WSC’s Guide To The LIBOR Scandal

What is LIBOR?

London Inter Bank Offered Rate is the rate at which banks in London lend money to each other for the short term in a particular currency. A global benchmark interest rate used to set a range of financial deals. It is also a measure of trust in the financial system and the faith banks have in each other’s financial health.

 

Every day a group of leading banks submit rates for 10 currencies and 15 lengths of loan ranging from overnight to 12 months. The most important is the three-month dollar Libor. The rates submitted are what the banks estimate they would pay other banks to borrow dollars for three months. This is a simple example of
how it works.

Since the rates submitted are estimates not actual transactions it’s relatively easy to submit false figures.

Traders at several banks conspired to influence the Libor by getting colleagues to submit rates that were either higher or lower than their actual estimate.

 

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World’s First Financial Bubble – The Tulip Mania

Could a mere tulip bulb be worth $76,000? It is, if people are willing to pay for it. It may sound preposterous, but this is exactly what happened during the Dutch Tulip Mania or Tulipomania of the 1630′s.

The Semper Augustus which was considered the rarest, most valuable and the greatest tulip ever found, was valued at 10,000 Florence at a time where an average Dutch worker survived with a family with only 300 Florence a year. Another irrational incident witnessed was 12 acres of land being offered for a Semper Augustus bulb. Such was the madness at the peak of Tulipomania.

 

So this is how it all began….

Initially, only true connoisseurs (a person who is especially competent to pass critical judgments in an art) bought tulip bulbs, but the rapidly rising price quickly attracted speculators looking to make a profit. It didn’t take long before tulip bulbs were traded on local market exchanges, which were similar to modern stock exchanges. By 1634, tulip mania had spread to the Dutch middle classes and soon practically everybody was trading tulip bulbs, looking to make a quick fortune.

The majority of tulip bulb buyers had no intention of planting these bulbs – the name of the game was to buy low and sell high, just like in any other financial market. The entire nation was caught in a sweeping mania and some people even traded in their land, livestock, farms and life savings to acquire a single tulip bulb.

After some time, a few tulip bulbs contracted the non-harmful mosaic virus, which caused tulips to grow petals with beautiful “flames” of color. This unique effect increased the value of the already rare and highly exclusive tulip bulb triggering the bubble to build up.

At the peak of the mania, the price of tulip bulbs went up twenty-fold in just one month. To put that into perspective, a person who had invested $1,000 in tulip bulbs would have seen their investment balloon to $20,000. With gains such as these, it is not hard to understand the mad rush to buy tulip bulbs at any cost.

By 1636, tulips were trading on the Amsterdam Stock Exchange as well as on exchanges in other nearby European countries. These exchanges started to offer option contracts, which allowed speculators to trade in the tulip bulb market for a fraction of the price of a real tulip bulb.

Dutch traders aggressively speculated in tulip bulb options due to the common belief that the tulip market was immune to falling and that it would “ALWAYS GO UP”.

And the mania ends….

After some time, the Dutch government started to develop regulations to help control the tulip mania. It was at this point that a few informed speculators started to liquidate their tulips bulbs and contracts to lock-in their profits. In addition, more tulip bulbs were added to the supply due to increasingly large tulip bulb harvests. Suddenly, tulip bulbs weren’t quite as rare as they were before. Tulip prices began to ease, gently at first, and then started to plummet at a much faster rate than prices rose. Suddenly, the market experienced a widespread panic as traders rapidly began to realize that tulips were not worth the prices people were paying for them. A default on a tulip bulb contract by a buyer was the main bubble-popping catalyst and caused the tulip bulb market to violently implode as sellers overwhelmed the market and buyers virtually disappeared altogether. Within just a few days, tulip bulbs were worth only a hundredth of their former prices, resulting in a full-blown panic throughout Holland. Dealers refused to honor contracts, further damaging confidence in the tulip bulb market. In less than six weeks, tulip prices crashed by over 90%, causing vast fortunes to be lost.

The traumatic tulip bulb crash resulted in a suspicion toward speculative investments in Dutch culture for a very long time after. The tulip bulb crash threw the Dutch economy into an economic depression that lasted for many years.

Investors came to know that it is better to stop and smell the flowers than to stake your future upon one.

India : Powerless?

On the eve of 30th of July, yet again India woke up to find itself plagued by the darkness of corruption and politics, but this time literally in the form of a “Power Crisis”. Weakness and instability of India’s power reforms, policy paralysis during UPA’s eight year tenure and the biggest blackout ever, as the Economist puts it ”Has made India feel like the giant set of a disaster movie”. The roots to the cause lie much far deeper than just failure of the system.

Just like other countries, India too had a modest beginning in electrical transmission grid. It started off decades ago as a large collection of state-level-networks with a few links among themselves. In the early 60’s the states slowly began developing links among their grid networks. But, it wasn’t till 2002 where the Northern, Western and Eastern grids were all linked up to form a “Superhighway” across central and east India. The commissioning of Agra and Gwalior link was crucial in sealing this mega loop.

The stability of the grids depends on a delicate equilibrium of demand-supply chain. The amount of load is directly proportional to the amount of power generated. When the equilibrium between power generated and power consumed gets disturbed, the load increases, tripping the line.

HOW IT ALL STARTED:

However the crucial question remains, why they were all linked up to form a Mega grid spanning across 8 of India’s most industrialized centers? The solution lies all in the basic fundamental of demand and supply. The coal fields of Chattisghad and Jharkhand are critical source for cheap coal. Rather than moving coal to where it is needed, it is lucrative to set up generating stations near coal fields and then distribute the power to consumers. Intra-Grid coordination for the movement of electricity is done by hierarchy of Load Dispatch Centers (LDC). This is where politics kicks in.

As obvious it may seem, overdrawing of power is not the reason. If Delhi, UP and other states withdrew excess power, then why would the grid fail only on those two days? And moreover there must be a registered frequency drop intermittently transmitted to all the states (Imagine a water tank with an inlet and outlet pipe, so if the rate of water flowing in from inlet pipe is lower compared to the rate at which it is being withdrawn, then the water level in the tank will drop) which was not to be.

So what exactly happened? Two of the grid components were weak (see image  – next page), the western grids of Kankroli and Zerda were down due to repair and upgrade work. With these two important grids down, there was tremendous pressure on the remaining grids (specially the Agra-Gwalior) to bear the excess load, which eventually triggered a domino effect.

On July 29th, almost 1000MW of power was flowing through the Agra-Gwalior line, whereas the allowed limit for regular and safe use is 850MW. Can’t figure out why? Politics is the answer.

The lines are fitted with special circuit breakers which disconnect automatically once they register a sharp fall in frequency, signifying high loads. As the line disconnects, the supply for the rest of the grid should increase as the section of consumers have been cut off thereby bringing the demand supply back to sane conditions.

So the politicians buy their way through the system, tampering with the permissible frequency and load levels, which unsurprisingly lead to higher power transmission to their respective states (increasing cutoff levels  to hazardous levels).

GRID ECONOMICS:

Grid economics has been constantly changing ever since the Mega Grid has been set up.

Apart from massive infrastructure, the economic policies also play a decisive role. For example: If on average, Delhi requires 2300MW for Sunday morning it makes an order to its supplier 24 hours in advance. And then if Delhi requires less power as the day progresses, they correspondingly reduce the supply. So for a few years now, the states started demanding more than they actually needed, overworking the grid when they demanded for 3500MW when only 3000MW was needed.

India is not the only country that suffers from grid issues. In 2003, there was a massive power failure in North America with New York plunging into darkness. But India seems to have suffered arguably the worst crisis in terms of the population that got affected.

 

ROAD AHEAD:

One third of India’s household live in darkness and many still have limited access to electricity. Very little has been done to overcome these issues. Reforms such as refinancing Load Dispatch Centers (LDC) and also maintaining autonomy helps it from being tampered by politics.

Freeing up pricing to make consumers more responsible and also privatizing this sector to a large extent to introduce competition in generation, transmission and distribution.