The Financial Services Club's Blog

The future of capitalism

It’s Davos time, as usual.

In the last week of January, the great and the good of the world’s leadership from governments, business, academia and media all gather in Switzerland to debate the future of the world’s economies and the World Economic Forum, #WEF.

In the build-up to this year’s WEF, it seems that all the magazines, media and men are talking about capitalism, what capitalism means post-crisis and what the future of capitalism will be.

David Cameron made a speech about this last week, as did Nick Clegg and Ed Miliband, and much of the debate resonates with the speech of Amartya Sen that I attended last week.

The core of the debate is embodied in the quote by Winston Churchill that “capitalism is the worst form of economics, except for all the others that have been tried.” 

Link: TrogloPundit

True.

The debate is then what form of capitalism you want: state capitalism or liberal capitalism.

A wholly state run economy fails, as demonstrated by communism; whilst a wholly liberalised, free market economy also fails, as demonstrated in 2008.

So there needs to be a middle ground, but how middling is that middle ground?

Somewhere between the extremes of Western and Eastern approaches to commerce.

Some believe that the West is crumbling due to over-excessive free market liberalism.

In a 2011 report, the Organisation for Economic Co-operation and Development figured that the level of income inequality in the 22 member nations it studied increased by 10% since the mid-1980s, with conditions deteriorating in 17 of them.

A recent report  by the Institute for Policy Studies, a Washington-based think tank, found that CEOs at large U.S. firms earned, on average, $10.8 million in 2010, a 28% increase from the year before, while the average worker took home $33,121, a mere 3% more. At that level, CEOs’ paychecks are 325 times bigger than their employees’. In the 1970s, CEO pay rarely topped 30 times more.

Meanwhile, the average income for an American has reduced every year for the past three years.

On the other extreme, Asian markets are rising fast and taking over, using a more state-led capitalistic approach.

“The world’s ten biggest oil-and-gas firms, measured by reserves, are all state-owned …  state-backed companies account for 80% of the value of China’s stockmarket and 62% of Russia’s.”  [The Economist]

“The ten largest economies in Asia now spend roughly $400 billion a year on research and development (R&D)—as much as America, and well ahead of Europe’s $300 billion. China’s investment leapt 28% in a year, propelling it past Japan to become the world’s second-biggest spender … America’s share of global R&D spending is falling. In the decade to 2009, it tumbled from 38% to 31%, whereas Asia’s rose from 24% to 35%. But science is not a zero-sum game.”  [The Economist]

So there is a new model rising which, according to Time Magazine, “is not so much between capitalism and another ideology but between competing forms of capitalism. The financial crisis, growing inequality and faltering economic performance in the U.S. have tarnished American ‘leave it to the markets’ capitalism, which is being challenged by ‘capitalism with Chinese characteristics’, euro­capitalism, ‘democratic development capitalism’ (India and Brazil) and even small-state entrepreneurial capitalism (Singapore, UAE and Israel). All these models favour a more significant role for the state in regulation, ownership and control of assets.”

The Economist furthers this debate, asserting that the winner is ‘state capitalism’.

Link: Ifyouhavetoaskyoudontknow

“The crisis of liberal capitalism has been rendered more serious by the rise of a potent alternative: state capitalism, which tries to meld the powers of the state with the powers of capitalism. It depends on government to pick winners and promote economic growth. But it also uses capitalist tools such as listing state-owned companies on the stockmarket and embracing globalisation.”

Examples of state capitalism include:

“The 13 biggest oil firms, which between them have a grip on more than three-quarters of the world’s oil reserves, are all state-backed including the world’s biggest natural-gas company, Russia’s Gazprom, China Mobile and Saudi Basic Industries Corporation is one of the world’s most profitable chemical companies. Russia’s Sberbank is Europe’s third-largest bank by market capitalisation. Dubai Ports is the world’s third-largest ports operator. The airline Emirates is growing at 20% a year ...  State companies make up 80% of the value of the stockmarket in China, 62% in Russia and 38% in Brazil. They accounted for one-third of the emerging world’s foreign direct investment between 2003 and 2010 and an even higher proportion of its most spectacular acquisitions, as well as a growing proportion of the very largest firms: three Chinese state-owned companies rank among the world’s ten biggest companies by revenue, against only two European ones.” [The Economist]

“State-Owned Enterprises (SOEs) make up most of the market capitalisation of China’s and Russia’s stockmarkets and account for 28 of the emerging world’s 100 biggest companies.” [The Economist]

“France owns 85% of EDF, an energy company; Japan 50% of Japan Tobacco; and Germany 32% of Deutsche Telekom. These numbers add up: across the OECD state-owned enterprises have a combined value of almost $2 trillion and employ 6m people.” [The Economist]

The Economist believes the trend for the next decade will be towards state capitalism based upon the Chinese model, albeit with caveats and issues along the way, and  concludes that “the Chinese no longer see state-directed firms as a way-station on the road to liberal capitalism; rather, they see it as a sustainable model. They think they have redesigned capitalism to make it work better, and a growing number of emerging-world leaders agree with them. The Brazilian government, which embraced privatisation in the 1990s, is now interfering with the likes of Vale and Petrobras, and compelling smaller companies to merge to form national champions. South Africa is also flirting with the model:

• Over the past 30 years China’s GDP has grown at an average rate of 9.5% a year and its international trade by 18% in volume terms. Over the past ten years its GDP has more than trebled to $11 trillion.
• China has taken over from Japan as the world’s second-biggest economy, and from America as the world’s biggest market for many consumer goods.
• The Chinese state is the biggest shareholder in the country’s 150 biggest companies.
• China’s 121 biggest SOEs saw their total assets increase from $360 billion in 2002 to $2.9 trillion in 2010 … in 2009 some 85% of China’s $1.4 trillion in bank loans went to state companies.”

But note that, unlike America where CEOs’ paychecks are 325 times bigger than their employees, state capitalism is fairer in terms of income disparities: “in 2009 the average SOE boss earned $88,000 and the highest-paid, the chairman of China Mobile, $182,000.” [The Economist]  China Mobile has 600 million customers and is one of the largest telecoms in the world.

FYI, I debated these points a couple of years ago, and concluded that the future is one where capitalism is heavily influenced by the influence of the Chinese and Islamic principles.  

Seems to be coming true?

Link: The World Is Not Enough

Postnote:

The main reading behind this blog post is inspired by two cover page stories:

• How to Save Capitalism, Time Magazine
• State Capitalism, Economist supplement

 

Amartya Sen: thoughts on poverty and the global financial crisis

I attended an interesting lecture last night from an economic legend: Professor Amartya Sen of Harvard University.

If you haven’t heard of him, he’s known as the Mother Teresa of economics in his native India, and has spent a lifetime fighting poverty with analysis rather than activism. 

Awarded the Nobel Prize in Economic Sciences in 1998, for his contributions to welfare economics and interest in the problems of society's poorest members, Sen is best known for his work on the causes of famine.

He is currently Professor of Economics and Philosophy at Harvard University, as well as being a senior fellow at the Harvard Society of Fellows, distinguished fellow of All Souls College, Oxford and a Fellow of Trinity College, Cambridge, where he previously served as Master from 1998 to 2004.

An impressive guy.

Amartya delivered his speech as part of the London Stock Exchange Group series of lectures on the future of global finance, and the evening was hosted by LSE Chairman, Chris Gibson-Smith.

Here’s a brief summary of Amartya’s sentiments (I say ‘sentiments’ as this is not a record of his speech and incorporates my own spin on his words).

Some people say we live in interesting times, but I think we live in baffling times.

We live in baffling, rather than interesting, times because it is very hard to get any clarity about the future. 

The only thing that is certain is, in the words of George Bernard Shaw, “the greatest of evils and the worst of crimes is poverty”.

Shaw wrote this in the Preface to his brilliant play, Major Barbara, published in 1907. 

The tragedy of poverty is, of course, obvious to all - whether in Latin America, or in Asia or Africa, or in Europe and the United States. 

The calamity of deprivation and penury can hardly be missed by those who have bothered to think about the subject, no matter whether they are themselves poor or not. 

Lives are battered, happiness stifled, creativity destroyed, freedoms eradicated by the misfortunes of poverty. 

But Bernard Shaw was not talking, on this occasion, about the hardship of poverty, or the misfortune that goes with it. 

He was commenting, in a rather unusual way, about the causation and consequences of poverty - that it is bred through evil and ends up being a crime.

If poverty is indeed an evil, not to mention “the greatest of evils” as Shaw puts it, then there must be some wickedness, or at least some culpability, behind poverty - some wrong-doing that allows such human tragedies to occur and persist. 

This raises the immediate question: who, then, are the wrong-doers?

If you look to protesters today, such as the Occupy Wall Street movement, the wrongdoers are represented by the corporate greed of capitalists and the banks.

You can just as easily take the opposite view however, and look to the Tea Party movement who see the failure being that of government and government policies.

The Tea Party align with Adam Smith, the guru of capitalism, and believe that free markets should rule.

Who is right and who is wrong?

Or is this the right question? 

In thinking about strategic issues, we cannot but go into the question of culpability and the failure of duties and obligations. 

We have to ask: how can things be done differently so that the evil of poverty is ousted? 

We have to identify the nature and genesis of the wrong-doing that is responsible for the affliction. 

That is not, however, the same as trying to identify the wrong-doers?

The identification of wrong-doers is not our task and trying to identify the evil-doers is not the right strategy since the responsibility for creating an evil is very widely dispersed in the society. 

We have to see how the actions - and indeed inactions - of a great many persons together lead to this evil, and how changing our modes of actions - our policies, our institutions, our priorities - can help to eliminate poverty. 

Our focus definitely has to be on removing evil-doing, as part of our strategies and programs, rather than going on the wild-goose chase of catching the hugely dispersed collectivity of evil-doers, who may not even fully understand how their actions can be seen as part of an evil state of affairs.

In fact, we should eliminate the discussion of wrong doers completely, and focus our efforts more on how to stop poverty full stop.

This is why strategies such as closing sweatshop labour factories in poor countries, or arresting those who employ children in the making of carpets, would fail to eliminate the poverty of the victims if such action is separated from a general economic and social program. 

In the vast majority of cases the employees are there in those terrible jobs because they have very few options - none that are particularly good. 

This is because there has been a failure of the state and the society to create opportunities for decent employment, which makes it possible to recruit labour to do terrible jobs as the alternative may be unemployment and starvation.

That is why exploited labourers are led to soul-destroying work today in the poorer countries, and closing down sweated-labour factories without giving the victims alternative opportunities for employment or education - the latter is extremely important in the case of child labour - is not an adequate solution to the problems and predicaments of the precarious poor. 

There is, of course, moral merit in restraining the pursuit of profit of businessmen through exploiting vulnerable and freedom-less labour, but a fuller solution can emerge only through positive opportunities of alternative employment and occupation, and that demands societal action. 

So the first action to address poverty is to expand labour opportunities and assist in education, and not to just shutdown existing sources of income.

My argument so far has been based on seeing poverty as lowness of incomes. 

Is employment with income a full solution to all problems of poverty? 

To believe that would be to underestimate vastly the complexity of poverty, particularly the nature of persistent poverty. 

By way of example, lowliness of income is the primary cause of starvation rather than the lowliness of the availability of food.

Is employment for income in order to buy food the answer to everything therefore?

No, as this misses the point of why there is persistent poverty

Strategic examination about eliminating poverty, or even reducing its burden, has to go more deeply into the nature of poverty. 

Poverty is about the inability to lead a decent, minimally acceptable life, and while low income does make it difficult to lead a life of freedom and well-being, an exclusive concentration on seeing poverty as lowness of income misses out a great many important connections.

What are the other non-income factors that contribute to poverty: a lack of education, availability of work, investment in infrastructure and more, and capitalism addresses these issues by providing an insurance.

For example, all affluent societies have addressed extreme poverty issues through public policy programs, such as the public pension, the provision of school education, the availability of healthcare and more non-market non-commercial arranged facilities.

The economics of these areas are not obvious except that an insurance system run by the state or by some other social support system, not by profit-oriented private firms, may be a necessary part of the elimination of poverty. 

Affluent societies focus upon profit maximisation and the unrestricted search for profit, but if they only relied on profit maximisation they would not function.

As a result, they balance between market mechanisms and state activities.

There is no strategic formula as to the correct balance between market mechanisms and state activities – the contrast between China and Taiwan or America and Sweden are good examples of how approaches differ – but we need to understand these balances in order to create a better world that addresses poverty with finance.

Does this mean arguing against Adam Smith’s principles for free markets?

Not really.

That view is a result of a huge misunderstanding of Adam Smith’s principles, and my position is strongly influenced by his.

Adam Smith clarified how markets work and how they can work exceedingly well.  He believes that you need a well-functioning market economy and clarity of why you want such efficient markets to be.

The task of politicians in managing the economy is then to search for two distinct objectives: first, to provide plentiful revenue to cover the basic subsistence needs of the people before the subsistence needs of the state; and second, to provide the state with enough revenue to finance public services.

The financial focus of public services is a critical part of Smith’s work and Adam Smith had an overwhelmingly clear view about support of the poor and undersupported in his market view.

Within his free market principles, he clearly defended the role of the state to fund public services, such as education and poverty relief.

Adam Smith was deeply concerned about the inequality of society and never used the word capitalism.

The word capitalism does not appear in any of his books or any other writing, and it would be hard to carve out anything in his works on market economies that were based purely upon capital.

For example, he specifically argued about protections from unlimited usury practices.

So how should we think about the wrongdoers that need rectification, and how should we address poverty?

According to Adam Smith and my own thinking, the key is increasing employment.

Increasing employment must remain a worldwide priority and China, Brazil and India are doing much better at this than America and Europe.

As employment and economic welfare rises, the state must use such employment to improve public services for good living and public welfare and, in this respect, India is not doing this as well as China and Brazil.

Finally, for the West in general and Europe in particular, the crisis of 2008 was created by the malfunctioning of market economies – the result was the state had to create support for their economies and this is the reason for rising sovereign debt.

But the cause of this malfunctioning is clearly what was thought of as lack of accountability of governments, but governments are accountable and this is what we are seeing today.

What we are seeing is that, in order to pay back their debts, governments have far more accountability.  However, they are addressing this accountability in the wrong way.

It’s hard to see how massive austerity drives, which cuts demand and growth, can therefore be supported,

Just look at Japan and learn from what happened there over the last 20 years of austerity, which is still biting.

What these governments need is fast economic growth.

Economic growth creates resources to address unemployment and poverty.

This is the key to addressing issues in Europe and the West, and it is the indiscipline of governments that has failed the markets, not the markets themselves.

Europe needs a better form of economic accountability and management of their economies, rather than austerities which decimate human lives and economic growth.

In conclusion, I end by affirming that George Bernard Shaw was right, a hundred years ago today, to point to the connection between poverty and evil and crime.  The fact that this insight came not from an economist but from a dramatist and literary giant fits in well with my general thesis that the economics of poverty involves much more than just economics.  Human lives in society are interlinked through economic, social, political and cultural associations.  The nature, causes and consequences of poverty reflect the richness of those connections.  We have no reason to be surprised by that elementary understanding.

Amartya then took Q&A from the floor and was asked a few interesting questions.

Q: You appear to be saying that in this current crisis, it is the failure of states to regulate markets effectively that failed, rather than the markets themselves. Is this your view?

You cannot separate markets and state, and this crisis was a failure of both, but you also have to be aware of the relationship between free markets and state influence. 

For example, Adam Smith argued against usury, but was convinced to change his thoughts on interest after reading the works of Jeremy Bentham. 

The core of how markets and state should work is that free markets is the most efficient model of economic management, but free markets need states that set efficient regulations to avoid failure in order to be truly workable.

As this shows, free markets and the state are two separate entities that are interdependent.

A key question in the last crisis however is whether globalisation killed that interdependency to cause the spiral of crisis we see today.

Globalisation may have undermined national states, as government can no longer effectively regulate the free markets?

There may be some truth in this statement, and this is why the G20, G8 and other global activities – the World Bank and IMF included – are key to solving these issues this time around.

Q: Do you think the euro will survive?

No.

When the euro was created, I didn’t see why it was needed and didn’t believe it made sense.  I am a fan of Europe, don’t get me wrong there as my late wife was Italian, but to start a European integration without a fiscal foundation meant that it was never going to work.

You can see this today as many parts of the EU are not served well by a Europe that has no fiscal union.   Greece is a good example.

Now however the loss of a country would be very destabilising for this European Union.

This is why Germany is being forced to bailout Europe.

Could they retreat out of it? Yes.

Is that the right thing to do? I think so.

 

Postnote: some of Amartya’s speech is taken from a write up of an earlier presentation he made in 2007.  These words of wisdom are integrated in parts of this article to ensure more accuracy of content.

 

How will the world look post-crisis?

I’ve been debating some future presentations with various folks today, and a little ray of light went off in my head.

The light was triggered by a comment: “can you talk about what impact regulatory change may have on bank to corporate relationships using examples historically?”

The question was really asking about the unintended impact of regulatory change in the past and what it might mean for their future, but it made me think about something else.

Each time we have seen a major bubble burst, the cause has been a coagulation of several forces of change.

Forces for change come from four major directions: Political, Economic, Social and Technological (PEST).

These forces for change are used in many ways, and can be seen in my banking history discussions (and soon to be published book) which talks about many historical periods including the Italian Renaissance, the Great Depression and the Credit Crisis.

In each of these, we can see Political, Economic, Social and Technological forces working together at the same time to drive change.

In the fall of the Renaissance Italians, it was a mixture of change between the break from the Catholic Church with the Protestant and other movements (Political), mixed with the ruin of the Italian banks due to over-extension of credit to overseas Royal Houses (Economic), along with expansion of merchant shipping and colonisation (Technological).

In the Great Depression, we saw the end of the Industrial Revolution (Technological) combined with post-war wrangling over the gold standard (Political and Economic).

Right now, we see a major world of change too.

We have the rebalancing of power between America and Asia/China (Economic) combined with an internet revolution that is connecting everyone on the planet (Technological), leading to changes in society, where a Molly Katchpole can reverse a bank’s policy and an #Occupy movement can change global thinking (Social).

The Political outcome of all of this is what is driving bank regulations right now.

And the outcome of all of this will be a massive change.

A New World Order?

Probably not.

We already have a New World Order as China is expected to be the world’s largest economy by 2018 (ten years ago, it was estimated to be 2047).

But we will see a restructured playing field and one that is not level.

We can see this already as one major economy (America) bans prop trading whilst another (UK) just separates prop trading from retail bank operations.

Even more pronounced are the differences between the US and EU on OTC Derivatives regulations and how to define and regulate Systemically Important Financial Institutions (SiFi).

From CME Group in October 2011:

“In an ideal world, global financial regulators would function something like a team of horses, with policymakers in the United States, Europe, Asia and elsewhere all pulling at once in the same direction, and moving toward a common goal.

“Reality is turning out be far more chaotic, however. Regulators and lawmakers are having a tough time forming a consensus even within their own national borders, let alone across international boundaries. The result is turning out be a patchwork of overlapping and often inconsistent approaches to regulation in the aftermath of the financial crisis that gripped global markets in 2008 and 2009. Many financial experts fear that the inconsistent global regulatory framework will alter the flow of capital around the world, as trades are directed to the cheapest jurisdiction, a process known as regulatory arbitrage.”

So we end up with a world where the politicians are trying to react to the implosion of markets at the end of another revolution – Globalisation – and find that they are seriously lacking consistency, vision, leadership or agreement.

The Eurozone is one of the best illustrations of this, although America and China aren’t guaranteed to come out of this stainless as the American elections will change ground again, as will China’s challenges of a property market bubble and inflationary pressures.

All in all, the PEST approach to the world today says that we are going through a momentous change from all angles – Political, Economic, Social and Technological.

Where will it end up?

Probably in a place no-one expects and one which, on this blog, I’m going to avoid predicting decisively.

From Reuters:

“By 2020, the workforce in western Europe will shrink by 2.4 percent, including a 4.2 percent contraction in Germany, according to a Boston Consulting Group study.

Looking further ahead, HSBC projects that Germany's working population will shrivel by 29 percent by 2050, Russia's by 31 percent and Japan's by 37 percent.

Over the same period, the population of many African countries will double. Nigeria will log a rise of 3 percent a year in its workforce - in contrast to a 1 percent decline in Russia and Japan - and will have as many people as the United States by 2050.

On current projections, Pakistan will be the sixth most-populous nation by the middle of the century. And the Philippines could be the world's 16th-biggest economy, HSBC reckons.”

 

2012: an economic outlook

2012 is here and we all hope it’s better than 2011.  Sure, some of you may have had a very good last year, but most thought it pretty dire with job losses, austerity measures, civil uprisings, protests, a second financial crisis in the Eurozone and more being the name of the day.

Time Magazine named their Person of the Year as a collective Protestor, rather than an individual …

And the Times named Mohamed Bouazizi - the young market trader who set fire to himself outside the government offices in Tunisia as a martyrdom act that fuelled the Arab Spring - as their Person of the Year.

Is this a time when societies worldwide change their world or will media, finance and government, continue to control and direct?

Probably a mixture of both.

Thanks to this internet age, the individual can change things and change things fast – the Arab Spring, Occupy Wall Street, Anonymous and Wikileaks prove this – but those in power will still direct, as far as they can.

The question may be who is in power, as demonstrated by the Eurozone issues of 2011.

Where are we going in 2012, is therefore a key question.

To put this question in context, I said three years ago that the next resurgence in the economy would be in 2014, after plateauing in 2012. 

I still believe that.

This year is going to be a tough one, as things haven’t finished yet, but things are stabilising. 

Europe’s going to a have a mild recession, America is going to revive and Asia is going to wonder where it’s going.

So here are the four key things that reflect the economic times of 2012:

1. Asia’s light continues to shine, but not quite as bright
2. American equities is the place to invest
3. There will be a major European bank failure
4. A country will leave the Eurozone

Asia’s light continues to shine, but not quite as bright

Asia, particularly China, continues to astound. 

 

From Urban Times, 2010 

Ten years ago, China had more mobile phone users than America, and last year it manufacturer more and registered more patents.  In 2014, its retailers will sell more too and the day that China becomes bigger than America is getting ever nearer.

In 2003 – when Jim O’Neill coined the term the BRICs for Brazil, Russia, India and China – he estimated that China’s economy would overtake America’s by 2041.  Last year, that estimate had moved fourteen years nearer, to 2027, thanks to the economic crisis.  As the crisis has continued, the estimate is now that 2018 will be the year China gets to be bigger than the USA, according to Emma Duncan in the Times.

Nevertheless, with the American and European market demands contracting, China is not sailing a static sea.  For example, Reuters Breaking Views blog states that China’s growth may dip under the magical 9% this year – even falling under 8% – as multiple challenges hit: falling house prices, a slump in property investment, and slowing exports.  Add to this that salaries surged 40% last year – admittedly to just $160 per month – and we can see that global growth and stability will not be plain sailing at all in 2012. 

 

Source: PhilSTAR / Bloomberg

So where should you invest?

American equities is the place to invest

In a bout of good news for Barack Obama, in the year where he fights for his political future against Mitt Romney, the US looks to be a safe bet for investments in 2012.

Terry Ewing, head of US equities at Ignis Asset Management, believes the US can continue to surge, as its economy has differentiating growth characteristics that will underpin both earnings growth and the stock market.

Mr. Euwing has expectations of 2% GDP growth, compared with the 'inevitable European recession' this year. By way of history, US industrial production rose by 8% between 1993 to 1995 whereas Europe's shrank by 5% and he believes a similar divergence could well happen again.

He lives with good company, with Jim O’Neill of Goldman Sachs saying that American equities could rise by as much as 20% this year, and Paul Frank agrees.  John Paulson promotes buying US stocks over US government bonds, whilst James Paulsen sees this year as the ‘gear year’.

Source: PhilSTAR / Bloomberg

With all those “Pauls” behind it, something’s gotta be right and so yes, invest in America is the message in 2012.

Unfortunately, that means don’t in Europe.

There will be a major European bank failure

In July 2011, the European Banking Authority (EBA) issued its summary of how fragile the European bank system was after stress tests on 90 European banks.  Eight failed that test – nine if you include the German Helaba Bank that dodged it – and a further 16 were in the danger zone.

However, the tests did not include a sovereign debt default, such as the issues we now see in Greece.

And with the ECB lending €500 billion it should stabilise the system, except that the ECB is receiving a similar amount back in overnight deposits and European banks still have to face almost €2 trillion of toxic assets on their balance sheets.

Add on to this that European banks also face a major capital shortfall – at least €115 billion and more like €350 billion – and we are bound to see more European banks failing this year.

I said a third of European banks would fail two years ago.  It won’t be that many, due to the €440 billion European Financial Stability Facility, but there will still be some major failures with Commerzbank already in the frame.

It should be noted that this is not unique to Europe however, as 92 banks failed in the USA in 2011.  It’s slightly down on 2010 (157 failed) and 2009 (140) but it’s still high and will continue as an analysis by The Wall Street Journal suggests that failures are down because troubled banks aren't failing as quickly.

A country will leave the Eurozone

Due to fragility in the European banking system continuing, along with a lack of confidence in Europe’s leadership, one or more countries will be forced to leave the euro.

There’s already been lots of speculation that a Eurozone member will need to breakout of the euro.  Greece is the usual one cited, but Italy and others are also regularly debated.  There has been lots of simulation and planning for such an event and so, when it does, it won’t cause any major ripple in the markets at all.

It will be a disaster for the country concerned of course, but the idea of continuing the Eurozone where a third of the members – Portugal, Italy, Greece, Ireland, Spain and more – are being propped up by Germany, and to a lesser extent France, is just not workable long-term.

And I’m not the only one saying this.

The Wall Street Journal is charting its demise, whilst the Guardian is talking about it every day, as are many people in the countries affected themselves, such as Greece and Ireland.

The UK Treasury is planning for it to fail; as are most bank analysts, banks and companies.

In fact, the only ones saying it won’t happen are the ECB, obviously, and Wolfgang Schäuble, the German Finance Minister.

But what does it mean if it happens?

Well, it ain’t good, but it doesn't mean the end of the Eurozone.  Just that Europe has to rethink a lot of the Maastricht Treaty, and come up with a new Economic & Monetary Union approach.

Peter Sands, CEO of Standard Chartered, puts it succinctly:

“I think the probability of countries leaving the Eurozone has increased because we have had several successive plans announced to solve the problem of the Eurozone which simply haven't convinced the market.

“Nobody should underestimate what a big deal that would be, because it would be very difficult to manage the contagion risk, even if it was only Greece. The disruption from that would really be quite significant.

“That will have ramifications all over the world . . . because the simple maths is that the Eurozone is a very large part of the global economy and if it is going slower, then economic trade will be slower around the world.”

So there’s a short guide to the 2012 economic outlook:

• Asia’s light continues to shine, but not quite as bright
• American equities is the place to invest
• There will be a major European bank failure
• A country will leave the Eurozone

This is one of three 2012 outlook pieces:

• 2012: an economic outlook
• 2012: a banking outlook
• 2012: a bank technology outlook

 

Just a brick in the Wall ... Street

Obviously, many of you will be aware of the #OccupyWallStreet protest by now.

If you’re not, it may be that you were at #SIBOS when it all started, so here’s the low down.

My friend who lives on Wall Street told me that a bunch of around 200 protestors set up camp in the park by Wall Street just over two weeks ago, and they started taking it in shifts to block access into and out of Wall Street holding up placards and shouting with drums.

It’s very annoying he says.  In fact, it’s very, very annoying.

And that may be how it started, but it’s gradually getting more and more serious.

For example, the police didn’t know how to handle a ‘peaceful protest’, so they started to deal with it by manhandling people with force …

Unfortunately, in this age of never ending streaming smartphones and tweets, you can’t get away with anything.  The result is that the mood is now also anti-police, with chanters shouting: “racist, sexist, anti-gay! NYPD go away!”

This is due to the mass arrests that have been taking place since the protests became so belligerent and irritating to everyone in downtown New York, with 700 arrested on Saturday alone.

Mind you, it's not irritating everyone as celebrities from Susan Sarandon (particularly vocal) to Mark Ruffalo (who?) are  getting involved.

To keep up with what's happening, I suggest you follow #OccupyWallStreet on twitter, as it is a great source of news and views about what’s going on.

It's also interesting to see that the US protesters are using Vibe to avoid the UK tactics where, , after the UK rioting, the police forced Blackberry's hand to share instant messaging details about the riotous organisers.

Vibe allows users to send any-to-many messages, similar to twitter, but the message are always anonymous and can be set to self-destruct after a set period of time.

Another difference is to note that, due to the viral nature of such social networking, the protest is now spreading.

It’s no longer Occupy Wall Street, but also Occupy Any Business District from LA to Seattle to Chicago to Boston.

What do they want?

No-one knows, except to protest.

Protest about what?

The economy, banking, unemployment, welfare, prices, life … the government.

The message is mixed because there is a core group who offer a manifesto with a list of demands and a declaration that is being refined ...  but they have been joined by so many other protest groups that there appears to be no big message, except that people are angry about the world and want change (something I thought Barack Obama had promised).

This has been critiqued by many but, as one tweeter puts it, it “is more than just a protest. It's the start of a new government. A government free from greed and corruption.”

And how do the banking fraternity feel about this annoying development?

Watch this (one minute in) …

I'm sure the musical version will be here soon, with a slightly different theme tune:

We don't need no occupation 
We don't need no thought control
No dark sarcasm from the government
Police leave them kids alone
Hey! Police! Leave them kids alone!
All in all it's just a brick in the Wall ... Street.
All in all you're just a brick in the Wall ... Street.

 

The outlook for UK banking results this week

So today marks the start of the bank reporting season in the UK which, based upon last week’s results in the USA and Europe, will be pretty bleak too.

First, we have HSBC which is a mixed bag of news.

According to the Telegraph, HSBC will report “a profit for the first six months of the year of $10.9 billion, becoming the first of the UK's major banks to announce its interim financial performance.

“The profit figure, which means HSBC made nearly $1.7 billion of profit in each of the first months of the year, is slightly down on the same period in 2010 when the bank reported a before-tax profit of $11.1 billion.

“HSBC currently employs 335,000 staff around the world and the redundancies would equal about 3pc of its total workforce.

“Mr Gulliver wants to reduce HSBC's cost income ratio to between 48pc to 52pc. In the second half of last year the bank reported a cost income ratio of 60pc and in the first six months of this year analysts at Credit Suisse estimate this has fallen to 57pc.

“Profits from HSBC's personal financial services business are forecast to have more than doubled to $3.2 billion compared with the same period in 2010, largely as a result of reduced losses in the bank's North America business, which lost $1.5 billion in the first half of last year …

“Global banking markets, HSBC's investment banking division, is expected to have recorded about a £1 billion fall in profits compared with the first six months of 2010 at £4.6 billion.”

One point of note is how HSBC is restructuring, started with the sale of its 195 branch network in upstate New York to First Niagara Bank for $1 billion (£609m).

HSBC also recently sold its Russian business and further sales of international retail banking businesses are considered likely, though the bank has ruled out selling any of its UK, French or German operations.

One point to note in HSBC’s globality is the retrenchment of operations, and the refocusing from shrinking markets – the USA – to growth markets – Asia.  For example, although profits were boosted by growth in emerging markets, there were still write-downs in the USA of around $3 billion, two-thirds the figure of last year and adding to the cumulative pot of near $70 billion losses on Household since its acquisition in 2003.

This is why Stuart Gulliver announced in May, that HSBC would slash costs by up to $3.5 billion by 2013 with the savings “ploughed back into fast-growing markets around the world, especially in Asia.  The lender has already said it would be hiring at least 2,000 extra people in mainland China and Singapore over the next five years, as it seeks to tap the fast-growing Asia Pacific market.”

Apart from HSBC, and looking around the other banks, the outlook is also grim.

Lloyds and RBS have seen their shares plunge 30% and 17% respectively in the last six months alone, while Barclays' shares have plummeted 26% and HSBC has lost 14%.

Much of this is down to severe downturns in trading, with some bulge bracket firms reporting that year-on-year trading was down by over 25% in June.

At Barclays Capital, the investment banking arm of Barclays, analysts estimate that profits could have fallen by about 40pc to just over £2 billion in the first half of the year compared with the same period in 2010.  In 2009 the division reported revenues of £13.7 billion, up nearly 90pc on 2008. A year later revenues had dropped by more than a third to less than £9 billion and this year the forecast is for a fall of another 8pc to around £8.1 billion.

Taxpayer-backed Lloyds Banking Group is expected to report pre-tax profits of £1 billion on Thursday, a steep reduction on the £1.6 billion reported a year earlier.  Losses in Ireland and Australia, although still high at £2.2 billion, will be £1.4 billion lower than the second half of 2010.

Royal Bank of Scotland closes the week with its results on Friday, which are expected to reveal £611 million in reported profits, down 19% on the previous year.  Much of this will be due to disappointing investment banking results, down 31% over the same period last year.  This represents a more than halving in profits in its global banking and markets business to £1.3 billion. Nevertheless, RBS will show overall business lending is up, driven by increased borrowing from large corporates.

Analysts estimate the combined pre-tax profits of the so-called "casino banking" divisions at Barclays, HSBC, Royal Bank of Scotland, Standard Chartered and Lloyds Banking Group fell from £11.1 billion in 2010 to £9.1 billion in the first six month of this year.

All of this means lots and lots of job losses.

Apart from the 10,000 at HSBC, there were 15,000 job losses announced in June by Lloyds Banking Group, taking the total number of redundancies at the bank since its rescue by the taxpayer to about 40,000. Royal Bank of Scotland has already shed 28,000 staff since the financial crisis started.

Barclays has been shedding staff for months, with Barclays Capital, its investment banking arm, cutting about 600 people worldwide since January and its retail business losing almost 2,000.

At UBS, as many as 5,000 jobs are set to go across the group, including the bank’s wealth management arm. Credit Suisse is eliminating about 2,000 positions, largely in its investment bank.

Goldman Sachs, the US investment bank, was the first to announce a substantial cull of jobs last month, saying it was trimming 1,000 posts after a poor performance by its fixed- income trading division.

The overall expectations are that as many as 15,000 City-workers, or about 5pc of London-based financial services staff, will lose their jobs before the end of the year, resulting in a drop of more about £1.3 billion in lost income tax revenues for the Exchequer.

This is based on an average salary of £150,000 and income tax of 50pc, employer national insurance of 2pc and employee national insurance of 2pc, this works out an average lost tax income per lost City job of £81,000, or a total loss of about £1.3 billion in tax revenue.

To put this into context, financial services workers paid a total of £18 billion income tax for the tax year 2009/10, or 15pc of the UK total, so this year's redundancies alone could lower the sector's income tax contribution by about 7pc.

It’s not all bad news however, as Standard Chartered is set to announce pre-tax profit of around $3.5 billion, up from $3.1 billion in the first half of 2010.  Again, this reflects the strength of Asia.

Also, the taxpayer “made a net profit of £339.8 million pounds in the first half of 2011 from the assets they still hold in Bradford & Bingley Plc and Northern Rock (Asset Management) Plc.”  So that’s not so bad then.

Meanwhile one Spanish Bank, Bankia, has offered the ECB Cristiano Ronaldo as collateral for their loans.  What is the world becoming?

The above is an amalgam of a variety of articles as follows:

• HSBC to cut 10,000 jobs despite $11bn profit – the Telegraph
• HSBC sells 195 New York branches for $1bn – the Telegraph
• HSBC expected to announce 10,000 jobs cut, disappointing results next week – the Australian
• HSBC set to 'confirm 10,000 job losses'– the Independent
• Market braces for banking results bonanza – the Independent
• Investment profits at UK's biggest banks 'fall by £2bn’ – the Telegraph
• City job cuts to cost the Government £1.3bn in lost tax revenue – the Telegraph
• UK banks’ jobs cull intensifies – the Financial Times
• Taxpayers Get 339.8 Million-Pound Profit From Nationalized Banks – Business Week
• Spanish bank fields Ronaldo as collateral – the Telegraph

 

 

 

In the bleak mid-summer

It seems like a long bleak summer in the financial markets, as banks are reporting dire results.  It’s a combination of investment banking in the second quarter suffering serious damage across all fixed income desks, along with the Eurozone and American debt crises.

There is no certainty in such times.

For example, banks that usually do well are reporting red.  Goldmans Sachs led the way:

Goldman said its net income in the second quarter of 2011 was $1.05 billion, more than double the figure from the same period last year, but well below analysts' consensus forecasts.  Revenues were $7.28 billion, down 18 per cent from the second quarter of 2010 and 39 per cent lower than in January-March of this year, Goldman said. Analysts had projected revenues of $8.14 billion. Earnings per common share were $1.85, substantially below the consensus analyst forecast of $2.27.

But there is worse. 

After first quarter revenues at:

• JP Morgan were down 1%;
• Goldman Sachs was down 7%;
• UBS investment bank was down 11%;
• Credit Suisse was down 6%;
• Barclays Capital was down 14%; and
• Citigroup was down 25%;

now, in the second quarter, UBS are already in trouble:

UBS Chief Financial Officer John Cryan told analysts, "UBS faces weaker second quarter earnings after capital markets turbulence led to a sharp slowdown at its investment bank and lower activity by rich clients".

Result, they are laying off 5,000 staff whilst Goldmans are laying off 1,000, and several other banks are in trouble:

Credit Suisse is expected to suffer the steepest percentage fall in revenues from its fixed-income, currency and commodities division of the big four European investment banks, with Morgan Stanley forecasting a 41 per cent quarter-on-quarter decline.

A significant rise in mergers and acquisitions activity and underwriting of debt and equity issues will partially plug the gap for European banks, analysts said. Globally, investment banking fees were up 23 per cent year-on-year in the first half, and 26 per cent in Europe, according to Thomson Reuters.

Overall, investment banking revenues at Deutsche Bank, UBS and Credit Suisse will be down by an average of 25 per cent from the seasonally strong first quarter, while net profits are expected to have tumbled by an average of 49 per cent over the same period, according to analysts at Citigroup.

In the UK, investment banking revenues at Barclays and Royal Bank of Scotland Group revenues are expected to be down about 30 per cent from the first six months of 2010, with pre-tax profits falling a similar amount on average.

Meanwhile, there is still a crisis in retail banking due to non-performing loans, as evidenced by AIB’s results this morning:

Allied Irish Banks (AIB) unveiled a 2.6 billion euro($3.7 billion) underlying first-half loss as more loans turned bad, but said it expected 2011 to be the last year of major loan writedowns.

Alongside such news is the challenge banks are experiencing in capital raising in order to shore up their capital reserves to comply with the EBA stress tests announced a week last Friday.

The EBA data showed Europe's banks held €98.2 billion of Greek sovereign bonds at the end of December, with two-thirds of that held by Greece's banks, 9% by German banks and 8% by France's.

Banks' exposure to Irish sovereign debt was €52.7 billion (61% held domestically) and to Portugal it was 43.2 billion (63% held domestically).

This sovereign debt data has been crunched by analysts at big banks over the weekend in tests that were toughened up with default scenarios – something the EBA was barred from doing by nervous EU finance ministers.

Europe's banks would need €41 billion to keep their core capital ratio above 7%, the new global minimum from 2013 under the Basel III accord and already required by markets in practice, according to Reuters' calculations.

This compares with the 5% pass mark in the test.

JPMorgan's Abouhossein said a tougher test of 27 of the bigger banks using EBA data would show 20 are a combined €80 billion short of capital.

His test applied a haircut to sovereign bond holdings in the banking book and required banks hold core capital of 7%.

Credit Suisse analysts said applying larger haircuts on peripheral eurozone bond holdings, including for Italy, as per current market prices, would leave a €45 billion deficit for 49 banks it tested.

But capital raising isn’t simple, as the Bank of Ireland is about to find out. 

Bank of Ireland is trying to raise 1.9 billion euros ($2.7 billion) in a rights offering that closes on July 26 … the government will likely end up controlling as much as 65 percent.

So we have investment bank revenues and profits collapsing, retail banks still finding bad loans on their books, and Europe’s banks seriously challenged in shoring up their already crippled balance sheets.

Combine this with the who-will-chicken-out-first game in the USA over their debt crisis, and times aren’t great.

That's all past and present however.  

Looking forward, add on a few more jitters by thinking about a Q3 that is normally quiet, low M&A activity, more challenges in equities and fixed income, a euro crisis that rolls on and on and on, and you can see why I’m not a happy bunny.

These are a few of the thoughts I shared with Bloomberg this morning.

The only ray of light is JPMorgan and Deutsche Bank who consistently seem to over perform.

Will Deutsche continue to do that as their boardroom battle comes to a head?

Will JPMorgan be the last bank standing?

 

Postnote (26th July 2011, 08:29)

Times change fast.  After writing this yesterday, today Bank of Ireland have sold their rights issue to private investors and avoided state control and Deutsche Bank have confirmed their succession planning.

Bank of Ireland Sells Stake to Investors
Business Week

Deutsche Bank names new chief executives
The Independent

 

But, as expected, UBS report they are going to cut costs heavily in light of bleak trading conditions.

 

UBS expected to cut jobs as it seeks to save $2.5bn

BBC

 

Volcker versus Vickers, Round One

Paul Volcker’s in town and he’s been everywhere!

He popped up on Bloomberg, and “said the pace of financial-regulatory reform has slowed ‘to the point of ineffectiveness’ because of the complex work needed and resistance of lobby groups.”

He made a few comments on Reuters, and said “there are limits as to how much more (the Federal Reserve) can do within things that are feasible for a central bank” with regards to the debt crisis in the USA.

And he delivered the prestigious Mais Lecture at Cass Business School last night.

I was invited to one of the events he attended at the Official Monetary and Financial Institutions Forum (OMFIF), and it’s ten years since I last bumped into Paul Volcker.

Back in 2000, he joined me on a panel at BAI Retail Delivery.

Back then, he was a highly respected, former Chairman of the Federal Reserve.

Today, he is a highly respected, former Chairman of the Federal Reserve, who has a rule.

The Volcker Rule.

The Volcker Rule is the modern version of Glass-Steagall, and says that banks cannot deal off their own book of business in the investment markets.

In other words, he’s effectively ended the US investment banking operation forever.

It’s been watered down a bit since, but Volcker is adamant that banks gambling in the world’s markets are not good for business.

He’s adamant about a lot of other things too, and here are a few highlights from the session I attended.

Paul began with a comment around China’s $3 trillion of reserves, and the imbalances this creates.  When China has enough dollar reserves to buy a quarter of America’s annual GDP, and America is at the tipping point of a debt crisis, something has gone a bit skewwhiff.

He’s also no fan of derivatives, and said that he has a standard offer to every freshly minted PHD student to prove whether any financial engineering instruments have delivered real improvements in the productivity and efficiency of the economy.

He has yet to receive a submission.

In fact, the instruments have purely lined the pockets of Wall Street as the wealth and income of the typical American family has not improved over the last twenty years.

Meanwhile there was an amazing increase in the concentration of wealth in the top 0.5% of the population.

That’s wrong and creates a world less about the haves and have nots, and more about the have nots and have yachts.

After around 35 minutes, I managed to get my question in about what he thought about Sir John Vickers’ Independent Banking Commission (ICB).

The ICB’s interim report recommends that banks are ring fenced so that, if there is another crisis and the investment bank fails, it can just be closed down.

Volcker would instead have the ruling that the investment bank that trades speculatively just should not exist within the bank.

He said that he “completely doesn’t understand the British approach, where they can leave all these questions unanswered.  They said they wanted a retail bank in the same holding company as everything else. I don’t know what ‘everything else’ means.  Is that not a bank too?  It’s just a wholesale bank.  Who makes the payment system work – the retail bank or the wholesale bank?

“… the philosophy is you are a group of banks that serve the consumers, the retail customer, and that hold their deposits with the central bank and so forth, does not solve the problem with all the other parts of the financial system.  I also don’t believe in a firewall or Chinese wall between them, as you need a very high ring fence to stop the deer jumping over.”

This view was expanded upon in the Cass lecture: “The question will inevitably arise as to the financial and regulatory logic of maintaining a ‘retail bank’ as part of what in most cases would appear a much larger, highly diversified and ‘systemically significant’ organisation … in any event, the nagging overriding question will still arise: how to deal with the imminent or actual failure of such a large, systemically significant, financial institution whether or not it is a ‘bank’.”

Back to the lunchtime meeting, he was asked his views on the European Central Bank (45 minutes), and was just as damning about them too: “It’s odd to have a very strong and very independent central bank without a government.”

On the euro, Paul hopes the euro will survive but the current crisis is “obviously The Test, and it’s a very big test.  Nevertheless, I wonder what would have happened today if you had not had the euro.”  Either way, “Europe will need bold and confident leadership to get through this.”

In terms of this crisis and how fast it will conclude, he said that “we’ve been going through a crisis of excessive debt creation around the world, and that deleveraging will take time … when you have a business crisis coupled with a financial crisis, it always take a long time to recover.  Just look at Japan.”

He said a lot more of course, and you can listen to the whole one hour discussion if you want, although the sound quality is poor …

Paul Volcker from Chris Skinner on Vimeo.

… the discussion opens with a few words from George Milling-Stanley (left), Managing Director of Government Affairs at the World Gold Council and Professor Lord Meghnad Desai (right), Chairman of the OMFIF Advisory Board, and is chaired by David Marsh (second from right), co-Chairman of OMFIF.

It began with nostalgia about the Mexican Financial Crisis, Helmut Schmidt, Walter Wriston and other stuff from the 1970s and 1980s.  Start listening at around 32 minutes if you want to miss the nostalgia.

 

The Top 20 Banks of the World, 2011: China hits the Big Time

I’ve enjoyed the Banker’s Top 1000 listings for a long time now and, when last year’s listings came out, looked back over the last twenty years to see how things had changed.

This year’s list has now just been published (get a copy by subscribing) and makes for interesting reading, especially as Chinese banks have finally made the big time (doubleclick image to see large version).

All in all, this list when combined with my reflections in 2010 over the last twenty years, makes for a fascinating story of risk bubbles and bursts.

You had the banks from the rising sun rising up the charts in the early 1990s.

Then, as the Asian crisis nuked most of the region, the Japanese banks disappeared and the Anglo-Saxon banks took over.

The principle-led regulatory regime was rife and the Americans and Brits ruled until 2008 when their “debt whore” approach failed.

Now, everyone is bailing out everyone else, with PIGS, TARPS and QE’s by the shedload.

So last year’s list was interesting, in that we finally saw Chinese banks rising up the list and more diversity as the American and British banks stumbled a little.

I have been saying that China’s banks will dominate global banking since 2005, and certainly there is a growing swagger of China’s banks as they watched the failure of the West.

For example, it used to be that Chinese bankers were desperate to learn how the West did banking and would send troops of managers to European and American conferences to learn their ways, as well as hiring the best talent to import into Chinese territories.

Back then, we all scoffed at Asia for their poor risk management of credit leading up to the 1997 crisis, with debt defaults and NPLs everywhere. 

Now the Asians and Chinese may scoff at the West for the same reasons, although there is still risk in the Chinese system as most enterprise is propped up by financing given through the governmental influence over the banking system.

That aside, the fact that China's market capitalisation will rise to $41 trillion by 2030 from $5 trillion today, according to Goldman Sachs, makes it a market that cannot be ignored.  After all, this would make China's stock market the biggest in the world, as American market capitalisation rises to $34 trillion from $14 trillion over that time.   

This is one of the reasons why this year's Banker list is important as, for the first time, THREE of the TOP TEN banks of the world are Chinese.  Last year, there was just one.

This year, four of the top twenty banks of the world are Chinese, when there were none just a few years ago in 2004’s list.

So, no matter the risks, China’s banks have finally risen to the top ... but at what risk?

The original Asian crisis was created by a higher than expected percentage of Non-Performing Loans (NPLs) and Moody’s has recently downgraded China’s banks on the basis that “8 to 12 percent of all the loans made by Chinese banks could go unpaid.  Moody's had earlier estimated only 5 to 8 percent of the loans would be classified as ‘non-performing’.”

If China has a financial crisis, then we really will all be up the swanee ...

 

 

 

ING: selling the rebels with a cause

I still remember fondly the BAI Show of 2008 where there were several key highlihgts.  One of the biggest was the one-to-one interview with Arkadi Kuhlmann, Chairman, President and Chief Executive Officer of ING Direct USA. 

At the time, Arkadi had just produced his book: “The Orange Code: How ING Direct Succeeded by Being a Rebel with a Cause”, a very good read, which told the story of ING Direct USA, from a startup predicted to fail to one of the largest US banks in the course of a decade.

Today, ING Direct USA is the largest direct bank in America with 2,275 employees and 7.7 million customers across its savings accounts, checking accounts, mortgages and brokerage services. ING Direct USA had US$8.3 billion (€57 billion) in funds and US$40 billion (€29 billion) in own originated mortgages, as of 31^st March.

So it’s sad but not surprising to see ING Group sell ING Direct USA yesterday to Capital One Bank.

Sad, because it’s a bank that is so very different.  After all, how many bank leaders would have made this sort of statement:

“I don’t like and don’t want rich Americans. I don’t want all their bitching and moaning. They come in and say, ‘I’m willing to give you a million dollars, what are you going to do for me?’ and I say, ‘Nothing’.  There’s no hierarchy here. It’s a democracy and we’re all level.”

Not surprising because ING ran aground in the financial crisis, as have so many, so they need the cash from the sale of assets that are easy to sell, such as their standalone, rampantly successful American business.  Oh, and also because they were told to sell it by the European Commission.

As Jan Hommen, CEO of ING Group states: “In addition, the transaction today shows ING is taking decisive steps in the restructuring of ING Group and underlines our commitment to meet the requirements of the EC in a prudent yet decisive manner.”

Hmmm … sounds a bit like Stephen Hester of RBS or Antonio Horta-Osario of Lloyds.  They don’t say it, but they’re all thinking: “We will sell these assets, but we don’t like it and think the Eurocrats are just being mean and spiteful.”

Shame.

However, the Eurocrats might respond: “You got yourselves into this mess and forced us to get you out of it, so we’ll do whatever we can to make you stable for the future.”

And, in reading the fine print, it is clear that the sale will have a substantial positive impact on ING Bank’s Core Tier 1 Capital Ratio.  According to the sale detail, Tier 1 Capital will improve by 99 basis points, based on the ING Core Tier 1 Ratio of 10.01% per 31 March 2011.

The sale has also produced some interesting insights.

First, the headlines:

• Total proceeds of US$9 billion (€6.3 billion) in a combination of cash and shares
• ING to receive US$6.2 billion in cash and US$2.8 billion in the form of 55.9 million shares of Capital One
• Transaction expected to result in capital release at closing of US$4.1 billion
• ING to have 9.9% stake in Capital One after closing

But here’s the really interesting bit of the sale. 

The Investor Presentation of the acquisition that Capital One placed on their Investor Relations space yesterday.

I said that ING Direct USA was “rampantly successful” for example.

How successful?

I think this slide says it all (doubleclick image to see larger version):

Another slide that intrigued me was the one that outlined customer attrition rates …

Capital One’s presentation states that ING Direct USA’s customers are incredibly loyal but one in twenty leave every year!  But then, it’s better than the national average where almost one in five leave each year. 

Then there’s this slide, which gives a great overview of the state of American bank competition:

The USA, like the UK, has the Big Five banks and then the rest.

There’s then a great slide about demographics …

So, direct banks attract young, rich people whilst branch-based banks are more popular with old, poor people.  That’s good news for the future as my favourite slide has to be this one ….

… which clearly shows the branch-based model is withering on the vine.

Trouble is that people still want branches, as that creates trust in an institution if you can eyeball them, which is why bank branch numbers are still growing.  For example, the Market Rates Insight website reports in January that:

“Banks branches are expanding across the United States, even in areas that showed little or no population growth. It seems that banks are continuing to add local branches across the board in a disproportionate rate to changes in population … in Rhode Island, the population growth was less than 1%, yet the number of branches grew by 15% and in New York State, despite a population growth of only 3%, the number of branches increased by 19% in the last decade.

“In the 10 highest population growth states – Nevada, Arizona, Utah, Georgia, Idaho, Texas, Colorado, North Carolina, Florida and South Carolina – the number of bank branches increased at the same rate or higher than the population growth since the 2000 census. For example, Nevada’s population increased 32% over the last 10 years, but the number of bank branches increased by 45%.”

Interesting logic.

 

 

HT to Ron Shevlin 

 

The similarity between OTC derivatives and cheese

I recently chaired a conference focused upon FXMM, or foreign exchange money markets for those unfamiliar.

It’s a strange territory full of hedging and algo’s, but the bit of the day that really caught my attention was when Heather Pilley from the OTC Derivatives and Post-Trade Policy Division of the FSA, presented the plans for new regulations in this area.

She began by saying that the G20 has made it clear that by the end of 2012 there needs to be global regulations in place to ensure that OTC derivatives are traded on regulated exchanges.

This agreement is a drop dead date that the FSA, the EU and the USA are all working to such that, by 31st December 2012 or before, global markets will have fully regulated OTC derivatives markets.

On the 15th September, the European Commission released their proposed European Market Infrastructure Regulations (EMIR), and Heather made it is clear that these are similar, but not the same as, those proposed in the USA.

For example, EMIR includes FX exotics and forwards if they are being used for investment rather than commercial purposes. The US excludes FX forwards, so it’s different.

America restricts bank ownership of CCPs but Europe does not; EMIR instead strengthens the governance and surveillance requirements of CCPs but does not stop banks having ownership.

Similarly, smaller financial counterparties who are ‘not systemically important’ are excluded in American rules, but Europe bases ‘systemically important’ on a clearing threshold rather than the size of the counterparty.

This creates the shadiest area: the actual definition of what is ‘systemically important’.

Equally, a large OTC derivative contract for hedging based upon ‘commercial activity’ is excluded, whilst the same derivative if it is for investment purposes is included. Question: how do you separate and define these activities?

When a contract is made by an airline to hedge against oil price rises, is that commercial activity or investment activity?

This has not been defined in EMIR and are ‘still being worked upon’, hopefully in time for an agreement before the end of 2012.

Other areas that may confuse are that clearing obligations for these contracts are in two forms.

First, from a bottom-up view, the Central Counterparty (CCP) in Europe must be named and authorised by the national regulator, which will be identified through registration with the European Securities and Markets Authority (ESMA). This also determines the competent authority responsible for the contract, based upon the country of the CCP’s location.

Second, from a top-down view, ESMA determines which contracts must be cleared centrally and once a contract is in, it’s in 100%.

This begged the question as to whether that means every contract is reviewed on a contract-by-contract basis, or whether it is by definition of the type of OTC contract being made. According to Helen, it is based upon the class of contract, not every contract one by one.

Bearing in mind the confusion of the above, Helen then said that the legislation is likely to be ready by April 2011, the technical standards by Spring 2012.

With all of these things still to be defined, such as thresholds, this seriously worried the corporates in the room, especially the definition of ‘commercial activity’. For example, Malcolm Cooper, Global Tax & Treasury Director for the National Grid, asked a range of questions including: can we ensure that commercial activity includes cross-currency swaps where there is no trade involved, but it is a valid hedge of commercial activity? Has anyone looked at the cost implications, as few treasury departments will have the resources to cover intraday margin calls if that’s the direction such regulations take?

Heather reassured by saying that most legitimate trading would be allowed and that it is only the systemically important areas that are the focus of the regulation.

This led to Mike Hazell, Group Treasurer with Debenhams, asking whether a $500 million currency swap is systemically important, as that’s a pretty regular and common deal for his firm.

Heather responded that they would be looking at net exposures, and that this still needs further definition.

Another audience member asked why OTC regulations will apply to FX forward contracts for investment purposes which operate on a three-day cycle, but do not apply to FX spot trading which operates on a two-day cycle. Is it fair to exempt one and not the other, just for one day’s difference?

All in all, the whole conversation left me with the sense that those who are developing the regulations really do not know what they’re doing.

There are massive inconsistencies between the European Commission’s papers and views, and those of member states. Equally, there are big incongruence’s between the US view and the EU view.

Finally, the fact that the G20 has laid this down as drop dead by end of 2012, there’s a big danger of creating something so full of holes, that Emmental Cheese will look positively robust by comparison.

Which nation will be next global superpower?

As mentioned the other day, we are asking some big ticket long-term questions at SIBOS this year, such as:

• When will we know that financial systems work?
• How will we know when financial risk is not an issue anymore?
• What will America and Europe be doing when the economic power balance has shifted to Asia?
• Can we confidently create a way of investing for the long-term instead of our net present value short term view of today?
• Can we foretell a future where a human right includes "to not be poor", and what happens to work, life and war if there is no poverty?
• If money is just a way of exchanging value, and it's all now digitised, can we create digital money without the need for real money? How do virtual exchanges and virtual currencies change the commercial infrastructure?
• Could we create a world where financial transactions are sponsored, for example by Google ads, so that they are free? If so, what is the role of a bank and how will it make money, if all financial transactions are free?

This is all part of the focus upon the work of the Long Now Foundation and Long Finance group, of which I’m a part.

Long Now looks out at what will change over the next ten millennia, whilst the Long Finance looks out at a financial lifetime and how to build a financial system that could last 100 years.

In this series of discussions, I thought I would tackle one of the big questions we are considering: What will America and Europe be doing when the economic power balance has shifted to Asia?

Regarding the shift to the East, this is not a Long question, as the shift has already happened, if you listen to some folks.

But does it matter?

If America is no longer the great superpower but just a power, does it matter?

If Europe has zero competitiveness due to its fragemented structures, does it matter?

And what about Latin America and Brazil, don’t they matter?

And Russia?

And the Middle East?

The answer to all of the above is that of course it matters.

Any shift of economic or military power matters.

For example, we could pose a different view to the above if we really want to be Long, and ask: what happens when the balance of economic power is determined by Africa?

When we think of our land masses and populations, the real matters are determined by commodities, capabilities, processes and capital.

So let’s look at these areas, and then consider who has the balance of power and who will get it.

When we think of commodities, we think of oil, metals, cocoa, gold and similar.

Those who have an abundance of scarce commodities that have value are naturally going to be richer than those who have none but need them.

The Middle East has lived on their oil riches for long and will do so for the near future but, in the Long Now, some will fail.

This is because the oil riches are a finite resource, and will eventually be drilled to extinction.

The illustration of this issue is no better exemplified by Yemen, where poverty is rife having squandered away millions in oil revenues years ago, and being unable to create any substitute.

This is unlike the Emirates, who ballooned into a prosperous construction, tourism and trading centre, built upon sand.

So when we talk about commodities we are talking about a finite property, which is why there is scarcity and value. From a Long Now viewpoint, it must beg the question: what are you investing your finite billions in today for the infinite post-commodity years later?

The answer is that these nations should be investing in education, knowledge, brains and science, as these capabilities build a sustainable future.

The capability battle is one that Britain used well to build an empire a century ago, and that America used well to create prosperity through the twentieth century. It’s also what other nations, such as Singapore and India have realised in building their empires of today.

It’s all about looking at things that humans can create that are of value and, by building leadership in this area, it means that your nation can stay ahead of the world when it comes to technological, scientific or commercial scarcity.

Britain had that scarcity during Queen Victoria’s reign, with a technological leadership based upon naval and military strength. This allowed one small nation to colonise many other nations. By doing so, the strength of the nation increased by being able to access commodities of those nations, and gain commercial value, capital and further technological strengths which became a virtuous circle.

This leadership faded as the industrial revolution led to America, with its vast swathes of land and resources, to take over as the manufacturing engine of the world.

In America, that leadership came from building cars and computers, creating value through innovation, and through using knowledge to gain power over capital, commodities and resources.

Today, this is the piece that is shifting to the East.

China’s leadership is based upon people, processes, resources and investment in capabilities for building cheaper, faster and better.

China’s a nation that saw the weakness in the model of the world – the cost of manufacturing – and exploited it to gain growth. Now, having gained that edge, they are investing in all the other things to generate wealth from science and knowledge, and to maintain and sustain future growth.

This is why China has a space mission, as does India.

These are indicators of building capability leadership through scientific and technological research.

India saw a different weakness in the world’s model – the cost of service – and their strategy was therefore to invest in knowledge, and specifically to use their brainpower to gain economic growth. The use of English language and investment in technology skills, restructured the world’s knowledge chains in the same way as China re-engineered the world’s supply chains.

It is these investments in human capabilities that led to other nations, who had the commodity resources to support the wealth of manufacturing and services growth in China and India, to also enter a growth phase, particularly Brazil and Russia.

Now, Brazil has invested in human capabilities to sustain their growth, whilst Russia is still a fragile economy due to a lesser focus on building such a sustainable future.

So that outlines two cycles of economic power shifts: commodities and capabilities.

The thing that now makes the difference is that, if you start with an abundance of resources and use the investment capability of such resources to create capabilities, which nations get the Long Win, as in they become a superpower.

This is all down to processes.

The two go hand-in-hand, and are easily reflected by Germany and Japan.

Since the 1970s, we all say that Germany and Japan are the world’s leading nations in terms of their excellence in making cars and electronics.

This is because Germany and Japan had a huge squeeze on capital after the War, and therefore had to create efficiency and effectiveness in processes.

Luckily they could do that, thanks to a clean spread of land and knowledge that had a focus upon creating processes that maximised the efficiency and effectiveness of manufacturing.

Just look at the work of W. Edwards Deming in post-War Japan to see how Just-in-Time manufacturing re-engineered the world.

So where does this lead us to, in thinking of the Long Now future world?

Who will be the future superpower?

Not Europe, if the region continues in its current form.

This is because Europe has a problem with managing the four dimensions of commodities, capabilities, processes and capital, mainly because Europe is a grouping of 27 individual nations rather than a singular whole.

This is why Europe is bad at dealing with these, although some nations within Europe excel, as in Germany. This is why Europe is grappling with the question right now as to whether the Union can survive long-term if one or two nations are good at building a sustainable model of wealth, whilst having to give it all away to support the nations that aren’t.

China and America are different as they are a nation and not a region.

Admittedly, they are not a singular whole either – China and America are a formation of many individual states, like Europe – but they do have centralised governance for strategic planning and control, as well as a common language and currency. Again, I know some will be tutting at this point, saying that Mandarin and Cantonese are different languages and almost half of America speaks Spanish, but it is fundamentally different. This is because these nations do have a cohesive structure for planning, investment and management of commodities, capabilities, processes and capital, whereas Europe does not. Europe may in the future but, right now, it does not.

Equally, many claim that Europe fails due to disparate and historical legacy infrastructures, whilst America succeeds by starting as a new Nation, with a new currency and agenda. China’s a new nation, in terms of infrastructure, and again can exploit and leverage that capability.

So when we look at the capabilities criteria, China and America are the two large nations that both fit. Russia, Brazil, India and Africa would be the other contenders.

We can leave Africa off the list for the moment, as they suffer the same paranoia and fragmentation as Europe. Similarly with Russia, for they need some serious investment in people and capability if they are ever to maximise their resources and opportunities.

So, America, China, Brazil and India are the four Long Finance nations on the radar.

They are all single nations with central planning structures and a relatively new Nation mentality, which means that they are not bogged down by legacy infrastructures from an economic viewpoint.

They all have strong capabilities and access to resources, so we don’t need to think of these as an issue.

Therefore, for the next century, the superpower from these four will be based upon processes.

And here’s where it gets radical.

America has been very good on process, and India is very good on process.

Everything is in signed off in triplicate, checked, double-checked and authorised.

The thing is that this procedural approach to processes is not adept for the new millennia process, where the fast beat the slow.

Today’s globalised world works in seconds, not years, and the heavy-duty processes and rigid disciplines of the twentieth century will fail in the twenty first.

So, for these reasons, America and India may be hindered culturally in the Long Finance twenty-first century, which leaves Brazil and China.

You probably think it’s China, don’t you?

China will be the Big Superpower of the twenty-first century.

Well, maybe not.

Maybe Brazil holds the balance of power for the Long Finance world.

The reason for this conclusion is that China will be contracting in power in 2050-2060, due to their single child policy.

The lack of new blood and an aging population could drag China’s economic tiger into a toothless and clawless sloth in the Long View.

Meanwhile, Brazil has the commodities, capabilities, processes and capital to be the world’s largest economic force in the next century.

If that’s the case, North America will feed off South America, and will be the subservient economy to Brazil. It will be a reverse relationship to the structure of the twentieth century, where you had the poor South and rich North.

Similarly, Africa will have been raised from poverty, and India and China will still be forces of power, but not necessarily THE force of power.

Europe will still be fragmented, with member states fighting for capital and control just as they are today, and Russia will still be tipped as the next big economy and, if the government does invest more strategically in commercial capabilities and processes, it just might make it.

Meanwhile, I’m moving to Australia as, in the picture I’ve just painted, the world has turned upside down. All the wealth and control that was in the Northern Hemisphere has moved to the South, and so the natural juxtaposition of London will to live in Sydney.

Interesting.

Instead of coming from a land down-under, I’ll come from a land up-over ...

G’day mates.

So what was the cause of the 'flash crash'

I got into a bit of trouble yesterday, as various colleagues told me that the discussion on the flash crash was inaccurate and full of errors. A key issue was the discussion of flash orders being part of the problem as, apart from a rare exception such as Direct Edge, flash orders no longer exist in the US markets.

What is Direct Edge?

“Direct Edge, America's newest stock exchange, offers the next generation of displayed markets. With U.S. cash equities volume routinely exceeding 1 billion shares per day, Direct Edge uses multiple platforms and unique order types to match complementary forms of liquidity based on sensitivity to transaction cost, fill rate, and fill speed, while maintaining high execution quality and low latencies. Our innovative business model creates opportunities for the trading community unlike any other market centre. This is what the future of trading looks like.”

Direct Edge argues “that flash trading reduces market impact, increases average size of executed orders, reduces trading latency, and provides additional liquidity ... (as a result) NASDAQ and BATS created their own flash market in early 2009 in response to the Direct Edge market. Both voluntarily discontinued the practice in August 2009. The Securities and Exchange Commission in September 2009 proposed banning the practice as part of regulatory reforms in the wake of the Financial Crisis of 2007–2010. As of May 2010, the proposals have not been implemented. Even though most programs have been stopped voluntarily, it is still possible, at least with Direct Edge.”

Yea right. To be honest, Direct Edge may have promoted flash orders in the past, but they will be forced to adapt and eradicate such practices by the SEC, as they are now Regulated Exchanges in the same category as NYSE, NASDAQ and BATS.

Even if Direct Edge did contribute to the market issues, I was told that this would not mean that they would have had any impact on the flash crash, as they would only be able to flash trade their own order book.

Hmmmm ... another point was made that, for the US markets in general, all orders are seen by everyone before they are filled. This is definitely not true in Europe as pre-trade transparency is what everyone is fighting against. That’s the point of Dark Pools: to enable block trading to be achieved unseen. After all, if you’re going to trade millions in an equity such that the price moves, the last thing you want is for the markets to know this BEFORE trade execution.

I am interested to hear more on this as the comment implies that the US markets are moving towards, or have already achieved, pre-trade transparency whilst Europe is struggling to achieve any form of transparency (more on this later in the week).

Meanwhile, it also contradicts the FT who reported yesterday that:

“Spoofing, layering and front-running ... strategies for market manipulation may be long-established – but the May 6 “flash crash” has given a fresh sense of urgency to US regulators’ efforts to crack down on the abuse. An inquiry into the crash has yet to pinpoint any definitive cause. But the regulators’ review has focused attention on the substantial growth in high-frequency trading and its use of computerised trading programmes – algorithms – to profit from fractional price differentials.”

This was followed up today by saying that “BM&FBovespa, Brazil’s multi-asset exchange, is introducing a new limit on asset price fluctuations of more than 15 per cent in any given day.”

So here’s one key point.

Regulators are creating rules that limit price fluctuations to avoid another flash crash, and these are likely to be copied worldwide. For example, the SEC introduced a rule in June that a stock movement of more than ten percent in any five minute period will stop trading in that stock, and now Brazil has followed suit.

However, these rules (a) would not necessarily have avoided a flash crash; (b) does not discover the real cause of it; and (c) does not recognise that, if it is due to market abuse, then it’s not the systems that caused the problem but the traders.

This last point is the key, as my algo tech friends tell me that machines don’t cause the issues but the way you program them.

Obvious.

So why shut down, attack or undermine High Frequency Trading (HFT)?

Instead, the SEC should shut down and attack the cause of the irrational movements. If these were system generated, it should then plug the programming error that allowed it – a simple fix such as halting trading if stocks move irrationally too quickly – but then they need to find the people who did the programming and discover their intentions. If the intention of the traders who created it was for market abuse, then that’s where the issues really lie and that’s what the SEC is trying to disover.

Meanwhile, if it’s not flash orders or HFT that caused the crash, then what is the real cause?

My American friends tell me it’s LRP, the Liquidity Replenishment Point.

The New York Stock Exchange (NYSE) has various LRP points to ensure that algorithms cannot go nuts and send markets into freefall, and yet this is what happened on May 6th.

So how could it happen?

Well, LRPs only work on NYSE and NASDAQ, but now there are BATS and Direct Edge. This is therefore how the issue could arise and was discussed in depth by Bloomberg the day after the crash:

“More than 29.4 billion shares changed hands in U.S. markets yesterday, the most since October 2008. In addition to traditional exchanges such as the NYSE, rivals Bats in Kansas City and Jersey City, New Jersey-based Direct Edge Holdings LLC handled millions of trades. About 2.6 billion shares traded on the NYSE, the lowest level relative to overall volume in three years, data compiled by Bloomberg show.

“Rapid-fire orders trigger what the NYSE calls liquidity replenishment points, or LRPs, shifting trading into auctions overseen by market makers. While the system is designed to restore efficient trading on the Big Board, selling is so fast during times of panic that orders routed past the exchange may swamp other venues and exhaust buyers, said James Angel, a finance professor at Georgetown University in Washington.

“That’s when prices may plummet as orders execute against so-called stub quotes. Brokers can set those as low as a penny a share because they’re never expected to be used. ‘In a situation where only one market stops trading, not only does it not help, it likely exacerbates the situation,’ said William O’Brien, CEO of Direct Edge, which was founded in 2005. ‘Yesterday is a day that no exchange should be proud of.’

“Increasing automation and competition have reduced the NYSE and NASDAQ’s volume in securities they list from as much as 80 percent in the last decade. Now, less than 30 percent of trading in their companies takes place on their networks as orders are dispersed to as many as 50 competing venues, almost all of them fully electronic. Twenty years ago, fewer than 10 exchanges competed for all U.S. equity trades.

“The replenishment points are triggered regularly on the NYSE and promote efficient trading, according to Ray Pellecchia, a New York-based spokesman.‘Today you’re hearing about it because of the magnitude of the fall,’ Pellecchia said. ‘Usually it’s not a market-wide move, it’s just a small group of stocks.’”

All well and good.

So here’s my challenge: if Bloomberg could give such a good account of the flash crash the day after it happened and attributed it to LRPs, then why is the SEC looking into spoofing and layering four months after the event?

Equally, you cannot say Direct Edge and their flash orders have no impact on markets other than their own, as the above shows the interlinkage between BATS and Direct Edge with NYSE and NASDAQ. As liquidity platforms they affect price movements and executions with the other Exchanges such that, if the order isn’t filled on NYSE due to Direct Edge having a better price, then the order is filled on Direct Edge through smart order routers. This affects NYSE’s liquidity and brings in the issues of LRP. So that does imply that Direct Edge allowing flash orders could impact LRP through their order flows on algorithmic smart order routers between NYSE, NASDAQ and BATS, and hence possibly cause a flash crash moment.

Now I know this is complex – it’s doing my head in - so gawd knows what it’s doing to the SEC, but it is clear that there is nothing simple about the causes of the flash crash and, until discovered, I would be very wary of making it a simple blame attribution to one cause – HFT – or another – LRP.

This is Part Two in a Series of Posts on the Regulatory Agenda for Capital Markets:

• Part One: SEC to crackdown on HFT?
• Part Two: What was the cause of the 'flash crash'
• Part Three: Exactly what is and how big are 'dark pools'?
• Part Four: MiFID II - the post-trade agenda
• Part Five: Best Execution and Global Trading
  

These items also build upon a series of posts about the Deutsche Börse:

• If you can't afford the tech, get out of the market
• Circuit breakers on the Deutsche Börse
• Forget Frankfurt, I'm moving to Basildon

SEC to crackdown on HFT?

I gave my first presentation for a while last week on capital markets and what’s top of mind. Here are the headlines of key areas of focus:

• High Frequency Trading (HFT)
• Dark Pools
• Best Execution
• Post-Trade Transparency
• Global Trading Platforms
• MiFID II

I’ll review these areas in more depth during the week, and start today by looking at High Frequency Trading.

As discussed frequently here, High Frequency Trading (HFT) is being investigated as the most likely cause of the flash crash:

• More Banking Statistics: Algo and High Frequency Trading
• Who's afraid of HFT, HFT, HFT?
• Revising MiFID and RegNMS for HFT
• The Return of the MiFIDs, 2010-2012+

But it all began back on May 6th when the markets went into major meltdown, with sudden peaks and troughs. Accenture were a good illustration of the issue, with their share price nose-diving from $41 to $0.01 in a few minutes. Some would say that’s about right, but obviously it’s not as Apple’s share price shot up to $100,000 in the same period. Some would say that’s about right too, but this market volatility and instability is obviously not right.

So far, the SEC has not come out and said what caused it. They’ve said what hasn’t caused it – it wasn’t fat fingers, terrorists, hackers or similar attacks – and they are narrowing down on the real cause: HFT.

The focus upon HFT is whether this creates both market instability and an unfair advantage. The answer imho is that of course it does. HFT means that only those with the tech budgets can get access to markets and arbitrage on a global basis. HFT also means that any order entering the markets can be seen before it is filled and the price bucked by orders that ask for a fill and get cancelled just as fast. This is illustrated well by the $2.3 million fine issued by the SEC this week to Trillium Trading (now Trillium Brokerage Services), a small American proprietary trading firm.

What did they do wrong? They used layering to make $575,000 over a three-month trading period.

“Layering involves traders entering multiple fictitious orders, which are then cancelled within seconds. The strategy is used to drive a stock price up or down, before using a real order to profit from the artificially inflated or depressed price.”

It is one of several high-frequency trading techniques such as ‘spoofing’, where traders express interest in a stock, to drive the price up or down, with no real interest in buying it. Such practices are widely believed to have been part of the cause of May 6th flash crash.

Between November 2006 and February 2007, Trillium Trading used layering in “at least 46,152 instances”, according to the settlement agreement published by the SEC.

And it’s not the only one to be caught causing gaming. From Reuters in August:

Infinium’s “algorithm was turned on at 2:26:28 p.m. (Eastern) on February 3, less than four minutes before NYMEX closed floor trading and settled oil prices. It immediately started uncontrollably buying oil futures, according to the documents, which include letters from Infinium's lawyer to the regulation unit of CME Group, and cite notes from a company developer.

“Infinium placed 2,000 to 3,000 orders per second before its flooded order router ‘choked’ and was ‘dead in the water’ a few seconds later, the developer's notes said. The algorithm was shut down five seconds after it was turned on.

“By then, the documents show, the firm had sent 4,612 ‘buy limit’ orders into the market. It quickly offset the position, mostly with large ‘block’ trades in the next few minutes, leaving it with a $1.03-million loss.

“Infinium's burst of buying and selling represented about 4 percent of average daily trading volume in the contract, and caused a brief 1.3 percent jump in oil prices, from $76.60 to $77.60, before settling at $76.98, Reuters data show. Trading volume spiked nearly eight-fold in less than a minute -- and the reverberations turned some heads.

“The next day, February 4, commodities traders struggled to explain a 5 percent plunge in oil prices, the biggest one-day drop in half a year. On February 5, crude fell further, to $71 a barrel, and volume touched a then-record high.”

This is one key area of focus for the regulators.

I’ll talk about some of the others tomorrow.

From today's FT: an Ode to HFT based upon the song Those Magnificent Men in their Flying Machines

Those magnificent men and their trading machines,
They trade up, diddly, up, up!
They trade down, diddly, down down!
They stuff lots of quotes, then they empty the screens,
With their up, diddly up, up!
And their down, diddly, down down!

Up! Down! Flashing around.
Pulling their quotes, at such speed they astound.
They’re, all, raking in green,
Those magnificent men and their trading machines!

They can trade upside down
with their feet in the air,
They don’t think of value,
they really don’t care.
Ben Graham he would think he had made a mistake,
To see those young men, and the profits they make!

Those magnificent men and their trading machines,
They trade up, diddly, up, up!
They trade down, diddly, down down!
They stuff lots of quotes,
then they empty the screens,
With their up, diddly up, up!
And their down, diddly, down down!

Up! Down! Flashing around.
Pulling their quotes, at such speed they astound.
They’re, all, raking in green,
Those magnificent men,
Those magnificent men,
Those magnificent men,
And their tra-ding ma-chines!

This is Part One in a Series of Posts on the Regulatory Agenda for Capital Markets:

• Part One: SEC to crackdown on HFT?
• Part Two: What was the cause of the 'flash crash'
• Part Three: Exactly what is and how big are 'dark pools'?
• Part Four: MiFID II - the post-trade agenda
• Part Five: Best Execution and Global Trading
  

These items also build upon a series of posts about the Deutsche Börse:

• If you can't afford the tech, get out of the market
• Circuit breakers on the Deutsche Börse
• Forget Frankfurt, I'm moving to Basildon

Bunfight at the Wall Street Corral

America has a new Consumer Financial Protection Bureau (CFPB), thanks to the Dodd-Frank reforms.

The CFPB is a bit like the FBI, but focused upon money.

Who could possibly run the CFPB?

They would need to be an Eliot Ness Untouchable sort of person.

A big swinging heavyweight, who can shoot the baddies of the financial world where it hurts.

Like a Bunfight at the Wall Street Corral, this meanass mother will throw their weight around the bankers’ town, looking for evil wherever it lurks and making merry mirth in a shoot ‘em up and sort them out suckerfest.

Who could handle such a challenging task?

Who can be our Pat Garrett for the 21st century wild west of wall street?

Well ... it turns out it’s a woman.

A woman called Elizabeth Warren, if the Huffington Post gets their way.

Who is Elizabeth Warren?

She’s a professor of law at Harvard and an attorney, who was appointed to manage the Troubled Assets Relief Program (TARP). She’s also been the most outspoken advocate for the creation of the CFPB, so she should run it, shouldn’t she?

Along with Mary Schapiro (SEC) and Sheila Bair (FDIC), Warren is now one of the three Sheriffs of Wall Street creating the new financial landscape for the US of A.

She’s also pretty cool too, according to rap group the Main Street Brigade:

A few of the lyrics from their rap:

Sheriff Warren is what we need, yo, and we plead, yo.
She's not about the money, money, money and the green-o.
She's about working class families
And bringing 'em out of financial crisis and tragedies. ...
She wants to expose the banks and all the greed
and get rid of unnecessary fees
Which means more money in my pocket ...
Got, got a new sheriff - Warren.
Got, got a new sheriff - Elizabeth.
Got, got a new sheriff - Warren. Elizabeth Warren.

Love it and, oh yes, God Bless America (and Tom Groenfeldt for the headsup).

Why a double dip appears more likely

Everyone wants to avoid double-dips and market issues, we want to talk up the economy and feel good, we want our glasses half-full and capital secure. And after this week’s bank results, you could be forgiven for thinking everything was back to normal:

• Lloyds Banking Posts First Profit Since HBOS Purchase...
  

• Standard Chartered reports a 10% rise in first-half profit, helped by a reduction in impairment provisions ..
  

• The UK's biggest bank HSBC reports pre-tax profits of $11.1bn (£7bn) for the first six months of 2010.
  

• Quarterly profits at Société Générale more than triple after an "excellent performance" in its retail bank.
  

• French bank BNP Paribas sees its second-quarter profit grow, thanks to gains in its retail banking division.
  

Even state-owned bank Northern Rock reports a return to profit during the first half of the year.

Then we have all of these new bank start ups including Metro, Virgin and Tesco, along with Santander becoming one of the largest banks in Britain as they take over the branches RBS have had to sell.

So things are all good aren’t they?

Yea ... but maybe no.

You see, I’ve got a little bit of worry as we read the signs in the tea-leaves of economists and financiers. Those signs make it sound like times ahead aren’t quite so good.

First, most of the profits have been delivered as a result of the 2010 losses on debts being lower than anticipated.  In other words, 2009's losses due to reserving capital to cover 2010's bad debts have not been realised.  That won't happen again.

Second, we had the leader of the world’s markets – the Federal Reserve and Ben Bernanke – saying that times are too uncertain to withdraw fiscal stimulus.  In fact, Bernanke is seriously worried about life as house prices are still tanking whilst unemployment insurance claims are still rising.

He claimed that things should get better as consumer spending would turn things around.

I don’t think so.

A day after Ben Bernanke said rising wages would likely spur household spending, a range of very weak American economic reports paint an entirely different picture.

In fact, the question everyone is now asking is whether the USA can handle a lost decade of deflation, like Japan did during the 2000’s.

Mmmm ... I don’t like that.

That’s why Mervyn King was so dour the other week, saying that “the wider economic problems around the world underline the fact that we cannot be confident that the recovery in demand, output and employment here in the UK will be sustained.”

Why’s he so worried?

I guess because if the USA takes a dive, what does that mean for Europe?

Which brings me to my third point.

Europe is still suffering from stress. The stress tests may have distressed the situation for a while, but the underlying stress is still there.

The PIIGS are still an issue and their debt and sub-AAA grading are still a problem.

This is why so many are saying Europe still has a problem. Here’s just a couple of comments that show the flavour of things:

“It is getting very, very difficult for us to make a forecast about where we'll end up at the end of this year. There clearly has been a substantial decline in confidence. Europe is making people nervous.” Nicholas Moore, Chief Executive, Macquarie

“We've got a coalition government in the UK (that) may or may not hang together. We've got Angela Merkel in Germany doing the right things but under a lot of heat from a lot of people because they don't like what she's doing, so I mean, I think that there is a lot of uncertainty around.” Tim Pistell, Chief Financial Officer, Parker-Hannifin Corp

Then I sit down with regulators and policymakers here in London and they’re worried.

You see, their real worries start with the government’s policies of reducing spend and increasing taxation.

Sure, the rise in VAT from 17.5% to 20% will have an impact of increasing inflation in the short-term, but come 2011, the austerity measures will begin to bite and, in 2012, will really hurt.

Although George Osborne defends his budget, the idea that we can cut to growth just doesn’t stack up.

How can you take out £6 billion a year from the public services and expect the economy to grow?

And if you want any proof of the wheels coming off that trolley, just look at last night’s Evening Standard:

“Research today from the Chartered Institute of Purchasing and Supply showed the dominant services sector — which includes hotels, restaurants, estate agents and stockbrokers — grew at its weakest pace for a year in July.”

You may think exports may save us, but it’s no better in our major export markets – Europe – as Europe is also following the austerity route of cutting for growth. That’s bad news as, bearing in mind that the UK exports less to the BRIC economies combined than it does to just Ireland, this means we won’t see growth through balance of trade.

Maybe that’s why some say this means buy dollars.

Not sure about that myself, as Macquarie’s CEO Nicholas Moore went on to say that the USA makes him nervous. It should. From the latest publication of the American:

“Europe’s PIIGs are in a poke, but U.S. states and municipalities risk their own sovereign debt crisis, with a huge liquidity risk from short-term debt. According to the Federal Reserve, at the end of the first quarter of 2010, state and local governments had $2.8 trillion in outstanding debt.”

No wonder Business Week leads this week with the front page headline “The New Abnormal”: “Americans are broke and depressed—and also swilling $3 lattes and waiting in line for iPhones. Welcome to the schizophrenic economy.”

Finally, the banks tell me that 2011 and 2012 will be challenging because the government and central bank’s policy of fiscal stimulus and quantitative easing has come to an end.

Now I blogged in April about the UK bank’s trillion dollar maturing debt mountain.

Since then, the Bank of England has produced an updated financial stability report with several telling charts. Here’s Chart 9 that outlines Bank refinancing requirements internationally:

And Chart 4.16 that shows the maturing debt mountain updated:

Now you could remove the Residential Mortgage Backed Securities (RMBS), according to some (see discussions at end of last blog item), but everyone believes the cost of refinancing UK bank debt is going to be an issue.

“Morgan Stanley says UK banks have to refinance £450bn of funding across 2011 and 2012. To do so, the Bank of England believes, this means raising £25bn a month – a historic high. As the markets are not as open as they once were, the funds will be expensive. The Bank estimates refinancing will cost the industry as much as £10bn above current costs. The crisis is twice as severe for UK banks, particularly Lloyds and RBS.”

So you have a storm of issues still to come: American stagnation and then deflation; European contraction, spending cuts and depression; the end of financial stimulus and access to central bank generated liquidity; and the possibility that all of this leads to consumer and business contraction.

For example, in Lloyds Banking Group’s results yesterday, CEO Eric Daniels noted that customers had been repaying loans faster than it was able to grant them, as its overall loans and advances to customers fell to £612bn from £627bn the same time last year.

The trouble there is that if you add in a business investment contraction and consumer spending downturn, then everything moves towards a double dip in 2011.

Mmmm ... best tip: move to Hong Kong.

p.s. found these great charts from Reuters whilst researching this ...

EU Banks' First Half 2010 Profits

EU Banks' Market Capitalisation

 

EU Banks' Tier 1 Risk-Adjusted Capital Ratio

 

 

How the Dodd-Frank Legislation impacts Capital Markets

I just got this in my intray from Woodbine Associates, an American research firm that works with the exchange, broker/dealer, asset manager, hedge fund and technology vendor communities.

It’s really interesting and talks about the impact the new American reforms, known as the Dodd-Frank Legislation, and how this law will impact the Capital Markets. Therefore, they’ve kindly given me permission to repurpose the material here.

Dodd-Frank Legislation: How the Law Might Really Impact the Capital Markets

The Dodd-Frank Wall Street Reform and Consumer Protection Act has now become law. Interestingly, a wide range of opinion still exists as to how the law will impact financial markets and, not surprisingly, there is still a great deal of spin coming from various parties that seem more intent on unsettling the public than explaining the law. Dodd-Frank proponents applaud new consumer protection measures and rules focused on reducing systemic risk. Opponents of the law assert the legislation is likely to result in less consumer and small-business credit availability and that it will lead to the export of financial services jobs.

In our view, the Dodd-Frank law has a good chance of meaningfully impacting the financial markets by enhancing oversight, reducing systemic risk, and improving consumer protection. We discuss the first two points and highlight potential forthcoming market changes below.

Improved Oversight

Dodd-Frank makes formidable strides in reducing regulatory oversight gaps. Some of the law’s mandates are very straightforward and, we believe, can’t help but improve regulators’ ability to oversee market activity.

Some of the law’s more notable elements in this vein include the creation of the Financial Stability Oversight Council (FSOC), placing of over-the-counter (OTC) derivatives under regulatory oversight, and reassigning particular responsibilities across various agencies within the oversight framework. Combined, these changes should go a long way to correcting various existing weaknesses and shortcomings.

Establishment of the FSOC should lead to better agency cohesion and improved coordination in implementing Dodd-Frank and new policy initiatives. One attractive aspect of the organization is that it will use resources already in place within the existing regulatory structure. Instead of creating yet another agency, this organization will unite talent from a range of existing organizations including the Treasury and Federal Reserve to identify and respond to issues pertaining to systemic risk in the financial system. The Council will also provide guidance to regulators in their respective markets.

OTC derivatives will be subject to regulatory oversight for the first time in history. While not reflecting the majority of transaction volume, OTC derivatives and highly structured products account for substantial market risk that, to this point, has not been monitored or measured on a market-wide level. Simply bringing visibility to this area of market activity is very likely to result in a clearer assessment of aggregate risk and leverage in the financial system.

Dodd-Frank also addresses certain deficiencies that exist in the current regulatory regime and redefines responsibility across a number of agencies. Without exploring those intricacies here, it suffices to say that the law reduces overlap and clarifies agency responsibilities rather than adding to or revamping the existing fragmented system.

Reduction in Systemic Risk

The new legislation is likely to lead to a notable reduction in systemic risk.

As we pointed out in our last Woodbine Opinion, the Volcker Rule will restrict bank investment in hedge funds to 3% of capital. An 11th hour compromise in Congress to pass the law diluted this aspect of the rule by changing the definition of 3% from "tangible" to “Tier 1” capital. Though slightly less stringent than the original provision, the measure still limits banks from potentially becoming heavily invested in risky hedge funds and indirectly putting the deposit base at risk.

In the same vein, the bank proprietary trading ban (which survived the legislative process intact) will substantially limit deposit-taking institutions from engaging in highly risky trading strategies for their own books. This will spell an end to large scale proprietary trading as it has existed at banks for the past 30 years and drive them to deposit services, extending credit, and client-oriented capital market business as their primary sources of revenue. Profits will decline as less glamorous but all-important commercial finance, retail lending, and account services become the central focus.

Impact on Markets

Equities

We expect the reduction in proprietary trading to have an adverse impact on equity market liquidity. However, the degree to which liquidity will be affected is unclear.

Proprietary trading formerly accounted for a significant portion of daily share volume. Although the trading landscape has changed in the past several years, the expansion of high frequency trading has caused a tremendous increase in trading volumes.

Accordingly, the adverse impact of declining liquidity due to the elimination of bank-related proprietary trading may well be offset by the benefits to market operations associated with high frequency trading. Recent data-based research we conducted (“The Impact of High Frequency Trading Highly Liquid U.S. Equities” April, 2010) supported assertions that high frequency trading is beneficial to the market in a majority of the 39 most liquid U.S. securities in that, on average, it improves execution quality and reduces volatility. We believe these favorable effects will “buffer” the impact of spread pressure resulting from the absence of bank proprietary trading in these 39 securities that, collectively, constitute approximately 20% of the daily market volume. However, the impact on spreads may be more keenly felt in smaller, more thinly traded securities. Without high-frequency trading to offset the decline in proprietary trading, the cost of raising equity capital through the public market could increase for smaller, less-established businesses.

Derivatives

Increased transparency in the derivatives markets resulting from Dodd-Frank should also be beneficial in terms of systemic risk reduction by placing specific controls around OTC derivatives. As has been previously noted, OTC derivatives contracts and most structured products are currently traded in a largely unregulated environment.

We believe the law will increase transparency and reduce credit exposure without significantly affecting the transfer of risk in the market. The new mandates will require large derivative trading firms to execute transactions electronically in an exchange or swap execution facility, clear through a clearinghouse, and report to a trade repository. Trades that are exempt from these requirements will face a higher capital charge, reflecting their additional risk. The resulting reduction in counterparty credit risk among trading partners is a significant element of the law's goal to reduce the inter-connectivity among major securities dealers.

The law also requires insured banks to spin off or “push out” non-hedging related derivative trading to separate affiliates. As this area becomes clarified by regulators, the ultimate impact on the market can be better discerned. As it stands, we expect that the impact will be largely organizational, with associated capital implications. We do not expect this provision to significantly affect trading.

The combination of electronic markets, clearing, and reporting will add significantly to market depth and liquidity. This will level the playing field for less creditworthy counterparties and foster greater price competition among a larger group of market makers. Less liquid products, such as some of the more esoteric credit default swaps (CDSs) and collateralized debt obligations (CDOs), stand the most to gain in terms of price discovery and spread compression.

Fixed Income

Almost nothing in the law, outside of the ban on bank-related proprietary trading, will directly affect overall operation of the U.S. fixed income market. Specific areas will be impacted, such as asset backed securitization where underwriters are required to retain 5% of the credit risk in originated securities. A similar risk retention requirement will exist for certain types of non-exempt residential mortgage backed securities as well; however, the securities that will be affected have yet to be determined. We believe that this will be positive for the markets as underwriters will now have some “skin in the game,” increasing their due diligence.

New accountability facing credit rating firms (including legal liability to investors for their ratings) should bolster their accuracy and independence and restore some confidence in their assessment of creditworthiness. This should be a welcomed change since credit rating arbitrage, coupled with insufficient investor due diligence, played a significant role leading up to the structured credit market meltdown.

Perhaps the most interesting part of the law with respect to the fixed income market will be the effect that electronic trading of fixed income derivatives has on the underlying cash markets. We believe movement toward more robust electronic trading is inevitable for most fixed income securities as the efficiencies derived from current technology are too overwhelming to be ignored. More advanced electronic trading is currently conducted almost exclusively among the major market participants. Forthcoming changes to the derivatives market may well provide the catalyst for more widespread adoption of electronic trading.

Reduction in Bank Lending Largely Hype

We are not clear how opponents to the Dodd-Frank law purport that reform will lead to a decline in the availability of business and retail credit. The best we can determine is that they believe that greater regulation will raise business cost for smaller lending institutions, driving some out of business, and resulting in less available, more expensive credit for small businesses and less creditworthy individuals, from fewer banks.

The business cost argument is not new. In our experience, it has been one of the most widely used arguments against regulation when opponents lack reasonable or rational grounds upon which to object. We have yet to see any bank, broker, exchange, ECN, or ATS be truly hurt through compliance-oriented spending in connection with new regulation.

We think the cost argument is largely hype that could be traced to banks intent on protecting their bottom line. In other words, the cost argument is really an indirect objection to impending revenue reductions likely to result from the new legislation. In fact, once the legislation is implemented, bank operating models may very well resemble those at banks between the 1930s and 1990s while the Glass-Steagall Act was in place.

Glass-Steagall prohibited deposit-taking institutions from underwriting and trading in equity securities. During this period, widespread derivatives trading, for the most part, was non-existent. Banks focused their business efforts on account services and lending. Guess what? Business was just fine.

Job Export

We agree with Dodd-Frank opponents that the new legislation is likely to result in firms shifting certain financial services positions overseas. A more restrictive business environment may well result in so-called “regulatory arbitrage,” in which firms move business activities to less restrictive markets. Some trading will, no doubt, find its way to such geographies.

In regard to the potential export of jobs, we ask the fundamental question: Does it make sense to forgo beneficial legislation in the interest of repatriating a limited number of financial services positions?

We believe the answer is a resounding “no.”

We are not insensitive to those who have or may lose employment. However, it is what is natural and necessary during periods of structural economic change. Changes short of those mandated by the law would simply preserve a flawed business environment to protect the interests of a few. Preserving a flawed system to retain a relatively small number of jobs potentially places our nation’s economic engine and standard of living at risk.

In all, we believe that the Dodd-Frank Wall Street Reform and Consumer Protection Act is a remarkable piece of legislation that is bound to bring about beneficial changes to the financial markets. While no legislation is perfect and, no doubt, there are certain to be meaningful issues surrounding the law, we are impressed that legislators held their ground and retained important substance necessary to correct flaws in financial market operations. It is always easier to repeal rules than to implement them. Let’s hope this law helps achieve the best balance of our free market engine and social objectives.

Revising MiFID and RegNMS for HFT

Gawd, I hate acronymns and look at that!  Three in one blog entry title!!!

Anyways, for the nerdy-nerd equities guys, this will grab their attention.

It's all to do with trading in European and American stocks and shares using High Frequency Trading (HFT) systems, and the regulations therein with EU MiFID rules applying over here and USA RegNMS rules applying over there.

These rules are going to be overhauled soon thanks to the Flash Crash, that dreaded thing that caused US stock markets to go haywire on May 6th.  There has been lots and lots written about the Flash Crash of May 6th, but there’s not been a great deal saying it was a good thing ... until you meet JPMorgan.

In this week’s Eye on the Market, they identify five things they like about the Flash Crash, namely:

[1] Stock-specific circuit breakers.

The U.S. has been slow to install circuit breakers on major exchanges, relying instead on “clearly erroneous trade rules” that cancel trades after the fact. In Asia and Europe, circuit-breakers have been around for a while. In Asia, trading is restricted outside of pre-specified daily bands of 5%, 10% and 15% (different by market). In Europe (e.g., Deutsche Bourse), trading is halted for 5 minutes after a 3%-10% move, and then reopened. In the wake of the Flash Crash, 10% circuit breakers are now applied to a few stocks as part of a pilot program (they have already been triggered on Citigroup, Anadarko and the Washington Post Company). If we are going to exist in a world with automated robots doing the lion’s share of daily trading, circuit breakers may be needed to prevent unintended and unmanageable meltdowns.

Another topic under discussion by the SEC: prevent HFTs from having “unfiltered, naked access” to the exchanges by requiring them to live by the same pre-trade risk management controls that clearing members do. Why? As noted by the Chicago Fed, “high-frequency trading has the potential to generate errors and losses at a speed and magnitude far greater than that in a floor or screen-based trading environment”.

[2] More balance to the HFT discussion.

HFT supporters claim they are providers of liquidity to the market, and that HFT makes U.S. markets more efficient than ever. Suggestions to the contrary have been deemed “utterly laughable” by firms defending them. However, the Flash Crash highlights the uncertainties around these assertions.

While volumes have tripled in the last few years, there’s a big difference between volume and liquidity (the ability to transact without moving the price). In an industry barometer survey1 conducted by the Tabb Group in May of this year, barely half the participants had a high degree of confidence in the US equity market structure; 73% did not believe the market structure is “orderly”.

One of the survey recommendations: HFTs should be required to register as broker-dealers.

To be sure, there were weaknesses in the old specialist system as well2. But specialists were required to maintain a fair and orderly market, and post quotes that were part of the National Best Bid and Offer system; their reputations mattered. HFTs have no such requirements (no minimum shares or minimum quote times); one proposal would require quotes to be valid for at least one second. The SEC has broadened the trader reporting system in order to analyze HFT activity more closely.

[3] Proposals requiring HFTs to act more like the floor specialists they’re replacing.

With the advent of HFTs, cancelled orders have soared. Today’s ratio of 30 cancelled orders for each one executed means that 97% are cancelled.

To curb abusive practices, some market participants recommend applying a fee to HFTs for an excessive number of cancelled orders. The increase in cancelled orders is one reason we do not agree that increased order depth on S&P 500 stocks at the NBBO is a clear indication of greater liquidity, as some market research alleges. Quotes pulled within a nano-second of being posted, and which are part of an algorithmic order detection exercise, don’t seem like liquidity in the traditional sense. Ameritrade’s representative on the recent SEC Roundtable referred to this as “opportunistic liquidity”.

[4] More discussion around HFT “co-location”.

Some HFTs co-locate computer servers inside stock exchanges3 to minimize the milliseconds (or nanoseconds) required to scan existing orders, and have algorithms act on this information. As trading execution and IPO listing fees declined, exchanges have tried to make up the difference by selling access to market data. Some exchanges have products which give clients a faster look at quotes, in exchange for a fee. As a result, some HFTs end up with access to information sooner than institutional or retail investors who rely on more standard venues (such as SIP Quotes).

The search for co-location benefits has existed forever (in polite company, “order anticipation strategies”). Broker-dealers in past decades argued that being closer to floor traders on the CBOT was an advantage to their clients. But historical parallels can lose their meaning when the instruments of battle change: one HFT computer can reportedly decode more than 5 million messages per second. The Flash Crash has increased the debate around whether co-location confers advantages to HFTs, and whether there should be obligations and responsibilities that accompany them.

[5] Asset managers learn that “cheapest <> best”.

After the NYSE moved to decimalization in 2001, bid-offer spreads fell almost in half on S&P 500 stocks (less so for the Russell 2000 stocks, where HFTs are less active). Schwab retail commissions fell from $35 in 2003 to less than $10 in 2009. This trend is confirmed by broader research from the American Association of Individual Investors. So if the prism of success is bid-offer costs and commissions on individual trades, the battle has been won.

But is that the right prism to define what makes an optimal marketplace? Part of the HFT industry tracks the order flow of larger investors who leave electronic footprints4. Using algorithms which include spraying the tape with thousands of quotes, the intentions of large investors is ferreted out. This can result in higher trading costs for such investors, and by extension, their clients, who include 401k investors, and pensioners participating in state and corporate plans. Quantitative Services Group computes analyses of HFT impacts on execution costs. They estimate that HFT tracking algorithms can drive execution costs up 1.5 to 3 times, even when institutional investors parcel trades into smaller orders to avoid detection.

There’s lots more of interest in their report, which you can read in full and download if you want:

JPMorgan's Eye on the Market

Meanwhile, you may note that a lot of it is about High Frequency Trading (HFT), which I’ve written quite a bit about recently:

• Who's afraid of HFT, HFT, HFT?
• High frequency trading in jeopardy thanks to flash crash
• More Banking Statistics: Algo and High Frequency Trading

as have many others.

This means that this area is going to get regulated, and it will mean significant restructuring.  For example, back in January, the SEC started a consultation through the Concept Release - a request for public comment on securities issues - on HFT and more.

Key areas under review include:

Market Quality Metrics

What are the best metrics for assessing market quality for long-term investors and have these metrics improved or worsened in recent years?

Fairness of Market Structure

Is the current highly automated, high-speed market structure fundamentally fair for investors?

High Frequency Trading

What types of strategies are used by the proprietary trading firms loosely referred to as high frequency traders, and are these strategies beneficial or harmful for other investors?

Is the overall use of any harmful strategies by proprietary firms sufficiently widespread that the Commission should consider a regulatory initiative in this area?

Co-Location

Do co-location services (which enable exchange customers to potentially route trades faster by placing their computer servers in close proximity to an exchange's computer system) give proprietary trading firms an unfair advantage?

If so, should the proprietary firms that use these services be subject to any specific trading obligations?

Dark Liquidity

Has the trading volume of undisplayed trading centres (such as dark pools) reached a sufficiently significant level that it has detracted from the quality of public price discovery?

If more individual investor orders were routed to public markets, would it promote quote competition in the public markets, lead to narrower spreads, and ultimately improve order execution quality for individual investors beyond current levels?

Are a significant number of individual investor orders executed in dark pools and, if so, what is the execution quality for these orders?

Lots of comments have been received on the Concept Release, and its conclusion cannot be far away.

Now we have a European response to this area with Kay Swinburne, rapporteur to the Economic and Monetary Affairs committee of the Parliament, producing a draft report last week. This report provides indication of much of what might be in the revised MiFID and very little is left untouched.

Jeremy Grant over at the Financial Times, has picked out some of the more interesting nuggets from Kay’s report:

• She suggests it may be necessary for “informal market makers” – read: HFTs – to be subject to mandatory liquidity provisions;
• Calls for an “ongoing regulatory review” of the algorithms used by HFTs;
• Seeks an examination of HFT to determine whether market flow generated automatically is providing “real liquidity” to the market and what the effect of this is on overall price discovery;
• Suggests that, “in the interests of equitable treatment”, rules need to be introduced so that MTFs (multilateral trading facilities”, like Chi-X Europe) are subject to the same level of supervision as exchanges, under certain circumstances;
• Calls for new provisions under Mifid for “broker crossing networks”, including requirements that they submit to authorities “orders matched in the system”, and “details on access to the system”; and
• Suggests a minimum order size for dark pools.

This is pretty dramatic stuff and Jeremy finishes his column by referencing David Doyle, a regular speaker at the FSClub, returning to the London meeting on 12th January 2011 for our annual EU regulatory update.

David presented on the key changes in MiFID at a conference at the London Stock Exchange last week, stressing that “the whole review of MiFID will have as its driving principle investor protection – that is, the interest of the retail investor, not the operators of exchanges, dark pools and HFTs.”

Too true David, too true.

If you’re interested in more of what David had to say, here are his slides:

Mi fid, david doyle, july2010

View more presentations from Chris Skinner.

EU's bank stress tests creating more bank stress

It turns out that 91 European banks are to be put through a ‘stress test’ to see how well or badly they will cope with a shock to the system. The stress test itself was a little unclear until late last week, when the Committee of European Banking Supervisors (CEBS) detailed what would happen. As a result, a lot of folks think it’s a fudge, and the intention of creating more confidence in the EU’s banking system may actually have achieved the opposite.

Here’s the lowdown.

CEBS stress tests were announced after their initial approach was viewed as being too little and too narrow. The intention was to stabilise confidence in the EU banking system following the crisis in the Eurozone, and the approach was meant to follow the example set by America in May last year.

Back then, everyone felt the American banking system could not deal with the exposures they had to OTC derivatives, so the Federal Reserve tested the banks to see if they could deal with not just those exposures, but any other severe shocks to the system.

The US tests used two economic scenarios: one mirroring the consensus of economic experts on the course of the downturn through 2010, and the second modelling a worse-than-expected course of economic activity.

This resulted in recognition of a $74.6 billion shortfall, which was far less than the figures being bandied around before the stress test results. For example, the IMF estimating that the U.S. banks needed another $275 billion to $500 billion whilst some analysts throwing figures around that the industry may need as much as $1 trillion.

The less than anticipated shortfall led to increased confidence in the American banks. That confidence led to some stability in the system thereafter, financial stocks jumped 36% in the seven months after the tests, which is why it was worth doing.

This is why the US example was followed by the lengthy discussion of living wills in the UK regulatory sector, and the idea of reverse stress testing as implemented by the FSA last December. In these tests, banks are meant to imagine that they have failed and then have to work backwards to determine which risks and vulnerabilities caused their hypothetical collapse.

The FSA’s approach to stress testing consists of three main elements: companies’ own internal stress testing, where they assess their ability to meet capital and liquidity demands in a sudden downturn; the regulator’s testing of specific companies; and simultaneous “system-wide” stress testing, based on a common crisis scenario.

In both the US and UK examples, the stress test methodologies were completely transparent and now we come to the European bank stress tests.

In the EU tests, CEBS will study 91 banks, mainly in Spain and Germany, but also several other key banks including Britain's "Big Four" – RBS, HSBC, Barclays and Lloyds. In the latter example, thanks to the FSA’s scrutiny, they have already been subject to tough tests at home and should pass with flying colours.

The list is actually considerably longer than the original announcements in June which selected just 25 banks for review, and includes the German Landesbanken for the first time.

The significance of that decision cannot be underscored more deeply as BaFIN, the German regulator, announced a year ago that €800 billion of toxic debt sat on the balance sheets of these banks, particularly some of the Landesbanken, and that was double the amount they had estimated just three months earlier.

With almost $1 trillion in deposits, 2,500 banks and 45,000 branches, Germany also has one of the densest banking networks in the world, and hence a weakness in the German system would be a weakness for all, particularly as Germany has been bailing out Greece and, soon, Spain, Italy, Portugal and more.

In Spain’s case, as recently blogged, there is a big problem with the mid-size banks where the savings banks, regional banks and mid-sized banks are all closing, merging and consolidating, with anything from a quarter to a third of all Spanish bank branches to close.

That’s not good.

But the stress tests can turn this situation around by showing that Europe can cope with even the worst case scenario.

That’s a tough call, as we are all asking: ‘Can it?’

After all, a stress test if it turns out to be negative will worsen the situation but, if it’s positive, it will improve everything.

So the stress tests are being reported to be as transparent as the US version, with a three scenario test, according to the German newspaper Handelsblatt.

The first will analyse how banks perform if economic growth is at the rate forecast by the European Commission; the second will test the effect of a 3% drop in gross domestic product; and the third will look at how banks would cope with a "shock" situation in government bond markets, a scenario similar to events in May this year when Greece was downgraded by Standard & Poor’s.

It is that downgrade which has caused all of these jitters anyway, and created the uncertainty and lack of confidence in the Eurozone. Without confidence in the European banking system, then even worse scenarios could be considered, such as the collapse of the Eurozone and a return to national boundaries and nationalistic tendencies therein.

But there is already an issue with the European stress tests as the approach, structure and details of the tests have been changing over time, and many think the results – to be announced on 23rd July – will be a fudge. This view was given even more fuel when there were rumours that France and Germany were trying to suppress the methodology to be used for the tests.

This is bad news, as the lack of confidence in European banks will be made worse when or if there is a lack of confidence in the European banks’ stress tests, and the stress tests will only increase market uncertainty, rather than decrease.

All in all, my view is that Europe is caught between the Devil and the Deep Blue Sea.

If they complete the stress tests and release the results with complete transparency, there is likely to be some fallout. Unless the results show that the fears for bank counterparty risks in Europe are unfounded, which in the case of the Landesbanken and Spanish caja banks is unlikely, then it will just confirm what many already suspect: Europe’s broke.

On the other hand, if they complete the stress tests and release the airbrushed results that show some manipulation or opaqueness, then everyone will believe that their fears for bank counterparty risks in Europe are proven.

Therefore, what seemed to be a great idea to bolster confidence in the Eurozone may actually prove to be a lose-lose situation.

So how can the Eurocrats create a win out of this?

Just be totally honest.

If there are real issues in the heartland of Europe’s banks, be brutally frank about them.

It is only with total honesty, transparency and clearly washing any dirty laundry in public at the end of the month that Europe has any hope of surviving this current battering.

The World's Top 20 Banks 1994-2010 ... Anglo-American Banking Rules!

I’ve just received this month’s Banker magazine which the editor, Brian Caplen, describes as their most important issue of the year as it covers the latest Bank 1000 listings.

This year’s listings show a surprisingly stable crew of American and British banks.

World   Bank                               Tier One              Pre-tax
Rank                                            Capital                profit
                                                      $m                    $m
1        Bank of America Corp        160,387.77           4,360.00
2        JP Morgan Chase & Co       132,971.00         16,143.00
3        Citigroup                          127,034.00          -8,445.00
4        Royal Bank of Scotland       123,859.00          -4,366.29
5        HSBC Holdings                   122,157.00           7,079.00

Considering the crisis was meant to have killed these banks, you may find it surprising to see that Citigroup and RBS have maintained their leading positions.

This is down to the fact that the Banker measures a bank’s strength by its Tier 1 Capital, and so their positioning is more of a reflection of the sheer size of these firms than by their brand or market capitalisation, which is used in some other studies of size.

The Banker’s data is fascinating though, as the database also contains profitability, revenue, cost-income ratio and more, so it’s a useful tool in all senses.  And the online data goes back to 1996, so you can do some useful comparisons.

Mind you, my data - old Banker magazines - goes back even further so I quickly took a snapshot of a few useful year’s – 1994, 1999, 2004, 2008 and 2010 – to see how things have changed.  Mapping out the Top 20 banks of the world for each year makes for an interesting picture (doubleclick the picture to see a larger version):

Back in 1994, Japan ruled the world.

Then their economy went South and Origami Bank folded, Sumo Bank went belly up, Bonsai Bank cut back their branches and something fishy went on at Sushi Bank where staff got a raw deal.

Post-Japan’s slump, the Anglo-American financial system ruled. So you would think that, as that system failed, it also would have gone South.

Not the case.

Maybe that’s a reflection of the sheer scale of investment American and European firms have put into these economies to avoid such a crash.

Well worth spending time looking at the data and looking forward to playing around with it further.