magazine

Issue 24 | Summer 2014 | www.markit.com
magazine
Inside
Goldman Sachs
Gary Cohn opens up
The HFT debate
Has the market
moved on?
Margin
manoeuvre
The grab for
collateral
DAWN’S
LIGHT
WELCOME
Stars and Stripes
W
elcome to the Summer issue
of Markit magazine. The big
sporting event of the year has
just kicked off in Brazil, and
we look forward to much
excitement over the coming weeks. The US
will be making its seventh consecutive
appearance at this year’s football World Cup
finals, a remarkable achievement for a country
more famous for American football, baseball
and basketball.
We have dedicated our front cover to the
proud symbol of the US, the Stars and
Stripes, as we have a distinctly US-led theme
this issue. Our lead interview is with Gary
Cohn, president and chief operating officer
at Goldman Sachs, who discussed with us
the technological opportunities driving one
of Wall Street’s most iconic institutions.
The US is also our country in focus and in
our commentary section we have highlighted
many of the US asset classes that may make
waves in the coming months. We profile Bill
Mertens, the former banker turned
entrepreneur who is now running his own
restaurant on Florida’s beautiful Amelia
Island.
As ever, we aim to stay close to the issues
that matter to the financial markets and in
this issue we take an in depth look at
operational and processing challenges in the
loan space and find a market set to throw
off its reputation as a technological laggard.
High frequency trading has hit the
headlines in recent times; we take a coolheaded tour of the arguments and find there
is more to that world than meets the eye.
Elsewhere we lift the lid on securities
lending and discuss rule book changes that
are causing controversy. We also assess
proposals for initial margin requirements on
uncleared derivatives and find that
regulators and market participants still have
much to discuss.
We hope there is plenty of food for
thought here as you fire up your summer
barbecues and cheer on your favourite
football team!
Lance Uggla
Chief executive officer, Markit
Editorial board
Robert Barnes, Turquoise
Bronwyn Curtis OBE
Tim Frost, Cairn Capital
Sal Naro, Coherence Capital Partners
Larry Tabb, Tabb Group
Daniel Trinder, Deutsche Bank
Writers
Dan Barnes
Nicholas Dunbar
Gavin O’Toole
Edward Russell-Walling
Lynn Strongin Dodds
Peter Truell
Markit editorial team
Alex Brog
Ed Canaday
Teresa Chick
Ed Chidsey
Eric Maldonado
Will Meldrum
Fleur Sohtz
Roger Spooner
Joanna Vickers
Editor
David Wigan
Industry contributors
Bill Hodgson, The OTC Space
Paul Jones, Markit
Marcus Schüler, Markit
Henry Yegerman, Markit
Chief sub editor
Jennifer Laidlaw
Design
Lemonbox
Photography
Cy Cyr/Getty Images
Shutterstock
Enquiries
[email protected]
Opinions, estimates and projections in this
magazine constitute the current judgement of
the author at the time of writing. They do not
necessarily reflect the opinions of Markit.
Although effort has been made to ensure the
accuracy of the information contained in this
publication at the time of writing (June 2014), Markit
does not have an obligation to update or amend
information or to otherwise notify a reader thereof in
the event that any matter stated herein changes or
subsequently becomes inaccurate.
Markit shall not have any liability whatsoever to you,
whether in contract (including under an indemnity),
in tort (including negligence), under a warranty,
under statute or otherwise, in respect of any loss
or damage suffered by you as a result of or in
connection with any opinions, recommendations,
forecasts, judgments, or any other conclusions,
information or materials contained herein.
Printed in England by Wyndeham Grange, Butts
Road, Southwick, West Sussex BN42 4EJ.
www.wyndeham.co.uk
The Markit Magazine ISSN: 1757-210X is published
quarterly (March, June, September & December)
by Markit and distributed in the USA by Mail Right
International Inc, 1637 Stelton Road B4, Piscataway
NJ 08854.
Periodical postage paid at Piscataway NJ and
additional mailing offices. POSTMASTER send
address changes to The Markit Magazine, Markit
c/o 1637 Stelton Road B4, Piscataway NJ 08854.
To subscribe to the Markit Magazine, please log on
to www.markit.com/sites/en/about/registrations/
markit-magazine.page
Total average net circulation 10,996.
July 1 2012 - June 30 2013.
Markit is a registered trade mark of Markit Group
Limited. Copyright © Markit Magazine. All rights
reserved. Reproduction in any form is prohibited
without the written permission of Markit.
Summer 2014
3
CONTENTS
8
COVER STORY
Golden
opportunities
Gary Cohn, COO at
Goldman Sachs, talks to
Markit exclusively
Issue 24 | Summer 2014
REGULARS
6
News
14
Country Focus
43
Book review
All the latest from Markit and our partners
American contradictions
Stephen Blyth on quants, Hugo Dixon on the
UK’s European obsession and Philippe Legrain
on economy
FEATURES
16
14
Facing the fax
How loan settlement is moving from
analogue to digital
21 Flash crash
Have the pundits got it wrong on
high frequency trading?
27 Regulatory fever
Securities lending faces up to the new normal
21
32 Margin conundrums
Initial margin proposals cause controversy
38 Markit life
Bill Mertens on swapping credit derivatives
for fine dining in Florida’s tropical paradise
COMMENTARY
27
58
38
46
Market insight
58
Markit infograph
Our analytics teams discusses prospects
for the coming quarter
US by numbers
Summer 2014
5
MARKIT NEWS
Genpact joins Markit
in KYC initiative
BUSINESS PROCESS and
operations specialist Genpact is
working with Markit and a group
of banks to design an
on-boarding and knowyour-client (KYC) data
management service.
The companies in late May
announced the launch of
Markit | Genpact KYC Services,
designed in partnership with
Citi, Deustche Bank, HSBC and
Morgan Stanley. The services
standardise and centralise the
collection and management
of KYC data with the aim of
streamlining client on-boarding.
“The combined capital markets
technology, data analytics and
domain expertise from Genpact
and Markit, along with insights
provided by our banking partners,
has led to a service that marks
an inflection in the way business
process services are delivered, “ says
Mondy Singh, vice president and
business leader, Capital Markets
and IT Services at Genpact. “This
collaboration demonstrates how the
banking industry is implementing
new operational strategies in
response to regulatory changes.”
Built to collect, enrich and
centrally administer legal entity
data and documents that banks
require from their clients,
Markit | Genpact KYC Services
will also guarantee compliance
with anti-money laundering
regulation and rules under
the Dodd-Frank Act, Emir,
Fatca and Mifid. The service
will actively monitor client
information and automatically
revalidate data as required.
New securities finance
platform launched
MARKIT HAS LAUNCHED a
new securities lending data
online platform that caters to the
workflow requirements of
borrowers and lenders. The new service will introduce
complementary Markit datasets,
offer more timely data with the
inclusion of pending and
intraday trades, and enhance the
functionality of several existing
products.
Book management functionality
built into the solution enables
lenders and borrowers to
benchmark trading positions
against market positions, while
6
Summer 2014
interactive charting allows users to
create customisable views based
on three years’ history, with
integrated news and configurable
criteria spanning key securities
lending metrics. “We have invested in our online
platform following extensive
feedback from our lender and
borrower customers,” says David
Carruthers, managing director
and cohead of securities finance at
Markit. “This new delivery
channel is intuitive and can be
easily scaled to meet the rapidly
evolving requirements of the
converging worlds of stock loan,
David Carruthers
repo and collateral management,
and is part of a broader
programme to address the
growing collateral management
requirements while continually
enhancing our products as the
securities lending market evolves.” Other applications include
market share analysis, which
supports assessment of
concentration risk, and
The new service brings
together technologies based
on Genpact’s Remediation as a
Service platform and Markit’s
Counterparty Manager Service.
Counterparty Manager is used
by 900 financial institutions
and around 5,000 corporate
customers to automate
how they share regulatory
compliance information and
KYC documents with more
than 80 banks globally.
Online
Subscribe to the new tools online at
http://www.kyc.com
opportunities and trading flow
highlights, which help identify
squeeze risks and shine a light on
the biggest changes in securities
lending fees, lendable inventory
and loan balances.
Meanwhile, portfolio
monitoring helps lending desks
create and monitor bespoke
portfolios and watch lists, while
rerate tracking helps gauge
changes in rate trends.
Markit’s daily global securities
financing data covers $15trn of
securities in the lending
programmes of over 20,000
institutional funds and tracks
loan balances of $2trn. It provides
a comprehensive view of short
interest data and institutional
fund activity across equities and
fixed income spanning all market
sectors.
MARKIT NEWS
BRIEFS
Regulation
and best sellers
Delegates at Markit’s annual
customer conference in London
were discussed the evolving
regulatory environment, with
compliance cited as the key
driver of innovation.
Comparing US to European
regulatory progress, some
delegates considered the
European regulators to be
playing catch up. Others
believed it may prove
advantageous to learn from
Dodd Frank’s successes and
failures.
The critique of high
frequency trading (HFT) in
Michael Lewis’ Flash Boys
provoked a lively debate during
the final panel. Most
participants strongly revoked
the book’s accusation that the
buy-side largely doesn’t know
or understand the market’s
true structure and disagreed
with Lewis’ equation of HFT
with front-running.
Meanwhile in New York,
Markit customers came
together to discuss equity
market structure and the role of
Regulation National Market
System. Participants were split
on whether high frequency
trading adds noise or
complexity (for a full discussion
of the issue see page 21). There
followed lively debates on the
role of innovation, a ‘fireside’
chat with Citi copresident
James Forese.
Waters names Markit
sell-side technology
provider of the year
Markit has won Sell-Side
Technology Provider of the Year
and Best Sell-Side Newcomer in
the annual Sell-Side Technology
Awards presented by Waters
magazine, which covers
innovation and best practice in
financial industry technology. The Sell-Side Technology
Provider of the Year recognises
Markit’s technology and
services that help make
markets more transparent,
reduce risk and improve
operational efficiency.
Technology solutions
announced by Markit in
the past year include
Credit Centre, for pre
trade credit checking
for OTC derivatives,
and Collaboration
Services.
Flash PMI set to offer Japan snapshot
A NEW INDICATOR offering
market participants the earliest
possible indicator of Japanese
industrial activity has launched.
The Markit/JMMA Flash
Japan Manufacturing PMI
will be published on a monthly
basis around one week before
final PMI data are released,
making the Markit Japan PMI
one of the earliest available
indicators of manufacturing
sector business conditions in the
world’s third largest economy.
Markit has been collecting PMI
data from Japanese producers
since October 2001, and its
survey panel comprises over 400
manufacturers. The methodology
for PMI surveys is identical across
global PMI series. The Markit
Flash Japan Manufacturing
PMI is an early view based on
85 per cent–90 per cent of total
PMI survey responses each
month, and will be followed
by the release of final Japan
Manufacturing PMI data on the
first working day of every month. “Markit has been collecting
PMI data from Japanese
producers since October 2001,
and its survey panel comprises
over 400 manufacturers,”
says Luke Thompson,
managing director and head
of economic indices at Markit.
“The methodology used by
Markit for its PMI surveys
is identical across its global
PMI series conducted in
more than 30 countries.
The Markit Flash Japan
Manufacturing PMI will be
released alongside existing
Markit Purchasing Managers’
Index™ (Markit PMI) surveys
for the United States, the
eurozone and China, providing
the first global snapshot of
manufacturing operating
conditions each month.
Markit PMI surveys are
among the most closely watched
business surveys, favoured by
central banks and financial
market participants alike.
GlobalCapital hands Markit laurels
MARKIT has been named
Data Vendor of the Year by
GlobalCapital Derivatives.
The award celebrates Markit’s
excellence in delivering pricing
and valuation products and
services to its customers
across the trade lifecycle.
"Both buyside and sellside
derivative users that were
interviewed by the editorial
team of GlobalCapital highly
praised Markit's analytics,
portfolio management and
data delivery services,” says
Robert McGlinchey, editor
of GlobalCapital Derivatives.
“The MarkitSERV platform was
From left:
Ed Chidsey
managing director,
Markit Group;
Laura Kholodenko,
director, Markit
portfolio
valuations;
Beth Shah,
GlobalCapital
Derivatives.
also highlighted by derivative
users throughout the awards
process for its leading role in
end-to-end trade processing
such as pre trade clearing credit
checking and post trade notices
across areas including clearing,
execution and confirmation."
GlobalCapital magazine
combines Euroweek, Derivatives
Week and Total Securitization
and covers derivatives,
syndicated loans, bonds and
structured products.
MarkitSERV and OCC partner on equities
MARKITSERV, the leading
electronic trade processing
service for over-the-counter
derivatives, has launched trade
affirmation, connectivity and
trade status messaging services to
support clearing of OTC equity
derivatives by
the Options
Clearing
Corporation
(OCC),
the first
clearinghouse
in the United
States to clear those transactions.
J.P. Morgan and Morgan
Stanley were among the first
institutions to route OTC equity
index option trades to OCC via
MarkitSERV after the service
was debuted on April 25th.
“We are very pleased to have
worked with MarkitSERV to
launch a clearing solution that
will mitigate counterparty and
systemic risk in the OTC equity
derivatives market,” says Michael
E. Cahill, OCC president and
ceo. “Working with MarkitSERV
for the pre clearing trade
confirmation and affirmation
process is a critical component
of this industry solution.”
MarkitSERV provides market
participants and execution venues
with a single point of access to 16
clearing houses worldwide and
an integrated, multi asset class
service for trade confirmation,
clearing and regulatory reporting
in several jurisdictions.
Online
Latest news at www.markit.com/
Company/Media-Centre
Summer 2014
7
TALKING BUSINESS
GOLDEN
OPPORTUNITIES
Gary Cohn, chief
operating officer at
Goldman Sachs explains
how the bank is betting
on technological
innovation and mergers
and acquisitions to
deliver growth.
Peter Truell reports.
Photography: Amy Fletcher
A
8
s President and Chief Operating
Officer of Goldman Sachs,
Gary Cohn is often asked to
identify the major opportunities
and challenges facing the
financial services industry right now.
On the opportunities side, improving
confidence in corporate boardrooms is
spurring on mergers and acquisitions, says
53-year old Cohn, a 24-year veteran of
Goldman Sachs. Volumes in the second
quarter are on pace to more than double
on last year, driven by strategic and crossborder activity. Equity and debt
underwriting businesses are also gaining
strength, he notes.
But at the same time, the industry as a
whole is facing formidable challenges.
Volumes in a number of fixed income
markets have come under significant
pressure in 2014. For example, foreign
exchange volumes are down 45 per cent
on the year. It’s the same story for
mortgage-backed securities which have
seen a drop of more than 20 per cent and
corporate bond volumes, dwindling by
almost 15 per cent. Cohn blames the
operating environment on macro
influences, including fiscal and monetary
policy, regulation and uncertainty over the
global economic recovery.
“We believe all of these factors play a
role,” says Cohn from a conference room
on the 43rd floor of the firm’s headquarters
in downtown Manhattan, overlooking
New York harbour. “But from day-to-day,
the significant factors are economic.”
Summer 2014
Low volatility
Cohn says that the consequence of
quantitative easing and almost flat interest
rates is low volatility. The impact can be
seen clearly in the data, he adds. The
Chicago Board Options Exchange
(CBOE) Volatility Index (VIX) is running
almost 40 per cent below its 10-year
average; currency volatility is also roughly
40 per cent less than its 10-year average;
and interest rate volatility is running more
than 35 per cent below its 10-year average,
with the US 10-year note trading in a
narrower band over the past three months
than any time period over the past 35
years.
“The point is, macro factors are driving
reduced market volatility, and this in turn
weighs on volumes, bid-offer spreads, risk
appetite and the ability of our clients to
generate alpha,” says Cohn. “We
understand that reality, and we aren’t
waiting for things to get better. We are
staying close to our clients, maintaining
our risk-return discipline and aggressively
managing our capital and expenses.”
The Goldman business most affected by
low volatility is Institutional Client
Services, which houses the firm’s fixed
income, currencies, commodities and
equities franchises. However, Cohn says
the benefits of running these entities as an
integrated business provides the division’s
7,000 clients—including professional
money managers, corporates, pension
funds, insurance companies and
governments—with a one-stop shop, a
common risk management platform and
flexibility in any market environment. It
also maintains a diverse range of products
across asset classes and geographies.
Market share
Notably, while some of its peers are
reducing their presence in fixed income,
currencies and commodities, Goldman is,
on the contrary, increasing market share.
“People are going to need to continue
borrowing money, hedge interest
rates, currencies and commodities
and to grow their businesses and
grow the economy,” says Cohn.
“Our investment in
technology—across client
interface and internal risk systems—has
been critical to providing superior
execution capabilities, while protecting
our profit margins. And given the muted
operating environment for FICC, we have
focused on pricing discipline. We allocate
all relevant costs and provide our traders
with the tools to assess capital intensity
and returns.”
From an expense perspective, Cohn says
Goldman has continued to leverage
technology, manage its geographical
footprint and pay for performance. Since
2010, the firm has also reduced its FICC
headcount by approximately 10 per cent.
In terms of capital efficiency, Cohn says
Goldman has achieved FICC riskweighted asset mitigation
of nearly $90bn since
June 2012.
“If not for these
capital efficiency
efforts, we would
have needed roughly
$8.5bn of
incremental capital
to have the same
advanced Basel III
Tier 1 Common
ratio that we have
today, and this
would have
diluted our
returns by
approximately
120 basis
points in
2013.”
People need to continue
borrowing money, hedge
interest rates, currencies and
commodities, to grow their
businesses and the economy.
TALKING BUSINESS
TALKING BUSINESS
Photography: Amy Fletcher
Macro factors are driving reduced market volatility,
and this in turn weighs on volumes, bid-offer
spreads, risk appetite and the ability of our clients
to generate alpha.
Goldman has also concentrated on
gaining operating leverage in equities.
Excluding the recent sales of non-core
businesses, revenues from the equities
business have been relatively stable, down
only about six per cent over the past three
years. This is particularly significant
considering the lower-volume
environment, with US volumes down
roughly 20 per cent over the same period,
according to Cohn.
“If you look at productivity, revenue per
head is up more than 25 per cent since
2005 within our equities business.”
M&A
A rise in mergers and acquisitions is
pushing Goldman’s revenues upwards.
Sectors with the strongest pick-up include
healthcare, pharmaceutical and biotech,
energy and power, and technology, media
and telecom (TMT), according to Cohn.
Furthermore, Goldman says companies
are merging to create real synergies and
drive greater efficiencies. In corporate
mergers, conventional wisdom has
dictated that the buyer’s stock typically
goes down initially while the market
absorbs the news, but lately that has
Summer 2014
11
TALKING BUSINESS
In this M&A cycle, corporate acquirers
have been buying companies and they
have been accretive to shareholder
value from day one, and their stocks
have been rallying.
changed, with the buyer’s stock rising on
average by about 80 per cent.
“In this M&A cycle, corporate acquirers
have been buying companies and they
have been accretive to shareholder value
from day one, and their stocks have been
rallying,” says Cohn. “That’s really
unprecedented. But investors are eager to
see companies that are in good shape take
strategic actions and they are rewarding
management for having done so.”
In that vein, Goldman sees merger and
underwriting activity staying strong for
some time and the firm remains
committed to its investment banking
franchise. Equity and debt underwriting
have enjoyed steady improvement in
revenue share and rankings over the past 5
years. The firm also has a dominant
market share in the advisory business,
where its revenues are 50 per cent higher
than its closest peer over the last 12
months. About a third of its advisory deals
have been greater than $1bn over the last
three years.
“Strong merger activity drives the need
for other services we provide,” says Cohn.
“There is still potential for continued
revenue growth as the cycle improves.”
Global investment manager
With more than $1trn in assets under
supervision, Goldman is also one of the
12
Summer 2014
world’s largest investment managers.
Improving performance has attracted
more assets. Cohn talks enthusiastically
about how the firm has built “a
performance-driven culture” in the
investment management business. The
first quarter of 2014 represented the 10th
consecutive quarter of relative
outperformance across the firm’s mutual
fund assets. In 2013 Goldman generated
industry-leading flows in fixed income,
and over the last eight quarters the firm
has seen over $100bn of total longterm net
inflows.
“We essentially created a new, top 100
asset manager in those eight quarters
alone,” he says.
Goldman has also made strategic
acquisitions to build out its franchise,
including Dwight Asset Management,
Deutsche Bank’s stable value business and
the Royal Bank of Scotland’s money
market funds.
“We are focused on strategic,
manageable acquisitions to address secular
industry trends and client investment
needs,” says Cohn.
Technological future
Cohn understands how critical investing
in and understanding technology is for
the future of Goldman Sachs and its
clients. Goldman’s experience in
providing investment banking services to
both start-ups and major technology
companies has garnered the firm top spots
in US and global technology-banking
league tables.
“There is a lot innovation going on, most
of it driven by technology, a lot of it driven
by the regulatory environment, and all of
it so that we can meet the needs of our
clients,” says Cohn.
“We have to continually adapt to meet
the needs of our customers, the
expectations of our investors and we have
to prepare our employees for the
boundary-less 24/7 world created by
globalisation and new technologies.”
Underscoring the point, he says the
firm’s management considers Goldman,
which has about 33,000 employees and
annual earnings of $8bn, as much a
technology venture as an investment
bank.
“We’ve got over 8,000 technologists in
the company; we are a technology
company delivering technology to our
clients,” he said.
So, what is key for Goldman going
forward in a post-crisis economy? “It’s
all about servicing clients,” says Cohn.
“We are making sure our resources are
in the right place. We’re growing our
businesses when the opportunities are
there.”
As the global economy steers into calmer waters, the United States
will be its guiding force. But Americans are increasingly uneasy
with their country’s role. David Wigan investigates.
Global Beacon
T
6.3%
US unemployment rate is at
6.3 per cent
14
Summer 2014
he United States is the world’s largest
economy, a wellspring of innovation and for
many a paradigm of modern liberal
democracy. It is also shockingly unequal,
the world’s biggest debtor and is losing
competitiveness to many of its economic rivals.
Those contradictions, and the country’s glorious
diversity, make the US almost impossible to define
and characterise, and any generalisation is likely to be
undermined by specificities showing the opposite.
However, as the global economy slowly emerges from
the most serious economic crisis since the World War
II, the fortunes and fashions of the US remain a
global beacon by which other nations navigate and
against which they will judge their progress.
Perhaps the most striking example of the sway the
US holds is in the economic sphere, where the Federal
Reserve’s intentions in respect of monetary policy are
minutely examined, pondered upon and discussed
from the manufacturing canyons of China to the pinstriped salons of the City of London. What the Fed
decides in respect of the timing of changes in the key
US interest rate is perceived, fairly or not, to be the
capacitor that will define the intensity of the global
economic recovery.
The outstanding example of the Fed’s power in
recent times was the impact of the talk of ‘tapering’
on emerging market economies, when expectations
for an end to the extraordinary measures taken to
guarantee liquidity following the financial crisis led to
outflows of funds and bouts of currency volatility that
created unease among central bankers from Sao Paolo
to Istanbul.
Such is the power of the Fed that the world’s
economists spend much of their time second-guessing
its intentions and reading the signs that may signal a
COUNTRY FOCUS
change of policy. The preferred oracle of the day is
the US jobs report, the monthly indication of how
many jobs are added or lost in the previous period.
The most recent report showed that some 288,000
jobs were added in April, more than the 218,000
economists were expecting, as the unemployment
rate fell to 6.3 per cent from 6.7 per cent. The labour
participation rate, however, came in at 62.8 per cent,
its lowest level for decades, as the post-war baby
boom generation continued its graduation into
retirement.
The minutes of the last meeting of the policysetting Federal Open Market Committee showed
policy makers discussed a range of tools that might
be used for the eventual ‘normalization’ of monetary
policy. However, no decision was made and further
testing and analysis was deemed necessary.
Given the prevarications at the Fed, investors have
been caught between a rock, which is expectations
for inevitable rate rises, and a hard place that is the
agonising wait for them to do so, a dynamic that has
played out in the US Treasury market.
“The most conspicuous “pain trade” of 2014 has
been the rally in US Treasuries,” says Bank of
America Merrill Lynch chief investment strategist
Michael Hartnett, in a note published in late May
“On 1 January the 10-year Treasury yield was 3.0 per
cent. It is currently 2.53 per cent, rather than the 3.53
per cent everyone was positioned for. “
Explanations for the rally in US government bonds
range from China’s decision to rein in credit growth,
leading to increased inward capital flows and a rise in
Chinese purchases of US Treasuries, to ‘safe haven’
bids emanating from concern over instability in the
Middle East. However, the most obvious explanation
is weak US economic growth and low inflation.
“Unimpeded by Washington and Europe, 2014 was
set to be the ‘breakout’ year for US growth after zero
rates, record profits, record stocks, record credit prices,
record corporate cash, energy independence, housing
boom, tech revolution, fiscal policy certainty, cheap
dollar and so on and so on, would conspire to shift the
US from its 1½-2½ per cent real GDP growth into a
higher 2½ -3½ per cent range,” says Hartnett. “It
didn’t happen.”
Away from shortterm growth concerns, the US is
grappling with deeper issues. The country is afire with
creativity, with companies such as Google, Apple and
Microsoft among the most recognised brands in the
world, but nowadays manufacturing is often
outsourced and funding for pure sciences curtailed,
after many ‘idea factories’ closed in recent years.
Meanwhile, the rest of the world is investing
aggressively in innovation, with governments
The most striking example of the
sway the United States holds is in
the economic sphere.
adopting the US model of close collaboration
between universities, business, public and private
pools of capital.
“In this highly competitive environment, the US
needs, once again, to devote policy attention and
resources to the process of innovation because our
future competitiveness as a nation is at stake,” says a
recent report by the US Committee on Comparative
National Innovation Policies (part of the National
Research Council).
Meanwhile, the US public and political class is
engaged in a debate over the country’s role in the
world. Some 52 per cent say the “US should mind its
own business internationally”, the highest proportion
in more than 50 years, according to a recent poll by
Pew Research-CFR.
A rise in the number of people wishing to
disengage from global issues has led to talk of the US
returning under President Obama to the
protectionist policies that were most prevalent in the
19th century. The world, as it watches and waits,
will hope things do not turn out that way.
2.53%
The 10-year Treasury yield is currently
2.53 per cent
Facing
the fax
A
The complexity of the
loans market means it
has been living in the
technological past, but dig
a little deeper and there are
signs of change.
Gavin O’Toole reports.
s financial markets move
towards greater transparency,
more electronic processing and
stricter settlement frameworks,
the loans asset class appears to
have missed the technological boat.
Volumes are growing, with total
leveraged loans outstanding reaching $1.3
trn by December, according to Markit, as
new entrants join the sector and CLO
issuance rebounds.
However, fax machines, labour-intensive
manual processes and human inefficiencies
abound, and average par settlement times
hit a new record of T+24.75 in the third
quarter of 2013, according to the LSTA.
Meanwhile, inefficiencies
around data management
and reporting, as well as a
lack of standardisation and
integration, are
commonplace.
The explanation for the
slow evolution of processing
It is addressing its problems with
a range of solutions that inevitably
coalesce around technology.
16
Summer 2014
originates in the relative complexity of the
asset class, analysts say.
“There are two things that make this
such a unique asset class,” says Scott
Kostyra, managing director and head of
loan settlement at Markit. “One is the
syndicated model, so the fact that you
have got one bank managing all these
loans across the syndicated lenders for one
borrower creates a complex
communication cycle. The other is that
the loans are unique in a technical sense—
they are floating, don’t have a fixed
payment schedule and have a variable
nature for repaying interest. That
complexity makes it a burden to track or
manage the assets from an accounting and
communications standpoint.”
Unregulated market
Loans are mostly private deals that make
securing detail challenging, and legal
counsel from both sides has to sign off on
trade terms. The market is also
LOANS
unregulated, which means standards are
non-enforceable and hence processing
bespoke.
“It’s an asset class that has perhaps a
larger level of private information than
other asset classes, which means
everything from reference data to details
of the actual loan you are trading are not
necessarily combined. There are
unscheduled events, unscheduled
paydowns, and payments on the principal
of the loan, which also means information
doesn’t flow as easily,” says Kostyra.
As there is no clearing platform per se,
transactions rely on the exchange of
detailed documentation. While par loan
docs are now largely standardised,
distressed loan docs are customised - and
brimming with legalese. The outcome
can be a chain of documentation issues
whereby a party desperate to settle may
have to wait for three others down the
line.
“We are all aware of the inherent
inefficiencies which exist in the loan
market, especially in terms of trade
settlement and the length of time it takes
to settle the loans in the market,” says
Alan Kennedy, head of operations for
Mitsubishi UFJ Fund Services in the US.
“Because a lot of the notifications from the
agents to the loans are not standardised or
not integrated in a seamless manner, it
means that the process at the moment is
not as efficient as it probably could be; so
if there were, for example, standardisation
of format of these notifications coming
from the agent and the agent banks to the
processing units, let’s say Markit’s WSO,
then we could probably account for them
in a seamless manner and automate the
process rather than having so much
manual human intervention as we
currently have.
“Some of the challenges that have
caused problems lie in the integration of
systems and trying to standardise
documentation, also just gathering the
Know Your Customer (KYC). These
documents have to be signed by both
parties to the agreement so often the hard
part is just getting people in a room to
actually review them and sign them.”
“The agent model is interesting because,
obviously, they are not really involved in
the actual trading market, as such, and
therefore they are not beholden to
anybody—nobody has any particular
amount of leverage over them to get
things settled more or less quickly, and
they will impose freezes which causes
bottlenecks in the market where nobody
can settle,” says Matt Lindsay, operations
manager for BlueMountain’s London
office.
Transactions can also be held up by
newcomers lacking experience in the
market, and there are participants who
might actively seek to delay settlement
because of liquidity issues.
Manual processing is foremost among
the gripes that
emerge from any
discussion with
market players,
which they say
fosters a climate in
which poor
performers drag
down the efficient.
It is wholly
unsurprising, then,
that the consensus
is a yearning for
change.
“It is still a very old-fashioned manual
process,” says Ian MacWilliams, head of
bank loan operations for SEI Investments
in Pennsylvania. “We’re here in 2014 and
we’re still dealing with communications
that are fax-based: things should be more
streamlined. The industry hasn’t invested
as significantly in bank loan computer
technology as in other assets, data links
and integration across platforms—we
should be able to have messages that
interact with systems in realtime. Yet
today the industry still involves receiving
faxed notices where we have to interpret
what it is stating and then key that into
our accounting platforms.”
And even though automated
communication and the ability to process
trades in a mass way are largely available,
side issues - KYC, tax, smaller customers continue to frustrate.
“The heart of straight-through
processing is more or less there. What’s
missing is the extra stuff around it - what
happens on the side. We know that KYC
is an issue in the market, updated tax
documentation and administrative details
can cause an extra delay, and there are
behavioural issues, human factors. I
wouldn’t say that it’s mostly manual, the
heart of it is already there, but it’s the
inconsistency,” says Markit’s Kostyra.
While there appears to be some
The average number of transactions
has gone up threefold. That’s pretty
significant – and it couldn’t have
happened without technology.
resistance to change, this cannot by itself
explain the survival of a significant
manual component, which may also be
down to timing, in particular how the
waxing and waning commitment to
reform has coincided with boom and bust
in the market.
After 2007 many loans were pushed on
to distressed documentation, reducing the
incentive for platform providers to develop
straight-through solutions for par loans.
Now, as platforms jostle for position in an
ever-more competitive market, a chicken
and egg situation prevails whereby until
one provider starts to make traction
people are unlikely to forsake the others.
Grading operational efficiency around loan trade settlement
Manual processing
Even if parties and counterparties agree
and sign quickly, a position is not going
to move on the register until the
documents have all been sent to an agent
and countersigned. Agent notifications
mostly come in via fax and are nonstandardised, meaning a human being
must trawl through the data, understand
each notification or request, and then
add it to the system.
0%
A
(Excellent)
9%
B
(Satisfactory)
21%
C
(Needs improvement)
37%
D
(Dissatisfactory)
33%
F
(Failing)
Source: Based on Loan Market Automation: The Route to Operational Excellence, Markit, 2013.
Summer 2014
17
In a world where generating revenue is a
priority, outsourcing operations to experts
gives managers more time to focus on the
investment process.
how far standardisation can ultimately
be taken.
Poor integration
Top: Matt Lindsay,
operations
manager, Blue
Mountain Capital in
London.
Alan Kennedy,
head of operations
for Mitsubishi UFJ Fund
Services in the US.
KYC also invites procrastination, yet,
in principle, there are few real obstacles
to automation—providers are convinced
this rudderless ship can be steered.
Nonetheless, manual processes are
unlikely to disappear, and a key issue is
18
Summer 2014
A second recurrent theme is poor
integration between segregated front,
middle and back office functions–an area
where platforms such as WSO, which
Markit acquired in 2009, and Misys Loan
IQ have made headway.
A shortage of human capital and, in
particular, cutbacks in operational staff
have clearly not helped.
“It’s one of those things where as soon as
you get into this manual documentation
process where somebody’s got to check
through the documentation, it’s got to be
signed by the various authorised
signatories, and there’s a back and forth of
information between the two parties, that
tends to drive delays,” notes
BlueMountain’s Lindsay. “It then becomes
about how much human capital both sides
have actually got to put to work to inspect
those documents. Ultimately it’s a
numbers game.”
Market developments may have
conspired to hold back investment in
operations, not least cutbacks since 2009.
“Do most managers put enough
resources into their operations?” asks
MacWilliams. “No, because that’s not
where they believe their competitive
advantage lies. What happens is that you’ll
find staff not immersed in bank loans
asked to do a lot of manual work that
hasn’t to date been able to be fully
automated, and like all human
interactions, the more they are working
outside of proven technology, the more
opportunity and risk there is for
something to go wrong.”
Moreover, outsourcing creates a chicken
and egg scenario, making managers
reluctant to spend capital ramping up
operations teams. Finding specialist staff
can also be easier said than done.
Real strides
Yet these gripes aside, there is a strong
sense among market participants that the
loans sector has made real strides.
It is addressing its problems with a range
of solutions that inevitably coalesce
around technology, which can now enter
the equation from the very start of the
transaction and provide straight-throughprocessing, at least for par loans.
While there are few platforms that
support the syndication phase, once the
primary allocation is communicated
heavyweight solution providers come into
their own. In addition, applications such
as online document repositories are being
employed to increase the efficiency of
workflow management.
Standardising agent notifications that
give details of corporate actions or
restructures and coupon payment changes
so that they flow automatically onto
platforms is now the new frontier.
Mitsubishi UFJ has built an interface
directly from WSO to its general ledger,
Advent’s Geneva, which copies trading
and security master data nightly –
removing manual intervention.
LOANS
Figure 6: Average par settlement times
Picking up pace
All these developments mean that the pace
being set by technology in the loans
market is accelerating. Providers now offer
sophisticated loan settlement services,
whereby a battery of loan-closing experts
work on behalf of customers picking up a
trade and managing it through its lifecycle
“Over the last couple of years loan
trading has just been explosive and
growing year on year–58 per cent growth
from 2012 to 2013,” says Kostyra. “One
of the things that we have looked at is:
how are people dealing with that volume?
What we found was that across the board
resources were actually the same or down.
That means that the average number of
transactions per closer in a year has gone
up threefold over the last year whether it
is WSO or some other option.”
Yet perhaps the most significant—but
largely understated—sign of progress
towards greater market efficiency has been
the growth of outsourcing.
In a world where generating revenue is a
priority, outsourcing operations to experts
gives managers more time to focus on the
investment process: it allows the traders to
trade.
“In terms of the actual management of
your holdings, accounting, the portfolio
aspects, we have almost 300 customers
that either use our software to track all the
nuances to these loans or outsource all or a
portion to us in which we actually provide
the back office people, the technology, the
software, everything,” says Kostyra. “ So
outsourcing is definitely a rising trend.”
Settlement accelerating
Outsourcing is almost certainly speeding up
settlement, by reducing the sheer number of
people involved and leveraging specialist
Average par settlement times
25
Number of business days to settle
There have been initiatives to rationalise
identifiers for loans, and high hopes are
also placed on the evolution of FPML, or
financial products mark-up language.
Trying to formalise the language across
an industry with so many different players
has been a huge challenge, and one that
would arguably benefit from regulatory
intervention.
“People are resistant to change and like
things the way they are yet are often quick
to complain about things being inefficient,
according to Kennedy. “So what we need
to do is promote the use of FPML to these
agents. What also would be helpful would
be if there was intervention from a
regulator to standardise this and make
sure that everyone uses it, in a similar way
to the way they are doing centralised
clearing in CDS contracts now, where it
just becomes mandatory.”
24.75
20
18.6
15
10
5
Q4 2011
Q1 2012
Q2 2012
Q3 2012
Q4 2012
Q1 2013
Q2 2013
Q3 2013
Source: Based on Loan Market Automation: The Route to Operational Excellence, Markit, 2013.
relationships with banks. It is a clear win for
customers that don’t trade often or cannot
invest in additional headcount, although
inevitably it will impact on existing
in-house operations teams.
“We are seeing a trend in terms of the
desire by managers to move away from
the operational side of their business
towards revenue-generating.” says
Kennedy. “So we have a number of
managers now who have basically said
they want to outsource the vast majority
of their operational work—so they
maintain a CFO, a COO and maybe a
senior manager, but in terms of the actual
day-to-day administrative role associated
with closing loans or even doing their
own internal accounting they are looking
to outsource that to us. Mitsubishi UFJ
Fund Services has
developed a onestop-shop
solution in
collaboration
with WSO,
which allows
investment
managers to trade
bank debt
without adding
one additional member of staff to their
internal operations teams.”
These signs of progress confirm that the
loans market has not been standing still,
even if it has not yet reached a discernible
turning point. But should regulators be
more proactive?
“When regulators got involved in the
derivatives space, it was the risk of
unsettled transactions that really drove
standardisation,” notes Kostyra. “Our
asset class isn’t large enough yet for the
volume of unsettled trades to catch the
attention of regulators. It’s towards the
bottom of the pack.”
Regulation welcomed
A consensus view is that a regulatory
intervention to prescribe the models in
which the asset class can be defined would
be beneficial—although observers do not
see this any time soon.
“If you were to ask me five years ago if
we were to be regulated today I would
have said yes, but now I don’t see that in
the near future,” Kostyra says. “It would
certainly make a big difference in this
industry, as you have seen in areas like
derivatives which have taken a sharp turn
towards the efficient and streamlined–but
I don’t know if it’s going to happen any
time soon here.”
Still, some see reason for optimism.
“Streamlining is definitely underway,
and there are plenty of market
Streamlining is definitely underway,
and there are plenty of market
participants out there with this goal.
participants out there with this goal—and
you’ll get a better product for it at the
end,” Lindsay says. “But the nature of
competition means that you don’t have all
the participants piling in behind one
service provider and therefore you’re not
necessarily getting the critical mass that
you are eventually going to need to call it
a standard settlement procedure.
Nonetheless, as with everything else, it
will happen eventually because the weight
of opinion will end up moving behind one
or two providers—whatever the market
can cope with. We need to whittle that
list down to a critical number.”
Summer 2014
19
HFT
Some consider high-frequency trading
to be the dark side of the trading world.
But are things really that black and
white? Dan Barnes investigates.
Flash crash
“I
saw a discussion about high-frequency trading
(HFT) on Good Morning America,” says
Mark Goodman, head of quantitative
electronic services for Europe at broker Société
Générale. “When the debate gets to that level,
clearly it is has moved away from an industry
discussion on the nuances of finding the right type of
liquidity, and towards representing a very black and
white picture to the public. Whether it is for better or
worse I don’t have an opinion, but with a debate at
that level I can see that legislation could be brought in
to regulate HFT.”
The trigger for a discussion about HFT on a
breakfast television show, was the book ‘Flash Boys’
by Michael Lewis, released on March 31st 2014.
Lewis’s book follows the creation of the IEX trading
platform, aimed at helping asset managers avoid HFT
order flow. IEX ceo Brad Katsuyama asserts in the
book that the market “is rigged” in favour of a
specific HFT strategy, latency arbitrage.
Latency arbitrage makes money in an aggressive
manner from buyside orders; they can only exist in
symbiosis. Buyside orders for large blocks of securities
take a long time to fill and traders are careful not to
reveal their positions as they are executing their
trades, in case the market moves against them.
In the US, orders must be routed to every exchange
to find which has the best price, according to market
rules. The route taken is predictable. Latency
arbitrage firms place lots of orders on exchanges,
which they cancel before they are filled. Thus, when
they get a hit from a big buyside order they can
establish its price and size without committing to fill
the order. As they know which route the order will
take to circulate around the exchanges, they leap
ahead of it using high-speed connections, playing that
Summer 2014
21
unwanted middle-man role at very high speed.
By placing bids or offers, HFT firms can also
move the price of a security up or down, then
withdraw the orders in microseconds and switch
sides to buy or sell at an artificially high/low
price. On April 4 2014, Joseph Dondero,
co-founder of the firm Visionary Trading, was
barred from market trading and fined $1.9
million by the Securities and Exchange
Commission (SEC) for placing and cancelling
layers of orders. This had created fluctuations in
the national best bid or offer of a stock,
increased order book depth, and used non-bona fide
orders to send false signals to other market
participants, according to the SEC.
Previous warnings
Simo Puhakka, chief executive
officer at Pohjola Asset Management
Execution Services and Saurabh
Srivastava, global head of electronic
trading at Invesco
22
Summer 2014
These strategies are nothing new. Chris Marsh, head
of alternative execution services at broker Credit
Suisse, warned of predatory electronic trading firms
placing fake orders in the October 2005 edition of
The Banker magazine. The market regulation that
requires the routing of US orders, Reg NMS, which
enabled latency arbitrage to be effective has been in
force since 2007. Market regulators in Europe and the
US have been publicly discussing fake orders since
2009.
Buyside traders have also long been aware of the
issues and vocal in their concern. In a
representation to the Joint CFTC-SEC Advisory
Committee on Emerging Regulatory Issues on
August 11 2010, Kevin Cronin, global head of
trading at buyside firm Invesco, said: “While
Invesco believes there are many beneficial highfrequency trading strategies and participants which
provide valuable liquidity and efficiencies to the
markets, we also believe there are some strategies
that could be considered as improper or
manipulative activity.”
Methods of avoiding unwanted middle-men are
long-established. Firms can trade over-the-counter
(OTC) directly with other firms to avoid showing
their hand. Markets that do not disclose order
information pretrade called dark pools, facilitate
concealment from aggressive trading. These can be
run by broker-dealers and HFT firms themselves
e.g., Chi-X Global or stock exchange operators.
Some, like OTC market Liquidnet, use a brokerdealer licence to provide matching services without
trading on their own book. Liquidnet, which only
matches up buyside block trades, was launched in
2001 in the US and now covers 43 markets. By
crossing large block trades for buyside firms it has
specifically been designed to avoid the risks of
aggressive trading and information leakage. Others
match the orders that a broker receives from two
clients internally within the client.
IEX launched in October 2013, and ensures that
client orders are routed to all other US markets with a
time delay to prevent latency arbitrage firms from
taking advantage of them.
Given the established nature of the debate and the
avoidance tactics, it may seem surprising that the
publication of Flash Boys coincided with
HFT
A sustained period of trading for months
without making a loss is statistically
improbable, but many proprietary HFT
firms pull it off for even longer.
investigations into HFT trading practices by the
Federal Bureau of Investigation and the SEC.
Unfair manipulation?
What they are investigating are unfair practices. The
original question that aroused Lewis’s interest was
whether firms, brokers or otherwise, could manipulate
markets unfairly using HFT technology. During the
2009 prosecution of a former Goldman Sachs
programmer for allegedly stealing code, a government
prosecutor said: “The bank has raised a possibility
that there is a danger that somebody who knew how
to use this program could use it to manipulate
markets in unfair ways.”
That struck a chord with Lewis, as nine months
prior to the programmer’s conviction in December
2010, later ruled wrongful, Goldman Sachs traded for
63 days without losing a penny; in fact in Q1 2010 it
made more than $25 million every day in revenue and
over $100 million for more than half of those days. A
sustained period of trading for months without
making a loss is statistically improbable, but many
proprietary HFT firms pull it off for even longer.
Virtu, a major HFT player, only faced a trading loss
on one day in four years of trading, according to its
2014 IPO prospectus.
As the law of averages is tamper-proof, the only
explanation was that the rules of the game did not
expose HFT firms to the same risks that other firms
faced when they traded.
The next question was whether brokers and exchanges
were supporting HFT activity, enabling it to gain an
advantage over other traders. It
is this that the authorities are
investigating. As both brokers and
exchanges are shareholder-led, forprofit entities, paid according to the
volume of trading they process, support for HFT
is hardly surprising, says Saurabh Srivastava, global
head of electronic trading at Invesco.
“We shouldn’t be surprised that the market works
the way it does, when the principles of the market are
revenue maximisation,” he says.
“[Lewis’s book] made the point that broker-dealers
are conflicted, and buyside investors should
understand that broker-dealers don’t necessarily have
their best interests at heart because they exist to make
money. Every broker will manage the conflict of
interests that exist in different ways. As a buyside
trader you better pay attention to this, to understand
where your broker routes your orders, to measure
their performance.”
A further concern is that in the US the market
infrastructure actively provides advantages to highspeed traders. It allows them to access data at a higher
speed than is provided for regular traders through
feeds mandated by regulators (the Securities
Information Processor or ‘SIP’) of which there are
two for equities managed by exchange operators
NYSE Group and Nasdaq OMX.
“There is a two-tiered market, with the SIP and the
direct data feed,” says Srivastava. “The fundamental
question is why do we need two market data feeds?
Shouldn’t everybody in the world operate off the same
Mark Goodman,
head of quantitative
electronic services
for Europe at Societe
Generale
Summer 2014
23
HFT
The markets as they exist today do not serve
the interests of long-term investors, who are the
cornerstone of the capital formation process.
market data feed? That needs to be addressed.”
The threat of increased trading costs from latency
arbitrage is not a US-only phenomenon. In Europe,
the monopoly of national exchanges was removed in
2007 under the Markets in Financial Instruments
Directive (MiFID) and created a fragmented
market similar to the US. Without the regulatory
imperative to route orders, the obligation to provide
best execution falls upon the asset manager’s broker,
under a best-execution agreement. Sellside firms
provide the smart-order routers (SORs) that are
intended to find the best execution point for their
clients. Yet, arbitrageurs are using the same
strategies in Europe as they use across the Atlantic.
“We can see that latency arbitrage is certainly taking
place in Europe as well and the buyside should be aware
that controlling latency makes a difference in your
execution performance,” says Simo Puhakka, chief
executive officer at Pohjola Asset Management
Execution Services. “This is something that people have
begun to pay attention to in the last year or so. When a
smart order router (SOR) starts to send your order out
to find liquidity, the exact route it takes will depend on
where the broker’s data centre is located. However it
will still typically follow a pattern, so the same problem
occurs in Europe as has developed in the US.”
Europe’s reliance on the broker to route orders has
led to a greater level of transaction cost analysis
24
Summer 2014
(TCA) by the buyside of execution data, says
Rebecca Healey, senior analyst at Tabb Group. TCA
takes feedback information on trade executions to
determine how performance was affected by the
brokers, strategies and venues that were used.
“In Europe, the buyside has had to invest in TCA to a
greater degree to demonstrate best execution to their
underlying clients,” she says. “FIX tags are enabling the
buyside to better interrogate the information that a
broker is giving back to them, around Tag 29 (whether
the broker’s capacity was as an agent or principal), Tag
30 (on which venue an order was filled) and Tag 851
(whether the broker engaged in maker-taker activity).
Firms are trying to understand how the broker had
behaved in the market place and whether that had
impacted execution performance.”
Dark pools
Pohjola Asset Management Execution Services began
developing a buyside operated SOR four years ago, in
order to mitigate any risk that asset managers faced if
their brokers failed to act in their best interests when
routing orders. Lewis’s book notes that disproportionate
numbers of trades routed into broker dark pools are
executed there. As these trades are internalised i.e.
matched with other client orders, he suggests it is
improbable that trades could achieve best execution
coincidentally via the same firm that is in control of
their routing, when the majority of trade executions
occur outside of that firm’s clients.
These concerns are about market structure and
brokers’ conflicts of interests, which certain HFT
firms are able to exploit for profit with minimal risk,
rather than HFT itself. When providing orders to a
market could result in a rebate payment under the
‘maker-taker’ model, or a market owner saved money
HFT: market friend
or foe?
by executing orders without ever touching an
exchange, it is not surprising that order routing was
skewed away from the customer.
Speaking at the TradeTech Europe conference on
April 9 2014, Ryan Ronan, IEX chief operating
officer, said that order routing by brokers, not HFT,
was the main issue.
“At the end of ‘Flash Boys’, Michael Lewis does not
pin [the problems] on HFT firms. If broker A has
50,000 shares to sell and broker B has 50,000 shares
to buy, both will admit behind closed doors they do
firms must maintain a “reasonable order-to-trade
ratio” and note that “trading techniques involving
computer algorithms may, under certain
circumstances, constitute market manipulation.”
The Australian Securities and Investment
Commission conducted a study into the impact of
dark pools and HFT on market orderliness but
concluded that much HFT activity often considered
problematic, such as frequently cancelling orders, is
often displayed by non-HFT firms including longonly buyside traders. However, it did introduce
restrictions on dark pools
in May 2013 that oblige
them to offer price
improvement on the
main market if they are
not executing block
trades. It reported on
May 19 2014 that bidoffer spreads had become
more “equitably
distributed between
parties executing below block size dark trades” because
of the rule change and that it had had no negative
impact on bid-offer spreads.
Srivastava suggests it may be the markets, not the
traders, which hold the key to reform.
“The markets as they exist today do not serve the
interests of long-term investors like us, who are the
cornerstone of the capital formation process,” he says.
“With the exchanges’ interests aligned with revenues
or high-volume customers and not long-term investors,
the markets are not facilitating the capital formation
process as efficiently as they should. Competition has
to be fostered between exchanges but aligned with the
greater purpose of the stock market.”
“The markets as they exist today do not
serve the interests of long-term investors
like us, who are the cornerstone of the
capital formation process.”
not want to send the order to each other,” he said. “If
HFT firms bridge the gap that brokers won’t
themselves, it is hard to argue that [HFT] is doing
something bad there. What I would argue is that it is
doing something unnecessary. If brokers were more
apt to interact with each other, then there wouldn’t be
the need for someone to provide liquidity in less than
a millisecond between two pools.”
Nevertheless, HFT management rules are being put
in place. In Germany, under the ‘Act on the
Prevention of Risks and Abuse in High-frequency
Trading’, from May 15 2013 and after a nine-month
grace period, HFT firms trading in the country had
to register with Bafin, the market regulator. Those
One of the major issues
confronting regulators and policy
makers is whether HFT helps or
hinders the market. A number of
academic studies have
demonstrated that HFT increases
liquidity and thus lowers overall
trading costs for large cap stocks
(although there were no clear
benefits for small caps).
On the other hand, HFT firms
have come under pressure for
contributing to market failures.
HFT firms like to think of
themselves as modern day
electronic market makers. The
role of traditional market makers
was to provide liquidity to
investors on the other side of the
trade and stabilise stock prices in
times of market volatility. There is
strong evidence, however, that
HFT firms did not fulfill their
market maker role in recent
market tumbles and preferred to
walk away, the best example
being the “Flash Crash” of 2010.
There are over 50 trading
venues in the US and
approximately another 50 in
Europe. Some of these have
commercial models (rebate
incentives) and fast electronic
connectivity that make them “HFT
Hotels”, or venues which HFT
trading strategies often visit.
It is up to the buyside portfolio
manager and trader to determine
if they can justify paying a
premium for immediate access to
the additional liquidity HFT firms
can provide. They also need to
ascertain how HFT frequented
trading venues fit into their
implementation strategy. More
simply put, the buyside is
increasingly looking at how they
can use—and not be abused by
HFT trading activity.
To do this effectively, buyside
investors need to proactively
review the order routing logic of
their brokers. They also must look
at the quality of the dark pools
and other venues where their
trade flow is routed. Markit, in
response to this need, has
created state of the art TCA tools
for venue and routing analysis
which measure the effectiveness
and cost of different venues in
providing liquidity.
The company differentiates with
metrics necessary to streamline
performance-based order routing
and optimal trade strategy
selection alongside toxic liquidity
and front-running surveillance
tools, which help assess the
performance of execution
venues.
Henry Yegerman,
Markit, director, quantitative
trading products
Summer 2014
25
SECURITIES
LENDING
The securities lending industry is
facing a major upheaval in its rule
book, but investors will need a crystal
ball to determine the impact on the
market, writes Lynn Strongin Dodds.
Regulatory fever
L
ike many sectors in financial services, the
securities lending industry is facing gamechanging regulation, but while many rules
are a work in progress, market participants
hope for opportunities alongside the
inevitable challenges.
Regulation expected to have an impact on securities
lending includes Basel III, the European Securities
and Markets Authority’s (Esma) guidelines on
exchange-traded funds and other Ucits issues, the
Financial Transaction Tax (FTT) and the Financial
Stability Board’s (FSB) work on shadow banking.
Meanwhile, the industry is still recovering its
equilibrium after the financial crisis. Beneficial
Summer 2014
27
SECURITIES
TALKING BUSINESS
LENDING
owners including pension funds, asset managers and
insurance companies are fully back in the game, with
the inventory of securities that can be borrowed at
pre-crisis levels. However, they have adopted a much
more conservative tone and gone back to an old
framework, the intrinsic value model, whereby
returns are based on securities and not the collateral
reinvestment. This is tied to the losses some borrowers
suffered in the wake of the financial crisis due to cash
reinvestment into highly illiquid vehicles.
“We are also seeing demand for different term
structures - both bullet trades, or single term ranging
from 30 days to 360 days, as well as evergreen trades,
where the term rolls continuously,” says Sunil
Daswani, head of client relations, capital markets at
Northern Trust. “There doesn’t seem to be any
preference. It depends on the borrower, the collateral,
margin requirements and assets. We take the best bid,
via an auction process from the street, and let the
clients decide.”
Demand side
The story is different on the demand side where hedge
funds and investment banks have not fully regained
their appetite, though there has been an increase in
activity. Figures from Markit show there is $1.8trn of
global securities on loan, a slight uptick over the year,
against a lendable supply of $15.6trn. This is an
increase from $14.7trn since the beginning of 2014.
This small revival of short interest in 2014 means that
longs outnumber shorts by 8.79 times, below the seven-
Figures from Markit show there is $1.8trn
of global securities on loan, a slight uptick
over the year.
28
Summer 2014
year high of 9.8 seen at the beginning of January.
According to industry participants, banks in
particular have been preoccupied with stricter capital
and disclosure requirements as well as leverage ratio
framework under Basel III. They will have to raise
their minimum Tier 1 Capital from four per cent
under Basel II to seven per cent.
Although the new rules do not take effect until
2019, many agent lenders backed by banks are
revising their current business models. In some cases,
this has translated into being more discerning in
terms of the trades they are willing to enter into, as
well as the types of assets they are willing to borrow
and the tenor of those loans.
“Basel III will significantly transform the business,”
says Pierre Khemdoudi, director, securities finance at
Markit. “The cost of running a business is massively
under scrutiny and we will see a change in the type of
activity and the type of trades. For example, it will
not be about overnight financing but more about term
transactions and the emergence of evergreen trades.”
The regulation is also expected to impact
indemnification, which has traditionally been provided
by agent lenders to their securities lending clients to
shield them against counterparty default. They have
borne the cost, but once the regulations start to bite,
agent lenders may be more selective in terms of whom
they do business with and the types of assets they offer
to include under the coverage. It is a tricky subject area
and, for now, no one is willing to make the first move
and pass the extra charges onto their clients.
FTT
The other piece of regulation casting a pall is the FTT
which is not only causing reverberation in the
industry but also within the political classes of the
eurozone. “The FTT could potentially wipe out the
business,” says Khemdoudi. “It is a major threat to the
market and you can already see regulatory arbitrage
SECURITIES
LENDING
Long-Short Ratio
18,000
16,000
14,000
12,000
10,000
8,000
Value ($)
happening in Italy, which introduced the tax last year. their collateral. If not addressed, this could cause a
squeeze in liquidity and impact fund performance
The final version is still being decided in Europe.”
due to them maintaining cash buffers and not fully
In its original incarnation, the FTT, also dubbed
investing to maximise returns.”
the Robin Hood and Tobin tax, was poised to impose
For example, the guidelines stipulate that Ucits
a sweeping levy with the rate slated at 0.1 per cent for
funds, which have become a significant force in
bonds and shares and 0.01 per cent for derivatives.
securities lending will need to be able to recall any
Figures last year from the International Securities
Lending Association warned that it could erase 65 per security that has been lent out as part of a securities
lending transaction at any time. The aim is to
cent of European lending activity and significantly
minimise liquidity risk and meet redemptions, but
cut the €3bn a year of windfall revenues earned by
the fear is that the rule could reduce the pool of
longterm asset owners such as pension funds and
securities that borrowers may borrow on a term basis.
mutual funds to just €1bn.
Andy Dyson, chief operating officer at the
France and Italy have their own versions, and the
International Securities Lending Association believes
deadline for the rest of Europe was set for this past
there is a lot of “talk about transformation but not yet
January. Only recently have the so called FTT 10
the evidence. You can’t forget the market dynamics.
agreed to a new date in 2016 but the details are yet to
Banks are looking at the most efficient ways to source
be agreed. One major source of contention is whether
collateral and at the moment they can get it more
to tax all derivatives, only equity derivatives or none
cheaply from central banks. I do think though that
at all. Nations pushing for the levy are also split over
in time collateral will becomes scarcer.
who should collect it; a trading firm’s country of
origin or the nation where trading takes
place. The dividing lines are between
Long-short ratio (All securities)
smaller countries which have generally
Long-Short Ratio (All Securities)
sought a broader tax that raises greater
revenue and the larger countries which
12
want to start on a smaller scale.
Three options are currently being
10
presented by the Greek presidency of the
Council of the European Union. The first
8
would cover an FTT for shares and an
initial set of derivatives, with the
6
expansion of the FTT to cover other
products to be proposed at a later date.
4
This would include other instruments,
such as bonds, other derivatives and
2
structured products. Option two would
propose one single FTT legislation,
July 2006
July 2007
July 2008
July 2009
July 2010
July 2011
July 2012
July 2013
setting a January 2016 deadline for shares
and some derivatives, and a further
Institutional Long Value (Inventory)
Short Sale Value (Loans)
Long-Short Ratio (All Securities)
unspecified deadline to cover other
instruments after a review. Last but not
least is to determine all financial instruments to be
“It will not happen suddenly but progressively and
covered by the FTT at the outset, without the need
is likely to coincide with the tightening of monetary
for further consultation, with a January 2016 start
policy. People will then be willing to pay and the
date for shares and some derivatives and a later start
pools of collateral will be unlocked,” he says.
date or an initial zero-rate tax for other instruments.
6,000
4,000
2,000
Need for collateral?
Opportunistic players
Jane Karczewski, managing director, prime finance
and delta one, Citi Investor Services also believes the
market has been impacted by the withdrawal of
certain opportunistic players. “The days are over
where certain market counterparts would pay
significant outperformance returns to trade aggressive
corporate action strategies. The big question is what
will replace the loss of revenues and flow? There has
been talk of collateral transformation and
optimisation but so far most of the activity is broker/
dealer to broker/dealer as banks with varied balance
sheet constraints look to improve their RWA (risk
weighted assets).
“As for beneficial owners, they are subject to
conflicting regulation, with Esma guidelines on
exchange-traded funds and Ucits parameters as well
as Emir, preventing them from really “transforming”
One of the big unknowns is whether the greater need
for collateral on the back of derivatives regulation
embedded in EMIR and Dodd Frank can stimulate
future borrowing demand. These rules will require
swaps trades, which have been historically negotiated
privately between two counterparties, to be guaranteed
using collateral posted at clearinghouses. This
translates into initial margin at the start of the trade
and additional margin through the lifecycle to reflect
the changing mark-to-market value of an exposure.
OTC derivatives contracts that are not suitable for
central clearing and remain privately exchanged will
be subject to higher collateral requirements, set out
by the Basel Committee and International
Organization of Securities Commissions. In
addition, the liquidity coverage ratio included in
Basel III will require institutions to hold a certain
level of highly liquid assets to guard against shortSummer 2014
29
SECURITIES
LENDING
CCPs have become more
open in terms of the
collateral they will accept.
they have widened the net to include highly liquid
equities and top quality corporate bonds.
For now, many asset owners have enough eligible
collateral to meet the margin requirements and are
waiting to see how the landscape unfolds. Mandatory
clearing is unlikely to take effect in Europe until next
July, but European pension plans have an additional
two-year grace period—and possibly a third year—
which could push out their deadline until mid-2018.
They do have an option though from August 2015 to
make an early switch.
term disruptions to liquidity. This means they will
want to borrow high quality securities for longer
periods of time, translating into a collateral
downgrade from the lender’s perspective, and the
question is whether they will want to exchange
higher for lower quality collateral. The main issues
revolve around “pricing and whether the risks are
commensurate with the returns”, according to
Dyson.
Northern Trust’s Daswani agrees that there could
be opportunities for beneficial owners but they will
need to amend their risk profiles and parameters.
“This will depend on the client base. They mainly
consist of pension funds, insurance companies,
sovereign wealth funds and asset managers who are
buy and hold, and invest in high grade government
bonds. However, they may agree to do this on an
indemnified basis.”
It will of course take time for the dust to settle and
for appropriate pricing structures under the new
regulatory regime to emerge. A more realistic picture
of the collateral shortfall should also be drawn.
Forecasts have varied widely, although conservative
estimates from the Bank for International
Settlements and other organisations suggesting that
the potential requirement to be around $4trn.
Breaking it down, this would include $1.4trn for
OTC trades moving to central clearing, $1trn of
non-CCP traded collateral and $1.8trn needed for
banks to hold assets for the upcoming Liquidity
Coverage Ratio.
One reason the shortage may not be as dire as
originally predicted is CCPs have become more open
in terms of the collateral they will accept. In the past,
G7 government bonds or cash collateral were the only
options to support settlement guarantees, but today
30
Summer 2014
Uncertain future
Against this evolving backdrop, it is difficult to
predict the future, particularly until the rules on FTT
become clearer. While all agree securities lending can
play a role particularly on the collateral
transformation front, Citigroup’s Karczewski believes
“that asset managers may decide to do a transaction
via a swap and not bother with the complexities of a
securities lending programme. This is already
happening in France because of the FTT.”
Dyson agrees that it “may be more beneficial for
asset owners to look at the swap market or use a CCP
to capture the value of the portfolio versus going
through securities lending. However, I think there
will always be a demand for securities lending to
cover trading and short positions. This should not be
underestimated.
“We may also see an increase in the use for
collateral transformation. The industry though will
change because people want more options to source
securities. This means an increase in the routes to
market. The agent lender will exist but it will be only
one of many ways to get the securities out there. There
will also be CCPs, swaps and principal brokers which
are beginning to make their presence known,” he
notes.
Ben Challice, head of Global Equity Finance at
Nomura, agrees that people want more choice.
“Flexibility is key, particularly in terms of the types of
collateral and the ability to transform that collateral,
independent of the ultimate use. Market participants
are cognisant of the cost of capital due to regulation,
and they want to make the most efficient use of their
inventory. Firms need to be able to trade financing
products to better suit individual clients and offer
different routes to market.”
IM
Margin
conundrums
While regulation pertaining to IM might look simple
on paper, its implementation will be more challenging.
Markit’s Paul Jones investigates.
I
Paul Jones , director, analytics at
Markit.
f we want to understand the challenges facing
regulatory authorities in setting standards for
margining of bilateral business, it is worth bearing
in mind a few principles likely to provide a
framework for a regulator’s thinking.
The objective of bilateral initial margin is to reduce
systemic risk and incentivise the clearing of over-thecounter (OTC) derivatives. Systemic risk, as seen
during the financial crisis, is caused by the
interconnectedness of financial institutions. One
firm’s default can create a domino effect, often
requiring state intervention as a last resort. By
increasing the amount of collateral that must be
collected from uncleared derivatives, regulators seek
to ensure that a defaulting dealer will already have
provided sufficient collateral. This avoids the need for
absorbing credit risk losses in the capital cushions of
healthy banks.
Initial margin is intended to give both
counterparties to a Credit Support Annex (CSA) a
buffer of over collateralisation to absorb losses during
the close out of the defaulting party’s portfolio,
especially at a time when the market is expected to be
under stress and highly volatile.
Initial margin is a central part of the risk mitigation
used by central counterparties (CCPs). It successfully
absorbed the losses of the Lehman default when just
Financial counterparties must report
unresolved disputes greater than €15m
and outstanding for at least 15 days to
their regulator.
32
Summer 2014
36 per cent of the initial margin posted by Lehman
Bros was required to meet replacement and hedging
costs of their portfolio, according to industry sources.
In addition, there were concerns in some quarters
that additional capital requirements under Basel III,
including the Credit Valuation Adjustment Value-atRisk (CVA VaR) charge, were not sufficient incentives
for participants to clear. The cost of capital did not
always exceed the cost of capital contribution to the
CCP default fund made by clearing members.
Given its success during the Lehman default, the
idea of applying CCP-style margining to the world of
bilateral derivatives received regulatory support
because it seemed consistent with the objective of
ensuring the safety of the financial system. However,
despite some perceived similarities between initial
margin within CCPs and the use of IM for uncleared
over the counter derivatives (OTC) a close
examination reveals some stark differences. The delays
in the implementation of the rules bear testament to
the fact that regulators and market participants are
having to work very hard to avoid unintended
consequences, which could create a situation where the
regulations increase systemic risk.
Bilateral and CCP
These challenges stem from the fact that bilateral
margining differs in two main ways from CCP
margining. First, in the complexity and liquidity of
the products they margin and second, in the processes
around which margin calls can be disputed.
The population of uncleared derivatives will include
products that are too complex and too illiquid to clear
and risk manage within a CCP. The same risks that
are currently borne by capital on banks’ balancesheets will have to be absorbed by collateral held in a
custody account. This means that the risk models
used to calculate initial margin must handle many of
the same exposures currently treated within banks’
internal capital models. Banks’ capital models have
always been subject to regulatory supervision,
requiring banks to carry out significant testing.
The casual observer might think that if banks are
already modelling these risks then it’s just a question
of using these same risk models. Indeed, some firms
are looking to leverage some of these capabilities.
Banks’ internal capital models attempt to capture
illiquid and hard to observe risks, such as basis risk
and correlation and must make significant subjective
assumptions. Post-crisis, they have come under
significant scrutiny as many of these assumptions
failed and banks were regarded as undercapitalised
as a result. A comparative analysis was carried out by
the Basel Committee on Banking Supervision
(BCBS) in 2013 and found a very wide variation
between different firms’ calculations on the same
portfolio. For example, in a portfolio containing a
two-year swaption on a 10 year interest rate swap,
the largest VaR was five times greater than the
smallest.
Capital modelling
However, capital modelling is a matter that is internal
to banks’ balance sheets. Any inaccuracies in the
models, while serious, are a matter for the bank and its
prudential regulator as part of a model review process
typically over a period of months. Conversely,
unexpected or erroneous margin calls on OTC
derivatives can have serious effects by creating shortterm liquidity squeezes, as was seen when AIG received
$32bn in margin calls in Q2 2008. Even within the
cleared world market disciplines, regulators are
working to ensure that potential model and operational
risk within CCP margining models do not themselves
become a source of the systemic risk by creating shortterm liquidity spikes due to overstated margin.
In contrast to clearing, when the margin calculated
by the CCP must be paid in order to avoid a default,
counterparties that are unwilling or unable to meet
margin demands requested of them may begin
a dispute process. This can be time consuming and
occasionally require third-party intervention to
provide independent margin calculations. In July
2007 Goldman Sachs sent a $1.8bn collateral call to
AIG, according to the US government’s Financial
Crisis Inquiry Report. AIG disputed the valuations
that Goldman was using for credit default swaps on
asset backed securities. After protracted discussions,
with both sides agreeing that the market was illiquid
and accurate pricing was challenging, AIG ended up
paying only $450m in August. In September 2007
Goldman Sachs made a further call for $1.8bn that
AIG did not pay.
Variation margin disputes have also become more
complex since the crisis as firms are diverging in terms
of their view on the appropriate credit risks, funding
cost risks and balance sheet costs to incorporate in
derivative pricing including issues such as overnight
index swaps discounting. This trend is only set to
continue and a Markit survey of heads of credit value
adjustment at 15 dealers indicated that six expected
initial margin for uncleared to be incorporated within
accounting valuations.
Events from the crisis have prompted increased
regulations around margin calculations and capital
requirements for bilateral collateralised exposures. They
also illustrate the difficulty of calculating the valuations
used for variation margin on some illiquid products.
These difficulties are further compounded when
calculating initial margin. It requires risk modelling
that presents the same challenges banks have faced with
$32bn
margin calls received by AIG
in Q2 2008.
Summer 2014
33
IM
In a portfolio containing a two-year swaption
on a 10-year interest rate swap, the largest
VaR was five times greater than the smallest.
their internal risk models. Possible causes of differences
in data that may cause a dispute in variation margin
include disparities in trade details, missing trades,
different curves used to value trades. In the case of
initial margin additional differences may give rise to
disputes, over issues such as risk factor modelling and
correlations. The variation of these assumptions
between firms is highlighted by the Basel III Regulatory
Consistency Assessment Programme (RCAP) described
above and has led Isda to spearhead a standardised
initial margin model. However, differences can still
remain in terms of how firms calculate trade sensitivities
or implement the model. Many participants see the
need for a third party offering to resolve those
differences and minimise disputes.
Dispute mechanism
Regulators have moved to prevent banks using a
dispute mechanism to avoid paying for margin.
Banks frequently involved in disputes are subject
to increased disputes capital charges. Under
European Market Infrastructure Regulation
(Emir), firms must have procedures to record the
length of time, the counterparty and the amount
disputed. Firms must establish a mechanism to
resolve disputes in a timely manner and establish a
specific process for disputes outstanding longer
than five business days. Financial counterparties
must report unresolved disputes greater than €15m
and outstanding for at least 15 days to their
regulator.
As well as margin call disputes becoming more
complex, there are a number of factors which mean
that the number of margin calls is expected to
increase significantly. The initial margin
requirements for bilateral trades will create a new
CSA (variation margin and initial margin) which
must be margined separately from the old CSA (VM
only). There will also be fragmentation across CCPs,
increased segregation of funds and potentially the
break down of margin into currency buckets.
These new regulations all combine to create an
intensively challenging period for market participants
and regulators alike. But the proof of the pudding
will be in the eating, and only time will tell how
successful they have been.
REDUCING RISK
New margin requirements
will increase protection from
default and create a more level
playing field.
Bill Hodgson, owner The OTC Space.
34
Summer 2014
F
rom December 2015, all over-the-counter
(OTC) derivatives trades must be covered
by new margin arrangements specified by
the Bank for International Settlements. The
purpose is either to protect parties from
default risk, to avoid arbitrage by not clearing trades
and keeping a level playing field. All parties outside
clearing must begin to exchange margin using a
similar model to those in clearing, namely initial and
variation margin. Banks currently pay variation
margin using their existing credit support annexe
(CSA) agreements, so adding initial margin is the
implementation challenge.
The International Swaps and Derivatives
Association (Isda) on behalf of its members has
responded to this new requirement by proposing a
‘standard’ model for initial margin (Simm). Isda
points out that if every OTC user implemented their
own proprietary model, nobody would have the
resources to replicate each other’s margin models, and
therefore counterparties would never be sure who was
right.
The BIS regulations require each firm to exchange
IM individually. Thus those concerned will aim to
deliver around the same amount of IM as they
receive, to match funding costs and credit risks of the
exchange of assets.
The Isda proposal mirrors the approach of central
clearing counterparties (CCPs) in that it proposes an
IM model in line with the CPSS-IOSCO Working
Group on Margin Requirements (WGMR) historic
value-at-risk model, using a five-year market history
period, a 99 per cent confidence level and a 10-day
holding period. These parameters are similar to those
of the major CCPs, although each has its own specific
variation.
Isda have defined nine principles that their model
must support. (See table)
Achieving these principles gives rise to several
challenges, which include:
Each firm uses its own sources of market data and
quality review methods
Each firm has its own proprietary pricing models
To achieve speed a sensitivity based approach is
suggested, which will also be influenced by pricing
models
Where do the historic scenarios come from?
Will these be developed and distributed by a
central body?
Who calibrates each bank’s implementation to
Principle
Explanation
Margins are not subject to continuous change due to changes in market volatility
Easy to replicate calculations performed by a counterparty, given the same inputs and trade
populations
3. Transparency
Calculation can provide contribution of different components to enable effective dispute
resolution
4. Quick to calculate
Low analytical overhead to allow quick calculations and re-runs of calculations as needed
by participants
5. Extensible
Methodology is conducive to addition of new risk factors and/or products as required by the
industry and regulators
6. Predictability
IM demands need to be predictable to preserve consistency in pricing and to allow
participants to allocate capital against trades
7. Costs
Reasonable operational costs and burden on industry, participants, and regulators
8. Governance
Recognises appropriate roles and responsibilities between regulators and industry
9. Margin appropriateness Use with large portfolios does not result in vast overstatements of risk. Recognition of risk
factor offsets within the same asset class.
1. Non-procyclical
2. Ease of replication
verify it meets minimum standards to be
compliant with these principles?
How will each firm map the many disparate trade
structures into a common asset class structure for
pricing and risk analysis?
One Isda proposal which deviates from typical
clearing house practice is not to update the historic
scenarios on a regular basis, but to make this an
annual event, driven by a central regulatory body.
The reasoning is to avoid models being oversensitive
to market conditions and meet principle number
one.
The CPSS-IOSCO proposals require IM to be
calculated in asset class silos for rates, equity, credit
and commodities, based on the assumption that the
correlation across those classes breaks down in a
stressed market. Isda points out that there will be
difficulties with this approach, as some products such
as “option structures embedded in convertible bonds
contain interest rate risk, credit risk and equity risk
each in material amounts with the dominant one
dependent on market conditions” and lists other
pitfalls, such as using trades in one asset class to
reduce market risk in another.
To increase efficiency, Isda proposes a sensitivitybased approach; that is, precalculate the ‘greeks’ for a
portfolio and multiply by the risk factors, a quicker
process than full mathematical recalculation of all
trades versus all risk factors and historic scenarios. The
reason for this approximation approach is the need for
measurement of the amount of IM pre-execution for
cost and limit purposes. For a bank to quote a price to
an end-user, for many trades per day, the incremental
margin on its ‘house’ portfolio would be so resource
intensive as to bring price-making to a stand-still.
Hence the shortcut to deliver an IM number at a
reasonable cost in a reasonable amount of time.
One conclusion we can draw is that there is still
time for this SIMM to be developed. This may be a
golden opportunity for software vendors capable of
delivering a SIMM implementation in an affordable
manner. Major banks have the resources to extend
their existing risk management framework to
implement SIMM, but many end-users will not.
Perhaps we will see more use of the Internet cloud to
provide a platform for small volume firms to achieve
the necessary calculations.
THE RULE BOOK
Regulatory bodies agree to
disagree on how to enforce IM
supervision. Marcus Schüler,
Markit’s head of regulatory
affairs, explains.
A
s part of the 2009 Pittsburgh
commitments on OTC derivatives, G20
leaders agreed that non-centrally-cleared
derivative contracts should be subject to
higher capital requirements. This was
designed not only to compensate for the additional
risk that counterparties would be exposed to but also
to encourage central clearing. In 2011, the G20
agreed to add margin requirements on non-centrallycleared derivatives to the reform programme and
called upon the Basel Committee on Banking
Supervision (BCBS) and International Organization
of Securities Commissions (IOSCO) to develop
consistent global standards.
Starting in April 2011, various global regulatory
authorities, including the Commodity Futures
Trading Commission (CFTC), the Securities and
Exchange Commission (SEC), the US banking
regulators and the European Supervisory Authorities
(ESAs), each came up with their own margin rules to
implement the G20 commitment. However, it
Marcus Schüler, Markit head of
regulatory affairs.
Summer 2014
35
IM
Top: The G20 Saint Petersburg
Summit 2013
quickly became apparent that each regulatory
authority had different views on how to appropriately
design a margin regime. Differences between
regulators extended to fundamental questions such as
whether both counterparties should be required to
collect margin for all transactions or whether only
one of them would need to do so for some deals,
depending on the nature of the counterparties.
In October 2011 the CPSS-IOSCO Working
Group on Margin Requirements (WGMR) was
formed with the goal of creating internally consistent
standards. The group published its final principles to
establish a globally agreed framework for margin
requirements in autumn last year. In its final report,
the global regulators voiced concern about the
potential impact that the margin requirements for
uncleared derivatives could have on market
functioning and left some areas open for further
investigation. Specifically, a monitoring group was
established to consider the overall efficiency and
appropriateness of the margin methodologies and
standards, including “exploring the possible
alignment of the model and standardised schedule
approaches for calculating initial margin, and
assessing the potential procyclicality of the margin
requirements”. The WGMR also provided additional
time for implementation with the first stage starting
in December 2015 for transactions between the very
biggest firms (with more than $3trn in uncleared
derivatives outstanding) and full implementation
envisaged in December 2019 (when this threshold
would drop to $8bn).
Divergence
The ESAs are the first regulatory authorities to come up
with new rules following the publication of the
IOSCO framework. Their proposals are in line with the
IOSCO principles, including implementation timing,
minimum thresholds, minimum transfer amounts and
treatment of physically settled FX forwards. However,
several areas of divergence are notable:
The WGMR proposes allowing rehypothecation of
the collateral received under 12 strict requirements,
for example its use “only for purposes of hedging
the IM collector’s derivatives position arising out of
transactions with customers for which IM was
collected, and it must be subject to conditions that
protect the customer’s rights in the collateral”. By
contrast, the ESAs proposed to not permit
rehypothecation at all. This is based on its view that
the restrictions set by the WGMR would only be of
limited use in the European context and that ruling
out rehypothecation altogether would help simplify
the overall framework.
The ESAs propose to allow the use of a wider set of
collateral compared with the WGMR. However,
they would also require the use of a standardised
haircut schedule for those instruments.
In relation to IM calculation, the ESAs seem to
share the WGMR’s concerns about the potential for
disputes between counterparties about IM amounts
that they calculate on the basis of their proprietary
models. To address such concerns, the ESAs are
open to discussing all options and would also allow
for a wider use of model-based calculations or
standards.
This contrasts with the WGMR’s more restrictive
approach, which states that a “model must be
approved for use within each jurisdiction and by
each institution seeking to use the model”.
What’s next?
In Europe, following consultation, the ESAs are
expected to submit their regulatory technical
standards (RTS) to the European Commission by
the end of 2014. Adoption of these RTS is likely in
early 2015, with application expected from December
1st, 2015. Other jurisdictions are also likely to
recommend new margin rules over the coming
months. Specifically, the CFTC is likely to come up
with its rules by midyear and the contents are likely to
be consistent with the IOSCO framework.
TALKINGLIFE
MARKIT
BUSINESS
TRADING
TABLES
We meet the former derivatives trader
who swapped the heat of Wall Street
for his own restaurant on an island
paradise in the Florida sun.
Edward Russell-Walling reports.
We saw an obvious opportunity to bring in
a good chef, build the dinner business and
double the revenues.
Photography: Cy Cyr/ Getty
A
sk former derivatives trader Bill Mertens
when would be a good time to call, and he
opts for late morning. “Being in the
restaurant business, my day starts and
ends a bit later now,” he explains. The
hospitality industry may have a different timetable to
the trading floor but, as Bill has discovered, it is no
less subject to the idiosyncrasy of market forces and
human invention.
That said, it’s a long way by any measure from Wall
Street to Amelia Island. Here, after a quarter century
in the breakneck world of derivatives, Bill and his
family invested their capital and their lives in the
Gourmet Gourmet restaurant.
Amelia Island lies off northeast Florida, part of
the busy fretwork of barrier islands that lines the
southeastern US coast. Known for its beautiful soft,
sandy beaches and its bird life, it boasts seven golf
courses, on one of which you may intermittently
find Bill. The island has a substantial permanent
population, which was an important factor in his
decision to buy a business there. But it also attracts
the tourists with an annual shrimp festival and a
medley of music festivals – chamber music, jazz,
and blues. For those who like their sports
unhurried, each year it hosts the Pétanque America
Open.
Amelia Island is clearly treasured by its visitors.
Readers of Condé Nast Traveller have named it one of
their top 10 US islands for the last seven years on the
trot, and in 2013 they voted it one of “The Top 25
Islands in the World”.
Paradise
So, Amelia is something of an island paradise. Even if
it seems far from lower Manhattan, it’s light years away
from Cambridge, Ontario where Bill grew up. While
he was taking an economics degree at Wilfrid Laurier
University, he took a summer job with the Bank of
Montreal. The bank had created a derivatives portfolio
and was looking for students with good maths to write
code. Bill’s professor put him forward and, in the
summer of 1986, he began writing option models. He
didn’t know it, but he had just begun a career that
would take him to the heart of the international
financial markets, a fast ride from the birth of complex
derivatives trading to its spectacular implosion.
“I had no idea that this world existed,” he recalls.
“There wasn’t the public awareness of investment
banking, trading and capital markets that there is
now.” In this state of blissful ignorance, he had set his
sights on a different life altogether, planning to go to
graduate school and to study for a PhD at the
University of Western Ontario.
“I was going to be a professor,” he says. “But getting
a pocketful of cash as a student was a real eyeopener.” The following summer, Bill did the same job
for Chemical Bank. Just as he was preparing to report
Summer 2014
39
TALKINGLIFE
MARKIT
BUSINESS
Swapping
CDS for
grand cru.
After 25 years in the financial business,
entertaining and being entertained on
expense accounts, I had become a foodie.
to graduate school, the bank offered him a job as a
derivatives trader. “It was too good to refuse.”
So, in the first of many trades, Bill swapped the
placid pond of academia for the noisy roller-coaster of
the markets. This being the Autumn of 1987, it wasn’t
long before the markets popped their first surprise,
with Black Monday and that year’s October crash.
Chemical responded by closing down in Toronto, and
Bill moved to the Bank of Nova Scotia, where he
spent the next seven years.
Own code
He had worked with some “real luminaries” at
Chemical – including Lee Wakeman, a pioneer of
40
Summer 2014
the interest rate swap, and Joe Baumann, head of
Chemical’s derivatives group and the first chairman
of the International Swaps and Derivatives
Association.
“The derivatives market was just starting out,” Bill
remembers. “Banks were not running swap portfolios
back then. It was all on paper. You had to find a
customer who wanted to receive and one who wanted
to pay. You would get them to agree and the bank
took a spread out of the middle.”
The personal computer was only a couple of years
old, and traders had to create their own pricing
models and write their own code. “I was considered a
rocket scientist back then, with my undergraduate
degree in economics,” Bill says. “Today a PhD in
particle physics is a minimum requirement.”
As commercial software became more available, Bill
and his colleagues were able to focus more on trading,
and by the end of his time at Bank of Nova Scotia he
was running their US swaps and options portfolio. As
he points out, before the consolidation that took place
in the US industry, Canadian banks were among the
biggest in the world and had a significant presence in
the derivatives market. They were very visible and so
were the people who worked there. One man who
decided he could make use of Bill’s presence and
connections in the market was Michael Spencer,
chairman of London-based interdealer brokers Icap.
He had been trying to get a New York office up and
running, but never entirely successfully, and offered
the job to Bill – who accepted.
Though Bill would have an enduring association
with Icap, broking had not yet fully claimed him.
Only nine months later, he got a call from Deutsche
Bank’s Gopal Veradhan – “the biggest BSD in the
market” – asking what he thought he was doing
broking when he should be back trading. Veradhan
was number two on the derivatives book at Deutsche,
under Vince Balducci, later head of global risk
finance at Barclays Capital. Bill didn’t take much
persuading and took on the running of Deutsche’s
Bermudan callable swap business and their
structured and exotic notes.
Credit derivatives
Then in 1996 Deutsche bank started a credit
derivatives book. “Credit derivatives were brand new
in 1996,” Bill says. “I was always a guy who gravitated
towards the new, and they needed a trader.” While
still running his interest rate swaps business, Bill
became the German bank’s sole trader in the nascent
market for credit default swaps (CDS). This was all
good, until 18 months later when the bank hired a
young Boaz Weinstein, and he would rapidly become
a star of the credit derivatives trading universe.
“The kid was remarkable,” Bill acknowledges. “He
was on his way to stardom, and had more talents than
I had. I was at an awkward level of seniority, and I
knew I was vulnerable. They didn’t need me any
more, so they let me go.” He doesn’t sound bitter.
That’s life on the Street. And with the Asian financial
crisis of 1998 under way, the Street was downsizing.
Trading positions were tight, so Bill returned to
brokerage for a couple of years before partnering with
his old chums at Icap (including Doug Rhoten, now
chairman of Icap Americas) to trade bandwidth. That
market tanked with the collapse of Enron, which had
been trying to turn bandwidth into a financial
product. The inflated prices of bandwidth assets
promptly crashed to zero.
Bill then moved to London for a time to run the
credit derivatives broking desk for Tullet & Tokyo,
the international interdealer broker. Later he was
contacted by a Citi team, led by Andy Hollings,
working on a new product for managing counterparty
credit risk, the contingent credit default swap
(CCDS). They were looking for a broker who would
help them to fire up the market. “The firm I was then
with was not interested in investing, so in 2005 I
went to Icap,” he reports. They gave him a seat, a
headcount and a budget and, as head of credit
hybrids, he got to work.
“It took two or three months to get the first trade,”
he remembers. “But before too long we were making
serious money.” The sub-prime crisis and Lehman
Brothers were coming down the track, however, and
by late 2008 CCDS had gone down in flames along
with CDS. Before the crisis, there was no shortage of
sellers of protection, and the market was driven by
buyers. By the end of 2008, everyone was a buyer..
“After 2009, some balance returned to the market,”
Bill says. “And there was another innovation – quanto
CDS, which allowed you to hedge currency risk in
your credit portfolio.” In quanto CDS, premiums and
payments on default are in a different currency to that
of the reference asset.
“While it was very bespoke at the beginning, we
standardised the product,” says Bill. “Then the
sovereign debt crisis hit Europe. It turned out there
was masses of quanto risk attached to sovereigns, so
that market exploded. But the sovereign brokers had
more weight, and we had standardised so well that
they could take [the business] away from us.”
By now the tide was moving against credit hybrids.
Trading was “severely inhibited” by a push towards
central clearing and regulatory uncertainties as the
Basel rules were rewritten. When Icap decided it was
time to pack it in, Bill and his team moved to New
York broker-dealer Avatar Capital. They continued
with CCDS and tried to win back quanto business,
but it was an uphill battle. Bill began to cast his eyes
beyond the city wall.
Becoming a foodie
Icap had given him more than a serial career. It was
where he met his wife, Dominican Republic-born
Yamilka. Now the two of them checked over their
capital and agreed it was time to get out, to find a
small business that could provide an income big
enough to support them and their two children. They
zeroed in on northeast Florida and began to check out
what businesses were for sale, ones that they knew
something about, could afford and could be
passionate about. That led them, in a more or less
straight line, to the restaurant business.
“After 25 years in the financial business,
entertaining and being entertained on expense
accounts, I had become a foodie,” Bill explains. “I was
conversant with wine. I was writing restaurant
reviews, saying why this one was succeeding and that
one was not.” With all that experience of observing
2013
Readers of Condé Nast Traveller
named Amelia Island one of the Top
25 Islands in the world in 2013.
Summer 2014
41
ARKIT
LKINGLIFE
BUSINESS
MARKIT LIFE
restaurants in operation, he reckoned he had the skills
to run one. And they found just what they were
looking for on Amelia Island.
They were familiar with the location, having
vacationed on the island, and the business looked
profitable, so they were comfortable with their
purchase. Due diligence verified the revenues that
were being claimed, and the expense ratios, as
reported by the previous owner, were healthy. “You
want labour cost ratios below 25 per cent, and
Gourmet Gourmet’s were around 20 per cent. The
ideal food cost ratio is 30 per cent to 35 per cent, and
these were in the low 20s.”
The island demographics were comforting too.
Down in southern Florida, you can run a restaurant
business for only perhaps five months a year, from
December to May, and then everyone leaves,
including many locals, Bill reckons. Here, further
north, there were two large resort complexes, the
Summer Beach/Ritz Carlton and the Omni
Plantation, both with year-round residents as well as
holidaymakers. Average annual income for island
residents is over $100,000.
Gourmet Gourmet had a very good Sunday brunch
business, and a good lunch and catering business,
though it did poorly at dinner. “We saw an obvious
opportunity to bring in a good chef, build the dinner
business and double the revenues,” Bill says. He and
Yamilka closed the deal in summer 2012 and began
their new lives as restaurateurs.
Challenging financials
It took only a couple of weeks
for reality to set in. “The
financials were not truthful,”
says Bill, with some restraint.
“In fact, both the labour and
the food cost ratios were over
40 per cent, and they had
been paying staff in cash off
the books.” Nor, on closer
inspection, were the
comforting demographics
quite so comforting. The
local residents’ income may have been comparable to
that of New Yorkers, but their fondness for spending
it – most having been retired for 20 years or more –
was not.
“Yes, they will spend on capital assets like cars and
some fantastic houses,” Bill notes. “But they don’t
like to spend more than $7 on lunch.” What’s more,
they don’t drink much, or at all. Gourmet Gourmet
provides full service using the freshest, highest
quality ingredients, and it can’t do that for $7. “We
need $18 per person and we need to turn over the
table three times. They love coming here for lunch,
but they all show up at precisely 12 noon and spend
an hour and a half hanging out, spending next to
nothing.”
Bill and Yamilka started to tackle their costs and to
develop their dinner offering. Some staff members
were “absurdly” overpaid and they either had their
wages negotiated down or were replaced. Bill says
some waiters are now earning one third of what they
had been getting and haven’t walked.
Next, they took a hard look at everything on the
menu. They shrank the lunch menu, which was a
staggering 65 separate items or thereabouts, requiring
a huge inventory. Then they analysed the component
cost of what remained. They found which items were
selling below cost and either raised their prices or
eliminated them. Then they created a lot more crossover between lunch and dinner – the new dinner
menu uses elements of the lunch menu and vice versa.
Getting the dinner business going became a
priority. “We found a very talented chef and
developed a fantastic menu,” Bill says. Then they set
about converting their lunch customers into dinner
customers. It’s key to the financial services industry –
you own a customer on this product, then you get
them to buy that one. Except that while the Amelia
Island crowd liked lunching at Gourmet Gourmet,
they went to another place for dinner.
New customers
It took the couple a while to realise that a) the lunch
mob wouldn’t convert and b) they didn’t really want
them to, because they were so cheap. “They are not
heavy drinkers and they split meals,” Bill observes.
“We had to get out and find new customers, and we
found them at my golf club.”
This was a whole new demographic of retired and
semi-retired men who like to have a drink, like to
dine out with their wives and are open-minded about
where they go. “Through my involvement in the club,
I became known and got them to come to the
restaurant,” Bill says. “They have loved our products
The lunch business is what it is. But if we
can grow the dinner business by another
25 per cent, that puts us over the top.
42
Summer 2014
and given us great word of mouth – and they spend
money.”
The two best-selling dishes are ‘Slow-braised Italian
short ribs’ (braised for a mere 11 hours) and ‘Shrimp
and lobster fettucine’. The wine list is a judicious mix
of good-value sleepers and well-known names, and
Bill is particularly pleased with a recent “significant”
allocation of Sea Smoke Californian pinot noir. “It’s
the best pinot in the world and we are probably the
only restaurant in north east Florida to have it,” he
says.
It has been a tough couple of years for team
Mertens, and Gourmet Gourmet has yet entirely to
fulfill its promise. But the expense ratios are now
close to where they ought to be, and the dinner trade
is starting to prove its worth. “We are now reaching
the cusp,” Bill reckons. “The lunch business is what it
is. But if we can grow the dinner business by another
25 per cent, that puts us over the top. Potential
growth could take it up by 300 per cent and, if we
can hit that, we’ll have a home run success.”
BOOK REVIEW
An Introduction to
Quantitative Finance
by Stephen Blyth
Book review by Nicholas Dunbar
I
f one were to write a creation myth for modern
finance, the wave of mathematicians and physicists
who left academia for Wall Street from the mid1980s onwards would be at the heart of it. As Stephen
Blyth recounts in the preface to his book, these quant
pioneers knew virtually nothing about finance yet
succeeded in building a vast over-the-counter (OTC)
derivatives industry in the space of 25 years. Some
of the foundations, such as the Black-Scholes option
pricing formula were already there, but most of the
intellectual superstructure had to be built at the
trading desk.
Blyth’s own induction to finance came in 1993
after two physicist classmates from Harvard joined
Goldman Sachs. A PhD statistician, Blyth joined
HSBC in London, and on his first day was asked to
compute a bivariate normal integral. He soon began
trading, working at Morgan Stanley as a dollar options
market maker and Deutsche Bank as a proprietary
rates trader. Finally his career came full circle. He
was hired by Harvard’s endowment in 2006 and now
combines trading with teaching statistics in his old
department.
This textbook came about as a result of Blyth’s
teaching activity, and it’s worth asking the question
why such a book is needed now. There are already
dozens of quant textbooks out there, going back
to 1988 when John Hull first published ‘Futures,
Options and Other Derivatives’. This encyclopaedic
text is now in its ninth edition and close to 900
pages long. That’s before you get to the hundreds of
journals, conferences and working papers devoted to
quantitative finance.
However, Blyth has been critical of this quant
industry for some time, in particular the way that
experts devised clever formulae that were then used
mindlessly for pricing and risk managing derivatives.
In credit, the most egregious example was the nownotorious Gaussian copula, but other examples
abound. Instead, Blyth argues, traders should focus on
the logical consistency of what they are attempting to
do. For example, that means ensuring that a particular
asset isn’t described by several probability distributions
at the same time.
For years, Blyth’s critique served him as a modus
operandi in prop trading, helping him sniff out
opportunities in markets where other traders were
using models in a mindless way. Then the 2008 crisis
came along, when the most fundamental assumptions
of quantitative finance —including those that Blyth
assumed to be sacrosanct —broke down. That led to
a flurry of new research as traders struggled to update
their old models to incorporate counterparty or
collateral risk, as well as new regulations such as central
clearing, and a crackdown on abuses such as market
rigging.
The crisis put the old textbooks out of date and gave
Blyth’s quest for logical consistency increased validity.
That philosophy is the driving spirit behind his book.
Aimed at mathematically-literate readers with no
financial knowledge, Blyth aims to kindle an interest
in derivatives as an intellectual puzzle in probability.
The book is structured around the theoretical
assumptions needed to price derivatives, and right
from the start he pushes readers to think about the
consequences of the assumptions breaking down.
Take the concept of arbitrage. Starting with forward
contracts, the idea of no-arbitrage is a key driver of
derivative pricing. To work, it depends on the existence
of traders or algorithms sitting in the market trying to
pick off discrepancies. After Lehman Brothers, these
arbitragers—whose existence depended on access to
funding and leverage—disappeared, allowing the
discrepancies to persist for months.
Closely linked to arbitrage is the concept of riskneutral probabilities, essential for option pricing.
Using an intuitive binomial model, Blyth derives
the classic result that the return of a hedged option
portfolio is the risk-free rate. That leads him to the
idea of martingales, the mathematical equivalent of a
‘fair game’ whose expected value tomorrow is the same
as today.
By showing that a derivative (appropriately
discounted) is a martingale, Blyth teaches his readers
a powerful and general tool for pricing derivatives.
While none of this is new, Blyth’s approach is
refreshing, for instance his exercise where readers get to
show how two traders can collude by taking opposing
positions and splitting bonus payments.
Blyth then moves to a continuous time limit,
allowing him to derive the Black-Scholes formula.
He then goes on to discuss interest rate products, his
own speciality. Here Blyth’s philosophy of logical
consistency comes to the fore. Rather than focus on
complex price formulas for Bermudan swaptions, he
invites readers to rank trades under different scenarios,
getting them to think about the assumptions.
Blyth’s short book is unlikely to replace the likes of
Hull in the near term. He avoids credit derivatives and
commodity products, and doesn’t address current hot
issues such as counterparty, collateral and funding risk.
However, in the post-crisis world his approach to old
results is refreshing and ought to be a template for the
future.
Nicholas Dunbar is a
financial journalist and author
of The Devil’s Derivatives
Summer 2014
43
BOOK REVIEW
The In/Out Question: Why Britain should
stay in the EU and fight to make it better
by Hugo Dixon
European Spring: Why our Economies and
Politics are in a Mess and How to Put Them Right
by Philippe Legrain
Book review by Nicholas Dunbar
A
s the May elections to its parliament showed,
the European Union is at a crossroads.
Lacklustre economic performance has eroded
trust, compounded by increasing fears of immigration
leading to a rise in support for anti-EU and extremist
parties. Threatened by the UK Independence Party,
British Prime Minister David Cameron has promised
voters a referendum on EU membership.
Against this context of rising anti-EU feeling come
two books aiming to shape the debate over EU reform.
Journalist Hugo Dixon takes a very narrow focus: the
UK in or out debate.
In a crisp, readable text only 130 pages long, Dixon
tries to inject some hard factual analysis into a debate
dominated by emotion and populist rhetoric. He
demolishes false arguments such as ‘welfare tourism’
(which actually benefits British expats while immigrants
to the United Kingdom pay proportionately more tax
than natives).
He argues that the United Kingdom would be worse
off outside the European Union because it would lose
the leverage it now has with other trading partners such
as the United States and China. Half-measures such as
a Norwegian, Turkish or Swiss-type affiliation would
also be worse for Britain, he says. Instead, the UK should
work on reforming the EU from within.
Dixon has pitched his book carefully. He knows that
likely ‘no’ voters will consider the UK’s economic model
superior to continental countries and they certainly
won’t be sentimental about EU social programmes.
So Dixon presents the EU as a favourable economic
transaction for Britons that is more suitable than its
alternatives. Euro-scepticism across the EU offers what
he calls a ‘golden opportunity’ for reform which can
only benefit Britain, such as fully opening up the market
for services and supplanting the EU’s ailing banks with
capital markets based in the City of London.
Insider’s perspective
Nicholas Dunbar is a
financial journalist and author
of The Devil’s Derivatives
44
Summer 2014
Philippe Legrain may reach similar reformist
conclusions to Dixon but his approach is very
different. More of a policy wonk than journalist,
Legrain has something of an insider’s perspective
by virtue of his stint as special adviser to European
Commission president Jose Manuel Barroso between
2011 and 2014.
His book attempts to do several things. He gives a
blow-by-blow account of the euro crisis and what he
sees as the mistakes of policymakers in responding
to it. He provides a withering account of the bungles
that worsened the crisis and only eased after Mario
Draghi’s dramatic ‘whatever it takes’ speech in July
2012.
Lest his British audience starts feeling smug reading
about the plight of southern Europe and Ireland,
Legrain diagnoses a deeper economic malaise within
the European Union, including the United Kingdom,
resulting from low productivity and vested interests.
British politicians are lambasted for the ‘unforced
error’ of leaping on the austerity bandwagon in 2010
and British companies for squandering the flexibility
provided by sterling. Germany also gets a pasting
from Legrain. Its power as the eurozone paymaster
masks deep economic weaknesses in its workforce and
industrial base.
After 280-odd pages of naming and shaming,
Legrain comes up with a recipe for reform, arguing
for a complete reshaping of fiscal policy as well as
political institutions. To make the EU more adaptable,
dynamic and decent, Legrain comes up with an
ambitious wish list.
For example, he wants to start taxing land values (and
thus help cool the UK’s overheated property market).
To reduce inequality he wants governments to hand out
education vouchers and provide young people with a
capital sum to start their own businesses.
Legrain has argued neoliberal views for over
a decade, and his previous books promoted
the benefits of globalisation and immigration.
Continuing that theme in European Spring, he
wants to see disruptive innovators like Uber or
AirBnB break down closed EU markets. He thinks
Europeans should embrace fracking, eat GM food
and build on green belts. Although he doesn’t quite
express it like that, Legrain wants Europeans to
become more American.
The question readers might ask is how likely is this
to happen? Will the rise of anti-EU parties bounce
Brussels into reform, or will integrationists use their
blocking majority and carve out a two-speed Europe?
In the same way that actions by policymakers during
the crisis made eurozone sovereign bonds more volatile
than anyone expected, these tensions inject a wildcard
element into the EU’s future. The lesson of both
these books is that volatility may be suppressed but it
certainly hasn’t gone away.
MARKET INSIGHT
MARKET
INSIGHT
FOREWORD
Record breakers
S
Armins Rusis and
Chip Carver, Coheads
of Information
at Markit
46
Summer 2014
wings and roundabouts
in financial markets and
the global economy. High
volatility and emerging market
outperformance has been replaced
by low volatility and developed
market resurgence. Many asset
classes are trading near historical
highs. But how long can it last?
Chris Williamson points out
in his economic overview that
the US and UK are now the
fastest growing manufacturing
economies, a state of affairs that
seemed unlikely a few quarters
ago. Meanwhile Russia and China
are in reverse gear.
There are several reasons
why the supposedly ‘postindustrialised’ nations are
enjoying manufacturing revivals,
Chris observes. The most
commonly cited is exchange rate
depreciation, helping to boost
exports and fuel demand for
domestic goods.
No wonder that some see the
resistance of the US Federal
Reserve and the Bank of England
to higher interest rates being
driven by fear that currencies
might appreciate.
In the credit markets, investor
confidence is soaring, helping to
push spreads on both sides of the
Atlantic to multi-year lows, and
fuelling concern that a turn could
lead to a rush for the exit. For
now, however, the consensus is
for spreads to continue tightening
against sovereign benchmarks.
The slow start to 2014 in new
issuance of collateralised loan
obligations and other areas of
structured products seems to be
over, our loan team notes. Year to
date numbers are now on a par or
have exceeded those of the same
period last year.
In the sovereign bond markets,
European peripherals have
been the place to invest this
year. Italian, Spanish and Irish
government bonds have made
impressive returns of 7.1 per cent,
7.6 per cent and 6.56 per cent,
according to their respective
Markit iBoxx indices. However,
are yields straying into bubble
territory? We take a look.
Amid continuing low interest
rates investors are reaching
for yield and we highlight the
potential of small cap equities.
This year Markit expects FTSE
SmallCap companies to distribute
£913m in dividends, an increase
of five per cent and higher than
the projected growth for large
and mid-cap FTSE 350 stocks.
Homebuilders are expected to be
star performers.
Elsewhere in equities, we focus
on actively managed funds, and
highlight that while assets under
management have climbed they
have a long way to go before
they equal their benchmarked
rivals. At the same time, a whole
host of new vehicles has sprung
up, including leveraged loan
ETFs and new total return swap
products.
Securities lending markets,
meanwhile, have seen demand
to borrow American Depository
Receipts (ADRs) jump by a quarter
in the past 12 months. South
American shares, and particularly
Brazilian securities, stand out as
the most popular ADRs to borrow,
while Chinese shares dominate the
list of shares trading special.
An interesting time in securities
markets and we hope you find
plenty of food for thought.
MARKET INSIGHT
ECONOMICS
So near, so far
US and UK investors can
now look to their home
markets for growth.
Photograph: Shutterstock
A
nyone suggesting, back in
2004, that we shouldn’t
get too carried away with
the ‘BRIC’ frenzy because in 10
years’ time, the fastest growing
manufacturing economies would
be found in the UK and US
would have been laughed out of
the room. Now, they would be
lauded for their foresight.
So far this year, according to
Markit’s Purchasing Manager’s
Index (PMI) survey data, the
UK’s manufacturing sector has
been the fastest growing in the
world. The US is in third place. In
fact, of the 25 countries for which
Markit produces manufacturing
PMI surveys there are only three
so-called ‘emerging markets’ in
the top half of the rankings. Two
of these —the Czech Republic
and Poland—owe at least some of
their success to their geographical
proximity to Germany, which
holds fourth place in the table.
Remember Germany, the ‘sick
man of Europe’? Look who’s
appearing decidedly off-colour
now: the three worst performing
manufacturing economies so far
this year have all been BRICs.
Manufacturing PMI
PMI 48
49
50
51
52
53
54
55
56
57
UK
Czech Rep.
US
Germany
Poland
Ireland
Netherlands
Japan
Taiwan
Italy
Canada
World
Spain
Austria
Crumbling BRICs
Two of the BRICs—Russia and
China —are definitely in reverse
gear. Even before any Ukraine
related sanctions may have hit,
Russia was sliding into a renewed
decline in the second half of last
year and is now going through
its steepest downturn since 2009.
Another recession looms.
China’s manufacturing
economy, according to the PMI,
meanwhile contracted in the three
months to April. At the same
Mexico
Turkey
Vietnam
India
Greece
Singapore
Indonesia
France
S Korea
Brazil
50 = no change on prior month
Average reading in year to date 2014 (Jan - Apr)
China
Russia
Source: Markit
Summer 2014
47
COMMENTARY
MARKET
INSIGHT
AND DATA
PMI Output/Business Actively Index*
PMI
60
55
50
45
40
Developed world
Emerging markets
35
2006
2007
2008
2009
2010
2011
2012
2013
2014
Year
* covers both manufacturing and services
Source: Markit
Manufacturing PMI
PMI
60
55
50
45
40
35
US
UK
China
30
25
2007
2008
2009
2010
2011
2012
2013
Year
Source: Markit
time, any soccer World Cup boom
in Brazil has failed to appear; the
economy is stagnating. India is
at least starting to see some signs
of a return to modest growth,
after having gone through a
steep downturn late last year,
but is nonetheless in dire need
of economic reform to boost
lacklustre growth.
But isn’t this just what we
might have expected to see in
the development process of these
emerging markets? Is this not
simply a rebalancing in the BRIC
economies away from exports and
manufacturing towards services?
No: having been booming in
2006 and 2007, the service
sectors of all four BRICS are now
either lacklustre, stagnating or in
decline.
Not so ‘post’ industrialised
Instead of the BRICs
holding centre stage on the
economic podium, the focus
is turning towards developed
world economies. The UK’s
48
Summer
Spring 2013
2014
manufacturing economy is the
star performer, enjoying its best
growth spell for two decades. The
goods-producing sectors in the
US and Germany have also been
enjoying one of the best growth
spells seen in recent history.
There are several reasons
why the supposedly ‘postindustrialised’ nations are
enjoying manufacturing revivals.
The most commonly cited is
exchange rate depreciation and
the cries of ‘currency wars’.
Companies participating in the
UK PMI survey are telling us that
they are seeing near-record export
growth. Demand in overseas
markets is buoyed by the fact that
sterling remains around 20 per
cent weaker than its pre-crisis
peak. In the US, exports feature
less in the equation, but the
import substitution effect of the
dollar’s weakness has no doubt
helped encourage more people to
buy home produced goods rather
than imports.
No wonder, therefore, that
some see the resistance of the US
Federal Reserve and the Bank
of England to higher interest
rates as being driven by fear that
currencies might appreciate.
However, with the current pace
of growth that we are seeing in
the UK and the US, it’s becoming
harder for central banks to delay
the first rate hikes. Any return
to ‘normal’ monetary policy and
positive real interest rates should
be seen as a success story. The
impact on goods trade from a
resulting currency appreciation is,
on the other hand, a big concern.
However, the growing success of
developed world manufacturing
is not just due to favourable
exchange rates. In particular,
the trend towards ‘reshoring’ is
gaining momentum. Ten years
ago, companies were scrambling
to relocate production facilities
towards low cost countries such
as China. However, as economies
develop, so does the negotiating
power of the workforce and labour
cost advantages narrow. These
days, a good factory manager
in China is often paid the same
as his or her peer in the US.
As economies develop, so does
the negotiating power of the
workforce. Labour cost advantages
have narrowed. Lower US energy
prices resulting from shale gas
also present a major competitive
advantage.
When nonprice factors are
also brought into the equation,
such as the time it takes to bring
a product from the factory to the
distribution centre, quality control
and brand reputation, it now
makes less sense to manufacture
half way around the world when
your customers might live a few
miles away.
Viva España
For some companies, the financial
crisis has snapped them out
of complacency. Longer term
‘reforms’ remain key. One of
the best illustrations is provided
by Spain, which has seen huge
pressure to restructure since the
region’s debt crisis rocked the
world. Companies have raised
productivity, reduced labour costs
and become more competitive.
These reforms have paid
dividends. Spain’s manufacturing
economy is now enjoying the
strongest growth since 2007. By
comparison, France, a laggard as
far as reforms are concerned, is
stagnating.
The encouraging lesson is that,
following reform, manufacturers
in developed markets can still
be world leading and a principal
driver of economic growth. In
the meantime, emerging markets
still have a long way to go in
boosting domestic demand and
rebalancing their economies away
from export-led growth, now that
international trade advantages
have been eroded.
Chris Williamson
chief economist
[email protected]
@WilliamsonChris
China’s economic
growth is stalling
CDS
Summer fever
Investors are shrugging
off a series of potential
risks to global markets.
Photograph: Shutterstock
T
he potential catalysts that
could trigger a reversal in
risk appetite are familiar:
a hard landing for the Chinese
economy; US monetary policy
tightening; and geopolitical risk.
But as we head into the summer,
credit markets don’t seem to be
taking any of these seriously.
Spreads are bumping along
around multi-year tight levels
amid low defaults and an excess
of liquidity caused by record low
interest rates. US jobs data have
provided further evidence of a
strengthening labour market,
and ISM surveys point towards a
buoyant second-quarter.
Most market watchers consider
China’s economic trajectory as
the biggest risk for the global
economy. Expectations are that
the government’s forecast of
7.5 per cent growth this year
will prove optimistic, and the
direction of travel will be towards
6 per cent or even lower in the
coming years. China’s adjustment
away from excessive investment
and towards higher domestic
consumption will almost
certainly entail lower growth, and
the country’s financial system
could struggle to cope with this
transition in an orderly fashion.
But the market seems to believe
that the government has the
policy tools to prevent a hard
landing, and this could be a story
for later this decade.
Europe’s growth rate lags behind
the United States and China, and
that is unlikely to change for the
foreseeable future. But even here
there are reasons to be cheerful.
Markit purchasing manager’s
index (PMI) showed that the
eurozone economy continues to
pick up, though the painfully high
unemployment rates in peripheral
countries suggest that the
authorities should be doing more
to stimulate growth. The UK’s
CDS spreads
bps
70
60
50
40
30
20
10
Astrazeneca
Pfizer
0
May
2013
Jun
2013
Jul
2013
Aug
2013
Sep
2013
Oct
2013
Nov
2013
Dec
2013
Jan
2014
Feb
2014
Mar
2014
Apr
2014
Month/Year
Source: Markit
Volatility
250%
200%
Markit VolX Europe
Markit VolX IG
150%
100%
50%
0%
Jan
2007
Jan
2008
Jan
2009
Jan
2010
Jan
2011
Jan
2012
Jan
2013
Jan
2014
Year
Source: Markit
Summer 2014
49
Photograph: Shutterstock
MARKET
COMMENTARY
COMMENTARY
MARKET
INSIGHT
AND
DATA
robust but imbalanced recovery
continues apace.
So the economic backdrop is
favourable for credit. Geopolitical
risk always has the capability
to derail rallies, as we have seen
on numerous occasions in the
past, but the conflagration in the
Ukraine hasn’t really troubled
global markets. A full-blown civil
war might stir investors, and it is
still difficult to see the endgame
there. The consensus view,
however, appears to be that it is an
internecine conflict with limited
consequence beyond Ukraine and
Russia.
If Ukraine is having little
impact, the same can’t be said
of the world’s central banks. US
Federal Reserve Chairwoman
Janet Yellen’s dovish comments
have boosted sentiment. ECB
President Mario Draghi has given
ample support by hinting that
policy easing may finally come
soon. Quantative easing still
seems some way off, but credit
investors remain hopeful that it
will be implemented.
Markets have ignored Yellen’s
warnings about the chase for
50
Summer 2014
yield, and investors are clearly
enjoying the clement conditions.
Issuance, particularly in subinvestment grade, remains at
stratospheric levels, and demand
for higher yields creates the
perfect environment to sell
debt. The Numericable/Altice
jumbo deal was a prime example.
Investors can either go down the
ratings scale or increase duration
to gain higher returns, with low
default rates providing another
reason to go long on credit.
The Markit iTraxx Europe was
trading at 66 basis points in late
May, just over 3bps wider than
the Markit CDX.NA.IG. The
European index hasn’t traded
tighter than its North American
counterpart since August 2010,
and it could soon cross this
threshold if the rally continues.
The systemic risk from sovereign
debt has been neutered by the
ECB, and the prospect of QE
should give additional impetus to
European credit.
Volatility has, unsurprisingly,
remained relatively low during
this period. The Markit VolX
Europe and VolX IG indices,
which track realised volatility in
the Markit iTraxx Europe and
Markit CDX.NA.IG indices
respectively, are at 36 per cent
and 22 per cent. The European
index includes banks and
peripheral corporates, so it is only
normal that volatility is higher
than in North America. But
the levels are low by historical
standards and are nowhere near
the heights reached during the
financial and sovereign crises of
recent years.
If the macro picture is calm,
then credit investors may choose
to focus on event risk. Pfizer’s
bid to takeover British rival
Astrazeneca resulted in the credit
default swap spreads of the two
companies converging (both
trading around 30bps), suggesting
market confidence the deal
would be completed.
Bondholders in
Astrazeneca
would have benefited from a
combination, as the US firm has a
superior AA credit profile. Indeed,
single A-rated Astrazeneca
started to trade like an AA credit,
according to Markit implied
ratings.
But Astrazeneca mounted
a robust defence, and the
transatlantic takeover approach
attracted political scrutiny on
both sides of the Atlantic. Pfizer
was forced to walk away from the
deal, and the CDS basis between
the two credits opened up again.
The basis is not as large as it was
pre-deal speculation, so there may
be some investors expecting Pfizer
to renew its efforts in the not too
distant future.
Hedge funds focused on event
risk have outperformed their
macro- and arbitrage-driven
rivals, and we can expect to see
increased demand for single name
CDS as a result.
Gavan Nolan
director, credit research
[email protected]
@GavanNolan
MARKET INSIGHT
MARKIT IBOXX INDICES
iBoxx peripheral versus Germany
Yield (%)
25
iBoxx Portugal
iBoxx Italy
iBoxx Ireland
iBoxx Germany
iBoxx Spain
20
15
10
5
Italy can borrow
at 2.8 percent
0
Lehman
collapse
Onset of
Euro crisis
LTRO
“whatever it
takes” speech
-5
Bubble or
fundamentals?
Investors are showing a healthy appetite for
peripheral bonds in the Eurozone, but need to be
aware of the risks.
E
uropean peripheral bonds
are the place to invest this
year. Italian, Spanish and
Irish government bonds have
made impressive returns of 7.1
per cent, 7.6 per cent and 6.56 per
cent, according to their respective
Markit iBoxx indices. The Markit
iBoxx Portugal index has soared
15.2 per cent, and as a result is the
best performing fixed income asset
class. It’s a remarkable recovery
given the fact that two years ago
the aforementioned countries were
on the verge of being ejected from
the eurozone. So what exactly is
driving the convergence of yields
in periphery and core bonds in the
euro area?
To answer that question, we
have to look back to the onset of
the euro crisis during the winter
of 2009. The combination of
lower economic output,
overblown government debt levels
and a fragile banking system led
to a sharp drop in confidence in
the ability of peripheral
economies to refinance their debt.
That had a knock-on effect on the
fixed income markets as bonds of
peripheral sovereigns started
trading at distressed levels. Yields
on Markit iBoxx Ireland and
Portugal hit 15 per cent and 20
per cent respectively before the
two countries were bailed out by
the IMF and the EU. Long term
Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul
Jul
2006 2007 2007 2008 2008 2009 2009 2010 2010 2011 2011 2012 2012 2013 2013 2014
Month/Year
Source: Markit
Peripheral PMI
65
60
55
50
45
40
35
Spanish and Italian bond yields
also attained levels of 6-7 per
cent, unsustainable for their long
term financing.
ECB head Mario Draghi’s
speech in July 2012 was the
market game changer, as he
committed to do “whatever it
takes” to save the euro. As the risk
of eurozone collapse diminished,
peripheral government bond yields
followed a downward path except
for a short time during the
summer of 2013. The trend was
undoubtedly helped by Outright
Monetary Transactions, an ECB
programmeme to buy sovereign
bonds, and ECB long term
financing provided to eurozone
banks (LTRO).
However, since the end of last
year peripheral debt yields have
fallen to historically low levels,
raising concerns over whether the
rally is overblown. Economic
fundamentals may be playing a
part, but do not fully justify the
contraction in yields.
There’s no doubt that the four
countries in question are
showing signs of improvement as
economic actively picks up. The
Markit Composite
(Manufacturing + Services)
PMI numbers have been
consistently above the 50
mark since the end of 2013,
a signal of economic
30
Italy PMI Composite
Spain PMI Composite
Ireland PMI Composite
25
20
Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan
2006 2006 2007 2007 2008 2008 2009 2009 2010 2010 2011 2011 2012 2012 2013 2013 2014
Month/Year
Source: Markit
expansion. Another positive
factor is that these countries have
all started rebalancing their
economies in order to make them
more competitive. Unit labour
costs in Spain, Ireland and
Portugal have been dropping
since 2009 while those in
Germany have been going up.
The only exception is Italy where
unit labour costs have been rising
throughout the period.
However, there are still
underlying structural problems.
Unemployment is stubbornly
high, public debt is still at
elevated levels and on the rise,
and banking sector problems
persist. Yet incredibly, Italy with
its public debt to GDP ratio of
133 per cent and unstable politics
was able to
borrow at
2.8 per
cent for a
10-year
period mid-May. Although rated
below investment grade,
Portugal’s refinancing rates are at
3.5 per cent for similar maturities.
Even struggling Greece, which
endured debt restructuring,
tapped the markets with a fiveyear bond yielding at 6.5 per cent.
Signs of strong fundamentals?
No, more of a signal that the
market is stepping into bubble
territory.
Investors need to be wary
because market sentiment can turn
quickly. Unexpected central bank
moves can result in unwanted
distress and a drop in liquidity, as
we have seen with emerging
market debt in the recent past.
Worse-than-expected data released
in the eurozone periphery could
also have an impact. Investors may
be hungry for yield in the
eurozone, but they need also be
aware of the credit and liquidity
risk they may be taking on.
Ivelin Angelov
associate, fixed income indices
[email protected]
Summer 2014
51
COMMENTARY
MARKET
INSIGHT
AND DATA
LOANS
New vehicles to drive loan market
The loans market is
opening up with the
creation of new vehicles.
W
ith leveraged loan
volatility, defaults and
expected returns all
near long-term lows, investors are
sidelining cash or seeking new
alternatives to generate yield. At
the same time, a whole host of
new vehicles have sprung up.
Discounting the longanticipated default of Energy
Future Holdings Corporation
(commonly traded under the
name TXU), one of the largest
deals and subsequent defaults in
US loan market history, leveraged
loan defaults remain close to
historic trends at around a two
per cent default rate on a trailing
12 month basis. Leveraged loan
market returns have continued
their slow and steady march
upwards, gaining 1.63 per cent in
the first five months of this year.
The loan market is set to meet
analyst expectations of four to five
per cent full-year total returns,
in line with last year as measured
by the Markit iBoxx USD Liquid
Leveraged Loan Index (LiLLI).
Meanwhile, loan market volatility
is tracking at an all-time low.
The Markit iBoxx USD Liquid
Leveraged Loan Index (LiLLI)
is a market-weighted index of
100 of the most liquid tradeable
leveraged loans, as assessed by
Markit’s proprietary liquidity
scores. It is the only loan index
incorporating realtime market
data, and up-to-date reference
and corporate actions data. Given
that 80 per cent of LiLLI index
constituents are priced above 99
per cent of par value, with the
index currently yielding 5.24
per cent all-in, a rise in price
returns is unlikely. The run-up in
leveraged loan prices from 2009
to 2012 and the low interest rate
environment limiting coupon
interest means investors may
prefer to stay on the sidelines
until there is a hike in interest
rates. Indeed, while US retail loan
fund flows have risen from $70bn
to $170bn in the last two years,
retail investors have pulled back,
withdrawing $1.8bn over the last
six weeks.
Despite the subdued outlook
for loan market returns, there
has been an explosion of new
leveraged loan vehicles, opening
up innovative ways for fresh
participants to access the US loan
market. The first loan exchange
traded fund (ETF), PowerShares
Senior Loan Portfolio, was
launched in 2011 and several
more followed hot on its heels,
including the Highland/iBoxx
Senior Loan Portfolio, the
Blackstone/GSO Senior Loan
ETF, and the First Trust Senior
Loan ETF; PowerShares and
Blackstone ETFs being the largest
USD Liquid Leveraged Loan Index return
160
4%
150
3%
140
2%
1%
130
0%
120
-1%
110
-2%
100
-3%
Photograph: Shutterstock
90
52
-4%
80
-5%
70
60
April
2008
Daily Total Return
Total Return Index Level
with $7.3bn and $600m assets
under management, respectively.
In March, J.P. Morgan
launched a total return swap
(TRS) based on LiLLI. This
is the latest J.P. Morgan TRS
that references Markit’s family
of iBoxx corporate benchmark
credit indices. While TRS on
single-name loan credits have
existed for years, the new iBoxx
Loan TRS is the first of its kind
in the leveraged loan space. The
vehicle offers investors a cheap
way to gain passive exposure to
the US leveraged loan market,
without the usual headaches
that accompany loan investing:
settlement delays, operational
processing of agent fax flow,
etc. The iBoxx Loan TRS also
provides the first real opportunity
for investors to take a negative
view and short or hedge loan
exposure. Further, while loans
are not eligible investments in
Ucits funds, TRS
– including
loan index
TRS – are
eligible,
allowing this new TRS to be
included in funds marketed to
retail investors Europe-wide.
Loan ETFs can be used to
short the loan market, though
structural issues may make loan
index TRS a more efficient way
to gain the same exposure. First,
loan ETF managers have to buy
and sell loans to try and match
the performance of the index to
which the ETF is benchmarked.
TRS, on the other hand, is
simply tied to the reference index.
Second, loan ETF shares have
to be sourced and borrowed to
be shorted while one can take
positive or negative exposure to
TRS with equal ease.
With new structures providing
enhanced access and liquidity to
an asset class traditionally limited
to sophisticated investors, retail
investors can allocate capital to
this area more easily. Institutional
investors are now able to take
quick positive or negative exposure
to the loan market. This in turn
could increase the sector’s liquidity
by attracting new investors and
money into the asset class.
-6%
-7%
April
2009
April
2010
April
2011
Month/Year
April
2012
April
2013
April
2014
Source: Markit
Summer 2014
Colin Brunton, CFA
vice president, loan pricing
[email protected]
MARKET INSIGHT
SECURITIES FINANCE
Shorting ADR
U
South American and
Chinese shares are
leading the demand
for ADRs.
S investors are taking a
strong interest in American
Depository Receipts
(ADRs) this year as they seek to
take advantage of international
developments that are too
complex to short in domestic
markets.
For example, demand to borrow
ADRs has jumped by a quarter in
the last 12 months, and securities
lending fees to borrow these assets
have been rising as lending
programme inventory has trailed
off. In terms of markets, South
American shares stand out as the
most popular ADRs to borrow,
while Chinese shares dominate
the list of shares trading special.
So why is this? Following the
robust performance of US
equities in 2013, many investors
are looking abroad to diversify
their portfolios away from
domestic equities. To this end,
$3.9bn of inflows in US-listed
exchange-traded funds (ETFs)
with domestic exposure have
lagged those of their international
peers by a ratio of three to one so
far this year.
Yet international investing has
its fair share of downsides,
illustrated by the ongoing
Ukrainian crisis, the lowest
Chinese economic growth in
over two decades and weakening
emerging market currencies.
Investors looking to target this
uncertainty have few options as
many emerging markets have
either outright short sale bans or
underdeveloped securities lending
markets which make shorting
Long-short ratio (American Depository Receipts)
Long-short ratio
10
Value ($)
180
9
160
8
140
7
120
6
100
5
80
4
3
60
2
40
1
20
0
May
2012
Jul
2012
Sep
2012
Nov
2012
Jan
2013
Mar
2013
May
2013
Jul
2013
Sep
2013
Nov
2013
Jan
2014
Mar
2014
Month/Year
Institutional long value (Inventory)
Short sale value (loans)
Long-short ratio (American Depository Receipts)
Source: Markit
Summer 2014
53
MARKET
COMMENTARY
COMMENTARY
MARKET
INSIGHT
AND
DATA
individual shares outrageously
expensive if not impossible.
One possible solution for
investors is to short depository
receipts in domestic markets.
Short interest in ADRs, by far the
most popular repository receipt
class, has seen a resurgence in
demand to borrow as US short
sellers are increasingly looking
abroad. Currently there are
$26bn of aggregate loans, a
number that has grown by a
quarter in the last 12 months and
is the highest aggregate
borrowing in over two years.
Bright spot
ADRs as a whole have proven to
be a bright spot in the securities
lending space as they have
generally been able to avoid the
chronic oversupply problems
that have eroded profitability in
developed markets in recent years.
Interestingly, the aggregate supply
of ADR assets sitting in lending
programmes has actually fallen by
a quarter in the past three years to
$144bn.
There is no single reason for
this fall. A number of issues
driving the trend include
companies choosing to raise
capital in their increasingly
mature domestic markets, falling
asset values and the rising dollar.
However, the decline in the
lendable pool has ensured that
lending out of US ADRs has
been able to command a higher
aggregate fee, which has jumped
from 65bps a year ago to 134bps.
Overall, ADR assets in lending
programmes are three times
more profitable than other US
traded assets.
Again, short sellers do not seem
to have been put off by this
relatively expensive cost to
borrow, especially when
compared to the costs of
borrowing and trading local
markets. Brazil, for example,
ADR by value on loan
Value on loan (billions)
30
25
20
15
10
5
American Depository Receipts
0
May
2012
Jul
2012
Sep
2012
Nov
2012
Jan
2013
Mar
2013
May
Jul
2013
2013
Month/Year
Sep
2013
Nov
2013
Jan
2014
Mar
2014
May
2014
Source: Markit
ADR by country
Brazil
China
Great Britain
India
Mexico
France
Taiwan
Switzerland
Netherlands
Australia
Source: Markit
54
Summer 2014
Bogota, Colombia
costs 290bps to borrow local
listings while the cost to borrow
Brazilian ADRs is less than a
tenth of that.
Brazil tops demand
Brazil currently has the largest
aggregate short position with
over $4.3bn of total loans.
Driving this demand is the
country’s large natural resources
sector, with mining company
Vale and state oil monopoly
Petroleo Brasileiro enjoying the
largest demand to borrow out of
the listed ADRs.
The demand to borrow
Brazilian ADRs could be driven
by hurdles in the domestic stock
loan market as Brazilian ADR
loans outnumber those in the
domestic market by over three
to one. Despite seeing the largest
aggregate short position,
Brazilian shares still see
moderate amounts of bearish
sentiment as only 12 per cent of
the aggregate supply in lending
programme is currently out on
loan.
Fellow South American market,
Columbia, on the other hand sees
much more bearish sentiment
with 40 per cent of available
supply out on
loan. The large
demand to
borrow
Columbian
shares is driven by Ecopetrol
which has two thirds of the
aggregate short position with
$365m of loans.
Greece takes the honours as the
most shorted country with a
utilisation rate of 65 per cent,
meaning that almost two thirds of
the shares that can be borrowed
from lending programmemes are
on loan. This is driven by recent
capital raising exercises by the
country’s banks, National Bank of
Greece and Alpha Banks which
have nearly all of their available
supply out on loan.
Special markets
As to the “special” shares which
see both large short positions
and high fees, China dominates
the list of the 25 shares which
command an annualised
borrowing fee of more than three
per cent and a short position of
more than $5m. Of the country’s
eight specials, Mindray Medical
has the largest short position
with $628m on loan. Recently
listed Weibo has proven a
popular short with over $43m
on loan since it listed last month.
This large short position in the
microblogging firm has proven
expensive for short sellers as the
current fee to borrow sits at over
28 per cent, making it the most
expensive special in the Markit
dataset.
Simon Colvin
vice president, securities finance
[email protected]
Photograph: Shutterstock
STRUCTURED FINANCE
Home alone
The loans market is upbeat, but remains in the
shadow of the Volcker rule.
T
he slow start to 2014 in new
issuance of collateralised
loan obligations (CLOs)
and other areas of structured
products seems to be over. Of
late, there has been a noticeable
uptick in revisions across the
board, especially within CLOs.
Year to date numbers are now on
par or have exceeded those of the
same period last year and given
this trajectory new issuance could
total close to $100bn.
One marked difference
between this year and last is the
consistency of new issue prints.
Last year, spreads on new issue
AAAs were much tighter as they
came to market, with some even
closing inside of 120 basis points.
However, this year, despite the
issuance, they are in the 140-160
basis point range, depending
on the manager. CLO demand
remains strong because the asset
class offers relatively attractive
returns, even when compared
to commercial mortgagebacked securities (CMBS), its
closest rival from a new issue
perspective.
While loan fund outflows
remain a concern, the CLO
machine marches on, scooping
up the majority of newly issued
paper. CLO spreads have
remained firm on both sides of
the Atlantic but, as a result of new
issue paper and general supply,
some mezzanine tranches have
started to drift wider, especially in
Europe.
The European spread
movement could be due to the
fact that 2014 issuance is off to
its strongest start since the boom
years of 2006 and 2007. More
than $5bn has been issued in the
market so far this year, compared
with $2bn in 2013. However,
this is tiny in comparison to
the $35bn issued in 2007. The
current deals appear to be more
investor friendly, consisting of
only loans, and the structures are
more uniform across the board.
As a result, investors may be
choosing these deals as opposed
to competing in the secondary
market for legacy paper.
Market uncertainty
The US authorities’ decision to
allow banks two more years to
CLO spreads
bps
180
160
140
120
100
80
60
US 1.0 AAA Spreads (DM)
40
US 2.0 AAA Spreads (DM)
20
0
Dec
2013
Jan
2014
Feb
2014
Mar
2014
Apr
2014
May
2014
Source: Markit
divest CLOs that come under
the Volcker rule has not done
much to alleviate the uncertainty
in the CLO market. Under
Volcker, banks have to shed risky
investments, but the delay may
have simply kicked the can down
the road.
However, it does give banks
some additional time to consider
other options and avoid a forced
sale of assets. Most industry
analysts anticipate
that the
majority of
AAA tranches
of non-Volcker certified deals
will be paid down by that time.
Banks have several tools at their
fingertips to avoid asset sales,
such as trading out of all nonloan securities or relinquishing
their manager removal clause.
Given the arsenal of out
clauses and manoeuvres that are
at the banks' disposal, Markit
believes the forced sale of assets
is unlikely. However, it does
reinforce the fact that regulators
and lawmakers really need to put
their heads together to end the
unease in the CLO market.
Matthew Fiordaliso
director, US structured finance
[email protected]
Summer 2014
55
COMMENTARY
MARKET
INSIGHT
AND DATA
DIVIDENDS
Crown jewels
Investors may be missing out on a potential dividend
bounty in UK small caps.
I
n the United Kingdom, it’s the
large cap FTSE 100 index that
always grabs investors’ attention,
and it’s not unusual to find over
20 analysts covering each of the
large caps, compared with just
two analysts for the small caps.
But given the rebound in the UK
economy, which is touching all
sectors from real estate to media,
investors may be neglecting future
wealth amongst UK small caps.
The United Kingdom is one
of the fastest growing developed
economies of the moment
with positive Purchasing
Manager’s Index (PMI) numbers
across a range of sectors from
manufacturing to services.
Smaller cap stocks tend to have
greater exposure to this buoyant
domestic market. This year
Markit expects FTSE SmallCap
companies to distribute £913m
in dividends, an increase of five
per cent and higher than the
projected growth for large and
mid-cap FTSE 350 stocks.
Among the 137 companies
covered by Markit, one-third have
increased dividends for the past
three years and show no reason
for stopping this trend. Seven
companies have delivered double
digit dividend growth and are
likely to continue doing so. Not all
of these are low yielding growth
stocks. For example PhotoMe-International and Hyder
Consulting are currently both
offering more than three per cent.
Growth sectors
Homebuilders are expected to
post strong growth given the
recent sharp rise in UK house
prices and increasing demand for
newly-built homes. As a result,
small cap companies poised to
generate strong cash flows and
pay handsome dividends include
homebuilders such as Gleeson,
which should double its pay out
in the next two years. Not far
behind is Tyman, which increased
its dividend by 33 per cent last
year and is forecast to increase it
by another 25 per cent this year.
Henry Boot, one of UK’s leading
property investment companies, is
expected to see its pay out gain 20
per cent this year and 39 per cent
in the next two years.
Small cap retailers are also
cashing in on the housing boom
as spending on furniture and
flooring has grown at the fastest
rate since 2006. For example,
Topps Tiles posted a whopping
76 percent rise in first-half
earnings and it is estimated its
full-year dividend will grow by
Payout FTSE Small Cap (millions)
£1,100
977
£1,000
913
£900
869
£800
£700
more than half.
Real estate companies are also
fuelling the growth in small cap
dividend pay outs and they are
forecast to increase dividends
by nine per cent. Some offer
attractive yields, notably Redefine
International and Primary
Healthcare at more than five
per cent. Driven by the buoyant
UK home market and the
international demand for London
real estate, LSL Property Services
is expected to boost its dividend
by around 38 per cent for next
two years. Safestore Holdings and
Helical Bar should be able to raise
pay outs by a quarter.
Consumer confidence
Higher consumer confidence
and better credit availability
combined to help the UK's largest
car dealer, Pendragon, raise its
dividend by 300 per cent last
year. Based on the latest earnings
projections, we believe the
company could add another 50
per cent in 2014.
In the media sector,
companies adapting to the rapid
transformation in technology will
be in a good position to reward
shareholders. Two dividend picks
are Trinity Mirror, which will
likely resume
payments
this year,
and
Chime
Communications which has
increased its dividend by 55 per
cent over the past three years.
The industrial goods and
services sector accounts for the
biggest share of the index pay
outs, but the size of the sector
means there are large disparities
among conVstituents. There may
be significant dividend hikes of
around 50 per cent in the next
two years from Xchanging,
Lavendon, Speedy Hire, Tribal
Group and Avon Rubber.
Industrial maintenance supplier
Brammer is currently sitting top
of the reserve list for promotion
to the FTSE 250 at next June’s
rebalance, and Markit predicts a
dividend increase of 26 per cent
in the next two years.
An aging population and
decreased reliance on state
pensions means there is a
growing incentive for companies
to pay meaningful dividends
which will attract shareholders
seeking income. As a result,
dividend payments and policies
will take on increasing
importance in the coming
months and years.
£600
£500
FY0 (reported)
FY1 (current)
FY2
Source: Markit
56
Summer 2014
Harshit Jain
associate, dividend forecasting
[email protected]
COMMENTARY
MARKET
INSIGHT
AND DATA
DIVIDENDS
Crown jewels
Investors may be missing out on a potential dividend
bounty in UK small caps.
I
n the United Kingdom, it’s the
large cap FTSE 100 index that
always grabs investors’ attention,
and it’s not unusual to find over
20 analysts covering each of the
large caps, compared with just
two analysts for the small caps.
But given the rebound in the UK
economy, which is touching all
sectors from real estate to media,
investors may be neglecting future
wealth amongst UK small caps.
The United Kingdom is one
of the fastest growing developed
economies of the moment
with positive Purchasing
Manager’s Index (PMI) numbers
across a range of sectors from
manufacturing to services.
Smaller cap stocks tend to have
greater exposure to this buoyant
domestic market. This year
Markit expects FTSE SmallCap
companies to distribute £913m
in dividends, an increase of five
per cent and higher than the
projected growth for large and
mid-cap FTSE 350 stocks.
Among the 137 companies
covered by Markit, one-third have
increased dividends for the past
three years and show no reason
for stopping this trend. Seven
companies have delivered double
digit dividend growth and are
likely to continue doing so. Not all
of these are low yielding growth
stocks. For example PhotoMe-International and Hyder
Consulting are currently both
offering more than three per cent.
Growth sectors
Homebuilders are expected to
post strong growth given the
recent sharp rise in UK house
prices and increasing demand for
newly-built homes. As a result,
small cap companies poised to
generate strong cash flows and
pay handsome dividends include
homebuilders such as Gleeson,
which should double its pay out
in the next two years. Not far
behind is Tyman, which increased
its dividend by 33 per cent last
year and is forecast to increase it
by another 25 per cent this year.
Henry Boot, one of UK’s leading
property investment companies, is
expected to see its pay out gain 20
per cent this year and 39 per cent
in the next two years.
Small cap retailers are also
cashing in on the housing boom
as spending on furniture and
flooring has grown at the fastest
rate since 2006. For example,
Topps Tiles posted a whopping
76 percent rise in first-half
earnings and it is estimated its
full-year dividend will grow by
Payout FTSE Small Cap (millions)
£1,100
977
£1,000
913
£900
869
£800
£700
more than half.
Real estate companies are also
fuelling the growth in small cap
dividend pay outs and they are
forecast to increase dividends
by nine per cent. Some offer
attractive yields, notably Redefine
International and Primary
Healthcare at more than five
per cent. Driven by the buoyant
UK home market and the
international demand for London
real estate, LSL Property Services
is expected to boost its dividend
by around 38 per cent for next
two years. Safestore Holdings and
Helical Bar should be able to raise
pay outs by a quarter.
Consumer confidence
Higher consumer confidence
and better credit availability
combined to help the UK's largest
car dealer, Pendragon, raise its
dividend by 300 per cent last
year. Based on the latest earnings
projections, we believe the
company could add another 50
per cent in 2014.
In the media sector,
companies adapting to the rapid
transformation in technology will
be in a good position to reward
shareholders. Two dividend picks
are Trinity Mirror, which will
likely resume
payments
this year,
and
Chime
Communications which has
increased its dividend by 55 per
cent over the past three years.
The industrial goods and
services sector accounts for the
biggest share of the index pay
outs, but the size of the sector
means there are large disparities
among conVstituents. There may
be significant dividend hikes of
around 50 per cent in the next
two years from Xchanging,
Lavendon, Speedy Hire, Tribal
Group and Avon Rubber.
Industrial maintenance supplier
Brammer is currently sitting top
of the reserve list for promotion
to the FTSE 250 at next June’s
rebalance, and Markit predicts a
dividend increase of 26 per cent
in the next two years.
An aging population and
decreased reliance on state
pensions means there is a
growing incentive for companies
to pay meaningful dividends
which will attract shareholders
seeking income. As a result,
dividend payments and policies
will take on increasing
importance in the coming
months and years.
£600
£500
FY0 (reported)
FY1 (current)
FY2
Source: Markit
56
Summer 2014
Harshit Jain
associate, dividend forecasting
[email protected]
MARKIT INFOGRAPH
s
e
t
a
t
S
d
e
t
i
n
U
The
Key numbers
providing a
snapshot of
the US
All data correct at time
of going to press
$17.5trn
US Gross
14.7
s to
long s
f
o
itie
iple
Mult ts in equ
shor
$365.6b
n
US equ
ities on
loan
National De
bt
bn
$239.9
ers for
New ord
d durable
manufacture
l
goods in Apri
23
318,129,5
tion
US popula
$28.2bn
ETF US
inflows equity
this yea
r
58
Summer 2014
430
US high yield
issuers