PrefBlog

Jim Hamilton of Jim Hamilton’s World of Securities Regulation reports House Marks Up Bi-Partisan US Covered Bond Legislation:

The House Capital Markets Subcommittee marked up legislation creating a covered bond market for the US. This is bi-partisan legislation with a good chance of passing Congress this year. The U.S. Covered Bond Act of 2011 was introduced by Rep. Scott Garrett (R-NJ), Chairman of the Financial Services Subcommittee on Capital Markets and Rep. Carolyn Maloney (D-NY), Ranking Member of the Financial Services Subcommittee on Financial Institutions and Consumer Credit. H.R. 940 will help facilitate a robust covered bond market in the U.S. to add liquidity and certainty to the capital markets. The legislation was passed out of the subcommittee by voice vote and will now be considered by the full Financial Services Committee and is expected to garner wide bipartisan support.
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According to recent testimony from the US Covered Bond Council, the public supervision of covered-bond programs by a federal regulator, whose mission is the protection of covered bondholders, is central to any legislative framework. In the European Union, this feature is enshrined in the Directive on Undertakings for Collective Investment in Transferable Securities (the UCITS Directive), compliance with which is what has given covered bonds their unique status in Europe, including privileged risk weighting under the Capital Requirements Directive and preferential treatment by the European Central Bank in Eurosystem credit operations. Issuances by regulated financial institutions is another fundamental element of covered bonds that is also recognized in the UCITS Directive. One other indispensable feature of covered bonds is a cover pool that contains performing assets and that is replenished and kept sufficient at all times to fully secure the claims of covered bondholders. This too receives specific mention in the UCITS Directive.

With covered-bond programs subject to rigorous public supervision, investors will be well protected. As a result, an expansion of existing securities-law exemptions may be appropriate.

I wrote a very brief primer on covered bonds a while ago. The proposed and defeated federal budget promised covered bond legislation, but so did the prior year’s: you can’t take these clowns too seriously.

The Securities and Exchange Commission has announced:

the panelists and final agenda for the Money Market Funds and Systemic Risk Roundtable to be held May 10.

The roundtable will address:

• The potential for money market funds to pose a systemic risk to broader financial markets – what makes money market funds vulnerable to runs and how should the role of money market funds be viewed through the prism of systemic risk analysis.
• Possible options for further regulatory reform and their implications, including floating NAV, bank regulation, and options that reflect a hybrid of these regulatory approaches: a private liquidity bank; mandatory reserve or capital requirements; and liquidity fees.

The agenda and list of panelists can be found on the SEC website.

The roundtable discussion will begin at 2 p.m. and be available by webcast on the SEC website. The webcast also will be archived for later viewing.

I am very pleased to see Paul Volcker on the list of participants. It was his discussion of the issue and plan for regulation that got me interested in the subject, which I subsequently addressed in an article.

The sessions won’t be particularly long, but will serve as a basis for further discussion:

2:20-3:05 p.m. Discussion — Potential for Money Market Funds to Pose a Systemic Risk to Broader Markets

• What makes money market funds vulnerable to runs?
• How should the role of money market funds in the short-term funding market be viewed through the prism of systemic risk analysis?

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3:20-5:00 p.m. Discussion — Regulatory Options and their Implications

• Floating NAV vs. Bank regulation
• Hybrid approaches to regulation: Private liquidity bank
• Hybrid approaches to regulation: Mandatory reserve/capital requirements
• Hybrid approaches to regulation: Liquidity fees

On this general topic, the Chicago Fed notes:

Firms face increasing pressure to weigh the value proposition MMFs offer over the intermediate term. Budget projections factor MMF waivers well into next year. While MMF fee waivers have been subsidized by higher asset management fee revenues a second abrupt market decline could cause further strain.
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MMFs have reduced their holdings of CP in favor of repos and government debt. At the same time, CP issuers seek to lock in longer term funding rates due to Basel III higher liquidity standards. Net result is a more limited, concentrated pool of eligible CP debt offerings for MMFs. MMFs are a major funding source for bank issued CP, comprising 40% of all CP issuances.

Update, 2011-5-11: The stable NAV is the focus of criticism:

Federal Deposit Insurance Corp. Chairman Sheila Bair called money-market mutual funds “destabilizing” to the financial system and said investors would be served just as well if share prices floated.

“Money-market funds are maintaining a fiction of a stable” net-asset value, as shown by the September 2008 failure of the $62.5 billion Reserve Primary Fund, Bair said yesterday at a round-table meeting of fund-company executives and regulators arranged by the U.S. Securities and Exchange Commission in Washington. “That is skewing investment dollars into a structure that is highly unstable in a crisis.”

Former Federal Reserve Chairman Paul A. Volcker called a floating share price the “simplest” solution to the risk posed by money funds, which trade at a constant $1 a share.

This may be because it’s the only possible measure that can be introduced that won’t cost anybody any money!

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.

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.

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.”
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“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.”
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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.