PrefBlog

Christopher Condon and Robert Schmidt of Bloomberg report that:

Money-market mutual funds would be forced to create capital buffers equaling 1 percent to 3 percent of assets to protect against losses under a plan now favored by staff at the U.S. Securities and Exchange Commission, according to three people briefed on the regulator’s deliberations.

Top SEC officials, seeking to make money funds safer, prefer the plan over another capital buffer idea crafted by Fidelity Investments and calls to eliminate the funds’ stable share price, said the people, who asked not to be identified because they weren’t authorized to speak publicly. The concept is based on recommendations submitted to the agency in January by university economists known as the Squam Lake Group.

Readers will remember the Squam Lake proposal on contingent capital, which I didn’t like, but was a whole lot better than OSFI’s idiotic approach.

I reported in May that the SEC was grinding ahead on MMF regulation; readers will remember that I have a long-standing interest in the topic.

The Squam Lake Proposal for MMF regulation points out:

In the past, without the prospect of government guarantees, whenever money market funds threatened to break the buck, it had been common for their managers to bail them out in order to preserve the franchise values of their fund management businesses. Between August 2007 and December 31, 2009, at least 36 U.S. and 26 European money market funds received support from their sponsor or parent [footnote] because of losses incurred on their holdings of distressed or defaulted assets, as well as the costs of meeting the redemption demands of investors through sales of assets. Going forward, if sponsors believe that their funds will receive government support, their incentive to bail out their own funds may be substantially reduced, particularly given the squeeze on profitability associated with exceptionally low money-market interest rates.

Footnote: See “Sponsor Report to Key Money Market Funds,” by Henry Shilling, Moody’s Investor Service, !ugust 9, 2010; The forms of support included capital contributions, purchases of distressed securities at par, letters of credit, capital support agreements, and letters of indemnity or performance guarantees.

They propose a capital buffer:

Thus, as an alternative to floating NAV, a second broad approach, which we focus on below, preserves the stable NAV structure but enhances its safety by requiring sponsors to establish contractually secure buffers that could absorb at least moderate investment losses to their money market fund investors. This is akin to a capital requirement for stable-N!V funds; The President’s Working Group Report (2010) describes various alternatives, including some forms of liquidity facility or insurance that are consistent in spirit with this approach, but it does not make a specific recommendation. [footnote]

Footnote: See “Report of the President’s Working Group on Financial Markets: Money Market Fund Reform Options,” October 2010, [published by the Treasury] which suggests that money market funds continue to pose systemic risk. Among the alternative policies described in the President’s Working Group Report are: conversion of all funds to floating NAV; a private or public insurance scheme for stable-NAV funds; a rule by which large redemptions would be paid in kind (that is, with a portfolio of assets held by the fund); a two-tier system of both floating-NAV and stable-NAV funds under which stable-NAV funds would be required to have some support mechanism; a two-tier system under which stable-NAV funds are only available to retail investors; a rule forcing stable-NAV funds to convert to special purpose banks, holding capital and having access to lender of last resort facilities, and for which depositors would have some insurance coverage.

The Squam Lake group proposes:

The manager of a stable-NAV money market fund must provide dedicated liquid financial resources that, in combination with those represented by the assets of the fund class investors, are sufficient to achieve a net buffer of “X” per dollar of net asset value. These additional resources are to be drawn upon as needed to support fund redemptions at one dollar per share until the fund converts to a floating-NAV or until the buffer resources are exhausted. That is, at the end of each business day, the combined resources available to fund investors represented by the sum of dedicated additional sources and the previous day’s marked-to-market per-share value of the fund’s assets must exceed 1+X per share held as of the end of the current day. The fund must convert to a floating-NAV fund within a regulatory transition period, such as 60 days, in the event that the fund manager falls out of compliance with this buffer requirement.

They do not formally recommend a buffer size (that is, the value of X in the proposal) but indicate that 3% is a good place to start discussion:

When setting the size “X” of a required buffer, regulators may wish to consider the amounts by which money market funds have broken the buck in the past, or the amounts per share that fund sponsors have contributed in order to prevent them from breaking the buck. In the two-day period following Lehman’s bankruptcy, the Reserve Primary Fund reported a minimum share price of 97 cents.9 Had redemptions not been halted by the Reserve Fund’s sponsors, a fire sale of additional assets could have caused significant additional losses. A buffer of at least $0.03 per share would therefore have been necessary to prevent the Reserve Fund from breaking the buck.

Another consideration in determining the size of a buffer requirement is the concentration of fund assets among the debt instruments of a small number of borrowers. As of June 2010, for example, the top 5 exposures of U.S. prime money market fund assets, were all to European banks, with each of the 5 banks representing an exposure of at least 2.5% of aggregate fund assets.

Frankly, I think this is unnecessarily complex and specialized. Money market funds are, essentially, banks. They should be regulated as banks.

Update, 2011-8-3: The Fidelity plan is a little different:

Given that tepid response, the SEC is discussing other ideas such as those suggested by Fidelity Investments, which opposed the notion of a liquidity bank in its comment letters to the President’s Working Group.

Under the Fidelity proposal, money market funds would create a capital reserve or an “NAV buffer” by charging investors more over a period of time, said Norman Lind, head of trading for the taxable- and municipal-money-market desks at Fidelity Management and Research Co., the investment adviser for Fidelity’s family of mutual funds.

The SEC would work with fund boards to determine a range that a fund should keep for capital reserve, he said during a panel discussion.

“Let’s say you retain five basis points per year and you accrue that over time,” Mr. Lind said. “The idea is that once you have a buffer in place … you stop charging that fee.”

Unlike the ICI’s proposal, Fidelity thinks that its idea is simple to implement and doesn’t require regulatory changes, Mr. Lind said.

I don’t get it, frankly. Who owns the buffer?

The Financial Stability Oversight Council (comprised of an alphabet soup of US financial regulators) has released its 2011 Annual Report.

There are many items of interest in this excellent report; one issue that I find interesting is the regulation of money market funds:

The stable, rounded $1 NAV fosters an expectation that MMF share prices will not fluctuate. However, when shareholders perceive that a fund may suffer losses, each shareholder has an incentive to redeem shares before other shareholders, causing a run on the fund. Such redemptions can accelerate the likelihood of a break-the-buck event to the extent that the fund’s asset sales to meet redemptions significantly depress the market value of the fund’s remaining assets. In such a scenario, the ability of early redeemers to receive the full $1 NAV is essentially subsidized by the losses absorbed by remaining shareholders.

Click for Big

MMFs invest in assets that may lose value, but funds have no formal capital buffers or insurance to absorb loss and maintain their stable NAV. When losses do occur, MMFs have historically relied on discretionary sponsor support to maintain a stable NAV and preserve the franchise value of fund management businesses (Chart D.2). That support may come in the form of capital contributions or the purchase of assets that have lost value, for example.

Sponsors do not commit to support an MMF in advance, however, because an explicit commitment may require the sponsor to consolidate the fund on its balance sheet. Thus, although investors ostensibly bear the risk of an MMF breaking the buck, sponsors have in the past borne that risk themselves, fostering the perceived safety of MMF investments. Moreover, the uncertainty about the availability and sufficiency of such support during crises, and the fact that many MMFs lack deep-pocketed sponsors, contribute to their susceptibility to runs.

Expectation of Government Support

Given the unprecedented government support of MMFs during the crisis in 2008 and 2009, even sophisticated institutional investors and fund managers may have the impression that the government would be ready to support the industry again with the same tools.
…
Although these new rules are a positive first step, the SEC recognizes that they address only some of the features that make MMFs susceptible to runs, and that more should be done to address systemic risks posed by MMFs and their structural vulnerabilities.

The report takes a much more reasonable view of the Flash Crash than did the highly politicized SEC report:

During periods of violent price movements, market liquidity can evaporate as hedging strategies to protect against market risk become strained or directly amplify the price movements. For example, in the October 1987 equity market crash, portfolio insurance programs were designed to sell when prices declined; in fact, they were set to sell at an increasing rate, thereby accelerating the market decline. Similarly, in the flash crash of May 6, 2010, liquidity evaporated and market functioning deteriorated rapidly. Regulators have added circuit breakers in equity markets to mitigate such dynamics (see Section 5.3.4), but this event illustrated the potential fragility of market liquidity, particularly in areas characterized by rapid innovation and change in market behaviors.

The role of exchange traded funds (ETFs) during the flash crash has focused attention on these products. The rapid rise of ETFs has been driven by the attraction of gaining liquid exposure to less liquid asset classes—such as commodities and certain emerging markets—without having to execute trades directly in less liquid markets (Chart E.1). However, the liquidity of ETFs depends heavily on the support of market makers and on market functioning in the underlying asset. The relationship between ETF turnover and market volatility bears further analysis, and regulators must continue to monitor the development of more complex products in both U.S. and foreign-domiciled funds that might heighten liquidity concerns.

One item of great interest to me was developments in the idea that insurance companies should be regulated at the consolidated level – there is not a single mention of this in the report, so for the moment I will assume that this highly desirable reform has been dropped. Instead, the report discusses the new Federal Insurance Office (FIO), which is just another micromanaging job-creation scheme.

The Committee on the Global Financial System, a unit of the Bank for International Settlements, has released a Working Group Report titled Fixed income strategies of insurance companies and pension funds:

Insurance companies will be affected to a greater extent by the introduction of Solvency II, a comprehensive risk-based regulatory framework to be phased in from 2013. Solvency II and other risk-based regulatory regimes in Europe require that assets should be marked to market and that liabilities be discounted at risk-free rates (possibly augmented by an illiquidity premium). Solvency II also requires insurers to hold loss-absorbing capital against the full range of risks on both their asset and liability side to weather unexpected losses with a probability of 99.5% over a one-year horizon. While the latest quantitative impact study by European insurance regulators suggests that the majority of insurance companies will not face an imminent need to raise new equity, they may rebalance their asset portfolios in line with the new risk charges. The proposed changes tend to make it more expensive to hold equity-like instruments, structured products, and long-term or low-rated corporate bonds, whereas government bonds and covered bonds will receive relatively favourable capital treatment.

A related concern is whether life insurers and pension funds can maintain a long-term investor perspective. Factors contributing to this concern among market participants include the steep regulatory risk charges and short horizons to be used for assessing solvency and for addressing funding shortfalls. Prospective volatility in financial statements under international accounting rules may also limit the scope for taking long-term or illiquid positions without any concern for short-term fluctuations in their value. As is the case for institutional investors more generally, these factors tend to encourage a shift away from long term investing in risky assets, in addition to the ongoing trend toward more conservative asset allocations in the aftermath of the financial crisis. This could alter the traditional role of life insurance companies and pension funds as global providers of long-term risk capital. A partial retreat of institutional investors from the long-term and/or illiquid segment of the credit market could reduce the private and social benefits the sector generates through long-term investing, and the extent to which it mitigates the procyclicality of the financial system.

In Solvency II, both assets and liabilities are marked to market, ie fair valued. The present value of liabilities, or technical provision, is defined as the amount an insurer would have to pay to transfer its insurance obligations immediately to another willing buyer. It consists of the best estimate, the present value of the expected future cash flows (net payments to policyholders), calculated on a specified discount rate curve (term structure), and the risk margin, which is an additional premium above the best estimate. How the discount rate is constructed is of considerable importance given that the risk margin, and the present value of liabilities, will increase when this rate decreases.

The current expectation of how this rate will be constructed, is the swap curve (excluding credit risk), augmented by an illiquidity premium for those obligations coming due more than a year ahead. (This was also the discount rate used in Quantitative Impact Study 5.) In addition, an extrapolation (technique) towards a fixed rate (ultimate forward rate) will be used to get the discount rates for longer maturities than those available from market rates in different countries.

The motivation for adding an illiquidity premium, according to the proponents, is that there is general acceptance that the valuation of corporate bonds should take into account risk spreads in the discounting of future cash flows.35 Bond spreads during the crisis far exceeded the cost of credit risk mitigation (CDS spreads), and therefore included a substantial component pricing in illiquidity. The important role the illiquidity premium played in the valuation of assets, while liability cash flows continued to be discounted at the risk free rate, was largely responsible for a substantial shortfall in insurers’ balance sheets. The application of the illiquidity premium on the liability side would aim to reduce this valuation mismatch to avoid situations where insurers are forced to dispose of illiquid assets. The financial condition of insurers would be improved by allowing them to discount liabilities at a higher rate when markets are illiquid. Such a countercyclical mechanism might even mean that insurers would be willing to take on additional illiquid assets in a period of market distress, depending on whether the change in their net asset-liability position would improve their capital position.

Government bonds. Since European government bonds in domestic currency are classified as risk-free under Solvency II, there is a clear regulatory incentive to increase exposure to this asset class, including to euro area periphery debt. However, major insurance companies also rely on internal risk models that account for spread and default risk on sovereign debt. As in the case of banks, this would tend to moderate the incentive to shift toward high-yield sovereign debt even if the overall demand for sovereign debt is likely to rise. On balance, however, one may expect greater demand for long-dated sovereign debt which, all else equal, will further contribute to low long-term interest rates. In addition, insurers’ efforts to reduce their duration gaps tend to reinforce the demand for long-dated government debt from an ALM perspective.

Any sizeable shifts in the government bond space may lead to noticeable financial market implications, given the volume of government bonds on the balance sheets of insurers (as well as on those of pension funds, see Section 2.4). Depending on initial conditions and current bond holdings, further shifts into government bonds may well produce downward pressure on yields, although differentiation across issuer countries is likely to occur.

Corporate and covered bonds. The impact of Solvency II on the corporate bond market is also potentially significant. Historically, insurance companies constitute a key investor base, holding more than 30% of the corporate bond supply.48 Solvency II will impose capital charges on corporate and covered bonds that did not exist under Solvency I, although internal models at large insurers had taken into account credit risk before Solvency II was developed.

Under the standard formula, Solvency II capital charges have relatively steep duration and credit slopes which can be expected to lead to some portfolio adjustments. The capital requirements for corporate and covered bonds are calculated by multiplying a rating-induced shock factor with the duration of the bonds. A BBB-rated bond with a duration of 10 therefore requires 25% (=2.5%*10) in equity capital before diversification benefits. This formula appears to penalise long-term bonds since credit spreads at the long end are less volatile than those at the short end. The credit slope is similarly steep.49 Corporate bonds with a low rating effectively attract a capital charge similar to that of equities.

Under the instrument-specific capital requirements in Solvency II, the following
investment allocations generate the same capital requirement under the standard formula:

• 100% in covered bonds (AAA-rated) with a duration of one year,
• 20% in covered bonds (AAA-rated) with a duration of five years, and the rest in EEA government bonds,
• 13.3% in corporate bonds, AAA-rated, with a duration of five years, and the rest in EEA government bonds,
• 8.6% in corporate bonds, A-rated, with a duration of five years, and the rest in EEA government bonds,
• 1.6% in corporate bonds, B-rated, with a duration of five years, and the rest in EEA government bonds,
• 1.5% in “global equities” and the rest in EEA government bonds,
• 1.2% in “other equities” and the rest in EEA government bonds.

What it looks like to me is that the net effect will be to shift funding risk from the financial economy to the real economy. Once this is in place look for the next financial crisis to be propogated much more thoroughly to the real economy, with lots of firms finding they have debt coming due that cannot be rolled.

The Bank of England has released its Financial Stability Report, June 2011.

Unfortunately, the Bank has taken action to ensure that the information published in this report does not fall into the wrong hands. The PDF document is secured (at the 128 bit level, no less!) in a manner which prohibits copying of extracts. Hah! That will teach Al Qaeda to quote from the Bank of England Financial Stability Report!

My attention was immediately caught by the fact that BIS concerns regarding synthetic ETFs have been given a prominent place in the threat list. Box 1 (on pages 16-17 of the PDF) points out that:

Because the collateral does not need to match the assets of the index being tracked, the bank might have incentives to use the synthetic ETF structure as a source of collateralised borrowing to fund illiquid portfolios

I’m not going to report on this any more because, quite frankly, I’m too pissed off at the moronic at worst and picayune at best restrictions on fair use imposed by the Bank’s encryption of the document. But read it; the research is quite good, which is presumably why it is being kept secret.

Update: Chart 1.4 has an interesting reference to Panigirtzoglou, N and Scammell, R (2002) ‘Analysts’ earnings forecasts and equity valuations’, Bank of England Quarterly Bulletin, Spring, pages 59-66

Bruno Biais and Richard C. Green, The Microstructure of the Bond Market in the 20th Century:

Bonds are traded in over-the-counter markets, where opacity and fragmentation imply large transaction costs for retail investors. Is there something special about bonds, in contrast to stocks, precluding transparent limit-order markets? Historical experience suggests this is not the case. Before WWII, there was an active market in corporate and municipal bonds on the NYSE. Activity dropped dramatically, in the late 1920s for municipals and in the mid 1940s for corporate, as trading migrated to the over-the-counter market. The erosion of liquidity on the exchange occurred simultaneously with increases in the relative importance of institutional investors, who fare better in OTC market. Based on current and historical high frequency data, we find that average trading costs in municipal bonds on the NYSE were half as large in 1926-1927 as they are today over the counter. Trading costs in corporate bonds for small investors in the 1940s were as low or lower in the 1940s than they are now. The difference in transactions costs are likely to reflect the differences in market structures, since the underlying technological changes have likely reduced costs of matching buyers and sellers.

The authors point out the central question:

Perhaps corporate and municipal bonds have low liquidity and high trading costs because they are traded in opaque and decentralized dealer markets. Alternatively, perhaps they trade over the counter because the infrequent need for trade, and sophistication of the traders involved, renders the continuous maintenance of a widely disseminated, centralized limit-order book wasteful and costly.

What is often ignored is the fact that exchange trading of bonds has been tried before:

Until 1946, there was an active market in corporate bonds on the NYSE. In the 1930s, on the Exchange, the trading volume in bonds was between one fifth and one third of the trading volume in stocks. In earlier periods, there was also an active market for municipal bonds and government bonds…Municipal bond trading largely migrated from the exchange in the late 1920s, and volume in corporate bonds dropped dramatically in the late 1940s.(footnote) Since this collapse, bond trading on the Exchange has been limited.

Footnote: The historical evolution of trading volume in municipal and corporate bonds is documented in the present paper. The Treasury and Federal Study of the Government Securities Market, published in July 1959, mentions (Part I, page 95) that trading volume in Treasury securities migrated from the NYSE to the OTC market during the first half of the 1920s.

Two possible explanations for the collapse of the exchange market are dismissed:

First, we ask whether decreases in liquidity could have been associated with changes in the role of bond financing generally. Based on data assembled from different sources (Federal Reserve, NBER and Guthman (1950)) we show that bond financing actually grew during the periods when trading volume collapsed on the Exchange.

Second, we ask whether the drop in liquidity could have resulted from SEC regulations increasing the cost of listing on the Exchange. We show that the decline in liquidity was not correlated with a decline in listings. Furthermore, while Exchange trading disappeared in securities that were exempt from the 1933 and 1934 acts (such as municipal bonds), it remained active in securities which were subject to this regulation (most notably stocks).

The third possibility is due to the interaction of groups with differing objectives in a heterogeneous market:

Different equilibria will vary in terms of their attractiveness for different categories of market participants. Intermediaries benefit when liquidity concentrates in venues where they earn rents, such as opaque and fragmented markets. For reasons we will show were quite evident to observers at the time, large institutional investors fare better than retail investors in a dealership market. This was especially t ue on the NYSE until 1975, because commissions were regulated by the Constitution of the Exchange, while intermediary compensation was fully negotiable on the OTC market. We find that liquidity migrated from the exchange to the OTC market at times when institutional investors and dealers became more important relative to retail investors. As institutions and dealers became more prevalent in bond trading, they tipped the balance in favor of the over-the-counter markets.

TRACE, of course, has had an impact:

In their studies of the corporate bond market, Edwards, Harris and Piwowar (2007), Goldstein, Hotchkiss and Sirri (2007) and Bessembinder, Maxwell, and Venkataraman (2007) show that the lack of transparency in the corporate bond market led to large transactions costs, while the recent improvement in post-trade transparency associated with the implementation of the TRACE system lowered these costs for the bonds included in the TRACE system.

A later paper by Bessembinder & Maxwell has been reviewed on PrefBlog, in the post TRACE and Corporate Bond Market Transparency. The referenced paper, by Bessembinder, Maxwell and Venkataraman, is titled Market Transparency, Liquidity Externalities, And Institutional Trading Costs in Corporate Bonds:

We develop a simple model of the effect of transaction reporting on trade execution costs and test it using a sample of institutional trades in corporate bonds, before and after the initiation of public transaction reporting through the TRACE system. The results indicate a reduction of approximately 50% in trade execution costs for bonds eligible for TRACE transaction reporting, and consistent with the model’s implications, also indicate the presence of a “liquidity externality” that results in a 20% reduction in execution costs for bonds not eligible for TRACE reporting. The key results are robust to allowances for changes in variables, such as interest rate volatility and trading activity, which might also affect execution costs. We also document decreased market shares for large dealers and a smaller cost advantage to large dealers post-TRACE, suggesting that the corporate bond market has become more competitive after TRACE implementation. These results reinforce that market design can have first-order effects, even for sophisticated institutional customers.

The paper by AMY K. EDWARDS, LAWRENCE E. HARRIS, MICHAEL S. PIWOWAR is titled Corporate Bond Market Transaction Costs and Transparency:

Using a complete record of U.S. OTC secondary trades in corporate bonds, we estimate average transaction costs as a function of trade size for each bond that traded more than nine times between January 2003 and January 2005. We find that transaction costs decrease significantly with trade size. Highly rated bonds, recently issued bonds, and bonds close to maturity have lower transaction costs than do other bonds. Costs are lower for bonds with transparent trade prices, and they drop when the TRACE system starts to publicly disseminate their prices. The results suggest that public traders benefit significantly from price transparency.

The paper by Michael A. Goldstein, Edith S. Hotchkiss and Erik R. Sirri is titled Transparency and Liquidity: A Controlled Experiment on Corporate Bonds:

This article reports the results of an experiment designed to assess the impact of lastsale trade reporting on the liquidity of BBB corporate bonds. Overall, adding transparency has either a neutral or a positive effect on liquidity. Increased transparency is not associated with greater trading volume. Except for very large trades, spreads on newly transparent bonds decline relative to bonds that experience no transparency change. However, we find no effect on spreads for very infrequently traded bonds. The observed decrease in transaction costs is consistent with investors’ ability to negotiate better terms of trade once they have access to broader bond-pricing data.

The Biais and Green paper makes a hiliarious point about trading frequency:

Table 6 shows the number of trades and average trade size on the NYSE by year for the six corporate issues in our sample. In 1943 and 1944, trading activity was relatively high. There were around 800 trades per bond issue each year, which is over two transactions per trading day. The trading frequency observed in the modern OTC corporate bond market has been documented in modern studies. Using TRACE data Goldstein, Hotchkiss and Sirri (2007) observe on average 1.1 trade per day, and Edwards, Harris and Piwowar (2007) around 2.0 trades per day.

More Biais & Green:

Furthermore, the professionalized management and relatively frequent presence in the market of institutions makes transparency less important to them than to less sophisticated small investors who trade infrequently. The repeated interaction that dealers and institutions have with each other renders them less vulnerable to the opportunities which a lack of transparency affords other participants to profit at their expense on a one-time basis. Smaller institutions and individuals, for the opposite reasons, will tend to fare better in an exchange-based trading regime. Indeed, the theoretical model of Bernhardt et al (2005) shows that, in a dealer market, large institutions will trade more frequently and in larger amounts than retail investors, and incur lower transactions costs.(footnote)

Footnote: Bernhardt et al (2005) also offer an interesting empirical illustration of these effects in the case of the London Stock Exchange.

The paper by Dan Bernhardt, Vladimir Dvoracek, Eric Hughson & Ingrid M. Werner is titled Why Do Larger Orders Receive Discounts on the London Stock Exchange?:

We argue that competition between dealers in a classic dealer market is intertemporal: A trader identifies a particular dealer and negotiates a final price with only the intertemporal threat to switch dealers imposing pricing discipline on the dealer. In this kind of market structure, we show that dealers will offer greater price improvement to more regular customers, and, in turn, these customers optimally choose to submit larger orders. Hence price improvement and trade size should be negatively correlated in a dealer market. We confirm our model’s predictions using unique data from the London Stock Exchange during 1991.

Biais & Green also make the point:

Over-the-counter and exchange-based bond trading coexisted for decades in the 20th century with viable levels of activity in each setting. What upset this balance? Was the migration to the OTC market triggered by changes in the structure of the population of bond investors? Combining Guthman (1950) and data from the Fed, we present in Figure 5 the evolution of bond ownership between 1920 and 2004.13 As can be seen in Panel A, there was a dramatic increase in institutional ownership in corporate bonds between 1940 and 1960. In the 1940s the weight and importance of institutional investors in the bond market grew tremendously. These investors came to amount for the majority of the trading activity in the bond market. Naturally, they chose to direct their trades to the OTC market, where they could effectively exploit their bargaining power, without being hindered by reporting and price priority constraints, and where they could avoid the regulated commissions which prevailed on the Exchange. Thus, the liquidity of the corporate bond market migrated to the dealer market.

Biais & Green also make an important point, which may be relevant to the debate on High Frequency Trading:

An obvious question is why exchange trading remained predominant in the stock market, in such a stark contrast with the bond market. One important difference between bond and stock trading on the Exchange is that, while the bond market has always been purely order driven, specialists have traditionally supplied liquidity in the stock market. It is possible that the presence of the specialist anchored the liquidity on the exchange. Because it was common knowledge that the specialist would be there to supply liquidity, small and medium sized trades could continue to be directed to the exchange. Because liquidity attracts liquidity, the larger traders also found it attractive to trade there, in line with the logic of Admati and Pfleiderer (1988).

The Bank of Canada has released the Bank of Canada Review, Spring 2011, a Special Issue devoted to Lessons from the Financial Crisis with articles:

• Understanding and Measuring Liquidity Risk: A Selection of Recent Research
• Unconventional Monetary Policy: The International Experience with Central Bank Asset Purchases
• Lessons from the Use of Extraordinary Central Bank Liquidity Facilities
• Central Bank Collateral Policy: Insights from Recent Experience

Sadly, despite the promising focus of the special issue, I found nothing of particular interest in the material.

Thomas J Jordan, Vice Chairman of the Governing Board of the Swiss National Bank, gave a speech at the International Center for Monetary and Banking Studies, Geneva, 17 May 2011 titled Approaching the finishing line – the too big to fail
project in Switzerland

A central component of the Swiss approach is that systemically important banks should markedly improve their capital base and liquidity positions, both qualitatively and quantitatively, and reduce their risk exposure to other banks.(footnote)

Footnote: The new capital adequacy regulations for systemically important banks are to apply to risk-weighted capital and to the leverage ratio. Furthermore, they are designed to be progressive. In other words, the bigger the bank, the higher the requirement. Given the current size of Switzerland’s two big banks, the requirement would be 19% total capital of the risk-weighted assets, of which 9% can be held in convertible capital (cocos) and 10% must be held in common equity.

I am very pleased to see that the capital adequacy requirements are progressive and that the exposure to other banks is being addressed.

I can’t say I’m similarly impressed by the trigger for the cocos (I would prefer a trigger based on market price of the common)

If common equity falls below the threshold of 5%, the cocos will be converted and the emergency planning for separating the systemically important functions from the rest of the bank will be initiated.

… but you can’t have everything!

He takes a little dig at the US solution of banning prop-trading by the banks:

Firstly, regulation is never free of charge for every participant. However, analysis of the possible costs of regulation must always differentiate between the private and the social costs: in practice, regulation is bound to lead to additional costs for those regulated. This is part of the plan and makes economic sense provided that these additional costs are smaller than the benefits that regulation brings to the entire economy. If regulation leads to the elimination or reduction of market distortions – such as subsidies, for example – then an economically more efficient result is obtained.

Secondly, regulation can be formulated in a more or less cost-efficient manner. Particular attention was paid to this element in Switzerland. For instance, the additional capital required here by systemically important banks can largely be held in the form of more cost-efficient convertible capital. Other, far more drastic measures, such as a strict ban on certain business activities or the introduction of a bank tax – as discussed in other countries – were firmly rejected, partly for cost reasons.

He then provides an economic rationale for CoCos:

an increase in capital should not have any effect on a bank’s overall financing costs. Owing in part to the preferential tax treatment of borrowed funds, the Modigliani-Miller theorem referred to here, cannot be applied directly in practice, which means that overall financing costs would rise if capital increases. However, this is exactly what the proposed measures on convertible capital take into account. They create better conditions, so that capital structure will have less influence on a bank’s financing costs.

I liked Chart 2:

Click for big

But Chart 8 was pretty good to:

Click for Big

And there’s a handy scoresheet!

Click for big

Nicholas Dorn, Erasmus University Rotterdam – Erasmus School of Law, Ponzi Finance, Regulatory Capture and the Credit Crunch:

The unfolding financial market instability provokes questions about the safety of all financial investments and, in doing so, reveals some large investment frauds, which can flourish only in buoyant markets. More broadly, as is now recognized by market regulators, there has been insufficient attention to fraudulent practices, conflicts of interest and evasion of regulatory controls, notably in relation to promotion of sub-prime mortgages, the role of ratings agencies, the packaging and selling on of the resulting debt instruments to investors worldwide, and circumvention of risk controls. So, where were the regulators? This paper proposes that institutional capture of the regulators by the market – in terms of adoption by the regulators of technical assumptions, ‘models’ and data defined as relevant by the private sector – provides a narrative on ‘what went wrong’. Moving towards a vision of the way forward for regulatory reform, the paper argues against the exclusionary notion of regulation that makes it a matter of coordination between those possessing technical expertise, separated off from moral questions, public politics and debate amongst citizens. The literature on security governance and ‘public goods’ is explored as one way of opening up the debate on financial regulation, reversing regulatory capture.

Daniel C. Hardy, Monetary and Financial Systems Department, International Monetary Fund, Regulatory Capture in Banking:

Banks will want to influence the bank regulator to favor their interests, and they typically have the means to do so. It is shown that such “regulatory capture” in banking does not imply ineffectual regulation; a “captured” regulator may impose very tight, costly prudential requirements to reduce negative spillovers of risk-taking by weaker banks. In these circumstances, differences in the regulatory regime across jurisdictions may persist because each adapts its regulations to suit its dominant incumbent institutions.

The Report of the Second Warwick Commission, The Warwick Commission on International Financial Reform: In Praise of Unlevel Playing Fields:

Capture was helped by the emergent view that public agencies ought to be independent of politics. As part of this process, a policy role for the private sector was legitimised. Intellectual capture, in turn, also relates to the ‘group-think’ that has taken hold in the making of financial policy. Regulatory and supervisory arrangements are discussed and agreed in expert and apolitical terms, bringing like-minded individuals who, whether in the official, private or academic sphere, can reach common understandings based on shared training, practice and access to economic ideas. Both in the national arena and, increasingly, in the international fora around the Basel process, such networks are technocratic, informal, politically unaccountable and have a narrowly defined understanding of financial policy. They are also often de-coupled from other economic considerations or broader questions about the role of finance.

It is important to break ‘group-think’ and introduce new voices and interests to debates about financial regulation.

Independent Evaluation Office of the International Monetary Fund, IMF Performance in the Run-Up to the Financial and Economic Crisis IMF Surveillance in 2004–07:

On the other side, the report ultimately ascribes the failure to warn about the crisis to “groupthink,” which is as much a description as an explanation. The report could have looked more at the extent to which staff considered contrarian views (arguably, they did) and how they judged these positions against the much larger evidence marshaled by the mainstream (clearly, they judged incorrectly). This also speaks to the IEO recommendation to increase financial expertise and staff diversity—which undoubtedly is correct, and indeed a goal of the institution, but does not follow from the pre-crisis experience: the vast majority of financial experts, from a diversity of countries and backgrounds, also failed to see the crisis coming. (Ironically, the prescient individuals cited by the report are from remarkably undiverse backgrounds—i.e., macroeconomists with PhDs from U.S.-U.K. universities.) That said, the recommendation to access thoughtful and diverse opinion is a very important one, and one that we return to below.

The Bank for International Settlements has released a working paper by Srichander Ramaswamy titled Market structures and systemic risks of exchange-traded funds:

Crisis experience has shown that as the financial intermediation chain lengthens, it becomes complicated to assess the risks of financial products due to a lack of transparency as to how risks are managed at different levels of the intermediation chain. Exchange-traded funds, which have become popular among investors seeking exposure to a diversified portfolio of assets, share this characteristic, especially when their returns are replicated using derivative products. As the volume of such products grows, such replication strategies can lead to a build-up of systemic risks in the financial system. This article examines the operational frameworks of exchange-traded funds and identifies potential channels through which risks to financial stability can materialise.

The part I found most interesting was:

Some of the product innovation might also be driven by dealer incentives to seek alternative funding sources to comply with the liquidity coverage ratio (LCR) standard under Basel III.2 For example, certain product structures might facilitate run-off rates on liabilities to be reduced despite keeping the maturity of liabilities short. As a result, ETFs have moved away from being a plain vanilla cost- and tax-efficient alternative to mutual funds to being a much more complex and diverse array of products and replication schemes (Russell Investments (2009)).
…
Liquidity regulation, such as the standards now proposed under Basel III, may also create incentives to use synthetic replication schemes. For example, under the proposed LCR standard, unsecured wholesale funding provided by many legal entity customers (banks, securities firms, insurance companies, fiduciaries, etc) as well as secured funding backed by lower credit quality collateral assets or equities maturing within 30 days will receive a 100% run-off rate in determining net cash outflows. By employing equities and lower credit quality assets to collateralise the swap transaction with the ETF sponsor that might typically have a maturity greater than one year, the bank engaging in this swap transaction will be able to reduce the run-off rate substantially on the collateral posted. Yet, the collateral substitution option allows banks to effectively keep the maturity of the funding short. The bank will still face a cash outflow run-off rate of 20% for valuation changes on the collateral posted,7 but this is far lower than the 100% run-off rate that it might otherwise face. When significant volumes of such transactions are done, this may result in a substantial improvement in the banks’ LCR, which would make compliance with the LCR standard less expensive.
…
Synthetic replication schemes, by contrast, transfer the underperformance risk to the swap counterparty. Within investment banking, the risk of underperformance or tracking error might be co-mingled with the rest of the trading book risk. This could potentially undermine the oversight function and compromise sound risk management. Moreover, the capacity of the swap counterparty to bear the tracking error risk while providing the market liquidity needed when there is sudden and large liquidation of ETFs is untested. Hedge funds often manage the liquidity risk through techniques such as “gating”, ie by restricting investor withdrawals

In Canada, there is the Horizons S&P/TSX 60™ Index ETF (HXT) that operates in this way. There may be others.

This may be just another instance of the regulators not thinking things through. Yes, the swap transaction may have a term of greater than one year. But if investors can redeem at any time, then it’s just another wholesale demand deposit, and should be treated accordingly.