PrefBlog

In a developement that will bring tears of joy to (until recently?) Assiduous Reader madequota, Regulation Services has released a notice of hearing in a contested case against TD Securities and some of its traders.

The allegations against the individual traders may be summarized as:

During the relevant period, Nott, Sadeghi, Kaplan, Nemy and Poulstrup (collectively, the “Individual Respondents”) entered orders to purchase securities of one or more of African Copper PLC (“ACU”), Canaco Resources Inc. (“CAN.H” until May 26, 2005 while listed on the NEX and “CAN” as of May 27, 2005 while listed on the TSXV), Central Canada Foods Corporation (“CDF.A”), Peterborough Capital Corp. (“PEC”) and Titanium Corporation Inc. (“TIC”) without any intention that the orders would be executed and for no bona fide purpose. The Individual Respondents entered the orders with the intention of establishing a high closing bid price in order to improve the daily profit and loss position of the shares held in their inventory accounts, or to assist their colleagues improve their daily profit and loss position, and thereby to misrepresent the performance of the securities. The high closing bid prices were artificial in that they were not justified by any real demand for the securities. The high closing bid prices misrepresented the performance and actual demand for the securities to the market and to other market participants.

… while the allegation regarding TDSI is …

During the relevant period, TDSI failed to implement a trade supervision system that was adequate, taking into account its business and affairs, to ensure compliance with UMIR 2.2(2)(b). TDSI failed to ensure that the risks associated with proprietary trading by the Trade Execution Group (the “TEG”), and specifically the Burlington sub-branch, had been identified and that appropriate supervision practices and procedures to manage those risks had been implemented. As a result, TDSI failed to adequately review and monitor the Individual Respondents’ order entry activity and failed to detect or prevent the Individual Respondents from violating UMIR 2.2(2)(b).

The date of the hearing is yet to be determined. The Notice of Hearing, linked above provides the usual excruciating detail regarding the allegations.

Two of the traders were fired shortly after TDSI commenced its internal investigation of some of the actions at issue. There is some speculation that RS is trophy-hunting:

What’s got the Street’s attention is RS’s decision to go after TD Securities. “RS is trying to put a big trophy on the mantle by targeting the dealer, as well as the traders,” said a senior executive at a rival firm. Talk on trading desks is that TD Securities appeared to do everything right, by reporting a problem once supervisors realized what was taking place.

The danger of RS’s approach in going after TDSI is that it will simply encourage cover-ups. Whenever there’s a screw-up, the second guessing starts … I should have noticed this, I should have checked that, instead of sending a polite inquiry I should have stormed into his office and banged my fist on his desk. And I can assure everybody, RS included, that there will always be fault to find by somebody who wants to find it.

So … you’re a supervisor, you figure something may be happening that’s against the rules. What do you do? Do you actually investigate? If you find something and report it, RS will go after you for not finding it faster, fine you and possibly lift your license. Even if they don’t lift your license – even if they don’t go after you at all – your employer might fire you, just to make themselves look good (particularly if, as in the case of David Berry, they’re looking for an excuse anyway).

So … do you investigate thoroughly? Do you communicate your findings after a thorough investigation? Or do you just casually drift into the trading room and announce to nobody in particular that there’s some new procedures designed to catch some behaviour, to be put into effect next week?

The last option makes you, ethically if not legally, party to a cover-up. Which may, of course, be RS’s intention … if everybody’s guilty of something, then they have uncontrolled power to end careers at a whim. Then, finally, they’ll get some respect!

Quite frankly, high-closing isn’t a trading issue I get all that excited about – when the price of something gets high, I sell it. When the price gets low, I buy it. All this seems pretty simple to me. The high-closing / market manipulation rules are in place solely to protect the stupid, who would be much better off if they just got better investment advice.

I am much more annoyed with the RS restrictions on algorithmic trading which, in requiring algorithmic trading engines to be vetted by the executing broker, have a clear effect of stifling creativity, increasing the inefficiency of the market and encouraging high-closing. If I were to suspect high-closing on a particular issue I was watching, for instance, I could build an algorithm to jump on those bids within a second of order entry … and make the little snot pay through the nose for his temerity.

But then, that would leave RS with less to regulate …

Maple Bonds are wonderful things! Portfolios can be diversified and, given current conditions, institutional investors can take advantage of some of the greatly elevated yields on US Financials without taking on currency risk.

This post, however, is due to a paragraph in an IIAC review of the Maple market:

Costs still need to come down

Having to possibly deal with legislation and regulation in 13 different jurisdictions can dissuade distribution in some provinces and territories and disadvantage investors. Regulatory fees range from $0 in Prince Edward Island to flat fees of up to $500 in Ontario to fees of three basis points of face value in British Columbia. For example, $100 million in Maple bonds distributed to B.C. residents adds $30,000 to all-in costs; distribution of $100 million to Quebec or Alberta investors adds a further $25,000 per province to issuer expenses for little or no work by the regulators. Market-watchers are concerned that the differences in registration fees could distort efficient distribution of the securities or – worse – make it uneconomical for issuers to issue in parts of Canada at all.

The IIAC has written to the Canadian Securities Administrators (CSA) asking them to extend the passport framework as part of Passport 2 to exempt market instruments, including Maple bonds. For exempt issuances, the IIAC asked the CSA to allow a simple single form filing with a lead regulator and payment of a single low flat, rather than ad valorem, fee to promote national distribution. This would also help CSA members meet their common goal of fostering fair, efficient and transparent capital markets for investors.

What would be really nice would be if the materials relevant to each issue were centrally published via a SEDAR-like facility. There is, for example, a Lehman Brothers issue in which I am interested, but the lead manager is of the view that showing the offering documents to anybody other than a primary purchaser is illegal, since it’s a private placement. The details are on Bloomberg, right? And due-diligence consists of looking at Bloomberg, right? Idiots.

Christopher Cox, Chairman of the SEC was criticized in PrefBlog on February 8 for his apparent belief that what this world needs is more rules.

I was very happy to be alerted by Naked Capitalism to some remarks he has made that show a better appreciation of the problem:

So how would the SEC substitute — and diminish — the regulatory reliance on ratings?

Mr. Cox said “one means of substituting … would be to substitute the current definition of the rating currently provided by the rating itself.”

What that means is that the SEC is considering ways of setting criteria that gets away from the ratings but focuses instead on the underlying concept. For example, for some rules the SEC could require bonds to be liquid and then develop some measure by which to sort them other than a credit rating, says one person familiar with the matter.

I posted yesterday in Earth to Regulators: Keep Out! that there wasn’t much point in regulation. All the rules in the world won’t make anybody a better analyst … or, indeed, to avoid blow-ups of any kind in this uncertain world.

The problem the regulators face is that under Basel II there is a good chance that a pro-cyclical bias will be introduced to bank capital requirements:

Under Basel II, the capital requirements for the largest banks would be based on their current assessment of the probability of default of the borrower (ie rating) – Basel Committee of Banking Supervision (2003). There is a live policy debate over whether different rating approaches adopted by the banks would lead to different procyclical outcomes and if they did which approach banks would choose to adopt. We find that less forward-looking bank rating systems, conditioned on the point in the economic cycle, could lead to a substantial increase in capital requirements in recessions. Looking at the 1990–1992 recession, ratings based on a Merton-type model, which reflect the point in the cycle through the use of current liabilities, lead to a 40% to 50% increase in capital requirements. In contrast, Moody’s ratings which are more forward looking, lead to little increase in capital requirements.
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The new Accord which will be introduced in 2006 could, however, have a profound effect on the dynamics of bank minimum capital and lending in recessions. In contrast to the current Accord where, for a given quantum of lending to a particular set of borrowers, the capital requirement is invariant over time, under the new Accord the capital requirements will depend on the current assessment of the probability of default (PD) of those borrowers. If borrowers are downgraded by a bank in a recession, then the capital requirements faced by the bank will rise. This would be in addition to the possible reduction in the bank’s capital because of write-offs and specific provisions.

It’s amusing that the authors (Eva Catarineu-Rabell, Patricia Jackson and Dimitrios P. Tsomocos) of the quoted paper prefer the Ratings Agency style of attempting to rate “through the cycle” as opposed to the more dynamic Merton-style approach, but that’s beside the point for now.

There is only on legitimate reason that Credit Ratings might be of importance to regulators of any kind: the effect on bank capital requirements. And it should be noted that the only reason they have any effect on bank capital requirements is because the concept was written into the Basel Accords. And, of course, they were written into the Basel Accords because of the superb track-record (remember that concept? track record?) of the Credit Rating Agencies.

Not perfect, by any means. There are big blow-ups and minor whoopsees, but it’s an uncertain world dominated by human frailty. Get used to it.

So, I suggest, if the regulators wish to improve their legitimate regulation via new and improved credit ratings, it is only right and proper that they do it themselves, rather than imposed ludicrous constraints and requirements on private businesses in a horrific central planning exercise. Cox is on the right track.

Naked Capitalism takes a very dim view of the remarks:

Require bonds to be liquid?. That is the most deranged thing I have heard in a very long time, and this presumably coms from someone within the US’s top securities regulator. It confirms what I have long suspected: that the SEC is preoccupied with the equity market and knows perilous little about debt.

A simple illustration: just about all corporate bonds are illiquid. That’s one reason credit default swaps are popular. Investors can use CDS to create synthetic corporate bond exposures, which unlike the underlying bonds, can be readily traded. But Cox would have us write off the corporate bond market.

Corporate bonds are illiquid relative to, say, stocks. Sure. I discussed this on November 19, in relation to Prof. Cecchetti‘s desire to have all financial instruments traded on an exchange:

Looking at the topography of the financial system, we see several immediate candidates for migration to exchange trading.  I will mention two:  (1) bonds and commercial paper, and other fixed income securities; and (2) interest-rate swaps and other derivatives that are traded in large volume. Bonds as we know them have been around since at least 16^th century.  And the quantities outstanding are substantial – in the United States there something like 4000 distinct corporate bond issues with a market value of roughly $10 trillion.  I can see no reason that these “fixed-income” instruments are not traded on an exchange.
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How can we encourage the movement of mature securities onto exchanges?  The answer is through a combination of information and regulation.  On the information side, it is important that less-sophisticated investors realise the importance of sticking with exchange-traded products.  The treasurer who manages the short-term cash balances for a small-town government should not be willing to purchase commercial paper, or any security, that is not exchange traded.

However … there are degrees of illiquidity! Assiduous Readers of PrefBlog will be very familiar with the idea that, while the average trading value (however calculated!) of a particular preferred share might be only $100,000, it is generally possible (for MOST issues, MOST of the time) to call a dealer and trade a block worth $10-million … maybe not right away, but, say, within a week.

So, subject to problems with measurement and control that must be addressed, I’m entirely comfortable with the SEC (or other regulators) coming up with some kind of way in which liquidity will be measured and applying some kind of concentration penalty on banks who hold a position that is too large to be regarded as liquid. This would be a little easier in the case of the States, which already has the NASD TRACE system in place.

There is also the potential for so-called liquidity guarantees to be put in place at time of underwriting. So-called? Well, the European Covered Bond market association called for suspension of the agreement on November 21 and there are current problems with liquidity on Auction Rate Municipals, as mentioned yesterday. I’ve mentioned my own problems in not being able to get a bid for less than a million of good quality corporate paper. So, while I would not put too much faith in the ability of the private sector to provide a bottomless pit of liquidity for bonds in general, liquidity could be enhanced … central banks, for instance, could enter into “liquidity provider of last resort” agreements and accept corporate and other bonds as collateral on a routine basis.

I would not advocate formal liquidity guarantees. It’s too much central bank intervention in the economy … in times of stress, the private sector just ain’t gonna want to take long term debt onto its books, especially not if it’s esoteric. But liquidity could be measured and a capital penalty applied to instruments whose liquidity in times of stress was feared to be sub-normal. 

I’m not sure that I agree with Naked Capitalism‘s point about CDSs. They are sometimes more liquid, sure – it’s a lot easier to go long a CDS than it is to short a corporate bond, especially in size. But as I see it, the main attraction of CDSs has been that they make it a lot easier to lever up a portfolio, compared with taking a cash position (long or short) and (financing or borrowing it). That’s related to liquidity, but is not exactly liquidity.

The guts of the problem, however, is step 2 of Mr. Cox’s idea: and then develop some measure by which to sort them other than a credit rating.

Market prices won’t do it. I’ve posted elsewhere about market implied ratings and how dubious I am that such a system will prove to be a better indicator of credit quality than what we already have. The Fed is dubious too!

And, as noted, structural models such as Merton’s (equity implied ratings were briefly mentioned on October 18) (a) have a lot of problems, and (b) are pro-cyclical.

I’ve also noted that any quantitative system performs badly at trend changes … and it is at precisely the time of trend changes that stresses on the financial system become pronounced.

So what’s the Fed to do? The only answer is … if they want to come up with some way of defining credit risk, they’ll have to set up their own in-house credit rating service. Good luck with that!