Archive for the ‘Regulation’ Category

IAIS SecGen Discusses ICS 2.0 Timeline

Monday, May 27th, 2019

The International Association of Insurance Supervisors released its May, 2019, Newsletter today, which was led by a piece from the Secretary-General, Jonathan Dixon:

Our committee meetings next month in Buenos Aires mark an important point in the IAIS’ journey to a global Insurance Capital Standard (ICS). The IAIS embarked on the development of the ICS to create a common language
for supervisory discussions of group solvency of internationally active insurance groups. In June, the focus of our committee discussions will shift from design to implementation issues.

The final round of field testing is now underway, with data due at the end of July. While some ICS design elements remain to be finalised this year, the IAIS remains committed to resolving those elements and beginning the monitoring period in 2020, while recognising that the ICS will continue to evolve during this period. This includes possible refinements and corrections of major flaws or unintended consequences identified during the monitoring period.

In June, we will discuss the overall framework for the monitoring period, including confidentiality safeguards around disclosure of the ICS results and modalities for considering unintended consequences, given that our intention has always been to undertake this work once the ICS is sufficiently developed. We will also further our discussions on the timelines, process and governance for developing comparability criteria and completing the comparability assessment of other solvency regimes relative to the ICS.

As we move towards November and the adoption of ICS Version 2.0 for the monitoring period, we will continue our constructive engagement with stakeholders in order to ensure that there is greater clarity on the process for finalising and implementing the ICS.

This is all consistent with previous schedules provided for ICS 2.0, which include the IAIS deliberations regarding the definition of Insurance company Tier 1 Limited Capital (which includes preferred shares); I take the view that rules comparable, if not identical to the bank NVCC rules will be imposed by OSFI at some point in the future.

IAIS Releases ICS 2.0 Consultation Comments

Friday, April 5th, 2019

The International Association of Insurance Supervisors has released the comments received to its 2018 ICS 2.0 Consultation. Assiduous Readers will remember that the comment period closed at the end of October, 2018 and included the following questions that are critical to the question of Deemed Maturities for Insurance issues:

The consultation document, downloadable from the above page, contains the critical (for our purposes) question:
173. The IAIS is considering whether to set an additional criterion requiring Tier 1 Limited instruments to have a principal loss absorbency mechanism (PLAM). Such mechanisms would provide a means for financial instruments to absorb losses on a going-concern basis through reductions in the principal amount and cancellation of distributions. Without such mechanisms these instruments might only provide going concern loss absorbency through cancellation of distributions.

deemedretractiblequestion_181103
Click for Big

The consultation document, and the files with respondents’ answers to the questions, may be downloaded from the IAIS Insurance Capital Standards page. The ‘critical questions’, ##52-54, are found in Section 6 Reference ICS – Capital resources (public). The IAIS notes that:

The IAIS received 56 submissions in response to the 2018 ICS Consultation Document of which 18 were requested by the respondents to be kept confidential. Therefore, the comments that are posted here publicly are a subset of those that the IAIS will be taking into account as it moves forward with the ICS.

Q52 Section 6 Is a PLAM [Principal Loss Absorbency Mechanism] an appropriate requirement for Tier 1 Limited financial instruments? Please explain any advantages and disadvantages of requiring a PLAM.

There were 17 responses, 8 yes and 9 no.

OSFI answered “No”:

A PLAM is one option considered to assess loss absorbency in a going concern. However, OSFI’s view is that PoNV (point of non viability) loss absorbency could also be considered. Specifically, the IAIS could consider loss absorbency on a going concern basis, as well as on a gone concern basis with contractual or statutory) PoNV triggers. It is possible that an insurer could fail before a PLAM trigger occurs due to the lagging nature of PLAM triggers. Moreover, PLAM triggers could have adverse signalling effects in respect of the financial condition of the issuer, which could precipitate non-viability.

This advocacy of ‘point of non viability loss absorbency’ is consistent with the NVCC rules OSFI has imposed on banks and with its answer to the 2016 consultation. Assiduous readers will remember that I consider the ‘adverse signalling effects’ of a PLAM trigger to be a feature, not a bug; high triggers are good things, and I’m not the only one who says so:

Moreover, high-trigger CoCos would presumably get converted not infrequently which, in terms of reducing myopia in capital markets, would have the merit of reminding holders and issuers about risks in banking.

Broadly speaking, Europeans were in favour of PLAM, although some expressed concerns about complexity: China Banking and Insurance Regulatory Commission (CBIRC); European Insurance and Occupational Pensions Authority (EIOPA); Insurance Europe; Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); General Insurance Association of Japan; Financial Supervisory Service (FSS) & Financial Services Commission (FSC); Legal & General; Association of British Insurers. Comments included EIOPA’s remark:

Requiring a PLAM, i.e. write-down or conversion features, provides a means for the principal of a financial instrument to absorb losses on a going-concern basis. Without such mechanisms these instruments only provide going concern loss absorbency through cancellation of distributions.

Naysayers were dominated by American regulators and firms: Dai-ichi Life Holdings, Inc., American Council of Life Insurers, National Association of Mutual Insurance Companies; Prudential Financial, Inc.; American Property Casualty Insurance Association (APCI); MetLife, Inc; Property Casualty Insurers Association of America (PCI); and the National Association of Insurance Commissioners (NAIC). The Americans have a high degree of concern regarding the continued eligibility of “surplus notes”, as exemplified by the response of the National Association of Mutual Insurance Companies:

PLAM is an addition to the discussion that NAMIC strongly opposes. NAMIC does not see any value in a PLAM requirement. It is simply a way to further complicate the ICS 2.0 providing no value. It seems to be designed to reduce the value of allowing surplus notes to qualify as Tier 1 capital resources.

The elephant in the room is AIG and the European bank bail-outs that left Tier 1 noteholders unscathed, at least relatively. How can anybody say with a straight face that loss absorbency via cessation of dividends is sufficient in the face of those memories?

Q53 Section 6 If a PLAM requirement is not introduced, what amount should be included in ICS capital resources for instruments that qualify as Tier 1 Limited, to reflect going concern loss absorbency? Please explain.

OSFI’s answer is a disgrace:

Capital composition limits address the concerns related to loss absorbency of Tier 1 Limited instruments and therefore their full face amount should be included in the ICS capital resources.

In other words, OSFI would have us believe that since Limited Tier 1 Capital is a limited proportion of the insurers’ high quality capital, it doesn’t really matter whether it’s actually high quality or not. Disgusting.

EIOPA and BaFin stepped into the breach:

Without a PLAM requirement, it is difficult to see how the principal of an instrument absorbs losses in a going concern basis.

Interestingly, the Property Casualty Insurers Association of America (PCI) stated:

In support, PCI cites the response of OSFI-Canada to a similar question in the prior ICS consultation

and quoted in full the dovish response to the 2016 consultation … including the grudging support for a NVCC solution.

Others stated that cessation of distributions worked just fine, e.g., American Property Casualty Insurance Association (APCI):

Tier 1 Limited instruments already provide loss absorbency on a going concern loss basis through cancellation of distributions. Reducing the principal amount of these instruments is only necessary during resolution.

Q54 Section 6 Are there other criteria that could be added to enhance the ability of financial instruments to absorb losses on a going concern and / or on a gone concern basis? Please explain.

OSFI had nothing to say. BaFin and EIOPA had identical answers again:

• In T1, mandatory cancellation of distributions on breach of capital requirement (i.e. a lock-in feature).
• In T2, mandatory deferral of distributions and redemption of principal on breach of capital requirement (i.e. a lock-in feature).
• Requirement for early repurchase (within 5 years from issuance) to be funded out of proceeds of new issuance of
same/higher quality (all tiers).

I don’t quite understand this response. Does “cancellation” mean cancellation forever and ever on T1, as opposed to a temporary “deferral” on T2? How about redemptions? Would such instruments have any rights if the issuer actually did go bankrupt ten years later? And I don’t understand what they mean by an early purchase requirement at all.

So, there you have it. I don’t find anything particularly surprising here; there might be some meaning behind the heavy American participation in this consultation, but an outsider such as myself would be foolish to speculate on just what that meaning might be.

DBRS: Canadian Banks’ Trends Now Stable on Bail-In Approval

Wednesday, April 25th, 2018

DBRS has announced that it has:

changed the trend to Stable from Negative on the Long-Term Issuer Ratings, Senior Debt Ratings and Deposits ratings of the Bank of Montreal, The Bank of Nova Scotia, the Canadian Imperial Bank of Commerce and the National Bank of Canada. These actions result from the publication by the Minister of Finance of the final rules related to the Bank Recapitalization Regime (the Bail-in Regime). DBRS notes that the Stable trends on the long-term ratings of The Toronto-Dominion Bank and Royal Bank of Canada were unaffected. For these domestic systemically important banks (D-SIBs) to which the Bail-in Regime is applicable, DBRS has created a new obligation named Bail-inable Senior Debt. This new obligation rating reflects the senior debt that these banks will begin issuing once the Bail-in Regime goes into effect on September 23, 2018. Lastly, DBRS has downgraded the legacy Subordinated Debt ratings of these D-SIBs by one notch.

The revision of the trend to Stable from Negative for the affected long-term ratings reflects DBRS’s view that a downgrade of existing senior debt for the D-SIBs is now unlikely. It is anticipated that systemic support would still be sufficient to add a notch for such support until the D-SIBs issue adequate amounts of Bail-inable Senior Debt to meet their total loss-absorbing capacity (TLAC) requirements. Once an adequate level of bail-inable debt has been issued, the likelihood of future systemic support would be much lower. Accordingly, the notch of support would then be withdrawn. However, the new Bail-inable Senior Debt creates an additional buffer that better protects all senior obligations that cannot be bailed in under the regulation. Therefore, DBRS does not expect to downgrade any long-term ratings of existing senior obligations of the D-SIBs.

When issued, DBRS will rate the new Bail-inable Senior Debt at the level of each bank’s Intrinsic Assessment (IA), reflecting the risk of a D-SIB being put into resolution.

The downgrades of the legacy Subordinated Debt ratings reflect the structural subordination to the Bail-inable Senior Debt.

This has been telegraphed for a long, long time:

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.