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Tuesday, 23 September 2008

Over The Counter v. regulated exchanges

It is a cold crisp sunny morning in Edinburgh at the end of a relentlessly sodden Autumnal Summer. Climate change is in the air and nowhere more so than in financial markets. Last night the First Minister met with financial and property professionals to discuss the implications of the HBoS/LTSB merger. The fear is of the multiplier effects of losing a FTSE100 company headquarters heralding a deeper malaise of possibly a long recession? The stress is numbing and not helped over breakfast by reading Bill Jamieson's necessary and admirable gloominess in The Scotsman, a long rambling piece that begins "GOOD morning, Austerity Scotland. Good morning to a world so old we think it new – and to a world we thought would never return. In one convulsive week our prospects have moved from summer to winter, from lightness to dusk, from hope to apprehension!" Jamieson, like any economist looking at the financial markets, has been gloomy for far longer than a week, this being only the latest of a long list of gloomy pieces by him and others in The Scotsman, and in all other quality papers, though none have devoted more trees to credit crunch despond than the FT, which over the past years has probably generated more analysis, news and commentary than all other newspapers added together! What has especially intrigued me is how much of what is said is by economists far more than bankers. I only wish that banking finance had been a bigger more central topic for analysis in traditional economics. The relation between finance and economic theory and empirical modelling has for too long been taken as implicit, as a given, or merely a secondary outcome that is fundamentally led by the underlying "real economy". It must now be clear to all that finance is wholly part of the so-called "real economy".
In Edinburgh, a significant finance centre and home of the moral philosopher Adam Smith (who I wished could have written Wealth of Nations fifty years later when he would have had to explain urbanism as the engine of capitalism rather than dwell so much on the factory model as the explanation for productivity and productivity the main explanation for capitalist growth) in these fin de siecle days, in the eye of the storm, Scottish gloom is focused on HBoS. Since HBoS shareholders are offered over 40% of shares of the combined group, it feels more like a merger than a takeover, but is subject to 75% shareholder approval (when 25% of shares are held by small shareholders who may oppose as they shunned the rights issue). They are angry with the Harvard MBA star and retail tyro CEO Andy Hornby, who looked shaken, stressed out, in interviews scarcely able, as all through the crisis, to say anything of special note. It is also not a done deal beyond LTSB's £120m break-up clause; other bidders may emerge for HBoS? Shareholders may seek to balance the deal more towards a 50/50 merger of equals - but that remains to be seen. HBoS is better capitalised and more profitable than LTSB and while its exposure to mortgages is nearly four times greater, surviving a property crash and a recession should not be beyond the means of this bank. This brings me to my point that the liquidity crisis (aka credit crunch) is not merely the fault of the banks; it is a problem of the wholesale banking markets!
Jamieson and other commentators (FT especially) are all saying that the markets of the future will be very different from the recent past, "back to the future" etc..
The biggest market failure has been in the Over-the-Counter (OTC) capital and credit derivatives markets. OTC really means telephone dealing where the pricing of deals is negotiatable by 'humans' though increasingly also transacted through money-brokers systems, central order book transaction systems, crossing networks, and via black box algorithms and other computer automated order giving and deal processing, but not in 'regulated' exchanges fully subject to prudential and investor protection rules. OTC markets were allowed if for professionals only, but that has changed dramatically as the internet has been allowed to facilitate millions of private individuals to transact in OTC cash and derivatives instruments (with off-exchange brokers as counterparties rather than private individuals being able to transact direct with derivatives exchanges). FX, money market and most bonds trading is OTC, and increasingly large % of equities trading too. The result is that the authorities lose sight of volumes, market quality, price creation etc. and while they and we can see prices, we cannot examine them for any wider systemic implications in terms of capital flows, trends and the underlying funds committed to these markets where for example (based on analysis I did for Reuters over many years) that funds available for trading may churn at rates ranging from more than once a day through to only once a month or once every 6 weeks.
In line with others I favour bringing huge swathes of OTC trading into fully regulated exchanges. This is now becoming a mantra in the USA. The FT today reports that the "reconstruction of Wall Street is expected to boost derivatives exchanges as regulators push for transparency and (confidence) shaken investors think twice about their trading partners". I believe that the Fed and US Treasury are now sitting on so much of several amrkets' assets that they have a golden opporunity (and I mean "golden") to design and implement new exchanges for mortgage products and credit deriatives, and other ABS structured products.
The FT suggests that a shift in transaction volumes is happening anyway, from OTC markets to exchanges. "Exchanges could benefit at the expense of the vast over-the-counter (OTC) market, where traders deal directly with each other and where major investment banks -- now either collapsed or badly shaken -- play a key role. The risks of trading in the hidden OTC markets were laid bare last week after derivatives dealer Lehman Brothers LEHMQ.PK filed for bankruptcy, sending counterparties scrambling to re-hedge trades elsewhere."
For years the debate about exchanges has focused on fragmenting them, reducing membership rights and turning them into public companies, and encouraging alternative ways of trading, as if this is the heart of competition, to reduce transaction costs and allow more entrepreneurial and technology experiments. Now, it seems that fashion is over and we have again to concentrate on the question of "quality of markets" in all its detailed aspects that often seem perplexingly intractable such as concluding how prices are best determined that most accurately reflect the "true market" given the variety of price discovery systems. Should we bring back broker-dealer "market-makers" and consider tiered systems where larger deals are able to be negotiated only by humans?
Related issues concern clearing houses. Their data has always been opaque and yet can tell us a lot about market quality. But, just as exchanges have been fragmented and disintermediated so too have clearing houses. Banks and brokers can create their own offerings. This means that markets find their liquidity is further fragmented, decentralised, and it is probably beyond the ability of the major market data vendors, Bloomberg and Thomson-Reuters, to aggregate or even to see all of this. The biggest clearing house in the world is the US DTCC, but it has traditionally only published net balances and therefore we cannot get to see actual volumes as to the underlying that has been transacted. Back in May, The Clearing Corp. (CCorp) reached an agreement with the Depository Trust & Clearing Corp. (DTCC) to build a central clearing house for the $62 trillion credit derivatives (actually CDS) market to be launched this Autumn (ambitious target). The service will start with trades in the Markit CDX high-yield and investment-grade credit default swaps (CDS) indexes in North America, and address 2 problems: bank capital constraints and counterparty risk (well of course, but liquidity and pricing remain problematic, not least given that, following takeovers and mergers, there is only one global third party pricing company (Markit/ iTRAXX/ FCS/ Creditex with a mere 1,000 banking clients)that has issues of analytical transparency that overlap with those of the ratings agencies S&P, Moody's, Fitch. Reuters and Moody's KMV who recently bought Fermat and a handful of others are also in this risk pricing market, but fundamental practical and theoretical problems remain, mainly to do with how banking and economies cotrrelate, interact or inter-depend.
Bear Stearns demise was triggered by Citigroup grabbing and selling off Bear's margin call collateral too cheaply. Clearing houses assume the credit risk that one side of a trade might fail to honour their commitments and this is a cost that can be borne by all members. bringing OTC trading on exchange and into central clearing houses is all about making the financial market players bear the first losses of systemic failure and letting the central banks and governments withdraw to the role of lender of last resort instead of being almost lender of first resort as we have seen over the past days and weeks and months!

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