Category: Regulation

Regulation

CSA/IIROC: Your Order is State Property

This commentary is terribly late, but better late than never! I’ve had the links in my “Draft Posts” pile for a long time, but am only now getting around to posting the stuff.

The Canadian Securities Administrators (which is the securities commissions) and the Investment Industry Regulatory Organization of Canada have released POSITION PAPER 23-405 DARK LIQUIDITY IN THE CANADIAN MARKET, which provides an update to 23-308 and 23-404, which have been discussed on PrefBlog. The comment letters have been published.

One conclusion is:

In our view:

  • An exemption to the pre-trade transparency requirements should only be available when an order meets or exceeds a minimum size (in the Position Paper, we will refer to this as the “minimum size exemption” or “minimum size threshold”). This minimum size threshold for posting passive Dark Orders would apply to all marketplaces (whether transparent or a Dark Pool) regardless of the method of trade matching (including continuous auction, call or negotiation systems), and for all orders whether client, non-client or principal.

They further explain:

Rule 6.3 of UMIR (the Order Exposure Rule) states that “A participant shall immediately enter on a marketplace that displays orders … a client order to purchase or sell 50 standard trading units or less of a security ….”. Aside from the specific exemptions under the Order Exposure Rule, it is currently required that client orders with a quantity equal to or less than 50 standard trading units will be directed to a transparent marketplace in order to be displayed. The Order Exposure Rule encourages transparency and supports the price discovery process, while still providing an opportunity for dealers to minimize large, passive order information leakage. Price discovery is enhanced by requiring smaller passive orders to be posted in a visible marketplace and rewarding those orders with increased execution opportunities. Additionally, IIROC has provided guidance in Market Integrity Notice 2007-019 with respect to the entry of client orders on non-transparent markets or facilities

So in other words, if you want to keep your order for 4900 shares dark – you can’t. It’s illegal. The powers that be have determined that your order is required as a critical part of the price discovery process. Those prefs you want to sell are quoted at 20.50-00, and you’d like to place an offer at 20.90, keeping it dark so the penny algos won’t move to 20.89? Tough luck, sucker. You are required to tip your hand to your broker, the exchange and the world.

The regulators don’t have a clue about the real world, though:

the Order Exposure Rule which requires that participants immediately enter on a marketplace that displays orders, all client orders for 50 standard trading units or less, subject to a number of exceptions. This is a benefit gained by passive, displayed orders in a transparent order book, in that active orders not meeting the size conditions of the rule are obligated to be routed to a transparent market, thus increasing the chances of execution for the displayed order.

If this was really beneficial to retail they wouldn’t need to make it mandatory. It is plainly apparent that not a single writer of this report has ever attempted to execute a trade in an illiquid market. They state that their motivation is:

The posting of limit orders in a visible book is important to maintain the quality of price discovery. To achieve this, limit orders should ideally be directed to, and displayed in visible marketplaces in order to facilitate the price discovery process.

In other words, the purpose of limit orders is not to save some money. The purpose of limit orders is to “facilitate the price discovery process.”. At least, according to the regulators.

It is in the discussion of the rule that the regulatory contempt for retail shines through:

allow larger orders to be executed with decreased market impact costs. However, as the “market impact cost” rationale described above may be less relevant to small Dark Orders, a possible rationale for allowing smaller orders to be posted as Dark Orders and be exempted from pre-trade transparency requirements is that they offer price improvement over the NBBO. While small orders may provide some price improvement when posted as a Dark Order, the limited quantity diminishes the value of price improvement to all market participants when compared to the value, or net benefit, of having larger Dark Orders offering the same price improvement, as well as providing much greater amounts of liquidity to the market as a whole. Currently in Canada, there are Dark Pools or Dark Order types that offer as little as 10% price improvement over the NBBO. In the situation where the NBBO spread for a particular security is very small (for example, one penny), we question whether the price improvement provided by small non-transparent orders is sufficiently meaningful for contra-side participants.

So if you feel that 10% price improvement (which, I take it, is 10% of the quoted spread, not the quoted price) is a worthwhile thing to have in your pocket – tough! Your orders are not for your benefit, they are for the benefit of other marketplace participants.

This is made explicit in the official staff view:

It is our view that the potential negative impact on price discovery of a greater number of small orders being entered without pretrade transparency and the potential drain on visible liquidity outweighs the benefits of the possible price improvement that they may offer. While post-trade information contributes to the price discovery mechanism, pre-trade transparency is an important element. The risk of a significant erosion of the quality of that mechanism exists if a substantial number of small orders are posted in the dark. As regulators, part of our mandate is to foster fair and efficient capital markets. The requirements to post small orders to a visible market and facilitating price discovery are key components of fair and efficient capital markets.

Consequently, we are of the view that an exemption from the pre-trade transparency requirements should only be available for orders meeting the minimum size threshold.

The staff, by the way, are not people with any knowledge of, or interest in, the capital markets and have no idea of what is meant by the phrase “fair and efficient capital markets.” They’re 25-year old B-School grads and 30-year-old lawyers with majors in boxtickingology.

They asked for responses on or before January 10, 2011.

One response which attracted some press attention was a tearful wail from David Panko of TD Securities, who is distraught that he cannot compete unless he has privileged access to the markets:

In addition, the existence of rebates encourages sophisticated high frequency traders to “stack the quote” by bidding and offering in large size. While this is certainly a benefit for small investors with orders that can be filled “on the quote”, it also disincents traders from placing natural bids and offers in the market, as these new bids and offers would be behind a large volume of HFT orders In turn, this leads to a greater proportion of client orders filled actively by crossing the bid-ask spread. The result is a combination of worse average fill prices for the end clients (through more frequent crossing of the bid-ask spread) and much higher marketplace fees for the broker (through a higher active/passive ratio)

Mr. Panko either does not know, or does not care, about the distinction between “informed” and “uninformed” traders.

These are the two types of traders who execute actively. Basically, so the theory goes, there is a “market price” for a security, which is the mid-point of the bid-offer spread. Call that “P” and the spread “S”. There is also a “Value Price” for the issue, P’, which is the Platonic Ideal price in a perfectly efficient world in which all private information has been put to work. It is assumed that over the long run P = P’, but these can vary over the short-run.

An uninformed trader will execute his active order and, on average, lose 0.5*S on each of his trades. If, however, an informed trader oberves that P’ > P + 0.5*S … back up the truck! He’ll execute all kind of active orders, happily paying the spread in exchange for getting his buys filled at a price that may be significantly less than P’.

So while one can certainly say that end-clients, as a group, are getting worse average fill prices, it is trivial to demonstrate that informed traders are getting better average fill prices and uninformed traders are getting worse ones. Informed traders will receive market rewards that reflect the accuracy of their estimates of P’.

To which I say – “Wonderful”. If there is anybody out there who truly wants to encourage price discovery as a valuable social good, they will do everything they can to reward informed traders and punish the uninformed. If we’re lucky, the uninformed ones will go bankrupt, go on welfare and die – that would be good.

Sufficient bankruptcy of the uninformed will, eventually, lead to a higher proportion of informed traders in the market, greater losses by HFT, therefore somewhat wider spreads, therefore more incentive to place “natural” bids and offers in the marketplace and give Mr. Panko something to talk about with his clients. It’s called competition.

So, with the shift to HFT stacking the quote, informed traders are winners – since they can execute at better prices. Uninformed active traders are also winners – since their market orders are executed at better prices. The only losers are the uninformed “market-maker” traders – those who, when attempting to buy a stock, consider it to be the height of genius to place a bid inside the quote rather than lifting the offer. These guys are now having their lunch eaten by people who can do it better. Boo-hoo-hoo. It’s called competition.

Mr. Panko also squares his rot for a good boo-hoo-hoo about how unfair it is for brokers to pay so much money for execution of active orders. Well, Mr. Panko of TD Securities, today is your lucky day because after a lifetime of research into market microstructure I think I’ve hit on a solution for you, which I will provide to TD Securites free, gratis and for nothing: if it costs more, charge more. A crazy idea, I know, but it just might work! Why should an off-quote limit order attract the same commission as a market order?

It’s a shame I’ve been so critical of Mr. Panko’s commentary, because his discussion was quite interesting, with more supporting numbers than is usual with self-serving sell-side lobbying letters in Canada, although the numbers themselves did not get much support. Unfortunately, the decision to “strongly recommend” the complete elimination of liquidity rebates is not particularly well supported by his discussion and argumentation: perhaps TD Securities wrote the recommendations in the executive suite, then assigned him the task of writing the rest of the letter.

Regulation

"You Are Stupid", say Canadian Securities Administrators

Janet McFarland reports in the Globe and Mail :

Canadian regulators are proposing major new restrictions on the sale of securitized financial products like asset-backed commercial paper, arguing unsophisticated investors should not be buying products that are potentially too complex and risky.

The Canadian Securities Administrators, an umbrella group for Canada’s provincial securities commissions, has unveiled a host of reforms to govern the sale of securitized products, responding to calls for tighter regulation following the melt-down of Canada’s $32-billion market for non-bank asset backed commercial paper (ABCP) in the summer of 2007.

In the CSA’s own words:

A key element of the proposed rules is the narrowing of the class of investors who can buy securitized products in the exempt market to a smaller, more sophisticated group. This feature is intended to help investors avoid products whose risk profiles and underlying components may be unsuitable for their investment objectives.

The CSA is seeking input from investors and marketplace participants on the proposals. The comment period is open until July 1, 2011.

The Requiest for Comment states:

The following is a summary of several significant features of the Proposed Exempt Distribution Rules.
(i) Removal of existing prospectus exemptions
We propose that the following prospectus exemptions in NI 45-106 be unavailable for distributions of securitized products that are not covered bonds or non-debt securities of MIEs:

  • • section 2.3 (the accredited investor exemption);
  • • section 2.4 (the private issuer exemption);
  • • section 2.9 (the offering memorandum exemption);
  • • section 2.10 (the minimum amount investment exemption);
  • • subsection 2.34(2)(d) and (d.1) (financial institution or Schedule III bank specified debt exemption);
  • • section 2.35 (the short-term debt exemption).

Instead, we propose to add a new prospectus exemption for the distribution of securitized products.
(ii) New Securitized Product Exemption (section 2.44)
Proposed section 2.44 contains the new prospectus exemption for distributions of securitized products to an “eligible securitized product investor” purchasing as principal (the Securitized Product Exemption). The definition of “eligible securitized product investor” essentially is the same as the definition of “permitted client” in National Instrument 31-103 Registration Requirements and Exemptions.

The definition comes later:

“eligible securitized product investor” means
(a) a Canadian financial institution or a Schedule III bank;
(b) the Business Development Bank of Canada incorporated under the Business Development Bank of Canada
Act (Canada);
(c) a subsidiary of any person referred to in paragraph (a) or (b), if the person owns all of the voting securities of the subsidiary, except the voting securities required by law to be owned by directors of the subsidiary;
(d) a person registered under the securities legislation of a jurisdiction of Canada as an adviser or dealer, other than as a scholarship plan dealer or a restricted dealer;
(e) a pension fund that is regulated by either the federal Office of the Superintendent of Financial Institutions (Canada) or a pension commission or similar regulatory authority of a jurisdiction of Canada or a wholly owned subsidiary of such a pension fund;
(f) an entity organized in a foreign jurisdiction that is analogous to any of the entities referred to in paragraphs (a) to (e);
(g) the Government of Canada or a jurisdiction of Canada, or any Crown corporation, agency or wholly-owned entity of the Government of Canada or a jurisdiction of Canada;
(h) any national, federal, state, provincial, territorial or municipal government of or in any foreign jurisdiction, or any agency of that government;
(i) a municipality, public board or commission in Canada and a metropolitan community, school board, the Comité de gestion de la taxe scolaire de l’île de Montréal or an intermunicipal management board in Québec; (j) a trust company or trust corporation registered or authorized to carry on business under the Trust and Loan Companies Act (Canada) or under comparable legislation in a jurisdiction of Canada or a foreign jurisdiction, acting on behalf of a managed account managed by the trust company or trust corporation, as the case may be;
(k) a person acting on behalf of a fully managed account managed by the person, if the person is registered or authorized to carry on business as an adviser or the equivalent under the securities legislation of a jurisdiction of Canada or a foreign jurisdiction;
(l) an investment fund if it is one or both of the following:
(i) managed by a person registered as an investment fund manager under the securities legislation of a
jurisdiction of Canada;
(ii) advised by a person authorized to act as an adviser under the securities legislation of a jurisdiction of
Canada;
(m) a registered charity under the Income Tax Act (Canada) that obtains advice from an eligibility adviser or an adviser registered under the securities legislation of the jurisdiction of the registered charity;
(n) an individual who beneficially owns financial assets, as defined in section 1.1 having an aggregate realizable value that, before taxes but net of any related liabilities, exceeds $5 million;
(o) a person that is entirely owned by an individual, or individuals referred to in paragraph (n), who holds the beneficial ownership interest in the person directly or through a trust, the trustee of which is a trust company or trust corporation registered or authorized to carry on business under the Trust and Loan Companies Act (Canada) or under comparable legislation in a jurisdiction of Canada or a foreign jurisdiction;
(p) a person, other than an individual or an investment fund, that has net assets of at least $25 million as shown on its most recently prepared financial statements;
(q) a person that distributes securities of its own issue in Canada only to persons referred to in paragraphs (a) to (p);”

I told you that things like this were going to happen! The regulators will not be happy until the only investment options available to retail are homogenized vanilla funds sold by banks, who must be good, since they employ a lot of ex-regulators.

Contingent Capital

BoE's Haldane Supports McDonald CoCos

I use the term “McDonald CoCo” to describe a hybrid security that is initially debt-like coverts into equity when the issuer’s common equity price declines below a preset floor. The conversion is performed at the equity trigger price.

I will note immodestly that, were there any justice in the world, they would be called Hymas CoCos, since I published first, but there ain’t no justice and McDonald has the union card.

Anyway, Andrew G Haldane, Executive Director of the Bank of England, has published remarks based on a speech given at the American Economic Association, Denver, Colorado, 9 January 2011:

For large and complex banks, the number of risk categories has exploded. To illustrate, consider the position of a large, representative bank using an advanced internal set of models to calibrate capital. Its number of risk buckets has increased from around seven under Basel I to, on a conservative estimate, over 200,000 under Basel II. To determine the regulatory capital ratio of this bank, the number of calculations has risen from single figures to over 200 million. The quant and the computer have displaced the clerk and the envelope.

At one level, this is technical progress; it is the appliance of science to risk management. But there are costs. Given such complexity, it has become increasingly difficult for regulators and market participants to vouch for the accuracy of reported capital ratios. They are no longer easily verifiable or transparent. They are as much an article of faith as fact, as much art as science. This weakens both Pillars II and III. For what the market cannot observe, it is unlikely to be able to exercise discipline over. And what the regulator cannot verify, it is unlikely to be able to exercise supervision over. Banks themselves have recently begun to voice just such concerns.

… and complexity is Bad:

This evidence only provides a glimpse at the potential model error problem viewed from three different angles. Yet it suggests that model error-based confidence intervals around reported capital ratios might run to several percentage points. For a bank, that is the difference between life and death. The shift to advanced models for calibrating economic capital has not arrested this trend. More likely, it has intensified it. The quest for precision may have come at the expense of robustness.

Hayek titled his 1974 Nobel address “The Pretence of Knowledge”. In it, he highlighted the pitfalls of seeking precisely measurable answers to questions about the dynamics of complex systems. Subsequent research on complex systems has confirmed Hayek’s hunch. Policy predicated on over-precision risks catastrophic error. Complexity in risk models may have perpetuated Hayek’s pretence in the minds of risk managers and regulators.

Like, for instance, in the run-up to the height of the crisis:

To see that, consider the experience of a panel of 33 large international banks during the crisis. This panel conveniently partitions itself into banks subject to government intervention in the form of capital or guarantees (“crisis banks”)
and those free from such intervention (“no crisis banks”).

Chart 5 plots the reported Tier 1 capital ratio of these two sets of banks in the run-up to the Lehman Brothers crisis in September 2008. Two observations are striking. First, the reported capital ratios of the two sets of banks are largely indistinguishable. If anything, the crisis banks looked slightly stronger pre-crisis on regulatory solvency measures. Second, regulatory capital ratios offer, on average, little if any advance warning of impending problems. These conclusions are essentially unchanged using the Basel III definitions of capital.


Click for Big

Got any better ideas?

What could be done to strengthen the framework? As a thought experiment, consider dropping risk models and instead relying on the market. Market-based metrics of bank solvency could be based around the market rather than book value of capital. The market prices of banks are known to offer useful supplementary information to that collected by supervisors when assessing bank health.8 And there is also evidence they can offer reliable advance warnings of bank distress

To bring these thoughts to life, consider three possible alternative bank solvency ratios based on market rather than accounting measures of capital:

  • Market-based capital ratio: the ratio of a bank’s market capitalisation to its total assets.
  • Market-based leverage ratio: the ratio of a bank’s market capitalisation to its total debt.
  • Tobin’s Q: the ratio of the market value of a bank’s equity to its book value.

The first two are essentially market-based variants of regulatory capital measures, the third a well-known corporate valuation metric. How do they fare against the first principles of complex, adaptive systems?


Click for big

Having set the stage, he starts talking about CoCos:

Alongside equity, banks would be required to issue a set of contingent convertible instruments – so-called “CoCos”. These instruments have attracted quite a bit of attention recently among academics, policymakers and bankers, though there remains uncertainty about their design. In particular, consider CoCos with the following possible design
characteristics.

  • Triggers are based on market-based measures of solvency, as in Charts 6–8.
  • These triggers are graduated, stretching up banks’ capital structure.
  • On triggering, these claims convert from debt into equity.

Although novel in some respects, CoCos with these characteristics would be simple to understand. They would be easy to monitor in real time by regulators and investors. And they would alter potentially quite radically incentives, and thus market dynamics, ahead of banking stress becoming too acute.

He points out:

CoCos buttress market discipline and help lift the authorities from the horns of the timeconsistency dilemma. They augment regulatory discretion at the point of distress with contractual rules well ahead of distress. Capital replenishment is contractual and automatic; it is written and priced ex-ante and delivered without temptation ex-post. Because intervention would be prompt, transparent and rule-based, the scope for regulatory discretion would be constrained. For that reason, the time-consistency problem ought to be reduced, perhaps materially. A contractual belt is added to the resolution braces.

These are the most important things. As investors, we want as much certainty as possible. Contractual conversion with a preset trigger and conversion factor removes the layer of regulatory uncertainty that bedevils most other approaches.

He highlights one concern that has been of interest to the Fed, and which seems to be the thing that industry professionals focus on when I discuss this with them:

If such a structure is for the best in most states of the world, why does it not already exist? At least two legitimate concerns have been raised. First, might market-based triggers invite speculative attack by short-sellers? The concern is that CoCo holders may be able to shortsell a bank’s equity to force conversion, then using the proceeds of a CoCo conversion to cover their short position.

There are several practical ways in which the contract design of CoCos could lean against these speculative incentives. Perhaps the simplest would be to base the conversion trigger on a weighted average of equity prices over some prior interval – say, 30 days. That would require short-sellers to fund their short positions for a longer period, at a commensurately greater cost. It would also create uncertainty about whether conversion would indeed occur, given the risk of prices bouncing back and the short-seller suffering a loss. Both would act as a speculative disincentive.

A second potential firewall against speculative attack could come from imposing restrictions on the ability of short-sellers to cover their positions with the proceeds of conversion.

I like the first solution and am particularly gratified that he chose essentially the same VWAP measurement period that I chose as a basis for discussion.

I don’t like the second firewall. Stock is stock is stock. Everybody knows you can’t cheat an honest man, right? Well, you can’t manipulate a healthy stock, either. Not on the scale of a 30-day VWAP, you can’t.

A related concern is that CoCos alter the seniority structure of banks’ capital, as holders of CoCos potentially suffer a loss ahead of equity-holders. But provided the price at which CoCos convert to equity is close to the market price, conversion does not transfer value between existing equity-holders and CoCo investors. And provided conversion is into equity it need not imply investor loss. If a market move really is unjustified, prices will correct over time towards fundamentals. The holder of a converted CoCo will then garner the upside.

I don’t understand this bit. As long as the trigger/conversion price is set well below the market price at CoCo issue time (I suggested that “half” was a good figure), then CoCos will retain significant first-loss protection.

Interesting External Papers

SEC Market Structure Report a Disappointment

On February 18 – sorry, I’ve been busy – the SEC released the RECOMMENDATIONS REGARDING REGULATORY RESPONSES
TO THE MARKET EVENTS OF MAY 6, 2010
, which is the Summary Report of the Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues.

I found it rather disappointing, but this is unsurprising. On February 7 I passed on a Reuters report in which it was stated:

While “Sunshine” laws have prevented the committee from regularly meeting, [Nobel Prize-winning finance professor at New York University Robert] Engle said the subcommittee has discussed a bevy of sometimes esoteric market structure issues

In other words, they knew that their process wouldn’t withstand scrutiny, so they hashed it all out in the back rooms instead.

The report in Bloomberg harshly criticized the recommendation for the “trade-at” rule:

Individual investors could be hurt should regulators alter an equities-trading rule limiting the prices at which brokers can execute orders away from public markets, an executive at TD Ameritrade Holding Corp. said.

An eight-member committee urged the Securities and Exchange Commission in a report yesterday to adopt a restriction called a trade-at rule. It would prevent venues and brokerages from executing orders within their walls unless they improve pricing by a specified amount versus the market’s best level.

“I was disappointed,” Nagy, a managing director for order routing, sales and strategy at the third-largest retail brokerage by client assets, said in an interview. “The report appears to be a politically motivated stalking horse to implement the trade-at rule. A trade-at would serve to increase costs for retail investors by creating an inconsistent trading experience.”

We never see TD criticizing the regulators so heartily in Canada. The regulatory-industry complex in Canada is way too cosy, as discussed on March 15.

Be that as it may, the committee was good enough to state the purpose of the report quite clearly:

One additional, specific point of background is appropriate to mention at the outset. The broad, visible, and often controversial, topic of High Frequency Trading (HFT)— including the definition of the practice, its impact on May 6, and potentially systemic benefits and problems that arise from the growing volume of HFT participants in all of our markets—has been pervasive in our discussions and in comments received from others. Rather than detail specific recommendations about HFT in this report, steps to address issues associated with this practice are evident throughout our report.

In other words, the committee was set up to do a hatchet job on HFT and eagerly went about its task of pleasing the established players, who are most upset that arrivistes are introducing competition to their comfortable lives. This serves – unsurprisingly – as a continuation of the intellectually dishonest Flash Crash report.

Anyway, back to the report – while skipping over the recommendations that don’t interest me! – which makes a point of telling the committee’s paymasters what an excellent job they’re doing:

The Committee supports the SEC’s “naked access” rulemaking and urges the SEC to work closely with FINRA and other Exchanges with examination responsibilities to develop effective testing of sponsoring broker-dealer risk management controls and supervisory procedures.

So what’s wrong with naked access? I mean, really? The official line:

According to the SEC: “The new rule prohibits broker-dealers from providing customers with ‘unfiltered’ or ‘naked’ access to an Exchange or ATS. It also requires brokers with market access – including those who sponsor customers’ access to an Exchange or ATS – to put in place risk management controls and supervisory procedures to help prevent erroneous orders, ensure compliance with regulatory requirements, and enforce pre-set credit and capital thresholds.”

I would like to see a lot more discussion of access as an economic transaction. Say we’ve got a small firm trading its own capital (call it $10-million) as principal. Why can’t the exchanges and marketplaces offer them direct access themselves? I have no idea what the requirements are for gaining such access, but I’ll bet it involves a lot of regulatory expense and rigamarole that is completely unnecessary in such a case.

Why isn’t it happening? What are the risks? What controls can be justified? And how would it interact with the rest of regulation?

Say, for instance, I am the risk manager at Very Big Brokerage Corp. (and I mean the real risk manager, not the clown with the title). And say, there is a marketplace (“Sleazy Trading Inc.”) that I’m not happy with, in terms of counterparty risk. I’ve looked at their controls and their access requirements and come to the conclusion that if I execute a big trade that makes a lot of money for me prior to settlement, I’m taking on too much exposure to the notion that the trade won’t settle. Or maybe I have made a decision on how much exposure I’m willing to take with Sleazy, and they’re currently over the limit.

Now, I’ve got a client order to sell 10-million shares of IBM and wouldn’t you know it, there’s a good bid – the best bid – for 10-million shares at Sleazy Trading. Will the regulations allow me to ignore it? I don’t believe so. And that is a problem.

In Canada, there are strong inducements that say that each “protected marketplace” is as good as any other protected marketplace.

We also applaud the CFTC requesting comment regarding whether it is appropriate to restrict large order execution design that results in disruptive trading. In particular, we believe there are questions whether it is ever appropriate to permit large order algorithms that employ unlimited use of market orders or that permit executions at prices which are a dramatic percentage below the present market price without a pause for human review.

Accordingly:
7. The Committee recommends that the CFTC use its rulemaking authority to impose strict supervisory requirements on DCMs or FCMs that employ or sponsor firms implementing algorithmic order routing strategies and that the CFTC and the SEC carefully review the benefits and costs of directly restricting “disruptive trading activities “with respect to extremely large orders or strategies.

Note how careful they are in restricting their concerns to “large orders”. In other words Stop-Loss orders, beloved of the brokerage community because they’re so insanely profitable, are not in the scope of this recommendation.

But, as I argued in the November, 2010, edition of PrefLetter, Stop-Loss orders appear to have been the exacerbating cause that turned a sharp decline into a rout. But the sheer size of the Stop-Loss avalanche only made it into one insignificant speech – never into any official report of any kind. Ms. Schapiro’s speech was reported on PrefBlog in an update to the post The Flash Crash: The Impact of High Frequency Trading on an Electronic Market.

Perhaps the committee’s most laughable recommendation is:

We therefore believe that the Commission should consider encouraging, through incentives or regulation, persons who regularly implement marker maker strategies to maintain best buy and sell quotations which are “reasonably related to the market.”

We recognize that many High Frequency Traders are not even broker-dealers and therefore their compliance with quoting requirements would have to be addressed primarily through pricing incentives. We note that these incentives might be effectively interconnected with the peak load pricing discussed above.
Accordingly:
9. The Committee recommends that the SEC evaluate whether incentives or regulations can be developed to encourage persons who engage in market making strategies to regularly provide buy and sell quotations that are “reasonably related to the market.”

Earth to Committee: Market Making loses money in a directional market. There is no amount of exchange pricing incentive that can possibly counteract this fact.

The original Flash Crash report makes some useful classifications of market participants:

In order to examine what may have triggered the dynamics in the E-Mini on May 6, over 15,000 trading accounts that participated in transactions on that day were classified into six categories: Intermediaries, HFTs, Fundamental Buyers, Fundamental Sellers, Noise Traders, and Opportunistic Traders.

Opportunistic Traders are defined as those traders who do not fall in the other five categories. Traders in this category sometimes behave like the intermediaries (both buying and selling around a target position) and at other times behave like fundamental traders (accumulating a directional long or short position). This trading behavior is consistent with a number of trading strategies, including momentum trading, cross-market arbitrage, and other arbitrage strategies.

It seems to me that if you want to encourage tranquility of market prices, you should be concentrating on the potential for getting contra-flow orders from Opportunistic Traders, rather than market makers; and the only way I can see that being done by regulators is encouraging the development and execution of opportunistic algorithms by “real money” accounts, rather than discouraging this process.

The committee has another recommendation good for not much more than a laugh:

Accordingly:
10. The Committee recommends that the SEC and CFTC explore ways to fairly allocate the costs imposed by high levels of order cancellations, including perhaps requiring a uniform fee across all Exchange markets that is assessed based on the average of order cancellations to actual transactions effected by a market participant.

Central planning at its finest, complete with the implicit assertion that prices can only be fair if they are both uniform and approved by the central planners. If data flow from order cancellations gets to be a problem, it’s easy enough to sever connection with the offending marketplace – which should be sufficient to ensure that fees are put in place to charge the cancellers and rebate the other participants. But, oops, sorry, not possible to sever connections. One market’s as good as any other – just ask the regulators.

The “Trade-At” recommendation is number 11; the committee’s justification is:

We believe, however, that the impact of the substantial growth of internalizing and preferencing activity on the incentives to submit priced order flow to public exchange limit order books deserves further examination. While the SEC has properly concluded in the past that permitting internalization and preferencing, even accompanied by payment for order flow agreements, increases competition and potentially reduces transaction costs, we believe the dramatic growth argues for further analysis. Notable in the trading activity of May 6 was the redirection of order flow by internalizing and preferencing firms to Exchange markets during the most volatile periods of trading. While these firms provide significant liquidity during normal trading periods, they provided little to none at the peak of volatility.

The last sentence is simply so much horseshit. The original Flash Crash report makes it quite clear that orders were routed to the public exchanges only when the internalizers has provided so much liquidity that they were up to their position limits.

The recommendation simply shows the committee’s total lack of comprehension of the market maker’s role; additionally, they didn’t waste their precious Nobel Prize-winning brain power discussing – or even considering – the possibility that such requirements will make internalization less profitable, therefore (surprise!) leading to a lower allocation of capital and therefore (surprise!) increasing the odds that another market break will exhaust that capital.

Update: Public comments are available.

Update: The CME comment letter recommends that regulators keep their cotton-picking hands off algorithms:

Large orders represent demand for liquidity and that demand necessarily informs price discovery. Participants typically rely on algorithms to execute large orders today precisely because sophisticated algorithms can employ intelligent real time analytics that allow traders to significantly reduce the market impact of their orders and enhance the quality of their execution. As discussed in our previously referenced letter on this topic, we do not believe the Commissions are equipped or should be involved in regulating the design of algorithms, and should instead focus on regulating conduct that is shown to be harmful to the market.

It also points out:

CME Group does not believe that high frequency traders, however such traders are in fact defined, should be required by third parties to put their own capital at risk when it is unprofitable to do so. High frequency traders, like other independent traders who are uncompensated by the trading venue, should quote responsibly based upon their ability to responsibly manage the risks associated with the orders they place. It would be extremely irresponsible for a high frequency trader, or any other trader, to continue to operate an algorithm under conditions in which it was not designed to operate or when the inputs to the algorithm are not reliable. Doing so could potentially put the firm itself at risk and arguably subject the firm to regulatory exposure if their algorithm malfunctioned and created or exacerbated a disruption in the market.

Rules that would undermine a trading firm’s own risk management processes by creating affirmative trading obligations in highly volatile periods are misguided. Assuming participants in fact complied with such obligations, which they likely would not, this “cure” would simply lead to the depletion of market making capital and result in less liquid and more volatile markets.

With respect to cancellation fees:

As an initial matter, the Committee has not identified how the market will be served by this proposal or how it will enhance the stability of markets. Other than apparently seeking to impose a tax on a high frequency trading, the objective is unclear.

CME Group additionally employs a CME Globex Messaging Policy that is broadly designed to encourage responsible messaging practices and ensure that the trading system maintains the responsiveness and reliability that supports efficient trading. Under this policy, CME Group establishes messaging benchmarks based on a per-product volume ratio which measures the number of messages submitted to the volume executed in a given product. These benchmarks are tailored to the liquidity profile of the contract to ensure that contract liquidity is not compromised. CME Group works with firms who exceed the benchmarks to refine their messaging practices and failure to correct excessive messaging results in a surcharge billed to the clearing firm.

Knight Capital’s letter commits lese majeste by asking for data:

Many have posed the following question time and again:

“What is the quantitative and qualitative justification for taking steps to change or slow internalization?”

To date, there has been no answer offered and no credible data presented to support such a dramatic shift in market structure.

and with respect to Trade-At:

In short, there has been no qualitative or quantitative data offered to suggest that such shift in market structure is warranted. Rather, the evidence offered in support has been anecdotal at best. As a result, we strongly encourage the SEC to proceed with the same thoughtful consideration that has guided its decisions in the past. It should demand empirical data, and thoroughly vet that data before making any determination to propose such a rule.

Regulation

Sweden to Impose Onerous Capital Requirements

The Swedish Financial Supervisory Authority has announced:

According to the Basel Committee, the new requirements can be phased in over a period of several years, but after full phase-in the requirements for total capital will be between 10.5 and 13 per cent and for core Tier 1 capital between 7 and 9.5 per cent. Two additional components, one for requirements in accordance with so-called Pillar 2 (capital increases for other risks) and one for possible future extra requirements for systemically critical banks, will be added.

The major Swedish banks should prepare themselves for a faster implementation of the regulations in Sweden than what is proposed by the Basel Committee in the transition rules. The requirement for total capital for the major Swedish banks is expected to be 15-16 per cent in a few years, of which at least 10-12 percentage points shall consist of core Tier 1 capital. These are approximate figures since the Pillar 2 assessment is individual – it is partly based on stress tests – and the size of the countercyclical capital buffer per definition will vary over time.

Sweden needs high capital requirements for its major banks since a large banking sector can expose society to large risks. The total assets of the four major banks are approximately four times the size of Sweden’s GDP. If one of these banks experiences problems or fails, the costs for society may become very large, while the increase in the cost of capital as a result of the new regulations – and thereby any effects on lending rates – is small. In reality, the major banks already fulfil or are very close to fulfilling the new requirements today.

Four times GDP is a big number. In the post Banks: How Big is too Big?, the UK ratio was estimated as 440% and the Canadian number as 200%. .J. Masson of the Graziadio School of Business and Management at Pepperdine University, estimates 156% for Canada and 47% in the US, as of 2006.

Reaction was outraged:

Lenders condemned the proposal, claiming the plan will create an uneven playing field.

“Swedish banks have a very good capital situation and there is no reason to rush out separate rules, which create competitive disadvantages both for the banks and for Sweden as a country,” Kerstin af Jochnick, chief executive of the Swedish Bankers’ Association, said in a statement.

Thomas Backteman, head of corporate affairs at Swedbank AB (SWED-A.SK), told Dow Jones Newswires there is already a problem with regulation in the U.S. and Europe moving at different speeds, and that the situation would worsen if rules in EU countries also differ.

Nordea Bank AB’s (NDA.SK) CEO Christian Clausen said in a February interview that different rules within the EU would distort competition and harm Europe’s ability to promote economic growth.

Nordea Bank, the Nordic region’s largest bank, had a 10.3% core Tier 1 ratio at the end of 2010, while Skandinaviska Enskilda Banken AB (SEB-A.SK) and Swedbank, the biggest lenders in the Baltics, had core Tier 1 ratios of 12.2% and 13.9%. Svenska Handelsbanken AB (SHB-B.SK), Sweden’s second-largest bank by market capitalization and the one deemed most overcapitalized by Goldman Sachs, has a 13.8% core Tier 1 ratio.

But Norway may follow:

Norway is signaling it may follow Sweden’s target of imposing some of the world’s toughest capital requirements on lenders as policy makers in Scandinavia embrace post-crisis measures that banks warn will undermine competition.

“There are good reasons for the level suggested by the Swedish authorities,” Bjoern Skogstad Aamo, the head of Norway’s Financial Supervisory Authority, said in an interview in Oslo yesterday. “I don’t have very different views.”

“We are in favor of consultation between the Nordic countries on the speed of the new capital requirements,” Skogstad Aamo said. “The most important banks have to expect higher capital requirements than others.”

Norway’s banks may also face a financial stability fee and taxes on bank profits and pay if proposals by the country’s Financial Crisis Commission are adopted by the Finance Ministry. The FSA wants banks to achieve capital and liquidity goals before looking into new taxes, Skogstad Aamo said.

“That proposal that will increase taxation should rather wait until we have strengthened capital and liquidity,” he said.

Contingent Capital

BoE Deputy Governor Tucker Supports High Trigger for CoCos

Mr Paul Tucker, Deputy Governor of the Bank of England, made a speech at the Clare Distinguished Lecture in Economics, Cambridge, 18 February 2011 titled Discussion of Lord Turner’s lecture, “Reforming finance – are we being radical enough?”:

But none of what I have said makes a case for placing all of our eggs in the resolution basket. Switching metaphors, we need belt and braces. Which is why the G20 agreed that the so-called Global Systemically Important Financial Institutions (G-SIFIs) should carry greater loss absorbing capacity (or GLAC) than implied by Basel III.

First best would be equity. Indeed, Adair has argued this evening that ideally Basel 3 would have set a higher equity requirement. But that did not happen. In practice, we are going to have to be open-minded, but also principled, about quasi-equity instruments contributing to GLAC for SIFIs (sorry about the acronyms!). Currently, the leading candidate is so-called Contingent Capital bonds (CoCos), which convert from debt into equity in certain states of the world. It seems to me that to serve the purpose of GLAC for large and complex firms, such instruments would need to convert when a firm was still fundamentally sound, which is to say that they should have high capital triggers. For a large and complex firm, a low capital trigger would be dangerous, as funders and counterparties would be likely to flee before reaching the point at which the firm would be recapitalised through the CoCos’ conversion.

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.

Lord Turner’s speech discusses a particular hobby-horse of mine:

It is therefore crucial that our answers to the SIFI problem cover also the more difficult but more likely scenario of multiple bank systemic stress. And in such conditions, bail-inable bonds will only enable us to avoid the dilemma of Autumn 2008, if the following vital conditions are met:

  • • If regulators could be confident that those bonds are held outside the banking system; and
  • • in addition, confident that the bonds are held by investors who have so arranged their assets and liabilities that they could face the imposed losses without that in turn inducing systemic effects.

And it may be very difficult to be confident that those conditions we met.

There are two ways to gain that confidence – the first relies on empirical observation, the second on an assumption of fully informed investor rationality. Neither route may be entirely robust.

  • • The first way to seek such confidence, would be for regulators to understand, or to regulate, which investors hold bank medium-term debt. Our information on this today is imperfect. We believe a significant proportion is initially held by other banks, and a larger proportion still by a broadly defined group of ‘fund managers’. (Slide 7). But ownership after secondary market trading could be significantly different. And some of these ‘fund managers’ may be in turn financed by banks (e.g. hedge funds by prime brokers), or linked to the banking system by complex repo and derivative relationship so that losses suffered by one bank, could indirectly impose losses or confidence shocks on others. And our ability to track these complex inter-connections, and as a result to predict the knock-on consequences of initial losses in conditions of systemic fragility is imperfect today and likely to remain so. We need to improve our understanding of the complex interconnections of our financial system: but it is unclear that understanding will ever be good enough for us confidently to impose large losses simultaneously on the senior debt of multiple large banks (or indeed multiple small banks), in conditions of macro-systemic stress.
  • • The other route to confidence, would be based on faith in market and investor rationality, assuming axiomatically that investors who buy bail-inable bonds will only do so on the basis of rational assessments of their ability to absorb risks in all possible future states of the world, including those of macroeconomic stress. As Section 3 will discuss, this axiomatic assumption was at the core of the pre-crisis conventional wisdom, the reason why public authorities thought they could sleep easy in the face of an explosive growth in financial scale, complexity and interconnectedness. But it relies on an assumption of fully informed rationality, which may be simply untrue, and indeed impossible. For as Andrei Shleifer et al (2010) have argued in an extremely perceptive recent paper, it may be inherent to human nature that in the good times investors systematically fail to take rational account of the tail of low probability adverse events.

A bail-inable bond will have a highly skewed probability distribution of pay-outs. (Slide 8 ) Over a long period of time, only the zero-loss segment of the distribution will be observed. A low probability of significant loss continues to exist, but Gennaioli, Shleifer and Vishay argue that that low probability will be wholly discounted through a behavioural process which they label ‘local thinking’ – the reality, deeply rooted in human nature, that not all contingencies are represented in decision makers’ thought processes. After a period of good times, investors will assume that senior bank debt is effectively risk-free: as indeed they did, in the years before the crisis (Slide 9). Regulators cannot therefore rely on free-market discipline to ensure that the debt is only held by investors who can suffer loss without that causing knock-on systemic disruption.

If therefore we can neither perfectly and continuously monitor or regulate who owns bail-inable debt, nor rely on free-market discipline to ensure that it is always appropriately held, contractually bail-inable debt and technical resolvability will be valuable but still imperfect solutions to the ‘too big to fail’ problem. We can only be sure that losses can be smoothly absorbed if we are sure that the investors who provide funds do not suffer from ‘local thinking’ but remain perpetually aware of the full distribution of possible results. Subordinated debt which can convert to equity well before potential failure (‘early trigger CoCos’) may approach what is required since the price will presumably vary with probabilistic expectations of future conversion. But only with pure equity can we be fully confident that the dangers of ‘local thinking’ will not creep in over time, and that investors, facing day-by-day price movements up and down will remain continually aware that they hold a potentially loss absorbing instrument. The implication of Shleifer’s ‘local thinking’ theory is that if investors are to remain continuously aware of the full frequency distribution of objectively possible results the observed frequency distribution of returns needs to include negatives and well as positives. This is achieved by equity returns but not by low risk debt.

OSFI, in its infinite wisdom, is going in entirely the opposite direction: the lowest possible conversion triggers for CoCos, and seeking to include CoCos in the regular bond indices so that investors will be fooled into buying them.

Contingent Capital

Credit Suisse Contingent Capital

Credit Suisse is issuing contingent capital:

The bank agreed to sell $3.5 billion of contingent convertibles with a coupon of 9.5 percent, and 2.5 billion francs with a coupon of 9 percent, it said. The sale will happen no earlier than October 2013, which is the first call date on $3.5 billion of 11 percent and 2.5 billion francs of 10 percent Tier 1 capital notes the bank sold in 2008.

The notes will convert into shares if the bank’s Basel III common equity Tier 1 ratio falls below 7 percent. The conversion price will be the higher of the floor price of $20 or 20 francs per share or the daily weighted average sale price of ordinary shares over the trading period preceding the notice of conversion, the bank said.

The transaction is subject to the implementation of Swiss regulations and the approval of shareholders, the bank said. The Swiss committee proposed that the country’s two biggest banks should hold common equity equal to at least 10 percent of their assets, weighted according to risks. In addition, the companies may hold up to 3 percent in so-called high-trigger CoCos that would convert into shares if the bank’s common equity ratio falls below 7 percent, plus 6 percent in CoCos that would convert at a 5 percent trigger.

Credit Suisse said the 6 billion-franc sale would satisfy about 50 percent of the high-trigger requirement. The bank said it would like to see the market for contingent convertible bonds expand to a wider group of buyers and is pursuing an additional offering of such notes to potential investors outside the U.S. and certain other countries.

On the positive side, conversion occurs well before the the point of non-viability. On the negative – the trigger is based on Capital Ratios, which I have strongly criticized in the past and continue to criticize.

The Financial Times comments:

Switzerland’s other big bank, UBS, takes a diametrically opposed view to Credit Suisse, on cocos, arguing that they will be excessively expensive because no one knows how to price them properly. UBS prefers the “haircut bond” as an instrument.

But investors believe that other UK banks, such as HSBC, could be drawn to cocos. “That would really seal cocos’ reputation,” said one London-based investor. “But in the meantime, we expect the Nordics, particularly Sweden, to be big issuers. We also think this will take off in the US.” In spite of a lack of enthusiasm from US regulators, the likes of Morgan Stanley and Goldman Sachs are privately intrigued by cocos.

Senior bankers at BNP and Société Générale have similarly signalled a willingness to consider coco issuance to finance buffers. Analysts at Barclays Capital said the market for European cocos alone could be close to €700bn ($945bn) by 2018.

Many traditional fixed-income investors are barred from owning instruments such as cocos that can convert into equity.

Update, 2011-2-23: The deal was a huge success:

Investors rushed to take up the benchmark issue by Credit Suisse of a new financial instrument hailed by regulators as a key tool for rebuilding the capital strength of banks, placing orders of $22bn – 11 times the $2bn on offer.

The deluge of orders represented a big vote of confidence in the nascent market for contingent capital bonds, dubbed cocos.

Asset managers took about two-thirds of Credit Suisse’s cocos, while private banks took a third on behalf of their clients. A total of 550 different investors – an unusually large number – put in orders for the bonds. The strong demand from asset managers was particularly important since they will form the backbone of any sustainable market for the products.

Credit Suisse’s deal was helped by the fact the bank anchored its coco deal by simultaneously announcing a agreement to swap $6.2bn of its existing hybrid debt for cocos – covering in one go about half the total cocos the bank needs to issue.

Regulation

Regulatory Event Clause To See Minimal Use

Royal Bank states:

As a result of changes to the qualifying criteria for capital under the guidelines published by the Basel Committee on Banking Supervision (BCBS) on December 16, 2010 and January 13, 2011 and subsequent OSFI guidance regarding the treatment of non-qualifying capital instruments published on February 4, 2011, certain capital instruments may no longer qualify as capital beginning January 1, 2013. RBC’s non-common capital instruments will be considered non-qualifying capital instruments under Basel III and will therefore be subject to a 10 per cent phase-out per year beginning in 2013. These non-common capital instruments include preferred shares, trust capital securities and subordinated debentures.

The regulatory event redemption clause applies to RBC’s innovative tier 1 capital instruments (RBC trust capital securities). Based on current analysis, RBC does not intend to invoke the clause to effect early redemption of these instruments.

RBC maintains the right to redeem capital instruments based on other existing terms and conditions not linked to regulatory event clauses. RBC also retains the right to invoke any applicable regulatory event redemption clause in accordance with its terms should circumstances change.

CIBC states:

Based on the rules as set out in OSFI’s February 4th Advisory regarding the Treatment of Non-Qualifying Capital Instruments, CIBC currently expects to exercise a regulatory event redemption only in 2022 and only in respect of the Series B Innovative Tier 1 Notes issued by CIBC Capital Trust.

Future circumstances within or outside CIBC’s control, including generally applicable legal changes that have the effect of causing non-qualifying regulatory capital to become compliant, may cause CIBC to change its expectation regarding the exercise of regulatory event redemptions and require CIBC to disclose an updated regulatory event redemption schedule.

TD says:

As stated in the advisory, OSFI intends to adopt the Basel III changes in its domestic capital guidance. Under the Basel III rules text, any non-qualifying capital instruments outstanding as of 2022, the final year of the phase-out period, will not be recognized as regulatory capital. Based on the rules set out in OSFI’s advisory, TD currently expects to exercise a regulatory event redemption right only in 2022 in respect of the TD Capital Trust IVTM Notes – Series 2 outstanding at that time.

TD’s expectations are based on a number of factors and assumptions, including, but not limited to TD’s current and expected future capital position taking into account the expected redemptions of TD’s capital instruments, the assumption that other redemption rights, as applicable, are not exercised or other capital management actions are not taken, and current market conditions. These expectations are not intended to apply to capital instruments issued by TD’s U.S. subsidiaries. Given the uncertainty related to the financial, economic, legislative and regulatory environments, these factors – some of which are beyond TD’s control and the effects of which can be difficult to predict – could change materially over time and result in a change in the expectations expressed in this press release.

Scotia says:

While the Bank has no present intention of invoking any regulatory event redemption features in its outstanding capital instruments, the Bank reserves the right to redeem, call or repurchase any capital instruments within the terms of each offering, in accordance with OSFI’s advisory.

BMO states:

BMO Financial Group today confirmed that it does not anticipate redeeming any of its outstanding regulatory capital instruments through the use of a regulatory capital event and that the Bank will not be disclosing a regulatory redemption event schedule. Regulatory capital instruments include the Bank’s outstanding preferred shares and subordinated debt, innovative tier 1 capital instruments issued by BMO Capital Trust and BMO Capital Trust II, and innovative tier 2 capital issued by BMO Subordinated Note Trust.

National Bank has not issued a press release at time of writing.

So those purchasing Innovative Tier 1 Capital securities at issue time, with the legitimate expectation that extant IT1C issues would be grandfathered in the event of rule changes (as was done with retractible preferred shares), and were willing to pay up for a long “no call” period … have had their expectations dashed.

And those who took the view that instruments would not be grandfathered, and took investment action on the basis of a legitimated expectation that the regulatory event clause would be applied in a manner consistent with the economic best interests of the issuer … have had their expectations dashed.

Those issuers with the foresight (and luck!) to issue Straight Preferred shares at the top of the market in the first quarter of 2007 and have been congratulating themselves ever since that they have financed with cheap money … have had their legitimate expectations dashed.

The OSFI advisory on extant issues was discussed in OSFI Does Not Grandfather Extant Tier 1 Capital. The probable new rules for Tier 1 are discussed at OSFI Releases Contingent Capital Draft Advisory. Rumours of potential bond index manipulation are discussed at OSFI Seeking to Manipulate Bond Indices and Retail Investors?.

Regulation

OSFI Announces Another Conference Call

For all those second-rate investor-scum who weren’t good enough to be permitted to listen to the VIP Conference Call, OSFI has announced:

Analysts are invited to participate in a briefing via teleconference with the Office of the Superintendent of Financial Institutions (OSFI) on two Advisories relating to BASEL III: Treatment of non-qualifying capital instruments under Basel III and Non-Viability Contingent Capital.

Mark White, Assistant Superintendent, Regulation Sector, will provide a brief overview and will be available to answer questions.

DATE: Monday, February 7, 2011

TIME: 8:30AM

PLACE: 613-960-7526 (Ottawa)
1-877-413-4814

Participant pass code: 3733077

I’m not going to waste my time listening to second-hand rationalization from the Chief Croupier, but I thought I’d pass it on. Just keep your fingers crossed that those morons have mastered the intricate art of conference call technology over the weekend!

The two advisories have been discussed in the posts OSFI Does Not Grandfather Extant Tier 1 Capital and OSFI Releases Contingent Capital Draft Advisory.

Contingent Capital

OSFI Releases Contingent Capital Draft Advisory

OSFI has released a Draft Advisory titled Non-Viability Contingent Capital (NVCC):

OSFI has determined that, effective January 1, 2013 (the Cut-off Date), all non-common Tier 1 and Tier 2 capital instruments issued by DTIs must comply with the following principles to satisfy the NVCC requirement:

Principle # 1: Non-common Tier 1 and Tier 2 capital instruments must have, in their contractual terms and conditions, a clause requiring a full and permanent conversion [Footnote 4] into common shares of the DTI upon a trigger event.[Footnote 5] As such, original capital providers must not have any residual claims that are senior to common equity following a trigger event.

Footnote 4: The BCBS rules permit national discretion in respect of requiring contingent capital instruments to be written off or converted to common stock upon a trigger event. OSFI has determined that conversion is more consistent with traditional insolvency consequences and reorganization norms and better respects the legitimate expectations of all stakeholders.

Footnote 5 The non-common capital of a DTI that does not meet the NVCC requirement but otherwise satisfies the Basel III requirements may be, as permitted by applicable law, amended to meet the NVCC requirement.

Some extant contingent capital has a “write-up” clause, whereby amounts written down can be recovered if the company squeaks through its troubles.

The minimum condition reveals that OSFI is more interested in political posturing than averting a crisis. If they wanted to avert a crisis, they would insist that conversion took place long before the point of non-viability, when the common still had value.

Principle # 3: All capital instruments must, at a minimum, include the following trigger events:

  • a. the Superintendent of Financial Institutions (the “Superintendent”) advises the DTI, in writing, that she is of the opinion that the DTI has ceased, or is about to cease, to be viable and that, after the conversion of all contingent capital instruments and taking into account any other factors or circumstances that she considers relevant or appropriate, it is reasonably likely that the viability of the DTI will be restored or maintained; or
  • b. a federal or provincial government in Canada publicly announces that the DTI has accepted or agreed to accept a capital injection, or equivalent support [Footnote 6], from the federal government or any provincial government or political subdivision or agent or agency thereof without which the DTI would have been determined by the Superintendent to be non-viable [Footnote 7]

    Footnote 6: OSFI, after consulting with its FISC partner agencies, will provide guidance to DTIs upon request whether a particular form of government support being offered to such DTI is considered equivalent to a capital injection. For example, the Bank of Canada’s Emergency Liquidity Assistance (ELA) does not constitute equivalent support as it is targeted at solvent institutions experiencing temporary liquidity problems.

    Footnote 7: Any capital injection or equivalent support from the federal government or any provincial government or political subdivision or agent or agency thereof would need to comply with applicable legislation, including any prohibitions related to the issue of shares to governments.

So the Superintendent, an employee of the federal Ministry of Finance, has absolute power – there is no appeal. There is nothing to prevent the Superintendent from saying tomorrow that the Royal Bank is non-viable, the Government is buying a hundred-billion shares for a dollar, fuck you suckers, goodbye. Five hundred years of bankruptcy law out the window.

Principle # 8: The issuing DTI must provide a trust arrangement or other mechanism to hold shares issued upon the conversion for non-common capital providers that are not permitted to own common shares of the DTI due to legal prohibitions. Such mechanisms should allow such capital providers to comply with such legal prohibition while continuing to receive the economic results of common share ownership and should allow such persons to transfer their entitlements to a person that is permitted to own shares in the DTI and allow such transferee to thereafter receive direct share ownership.

Since we’re ignoring bankruptcy law, why not ignore every other law and contract while we’re at it?

Section 3: Issuance of Capital Instruments prior to the Cut-off Date

3. DTIs are encouraged to consider amending the terms of existing non-common instruments that do not comply with the NVCC requirement to thereby achieve compliance, or to otherwise take actions, including exchange offers, which would mitigate the effects of such non-compliance.

It’s possible that some issuers might try this, but it’s awfully hard to imagine the kind of coercion that would be required to get something like this to pass for a PerpetualDiscount, given the reasonable expectation of redemption at par within ten-odd years.

Section 4: Criteria to be considered in Triggering Conversion of NVCC

In triggering the conversion of NVCC, the Superintendent will exercise his or her discretion to maintain a financial institution as a going-concern where it would otherwise become non-viable. In doing so, the Superintendent will consider the below list of criteria and any other relevant OSFI guidance [Footnote 16]. These criteria may be mutually exclusive and should not be viewed as an exhaustive list.[Footnote 17]

The exercise of discretion by the Superintendent will be informed by OSFI’s interaction with the Financial Institutions Supervisory Committee (FISC)[Footnote 18] (and any other relevant agencies the Superintendent determines should be consulted in the circumstances). In particular, the Superintendent will consult with the FISC member agencies and the Minister of Finance prior to making a non-viability determination.

Footnote 16: See, in particular, OSFI’s Guide to Intervention for Federally-Regulated Deposit-Taking Institutions.

Footnote 17: The Superintendent retains the flexibility and discretion to deal with unforeseen events or circumstances on a case-by-case basis.

Footnote 18: Under the OSFI Act, FISC comprises OSFI, the Canada Deposit Insurance Corporation, the Bank of Canada, the Department of Finance, and the Financial Consumer Agency of Canada. Under the chairmanship of the Superintendent of Financial Institutions, these federal agencies meet regularly to exchange information relevant to the supervision of regulated financial institutions. This forum also provides for the coordination of strategies when dealing with troubled institutions.

Full discretion, no judiciary, no appeal. Goodbye Canada, hello Soviet Union.

Update, 2011-2-7: DBRS says:

OSFI has also issued a draft advisory on non-viable contingent capital. Again, the draft advisory was consistent with the BCBS’s release on minimum requirements to ensure loss absorbency at the point of non-viability (January 13, 2011). The NVCC Draft Advisory sets out the governing principles, information requirements and criteria to be considered in triggering a conversion of non-viable contingent capital. DBRS will state its views on non-viable contingent capital when OSFI publishes a final release of the advisory, expected in 2011.

Notwithstanding the NVCC Draft Advisory, DBRS’s global bank rating methodology continues to deem the five largest Canadian banks (Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Royal Bank of Canada, and The Toronto-Dominion Bank) systemically important in Canada, which positively impacts DBRS’s senior and subordinated debt ratings of these banks.