The Financial Services Club is a unique service designed for Senior Executives and Decision Makers from any firm interested in understanding and planning strategies for the future of banking and finance.
Certainly in the UK it’s getting ridiculous as this week we saw the hysterical media coverage over Stephen Hester getting a million pound bonus for steering Royal Bank of Scotland (RBS) through this crisis, immediately followed by the Queen stripping Fred Goodwin, the former RBS CEO, of his knighthood.
Are these hysterics deserved?
Possibly some of it, but the bonus rage is not justified.
Sure, Stephen Hester’s bonus sounds amazingly rich to those who aren’t in a job of that stature, but a million pound bonus for someone whose package comes to over £7 million a year is about right.
This is because not all bonuses are the same, and the danger is that everything is lumped into a lynch mob cauldron of hate against bankers per se.
Take Stephen Hester’s bonus.
It’s not a bonus for being a risk-taking casino capitalist; it’s a bonus for meeting some of his objectives, managing a bank through a crisis.
That is normal business practice as many people get a bonus for annual achievement.
It is normal to have management-by-objectives and to reward staff for achieving those objectives.
In most firms, staff will get a bonus as a percentage of their salary each year, based upon achieving objectives in terms of staff management, customer satisfaction, revenues and profits.
That is usual and no-one in any other business sector is being forced to give up their annual bonus in the same way.
The trouble today is that any mention of ‘banker’ and ‘bonus’ gets people angry.
A bit like saying ‘daylight’ and ‘robbery’, a banker’s bonus is immediately seen as bad.
But the bonus that should be seen as bad is the one that is given with no recognition of the risks being taken, or the long-term return of that risk.
You hear several stories of bankers during the boom years making risky investments in complex instruments and getting multimillion pound rewards, only to leave the bank just before their investment portfolio crashes and burns.
No recognition of the risks that were taken, and no ability for the bank to get those bonuses back.
That was the mistake made in the boom years, and that is being addressed.
Multimillion pound packages are now taxed at 50% and are tied to long-term shares in the bank rather than cash.
The cash bonus days are over.
But how did we get to a stage where a banker can get a million pound bonus simply for being there?
It all goes back to the days of partnerships in the market maker world.
Checkout the history of Goldman Sachs, Morgan Stanley and you find investment banking bonuses originate from private partnerships, where the partners risk their own funds in order to share the rewards of their capital at risk.
Equally, the rewards were distributed on the basis of how well each partner performed, and bonuses were not a God-given right.
Unfortunately, as Goldmans reluctantly IPO’d in 1999 as the last private partnership in the investment world trying to keep this status, the bonus culture rippled over and the reckless risk of what is now referred to as ‘casino capitalism’, spilled over into the mainstream banking system.
What happened?
Well, the private partnerships were now competing with other mainstream banks and, in order to attract the best talent, the proprietary banks offered similar bonus packages and benefits as the private partnerships.
The difference however is that the mainstream banks didn’t have partners who put their own capital at risk.
They were just workers.
Staff.
Employees.
That’s where the bonus culture came from and where it all went wrong.
It’s being addressed today, but it got out of hand for a while and the hardest aspect is how to manage the transition from an over-the-top bonus culture to one that is managed through regulation.
You cannot force banks to be tough on bonuses.
As soon as you do that, you potentially drive a bank to other shores and lose fiscal revenue, as the UK government realises all too well.
The banking sector contributes over £50 billion to the Treasury’s coffers each year, and they don’t want to lose that income.
And banks gradually shake out poor talent over time anyway. That’s why 200,000 bankers lost their jobs last year.
Finally, bankers who really want to invest and put capital at risk will evolve over time. They’re called private equity managers.
So, the bonus battle will rage, but the media headlines are in the extreme.
In fact, much of it is just envy over wealth and the fact that somebanking people were paid millions for doing nothing in the past.
We'll know this crisis is truly over therefore when the media's rage stops being with a manager in a bank, to any manager in any business who is being over- or under- paid.
Yesterday I wrote about the concept of banks being barred from betting on the bonds and equities markets.
“Own account” trading disappears and the only folks who can “speculate” are those with their own chips to play in the game: the private equity, sovereign wealth, high net wroth assets and their asset managers who back all punts with collateral and cash.
In other words, the current players who systematically internalise will leave.
Bear in mind that a systemic internaliser is defined as a market maker who regularly trade off their own book of business:
MiFID provides that a firm should be treated as a systematic internaliser if it deals with client orders in shares on an “organised, frequent and systematic basis” from its own business account. These shares would normally be traded through an exchange or regulated market, but the investment firm is basically holding the shares themselves, waiting for the right price to match.
Some fear such trading is risky and allows banks to buck the price because the banks themselves can trade for their own benefit through such internalisation, known as prop or proprietary trading.
It is this trading that is now being targeted as being unacceptable, according to the American Volcker Rule.
The “Volcker rule”, named after Paul Volcker the former Federal Reserve chairman who proposed it, would restrict the ability of banks trading for their own benefit.
The Volcker Rule, along with others such as Vickers, could push systemic internalising out of the banking sector and, as mentioned yesterday, such that trading is purely operated through funds and asset managers who have the collateral.
So who would this impact?
We mentioned Goldman Sachs and Morgan Stanley in the USA yesterday, but the main European systematic internalisers are BNP Paribas, Citigroup, Credit Suisse, Goldman Sachs, Knight Equity Markets, Nomura, Royal Bank of Scotland N.V. (ABN AMRO as was) and UBS.
Now I know I’m pulling the chain a little here but let’s just say that all these guys trading desks, due to regulations and bonus restrictions, see mass exodus.
What is the future?
What does this mean for investment banks?
It means they purely become platform providers.
A little like the City of London describes itself as the Wimbledon of finance – we have no players, but provide the best courts to play upon – future banks will provide the infrastructure but not play.
So the world’s investment markets purely become technology oriented platforms which players plug into to play.
Kind of like Betfair, Bet365,Ladbrokes, Paddy Power, William Hill and other online gambling and betting services, investment firms become providers of platforms but they don’t play their platforms.
The market makers and systematic internalisers become technology firms, offering the fastest execution at lowest cost with best price, and the high frequency traders in the hedge funds, private equity firms and others trade.
They may trade on their own account or on behalf of sovereign wealth funds and institutional investors, but they trade with collateral, not with depositors’ savings.
And by offering the platforms to trade effectively, the systems move everyone towards best execution.
Best execution is all about trading at fastest speeds at best price and lowest cost, with a guarantee for the likelihood of settlement.
Somehow I can see the regulators being sorely tempted to follow this line of thinking as best execution has been embodied in European and American regulations for some time.
Mind you, you don’t have to think that this is necessarily going to happen as I’ve just re-read the last write-up of the Volcker Rule in the New York Times:
When Paul Volcker called for new rules in 2009 to curb risk-taking by banks, and thus avoid making taxpayers liable in the future for the kind of reckless speculation that caused the financial crisis and resulting bailout, he outlined his proposal in a three-page letter to the president.
Last year, when the Dodd-Frank Wall Street Reform and Consumer Protection Act went to Congress, the Volcker Rule that it contained took up 10 pages.
Last week, when the proposed regulations for the Volcker Rule finally emerged for public comment, the text had swelled to 298 pages and was accompanied by more than 1,300 questions about 400 topics.
Somehow, as with all regulations, it’ll get messed up on the process, whittled down and weakened until it’s a shadow of its former self.
For some time there’s been debate about whether Vickers or Volcker is the right way to go.
Should investment banks be divided from their retailing and commercial siblings by a fence, or completely separated so that one cannot poison the other?
Should banks be allowed to play in the markets off their own account, or should such risky practices be outlawed?
The debate will continue for a while and it’s clear there is a possible revolutionary outcome as, eventually, markets will decide how to behave.
This will be through a mixture of the law of unintended consequences and the law of Darwinism.
For the former, we’ve seen the impact of unintended regulatory consequences before.
When the Markets in Financial Instruments Directive (MiFID) was formulated, everyone believed it would seriously impact the systematic internaliser – the banks that trade mainly off their own account.
It did, but not in the way the regulations intended.
Instead, the regulations opened Europe’s markets to full electronic trading strategies and allowed Chi-X to decimate the traditional equities exchanges’ business.
The systematic internalisers leveraged such facilities, particularly through dark pools, and suddenly the majority of equities trading in European markets flowed through systems rather than people.
It is also why the surge in OTC Derivatives trading arose, some would say, as the human touch in banking moved from trading to creativity.
Now the regulators are trying to rewrite the rules for high frequency operations and OTC Derivatives.
We all know that means that, in the law of unintended consequences, they are again creating a new market structure that they may not foresee.
This is because the Volcker Rule – the rule introduced as part of Dodd-Frank in the USA that bans proprietary trading – means that many of the world’s leading speculators, traders and masters of the universe are already moving out of the banking network and into the investor network.
From Forbes Magazine recently: “The Volcker Rule would impact investment banking giant Goldman Sachs the most followed by Morgan Stanley. The two firms derive 48% and 27% of their total consolidated revenues from principal transactions respectively … Bank of America and JPMorgan Chase see about 9% and 8% of their total consolidated revenue come from such transactions. Citigroup will be the least hit with just 5% of its total revenue at stake.”
No wonder Goldman is seeing a mini-Exodus.
Bloomberg recently reported that Goldman Sachs lost two leaders of its biggest division.
“Edward K. Eisler, 42, and David B. Heller, 44, are retiring from the company, where they helped lead the securities trading division since February 2008 … Eisler and Heller join about 50 Goldman Sachs partners who left the firm in the past 12 months, according to company filings, internal memos and news reports.”
What is today a mini-Exodus is likely to become a waterfall over time, as banks close down areas of business that the regulators make undesirable or untenable such as proprietary trading, along with restrictions around the level of pay rewards by curtailing bonuses.
For example, the law in the UK has changed such that “the practice of up-front cash bonuses has stopped. The practice of guaranteed bonuses has been sharply curtailed, at least in the London market. Bonuses now have to contain a very significant element of deferral. At least 40% of the bonus for a significant risk taker has to be deferred for a period of at least three years.”
Increasing tax, decreasing bonus levels, a tougher job climate – over 200,000 banking jobs were taken out last year – and a general gloom over investment banking – RBS is closing its investment division – all mean that the world of capital markets is being reinvented.
The reinvention is slow at first, but will become noticeable by 2015 and notable by 2020.
What does it look like?
It’s a guess, but the future looks like one where banks no longer participate in active trading and risk.
The trading risks are taken by those who are willing to lose, and they have to have their own collateral and assets upfront in order to be able to play therefore.
That means private equity, sovereign wealth and the high net worth will be the risk takers and trading speculators.
Institutional investors, pension funds, hedge funds will also be in the game.
But banks will not be able to play.
Their inability to play will be partly due to limitations by law – Volcker, Vickers and the like – but more by the natural market selection for talent.
Real trading talent will no longer be won by the banks, due to their inability to pay and remunerate, and therefore others will hire the big guns.
Banks will be forced to focus away from trading and more toward client acquisition and satisfaction.
Banks will become hugely focused upon corporate relationship management, improving treasury returns and demonstrating real value to their clients’ CFO.
Their focal point will be to gain and retain high value relationships at the top tier of the markets, looking after their corporate client’s needs for risk management and advising them on hedging strategies for the future.
A new world where casino capitalism will only be played by those who can afford the chips.
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.”
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’.
“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.
Yesterday, we talked about the economic outlook for 2012. What about the banking outlook?
Well it’s also challenging, with five clear things happening:
Regulatory change will still be high on the agenda
Investment banking will get a radical overhaul
Clearing and settlement will become a much bigger focus
Reconstructing distribution will be a big challenge
Contactless mobile will reach a tipping point in retail payments
Regulatory change will still be high on the agenda
It’s pretty obvious that the world’s regulators are continuing to struggle with how to manage the financial system, as most cannot even agree on a definition of what is a commercial versus speculative trade.
They’re getting there … but it’s taking time (three years so far).
Maybe that’s good, as we don’t want to rush into senseless change, but it’s also bad as every regulator has a different idea of how to tackle this crisis.
For example, in the USA Paul Volcker, the wonderfully outspoken former Chair of the Federal Reserve and creator of the Volcker Rule which bans proprietary trading in investment banks, says that working out what is speculative or not is easy: “Bankers know when they're doing a proprietary trade, I assure you. If they don't know, they shouldn't be in the business. If there are big unhedged positions constantly, then it's proprietary trading.”
That’s the rule: if it's not hedged, it's pure speculation.
But this rule will cost, and cost a lot according to Oliver Wyman , who found that the decrease in market liquidity will deliver a $315 billion paper loss for investors in US corporate bonds.
Certainly, it will reduce trading volumes with the Financial Times quoting Brad Hintz of Sanford C. Bernstein, who reckons the Volcker Rule will see Wall Street’s fixed-income desks experience a 25% decline in revenue and a 33% cut in pre-tax margin. That ain’t good for jobs, and will only pile more misery on top of the 200,000 jobs lost on Wall Street in 2011 (compared to 174,000 in 2009).
London’s going through the same, but the challenges are different as the approach is different.
Here in the UK, we are ring-fencing investment and commercial banks under the Vickers report recommendations, which now have the government’s backing.
The idea is that banks are separated into two – an investment bank and the commercial retail bank. The idea is that if the investment bank dies, it can be killed without murdering its sibling.
That’s great in principle, but in practice is far more difficult.
For example, the separation will cost anything up to £8 billion a year and it doesn’t even achieve the derisking it seeks.
The Vickers Report is designed to get rid of the results of casino capitalism, if it causes death to the investment bank; whilst the Volcker Rule is designed to get rid of casino capitalism.
The Vickers Report tackles the issue without recognition that it is often poor practices in commercial and retail banking that messed up our biggest banks. Nothing to do with casino capitalism at all.
HBOS’s commercial lending portfolio, secured through easy access to wholesale funding markets, is the reason why it collapsed. Same with Northern Rock and Bradford & Bingley with high risk mortgages.
So the idea of keeping the commercial and retail banking system ‘safe’, by ring-fencing it from the investment markets, is not something most people accept or believe.
Paul Volcker doesn’t believe it: “I 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.”
Then there’s the human cost of these proposals, with many thousands more losing their jobs in the City, and some estimating it could be up to forty percent of the total workforce in the City. RBS, for example, has already shed a quarter of their workforce, with another quarter expected to go after Vickers.
Unintentionally, there is a belief that the Vickers reforms will also be a gift for foreign banks.
Add to this the lurking storm of Europe and the UK’s veto over reforms due to City concerns, and it is no wonder that regulatory matters are still high on the agenda in 2012 … and 2013, 2014, 2015 …
Investment banking will get a radical overhaul
I’ve only put this heading in there as a follow-on to the regulatory piece that preceded this paragraph.
Personally, I have a vision that investment banking will end up being a facilitative role, with platforms and technologies to enable trading, but no trading in the bank itself. Instead, all the speculators and traders will be out there in private equity and hedgeland, not in the banking system.
Just a thought.
Clearing and settlement will be the big focus
Due to the changes taking place across the spectrum of investment banking and capital markets, clearing and settlement infrastructures will become a big focus.
This is partly down to the new regulations for OTC Derivatives and more, but also due to increased focus upon liquidity risk and collateral management.
Markets have an extreme between the high risk and high leverage we saw leading up the crisis – when Lehmans collapsed, every $1 of debt was leveraged twenty times across the markets so their $400 billion of losses escalated to near $10 trillion of risk – and minimal risk and leverage you see in markets like Russia.
When I visited Russia’s exchanges in 2009, here’s what I wrote about SPIMEX and RTS:
“Both exchanges proudly talk about their focus upon real-time analysis of traders’ positions. In the case of SPIMEX, they offer real-time settlement and straight through processing, so there is no risk for trading. In the case of RTS, they offer real-time positioning of every trader and every trader’s client portfolio, not just in real-time for their own trades but also for the knock-on effect of their dealings in derivatives down the line.
“I asked RTS about their risk management, and they made clear that for each transaction, the risk is calculated for the trader’s portfolio, including all orders to be filled, in real-time. There are then two clearing sessions during the day. One at 14:00, which takes three minutes to process, and the second is at end of day, and takes fifteen minutes. If a margin call is made, the broker must cover their position within two hours or, if at end of day, before the start of the next day’s trading.
“This discussion got interesting, as RTS and SPIMEX appear to be developing systems that ensure no trader can leverage risk to the levels where the market implodes, and they do this in real-time.”
So we’re now seeing US and European markets grappling with how to implement clearing and settlement systems that enable liquidity, minimise risk, and strikes a balance between unbridled speculation and zero risk.
This is an area that has grown in interest with our clients and sponsors, so much so that on February 29th the Financial Services Club is launching a Clearing & Settlement Working Group (CAS-WG).
The CAS-WG will hold its first meeting at BT’s offices in Newgate Street, and is organised in association with the Realization Group.
The aim of the CAS-WG is to debate and discuss all aspects of clearing and settlement infrastructures, and the first agenda will have four panels discussing:
Volker/Vickers/MiFID II and impacts on post-trade operations and IT, particularly with regard to OTC Derivatives and Clearing
T2S – problems of change and implementation for settlement
Giovannini Group Recommendations, Innovation & Technology – what progress has been made?
Standards in Post-trade operations
Panellists from organisations including Euroclear, LCH.Clearnet, EuroCCP and EMCF will be attending. If you would like to attend, then let us know.
Reconstructing distribution will be a big challenge
Moving away from investment markets, retail and commercial banking is still undergoing big changes. As discussed all the time here, branches specifically are a problem.
Banks will have to deal with this problem in 2012, as they cannot sustain loss-making operations anymore.
In some regions, six out of ten branches have closed (Iceland); in others three out of ten (Denmark); in the USA, four out of ten branches are loss-making; whilst in the UK, some analysts (me) estimate that as many as four out of five bank branches could close by the end of the decade.
The fact at the core of this change is that banks are electronic businesses distributing through electronic media, and the branch just does not fit that model of business.
As banks need to be the most cost effective they can, why have a branch?
It would be like bookshops fighting to keep their stores open, when it’s obvious they’re dead as they’re all losing money; or travel agents, record shops, video rental stores, etc, etc.
When your business model is dead, admit it and move on.
Contactless mobile will reach a tipping point in retail payments
Speaking of new business models, the one that most retailing banks will move towards is contactless mobile and contactless tablets.
The experience is highlighted well by various firms, but my favourite contactless illustration is from Discover Card and Square:
The reason why I use this one is that everyone assumes contactless = NFC chips. It doesn’t have to be. Contactless in my world, is any payment that is simple, automatic and wireless.
That’s what the Discover video shows.
However, NFC is a key part of most contactless plans, so it is also a key part of the process of evolution.
Contactless chips have been around for ages but, on their own, are relatively useless. We then put chips in cards, but these again are not great.
But put a contactless chip into a mobile and then we’re rocking.
That’s again illustrated well be Google.
The tap-and-go experience is good one, and one that provides major convenience for the customer – whether the customer is a corporate who wants to drive higher sales through their checkout points, or the consumer who wants speed, ease, convenience and value.
It can focus upon not just turning phones into higher volume purchasing points, but into point of sale points too, and all geolocated as contextualised point of focus.
That’s why Movenbank is launching in 2012, as the first cardless and cashless bank.
So, if the major conversation of 2010-11 was mobile, the focus in 2012-13 will be contactless mobile.
2012 set to be the tipping point for mainstream contactless adoption
77% of contactless owners across all three markets agreed or strongly agreed that contactless technology would ultimately become more commonplace than cash as a payment method (UK: 73%, Poland: 79%, Turkey: 79%)
87% also agreed that contactless will be instrumental in bringing mobile contactless payments to market in the near future (UK: 84%, Poland: 89%, Turkey: 89%)
And, just in case you want any further detail, checkout this infographic from NFC rumors:
‘Nuff said.
So there you go, the five biggest things that will happen in 2012 in banking:
Regulatory change will still be high on the agenda
Investment banking will get a radical overhaul
Clearing and settlement will become a much bigger focus
Reconstructing distribution will be a big challenge
Contactless mobile will reach a tipping point in retail payments
This is not exhaustive of course, as there’s plenty of other things happening, such as Fred Goodwin being brought to trial for breaching company rules (a sure vote winner for the coalition government).
Anyways, a final set of predictions tomorrow about how and which technologies to watch in banking in 2012.
One of the panels at the trading technologies show that I chaired was all about pre- and post- trade risk, and the impact of real-time risk management.
We were meant to talk about real-time risk, what it would mean, the ability to be able to see credit, market and liquidity risk across counterparties, asset classes and instruments throughout the day as it happened, rather than intraday or, worse, yesterday.
Yea.
Hmmm.
As the panel progressed, I realised something was wrong.
I realised that real-time risk is irrelevant.
It means nothing.
Forget it.
Real-time risk is too late.
It means it’s happened.
What you need is forecast risk, not real-time.
You need a great way of looking at future risks and being able to map them, then you need real-time to address emergency situations as risks hit the business that were either unknown known’s or unknown unknowns (that old chestnut again).
The thing is that we’re all talking about risk these days, and that banks must take on risk to be in business.
The nature of banking is to borrow your money, in the form of deposits that they pay you interest against to look after, and then lend that money at a profit to others in the expectation that others will pay it back at some point.
That last part is where the risk exists, and it’s a simple matter of assessing the risk of default.
It was simple, but not anymore.
It was simple because it was purely credit risk: if I lend you money, will you pay it back?
It got complicated as the banks began to speculate with money through investment instruments: if I invest in this equity or currency, will I make a profit?
That’s when market risk became a discipline.
Now it’s hellishly complicated, as banks have to build in a new form of risk dimension: if I invest in this equity, currency or derivative, and suddenly the credit lines for those assets are taken away due to the market volatility and irrationality, can I cover my liquidity position?
No wonder banks have to run massively complicated scenario models through Monte Carlo simulations to try to ensure they catered for every potential eventuality and ensured it can be managed.
That’s the forecasteable aspect of risk which we’re really trying to get at today: being able to cater for any market movement, loss of credit or liquidity in real-time thanks to having fantastic scenario models and plans to manage every forecasteable situation.
Obviously impossible, but a good objective.
What is possible is to minimise risk exposure.
You can’t eradicate risk, otherwise there would be no risk, but you can minimise exposures.
A little like fraud: you can’t get rid of it, but you can reduce it to an acceptable level of tolerance.
And this is where it gets real interesting, as it means that risk is a management discipline and science.
You can run risk modelling and crunch it through FPGA systems and then manage the whole lot in real-time.
But even that’s not good enough.
And this was the other realisation I had as the panel debated and dialogued.
It’s not good enough as, even with all of the best systems, simulations, models, disciplines and risk scientists in the world, risk is nothing to do with technologists or analytics.
It’s to do with culture.
That’s where the operational risk exposure kicks in.
The culture of a bank determines it’s appetite for risk.
In the case of RBS, their risk appetite was determined by Sir Fred Goodwin, the Chief Executive.
That’s what screwed them.
If you want to know what I mean, here’s an insight.
In the good old days of Sir Fred, all decisions on important matters of risk were made by a panel of risk managers from across the business. But if Sir Fred disagreed with the Chief Risk Officer’s view, he could override that decision.
In other words, RBS’s former Chief had the final risk vote, not the discipline and management who understood risk.
The same could be said to be true of HBOS, which was run by a retailer who understood selling but not risk. No wonder they sold billions of pounds of commercial loans that then went belly up.
And the same is true where we see rogue traders like Jérôme Kerviel of Société Générale and Kweku Adoboli of UBS appear.
In these instances, the culture of the trading room was all about alpha at the expense of prudence.
The management encouraged such irrational practices and the risk management discipline was lost for the expense of bonuses and profit.
And there’s where all banks are now trying to sort out the issues, as are regulators.
But the issues will not be resolved if the bank’s culture is one that encourages risk without discipline, accepts opportunity without prudence, and seeks alpha without beta.
Like the Greeks, the bank will be insolvent, and the markets will feed on its rotting bones.
So risk is nothing to do with systems and models, but all to do with people, management and culture.
This week is a trading technology week, chairing panels at two trading technology events.
The first is focused upon trading architectures and I’m surrounded by engineers.
Forget strategists, technologists, programmers or developers.
Engineers.
The reason is that it’s all about FPGA’s.
What the hell?
FPGAs – Field Programmable Gate Arrays.
This is basically a chip that allows you to place a program on the chip for processing at lightspeed.
It links with low latency, high frequency trading, except that the debate about low latency was all about speed of processing; FPGAs are now all about using massively parallel processing (MPP) to analyse what is being processed.
It’s a data flow analytic, rather than a process flow throughput service.
And yes, it’s the next evolution of debate about trading architecture, after high frequency trading (HFT).
Strangely enough, I’d given up on these things years ago as I thought MPP was done and dusted.
Instead we moved onto discussions around cloud, grid, virtualisation and such like.
The big conversation in fact was about colocated data centres and getting massive amounts of processors to crunch through data in low latency volumes.
Now it’s moved from processing to analysis, which is why parallelism is back on the agenda, or concurrency as some call it.
The reason it’s become important is that if you can run an analytic on the chip, then it can be done far quicker than through the CPU.
This means you can run risk analytics of high frequency data throughput in real-time, rather than after the event.
You can also run complex simulations of massive amounts of data quickly, easily and cheaply.
FPGA is back on the agenda because it’s also far simpler than ten years ago.
Ten years ago, these systems needed hard coding and sat firmly in the telecommunications sector.
As an engineering technology, it was incredibly complex but now the level of tool support from vendors is much greater than ever before, and has made it far easier to use.
In other words, the design issues are no longer part of the problem.
These things can now just be programmed into the system.
It is important as effectively FPGAs allow a compute cycle of data to be programmed onto a cahip or, in this case, a processing board.
The result is savings in heat and power usage, but also a massive increase in raw compute power.
For example, one bank was talking about Monte Carlo simulations that showed performance levels 30 times better than doing this through a CPU and 175 times better in efficiency terms.
Bear in mind that Monte Carlo simulations can involve fifty year or more scenarios with roll back, querying, resets and roll forward all built into the modelling and now in real-time.
That’s complex and involves massive amounts of data analytics.
A little like taking petabytes of real-time data and churning through it all in real-time.
Forget batch and overnight. It’s all real-time.
This is why FPGAs are being used extensively for scenario modelling of real-time risks, calculating positions for the traders of the world in their positioning against Greece, Italy and each other in real-time.
And all of this is achieved with far less power and far faster clock times than traditional CPU processing.
This is because FPGAs are actually SoCs.
WTF?
SoC – System on a Chip.
What this means is that you can put a board into the computer processor, and on that board is all the analytical system requirements to run fast cycle analytics.
So the software and hardware are married as one on the chip – a complete System on a Chip (SoC).
Imagine therefore that you have massive amounts of data flowing in high frequency and high volume across low latency engines throughout the world’s markets looking to trade.
Then you have lots of FPGAs deployed across those processes, looking at the data and tracking risk, opportunity, collateral, liquidity, credit and more.
Each FPGA is given a specific analytical function as a SoC, and it allows you to run huge volumes of trading without concern about the processing power limitations of old, or analytical delays due to hitting CPU limits.
This is why FPGA is big news in trading, allowing traders to take huge amounts of streaming data flows, analysing the data concurrently, and all with easy implementation and deployment.
So we’ve gone from the technical low latency discussions to how to analyse these streams of data – these massive volume, high speed systems – and working out how to analyse all that data in real-time using FPGAs.
We’ve gone from process and processing to analysis and data flow.
I was just reading through my notes as Chair of the #TradeTech conference last week, and found a bunch of interesting notes and quotes.
Rather than assembling them into a sensible blog post, I’m just going to write them up ad hoc and you can make your own mind up about the meaning, context and implications.
However, for FSClub members interested in these areas, we have a Club meeting on 2nd November with Dr. Kay Swinburne MEP on: "Dark Pools and HFT: Good or Bad". See the end of the blog for details.
Chairing the #tradetech architecture conference today - get the impression markets are still struggling with same issues as 2010
One big issue is clearing and settlement, another is risk, a third is regulators not knowing what the hell they're doing
Average equities trade on exchange is now under €1,000 - how do you do x-asset mix of high value and low
In cross-asset classes, the lack of meaningful reference data to track mixed instruments is a big issue
How do you get back office and front office aligned when the back office is always a step behind
Could ask same of regs: how do you get regulations and FSIs, aligned when regulators are always a step behind
With SWIFT, you can settle within 15 seconds so T+0 is feasible - the issue is the FSIs internal inability to exploit this tech
Wow - the Large Hadron Collider produces 15 Petabytes (15 million Gigabytes) of data annually http://bit.ly/cGr8Bi - most in a millisecond
“CERN is collecting millions of data points in milliseconds … markets need to do the same.” Peter Legizinski, former CIO, Allianz Investment Bank
An equity trade across 8 exchanges in different global cities, including price discovery and execution, would take about 2 seconds
Latency harmonisation is meaningless as exchanges always find a way to make some more equal than others
Another issue raised by Iran Hutchinson: "60% of the world's order executions are on mainframes"
Someone just asked me what the difference is between HRT and HFT at #tradetech lol ... must be the hormones
Prediction from Clem Marsh, BATS Europe: if the EU transaction tax is implemented, all HFT trading disappears in EU & firms move
Just look at Sweden’s experience: "90%-99% of traders in bonds, equities and derivatives moved out of Stockholm to London", Anders Borg, Sweden's Finance Minister
But is this true if transaction tax is only applied to filled orders?
“Over-regulation should be avoided because it slows down financial innovation & undermines economic growth” Jacques de Larosière
“I fear we have lost the momentum that was created at the start of the financial crisis”, Diego Valiante, CEPS
“We are using regulation as a substitute for supervision …. and regulation cannot substitute supervision”, Diego Valiante, CEPS
“Pre-crisis markets were shaped by customers; post-crisis by regulators. We have to ask if that is right.” Anthony Belchambers
“Somebody’s got to bring back proportionality to this and take away the regulator’s punchbowl.” Anthony Belchambers, FOA
“There’s no point in locking up capital in a capital-intensive business.” Anthony Belchambers, FOA
"MiFID1 was close to a farce with dates moving all the time. We can’t allow that to happen again.” Anthony Belchambers
UBS say that one City FSI lost millions when someone flicked the wrong switch and added 20ms per transaction, so latency does matter
"Volatility is built into the markets and is advantageous for some whilst disadvantageous for others" Marcus Hooper, Pipeline Financial
“Long-only asset managers trading has slowed for several years as it’s too difficult to find alpha that way.” Marcus Hooper
"If you become clever at moving between algorithms, people will not be able to follow your algorithmic behaviours." Marcus Hooper, Pipeline Financial
"If you can't manage and measure transaction costs, you might as well not bother." Marcus Hooper
"The question is whether you can make orders out of thin air, as that's what we do." Marcus Hooper
"MiFID2 should create a level playing field but will just encourage regulatory arbitrage as happened with MIiFID1." Marcus Hooper
"The things that need to be regulated are not well understood by the regulators, let alone the politicians." Marcus Hooper
Dr Kay Swinburne, MEP, UK Conservative Spokesman - Economic and Monetary Affairs will speak at the Financial Services Club on the theme of: “Dark Pools and HFT: Good or Bad?” on 2nd November.
Kay Swinburne has been instrumental in moulding the principles of the revisions to the next generation of investment markets regulations, thanks to her report ¬ “The regulation of trading in financial instruments: dark pools etc” ¬ from summer 2010. The revised version of the paper was adopted by the European Parliament’s Committee on Economic and Monetary Affairs (ECON) on 9th November 2010, and means that all broker dark pools are reclassified as multilateral trading facilities (MTFs) or systematic internalisers (SIs), and that dark executions should be subject to size restrictions.
Looking at MiFID II and beyond, are such changes to dark pools and regulations restricting High Frequency Trading a good or a bad thing? To find out, we’ve asked Kay to tell us her current thinking.
Kay was elected as the Conservative MEP for Wales in June 2009. This saw the Conservative Party top the elections for the first time in Wales in modern history. A successful career in investment banking has equipped her with in-depth knowledge of the global financial markets. This, combined with her experience advising businesses in Europe and the US, has led to her appointment on the Economics and Monetary Affairs Committee in the European Parliament.
At present, Kay is deeply concerned about how quickly the European Union is responding to financial service regulation without having properly looked at the impacts of what it is doing. She believes that the EU should work within a global framework as the crisis that we are facing is global; therefore it needs to work with the United States and so a global co-ordinated strategy needs to be implemented that is in line with the agenda of the G20.
As mentioned, I was chairing a conference on trading technologies and one technologist told me that, in theory, it would be technically possible to send an order around the world in 400 milliseconds or less today.
Most people disagree with this, talking about time lapse, speed of light and more, and that the order would have to be a neutrino to be that fast.
But I did ask another panellist in a session on low latency how fast an order could be filled that looked across nine world exchanges for fulfilment.
The idea being that I might want to trade in HSBC stocks for example, that are listed in London, Frankfurt, Mumbai, Shanghai, Sydney, Tokyo, San Paolo, Mexico and New York.
How fast, in principle, could that order be processed through these nine exchanges, filled and returned completed for settlement to London, I asked.
About two or three seconds was the answer.
That’s taking into account latency between systems and exchanges, time to cross match and complete, globally circuit and return filled.
Wow!
Such a feat would have been impossible just a year or two ago, and even now seems conceptual, which it is.
In concept, this would be feasible.
In practice, such things are unlikely in the near-term and, for real visionary trading across assets, unlikely in the long-term.
There are many reasons for this.
First there is too much latency dropout between platforms and systems.
Half of the debate over speed is purely concerned with who’s order is filled first on the target execution platform.
This is because the first to be filled is the only one to be filled.
You hear various numbers, but let’s say that 99% of orders on exchange are unmatched and therefore lost.
This means that only 1 in 100 are completed, and the winners of those that complete are the ones that are fastest to platform.
A wee bit like the end of an eBay auction, the only winner is the final person to bid.
In the low latency race, the only winner si the first person to complete.
But that’s only important once the order needs to be executed.
In the meantime, you have all of your algo strategy formulation, trading and portfolio projection and internal arbitrage and hedging capabilities,.
Execution is just a thin veneer on the layers of trading, and is purely the varnish of speed for whne you have a strategy requiring execution.
Therefore, the idea of ploughing across the world’s exchanges at high speed finding best price is unlikely right now, as the majority of trading strategies are localised.
But let’s say someone does start going down this route, we then got into another debate about cross-asset class approaches and this also proved to be not true.
The idea of mixing FX and equities, or equity derivatives, in a cross-asset class HFT strategy is do-able, although still small beans right now.
But the idea of mixing bond trading instruments and derivatives in a complex spread of FX and equity arbitrage trading that is automated and high frequency is a fallacy and will be for some time.
Why?
In part, because the size and speed of trading of bonds and treasury gilts is very different to equities and FX.
In part, because the need to arbitrage and mix such spreads of instruments in high frequency is not a real requirement right now.
And primarily because even if such need existed and were required, the reference data around such trading capabilities and systems is just not there.
The reference data and silo systems are there for historic reasons, as all of these asset classes were separately traded instruments and markets.
The platforms are structured in different ways, regulated in different ways and automated in different ways.
In particular, the data is captured and stored, transacted and matched, collateralised and settled in different ways, and this is the bit that would need a radical overhaul for cross-asset class trading to be mainstream, let alone HFT of cross-asset class instruments.
So let’s not delude ourselves.
We live in a world of HFT today, but it’s very precise and focused upon highly liquid stocks in localised markets, not globalised across-asset class HFT as is the dream of some and the long-term vision of more, but not many.
In fact, we had a lot of discussion during the conference about even faster speeds, with one wag asked if orders could be filled before they are sent based upon neutrinos.
You may already know about neutrino’s but, if not, it was the big news of a week or so again when scientists working on the Large Hadron Collider experiment found the atom, called a neutrino, can travel faster than the speed of light.
It’s a ground breaking piece of news as it means that basic science is turned on its head when something can arrive before it leaves.
Here’s a good summary of what the scientists found:
“Neutrinos fired 454 miles from a supercollider outside Geneva to an underground laboratory in Gran Sasso,Italy, took less time (60 nanoseconds less) than light to get there. Or so the physicists think. Or so they measured. Or so they have concluded after checking for every possible artifact and experimental error. The implications of such a discovery are so mind-boggling, however, that these same scientists immediately requested that other labs around the world try to replicate the experiment. Something must have been wrong to account for a result that, if we know anything about the universe, is impossible. And that's the problem. It has to be impossible because, if not, everything we know about the universe is wrong.”
Everything is wrong, because it does mean that time travel is possible as atoms are arriving before they are sent, according to the speed they are travelling which is faster than light?
Could such technology be applied to trading? was the big question last week.
There are already predictions that some exchanges can process orders in under a nanosecond.
That’s fast.
Can they get much faster and what does it mean?
This was the big chat of last week, which I’ll cover in more depth in my next blog entry.
Meantime, here’s my favourite quote of the week:
A bartender says: "I’m sorry, we don't serve neutrinos here".
MAG-net is the networking group in the City for the Mines Advisory Group, MAG, a charity supported by the Financial Services Club and others that clears areas of mines so that schools, villages and life can continue as it should in post-war territories.
They invited me to speak about anything I wanted, and so I created a new presentation about the similarities between banks and landmines (see UBS today).
The presentation developed around the idea of banks being mines that explode in economic terms, in a similar way in which landmines explode and blow away people and animals in the real world.
My premise was that just as landmines blow the legs away from humans, banks blow the legs off economies.
It’s obviously the case that this is true today, what with the Lehmans collapse with Credit Default Swaps creating the first financial crisis; and now sovereign debt in the Eurozone is developing the second.
How can such economic landmines exist in a world where we should have cleared them by now?
They exist because we allow innovation in financial instruments in an unregulated form.
That innovation is all around derivatives of derivatives.
Untried and untested weapons of financial destruction are being created every day and planted as hidden potentially unexploded bombs across the financial system.
This has been well documented in many books, with F.I.A.S.C.O. cited by many as a great illustration of the issues in a storybook form or, if you prefer the academic version, Infectious Greed, gives you the lowdown.
These two books by Frank Partnoy document the issues of derivatives, which are both good and bad.
They are good in creating leveraged risk which allows commerce to become more capable. They are good in hedging risk, allowing trades to take place that otherwise could not. They are good in bringing together mixed asset classes, so that previously unrelated goods and services can now be traded together. They are good in offsetting future uncertainty, which is why they are used.
They are bad because they are so complex, most traders don’t understand them. They are bad because they are called ‘exotics’, and are so exotic that they can explode. They are bad because they allow firms, such as Goldman Sachs, to create a massively web of interlinkage between risk that ensures those in their world can have huge exposures whilst Goldmans themselves avoid such loss. They are bad because they allow debt to be leveraged so greatly that it becomes unmanageable.
All of the latter are the landmines of economies, and are no better demonstrated than by Lehmans collapse and Europe’s sovereign debt crisis.
I illustrated these two points with two charts.
The first is from June 2008, and shows the notional exposure of Goldman Sachs’ main counterparties just before the collapse of Lehman Brothers (doubleclick image for larger version):
Oh what a tangled web we weave, when first we practise to deceive! Sir Walter Scott
Now don’t think I’m Goldman bashing because, as I said last night, they are the most effective bulge bracket player in the world’s markets in creating risk and therefore alpha returns. That’s why their clients use them. However, they are also the most effective institutions in the world’s markets in creating risks that can explode in the face of their clients. That’s why they sell ‘crap’ to their customers (by their own admittance) and are happy to do it.
The second chart I used to illustrate the landmines that firms such as Goldman Sachs lay in the world’s economies is the European sovereign debt crisis and a data visualisation of which countries are most exposed to whom:
Again, derivatives were used to package sovereign debt in the same way as mortgage debt, and has created this second loss of confidence in the European economies.
The whole presentation can be seen here (needs the words to make sense probably) ...
... and the only positive note is that we can save human limbs by clearing landmines using mice to sniff the mines out.
Let’s get some more mice in the financial markets.
Postnote:
In researching the presentation, I found large numbers of images of people with limbs missing. Some were graphic, some were funny, some were moving and many were tragic. Give MAG five minutes of your time http://www.maginternational.org/ to consider supporting them. And any MAG-net member gets a 20% discount if they join the Financial Services Club so it’s worth supporting them for that reason alone surely?
So the Vickers Report has finally crept out into the wilderness.
All 358 pages of it.
Half of it talks about how to increase the competitiveness of banking and the other half about what to do if a bank fails in another crisis.
The latter has garnered all the news headlines, whist the former has been generally overlooked.
More copy has been written about this report than anything else in banking over the past week or so, with a selection of headlines that makes the mind reel. Here’s just a few:
If you want the truth, you can read the full Vickers report, which I’ve been reading this morning and so far have found nothing too surprising, as most has already been leaked.
Ring-fencing is confirmed, where banks separate domestic retail banking services from global wholesale/investment banking. The commission is vague about whether banking to large companies should be in or outside the ring-fence but it suggests that between one-sixth and a third of the £6 trillion of bank assets should be inside the ring-fence.
The ICB describes the ring-fence as "high" and said that the ring-fenced part of the bank should have its own board and be legally and operationally separate from the parent bank.
Ring-fenced banks should have a capital cushion of up to 20% comprising equity of 10%, with an extra amount of other capital such as bonds. The largest ring-fenced banks should have at least 17% of equity and bonds, and a further loss-absorbing buffer of up to 3% if "the supervisor has concerns about their ability to be resolved without cost to the taxpayer".
Capital could be moved from the ring-fenced bank to the investment bank, as long as the capital ratio of the ring-fenced bank did not fall below the 10% minimum.
And on creating new competition:
The ICB has backtracked on an idea in its interim report that Lloyds Banking Group be required to sell off more than the 632 branches it currently has on the market to meet EU rules on state aid. It dilutes this, to say that it "recommends that the government seek agreement with Lloyds Banking Group to ensure that the divesture leads to the emergence of a strong challenger bank."
It should be easier to switch bank accounts and the ICB recommends "the early introduction" of a system that makes it easier to move accounts and that is "free of risk and cost to customers". It rules out number portability — as is used with mobile phones — in favour of this switching service. The amount of interest that customers miss out on by having a current account — known as interest foregone — should also be published on annual statements.
The industry should be referred for a competition investigation in 2015.
For the most part, I’m disappointed with this report. It’s not that I’m against bank reform, but what is the right sort of bank reform?
What this report appears to do is tread a fine line between bank anger, government need and public input, and comes out on the side of muddle.
It’s already had plenty of flak for this, but let’s pick on a couple of things.
First, account portability. Why hasn’t the ICB included this, as it makes eminent sense as discussed back in December at the ICB meeting I attended.
What the report actually says about this is as follows:
“The Commission recommends the early introduction of a redirection service for personal and SME current accounts (to make account switching easier) which, among other things, transfers accounts within seven working days, provides seamless redirection for more than a year, and is free of risk and cost to customers. This should boost confidence in the ease of switching and enhance the competitive pressure exerted on banks through customer choice. The Commission has considered recommending account number portability. For now, it appears that its costs and incremental benefits are uncertain relative to redirection, but that may change in the future.”
In other words, the cost of using different account numbers between banks allowing portability is too great. For example, if might from RBS to Lloyds with account number 75280025, there may already be someone at Lloyds with that account number. Therefore, to introduce account portability of account numbers, you would probably need to renumber all the bank accounts in Britain with unique ID’s. That’s why it’s been dropped.
But then the report adds more details to this idea (page 218) and shows it is feasible:
“Under account number portability, a customer’s sort code and account number would not change when the customer changed banks, thereby avoiding the need to change any payment or credit instructions. Evidence to the Commission suggested that the effect of account number portability could be achieved through the creation of an ‘alias database’. This proposal is for a new database to be created with a new code for each account that would be assigned to each sort code and account number: a customer would give the direct debit originators (and creditors) they deal with the new code, which would never change; when the customer moved banks, the sort code and account number assigned to the customer’s code would change and nothing else.”
Later on (page 222), it expands on the risks and opportunities of account portability:
“One significant benefit of account number portability (whether done through making existing account numbers effectively portable, or through the creation of an alias database) is that it would remove the cost of switching to direct debit originators, as well as those who make automatic payments into customers’ accounts. However, given the importance of the payments system, it would be critical to ensure that the migration to account number portability did not disrupt the flow of payments or introduce greater operational risks into the payments system.”
In light of a need for bank reform, this would have been a worthwhile aspect to develop now, and it is something left in the report for further evaluation so you never know.
Nevertheless, the big question is whether this would improve competition anyway?
Competition is more about the barriers to entry – governance, licensing, capital, technology etc – and hence, these are more mighty areas … that the report also fails to address.
The report mentions competition 414 times, and yet the main recommendations of the interim report:
“that the divestiture of Lloyds’ assets and liabilities required for EU state aid approval will have a limited effect on competition unless it is substantially enhanced;
“that it may be possible to introduce greatly improved means of switching at reasonable cost, and to improve transparency; and
“that the new Financial Conduct Authority (FCA) should have a clear primary duty to promote effective competition”;
... have all been watered down.
Then we move onto ring-fencing, which purely addresses the aspects of what to do if a bank fails.
"Structural separation should make it easier and less costly to resolve banks that get into trouble. By ‘resolution’ is meant an orderly process to determine which activities of a failing bank are to be continued and how. Depending on the circumstances, different solutions may be appropriate for different activities. For example, some activities might be wound down, some sold to other market participants, and others formed into a ‘bridge bank’ under new management, their shareholders and creditors having been wiped out in whole and/or part. Orderliness involves averting contagion, avoiding taxpayer liability, and ensuring the continuous provision of necessary retail banking services – as distinct from entire banks – for which customers have no ready alternatives. Separation would allow better-targeted policies towards banks in difficulty, and would minimise the need for support from the taxpayer. One of the key benefits of separation is that it would make it easier for the authorities to require creditors of failing retail banks, failing wholesale/investment banks, or both, if necessary, to bear losses, instead of the taxpayer."
Living wills and all that aside, the proposal to leave banks as integrated universal operators – good for Barclays – by purely creating a delineation between their domestic commercial and retail banking operations versus their global links is a duck out.
Why?
Because it does not address the issue of why banks fail, but just what to do when they fail. This is a positive thing according to some and yes, sure, it's a good thing to know what to do when a bank fails ... but why not try to deal with the core of failure as, even if we know what to do, a bank failure in its investment arm will still destroy value in its overall operations.
Northern Rock illustrates this well where, as a pure retail bank, it failed due to securitising its loans and mortgages in the wholesale markets. Surely these aspects of potential liquidity failure should have been in the report, and how a bank builds an illiquid position that leads to failure, rather than just what to do post the event.
And no, I'm not forgetting that through a ring-fence recommendation increased capitalisation of both the retail and investment operations will help, but an illiquid position is still on the cards and that is surely a point that should have been the core of the reforms, not the post-failure fall out?
Equally as Sir John Vickers has been saying in today's press calls: “the too big to fail problem must not be recast as a too delicate to reform problem”, but is he reforming or just adding insult to injury?
As the action of ring fencing is a unilateral action not being followed by any other major nation right now, it may be the latter.
Renowned former Federal Reserve Chairman Paul Volcker gets to the heart of the matter when he says 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.”
Sir John may claim the fence is high, but it cannot be high enough.
When a Barclays investment bank fails, it will still bring down Barclays Bank as Barclays investment banking operations represents 42% of the bank's total revenues (Royal Bank of Scotland generates a third of all revenues from investment operations; HSBC 27%; and Lloyds Banking Group is unceratin as it has no official investment banking arm).
Meanwhile, the costs are at least £4 billion to implement these reforms and the overall programme has really hammered the value of the UK banking sector in the world's financial markets:
With much of the loss of value this year due to Sir John's committee's actions combined with the Eurozone crisis.
So my key question is that we are living in a world where Basel III, G20 reform, European Union Directives along with American restructuring is creating so much imbalance in the global financial system that adding to such imbalance though unilateral action is questionable.
“Among just those working in the banking sector, however, support for the idea has collapsed - and while a small majority of bankers still back a ring-fence, net support have fallen from +46% to +15%. This is surely a reflection of recent rumbling in the press on the dangers of such a scheme to the sector.
Those working in the banking sector, however, thought the idea would make no difference in preventing a repeat of 2008, while thinking it would be actively damaging to promoting UK economic recovery, getting banks lending, as well as keeping HQs in the UK.
All in all, the whole area is a cauldron of trouble and messiness that this report has done little to resolve and, if anything, has fuelled more debate about the UK’s sole stance in the face of global regulatory drives.
So what should we do?
We should ensure that we work in harmony with Wall Street on the capital market reforms whilst implementing domestic policies to lower the barriers to entry for new entrants in banking.
The former may be seen as being difficult, but the #1 objective of the UK should be to maintain UK’s attractiveness as a centre for financial services.
That’s the piece that has been most badly damaged by these proposed reforms.
Luckily, it won’t be implemented until 2019 in order to ensure consistency with the developments of Basel III, so delay was inevitable after all.
A few further comments:
Andrew Gray, UK banking leader, PwC, said: “The report from the ICB today sets out a clear statement of the direction it believes should be followed in order to reduce the risks of banking in the UK, increase competition and ensure globally competitive banking based in the UK. The measures recommended will have a far-reaching impact on the way in which banks operate in the UK in future. A key question for government to consider will be the trade-off between improved financial stability and facilitating economic growth. The core proposals revolve around the use of ring fencing of retail banking activities to ensure both the financial stability of the banking sector, but also to ensure the government is not called on to rescue the banking sector in the future. Ring-fencing on its own does not change the risks inherent in banking (except when it comes to resolving failed firms) and the ICB recommends higher capital levels than those proposed by the Basel Committee. The importance of a strong banking sector as an integral part of the UK economy is clearly recognised, as is the need to ensure the UK remains a globally significant centre for financial services. Overall, these proposals, while not unexpected, will represent a significant change to the UK banking landscape. These are detailed proposals which will take time to digest and, in doing so, more questions will emerge. It is too early to assess the real impact on the UK banks and the wider economy. The real consequences will only become clear once the Government decides what is to be passed into law.”
Michael McKee, Head of Financial Services Regulation at DLA Piper, commenting on the Independent Commission on Banking - Final Report, said: "The ICB Final Report has stuck to the line set out in the Interim Report. Most interesting is the detail of how the ring fence will operate. It will focus on deposits of individuals and small businesses - but this is likely to catch a lot of private banking business too. The ring fence looks like it will be quite a "hard" ring fence - a retail bank will have to deal at arms length with other parts of the group and apply large exposure rules. Moreover the ICB sticks to its guns about a minimum level of 10% capital for retail banks and also wants a lower leverage limit than international proposals. Overall, therefore, the ICB has withstood political pressure from the Liberals but has taken a tough line on the content of its ring fence."
Edward Sankey, Chairman of the Institute of Operational Risk (IOR), said: “We are concerned that the Vickers Commission are proposing economic solutions to what they believe are economic problems. However the IOR believes that the root causes of the financial crisis were failures in people, processes and systems, which are the targets of operational risk management. The proposals will not on their own do anything much to reduce the possibility that failures by people, processes and systems will not again threaten banks and their clients. Time and again we have seen that more sophisticated regulation and restriction leads to more sophisticated efforts to find ways through them, or even plain evasion. We have a great opportunity to make lasting reforms that will not only help to ensure a sustainable and profitable UK banking sector, but also strengthen UK economic growth. Unfortunately the Vickers Commission is focusing on the wrong solutions – solutions that will do little to correct the failures in people, processes and systems that preceded the crisis.”
Andrew Wingfield from SJ Berwin’s Financial Institutions Group commented: “The ICB’s proposals totally focus on retail protection and would impose a cost ahead of any bank failure. The costs of restructuring and higher equity capital levels will place returns under further pressure and the ICB’s proposal will likely be a Herculean task given that people and IT systems are intertwined within banks. The key recommendation (in our view) is around a clear message to UK banks to ring-fence their operations with the tone of the political debate already showing signs of an irreversible process and the Government committing to immediate steps towards implementation. Over the next few weeks, it will be interesting to see whether support for the recommendations wanes as the party conference season approaches. However, the message is softened by a long final implementation deadline of 2019, which is intended to synchronise the timeline with the implementation of new international standards under Basel III. In our view, all Banking reform measures adopted by the UK authorities need to be carefully analysed in order to ensure that the full consequences on the economy and the recovery of banks’ ability to support customers is understood.”
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:
Another aspect of trading that cropped up last week was the whole thing about trading psychologies.
This was kicked off by one of the speakers, a Psychology Professor, exploring the psychology of trading.
In his and many other studies, trading is very much akin to madness, with ‘the deal’ being linked to gambling, sex and worse.
One of the best examples of such madness is described in the book and movie American Pyschoby Bret Easton Ellis, about a guy who is a Wall Street trader by day and a homicidal maniac by night:
“I have all the characteristics of a human being: blood, flesh, skin, hair; but not a single, clear, identifiable emotion, except for greed and disgust. Something horrible is happening inside of me and I don't know why. My nightly bloodlust has overflown into my days. I feel lethal, on the verge of frenzy. I think my mask of sanity is about to slip.”
A fine line between sanity and madness in the trading rooms of the world’s financial markets.
If you don’t think so, then checkout another fine book by David Charters, a former investment banker: “At Bonus Time, No-one Can Hear You Scream” (free eBook, courtesy of efinancial news):
“Last night I killed my boss. It was the second time this week, only this time it was much worse. He was sitting at his desk in his big, glass-sided, corner office, looking out at the trading floor with its hundreds of identical workstations, the computer screens, the phones, and us, the worker bees who feed the machine. Looking at us, as we stayed late in the run-up to the annual bonus round, putting in face time to look good, keeping busy, trying to persuade him how essential we all were. Well, I’d had enough.”
The truth is the markets are mad, and the people who work the markets are mad.
Want any more proof, then just check out the true story of the Wolf of Wall Street, Jordan Belfort:
As a 31-year-old multimillionaire stockbroker, Belfort once landed his helicopter on his back lawn, flying with just one eye open because he was so stoned he had double vision. He sank his 167ft motor yacht, complete with seaplane and helicopter, after overruling the captain and taking it into a Mediterranean storm. He organised a midget-throwing contest to entertain brokers on his trading floor. And when he wasn't completely out of his head on drugs, or getting executive relief from prostitutes in the presidential suites of luxury hotels, the man nicknamed the Wolf of Wall Street was presiding over a firm that swindled investors out of $200 million in a shares fraud that landed him and his chief confederates in prison.
I could name many more illustrations – both factual and fiction – of the madness of markets, but the core of how to work these markets is to detach the madness from the rational.
To be detached and remote from the action, and to watch it with a heart rate of 80bpm or less.
After all, going back to our psychology professor's presentation, he makes clear that it is emotions that ruin traders.
Citing experiments by various psychologists just shows that all sorts of factors from sunshine and clouds to wind and the cycles of the moon affects our trading strategies.
In this 2007 experiment, people were shown angry and happy faces and tested to see how it affected their decision making. Interestingly, those who had seen the angry and frightened faces were far more risk-averse than those who saw the happy ones.
If everyone’s happy, you follow the crowd; if everyone’s sad, you are too.
It’s all about the pre-frontal cortex and what makes us man, and is the reason why Warren Buffett says: “Be fearful when others are greedy, and be greedy when others are fearful”.
Another presentation at TradeTech that I was interested to hear was Larry Tabb’s.
Larry is CEO of TABB Group, a research firm focused on capital markets that Larry founded in 2003 after several years leading TowerGroup’s Securities & Investments Practice.
Due to our involvement in TowerGroup – I co-created TowerGroup Europe – Larry’s one of the interesting guys for me, as he has grown his firm to around thirty people today and has a strong knowledge of all things in the investment markets.
Larry has spent some time on the subject and forensically analyses it in depth in various research.
As we all now know, the flash crash began when one mutual fund group, Waddell & Reed, put in a large sell order for e-Mini futures.
This was on May 6th 2010 and it is important to remember that this was when there was a lot of economic uncertainty, with Greece imploding a lot of nerves in the markets.
Larry reckons that Waddell & Reed put in a sell order for 75,000 eMini contracts worth over $4 billion at 14:32 that day through their algorithmic trading machines.
The result was that Liquidity Replenishment Points (LRP) kicked into the NYSE index as algos started selling massively with other algos, and high frequency trading (HFT) systems were trading futures and eMinis among themselves looking for any systems out there that would trade.
Internaliser engines stopped trading and stub quotes - absurdly priced quotes that acts as placeholders when trading firms don't want to trade – were being issued for a cent each.
By 15:00, over two billion shares were being traded during a ten-minute period. Normally, you wouldn’t see that sort of volume of trading in a whole day.
Making matters worse, FINRA cancelled most of the trades that were placed at that time, describing them as ‘erroneous’, causing a huge reconciliations backlog of work.
What a mess.
Since the flash crash, the markets have seen some activity picking up to regulate this.
There are short-selling limits, circuit breakers and a tightening of market thresholds on NYSE and NASDAQ. There’s some other ideas about circuit breaker rules for limit up and limit down to ensure that trades are only executed within a range tied to recent prices for a security, as well as other direct access rules.
What was more interesting in Larry’s presentation is what’s also under discussion.
For example, having the algorithms used by trading firms checked and vetted by a competent authority or regulator.
How do you define what is an algorithm?
Do the authorities have the resources to fully investigate such systems?
Do they have the competence?
There’s a view that “time in force” rules need to be introduced for non-market makers. This rule ensures that buy orders stay in the markets long enough to be filled, as many buy orders are used to potentially lift prices using ‘flash orders’.
Flash orders appear in a short burst and are cancelled just as fast in order to change prices on exchange to the traders’ favour. Hence, the idea of flash orders causing the flash crash is in the regulator’s heads.
However, this rule is viewed as inappropriate by the markets, as exchanges queue orders at their servers and process them sequentially. Therefore, cancelled orders pose no threat to the exchanges. In particular, time in force is a problem as it would allow market makers to pick off the non-market makers and get market gains as a result.
There are other views in this area also, such as reallocating the cost of market infrastructure based upon order cancellation rates on a pro rata across trading firms. Again, sounds good in principle, but any reallocation of costs will simply get passed through to clients, so that’s not good either.
The Consolidated Audit Trial should allow regulators to track information related to orders received and executed across the securities markets and, similar to the FSA’s view, should allow date-time stamping and order flow to be monitored and audited.
This sounds good in principle, although Tabb estimates that this will cost over $4 billion to build and $2 billion per annum to maintain.
Sounds costly.
Finally, things like a Central Limit Order Book (CLOB), a ban on stub quotes and concentration rules to bring order flow back onto exchanges are all being mooted.
All of these have issues, particularly the last which has not only been eradicated in Europe recently (MiFID reversed the national exchanges’ ‘concentration rule’) but it also would force orders from dark pools into lit markets. That’s not good for liquidity.
So what should be done?
Larry split this into four buckets.
First, the easy stuff such as co-ordinated circuit breakers.
This is a good move as part of the flash crash issue was uncoordinated markets. As the flash crash began, CME hit the circuit breakers but NYSE hit the LRPs. This meant that CME indexed products stopped trading, but cash products carried on so, while NYSE stopped trading in the cash markets, other markets didn’t.
Co-ordinated market breakers is an easy thing to bring in under regulatory process as it would just ensure all markets are consistent in approach.
Slightly harder but do-able is the Consolidated Audit Trail, already discussed. Add onto this an increase in collateral held with the CCP for HFT firms, new pre-trade and post-trade risk rules, and this may all help.
Tabb sees it as being really harder to do things like CLOB, which is probably why this has been discussed for over a decade but still not happening.
And it is impossible and undesirable to even think of going down the route of algo vetting or introducing market maker incentives, transaction taxes or other rules, according to Tabb.
All in all, a great overview of a complex subject and something that is still under wide debate across the industry.
It will be interesting to see how the debate concludes and, going back to my regulatory DUPE discussion, how the market is squeezed and the resultant bubble that forms.
I was at TradeTech the other day, one of the largest conferences and exhibitions focused upon buy and sell side technologies.
It had a good attendance and agenda, although I did wonder why it was sponsored by Virgin Money.
As I walked into the London Excel Centre, where this year’s TradeTech was held (next year it looks like being back in Paris), I was amazed at the over-the-top Virgin branding all over the walkways.
Maybe this is the new ploy of Jayne-Anne Ghardia, the Virgin Money CEO, who has decided to take on Goldman Sachs rather than easier targets like NatWest.
But no!
In a BBC interview this weekend, Jayne-Anne makes it quite clear what their strategy is:
The five big banks are much of a muchness, so people can't understand what difference in service they'd get if they went from bank A to bank B.
Transparency would help with that. They feel they could have their standing orders and direct debit left behind, because it's not straight-forward to transfer your account from one bank to another.
I have been pushing to have a portable account number, like one national insurance number for every employer, and one telephone number you can take with you whichever provider.
As she only mentions five banks in that quote, it's obvious they are more interested in retail than investment banking.
Oh, and then I get into the Excel Centre and find that the London Marathon registration desk is there sponsored by Virgin Money, and nothing to do with TradeTech at all … ah well.
Then I find there’s a bunch of folks shouting and chanting.
They’re protesting about something to do with BP.
Banker’s Pay?
Banks’ Profits?
Banking Panaphobia?
Oh no, it’s something far more mundane … Broken Pipe … sorry, no scrub that. It’s just the BP Oil Company, suffering from lots of protestors who seem to dislike them for some reason.
Their AGM happened to be taking place the same day as I’m walking into TradeTech.
Wow!
It’s a busy morning already and I haven’t even got into the show yet.
Then I do and it’s the usual TradeTech with lots of buzz about the flash crash and concerns about the future.
… you do wonder why the head of MI5 is so well-known to the world, but then it’s no longer the secret service. Instead it’s just another government department or, as chair for the day John Humphreys kept saying, it’s all about Spooks.
In this case, the Spooks are the ghosts of the secret service who quietly target terrorists all the time and generally keeping the bad guys at bay, day after day.
It’s not MI6. That’s James Bond, M and Q. They keep the bad guys out overseas. MI5 target the bad guys in the UK, but it’s much the same line of work.
What’s this got to do with trading strategies you wonder?
A lot as it turned out, as her theme was all about dealing with challenge and making difficult decisions under pressure.
We are “sifting through a torrent of information all the time, looking for the one bit that might indicate when something will happen”, she began.
Wow! That’s what traders do, using technology to sift through thousands of bids and offers all day to find the ones that match.
Baroness Eliza was head of MI5 from October 2002 to April 2007, during the period of the shoe bomber, the bottle bombers at Heathrow, the 7/7 tube bombings of 2005 and the follow up shortly after on 21/7 when the bombs luckily didn’t ignite.
A dangerous period.
The issue, she stated, is that you have all this data but “if you go too soon, there’s not enough evidence to charge; go too late, and the bomb’s gone off.”
This was the issue of 9/11 apparently, where “we knew a bomb was going to go off – just didn’t know where or when.”
What was worrying is that “if the plot at Heathrow had worked, it would have been far bigger than 9/11.”
This was the 2006 terrorist plot to detonate liquid explosives on at least ten airliners travelling from the United Kingdom to the United States and Canada.
MI5 intelligence caught the plan before it was executed, but it resulted in the introduction of these dreadful restrictions of 100ml bottles as a limit on all carry-on luggage.
She was asked if that was really necessary during the Q&A, and said that “the liquid bombers had drilled a hole in the bottom of a drinks bottle. They had then taken the drink out, filled the bottle with liquid explosives and the bottle looked unused because the seal on the top of the bottle was unbroken. They then had disposable hammers that would act as the detonator by hitting the bottle from underneath. It was easy if they had got away with it. For these reasons, removing shoes and liquids at airports does make sense.”
You may or may not agree, but the scariest part of her presentation was probably the bit where she said that “7/7, 21/7 and the shoe bomber were all under my watch, and two out of three failed due to the incompetence of the terrorists. However, there were 12 other attempts you didn’t see …”
It’s all about finding needles in haystacks using intelligence and technology.
We are pleased to provide our monthly monitor of MTF performances in European Equities trading, in partnership with Thomson Reuters Equity Market Share Reporter (EMSR).
* these figures reflect auction and non-auction transparent order book and dark pool trades, but excludes real-time and post-trade on-exchange reported and off-exchange OTC trades in order to provide a true comparison between the MTFs impact and the traditional exchanges.
OK, so I said that banks would absolutely not be disintermediated last week, and it sparked some interesting debate and dialogue.
A few folks were incredulous that I could say this; others thought it made eminent sense; some noted that the movement of money could be disintermediated, but the holding of money could not; whilst others were up in arms over the fact that I could possibly believe any of it.
Well, for those who know me, it was written with a deep sense of irony and disbelief.
I absolutely believe that banks will be disintermediated and have believed it for a long time.
However, I also believe that some of the system will be protected and will never be destroyed or replaced.
This is the part that governments are regulating, protecting, licensing and calling too big to fail, or 2B2F.
The 2B2F area is the core of the monetary system, and needs to be protected.
If your social media account is compromised, it doesn’t matter too much that someone sends a status update saying: “I’m flat on my face in a flap” or worse from your account.
Sticks and stones will break my bones, but names cannot hurt me.
Losing money can hurt though, so it does matter if they steal all your worldly wealth.
This is the part that will never be disintermediated, and I guess that’s the part that Nancy Pierce of HSBC and Mark Buitenhek of ING were saying is core.
“We will absolutely not be disintermediated … who’s better to move the money than the banks?” Nancy Pierce, Head of Product Management for Payments and Cash Management Europe, HSBC
“Banks need to reinvent themselves as they will be disintermediated by other banks, because we are the only ones that are trusted for secure transaction processing.” Mark Buitenhek, Global Head of Payments and Cash Management, ING
But it’s open season for the rest of the financial system and yes, there are companies that claim they could replace VISA, MasterCard, SWIFT and other infrastructures.
In fact, as discussed on Monday, it’s warfare between the banks, card processors and PayPal.
The iDEAL system originating from the Netherlands gains more traction for banks across Europe as an alternative to PayPal; this is in the same moment as AMEX opens a P2P platform, as does VISA, as an alternative to PayPal; and this is in the same breath as PayPal stretches out towards physical store paypoints to compete with VISA, AMEX and MasterCard, as the online world merges with the offline.
A similar story can be seen in capital markets where the rise of Chi-X, from upstart electronic trading platform to the biggest trading system in Europe, took place in just two years (doubleclick image to see full size version):
A similar story can be seen with BATS in the USA, which is why BATS is buying Chi-X.
So disruption can occur.
In the latter case, it’s down to deregulation.
In the case of PayPal, it’s down to disruptive innovation and the dilemma of something that appears to be innocuous at first but soon becomes mainstream, e.g. with $4.2 billion revenues forecast for 2011, PayPal is now almost half the size of Citigroup’s Global Transaction Services business.
The real issue of disintermediation therefore, is not around the core of banking – the holding money area that is protected by banking licences – but around the boundaries of banking.
The thing is the boundaries is where all the profit lies.
The boundaries is everything from savings to investments, cards to loans, trade finance to treasury dashboards, insurances to wealth management, foreign exchanges to bond markets, pensions to mutual funds, swaps to futures, mortgages to marriages …
In fact, everything in a bank can be broken down into components of functionality and then traded in and out by new competitors.
Source: ACI Worldwide
This is the picture I’ve talked about for a while, where all of the processes and functions of a bank can become apps that users can download and integrate to build their own bank.
The Build-Your-Own-Bank (BYOB) is the new generation of banking.
It’s the generation where anyone from a banksimple to a Mint can step in and take out a piece of core banking.
That’s what disintermediation is really all about.
Taking out the parts of banking where there is not enough competition, and leaving the bits of banking that aren’t worth competing against … which is the part that is protected by licence because it’s too big to fail.
BYOB will absolutely be disintermediating, whilst 2B2F will never be disintermediated.
That’s the real bottom-line.
“Could we see a wholesale version of Zopa or PayPal? Yes, I think we can.” David Birch, Director, Consult Hyperion
“Disintermediation is well under way, and will happen very quickly.” Daniel Marovitz, Head of Product Management, Global Transaction Banking, Deutsche Bank
Just sat through a day of academic debate about the financial crisis and how much technology was to blame.
We’ve had these blame games many times in the past, usually to try to point a finger at an individual like Greenspan or Brown, so taking the finger to point to an inanimate pile of metal processors was going to prove interesting I thought.
But it wasn’t, as this was run by the London School of Economics who pretty much made the day a disinfected affair with professors emeritus pondering and pontificating.
As one of my friends said: “an academic is someone who looks at something working in practice and wonders what it would be like in theory”, and this was the case here.
However, there were a few brighter spots, including addresses by CIOs from the European Central Bank and Royal Bank of Scotland.
The real point of the whole day was to point to the origins of the crisis – the rich and diverse world of derivatives – and to say that the complexity of quantum analytics that drove us down the spiral of debt was due to the systems handling our formulas in such a way that it made it look like risk was managed … but it wasn’t.
In other words, the computers messed up.
One speaker pointed out that risk was hidden because regulators focused upon individual financial institutions instead of systemic risks across the industry.
Another talked about the origins of the Black Scholes system, and said that “it wasn’t technologists who caused the crisis, but physicists”.
Another mooted the scale of computing, and how complex analytics had moved us into grids, data centres and clouds, that provided unlimited processing and scalability. Hence, what could never have been mapped, simulated or contemplated before could now just be modelled and deployed overnight.
Whatever your view, systems are a contributor to this crisis, but it’s not the systems that caused it but the people who programmed them. So here’s my potted view of how technology exacerbated the crisis and what will happen next …
Back in the 1960s, markets were inefficient and ran on open outcry systems where lots of men stood in pits shouting at each other.
These men were “chaps” and “blokes”, with the chaps being the ones who wore top hats and the blokes bowler hats.
The top hat brigade didn’t like the bowler hat lot – mainly because blokes spoke with common accents shouting out things like “cor blimey guv’nor, catch a load of this stock at five and ten” – and so they found a new-fangled thing called a computer and wondered what they could do with it.
Luckily, two men called Fisher Black and Myron Scholes came up with an exceedingly complex formula which they called the Black-Scholes formula as they were very imaginative.
The formula meant that if you were buying or selling stocks, you could break the buy or sell order into pieces and manage the risk by placing the purchase with other related instruments in a derivative.
Luckily, this formula was perfect for the computer age and allowed the chaps who could afford such technologies to trade bits of equities.
This was no big deal as the processors back then were not very sophisticated – a mainframe would have been the equivalent of your Nokia mobile of five years ago – but it did allow some complex analysis to begin.
In particular, it allowed the age of leverage to start, and introduced new disciplines in market and credit risk.
This bubbling area of derivatives and risk didn’t really take off until the 1990s, when systems had become more and more distributed, powerful and capable. Such systems enabled the chaps to do more hedging and complex investment strategies began. This was further supported by electronic trading, which had also increased in prevalence after the automation of the main markets in New York and London known, over here, as the Big Bang.
Now things were getting a little more efficient, and markets started referring to exotics and “the Greeks”. And risk became more destructive as a result with Nick Leeson destroying Barings Bank; Long Term Capital Management (LTCM) almost blew up the financial world; Frank Quattrone was indicted over the internet boom for misrepresenting IPOs; and Henry Blodget got into trouble for mixing securities research with securities trading.
What was really happening is that the mixture of market greed and gaps in regulations allowed many to create more and more complex risk.
Risk management was evolving and trying to keep up, as were the lawmakers, but creative and innovative masters of the universe were seeing the opportunity to combine processing power and automated trading with arbitrage and exotic instruments to create ever increasing returns at the expense of those who did not have the ability to make these combinations work.
And yes, there were some big deals like LTCM but the markets coped.
That was until David Li’s formula cropped up.
David Li’s formula is the one that almost killed Wall Street, as Wired Magazine so eloquently put it, and it goes like this:
No big deal.
But it is a big deal as it created a number of false assumptions and operations.
First, it made traders believe credit risk was managed and covered, when it wasn’t.
Second, it ignored real world assets to simulated models, and hence separated two key areas that were mutually inclusive and made them mutually exclusive.
Third, it didn’t incorporate the new forms of market risk we now look towards, namely liquidity risk and systemic risk.
And the real issue that occurred is that the trading systems leveraged the formula to death because, just as this formula was released, electronic trading moved a step forward into algorithmic trading and high frequency trading.
This is why the FSA’s Prudential Risk Report 2011 shows that credit went through the roof over the last forty years.
Similarly, worldwide, OTC Derivatives exploded from a market worth $100 trillion in 2000 to $300 trillion in 2005, growing at thirty percent year on year. It then gathered momentum to grow at forty percent per annum from 2005 through 2008 reaching a peak of almost $700 trillion when the crisis hit.
This debt and credit explosion was a result of the dangerous concoction of leverage, OTC derivatives, unregulated markets, complex analytics and unlimited processing capacity.
This heady mixture had stepped up the financial game into markets that were unmanageable.
From a systems viewpoint, the technology enabled and supported this explosion but was not the cause. The cause is the humans who program the systems.
But the systems capabilities are illustrated well by the fact that, in 2000, the New York markets were processing around 5,000 electronic trade movements per second. This has now risen to levels of over ten million per second.
The financial markets have flared up server processing on an unprecedented scale.
For example, RBS Global Banking & Markets are using over 20,000 server blades for core market processing today, compared to a single processor two decades ago.
And, as the BBC reported last week, those processors are now operating at near the speed of light: “Trades now travel at nearly 90% of the ultimate speed limit set by physics, the speed of light in the cables”.
How fast is that?
Well the speed of light travels at around 299,729,458 metres per second, or near 300,000 kilometres per second, so systems are moving trades around at about 270,000 kilometres a second.
Pretty darned fast if you ask me.
In real life, Professor Doctor Roman Beck of the e-finance laboratory of the Goethe University Frankfurt, says that we’re moving electronic orders around at 5.8 milliseconds between London and Frankfurt. That’s about 52 trips between here and Frankfurt in the time it takes you to blink your eyes (a blink being around 300 milliseconds).
Not bad.
So, we have these completely automated systems processing everything in lightning fast speeds globally with all the opportunities for a bit of a byte of a stock or commodity being built into complex arbitrage systems with unlimited scale and processing power.
Sounds like a recipe for a disaster if you ask me.
And it has been.
But it’s also been a recipe to allow some firms, such as Goldman Sachs, to generate $100 million profit every day that they’re open for business. Consistently.
So where does this leave us?
In a bit of a bind I guess.
We’re not going to get rid of these systems, processors and capabilities are we?
But equally, can we effectively control and regulate them?
I think not.
As the general counsel of Salamon Smith Barney is quoted in Liar’s Poker: “My role is to find the chinks in the regulator’s armour”, and that attitude prevails.
So whilst systems look for chinks, the fragmentation, complexity and geographic spread of systems and regulations allow for arbitrage … and that makes money.
This is why there is no way to demand and force transparency on the markets. For all the calls of the FSA for real-time liquidity reporting, that reporting is meaningless if the Shanghai or San Paolo operation of the financial firm is leveraged to the hilt.
And the idea of a global response to this is also unlikely.
As one speaker said here: “I don’t trust any solutions that claim to be global as most global projects fail”.
Maybe he was involved in the GSTPA or similar ventures.
So the solution: to continue to try to regulate in hindsight and hope that the banks, in foresight, don’t create unsustainable or unmanageable risks.
We are pleased to provide our eleventh month of monitoring the MTF performances in European Equities trading, in partnership with Thomson Reuters Equity Market Share Reporter (EMSR).
* these figures reflect auction and non-auction transparent order book and dark pool trades, but excludes real-time and post-trade on-exchange reported and off-exchange OTC trades in order to provide a true comparison between the MTFs impact and the traditional exchanges.
Recent Comments