Man FRM Early View

One of the difficulties of commenting on financial markets in real-time is that the magnitude of the importance of events is only truly apparent in hindsight. In February 2007, HSBC warned that bad-debts from their sub-prime mortgage book would be higher than expected. That month the S&P 500 Index fell by around 2% but then rallied back to fresh highs over the next four months. Of course, from our current vantage point it is now easy to draw a causal path from that point through to the collapse of Lehman Brothers in September 2008.

We may look back at August 2017 as another turning point in the risk appetite of investors. Once again, the S&P retreated following a good run, down around 2% during the month, only to rally over the last two days to finish the month flat. Of course, the late rally probably means that things have returned to normal – the macroeconomic backdrop remains strong enough to carry risk assets in the absence of a large exogenous shock (Trump making a mess of the presidency doesn’t appear to be enough of a shock while the data stays good) and Central Bankers seem to be competently managing the end of Quantitative Easing (“QE”). The long-awaited Jackson Hole Symposium failed to deliver anything seismic and, in isolation, there is no reason for us to believe that Central Banks could not start to collectively shrink their balance sheets in a controlled manner. But as history shows things do not take place in isolation, and it is the improbabilities of the current outlook that interest us, since they appear to be growing in our view.

CIO Perspectives

Writing papers for me is very therapeutic. It gives me a chance to share thoughts and views on the future that combine macro themes with markets and psychology. The internal debate involved in the learning process in my head before these words hit the paper is fairly intense. As these views are shaped, I question everything and look for more and more external insights before feeling my thoughts are clear enough to share. Many times, the paper changes dramatically during this process. Much of this learning process comes from the experience of growing up in a house where my father was very argumentative and cynical, thinking the best way to teach me was to never agree with me and to try to prove that in life you will hear few facts and infinite opinions. Spending many years after I left home reading books on psychology for obvious reasons, I am sure that internal debate in my head is directly related to those combative debating sessions with my father. Needless to say when you are taught 2+2=4 and the rest is up for discussion, I had a hard time enjoying the ‘sage on the stage’ routine that school offered up. Once I entered into the world of finance, and in particular derivatives, the opportunity to brainstorm ideas and solve problems with others, combined with the job of a stock market cryptographer, created an environment where learning became enjoyable and quickly an obsession. Remembering what my father taught me that most of life is art, not science, I write these papers as a Bayesian thinker knowing that these views are all probabilistic and need to evolve as new data comes into play. Once a paper is done, there are usually a lot of differing views from the readers which many times has helped set up the next journey of thought into the following paper.

MiFID II and Evolving Equity Execution

Fragmentation of equity market microstructure and liquidity has manifested in a near doubling of trading venues from 17 in 2007 to 30 a decade later, while average ticket sizes have been divided by seven, dropping from EUR 28-30,000 to EUR 4-5,000 over the same period. The increased complexity of navigating these markets has forced asset managers to raise their game. “Execution efficiency is a cost of doing business and it is getting harder and harder not to invest a lot of money,” says Francois Banneville, Societe Generale’s Prime Services Head of Execution, who has seen most of his clients reorganise their desks over the past two years. There have been two key trends. “One big theme was trading across asset classes. Another was trading electronically, partly to manage costs and increase the STP rate, but also to tackle more efficiently the evolving market microstructure,” he notes.

Interest Rate Arbitrage in Negative Yielding Currencies

In a world of negative interest rates and growing risk for asset price bubbles everyone is seeking new high yield/low risk opportunities. One might be based on the weird situation that banks pay deposit rates which are above the inter-bank lending rates. This offers a possibility of arbitrage in CHF and EUR especially for wealthy private investors with a sizeable bond or equity portfolio.

1. Idea
The idea is very simple. Get a loan with negative interest rates, use your bond or equity portfolio as collateral and deposit the capital that you get from the loan for an interest rate of zero. The result is that you’ll get interest for the loan (because of the negative interest rates) and you’ll get and pay nothing for the deposit. Ideally you even receive interest on your deposit and you can leverage this deal 10+ times and you will earn a high return with a low risk profile, but let’s see how the trade works.

Taking Away the Punch Bowl

Large-scale, continuous, and at least somewhat coordinated, fiscal and monetary responses from governments and central banks around the world have changed the landscape of markets and the pricing of assets. Like an open-minded and overtly obliging doctor, the Fed has been doling out prescriptions of reduced fear and enhanced greed to anyone needing a fix. Driven by investor feelings of bravado from being handed a free put option and expectations of a new normal (low interest rates for the indefinite future), most measures of market value have skyrocketed to all-time highs as speculators have demonstrated disregard to the quality of earnings or credit. Interest rates have been kept at rock-bottom levels, while quantitative easing, once little more than a footnote in textbooks, has become a common monetary policy mechanism that the market has, at least implicitly, taken for granted. Now investors scratch their heads as they ponder the implications of tighter monetary policy as the Fed heralds the “long march to normal” as they “embark on the great unwinding”. Call it what you will, but note with near certainty that this is the beginning of the end of easy money. The market, if weaned gradually, may traverse a non-traumatic transition to a not-so-new new normal. But it just may be that the Fed, in the famous words of William Martin, its longest serving Chairman, is abruptly fulfilling its duty “to take away the punch bowl just as the party gets going”. If so, the hangover comes next.

Endowment Style Investing Made Accessible

The current period of low rates, unprecedented low volatility, lack of dispersion at all levels, and middling non-equity portfolio returns continues to draw investors towards considering multi-asset investment managers. Multi-asset investing generates a good deal of press, ranging from the definition to the proper implementation. For the past several years asset managers have commercially built out capability and rolled out products to meet the interest level. The offerings, historically available to large institutional investors, are now available to a wider swathe of investors in co-mingled and customized vehicles. It is this access by most levels of investors, including private investors, to the “endowment style” of investing employed by the most sophisticated investors that is getting a great deal of attention.

Multi-asset investing can trace its roots back to the balanced funds of the 1920s (some of which still exist) which first incorporated standard, liquid equities and bonds in a single fund. This mix of domestic equities and investment grade bonds in 60/40 weights has certainly stood the test of time and is still a benchmark.

Sluggish Wage and Productivity Growth

Despite a tight labor market, wage and productivity growth remain low in the US. Wage growth stood at just 2.5% in July 2017, on par with post-Recession performance. Labor productivity growth averaged only 1.1% between 2007 and 2016. Between 1995 and 2007, by contrast, the average growth rate was 2.5%. Although cyclical factors may be partially to blame, there are several key structural features of the US economy contributing to diminished growth. Wage and productivity growth are being held back by persistently low inflation expectations, workforce demographics, and the shift in the payrolls distribution in the economy in favor of lower-wage sectors.

The Federal Open Markets Committee’s (FOMC) minutes of the July 25-26 meeting underscored its concern with wage and productivity data. The committee noted there was “tightness in the labor market, but. . . little evidence of wage pressures.” Some FOMC participants speculated if the “hiring of less experienced workers at lower wages” was a contributing factor. Others pointed out that low wage growth is in line with what productivity growth and the inflation rate (both sluggish, of late) would suggest. Indeed, the Federal Reserve’s concern about wage and productivity growth is likely to be a major factor in the debate over the timing and termination point of future rate rises – arguing for fewer and further apart hikes, and perhaps a termination point around the range of 1.50% to 1.75% for federal funds.

Asian Hedge Funds

1. Why are Asian hedge fund assets small relative to GDP and local savings rates?
Firstly, financial markets in Asia are less mature than their US or European equivalents. This results in a smaller range of securities and instruments that a hedge fund can access and utilize in the context of a hedge fund strategy. For example, access to borrow in the China A-share market is limited, cutting off a significant opportunity set/risk management tool for a large number of managers. While this type of exposure can be accessed elsewhere (i.e. H-shares, US-listed ADRs), the regulatory environment in the A-share market effectively limits the amount of AUM that China-focused L/S managers can optimally run in this space. Furthermore, credit markets in Asia are less developed than their US and European counterparts where CMBS, RMBS, ABS and corporate loans and bonds are all of significant breadth and depth. All in all, financial markets in Asia do not offer the same broad range of building blocks as peers in the US and Europe, restricting the range of hedge fund strategies that can be operated at meaningful size (more than $1bn).

Editor’s Letter - Issue 126

AIMA are fielding more member queries about MiFID II (unbundling, call taping, best execution etc.) than anything else, says Deputy CEO Jiri Krol, but there are other important items on the European regulatory agenda. To “strengthen the powers of ESMA to promote the effectiveness of consistent supervision across the EU and beyond” is now priority action #1 of the EU’s CMU mid-term review. ESMA opinions are now focusing on differences between countries’ authorisation and delegation arrangements. These must meet minimum standards, but many regulations, including MiFID II, allow for different application. Some regulators complain about perceived lighter standards applied by others. The UK has historically “gold plated” MiFID whereas other countries stuck to its minimums.

Any shift from a “lowest common denominator” to a “highest common denominator” philosophy for harmonising European regulation could threaten the delegation model that provides the foundation for Europe’s globally competitive asset management industry. “Delegation is vital for the EU asset management industry to survive as a single market that can benefit from specialisation. It encourages member states to group service providers within a single jurisdiction. This lets asset managers inside and outside the EU outsource activities such as the depositary function. The model has worked well and has not caused any issues in terms of financial stability or investor protection,” reflects Krol. “Though some additional conditions are imposed on third countries, delegation criteria are broadly similar for countries inside, and outside, the EU. So a Brazilian fund manager can act as adviser for a UCITS.” AIMA is reiterating the importance of delegation in discussions with ESMA and European Commission officials.

National Exam Program Risk Alert

This Risk Alert provides a summary of observations from OCIE’s examinations of registered broker-dealers, investment advisers, and investment companies conducted pursuant to the Cybersecurity Examination Initiative announced on September 15, 2015.

I. Introduction
In OCIE’s Cybersecurity 2 Initiative, National Examination Program staff examined 75 firms, including broker-dealers, investment advisers, and investment companies (“funds”) registered with the SEC to assess industry practices and legal and compliance issues associated with cybersecurity preparedness.2  The Cybersecurity 2 Initiative built upon prior cybersecurity examinations, particularly OCIE’s 2014 Cybersecurity 1 Initiative.3 However, the Cybersecurity 2 Initiative examinations involved more validation and testing of procedures and controls surrounding cybersecurity preparedness than was previously performed.

The examinations focused on the firms’ written policies and procedures regarding cybersecurity, including validating and testing that such policies and procedures were implemented and followed.  In addition, the staff sought to better understand how firms managed their cybersecurity preparedness by focusing on the following areas: (1) governance and risk assessment; (2) access rights and controls; (3) data loss prevention; (4) vendor management; (5) training; and (6) incident response.


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