Gawd, I hate acronymns and look at that! Three in one blog entry title!!!
Anyways, for the nerdy-nerd equities guys, this will grab their attention.
It's all to do with trading in European and American stocks and shares using High Frequency Trading (HFT) systems, and the regulations therein with EU MiFID rules applying over here and USA RegNMS rules applying over there.
These rules are going to be overhauled soon thanks to the Flash Crash, that dreaded thing that caused US stock markets to go haywire on May 6th. There has been lots and lots written about the Flash Crash of May 6th, but there’s not been a great deal saying it was a good thing ... until you meet JPMorgan.
In this week’s Eye on the Market, they identify five things they like about the Flash Crash, namely:
[1] Stock-specific circuit breakers. The U.S. has been slow to install circuit breakers on major exchanges, relying instead on “clearly erroneous trade rules” that cancel trades after the fact. In Asia and Europe, circuit-breakers have been around for a while. In Asia, trading is restricted outside of pre-specified daily bands of 5%, 10% and 15% (different by market). In Europe (e.g., Deutsche Bourse), trading is halted for 5 minutes after a 3%-10% move, and then reopened. In the wake of the Flash Crash, 10% circuit breakers are now applied to a few stocks as part of a pilot program (they have already been triggered on Citigroup, Anadarko and the Washington Post Company). If we are going to exist in a world with automated robots doing the lion’s share of daily trading, circuit breakers may be needed to prevent unintended and unmanageable meltdowns.Another topic under discussion by the SEC: prevent HFTs from having “unfiltered, naked access” to the exchanges by requiring them to live by the same pre-trade risk management controls that clearing members do. Why? As noted by the Chicago Fed, “high-frequency trading has the potential to generate errors and losses at a speed and magnitude far greater than that in a floor or screen-based trading environment”.[2] More balance to the HFT discussion. HFT supporters claim they are providers of liquidity to the market, and that HFT makes U.S. markets more efficient than ever. Suggestions to the contrary have been deemed “utterly laughable” by firms defending them. However, the Flash Crash highlights the uncertainties around these assertions.While volumes have tripled in the last few years, there’s a big difference between volume and liquidity (the ability to transact without moving the price). In an industry barometer survey1 conducted by the Tabb Group in May of this year, barely half the participants had a high degree of confidence in the US equity market structure; 73% did not believe the market structure is “orderly”. One of the survey recommendations: HFTs should be required to register as broker-dealers.To be sure, there were weaknesses in the old specialist system as well2. But specialists were required to maintain a fair and orderly market, and post quotes that were part of the National Best Bid and Offer system; their reputations mattered. HFTs have no such requirements (no minimum shares or minimum quote times); one proposal would require quotes to be valid for at least one second. The SEC has broadened the trader reporting system in order to analyze HFT activity more closely.[3] Proposals requiring HFTs to act more like the floor specialists they’re replacing. With the advent of HFTs, cancelled orders have soared. Today’s ratio of 30 cancelled orders for each one executed means that 97% are cancelled.To curb abusive practices, some market participants recommend applying a fee to HFTs for an excessive number of cancelled orders. The increase in cancelled orders is one reason we do not agree that increased order depth on S&P 500 stocks at the NBBO is a clear indication of greater liquidity, as some market research alleges. Quotes pulled within a nano-second of being posted, and which are part of an algorithmic order detection exercise, don’t seem like liquidity in the traditional sense. Ameritrade’s representative on the recent SEC Roundtable referred to this as “opportunistic liquidity”.[4] More discussion around HFT “co-location”. Some HFTs co-locate computer servers inside stock exchanges3 to minimize the milliseconds (or nanoseconds) required to scan existing orders, and have algorithms act on this information. As trading execution and IPO listing fees declined, exchanges have tried to make up the difference by selling access to market data. Some exchanges have products which give clients a faster look at quotes, in exchange for a fee. As a result, some HFTs end up with access to information sooner than institutional or retail investors who rely on more standard venues (such as SIP Quotes).The search for co-location benefits has existed forever (in polite company, “order anticipation strategies”). Broker-dealers in past decades argued that being closer to floor traders on the CBOT was an advantage to their clients. But historical parallels can lose their meaning when the instruments of battle change: one HFT computer can reportedly decode more than 5 million messages per second. The Flash Crash has increased the debate around whether co-location confers advantages to HFTs, and whether there should be obligations and responsibilities that accompany them.[5] Asset managers learn that “cheapest <> best”. After the NYSE moved to decimalization in 2001, bid-offer spreads fell almost in half on S&P 500 stocks (less so for the Russell 2000 stocks, where HFTs are less active). Schwab retail commissions fell from $35 in 2003 to less than $10 in 2009. This trend is confirmed by broader research from the American Association of Individual Investors. So if the prism of success is bid-offer costs and commissions on individual trades, the battle has been won.But is that the right prism to define what makes an optimal marketplace? Part of the HFT industry tracks the order flow of larger investors who leave electronic footprints4. Using algorithms which include spraying the tape with thousands of quotes, the intentions of large investors is ferreted out. This can result in higher trading costs for such investors, and by extension, their clients, who include 401k investors, and pensioners participating in state and corporate plans. Quantitative Services Group computes analyses of HFT impacts on execution costs. They estimate that HFT tracking algorithms can drive execution costs up 1.5 to 3 times, even when institutional investors parcel trades into smaller orders to avoid detection.
There’s lots more of interest in their report, which you can read in full and download if you want:
This means that this area is going to get regulated, and it will mean significant restructuring. For example, back in January, the SEC started a consultation through the Concept Release - a request for public comment on securities issues - on HFT and more.
Key areas under review include:
Market Quality MetricsWhat are the best metrics for assessing market quality for long-term investors and have these metrics improved or worsened in recent years?Fairness of Market StructureIs the current highly automated, high-speed market structure fundamentally fair for investors?High Frequency Trading
What types of strategies are used by the proprietary trading firms loosely referred to as high frequency traders, and are these strategies beneficial or harmful for other investors?
Is the overall use of any harmful strategies by proprietary firms sufficiently widespread that the Commission should consider a regulatory initiative in this area?
Co-Location
Do co-location services (which enable exchange customers to potentially route trades faster by placing their computer servers in close proximity to an exchange's computer system) give proprietary trading firms an unfair advantage?
If so, should the proprietary firms that use these services be subject to any specific trading obligations?
Dark Liquidity
Has the trading volume of undisplayed trading centres (such as dark pools) reached a sufficiently significant level that it has detracted from the quality of public price discovery?
If more individual investor orders were routed to public markets, would it promote quote competition in the public markets, lead to narrower spreads, and ultimately improve order execution quality for individual investors beyond current levels?
Are a significant number of individual investor orders executed in dark pools and, if so, what is the execution quality for these orders?
Lots of comments have been received on the Concept Release, and its conclusion cannot be far away.
Now we have a European response to this area with Kay Swinburne, rapporteur to the Economic and Monetary Affairs committee of the Parliament, producing a draft report last week. This report provides indication of much of what might be in the revised MiFID and very little is left untouched.
Jeremy Grant over at the Financial Times, has picked out some of the more interesting nuggets from Kay’s report:
She suggests it may be necessary for “informal market makers” – read: HFTs – to be subject to mandatory liquidity provisions;
Calls for an “ongoing regulatory review” of the algorithms used by HFTs;
Seeks an examination of HFT to determine whether market flow generated automatically is providing “real liquidity” to the market and what the effect of this is on overall price discovery;
Suggests that, “in the interests of equitable treatment”, rules need to be introduced so that MTFs (multilateral trading facilities”, like Chi-X Europe) are subject to the same level of supervision as exchanges, under certain circumstances;
Calls for new provisions under Mifid for “broker crossing networks”, including requirements that they submit to authorities “orders matched in the system”, and “details on access to the system”; and
Suggests a minimum order size for dark pools.
This is pretty dramatic stuff and Jeremy finishes his column by referencing David Doyle, a regular speaker at the FSClub, returning to the London meeting on 12th January 2011 for our annual EU regulatory update.
David presented on the key changes in MiFID at a conference at the London Stock Exchange last week, stressing that “the whole review of MiFID will have as its driving principle investor protection – that is, the interest of the retail investor, not the operators of exchanges, dark pools and HFTs.”
Too true David, too true.If you’re interested in more of what David had to say, here are his slides:
It turns out that 91 European banks are to be put through a ‘stress test’ to see how well or badly they will cope with a shock to the system. The stress test itself was a little unclear until late last week, when the Committee of European Banking Supervisors (CEBS) detailed what would happen. As a result, a lot of folks think it’s a fudge, and the intention of creating more confidence in the EU’s banking system may actually have achieved the opposite.
Here’s the lowdown.
CEBS stress tests were announced after their initial approach was viewed as being too little and too narrow. The intention was to stabilise confidence in the EU banking system following the crisis in the Eurozone, and the approach was meant to follow the example set by America in May last year.Back then, everyone felt the American banking system could not deal with the exposures they had to OTC derivatives, so the Federal Reserve tested the banks to see if they could deal with not just those exposures, but any other severe shocks to the system.The US tests used two economic scenarios: one mirroring the consensus of economic experts on the course of the downturn through 2010, and the second modelling a worse-than-expected course of economic activity. This resulted in recognition of a $74.6 billion shortfall, which was far less than the figures being bandied around before the stress test results. For example, the IMF estimating that the U.S. banks needed another $275 billion to $500 billion whilst some analysts throwing figures around that the industry may need as much as $1 trillion. The less than anticipated shortfall led to increased confidence in the American banks. That confidence led to some stability in the system thereafter, financial stocks jumped 36% in the seven months after the tests, which is why it was worth doing.This is why the US example was followed by the lengthy discussion of living wills in the UK regulatory sector, and the idea of reverse stress testing as implemented by the FSA last December. In these tests, banks are meant to imagine that they have failed and then have to work backwards to determine which risks and vulnerabilities caused their hypothetical collapse. The FSA’s approach to stress testing consists of three main elements: companies’ own internal stress testing, where they assess their ability to meet capital and liquidity demands in a sudden downturn; the regulator’s testing of specific companies; and simultaneous “system-wide” stress testing, based on a common crisis scenario.In both the US and UK examples, the stress test methodologies were completely transparent and now we come to the European bank stress tests.In the EU tests, CEBS will study 91 banks, mainly in Spain and Germany, but also several other key banks including Britain's "Big Four" – RBS, HSBC, Barclays and Lloyds. In the latter example, thanks to the FSA’s scrutiny, they have already been subject to tough tests at home and should pass with flying colours.The list is actually considerably longer than the original announcements in June which selected just 25 banks for review, and includes the German Landesbanken for the first time.The significance of that decision cannot be underscored more deeply as BaFIN, the German regulator, announced a year ago that €800 billion of toxic debt sat on the balance sheets of these banks, particularly some of the Landesbanken, and that was double the amount they had estimated just three months earlier.With almost $1 trillion in deposits, 2,500 banks and 45,000 branches, Germany also has one of the densest banking networks in the world, and hence a weakness in the German system would be a weakness for all, particularly as Germany has been bailing out Greece and, soon, Spain, Italy, Portugal and more.In Spain’s case, as recently blogged, there is a big problem with the mid-size banks where the savings banks, regional banks and mid-sized banks are all closing, merging and consolidating, with anything from a quarter to a third of all Spanish bank branches to close.That’s not good. But the stress tests can turn this situation around by showing that Europe can cope with even the worst case scenario.That’s a tough call, as we are all asking: ‘Can it?’After all, a stress test if it turns out to be negative will worsen the situation but, if it’s positive, it will improve everything.So the stress tests are being reported to be as transparent as the US version, with a three scenario test, according to the German newspaper Handelsblatt.The first will analyse how banks perform if economic growth is at the rate forecast by the European Commission; the second will test the effect of a 3% drop in gross domestic product; and the third will look at how banks would cope with a "shock" situation in government bond markets, a scenario similar to events in May this year when Greece was downgraded by Standard & Poor’s.It is that downgrade which has caused all of these jitters anyway, and created the uncertainty and lack of confidence in the Eurozone. Without confidence in the European banking system, then even worse scenarios could be considered, such as the collapse of the Eurozone and a return to national boundaries and nationalistic tendencies therein.But there is already an issue with the European stress tests as the approach, structure and details of the tests have been changing over time, and many think the results – to be announced on 23rd July – will be a fudge. This view was given even more fuel when there were rumours that France and Germany were trying to suppress the methodology to be used for the tests.This is bad news, as the lack of confidence in European banks will be made worse when or if there is a lack of confidence in the European banks’ stress tests, and the stress tests will only increase market uncertainty, rather than decrease.All in all, my view is that Europe is caught between the Devil and the Deep Blue Sea.If they complete the stress tests and release the results with complete transparency, there is likely to be some fallout. Unless the results show that the fears for bank counterparty risks in Europe are unfounded, which in the case of the Landesbanken and Spanish caja banks is unlikely, then it will just confirm what many already suspect: Europe’s broke.On the other hand, if they complete the stress tests and release the airbrushed results that show some manipulation or opaqueness, then everyone will believe that their fears for bank counterparty risks in Europe are proven.Therefore, what seemed to be a great idea to bolster confidence in the Eurozone may actually prove to be a lose-lose situation.So how can the Eurocrats create a win out of this?Just be totally honest.If there are real issues in the heartland of Europe’s banks, be brutally frank about them.It is only with total honesty, transparency and clearly washing any dirty laundry in public at the end of the month that Europe has any hope of surviving this current battering.
I’ve just received this month’s Banker magazine which the editor, Brian Caplen, describes as their most important issue of the year as it covers the latest Bank 1000 listings.
This year’s listings show a surprisingly stable crew of American and British banks.
World Bank Tier One Pre-tax Rank Capital profit $m $m 1 Bank of America Corp 160,387.77 4,360.00 2 JP Morgan Chase & Co 132,971.00 16,143.00 3 Citigroup 127,034.00 -8,445.00 4 Royal Bank of Scotland 123,859.00 -4,366.29 5 HSBC Holdings 122,157.00 7,079.00
Considering the crisis was meant to have killed these banks, you may find it surprising to see that Citigroup and RBS have maintained their leading positions.
This is down to the fact that the Banker measures a bank’s strength by its Tier 1 Capital, and so their positioning is more of a reflection of the sheer size of these firms than by their brand or market capitalisation, which is used in some other studies of size.
The Banker’s data is fascinating though, as the database also contains profitability, revenue, cost-income ratio and more, so it’s a useful tool in all senses. And the online data goes back to 1996, so you can do some useful comparisons.
Mind you, my data - old Banker magazines - goes back even further so I quickly took a snapshot of a few useful year’s – 1994, 1999, 2004, 2008 and 2010 – to see how things have changed. Mapping out the Top 20 banks of the world for each year makes for an interesting picture (doubleclick the picture to see a larger version):
Back in 1994, Japan ruled the world.
Then their economy went South and Origami Bank folded, Sumo Bank went belly up, Bonsai Bank cut back their branches and something fishy went on at Sushi Bank where staff got a raw deal.
Post-Japan’s slump, the Anglo-American financial system ruled. So you would think that, as that system failed, it also would have gone South.
Not the case.
Maybe that’s a reflection of the sheer scale of investment American and European firms have put into these economies to avoid such a crash.
Well worth spending time looking at the data and looking forward to playing around with it further.
For some time now, I’ve been meaning to blog about the big issue bubbling away over SWIFT, and the access to SWIFT records demanded by the US authorities.
I remember having lunch with some executives at SWIFT back in the summer of 2006, when the news first broke about this. Back then, the New York Times had just broken the previously secretive story that SWIFT was sharing bank data with the US authorities, after having been subpoenaed to share such data. The aim was to track terrorist funding and any transactions that involved suspected terrorist related activities were shared. The problem is (a) what right does the USA have to subpoenae and access the records of a Europe-based institution and (b) how does SWIFT ensure it's just limited to terrorism records, and not the records of you and I. SWIFT weren't happy about this action, and particularly that it had now come into public domain. One SWIFT executive said to me: “when that New York Times journalist is walking around the next Ground Zero and sees the thousands of bodies caused by his exposing this story, see how happy he is then.” Over a glass of wine, he admitted that he’d like to crush the bones of the journalist and bury him six feet under.You see SWIFT is meant to be private. It’s a bank consortia, and not meant to be open to any old authority raking over its records.And, bearing in mind that SWIFT is head officed just outside Brussels in Belgium, the centre of and capital of Europe, having some gung-ho Yankees barking orders at them does not go down well.Nevertheless, in the spirit of cooperation, the European Commission, Parliament and politicians have been trying to work hard to come up with something that meets the needs of the American authorities whilst not compromising our very European principles.It won’t work.But we’ll try.You see, when it comes to privacy, Europe is from Mars and America is from Venus. Europe believes the individual has a basic human right to protect their privacy. America believes that the State is far more important than the individual, and so listening in to any conversation, no matter how private, is fine.This is all coming to a head as Members of the European Parliament are debating this topic this week and pushing through a revised agreement with the United States on Wednesday.
This follows the block on the original deal in February, which was meant to allow a continuance of the access that came to light in 2006. That was blocked due to ‘insufficient data privacy safeguards’.The amended agreement now states that the USA can request European financial data relevant to a specific terrorist investigation, as long as they substantiate the need for the data.
The whole argument over data privacy is illustrated best by this discussion between Frank Gaffney, a lobbyist for US Security, and Baroness Sarah Ludford, MEP, on the BBC’s Radio 4 programme “The World This Weekend”, aired yesterday and presented by Shaun Ley.
Shaun Ley: If you pop down to the garden centre or a supermarket this afternoon, what you buy could end up being examined by the Pentagon. As part of the fight against terrorism, the United States has been seeking authority to receive details of any personal financial transactions from Britain and other European countries. Since 9/11 they’ve had some access informally but, in March the European parliament blocked a government level agreement on data transfer, worried about the threat to privacy. On Wednesday, MEPs will vote on a renegotiated deal. Frank Gaffney, who was responsible for international security in the State Department under President Reagan, thinks it’s about time.I’ve been speaking to him and to Baroness Sarah Ludford, Liberal Democrat MEP, who’s been telling me about her concerns including something known as ‘data drilling’.Baroness Sarah Ludford: Well, rather than searching specifically for a name of a particular individual or particular data in a bank account, you would do a big trawl. A fishing expedition, as it were. Now we haven’t got 100% perfection and we are still concerned that it involves the bulk transfer of data. So European banking data is transferred en block, in bulk, to the United States and it is searched there. What we would like and we have got certain commitments that in the medium term, the option will be explored and hopefully developed, of the data being extracted in a targeted way on European soil. So we don’t have to hand over this mass of undifferentiated data, because clearly there are concerns about that.Ley: Frank Gaffney, from the US perspective, your authorities wanted this data and wanted this opportunity. Why is it so important to be able to drill down into people’s bank details in that way?Frank Gaffney: We are confronting enemies that are increasingly sophisticated. Getting insights into the movements of funds that enable this kind of activity to take place is, I think, essential to countering these sorts of threats, both of the violent and of the stealthy kind. The more hamstrung we are, the more likely it is that these sorts of seditious activities will go forward with ever greater success. That’s something I don’t think we can tolerate.Ley: And are you worried that these kinds of restrictions that are being negotiated with the EU might leave the investigative powers hamstrung?Gaffney: I do worry about that. I think that’s sort of the object after all, is to constrain those investigatory efforts in the interest of privacy. I like my privacy, like everybody else. I just don’t want to die.Ley: So a lot of these changes potentially put lives at risk.Ludford: I don’t believe so. I strongly believe in trans-Atlantic cooperation in a whole series of areas. I’m vice-chair of the European Parliament’s US delegation. We don’t have reciprocal right to US banking data and some of us have wondered what Congress, and the Senate in particular, would say if Europe was to request that the banking data of all US citizens was to be transferred in bulk, en block, to Europe.Ley: Frank Gaffney, that’s fair enough isn’t it. If you’re going to be given access to my bank details, shouldn’t that work the other way around as well?Gaffney: I can’t speak for the US government obviously, as I’m not a government official anymore, but I suspect that one of the reasons why there might be a resistance to the kind of reciprocity that seems otherwise unobjectionable and fair, is to the extent that European governments and maybe even the European Parliament itself, have been penetrated by folks who are sympathetic to or actually working for organisations like the Muslim Brotherhood. That would be a real problem from the security point of view that I’m talking about.Ludford: I can assure you that that is not the case.Gaffney: I can assure you that it is the case.Ludford: I don’t like this portrayal somehow of Europe is Venus and America is Mars. I think that is a gross misrepresentation. It’s not about being soft on terrorism but, specifically among the Muslim community, we do need leads and cooperation with the police in that community so you have to be, for law enforcement purposes, quite intelligent about the way you seek to isolate the real terrorist suspects from the bulk of the community.Gaffney: I agree very strongly with that, but I don’t believe it is intelligent to embrace the Muslim Brotherhood and organisations like that.Ludford: I don’t think anybody is suggesting that it is.Gaffney: I can assure you ma’am that that is being done in Britain, it is being done in the Continent of Europe, it is being done in the European Parliament.Ludford: I can assure you that the European Parliament MEPs are not at all motivated by concern for the Muslim Brotherhood in our insistence on stricter data protection privacy safeguards.Gaffney: I can simply assure you that it is absolutely a point on which you agree with the Muslim Brotherhood. Whether you are doing it at their behest, or whether you are simply doing it in parallel, is beside the point to my way of thinking.Ludford: I think that is really unhelpful. I’m sorry, I just find that so unhelpful to somehow cast aspersions on anyone who is championing data protections and saying – whether it’s our banking data, our email, our internet usage, our phone calls, travel information – that it ought to be open season for law enforcement to go fishing around in it all because if you don’t agree to that, you are somehow a front for the jihadists. I think that is so absurd that we can’t discuss this sensibly.Gaffney: That is not what I have said.Ludford: Well it comes pretty close to what you said.Gaffney: What I’ve indicated in the comments so far is that there is an obvious need for a balance between privacy and the need to defend ourselves, especially when civil liberties are being used by our enemies as part of this stealth jihad to undermine and to destroy us.Ludford: MEPs have spoken on behalf of the majority of people, who are not the ones you are talking about, and I’m sure that MEPs will next week support this new agreement because it has two effects. One is indeed to try and make sure that we can combat terrorism through finding out about terrorist financing, but it also does so under pretty strict safeguards for data protection, and I think that is a win:win situation.Ley: Frank Gaffney, your last word?Gaffney: I just hope you’re right. We’ll see.
WARNING: THIS BLOG ENTRY WILL NOT CHEER YOU UP [sorry]
I spent the morning with a group of futurists debating the long-term outlook for financial markets and am never sure about the usefulness of such debates, although there is definitely something of use in creating scenario plans for the future which is where we were focused.
The key question I kept asking myself during the conversation is: when will the next financial crisis take place, what will cause it and is it predictable?
To answer the first part of that question, we only need to look back in history.
If we take the first financial crisis as the fall of the Roman Empire then it was about 1,000 years until the second financial crisis occurred, with the collapse of the Medici banks of Renaissance Italy. Four centuries later, the South Sea Bubble and Great Tulip Collapse took place. 250 years after that, we hit the Great Depression; and 80 years after that we imploded in the Subprime Crisis and Global Credit Crunch.
Sure there were plenty of hiccoughs along the way - LTCM, Asia, Russia and Latin American implosions in the late 1990s for example - but global crashes have been notable. Loosely speaking, global crisis are now occuring twice as fast as the previous ones:
1,000 years – the Roman Empire to the Medicis
400 years – the Medicis to the South Sea Bubble
250 years – the South Sea Bubble to the Great Depression
80 years – the Great Depression to the Subprime Crisis
On that basis, you could bet on the next crisis being anything between thirty and fifty years from now.2040 to 2060.So what would cause the next financial crisis? After all, we’re only just trying to get through this one. Surely we can regulate to avoid another one?Maybe not.Here’s a view you could take of the factors that contribute to the next financial collapse. I should say that it doesn’t make for fun reading, but the logic could have some grain of accuracy.2011Banks globally are heavily regulated, taxed and governed to avoid another subprime crisis. The focus is on derivatives, liquidity, capital and governance.2012The European Union struggles through a fragile and fallow period of financial and political instability with Portugal, Italy, Greece and Spain managing to just about maintain Eurozone requirements. Unfortunately, it is at the expense of citizens and governments in many of these nations. In fact, the cuts and tight budgets in these Southern member states creates a major movement of economic migrants from Southern Europe into Northern Europe, with the associated tensions and fissures appearing between Northern Europe and Southern Europe as a result. The outcome is that Europe never quite achieves the competitive economic zone it dreamed of becoming.2016China opens its markets to full financial servicing, with a rocking stock exchange in Shanghai that becomes the world’s second major investment banking city by volume and value by 2020, just behind New York This is combined with a revaluation of the Remnimbi (RMB) that satisfies their critics but worries some, particularly the USA, as the Chinese currency is looked towards by the investment community as a possible alternative reserve currency.2019Rather than creating a reserve currency for the world, the investment community creates a basket of currencies to avoid too much exposure to risk in one economy – after all, they don’t want a repeat of the 2008 crisis. The basket includes Euro, RMB and Dollar, along with Gold and other commodities. Nevertheless, the decision to place a weighting towards RMB rather than the Dollar creates issues for the USA, which has spent most of the 2010s in stagnation.2022The Middle East enters a major crisis, as oil becomes less needed as a commodity due to the rise of alternative energy sources and conversion of many motorised vehicles to electricity. Iran and Israel go to War and there is a huge effort by the United Nations to bring stability to the region. Eventually, Sovereign Wealth from the GCC outflows towards new and rising economies, such as Africa, and tensions continue to rage across the region on an ongoing basis.2025Africa’s economy is raging onwards and upwards. Like the BRICs of the 2000s, Goldman Sachs creates a new investment portfolio known as CAGES – Congo, Angola, Guinea, Ethiopia and Sudan – where natural resources of platinum, cobolt, gold, diamonds, manganese, uranium, chromium and tantalite are abundant. Johannesburg is rising fast as one of the largest world financial centres.China is now the largest trading partner and region with Africa, thank to their investments at the turn of the century. America finds this to be particularly challenging, as their view of Africa had been one of occupation and charity, rather than investment and growth, during this period. But China doesn’t care too much, as China has now become the world’s largest economy.2028American and European investment firms decide to make RMB the reserve currency of the world, and drop the concept of the basket of currencies.2032The quiet rise of India as the world’s second largest economy had largely gone unnoticed but, in 2032, for the first time China’s economy had less than 3% growth. This was put down to the lack of skills in the country where skills were needed, and is a reflection of the aging population in China and lack of new blood. China’s one-child policy of the previous century, and a distinct lack of female population for the overly male populated society that resulted, means that 2 in every 5 citizens has reached or is near retirement age. This, combined with strict immigration controls, places a strain on continued growth and industry.2039India’s continually booming economy has created frictions between their Chinese border rivals, and a Cold War commences between the two nations. Like the Cold War of the previous century, no arms are traded or battles take place, but the economic controls freeze out much of China from India’s trading partners and vice versa. The result is an economic climate where India’s investment community trade with India and China’s with China.There are ripples through the Shanghai and Mumbai stock exchanges as a result.2044India continues to see success as a stable and harmonised country. China appears to be becoming more unstable as the government struggles to maintain investment and trading, and avoid the inflationary pressures created by their exposure to investments in Africa for future commodities that can no longer be utilised.The economy fails to achieve growth rates above 1% for three quarters, and the government determines that the Remnimbi needs devaluation. This angers the USA and Europe, who have major investments in Chinese land and other illiquid stocks, along with major reserves of Chinese currency. The decisions taken by the Chinese government force them to look towards India and Africa.2050The outflow of investment by American and European investment houses from China results in aggressive currency arbitrage between the Chinese RMB and the Indian Rupee, with the latter winning as the RMB’s reserve currency status ends. The resultant big time betting against the continued stability of China causes the Cold War between India and China to spill over into skirmishes. The world sees a period of major instability ensue and the China Crisis is put down to currency speculation amongst the world’s capital markets created by complex foreign exchange instruments intertwined between the major economies.
Nothing to do with housing this time.
Jeez, that was a depressing vision and I told you this conversation wouldn't cheer you up.Thank goodness it’s just fiction.
However, if you like this sort of future conjecture and dialogue, you are welcome to join us for two more optimistic discussions (hopefully) at the FSClub in June:Monday, 07 June 2010 The Long Now of Finance A panel discussion with Professor Michael Mainelli and guestsThis evening is dedicated to a panel discussion focusing upon: "The Long Now of Finance - a Framework for the next 10,000 years". Many financiers and academics are beginning to focus upon how to invest in long-term projects that secure the planet for our children and grand children and great grandchildren. Short-term thinking is killing the planet. So how do we think long term: the Long Now, and how do we fund it: Long Finance?Long Finance is an initiative begun in 2007 by Z/Yen Group in conjunction with Gresham College, to establish a World Centre of thinking on Long-Term Finance. The initiative began with a conundrum – “when would we know our financial system is working?” and has worked on a variety of projects, including the signature program focused upon an Eternal Currency.This debate will be chaired by Professor Michael Mainelli, a cofounder of Long Finance and Executive Chairman, Z/Yen Group.Monday, 14 June 2010 The Future of Banking, a discussion with Professor Ray Barrell, Professor David De-Meza and Professor Donald MacKenzie of the Economic and Social Research Council, chaired by Brian Caplen, editor of the Banker Magazine.
The Economic and Social Research Council (ESRC) is the UK's leading agency for research funding and training in economic and social sciences.
Established in 1965 as the Social Science Research Council, under a Royal Charter, the ESRC covers a wide range of disciplines, ranging from anthropology to statistics with a budget that has grown from £73 million in 2001-02 to £204 million in 2009-10. Financial services are a key sector for the Council's business engagement strategy. The ESRC is partnering with the Technology Strategy Board on the new Financial Services Knowledge Transfer Network.
This evening the ESRC has kindly agreed to host a discussion focused upon the Future of Banking featuring three very distinguished scholars.
Professor David De-Meza is with the London School of Economics and has published many papers on banks policies in a wide range of journals. He is the on the Council of the Royal Economic Society and the Institute of Economic Affairs; Associate Editor of the Journal of Industrial Economics and Joint Managing Editor of the Economic Journal.
Professor Donald MacKenzie is a Professor of Sociology at the University of Edinburgh, with work that has constituted a crucial contribution to the field of Social Studies of Finance. He has also undertaken widely-cited work on the history of statistics, eugenics, nuclear weapons, computing and finance, and was awarded the Chancellor's Award from HRH Prince Philip, Duke of Edinburgh and Chancellor of the University of Edinburgh, in August 2006 for his contributions to the field of Science and Technology Studies.
Professor Ray Barrell is a visiting professor at Brunel University, Director of Macroeconomic research and Forecasting for the UK and World Economies, and Senior Research Fellow at the National Institute of Economic and Social Research. Previously, he has been a visiting Professor of Economics, Imperial College, London from 1996 to 2004, and was a part-time professor at the European University Institute, Florence, 1998-1999. He is on the editorial boards of Economic Modelling and was on the board of the Journal of Common Market Studies until 2007.
Whilst I hid in Singapore last week, Finovate - the excellent financial innovation conference run by Jim Bruene and co at NetBanker - took place in San Francisco. I wanted to go this year, as Finovate is definitely the one place you will find the NEXT generation of banking and financial solutions and providers.
The way it works is that the NetBanker team pick out the most innovative firms in the online financial world and invite them to appear on stage for seven minutes to pitch their wares. At the end, a small few are picked out and tipped for the top, with previous winners including highly disruptive and now successful firms such as SmartyPig and MINT.
There was obviously a good buzz going on there this year, with over thirty-six firms getting their seven minutes of fame in front of a record audience of 500 industry executives ...
The winners of the Finovate awards for Best of Show were announced on Wednesday last, and these are:
Bobber
Interactive: Launched a youth-oriented online
banking/savings program with gaming and social features.
Expensify:
Demoed new tools for managers to track and monitor employee
spending via "expense reports that don't suck."
oFlows:
Showed its new end-to-end paperless loan-
application system.
Wikinvest:
Launched its new Hurricane stock information system to
deliver real-time info faster than other outlets.
Meanwhile, other bloggers have been commenting, with Tom Cochrane picking out these firms to be of note:
Wikinvest: There would seem to be little doubt about
the future success and impact of this company. Financial services data
aggregation is a common theme at Finovate but it is rapidly becoming a
commodity. Wikinvest is heads and shoulders above the field when it
comes to leveraging data aggregation to provide interesting
features/analytics and outstanding products.
Kabbage: On-the-fly credit risk analysis and
lending to online sellers. This is something very different, innovative
and potentially disruptive. An impressive demo with an applicant’s
account funded in less than 7 minutes.
Bobber Interactive: I am not sure whether this was a
product or a very elaborate demo that has yet to become a product. In
any event, it was very impressive and I am certain would appeal to my 15
year old nephew. Certainly seems that this company and demo should
have caught the eye of any early stage venture investors in attendance.
Cortera: Think of a Web 2.0 version of Dun and
Bradstreet that is focused on small medium sized businesses. In other
words, commercial credit analysis and information with a social media
bent that covers the vast majority of American business. Not
necessarily sexy, but very, very interesting.
Continuity Control: Financial institution compliance
services. Seems like a no-brainer in light of pending financial reform
and everything other crisis-reform cycle that has taken place in the
financial services sector over the past decade or so. A solid
presentation and what appears to be a solid management team.
eRollover: Have to them a nod as the company hits
close to home with the focus on retirement planning. Also spent some
quality time with their very high quality CEO . A breath of fresh air
for the retirement income industry and a company we will
continue to follow.
Meanwhile, if you wanna know more, it would do you no harm to follow their twitter stream.
Finally, there are two more Finovates coming up in the next year:
FinovateFall, October 4th and 5th, New York (I've already booked my ticket); and
This is so politically incorrect that I almost didn't post it ... but then I did to show how cultures are different and sensitivities are not the same.
As I left Singapore, I saw this and felt quite offended:
Yet Singaporeans are desperate to avoid offending foreign visitors, as are most Asian countries, so how could I be offended?
Well, look more closely ...
I'm sure that my Western colleagues will get the point.
No wonder, following on from Damian Glendinning's points raised earlier, that we don't always agree:
But then we arrive in Asia and handout business cards with one hand and immediately put a received business card in our pocket without reading it.
In Asia, the protocol is that we should offer the business card to the receiver as a gift, with the upper top corners held in each hand so that the card is presented the right way round to be readable. Similarly we should take their card with honour, and read the details of title properly before putting the card away.
These nuances of societies are brilliantly described in Richard Lewis's book, When Culture Collide, and have been used in HSBC's advertising to great effect for the past eight years.
It was 2002 when this ad first aired ...
... and it's true.
When global, think local, so I wasn't offended after all, as the meaning of the word is not intended.
Some years ago, I delivered a presentation as a keynote with the title: “All Bankers are Criminals”.
I actually didn’t mean “all”.
The chicken feed, battery farmed, commercial, transactional and retail bankers are pin-stripe suited, humble pie, nice guys.
I was talking about the evil animals of Wall Street and the City.
These jungle animals hunt you down, rip out your wallet and tear your money apart note-by-note.
OK, I exaggerate a little, but you get the idea.
The first time I gave this presentation was back in Summer 2005 at a European Conference, and repeated it again in Spring 2006, as an Associate Director of TowerGroup.
The theme of the presentation mainly came from Frank Partnoy’s excellent book Infectious Greed, which traces the growth of weapons of financial destruction: derivatives, as named by Warren Buffett in his 2002 shareholder letter.
It is quite clear from this book that unchecked investment markets will run free of scruples and morals. This is what happened with Frank Quattrone of Credit Suisse and the dotcom boom and bust, along with many other examples through history.
It is not necessarily as true when we talk about arbitrage strategies and the John Meriwether’s of this world. However, these people are far more dangerous because they create financial markets systemic risk that can bring down companies and countries.
For example, in case you are wondering who John Meriwether is, he was one of the first arbitrage players and built Salomon Brothers into the big swinging dick master of the universe world so brilliantly depicted in Michael Lewis’s book Liar’s Poker.
With his colleagues, the use of arbitrage instruments led to the downfall of Salomon Brothers – they were subsequently merged into Citigroup – and Meriwether went on to create Long Term Capital Management (LTCM).
In 1998 LTCM lost $4.6 billion in less than four months and became the leading case study for how systemic risk created by derivatives products, combined with massive leverage
and arbitrage risk-models, creates a financial deck of cards. A deck that can rise and fall in the blink of an eye, with the latter potentially ruining companies, markets, countries and governments, as happened in the most recent crisis.
Anyways, not to be dissuaded from his cause, Meriwether went on to found JWM Partners, another highly leveraged "relative value arbitrage" firm. Yet again, he built leverage through this hedge fund from its opening with $250 million under management in 1999 to a massive $3 billion firm by 2007. Of course, it was all just on paper as the latest crisis battered the fund, losing almost half of its value between September 2007 and February 2009. The deck of cards strikes again. It closed in late 2009 and guess what? Meriwether’s about to launch yet another hedge fund, based upon just the same concepts.To me, this is the criminality of the financial system in action. Firms that build highly leveraged derivatives instruments for short-term arbitrage, with unproven skills and massive risk.Not that I’m calling Meriwether a criminal, as it’s all perfectly legitimate under SEC and FSA Rules.Or it was.It may be that the Goldman Sachs furore will change all this.You see, Goldman Sachs, like Meriwether, is very good at taking leverage and risk and managing the markets to gain short-term profit. Like Meriwether, Goldman Sachs succeeded in using these tools and instruments to generate massive profits. They achieved a record 131 trading days last year, in which the bank made at least $100 million net trading revenue each day.
Unlike Meriwether, Goldman Sachs managed to offload and hedge their risks back to others, such as AIG and IKB, such that when the markets collapsed their clients, suppliers and partners got burnt, but not them.Nothing wrong with that, as it’s all perfectly legitimate under SEC and FSA Rules. Unless the SEC and FSA find Goldman Sachs guilty of fraud.But how can they be guilty of a crime that was not a crime at the time it was committed?There’s the rub.I’m sure the SEC will aim to build a bulletproof case, and their cause is a worthy one: clean up the financial system. Is it worthy to do this so publicly?Not sure.Is it worthy to name the defendant up front, when the burden of proof has yet to be proven?Not sure.The Goldman Sachs case is actually more like watching a rape trial in action, where the defendant is a shifty looking guy who probably seems guilty whether guilty or not.For example, if you name someone like Jack Tweed in the UK, you might still associate him with being a rapist even though he was found not guilty.The guilt sits there, and that’s what will happen with Goldman Sachs.Whether guilty or not – and they’ve hired the best team possible to defend themselves, including “Master of Disaster” Mark Fabiani – we will always associate Goldman Sachs with something smelly for the foreseeable years to come.Ho-hum.At least all of this seems to inspire some humour. For example, in an April episode of hit comedy US TV series This American Life (TAL), they tell the story of a hedge fund that comes up with an elaborate plan to make money. It sponsors the creation of complicated and ultimately toxic financial securities while, at the same time, betting against the very securities it helped create. TAL commissioned a Broadway song to go along with the story:
The only thing that really gets me, in finishing this blog entry, is Warren Buffett.The Sage of Omaha has made his billions through prudent focus upon ‘value investing’. That means investing in strong and robust businesses like Coca-Cola, American Express, Gillette and the Washington Post. So when he referred to derivatives as ‘weapons of financial destruction’ in his shareholder letter of 2002, I respected the man and his integrity of thought.Now, having found Goldman Sachs under attack, he has stepped up to their defence, and I wondered why.Warren Buffett is an intriguing character, as we all know. The friend of kings and kingmakers, he walks a path separate to most.He knows the dangers of arbitrage, derivatives and leverage, because he had to step into Salomon Brothers in 1991 to clean up Meriwether and his colleagues mess.An extract from Carol Loomis’s in-depth review of Buffett’s experience at Salomon’s:
“You may reasonably ask what was going on in Salomon's stock while all of this was transpiring. It was emphatically down, from above $36 per share on Friday to under $27 on Thursday, when the second press release rocked the market. But the stock was only the facade for a much graver matter, a corporate financial structure that by Thursday was beginning to crack because confidence in Salomon was eroding. It is not good for any securities firm to lose the world's confidence. But if the firm is "credit dependent," as Salomon was to an extreme, it cannot tolerate a negative change in perceptions. Buffett likens Salomon's need for confidence to a mortal's need for air: When the required good is present, it's never noticed. When it's missing, that's all that's noticed.
“Unfortunately, the erosion of confidence was occurring in a company grown enormous. Salomon in August of 1991 had bulged up to $150 billion in assets (not counting, of course, huge off-balance-sheet items) and was among the five largest financial institutions in the U.S. Propping the company on the right-hand side of the balance sheet was--are you ready?--only $4 billion in equity capital, and above that was about $16 billion in medium-term notes, bank debt, and commercial paper. This total of about $20 billion was the capital base that supported the remaining $130 billion in liabilities, most of these short-term, due to run off in one day to six months.”
The result meant that Warren Buffett had to actually take over physically as manager of Salomon Brothers for a nine-month period, and it was emotionally exhausting for him.
Switch to 2010.
Warren Buffett invested heavily in Goldman Sachs in September 2008 – when Lehman Brothers, Merrill Lynch and Morgan Stanley were all imploding – buying $5 billion of preferred stock at a 10 percent dividend. These investments earn him $950 a minute, or $500 million a year today. No wonder he claims to be in love with that investment.
Trouble is that the alleged fraud at Goldman Sachs has really hit their share price. For example, Standard & Poor's downgraded Goldman
shares to "Sell" and lowered their target price by $40 to
$140 the other day.
Thinking back to Salomon's - if the firm is "credit dependent," as Salomon was to an extreme,
it cannot tolerate a negative change in perceptions - Buffett must be seriously worried about Goldman Sachs losing its credit worthiness, especially as it depends on good credit.
Oh yes, and having called derivatives ‘weapons of financial destruction’, guess what? Berkshire Hathway, Warren Buffett’s investment firm, has a massive portfolio of derivatives investments. From the Wall Street Journal last week: “Democrats took a step toward their goal of overhauling financial regulation, reaching a tentative deal to set restrictions on trading in exotic financial instruments known as derivatives. Among the considerations still in the balance: A big provision being sought by Warren Buffett in recent weeks ... the provision, sought by Berkshire and pushed by Nebraska Senator Ben Nelson in the Senate Agriculture Committee, would largely exempt existing derivatives contracts from the proposed rules. Previously, the legislation could have allowed regulators to require that companies such as Nebraska-based Berkshire put aside large sums to cover potential losses. The change thus would aid Berkshire, which has a $63 billion derivatives portfolio, according to Barclays Capital.”
Hmmm ... maybe that greed is infectious, although Morningstar Analyst Bill Bergman supports Mr. Buffett's exemption by stating that: "claiming Berkshire poses a risk to the financial system is a difficult
case to make."
Either way, the US movement towards an approval of a Financial Reform Bill to handle the issues of banks that are 'too big to fail' yesterday, takes it one step nearer to the American system taking a lead role towards a new financial architecture.
Derivatives are next ... and Warren Buffett, like Lloyd Blankfiend at Goldman Sachs and all of those current and former bankers and brokers who dealt in toxic derivatives across the world, must be worried.
Postnote: here is Berkshire Hathaway’s full commentary on derivatives from that shareholder letter back in 2002:
Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.Having delivered that thought, which I’ll get back to, let me retreat to explaining derivatives, though the explanation must be general because the word covers an extraordinarily wide range of financial contracts.Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values. If, for example, you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction – with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration (running sometimes to 20 or more years) and their value is often tied to several variables.Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands.The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen). At Enron, for example, newsprint and broadband derivatives, due to be settled many years in the future, were put on the books. Or say you want to write a contract speculating on the number of twins to be born in Nebraska in 2020. No problem – at a price, you will easily find an obliging counterparty.When we purchased Gen Re, it came with General Re Securities, a derivatives dealer that Charlie and I didn’t want, judging it to be dangerous. We failed in our attempts to sell the operation, however, and are now terminating it.But closing down a derivatives business is easier said than done. It will be a great many years before we are totally out of this operation (though we reduce our exposure daily). In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit. In either industry, once you write a contract – which may require a large payment decades later – you are usually stuck with it. True, there are methods by which the risk can be laid off with others. But most strategies of that kind leave you with residual liability.Another commonality of reinsurance and derivatives is that both generate reported earnings that are often wildly overstated. That’s true because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them.Those who trade derivatives are usually paid (in whole or part) on “earnings” calculated by mark-to-market accounting. But often there is no real market (think about our contract involving twins) and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counterparties to use fanciful assumptions. In the twins scenario, for example, the two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.Of course, both internal and outside auditors review the numbers, but that’s no easy job. For example, General Re Securities at yearend (after ten months of winding down its operation) had 14,384 contracts outstanding, involving 672 counterparties around the world. Each contract had a plus or minus value derived from one or more reference items, including some of mind-boggling complexity. Valuing a portfolio like that, expert auditors could easily and honestly have widely varying opinions.The valuation problem is far from academic: In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” – until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly “mark-to-myth.”I can assure you that the marking errors in the derivatives business have not been symmetrical.Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counterparties tend to build up over time. (At Gen Re Securities, we still have $6.5 billion of receivables, though we’ve been in a liquidation mode for nearly a year.) A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. Under certain circumstances, though, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times.In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain.When a “chain reaction” threat exists within an industry, it pays to minimize links of any kind. That’s how we conduct our reinsurance business, and it’s one reason we are exiting derivatives.Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.Indeed, in 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-TermCapital Management, caused the Federal Reserve anxieties so severe that it hastily orchestrated a rescue effort. In later Congressional testimony, Fed officials acknowledged that, had they not intervened, the outstanding trades of LTCM – a firm unknown to the general public and employing only a few hundred people – could well have posed a serious threat to the stability of American markets. In other words, the Fed acted because its leaders were fearful of what might have happened to other financial institutions had the LTCM domino toppled. And this affair, though it paralyzed many parts of the fixed-income market for weeks, was far from a worst-case scenario.One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the bank realizes.Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.
Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.
Just back from a short haul flight to Spain. Reading the BA Business Mag, I stumbled across this (doubleclick photo to see the full-size picture):
Yes, it's Joseph Stiglitz: Poster Boy!
Actually, it's the Nobel prize winner Joseph Stiglitz, economist and professor at Columbia University.
In a short interview, he talks about life and views of the world and the financial crisis, with a key section on the bank bailout:
You’re very critical of the bank bailouts worldwide and
particularly in the US. Why?
The main reason is that
the bailout failed to do what it was supposed to do, which is rekindle
lending. It gave money unnecessarily to the banks without getting
anything in return, the result of which is that we have a much bigger
national debt than we otherwise would have had, if we’d done it better.
And we didn’t have any vision of where we wanted the financial system to
go, so we’ve wound up with a more distorted financial system with more
weight on the gambling institutions and less weight on the institutions
that actually create a better economy. Because we bailed out the banks,
and not just the banks but the bankers, shareholders and bondholders, we
enhanced the problem of moral hazard — we created a system of ersatz
capitalism where we socialised the losses and privatised the gains.
For example, I stumbled across a great discussion about the future of the internet with Google CEO Eric Schmidt:
This is a 45 minute interview with Mr. Schmidt at a Gartner Symposium in the USA last year.
Key comments from the interview, identified by Read-Write Web, include:
Five years from now the internet will be dominated by Chinese-language content.
Today's teenagers are the model of how the web will work in five years - they jump from app to app to app seamlessly.
Five years is a factor of ten in Moore's Law, meaning that computers will be capable of far more by that time than they are today.
Within five years there will be broadband well above 100MB in performance - and distribution distinctions between TV, radio and the web will go away.
"We're starting to make significant money off of Youtube", content will move towards more video.
"Real time information is just as valuable as all the other information, we want it included in our search results."
There are many companies beyond Twitter and Facebook doing real time.
"We can index real-time info now - but how do we rank it?"
It's because of this fundamental shift towards user-generated information that people will listen more to other people than to traditional sources. Learning how to rank that "is the great challenge of the age." Schmidt believes Google can solve that problem.
This stumble was followed by an email from FSClub friend Milos Hoschek who sent me a link to this video of PayPal's vision for the future:
Fantastic. Everywhere you go, you pay with PayPal.
What happened to Visa and MasterCard I wonder?
It reminds me much of a video made by AT&T in the 1990's:
Recognise the voice? Here's a clue:
Anyways, strong American male cheesy voice-overs are the de facto standard for technology future focused videos, as evidenced by this one from Microsoft:
I don’t know if any of you read the IMF report recommending two new bank taxes:
a bank levy based upon the risk banks represent, called a Financial Stability Contribution (FSC); and
a straight tax on profits and bonuses called the Financial Activities Tax (FAT).
If you haven't, then I can recommend it's worth a skim. For example, they reject the Tobin Tax / Robin Hood Tax idea, saying that this would just get passed on to customers by the banks.
However, the fact that they support the idea of a levy and a tax – a double whammy – could have bankers worried ... except that bankers are pretty clever at tax avoidance and Canada and Japan have said they won’t implement these plans so it’s a G18 agreement right now, or less.
In my view, the document is also flawed. Here's why.
Now the actual content is debatable and not set in stone.
As I said, it’s for discussion.
But it does contain some really interesting appendices which are noteworthy as useful research materials, covering diverse subjects from each country’s proposals for reform to their contributions to the bank crisis to date.
For example, here are the amounts announced or pledged for financial sector support so far, as a percentage of 2009’s GDP (doube-click chart to see a bigger version):
What this shows is that for the ‘advanced economies’ – think USA, UK, France, Germany, Japan et al – the cost has been 6.2% of GDP in direct support and a further 10.9% in guarantees.
The total of columns A to E represents 29.8% of advanced economies’ GDP in 2009.
That compares with 1.8% in the emerging economies – think the BRICs, Indonesia, et al.
Mind you, they then go on to say that “for the advanced G-20 economies, the average amount utilized for capital injection was 2 percent of GDP, that is $639 billion, or just over half the pledged amounts. France, Germany, the USA and the UK accounted for over 90 percent of this. For the advanced G-20 economies, the utilized amount for asset purchases was around 1.4 percent of GDP, less than two-thirds of the pledged amount. Similarly, the uptake of guarantees has been markedly less than pledged.”
This is why the report reckons that the global financial crisis has cost about $533 billion less than originally estimated, and is now just a mere $2.28 trillion when all is said and done.
Now how much is $1 trillion again?
Thanks Mint.
So yes it’s still a lot, but it’s half a trillion dollars less than before.
Phew!
Now who’s the daddy when it comes to global bailouts and guarantees:
Wow, the UK wins!
We’re number one, we’re number one, we’re number wohohohohone.
Wait a minute.
That means we’re #1 in global bailouts of banks.
Hmmm ... not sure if we should be so thrilled with that accolade and maybe this is why Gordon Brown is so keen on the idea of a Tobin Tax or a Robin Hood Tax or a Financial Activities Tax or ... well, any tax really to help with our debt mountain to be honest ...
Source: the Daily Mail
... as the burden of national debt amongst the G7 nations is at a 60-year high, with the UK’s Treasury planning to increase national debt by over £560 billion between now and 2015. That’s about $800 billion or almost a trillion (how much is a trillion again?).
Meanwhile, the emerging economies paint a very different picture:
Apart from Russia, this crisis has cost the key future economies of the world urrmmmm ... nothing.
These charts make it clear that NINE of the G20 nations have had no crisis. Add to this the fact that Canada’s financial system has been the most stable in the world, and Japan do not intend to implement these tax and levy options, and you realise that under half of the G20 will be keen to support any radical changes to the financial markets.
It's not as clear cut as this, as the fact that the Advanced Economies bailouts allowed the Emerging Economies to survive this crisis without their economies also imploding is a key part of the dialogue.
Another useful chart shows why the IMF has reduced the bailout numbers by $533 billion where financial markets have used far less of the pledged amounts than those offered by their respective governments:
Finally, these charts are followed by a review of each country’s bank taxation policies implemented or proposed (Appendix 2, Page 32), a review of corrective taxation and prudential policies (Appendix 3) and the current taxation policies (Appendix 4).
This last section is also particularly intriguing as it demonstrates why banking has been so critical to Gordon Brown’s policies of the past decade. For example, here’s the percentage of a country’s total tax pool raised from financial firms by country.
G20 Corporate Taxes Paid by the Financial Sector (in percent)
This makes it clear that for every country, but particularly for Italy, Turkey, Canada and the UK, the role and influence of the financial sectors on their economies and government policies is fundamental to the country and its economic and public sector health.
Without bank taxes, countries fail.But with bank failures, countries fail.And that is their Catch-22 and the reason why this is so hard to change.
Between domestic interests and focus, aligned with the radically different ways in which this crisis has impacted each G20 nation, it is unlikely that we shall ever see a simple agreement of policy reform now, or at the G20 meeting in Toronto in June.
The International Monetary Fund's managing director said he worried
that rivalries among countries could thwart a global overhaul of
financial regulation, as governments split over the merits of an IMF
proposal to levy a new tax on the world's banks.
"The risk…is that different parts of the world will have their
proposals which make sense" to them, but "which may be somewhat
inconsistent," Dominque Strauss-Kahn said at a press briefing ahead of
this week's meetings of financial officials from around the world.
There are so many articles and analysis into Goldman Sachs practices at the moment ...
... that I’m not going to write a lengthy analysis to add to all of these, but have picked a few of the best articles at the end of this blog entry.
What I would like to say is that the Goldman Sachs area of this blog shows that the SEC’s actions announced last Friday could be easily anticipated. From their near admittance of market manipulation in July 2009, followed in August 2009 of talk about the SEC looking at their flash trading practices; to the comments I made in January about the fine line “between making markets and moving markets that Goldman walk. It will be interesting to see how Goldman and company make markets in the future, between the Obama tax and the new regulatory regime.”This was followed by the way they had to defend themselves recently, as evidenced by Chief Executive Lloyd Blankfiend’s letter to shareholders earlier this month.
Now the USA’s SEC has announced their formal investigation of Goldman Sachs, followed by the UK FSA's agreement to coordinate this investigation across borders.
There has to be a concern about their future.
Here’s my take on it.The case for Goldman Sachs
They are the world’s most successful investment bank
They are able to create incredible profits from complex instruments
They are the preferred choice of most clients for investment advice for these reasons, and this is why they maintain their success
The case against Goldman Sachs
They are the world’s most successful investment bank ... and most of their brethren – Bear Stearns, Lehman Brothers, Merrill Lynch have imploded through this crisis
They are purely driven by greed and pay massive bonuses
They manipulate markets in their own favour
Sure the list could be longer, and sure we can argue the toss over some of these points, but overall there could be a case of saying the investigations into the bank are all driven by schadenfreude and political motivations. For example, Barack Obama presents his financial reform bill to the Senate this week, so what better timing.Nevertheless, for the SEC to have “Pit Bull” Richard (Rick) Simpson in there litigating against the bank, means that there has to something in this and that must be a worry for them. Equally with the share price dropping 13 percent on Friday and further again today, even with their stunning results of $3.6 billion profits and $5.5 billion in bonuses for the last quarter, the reputation of the bank is taking a battering.The core of this debate is the question: does Goldman Sachs make stunning profits – over $100 million every day for 131 trading days last year – by betting against clients?If the answer is yes, then it’s more a case of Sack Goldmans rather than Goldman Sachs.Best of the media coverage from The Week, via the NY Times, Reuters, Naked CapitalismWhy the SEC is going after the Wall Street powerhouse, and what it means for the financial industryThe Securities and Exchange Commission took on Wall Street titan Goldman Sachs on Friday, filing a potentially explosive civil lawsuit accusing the investment bank and one of its mortgage traders, Fabrice Tourre, of fraud. (Watch a CBS report explaining the SEC's charges.) Here's a brief rundown of the charges, and what they could mean for Goldman, Wall Street, and financial reform legislation:
What is Goldman accused of?
The SEC says that Goldman created and sold a package of mortgage-backed securities to investors in 2007 without telling them that the person who picked or approved the securities, hedge fund manager John Paulson of Paulson & Co., was betting heavily that they would fail. Goldman brought in independent fund manager ACA Management to help pick the portfolio, allegedly to make the deal seem more trustworthy. But the SEC says Goldman misled ACA, too, not disclosing that deal "sponsor" Paulson was betting against, not on, the investments. Paulson's role was withheld from investors, too.
What's Goldman's defense?
That the investors who bought the securities were given "extensive information" about the securities they were investing in, and were "sophisticated" enough to know that somebody was going to take the opposite side of their bet. Also, Goldman says that while it earned $15 million in fees, it lost $90 million in the deal, although it didn't explain how.
Who else lost, and made, money on the deal?
The investors collectively lost $1 billion, with the primary losers being ACA Capital and German bank IKB. Paulson & Co. earned almost $1 billion in profit.
Is Paulson being charged?
No. Legal scholar Alan Dershowitz thinks that was a somewhat arbitrary choice by the SEC, though, saying in The Daily Beast that Paulson "could easily have been charged with conspiracy to defraud."
How damaging is this for Goldman?
Analysts say the hit to Goldman's "seemingly invincible" reputation could be much worse than any punitive damages. Given how important trust is on Wall Street, "it's very bad for business" if your clients think "you are doing shady things," says NYU law professor Marcel Kahan. And while any SEC fine would be "really small potatoes" for the firm, Goldman's stock price tumbled 13 percent on the news Friday, erasing more than $10 billion in market capitalization. Also, Britain and Germany are mulling their own investigations, based on the SEC allegations.
Are other Wall Street banks facing similar SEC charges?
It's certainly possible. SEC enforcement chief Robert Khuzami says the agency is stepping up its anti-fraud actions, and specifically looking at "similar deals" involving other Wall Street firms. Until Friday, Goldman employees were able to "sleep soundly after collecting their huge bonuses," says The New York Times in an editorial. Since Goldman wasn't the only bank betting against its own mortgage products, "others on Wall Street may have a harder time sleeping" now, too.
What are the politics of this case?
The SEC is an independent agency, but political strategists and banking lobbyists say the Goldman fraud allegations could help the Democrats pass a financial reform bill. The House passed its version last year, and the Senate finance committee recently sent its version to the full Senate (on a party-line vote) for debate this week. Some Republicans and TV pundits suggest that the announcement was timed to help secure the bill's passage. Business Insider's Henry Blodget says the SEC also might have rushed out the lawsuit to divert attention from a damning internal review of the agency's enforcement over the past few years.
I sometimes get unusual things in the email – no comments thanks – such as the full post-conference write up of a cards and commercial payments conference in the USA last month.
Here’s a few quotes and notes that caught my attention ... Marcie Verdin, Group Head of Large Market Segment, Global Commercial Products (why do people have such strange job titles in American firms) for MasterCard Worldwide stated that there are $90 trillion commercial payments made each year, of which cards were responsible for less than $1 trillion. Oh yes, being a US conference, I guess all of the other payments must be made with paper cheques.As if to back that up Peggy Yankovich, Senior Vice President for Global Transaction Banking Division at HSBC, stated that the total amount of American B2B payments were currently worth around $18 trillion per annum. The majority of these - $14 trillion worth – are for transactions worth over $5,000 each. What is astounding therefore is that cheques accounted for around 70% of B2B payments.Get electronified America!!Thinking that this might be the case, it was nice to see that einvoicing made the agenda with Henry Ijams, Managing Director and Founder of PayStream Advisors, noting that half of all companies were evaluating einvoicing and one in five are currently using this process. Conversely, it was a bit disappointing that 80% don’t use einvoicing though and, most tellingly, 64% said that they process fewer than 25% of their invoices electronically. A long way to go to get efficiency in those processes.
Just to get in on the act, Darren Parslow, Head of Global Commercial Solutions at Visa, estimated that prepaid is worth about $3 trillion of payments.
Interestingly, this was the figure that TowerGroup put on prepaid market for 2010 ... back in 2005!
Tony Cunningham, Vice President Business Development at UATP, then made a point that surprised even yours truly: ‘30% of the largest global retailers now accepted an alternative form of payment such as PayPal’.Wow!There’s a whole load of other useful stuff for those interested in commercial payments, so may well be worth a look.
Story breaking in the USA this week is all about Washington Mutual (WaMu), the Seattle-based mortgage bank closed down by the FDIC in September 2008 to be taken over by Bank of America.
What a difference a year or two makes.
In 2006, just two years before their collapse, an employee annual jamboree for the best staffers took place in Hawaii - the "President's Retreat" - and resulted in a range of amusements which WaMu has been desperately trying to keep secret, but are now revealed in the Senate Committee's investigations.
Not surprising they wanted to keep these things quiet as they had a few fun moments that are great for internal morale and motivation ... but can look a bit dubious externally.
For example, they staged a mock funeral
for
their biggest rival, Countrywide Financial, a mortgage lender that collapsed just eight months before WaMu and, like them, was 'saved' by Bank of America in January 2008.
WaMu's take on Countrywide in 2006?
Well, as four pallbearers entered stage left with a coffin emblazoned with the Countrywide logo, the WaMu host said: “So many of us warned the dearly departed about the risky – some say
reckless – behaviour they engaged in,” and then the sound system broke into the great songtune: Na na na na, na na na na, hey, hey hey, goodbye.
This was followed by the rather amusing rendition of Sir Mix-a-Lot’s hip-hop hit “Baby
Got Back.” Now, you may not be familiar with that song so, just in case, here's the original:
I like big bucks and I cannot lie You mortgage brothers can't deny
That when the dough roles in like you're printin’ your own cash
And you gotta make a splash
You just spends Like it never ends
Cuz you gotta have that big new Benz
All of that bling you're wearin'
Shining so bright peoples starin'
It's crazy, I gotta ski Aspen
That's all I'm askin'
The presentation included cheerleaders moving in time to the
music and choreographed moves by the singers. A kind of Glee, 2006 stylee.
Here's the whole of the original papers aired in court:
The first tale is The 13 Bankers by Simon Johnson and James Kwak. I hope they don’t mind being so prominently mentioned. There is no affiliation, except that they and I, and some of you, are living in these times and responding to the them. Their tale, a history, is about banking, where it came from, what it came to, what it could be and how it was hijacked. I encourage you to read this book. You will find it liberating because transparency and truth are always liberating. We think that power has been taken from us, but it is easily enough taken back, if we realize that we are free to choose. We will discuss how we come to feel free.
The second tale is that from a southern university. It is the story of the 12th Man at Texas A&M. The 12th at Texas A&M was an “everyman” who was there to support his team. When needed, he stepped out of the masses, donned the uniform and joined his team on the gridiron for the battle. For this to be a useful metaphor we have to decide several things. Who do we stand with? What crowd? What common interest? What motivates us to step out? Is it our own greatness? I hope never. Courage and conviction are more than enough. We don’t need any more “greatness” in this industry. How many of the “greats” have fallen? What is the battle about? Much more than a sporting event this time. Who is our opponent? A heavy favorite no doubt. Overwhelming. Invincible. At least that is how they appear. Is the opponent strictly a separate person or entity or is it something we must excise from ourselves first?
Perhaps The Fourteenth Banker will become a symbol, much like the 12th man.And why is the blog worth reading?I guess that’s answered by the Huffington Post’s interview with him. They introduce the interview with these lines:
‘The system is built to be gamed.’ ‘The voices of dissent are not being heard.’ These are the words of an anonymous executive at one of America's 10 largest banks, who after many years of watching the worst of Wall Street's ethics transform his company, has decided to speak out ...
At the heart of the executive's moral crisis is his bank's compensation structure, which has come to resemble the pay schemes of bank trading operations. Though he hasn't been explicitly told to stop making loans, he says the retail banking industry's compensation systems have come to put an outsized emphasis on selling fee-based products (think credit cards) and acquiring deposits. In other words, it no longer pays for him to actually lend money. Here’s a brief summary of the interview itself (for the full monty, click here).
Question: What is your job at the bank?
Answer: I deal [in] traditional bank branch activities, commercial lending and lending to businesses below the large corporate level.
Q: why did you choose to speak out now?
A: I decided that I cannot live with the extent of the compromises to my value system. My choices then are to leave or to try and change things. But when you leave, then you leave behind the system intact, you leave behind your customers, your fellow employees and you leave behind the system. The reason I'm choosing to speak out now is that neither of those are acceptable choices to me.
Q: Was there a specific moment that prompted you to speak out?
A: With my particular organization in the last few years, there has been change in management and ... the Wall Street mentality has been pushed into the traditional bank, and it's not always welcome there. It's welcome to the extent that people can make a lot money, but it's not welcome to the extent that it becomes all about money.
Q: How has that impacted your bank’s relationships with clients?
A: I've sat with people been who've been deflated. They'll say, "Why are you kicking me when I'm down? 2009 is the one year in which I have had really bad results which, by the way, big bank, you had bad results too, and yet you're in the position of power and you're kicking me when I'm down?" That's a natural human reaction... but those kind of conflicts are now coming up more often then they should.
Back in 2004, I asked a group of bankers when mobile would take off in banking. They all said: “not in our lifetimes”.
In 2007, Bank of America launched their mobile banking applications and has seen a rapid uptake of users. In less than a year, they reached a million customers on mobile, and saw a further 300% growth in 2008. It took them over a year to get the first million customers; a pregnancy period of just nine months to get the second million; and a short six months to get the third.
According to Doug Brown, the man responsible for mobile banking at Bank of America, the speed of take-up is accelerating even faster in 2009, with 150,000 new mobile customers in September 2009, 210,000 in August and 220,000 in July.
What are they doing?
99% of mobile users’ view balances, 90% view transaction details and about $10 billion of funds have been moved via mobile.
But this is not just for existing accountholders wanting account access. The bank has gained over 150,000 new accountholders from competitors during 2009, just because they wanted mobile banking.
So far so good.
Now jump to Africa.
M-PESA is the story in Africa.
M-PESA is the mobile text service introduced by Vodafone’s subsidiary, Safaricom, back in 2007. Suddenly a country with zero electronic methods for making payments for the masses had an electronic access which has revolutionised the country.
Within a year, one in five Safaricom users were using M-PESA to make payments, and one in ten Kenyans had used the service. By November 2009, M-PESA had become the world’s biggest mobile money service with over 10% of Kenya’s GDP moved by mobile payments. Accidentally, Safaricom had become the biggest bank in Kenya with 8 million users registered and over $2 billion transferred by mobile.
Now M-PESA is being expanded into Nigeria, South Africa and other African countries, whilst banks are saying that customers are actually switching banks to get mobile channel access.
Now jump to Japan.
A bank launched in Japan in June 2008 called Jibun Bank.
Jibun Bank is a mobile only bank. The Bank is designed for access via mobile only. You try to use the bank online, and it’s rubbish. As for branches, forget it. This is a multimedia rich, mobile only bank.
The bank is a joint venture between the Bank of Tokyo-Mitsubishi UFJ and telecom operator KDDI.
Jibun Bank, which means my bank, gained 500,000 account openings in just eight months and, after eighteen months, had Y140 billion ($1.5 billion) of deposits by December 2009, from over 850,000 accounts.
At the start of March 2010, the bank opened their millionth account.
What is the point of these three short case studies?
Well, there are many, many examples of banks innovating with mobile worldwide today, but the lesson is this.
In 2004, bankers believed this revolution would not take place in their lifetime.
One banker actually said to me, in writing: “I think this idea is way out there – ten to twenty years – before this plays out in any sizable way.”
Six years later, the battleground is already defined and being won.
Are you fighting in this space?
Have you lost already?
As those who follow this blog know, I write regularly about services such as Facebook and PayPal.
This is because they are disruptive and fresh, as well as being incredibly successful. For example, Facebook is now the world’s #1 website, bigger than Google. Not bad for a five year old. Meantime, PayPal is still growing fast, making over $95 a second in revenues based upon $3 billion in revenues this year. This makes them the interweb’s sixth most successful website by earnings. Not bad for a ten year old.But these sites are not the be-all and end-all. You have to bear in mind that they are purely popular in their language of origin: English.
As a result, there are several other search engines, social networks and P2P payment services that are succeeding out there, from China’s QQ to Russia’s Yandex.
Here's a world map of social networks, taken from the blog of Vincos, Italy (doubleclick to enlarge picture):
Although Facebook is a big hit worldwide with 400 million users, it’s tiny in some countries like the Czech Republic (Lidé is the #1 social network), Hungary (iWiW), India (Google’s Orkut), Japan (Mixi), Netherlands (Hyves), Philippines (Friendster), Poland (Nasza-Klasa), Russia (vkontakte), South Korea (Cyworld), Taiwan (Wretch) ...
Similarly, PayPal is hardly recognised in some countries. In the Netherlands, for example, the banks launched iDEAL, a set of standards to facilitate online payments. iDEAL was created in 2005 by a range of participating banks with ABN AMRO, ASN Bank, Fortis, Friesland Bank, ING, Rabobank, SNS Bank, SNS Regio Bank and Triodos Bank on board today.Some of the major features of iDEAL include the fact that it offers both real-time payment initiation and authorisation by both the issuing and acquiring bank, followed by irrevocable credit transfers to the merchant at the time of online purchase.The participation of the banks along with real-time processing, has created a strong perception of iDEAL being SAFE. As a result, iDEAL has gained over 15,000 participating merchants and 5.8 million users, resulting in a total of 45 million transactions in 2009 worth over €3.4 billion (up 60% over 2008). * maandtotalen = monthly total In other words, iDEAL has a 40% market share of all e-payment transactions in the Netherlands, with an acceptance rate at almost 9 out of 10 online merchants (88% of all Dutch merchants) compared with only 1 in 4 for PayPal (although that’s up on 1 in 5 a year ago, thanks to the decline of AMEX in the Netherlands). So the banks do have a PayPal service equivalent ... but, right now, only in the Netherlands, although iDEAL aims to expand across more of Europe by gearing up for SEPA Credit Transfers (SCT) and the Unify XML standards.Meanwhile, in Russia, their version of Google Checkout has taken a place ahead of the market.Google Checkout is actually called Yandex.Money run by Yandex, Russia’s largest search engine.According to Liveinternet.ru, Yandex increased its share of search traffic from 56% in January 2009 to 59% in December to 62% in February 2010.
Yandex.Money claims to be the leading online payment system in Russia as a wholly owned subsidiary of Yandex. Founded in 2002, Yandex.Money has seen payment volumes grow 135% CAGR, processing 21.5 million transactions per year worth $350 million.
This may sound small, but the appeal of Yandex.Money is for the vast numbers of unbanked and underbanked Russians who want to deal online.
Yandex.Money provides over a million prepaid cards per year through 100 distributors, to be used in over 50,000 participating outlets all over Russia. They have over 200,000 participating terminals to load cash on the cards in 80 of Russia’s largest cities, and 1 in 5 customers use them as top-up wallets. Meanwhile, 61% of users pay directly from the Yandex.Money interface online.
So Russia’s online payments market has developed a slightly different way.Meanwhile, China has an incredible story of the success of Alipay, a division of Alibaba the B2B ecommerce portal.
Alipay is China's primary payment platform thanks to being the preferred payment system for sister firms Taobao and Alibaba.com, along with over 460,000 external merchants. The result is that Alipay has a 49% market share today for all online payments in China:
Q1 2010 market share figures from iResearch
Equally, it has a larger userbase than even PayPal with over 300 million registered users as of March 2010, with five million transactions per day worth an average RMB 1.2 billion (US$176 million).
Why should this be of interest to our global banking community, and PayPal specifically?News Headline, April 11th 2010: “Alipay, China’s largest online payment network, has announced that Alibaba Group will invest a total of RMB5 billion (US$732 million) over the next five years to upgrade the payment solution for e-commerce in China and around the world.”Serious stuff!Meanwhile, in a non-exhaustive list, there are many other online payment services worth a look including 2CO, AlertPay, Bill Me Later, C-gold, CashU, Dotpay, E-Gold, LiqPay, Mobile Wallet, Nochex, PayPay and Z-Payment.So in future, when I talk about PayPal, don’t forget that we’re also talking about their national equivalents such as iDEAL, Yandex.Money and Alipay. Similarly with Facebook, don’t forget that there’s also Mixi, Hyves, Orkut and Friendster.
The implications of these services on core banking is exactly the same which is that we are seeing the creation of many disruptive, fresh and incredibly successful web services for social and P2P finance ... leading, in future, to social B2B finance.
On April 1st, the European Commission announced their key work plans for 2010.
The plans are wide-ranging and imply a fundamental restructuring of the European banking markets.
If you don’t think it’s going that far, then think again as a wide range of strategic initiatives were announced including a new European supervision architecture and proposals in areas covering everything from derivatives markets, short selling and credit default swaps, deposit guarantee schemes, market abuse, crisis management tools and bank capital requirements. On this last point, they are even mooting a bank levy to generate €50 billion in case of future bailouts.
Alongside all of this, you have the hoo-ha of Paul Volcker’s proposals on getting rid of bank prop trading, which has now been shot down, and Gordon Brown’s Tobin Tax which may go by-the-by as a result of the UK general election.Whichever way you look at it though, we have governments and regulators everywhere saying that things must change, and trying to work out how to change things.Then you have all of the Committees, such as the UK’s Treasury Select Committee and the US congressionally chartered Financial Crisis Inquiry Commission, who are bank bashing on regular occasion to try to work out what things to change.In the case of the latter, they’ve had regular visitations from bank leaders and other besmirched economists and thinkers, to find out what caused the financial car crash of 2008.Of note in this parade of failed financial acolytes was the appearance of Alan Greenspan, the highly esteemed and now generally blamed former head of the US Federal Reserve.Mr. Greenspan makes regular appearances blaming the crisis on everything from the fall of the Berlin Wall and China’s emergence through globalisation, to the banks leveraging of subprime and complex trade-off and packaging of such debt through complex financial instruments.As the man at the helm during the build-up to the crisis, he rarely takes the blame or admits fault. For example, in his latest appearance before the Committee, he states: “In 2002, I expressed concerns to the FOMC, noting that ‘…our extraordinary housing boom…financed by very large increases in mortgage debt – cannot continue indefinitely.’”He may have said this but he omits to mention that, in 2005, he concluded a speech to the American Bankers Association with the closing lines: “In summary, it is encouraging to find that, despite the rapid growth of mortgage debt, only a small fraction of households across the country have loan-to-value ratios greater than 90 percent. Thus, the vast majority of homeowners have a sizable equity cushion with which to absorb a potential decline in house prices.”In fact, about the only accurate thing he said recently is that: “Regulators who are required to forecast have had a woeful record of chronic failure. History tells us they cannot identify the timing of a crisis, or anticipate exactly where it will be located or how large the losses and spillovers will be ... nor can they fully eliminate the possibility of future crises.”Now I don’t want to make this a Greenspan bashing column, as that would be too easy, but I do want to pick up on that phrase: “a woeful record”, as it is very relevant to where we are today.For example, as the European Commission considers its wide-ranging changes, I could pick up on many of their previous attempts to regulate the markets that have yet to succeed and would beg the question: why don’t you fix what you started whilst starting to work out what to fix?After all, we have Basel III, UCITS IV, Solvency II and CRD IV all coming up. Notice something about those? Yes, they are all updates of earlier regulations that did not work as expected.We have the same with regulations that I write about regularly such as MiFID, the Markets in Financial Instruments Directive. In the 2010 workplan, the European Commission announced that they were going to be taking a review of MiFID to make legislative proposals that would include the “dark pools issue”. What this demonstrates is the law of unintended consequences, where MiFID has made everything electronified, fragmented and opaque. The opposite of some of its intentions, which were for transparency and a level playing field.In summary, what worries me right now is: first, that the regulators and policymakers are scrabbling around not knowing what to do; second, that they have obviously got it wrong in the past; third, that they are woeful at working at the future; and finally, that their whole focus on shaking up the banking system will destroy it.Not being too much of a scaremonger am I?
After the long analysis of Jamie Dimon’s 36-page shareholder letter, we now have an 8-page shareholder letter from Goldman Sachs.
I cannot remember such letters being of such interest in the past, and wonder if the let’s tell-all letter writing from Bank CEOs is the new fashion for the teens (or 2010s if you prefer).
Alternatively, Goldmans just don’t like being called names, since this is their longest shareholder letter ever. If anything, it appears to be a direct response to the accusation of being a Vampire Squidlobbed at them last year by Rolling Stone’s Matt Taibbi (who I’m sure will have something to say about this letter).
Mind you, if I had just dished out $16 billion in bonuses for last year, for an average pay of $500k per staffer, you could call me anything you want.
It’s noteworthy that the letter refers to ‘clients’ on at least 56 occasions. A good example being: “We are responding to our clients’ desire either to establish, or to increase or decrease, their exposure to a position on their own investment views. We are not ‘betting against’ them.”
Yea, right.
That’s why Goldman Sachs managed to generate over $100 million in pure profit every day for over 131 days of trading last year I guess, a new record.
It also defends the bank’s controversial employee bonuses, relationship with AIG and role in short-selling the mortgage market.
Here’s a summary of the really juicy bits (the last three pages):
“In July 2007, as the market deteriorated, we began to significantly mark down the value of our super-senior CDO positions.
The letter refers to Collateralized Debt Obligations – click here to find out background on this stuff.
July 2007 was a key point as Goldmans had just lost billions on their Alpha Fund, due to their algorithmic systems messing up.
“Our rigorous commitment to fair value accounting, coupled with our daily transactions as a market maker in these securities, prompted us to reduce our valuations on a real-time basis which we believe we did earlier than other institutions.
They would do this on a real-time basis because their systems are controlling ahead of the markets.
“This resulted in collateral disputes with AIG. We believe that subsequent events in the housing market proved our marks to be correct — they reflected the realistic values markets were placing on these securities.
“Over the ensuing weeks and months, we continued to make collateral calls, which were based on market values, consistent with our agreements with AIG. While we collected collateral, there still remained gaps between what we received and what we believed we were owed. These gaps were hedged in full by the purchase of CDS and other risk mitigants from third parties, such that we had no material residual risk if AIG defaulted on its obligations to us.”
What this implies is that, acting as an intermediary in the markets and as a market maker, Goldman Sachs could see the ensuing implosion in the housing markets and specifically in Credit Default Swaps (CDS) and CDOs, in real-time.
These complex derivatives were integral to their trading strategies for hedging purposes, as well as being a prime broker of these risk instruments at the same time. Therefore, they were using these hedging strategies to cash-in their insurances with AIG to get out of any risk positions early.
This is why: “In mid-September 2008, prior to the government’s action to save AIG, a majority of Goldman Sachs’ exposure to AIG was collateralized and the rest was covered through various risk mitigants. Our total exposure on the securities on which we bought protection was roughly $10 billion. Against this, we held roughly $7.5 billion in collateral. The remainder was fully covered through hedges we purchased, primarily through CDS for which we received collateral from our market counterparties. Thus, if AIG had failed, we would have had the collateral from AIG and the proceeds from the CDS protection we purchased and, therefore, would not have incurred any material economic loss.”
So they aren’t saying they screwed AIG, but they legitimately ensured they weren’t screwed by insuring someone else was. All perfectly legal and above board. Only the fittest and strongest survive and all that.
The letter then goes on to talk more generally about their involvement in the mortgage securitisation market.
“The markets for residential mortgage-related products, and subprime mortgage securities in particular, were volatile and unpredictable in the first half of 2007 (which is why they unravelled their position with AIG). Investors in these markets held very different views of the future direction of the U.S. housing market based on their outlook on factors that were equally available to all market participants, including housing prices, interest rates and personal income and indebtedness data. Some investors developed aggressively negative views on the residential mortgage market. Others believed that any weakness in the residential housing markets would be relatively mild and temporary. Investors with both sets of views came to Goldman Sachs and other financial intermediaries to establish long and short exposures to the residential housing market through RMBS, CDOs, CDS and other types of instruments or transactions.
“The investors who transacted with Goldman Sachs in CDOs in 2007, as in prior years, were primarily large, global financial institutions, insurance companies and hedge funds (no pension funds invested in these products, with one exception: a corporate-related pension fund that had long been active in this area made a purchase of less than $5 million). These investors had significant resources, relationships with multiple financial intermediaries and access to extensive information and research flow, performed their own analysis of the data, formed their own views about trends, and many actively negotiated at arm’s length the structure and terms of transactions. We certainly did not know the future of the residential housing market in the first half of 2007 any more than we can predict the future of markets today. We also did not know whether the value of the instruments we sold would increase or decrease. It was well known that housing prices were weakening in early 2007, but no one — including Goldman Sachs — knew whether they would continue to fall or to stabilize at levels where purchasers of residential mortgage related securities would have received their full interest and principal payments.
“Although Goldman Sachs held various positions in residential mortgage-related products in 2007, our short positions were not a ‘bet against our clients’. Rather, they served to offset our long positions. Our goal was, and is, to be in a position to make markets for our clients while managing our risk within prescribed limits.”
In other words, Goldman Sachs puts everything down to prudent accounting and intelligent risk management.
Maybe ... but the fact that both clients selling and buying mortgage products and complex instruments (which no-one understood except Goldmans traders and a few others, such as JPMorgan Chase, creators of Credit Default Swaps) came to Goldmans, meant that they could see very early on that more people were getting out of the housing and mortgage markets than getting in.
Why are they coming to Goldmans?
Because Goldmans market manipulating systems for high frequency trading give them the best price. This resulted in Goldmans getting out of the mire before everyone else got into it, and is why they cashed in their positions with AIG before everyone else.
They were almost acting as a primary market in and of themselves and, as a market, therefore had much greater knowledge of what was being bought and sold.
Then, as not just the market but also an investor, they invested when everyone was getting out (buy low) and were selling when everyone was getting in (sell high).
The only difference with this market being that it just happened to be the whole US housing market, based upon leverage and funding fuelled by AIG's insurances and complex hedging instruments.
The result is that Goldmans is the nimblest firm at avoiding bubbles bursting and bandwagons rolling.
It’s not illegal of course. It just means they’re far more likely to be onto a sure thing than anyone else.
So, Matt Taibbi’s claim that Goldman Sachs is “a great vampire squid wrapped around the face of humanity” is obviously wrong, and their bonuses are fully justified.
I just downloaded Harris Interactive’s 11th annual reputation survey of America’s most visible companies.
The reputation survey assesses companies on a scale of twenty attributes in six dimensions ...
... and, during the first six weeks of 2010, Harris Interactive interviewed almost 30,000 people to see what they thought of America's 60 "most visible" brands.
The results are fascinating, with the Top 10 most reputable firms being:
#1 Berkshire Hathaway with a Reputation Quotient of 82.33 #2 Johnson & Johnson 81.88 #3 Google 81.49 #4 3M 80.96 #5 SC Johnson 80.76 #6 Intel 80.13 #7 Microsoft 79.83 #8 Coca-Cola 79.81 #9 Amazon 79.57 #10 General Mills 79.46And the least reputable firms are:#51 Delta Airlines 59.57 #52 Bank of America 57.72 #53 JPMorgan Chase 55.67 #54 General Motors 53.60 #55 Chrysler 51.90 #56 Goldman Sachs 51.36 #57 Citigroup 50.57 #58 Fannie Mae 41.77 #59 AIG 39.23 #60 Freddie Mac 38.94Goldman Sachs, Fannie Mae and Freddie Mac make the list for the first time ever and are viewed very poorly. Firms that were involved in TARP payouts fared badly, with the biggest drop in reputation of the whole list being Bank of America, a drop of 4.92 points over last year.AIG took a drop of 4.55 points, but at least they weren’t bottom of the list as they were last year. Nevertheless, they fail to score over 50 RQ points, a position that ranks them with Enron, Worldcom, MCI and Global Crossing after their collapses back in the early 2000s.The good news is that Financial Services has also moved off the bottom of the industry list. Last year only 11% of Americans had a good thing to say about the industry and it came in last, just under the tobacco industry, as the least reputable industry sector in the USofA.This year, financial services leaped to 16% favourable ratings, a five percent improvement and makes finance the second most hated sector, as tobacco still languishes at the bottom, down at 11%.Mind you, with the automotive industry jumping 9% after Toyota’s issues, that’s not saying much.
Meanwhile, the study is worth a look if you like watching the banking industry’s own car crash news ... whoops, didn’t mean that.
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