Category: Financial Markets

Policy Statements for Conduct in Operating Cash Equity Clearing and Settlement Services in Australia

The Council of Financial Regulators has released two policy statements setting out Regulatory Expectations for Conduct in Operating Cash Equity Clearing and Settlement Services in Australia and Minimum Conditions for Safe and Effective Competition in Cash Equity Clearing in Australia.

Trader

On 30 March 2016, the Government endorsed the recommendations of a review of competition in clearing Australian cash equities carried out during the first half of 2015 by the Council of Financial Regulators in collaboration with the Australian Competition and Consumer Commission (ACCC). These recommendations are set out in the report, Review of Competition in Clearing Australian Cash Equities: Conclusions, published at the time of the Government’s announcement.

Among these recommendations, the Council of Financial Regulators undertook to publicly set out:

  • its expectations for ASX’s conduct in operating its cash equity clearing and settlement services until such time as a committed competitor emerged (Regulatory Expectations )
  • a set of minimum conditions to ensure safe and effective competition should a competing provider of clearing services emerge (Minimum Conditions (Clearing) ).

The policy statements released today fulfil these commitments.

The Council of Financial Regulators also recommended that the relevant regulators be granted rule-making powers to impose requirements on ASX’s cash equity clearing and settlement (CS) facilities consistent with the Regulatory Expectations and the Minimum Conditions (Clearing). The relevant regulators would be empowered to make such rules if the expectations were either not being met or were not delivering the intended outcomes; and/ or if specific obligations on CS facilities were needed to support the minimum conditions for safe and effective competition in clearing. Further, the Council of Financial Regulators recommended that the ACCC be granted the power to arbitrate disputes about price and/or non-price terms and conditions of access to ASX’s facilities. The Government has committed to develop and consult on legislative changes in line with these recommendations.

The Regulatory Expectations cover a range of matters relevant to governance, pricing and access, and apply to ASX’s engagement with, and provision of services to, users of its monopoly cash equity clearing and settlement services for both ASX-listed and non-ASX-listed securities. The Regulatory Expectations have been prepared in accordance with a set of core elements outlined in the report, with some amendments and clarifications primarily to ensure their auditability.

ASX is expected to immediately publicly commit to acting in accordance with the Regulatory Expectations. ASX is also expected to commit to submitting an annual external audit of its governance, pricing and access arrangements to the relevant regulators and members of the relevant user governance arrangements, benchmarked against the Regulatory Expectations. The findings of such audits may be one input to any decision by the relevant regulators to employ rule-making powers or in an arbitration determination once the supporting legislative framework is in place. Consistent with the recommendations of the review, the Minimum Conditions (Clearing) cover the following: (i) adequate regulatory arrangements; (ii) appropriate safeguards in the settlement process; (iii) access to settlement infrastructure on non-discriminatory, transparent, fair and reasonable terms; and (iv) appropriate interoperability arrangements between competing cash equity central counterparties. The Minimum Conditions (Clearing) clarify that the Australian Securities and Investments Commission and the Reserve Bank of Australia would not be in a position to recommend the approval of a licence application from a competing clearing provider until the legislative framework underpinning the Minimum Conditions (Clearing) was in place and detailed specific requirements under Minimum Conditions (Clearing) had been developed. The Council of Financial Regulators and the ACCC expect to review the Minimum Conditions periodically, including in the event of material changes to the operating environment or market structure for these services, such as the emergence of a competing settlement facility.

The Minimum Conditions (Clearing) have been developed with reference to the prevailing market structure in settlement – in which there is a sole provider of settlement services. Recent rapid advances in technological developments may increase the prospect of competition emerging in this market. The Council of Financial Regulators and the ACCC will consider the need for specific policy guidance to be issued in respect of settlement facilities.

For further details, please see the Council of Financial Regulators policy statements:

 

Is The Stock Market About To Turn Significantly Lower?

From Zero Hedge.

Stock prices have been supported by high dividends and buybacks. But this may be ending, and if so, multiples will fall, potentially leading to a correction. And this is before the Fed moves their benchmark rate.

Over the past several years, there have been two primary sources of upside for the stock market: trillions in corporate buybacks, as companies themselves engaged in record repurchases of their own stock, often at price indiscriminate levels in a bid to not only raise the stock price but also the stock-linked compensation of management , and a similar amount of dividend payments which in a time of negligible yields, became one of the main drivers for buyers to scramble into the “safety” of dividend paying stocks. Collectively these account for an unprecedented amount of payouts to shareholders.

Today, Barclays’ head of equity strategy Jonathan Glionna quantifies just how much corporate cash flow has and will be used to fund these payouts.

Glionna finds that in aggregate the companies within the S&P 500 are returning a record amount of cash to shareholders through dividends and buybacks. Since 2009 dividends have increased by more than 100%, reaching $98 billion in the most recent quarter. Meanwhile, gross buybacks have tripled and Barclays forecasts that they will reach $600 billion in 2016. In fact, buybacks plus dividends could surpass $1 trillion in 2016, for the first time ever.

 Just like Goldman Sachs, Glionna says that “we believe the substantial increase in distributions is one of the primary justifications for the gains in the price of the S&P 500 during this business cycle (Figure 1).

However, this unprecedented surge in distributions may be coming to an end and as Barclays puts it, “alas, nothing continues forever. The growth rate of payouts, which has averaged 20% since 2009, will all but disappear in 2017, in our opinion.”

While companies have “taken advantage of a recovering economy and generous credit market to enhance both dividends and buybacks” for six years, they may not be able to push them higher much longer.

And here is a fascinating statistic: over the last few years payouts have exceeded earnings for the S&P 500, which is rare. It almost happened in 2014, when the total payout ratio was 99%. In 2015, it did happen. It will happen again in 2016, based on Barc estimates, as net income is likely to be less than $900 billion against $1 trillion of dividends and buybacks. Prior to 2015, companies in the S&P 500, in aggregate, had paid out more than they earned only six other times during the last 50 years. It has never happened more than two years in a row (Figure 2).

In addition, cash outflows for dividends and buybacks have been exceeding cash flow from operations after capital expenditures. We discussed this in The end of financial engineering? (February 29, 2016), which highlighted the S&P 500’s growing reliance on the investment grade credit market to cover its cash flow deficit. Based on our measure, companies in the S&P 500 have spent more than they generated in free cash flow every year since 2013.

The kicker: Glionna estimates that non-financial companies in the S&P 500 have a cash flow shortfall of more than $115 billion per year (Figure 3). In other words, companies will spend promptly send every single dollar in cash they create back to their shareholders, and then use up an additional $115 billion from cash on the balance sheet, sell equity or issue new debt, to fund the difference.

New laws on bankers behaving badly don’t matter in light of ASIC inaction

From The Conversation.

The governmnent’s new laws to tackle manipulation of the bank bill swap rate may seem like a crackdown on badly behaving bank employees but in reality the Australian Securities and Investments Commission (ASIC) hasn’t used the full force of the law in the past to prosecute. So perhaps it’s time Australia followed the lead of the US and UK who are really using law to hold banks to account.

The bank bill swap rate (BBSW) is used to set rates on hundreds of trillions of dollars worth of transactions, including interest rates on credit cards, student loans and mortgages. Banks also use the swap rate to determine the cost of borrowing from one another.

Chess-Husing

Three of Australia’s big four banks, ANZ, Westpac and NAB were accused of manipulating this rate. These latest measures, which include civil and criminal liability for bankers found guilty, come six years after the scandal first broke.

ASIC takes too long to prosecute

ASIC has dragged its feet so spectacularly on prosecuting this rate rigging, misconduct affecting A$20 trillion worth of financial products. In respect to some of the alleged wrongdoing, the clock has run out, and ASIC is now no longer able to prosecute. Added to that, it was not ASIC that uncovered the BBSW scandal in the first place.

The information was first volunteered by BNP Paribas. And while ASIC’s colleagues in the UK have brought down fines in the billions of dollars against UBS, RBS and Barclays for similar offences, ASIC is yet to dock a dime from our titans of finance.

There have been plenty of legal avenues where ASIC could have pursued the banks. For example, under section 12.2 of the Schedule to The Criminal Code Act, 1995 which allows a court to hold a corporation criminally liable for the criminal misdeeds of its employees. I know of no cases where ASIC has sought to prosecute under this provision.

Another is section 11CA (2)(e) of the Banking Act, 1959. This would allow APRA to remove members of the Board of a bank, and appoint their own nominee, if that bank has demonstrated corporate governance failures. Since 1998 when that provision was enacted, APRA has used it a total of zero times.

It seems the regulators are scared to take on the big banks. For one thing they fear that a misstep could precipitate panic in the market, resulting in a bank run leading to a financial crisis. And if our regulators are ever in any danger of forgetting that, the Australian Bankers’ Association is quick to remind them..

How this differs to the US and UK

While Australian regulators have been taking their time, regulators in the UK have brought to trial and achieved convictions.

Regulators in the US have arrested, among others, British citizens, such as Mark Johnson, HSBC’s global head of foreign exchange and Stuart Scott, then head of FX trading in Europe, for manipulating rates while they were in transit in the US.

Deutsche Bank is staring down the barrel of a US$10 billion fine, in the US, for malpractices it allowed to take place in Russia. Banks in the UK and Switzerland have been fined billions of dollars by US authorities for rigging rates in countries other than the US. All that is required is for the US Department of Justice to detect a malpractice or a fraud that can be shown to have affected US investors.

Already there is legal action in the US in the form of a class action suit against our banks for BBSW rigging. This could garner unwanted attention from US authorities and that could be actual punishment for Australian bankers.

Add to that the possibility that Australian bankers may find themselves under arrest when they pass through the US at any stage in the next five years, and one starts to put into perspective just how badly our regulators have done their job. Ironically, it’s US, not Australian authorities that Australian banks need fear, because of allegations of dishonest rigging of an Australian market, all of which allegedly took place in Australia.

Author: Andrew Schmulow, Senior Lecturer (1 July 2016 onwards), University of Western Australia

New (Weak) BBSW Rules Arrive

Treasurer Morrison has released new rules around the setting of the critical market benchmarks like bank bill swap rate (BBSW), which set pricing for many financial products. The rules cover how the BBSW is set and how the rate setting mechanism will be administered and licensed. However, the banks though still run the show. We think there is a case of an independent reference rate. And is the timing convenient, ahead of the banks appearance before the economic committee this week, to defuse the BBSW issue?

The Australian Securities and Investments Commission (ASIC) is already pursuing three of the four major Australian banks over unconscionable conduct and market manipulation in setting the BBSW from 2010 to 2012.

TraderMorrison took recommendations have been jointly developed by the Australian Securities and Investments Commission (ASIC), the Reserve Bank of Australia, the Australian Prudential Regulation Authority and the Commonwealth Treasury aka the Council of Financial Regulators (CFR).

To achieve the objectives outlined above, the CFR broadly recommends that:

  • significant benchmarks (broadly, systemically important benchmarks and those that will have a significant impact on investors) be covered by the regulatory regime;
  • significant benchmarks be identified in a publicly accessible list that can be amended;
  • administrators of significant benchmarks be required to hold a new, standalone, ‘benchmark administration licence’ unless granted an exemption, and the licence be supported by ASIC powers to write rules imposing obligations;
  • an ‘opt-in’ mechanism be created to allow administrators of non-significant financial benchmarks to apply to be licensed if they meet licensing requirements and doing so has value;
  • submitters to regulated benchmarks be required to comply with ASIC rules on regulatory matters related to benchmark submission, with benchmark administrators having primary responsibility for the operation of the benchmark;
  • ASIC be given the power to write rules to compel submission to a significant benchmark as a last resort when necessary to support market functioning;
  • the manipulation of any financial benchmark (significant or  non-significant) be made a specific criminal and civil offence; and Bank Accepted Bills and Negotiable Certificates of Deposit be expressly made financial products for the purposes of the offence provisions of Chapter 7 of the Corporations Act 2001.

So, the banks still maintain control of the BBSW. These changes are really pretty weak.

NAB’s Latest Financial Advice Customer Response Update

NAB has today provided an update on its financial advice Customer Response Initiative – a commitment made to improve transparency for Wealth advice customers.

Bank-Concept

Since February 2015, NAB has made $6.5 million in payments to 251 customers after resolving their claims for compensation. This uplift in payments to customers follows a significant investment by NAB into its capacity to investigate and resolve customer complaints.

NAB’s public commitments made in 2015 and the current status for each commitment is provided below:

Our commitment: Where there is professional misconduct in wealth advice we will move to write to all customers, where misconduct has occurred in the last five years.
Current status: On 21 October 2015, we announced that we had started to write to customers as part of the Customer Response Initiative. We are writing to groups of customers where there is a concern that they may have received inappropriate advice since 2009.

Our commitment: We will respond to all new customer complaints within 45 days.
Current status: We have committed to responding to new complaints within 45 days, and we are tracking well against this commitment.

Our commitment: We are going to add independence into our complaints and whistleblower process.
Current status: In addition to appointing an independent officer to sit on our own whistleblower committee, we have introduced six different measures to increase independence into our complaints resolution. They are:

  • appointing KPMG to help design the Customer Response Initiative
  • appointing an independent Customer Advocate for wealth advice
  • appointing Deloitte to review and report on our progress
  • Deloitte’s reports to us will be provided to ASIC – the independent regulator
  • offering customers $5000 to source their own additional independent financial advice if they need help understanding the outcomes of the CRI
  • negotiating a streamlined review process by FOS if customers do not accept the outcome of the Customer Response Initiative.

Our commitment: We will advise ASIC of all advisers who leave, with the categorisations and reasons of their departure.
Current status: In addition to our reporting obligations for the ASIC financial adviser register, we have implemented a process to notify ASIC in writing of any adviser departures, where we have had compliance concerns about that adviser.

Our commitment: We committed to look to remove confidentiality orders from settlements and to write to customers to advise them these orders had been lifted.
Current status: While our previous confidentiality obligations did allow customers to talk to the media, ASIC or advocacy groups about the facts leading to their complaint with NAB, we acknowledge they were written in such a way where customers may not have been aware of this. So, as part of our Customer Response Initiative, to remove any ambiguity, we have started to write to appropriate customers to advise them that past confidentiality obligations have been lifted. Furthermore, these clauses are no longer included in NAB Wealth Advice Deeds.

In addition to our 2015 commitments, NAB is committed and progressing to the package of industry initiatives announced by the Australian Bankers’ Association (ABA), aimed at enhancing our customers’ experience with us, and reinforcing the banking sector’s standards of service, integrity, trust and ethics.

When NAB last provided an update on its Customer Response Initiative in October 2015, we explained that since February 2015 to October 2015, NAB had made $1.7 million in payments to 87 customers after resolving their claims for compensation

Custody industry growth slowing

The Australian custodial and administration sector grew by 1.4% in the first half of 2016, with total assets under custody (AUC) for Australian investors at $2.9 trillion, according to the latest industry statistics released by the Australian Custodial Services Association (ACSA).

JP Morgan emerged as the largest overall provider in the custody market followed by NAB, BNP Paribas, Citigroup and Northern Trust.

custodyThe ACSA statistics reveal that while the sector is witnessing overall positive growth, the drivers have changed, with custody of on-shore assets outpacing that for off-shore.

In particular, it found in the six months to 30 June 2016, total AUC for Australian investors grew to $2.95 trillion; representing circa 183% of the capitalised value of All Ordinaries and indicating the growing need for alternative asset allocation and foreign markets.

Of this amount, $2.05 trillion represents Australian assets; a 3.1% increase from last period. The remaining $903 billion in foreign assets represented a decrease of 2.4%; Despite the fall, off-shore investment still constitutes 30.6% of the total AUC for Australian investors. The level of Australian AUC for foreign clients (sub-custody) grew by 3.4% to $1.2 trillion.

ASIC company data should be open and free

From The Conversation.

The Australian government is planning to privatise the management of the Australian Securities and Investments Commission database of companies. This is a potentially damaging move which goes against the government’s own open data policy.

Binary-PeopleOn behalf of the Australian government, ASIC currently charges businesses and individuals around A$50 million each year for company searches. The information covers everything from details of shareholders and company officers (A$19 per document) and their roles and relationships with other bodies, to financial reports and records of charges over company assets (A$38 per document).

It is undoubtedly a great money-spinner to charge members of the public more than A$1 per page for a downloaded pdf document. However, the original legislative purpose of making information about companies publicly available was surely not so that the Australian government could profit from selling that information. Indeed, there is no public policy or economic rationale for the charges.

I am yet to meet an economist who argues that levying costs on public information about companies helps markets operate more efficiently. What we’re actually doing is segregating the market into those who can afford public information about companies and those who cannot.

The movement of company data from public to private hands is likely to entrench the charges for public information about companies. The corporate database is likely to be treated as nothing more than a cash cow.

Inevitably the focus will be on how to fatten the cow. The question asked will not be should we make [so much] money from public information, but how can we make more? The adverse economic consequences and lost productivity benefits that flow from costly public data will not enter the calculations.

Malcolm Turnbull has supported open data

In March 2014 Malcolm Turnbull, then communications minister, made the following salient comments:

To be frank with you, I think it is really regrettable that ASIC’s data is behind a paywall.

I have to say as a matter of principle, I don’t think the government should be charging the public for data.

Obviously these are tough and troubled times from a budgetary point of view – and there will be all sorts of contractual issues – but really, the productivity benefits from making data freely available are so much greater than whatever revenues you can generate from them.

Our goal is … wherever possible to make that data accessible and free.

Our prime minister’s reported comments are consistent with the Australian government’s own 2015 Public Data Policy. This commits to optimising the use and reuse of public data, releasing non-sensitive data as open by default, and collaborating with the private and research sectors to extend the value of public data for the benefit of the Australian public.

I know many accounting academics who wish to conduct research to inform public policy using the financial reports on ASIC’s database. They are prevented from doing so because they do not have a spare A$50,000 lying around to buy the data.

Better corporate and tax regulation

Academics are not the only ones who would benefit from making ASIC’s public data freely available. It would also help individuals to scrutinise corporate affairs and, in doing so, make valuable contributions to the Australian regulatory authorities. This is the Jerry Maguire principle of public administration: help me, help you.

In carrying out its regulatory functions, ASIC relies heavily on complaints and reports of corporate misconduct received from individuals. Let’s do a cause and effect analysis here: the higher the charges for corporate information, the lower the scrutiny of corporate affairs by individuals, the fewer complaints made to ASIC, the weaker and more untimely corporate regulation.

The 2014 Senate inquiry report into the performance of ASIC must have had such an analysis in mind when it recommended that ASIC charges be brought into line with other jurisdictions. Searching for public information about companies is free in New Zealand and the United Kingdom.

The 2010 Senate inquiry report into insolvency practitioners is archetypal of the public policy problem. This committee found overwhelming evidence of bad and illegal practices in the insolvency industry. These practices thrived while there was low scrutiny and costly and missing financial information. ASIC was unaware of the nature and extent of what was going on.

Similar to ASIC, the Australian Taxation Office (ATO) relies on individuals to inform it of taxation misconduct by corporations. The same cause and effect analysis for complaints made to ASIC applies.

In carrying out its functions, the ATO is effectively hamstrung if individuals are unable to freely scrutinise the financial affairs of corporations and make timely complaints or reports. The heaving lifting of scrutiny and accountability in taxation falls on the few and the public purse is worse off because of it.

The 2015 Senate inquiry into corporate tax avoidance was remarkable not so much for the outlandish evidence of aggressive tax avoidance, but the incredulous expressions of senators in the Sydney hearing room as the evidence emerged. It was almost possible to read their thoughts: how could it be that we, the elected representatives of the people, could have missed this disgraceful state of tax affairs and for so long?

The answer, of course, is that there was a lack of timely genuine scrutiny by the public. It finally fell to investigative journalists such as Michael West (then of Fairfax) to blow the whistle after acquiring the financial reports of various multinational companies.

Cutting red tape for small business

Small businesses – often described as the engine room of the Australian economy – could also benefit from freely available company data. Small businesses and contractors should be able to educate themselves about the affairs of their corporate customers without having to pay the government for the privilege.

Unsecured creditors should be able to view the charges held against a company’s assets by secured creditors so they too can make informed decisions.

Employees and their representatives should likewise be able to freely access public information about corporate employers. Employees have an active and ongoing economic interest in a company, not least because of the employee benefits they accumulate such as annual leave, long service leave and superannuation contributions.

It is inefficient for the Australian government to levy charges that discourage timely regular scrutiny of large companies by employees. The social costs can be high when a company fails. Uninformed employees are likely to suffer shock and dislocation. Meanwhile the government often incurs the cost of paying out accumulated employee benefits.

In the public interest

Keeping public information about companies locked up behind paywalls and maintained by private interests is not in the public interest.

Free public information about companies in public hands will contribute to higher transparency, better governance and accountability, and less secrecy, incompetence, fraud and corruption. If the ASIC corporate database is sold, the opposite effects are virtually certain.

Author: Jeffrey Knapp; Lecturer/Accounting, UNSW Australia

ASIC reports on review of marketing practices in IPOs

ASIC has warned firms and issuers involved in initial public offerings (IPOs) in Australia to ensure their marketing campaigns comply with the letter and spirit of the law, particularly when using emerging social-media strategies.

Fintech-Pic

An ASIC review of marketing practices in IPOs has found that so-called ‘traditional’ means of communication – telephone calls, emails and websites – remain more important for the marketing of an offer to retail investors. The review found that the use of social media is not yet pervasive; it is only used occasionally by small to medium-sized firms to market IPOs.

REP 494 Marketing practices in initial public offerings of securities details the review’s findings, highlights areas of concern and provides for consideration ASIC’s recommendations to improve marketing practices for IPOs in the future.

Between October 2015 and March 2016 ASIC reviewed the online and social media marketing of 23 IPOs where a prospectus was lodged.  ASIC then conducted a more extensive review of the marketing practices and materials of 17 firms that were involved in 7 of the original IPOs.  ASIC also monitored the marketing of other IPOs as part of its usual prospectus review work.

Key findings of the report included:

  • There were some oversight weaknesses in relation to marketing done via telephone calls and social media, and in ensuring that marketing material is kept up to date.
  • The use of forecasts in communications or the targeting of investors from a particular background means special care may need to be taken to avoid misleading investors.
  • Firms and issuers did not always properly control access to information about the offer to ensure retail investors base their decision on the prospectus; and
  • Some good practices were adopted by firms to ensure that communication was consistent with the prospectus information.

ASIC Commissioner John Price said the purpose of the review was to understand current market practices and identify areas of particular concern.

‘The way that an IPO is marketed may unduly influence the decision to invest in an IPO,’ he said.

‘We are living in more innovative times where we are seeing new interactive methods of communication and marketing used in many corporate and commercial arenas, including taking a company public. While we embrace such innovation, we also want to remind firms and issuers to ensure that their marketing practices comply with the advertising and publicity restrictions in the Corporations Act,’ he said.

Managed Accounts Market Growing Fast

Further evidence of complexities in the investment sector in Australia are demonstrated by the latest estimates from  The Institute of Managed Account Professionals (IMAP) which uses data from their 2016 survey. This shows that based on responses from 29 out of 37 organisations surveyed, total funds under management/administration (FUM) held in managed accounts now exceeds $30.874 billion.

The results show that managed accounts are a very significant part of the retail financial services market – already equivalent to approximately 5% of all the investment assets held on platforms.

managed-accounts-aug-2016In February 2015, IMAP had surveyed the main providers and estimated that the market size exceeded $13 billion in total FUM. Morgan Stanley recently predicted that Managed Accounts would exceed $60 billion by 2020. So there has been significant growth.

Here is the list of entities who responded. There is an interesting  mix of integrated financial services players, and several stand alone organisations and start-ups. Many have fingers in multiple pies!

managed-accounts-aug-2016-listThe results show that managed accounts are a very significant part of the retail financial services market – already equivalent to approximately 5% of all the investment assets held on platforms.

IMAP says the inflow to managed accounts services has been strong through 2015-16 and is likely to continue to grow strongly. The growth since the 2015 survey has been largely in platform based services rather than in “client own name” services, showing the extent to which financial planners and advisers have now adopted managed accounts as a way of delivering their overall advice service.
Over 85% of the FUM measured in this survey would also be counted in a survey of the retail IDPS and Superannuation platforms. Also, this 2016 result is not directly comparable to the total FUM amount measured in the 2015 survey because the survey process this year continues to add new participants. The results also show significant growth for those who have participated in both surveys. Managed Accounts are provided in a variety in legal structures and several organisations can be involved in a single service. This means that there is a risk of overlap between the returns from several organisations, so the numbers are at best indicative.

ASIC says MDA services involve a range of financial products and financial services, such as offering and trading in financial products, operating a custodial and depository service, and giving personal advice. Because of the individualised nature of the range of financial services involved, they will regulate persons contracting with retail clients to provide MDA services as providers of financial services rather than issuers of a financial product. Managed accounts are increasingly considered a mainstream investment management solution and many managed account solutions are made available using a MDA approach.

However, advisers operating a managed discretionary account (MDA) service are expecting new tighter regulations soon.

A large number of industry participants provide MDA services to retail clients using a no action letter issued back in 2004. The no action letter came about because the industry argued that unlike “full service” MDAs, many advisers primarily used discretion to rebalance managed fund portfolios via a regulated platform which took care of administration, custody and reporting. It successfully argued that it wasn’t clear whether they needed to be licensed or not. If the no action letter is removed, Limited MDA arrangements, particularly those with portfolios across a range of instruments, will probably need to gain specific MDA authorisation on their licence to continue their current approach.

ASIC has also flagged plans to increase the capital requirements for MDA
operators so that net tangible assets (NTA) of 0.5 per cent of funds under administration (FUA) up to $5 million will need to be maintained  (assuming custody is outsourced).

Wither The Bond Rally?

Speculation by market commentators that the 35-year bond rally is finally coming to an end is nothing new, writes Nikko Asset Management’s Roger Bridges in InvestorDaily today.

Given that the yields on these securities are now negative, it is hard to believe that they can continue to drive global bond yields much lower.

Unless, for some reason, US Treasuries begin to narrow from current spread levels, it is hard to be too bullish on bonds.

However, I don’t believe that means we should necessarily be bond bears. Even if the great bond rally is drawing to a close, that doesn’t mean that it is now going to reverse violently.

It is more likely that we will see a period when bonds trade within a range, with any rally reversing fairly quickly and any sell-off likely to meet the same fate.

Potential causes of a bond sell-off

In my view, it is unlikely that a sell-off will emanate from US Treasury movements as it did in 2008.

JGBs and Bunds are more likely to be the catalyst for higher global bond yields, as they were in 2003 (JGBs) and 2014 (German Bunds).

Chart 1: 10-year JGB, Treasury and Bund yields

The 2013 ‘taper tantrum’ saw the sell-off in US Treasuries driving global bond yields.

Since then, however, global bond markets (including the US) have been very much dominated by Bund and JGB movements, with their spreads to US Treasuries widening to their current level of around 1.6 per cent for both markets (see chart 2).

Chart 2: Spread of JGB and Bund yields to US Treasuries

This rally in Bunds and JGBs is being driven mainly by the quantitative easing programs of the European Central Bank (ECB) and the Bank of Japan (BoJ).

However, the performance of the bank sector in both those markets also helps to explain bond movements.

Chart 3 shows that US Treasury yields have been closely correlated to the performance of European banks, particularly in the past year.

Chart 3: Relationship between 10-year US Treasuries and European bank bond yields

In July, we saw a sell-off in JGBs due to market disappointment over the lack of a rate cut from the BoJ.

Since this meant that interest rates weren’t pushed any further into negative territory, Japanese banks outperformed, causing longer-dated JGBs to sell off.

This sell-off was largely contained within the Japanese market and didn’t have much effect on US Treasuries since they were still being supported by the underperformance of European banks.

US Treasuries currently look expensive

Ten-year US Treasuries currently appear quite expensive due to negative interest rates in Germany and Japan and the continuing underperformance of those countries’ banks.

What would be fair value for US 10-year rates? According to the Laubach-Williams model, an estimate for the current neutral level of the Fed funds rate is around 0.18 per cent.

Adding the Federal Reserve’s target of 2 per cent for inflation would give a fair value rate at around 2.2 per cent.

Interestingly, that is in line with the Federal Reserve Bank of New York model for the term 10-year structure of short-term interest rates.

Based on this, the NY Fed’s model sees the current term premium for US 10-year Treasuries at -0.6 per cent.

However, the historical average for the Fed’s favourite measure of inflation is only 1.7 per cent and not 2 per cent, which is not very different from the market’s current pricing for inflation in 5 years’ time at 1.68 per cent.

This back-of-the-envelope calculation puts an upper limit on the current fair value for US Treasuries at between 2 and 2.2 per cent, focusing only on the US and ignoring interest rates prevailing globally.

Bunds and JGBs will be the likely culprits in any sell-off

US rates have been fairly range-bound in recent weeks. Hedging costs have increased as a result of the recent rise in 3-month LIBOR for both Euro- and Yen-based investors, which in turn has reduced the hedged return on US 10-year Treasuries for foreign investors (see chart 4).

Chart 4: Return on US Treasuries from 3-month currency hedging for foreign investors

This has resulted from regulatory changes on money market funds which will be implemented in October and so the impact is likely to reverse unless the Fed starts raising interest rates.

The impact on the long end of the US Treasury curve has been minimal, which may suggest that a gradual interest rate tightening by the Federal Reserve may also have limited long-term impacts on that end of the curve.

Over the past three months, the JGB sell-off and the rise in LIBOR rates have had limited effects on US 10-year bond yields.

Since the Federal Reserve is likely to be slow in raising rates, this may indicate that Fed hikes will be tolerated and may in fact provide buying opportunities.

The real risk is that we see both Bunds and JGBs sell off together, reversing the reason for much of the recent bond rally.

The likely cause of such a sell-off would be a reversal of local bank underperformance, which could result from a change in European policy on how non-performing loans are handled or if Japan changes its policy on negative interest rates such that local banks will be less negatively affected.

Perhaps we have seen the end of the bond rally, but a severe reversal is unlikely, in my view. One potential strategic trade in the current environment could be to go long US Treasuries against either JGBs or Bunds.

If the market rallies, then it is likely that this will happen via a US spread narrowing.

A major sell-off is also likely to see spread narrowing as US Treasuries are probably closer to fair value than JGBs or Bunds, the major drivers of the bond market rally in recent years.

Roger Bridges is a global rates and currencies strategist at Nikko Asset Management.