By Stephen Pope, Managing Partner of Spotlight Ideas
- Any investment is speculative.
- Speculation is not manipulation.
- Markets hold politicians to account.
- Shorting is an essential trading tool.
- Be wary about a cumbersome restriction on algorithms
The word “Hysteria” has its root in the Latin “hystericus”. It refers to “exaggerated or uncontrollable
emotion or excitement” [1]
Ever since the financial crisis of 2007/2008 global lawmakers, have been prone to hysteria, seeking
ways and means by which to blame financial services and fetter the industry.
For example consider “The Volker Rule” [2]. It refers to a section of the Dodd–Frank Wall Street Reform
and Consumer Protection Act designed to restrict US banks from placing certain kinds of speculative
investments that do not benefit their customers. It was argued that such speculation was at the root of
the financial crisis. Dodd-Frank is in effect a measure aimed at banning proprietary trading by
commercial banks, whereby deposits are used to trade on the bank’s own accounts. However, a
number of exceptions to this ban were included in the Dodd-Frank law.
Following several delays December 10th 2013 saw the granting of approval to implement the rule,
scheduled to go into effect April 1st 2014. However, as of the end of last year the final Volcker Rule was
not listed in the Federal Register. As is typical when politicians venture is fields they do not fully
understand, further evaluation had to be undertaken.
Spotlight does not claim that nothing was wrong with motivation or behaviour within the craft during
the run-up to the crisis. Indeed we can see merit in not putting depositor capital at risk, however; surely
there are certain parameters of risk that should be considered acceptable. For example if the bank
uses deposit funds to trade in asset markets e.g. US Treasury securities that are of higher credit rating
than the bank itself then is that not improving the security of the depositor base assets compared to
sitting on cash?
We accept that the fallout from the financial crisis did shed light on bad practice such as the dilution
of investment criteria to embrace lower quality paper or the acquisition of derivative structures that
were not fully understood. Similarly, LIBOR or Forex manipulation was far being from the industry’s
brightest moment. However, politicians in the US have threatened a national default whilst playing
politics and the Eurozone is mired in shady, creative accounting. So we say politicians and their
appointed regulators should look to themselves before casting too many stones at financial services.
Understanding the basic facts:
Any form of investment, even if an allocation of assets between two maturities by the same issuer, say
the US Treasury involves a degree of speculation. Consider the US Treasury 2 year ~ 10 Year spread.
“Operation Twist” is a program conducted by the Fed in late 2011 and 2012 to help stimulate the
economy. It involved the Fed’s initiative of buying longer dated Treasuries and simultaneously selling
some of the shorter dated issues it already held in order to bring down long-term interest rates.
“Twist” was conducted in two phases. The first ran from September 2011 through June 2012, and
involved the redeployment of USD400Bn in Fed assets. The second was conducted from July 2012 until
December 2012, valued at USD267Bn. The Fed announced the second phase of Operation Twist in
response to continued sluggish growth in the American economy.
Looking at the two “Twist” phases illustrated in Figure 1 one can see the spread narrows as the market
follows the Fed’s buying of longer dated paper. In the time period covered in the chart the 2/10
spread evolves from +193bps on March 16th 2012 and eight months later on November 16th 2012 it is
+133bps…a tightening of 60bps. Last year, when Fed Chairman Ben Bernanke proposed that QE may
be slowed or “Tapered” the market read this as at best an end of the Fed buying the 10 year Treasury
note or at worst the sale back to the market of the long dated paper it had acquired. Hence the
spread widened from +145bps on April 26th 2013 to +260 on December 27th 2013, a widening of
+115bps. This movement came not from market manipulation by traders, rather by following the Fed.
Of course, an investment play of this nature is not restricted to the US. Consider investing in paper
issued by a sovereign other than the benchmark Germany. This entails a degree of speculation and risk
and the weaker the credit of other Eurozone sovereign then the greater the yield return. Table 1
illustrates the basis points (bps) spread of selected European Government 10 Year debt for the closing
levels of the last two weeks in 2013 and the first two weeks this year. Austria and Netherlands are close
to Germany in economic and social structure and yet are still deemed to be riskier than the Eurozone
benchmark issuer. They may be well run economies, but they are far smaller than Germany.
Why is an investment in a bond issued by a non-benchmark issuer undertaken? Clearly it is because
the investor expects that the acquired asset will appreciate in value at a greater rate than the
benchmark. So surely, that is using market awareness and economic judgement.
An investor in the Spanish 10 Year on December 20th 2013 would have seen the yield decline from
4.15% down to 3.83% on January 10th 2014. Similarly the spread over the German 10 Year fell from
+228 bps to the tighter level of +198bps … i.e. -30bps. Here an investor in Spanish debt has judged that
the economy of Spain may be healing and that Spain is a credible investment. No one complains that
Spanish paper and not German has been acquired.
So why it was the case that in 2012 when the Spanish economy was in a dreadful state there were so
many cries of anger that investors used the same market awareness and economic judgement to
decide that Spanish 10 year debt was mispriced i.e. it was overvalued.
On June 22nd 2012 the yield on Spanish 10 year debt was 6.38% and the spread over Germany
+479bps, the market participants determined that this was not a fair reflection of the Spanish
economic situation and so either existing holdings were sold or the market was shorted until
July 20th 2012 when the yield / spread situation was 7.27% / +610bps.
This investment decision and we have no problem in calling it speculation is not manipulation. It does
not matter what price a politician believes their sovereign debt is worth … it is only worth what
someone in the international financial market will pay for it. Without the markets ability to pass
judgement too many politicians would tax, borrow and spend ad infinitum.
• Markets are law enforcers as they hold politicians to account.
However, on November 1st 2012 the ability to trade the creditworthiness of a European country’s debt
became more difficult. A “Short-Selling Regulation” (SSR) that was aimed at curbing speculation using
the bonds and credit default swaps (CDS) of European sovereigns was applied across the European
Economic Area. This regulation restricted the short selling of sovereign bonds and sovereign CDS, as
well as shares.
It was claimed that short selling of sovereign bonds and sovereign CDS was directly responsible for
exacerbating the Eurozone sovereign debt crisis as it drove up the borrowing costs of countries such as
Greece, Ireland, Italy, Portugal and Spain to levels that were unsustainable. The ban was an attempt
by the EU to stop borrowing costs becoming inflated.
Spotlight says this is an absolute nonsense. If the economies of Eurozone nations had been well
managed, not riddled with inefficiency borne of a bloated debt profile and too much state
intervention then markets would not have had any reason to take them to task. Without the pressure of
the markets what reform has taken place would not have happened. It is also a fact that always
seems to escape politicians and regulators in that if a short is taken out, but the market moves against
that position, then the short will be quickly unwound. The short is in fact an aide to market liquidity.
Investors that trade aggressively as they look for mean reversion trades do not do so in a wild
haphazard manner. No, such an undertaking is meticulously planned and evaluated to see if the
current market sits square with economic fundamentals.
• By taking away the liberty to make short trades weakens the liquidity of the market and
prevents the truth about a mismanaged economy seeing the light of day.
• It is as nonsensical as imposing a turnover tax of financial transactions. [3]
The European regulators and the US have targeted curbs on opening an unprotected or naked short
on CDS instruments. These are well known as an insurance policy on bonds or indexes.
• When “naked”, the CDS is not offering protection on an underlying holding.
The regulatory powers have stated that they want all investors that have positions in CDS to
“Prove Intent”. They will be obliged to show that they either hold the bond being insured or have a
genuine economic interest in an investment tied to the swaps.
• Of course…the economic interest is to make a profit.
However, what such a demand does is hold, wide open a gate through which governments can find
ways to interfere or meddle with markets. This will have the loaded potential to taint any trading
strategy with a political agenda and so diminish the illumination or transparency that has generally
characterised markets.
Once again, hysteria reigns as politicians and regulators adopt a knee-jerk response that will ultimately
make trading more expensive, raise costs and so reduce the number of market players and actually
lead to a market structure that tends to an oligopoly as against monopolistic competition. Why it could
even create more opportunity for deeper dark pools to arise and create more troubling collusion.
• Almost certainly the “Bid-Ask” spread will rise.
• It may take a while, but these regulatory requirements have the potential to come back and
undermine policies such as Dodd-Frank.
CDS have been singled out as they are seen as allowing one individual to acquire risk insurance on a
catastrophe affecting another. However, why just attack CDS when financial engineering and other
synthetic products are more than capable of allowing an investor to take a similar exposure. It has to
be repeated…speculation is not manipulation and it is essential to the health and efficient functioning
of markets.
• Longs, Shorts, Derivatives all generate the liquidity…i.e. the lifeblood that keeps trading going.
• Trading of sovereign, agencies and corporates enables the efficient raising of debt finance.
Europe emasculates efficiency:
On Tuesday, January 14th 2014 new and comprehensive rules that will govern financial markets were
agreed in the European Parliament and Council of Ministers. They seek to shut down all loopholes so
ensuring financial markets are safer, more efficient and that investors are better protected. As a result
commodity trading is to be curbed and high-frequency trading (HFT) is to be heavily regulated. This
new rulebook is to be applicable to all market participants so as to generate post-trade transparency
information within the EU. They are dealing with transparency and access to trading venues plus a
directive governing the authorisation and organisation of trading venues and investor protection.
Any platform that empowers market agents to buy and sell financial instruments is required to operate
as Regulated Markets (RM’s). It is intended that investment firms will undertake trades on RM’s.
Under these new rules, all firms will have the responsibility when providing investment services to act in
clients’ best interests. This would also include designing investment products for specified groups of
clients according to their needs. They will halt any trade or proposal to offer any product that could be
judged as being “toxic” and ensure that marketing materials are clear and certainly not misleading.
Clients must be informed whether the advice offered is independent or not and about the risks
associated with proposed investment products and strategies.
Spotlight wonders how far down the road of explanation a market firm has to go? If at the end of a
presentation the audience, be it a wide group or a single client, there is a lack of relevant questions will
the potential investors be required to sign a disclaimer stating they understood the product and the
potential downside risks? If not are we not turning financial service into the new version of the tobacco
industry?
How much information is enough? What if a product that has by law only to be stressed tested to say
three standard deviations, but is tested to four during the course of a presentation were to fail because
market variables all reached a perfect storm and endured a level of five or more standard deviations?
Can the financial service provider be sued because they did not foresee a “Black Swan” paddling on
the lake? What ever happened to “Caveat Emptor”…”Buyer Beware”?
It is not just debt and CDS that are under attack. The stuff of food, drink and industry, i.e. commodities
are similarly being targeted. The ruling of the European Parliament is that authorities be empowered to
limit the size of a net position which a person may hold in commodity derivatives. What will prevent
accounts creating shell companies to make parallel trades? It is believed that excessive positioning
has heightened the volatility on food and energy prices. Of course the weather has nothing to with it!
Positions held in commodity derivatives are going to be limited so as to support orderly pricing and
prevent market distorting positions and market abuse. What shall we say to differing global
governments who in times of perceived shortage ban exports or start to hoard? Rather than attack the
market agents why not look at the underlying problems such as governments guaranteeing domestic
farmers above market prices for crops so encouraging productive inefficiencies and over supply.
The European Parliament also showed how it can be extremely “Luddite” in its thinking as it has
attacked the notion of algorithmic trading in financial instruments. This is where a computer algorithm
automatically establishes variable parameters of orders:
However, if a market agent acts as counterparty it would be required to have in place an effective
command and control system so that a series of “circuit breakers” could intercede and prevent further
action if the trading process generates excessive price volatility.
The algorithm that creates the basket trade may split the component parts and send instructions to
different brokers or market makers. What if the full package is split across two or more counterparties?
Do they all have to have the same pre-set “circuit breakers” in place? What happens if the trade is left
only partially completed or certain elements of the full trade are executed ahead of others? It may be
that the partial trade is actually a more dangerous product than the completed one.
Further, what if by activating the safety switches it prevents other, unrelated transactions from taking
place. From the good intensions of the European Parliament one can see a myriad of other questions
that need answering. There should be random checks on the client’s execution desk and the market
makers sales officer or the inter-dealer broker who should be capable of explaining how such a basket
or programme trade works. Raising the standard of education in all agents of the financial markets is in
Spotlight’s view an absolutely essential step. Markets are now simply too complex for the old school
barrow boys.
It is said that these programme trades can destabilise markets; it is interesting no politician complains if
such a programme boosts their national bond prices and lowers the yield on their debt. Nor would oil
exporters complain if crude rises so allowing them to reduce any budget deficit or boost their surplus.
Too many non-market players are happy to ride the tail of a market move when it suits their interests
and yet squeal when the tide turns. Deal with it, markets move down as well as up.
Life, like the markets is not a game where everyone can win. Some loose…yes we can impose book
limits and make firewalls so that no one trader or desk can ever ruin a bank again and threaten a
systemic industry collapse. However, weak traders will lose their job if they rack up a series of losses.
Maybe, if we are a mood to restrict the use of algorithms we should enforce a tougher and more rapid
restriction on multi-dealer online chatrooms that were cited as forums where plans to manipulate LIBOR
and Forex markets were hatched. Here is where algorithms can suddenly become the regulators best
friend as sophisticated programming has created tools that contain powerful speech recognition filters
capable of detecting what could be troublesome patterns in traders’ communications. Already any
foul language or discussion that is inappropriate and even elevated stress levels in traders’ voices.
Within the chatroom typing a profanity that contains certain letters can be disguised e.g. using “@”
instead of “a”, however, now a word can be read in relation to the sentence it sits within. This may also
allow internal security to monitor words that are out of place or seem to increase in their irrational use.
Recent examples include “Chinese takeout”…”End of the world”…”On ice”.
Those forms of conversations can leave an electronic trace, so perhaps all, not just a few dealing
rooms should be screened to block the use of cell phones. That should apply to inter-dealer brokers as
well as market making banks or asset managers. Any conversation conducted on the dealing desk
phone is automatically logged. With ever more powerful data storage facilities such conversations can
be retained for many months if not years.
It has taken over two years for the EU to cease their haggling as it attempts to eradicate deficiencies in
the way capital markets function. Spotlight fully agrees that there had to be a change. However, it has
to be a root and branch reform. Still the Eurozone has yet to execute a meaningful bank stress test.
Would it not be to the benefit of the real economy and restore investor confidence if the banking and
broking system itself were cleansed? One has to wonder why there is still no Eurozone banking union?
Why are we still awaiting a root and branch, warts and all stress test that is meaningful within Europe?
Yes, markets were distorted and damaged in 2007/2008…but right now the greater danger is stifling
and inappropriate regulation whilst politicians an unelected bureaucrats find ways to keep themselves
gainfully employed.
References:
[1] “Oxford English Dictionary” © Oxford University Press 2012 www.oed.com
[2] Paul Adolph Volcker, Jr. (born September 5th 1927) is an American economist. He has served as Chairman of the Federal Reserve under Presidents Jimmy Carter and Ronald Reagan from August 1979 to August 1987. He is widely credited with ending the high levels of inflation seen in the United States during the 1970s and early 1980s. He was the chairman of the Economic Recovery Advisory Board under President Barack Obama from February 2009 until January 2011.
[3] “Tobin Tax Terror” © Spotlight Ideas November 11th 2011 www.spotlightideas.net
Contact Stephen Pope at Spotlight Ideas on +44 (0) 7931 543740 or +44 (0) 1255 863612 or via www.spotlightideas.net