Libor until end-2021 will enable a transition that can be planned and can be executed smoothly."

Of course you still need a benchmark for floating-rate loans -- and for trillions of dollars of derivatives -- and it's not exactly clear what competing "transaction-based benchmarks" will win out. Nor is it clear how complicated it will be to transition all of those trillions of dollars of derivatives to the new benchmark. It would be easier if they'd just rebrand the new benchmark "Libor," and report it in the same places as the old Libor: Then contracts that refer to "Libor" could keep referring to "Libor." It would just be a different Libor. 

Non-voting stock.

Earlier this year, Snap Inc. did an initial public offering in which it sold non-voting stock to the public. People complained a lot about this, before buying the stock. I was unmoved by their complaints. The way you are supposed to complain, in financial markets, is through price. If you don't like non-voting stock, don't buy it, or don't buy it at the price that you would pay for voting stock. But Snap did not seem to encounter any resistance: It priced its IPO above the marketing range, and the stock jumped when it opened. Investors "never credibly argued that they'd have paid more for voting shares," I said, as recently as yesterday.

But now they have

FTSE Russell said on Wednesday it planned to exclude Snap Inc from its widely followed stock indexes because the owner of the Snapchat messaging app has an unusual share structure that denies voting rights to investors.

The stock index provider said it made the decision based on client feedback, the latest sign of the growing importance of corporate governance rights to investors even as technology companies move to concentrate power with insiders.

I guess it is too late for Snap to care. But the next private company that wants to go public with non-voting stock is going to have to sit down for some very real talk with its bankers, especially if other index providers follow FTSE Russell's lead. "If you go public with non-voting stock," the bankers will say, "then index funds won't be able to buy your stock. Index funds make up a significant percentage of demand for most public companies, and that's not even considering quasi-indexers and closet indexers. And if index funds won't be buying your stock in a few months, then that will push down the price that IPO investors will be willing to pay, because knowing that there will eventually be index demand is what supports the price today." There will be charts showing the importance of index demand. There might even -- though I would not count on this -- be a dollar estimate of how much the loss of index demand will cost the company. And then the company can decide: Do we want to go public at $17 a share with normal voting rights, or at $16 a share with non-voting stock?

This is good! This is progress! I am all for letting companies go public with non-voting stock, if their investors are cool with it. But it really is a tradeoff, and the companies ought to feel the tradeoff, and face it directly, rather than just hearing and ignoring vague ominous rumblings from investors that non-voting stock is bad.

Still this seems like the dumbest possible way to do it. What happened here was not that the pickiest and most careful investors scrutinized Snap closely and made the bold decision not to buy its stock. Instead, the very least picky possible investors -- the index funds, whose mandate is to buy all the stocks in the market -- are the ones who won't be buying Snap. It makes no sense: In a reasonable world, you'd expect the passive funds to be passive buyers of whatever the market provides, while active funds would make active decisions about what the market should provide. In our actual world, though, the passive funds have all the power, and the active funds are constrained to follow their lead. 

How's Martin Shkreli doing?

Great, say prosecutors; less well, say his own lawyers:

While defense lawyers typically try to display their clients’ positive attributes, Mr. Shkreli’s lawyers have painted him as an erratic misfit, to the point that the government has repeatedly objected to the defense team’s unflattering portrayals of its own client. The goal of such a portrayal is presumably to get jurors to question whether Mr. Shkreli knowingly committed fraud, a key part of the charge against him.

That is not the only reversal in the case:

The defense, usually eager to limit prosecution witnesses’ testimony, had pushed the prosecution to call more victims.

And the victims, usually the emotional heart of a fraud case, may be difficult for jurors to connect with. Every MSMB investor who testified at the trial made all of his or her money back with a handsome profit, as Mr. Shkreli eventually arranged for them to get some combination of cash and Retrophin shares.

The victims were mostly rich, and not very sympathetic characters.

It is easy to say that this is legally irrelevant: It's illegal to lie about material facts to your investors, even if you later give them back all their money with a profit, and even if they're entitled jerks. But of course there's a reason that victims are "usually the emotional heart of a fraud case." In usual cases, prosecutors don't confine themselves to the legally central questions of whether the defendant knowingly lied about a material issue; they focus on the harm that the defendant did to sympathetic widows and orphans. That is easier to explain to a jury -- "look at these poor people who lost money to this jerk" -- than a technical argument about materiality. Here, though, it's the opposite: The alleged crimes were essentially technical, and no one will feel too bad for the victims.

Meanwhile, in Shkrel, Albania, feelings are mixed:

"We heard he had invented a cure for cancer and rejoiced that a fellow highlander had turned out to be a great scientist," said Pjerin Ivanaj, 54, a social insurance office worker, mistaking Shkreli's purchase of an anti-infection drug often used for HIV/AIDS patients.

"But we felt very bad when we learned from the internet and radio that he had pushed the price up so high."

Fed dividends.

The Federal Reserve System, as you may know, is made up of regional Federal Reserve Banks, each of which is "owned" by the banks chartered in their districts. I put "owned" in quotation marks because the Fed is in most practical senses a national central bank and regulatory agency, not a set of private companies; the quasi-privatized structure is a legacy of the Fed's founders trying to pitch it politically as something other than a national central bank. The banks who own stock in the New York Fed can't, like, mount a hostile takeover bid to sell it to Deutsche Bank. But they get some tokens of ownership: They get to elect some of the board members of their Fed banks, and, traditionally, they have gotten dividends of 6 percent a year on their capital.

The dividends have become controversial recently, since if you don't take the "ownership" concept seriously -- and you shouldn't! -- then the dividends just look like a giant random government handout to banks. And cutting giant government handouts to banks has been a reasonably popular political program of late. So in 2015 Congress cut the dividend and used the money to pay for highway construction.

So some banks sued, and the case is being argued today. It is a bit of an amazing lawsuit, claiming that the Fed breached its contractual obligation to pay 6 percent dividends:

Most important, the Reserve Bank also stated: “Dividends will be paid semi-annually on the last business day of June and December. Dividends are paid at the statutory rate of 6 percent per annum, or $1.50 per share semi-annually.” The Reserve Bank sent an Advice of Holdings confirming that Washington Federal had purchased 479,610 shares of Federal Reserve Bank stock.

Based on the plain meaning of the language in the Application, the Federal Reserve Act, the acceptance letter, and the Advice of Holdings, as well as the Federal Reserve’s 100-year practice of paying six percent dividends on Federal Reserve Bank stock, Washington Federal understood that it had contracted with the United States to receive a six percent dividend as long as it owned Federal Reserve Bank stock.

This is ... not how dividends work. Dividends on common stock are notably optional things; if a company cuts its dividend, the shareholders generally have no remedy other than trying to vote the board out. You don't have a contractual right to get your dividend forever, just because there was a dividend when you bought the stock, or even because you signed a subscription agreement when you bought the stock. Common stock doesn't work like a contract: It works like ownership, in which you share the upside and downside, feasting on dividends when times are good and losing your money when times are bad. Of course Federal Reserve stock doesn't work like ownership either, though, so it's a bit tough on the banks, but hard to see how they'd win.

The lottery scam.

Here is a fascinating Vice story about the lottery scam, in which "fraudsters trick victims into paying taxes and fees they say are needed to claim a nonexistent jackpot." It is a major business in Jamaica, where "gangs that once fought for control of the drug trade now kill each other for access to lead lists, which include names and phone numbers for would-be victims." Also the story includes this extremely Vice-y paragraph:

The dancehall superstar Vybz Kartel, who is currently serving a life sentence for murder, had a song called “Reparation” that includes lines about how the proceeds of scamming are reparations for slavery. He later released another song, called “Western Union,” with a video that shows how “hustle money” makes its way from the wire transfer office and trickles down through the entire community. (Full disclosure: Vybz Kartel released an album on VICE Records in 2012.)

One thing to think about here is how low-tech and old-fashioned this scam is. People have been running versions of it for centuries. This is a "global, serious cyberfraud issue," says a federal prosecutor in North Dakota who is working on several of these cases, but it is not really "cyber" at all. It is just calling people up on the phone and lying to them until they send you money! And yet it is incredibly lucrative, so lucrative that people in Jamaica will kill each other over lists of 80-year-olds in North Dakota.

It's weird because finance is so dependent on computer technology. For most of us, essentially all of our wealth consists of entries in the computer systems of financial institutions, and if someone were to modify those computer systems illicitly, they could get very rich and leave us very poor. And stuff like that happens occasionally, though mostly with bitcoin exchanges. But for the most part the big scams with the big payoffs are the old-timey scams, not the cyber-scams: not hacking into computers to steal money, but calling people up and convincing them to send you money. It's telling that when hackers breached the computer systems of JPMorgan Chase & Co. in 2014, they didn't steal money; they stole email addresses and phone numbers. Convincing people to send you money is easier than taking it for yourself; you hack into banks because that's where the phone numbers are.

An insurance scam.

Here is the most gripping fraud story you'll read all month. It's a Bloomberg Businessweek article about marine insurance fraud, which, unlike many other forms of fraud, involves pirates, car-bomb murders, Special Forces rescues, and a general James Bond atmosphere that you don't tend to get in say Libor manipulation. 

Safe assets.

Here are Ricardo Caballero, Emmanuel Farhi and Pierre-Olivier Gourinchas:

Over the last few decades, with minor cyclical interruptions, the supply of safe assets has not kept up with global demand. The reason is straightforward: the collective growth rate of the advanced economies that produce safe assets has been lower than the world's growth rate, which has been driven disproportionately by the high growth rate of high-saving emerging economies such as China. The signature of this growing shortage is a steady increase in the price of safe assets; equivalently, global safe interest rates must decline, as has been the case since the 1980s.

Blockchain blockchain blockchain.

Alexander Vinnik was arrested in Greece on Tuesday for being basically the Moriarty of bitcoin crime:

A Russian man was charged with overseeing a black market Bitcoin exchange that helped launder billions of dollars and stood at the nexus of several criminal enterprises, according to a federal indictment.

The indictment, which was unsealed in California on Wednesday, gave a long list of illegal activities that the Bitcoin exchange, known as BTC-E, facilitated, including ransomware fraud, identity theft, drug trafficking and public corruption.

Also just, like, on the side, he allegedly stole hundreds of thousands of bitcoins from the Mt. Gox exchange in 2014. 

Things happen.

Deutsche Bank Warns on Outlook as Cryan's Turnaround Slows. (Earnings release, financial supplement.) Deutsche Bank Expected to Keep $45 Million in Compensation From Ex-Executives. Deutsche Bank Has a Strange Idea of Fun. Fed Ready to Shrink Bondholdings as Soon as September. Mnuchin Cautions Congress About Cost of U.S. Debt-Limit Impasse. "Repricing activity is dominating loan markets in the U.S. and Europe." Talk Is Cheap: Automation Takes Aim at Financial Advisers—and Their Fees. Your Robo-Adviser May Have a Conflict of Interest. Wall Street Needs You to Borrow Against Your Stock. The Dog and the Boomerang: in defence of regulatory complexity. The quitting economy. Judge rules against ex-Goldman employee in Fed leak case. How to Make a Fortune Drinking, Gambling and Napping. How a Catholic School Turned $15,000 Into $34 Million Thanks to Snapchat. Lloyd Blankfein, Whose Favorite Leisure Activity Is To ‘Lie On The Couch,’ Tells Interns To Be More Interesting. French Mayor Who Lost Sports Bet Follows Through And Eats Dead Rat. "One actual person wrote 'ENJOYS BUSINESS-CLASS TRAVEL' as a descriptor, which I think is one of the purest things I have ever read."



    To contact the author of this story:
    Matt Levine at

    To contact the editor responsible for this story:
    James Greiff at

    Before it's here, it's on the Bloomberg Terminal.