Category Archives: markets

OTC RIP

On Monday, the Intercontinental Exchange, ICE, announced that as of January 2013 all of its cleared OTC energy swap products would switchover and be traded as futures products.

This is one of the outcomes of the Dodd-Frank Act’s reform of the OTC derivatives markets. A very large fraction of swap transactions are economically identical to futures transactions, and the only rationale for that portion of the OTC market had always been evasion of regulation. Now, with the OTC swaps market subject to a parallel set of regulations substantially comparable to the regulation of futures contracts, the rationale for trading many products as OTC swaps is gone.

The OTC swaps market will continue to provide customized products not suitable for trading and clearing on futures exchanges, and in its press release, ICE confirmed that that portion of its OTC swaps business would remain: “All uncleared swaps will continue to be listed on ICE’s OTC platform, which will register as a swap execution facility.”

During the debates over reform of the OTC swaps market, much was made of the OTC market’s ability to offer customized products. While this ability was advantageous, its relevance to the size of the OTC market was always exaggerated. ICE’s announcement for its energy products is likely to be just the first in a major switch back to futures trades for a sizable fraction of the OTC market. The exact extent and the timeline for this switch will depend on many factors, including the ongoing battles over how specific rules are implemented and the ongoing shakeout in the future business model for banking.

Deleveraging and the creation of the Eurozone Keiretsu

Many Eurozone banks are going through huge deleveraging: they are selling their portfolios of loans to hedge funds, reducing and cutting revolvers to corporations, and shortening the overall maturity of their exposures. Faced with higher capital requirements as they experience melting equity values, and unable to raise funds from the US money market, European banks are left with no options but downsizing and help from the European Central Bank.

The banks’ deleveraging is paralyzing the European economy. Even healthy borrowers can’t be certain they’ll have the loans and lines of credit necessary for their regular operations. Many are going capital light: cancelling investments, shrinking working capital and selling non-core assets. Banks’ deleveraging has fostered a downward spiral amplified by institutional and retail investors dumping the stocks and bonds of banks and bank dependent borrowers. This is particularly nasty for the Eurozone, given the role banks have traditionally played in funding European firms.

New forms of intermediation are being developed. The most vigorous are via internal capital markets. Holding companies are tightening their grip over funds available at their subsidiaries—even when these are exchange listed companies—and are playing a much more prominent role in the allocation of funds.

A few large corporations are going beyond that and creating their own banks to make up for the vacuum created by the banks disappearing from the funding scene. Having a bank allows these corporations direct access to funds from the ECB, and enables them to store their excess liquidity in-house, instead of in deposits at outside banks that may be vulnerable to runs. The European aerospace firm EADS is considering doing just that. EADS’ bank could be the financial center of a large network of entities with business relations with the corporation, each with access to funds and able to deposit funds with EADS bank. If one counts EADS’ suppliers and major customers, as well as the suppliers of EADS’ suppliers and all their employees combined, that could be a very large bank indeed.

Out of necessity, the European Keiretsu is born!

The unorthodox model of risk pricing behind the UK EMR #6: it gets better

Earlier this week, the UK government submitted draft legislation on its Electricity Market Reform (EMR).  In a series of blog posts from last July, I critiqued the central premise underlying this insurance proposal. The touted benefits overlook the cost of risk passed along to UK taxpayers or ratepayers. They are based on a fanciful imagination of the costs of nuclear new builds, how risk factors into investment decisions, and the ease with which the relevant risks can be transferred at the stroke of a pen. Of course, so long as the government’s scheme remains an abstract plan, this critique remains a theoretical one. It will only be once an actual price insurance contract is laid on the table in order to finance an actual nuclear new build that the faults in the government’s scheme will reveal themselves in specifics. The new draft legislation includes a little more information, but not much. However, I did enjoy the footnote to a curious calculation, which reads: “The following simplifying assumptions have been made: that required debt returns are fixed as long as minimum cover ratios are met, and that equity investors’ hurdle rates do not vary with gearing/variability of prospective equity returns.” (emphasis added) That’s exactly the type of simplifying assumption one needs to make sense of the plan.

Reply to “jump”

In a previous post, I criticized a report by the consulting firm IHS on the potential impact of the Volcker Rule on the US energy industry.  Kurt Barrow, Vice President of IHS Purvin & Gertz and co-author of that report, has sent me the following reply:

Thank you for your interest in our report.  We wanted to take an opportunity to clarify a few points about our work.

The first point in your Blog refers to “bans banks from proprietary trading” but should instead speak to “restrictions on market makers.”  We have no issue with bans on bank proprietary trading, and the banks have already exited, or are Continue reading

The quickest way to a conclusion, … jump.

Earlier today, the consulting firm IHS released a report decrying the horrible consequences that the Volcker Rule would have for the US energy industry and the economy.

It’s a hatchet job.

Why?

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Hedging by Racing Cash Out

Speaking at GlaxoSmithKline’s annual results presentation last week, CEO Andrew Witty disclosed some of the strategies the company is employing to manage the risk posed by the Eurozone debt crisis:

We sweep all of our cash raised during the day out of the local banks and send it to banks here in the U.K. which we think are robust and secure. … We don’t leave any cash in most European countries. … And we’ve done that with a huge focus on getting paid. Like all things, if you focus on it, then eventually you do get paid.

GSK is not alone. According to the WSJ, Switzerland’s Novartis changed the incentives for its sales force in countries with significant debt issues, to collect the cash, not just generate the sales and put receivables on the company’s balance sheet. And Vodafone moves cash out of Greece every evening to guard against an exit from the euro, according to its CFO Andy Halford.

In some earlier posts, we have described some of the risk mitigating strategies by companies doing business in the Eurozone–here, here and here. The case made public by the CEO of GSK shows that companies also take precautionary actions by moving money across borders and between banks, as well as by taking steps to claw back money owed them by clients in financially distressed economies. Racing cash out of troubled zones is often done by multinationals operating in third-world countries. What is new is the use of that in first-world Europe.

One might ask whether this is a good way to actively manage risks, since it appears that by cutting funds to these countries companies like GSK are making the crisis worse and increasing their own risks of doing business.

Asked why GSK has taken these steps, Witty replied:

There was a period when things looked more worrying. The action that the [European Central Bank] took over the last six months has clearly had a very positive effect on bank liquidity and confidence. But there was a period last year when every day you were getting a phone call about Bank A, B or C which was perceived to be about to go or there were risks or there was anxiety about different banks in different countries. And we did a very comprehensive review about which banks we thought were the strongest and which weren’t. We moved our cash accordingly.

Witty’s remarks highlight the problem of bank (or country) runs. Whether GSK stays or leaves, it matters little, for if others leave the system collapses. The only way to avoid failure is if everybody stayed, but this is impossible to coordinate when each suspects that the others might leave. Such belief is by itself sufficient to bring down the system. Thus, the role for Leviathan, in Witty’s words impersonated by the ECB, and its actions to provide liquidity and confidence.

One final remark: When asked what the hedging strategy is with the money brought back daily to the U.K., Witty replied:

Remember that we pay our dividend in sterling so actually bringing the cash back to the U.K. is not a bad thing anyway because we always have use for sterling-denominated resources, so it’s really not an issue for us.

Surely that can’t be the whole story, for Witty understands that there are many ways to hedge exchange rate risk. The real problems are the concern over counterparty risk (banking freeze) and having money locked in a country that might fall off the cliff and impose capital controls.  Witty still remembers an emerging markets crisis where the “general manager took bags of money to people’s [GSK staff’s] houses”.

The Value in Futures

Today’s Wall Street Journal has a piece by Ian Berry about the possible restructuring of the CME’s rice futures contract. The design of the contract determines how effectively “farmers, elevator operators and beer brewers” can use the contract to do their hedging. The article is about problems that have shown in up in recent times and proposals to fix them. These problems impact how farmers and others manage their operations and investments:

“We are losing rice acres to other crops, and the lack of ability to comfortably hedge is a major reason,” said John Owen, a Louisiana producer who has chaired a committee with the U.S.A. Rice Federation, a trade group, to examine the issue.

Farmers said growing rice becomes too risky if they can’t lock in prices at the start of the season. Most of their expenses come up front, so they need some assurances on what they will get for their crop.

“We need to get our rice farmers back to farming rice,” said John David Frith, a farmer in East Carroll Parish, La., where a vast majority of growers have stopped planting the grain.

Designing the terms of a futures contract is a tough problem. Getting it right is how a market like the CME helps make the economy more productive.

Duality and Uncertainty: Lessons from the carbon market

The Great Recession has hit the European carbon market hard. With output down, the demand for allowances is down, and so is the price. As recently as the start of this year, emissions allowances were trading at €14/t CO2. But last week the price was below €7. This is gloomy news for those who want the carbon price to incentivize innovation in low carbon technology. For example, David Hone, Climate Change Advisor for Shell, is one of many who have been advocating that the Union set aside a number of allowances in order to support the price. Earlier this week that proposal moved a step closer to becoming a reality with a favorable vote by the European Parliament’s Environment Committee. The price of carbon subsequently jumped up by 30% on Tuesday on the news.

I bring up this news because I think it highlights a weakness in the economic debate about the best means to the end of pricing emissions. The argument revolves around whether or not the government should set the price of emissions, and let companies choose the quantity of emissions, or whether the government should set the quantity of emissions it will allow, and let the market set the price. The former is a carbon tax, the latter is a cap-and-trade system. In a world of certainty, where the cost of abatement by companies is well known, the two are equivalent. When the government sets the price (tax level), it knows the quantity of emissions that companies will choose. Alternatively, when the government sets the cap, it knows the price that will emerge in the market. That’s duality.

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Manufacturers as Banks

EADS, the European aerospace group and owner of the Airbus family of jetliners is busy redesigning its boundaries to become a banker of last resort.

The company recently bought PFW Aerospace, one of its suppliers of specialty pipes and ducts, which became victim of the European credit crunch. With banks sharply deleveraging, even to suppliers of EADS, and with strong sales and orders that will sustain growth for years to come, the company has had to step in on several occasions and provide financial support to its sub-contractors.

EADS’ takeover of suppliers and its role as a financial intermediary are an act of necessity, not of choice. EADS cannot risk delay by suppliers that, for lack of bank credit, don’t meet its timing and quality requirements. Finding replacements and renegotiating contracts would involve huge costs and take years.

For many European corporations, coordinating production through the market has just become too risky. EADS never envisaged it would become a banker to its suppliers nor that it would have to bring some suppliers in-house in order to protect the integrity of its supply chain. Clearly, this is not in EADS’ nature. EADS’ example shows an often forgotten cost of the financial crisis: that firms are the (second best) alternative to the market mechanism. When the credit arteries get clogged it is more efficient to produce in a non-market environment.

Europe’s banking crisis is forcing many firms to redefine their boundaries. It is also sending many others to the graveyard.

UBS / OTC / CCP

It is becoming clear that the UBS scandal that rocked financial markets last week is not just about a single trader suddenly gone awry. UBS’s controls – both in risk management and auditing – failed miserably. Top bankers in the investment banking arm of UBS didn’t have a clue about what was going on in the trading desks and in the back office. When a kid can so easily blow a $2.3 billion hole in the balance sheet, and cause so much damage to the reputation of a top tier bank, there’s something awfully wrong.

But the failures of the system go beyond UBS alone. Kweku Adoboli made trades that apparently didn’t require prompt confirmation with its counterparties. Why? Because in Europe, where UBS’s Delta-One trading desk is based, the vast majority of trading in exchange-traded funds (ETF) occurs over the counter (OTC), in bilateral trades. The rapid growth in ETF trading (a profit center) has outpaced spending in back-office and reporting activities (a cost). According to the Wall Street Journal, a report published in 2009 states that over three quarters of European ETF trading didn’t require any reporting.  The Bank of England, among other supervisory authorities, has called attention to the growing complexity and interconnectedness of ETFs. Unregulated OTC trading also makes them obscure. The inherent lack of transparency of OTC markets provides a fertile ground for misrepresentation and outright fraud. It is also likely that opacity makes it much harder to measure the risks taken by ambitious traders.

The European Commission is now carefully saying that it will look into the possible regulatory implications of the case. The Commission, scared to death by the banks’ threat to leave if new regulations are imposed, has ignored the lessons of the 2008 Jerome Kerviel affair, responsible for Societé General’s $7.2 billion mishap with ETFs and related OTC derivatives transactions. It would serve the European Union well if it learned from the US, where ETF trades are reported and cleared through public and open exchanges. No opacity, less room for cheating.