ISDAfix Probe Unveils Obscure Rate

Measure plays role in instruments ranging from bonds to annuities.

ISDAfix rates at the center of a U.S. price-manipulation probe, while often relegated to the fine print of regulatory filings, help determine everything from borrowing costs on bonds that finance skyscrapers to interest on annuities.

Companies seeking to protect against soaring interest rates in the $379 trillion swaps market rely on them to mark the value of trades. Banks use the rates in setting coupons paid for $550 billion of bonds tied to commercial real estate. Fluctuations help determine the performance of structured notes bought by wealthy individuals and the amounts some states pay on pension annuities.

After fining Barclays Plc, UBS AG and Royal Bank of Scotland Group Plc more than $2.5 billion over the past year for rigging the London interbank offered rate, a global benchmark for $300 trillion of securities, regulators are now expanding their examination into measures that, while obscure, hold as much sway in the workings of the world’s financial system.

“Let’s treat this as seriously as we treated the Libor scandal,” said Robert Emerson, head of interest-rate derivatives at SuperDerivatives Inc. in New York, which provides market data, technology and valuation services. “We need public and institutional confidence in both our banking system and the structure of our financial markets. When something like this comes out, it erodes that confidence very quickly.”

The Commodity Futures Trading Commission has issued subpoenas to current and former brokers at ICAP Plc’s rates-swap desk in Jersey City, New Jersey, as well as to the International Swaps & Derivatives Association and as many as 15 Wall Street dealers, Bloomberg News first reported on April 8, citing people familiar with the matter.

Stephanie Allen, a CFTC spokeswoman, said last week the commission doesn’t comment on enforcement issues.

In an April 9 statement, ICAP said it had no knowledge of allegations of price manipulation by its brokers and is investigating them. “Until those investigations are complete, we will not make any further comment,” the company said.

ISDAfix rates were created in 1998 by the New York-based trade group with the predecessors of Thomson Reuters Corp. and London-based ICAP, the biggest arranger of rate-swaps trades between banks. The U.S. regulator is investigating swaps gauges including ISDAfix and prices displayed on a widely followed electronic screen on concern that brokers and dealers colluded to create inaccurate quotes that would boost bank profits.


Profit Potential

ICAP, which is also being investigated in the Libor case by Britain’s Financial Services Authority and Canada’s Competition Bureau, manages the electronic screen known as 19901 on which prices are displayed throughout the day to about 6,000 corporate treasurers and money managers so they can value positions. At the market’s peak, ICAP’s rate-swaps desk paid its brokers as much as $7 million a year, earning the group the nickname “Treasure Island,” two people familiar with the matter said last week.

The potential for a bank to boost profits from the derivatives trading begins when it needs to offset the risk of an interest-rate swap it has entered into with a customer such as a money manager or a corporation. To do this, the dealer enlists a broker at a firm such as ICAP to arrange a series of trades with other dealers that offset the swap with its customer.

Banks can earn millions in profit by convincing ICAP brokers to delay when they enter those trades into the 19901 screen, according to a former ICAP broker who asked not to be identified for fear of retribution.

If such a delay prevents the cost of the swap from moving one basis point, or 0.01 percentage point, that equals about $1 million of profit for the dealer on a $500 million swap that matures in 20 years.

Like Libor, ISDAfix is created by averaging submissions from banks rather than actual trade data. Administered by ICAP and Thomson Reuters, the rate is published at 11 a.m. in New York and is distributed by Reuters, Telekurs and Bloomberg LP, the parent company of Bloomberg News.

One difference between the two benchmarks that may limit the scale of rate-swaps manipulation is that, unlike ISDAfix, Libor isn’t based on an actively traded financial instrument, Emerson of SuperDerivatives said. That makes the ISDAfix rates harder to influence than Libor, he said.


Obscure Benchmark

“I can’t really manipulate the market because everyone knows it should be around 1.5 percent because that’s where it’s actively trading,” he said. While Libor rates were pushed around by 3 to 5 basis points, manipulation of the ISDAfix rate may be limited to moves within a 1 basis-point range, he said.

For all its importance to many markets, ISDAfix isn’t well known even among people who rely on it. The head of trading at a structured products desk at a Wall Street dealer, a derivatives lawyer at a major U.S. firm, academics at U.S. universities and a brokerage analyst all interviewed by Bloomberg News had never heard of the rate nor knew how it worked.

Trades in the interest-rate swaps market can be terminated and valued using ISDAfix. Issuance of U.S. securitized bonds, which are often sold with coupons linked to the rates on the 19901 screen, totaled more than $350 billion last year, according to data from Asset-Backed Alert, an industry newsletter.

The rate is also used to settle options on swaps, a derivatives market with $28.4 trillion of contracts outstanding as of April 4, according to the Depository Trust & Clearing Corp., which operates a central trade repository.

Structured notes, which are debt bundled with derivatives sold to wealthy individuals by banks from Barclays to JPMorgan Chase & Co., are often linked to the benchmark.

Since 2010, when Bloomberg began to comprehensively collect data on the securities, investors have bought $2.42 billion of notes tied to ISDAfix rates, the data show. The notes are typically bought through brokers or advisers.

“Something like this really hits home with the public,” Emerson said. “The public is very distrustful of the banking system. Having scandal after scandal tells them they were right all along.”

ISDAfix demonstrates the rate-swap market’s need for transparent pricing, said Marcus Stanley, policy director for Americans for Financial Reform in Washington.


‘Extra Cost’

“If you’re a dealer and you know the real price but the client has no idea, and is in fact misinformed, that gives you a lot of money-making opportunities,” he said.

Interest-rate swaps, the largest part of the $639 trillion privately negotiated derivatives market, are used by corporations, pension funds, and municipalities to guard against rates falling below the fixed payments they are obligated to make on bonds or pension plans.

“Every time they pay more for swaps, there’s a little slice of extra cost for all those businesses,” Stanley said. “They all have to pay above market price to the big Wall Street banks.”

The system for fixing prices in all asset classes, whether they be rates or commodities or equities, needs to be changed, Emerson of SuperDerivatives said.

“Let’s fix the structure so it’s very difficult to manipulate,” he said. “We need to create criminal penalties for manipulation.”


Bloomberg News

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