Mis-selling, Libor and HFT systemic risk

The week on Risk.net, October 21–28, 2016

MIS-SELLING at issue in Linz v Bawag case

LIBOR unfit for purpose, US Treasury says

CENTRAL CLEARING for Treasury bonds will help stop HFT crash spreading


COMMENTARY: Hidden risks

The Austrian city of Linz's dispute with Austrian bank Bawag is far from the first of its kind; it isn't even the first of its kind against Bawag. Back in early 2007, the Linz authorities decided to borrow Sfr195 million in a Libor-linked loan, hoping the euro would continue to strengthen against the Swiss franc and reduce the size of the debt over time. They added a 10-year cross-currency swap with Bawag to handle the risk of rising Swiss Libor rates, but the swap had significant downside risk – Linz would make substantial additional payments in the event of a fall in the euro.

Of course, the financial crisis began to bite later the same year, the euro dropped against the Swiss franc, and Linz found itself by 2011 faced with monthly payments in the Sfr10 million region, and stopped paying. Linz sued Bawag, Bawag countersued, and the case has been ongoing ever since.

The size of the suit – Bawag is countersuing for €617 million – makes it unusual, but otherwise it is similar to many other cases from the past decade. Deals with Prato in Italy, Metro de Porto in Portugal, Milan in Italy, Birmingham and Philadelphia in the US and dozens of others have led to losses and lawsuits from what looked even in 2006 like a dangerous game.

The customers have claimed the products were mis-sold and were too complex for them, and/or that they were ultra vires and therefore void; the banks have defended themselves by arguing that the products were suitable for what were, after all, fairly sophisticated customers, and that the losses were unfortunate but not unjust. To quote Captain Scott, they took risks, they knew they took them, and things have come out against them; therefore they have no cause for complaint.

As Risk warned more than a decade ago, though, the unwary risk-taking here was not all on one side. Ironically, it's starting to look as though the banks, not the customers, were the ones taking on risks they didn't perceive or understand. Many customers have successfully argued for mis-selling or ultra vires agreements, and thus exempted themselves from any further losses. But by failing to see the bigger picture – the one that included litigation risk, reputational risk and strategic risk, as well as market and credit risk – the banks have exposed themselves to heavy out-of-court settlements, costly court cases, negative publicity and the loss of an entire sector of the potential derivatives end-user market.

The Linz versus Bawag case continues, and judgement may yet be in the bank's favour. On the larger battlefield, though, the banks have already lost.


US banks have close to $150 billion total unfunded loan commitments to energy companies, while Canadian banks have nearly $100 billion



[A flash] event stresses the market, and under that stress it helps to have the same kind of margin regime in place that is transparent. The US Treasury market is one of the few markets where this is not the case. You have some margining between the IDBs and some of their clients and some margining that happens in FICC. This potentially causes a situation where, after a large move, you get a question of creditworthiness in the market. Given this dual structure, could this magnify a flash crash by market participants pulling away from the market and therefore halting the market?" – Giuseppe Nuti, head of US rates trading at UBS in New York



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Buy side turns to credit skew notes for yield pick-up
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Energy risk teams explore use of KRI metrics
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