Archive for the ‘Regulation’ Category

S&P Revises Bank Outlook to Stable on Federal Complacency

Saturday, December 12th, 2015

Standard & Poor’s has announced:

  • •We continue to evaluate the likelihood, degree, and timeframe with respect to which the default risk of systemically important Canadian banks may change as a result of the government’s progress toward introducing a bank bail-in framework.
  • •We now expect that the timeframe could be substantially longer than we had previously assumed. We see the absence of the topic from the new government’s Dec. 4 Speech from the Throne as recent, incremental evidence in this regard.
  • •We now do not expect to consider the removal of rating uplift for our expectation of the likelihood of extraordinary government support from the issuer credit ratings (ICRs) on systemically important Canadian banks until a point beyond our standard two-year outlook horizon for investment-grade ratings, if at all.
  • •When and if we remove such uplift, the potential ratings impact will also consider uplift for additional loss-absorbing capacity, as well as any changes to our stand-alone credit profiles on these banks.
  • •As a result, we are revising our outlooks on all systemically important Canadian banks to stable from negative.

RATING ACTION
On Dec. 11, 2015, Standard & Poor’s Ratings Services revised its outlooks on the Canadian banks that it views as having either “high” (Bank of Montreal, The Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Royal Bank of Canada, The Toronto-Dominion Bank), or “moderate” (Caisse centrale Desjardins and National Bank of Canada) systemic importance, to stable from negative (see ratings list). The issuer credit ratings (ICRs) on the banks are unchanged.

RATIONALE
We believe that the potential negative ratings impact of a declining likelihood of extraordinary government support, at least within our standard two-year outlook horizon, has subsided. This reflects our updated view that there could be an extended implementation timetable–2018 or later–for the proposed Canadian bail-in framework. Importantly, at the point we would consider removing any uplift from the likelihood of extraordinary government support from our ratings, we would also consider the potential ratings impact of any uplift for additional loss-absorbing capacity (ALAC), as well as any
changes to our stand-alone credit profiles (SACPs) on these banks. In our view, the extended timetable introduces some potential that either the presence of ALAC or fundamental changes in credit quality at individual banks might come into play more than under the previously contemplated timetable.

We had revised our outlooks on systemically important Canadian banks to negative chiefly in reaction to the former government’s “Taxpayer Protection and Bank Recapitalization Regime” consultation paper of Aug. 1, 2014, as we then expected a bail-in regime could be fully implemented by 2016 (see “Outlook On Six Big Canadian Banks Revised To Negative Following Review Of Bail-In Policy Proposal,” published Aug. 8, 2014, on RatingsDirect). A number of subsequent developments have caused us to re-evaluate this expectation:

  • •In its April 2015 budget proposal, the former government affirmed its intention to introduce a bank bail-in regime in Canada, but it provided only very limited additional information relative to what it had outlined in its 2014 consultation paper; nor did the government make substantial subsequent public statement on the topic; nor did it specify timing for the announcement of its fully-developed (post-consultation) legislative proposal.
  • •The Oct. 19 federal election changed the party in government to Liberal (center-left), from Conservative (center-right). The former government’s proposed bail-in regime did not feature prominently in election debates.
  • •The new government’s Dec. 4 Speech from the Throne made no mention of the proposed bail-in framework, nor were any of the legislative priorities enumerated therein closely related, in our opinion. We believe this indicates the introduction of a bail-in framework is not among the immediate priorities of the new government.

Moreover, with Canada experiencing no government bank bail-outs, nor large bank failures, for decades, we believe the political incentive to rapidly end “too-big-to-fail” is less in Canada than in the U.S. and several EU countries, which are jurisdictions under which we have already removed uplift for our expectation of the likelihood of extraordinary government support from our ratings (see “U.S. Global Systemically Important Bank Holding Companies Downgraded Based On Uncertain Likelihood Of Government Support,” and “Most European Bank Ratings Affirmed Following Government Support And ALAC Review,” both published Dec. 2, on RatingsDirect). We will take this factor into consideration as we continue to evaluate our view on the likelihood of extraordinary government support in Canada relative to not only the U.S. and Europe, but also other jurisdictions where we maintain a government support assessment of “supportive” or “highly supportive” under our criteria (such as for many countries in Latin America and Asia-Pacific; see “Banking Industry Country Risk Assessment Update: November 2015,” published Nov. 27).

We now believe the procedural hurdles to passing legislation and related regulations (the latter after passage of the former) for a bail-in regime will alone require a minimum of one-to-two years, after the new government decides on a final legislative framework to propose to Parliament. Considering all of this, we now expect the eventual date for initial implementation of the bail-in regime (that is, banks issuing bail-inable debt) could be in 2018 or later.

In addition, and in contrast to bail-in frameworks outlined by U.S. authorities or in European countries like Germany, Canadian officials’ statements have made clear that only debt issued or renegotiated after an initial implementation date would be subject to conversion. It will take some time for the banks to issue or renegotiate bail-inable debt. We believe this means it could take several years after the initial implementation date before we would consider a Canadian bail-in regime effective, so as to provide a viable alternative to the direct provision of extraordinary government support.

As well, and again in contrast to the U.S. and EU jurisdictions, Canadian governments have made no attempt to limit their ability to provide direct extraordinary support to their banks, if needed. We expect bailing in senior creditors to be the first Canadian policy response in the face of a crisis. At the same time, we believe Canadian governments would be likely to consider all policy options, in such a circumstance. It is therefore not certain that the introduction of a bail-in regime would of itself result in our revising our government support assessment on Canada to “uncertain” from the current “supportive” and the removal of rating uplift for our view on the likelihood of extraordinary government support from our ICRs on systemically important Canadian banks. Rather, our decision would depend, among other factors, on the details of the eventual bail-in regime, including the extent to which bail-inable and unbail-inable senior debt is distinguishable.

Partly to honor G-20 and other international commitments, the Canadian government will, we expect, present a finalized legislative proposal for the bail-in framework in 2016 or 2017. However, we expect an implementation date that could be in 2018 or later, and we think it could take at least one and possibly several years more for substantial bail-in eligible debt to be in place. With a runway that long, the potential ratings impact from removing uplift for the likelihood of extraordinary government support is beyond our standard two-year outlook horizon for investment-grade ratings, and could by then be more meaningfully affected by either ALAC uplift (from the bail-inable debt, assuming our related criteria are met) or SACP changes, than under the previously contemplated timetable.

When the government presents the detailed provisions of the framework, along with a more specific timeframe, we will review the applicable notching for various bank liabilities, taking into account the framework’s implications on different instruments. We expect that issue ratings on new bail-inable instruments will be at a level that is notched in reference to banks’ SACPs, while ratings on non-bailinable senior debt may continue to incorporate rating uplift above the banks’ SACPs, based on our expectation of the likelihood of extraordinary government support, or ALAC.

OUTLOOK
Our outlooks on the systemically important Canadian banks are stable, based on our reassessment of the likelihood, degree, and timeframe with respect to which the default risk of systemically important Canadian banks may change as a result of the government’s progress toward introducing a bank bail-in framework. We believe that the likelihood of extraordinary government support will continue to be a factor in systemically important Canadian bank ratings throughout the current outlook period.

Moreover, we believe these banks will continue to exhibit broad revenue diversification, conservative underwriting standards, and strong overall asset quality. Our current view is that the impact of low oil prices on their profitability and credit quality will be contained, given the modest direct exposure of the banks to the oil and gas sector, and the limited knock-on impact so far on consumer credit in regional economies affected by low oil prices.

On the other hand, we continue to monitor a number of key downside risks to our ratings on these banks, including low margins, high Canadian consumer leverage, residential real estate prices we believe are at least somewhat inflated in some parts of Canada, a Canadian macroeconomic outlook that is very tentative, and the higher-risk nature of certain recent foreign acquisitions.

The August 2014 imposition of Outlook-Negative was reported on PrefBlog, as was the federal consultation on the recapitalization regime. As far as I can tell, the comments received on the consultation paper have not been published; I believe this is because Canadians are too stupid to understand smart stuff like legislation and parliament and all that – if given a pile of comments to work through, we’d probably try to eat them.

Issues affected are:

BMO.PR.K, BMO.PR.L, BMO.PR.M, BMO.PR.Q, BMO.PR.R, BMO.PR.S, BMO.PR.T, BMO.PR.W, BMO.PR.Y and BMO.PR.Z

BNS.PR.A, BNS.PR.B, BNS.PR.C, BNS.PR.D, BNS.PR.L, BNS.PR.M, BNS.PR.N, BNS.PR.O, BNS.PR.P, BNS.PR.Q, BNS.PR.R, BNS.PR.Y and BNS.PR.Z

CM.PR.O, CM.PR.P and CM.PR.Q

NA.PR.Q, NA.PR.S and NA.PR.W

RY.PR.A, RY.PR.B, RY.PR.C, RY.PR.D, RY.PR.E, RY.PR.F, RY.PR.G, RY.PR.H, RY.PR.I, RY.PR.J, RY.PR.K, RY.PR.L, RY.PR.M, RY.PR.N, RY.PR.O, RY.PR.P RY.PR.W and RY.PR.Z

TD.PF.A, TD.PF.B, TD.PF.C, TD.PF.D, TD.PF.E, TD.PF.F, TD.PR.S, TD.PR.T, TD.PR.Y and TD.PR.Z

Update On OSFI Insurer Regulation

Thursday, December 10th, 2015

OSFI Assistant Superintendent Neville Henderson gave a speech to the 2015 Life Insurance Invitational Forum:

Domestic Insurance Capital Standards

On the domestic front, we are still on track to implement OSFI’s new life insurance regulatory capital framework in 2018. The new capital framework will provide a superior risk based assessment methodology for determining capital requirements. The new test will make use of more current analysis and methodologies as well as explicitly taking into account mitigating actions and diversification benefits. It will allow our capital requirements to remain state of the art compared to those of other jurisdictions.

The capital changes in the new framework are explicitly calibrated to a consistent level of conditional tail expectation (CTE) across the various risks. Actuarial valuation of insurance company liabilities are explicitly intended to include conservative margins with the degree of conservatism varying across risks.

To help ensure that this approach results in consistent capital measures across companies, OSFI has asked the Canadian Institute of Actuaries and the Actuarial Standards Board to consider certain issues with a view to updating actuarial standards and /or guidelines if required.

To avoid double counting and inconsistent treatment of different risks, this new framework will include margins for adverse deviations as an available capital resource.

While we are awaiting the results of Quantitative Impact Study (QIS)7, we are in the process of planning to conduct two framework runs, one in 2016 followed by another one in 2017. These “test drives” will allow us to validate the new capital test and help insurers gear up for the updated regulatory compliance requirements under the new framework.

We should also have a final guideline ready for issue in July 2016, following input from the industry on the draft. Any anomalies uncovered in the testing will be taken into consideration prior to implementation. This will allow time for industry feedback and enable insurers to plan and prepare their systems for implementation of the framework in early 2018.

Global Insurance Capital Developments

While work continues on the domestic front, there are also developments in standards for internationally active insurers.

The International Association of Insurance Supervisors (IAIS) is refining the Basic Capital Requirement (BCR) and Higher Loss Absorbency (HLA) requirements for Global Systemically Important Insurers (GSIIs) for implementation in 2019. Work in this area is aimed at mitigating or avoiding risks to the global financial system.

To eventually replace the BCR, the IAIS is developing an internationally agreed upon risk based capital test. The Insurance capital standard (ICS 1.0) for the broader list of Internationally Active Insurance Groups (IAIG) will be ready by the end of 2016, for implementation in 2019.

OSFI looks carefully at the Canadian marketplace and Canadian requirements before deciding whether to adopt international standards. We will take ICS into consideration as we fine tune our current capital tests. The work we do on the OSFI life insurance framework already includes many of the changes stemming from these international standards and we don’t expect ICS 1.0 to be as sophisticated as our current Minimum Continuing Capital and Surplus Requirements (MCCSR) capital test. Consequently, we do not foresee a need to implement any significant changes.

The significant changes will likely come as ICS 2.0 is finalized. It may bring sufficient worldwide convergence for OSFI to start thinking about implementation.

The important thing about ICS is that this is what will determine whether or not preferred shares must be convertible into equity (or have other pre-bankruptcy capital loss absorption features) in order to be counted as Tier 1 capital. This proposal is outlined in the Consultation Paper “Risk-based Global Insurance Capital Standard” which is available in a ludicrously inconvenient manner, paragraph 92 with associated question 25:

92. The IAIS is considering a requirement for a principal loss absorbency mechanism to apply to Tier 1 instruments for which there is a limit. This principal loss absorbency mechanism would provide a means for such instruments to absorb losses on a going-concern basis through reductions in the principal amount in addition to cancellation of distributions.

Question 25. Should Tier 1 instruments for which there is a limit be required to include a principal loss absorbency mechanism that absorbs losses on a going-concern basis by means of the principal amount in addition to actions with respect to distributions (e.g. coupon cancellation)? If so, how would such a mechanism operate in practice and at what point should such a mechanism be triggered?

OSFI’s response to this question is available in the document “Compiled Responses to ICS Consultation 17 Dec 2014 – 16 Feb 2015”, which is also available in a ludicrously inconvenient manner:

No, OSFI does not support the inclusion of a principal loss absorbency mechanism on Tier 1 instruments for which there is a limit. Tier 1 instruments must be able to absorb losses on a going concern basis, which these instruments do through coupon cancellation.

Despite this, I expect that OSFI will adopt whatever ends up being in ICS, as in this way any future criticism will be deflected to the international body and they will be able to keep their jobs and continue angling for future employment with those whom they currently regulate.

OSFI’s response to this – and other – questions has never been explained to the Canadian public as far as I know, because we’re disgusting taxpayer and investor scum, not worth the dirt underneath our own fingernails.

Further discussion of the capital standard and my reasons for believing that the NVCC rule will be applied to insurers and insurance holding companies are provided in every edition of PrefLetter.

CSA To Commence Crippling Canadian Corporate Bond Market

Friday, September 18th, 2015

The Canadian Securities Administrators have announced that they have:

published for comment CSA Staff Notice 21-315 Next Steps in Regulation and Transparency of the Fixed Income Market, which describes the CSA’s plan to enhance fixed income regulation.

The Notice sets out the steps CSA staff are taking to improve market integrity, evaluate access to the fixed income market and facilitate more informed decision making among market participants.

The CSA Staff Notice can be found on CSA members’ websites. The 45-day comment period will close on November 1, 2015.

Naturally the CSA can’t put actual links on the press release announcing their existence. That would be too simple, but after some poking around we find on the OSC website CSA Staff Notice and Request for Comment 21-315 Next Steps in Regulation and Transparency of the Fixed Income Market:

On April 23, 2015, staff of the Ontario Securities Commission (OSC) published a report titled The Canadian Fixed Income Market 2014 (the Report).{2} The Report presented a fact-based snapshot of the $2 trillion fixed income market in Canada, with particular emphasis on the $500 billion in corporate debt outstanding.{3} The Report also highlighted the following:

1. fixed income data available is limited and fragmented across a number of sources, which makes it difficult to conduct a comprehensive assessment of the fixed income market;

2. the secondary fixed income market is a decentralized, over-the-counter market where large investors have significantly more bargaining power than small investors;

3. there is limited adoption of electronic trading and alternative trading systems, especially for corporate bonds; and

4. direct retail participation in the primary and secondary fixed income market is low and retail investors typically access the fixed income market by purchasing investment funds.

The purpose of this notice is to set out the CSA staff’s plan to enhance fixed income regulation to:

1. facilitate more informed decision-making among all market participants, regardless of their size;

2. improve market integrity; and

3. evaluate whether access to the fixed income market is fair and equitable for all investors.

Each of these steps is discussed in the sections below.

The report was discussed on PrefBlog in the post The Canadian Fixed Income Market: 2014.

It is noteworthy that not one of the objectives involves answering the question “What is the corporate bond market for?”. If this question was ever asked and it was decided that the purpose of the corporate bond market was to give Granny a good place to invest her $5,000 in a single particular bond at a good price then the other objectives make sense. If, however, the purpose of the market is to give corporations access to debt funding that is less constraining and cheaper than bank funding, so they can invest money, help the economy grow and create jobs, then other conclusions might be drawn.

However, CSA staff already has jobs, currently on the public payroll and quite often with the banks afterwards, so job creation by other corporations is hardly a meaningful concern.

As they are on the public payroll, they have very prudently not commenced crippling the government bond market:

NI 21-101 sets out transparency requirements for government debt securities. Specifically, marketplaces and inter-dealer bond brokers are required to report order or trade information, or both, to an information processor. However, an exemption from these transparency requirements is in place and was recently extended until January 1, 2018, through amendments to NI 21-101. As indicated in the notice published with the amendments,{9} no other jurisdiction has mandated transparency for government debt securities. The extension was granted in order to allow CSA staff to monitor international developments, including the expected implementation of the transparency regime that will be established across the European Union by the new Markets in Financial Instruments Directive (MiFID II) and the Markets in Financial Instrument Regulation (MiFIR) adopted by the European Commission,{10} and to determine whether the NI 21-101 transparency requirements for government debt securities should be implemented or whether changes are appropriate.

It is laughable that CSA staff boasts about the wonders of public dissemination of information via SEDAR without permitting direct links to these public documents, but the funniest part of this diktat is their lip service to liquidity:

As noted above, it is CSA staff’s goal to achieve transparency for trades in all corporate debt securities by the end of 2017. We have considered how to achieve this goal in light of:

• the fact that IIROC will be implementing the IIROC Debt Reporting Rule in two phases (described below); and

• concerns that have been raised globally about a decrease in the liquidity in corporate debt markets, and the potential impact of additional transparency on liquidity.{19}

It is intended that transparency for all corporate debt securities will be phased in over the next two years in two phases, as follows:

• in Phase I (expected to occur in mid-2016), IIROC, as an information processor, will disseminate post-trade information for all trades in the Designated Corporate Debt Securities and for retail trades{20} for all other corporate debt securities reported to IIROC; and

• in Phase II (expected to occur in mid-2017), IIROC will disseminate information for all trades in all corporate debt securities and for new issues of corporate debt.

Footnote 19 reads: Specifically, concerns have been raised globally about a potential decrease in the liquidity of the fixed income markets due to a number of factors, including an increase in corporate bond issuances coupled with, some believe, decreases in dealers’ inventories resulting from changes in regulation. We have also heard these concerns raised by Canadian buy-side and sell-side firms during our discussions regarding liquidity and transparency.

Oh, isn’t that just the sweetest thing you can imagine! They’ve “heard these concerns” and, of course, having heard them we can rely on our Wise Masters to have made the correct decision. Just what these concerns were and just why certain decisions were made is none of your business – not only are you mere investor scum but you’re not even government employees, so dry up and blow away, vermin.

I have written about liquidity ant transparency many times on this blog and provided some of the links in my review of the OSC literature survey that is being used as cover for the CSA’s shenanigans. The short version is: increasing transparency leads to markets with a narrower bid-ask spread, but less depth. This has been shown time and time again by academics studying all sorts of markets. Naturally, the regulators are focussing on a definition of liquidity that emphasizes the bid-ask spread; Granny will be able to trade her $5,000 worth of bonds much more cheaply. Investors who trade corporates in $1-million+ sized chunks, however, experience a sharp decline in liquidity. This, naturally, increases the risk of flash-crashes and ‘crowded-trades’ as retail dumps ETFs … but who cares? That will merely give the regulators another excuse for some crocodile tears and another expensive study.

Institutional level liquidity is not a joke and it’s not trivial. When investments are more volatile and less liquid, you want to get paid more for holding them. That is to say, you demand more yield. It is the issuers who are paying that yield and increases in this yield increase their costs, and make building that new factory just that much less attractive.

But nobody cares and the regulators can’t even be bothered to ask ‘What is the corporate bond market for?’.

I’ve had it with this sham. However, for those who are interested, there was a story in the Globe about this issue titled Canadian regulators unveil new system to report corporate bond trading data. The plan has been greeted with rapturous applause from non-investors.

Coming up next: industry regulators take on the Ontario Food Terminal. It is disgusting that purchase of food at wholesale prices is restricted! Let’s see some FAIRNESS!!!

Update, 2015-9-19: Other press mentions have been Canada to Boost Corporate Bond Market Transparency by 2017 and CSA seeks comments on enhancing fixed-income transparency. The former article is notable for the paragraph:

“The steps we have set out to enhance regulation in the fixed income market will improve market transparency and better protect investor interests,” Tracey Stern, head of market regulation at the Ontario Securities Commission, said in an e- mailed statement. “With increased transparency, investors will be in a better position to assess the quality of their executions.”

Do I really need to point out that the concept of judging “quality of their executions” is a concept that applies only to brokered trades, while virtually all bond transactions are done on a principal basis? It would appear that I do.

Scapegoat For Flash Crash Isolated!

Tuesday, April 21st, 2015

Assiduous Readers will remember the highly politicized SEC Flash Crash Report. It’s taken five years, but they’ve finally isolated a scapegoat who spends his spare time rubbing his hands together and cackling about the triumph of evil:

NAVINDER SINGH SARAO was a futures trader
who operated from his residence in the United Kingdom and who traded primarily through his company, Nav Sarao Futures Limited.

“Layering” (a type of “spoofing”) was a form of manipulative, high speed activity in the financial markets. In a layering scheme, a trader places multiple, bogus orders that the trader does not intend to have executed-for example, multiple orders to sell a financial product at different price points-and then quickly modifies or cancels those orders before they are executed. The purpose of these bogus orders is to trick other market participants and manipulate the product’s market price (in the foregoing example of bogus sell orders, by creating a false appearance of increased supply in the product and thereby depressing its market price). The trader seeks to mislead and deceive investors by communicating false pricing signals to the market, to create a false impression of how market participants value a financial product, and thus to prevent legitimate forces of supply and demand from operating properly. The trader does so by creating a false appearance of market depth, with intent to create artificial price movements. The trader could then exploit this layering activity by simultaneously executing other, real trades that the trader does intend to have executed, in an attempt to profit from the artificial price movements that the trader had created. Such layering and trading activity occurs over the course of seconds, in multiple cycles that the trader repeats throughout the trading day. Given the speed and near simultaneity of market activity in a successful layering scheme, such schemes are aided by custom programmed, automated trading software.

Beginning in or about June 2009, SARAO sought to enrich himself through manipulation of the market for E-Minis. By placing multiple large-volume orders on the CME at different price points, SARAO created the false appearance of substantial supply in order to fraudulently induce other market participants to react to his deceptive market information. SARAO thus artificially depressed EMini prices. With the aid of an automated trading program, SARAO was able to all but eliminate his risk of unintentionally executing these orders by modifying and ultimately canceling them before execution. Meanwhile, he exploited his manipulation to reap large trading profits by executing other, real orders.

Matt Levine of Bloomberg – who I respect greatly as a reporter who really puts a lot of intelligence and sweat to work when writing his columns – writes a wonderful column regarding the indictment:

So straightforward that one of the biggest puzzles here is why it took so long — and the help of a whistleblower — for regulators to figure it out. They came tantalizingly close:
As reflected in correspondence with both SARAO and an FCM he used, the CME observed that, between September 2008 and October 2009, SARAO had engaged in pre-opening activity — specifically, entering orders and then canceling them — that “appeared to have a significant impact on the Indicative Opening Price.” The CME contacted SARAO about this activity in March 2009 and notified him, via correspondence dated May 6, 2010, that “all orders entered on Globex during the pre-opening are expected to be entered in good faith for the purpose of executing bona fide transactions.” The CME provided a copy of the latter correspondence to SARAO’s FCM, which suggested to SARAO in an email that he call the FCM’s compliance department if he had any questions. In a responsive email dated May 25, 2010, SARAO wrote to his FCM that he had “just called” the CME “and told em to kiss my ass.”

Emphasis added because come on: The futures exchange wrote to Sarao on the day of the flash crash, telling him to stop spoofing, and he called them back “and told em to kiss my ass.” And then regulators pondered that reply for five years before deciding that they’d prefer to have him arrested in London and extradited to face criminal spoofing charges. One conclusion here might be that rudeness to regulators really works.

It’s a tempting idea!

The CFTC claims that Sarao basically started his spoofing career by causing the flash crash, and then went ahead and kept spoofing for another five years without much interruption. I guess he got more subtle at it? Not very subtle though; he was a consistently large trader, “placing, repeatedly modifying, and ultimately canceling multiple 200-, 250-, 300-, 400-, 500-, 550-, 600-, and 900-lot sell orders,” versus an average order size of seven contracts. He also seems to have had some patterns (like putting in orders for exactly 188 or 289 contracts that never executed) that you’d think would make him easier for regulators or exchanges to spot.6 If regulators think that Sarao’s behavior on May 6, 2010, caused the flash crash, and if they think he continued that behavior for much of the subsequent five years, and if that behavior was screamingly obvious, maybe they should have stopped him a little earlier?

Also, I mean, if his behavior on May 6, 2010, caused the flash crash, and if he continued it for much of the subsequent five years, why didn’t he cause, you know, a dozen flash crashes?

And Mr. Levine closes with the key point:

I have always been impressed and puzzled that low-tech spoofers have much success ripping off whomever they rip off. It’s such a minimal fraud; it’s just saying that you want to sell when you don’t want to sell.10 It’s always surprising that that could have a major effect on markets. John Arnold has argued here at Bloomberg View that spoofing only hurts front-running high-frequency traders, while others point out that “algorithmic trading tools are used by a wide class of traders,” including long-term investors like Waddell & Reed who use algorithms to try to avoid the front-running HFTs. But the FBI’s and CFTC’s theory here is far more troubling: It suggests that existing algorithms are not just dumb enough to give spoofers some of their money, but dumb enough to give spoofers so much of their money that they destabilize the financial markets. It’s not especially confidence-inspiring to read that a guy with a spreadsheet can trick everyone into thinking that the market is crashing, and thereby cause the market to crash.

Well, if the extremely well-paid hard-nosed deep-thinking portfolio managers at Waddell & Reed have their naivety and incompetence exploited by someone who plays the game a little better than they do, you won’t find any tears here.

I hadn’t read the argument linked with “others point out” before, but it doesn’t impress me:

Even if we exclude cases such as this one and legalize the submission of spoofed orders with the proviso that they stay live for less than 100ms, there are plenty of unsophisticated market participants who would still be harmed. These days, algorithmic trading tools are used by a wide class of traders. There is an entire industry, possibly larger than that of vanilla HFT, focused on creating and marketing these tools. Tremendous volume is executed via algorithms on behalf of traditional long-term traders.[2] I’m not an expert on such algorithms, but my impression is that they tend to be much less sophisticated than a lot of vanilla HFT, and thus more likely to be tricked by spoofing. A basic example of one such execution algorithm would be a peg order, which is priced in a very simple fashion somewhere in between the best bid and ask. If a spoofer alters the best bid then a peg order will change its price in response, leaving the user open to losses.

The open question here is: why should anybody in his right mind care about unsophisticated market participants? If they show up at a gunfight with a boxing glove, that’s their problem; the sooner they go bankrupt and go on welfare, the better, as far as I’m concerned. If they are placing orders with no other thought than ‘Golly, I guess I’ll do whatever the rest of the market is doing’ then they are contributing to market inefficiency and harming the market’s price discovery function. So screw ’em; give a medal to the guys who punish ’em. Markets and market regulation should concentrate on the best interests of fundamental traders; any help, succor or encouragement given to techno-weenies is misplaced.

The other major argument in the linked objection is:

Say that you wanted to change this definition to allow spoofing with the intention of damaging order-anticipation strategies. Could you do so in a fashion that didn’t also allow other kinds of nasty manipulation? I don’t see how. Manipulation via self-trading is probably a behavior that everybody agrees should be prohibited. When a manipulator trades with themselves, they can do so risk-free at an arbitrary price, giving other traders a false sense of the market price.[3] Self-trading can be extremely damaging to market integrity. But which group, I wonder, is most hurt by self-trading? One could argue that so-called “front-runners” are. For example, say Apple stock is currently trading at $100, and a manipulator trades 10 million shares with themselves at $90. There could be order-anticipation algorithms, ‘predicting’ selling to come, that react to this and sell Apple stock.[4] There could also be strategies that take this as a signal that there will soon be selling across the entire sector, and sell stocks in related companies. These algorithms fall under Arnold’s definition of “front-running,” and would be expected to lose money when the manipulator decides it’s time to push Apple stock back to $100. Does that mean we should celebrate the manipulator? No.[5]

That’s a big leap of logic in the last word there! I will certainly celebrate the manipulator: he’s punished a few stupid rat-turds who aren’t trading on fundamentals. Good for him!

To his credit, the guy at Mechanical Markets does address my view in his footnote:

[5] If you’re a long-term investor, this scenario seems great, right? You can buy Apple stock at a $10 discount. So, if you thought the stock had an intrinsic value of $105, you’re getting a real bargain. In practice though, I’d imagine that you would hesitate to start buying stock in such a scenario. At least until you had confirmed that the price wasn’t plummeting because of some news that you hadn’t heard yet. By the time you could rule out any news, the manipulator would have pushed the price back to $100.

He who hesitates is lost! Many limit orders entered by fundamental traders during the manipulation phase will be executed prices more attractive than would otherwise be the case. In the long run, fundamental traders who pursue incredibly sophisticated strategies like “paying what they consider a fair price for their purchases” will scoop up all kinds of money from the empty-headed game-players.

But, of course, the Boo-Hoo-Hoo Brigade is in full cry:

“It’s incumbent upon regulators not to be asleep at the switches,” said Donald Selkin, who helps manage about $3 billion as chief market strategist at National Securities Corp. in New York. “They have been, time and time again.”

“Things like this don’t build a lot of confidence,” said Timothy Ghriskey, the chief investment officer at Solaris Asset Management LLC in New York, who helps manage about $1.5 billion. “It’s a risk that regulators are always going to be a step behind. That’s why they should be more aggressive.”

“It’s ridiculous, it’s the government at its best — inept,” Rick Fier, director of equity trading at Conifer Securities LLC in New York, said in a phone interview. “It really is just another one of many things to deal with, it’s extremely frustrating. We’ve seen flash crashes and we’ll see them again and it’s definitely disconcerting.”

“The [high-frequency trading] term’s just become meaningless at this point; it’s just a boogie-man,” said Dave Lauer, president of Kor Group, a market structure lobbying and research firm.

“There are high-frequency market-makers, there are high-speed proprietary traders who don’t care about making markets and I do think there are predatory high-speed traders and manipulative high-speed traders,” Lauer said. “What this guy was doing was using computers in a manipulative, high-order-volume manner.”

no more than 20 trading days when volatility was high.

“On the surface, the headline isn’t comforting, but perhaps it provides the avenue to prevent something of this nature from happening again,” said Walter Todd, who oversees about $1 billion as chief investment officer for Greenwood, South Carolina-based Greenwood Capital. “I’m glad we know definitively how it happened, but at the same time, the headline isn’t a great thing.”

Go have lunch with a client, guys, if that’s all you’re good for.

Update: Here’s more argument in favour of ditching the completely artificial spoofing and layering rules – look at just just who Navinder Singh Sarao is and how he did it:

Sarao, 36, has no record of having worked at a major financial firm in the U.S. or the U.K. At the time of the flash crash, Sarao was renting space from a proprietary-trading firm in the City of London and clearing his transactions through MF Global Holdings Ltd., the now-defunct firm headed by Jon Corzine, said a person with knowledge of the matter.

That picture, according to U.S. authorities, belies a years-long history of lightening-quick computer trading that netted Sarao $40 million in illicit profits.

By all accounts, the flash crash was more than a mere technical glitch. It raised fundamental questions about how vulnerable today’s complex financial markets are to the high-speed, computer-driven trading that has come to dominate the marketplace.

Sarao’s computer screen almost always flashed futures data tied to the Standard & Poor’s 500 Index and his interactions were typically limited to workers installing new trading algorithms, said the person, who spoke on the condition of anonymity.

When he started his allegedly manipulative trading in 2009, Sarao used off-the-shelf software that he later asked to be modified so he could rapidly place and cancel orders automatically. At one point, he asked the software developer for the code, explaining that he wanted to play around with creating new versions, according to regulators.

So he wasn’t an expert trader, using his years of industry experience to exploit infinitesimal little bugs in standardized software, or his deep knowledge of trade-matching and clearing to exploit some bizarre mismatch in the interface between various systems.

He was one guy, using slightly modified off-the-shelf software, who broke one rule. And a rule, by the way that I feel is probably bent many, many times per day despite a very expensive army of regulators devoted to enforcing the silly thing.

If the US financial system is so vulnerable to one guy breaking one silly rule then we’ve got a problem that will not be fixed by doubling the number of regulators who check out trade cancellations and try to decide just what the intent was when each order was originally placed. If the rule is so vulnerable to exploitation and so unenforceable: get rid of it. Unleash the real players in the industry to detect and enforce a level playing field, with spoofing algorithms, spoofing detection and counter-exploitation algorithms, spoofing cloaking algorithms, anti-spoofing-cloaking algorithms … the whole nine yards. And bring some sanity back to the world.

Update, 2015-4-22: Zero Hedge is irritated:

While we eagerly await for the SEC to retract its official 104 page report summarizing the “Findings regarding the market events of May 6, 2010” in light of “recent developments”, and as we follow the shift in the official narrative to the outright bizarre, in which the entire Flash Crash is now blamed on just one man (as opposed to just Waddell & Reed as per the previous narrative), we learn that the latest scapegoat for a broken, fragmented and manipulated market, Navinder Sarao, is not quite so eager to go to minimum security prison in the US for doing what leads to a slap on the wrist when someone like Citadel or Virtu does it, and will challenge the CFTC’s attempt to pin everything on him.

As previoisly reported, Sarao engaged in what every other HFT firms on a daily basis: namely spoofing. However, because he is a foreigner, he was easy prey for the US “justice” system, and as a result it is he that has been picked as a scapegoat (perhaps because the official investigation into Virtu, Citadel and the other HFT firms revealed something so dramatic it needed an easy and available cover up).

Eric Scott Hunsader of Nanex, whose work has been quoted admiringly on PrefBlog in the past, has posted a series of tweets:

If this futures trader *was* spoofing during Flash Crash, it means the CFTC completely missed what should have been easy to spot

Flash Crash Brit was just one of many #HFT ass-hats in the market on 5/6 contributing to a fragile system

We spotted the Flash Crash Brit years ago – red/yellow on this eMini chart is from his algo on 5/6

What Singh Sarao is being accused of is as common as Oxygen. I can’t stress this enough.

It is wrong to say Sarao caused flash crash. He contributed to causing it, yes, but it was Barclay’s leak that sent it down

Why didn’t the CME say anything about Sarao for what.. 5 years now?

How did Andrei Kirilenko (CFTC) miss Sara’s spoofing while analyzing a week’s worth of AUDIT TRAIL DATA??

Why is Sarao (DOJ flash crash spoofer) being singled out from so many other #HFT spoofing algos?

When I 1st saw Sarao’s algo in Summer 2010, I thought it was Tradebot because it stopped when Cummings said they pulled the plug

“Exploratory Trading” – another #HFT strategy used by top firms to manipulate eMini’s $ES_F http://www.nanex.net/aqck2/4136.html

What really caused Flash Crash: Someone LEAKED that a mutual fund was selling 75K eMini’s via participation algo. Wall St pounced

Sarao turned off his algo at 14:40:12. The market flash crash began 2 minutes 32 seconds later at 14:42:44 – an eon in market time

Detailed forensic evidence on the flash crash: http://www.nanex.net/aqck2/4650.html

FT Alphaville has some harsh words:

In a series of moves variously known as “layering” or “spoofing,” Sarao allegedly created the appearance of substantial supply in the market which didn’t actually exist — sparking a short-lived 600 point fall over in the Dow Jones Industrial Average in the space of five minutes.

Except you know, instinctively, that this is nonsense. It’s pure financial keystone cop-ery. This is a laughable piece of regulatory grand-standing from the Americans, which the British authorities look like fools for going along with.

The S&P futures market, across its various guises, is colossal. It is dominated by robot traders and other, highly capitalised professionals. The simple idea that a chap in West London, playing around at home with an off-the-shelf algo programme on his PC while his parents are off at the gurdwara, can up-end the entire US equity market is comical.

Or rather, if there’s any truth here at all, the guys under arrest should be those at the top of the CME and other key pieces of US market infrastructure.

Jack Mintz On Exempt Market Regulation

Wednesday, December 10th, 2014

Jack Mintz has published an excellent commentary titled Muddling Up The Market: New Exempt-Market Regulations May Do More Harm Than Good To The Integrity Of Markets:

From private debt and equity markets to crowd funding, exempt markets have been used to raise more money for Canadian enterprises in recent years than all public offerings put together. Vastly more: Between 2010 and 2012, exempt-market offerings raised four times as much capital as the initial and secondary public offerings during the same period. The precise reasons behind the immense popularity of exempt markets can only be guessed at; it may well be due to the desire, by both issuers and by investors, to avoid the regulatory costs associated with raising capital in public markets. We are left to speculate, however, because the Canadian exempt market remains relatively unstudied, despite its enormous role in funding capital investments in Canada.

The lack of information about exempt markets, however, is not stopping provincial regulators in Canada’s largest markets from charging ahead with new proposals for rules that would govern exempt markets. Unfortunately, with so little information available about these markets, whatever the aim of the reforms in pursuing the goals of effective market regulation, they may end up being more harmful than helpful.

Ontario is proposing to broaden the category of investors eligible to participate in these markets under a new exemption. But the category will remain stricter than in many other markets and Ontario proposes to also put very low limits on how much each investor is allowed to put at risk. Quebec, Alberta and Saskatchewan are also proposing the same $30,000 limit for any given 12-month period. And Ontario will prohibit the sale of exemptmarket securities by agents that are related to, or affiliated with, the registrant, even if measures are employed that have previously been accepted in managing and mitigating conflicts of interest. This will have a direct and damaging impact on exempt-market dealers, who are only allowed to sell exempt-market securities.

All of these proposals are intended to protect investors from the higher risks that are presumed of exempt markets. However, there is no evidence — given the paucity of information about them — that exempt markets necessarily pose a greater risk of fraud or poorer returns and losses than do heavily regulated public markets. And if risk is indeed higher in the exempt markets, one would expect these proposed regulations to assist high quality firms from distinguishing themselves in the exempt market from low-quality firms. However, these regulations may actually have the opposite effect, making it harder for better-quality firms to signal their worthiness to investors.

Canadian productivity — which continues to lag relative to other developed economies — relies heavily on businesses being able to acquire capital for investing in new technologies. Canadian companies and investors appear to be voting with their feet for exempt markets in raising that capital, possibly discouraged from public markets by regulatory costs and inefficiencies. For policy-makers to layer additional regulation on top of exempt markets without fully understanding the impact that it will have, could well result in making Canadian markets, and Canada’s economy, weaker, rather than stronger.

The paper was prompted by an initiative led by the OSC:

Currently, Ontario primarily limits exempt markets to “accredited investors” who must satisfy certain rules, such as an investor and spouse having at least $1 million in net financial assets, or $5 million in total net assets, or net income above $200,000 (or $300,000 with a spouse) over the previous two years with a reasonable expectation of exceeding that in the current year.

Generally, few limitations are imposed on how much equity an investor may acquire or the size of offerings of exempt securities, and there is no requirement for the issuer to provide any disclosure to the accredited investor.

The proposed Ontario rules will broaden the category of investors to include “eligible investors” in a way that is similar, but not the same as, existing rules in all other provinces. The proposed Ontario rules would allow investors to invest in exempt securities, if they have:
(i) $400,000 in net assets or more, including their primary residence; or
(ii) $250,000 in net assets or more, excluding their primary residence; or
(iii) $75,000 in net income (or, with a spouse, $125,000 of net income) in the previous two years, with the expectation of having the same or larger net income in the year of the offering.

This is all provided that the issuer gives to the investor an offering memorandum (described below) prior to the investment.

Each “eligible investor” will also be restricted from purchasing, in aggregate from the market as a whole, no more than $30,000 in exempt securities over a rolling 12-month period under such an offering-memorandum exemption. Investors in Ontario who are not accredited investors or eligible investors will be restricted to acquiring, in aggregate from the market as a whole, not more than $10,000 in exempt securities over a rolling 12-month period under such an offering-memorandum exemption.

Mr. Mintz points out:

Certainly, risks can be significant for ill-informed investors, and exempt securities can have significantly less liquidity than securities issued by some public issuers. Yet, despite these risks, the exempt markets are a significant source of capital. This raises the question of whether businesses are accepting the higher financing costs due to any additional investor risk with less information disclosure, in exchange for faster speed of raising capital and lower regulatory costs than would be faced in the public markets. In other words, are businesses and investors voting with their feet to move to exempt markets? If so, this raises questions about the effectiveness of financial-market regulations with respect to market efficiency, financial stability and investor protection, to which I now turn.

Well, sure. While Mr. Mintz is exclusively concerned with firms raising bricks-and-mortar capital on the exempt market, Assiduous Readers will remember that my fund Malachite Aggressive Preferred Fund is not a public fund because it would cost too much. At least $500,000 for a prospectus, probably more, and grossly inflated operating costs due to the necessity for an Independent Review Committee and a Custodian; the cost of which means better distribution is absolutely required, which means membership in the big boys’ FundSERV which is not exactly cheap, and trailer fees because, bleating of do-gooders notwithstanding, ain’t nobody gonna sell it for free, (or if trailer fees are banned, I might just as well burn my money because of the ‘nobody ever got fired for buying IBM’ mindset, as well as the not-really-tied-selling-honestly in bank channels) … all of which would mean

  • higher costs for investors
  • I have to change my title to “Chief Salesman”, a job for which I am ill-suited and totally disinterested
  • I’d have to employ an ex-regulator whose job would be to tell his old buddies how totally on top of compliance he is

Screw that, as they say in French. But it would be nice, very nice, to be able to offer the fund to a wider potential clientele.

Mr. Mintz concludes:

The largely unstudied exempt markets account for a major share of securities issues by Canadian businesses. This paper provides an overview of the regulatory framework, suggesting that much more effort is needed to study this important market. The exempt market plays an important economic role in Canadian capital markets — regulations should be optimal in their design to balance market efficiency, financial stability and investor protection as objectives.

Regulations vary by province with different standards used to regulate disclosure requirements and investor qualifications for holding exempt securities. However, these regulations are set in a vacuum of information, as we do not understand the characteristics of exempt markets, the economic impact of various restrictions and alternative forms of investor protection. Certainly, regulators should consider not just the characteristics of investors but also other factors, such as different levels of disclosure, in formulating regulatory policy.

In a recent panel discussion:

Mr. Mintz isn’t so sure such a cap is necessary, nor is he convinced the current rules must be changed. After thorough research, he’s concluded there is almost no data on the private markets. “The first question we should be asking is: what is the problem?” he said during a panel discussion to discuss his new paper in Toronto Monday.

When it comes to regulation, [former OSC chair] Mr. [Ed] Waitzer said, “we don’t know what works in protecting investors from fraudsters. We don’t know what works in protecting investors from themselves.” That doesn’t meant the OSC’s proposals are bad, but he believes the rules may not be necessary or the best means of protection. Instead of targeting caps on private investments, maybe regulators should simply ensure investment advisers follow their fiduciary duties, he argued.

The OSC has responded in a letter that has been published as a PDF image, in order (as far as I can tell) to hinder public dissemination via copy-pasting. Interested parties are assured that the OSC is “taking a more balanced approach that includes important investor protections”. The letter addresses process, not evidence and argument.

Terence Corcoran commented in the Financial Post:

Instead of responding to the substance of Mr. Mintz’s paper, Mr. Turner waffled through hundreds of words that said nothing.

There were ‘extensive consultations that support our proposals,’ he said. There is data, he insisted, there have been stakeholder meetings, and in any case “we believe an incremental approach to broadening access is appropriate.”

Sounds like the precautionary principle creeping into the regulator’s office.

And Mr. Mintz has responded:

“I believe the Ontario Securities Commission is following a prudent path in creating an Offering Memorandum regime similar to those in Quebec, Alberta, BC and other provinces.

However, Ontario is also considering imposing new restrictions on the exempt market that have not existed before. Particularly, the $30,000 cap on individual investments. Now, a similar cap is being considered by other provinces.

Per my research, I remain concerned that this cap could do more harm than good by inhibiting business capital financing, especially for better companies. Further, there remains an absence of empirical evidence that a ‎cap is needed at all. Before imposing a cap like this, it is important to take a step back, gather empirical data, and understand the potential impacts of a cap on investment into the exempt market.

Finally, I am grateful that the OSC has taken such an interest in my research. However, to the points made in the letter, I do not believe that “consultation” is a substitute for empirical, data-based research on the impacts of regulatory changes to the exempt market. The onus is on regulators to engage in this research and gather data before proposing changes that could have a significant negative impact on what is a very important source of business funding in Canada.”

Prof. Jeffrey MacIntosh on the National Securities Regulator

Sunday, November 30th, 2014

The following was originally part of the daily market report for November 28, 2014, but on reflection I have decided it deserves its own post.

A trade group that wants me to write them a cheque alerted me to a series of articles by Prof. Jeffrey MacIntosh on the new national securities regulator proposal. Assiduous Readers with extremely good memories will not need to be reminded that Prof. MacIntosh wrote a very good article on Pegged Orders. The first article of his new series, National Regulator 1: The Grand Market Regulator: Be afraid, very afraid, decries the enormous powers that are proposed:

In a provision that would be very much at home in Albania, North Korea, or The Peoples Republic of China, the federal legislation empowers the “Chief Regulator,” without holding a hearing or even giving advance notice, to “issue a notice of violation [for breach of the statute or regulations]… if the Chief Regulator has reasonable grounds to believe that the person has committed a violation.” The notice may specify a penalty of as much as $1-million for an individual and $15-million for non-individuals.

It is only after this notice is delivered that the person from whom the fine is demanded has an opportunity to make representations, and these representations are made to the very person who levied the fine in the first place – the Chief Regulator. Despite the potential economic burden, the pertinent burden of proof in the hearing is the civil standard (balance of probabilities) rather than the more demanding criminal law standard (beyond a reasonable doubt). Any director or officer “who authorized, permitted or acquiesced in the contravention” is potentially liable for the full amount of the fine.

The Chief Regulator can also order any person with a connection to capital markets to furnish the regulator (the “Authority”) with any kind of information, including information that is personal and/or confidential. No judicial warrant is required.

This information can be passed on to a law enforcement agency or “a governmental or regulatory authority, in Canada or elsewhere.” Indeed, it can be passed on to anyone of the Authority’s choosing. It can also be made public, if “the public interest in disclosure outweighs any private interest in keeping the information confidential.”

The statute specifically excludes any appeal to a court; the only appeal is to the regulatory tribunal.

The second article, A Category 5 blizzard of red tape is headed for Canada’s market players, decries changes in the laws:

Insider trading laws, for example, will now apply to any public company, and not just one that is a reporting issuer in Canada. They will also apply not merely to a purchase or sale of securities, but to any act in furtherance of a trade, a change with completely unknown ramifications. While under current rules, certain insiders are liable to the company in whose securities they trade for any “benefit or advantage” they receive, the new legislation extends the liability to include any benefit or advantage received by “all other persons as a result of the contravention.” Similarly, under current legislation only persons who actually trade with an insider have a right of action. Under the proposal, all persons trading on the opposite side of the market when an insider trades will have a cause of action, with no limitation on the aggregate damages that may be claimed. In a large public company, an insider trading profit of $100 could lead to an aggregate liability in the millions.

In the past, major overhauls of corporate or securities laws have invariably been effected by appointing a blue ribbon panel of experts to consult widely with stakeholders, ruminate at length, and publish a detailed report indicating not only the panel’s recommendations for change but the whys and wherefores of the proposed changes. Not in this case.

Shades of OSFI! The third article, Where are the efficiencies?, casts doubt on promised savings:

The agreement between the provinces and the feds, however, provides initially for the secondment, and subsequently for the transfer to the CMRA of all provincial employees currently engaged in securities regulation. In addition, no provincial regulator will disappear. Rather, each will morph into a branch office of the CMRA. Thus, there appear to be essentially no initial economies in moving to a cooperative regulator. Savings can only be achieved in the long run through expensive buy-out packages or attrition.

No doubt this is a handy-dandy inducement to get more provinces and territories to sign up, since no one in any of those respective organizations need hand out any pink slips. And indeed, to the extent that duplication is in fact eliminated, many employees will end up with a substantially reduced workload.

The final article in the series, The regulatory Leviathan, voices concern regarding accountability:

Various features of the CCMRA suggest that the administrative officials who staff the agency will be largely unaccountable to anyone. One of these arises out of the pesky little problem of maintaining legislative uniformity going forward, which will require legislative amendments in each and every one of the provinces and territories that are party to the scheme. Given the overwhelming lack of importance of securities regulation to the polity, and therefore the average politician, moving the legislative behemoth in a single jurisdiction is labour enough. Doing it in multiple jurisdictions is like attempting to safely shepherd an army of banana slugs across King and Bay during rush hour.

Unfortunately, the proposed cure for this problem is worse than the disease. The CCMRA essentially cuts the various legislatures out of the regulatory process. This is done by turning the uniform provincial legislation (the Provincial Capital Markets Act, or PCMA) into a skeleton, and imbuing the CMRA with the authority to tack on the fleshy structures that constitute the pith and substance of the regulatory apparatus. They do this via a purely administrative rulemaking process.

Market actors who are treated badly by securities regulators have little incentive to fight back. The practical imperative is almost always to get on with the business at hand. And everyone knows that fighting the regulator by insisting on a regulatory hearing is a mugs game. The regulators have made it clear that they will treat those who don’t “cooperate” (i.e. settle on Commission-dictated terms) much more harshly than those who role over and play dead. And if they decide to cream you, your right of appeal plus $4.08 will buy you a Grande Latte at Starbucks. Added to this is the powerful and ever-present incentive of securities lawyers and their clients to remain in the good books of the regulators, lest present squalls breed future tempests.

OSFI Squared! This is why we need academics – practitioners and practicing lawyers are too subject to intimidation.

No CoCos, Please, We’re British

Tuesday, August 5th, 2014

Retail investors in the UK have been barred from buying Contingent Capital instruments:

The U.K.’s Financial Conduct Authority will ban firms from selling contingent convertible bonds to individual investors, saying they’re too complex and risky for the mass retail market.

From Oct. 1, the FCA will limit sales of CoCos to institutional, professional investors and high-net-worth individuals for 12 months, the London-based regulator said in a statement today. The FCA will publish a consultation paper on a set of permanent set of rules for CoCos in September.

“In a low interest rate environment, many investors might be tempted by CoCos offering high headline returns,” Christopher Woolard, the FCA’s director of policy, risk and research, said in a statement today. “However, they are complex and can be highly risky.”

“Every time a bank gets into trouble and you have retail investors in subordinated debt or CoCos, it gets difficult and embarrassing for the regulators,” said Mark Taber, who helped organize a group of individual holders of Co-Operative Bank Plc bonds when the British lender was restructured following a capital shortfall. “They don’t want to have that problem every time that happens. They want to be able to deal with banks.”

Their press release states:

Temporary product intervention rules are made without prior consultation and thus will not undergo the usual process for testing draft rules and receiving feedback from the public before they are made. While every effort has been made to ensure these temporary rules have the effect described in this communication, we remain aware of the possibility of unintended consequences.

In a linked document the European Securities and Markets Authority acknowledges (emphasis added):

Investors should fully understand and consider the risks of CoCos and correctly factor those risks into their valuation. To correctly value the instruments one needs to evaluate the probability of activating the trigger, the extent and probability of any losses upon trigger conversion (not only from write-downs but also from unfavourably timed conversion to equity) and (for AT1 CoCos) the likelihood of cancellation of coupons. These risks may be highly challenging to model. Though certain risk factors are transparent, e.g., trigger level, coupon frequency, leverage, credit spread of the issuer, and rating of instrument, if any, other factors are discretionary or difficult to estimate, e.g. individual regulatory requirements relating to the capital buffer, the issuers’ future capital position, issuers’ behaviour in relation to coupon payments on AT1 CoCos, and any risks of contagion. A comprehensive appreciation of the value of the instrument also needs to consider the underlying loss absorption mechanism and whether the CoCo is a perpetual note with discretionary coupons (AT1 CoCos) or has a stated maturity and fixed coupons (T2 CoCos). Importantly, as one descends down the capital structure to sub-investment grade where the majority of CoCos sit, the level of precision in estimating value when compared to more highly rated instruments, deteriorates. ESMA believes that this analysis can only take place within the skill and resource set of knowledgeble institutional investors.

The FCA action comes at a time when investor appetite is very high:

Denmark may be forced to amend its policy on how much hybrid debt banks can use to meet capital requirements after European regulators recommended limits.

The European Banking Authority in London is proposing that contingent convertible debt make up no more than 44 percent of the additional capital that national regulators tell the banks they oversee to hold. The so-called Pillar 2 capital is used to address risks not covered by minimum European Union requirements.


Nykredit said in May it expected its 600 million-euro ($805 million) Tier 2 CoCo to be eligible for use as both Pillar 1 and Pillar 2 capital. The lender said at the time it “may be tempted to sell more” following investor demand. The bond, which has a coupon of 4 percent, yielded 3.63 percent today in Copenhagen trading, little changed from yesterday.

Danske sold a 750 million-euro Additional Tier 1 note in March with the intention that the security could be used to meet Pillar 2 requirements, Claus Jensen, the bank’s chief investor relations officer, said by phone. The 5.75 percent note yielded 5.32 percent today, versus 5.33 percent yesterday.

In a Financial Times, piece, Alberto Gallo, head of macro-credit research at RBS, writes:

The worry is that some buyers may not understand the differences and risks of coco structures. Around a fifth of buyers are private clients, and this proportion could rise as the market goes mainstream: the first bond index for cocos was recently initiated by Bank of America Merrill Lynch.

In its last Financial Stability Report, the Bank of England mentioned the investor base for cocos had broadened, but warned that “investors were placing insufficient weight on the likelihood of a conversion being triggered”.

An analysis of existing coco bonds published by RBS shows prices only compensate for the coupon deferral risk, not for potential losses from conversion. Finally, Tobias Berg of Bonn University and Christoph Kaserer of Munich Technical University recently suggested cocos could push banks to take more risk, given their asymmetric risk-return profile with losses skewed towards investors.

No one really knows what would happen if a bank were to suspend its coupon payments, or worse, had to convert its cocos. Several investors fear this could compound volatility or even disrupt the whole market: some already predict 10 percentage point price drops the first time a bank hits a trigger on its cocos.

Regulators must act now to avoid waking up to these problems when it is too late. The first thing to do is flag clearly that cocos are not regular bonds, before investors unaware of the risks start buying. The case of Bankia’s bail-in in Spain highlighted the social pain of pushing losses on to bonds held by retail investors. Cocos can expose holders to cliff-like losses: they are not for orphans or widows.

Second, regulators need to create standards and reduce complexity across jurisdictions, clarifying how triggers and conversion mechanisms really work in a crisis. In doing so, they should favour instruments where the risks and rewards are aligned with shareholders, like cocos that convert into and dilute equity in case of losses, and discourage writedown cocos, where bondholders crystallise losses but get no upside.

All this is happening as Barclays starts marketing a CoCo index:

“CoCo issuance has steadily grown in recent years and we anticipate further expansion of this market as financial institutions issue these bonds to help achieve required regulatory capital ratios,” said Brian Upbin, Head of Benchmark Index Research at Barclays. “Though CoCos are not eligible for broad-based bond indices such as the Global Aggregate, there are debt investors who hold these securities as out-of-index investments and need a benchmark of asset class risk and returns.”

The Barclays Global Contingent Capital Index includes hybrid capital securities with explicit equity conversion or writedown loss absorption mechanisms that are based on an issuer’s regulatory capital ratio or other explicit solvency-based triggers. Subindices by currency, country, credit quality, and capital security type are available as part of this family. Bespoke credit and high-yield indices that include traditional hybrid capital as well as contingent capital securities are also now available with this expanded security coverage. The inception date of this index is May 1, 2014, and the index universe contains 65 CoCo issues with a market value of $98bn as of May 31, 2014.

Barclays also indicates:

“Though CoCos are not eligible for broad-based bond indices such as the global aggregate, there are debt investors who hold these securities as out-of-index investments and need a benchmark of asset class risk and returns,” he [Brian Upbin, head of benchmark index research at Barclays] said.

Barclays plans to exclude securities with conversion features based solely on the discretion of local regulators, those that have an additional equity conversion option based on regulatory or solvency criteria, inflation-linked bonds and floating-rate issues, private placements and retail bonds, and illiquid securities with no available internal or third-party pricing source.

Update, 2014-8-14: It has just occurred to me that this is somewhat akin to Canadian ABCP – where vendors (completely voluntarily and not with a regulatory gun to their heads at all, definitely not) compensated retail investors who lost money. At least the FCA has the decency to ban things before they go wrong … even though it means won’t get a Canadian-style slush fund out of it.

Feds Consulting on Bank Recapitalization Regime

Tuesday, August 5th, 2014

The Ministry of Finance has announced:

a public consultation on a key element of the Government’s comprehensive risk management framework for Canada’s domestic systemically important banks.

The proposed regime focuses on a specific range of liabilities and excludes deposits. In addition, insured deposits will continue to be guaranteed by the Canada Deposit Insurance Corporation.

Comments on the attached draft consultation paper can be submitted to the Department of Finance at ConsultationsFSS-SSF@fin.gc.ca or to the address below. The closing date for comments is September 12.

I think the first thing to observe from this announcement is that this is a deliberate slap in the face to OSFI and an indicator, yet again, of the politicization of the bank regulatory framework.

The consultation paper claims as its objective:

The Taxpayer Protection and Bank Recapitalization regime for Canada’s D-SIBs would allow for the expedient conversion of certain bank liabilities into regulatory capital when a D-SIB fails (i.e., at the point when the institution becomes non-viable). It would thus enable a resolution strategy that protects taxpayers by ensuring that losses are borne by shareholders and creditors of the failed bank while preserving the same legal entity and contracts of the bank (i.e., keeping it open or “continuing”) and, in turn, maintaining the critical services the bank provides to its customers.

… and hints at a favourable view towards a holdco/opco bank structure:

The bail-in (or equivalent) powers introduced or planned in other jurisdictions reflect the way that major banks in those jurisdictions are structured. For example, the U.S. and U.K. have large banking groups that are organized with a non-operating holding company at the top of the group, and operating bank subsidiaries underneath. In contrast, Canadian banks are organized with an operating bank as the top-tier parent company. The Government welcomes views on the potential merits of a holding company model (similar to that of other major jurisdictions) in the context of reforms to strengthen Canada’s bank resolution framework.

It is not clear whether this would or could involve a decrease in the protectionism that has given rise to the Big 6 oligopoly.

… and summarizes:

The purpose of this consultation paper is to set out the major features of a proposed Taxpayer Protection and Bank Recapitalization regime for Canada. The overarching policy objective that drives the design of the regime is to preserve financial stability while protecting taxpayers. This objective is supported by the Taxpayer Protection and Bank Recapitalization regime by:
  • ◾Reducing the likelihood of a D-SIB failure by enhancing market discipline, limiting moral hazard and constraining incentives for excessive risk-taking by ensuring that bank creditors and capital providers bear losses in the event of a D-SIB becoming non-viable;
  • ◾Ensuring that, in the event that a D-SIB experiences severe losses leading to non-viability, it can be quickly restored to viability with no or minimal taxpayer exposure to loss through a resolution strategy which enables conversion of certain liabilities into additional equity capital; and,
  • ◾Supporting D-SIBs’ ability to provide critical services to the financial system and economy during normal times and in the event that a D-SIB experiences severe losses.

First, they want statutory conversion power:

The Government proposes that the cornerstone of the Taxpayer Protection and Bank Recapitalization regime be a statutory power allowing for the permanent conversion—in whole or in part—of specified eligible liabilities into common shares of a bank (see Scope of Applicationbelow) designated as a D-SIB by OSFI,[6] following certain preconditions (see Sequencing and Preconditionsbelow). The power would also allow for (but not require) the permanent cancellation, in whole or in part, of pre-existing shares of the bank. [Footnote]

[Footnote reads]: For greater certainty, this power would only be applied to common shares of the bank which were outstanding prior to the point of non-viability

Two pre-conditions would exist before this statutory conversion:

First, there must be a determination by the Superintendent of Financial Institutions that the bank has ceased, or is about to cease, to be viable. Second, there must be a full conversion of the bank’s NVCC instruments.[8]

Note that these are necessary, but not sufficient, preconditions for the exercise of the conversion power. Authorities would retain the discretion to not exercise the conversion power even if the preconditions had been met. For example, authorities may decide not to exercise the power if conversion of NVCC instruments were deemed to be sufficient to adequately recapitalize the bank.

This would apply to new senior debt; existing senior debt will be grandfathered.

In order to allow for a smooth transition for affected market participants and to maximize legal clarity and enforceability of the Taxpayer Protection and Bank Recapitalization regime, the Government proposes that the conversion power only apply to D-SIB liabilities that are issued, originated or renegotiated after an implementation date determined by the Government. The regime would not be applied retroactively to liabilities outstanding as of the implementation date.

The Government proposes that “long-term senior debt”—senior unsecured debt[9] that is tradable and transferable with an original term to maturity of over 400 days—be subject to conversion through the exercise of the statutory conversion power.[10] Authorities would also have the ability to cancel, in whole or in part, the pre-existing common shares of the bank in the context of exercising the conversion power. This scope of application would minimize the practical and legal impediments to exercising a conversion in a timely fashion. It would also minimize any potential adverse impacts on banks’ access to liquidity under stress and support financial stability more broadly.

They would choose the proportion of senior debt converted, and there would be no ‘cram-down’ on more junior instruments other than common shares:

The Government proposes that authorities have the flexibility to determine, at the time of resolution, the portion of eligible liabilities that is to be converted into common shares in accordance with the conversion power. All long-term senior debt holders would be converted on a pro rata basis—that is, each of these creditors would have the same portion (up to 100 per cent) of the par value of their claims converted to common shares.

Authorities’ determination of the total amount of eligible liabilities to be converted would be based on ensuring that the D-SIB emerges from a conversion well-capitalized, with a buffer of capital above the target capital requirements set by OSFI.

Conversion of eligible liabilities would respect the hierarchy of claims in liquidation on a relative, not absolute, basis. For example, for every dollar of their claim that is converted, long-term senior debt holders would receive economic entitlements (in the form of common shares) that are more favourable than those provided to former NVCC subordinated debt investors, but NVCC subordinated debt investors would not be subject to 100 per cent losses in the context of exercising the conversion power.

Conversion terms would be similar in form to NVCC conversion:

Building on this approach, and to provide greater certainty and transparency to investors and creditors that may be subject to the statutory conversion power, the Government proposes to link the conversion terms it would apply with respect to eligible liabilities to those of outstanding NVCC instruments. Specifically, the number of common shares that would be provided for each dollar of par value of a claim that is converted would be tied to the conversion formulas of any outstanding NVCC instruments.

This approach would be communicated to all market participants in advance, and would be applied as follows: long-term senior debt holders would receive, for each dollar of par value converted, an amount of common shares determined as a fixed multiple, X,of the most favourable conversion formula[12] among the bank’s NVCC subordinated debt instruments (or, if none exists, the bank’s NVCC preferred shares[13]).[14]

As with the overall approach, the fixed conversion multiplier, X, would be set in advance by public authorities through regulation or guidance (and would thus be public information).[Footnote]

[Footnote reads:] For example, a potential range for the conversion multiplier would be 1.1 to 2.0.

As discussed in the post Royal Bank Issues NVCC-Compliant Sub-Debt, the conversion multiplier is essentially affects the floor conversion price of the common (which may be assumed to be very low in a non-viability situation); $5 for preferred shares, For sub-debt, the formula is:

The “Contingent Conversion Formula” is (Multiplier x Note Value) ÷ Conversion Price = number of Common Shares into which each Note shall be converted.

The “Multiplier” is 1.5.

The “Note Value” of a Note is the Par Value plus accrued and unpaid interest on such Note.

The “Conversion Price” of each Note is the greater of (i) a floor price of $5, and (ii) the Current Market Price of the Common Shares.

If they want to keep the senior debt senior to the sub-debt, the conversion multiplier may have to be more than 1.5! However, they’re also giving themselves the ability to cancel existing common, so it doesn’t really matter what the multiplier is.

In a startling nod to the rule of law, there is actually an intention to allow access to the courts to complain!

The Government proposes that shareholders and creditors subject to conversion be entitled to be made no worse off than they would have been if the bank had been resolved through liquidation. The Government further proposes that the process for determining and, if necessary, providing compensation to shareholders and creditors that have been subject to conversion build on existing processes set out in subsections 39.23 to 39.37 of the Canada Deposit Insurance Corporation Act.

The Canada Deposit Insurance Corporation Act contains the usual bafflegab, but essentially allows dissenting bond-holders to take their case for additional compensation to court.

There will be a minimum amount of convertible instruments:

The Government therefore proposes that D-SIBs be subject to a Higher Loss Absorbency (HLA) requirement to be met flexibly through the sum of regulatory capital (i.e., common equity and NVCC instruments) and long-term senior debt (see Scope of Applicationabove) that is directly issued by the parent bank.

The Government proposes that the HLA requirement be set at a specific value (as opposed to a range). The Government further proposes that this value be between 17 and 23 per cent of risk-weighted assets (RWA). For example, a HLA requirement at the low end of this range (17 per cent of RWA) would ensure that banks could absorb losses of 5.5 per cent of RWA and emerge from a conversion with common equity of 11.5 per cent of RWA (Basel III minimum Total Capital Ratio of 10.5 per cent plus a buffer of 1 per cent).

They state an intention to fiddle with deposit insurance:

The Government is committed to ensuring that Canada’s deposit insurance framework adequately protects the savings of Canadian consumers. In this regard, deposits will be excluded from the Taxpayer Protection and Bank Recapitalization regime. As announced in Economic Action Plan 2014, the Government plans to undertake a broad review of Canada’s deposit insurance framework by examining the appropriate level, nature, and pricing of protection provided to deposits and depositors.

This is very mysterious, but I assume that uninsured deposits – and deposit notes! – will be senior to senior debt. I just hope to bloody hell they resolve the BA vs. BDN mystery.

Finally, they list the specific questions they want to pretend to address:

Questions for Consultation

1.Is the proposed scope of securities and liabilities that would be subject to the conversion power appropriate? Why / why not?

2.Is the proposed minimum term to maturity at issuance of 400 days appropriate for the purpose of differentiating between short-term and long-term liabilities?

3.Does the proposed regime strike the correct balance between flexibility for authorities and clarity and transparency for market participants?

4.Is the proposal for a fixed conversion multiplier appropriate? Why / why not? What considerations should be taken into account when setting the value of a fixed conversion multiplier as proposed?

5.Is the proposed form of the Higher Loss Absorbency requirement appropriate? What considerations should be taken into account when setting this requirement?

6.Should authorities have the flexibility to provide compensation to written-down creditors in the form of preferred shares in the bank (i.e., instead of common shares)? Why / why not?

7.What would be an appropriate transition period for implementation of the Taxpayer Protection and Bank Recapitalization regime?

8.Are the proposed objectives for the review of existing resolution powers and incorporation of the conversion power into Canada’s bank resolution framework appropriate? What additional considerations should be taken into account to maximize the effectiveness of the conversion power as part of the overall resolution framework?

9.Could a holding company model provide advantages in the application of the bridge bank powers (i.e., akin to the U.S. approach) or conversion powers (i.e., akin to the U.K. approach)?

As usual, there are two fundamental objections to the proposed scheme: firstly, these are all low-trigger conversions, which might be good enough to resolve a crisis, but do not even attempt to avert a crisis; secondly, it gives powers formerly held by a bankruptcy court to a handful of highly politicized, unscrutinized bureaucrats in the CDIC.

I see the whole thing as a lot of flim-flam; a fig-leaf over the ravaging of the rule of law. In any future horrific scenario, there will be so much uncertainty regarding the fate of capital instruments that a bank in dire straits simply will not be able to issue anything.

Royal Bank Issues NVCC-Compliant Sub-Debt

Friday, July 11th, 2014

Royal Bank of Canada has announced:

an inaugural Basel III-compliant offering of $1 billion of subordinated debentures (“the Notes”) through its Canadian Medium Term Note Program.

The Notes bear interest at a fixed rate of 3.04 per cent per annum (paid semi-annually) until July 17, 2019, and at the three-month Banker’s Acceptance Rate plus 1.08 per cent thereafter until their maturity on July 17, 2024 (paid quarterly). The expected closing date is July 17, 2014 and RBC Capital Markets is acting as lead agent on the issue.

The bank may, at its option, with the prior approval of the Office of the Superintendent of Financial Institutions Canada, redeem the Notes on or after July 17, 2019 at par, in whole at any time or in part from time to time, on not less than 30 days and not more than 60 days notice to registered holders.

We routinely undertake funding transactions to maintain strong capital ratios and a cost effective capital structure. Net proceeds from this transaction will be used for general business purposes.

It’s not clear to me how the floating rate of BAs+108bp was calculated. The Canada 10-year is trading at around 2.20%, the five year around 1.55% and three-month BAs a little above 1.20%. None of these values fits very well with the 3.04% initial rate to provide a 108bp increment.

However, the important thing – for some – is the fact that a clear demarcation exists between the five-year pretend-maturity and the ten-year actual maturity. This will make it easier for the sleazy to sell the debt to the stupid.

Not much meat on those bones. The heart of the matter is the conversion feature, as noted by Moody’s:

Moody’s assigned a rating of Baa1 (hyb) to Royal Bank of Canada’s (RBC, Aa3 Negative, C+/a2 Stable) 3.04% CAD1 billion Basel III compliant NVCC subordinated debt. Proceeds from the issuance will be added to the bank’s general funds and utilized for general banking purposes. The NVCC subordinated debt provides loss absorption as it is subject to automatic conversion into common shares, based on a predetermined conversion formula, at the point of non-viability, as defined by the Office of the Superintendent of Financial Institutions Canada (OSFI), subject to regulatory discretion. This incremental loss absorption feature is credit positive for holders of senior securities of RBC, as a layer of loss absorbing securities will reduce the risk of losses incurred higher in the capital hierarchy if the bank gets into financial distress.

This marks the first issuance in Canada of contractual non-viability subordinated debt. The rating is positioned 2 notches below the a2 adjusted baseline credit assessment (adjusted BCA) of RBC, in line with Moody’s standard notching guidance for contractual non-viability subordinated debt. An additional notch is added relative to the notching for “plain vanilla” subordinated debt with normal loss severity (currently 1 notch below adjusted BCA) to capture the potential uncertainty related to the timing of loss absorption.

By way of comparison, Moody’s has the NVCC-compliant Royal Bank preferreds at Baa3:

This marks the first issuance in Canada of contractual non-viability preferred securities. The rating is positioned 4 notches below the a2 adjusted baseline credit assessment (adjusted BCA) of RBC, in line with Moody’s standard notching guidance for contractual non-viability preferred securities. An additional notch is added relative to the notching for legacy Canadian non-cumulative preferred shares (currently 3 notches below adjusted BCA) to capture the potential uncertainty related to the timing of loss absorption.

Standard and Poor’s explains what makes them more creditworthy than preferreds (bolding added):

The ‘A-‘ rating is two notches below the stand-alone credit profile (SACP), incorporating:
  • •A deduction of one notch from the SACP for subordination, reflecting our belief that the Canadian legal and regulatory framework insulates senior debt from defaults on the subordinated debt; and
  • •The deduction of an additional notch to reflect that the subordinated notes feature a mandatory contingent conversion trigger provision. Should a trigger event occur (as defined by The Office of the Superintendent of Financial Institutions’ [OSFI] guideline for Capital Adequacy Requirements, Chapter 2), each subordinated note outstanding will automatically and immediately be converted, without the holder’s consent, into a number of fully paid and freely tradable common shares of the bank, determined in accordance with a conversion formula.

The following constitute trigger events:

  • •OSFI publicly announces it has advised RBC that it believes the bank has ceased, or is about to cease, to be viable and that, after converting the preferred shares and all other contingent instruments RBC has issued, and taking into account any other relevant factors, it is reasonably likely that the bank’s viability will be restored or maintained; or
  • •The federal government or a provincial government in Canada publicly announces that RBC has accepted a capital injection, or equivalent support, from a government or agency, without which the bank would be nonviable, according to OFSI.

Because we expect this instrument’s conversion to occur at or near the point of the banks’ nonviability, we view this mechanism as a nonviability trigger.

We expect to assign “minimal” (as our criteria describe the term) equity content to these subordinated notes because we do not consider notes that have only nonviability features to be able to absorb losses prior to the bank’s point of nonviability.

By way of comparison, S&P has the NVCC-compliant preferreds at BBB+, one notch lower on the global scale than the Sub-Debts A-.

So OSFI gets a lot of discretion in determining conversion – surprise, surprise! Since bond management firms are typically much larger than preferred share management firms (I believe there’s only one of these in Canada!), and since bond investors are typically much bigger than preferred share investors (aka, “retail scum”) I believe that in a crisis there will be frenzied and successful lobbying of OSFI personnel by their future employers to convert preferreds but to ‘just wait a bit’ before forcing sub-debt conversion.

Blair Keefe, David Seville and Thomas Yeo of Tory’s Law Firm recently wrote an article titled The Preferred Share Market Finally Re-Opens For Canadian Banks:

The market is still waiting for the first offering of NVCC subordinated debt. There are a few reasons why the banks have remained hesitant to tap that market. One reason relates to changes in capital ratios mandated by Basel III, which reduce the need for subordinated debt on a bank’s balance sheet. Prior to the introduction of Basel III, subordinated debt could account for almost one-third of the total capital of a bank. With the new minimum total capital requirement of 10.5%2 (including a countercyclical capital buffer of 2.5%) of risk-weighted assets and a 8.5% minimum for tier 1 capital, effectively the most that can be satisfied with subordinated debt is 2% of the bank’s risk-weighted assets. As well, under Basel III, most deductions from capital must be made from common share equity, whereas in the past, certain deductions could be made from total capital. Effective January 1, 2015, the leverage or asset-to-capital ratio in Canada will be based on tier 1 capital as opposed to total capital. This requirement is particularly important for smaller deposit-taking institutions because they tend to be limited by their asset-to-capital multiples. As a result, we expect that subordinated debt will be eliminated from the capital structure of many smaller institutions—and will form a significantly smaller portion of the capital structure of larger institutions than it has historically.

Market uncertainty also remains over how the proposed “bail-in” debt regime will interact with NVCC instruments. In October 2011, the Financial Stability Board issued a paper providing that regulators should have the power to convert (or write off) all or part of the unsecured and uninsured creditor claims of a financial institution under resolution into equity or other ownership instruments. It was proposed that such a conversion would be done in a manner that respects the hierarchy of claims in liquidation. The 2013 Canadian federal government budget includes a proposed plan to implement a “bail-in” regime for systemically important banks3; Canadian banks and the market generally are still waiting for details as to how the federal government intends to implement this regime. The institutional investors that make up the vast majority of the market for subordinated debt are particularly concerned with how the bail-in regime will function and the effect of further dilution after NVCC instruments are converted, resulting in a “wait-and-see” approach to investor interest in NVCC subordinated debt offerings.

The precise conversion formula to be adopted by the banks for NVCC subordinated debt is not yet known. Under OSFI’s requirements, conversion formulas for both NVCC preferred shares and subordinated debt need to be set to ensure respect for the relative hierarchy of claims between the two types of instruments in the event of a triggering event. In other words, since debt ranks ahead of equity in the traditional capital structure, in the event of a triggering event, holders of subordinated debt should receive more common shares on conversion than holders of preferred shares on a dollar-for-dollar basis. The banks have put substantial effort in the development of a formula used in the preferred share offerings which addresses concerns about potential market manipulation and death spirals in situations where conversion appears to be a possibility. As of the date this article was written, all offerings of NVCC preferred shares have used the same formula based on the issue price of the preferred shares, plus declared and unpaid dividends, divided by the volume- weighted average trading price over the 10 trading days before a triggering event, subject to a $5.00 floor price. It is unlikely that other banks will depart from this formula. The preferred share formula would suggest that the conversion formula for subordinated debt will use some multiple of the principal amount of the debt, together with accrued interest, to achieve the hierarchy of claims desired by OSFI. Issuers of NVCC subordinated debt should consider obtaining an advance income tax ruling from the Canada Revenue Agency confirming the deductibility by the bank of the interest payments, although we anticipate no difficulty in banks obtaining that ruling.

So my guess is that not only will the sub-debt benefit by delayed conversion, but the floor on the conversion price to equity will be lower – say, $3-4 instead of the now-standard $5 floor for preferreds. Senior “debt”, presumably, will be lower still.

The next matter of interest is whether this non-debt gets included in the bond indices; given that they’re bank issues, and the banks own TMX, and TMX runs the standard index (this arrangement has been blessed by the regulators, in exchange for regular payments), I’d say it’s a slam-dunk. But I have no information yet.

Update, 2014-7-12: OK, so I found the term sheet on SEDAR. It’s not under Prospectus, it’s under “Marketing Materials”, dated July 9. The conversion is:

The “Contingent Conversion Formula” is (Multiplier x Note Value) ÷ Conversion Price = number of Common Shares into which each Note shall be converted.

The “Multiplier” is 1.5.

The “Note Value” of a Note is the Par Value plus accrued and unpaid interest on such Note.

The “Conversion Price” of each Note is the greater of (i) a floor price of $5, and (ii) the Current Market Price of the Common Shares. The floor price of $5 will be subject to adjustment in the event of (i) the issuance of Common Shares or securities exchangeable for or convertible into Common Shares to all holders of Common Shares as a stock dividend, (ii) the subdivision, redivision or change of the Common Shares into a greater number of Common Shares, or (iii) the reduction, combination or consolidation of the Common Shares into a lesser number of Common Shares. The adjustment shall be computed to the nearest one-tenth of one cent provided that no adjustment of the Conversion Price shall be required unless such adjustment would require an increase or decrease of at least 1% of the Conversion Price then in effect.

“Current Market Price” of the Common Shares means the volume weighted average trading price of the Common Shares on the Toronto Stock Exchange (the “TSX”), if such shares are then listed on the TSX, for the 10 consecutive trading days ending on the trading day preceding the date of the Trigger Event. If the Common Shares are not then listed on the TSX, for the purpose of the foregoing calculation reference shall be made to the principal securities exchange or market on which the Common Shares are then listed or quoted or, if no such trading prices are available, “Current Market Price” shall be the fair value of the Common Shares as reasonably determined by the board of directors of the Bank.

It’s interesting that they’re implementing this with a conversion factor, rather than changing the floor price. Just what the implications of that might be is something that will bear thinking about.

Update, 2014-7-18: DBRS rates at A(low) [Stable].

OSFI’s Zelmer Advocates Increased Micro-Management

Thursday, June 26th, 2014

Mark Zelmer gave a speech touting OSFI at the C.D. Howe Institute Housing Policy Conference titled OSFI is on the Case: Promoting Prudent Lending in Housing Finance:

But, by same token, it is clear that the ability of the household sector as a whole to absorb major shocks is less now than it was a decade ago. Moreover, with interest rates near record low levels, there is not much scope for interest rates in Canada or the United States to fall further – something that helped people weather storms in the past. Governor Poloz recently noted in his testimony before the Senate that the Bank of Canada continues to expect a soft landing for the housing market and Canada’s household debt-to-income ratio to stabilize.Footnote 2 But he also acknowledged that imbalances in the housing sector remain elevated and could pose a significant risk should economic conditions deteriorate.

So from a prudential perspective, the environmental risks associated with lending to households are higher now than in the past. With interest rates expected to remain exceptionally low and household indebtedness high, these risks are likely to remain elevated for the foreseeable future.

Well, in the first place, he disingenuously declines to acknowledge the fact that from the banks’ perspective, a huge proportion of their mortgage debt is just as credit-worthy as Canada bonds, given that it’s insured by CMHC. This is the chief imprudence in the current situation and, I believe, the primary source of whatever bubble there might be in the housing market.

He then tries to insert a little revisionist history into the equation:

You may wonder what more a prudential supervisor really needs to do if lenders and private mortgage insurers are well capitalized. But in stress situations, creditors and investors often lose confidence in these institutions before they run out of capital. Recall that some financial institutions lost access to funding markets in the midst of the global financial crisis even though they were reporting healthy regulatory capital ratios at the time. Sitting back and relying on capital is not enough for either financial institutions or prudential supervisors.

Yes, and I also recall that numerous financial institutions went bust even though they were reporting healthy regulatory capital ratios. So let’s not have any more nonsense about healthy regulatory capital ratios.

In the wake of the global financial crisis, many observers are suggesting that bank regulators need to think about their tool kit and employ macro‑prudential tools like changes in loan‑to‑value limits to lean against rising environmental risks. But at OSFI we believe it makes more sense to promote prudent lending all of the time. Hence, the 80 per cent loan‑to‑value limit on conventional mortgages enshrined in the federal legislation; and, where necessary, deep dives like the ones I just described in the current environment.

Conveniently, none of these observers are named or cited, so we can’t check up on this. But the bit about ‘prudent lending’ is a little odd: is he saying that extending a mortgage is imprudent even when it carries a 100% government guarantee?

By the same token, let me note the focus in the B-20 and B-21 guidelines on governance and risk management principles. Such principles are meant to stand the test of time. They do not lend themselves to hard limits that one can vary in response to changing economic and financial conditions.

Frankly, OSFI generally prefers to take a principles-based approach in setting our regulatory and supervisory expectations. Hard limits like the 65 per cent LTV limit on Home Equity Lines of Credit (HELOCs) are more the exception than the rule. The key advantage of a principles-based approach is that it provides us the flexibility we need to tailor supervisory expectations to the situation at hand. This avoids safe harbours and compliance mentalities that breed complacency on the part of regulated entities, not to mention supervisors. Instead, principles help to underscore the point that regulated institutions are expected to use judgment and apply the guidelines to the situations they face on the ground within their own organizations.

And this is exactly the problem: the last thing we need is more herd mentality and nod-and-wink regulation; we know where that got us with Manulife in Canada and other institutions in other places.

All his points about high consumer debt-to-income ratios and so on is not an indicator of the need for principles-based regulation; it is indicative of a need for a counter-cyclical capital buffer. Why don’t we see any interest, let alone any research, into a counter-cyclical capital requirement based on debt-to-income? Funded by, but certainly not executed by, OSFI – we know what happens when those guys pretend to be academics.

At the end of the day, mortgage lenders and insurers must accept that they are responsible for the loans they are granting and insuring, and thus the risks they are running.

Ha! No they ain’t, buddy. The Feds are responsible for CMHC losses … no moral hazard there, no sir, not one bit!

Update: On a related note, Mark Gilbert of Bloomberg writes about Mark Carney’s Central Bank Mission Creep:

No matter how Governor Mark Carney dresses it up, the Bank of England’s decision today to impose caps on mortgage lending amounts to an explicit effort by the central bank to manage asset prices.

Today, he said: “We don’t target house prices, we care about indebtedness. We think that price dynamics in the housing market are going to slow in about a year as incomes pick up.”

There was also a half-buried message in today’s press conference about the central bank’s reluctance to raise interest rates for fear of missing its target of getting inflation back up to an annual pace of 2 percent. By imposing restrictions on lenders, “monetary policy does not need to be diverted to address a sector-specific risk in the housing market,” Carney said. In other words, if Carney can cool the housing market with tighter controls on mortgages, he can keep rates lower for longer.