The regulatory war on repo will have unintended consequences

In addition to the pending Basel-based regulation on minimum leverage ratio (see post), US regulators are pushing to set the minimum supplementary Tier 1 leverage ratio for the eight "systemically important" US banks to 5%. Once again, this is expected to hit the repo market as well as other assets with low risk weights.

Source: Barclays Research

This action will achieve the following:

1. Disrupt the functioning of money markets by pushing larger banks out of secured deposits. Deposits collateralized by treasuries (reverse repo) is the only way many institutional palyers can place cash with banks without taking unsecured bank risk. Now these institutions will be forced take bank risk or buy treasury bills - which will likely go negative as a result.

2. Reduce liquidity in the treasury markets. As discussed earlier, treasury trading volumes follow repo volumes - and this is not a great outcome for either.

3. Increase fails and the overall volatility of the treasury markets by making it harder to borrow treasuries.

Barclays Research: - A significant reduction in repo could reduce the ability of dealers to short securities without risk of being able to deliver, raising the prospect of the fails charge being triggered. This should factor into how aggressive they are at auction and actual auction pricing. Further, the possibility of increased fails could mean greater volatility in rates around Treasury auctions.

4. Create similar headwinds as in #2 and #3 above in the MBS markets and potentially other markets that involve some form of securities lending.

Barclays Research: - Full effects likely to be more widespread. We believe the knock-on effects of these rule changes are not likely to be limited to the Treasury and MBS markets. They would likely filter through to other markets, including credit and equities, potentially reducing liquidity and increasing volatility over time.

This regulation will certainly not reduce the risk of a systemic problem going forward - in fact it is likely to have the opposite effect. Banks will find other ways to make money, potentially by shifting to riskier assets. Ultimately it will be the end-users and market participants (mutual funds, ETFs, pensions, securities custodians, insurance firms, endowments, foundations, retail investors, etc.) who will feel the brunt of this regulation. Welcome to the world of "unintended consequences".


5 percent minimum for U.S. systemically important banks

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From our sponsor:

The Leverage Ratio regulation will hurt liquidity, introduce risks

New proposed bank regulation focused on the so-called Leverage Ratio is expected to do major damage to the US repo market. The measure is a blunt tool that does not permit any netting. That means if a client has a repo trade with a bank and an offsetting (reverse repo) transaction, the two can not be offset. Furthermore, the Leverage Ratio will show double the exposure by grossing up the transactions.

According to JPMorgan, this inability to offset positions will result in some $180bn of new capital requirements for major banks.

JPMorgan: - The inability of banks to offset repos against reverse repos could increase the denominator of the Leverage Ratio by up to $6tr. Applying the 3% minimum capital requirement to this $6tr potentially results in additional capital of $180bn across G4 banks.

That is expected to shrink the market considerably. And lower repo balances will reduce trading and liquidity in the underlying securities - the two markets are closely tied.

Source: JPMorgan

Some 80-90% of repo trades are collateralized with government securities, which will see declines in liquidity as the new rule goes into effect.

In 2008 financial institutions faced a major liquidity crisis that was in large part the result of short-term financing of highly illiquid securities. In order to address these problems, the regulators are now attacking the most liquid part of the market - the exact opposite of where they should be focusing. Ironically these new rules may actually introduce additional risks into the financial system by cutting trading volumes and reducing secured lending against government bonds, both of which are essential in a liquidity crisis.

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From our sponsor:

Credit hedge funds will continue to demand appropriate liquidity terms from investors

JPMorgan's prime brokerage division recently published a report on hedge fund liquidity terms (2012 Hedge Fund Terms Analysis). Here are some key highlights:

Over 60% of funds have quarterly or longer redemption frequency - which is to be expected. A large portion of the funds with longer periods between redemptions are credit funds, many of whom also restrict how much one can actually redeem per quarter (investor-level gate). This is important for these funds' survival because trigger-happy investors could quickly devastate them. Investors who "grew up" with listed equities often don't appreciate what it takes to liquidate credit assets such as bonds and CDS. And liquidity in these products is only getting worse, as the Volcker rule pushes dealers out of full market making (see discussion). This puts hedge funds at risk of having to unwind in markets where very few players stand behind their bid/ask quotes.

Hedge funds redemption frequency (source: JPMorgan PB)

Credit funds also require initial lockups (such as a year from initial investment) to make sure they build a diverse pool of investors. This way no one investor can force a devastating liquidation by pulling out. When it comes to "hard locks", lockup periods during which investors can not redeem under any circumstances, credit funds dominate.

Source: JPMorgan PB

Recently a more investor-friendly approach has been to impose the so-called "soft lockups". Investors are allowed to withdraw early, but are required to pay a penalty in these situations. Not surprisingly, credit funds have the highest penalties for early withdrawal.

Source: JPMorgan PB

As liquidity becomes more of a problem, the gap between terms for credit funds and other strategies (such as equities and futures) will only widen. Some funds will inevitably give in to investor demands for easier redemption terms (in order to raise more money). But these investors are asking for trouble. A large mismatch between the liquidity of assets (the portfolio) and of liabilities (investors' capital) will come back to haunt investors during volatile periods. That's when portfolios are dumped indiscriminately at ridiculous discounts just to meet redemptions, and investor losses are exacerbated.

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From our sponsor:

Jack Bogle wants to stop those naughty speculators

Jack Bogle, the founder of Vanguard, made some comments on CNBC today that warrant a discussion. He pointed out that the amount of new capital raised in the equity markets these days is about three quarters of a percent of the amount traded in the market during the same period.

CNBC: - "When you think about our financial system, the role of the financial system is to direct capital to its highest and best and most profitable uses," Bogle said.

While companies raise about $250 billion a year in equity financing through IPOs and additional equity offerings, Bogle said there's $33 trillion worth of trading going on, "which is basically betting on the psychology of the markets. It makes no sense."

He thinks it's a problem because people trade on sentiment rather than long-term investing, creating issues for the market and the economy. He is also saying that it hurts long-term investors.  Here are some thoughts on the topic:

1. The discussion initially was focused on high frequency trading. The real issue with that part of the market has more to do with quote spamming (which has been increasing) rather than the trading volumes.

2. High trading volume helps long-term investors by creating tremendous liquidity and reducing transaction costs. To buy or sell a stock costs a fraction of what it used to 10-20 years ago because of improved market liquidity and trading volumes. Transactions are also far more efficient in terms of execution than anything we've had in the 90s for example. And a long-term investor can have comfort that when it's time to sell a stock, she will be able to do it with ease (making her more likely to buy the stock in the first place).

3. Taking away liquidity, which is what would happen if trading volumes went down to several hundred billion per year, would turn the market into something akin to private equity. If Mr. Bogle thinks Wall Street is getting rich charging investors for stock trades, he hasn't seen the fees charged by private equity firms. And those who invest in private companies know you can't "rebalance" that portfolio.

4. The whole reason many firms can raise money in the US public equity market is its high liquidity. If liquidity is taken away, the $250 billion a year in IPOs and secondary offerings would decline to a fraction of current levels - a severe shock to economic growth. Imagine buying FB at the IPO and being forced to hold it for years (which would be Mr. Bogle's preference).

5. The fact that many investors trade in and out of stocks, even though most can't beat the overall market in the long run, should not concern Mr. Bogle. These traders (or what he calls speculators) are liquidity providers, and any healthy market absolutely needs them (whether it's stocks, futures, bonds, or FX).

Jack Bogle of course has a set of solutions to the problem of market "speculation".

CNBC: - He proposes three ways to limit market speculation — a transaction tax, a tax on very short-term capital gains and federal rules to make certain money managers are looking out for their clients' best interest.

Let's go through each of these:

1. Transaction tax will lower liquidity and end up hurting the small investor. As the French found out (see post), institutional investors often find a way to get around the tax (particularly if the regulation is poorly designed).

2. Tax on very short-term cap gains - and Jack Bogle wants it also to be charged to tax-exempt accounts - is simply a tax on people's 401Ks. That's because the bulk of 401K accounts hold some actively managed mutual funds. It's not enough for people to pay high fees on their retirement accounts (as mutual funds and the 401K providers both charge fees). Now they would have to pay taxes as well? Of course Mr. Bogle would prefer that everyone moves their money to Vanguard's index funds (which is not a bad strategy, but it's not for everyone and you can't force it on people). Another problem with this sort of tax is that investors would be encouraged to sell stocks that drop quickly (in order to offset their "very short-term cap gains" with "very short-term cap losses"). That would potentially precipitate sharp selloffs.

3. It's not clear what exactly he means by having "certain money managers looking out for their clients' best interest". Different clients have different needs and applying the Vanguard model is not for everyone.

Dictating (via legislation) to investors what they can and can't do is poor policy and goes against the concept of free markets. The whole idea of "punishing" this or that behavior with taxes and fees (in the name of fighting "speculation") is not productive.

Ironically, tax breaks for long-term holders is probably the best policy to encourage more long-term investing. Yet this policy is expected to be weakened shortly, as long-term cap gains tax is likely to be increased next year.

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From our sponsor:

Equity trading volumes in the US continue to shrink

As as sign of sharply declining share trading volumes in the US, the broad measure of exchange volume computed by Bloomberg (below) is at a level not seen since 2008.

US total exchange volume 180-day moving average (MM shares; source: Bloomberg)
Tape A, B, C on all US exchanges (exchange symbol US) plus OTC (exchange symbol UV) and OTCBB (exchange symbol UU) trading volume for all security types.

There is a great deal of debate about the reason for this trend and what it means for the market in general. One of the common explanations has been the fact that market volatility has declined recently, bringing trading volumes down with it.

WSJ: - Thankfully for many people, volatility is rather benign these days, which could explain why volumes as well are quieter.

The chart below shows S&P500 historical volatility (180-day moving window). Recent period volatility is indeed low, but it's by no means the lowest in the past 10 years. The relationship between volumes and volatility is not at all obvious.

S&P500 180d historical volatility (Bloomberg)

Another explanation is that retail investors, burned by a series of market shocks, are simply staying away.

USA Today: - Part of the reason volume is low is because retail investors have been turned off by stocks, says Ryan Detrick of Schaeffer's Investment Research.

Some view the retail investor staying out as a bullish sign. In the past retail involvement has been a fairly reliable contrarian indicator.

Credit Suisse (via Business Insider): - "We stay overweight of equities and raise our year-end S&P 500 target to 1,500 from 1,425 - introducing a mid-2013 target of 1,520," he writes. "We think weak volumes imply a high chance of a sharp move in markets - it could be up!"

But there are a couple of problems with viewing low trading volumes as a bullish sign. One is that the retail investor exit may be more of a structural change that is here to stay. Retail investors continue exiting equity mutual funds for example, in part replacing them with index ETFs (see discussion). This year alone, some net $68bn left equity mutual funds. That means betting on retail investors piling in all of a sudden - as they have done in the past - may not be prudent in this environment.

The other reason the contrarian bet may be premature is that some institutional participants such as hedge funds have also been less active in the market. The latest ISI Group Survey of hedge funds shows them to be on average underinvested (long or short). It's not all retail driven.

Whatever the case, declining volumes will be important to watch going forward. As the Volcker rule pushes dealers to cut inventories further, poor liquidity in some shares may quickly become a serious problem.

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Large corporate bond issues dominating secondary market

Earlier this year we discussed how the Volcker rule combined with Basel III is already reducing corporate bond liquidity by diminishing dealers' ability to make markets. It's just one of those "unintended consequences". Dealer inventories, which are essential for market making, have shrunk to the lowest level in 10 years. Some, including people at the Fed, have suggested that non-bank entities will step in to take the dealers' place as market makers. That is unlikely to happen in the near future.

One question that people are asking is why haven't we seen more lobbying from the corporate sector against the Volcker rule. There are multiple reasons for this, including corporations' unwillingness to put their reputation on the line by lobbying against this populist anti-bank regulation. But one of the key reasons is that the biggest impact will be on the medium to smaller US firms who simply don't have the resources to battle this legislation. With limited inventories the dealers increasingly make markets only in the largest bond issues, particularly those traded by the large corporate bond ETFs (LQD, HYG, etc.).

Source: CS

As liquidity in the smaller bond issues declines further, investors will demand a premium to hold them. Small to medium sized US firms will be disadvantaged relative to their large competitors due to higher cost of funds.

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Loan to deposit ratios comparison

Staying with the topic of periphery banks, here is a comparison of loan to deposit ratios for various nations' banking sectors. This is an indication of severe liquidity constraints that periphery banks have been experiencing. Much of that is driven by capital flows out of the Eurozone periphery.

Source: Barclays Capital

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Securities dealers' inventories at 2002 levels

US dealers continue to derisk their trading portfolios. Corporate securities (stocks and bonds) held on the balance sheets of major broker/dealers have hit the 2002 levels.

Dealer inventories (source: JPMorgan)

Furthermore as the market sizes have grown since 2002, the inventories now represent an even smaller percentage of the overall markets.

Dealer inventories as % of total markets (source: JPMorgan)

US banks and brokers currently hold roughly only 1% of all the stocks and bonds, down from the peak of 10%.   They have tightened their risk limits significantly due to increased risk aversion and in preparation for regulatory changes. This is expected to result in an overall reduction in liquidity, particularly in the credit markets.


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Unintended consequences: the new regulation will hurt the US corporate bond market

In their effort to remove proprietary trading from bank holding companies and increase capital requirements, regulators are destroying liquidity in the US corporate bond market. If you make markets (offer to buy and sell) in any product that has limited liquidity, you must run inventory. Baseball cards, antiques, or bonds - it's the same process. However between Basel III and the Volcker rule, the ability to maintain inventory is being undermined.

Barclays Capital: Increased regulation is a primary cause of this shift in dealer behaviour, in our view, in particular Basel III and the Volcker rule. Basel III significantly increases the risk-weighted assets associated with dealer balance sheets, thus making holding inventory more costly. Several banks have cited this change when noting material decreases in their fixed income balance sheets. For example, Credit Suisse announced that it plans to nearly halve the Basel III risk-weighted assets in its fixed income division over the next three years. Uncertainty about the implications of the limitations on proprietary trading included in the Volcker rule have also led dealers to reduce inventories. While the rule-writing process on that front is still ongoing, absent some substantial unexpected changes, the trend will likely continue towards reduced capital devoted to market making.

The dealers have started pulling back on inventory ahead of new regulatory framework   The chart below shows the levels of dealer inventory of corporate bonds, both High Yield (HY) and Investment Grade (IG) vs. mutual fund holdings.

Mutual funds tend to be "buy and hold" investors. Therefore price discovery in the corporate bond market comes from transactions facilitated by dealers or dealer quotes. As dealer inventories drop, transaction volumes decline and bid/ask spreads get wider.  In other words if you can't add bonds to you inventory or have no bonds in your inventory to sell, you will have to find the other side of the trade before you can transact.  If you don't have the other side of the trade ready (and usually market makers don't), you will make markets wide enough to compensate you for the risk of finding the other side later to unload your position.

Another troubling "unintended consequence" of the upcoming regulation is increasing concentrations.  Dealers will only make markets in the largest, most liquid names because the smaller names would not justify the capital usage in the new regulatory framework. The next two charts show the transaction volumes for HY and IG bonds sorted from highest to lowest.  The most liquid few issues account for the bulk of the volume.

Investment Grade

 

High Yield

Barclays Capital: As dealers shrink their corporate bond holdings and mutual funds demand higher liquidity, we see an increased risk of volumes becoming even more concentrated than they are currently. Indeed, in the first three quarters of 2011, of the nearly 628 tickers in the U.S. Corporate Index, the 37 most liquid credits accounted for 50% of the volume; only 10% of the volume was in the bottom 412 tickers (Figure 16). The volume concentration is even more pronounced in high yield – 50% of the volume in the first three quarters of 2011 was in 46 tickers (out of 1,140), with the bottom 821 tickers accounting for only 10%

Who cares, you might ask. It's the medium-size businesses who are going to get hurt. Because liquidity in their bonds is going to dry up, investors will become concerned that they would not be able to sell these bonds when they need to do so. Therefore they will demand an increasingly higher yield to purchase such bonds (liquidity premium). And the medium size business - who tend to create a great deal of new jobs - will be the ones paying significantly more to borrow money.

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Hedge fund liquidity may prove fleeting

This chart from Hedgebay shows the full history of secondary hedge fund transactions (that Hedgebay has in their database). The discount, which seems to be permanent for now indicates the liquidity premium one would demand to go into a fund that is presumably locked (via a lock-up, a gate, or a general redemption suspension).




Some of the discount may be valuation uncertainties, but with all the scrutiny on hedge funds these days, most valuation uncertainties would have been vetted with third parties. If they haven't been, no one would buy such fund even at a 10-15% discount.

Such liquidity premium means that funds who provide the best liquidity terms (within their strategy category) will be able to raise more capital than those who have long lock-ups and sidepockets.

It's somewhat of a dangerous game because this may create an asset-liability mismatch. That is funds will offer unrealistic liquidity terms just to get the capital in the door. As assets become fully priced and rates continue to stay low, hedge funds will be pressured to seek out less liquid strategies to squeeze out incremental returns. They may deploy leverage, making less liquid investments even more illiquid. The liquidity of the portfolio will become "mismatched" with the liquidity terms for redemptions (the liability side).

And when redemptions increase, funds will put up gates and we are back where we started. As much as institutions, particularly funds of funds seek the liquidity holy grail, these investments are not mutual funds, and the most "investor-friendly" liquidity terms may not provide the investor protection these institutions expect.

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The simplicity of financial regulation

With all the buzz on financial regulation and Obama's new proposal, people often miss the basics. Regulation of financial institutions (outside of securities and consumer protection regulation) should focus on two key items:

1. Capitalization. JPMorgan was involved in all the activities that Citi was. Securitization, mortgages, leveraged loans, investment banking, derivatives, etc. What put Citibank close to bankruptcy, while JPM got larger and potentially more profitable from the crisis (with Bear and WAMU acquisitions)? Citi was poorly capitalized relative to the massive risks they were taking.

2. Liquidity. Another critical issue that gets financial institutions into trouble is the inability to roll short-term liabilities that are used to finance illiquid longer term assets. Large entities holding long term illiquid bonds that are financed by commercial paper (short-term instrument) got Citi into huge trouble. Bonds financed via the overnight repo market got Bear into trouble. Examples of this are not limited to 07-08. Similar issues popped up in 98 and earlier. The inability to roll short term liabilities combined with difficulties liquidating the assets is a reoccurring theme. It's like buying a house with a one-year balloon mortgage. Corporate treasurers refer to this concept as Asset-Liability Management 101 – you must match your asset and liability profile.

The two issues above go hand in hand. If an institution is well capitalized, it can afford to take additional liquidity risk. If it matches assets and liabilities well (borrowing long-term to finance illiquid assets), it will not need as much capital.

One other regulatory item that is important to address has to do with derivatives. Institutions must maintain appropriate margin requirements on all derivatives transactions. If AIG was asked to put up margin (to institutions who bought protection) long before AIG got downgraded, the amount of CDS they had written would have been a fraction (if any) of the actual amount.

How does a regulator implement such requirements? A comprehensive set of stress tests that address deteriorating credit quality and/or market value of portfolios, inability to roll short-term debt, default of a major counterparty, etc. should do the trick. The stress tests would get adjusted periodically to pick up the latest trends. The rest is implementation and oversight to make sure institutions are applying the stress tests properly.

When it comes to regulation, conceptual simplicity is key. Creating thousands of complex rules and setting up layers of bureaucracy will only allow financial institutions to find another loophole. That’s what happened with the Basle Accord (see The holes of the BIS rule book.)

Unfortunately simplicity doesn’t get votes, and when you have an administration that runs a permanent campaign, populism sometimes becomes the mantra.

Secondary hedge fund transactions show less desperation

Hedgebay a facilitator of secondary hedge fund transactions (the supposed E-bay for hedge funds), released their monthly results on secondary transaction valuations. Numerous hedge fund investors in need of liquidity who got slammed with gates, redemption suspensions, or have long lockups have been trying to get their money out. The only way to do that is to privately sell their investment to a third party (who is less concerned about liquidity) at a discount to NAV. The index below is a compilation of some fraction of secondary transactions that Hedgebay was involved with (or has access to).



We saw a large dip earlier in the year as investors were desperate to get out. Now however the discounts are much smaller. Does that mean improved confidence in the hedge fund asset space? Explanations have to do with fund managers lifting (or promising to lift) gates, hedge fund improved performance this year (we'll discuss that shortly), and just the fact that those who desperately needed liquidity may already have it (so less need to sell at a large discount). This result however is basesd on significantly lower volumes:

"volume was muted – both in terms of number of transactions taking place as well as in the absolute amount of closed transactions. The two categories showed the lowest totals for the year while volume was the lowest monthly total in the last 8 months."