Financial Markets – Page 118 – Digital Finance Analytics (DFA) Blog

ASX To Administrate BBSW From 1 Jan 2017

Last week, the Australian Financial Markets Association (AFMA) announced that it will transfer administration of the BBSW benchmark rate to ASX. It is the intention of both parties that ASX will administer BBSW from 1 January 2017.

ASX was selected following a highly competitive process, which began in July 2016 with a public invitation for interested parties to register their interest as a potential alternate benchmark administrator for BBSW.

Ernst & Young provided financial advisory services to AFMA for the externalisation process, while Mills Oakley acted as AFMA’s legal adviser.

“AFMA is delighted to have found in the ASX an organisation with strong credentials to take responsibility as administrator for BBSW,” said AFMA’s CEO, David Lynch. “ASX has the appropriate attributes as a benchmark administrator and it has a strong and unique capability to continue the work underway to transition the BBSW methodology to a VWAP process.”

For further details on the methodology transition process, please refer to AFMA Market Notice 2016_5. AFMA will support the future evolution of BBSW by working with ASX, market participants and the Council of Financial Regulators to promote the market infrastructure and practices required to support widespread trading at outright prices in the underlying market. AFMA will also operate as the calculation agent for ASX until the systems required to support the new methodology go live in 2017.

Today’s announcement will allow AFMA to focus on its core activities in policy advocacy, market development and industry education and ensure that it supports its members and Australia’s financial markets in an optimal way. In May 2016, AFMA had announced its intention to step away from the function of being a benchmark administrator for this purpose – see AFMA Market Notice 2016_3.

Margining and Risk mitigation Requirements Start 1 March 2017 – APRA

The Australian Prudential Regulation Authority (APRA) has announced the new requirements for margining and risk mitigation for non-centrally cleared derivatives will commence on 1 March 2017, with a multi-year phase-in that reflects the internationally agreed timetable.

The requirements are contained in Prudential Standard CPS 226 Margining and risk mitigation for non-centrally cleared derivatives (CPS 226), which was released in its final form in October 2016 without a commencement date. CPS 226 implements an important component of the G20’s post-crisis reforms aimed at reducing systemic risk in the over-the-counter derivatives market in Australia.

CPS 226 will commence on 1 March 2017, with a multi-year phase-in that reflects the internationally agreed timetable. The risk mitigation requirements in CPS 226 take effect from 1 March 2018.

APRA has also granted a six-month transition period for variation margin requirements, which commences on 1 March 2017. While all new transactions entered into from 1 March 2017 are in-scope for the variation margin requirements, the transition period will provide additional time for entities to finalise their implementation and reach full compliance for all transactions executed from 1 March 2017.

APRA considers that the implementation timetable in conjunction with the transition period appropriately balances the benefits of international consistency with the need for sufficient time for implementation.

A letter to industry setting out the full implementation timetable and an updated version of CPS 226 can be found on the APRA website at: www.apra.gov.au/CrossIndustry/Pages/Response-margining-risk-mitigation-October-2016.aspx

Eurodollars – the best market in the world to understand global risk?

Interesting piece from Zero Hedge on the eurodollar market, a global financing system regulated by no one, influenced by many, and directly or indirectly affecting every asset price globally. Eurodollar futures, are cash settled futures contracts whose price moves in response to the interest rate offered on those dollar time deposits held in offshore (non-US) banks.

This recent chart from the BIS highlights the significant volumes involved.

All the indicators are that interest rates will rise.

Dollar deposits in their birthplace (US) are well, just dollars. Dollar deposits outside of the US are like Singlish or Ingrish and the dozens of variations across the globe. It’s the same language just in a different place. Just as dollar deposits outside of the US are still dollars.

So eurodollars are essentially all those dollar deposits outside of the US banking system. They are NOT nor have ANYTHING to do with that monetary experiment called the euro.

Eurodollars got their name originally from US dollar deposits in European banks, and in fact their origins date back to the communist days when the Ruskies and Chinese kept dollar deposits abroad (non-US banks) for fear of seizure. Today, however, they are dollar deposits in any bank outside of the US. So dollar deposits in Tokyo, Moscow, and London are all part of the eurodollar system.

What’s It Got to Do With Europe and the Euro Currency?

The term “euro” in eurodollar has as much to do with the euro currency, or the European Union, as peanut butter has to do with the solar system – nothing. You can, for example, have euroeuros or euroyen and these would be euro deposits outside of the EU and euroyen would similarly be yen deposits outside of Japan. Got it?

What’s important to understand is that the eurodollar system is THE biggest source of global funding, bar none. Nobody knows for sure how large it is as it’s basically a large unregulated financing system with thousands of participants globally. But we do know that the eurodollar futures market on the Chicago Mercantile Exchange (CME) is larger than S&P futures, larger than oil futures, larger, in fact, than the 10-year bond futures. It’s estimated over 90% of international trade is financed through the eurodollar market.

In fact, when cash settled eurodollar futures contracts were introduced to the CME in 1981 it was immediately the largest trading pit ever.

That so few investors know about this enormous market, its importance, and relevance is frankly pretty shocking.

Understanding the eurodollar market goes a long way to understanding why, despite the greatest monetary intervention we’ve ever seen by central banks, we’ve remained in a contractionary environment.

Our Global Financing System: Hidden in Plain Sight

The eurodollar system is a global financing system regulated by no one, influenced by many, and directly or indirectly affecting every asset price globally. Think of it as a deposit and loan market for offshore dollars. It affects asset prices because it is the wholesale financing system most used in the world. To be clear: there exist wholesale financing in other currencies (the eurocurrency market) but the dollar accounts for an estimated 75% of the eurocurrency market.

It is a critical component to how banks fund and manage their liability structures. It’s also worth pointing out that the eurodollar market is almost entirely a cashless market. It is for simplicity sake, banks’ balance sheets.

The advent of technology in finance has allowed for real time matching of assets and liabilities across financial institutions and the balancing of what are essentially banks’ balance sheets enacted with eurodollars. It is to a certain extent as close to a virtual currency as a real virtual currency like Bitcoin. Very efficient, close to instantaneous, and, in the case of eurodollars, allows for the tapping of huge pools of capital, which can be freed up for financing.

Why Should I Care?

Eurodollars provide us with what is THE best insight into global capital flows and credit demand. Problems in the eurodollar market are problems in the market. Heck, this IS the market.

The eurodollar financing market took a massive blow to the skull back in 2007, which makes sense given that so much collateral was wiped from the system.

What is both fascinating and scary at the same time is that despite all of the central bank QE programs collateral has failed to come back into the system. It’s as if the eurodollar market is suffering from concussion. We know this by looking at the eurodollar market which has never regained levels seen back in 2007.

What this tells us is that the offshore money market world is failing to produce collateral and this failure to produce collateral is reflected in the eurodollar funding markets. QE doesn’t address this problem as it is interest rate driven stimulus and this isn’t a cost of capital problem but a collateral problem.

This is deeply disturbing, and the actions taken by central banks have actually sucked high quality collateral from the system. And it is this collateral which has traditionally underpinned the wholesale funding markets, the largest of which is the eurodollar market.

Remember in 2008 when the Fed, in a blind panic, opened dollar swap lines, which they deployed in an unlimited fashion and which actually got to about $600 billion that year?

Well, what was happening was that even though the Fed had taken a chainsaw to the Fed funds rate and opened the credit spigot to full throttle, the international money markets never responded. LIBOR, which, remained elevated, which means the offshore dollar financing market was still bricking itself. Despite unlimited swap lines between the Fed and global central banks, the dollar shortage wasn’t ever resolved.

Dollar Shortage

The other thing this tells us is that there is a chronic dollar shortage in financial markets, and existing dollar financing is only going to continue to be constrained as the dollar moves higher.

Remember, dollar denominated debts become increasingly unmanageable as hedging costs rise.

This creates a feedback loop whereby, in order to decrease risk, market participants either hedge dollar risk (where their collateral is in other currencies but they have USD costs somewhere in their cost structure – think European manufacturers using US technology for example). These guys hedge this exposure by buying dollars and this pushes the dollar higher.

Or market participants reduce leverage by unwinding debt positions, and, in order to do so, they have to buy back dollars as they unwind what are short dollar positions. Once again, this pushes the dollar higher.

Protectionism: Gasoline to the Fire Dollar Shortage Fire

Ok, so Trump’s promised to bring jobs back to America. It’s protectionism writ large. He’s promised to lower tax rates to incentivise those jobs to return to the US.

Whether he manages to do this or not we’ll have to wait and see. To be clear I’m unconcerned with whether this is a good or bad thing or whether Trump is an angel or a demon.

That said, understand that there’s an estimated $3 trillion in corporate US profits sitting offshore. What happens if Trump manages to pull this off?

I’ll tell you what happens. Those dollars move OUT of the eurodollar market, a market already starved of dollars, back into US banks. Uh oh! And this brings me to eurodollar futures.

Bonds, Not Currency

Ok, so we’ve just run through an admittedly extremely abbreviated discussion of the eurodollar financing market but one which hopefully provides you with some grasp of how it functions and it’s importance. As complex as the eurodollar financing market is, understand that the eurodollar futures market is a market which ultimately prices risk, and it is, I believe, the best pricing of risk we can look at in the global market.

Eurodollar futures are NOT currency futures.

Let me explain. Take Aussie dollar currency futures. These are plain vanilla currency futures. Ditto any other currency.

Eurodollar futures, on the other hand, are nothing like this as they are in fact cash settled futures contracts whose price moves in response to the interest rate offered on those dollar time deposits held in offshore (non-US) banks.

They are therefore interest rate products not currency futures and this is why I just said that this market is the best market in the world to understand global risk.

These loans or time deposits between banks are reflected in an average rate of interest charged. This is the London Interbank Offered Rate (LIBOR).

LIBOR

The rate at which banks are borrowing from and lending to each other is therefore a derivative of the eurodollar market.

The essence of the eurodollar market is that it provides us a window into where the crowd thinks LIBOR will be at a point in the future. So eurodollars are all about expectations of the future.

LIBOR Rates – 30 Year Historical Chart

Will the Fed Hike in December?

LIBOR, which indicates the pricing of risk in the eurodollar market, IS the market. Take a look at the chart above. Right now it’s telling us we’ll get a rate hike in December

The US Money Machine

Moody’s says the recent ascent by Treasury bond yields threatens to offset the positive implications for corporate bond issuance stemming from widespread expectations of a declining default rate for 2017.

Markets now look for a Republican President and a Republican Congress to supply a major fiscal jolt to the economy even if tax cuts and additional infrastructure spending further widen a federal deficit that approximated 3.2% of GDP for the year-ended September 2016. By contrast, the federal deficit was a smaller 2.4% of GDP prior to the Great Recession. Moreover, late 2007’s outstanding federal debt approximated 35% of GDP, which was far lower than its recent 76% share.

The Republican Party’s many fiscal conservatives now sitting in Congress are likely to oppose the adoption of a fiscal stimulus program that adds significantly to federal indebtedness in the context of an economic recovery. They will warn of an even greater debt burden once the inevitable recession triggers a cyclical widening of the federal budget deficit. In addition, unforeseen national emergencies or military conflicts can quickly balloon the national debt.

Thus far, the market has been relatively sanguine regarding credit quality’s ability to shoulder recent and forthcoming increases by borrowing costs. However, the narrowing of corporate bond yield spreads since November 8’s Republican sweep masks a climb by the absolute level of borrowing costs that threatens to curb bond issuance noticeably. Were spreads to widen alongside higher bond yields, a likely sell-off of equities would probably spark a “fight to quality” that drives Treasury bond yields lower.

Already, important segments of the equity market have weakened in response to a possibly excessive climb by benchmark bond yields. For example, the interest-sensitive PHLX index of housing-sector share prices was recently down by -4.1% from November 25’s close.

Thus, in addition to Washington’s fiscal conservatives, the Treasury bond market can limit the scope of debt-financed spending. Once the climb by Treasury bond yields materially suppresses business activity, Washington’s new regime will better appreciate the limits to fiscal stimulus.

After considering the late stage of the economic recovery, the favorable default outlook, above-average interest rate risks, as well as the constraints imposed by an aging population and workforce, the prospects for US$-denominated corporate bond issuance appear modest. Following 2016’s prospective 7% increase to $1.416 trillion, investment-grade bond offerings may dip by -2% in 2017. Moreover, high-yield bond issuance’s likely -5% drop to $337 billion for 2016 may give way to a 3.5% increase in 2017, which would still leave 2017’s tally a deep -19% under 2013’s yearlong cycle high. Though the widely anticipated fiscal jolt may fall short of current expectations, less regulation might deliver an upside surprise.

Australia is discriminating against investors

From The Conversation.

Many Australians dream of starting their own businesses. But they face restrictions on where they can access startup capital. In Australia you must be certified as a “sophisticated investor” to invest in risky, early stage ventures that cannot yet comply with costly disclosure requirements.

A “sophisticated investor” is someone with an income of at least A$250,000 per annum or assets worth A$2.5 million. But this qualification not only discriminates against some investors, it is a very limited view of what it means to be “sophisticated”. It also ignores recent changes in how companies interact with an important group of early investors – their customers. Even more, it robs startups of valuable capital.

The argument against “sophistication”

The argument for this restriction is that investing in private companies with unregulated disclosures is risky. They are not subject to the same requirements of a public company and are potentially more difficult for a layman to evaluate. “Unsophisticated investors” should just stick to publicly listed investments because they are less risky and more transparent.

But there’s nothing particular about having money that makes you a good investor and investors get shortchanged in public markets as well.

In particular, it is well documented that, on average, shares sold to the public through an IPO significantly underperform other investments in the long-run. Even when a high quality IPO does come to the market, unsophisticated investors will struggle to get a meaningful allocation, while wealthy, well-connected investors end up with most of what they ask for.

The academic literature refers to this as the “winner’s curse”, whereby unsophisticated investors only receive shares in an IPO when sophisticated investors think it’s a lemon.

Many startups have a unique relationship with customers

But companies also have greater intimacy with their customers than ever before. Micro-investing startup Acorns recently sought to raise A$6 million in a private share issue, at least partially from its estimated 160,000 Australian users. Acorns’ users are reported to have already pledged more than A$1 million to help the startup replenish its cash and pursue further growth opportunities.

Acorns may be slightly unusual in being able to raise this money, as it is itself an investing app. It helps its users build wealth by saving “spare change” and investing this money for them. So its client base is at least familiar with the tenets of investing.

But Acorns’ ability to tap its user base as a source of capital also challenges the notion that only “sophisticated” investors are suitably qualified to participate in early stage deals. Acorns’ users are typically young tech savvy millennials who are unlikely to pass the sophisticated investor test (which is probably why they are using the app). Yet, because of their interaction with the app, these users have unique insights in evaluating Acorns’ prospects.

It raises questions as to whether the distinction between “sophisticated” and “unsophisticated” investors remains relevant in the world of app based tech startups. These startups often have aggressive go-to-market business models that attempt to capture as many users as possible relatively early in their life. Would someone that is cash rich have a better understanding of this business than a customer or user of it?

In making an early stage investment decision a “sophisticated” investor could try to determine whether an app solves a significant problem in its user’s life and thus how deeply a user will engage with it. But predicting the behaviour of app users is inherently difficult. So who better to predict it than the users themselves?

Discriminating against certain investors costs everyone

Under the current rules, a lot of “unsophisticated” users are denied access to such investment opportunities because they are simply not wealthy enough. This robs investors of an opportunity and startups of a potential source of capital. Even more, we all could lose as companies that create incredible products struggle or die for lack of funds.

For startups, drawing on customer support, as Acorns has done, would provide a source of capital that does not carry the costs and conditions that are typically attached to angel and venture capital funding. For small investors it gives them direct access to some potentially very lucrative (but very high-risk) investments that otherwise would be impossible or very costly to access.

Democratising the way startups are financed could create an environment whereby entrepreneurs, small investors and the economy as a whole all benefit from financing new and interesting endeavours. But it all starts with re-conceptualising the current arbitrary notion of “sophistication”.

Author: Jason Zein, Associate Professor, UNSW Australia

The good, the bad, and the ugly of algorithmic trading

From The Conversation.

Algorithms are taking a lot of flak from those in financial circles. They’ve been blamed for a recent flash crash in the British pound and the greatest fall in the Dow in decades. They’ve been called a cancer and linked to insider trading.

Government agencies are taking notice and are investigating ways to regulate algorithms. But the story is not simple, and telling the “good” algorithms from the “bad” isn’t either. Before we start regulating we need a clearer picture of what’s going on.

The ins and outs of trading algorithms

Taken in the widest sense, algorithms are responsible for the vast majority of activity on modern stock markets. Apart from the “mum and dad” investors, whose transactions account for about 15 to 20% of Australian share trades, almost every trade on the stock markets is initiated or managed by an algorithm.

There are many different types of algorithms at play, with different intentions and impacts.

Institutional investors such as super funds and insurance companies rely on execution algorithms to transact their orders. These slice up a large order into many small pieces, gradually and strategically submitting them to the market. The intention is to minimise transaction costs and to receive a good price – if a large order were submitted in one go it might adversely move the entire market.

Human market makers used to provide quotes to buy or sell a given stock and were responsible for maintaining an orderly market. They have been replaced by algorithms that automatically post and adjust quotes in response to changing market conditions.

Algorithms drove the human market makers out of business by being smarter and faster. Most market-making algorithms, however, don’t have an obligation to maintain an orderly market. When the market gets shaky, algorithms can (and do) pull out, which is where the potential for “flash crashes” starts to appear – a sudden drop and then recovery of a securities market.

Further concerns about algorithmic trading are focused on another kind – proprietary trading algorithms. Hedge funds, investment banks and trading firms use these to profit from momentary price differentials, by trading on statistical patterns or exploiting speed advantages.

Rather than merely optimising a buy or sell decision of a human trader to minimise transaction costs, proprietary algorithms themselves are responsible for the choice of what to buy or sell, seeking to profit from their decisions. These algorithms have the potential to trigger flash crashes.

Fast vs. slow algorithms

Proprietary algorithmic traders are often further divided, between “slow” and “fast” (the latter also referred to as “high-frequency” or “low-latency”).

Many traditional portfolio managers use mathematical models to inform their trading. Nowadays such strategies are often implemented using algorithms, drawing on large datasets. Although these algorithms are often faster than human portfolio managers, they are “slow” in comparison to other algorithmic traders.

High-frequency algorithmic trading (HFT) is on the other end of the spectrum, where speed is fundamental to the strategy. These algorithms operate at the microsecond scale, making decisions and racing each other to the market using an array of different strategies. Winning this race can be highly profitable – fast traders can exploit slower traders that are yet to receive, digest or act on new information.
Proponents of HFT argue that they increase efficiency and liquidity because market prices are faster to reflect new information and fast market makers are better at managing risks. Many institutional investors, on the other hand, argue that HFTs are predatory and parasitic in nature. According to these detractors, HFTs actually reduce the effective liquidity of the stock market and increase transaction costs, profiting at the expense of institutional investors such as superannuation funds.

The effects of algorithms are complicated

A recent study by Talis Putnins from UTS and Joseph Barbara from the Australian Securities and Exchange Commission (ASIC) investigated some of these concerns. Using ASIC’s unique regulatory data to analyse institutional investor transaction costs and quantify the impacts of proprietary algorithmic traders on these, the study found considerable diversity across algorithmic traders.

While some algorithms are harmful to institutional investors, causing higher transaction costs, others have the opposite effect. Algorithms that are harmful, as a group, increase the cost of executing large institutional orders by around 0.1%. This ends up costing around A$437 million per year for all large institutional orders in the S&P/ASX 200 stocks.

But these effects are offset by a group of traders that significantly decrease those costs by approximately the same amount. The beneficial algorithms provide liquidity to institutional investors by taking the other side of their trades.

They do so not out of the goodness of their little algorithmic hearts, but rather because they earn a “fee” for this service (for example, the difference between the prices at which they buy and sell). What makes these algorithms beneficial to institutions, is that “fee” they charge is lower than the “fee” institutions would face if these algorithmic traders were not present and instead had to trade with less competitive or less efficient liquidity providers, such as humans. The ability for algorithms to provide liquidity more cheaply comes from the use of technology, as well as increased competition.

What distinguishes the algorithms is that the beneficial ones trade against institutional investors (serving as their counterparties), whereas the harmful ones trade with the institutions, competing with them to buy or sell. In doing so, the beneficial algorithms reduce the market impact of institutional trading. This allows institutions to get into or out of positions at more favourable prices.

The study also found that high-frequency algorithms are not more likely to harm institutional investors than slower algorithms. This suggests institutional investor concerns about HFT may be misdirected.

We shouldn’t stamp out the ‘good’ algorithms

ASIC is now using the tools developed in the Putnins and Barbara study to detect harmful algorithms in its surveillance activities. These are identified by looking for statistical patterns in the trading activity of individual algorithmic traders and the variation in institutional transaction costs. The result is an estimated “toxicity” score for every algorithmic trader, with the highest-scoring traders attracting the spotlight.

So, we know the affect of algorithms is complicated and we can start to tell the harmful apart from the beneficial. Regulators need to be mindful of this diversity and avoid blanket regulations that impact all algorithmic traders, including the good guys. Instead, they should opt for more targeted measures and sharper surveillance tools that place true misconduct in the cross-hairs.

Authors: Marco Navon, Senior Lecturer in Finance, University of Technology Sydney; Talis Putnin, Professor of Finance, University of Technology Sydney

APRA On Securitisation – Will It Benefit Smaller Players?

APRA says their recent changes to securitisation will enable a much larger funding-only market and so provide ADIs the opportunity to strengthen their balance sheet resilience by accessing new sources of term funding, hopefully at relatively attractive pricing. In addition, with the more straight-forward approach to achieving capital relief, securitisation can also be valuable for capital management purposes, perhaps this is particularly so for smaller ADIs and this may bring benefits to the competitive environment. So said Pat Brennan, Executive General Manager APRA, when he spoke at the Australian Securitisation Forum Conference, Sydney and discussed the recent changes to the updated prudential standard APS 120 Securitisation (APS 120), and an associated prudential practice guide.

This marks the culmination of some five years of policy formulation, and APRA’s updates on progress over this period have featured prominently at previous ASF gatherings.

In all prudential policy development APRA is guided by its statutory mandate: to balance the objectives of financial safety and efficiency, competition, contestability and competitive neutrality – and in doing so, promote financial system stability. In addition, when finalising the prudential settings for securitisation APRA also remained true to the principles that guided the policy development process throughout:

to facilitate a much larger, simple and safe, funding-only market;

to facilitate an efficient capital-relief securitisation market; and

to have a simpler and safer prudential framework.

Over the last five years APRA’s policy deliberations were greatly assisted by the active engagement of industry in the consultation process. This was both through the ASF and bi-laterally, through formal submissions and informal meetings. It seems fitting at this point to reflect back on this process and note some key aspects of how policy evolved through the consultation process. I will then make a few comments thinking of the role of securitisation looking forward.

Funding only securitisation

Let me start with the subject of the first principle I noted – funding-only securitisation – that is where an Authorised Deposit-taking Institution (ADI) is not seeking capital relief, rather the focus is on accessing term funding to support their lending activities.

Early in the consultation process APRA had serious reservations regarding date-based calls when combined with a bullet maturity structure. Whilst contractually in the form of an option, such a feature may create an expectation that repayment will definitely occur on the stated date regardless of circumstances. This represents a prudential risk should investors be allowed the ‘best of’ either repayment from the underlying pool of loans or from the originating ADI. This type of arrangement is allowed in the case of covered bonds, but controlled within a legislative limit. To allow a proliferation of other covered bond-like arrangements would be imprudent.

Through consultation industry clearly articulated the benefits of bullet maturity structures:

with their more certain cash-flow structures, a much broader range of investors can be accessed;

hedging costs for ADIs are reduced, possibly materially so; and

these factors clearly support a much larger funding-only market.

Industry also accepted that the prudential risk can be managed by the requirements of APS 120, but also through the approach taken by ADIs. Specifically, an ADI should create no impression that the call is anything other than an option for the ADI, and that a call is only exercised when the underlying assets are performing. To put it plainly: an ADI must never bear losses that are attributable to investors.

The finalised APS 120 therefore facilitates bullet structures – this is probably the most significant single development in APRA’s securitisation reforms and is the product of constructive consultation and careful consideration by APRA of how to strike the best balance of the various elements of its mandate.

Tranching

Moving on, many in this room will recall APRA’s early aspiration for a simple, two-class structure with substantially all the credit risk contained in the lower ranking tranche. Such a structure would avoid the problems of complexity and opaqueness associated with securitisation – problems that manifested so clearly through the global financial crisis.

In a general sense simplicity is good – but finance is often not simple. Industry feedback was clear – the concept of a two-class structure has significant shortcomings as the risk preferences of investors in subordinated tranches are varied, and to have an active capital-relief securitisation market greater risk-differentiation, and therefore tranching, is necessary. APRA heard this not only from ADIs but other industry participants as well, including investors – and we were convinced.

As a result APRA has relaxed its approach regarding the number of tranches, though we hope industry will not pursue complexity for complexity’s sake – this is a trap structured finance has fallen into before, with unhappy outcomes.

As a side note, and one that applies much more broadly than securitisation, at times there is a need to consider how things may be, and not be unnecessarily anchored to the current reality we are familiar with. When APRA embarks on this type of consultation it can, on occasion, open possibilities for better outcomes, outcomes that were not previously contemplated, perhaps also bringing opportunities for industry innovation. Policy reform by its very nature is about changing the status quo and industry needs to acknowledge that just because something has traditionally been done a certain way is not, in itself, an argument that it should always be so.

Risk retention

Risk retention is another area where consultation lead to a significant change in APRA’s thinking. Whilst the originate-to-distribute model has not been prevalent in Australia, APRA’s early view was that if there was to be a risk retention requirement it should be set at a level that will truly make a difference and bring alignment of interests between originators and investors. We proposed a level of 20 per cent. At the time there was also an expectation that international practices would be broadly consistent.

As time progressed a variety of skin-in-the-game requirements emerged internationally, generally set at lower levels. Assisted by industry feedback APRA reflected that an Australian requirement, in addition to the varied international requirements, would add regulatory burden for limited prudential benefit. So when balancing APRA’s mandate in the context of the feedback received through consultation, we placed greater weight on efficiency considerations and hence did not implement a risk retention requirement.

Capital requirements

Whilst APRA’s securitisation reforms relate mainly to ADIs as issuers, we are also naturally interested in the amount of capital ADIs hold for their securitisation exposures. We have updated capital requirements following the Basel Committee’s framework, but with adjustments reflecting the Australian context and in light of APRA’s objectives.

Once such adjustment is that APRA has not implemented the approach involving the use of internal models for setting regulatory capital requirements. Instead APRA has implemented the remaining two approaches from the Basel framework: an approach based on external ratings and a standardised approach. Whilst many in industry would have preferred APRA to allow the use of internal models, as we have implemented the risk weight floor of 15 per cent this considerably limits the potential differences in outcomes. This is because a floor of 15 per cent is likely to have been applied to the majority of securitisation exposures if internal models were used, reflecting the relatively high credit quality of the underlying loans. In addition, not implementing the internal models approach is consistent with the objective to have a simpler and safer prudential framework.

A second adjustment is APRA’s requirement that an ADI deducts holdings of subordinated tranches from their own capital. There is frequent comment on APRA’s conservative approach to capital settings throughout the prudential framework. The Basel framework sets minimum standards and the relevant authorities around the globe are expected to set higher standards where they see this as being appropriate – Australia is not alone in setting conservative standards. In the Australian context, with the majority of ADI assets being residential mortgage loans, APRA’s view is there is substantial potential risk in having any incentive in the prudential framework for ADIs to hold the more risky tranches of other originator’s securitisations.

After the lengthy and detailed consultation, APRA is firmly of the view the principles underlying these adjustments are appropriate. I note that, as a result of the consultation process, APRA did relax the level at which the deduction approach applies as industry outlined that with limited additional risk certain common securitisation structures will be viable for ADIs to use if such a relaxation was applied.

Warehouse arrangements

Throughout the process of reforming APRA has been motivated to remove the current unsustainable situation that can arise through warehouse arrangements where capital leaves the banking system with no reduction in risk in the system. In 2014 APRA proposed that a concession remain, but be limited in time to a period of one year. This proposal proved unpopular with industry, which APRA found a little surprising at the time given it was designed to retain the concession in full for a year, and we anticipated this would be economically attractive over at least a two year period. Nevertheless, industry feedback was clear and negative.

In 2015 we put this subject back to industry to propose potential solutions, noting that in the absence of any viable option being identified APRA would simply treat warehouses as any other securitisation – either capital relief or funding only depending on the degree to which each arrangement meets the relevant requirements.

The feedback we received generally asked for the existing concession to remain indefinitely, and as APRA had said, that was unsustainable. So on warehouses, the consultation process did not offer any viable alternatives.

The final APS 120 accommodates warehouses, but with no special treatment when compared to other forms of securitisation. APRA hopes that efficient funding structures are agreed between market participants so the benefits of warehouse arrangements can continue.

From these examples you can see that the final form of APS 120 is different to how it would have appeared if it was finalised even just two years ago, and very different to how it would have appeared if it was finalised a year or two prior to that. APRA has materially changed some policy positions and modified others as a direct result of consultation. In a few areas, where the prudential stakes were sufficiently high, APRA did not change its basic position – though the consultation process brought healthy challenge to APRA’s approach and caused us to consider aspects of the policy from a new perspective. In both cases – where policy was changed and where it was not – a constructive consultation process proved essential to arrive at the best possible prudential policy.

Looking forward we all hope to see the Australian securitisation market grow and prosper. Having a much larger funding-only market would provide ADIs the opportunity to strengthen their balance sheet resilience by accessing new sources of term funding, hopefully at relatively attractive pricing. With the more straight-forward approach to achieving capital relief, securitisation can also be valuable for capital management purposes, perhaps this is particularly so for smaller ADIs and this may bring benefits to the competitive environment.

APRA is soon to finalise the Net Stable Funding Ratio (NSFR) to be applied to 15 larger, more complex ADIs, and this is expected to be implemented in 2018 alongside the securitisation reforms. The Australian banking system has some notable features that are not very common around the globe. On the asset side the banking system essentially funds lending for housing on its collective balance sheet, whilst on the liability side the Australian banking system has a relatively low deposit to loan ratio. Whilst the affected ADIs are reasonably well placed to meet the NSFR requirement, new opportunities to strengthen funding profiles will assist in strengthening this measure over time – and this strengthening will make the system more resilient.

Whilst a much larger Australian securitisation market depends on market forces, which have ebbed and flowed considerably in recent years, it seems certain that over time opportunities to grow the market will present themselves. The updated prudential framework, and accommodating bullet maturity structures in particular, places ADIs well to take advantage of those opportunities as they arise.

The Great Interest Rate Pivot

Following the news from the US last week, the yield on the benchmark 10-Year bond has risen. This may signal the end of ultra-low interest rates and low inflation, and may create new challenges for central banks.

This is because the US benchmark has impact on the global capital markets, and will push other rates higher. This may see stock markets fall. Inflation may rise.

So, in Australia, we are probably at the bottom of the rate cycle, and the next move will be up. But meantime, as banks continue to rely on the international capital markets for some of their funding, expect out of cycle rate rises. Some fixed rate mortgages have already risen. Most households are on a variable rate mortgage, so would feel a rise straight away.

However, it may be good news for savers because conceivably savings rates will also begin to improve.

The sleeper of course is the potential hit on international trade should the US start a trade war. The fallout of a trade tariff argument between USA and China could hit Australia hard. If it did, we have little left in rate cuts to stimulate further, so employment may fall.

But given household debt is high, and mortgage repayments already large, any rise in rates would reduce household spending and lift delinquencies higher. Both depressive on house prices.

The next few months will be “interesting”!

Aussie robo-advisers are ‘horribly manual’

From InvestorDaily.

A CoreData shadow shop of domestic robo-advisers has concluded that automated advice is at least six to eight months away from “working” for the typical Australian consumer. Speaking at the Calastone Connect Forum in Sydney, CoreData principal Andrew Inwood said Australian robo-advice processes are “pretty prosaic” and have not yet managed to deal effectively with ‘know your client’ rules.

CoreData has spent the past six months conducting a shadow shopping exercise on the Australian robo-advice sector, Mr Inwood said.

“We’ve been communicating with them, asking them questions, going through the process of setting them up, closing the funds down, opening them again, putting in money, changing systems, and changing bank accounts,” he said.

“Once you open your account you’ve got to go through the whole process of identifying yourself as a client, which is horribly manual,” he said.

Clients are often required to fill in a paper form and send it to the robo-advice company in order to prove their identity, Mr Inwood said.

There is only one exception – Acorns Australia – which has managed to circumvent lengthy processes by using the banks’ existing knowledge, similarly to UBank, he said.

“There is still a long way for [Australian robo-advice] to go. It’s not true of the US, and it’s not true of the UK – but it’s certainly true of Australia,” Mr Inwood said.

“We’ve kind of rushed into this space [in Australia]. A lot of people used to be [online financial] calculator businesses and they’ve rushed into this space to try and be the next robo-adviser.

“But it’s not quite working. I would suggest that we’re six to eight months away from actually having it work.”

That is not to say there will be a “big future” for robo-advice in Australia, he said.

“It systemises and robotises the whole front end of the sales process. The bit which is expensive for the banks and implies risk for the banks,” Mr Inwood said.

“The bit where the mis-selling is – the bit where the ASIC inquiries are. The more that [wealth management firms] can do that, the better off they’re going to be. My sense is that this wave is coming but it’s still some way out.”

M&A Is In Very Late Cycle Mode Says Moody’s

Mergers, acquisitions and divestitures tend to accelerate when profits are nearing a cyclical peak says Moody’s.

Once it becomes apparent that organic revenues will fall short of expanding rapidly enough to supply sufficient earnings growth, companies often either look to the outside to acquire growth or attempt to divest underperforming businesses.

The previous two record highs for yearlong M&A activity involving at least one US-based company as either buyer or target occurred in the third quarter of 2007 and 2000’s first quarter. The cycle peaks for the yearlong averages of pretax profits from current production were set prior to the tops for M&A, in Q4-2006 and Q4-1997, respectively.

Between the peaks for profits and M&A, yearlong M&A posted scintillating average annualized growth rates of (i) 32.5% from Q4-2006 to Q3-2007 and (ii) 37.2% from Q4-1997 to Q1-2000. Similarly, M&A advanced by 15.9% annually, to a record $3.325 trillion, between profits’ latest peak of Q1-2015 to Q1-2016’s new zenith for M&A.

Latest Ratio of M&A to Profits Hints of Final Stage for Current Upturn

Since 1988, the ratio of M&A to pretax operating profits has averaged 90%. Nevertheless, the ratio of M&A to profits changes considerably throughout the business cycle. For example, the ratio of M&A to profits increased from its 73% average of the first four years of 2002-2007’s business cycle upturn to 121% during the recovery’s final two years. Moreover, after averaging 58% of profits during the first seven years of 1991-2000 economic recovery, M&A soared to 197% of profits during the upturn’s final three years.

The current recovery has followed the same pattern. Through the first five years of the current recovery through June 2014, M&A averaged 74% of pretax profits from current production. However, for the following two years ended June 2016, M&A averaged 144% of profits. As inferred from the recent historical trend, the 154% ratio of M&A to profits for the year-ended June 2016 suggests that the current business upturn is much closer to its demise than to its inception.

Rebound by Equities Contradicts What Occurred Following M&A’s Prior Two Record Highs

The continuation of subpar profitability offers no assurance of new record highs for M&A, especially if some combination of higher share prices amid above-average earnings uncertainty increases the risk of overpaying for business assets. At some difficult to define inflection point, persistently soft profits begin to weigh on M&A.

The previous two record highs for M&A suggest that M&A is likely to recede amid below-trend profits once the market value of US common stock crests. Immediately after M&A’s yearlong sum peaked in Q3-2007, the market value of US common equity set a new record high in October 2007. Similarly, March 2000’s then record high for the market value of US common stock occurred at the very end of an earlier record high for the yearlong sum of M&A.

Though the moving yearlong sum of M&A is likely to continue to fall from its latest zenith of Q1-2016, the market value of US common stock’s moving 20-day average has rebounded by 16% from its most recent low of February 15, 2016. Nevertheless, M&A has been unable to respond positively to higher share prices owing to how both business sales and profits have yet to convincingly establish rising trends. The fact that Q3-2016’s moving yearlong sum of M&A was down by -12% from its Q1-2016 peak hints of a growing sense among prospective buyers that business assets are grossly overvalued. The longer M&A slides amid a rising trend for share prices, the greater the likelihood that an equity market bubble has formed.