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liquidity

Why is the story that some of Deutsche Bank’s investor clients have started shifting their accounts from the bank, as Bloomberg reports, particularly worrying?

A number of hedge funds, which use the bank’s prime brokerage service, have moved part of their listed derivatives holdings to other firms this week, according to an internal bank document leaked to Bloomberg.

Deutsche, like many other banks, acts as a clearing member of the central counterparties (CCPs) where trades in listed derivatives—primarily equity and interest rate futures and options—are cleared and settled. Clearing members act as intermediaries between clients, such as hedge funds, and the CCP.

And that’s the troubling part of the story. The whole point of a CCP is to interpose itself between trading counterparties, so that no one counterparty is exposed to the credit risk of the other (a panic over the prospect of widespread defaults in the non-listed, or “OTC” derivatives market, where such bilateral credit risks do occur, was the driver of the 2008/09 financial crisis).

It’s easy to understand why counterparties to AIG in 2008, concerned about the prospect of non-payment on bilateral trades, all demanded collateral from the failing firm, depleting its liquidity and driving it over the edge. But why might some of Deutsche’s hedge fund clients now be moving their business in centrally cleared derivatives, where any AIG-like counterparty risk concerns shouldn’t arise?

One problem, well explained by Scott Skyrm, is that in a number of recent failures of futures brokers/clearing firms, the firms dipped into supposedly segregated client assets (primarily cash) in the days prior to their collapse. Skyrm notes that, despite new regulations put into place after the failure of futures brokers like MF Global, Sentinel and Peregrine, client cash is still at potential risk.

In the UK, nervousness about the safety of clients assets held in custody has been inadvertently amplified by a 2012 court ruling.

As reported in a recent briefing on asset safety by consultancy Thomas Murray IDS:

“When Lehman Brothers’ UK entity went bust in 2008, it emerged that it had failed to segregate client from proprietary assets, leading to a multi-billion dollar shortfall in the UK client asset pool.”

“Conflicting claims by Lehman’s clients set in train a lengthy legal battle, which ended in the UK Supreme Court in 2012. At issue was the question of whether only those clients whose assets had been properly segregated were entitled to claim from the client pool, or whether all clients had a claim, irrespective of whether Lehman had followed correct procedures.”

“The UK Supreme Court took the latter view, even though this overturned longstanding principles of English trust law. The Supreme Court’s judgement meant that, henceforth, even if clients made efforts to ensure that their assets were properly segregated by an investment firm, in the case of the firm’s failure the properly segregated clients’ claims could be diluted through no fault of their own by the ability of non-segregated clients to access the pool of client funds.”

This judgement, meant to safeguard all clients, clearly incentivises a run on a bank that’s in potential trouble.

So you can see the potential for nervousness regarding client cash. But what about the holdings in futures themselves? In theory, listed derivatives positions ought to be immediately portable to a third party.

“If (and it’s a big if) you have individual segregation and portability, then you should not have to care who your clearing broker is—that’s the theory,” says Thomas Murray’s Tim Reucroft.

Under Europe’s Market Infrastructure Regulation (EMIR), clearing members of a CCP have to offer their clients a type of account called individually segregated, as opposed to “omnibus” accounts where clients’ holdings are commingled with those of other clients. This should guarantee the ease of movement of individual accounts’ holdings if a clearing firm fails.

“You just move somewhere else and it’s business as usual,” says Reucroft.

“But my guess is that a lot of the hedge funds will have opted for omnibus accounts, not individual segregation, since it’s too expensive.”

And Reucroft spots another potential risk elsewhere in the chain of post-trade market infrastructures.

“Imagine the scenario: the clearing broker goes bust, you port your positions to another bank—so far so good. But it’s turbulent times, your new clearing broker calls you more margin on your exchange-traded derivatives positions. Where does this come from? You sell equities or bonds to raise the cash, but your cash clearing broker is still the original bank and they’ve gone bust. There is no portability written into Europe’s Central Securities Depositary Regulation (CSDR). So now you go bust at your new clearing broker because you can’t meet the margin call. Dominos.”

So there’s a systemic risk aspect to the Deutsche/hedge fund story that merits close attention.

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US mutual fund manager Third Avenue Funds’ justified its decision on Wednesday to gate redemptions from its Focused Credit Fund (FCF) as follows:

“We believe that, with time, FCF would have been able to realize investment returns in the normal course. Investor requests for redemption, however, in addition to the general reduction of liquidity in the fixed income markets, have made it impracticable for FCF going forward to create sufficient cash to pay anticipated redemptions without resorting to sales at prices that would unfairly disadvantage the remaining shareholders.”

Instead, investors remaining in the fund will be placed in a Liquidating Trust and will have to wait for the return of their money until the fund manager can dispose of the assets at what it calls “reasonable prices”. That may take months or more.

US mutual fund investors entering and exiting a fund do so on the basis of the fund’s net asset value (NAV), which is hard to determine in illiquid markets. If exiting investors are able to do so at prices that do not reflect the liquidity of the underlying market, they obtain an unfair advantage over those remaining in the fund, whose interests are diluted.

A central question is unanswered in Third Avenue Funds’ statement. Why not mark down the fund’s NAV until it reflects the price at which its portfolio of junk bonds can be sold?

Marking fund NAVs to the “bid” side of quotes in the portfolio is common practice in a bond fund, since it represents the most conservative approach. A portfolio of assets is realistically worth what it can be sold at.

The fact that Third Avenue felt unable to do this is the most worrying aspect of its fund closure. There are persistent reports that liquidity in junk bonds is so poor that a request to market makers for a quote on a portfolio can be left unanswered. Bonds go “no-bid”, in other words. As a former market maker in emerging market debt, I remember from the Russian crisis of 1998 that the market could simply stop and there was no prospect of selling your holdings at all.

The risk of bond illiquidity reoccurring on its scale has been masked by central banks’ zero interest rate policies. As many have argued, putting illiquid, higher-yielding assets in funds promising daily liquidity to investors has created large-scale structural risk. In simple terms, it’s been an accident waiting to happen. Following Third Avenue Funds’ decision to suspend redemptions, the managers of other funds investing in junk bonds, bank loans and emerging market debt will be looking nervously over their shoulders.

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When you agree a trade with a counterparty you’re done, filled, executed, correct? My word is my bond, and all that?

Depending on where you do your trading business, yes, possibly, or not at all. In the worst case, you may have granted your counterparty a free option to reprice trades to its advantage.

Following last week’s dramatic breakdown of the Swiss franc/euro currency peg, several electronic FX brokers decided to “revisit” executed client orders.

For example, according to commenters on the Bronte Capital blog and elsewhere on the internet, Saxo bank told its clients that trades agreed and confirmed in the immediate aftermath of the currency move would be moved to a level more favourable to the broker.

One client’s apparently executed stop-loss at EurChf 1.20 was moved to 0.9625, another’s from 1.184 to 0.9625. For leveraged clients, such a repricing may have turned a painful shock into insolvency.

How are Saxo-like repricings possible?

It turns out that the Danish bank had covered itself via the legal small print of its client contracts, which stated:

“It is possible that errors may occur in the prices of transactions quoted by Saxo Bank. In such circumstances, without prejudice to any rights it may have under Danish law, Saxo Bank shall not be bound by any Contract which purports to have been made (whether or not confirmed by Saxo Bank) at a price which: 

(i) Saxo Bank is able to substantiate to the Client was manifestly incorrect at the time of the transaction; or 

(ii) was, or ought to have reasonably been known by the Client to be incorrect at the time of the transaction. 

In which case Saxo Bank reserves the right to either 1) cancel the trade all together or 2) correct the erroneous price at which the trade was done to either the price at which Saxo Bank hedged the trade or alternatively to the historic correct market price.”

But surely exchange-based trades—where the exchange stands between buyer and seller—aren’t vulnerable to such after-the-fact repricings or cancellations?

Unfortunately they are.

In 2013 Goldman Sachs was able to bust (get out of) a large number of options trades which it had priced incorrectly, apparently as the result of a computer error.

But why was Goldman able to do so, when in a similar case a year earlier market maker Knight incurred huge losses and was forced into a fire sale of its business?

Because the rules of NYSE Euronext’s options trading venue, where most of Goldman’s losing options deals were apparently executed, permitted it.

By contrast, cancellation trades for equities (imposed after the 2010 “Flash Crash”, another case of trades being torn up after the event on the basis of an arbitrary judgement by the exchanges involved), were apparently stricter, meaning that most of the trades spewed out by Knight’s rogue algorithm were forced to stand.

But it gets even more complicated. According to Bloomberg, while NYSE Euronext voided its share of Goldman’s options trades, the bank’s options trades executed on other exchanges were either left untouched or repriced:

“The majority of the reviewed trades at the International Securities Exchange were adjusted and not canceled, based on the exchange’s rules, Bats Global Markets Inc. let the few hundred trades on that venue stand while Boston Options Exchanges adjusted trades.”

“It’s crazy when you look at how ISE does it one way, CBOE does it another way, Amex does it yet another way, that is absurd and it is demonstrably dangerous,” Mark Longo, founder of the Options Insider, told Bloomberg at the time.

“Let’s say you’re a market maker and you put up the same trade on three different exchanges, then you have three different processes you have to deal with to bust or adjust the exact same trade and you may have three different outcomes. How is that beneficial to anybody?”

Good question. And in the aftermath of another algorithm-accelerated rout in the Swiss Franc last week, it’s one that every investor should be asking. Understand how the rules of your trading venues or counterparties work in a market crisis or you risk being the next victim.

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Today the main US-listed high yield bond ETFs, BlackRock/iShares’ HYG and State Street’s JNK, are trading at levels unseen for over two years. At the time of writing, HYG is at 88.10, down nearly seven points in price from an interim peak of 95 in late October.

Junk bond indices have been hit by the sharp post-summer decline in oil prices and fears of broader deflation: according to Dave Nadig of ETF.com, 15% of the index underlying HYG is in bonds issued by energy companies; for JNK’s index it’s 17%.

Here’s a three-year chart of HYG, JNK and Invesco Powershares’ BKLN, another high yield ETF, this time investing in senior bank loans from sub-investment grade companies. The three ETFs’ prices are rebased to 100 at the end of 2011.

hyg jnk bkln

Source: Google Finance

Over recent days many analysts have been pointing out the divergence between the weakness in the junk bond market and the relative strength of US equities. In the past such divergences have hinted at equity market falls to come, since the credit market tends to act as a leading indicator.

Unlike during previous bouts of market nervousness, the price declines in the high yield market haven’t so far been met with large-scale ETF redemptions. During the first half of 2013, the last significant sell-off, HYG and JNK lost up to 20% of their net assets, a collective outflow of $5 billion. This time round things have so far been different: Nadig noted earlier this week that the two funds have pulled in almost $3 billion in new assets so far in the fourth quarter. Of the three ETFs in the chart above, only BKLN has seen net redemptions for the quarter to date.

Here are the Q4 fund flows for the three ETFs, courtesy of ETF.com.

HYG flows Q4 JNK flows Q4BKLN flows Q4

That’s what’s concerning about recent price weakness in the sector. During previous market downturns (notably in June last year) the redemption mechanism of high yield ETFs has been put under strain. Meanwhile, by many accounts, the underlying liquidity of the corporate bond markets has worsened further.

What if the sell-off in junk bonds hasn’t even really started?

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Take two exchange-traded funds (ETFs), both on sale to retail investors, both investing in dollar-denominated high yield bonds. The funds are run by the same asset management firm, both track an index from the same benchmark provider and both promise their authorised participants (APs) the ability to create and redeem fund units daily on the basis of the underlying net asset value (NAV).

APs are the entities that transact in wholesale lots with an ETF fund issuer, an interaction that dictates how the fund is priced in the secondary market, where most of us buy and sell it.

Yet in one prospectus we read that the ability of investors to exit the fund may be curtailed in a number of circumstances. The ability of APs to redeem their fund units, says the prospectus, may be suspended if any of the principal underlying markets are closed or if the fund’s directors decide it’s difficult to determine the NAV.

More broadly, redemptions can be halted if the directors decide a suspension of dealing is in the interests of the fund, its shareholders or the investment company (an “umbrella” structure under which tens of ETFs are issued).

And even if none of these things occur, the fund may limit redemptions to 10% of the fund’s assets a day, meaning that large withdrawals may be scaled down and that those heading for the exits may have to wait.

Under any of these circumstances you could expect secondary market trading in the ETF to come to an effective halt.

In the other prospectus—remember, for a fund sold by the same firm, tracking an index in exactly the same asset class—there’s no mention of a possible suspension of redemptions.

All we read is that “if particular investments are difficult to purchase or sell, this can reduce the fund’s returns because the fund may be unable to transact at advantageous times or prices” and that, if it’s difficult to obtain reliable quotations for securities held by the fund, its manager may use a so-called “fair value” approximation of the securities’ worth in order to calculate the NAV.

Why the difference in language? The first fund operates in Europe and in compliance with the region’s UCITS rules. The second is a US ETF, operating according to the 1940 Investment Company Act, the governing regulation for US mutual funds.

A central principle of the 1940 Act is that investors should be able to redeem their fund units on demand. Unlike in Europe, where local regulators accept the possibility that redemptions may be suspended or “gated”, the US mutual fund rules dictate that fund inflows and outflows should continue even when the liquidity of underlying markets is compromised. There are very narrow exceptions to this principle, mainly relating to the closure of local (US) equity markets.

Does this difference in regional approaches matter?

In its March 2013 principles for the management of liquidity risk in collective investment schemes, IOSCO, the international coordinating body for securities regulators, accepted that liquidity crises in funds are less likely to cause systemic confidence problems than when the same occurs in the banking sector. Investors know they can lose money when buying a fund, or they should do.

But IOSCO’s principles are very high-level and non-prescriptive, no doubt as a result of the transatlantic differences in fund frameworks. In 2012 the regulatory body skirted around the fundamental gap in mutual fund rules by saying that the suspension of redemptions by a mutual fund may be justified only if permitted by (local) law.

IOSCO—whose principles are non-binding—has advised fund managers that they should not promise more frequent liquidity to investors than is appropriate for the underlying asset class and that liquidity risk and a fund’s liquidity risk management process should be effectively disclosed to prospective investors.

Again, this is subject to very wide interpretation in practice. Mutual funds promising daily redemptions (and, in the case of ETFs, instantaneous dealing), now invest on a large scale in a variety of asset classes that have been prone to liquidity crises in the past, from high yield bonds, to emerging markets equity and debt and even senior bank loans.

BlackRock, the asset manager responsible for the two ETFs I mentioned earlier (Europe-listed SHYU and US-listed HYG), has recently called for globally consistent best practices for fund structures, liquidity risk management and investor disclosure.

This is a hot topic, with those charged with ensuring the stability of the financial system now taking a much closer look at whether mutual fund run risk could cause wider contagion. IOSCO and the G-20 Financial Stability Board are due to issue a new consultation on systemically important non-bank financial institutions by the end of the month.

If a fund issuer gates redemptions in one jurisdiction, could there be a run from its funds elsewhere? I don’t know. But while local rules continue to differ so markedly, it’s hard to see how US investors are getting the same message on fund liquidity risk as those in Europe.

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Could the post-LIBOR regulatory crackdown on banks exacerbate price movements when indices are rebalanced?

Late afternoon on Friday shares in Dutch bank ING jumped nearly 5% in heavy trading on the Euronext Amsterdam exchange.

ING Price Spike

ING

Source: Yahoo Finance

The price spike has now been fully reversed. A 5.75% increase in ING’s share price on Friday has been followed by a 4.69% decline yesterday and a further 1.23% fall so far on Tuesday morning.

ING’s late-Friday price move seems related to the reconstitution of equity indices. Friday’s market close set the price at which ING’s shares entered two indices from STOXX—the Euro STOXX banks index and the STOXX Europe 600 Banks. The latter index is a popular one: it underlies several European equity sector ETFs and is reportedly used in many bilateral swap agreements.

Both STOXX and ING declined to comment on Friday’s share price movements.

Price movements in shares entering and exiting benchmarks are a well-known phenomenon, and an unsurprising one. Index changes mean unavoidable cash flows in a whole range of tracker products, including futures, swaps, ETFs and index funds, which other market traders can try to exploit.

STOXX announced the September constituent changes for its indices on August 26 and between August 25 and September 18 ING shares had already risen 8.43%, a not-uncommon price rise between the announcement date for an index addition and the date on which the addition becomes effective.

So why the unusual late-Friday action?

According to one trader I’ve spoken to, post-LIBOR restrictions by banks’ compliance departments on their traders’ index-related deals may be having the effect of forcing market participants into the end-of-day auctions on stock exchanges, which are used to set closing prices.

Previously, said the trader, bank dealers could pre-position their trading books for index changes. Now, he argued, after the LIBOR revelations banks are scared of being seen to exploit benchmark-related trading flows. Instead, he told me, they are now taking the most conservative option: trading at the actual price point at which the index change occurs, even if this leads to a less efficient execution.

Managers of index-tracking funds and financial products face a similar dilemma: place a trade in the closing auction and risk losing money (as anyone buying ING at Friday’s close would have done by Monday morning) or attempt to trade either pre- or post-close. Shunning the closing exchange auction may mean you avoid involvement in a crowded trade, but fund managers will incur tracking error if the fund’s execution price is significantly different from the price used by the benchmark calculator.

Rebalancing-related share price movements may be exacerbated by another factor, the trader told me: the widespread use of volume-weighted average price (VWAP) algorithms. VWAP algos automatically seek to trade when volumes are highest.

“The more volume in the closing auction, the more the VWAP will seek to execute there, leading to more volume in the auction, more VWAP execution….in other words, a feedback loop,” the trader told me.

Not everyone I’ve spoken to agrees with this explanation. The ING price spike could have been caused by someone realising late in the day that they were incorrectly positioned for the index change, or even by a mistake, other traders suggested.

As the volumes of money in tracker products increase, there’s more at stake when indices rebalance. It’s clear that these events involve a trade-off between transparency and making it difficult for those seeking to game index changes. But it would be ironic if, by making trades more crowded, measures taken to clean up the benchmark business had a detrimental effect on the efficiency of indices.

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On the face of it, mutual funds are a huge global success story.

Assets in collective investment schemes have grown seven-fold in two decades and now top $30 trillion.

Growth in global mutual fund assets

mutual fund assets

Source: Investment Company Institute

Yet the mutual fund structure contains weaknesses.

First, funds need to apportion correctly the costs associated with investors entering and departing the fund, a tricky job. So-called dilution levies (also called entry fees or front-end loads) and exit fees are there to make sure that the costs of any purchases (or sales) of securities incurred on behalf of an entering (exiting) investor are borne by that investor, rather than by the rest of the fund holders.

Unfortunately, many fund managers have historically set entry/exit fees too high and used them as a disguised source of revenue.

A more important drawback of funds is that they may carry liquidity risk.

If a fund invests in less liquid assets but promises immediate liquidity to its investors, the fund manager may cope with a sudden withdrawal of investors’ funds by selling the most liquid of the underlying assets. This would disadvantage those remaining in the fund by leaving them with a rump of less liquid securities. As a result, investors are incentivised to “run” from a fund in stressed market conditions.

Given the increasingly large size of many mutual funds (including ETFs) and the potential liquidity problems in certain asset classes (like corporate debt) it’s not surprising that regulators have been focusing on fund liquidity as a potential source of broader, systemic risk.

In most jurisdictions, the managers of mutual funds have the little-advertised ability to “gate” (ration) redemptions—a right that, if invoked, could contribute to a panic.

Mutual funds have historically been expensive, too. ETFs are a welcome recent exception to the trend of overcharging, but fund fees pay for hefty salaries at asset management firms, as well as for the services of a whole range of middlemen: lawyers, accountants, custodians and transfer agents.

The world’s largest investors don’t use mutual funds: they insist on their own, flexible managed accounts. What if smaller investors could follow suit?

It turns out that they now can.

Firms like US-based Motif Investing allow you to buy a diversified, thematic portfolio of stocks in one transaction. Motif charges $9.95 for a trade in up to 30 stocks, much cheaper than online brokers’ rates for buying or selling 30 individual securities. You can customise your own portfolio (called a motif) or copy someone else’s.

You end up with an investment that’s very similar to an index fund, but with significant advantages: no annual fees, no administrative overheads, no worries about how costs are mutualised and no concerns over gating. Unlike some funds, a stock basket doesn’t lend shares, use derivatives or incur collateral risks.

Under this model you own the stocks in your motif, with full entitlement to dividends. You retain voting rights, rather than delegating them to an anonymous fund manager, who may not even use them (except, potentially, if the small size of your basket means you own fractional, rather than whole units of shares).

Mutual funds first came into being as a way of spreading risk. Reducing company-specific exposure via a shared portfolio seemed an attractive prospect for European investors recently scarred by Tulipmania and the South Sea Bubble.

But that technological advance came nearly three centuries ago. Now we can see the prospects for another significant shift in the savings market. The emergence of cheap, tradeable thematic baskets of stocks threatens to render funds obsolete.

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According to the Financial Times (subscription required) the US central bank is concerned about the potential for a run on retail bond funds. The Fed has discussed imposing mandatory exit fees on those holding funds as a way of managing this run risk.

The FT reminds us that US retail investors have pumped over $1 trillion into bond funds since early 2009. Central bankers worry about investors buying funds that promise immediate liquidity while investing in potentially illiquid underlying assets like corporate bonds.

Ironically, the increasingly desperate search for yield by income-deprived investors is squarely the result of central banks’ own zero interest rate and quantitative easing (QE) policies. In recent months there’s been a top-of-the-market feel about bond ETF inflows, for example, with buyers focusing on the highest-yielding (and junkiest) part of the market, like leveraged loan funds.

I wrote in 2012 that regulators were soon likely to focus on fund liquidity risk. There’s an inherent tension between the promise of the retail fund “wrapper”—to allow investors to enter and depart at will—and the underlying assets of some funds.

In Europe, fund exit fees already exist in a rough and ready way in the form of redemption gates in fund prospectuses. If more than 10% of investors in a retail (UCITS) fund want to leave in a single day, the fund administrator can postpone redemptions until the next day.

Interestingly, some ETF issuers have told me that they’ve waived this right in the past, deciding not to halt occasional daily redemptions exceeding 10% of fund assets, presumably for fear of negative publicity.

ETFs, which are traded intraday on stock exchanges, provide a pressure valve in the sense that secondary market trading in a fund with suspended redemptions might continue—but it would be in limited volumes and presumably at a big discount to the fund’s net asset value.

We saw this happen on a small scale during a mini-panic in US-listed corporate bond ETFs last June, with one market-maker stepping away from its promise to process investors’ sell orders.

In the US mutual fund market, suspending redemptions is trickier because of the liquidity promise built into the 1940 Act structure. Fund managers must meet redemption requests within seven days and a suspension of redemptions is possible only in extreme circumstances.

At least 85% of fund assets have to be invested in “liquid securities” (I’m not sure how leveraged loan ETFs, which comply with the 1940 Act, can claim to be doing that).

You can see why the Fed is worried about run risk in junk bond mutual funds, particularly since there’s evidence that US investors are flightier than their European counterparts.

By cracking down on the banks, which can no longer hold large inventories of bonds for trading purposes, regulators have shifted risk to bond mutual funds. Now they are concerned about the consequences of their own policies.

I’ve written in the past about the potential for a crash in this sector. In particular, the shaky dealing infrastructure underlying bond funds seemed (and still seems) to me like an accident waiting to happen.

All the same, I feel uneasy about regulators’ current proposals to intervene so directly in the fund market. Investors buy funds knowing they may lose money. You can’t outlaw market bubbles and busts: they happen. If central bankers really think they can manage away all systemic risk then the next crash will be all the more violent.

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