Fly Paper

I have long wanted to write a viral potboiler on illiquidity in the commercial paper market but an experienced publisher like me knows one must launch a world-beating best-seller when the time is absolutely right. Fortunately, the Governor of the Bank of England kindly made CP illiquidity the centrepiece of his display window into the world of Libor Transition last month and in consequence I judge the time is ripe. Lucky you.

With banks moving to greater use of retail deposits and secured funding, rather than short-term wholesale interbank markets, Libor increased its reliance on transactions grounded in the commercial paper (CP) and certificates of deposit (CD) markets. This increased Libor’s vulnerability to short-term illiquidity effects apparent in these markets and the amplification of price moves.

Commercial Paper is the collective name for a genre of fiction and straight-to-video productions in which a ruggedly handsome protagonist (Max Maturity's Corporate Payroll is perennially popular with readers) seeks out an accommodating companion--say, Lenda du Jour--for a liberating short-term hook up to the advantage of both. In the racier editions they are joined by Lenda's friend, Intermedia, for a frisky threesome. The genre is particularly popular with middle-aged suburban readers who, it is said, enjoy the graphic descriptions of Corporate Payroll's implausibly well-developed Credit Rating. There is also a PG-rated, romance-heavy imprint for less adventurous readers ("Asset-Backed Commercial Paper"). You get the idea.

The issue of which the Guv'nor would like market participants to take cognisance is that for the past decade or so readers have been turning away from the Commercial Paper format and immersing themselves in alternatives. In these circumstances, with less money to go round and some reputable authors getting out of the game altogether, the genre has become unreliable. In market terms: everyone is chasing the few investors still interested in unsecured term lending and in times of stress when cash in the market is particularly scarce, interest rates tend to spike, irrespective of funding trends in other markets. If LIBOR panel banks submit values to the daily fix which reflect their transactions in this market (and they do), then their input data will not accurately represent the real cost of funds and the LIBOR fix will not serve adequately as a basis for the enormous weight of transactions which still use LIBOR as a benchmark.

You can see where the guy coming from. He's invested his whole career in the idea that monetary policy is transmissible via interest rates qua the cost of funds and here's a recalcitrant banking system preferring to track supply and demand in the Commercial Paper markets. Did you think looser monetary policy would benefit the economy as the Avian Swine Corona-flu pandemic hits and war breaks out between England and a newly independent Scotland? Well, the good news is that repo rates are at a historic low but I'm afraid the CP markets have all but dried up and LIBOR rates are fixing north of 10%. Tough cookie.

Moreover, the financial industry has spent decades trying to persuade a mistrustful public that derivatives are not just another form of rigged gambling with other people's money but are, in actual fact, a vitally important tool for socially useful commercial enterprise. With swaps, they say, ABC Bank can worry about unpredictable interest fluctuations, so that your grocery service or internet provider doesn't have to. The business of a bookstore, they urge, should be books, so why not offload the worry of rising interest rates onto JRP Banking Ltd via a nice little STIR future? Well, the Guv'nor bought into that message and who's to say he was wrong? (Not me, Sir, no way.) So, you can see why he might be reluctant to prop up a benchmark that will see all those interest rate derivatives spike in the wrong direction when CP illiquidity looms over the horizon.

Anyway, long-short: Commercial Paper novellas are now categorised as a niche product at your local bookstore and it's no longer appropriate to reference the LIBOR benchmark in transactions worth USD 240 trillion. The message is clear: we should move on. The Governor likes a mountaineering metaphor, apparently, but I prefer to think of it as turning a page.