Archive for the ‘Primers’ Category

Maker-Taker Fees and Inverse Markets

Thursday, January 21st, 2016

Tim Kiladze in the Globe introduces us to the concept of ‘inverted markets’:

As high-frequency trading and electronic trading grew, stock exchanges started experimenting with a new model that paid high-frequency traders (HFTs) to post orders on their marketplaces. Known as the “maker-taker” pricing model, traders who removed liquidity, or executed an order and removed it from the marketplace, had to pay a “taker” fee; traders who posted that order got a “maker” rebate.

That’s still the dominant model for Toronto Stock Exchange-listed stocks, but there is incredible growth of a new system, known as an inverted market. It works in the exact opposite fashion. People who execute orders and remove them from the marketplace are given a rebate, while people who post orders have to pay to do so.

The rationale: sometimes there is a plethora of orders sitting around, with 20 different investors looking to unload the same stock at the same price. Of that 20, there may be one who needs to get the sale done immediately, so he or she will be willing to pay a small fee to jump to the front of the line. That’s why inverted markets are also known as “first look” markets.

The number of investors using these orders is growing fast. In January, 2015, inverted markets made up 9 per cent of trading volumes for TSX-listed securities. Now they make up 15 per cent of all trades, according to ITG Canada.

I find the explanation a bit clumsy: the third paragraph implies that a trader can jump the queue in a time-priority stack of orders by paying a fee, which is not the case. The actual reasoning is fairly involved and comes from an Aequitas diatribe titled NOT ALL SPEED BUMP MARKETS ARE CREATED EQUAL:

OPR [Order Protection Rule] has provided a perfect eco-system for those seeking to carry out predatory trading strategies.

An example of such an OPR-enabled predatory trading strategy would be as follows:
1. Place small orders across multiple marketplaces using the speed advantage to set the National Best Bid and Offer (“NBBO”), knowing everyone else will be forced (because of OPR) to trade with these orders first;
2. Use computer algorithms to identify trades from institutional investors or large retail orders, i.e. long-term investors (“LTIs”) that frequently break up orders to reduce market impact;
3. When an LTI order trades with one of these small orders, leverage the speed advantage to receive the information about this trade before the rest of the market;
4. Use this information, and the knowledge that the LTI order will next try to trade orders on other marketplaces (because of OPR), to technologically front-run that incoming LTI order, fade displayed quotes and ultimately trade with the incoming LTI order at a less favourable price to the investor.

To understand the impact of inverted markets it is important to ask the following question: who posts orders on a marketplace where they have to pay a fee?
• It is not the cost sensitive retail dealer. Retail dealers will, however, be takers of liquidity on inverted fee model marketplaces because they will have the opportunity to receive a rebate to do so, which they cannot obtain on make/take marketplaces.
• It is typically HFTs that are prepared to pay a fee to post orders for the benefit of interacting with retail flow.

There is nothing wrong with any of this as long as the retail dealer can demonstrate best execution.

However, when we take OPR into consideration, we come to the following conclusions:
• It is not retail orders that are being protected on inverted fee model marketplaces but orders from HFTs and other technologically sophisticated intermediaries, which were not the intended beneficiaries of OPR protection.
• With OPR, all trades are required to go to the marketplace with the best prices first (regardless of size), this makes inverted fee model marketplaces the perfect place for predatory traders to post small orders to get the first look at any type of flow and then deploy the type of strategy discussed above.

Incidentally, the Aequitas paper argues in favour of their product being a ‘protected’ market, i.e., subject to the OPR.:

We believe it is possible to build a marketplace where all industry stakeholders can co-exist and flourish. The NEO BookTM was specifically designed to promote and protect liquidity formation to the benefit of all liquidity seeking investors. We believe in fair access and that all liquidity providers should be able to compete on equal terms, regardless if they are HFT firms or institutional or retail investors.

This would no longer be the case if the NEO BookTM were to become an unprotected market, for two reasons:
1. Institutional investors will be at a competitive disadvantage compared to proprietary HFT firms who are in complete control of which market they access, and have the ability to quickly post and cancel their orders on an unprotected displayed marketplace. On the other hand, dealers that trade on behalf of their clients will be hesitant to post client orders on such markets where they are not price-protected and could get traded through. This is due to the lack of a well-defined best execution regime that demonstrably takes into account, monitors and enforces all elements of execution quality.

I have no sympathy whatsoever for this position.

Institutional investors can also be in complete control of which market they access, provided they perform the highly unusual step of thinking about what they are doing. Institutional investors charge their clients fat fees for their expertise, so let’s not spend too much time wailing over their lack thereof.

The second point is entirely dependent upon regulatory vagueness. The solution for regulatory vagueness is regulatory precision, not increasing the complexity of rules and exceptions that have the objective of counterbalancing this incompetence.

However, all this is leading up to a wonderful SEC memorandum on the topic of Maker-Taker Fees on Equities Exchanges:

The purpose of this memorandum is to facilitate an objective assessment of maker-taker fees in the U.S. equity markets by outlining the development of the maker-taker fee model in the U.S. and summarizing the current public debate about its impact on equity market structure. The memorandum will present both the asserted advantages and disadvantages of maker-taker fee structures. Though less frequently the focus of contemporary debate, it is important to note the asserted advantages of the maker-taker fee model. Specifically, some believe the maker-taker model is an important competitive tool for exchanges and directly or indirectly can provide better prices for retail investors. On the other hand, some believe it may exacerbate conflicts of interest between brokers and their customers, contribute to market fragmentation and market complexity through the proliferation of new exchange order types, and undermine price transparency.

I found the discussion of the NASDAQ experiment fascinating:

To test the premise that high access fees may discourage the use of markets that publicly display their posted best bid and offer (“lit markets”), NASDAQ conducted an access fee experiment in which it significantly lowered access fees and rebates in 14 stocks for transactions effected on the NASDAQ Stock Market over a four month period. The NASDAQ Pilot began on February 2, 2015, and lowered the access fee to remove liquidity from $0.003 to $0.0005 and reduced the credit to display liquidity to $0.0004 (such credits otherwise ranged from $0.0015 to $0.00305). NASDAQ’s stated intent in conducting the pilot was to test assertions that high access fees discourage the use of public markets and to generate “much-needed data about the impact of access fees on the level of off-exchange trading and, potentially, on price discovery, trading costs, displayed liquidity and execution quality as well.” NASDAQ provided data and prepared reports of the effects of the pilot that analyzed trading in the 14 stocks compared to a set of similar non-pilot control stocks. With respect to market share, NASDAQ expected offsetting effects, where the lower taker fee would be expected to increase market share and the lower rebate would reduce market share. In the first month of its pilot, NASDAQ observed a 2.9% decrease in market share in the 14 stocks compared to a 0.9% decrease in the control stocks. With respect to displayed liquidity, NASDAQ observed an expected decrease in response to the lower rebate incentive to display on NASDAQ. For example, NASDAQ’s time at the NBBO in the 14 stocks declined 4.9% compared to 0.3% for the control group. NASDAQ’s data thus showed statistically significant effects resulting from significant reductions in the access fees to take liquidity and related credits to post liquidity on NASDAQ in the 14 pilot stocks.

And the effect of maker-taker fees on retail market orders is also discussed:

Another important potential benefit of maker-taker fee structures is that they artificially narrow displayed spreads because the liquidity rebate effectively subsidizes the posting of liquidity. Broker-dealers that today execute virtually all retail marketable order flow off-exchange either match or improve upon the best price displayed on exchanges. Thus, to the extent displayed prices are artificially aggressive, this inures to the benefit of retail investors in the form of improved execution prices.

And in a discussion of the effects of maker-taker on best-execution requirements, inverted markets get a good mention:

For marketable orders, a broker may have an incentive to route to a trading venue that charges low access fees, or so-called “inverted” markets, offering rebates to take liquidity. However, venues with low taker fees (or that pay rebates to takers) generally have lower maker rebates (or impose fees on makers), and as a consequence, all else being equal, such markets would be less attractive to traditional liquidity providers compared to markets that pay a more attractive rebate to post liquidity for a given execution probability and therefore may have less posted liquidity available at the best price. These markets’ pricing structures also may attract sophisticated market participants that are willing to post liquidity on relatively unfavorable terms for the chance that such markets’ high position on taker routing tables will allow traders to interact with the first tranche of a large market order, thus allowing the traders to detect the earliest signs of a potential price move and quickly adjust their quoting or trading strategies on other markets. Accordingly, when a broker routes marketable customer order flow to a low taker fee (or inverted) venue, there is a risk that it actually may impair the execution quality of the customer’s order, particularly for larger institutional orders, if there is a potential for market-moving information leakage.

Again, I have no sympathy for such arguments whatsoever. If an institution is trading stupidly then they – and their clients – will have to pay for their stupidity.

And market complexity is discussed:

Some have suggested that to compete with non-exchange markets, as well as other exchanges, exchanges are motivated to offer the highest rebate to attract liquidity. To fund these rebates, exchanges must charge artificially high taker fees that may approach the access fee cap of $.003 per share. According to this view, within the maker-taker fee structure, where the difference between the highest rebate and highest taker fee approaches $0.006, exchange net trading fee revenues – the difference between taker fee revenues and maker rebate expenses – is generally less than one-tenth that range, between $0.0005 and $0.001 per share. Within this narrow range of net revenues, however, exchanges compete aggressively. The pressure to establish novel and competitive pricing often leads exchanges to modify their pricing frequently, typically on a calendar-month basis, which may add uncertainty and complexity to the marketplace as market participants must regularly update their routing tables to accommodate these frequent pricing changes.

Oh, routing tables must be updated? Trading strategies must be thought through to account for novel and competitive pricing? Well, Boo-Hoo-Hoo. If you’re a big enough trader for this to matter to returns, you’re big enough to think about it. This argument is merely illustrative that the controversy is artificial; it’s merely a means for the entitled private-school crowd to maintain their fat margins without having to compete against the hoi-polloi, who set up shop with not much more than a computer and a brain.

History of Transfer Agents

Wednesday, December 23rd, 2015

The SEC has announced that it:

voted to issue an advanced notice of proposed rulemaking (ANPR) for new requirements for transfer agents, together with a concept release requesting public comment on the Commission’s broader review of transfer agent regulation.

The ANPR and concept release provide a summary of the history of the national clearance and settlement system, the role of transfer agents within that system, and the origins and current status of the Commission’s transfer agent rules.

The Commission also identifies in the ANPR certain areas in which it intends to propose specific rules or rule amendments, including registration and annual reporting requirements, safeguarding of funds and securities, antifraud requirements in connection with the issuance and transfer of restricted securities, and cybersecurity and information technology, among others.

The concept release seeks comment on a broader range of issues to help inform the Commission’s consideration of additional rulemaking. These include the processing of book entry securities, bank and broker-dealer recordkeeping for beneficial owners, administration of issuer plans, outsourcing and the role of transfer agents to mutual funds and crowdfunding.

The proposals themselves are not really very interesting – although I’m sure various specialists will be fascinated! – but I’m highlighting this because the Request for Comments: Release No. 34-76743; File No. S7-27-15 contains a short history of transfer agents in the US including a section on something that has long fascinated me: the Paperwork Crisis of the 1960s:

As trading volume increased throughout the 1960s and early 1970s, the burdensome manual process associated with transferring certificated securities created what came to be known as the Paperwork Crisis. It was, at the time, “the most prolonged and severe crisis in the securities industry”41 since the Great Depression and to this day is one of the largest challenges the U.S. securities markets have faced. The manual settlement processes for certificated securities could not keep up with increasing trading volumes, deliveries to customers of both cash and securities were frequently late, and stock certificates were lost in the rising tide of paper. The substandard performance of transfer agents was “a significant contributing factor” to the Paperwork Crisis.
42 At times during 1967 and 1968, the New York Stock Exchange (“NYSE”) closed early on some days and during a substantial portion of 1968 closed entirely on Wednesdays to attempt to allow the brokerages and other firms to keep up with the volume.43

In the immediate aftermath of the Paperwork Crisis, more than 100 broker-dealers went bankrupt or were acquired by other firms and “[t]he inability of the securities industry to deal with its serious operational problems . . . contributed greatly to the loss of investor confidence in the efficiency and safety of [the U.S.] capital markets.”44 However, other consequences of the Paperwork Crisis were deeper and longer lasting. As discussed below, over the next years and decades, Congress, federal and state regulators, and industry participants, including brokers, dealers, banks, and securities exchanges, worked together to drastically reshape critical operational aspects of the securities industry, ultimately leading to major revisions to both federal and state securities laws, and the advent of the modern national market system and National C&S System as they exist today.

What’s The Benchmark Five-Year?

Tuesday, February 24th, 2015

Assiduous Reader gsp of the Financial Wisdom Forum writes in and says:

as I posted on the Preferreds thread on FWF (LINK) I am having a hard time understanding which source to best trust when trying to figure out the GOC 5 year benchmark that resets are based on.

The site you link on prefblog(LINK) says the closing 5 year on Feb 20th was 0.72 while says 0.79. The definitive source(BOC) today posted it as 0.80. I’m confused by the variance in all these quotes, especially for a closing rate.

I like to be as precise as possible when using your YTC resets spreadsheet, what’s the best source for intraday BOC 5 year quotes that I can access for free? I have no real use for real time quotes but prefer not to be out to lunch when the rate moves considerably intraday.

Using today’s quotes, we see that CBID’s site (which is the one I use) shows a “Closing Markets as of: 4:00 PM EST 23-Feb-15” yield of 0.66% for the “Canada 5 year”, while the GOC-5 yield list yield of 0.741% for February 23 for “Canada 5-Year Bond Yield Historical Data”.

That’s a big difference for a five year! So what’s a five-year bond, anyway? Is it the same one today as it was yesterday? Just what exactly is a “five year bond”?

According to the BoC Benchmark definition:

Selected benchmark bond yields are based on mid-market closing yields of selected Government of Canada bond issues that mature approximately in the indicated terms. The bond issues used are not necessarily the ones with the remaining time to maturity that is the closest to the indicated term and may differ from other sources. The selected 2-, 5-, 10-, or 30-year issues are generally changed when a building benchmark bond is adopted by financial markets as a benchmark, typically after the last auction for that bond. The selected 3-year issue is usually updated at approximately the same time as changes are made to the 2-year, and sometimes with the 5-year. The selected 7-year issue is typically updated at approximately the same time as the 5- or 10-year benchmarks are changed. The current benchmark bond issues and their effective dates, shown in brackets, are as follows.
•2 year – 2017.02.01, 1.50% (2014.11.21);
•3 year – 2017.08.01, 1.25% (2014.10.09);
•5 year – 2020.03.01, 1.50% (2015.02.20);
•7 year – 2022.06.01, 2.75% (2015.01.26);
•10 year – 2025.06.01, 2.25% (2015.01.26);
•Long – 2045.12.01, 3.50% (2014.02.21);
•RRB – 2041.12.01, 2.00% (2010.10.21);

So that’s pretty cool! The “Five Year Benchmark”, as defined by the Bank of Canada, changed last Friday, February 20;

From their page BOC Bond Auction information, we see that their Excel spreadsheet (updated to 2015-1-31) lists two prior auctions (of $3.4-billion a pop) of the 1.5% March 1, 2020, bond, on 2014-11-26 and 2014-10-08. The three prior five year auctions were for the 1.75% September 1, 2019, issue, on 2014-8-6, 2014-5-7 and 2014-4-9, each of which also had $3.4-billion size. And we also see that there was another “five year” auction February 18 for delivery February 23. So, it would seem, that they changed their official benchmark as of the day prior to delivery of the third and final auction of the issue.

We can go back to the CBID page: at the bottom, there are quotes for individual issues and we see:

Canada 1.750 2019-Sep-01 104.85 0.66
Canada 1.500 2020-Mar-01 103.72 0.74

So – while it’s not absolutely definitive, it would appear that is quoting the yield on the 1.5% of March 2020, while CBID is quoting the 1.75% of September 2019 as the “Five Year”.

Who’s right? Who’s wrong? It’s a meaningless question: virtually everything in the bond market is quoted in terms of convention, which is often highly exasperating when discussing yields.

How does the US Treasury do it? They provide a Constant Maturity Yield:

Treasury Yield Curve Rates. These rates are commonly referred to as “Constant Maturity Treasury” rates, or CMTs. Yields are interpolated by the Treasury from the daily yield curve. This curve, which relates the yield on a security to its time to maturity is based on the closing market bid yields on actively traded Treasury securities in the over-the-counter market. These market yields are calculated from composites of quotations obtained by the Federal Reserve Bank of New York. The yield values are read from the yield curve at fixed maturities, currently 1, 3 and 6 months and 1, 2, 3, 5, 7, 10, 20, and 30 years. This method provides a yield for a 10 year maturity, for example, even if no outstanding security has exactly 10 years remaining to maturity.

Treasury Yield Curve Methodology. The Treasury yield curve is estimated daily using a cubic spline model. Inputs to the model are primarily bid-side yields for on-the-run Treasury securities. See our Treasury Yield Curve Methodology page for details.

… and on the Treasury Yield Curve Methodology Page it states:

The Treasury’s yield curve is derived using a quasi-cubic hermite spline function. Our inputs are the Close of Business (COB) bid yields for the on-the-run securities. Because the on-the-run securities typically trade close to par, those securities are designated as the knot points in the quasi-cubic hermite spline algorithm and the resulting yield curve is considered a par curve. However, Treasury reserves the option to input additional bid yields if there is no on-the-run security available for a given maturity range that we deem necessary for deriving a good fit for the quasi-cubic hermite spline curve. For example, we are using composites of off-the-run bonds in the 20-year range reflecting market yields available in that time tranche. Previously, a rolled-down 10-year note with a remaining maturity nearest to 7 years was also used as an additional input. That input was discontinued on May 26, 2005.

More specifically, the current inputs are the most recently auctioned 4-, 13-, 26-, and 52-week bills, plus the most recently auctioned 2-, 3-, 5-, 7-, and 10-year notes and the most recently auctioned 30-year bond, plus the composite rate in the 20-year maturity range. The quotes for these securities are obtained at or near the 3:30 PM close each trading day. The inputs for the four bills are their bond equivalent yields.

Between August 6, 2004 and June 2, 2008, to reduce volatility in the 1-year Treasury Constant Maturity (CMT) rate, and due to the fact that there were no on-the-run issues between 6-months and 2-years, Treasury used an additional input to insure that the 1-year CMT rate was consistent with on-the-run yields on either side of it’s maturity range. Thus, Treasury interpolated between the secondary bond equivalent yield on the most recently auctioned 26-week bill and the secondary market yield on the most recently auctioned 2-year note and inputted the resulting yield as an additional knot point for the derivation of the daily Treasury Yield Curve. The result of that step was that the 1-year CMT was generally the same as the interpolated rate during that time period. As of June 3, 2008, the interpolated yield was dropped as a yield curve input and the on-the-run 52-week bill was added as an input knot point in the quasi-cubic hermite spline algorithm and resulting yield curve.

Between December 3, 2007 and November 7, 2008, due to Treasury’s discontinuance of 3-year notes, we added a composite rate in the 3-year range based on an average of off-the-run securities in that time tranche. This composite was replaced on November 10, 2008 with the on-the-run 3-year note upon its reintroduction.

Treasury does not provide the computer formulation of our quasi-cubic hermite spline yield curve derivation program. However, we have found that most researchers have been able to reasonably match our results using alternative cubic spline formulas.

Treasury reviews its yield curve derivation methodology on a regular basis and reserves the right to modify, adjust or improve the methodology at its option. If Treasury determines that the methodology needs to be changed or updated, Treasury will revise the above description to reflect such changes.

Yield curve rates are usually available at Treasury’s interest rate web sites by 6:00 PM Eastern Time each trading day, but may be delayed due to system problems or other issues. Every attempt is made to make this data available as soon as possible.

This is a much more sensible way to estimate what a reasonable person might call a “Five Year Yield”, with the reservation that I have always been deeply suspicious of the cubic spline curve fitting methodology. It is too abstract for me and there are mathematical problems at the knot points. But I can’t deny that it fits the data well.

While all of this may be considered illuminating, it still doesn’t really answer Assiduous Reader gsp-from-FWF’s problem: what number should he plug into his calculation in order to estimate a projected future dividend rate for FixedResets? Because the following definitions from the prospectus for RY.PR.J are pretty typical:

“Annual Fixed Dividend Rate” means, for any Subsequent Fixed Rate Period, the rate (expressed as a percentage rounded to the nearest one hundred–thousandth of one percent (with 0.000005% being rounded up)) equal to the Government of Canada Yield on the applicable Fixed Rate Calculation Date plus 2.74%.

“Bloomberg Screen GCAN5YR Page” means the display designated on page “GCAN5YR” on the Bloomberg Financial L.P. service (or such other page as may replace the GCAN5YR page on that service for purposes of displaying Government of Canada bond yields).

“Fixed Rate Calculation Date” means, for any Subsequent Fixed Rate Period, the 30th day prior to the first day of such Subsequent Fixed Rate Period.

“Government of Canada Yield” on any date means the yield to maturity on such date (assuming semi-annual compounding) of a Canadian dollar denominated non-callable Government of Canada bond with a term to maturity of five years as quoted as of 10:00 a.m. (Toronto time) on such date and which appears on the Bloomberg Screen GCAN5YR Page on such date; provided that, if such rate does not appear on the Bloomberg Screen GCAN5YR Page on such date, the Government of Canada Yield will mean the arithmetic average of the yields quoted to the Bank by two registered Canadian investment dealers selected by the Bank as being the annual yield to maturity on such date, compounded semi-annually, which a noncallable Government of Canada bond would carry if issued, in Canadian dollars in Canada, at 100% of its principal amount on such date with a term to maturity of five years.

And we don’t know how the GCAN5YR page is calculated (because it’s Bloomberg), although we can guess that it’s more akin to the US Treasury interpolation-on-a-fitted=curve method than it is to the Canadian pick-a-bond method because of the way the alternative calculation is stated. But that’s not a guarantee! Don’t bother calling your salesman to find out: if there’s one thing I have learnt over the course of my career, it’s that front-line staff don’t have a clue how their software works and wouldn’t understand it if they were told. They’re bankers, the sweet little dears, it’s their job to say “0.74 per cent” in a sincere voice, not to have a clue.

And, what’s more, we can’t even look up (for free) just what the GCAN5YR page might be saying at any particular point in time because fuck you, that’s why.

I don’t have Bloomberg – it’s incredibly expensive, it’s completely useless for serious work and it rots the brain – so I can’t provide any clues as to how the number might be calculated. Perhaps if some kind reader who does have access could provide a screenshot or two taken at around 4pm we can examine the matter more closely.

Utilities and Preferred Shares

Friday, November 13th, 2009

This is way out of date, but I ran across it and thought I’d pass it along anyway.

The following is from the Alberta Energy & Utilities Board Decision 2006-100, regarding Atco Utilities [AU]:

AU submitted that its preferred shares have ensured that its customers have enjoyed the benefits of the lowest cost financing on the most flexible terms available in the Canadian financial market because AU’s existing preferred shares provide support to its credit rating.

The Board notes that AU provided an analysis indicating that replacing preferred shares with debt would provide initial savings but the cumulative savings would become negative within four years due to the cumulative higher costs of new debt issued each year.

The Board notes that the approach used by both AU and CG to determine the cost effectiveness of preferred shares is dependent on AU’s specific debt requirement needs, with a focus on the next four to six years. However, all debt would eventually be refinanced and accordingly would be affected by any lower credit rating. In the Board’s view, the cost effectiveness of using preferred shares should be evaluated on a more generic basis that considers the long-run steady state impacts and that is not dependent on the particular immediate borrowing needs of AU. This can best be accomplished by comparing the total yearly cost of non-common equity financing with and without preferred shares at current market rates for debt and preferred shares. In this context “current” refers to the most current market figures available on the record of this proceeding.

AU’s updated evidence indicated that preferred shares had a current market cost of 4.60% and that AU’s income tax rate was currently 31.37%. This translates to a pre-tax cost of (4.60/ (1-0.3137)) 6.70%. AU’s updated evidence indicated that the current market cost for long-term debt was 5.75%. As a result, preferred shares were estimated to have a current market cost that was 95 basis points higher than the current market cost of debt, at the time of that estimate.

The ATCO Utilities proposed a preferred equity ratio of 6% and a debt ratio that approximates 57% across the four ATCO Utilities, which would then approximate 63% if the preferred shares were replaced with debt. In these proportions, the debt portion of capital is approximately 10 times larger than the preferred equity portion of capital. On this basis, the Board calculates that if the debt costs were to rise by any more than approximately 10 ( i.e. 95/10) basis points, due to the replacement of preferred shares with debt, then the added cost of the (then) approximately 63% debt component would outweigh the approximate 95 basis points savings on the current 6% preferred share component. The Board notes that, in keeping with its steady-state approach, this calculation assumes that the added cost would apply to both existing and new debt.

AU’s expert, Mr. Neysmith indicated that replacing AU’s preferred shares with debt would lead to a debt credit rating downgrade of at least one to two notches. AU estimated that this would increase its debt interest costs by 30 to 60 basis points. AU also provided a letter from a financial market advisor, Mr. Engen, which indicated that AU’s interest costs would rise by 5 to 10 basis points if the market viewed CU’s regulatory environment to be largely unchanged and 20 to 40 basis points if the market viewed CU’s regulatory environment as having worsened because of the Board’s decision to remove the preferred shares. Both of these estimates were based on current market conditions. Mr. Engen indicated that in a less attractive spread environment, the differential could be expected to widen.

It is not clear how many basis points would be added to AU’s debt costs if preferred shares were replaced with debt. However, the Board accepts that directionally it should expect some increase in debt costs in such a scenario. The Board accepts AU’s submission that the debt cost impact would vary depending on market conditions. In the Board’s view, a 10 basis points or greater increase in debt costs for AU resulting from the discontinuance of the use of preferred shares in AU’s capital structure would be sufficient to demonstrate the continued cost effectiveness of employing preferred shares. The Board considers the evidence provided by AU and its experts persuasive that the discontinuance of the use of preferred shares could be expected in the present market conditions to increase AU’s debt costs by approximately 10 basis points. The Board also notes that AU’s evidence indicated that the impact could be as high as 60 basis points. Therefore the Board finds that the continued use of preferred shares is cost effective at this time.

Under cross-examination by Board Counsel, AU indicated the optimum amount of preferred shares had been estimated by AU to be within a range of 5% to 10%.

It should be noted that the Alberta Utilities Commission sets Return-on-Equity allowances for the utilities it regulates based on common equity:

In addition, in Decision 2009-216, 2009 Generic Cost of Capital, issued today, the AUC set a new return-on-equity (ROE) level of nine per cent for all the utilities for 2009 and 2010, and established moderately higher individual equity ratios for each of the firms. The changes were in part to address pressures stemming from the global credit crunch.

The changes apply to all regulated utilities in Alberta serving the electricity and natural gas sectors. These include distribution and transmission providers. The uniform, or generic, ROE is applied to the portion of a utility’s rate base financed by common equity to determine the utility’s return on equity capital.

CDS Recovery Locks

Thursday, September 4th, 2008

Well, the primer on plain vanilla Credit Default Swaps is getting a little messy, so here’s a dedicate post to recovery locks.

There was a good discussion in the Derivatives chapter of the BIS Quarterly Review of June 2006:

Under certain circumstances, a shortage of deliverable debt can drive up the price of such paper beyond the level that might otherwise be justified by the expected size of repayment. In the case of Delphi, the settlement price of 63.5% (and an average CDS recovery price of 53.5%) was considerably higher than the settlement prices of other firms from the same sector or than rating agencies’ estimates of the ultimate recovery rates on Delphi’s debt.

The Delphi auction underlined the importance of recovery risk for pricing CDSs. Several products have emerged that permit investors to trade this risk separately from default risk (see box). The prices of such products could provide a benchmark against which deliverables could be priced following a credit event, perhaps leading to a more efficient settlement process.

Fixed recovery CDSs In a standard CDS contract, the protection seller is exposed to recovery rate risk upon default of the reference entity in the contract. A fixed recovery CDS eliminates the uncertainty on the recovery rate by fixing a specific recovery value for the CDS contract. In the event of the reference entity’s default, the protection seller makes a cash settlement equal to 100 minus the contract’s fixed recovery rate. If the fixed recovery rate is set to zero, the instrument is referred to as a zero recovery CDS.

Recovery locks

A recovery lock is a forward contract that fixes the recovery rate irrespective of what the secondary market price for the bond is. A recovery lock is documented as a single trade.
Recovery swaps or digital default swaps. In practice, a recovery lock can be structured using two separate trades: a fixed recovery CDS and a plain vanilla CDS. For example, the purchase of a recovery lock at 44% can be seen as two separate transactions, the first one selling protection on a standard CDS, and the second one buying protection through a fixed recovery CDS on the same reference entity at 44%. If the CDS spreads for both transactions happen to be identical, then the premium payments on the transactions will net to zero. If the reference entity defaults, the recovery buyer will take delivery of the defaulted debt and pay 44% of the face value of the bond to the counterparty in the transaction. If the premium payments are not identical for the two transactions, the notional amount for which the recovery is purchased can be adjusted to ensure that there are no interim cash flows in the absence of the reference entity’s default. The paired transaction described here is referred to as a recovery swap or digital default swap. A recovery swap, unlike a recovery lock, is documented as two separate trades.

It wasn’t just Delphi that highlighted the issue, there was a problem with Dana:

Dana Corporation filed for bankruptcy on March 3, 2006. The auto parts maker had about $2 billion in bonds outstanding. However, there was more than $20 billion of CDS outstanding in notional amount referencing the company. This ignited some concerns about a possibility of a short squeeze, as most single-name CDS contracts require physical settlement (i.e., delivery of a bond). Indeed, prices of Dana bonds started to climb from the low 60s reached in late February, one week before the filing (see the chart below). The bond prices soared above 80 on days leading up to the ISDA-led CDS index auction on March 31.

A template contract is available from ISDA.

There was a report dated August 14, however, that the recovery lock market is very thin:

In their latest research report, Bank of America analysts say there are many risks involved in the recovery lock market. They maintain they are not suitable for all investors. Particularly, recovery locks are a relatively new and untested market. They also say recovery locks have significantly less liquidity than regular CDS, such as a smaller size, wider bid-offer premium and fewer dealers making markets. Since recovery locks trade on reference entities that have suffered significant spead widening over the past year, it indicates a greater degree of protection buying and potential for a one-way market, they say. Recovery locks may also be more difficult and more expensive to roll than regular CDS. Also, they say it may be harder to monetize profits in a recovery lock relative to CDS.

This is a problem with all structured products. Typically, you buy (or sell) a structured product because there’s nothing else available that does precisely what you want. Trouble is, this becomes a much more specialized market by definition, and the market will be thin – sometimes very thin indeed. This doesn’t necessarily make the product a bad one, but remember Rule #1: Never invest in anything you’re not prepared to hold forever.

Update, 2008-9-9: An interesting nuance has arisen as a result of the Fannie/Freddie Fiasco: the structured preferred share issue RPB.PR.A has a recovery lock of 40% on its GSE exposure … which might be triggered even though actual recovery will be close to, if not equal to, 100%

PerpetualDiscount Duration Calculation

Monday, August 11th, 2008

Very simple.

Given that the yield is “r” per period and that the first payment is received exactly one period hence:

Macaulay Duration = (1+r) / r

Modified Duration = 1 / r

And here’s the proof (TIF file).

Note that, strictly speaking, these are the durations of a perpetual annuity; the assumption of perpetuity gets shakier as redemption becomes more likely.

Basel II in the United States : CRS Report RL33278

Thursday, July 24th, 2008

This background report has been written by the Congressional Research Service.

Good background, an excellent primer. Of particular interest was:

The third pillar of the Basel II framework is public disclosure. Pillar three is a set of public information disclosures that a bank must make about itself. These disclosures are to make it easier for creditors and investors in financial markets to assess a bank’s risk posture more accurately and adjust borrowing and capital costs accordingly. The idea behind this requirement is to bring market discipline to bear to give bank management a cost incentive to adopt strong safety and soundness practices. The disclosure requirements will also make it easier for depositors, investors, and regulators to make comparisons across banking institutions. This knowledge, in turn, is expected to affect the willingness of investors to invest in banks and their related businesses. Without pillar three, financial institutions could become more opaque and more difficult to understand as the institutions develop new products and complex risk-hedging strategies that are difficult to evaluate. It could also make it more difficult to understand the risk profile of the firm creating and selling these products as well as the firms buying and using them.

Stirring principals certainly; I’m not sure how well it works in practice, but I do find American disclosure far superior to Canadian disclosure. OSFI, for instance, will not reveal why they have given Royal Bank an increased Assets to Capital multiple cap for the last five-odd years.


Wednesday, June 18th, 2008

On an old thread regarding RY.PR.K, Assiduous Reader Kaitas21 asked:

Hi Hymas,

I wonder if you could shed some light on the RY.PR.K or even the recent Brookfield Asset Management 5.00% Cumulative, Convertible Class A Preference Shares, Series 21. Both issues have the conversion privilege to convert the prefs into their underlying common shares at the discretion of the issuer AND the holder. But if the holder exercises his/her conversion rights, the issuer can decide not to give the shares and redeem them into cash. So it seems that this type of prefs are linked to the common shares. How does this affect the price of the pref ? RY.PR.K is trading above par and it’s IPO coupon is 4.72%.

thanks again!

Note that this is a question of great pith and moment because the mechanism of retraction is common among retractibles; it should be noted that RY.PR.K has been called for redemption.

On the PrefInfo Help Page, I note:

A Retraction is an option available to the shareholder, whereby the shareholder may force the issuer to purchase (or to find an alternate third-party to purchase) his shares at the indicated price. It should be noted that Hymas Investment Management is not aware of any retraction privileges which do not have accompanying Redemption options that are exercisable prior to the eligibility period for the Retraction at a price lower than that specified or implied by the Retraction – so it is most conservative to assume that such a Redemption Option will be exercised immediately prior to the first Retraction date.

It should also be noted that many Retraction options specify that the shareholder will not receive cash, but will receive common shares at a price of 95% that of market, to a total value equal to the par value of the preferred shares retracted. Allowing 1% of this total value for commissions and differences between the calculated market value and the price that the shareholder might actually recieve when selling these shares results in, for instance, a $26.04 = ($25.00 / 0.96) presumed retraction price on a share with a par value of $25 on which common is received at 95% of market and presumed to be sold immediately.

The stipulation that in the case of conversion into shares the shares are priced at 95% of the then current market price means that the prefs are not, in fact, linked all that closely with the common. In the case of a $25 preferred share being converted to shares, if the computation of 95% of the market price is $25, the holder will receive one common for each preferred. If the computation results in a figure of $100, the holder will receive one common for every four preferreds. In any event, assuming a steady market, the holder is receiving common at a rate of:

Market Value of Common Received = (Par Value of Preferred) / 0.95

or, for a $25 preferred, $26.32.

When entering figures into the HIMIPref™ database, I actually use a divisor of 0.96, resulting in a figure of $26.04, to account for commissions and differences between the computed market price and the price that the holder might actually sell it at. Note that this is an approximation! It is entirely possible that the market value of the common could plunge in the period between the computation and the first chance the holder has to sell the stock. The process is not a risk-free conversion.

One other nuance to be noted is that the minimum conversion price is usually set to $2, implying that the maximum number of common shares receivable for each preferred is 12.5. This protects the common equity holders from extreme dilution in the event that, for instance, the price of the common goes to $0.01 which, in the absence of a minimum, would result in preferred shareholders would get 2,500 common shares per preferred.

If there is no minimum price, the conversion feature is referred to as a death spiral conversion provision:

Company completed a convertible debt financing containing terms that are commonly referred to in the investment community as “death spiral” conversion provisions. In financings such as these, any drop in the Company’s stock price has the potential to create a negative feedback loop of massive dilution, occurring when a company uses its shares (valued at a 10% discount to market) to pay principal and interest on the debt, which dilution in turn could drive further steep drops in the Company’s stock price, which market decline could in turn lead to even greater dilution upon the next payment of principal and interest using company stock, and so on.

The chances of, say, Royal Bank’s common price going below $2 and thus resulting in a potentially massive short-changing of the preferred shareholders are very slim. However, this provision has been very important in the conversion of IQW.PR.C in which the $2 stated minimum price is used, rather than the market price of somewhere around $0.20. It may not happen often, but it does happen … and IQW.PR.C holders are getting about 13 shares (since the conversion amount includes about $1 in unpaid dividends), worth about $2.60, for their $25.00 retractibles. That’s one of the risks!

All in all … if the company is healthy and has a double-digit share price, you can assume for analytical purposes that the company will elect to pay out $25.00 cash rather than $26.00 in shares. There are risks, but they’re relatively minor.

If the company is not healthy and does not have a double-digit share price … well, then, the retractible preferred are a speculation with their equity characteristics overwhelming the fixed-income characteristics.

Bank Regulation: The Assets to Capital Multiple

Tuesday, April 15th, 2008

I have been fascinated with the IMF Global Financial Stability Report that was recently reviewed on PrefBlog … particularly Figure 1.17:


The IMF comments:

Some banks have rapidly expanded their balance sheets in recent years, largely by increasing their holdings of highly rated securities that carry low risk weightings for regulatory capital purposes (see Box 1.3 on page 31). Part of the increase in assets reflects banks’ trading and investment activities. Investments grew as a share of total assets, and wholesale markets, including securitizations used to finance such assets, grew as a share of total funding (Figure 1.16). Banks that adopted this strategy aggressively became more vulnerable to illiquidity in the wholesale money markets, earnings volatility from marked-to-market assets, and illiquidity in structured finance markets. Equity markets appear to be penalizing those banks that adopted this strategy most aggressively (Figure 1.17).

The variation in multiple for the banks listed is ENORMOUS. The new derisive nickname for UBS is Union Bank of Singapore … but what are the implications for Canadian banks?

First, let’s gather up the ratios for these banks:

Assets to Risk-Weighted-Assets Ratios for Canadian Banks
Risk-Weighted Assets 241,206 234,900 163,230 179,487 128,267
Total Assets 632,761 449,422 435,200 376,825 347,734
Assets:RWA 2.6 1.9 2.7 2.1 2.7

All the numbers are within the range for most banks – as reported by the IMF – but there are some fascinating differences that I might write about at another time.

Clearly, however, these differences can be significant and there is a clear indication that UBS was “gaming the system” by loading up with AAA assets that had no risk weight but – regardless of their investment merit – had, shall we say, considerable mark-to-market risk.

OSFI attempts to control such gaming by the imposition of an Assets-to-Capital multiple:

Institutions are expected to meet an assets to capital multiple test on a continuous basis. The assets to capital multiple is calculated by dividing the institution’s total assets, including specified off-balance sheet items, by the sum of its adjusted net tier 1 capital and adjusted tier 2 capital as defined in section 2.5 of this guideline. All items that are deducted from capital are excluded from total assets. Tier 3 capital is excluded from the test.

Off-balance sheet items for this test are direct credit substitutes1, including letters of credit and guarantees, transaction-related contingencies, trade-related contingencies and sale and repurchase agreements, as described in chapter 3. These are included at their notional principal amount. In the case of derivative contracts, where institutions have legally binding netting agreements (meeting the criteria established in chapter 3, Netting of Forwards, Swaps, Purchased Options and Other Similar Derivatives) the resulting on-balance sheet amounts can be netted for the purpose of calculating the assets to capital multiple.

Under this test, total assets should be no greater than 20 times capital, although this multiple can be exceeded with the Superintendent’s prior approval to an amount no greater than 23 times. Alternatively, the Superintendent may prescribe a lower multiple. In setting the assets to capital multiple for individual institutions, the Superintendent will consider such factors as operating and management experience, strength of parent, earnings, diversification of assets, type of assets and appetite for risk.

BMO is to be commended for disclosing its Asset-to-Capital multiple of 18.39, but I don’t see this number disclosed for any of the others. So … it will have to be done roughly, using the total assets from the table above, over the total regulatory capital:

Assets to Risk-Weighted-Assets Ratios for Canadian Banks
Total Assets 632,761 449,422 435,200 376,825 347,734
Total Regulatory Capital
Tier 1 + Tier 2
27,113 23,874 23,117 20,203 18,713
Very Rough
(internal check)
Total Capital
11.2% 10.2% 14.2% 11.3% 14.6%
The internal check on the Assets-to-Capital multiple is the Assets-to-RWA multiple divided by the Total Capital Ratio. Variance will be due to rounding.

Well! This is interesting! According to these very, very rough calculations, RBC has an Assets-to-Capital multiple of 23.3:1, which is both over the limit and well above its competitors. This may be a transient thing … there was a jump in assets in the first quarter:

RBC: Change in Assets
From 4Q07 to 1Q08
Item Change ($-billion)
Securities +6
Repos +12
Loans +8
Derivatives +7
Total +33

I have sent the following message to RBC via their Investor Relations Page:

I would appreciate learning your Assets-to-Capital multiple (as defined by OSFI) as of the end of the first quarter, 2008, and any detail you can provide regarding its calculation.

I have derived a very rough estimate of 23.3:1, based on total assets of 632,761 and total regulatory capital of 27,113

Update, 2008-04-17: RBC has responded:

Thank you for your question about our assets to capital multiple (ACM). In keeping with prior quarter-end practice, we did not disclose our ACM in Q1/08 but were well within the OSFI minimum requirement. Our ACM is disclosed on a quarterly basis (with a 6-7 week lag) on OSFI’s website. We understand this should be available over the next few days. Below is an excerpt from the OSFI guidelines outlining the calculation of the ACM. We hope this helps.

Update, 2008-6-4: From the FDIC publication, Estimating the Capital Impact of Basel II in the United States:


Wednesday, March 5th, 2008

The following has been copied from the comments to March 4, 2008. The rule of thumb is: if one person asks, twenty want to know! The question was:

I enjoy your blog but I still have a lot to learn. What do you mean by “crossed” in the Notes section of the volume highlights when you write “RBC crossed 15,000 at 19.07″ or “RBC crossed 100,000 at 23.20, then Nesbitt crossed 50,000 at the same price”? I assume you mean they bought the stock at that price but I am just not sure. Thks


A dealer “crosses” a trade when he acts for both the buyer and the seller. In institutional trading, it is very common for large trades not to be posted publicly – showing too much size might scare away counterparties, and lead to other traders playing traders’ games. 

There are other, better reasons: say, for instance that you are the investment manager for 100 clients holding varying numbers of shares. If you were to put it up publicly and only get a partial fill – say, 57,600 shares – you’ve got headaches splitting it up fairly and headaches having all those clients with tiny, virtually untradeable positions.

The best reason for doing this is if the order is contingent: maybe you want to sell PWF.PR.K to buy POW.PR.D and take out $0.45 on the switch. In that case, the dealer’s got two orders to fill. Maybe he can sell the PWF.PR.K, but can’t find any POW.PR.D for you (or he finds some, but he can’t put the deal together in such a way that you take out your $0.45). In that case, nothing will happen – and the next day, maybe you’ll call another dealer.

Whatever your reason, if you want to sell 100,000 shares of PWF.PR.K, you will not get your dealer to put this on the board for you. What you will do is ask him to find a buyer. He then checks his rolodex for people who have shown interest in PWF.PR.K in the past – or managers he’s talked to recently who have expressed a longing to purchase a high quality perpetual discount issue of any nature – and start dealing. Once he’s found a buyer who is willing to pay what you’re willing to sell for, he’s happy.

The exchange requires that this trade be recorded on their books. As long as the price is equal to or higher than the posted bid, and equal to or lower than the posted offer, then everything is OK and the trade gets filled as a cross.

A more specialized type of cross is when the dealer is acting for both the buyer and the seller – and so is the investment manager! This is an internal cross. The investment manager might have two funds: Acme Dividend Fund and Acme Preferred Share Fund. These two funds have differing cash flows, such that Dividend Fund needs to raise $2.5-million, and Preferred Fund needs to invest the same amount. In many cases – not all cases, but many cases – it makes sense according to the mandates of both funds that one sells to other. The investment manager gets the dealer to do it for him, the dealer ensures the price is fair, marks the trade as an “internal cross”, and Bob’s your uncle.

There are other specialized cross types as well.