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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.
Talking about the St Paul’s protesters yesterday, you do wonder if they maybe have a good point or two to make.
Like their American counterparts, I’m sure they do but unfortunately it’s all a bit loose and airy-fairy, with a mixture of happy-clappy hippies, anarchistic anti-capitalists and an articulate few who can say it’s all about corporate greed.
Trouble is that’s too loose and unfocused to be an agenda for change that will work.
What’s needed is a singular objective such as: tie every corporate action to something that delivers benefits to society, or something like that.
A method whereby every transaction, every commercial movement, every electronic transmission submits a direct benefit to communities, citizens and taxpayers.
It doesn’t have to be in a tax form – it could be committing staff time to community projects – but it has to be allied, linked and integrated into commerce directly and with transparency.
Anyways, that’s not my agenda.
My agenda is banking and what needs to change there, and it was interesting talking with bankers yesterday about St Paul’s and other matters, in that the subject of religion came up several times.
Morals, ethics and religious focus is a mantra that’s been around a while now.
It first came up for me when I presented at Gresham College a couple of years ago.
At the time, there was this big debate about much of banking being ‘socially useless’, and how to turn this into something socially useful.
Various banks made commentary about this theme, and it was interesting that the two most outspoken leaders were both lay preachers: Sir Stephen Green, Chairman of HSBC at the time, and Ken Costa, former Chairman of Lazard International.
Back in 2009, both were talking about the industry losing its moral compass and how it was requisite to bring that bank.
The latter is now very active in making that happen by promoting an ethical code to the City, after leaving Lazards in March this year.
The issue for Costa is one of faith, as he is very active in the Church.
This is why he’s penned several articles about faith in commerce, with the latest in the weekend Telegraph saying that the City must rediscover its morality.
In the article, he states that although he believes that free market are the best way to create growth and jobs, boards and shareholders must have a better understanding of what constitutes real value.
“The present duty – on all boards to maximise shareholder value as the sole criteria for satisfying the return to shareholders – cannot continue. I am aware that this is a big change that will need detailed discussion, but we need to start with big ideas.
“For some time and particularly during the exuberant irrationality of the last few decades, the market economy has shifted from its moral foundations with disastrous consequences. I cannot recall when public feeling worldwide has run so high, and even if only a minority takes its anger on to the streets, no one should imagine that the majority is indifferent to their cause.”
Mr. Costa should know what he’s talking about as he’s been appointed by St Paul’s to negotiate with the Occupy London Stock Exchange (#olse) group to see how to create an ethical corporate agenda for change.
He’s actually supported by a large group of people called: The City.
It may be surprising to some that the St Paul’s Institute ran research that was about to be published as the protesters moved in, which discovered most City workers believe inequality is a real issue.
The survey interviewed 515 financial professionals during August and September, and found that 75% thought that the wealth divide is too great and two-thirds believe that bankers are paid too much.
Interestingly, over half stated that deregulation of the financial markets had led to unethical behaviour (you can download the report if interested).
And maybe there’s the point.
Historically, banks have had a religious backbone.
For example, in my meeting yesterday were former directors of Barclays Bank and Barings Bank. Both said they started each day with “Director’s Prayers”, with a salutation to God each morning as a group.
That backbone has been lost since the Big Bang, they claimed (October 1986).
One of them said that the City would fall apart if you practiced what God preaches.
When queried, he clarified to say that you buy when you think the seller is an idiot and you sell hoping that the buyer is one. That’s how to make money in the City, and that’s where the ethos breaks down.
Does this mean that we all have to move to Sharia rule?
No.
But it does mean a change of thinking, a return to grass roots and a way of looking forward with more certainty.
This was the core of Bob Diamond’s speech to the BBC Today Lecture last week.
Bob Diamond is the CEO of Barclays Bank and, in a lengthy speech, he focused upon trying to answer the question as to how bankers can become “good citizens” again.
“First, we have to build a better understanding of how businesses and banks work together to generate economic growth; second, we have to accept responsibility for what has gone wrong; finally, most importantly, we have to use the lessons learned to become better and more effective citizens.”
He feels that banks have done a poor job of explaining how they can be ‘socially useful’ and makes clear that So banks make sure that a banks role is to make it easy for companies and governments to access capital by establishing a large consistent market of buyers and sellers.
“To do this they put capital at risk in order to discover what the market is willing to pay. When banks do this well, interest rates are lower. If interest rates are lower, government and business borrowing costs less. Without this, the result is clear - an increased cost of borrowing, higher taxes, lower public spending, slower economic growth and higher unemployment. Providing this kind of support to clients requires banks to take risk but this is not speculative trading, so it bothers me when these activities are caricatured as gambling.
“These activities serve a social purpose and meet a real client need whether they are carried out on behalf of governments, pension funds businesses or individuals.”
Critically, he makes the point that just as bankers caused the crisis they can also put it right.
“First, it's about how we behave, especially with our customers and clients; second, it's about what we do, and in particular how we help those customers and clients create jobs and economic growth; and third, it's about how we contribute to the communities we serve in many other ways.”
It’s a good speech – although some critiqued it as just being platitudes, motherhoods and apple pie – but as Bob says at the end:
“To the question ‘can banks be good citizens?’ the answer must be ‘yes’. But I'm mindful of what was said to me three years ago: ‘Bob, think about the fact that no-one will believe you.’ We're in the early stages of working to restore trust. I'd like to be able to say we're achieving that, but I know that for you, seeing is believing. You may not be able to see what's different today, but over time I very much hope you will see that and more.”
And note, he doesn’t use the words religion, ethics or morals once in this speech.
It’s not a question of religion.
It’s a question of culture.
“Culture is difficult to define, I think it's even more difficult to mandate - but for me the evidence of culture is how people behave when no-one is watching. Our culture must be one where the interests of customers and clients are at the very heart of every decision we make; where we all act with trust and integrity.”
Damn right.
And I’ll be watching to see just who makes decisions with trust and integrity.
I guarantee that under these definitions, it isn’t Goldman Sachs.
Lloyd Blankfein on the one hand claims that their bank is doing "God's Work" whilst, on the other, when asked by Senator Carl Levin at an SEC hearing last year: “Do you think (investors) care that something is a piece of crap when you sell it to them?”, Lloyd calmly answers: “no”.
There’s something slightly hypocritical in that response isn’t there?
And whilst one maverick firm can break the oath of morality to do what’s right, then all others have to follow to compete is the usual mantra.
A moral compass, an ethical view and a religious purpose in banking – or, just being a good citizen – surely has to merit a bank doing what’s right for the customer.
Until some banks and bankers get that through their thick skulls and cultures, nothing has changed.
Just tweeted to our friends in the #OccupyLSE group – that’s Occupy the London Stock Exchange (LSE) for those who are not aware of the protest outside the LSE at St Paul’s – that I attended a meeting at the London Stock Exchange this morning.
Yes, I occupied the LSE!
Well, just for an hour in order to hear the thoughts of one Jim O’Neill, Chairman of Goldman Sachs Asset Management.
Jim is the man who coined the term BRICs for the growth countries of Brazil, Russia, India and China ten years ago (his paper was published in November 2001).
Since then everyone has taken the success story of China as read, although it has also been noted that the Brazil, Russia and India growth story also came true.
Now, ten years later, Jim was asked the question by the LSE: “Do BRIC countries still need the West for growth or is the reverse now true?”, and this was the theme of his presentation.
Here’s my spin on his talk (this is not a direct transcription therefore):
The question “Do BRIC countries still need the West for growth or is the reverse now true?”, couldn’t be more apt after the G20 meeting in Cannes last week. In fact, I would claim that this is the most important question facing global economies and leaders today.
And my answer is yes, the reverse is true.
The West has been the most challenged since 2008 as their deleveraging crisis has been with them ever since, and the BRICs are an ever increasing part of the solution.
That being said, the BRICs are living in the same planet as the rest of us and cannot let the West completely implode. For example, as we watch the troubling worlds of Greece and increasingly Italy, the BRICs are seeing more and more impact.
This is especially key for London, in its role in global finance, and is illustrated by the interesting events taking place a few yards away outside St Paul’s Cathedral (where the occupy LSE movement is demonstrating), which means it is very important that all of us involved in business and finance get a bit more objective about the issues being discussed in public forum these days.
Over the last decade the nominal increase in GDP amongst the BRICs has been greater than any other group of countries, apart from the G7.
This is difficult for people of my generation to see or accept, because it is new, although younger people get it far more easily.
Maybe this is because older people find it hard to adapt or change.
During the last decade, the GDP of G7 increased by $11 trillion.
Meanwhile, the Growth8 as I call them – the BRICs plus Indonesia, Vietnam, Mexico and Turkey – increased by a similar amount.
These countries are therefore so economically important that it’s rather sad and stupid that people still call these countries “emerging markets” when they have now emerged, and are contributing so much to growth and global markets. We should call them something else, which is why I choose to call them the Growth8, as opposed to other countries which are emerging markets.
BRICs represent 80% of the Growth8’s $11 trillion growth in the last decade.
The ‘C’ in particular – China – has seen its GDP increase faster than the USA in the last decade.
Another example is Brazil, which has seen GDP increase faster than Germany, Japan and the UK.
From 2010 to 2019, the Growth8 will again rise faster, with China still leading the way.
BRICs will see GDP growth of over $12 trillion of the $16 trillion rise in the Growth8, with China contributing around $8 trillion, or half of that GDP growth. This assumes an 8% average growth rate in their economy, so it assumes China’s growth will slow down.
However, if you look at the figures, the USA will only grow about $3 trillion in GDP by comparison, and Euroland by under $2 trillion.
In these figures, you would need a magnifying glass to see where Greece would sit in the global economy. It’s not big enough to matter.
For example, China will grow by the equivalent of three Greece’s this year – it creates a new Greece GDP size every four months.
Unfortunately that is not the case with Italy.
Looking to the future, the global share of GDP in 2020 will be 41% for the G7; and 35% for the Growth8. Of these, 27% of global GDP will be with the BRICs; 19% with the USA; 17% for China; and 16% for the whole of Euroland!
So during the next decade, the BRICs will be bigger than the USA.
This is important change, as the G20 and IMF are already changing their thinking about the BRICs.
For example, the IMF said at last week’s G20 meeting that it is going to review its Special Drawing Rights (SDR) basket of currencies before 2015, when it was next scheduled for review.
This implies that the Remnimbi (RMB) will be brought into the SDR basket before 2015 because China has moved far closer to full convertibility of their currency sooner than expected, which is incredibly important for everyone in finance, whether you invest in China or not.
This means that debt or equity issued in Chinese RMB becomes normal, which is infinitely more important than what’s going on in terms of Greek and European politics.
For example, when we berate others about their fiscal affairs we have to be careful as, when you look at the budget deficits and government debt, it is clear that this not a sovereign debt crisis.
The gross government debt, as a percentage of GDP, in particularly high in the UK (85%), USA (100%) and Japan (233%) are far worse than in the Eurozone, but their governments still have highly rated sovereign debt.
So the Eurozone issue is more a question of revealing the issue of the weakness of the European Economic & Monetary Union (EMU), rather than a question of sovereign debt.
And if you look at debt in the Growth8, the gross government debt as a percentage of GDP is under 25% for many.
This is why these economies are so key to the future and is illustrated by retail sales.
Retail sales since 2007 have dipped significantly in advanced economies but, in growth and emerging markets, are going up rapidly.
This is why German exports in the last four years have seen the biggest rise in sales to China, India and Russia. By 2012, Germany will be exporting more to China than their neighbour France, which is a real shock.
This demonstrates why the BRICs are now independent of the West and the West needs them far more than they need us.
But the BRICs are not some homogenous area or singular market.
Two are democracies and two are not, and their wealth is very different. Brazil and Russia average around $15,000 a head; China $5,000; whilst India is under $2,000; so they are not similar in terms of wealth or politics. Equally, they differ in content with two commodity producers and two importers, so they are not a region together.
The fact that they now meet as a group annually however is a symbolic move to Western leaders for change in economic governance, and to have these guys at the centre of it.
For example, the G20 is way too big and ugly, so we need a new G7 or G8, of which the BRICs and China will form a key part. For the UK and Canada that’s tough as, in terms of their size of GDP, it makes you wonder what they’re doing there.
The real topic now is what’s happening to Chinese inflation.
It should get under 4% next year, which will be massively important as it will stop China’s tightening of monetary policy and will help the global economy as a result.
We should also note that 2020-2029 might be India’s decade.
China’s demographics will create a turndown and growing anywhere near 10% per annum will be tough a decade from now.
India has great demographics however, with India’s working population increasing by the size of the total USA population in a decade.
Finally, political instabilities are a factor in this outlook.
We have a Goldman Sachs Growth Environment Score (GES) that looks at 13 variables related to the sustainability of growth and productivity, and India scores the lowest of the BRICs on this score.
So when people ask me if I was mistaken about Russia being in this list, I respond by saying I’d take the ‘I’ out of BRICs before the ‘R’.
India is challenged in terms of sustainable growth due to government finances and the lack of a credible framework for economic policy. They also have many other issues of corruption and indecisiveness, which means that they can conceptually be a leader by 2020 or after only if they address these challenges first.
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?
I’ve enjoyed the Banker’s Top 1000 listings for a long time now and, when last year’s listings came out, looked back over the last twenty years to see how things had changed.
This year’s list has now just been published (get a copy by subscribing) and makes for interesting reading, especially as Chinese banks have finally made the big time (doubleclick image to see large version).
All in all, this list when combined with my reflections in 2010 over the last twenty years, makes for a fascinating story of risk bubbles and bursts.
You had the banks from the rising sun rising up the charts in the early 1990s.
Then, as the Asian crisis nuked most of the region, the Japanese banks disappeared and the Anglo-Saxon banks took over.
The principle-led regulatory regime was rife and the Americans and Brits ruled until 2008 when their “debt whore” approach failed.
Now, everyone is bailing out everyone else, with PIGS, TARPS and QE’s by the shedload.
So last year’s list was interesting, in that we finally saw Chinese banks rising up the list and more diversity as the American and British banks stumbled a little.
I have been saying that China’s banks will dominate global banking since 2005, and certainly there is a growing swagger of China’s banks as they watched the failure of the West.
For example, it used to be that Chinese bankers were desperate to learn how the West did banking and would send troops of managers to European and American conferences to learn their ways, as well as hiring the best talent to import into Chinese territories.
Back then, we all scoffed at Asia for their poor risk management of credit leading up to the 1997 crisis, with debt defaults and NPLs everywhere.
Now the Asians and Chinese may scoff at the West for the same reasons, although there is still risk in the Chinese system as most enterprise is propped up by financing given through the governmental influence over the banking system.
That aside, the fact that China's market capitalisation will rise to $41 trillion by 2030 from $5 trillion today, according to Goldman Sachs, makes it a market that cannot be ignored. After all, this would make China's stock market the biggest in the world, as American market capitalisation rises to $34 trillion from $14 trillion over that time.
This is one of the reasons why this year's Banker list is important as, for the first time, THREE of the TOP TEN banks of the world are Chinese. Last year, there was just one.
This year, four of the top twenty banks of the world are Chinese, when there were none just a few years ago in 2004’s list.
So, no matter the risks, China’s banks have finally risen to the top ... but at what risk?
The original Asian crisis was created by a higher than expected percentage of Non-Performing Loans (NPLs) and Moody’s has recently downgraded China’s banks on the basis that “8 to 12 percent of all the loans made by Chinese banks could go unpaid. Moody's had earlier estimated only 5 to 8 percent of the loans would be classified as ‘non-performing’.”
If China has a financial crisis, then we really will all be up the swanee ...
Investment banking has had a rocky year all year. Pilloried by politics, public and the media, the investment banker is currently about as popular as a Vampire at a Blood Bank ... not a bad analogy as the refrain all year has been about that giant Vampire Squid that is known as Goldman Sachs.
Goldmans do bring it upon themselves though, as paying $111 million in bonuses this year sits badly with the average Joe. And I must admit that any bank that makes $100 million a day in profit most days, along with an admittance of how they manipulate markets and screw customers, has to be suspect.
The trouble with this is that it brings a whole cloud over the industry, as all banks are now viewed as being casino capitalists, robbing the economies to line their pockets with cash.
However, it does mean that most of 2010 has been taken up with regulators and politicians wondering what to do about things like ‘dark pools’ and ‘high frequency trading’.
DARK POOLS
In the case of dark pools, they suspect these of being suspect because of the market manipulating suspicions created by the world’s leading investment bank, Goldman.
It means that regulators have been looking with deep scrutiny at trying to raise the illuminations on dark pools, even though these pools are argued to be good for markets as they increase liquidity by allowing block trading to occur that would otherwise be avoided if such trading was transparent.
Certainly, in Europe, the new revisions to MiFID could damage such trading, as illustrated by this May article from Financial News:
“NYSE Euronext and Deutsche Börse, have argued the regulators should use MiFID II to clamp down on the trading venues, known as dark pools, arguing they lack transparency and are open only to institutional investors, but not retail investors.
“But Rolet, who this week marks his first anniversary as chief executive of the UK exchange, said: ‘The biggest challenge is transparency and the balance between retail and institutional needs. Without institutional crossing networks (the so-called dark pools) some of the latent wholesale liquidity would go unexecuted or be simply more difficult to execute.’
“He said bank dark pools, which enabled customers to trade large orders privately away from the glare of the public exchange order books, served a valuable function in a market where there had been a sharp reduction in average trade size resulting from algorithmic and arbitrage activities.
“He added: ‘Transparency may have diminished in some areas but in formulating a response we should be careful to ensure that the differing needs of wholesale and retail participants are properly recognised.’
“The LSE chief executive and the exchange’s largest investment bank members, believe strict rules on bank dark pools would make it more expensive for institutional customers, such as pension scheme managers and hedge funds, to execute business.”
The result is that the European Parliament took on board a report produced by Kay Swinburne, rapporteur to the Economic and Monetary Affairs committee of the Parliament, during the summer recommending that dark pools be reclassified as multilateral trading facilities (MTFs) or systematic internalisers (SIs), and therefore lit.
The report has now been adopted as part of the MiFID review, and also places limits on order sizes. In other words, it wipes out the very reason for dark pools, as in large block orders placed outside the general exchanges to avoid market movements in advance of the order placement and processing.
HIGH FREQUENCY TRADING (HFT)
Swinburne’s report goes further and recommends a number of other restrictive changes, including:
Making High Frequency Trading (HFTs) subject to mandatory liquidity provisions;
An “ongoing regulatory review” of the algorithms used by HFTs;
Making Multilateral Trading Facilities (MTFs) such as Chi-X Europe, subject to the same level of supervision as Regulated Exchanges.
In particular, there is a focus upon HFT, which has been augmented after the issues in America in May that created the conditions for the ‘flash crash’, something I’ve blogged about too often this year.
Therefore, I won’t do it again, except to say that between targeting dark pools AND HFT, the regulators are doing their utmost to kill any market liquidity and alpha investing strategies that exist.
Is that a good thing?
No, because the regulators are in danger of throwing the baby out with the bathwater.
REGULATORY NIGHTMARES
This was demonstrating by the reactions of the corporates, where they made it clear that the discussions of regulators about ‘systemically important’ and ‘commercial activities’ was purely speculative wording with no practical implementation ability.
In fact, it is concerning that the regulations being developed will more likely kill the markets:
By clamping down on bonuses, investment bankers will all move out into hedge funds and private equity;
By eradicating risky activity, regulators are also eradicating worthwhile investment activity;
By locking down trading pools and practices that create liquidity, markets will seize up and cough and die;
By demanding collateral placement to cover trading exposures, markets will be more restricted to just the largest players with deep pockets; and
By banning prop trading, market makers will no longer make markets and trade and investment flows that fuel economies will disappear.
And none of the above really addresses the issue anyway, which was how the risk models created by the markets enabled massive risk exposures to be allowable when they were clearly, in hindsight, untenable and unworkable.
Where’s the regulation that addresses this area?
Which part of the regulatory structures of Dodd-Frank in the USA and MiFID II in Europe is addressing the fundamental question: how to eradicate products in banking that fuel risk, if the risk model has not been proven, tested and is comprehensible and comprehensive.
Meanwhile, we have had a few other key areas of regulatory focus, such as how to unravel a major global bank in 48 hours so that we can allow the too big to fail banks ... to fail.
CLEARING AND SETTLEMENT
Finally, there has to be a nod towards clearing and settlement. The whole clearing and settlement field is still a mess, with most of Giovannini’s barriers still unaddressed. That’s because of national market interests and focus.
During SIBOS, this all became clear as we spent so much time discussing interoperability that it became a buzzword, and we all know what you do with buzzwords don’t you?
Yep so, to finish the year, here’s a nice little buzzword bingo card for y’all to play with when you get back to the office in January (doubleclick to enlarge) ...
Oh yes, and if you're a real MiFID freak then Dechert produced a nice four-page PDF detailing the revised regulatory regime they anticipate this month.
Howsabout bankers big bonuses bashed by broadcasters but better being bashed by bank bosses.
Nah. Doesn't quite work as well as six swans swimming, swim swans swim, six swans swam, well swum swans, but it almost works.
What's all this about?
Well, Bloomberg released the latest news on bankers' bonuses this morning, and here's the league table:
Company Compensation Employees Compensation per Employee
Bank of America $26.3bn 284,169 $92,723 Citigroup $18.64bn 258,000 $72,264 Credit Suisse CHF11.23bn 50,500 CHF222,337 Deutsche Bank EU9.59bn 82,504 EU116,285 Goldman Sachs $13.72bn 35,400 $387,655 JPMorgan Chase $21.55bn 236,810 $91,014 Morgan Stanley $11.99bn 62,864 $190,682 UBS CHF13.14bn 64,583 CHF203,506
Note: 1CHF:1.02US$ and 1EU:1.41US$
You may be going "wow", but take note: "While average pay per employee has dropped 0.8 percent this year at the eight banks, it has fallen 11 percent at six that focus most on trading, such as Goldman Sachs and the investment bank unit of Credit Suisse Group AG."
I spent most of Friday thinking about the news of Goldman Sachs record $550 million fine from the SEC (here's the detail of what they were accused of).
The last fine of any consequence the SEC levied like this, in my memory, is the $100 million fine of UBS back in 2004 for supplying dollars to Iraq.That was pretty serious and yet this fine is almost six times more six years later. So it could be thought of as a big deal ...... but it’s not.It’s actually peanuts.It’s chump change.
In fact, it’s irrelevant.It’s irrelevant because this case is all about politics, money and morals.Politically, it is obvious that the case was purely introduced to assist in getting the financial reform bill through the senate. The SEC accusations were announced on 16th April, just as the financial reform bill was sent to the upper house, and then it was resolved on 16th July just as the upper house signed off on the bill.Obama and his team are arch politicos, and so they thought the bill needed an extra push to get through the upper house.This is because the Bill is pretty draconian, with the idea of prop trading being banned and speculative investing being confined to the pure speculator community – hedge funds and private equity firms.This is the Volcker rule – the bit that sends us back to the 1930’s and Glass-Steagall, or near enough.Everyone thought the Volcker rule would be thrown out or watered down but, by having the Goldman Sachs case on the go during the process of dialogue in the Senate, Obama got his way.
Which brings us to money.
This case is about money.
It’s about lots of money.Not the fine, where Goldmans is only paying a $550 million fine. That’s two week’s profit, based on the $12 billion they made last year. In fact, it’s less than two week’s bonuses, as they paid out $16 billion in bonuses last year.To put that in context, imagine you’re earning £16,000 ... this fine would be £550. About the level of a fine for being drunk and disorderly.Is that what the SEC thinks of Goldmans’ actions?They were just being drunk and disorderly all over the markets?OK, lesson learned. Big deal.
No, this was about bigger money.
For example, their stock price tanked 20% to just $140 in the months since the fraud investigation began, losing about $15 billion in Goldman's shareholders pockets, many of whom are Goldman's staff.
Since the fine was resolved, the share price has bounced 10% and will soon be back to pre-SEC charges levels.
But the market capitalisation the bank lost – about $15 billion worth – was a far bigger fine than the $550 million the SEC required. With that gone, it’s going back to the good old times again, which brings us to the final point: morals.Does Goldman Sachs have a moral compass?Goldmans make money at the expense of punters like AIG and Royal Bank of Scotland, by selling them sh*t and saying it’s your risk if you buy it.It actually appears like Goldmans were the bookie who not only took the bets but fixes the race.You don’t believe that.Well the Committee for the Fiduciary Standard released a video of Goldman Sachs executives squirming under questioning from Senators this spring, as hearings over the SEC lawsuit were held.The video shows Senator Carl Levin asking Lloyd Blankfein, Goldman CEO: “Do you think (investors) care that something is a piece of crap when you sell it to them?”Blankfein’s answer is no. As far as he’s concerned, the investor is purely concerned about the level of risk.In other words, the investor and his broker have no relationship related to suitability or appropriateness – core mandates under MiFID – but purely that the punter has to understand the risk, not their dealer, and they have to be happy to take on board that risk even if their broker is selling them a piece of crap.Great.So RBS et al lose billions and get offered a token amount in return.Of the Goldmans fine, RBS is being offered $100 million. They lost over $800 million. Those numbers don’t work in my book, and now that Goldman has been found guilty and, more importantly, ADMIT to misleading clients through their marketing materials in this deal, expect several high profile court cases to follow.
I’ve just received this month’s Banker magazine which the editor, Brian Caplen, describes as their most important issue of the year as it covers the latest Bank 1000 listings.
This year’s listings show a surprisingly stable crew of American and British banks.
World Bank Tier One Pre-tax Rank Capital profit $m $m 1 Bank of America Corp 160,387.77 4,360.00 2 JP Morgan Chase & Co 132,971.00 16,143.00 3 Citigroup 127,034.00 -8,445.00 4 Royal Bank of Scotland 123,859.00 -4,366.29 5 HSBC Holdings 122,157.00 7,079.00
Considering the crisis was meant to have killed these banks, you may find it surprising to see that Citigroup and RBS have maintained their leading positions.
This is down to the fact that the Banker measures a bank’s strength by its Tier 1 Capital, and so their positioning is more of a reflection of the sheer size of these firms than by their brand or market capitalisation, which is used in some other studies of size.
The Banker’s data is fascinating though, as the database also contains profitability, revenue, cost-income ratio and more, so it’s a useful tool in all senses. And the online data goes back to 1996, so you can do some useful comparisons.
Mind you, my data - old Banker magazines - goes back even further so I quickly took a snapshot of a few useful year’s – 1994, 1999, 2004, 2008 and 2010 – to see how things have changed. Mapping out the Top 20 banks of the world for each year makes for an interesting picture (doubleclick the picture to see a larger version):
Back in 1994, Japan ruled the world.
Then their economy went South and Origami Bank folded, Sumo Bank went belly up, Bonsai Bank cut back their branches and something fishy went on at Sushi Bank where staff got a raw deal.
Post-Japan’s slump, the Anglo-American financial system ruled. So you would think that, as that system failed, it also would have gone South.
Not the case.
Maybe that’s a reflection of the sheer scale of investment American and European firms have put into these economies to avoid such a crash.
Well worth spending time looking at the data and looking forward to playing around with it further.
Some years ago, I delivered a presentation as a keynote with the title: “All Bankers are Criminals”.
I actually didn’t mean “all”.
The chicken feed, battery farmed, commercial, transactional and retail bankers are pin-stripe suited, humble pie, nice guys.
I was talking about the evil animals of Wall Street and the City.
These jungle animals hunt you down, rip out your wallet and tear your money apart note-by-note.
OK, I exaggerate a little, but you get the idea.
The first time I gave this presentation was back in Summer 2005 at a European Conference, and repeated it again in Spring 2006, as an Associate Director of TowerGroup.
The theme of the presentation mainly came from Frank Partnoy’s excellent book Infectious Greed, which traces the growth of weapons of financial destruction: derivatives, as named by Warren Buffett in his 2002 shareholder letter.
It is quite clear from this book that unchecked investment markets will run free of scruples and morals. This is what happened with Frank Quattrone of Credit Suisse and the dotcom boom and bust, along with many other examples through history.
It is not necessarily as true when we talk about arbitrage strategies and the John Meriwether’s of this world. However, these people are far more dangerous because they create financial markets systemic risk that can bring down companies and countries.
For example, in case you are wondering who John Meriwether is, he was one of the first arbitrage players and built Salomon Brothers into the big swinging dick master of the universe world so brilliantly depicted in Michael Lewis’s book Liar’s Poker.
With his colleagues, the use of arbitrage instruments led to the downfall of Salomon Brothers – they were subsequently merged into Citigroup – and Meriwether went on to create Long Term Capital Management (LTCM).
In 1998 LTCM lost $4.6 billion in less than four months and became the leading case study for how systemic risk created by derivatives products, combined with massive leverage
and arbitrage risk-models, creates a financial deck of cards. A deck that can rise and fall in the blink of an eye, with the latter potentially ruining companies, markets, countries and governments, as happened in the most recent crisis.
Anyways, not to be dissuaded from his cause, Meriwether went on to found JWM Partners, another highly leveraged "relative value arbitrage" firm. Yet again, he built leverage through this hedge fund from its opening with $250 million under management in 1999 to a massive $3 billion firm by 2007. Of course, it was all just on paper as the latest crisis battered the fund, losing almost half of its value between September 2007 and February 2009. The deck of cards strikes again. It closed in late 2009 and guess what? Meriwether’s about to launch yet another hedge fund, based upon just the same concepts.To me, this is the criminality of the financial system in action. Firms that build highly leveraged derivatives instruments for short-term arbitrage, with unproven skills and massive risk.Not that I’m calling Meriwether a criminal, as it’s all perfectly legitimate under SEC and FSA Rules.Or it was.It may be that the Goldman Sachs furore will change all this.You see, Goldman Sachs, like Meriwether, is very good at taking leverage and risk and managing the markets to gain short-term profit. Like Meriwether, Goldman Sachs succeeded in using these tools and instruments to generate massive profits. They achieved a record 131 trading days last year, in which the bank made at least $100 million net trading revenue each day.
Unlike Meriwether, Goldman Sachs managed to offload and hedge their risks back to others, such as AIG and IKB, such that when the markets collapsed their clients, suppliers and partners got burnt, but not them.Nothing wrong with that, as it’s all perfectly legitimate under SEC and FSA Rules. Unless the SEC and FSA find Goldman Sachs guilty of fraud.But how can they be guilty of a crime that was not a crime at the time it was committed?There’s the rub.I’m sure the SEC will aim to build a bulletproof case, and their cause is a worthy one: clean up the financial system. Is it worthy to do this so publicly?Not sure.Is it worthy to name the defendant up front, when the burden of proof has yet to be proven?Not sure.The Goldman Sachs case is actually more like watching a rape trial in action, where the defendant is a shifty looking guy who probably seems guilty whether guilty or not.For example, if you name someone like Jack Tweed in the UK, you might still associate him with being a rapist even though he was found not guilty.The guilt sits there, and that’s what will happen with Goldman Sachs.Whether guilty or not – and they’ve hired the best team possible to defend themselves, including “Master of Disaster” Mark Fabiani – we will always associate Goldman Sachs with something smelly for the foreseeable years to come.Ho-hum.At least all of this seems to inspire some humour. For example, in an April episode of hit comedy US TV series This American Life (TAL), they tell the story of a hedge fund that comes up with an elaborate plan to make money. It sponsors the creation of complicated and ultimately toxic financial securities while, at the same time, betting against the very securities it helped create. TAL commissioned a Broadway song to go along with the story:
The only thing that really gets me, in finishing this blog entry, is Warren Buffett.The Sage of Omaha has made his billions through prudent focus upon ‘value investing’. That means investing in strong and robust businesses like Coca-Cola, American Express, Gillette and the Washington Post. So when he referred to derivatives as ‘weapons of financial destruction’ in his shareholder letter of 2002, I respected the man and his integrity of thought.Now, having found Goldman Sachs under attack, he has stepped up to their defence, and I wondered why.Warren Buffett is an intriguing character, as we all know. The friend of kings and kingmakers, he walks a path separate to most.He knows the dangers of arbitrage, derivatives and leverage, because he had to step into Salomon Brothers in 1991 to clean up Meriwether and his colleagues mess.An extract from Carol Loomis’s in-depth review of Buffett’s experience at Salomon’s:
“You may reasonably ask what was going on in Salomon's stock while all of this was transpiring. It was emphatically down, from above $36 per share on Friday to under $27 on Thursday, when the second press release rocked the market. But the stock was only the facade for a much graver matter, a corporate financial structure that by Thursday was beginning to crack because confidence in Salomon was eroding. It is not good for any securities firm to lose the world's confidence. But if the firm is "credit dependent," as Salomon was to an extreme, it cannot tolerate a negative change in perceptions. Buffett likens Salomon's need for confidence to a mortal's need for air: When the required good is present, it's never noticed. When it's missing, that's all that's noticed.
“Unfortunately, the erosion of confidence was occurring in a company grown enormous. Salomon in August of 1991 had bulged up to $150 billion in assets (not counting, of course, huge off-balance-sheet items) and was among the five largest financial institutions in the U.S. Propping the company on the right-hand side of the balance sheet was--are you ready?--only $4 billion in equity capital, and above that was about $16 billion in medium-term notes, bank debt, and commercial paper. This total of about $20 billion was the capital base that supported the remaining $130 billion in liabilities, most of these short-term, due to run off in one day to six months.”
The result meant that Warren Buffett had to actually take over physically as manager of Salomon Brothers for a nine-month period, and it was emotionally exhausting for him.
Switch to 2010.
Warren Buffett invested heavily in Goldman Sachs in September 2008 – when Lehman Brothers, Merrill Lynch and Morgan Stanley were all imploding – buying $5 billion of preferred stock at a 10 percent dividend. These investments earn him $950 a minute, or $500 million a year today. No wonder he claims to be in love with that investment.
Trouble is that the alleged fraud at Goldman Sachs has really hit their share price. For example, Standard & Poor's downgraded Goldman
shares to "Sell" and lowered their target price by $40 to
$140 the other day.
Thinking back to Salomon's - if the firm is "credit dependent," as Salomon was to an extreme,
it cannot tolerate a negative change in perceptions - Buffett must be seriously worried about Goldman Sachs losing its credit worthiness, especially as it depends on good credit.
Oh yes, and having called derivatives ‘weapons of financial destruction’, guess what? Berkshire Hathway, Warren Buffett’s investment firm, has a massive portfolio of derivatives investments. From the Wall Street Journal last week: “Democrats took a step toward their goal of overhauling financial regulation, reaching a tentative deal to set restrictions on trading in exotic financial instruments known as derivatives. Among the considerations still in the balance: A big provision being sought by Warren Buffett in recent weeks ... the provision, sought by Berkshire and pushed by Nebraska Senator Ben Nelson in the Senate Agriculture Committee, would largely exempt existing derivatives contracts from the proposed rules. Previously, the legislation could have allowed regulators to require that companies such as Nebraska-based Berkshire put aside large sums to cover potential losses. The change thus would aid Berkshire, which has a $63 billion derivatives portfolio, according to Barclays Capital.”
Hmmm ... maybe that greed is infectious, although Morningstar Analyst Bill Bergman supports Mr. Buffett's exemption by stating that: "claiming Berkshire poses a risk to the financial system is a difficult
case to make."
Either way, the US movement towards an approval of a Financial Reform Bill to handle the issues of banks that are 'too big to fail' yesterday, takes it one step nearer to the American system taking a lead role towards a new financial architecture.
Derivatives are next ... and Warren Buffett, like Lloyd Blankfiend at Goldman Sachs and all of those current and former bankers and brokers who dealt in toxic derivatives across the world, must be worried.
Postnote: here is Berkshire Hathaway’s full commentary on derivatives from that shareholder letter back in 2002:
Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.Having delivered that thought, which I’ll get back to, let me retreat to explaining derivatives, though the explanation must be general because the word covers an extraordinarily wide range of financial contracts.Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values. If, for example, you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction – with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration (running sometimes to 20 or more years) and their value is often tied to several variables.Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands.The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen). At Enron, for example, newsprint and broadband derivatives, due to be settled many years in the future, were put on the books. Or say you want to write a contract speculating on the number of twins to be born in Nebraska in 2020. No problem – at a price, you will easily find an obliging counterparty.When we purchased Gen Re, it came with General Re Securities, a derivatives dealer that Charlie and I didn’t want, judging it to be dangerous. We failed in our attempts to sell the operation, however, and are now terminating it.But closing down a derivatives business is easier said than done. It will be a great many years before we are totally out of this operation (though we reduce our exposure daily). In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit. In either industry, once you write a contract – which may require a large payment decades later – you are usually stuck with it. True, there are methods by which the risk can be laid off with others. But most strategies of that kind leave you with residual liability.Another commonality of reinsurance and derivatives is that both generate reported earnings that are often wildly overstated. That’s true because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them.Those who trade derivatives are usually paid (in whole or part) on “earnings” calculated by mark-to-market accounting. But often there is no real market (think about our contract involving twins) and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counterparties to use fanciful assumptions. In the twins scenario, for example, the two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.Of course, both internal and outside auditors review the numbers, but that’s no easy job. For example, General Re Securities at yearend (after ten months of winding down its operation) had 14,384 contracts outstanding, involving 672 counterparties around the world. Each contract had a plus or minus value derived from one or more reference items, including some of mind-boggling complexity. Valuing a portfolio like that, expert auditors could easily and honestly have widely varying opinions.The valuation problem is far from academic: In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” – until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly “mark-to-myth.”I can assure you that the marking errors in the derivatives business have not been symmetrical.Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counterparties tend to build up over time. (At Gen Re Securities, we still have $6.5 billion of receivables, though we’ve been in a liquidation mode for nearly a year.) A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. Under certain circumstances, though, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times.In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain.When a “chain reaction” threat exists within an industry, it pays to minimize links of any kind. That’s how we conduct our reinsurance business, and it’s one reason we are exiting derivatives.Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.Indeed, in 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-TermCapital Management, caused the Federal Reserve anxieties so severe that it hastily orchestrated a rescue effort. In later Congressional testimony, Fed officials acknowledged that, had they not intervened, the outstanding trades of LTCM – a firm unknown to the general public and employing only a few hundred people – could well have posed a serious threat to the stability of American markets. In other words, the Fed acted because its leaders were fearful of what might have happened to other financial institutions had the LTCM domino toppled. And this affair, though it paralyzed many parts of the fixed-income market for weeks, was far from a worst-case scenario.One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the bank realizes.Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.
Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.
Fascinating report in the FT this week about Global Brands, with the financial sector bouncing back the strongest of all. MasterCard and Visa led the financial pack, although Goldman Sachs saw a 25% growth in brand value over the last year ... I wonder how much they lost this year?
Anyways, considering banks had the worst results ever last year and lost all brand momentum, it’s no surprise I guess to see they’ve bounced back this year, and even beat beer as a sector for brand improvements:Year-on-year growth in 17 categories Category Brand value growth (%)Financial Institutions 12% Beer 10% Technology 6% Fast Food 1% Retail -1% Soft Drinks -1% Mobile Networks -1% Bottled Water -2% Gaming Consoles -3% Spirits -3% Luxury -3% Apparel -4% Personal Care -4% Coffee -6% Insurance -7% Cars -15%Source: Millward Brown Optimor (including data from BrandZ, Datamonitor and Bloomberg)
Strange how and why insurance is languishing down the bottom though ... maybe it's their lack of ability to cover Toyota's these days, which is why the car sector sits at rock bottom.
All in all, a big contrast between this and the Harris Interactive Reputation Survey I blogged about earlier this month ... so brands and reputation have nothing to do with each other, do they?
What surprised me is the list of the top 10 brands in our sector (doubleclick picture to enlarge):
Wow! ICBC from China, the #1 bank brand in the world!
In fact, they’re the 11th best brand in the world, just behind Google and Apple:
A great report from the FT again, and well worth a read if you have the time ...
Three headlines today relate to Goldman Sachs results, more on the implications of the Lehman Brothers collapse and recommendations for a new bank tax regime from the IMF
There are so many articles and analysis into Goldman Sachs practices at the moment ...
... that I’m not going to write a lengthy analysis to add to all of these, but have picked a few of the best articles at the end of this blog entry.
What I would like to say is that the Goldman Sachs area of this blog shows that the SEC’s actions announced last Friday could be easily anticipated. From their near admittance of market manipulation in July 2009, followed in August 2009 of talk about the SEC looking at their flash trading practices; to the comments I made in January about the fine line “between making markets and moving markets that Goldman walk. It will be interesting to see how Goldman and company make markets in the future, between the Obama tax and the new regulatory regime.”This was followed by the way they had to defend themselves recently, as evidenced by Chief Executive Lloyd Blankfiend’s letter to shareholders earlier this month.
Now the USA’s SEC has announced their formal investigation of Goldman Sachs, followed by the UK FSA's agreement to coordinate this investigation across borders.
There has to be a concern about their future.
Here’s my take on it.The case for Goldman Sachs
They are the world’s most successful investment bank
They are able to create incredible profits from complex instruments
They are the preferred choice of most clients for investment advice for these reasons, and this is why they maintain their success
The case against Goldman Sachs
They are the world’s most successful investment bank ... and most of their brethren – Bear Stearns, Lehman Brothers, Merrill Lynch have imploded through this crisis
They are purely driven by greed and pay massive bonuses
They manipulate markets in their own favour
Sure the list could be longer, and sure we can argue the toss over some of these points, but overall there could be a case of saying the investigations into the bank are all driven by schadenfreude and political motivations. For example, Barack Obama presents his financial reform bill to the Senate this week, so what better timing.Nevertheless, for the SEC to have “Pit Bull” Richard (Rick) Simpson in there litigating against the bank, means that there has to something in this and that must be a worry for them. Equally with the share price dropping 13 percent on Friday and further again today, even with their stunning results of $3.6 billion profits and $5.5 billion in bonuses for the last quarter, the reputation of the bank is taking a battering.The core of this debate is the question: does Goldman Sachs make stunning profits – over $100 million every day for 131 trading days last year – by betting against clients?If the answer is yes, then it’s more a case of Sack Goldmans rather than Goldman Sachs.Best of the media coverage from The Week, via the NY Times, Reuters, Naked CapitalismWhy the SEC is going after the Wall Street powerhouse, and what it means for the financial industryThe Securities and Exchange Commission took on Wall Street titan Goldman Sachs on Friday, filing a potentially explosive civil lawsuit accusing the investment bank and one of its mortgage traders, Fabrice Tourre, of fraud. (Watch a CBS report explaining the SEC's charges.) Here's a brief rundown of the charges, and what they could mean for Goldman, Wall Street, and financial reform legislation:
What is Goldman accused of?
The SEC says that Goldman created and sold a package of mortgage-backed securities to investors in 2007 without telling them that the person who picked or approved the securities, hedge fund manager John Paulson of Paulson & Co., was betting heavily that they would fail. Goldman brought in independent fund manager ACA Management to help pick the portfolio, allegedly to make the deal seem more trustworthy. But the SEC says Goldman misled ACA, too, not disclosing that deal "sponsor" Paulson was betting against, not on, the investments. Paulson's role was withheld from investors, too.
What's Goldman's defense?
That the investors who bought the securities were given "extensive information" about the securities they were investing in, and were "sophisticated" enough to know that somebody was going to take the opposite side of their bet. Also, Goldman says that while it earned $15 million in fees, it lost $90 million in the deal, although it didn't explain how.
Who else lost, and made, money on the deal?
The investors collectively lost $1 billion, with the primary losers being ACA Capital and German bank IKB. Paulson & Co. earned almost $1 billion in profit.
Is Paulson being charged?
No. Legal scholar Alan Dershowitz thinks that was a somewhat arbitrary choice by the SEC, though, saying in The Daily Beast that Paulson "could easily have been charged with conspiracy to defraud."
How damaging is this for Goldman?
Analysts say the hit to Goldman's "seemingly invincible" reputation could be much worse than any punitive damages. Given how important trust is on Wall Street, "it's very bad for business" if your clients think "you are doing shady things," says NYU law professor Marcel Kahan. And while any SEC fine would be "really small potatoes" for the firm, Goldman's stock price tumbled 13 percent on the news Friday, erasing more than $10 billion in market capitalization. Also, Britain and Germany are mulling their own investigations, based on the SEC allegations.
Are other Wall Street banks facing similar SEC charges?
It's certainly possible. SEC enforcement chief Robert Khuzami says the agency is stepping up its anti-fraud actions, and specifically looking at "similar deals" involving other Wall Street firms. Until Friday, Goldman employees were able to "sleep soundly after collecting their huge bonuses," says The New York Times in an editorial. Since Goldman wasn't the only bank betting against its own mortgage products, "others on Wall Street may have a harder time sleeping" now, too.
What are the politics of this case?
The SEC is an independent agency, but political strategists and banking lobbyists say the Goldman fraud allegations could help the Democrats pass a financial reform bill. The House passed its version last year, and the Senate finance committee recently sent its version to the full Senate (on a party-line vote) for debate this week. Some Republicans and TV pundits suggest that the announcement was timed to help secure the bill's passage. Business Insider's Henry Blodget says the SEC also might have rushed out the lawsuit to divert attention from a damning internal review of the agency's enforcement over the past few years.
After the long analysis of Jamie Dimon’s 36-page shareholder letter, we now have an 8-page shareholder letter from Goldman Sachs.
I cannot remember such letters being of such interest in the past, and wonder if the let’s tell-all letter writing from Bank CEOs is the new fashion for the teens (or 2010s if you prefer).
Alternatively, Goldmans just don’t like being called names, since this is their longest shareholder letter ever. If anything, it appears to be a direct response to the accusation of being a Vampire Squidlobbed at them last year by Rolling Stone’s Matt Taibbi (who I’m sure will have something to say about this letter).
Mind you, if I had just dished out $16 billion in bonuses for last year, for an average pay of $500k per staffer, you could call me anything you want.
It’s noteworthy that the letter refers to ‘clients’ on at least 56 occasions. A good example being: “We are responding to our clients’ desire either to establish, or to increase or decrease, their exposure to a position on their own investment views. We are not ‘betting against’ them.”
Yea, right.
That’s why Goldman Sachs managed to generate over $100 million in pure profit every day for over 131 days of trading last year I guess, a new record.
It also defends the bank’s controversial employee bonuses, relationship with AIG and role in short-selling the mortgage market.
Here’s a summary of the really juicy bits (the last three pages):
“In July 2007, as the market deteriorated, we began to significantly mark down the value of our super-senior CDO positions.
The letter refers to Collateralized Debt Obligations – click here to find out background on this stuff.
July 2007 was a key point as Goldmans had just lost billions on their Alpha Fund, due to their algorithmic systems messing up.
“Our rigorous commitment to fair value accounting, coupled with our daily transactions as a market maker in these securities, prompted us to reduce our valuations on a real-time basis which we believe we did earlier than other institutions.
They would do this on a real-time basis because their systems are controlling ahead of the markets.
“This resulted in collateral disputes with AIG. We believe that subsequent events in the housing market proved our marks to be correct — they reflected the realistic values markets were placing on these securities.
“Over the ensuing weeks and months, we continued to make collateral calls, which were based on market values, consistent with our agreements with AIG. While we collected collateral, there still remained gaps between what we received and what we believed we were owed. These gaps were hedged in full by the purchase of CDS and other risk mitigants from third parties, such that we had no material residual risk if AIG defaulted on its obligations to us.”
What this implies is that, acting as an intermediary in the markets and as a market maker, Goldman Sachs could see the ensuing implosion in the housing markets and specifically in Credit Default Swaps (CDS) and CDOs, in real-time.
These complex derivatives were integral to their trading strategies for hedging purposes, as well as being a prime broker of these risk instruments at the same time. Therefore, they were using these hedging strategies to cash-in their insurances with AIG to get out of any risk positions early.
This is why: “In mid-September 2008, prior to the government’s action to save AIG, a majority of Goldman Sachs’ exposure to AIG was collateralized and the rest was covered through various risk mitigants. Our total exposure on the securities on which we bought protection was roughly $10 billion. Against this, we held roughly $7.5 billion in collateral. The remainder was fully covered through hedges we purchased, primarily through CDS for which we received collateral from our market counterparties. Thus, if AIG had failed, we would have had the collateral from AIG and the proceeds from the CDS protection we purchased and, therefore, would not have incurred any material economic loss.”
So they aren’t saying they screwed AIG, but they legitimately ensured they weren’t screwed by insuring someone else was. All perfectly legal and above board. Only the fittest and strongest survive and all that.
The letter then goes on to talk more generally about their involvement in the mortgage securitisation market.
“The markets for residential mortgage-related products, and subprime mortgage securities in particular, were volatile and unpredictable in the first half of 2007 (which is why they unravelled their position with AIG). Investors in these markets held very different views of the future direction of the U.S. housing market based on their outlook on factors that were equally available to all market participants, including housing prices, interest rates and personal income and indebtedness data. Some investors developed aggressively negative views on the residential mortgage market. Others believed that any weakness in the residential housing markets would be relatively mild and temporary. Investors with both sets of views came to Goldman Sachs and other financial intermediaries to establish long and short exposures to the residential housing market through RMBS, CDOs, CDS and other types of instruments or transactions.
“The investors who transacted with Goldman Sachs in CDOs in 2007, as in prior years, were primarily large, global financial institutions, insurance companies and hedge funds (no pension funds invested in these products, with one exception: a corporate-related pension fund that had long been active in this area made a purchase of less than $5 million). These investors had significant resources, relationships with multiple financial intermediaries and access to extensive information and research flow, performed their own analysis of the data, formed their own views about trends, and many actively negotiated at arm’s length the structure and terms of transactions. We certainly did not know the future of the residential housing market in the first half of 2007 any more than we can predict the future of markets today. We also did not know whether the value of the instruments we sold would increase or decrease. It was well known that housing prices were weakening in early 2007, but no one — including Goldman Sachs — knew whether they would continue to fall or to stabilize at levels where purchasers of residential mortgage related securities would have received their full interest and principal payments.
“Although Goldman Sachs held various positions in residential mortgage-related products in 2007, our short positions were not a ‘bet against our clients’. Rather, they served to offset our long positions. Our goal was, and is, to be in a position to make markets for our clients while managing our risk within prescribed limits.”
In other words, Goldman Sachs puts everything down to prudent accounting and intelligent risk management.
Maybe ... but the fact that both clients selling and buying mortgage products and complex instruments (which no-one understood except Goldmans traders and a few others, such as JPMorgan Chase, creators of Credit Default Swaps) came to Goldmans, meant that they could see very early on that more people were getting out of the housing and mortgage markets than getting in.
Why are they coming to Goldmans?
Because Goldmans market manipulating systems for high frequency trading give them the best price. This resulted in Goldmans getting out of the mire before everyone else got into it, and is why they cashed in their positions with AIG before everyone else.
They were almost acting as a primary market in and of themselves and, as a market, therefore had much greater knowledge of what was being bought and sold.
Then, as not just the market but also an investor, they invested when everyone was getting out (buy low) and were selling when everyone was getting in (sell high).
The only difference with this market being that it just happened to be the whole US housing market, based upon leverage and funding fuelled by AIG's insurances and complex hedging instruments.
The result is that Goldmans is the nimblest firm at avoiding bubbles bursting and bandwagons rolling.
It’s not illegal of course. It just means they’re far more likely to be onto a sure thing than anyone else.
So, Matt Taibbi’s claim that Goldman Sachs is “a great vampire squid wrapped around the face of humanity” is obviously wrong, and their bonuses are fully justified.
The classic article of last year "Inside the Great American Bubble Machine" by Matt Tiabbi in Rolling Stone, where he coined the term 'vampire squid' in his description of the bank Goldman Sachs, has been visualised in this 10-minute YouTube stream:
It seems that I’m having a long whinge and rant all week, but I’m trying not to.
What I’m really trying to do is to get some answers to this crisis of confidence in the banks and, consequently, the banking system. This is nothing to do with the credit crisis, but the response of the banks to the credit crisis, which is to trash all trust and confidence in their ethics and approach.This is why there is this non-stop bleating about bonuses and interest rates. The banks justify this behaviour on the basis of all the other kids on the block are doing it so, if we didn’t, we would just get beaten up in the banking playground by the bonus bullies. This is what Stephen Hester said today:Mr Hester warned “that employees are leaving because it was offering lower bonuses than City rivals. He also said that profits at the bank, which is 84 per cent owned by the taxpayer, would have been about £1 billion higher if it had managed to stop staff leaving. The bank said it had ‘paid the minimum necessary to retain and motivate staff who are critical to the recovery of RBS’.”Trouble is, this doesn’t cut the mustard.MPs warned that the public would be astonished that the bank was paying £1.3 billion in bonuses given that it today reported a £3.6 billion loss for last year.
“Vince Cable, the Liberal Democrat Treasury spokesman, said: ‘Stephen Hester is trying to justify the unjustifiable. Most bankers owe their jobs to the taxpayer. His comments will just reinforce the view of bankers in many people's minds as greedy and selfish.’
“Shadow chancellor George Osborne echoed the views of Mervyn King, the Governor of the Bank of England, by telling BBC radio: ‘I do think the level of payment in the banking sector has got completely out of kilter with the rest of society. It is totally disproportionate to what doctors are paid, people working in industry are paid, teachers are paid and the like. We need to bring down pay across the sector — not just in one bank, across the sector — and things like a bank tax, internationally agreed, might help do that.’”
Oh yes, and I love the photograph the Evening Standard chose to run with that report.
Hmmm ... Hester, the fox killing, horse and hound man.
Nice.
Meanwhile, in the same paper, Chris Blackhurst writes about how we've blown our chances to rein in the banks:
“We somehow think that the bankers will take it upon themselves to lie down on the steps of St Paul's and seek forgiveness — and reform their ways and slash their incomes. They won't. They're human. Yes, they're pariahs, but they will carry on taking the money until they're forced to stop, until the authorities say bank licences will be relinquished if bonuses are paid.”But none of these arguments raging in the media address the real issue here.The real issue is not bonuses, profits, lending or interest rates.The real issue is a lack of internal market leadership within the banking industry.Nothing to do with regulators, politicians or press. The most significant failure has been the inability for the industry to act as a cohesive hole (sic: whole) to respond to the issues arising under their watch.Instead we act as a fragmented group of a thousand voices.Individual voices stand up and are counted, and some count more than others such as the Jamie Dimon’s, John Varley’s and Stephen Green’s. But nothing is co-ordinated or arranged in a way that makes sense or alleviates the public anger and distrust in the system.Take the example of the past week of banker’s bonuses.Initially, one bank – Barclays – set an example of waiving bonuses payments, as their leaders chose to repeat the actions of a year earlier and declined the multimillion pound pot they were entitled to. Reluctantly the rest then followed with RBS, Lloyds and now HSBC one-by-one agreeing not to award their leader’s bonus.The result is that they were accused of being lame sheep in doing so, just following the lead of one, and it just looked limp.It also rang of insincerity anyway, in that several of these leaders are purely deferring bonuses and have taken large swags of cash via other means (e.g. Bob Diamond’s $46 million payout on the sale of Barclays Global Investors last year) or just don’t need it as most are on million-pound plus packages. In fact, one cynic said that there would just be a top-up of their pension pots to compensate, and so no-one sees these token gestures as being anything other than that- ‘token’.Does this justify the payouts to their investment banking teams by making such sacrifices?No.Does it restore faith and trust and displace the anger and mistrust?No.So all it’s done is served as some form of internal justification for the continuance of mega-bonus payments to investment banking staff.The issue still lies with the press, politicians and regulators however: in this land of 1,000 voices, where no-one coordinated single voice resonates, where is the leadership to change the system?Take the example I’ve just given.What bankers should have done is worked together to create a co-ordinated plan across the sector pre-emptively and early on.For example, Stephen Hester (RBS), John Varley and Bob Diamond (Barclays), Eric Daniels (Lloyds) and Michael Geoghegan (HSBC) see each other often enough in front of Treasury Select Committees to be able to co-ordinate their responses.So why didn’t they all agree upfront to defer leader’s bonus payments, and announce this as a co-ordinated approach pre-results season?A joint announcement of rationale and reasoning would have been far more powerful than the sheep mentality manner of following the leader.Equally, Jamie Demon Dimon (JPMC), Vikram Pandit (Citi), Lloyd Blankfein (Goldman Sachs), Brian Moynihan (Bank of America) and John Mack (Morgan Stanley) see each other all the time in front of Federal Committees. So why didn’t these leaders co-ordinate responses to bailouts and bonuses?You may say they did, but not from an observer’s viewpoint externally.It looks like maverick individual actions and approaches, with no single voice to rally the industry to a resolution.Why these ‘leaders’ cannot organise themselves is beyond the ken.After all, if these global CEO’s of banks had created a co-ordinated and rational campaign to cap bonuses, waive their own, provide charitable donations, show how bank lending and bailouts had been atoned, then the media, public and politicians would not be baying for their blood.The fact that: (a) there is no single voice of leadership that is co-ordinated across these banks speaking on their behalf; and (b) these leaders have allowed banks to behave without change, as they were before and as if nothing had happened, is going to lead to a showdown.That showdown is not far away and, according got all my sources, will be far more draconian and vicious than any action that would have been taken if the industry had spoken with one voice, rather than thousand.But then, this industry’s ability to self-regulate with transparency and integrity historically has been pretty poor so this comes as little surprise.
Meanwhile, you only have to look at the fact that our poor old Queen has been forced onto the tube these days, to realise how hard times are in Britain ...
Great article in this month’s Bloomberg Markets Magazine on High Frequency Trading (HFT) which, according to Tabb Group, has increased from almost nothing to account for 61% of US stock market activity and 70% of individual trades since 2005. The SEC announced it is to review this area of trading last month but the focus of the article is what this means in reality from a broker dealer view.
Working with Ancero, Bloomberg has compiled a list of the best brokers using their global trade execution prices between July 2008 and June 2009. This is anannual review, and shows the impact of HFT upon the brokerage community as Goldman Sachs is the clear winner for brokers handling over $25 billion in trades annually.
According to Ancerno, Goldman is the closest at getting orders filled nearest to the price when the order is received whilst JPMorgan, last year’s #1, has fallen to joint fourth with Barclays Capital, behind Bank of America Merrill Lynch and Morgan Stanley.The World’s Best Brokers Loss in basis points*#1 Goldman Sachs -27.5 #2 BoA Merrill Lynch -32.7 #3 Morgan Stanley -33.6 #4= JPMorgan Chase -34.2 #4= Barclays Capital -34.2 #6 Investment Technology Group (ITG) -35.6 #7 UBS -36.3 #8 Deutsche Bank -38.8 #9 Citigroup -39.7 #10 Credit Suisse -41.3
A basis point is 0.01%, so Goldman Sachs' 27.5 = 0.275% or just over quarter of one percent. This means that, for a client who placed an order for 50,000 shares at $10 each with Goldman Sachs, they would get the shares for an average price of $10.275 cents; whilst Bank of America would fill the order at an average price of $10.327 cents; Morgan Stanley at $10.342 cents; and so on.
[Figures represent the difference between the executed stock price and the price when the order was placed for brokerage clients in the four quarters ended on June 30th 2009, according to Ancerno]
Why have Goldmans won?According to Roger Freeman, an analyst covering brokerage houses and exchanges at Barclays plc, because “they have the most developed and advanced electronic systems” and “can get some of the fastest execution times on trades.”This is why latency is so critical and illustrates the point well.For example, per day, the US exchanges averaged trading of 10.4 billion shares daily during the year to June 30 2009, with institutional investors globally paying $28.2 billion in trading commissions compared to $30.7 billion in 2008 and $26 billion in 2007.Interestingly, the basis point difference varies quite widely by region:Loss in basis points* USA Europe Asia Goldman Sachs -25.4 -32.6 -24.0 JPMorgan Chase -34.1 -35.8 -31.1This may be a reflection of the early state of low latency in Europe at that time, and demonstrates why Chi-X has succeeded so fast.
If you haven't seen it yet, here's Richard Curtis's (he of Four Weddings and a Funeral and Love Actually fame) short clip with Bill Nighy for the Robin Hood Tax campaign:
... well worth a look.
The idea of the campaign is to charge 0.05 percent per £1,000 transacted by
banks between each other, and that would raise about £250 billion
globally per year to help aid global poverty and climate change. Interesting to see that it has gained more than 16,500 supporters since it launched two days ago.
Oh yes, this was interesting as well (from today's Times):
The [Robin Hood tax] poll had to be
suspended shortly after 3.41pm when the "no" vote went from 1,400
to more than 6,000 in five minutes. Suspicious organisers suspended the ballot while they removed what they saw as
fake votes from the record. Their data revealed that the mystery “no” votes
came from two IP addresses — one privately-owned and hard to trace, the
other, it is claimed, registered to a computer at Goldman Sachs.
I’m continually impressed and amazed by the speed of change in the technology of the investment markets.
For example, last year was all talk about low latency and lit versus dark pools. This year, it’s all about private cloud-based services based upon colocation and proximity services. Next year, it will be all about real-time liquidity and settlement. Equally, the change from old to new trading venues is quite surprising. I was chatting with one of the MTFs yesterday for example. An MTF is a Multilateral Trading Facility, a new class of exchange introduced by MiFID, the Markets in Financial Instruments Directive. The conversation reminded me that only two years ago, everyone was saying that liquidity doesn’t move and there would be no threat to traditional exchanges from these new trading venues.
Two years later, Chi-X has more trading and market share than the London Stock Exchange (LSE); BATS is in the Top Ten ...
... LSE has acquired Turquoise and completely changed strategy and direction; Euronext has launched a major dark pool; Deutsche Bourse is heavily expanding in ultra low latency connections, targeting latencies under 3.3 milliseconds for Frankfurt-Amsterdam, under 4.5 milliseconds for Frankfurt-Paris, under 40 milliseconds for Frankfurt-New York, and under 49 milliseconds for Frankfurt-Chicago ...
... and so it goes on.
Just two years ago, many exchanges thought that seconds were fine. Today it’s milliseconds. Tomorrow it’s microseconds. And then what?Is it to achieve the ever elusive cross-asset class trading system? The one where a paired equities trade can be combined with an FX hedge across a global arbitrage? Nah, we’ve already got that.Is it to innovate new instruments, even when the last set of instruments – Structured Investment Vehicles, Credit Default Swaps and Collateralised Debt Orders – screwed up the world’s economies? Nah, we’ve already got that too.Is it to bring on board new exchanges and focus on emerging markets?Nah, we’ve already got emerging markets, cross-asset class structure exchange products.So what is the next wave of major change in trading systems and markets, and how will governments manage to derisk the next wave of innovation?Well, if the move does become one where real-time execution is combined with real-time settlement and real-time risk management, as I’ve stated before, then the challenge for broker-dealers will be to bring added value to clients through arbitraging across venues and instruments.But hey, that’s what they do now isn’t it?Of course.It’s what broker-dealers and market-markers have done for all time and will be what they do for the future. You see, the challenge is to keep up with the innovations of a Goldman Sachs and it is the reason why Goldmans made $100 million profits for every day of trading last year.Now there’s a fine border line between making markets and moving markets, and that’s the line Goldman walk.It will be interesting to see how Goldman and company make markets in the future, between the Obama tax and the new regulatory regime.But the key will be to continue to innovate with technology ... and they are and will be.That is why we are moving towards an almost seamless order flow through execution through settlement system, thanks to smart order routing combined with execution management systems.That’s one of this year’s big buzzes in trading tech, especially as Asia has followed Europe and America’s approach with Japan clearing the way for new Alternative Trading Systems and venues.So perhaps the big buzz will really be about arbitraging across venues and instruments using global smart order routing, combined with real-time execution and settlement in microseconds.
Hmmm ... sounds risky to me.
Will governments be up to the job of regulating all of these new innovations?
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