The embedded derivatives

LOBO loans contain embedded derivatives in the form of future options.

Until the 2011 Localism Act, councils were prohibited from taking out derivative contracts following a ruling in 1991 for the Hammersmith and Fulham vs Hazell case involving Goldman Sachs and other banks. The House of Lords ruled it was not councils’ role to speculate upon interest rates, and taxpayers should not be held liable.

Based on this ruling LOBO loans could be potentially considered illegal. However, some argue that councils were only prohibited from taking out standalone derivatives contracts and that the ruling should not be applied to LOBO loans where the derivative is embedded within the loan.

The underlying argument – that it is ultra-vires for councils to speculate with taxpayer money – remains in any case valid and could be used to challenge the legality of LOBO loans, especially in the case of some of the most risky LOBO loans (range and inverse floater).

Furthermore, banks should be held accountable for providing a debt instrument that appears to be specifically designed to circumvent regulation. As a result LOBO loans appear to have been sold only to councils in the UK. Outside of the UK councils were sold instead standalone derivative contracts.

The conflict of interest


Treasury management advisors’ advice, which should have been independent, was highly conflicted in the case of LOBO loans as they were receiving commission payments from brokers when LOBO loans were arranged.


Butlers was one of the most prolific TMAs advising councils on LOBO loans. However, many councils were not aware Butlers was a trading division of ICAP, one of the brokers involved in arranging LOBO loans, and that ICAP was transferring funds to its subsidiary Butlers when the TMA advised councils to take on LOBO loans via ICAP.

This is clearly stated in the 2011 Competition Commission report on the merger between Butlers and Sector Treasury Services. It says the main source of Butlers revenue came from:

“transactional income […] arising from Butlers referring its clients to ICAP and receiving a share of the brokerage fees from any resulting transactions involving certain money market instruments (eg LOBOs)”

“There was a relatively high degree of overlap between Butlers’ public authority clients and other areas of ICAP. About half the clients of ICAP’s Non-Banking desk (which is involved, among its other activities, in arranging LOBO transactions) were also Butlers’ clients.”

Sector Treasury Services

Sector Treasury Services (STS) was another prolific TMA advising councils on LOBO loans. Unknown to the councils, it was also receiving kickbacks from ICAP and Tullet Prebon, whenever they brokered a loan. This was up to May 2015 stated clearly on the website of Capita (of which STS was a subsidiary) under the heading “nonexclusive business relationships”:

“We also receive referral commissions from Tullet Prebon, Siemens and ICAP, when Lender Option Borrower Option (LOBOs) transactions are arranged by them.”

The payments from Tullet Prebon were also mention in the 2011 Competition Commission report:

“A share of the brokerage fees earned by the money broker Tullet Prebon, paid to STS if an STS client elects to transact through Tullet Prebon in relation to the arrangement of LOBO loans.”

All scenarios call into question the independence of advice upon which councils relied. Given the high profits being made by brokers and advisors when councils borrowed from banks, it is hard to believe that LOBO loans were recommended with the interests of taxpayers in mind.

“Outrageous, in the end if a council appoints and pays for an independent outside advisor to come in, they expect that advice to be independent and not to be paid for by somebody else who is gaining a profit from these loans being set up. That really is scandalous if it has happened. I think the FCA now ought to investigate this and if it hasn’t got the powers the government should give it the powers
to regulate this in the future. I think the Committee will want to look into this very seriously indeed.”

Clive Betts MP, Chairman of the CLG Committee commenting for the Channel 4 Dispatches documentary on LOBO loans

The conflicted relationship between TMAs and brokers was not unknown to central government. When Icelandic banks collapsed in 2008 and councils who had invested in them lost millions, the conflict of interest was central to the story.

A Communities and Local Government (CLG) Committee inquiry into local authority investments launched in 2009 stated:

“The evidence which we have examined has raised concerns about potential conflicts of interest and questions as to whether there are any financial transactions between treasury management advisers and brokers that might compromise the independence of advice being given to local authorities. There is a strong case for a full investigation by the FSA [Financial Services Authority] of the services provided by local authority treasury management advisers. We recommend that such an investigation be carried out as soon as possible.”

The FSA, the financial regulator at the time, refused to undertake any inquiry into TMA firms. No investigation was initiated following the LOBO loans scandal either, leaving the TMA and broker firms involved off the hook again.

The lack of benchmarking

LOBO loans can be considered unlawful as they were not taken out by councils in the public interest. Unlawful has a specific meaning in the 2014 Local Audit and Accountability Act when it relates to an item in a council’s financial accounts. An unlawful item in the accounts is spending or income that the council:

  • spent or received without powers to do so
  • took from or added to the wrong fund or account
  • spent on something that they had the power to spend on, but the decision to spend the money was wholly unreasonably or irrational – as in, no reasonable person would have made the decision.

LOBO loans could be challenged on the basis that they are unlawful, since no-one would rationally decide to enter loans that are so expensive and risky while having the option of borrowing more cheaply and at a lower risk from the PWLB.

Former Barclays trader Rob Carver says in the 2015 parliamentary inquiry:

“the nature of the risk itself means it is the kind of risk that makes traders and hedge fund managers, as I also used to be in the past, wake up at night screaming. It is just horrible stuff. I do not think anyone who fully understood it would do it.[…] I would not do these deals if you put a gun to my head.”

Because of the extra risk, one would expect councils to have taken out LOBO loans with interest rates lower than the contemporaneous PWLB rates. When this was not the case, it is likely benchmarking was not undertaken.

In the case when  LOBO loans were taken out with lower interest rates than contemporaneous PWLB debt, councils and auditors have often argued that it was cost effective. This is based on the assumption that the difference in cost between the loans can be determined simply by comparing the interest rates of the loans. However, this is not the case.

First of all, most LOBO loans have a maturity of 60 to 70 years for which there is no comparable type of loan to benchmark them against since PWLB loans have a maximum of a 50-year term (and had maximum terms of 30 years until 2005).

Furthermore, the Charted Institute for Public Finance and Accountancy (CIPFA) states very clearly in its 2015 bulletin on LOBO loans that one cannot benchmark the loans simply by comparing interest rates:

“When evaluating a LOBO borrowing opportunity, councils should compare the rate offered on the LOBO with both swap and PWLB rates. While a LOBO’s contractual maturity may be, for example, 50 years, comparing the headline rate to that available through 50-year PWLB is overly simplistic.”

CIPFA adds:

“A LOBO loan can be analysed in terms of its financial components, as follows:

    1. a loan at a floating rate which reflects the lender’s cost of capital, the credit risk of the borrower, and the lender’s profit margin
    2. an interest rate swap converting the variable rate into a fixed rate
    3. a series of options, one for each option date; these are known as Bermudan swaptions.”

It is very unlikely that councils had the tools and expertise to price LOBO loans in this way. So such calculations and projections over the lifetime of the loan should have been provided by their treasury management advisors. No council up to now has been able to provide any evidence of benchmarking of LOBO loans. When provided by councils, the projections have been given as if the loans were simple fixed-rate loans.

The rigging of benchmarks

Banks and brokers used international benchmarks when providing LOBO loans. In the last decade, a number of scandals were uncovered showing how both banks and brokers were complicit in rigging the benchmarks.

If LOBO loans contain derivatives that are bets with the banks on future interest rates, then clearly if the banks had the power to manipulate those rates, the bet cannot be considered fair.


LIBOR (London InterBank Offered Rate) is a global benchmark for interest rates, and was used as a reference for many LOBO loans.

Up to 2013 LIBOR was set in the following way: 16 to 18 leading global banks provided to the London-based British Bankers Association (BBA) an estimate of what they would be charged if they were to borrow from each other – hence the name interbank offered rate. Now LIBOR is administered by the Intercontinental Exchange (ICE) and its rates are calculated for five currencies and seven borrowing periods ranging from overnight to one year. LIBOR was often called “the financial markets’ most important number” because it was so widely used as a reference to set interest rates for loans, mortgages and credit cards. It is estimated that at least $350 trillion in derivatives and other financial products were pegged to LIBOR.


In 2012 it was uncovered that between 2006 and 2009 the LIBOR interest benchmark had been systematically rigged by the banks responsible for setting it, including Royal Bank of Scotland, Barclays, Deutsche Bank and HSBC – banks that were at the same time selling LOBO loans to councils.

Barclays was at the centre of the LIBOR scandal and was the first bank to be investigated by the Serious Fraud Office (SFO).  The first case against Barclays was based on the involvement of four of its traders who were charged in April 2014 with conspiracy to defraud by manipulating global interest rates. The conspiracy was stated by the SFO to have been undertaken between 1 June 2005 and 1 September 2007, a period during which Barclays was very active in the LOBO loan market.

The other period of interest in relation to Barclays’ LIBOR rigging is the period of so-called ‘lowballing’ where the Bank of England instructed Barclays to lower its rates between 1 September 2007 and mid-2009, including the key period in autumn 2008 when the financial markets went into meltdown. Emails between Paul Tucker at the Bank of England and Mark Dearlove at Barclays confirm the Bank of England was instructing Barclays to rig LIBOR lower to make it appear the financial sector was healthier than it was.

LIBOR rigging is particularly crucial in the case of Barclays LOBO loans, as the range LOBO loans the bank sold to councils were pegged to the GBP 6-month LIBOR rate by contract.

LIBOR rigging is a strong basis on which even LOBO loans that are not pegged to the rate by contract can be challenged, since LIBOR impacts the fair value of the loans. Arlingclose explain clearly how LIBOR was a crucial part of the LOBO puzzle in their submission to the 2015 parliamentary inquiry:

“The majority of banks funded long dated LOBOs via short-term deposits they receive on a variable rate basis, usually based on LIBOR. As Local Authorities pay interest on LOBOs at a fixed rate, and the bank’s cost of funds are variable, most LOBO lenders used swaps to eliminate interest rate risk from their investment.”

Less well publicised in the LIBOR scandal was the leading role of the broker firms such as ICAP, Tullet Prebon, and RP Martin. Six brokers from these companies, along with a former UBS trader, Tom Hayes, were charged by the SFO for their involvement in influencing the Japanese Yen LIBOR between August 2006 and December 2009. The broker firms were also arranging LOBO loans at the time. All the brokers were ultimately discharged, while Hayes remains convicted. Though this case cannot be used to challenge LOBO loans, as it refers specifically to the Japanese Yen LIBOR, it is telling of the role that brokers had in the manipulation of market rates while at the same time selling their clients products that were pegged to them.


In addition to LIBOR, banks and brokers rigged another obscure benchmark called ISDAfix. Set by ICAP and Thompson Reuters, it has been described by some analysts as “the oxygen that feeds financial markets”. ICAP was accused of manipulating the rate from at least 2009 to 2012 along with 14 major banks, including Royal Bank of Scotland (RBS), Barclays and Deutsche Bank.  Some of the worst types of LOBO loans, the ‘Inverse floaters’, reference ISDAfix directly. They were sold to councils by RBS and often brokered by ICAP who also advised councils on LOBO trades via its subsidiary TMA, Butlers.

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