From the desk of John Arnesen
Consulting lead, Pierpoint Financial Consulting
This is the second blog post detailing my observations from the impressive Deutsche Börse GFF conference I attended at the end of January. You can read Part One here.
I found it interesting that the inclusion of a CCP panel spent no time debating its merits. CCPs are likely going to take on more importance and relevance for a wider number of participants in the future. LCH reported that repo activity is growing by 7-8% per annum with cleared repo growing the fastest. They observe increased volume in voluntary cleared activity at and despite their natural clients being the sell-side, they see growing demand from the buy-side even though they don’t have direct access but can access LCH via a client clearing model which has to be sponsored by a sell-side agent.
Sell-side clients are continuing their search for scale, large liquidity pools, and collateral optimization engines. Currently, LCH sees more title transfer activity than pledges but expects this to grow as will the need to cross-margin from an OTC product into a cleared one.
There then followed a discussion on the resilience of CCP’s and their risk models. Panellists have increased the number of risk officers within their businesses since the global credit. The idea of mutualising more risk was discussed; the OCC mentioned they hold 12 months of operating capital in reserve and are only required to hold 8 weeks by the Fed. They then discussed CCPs having “skin in the game” but also couldn’t decide to what extent and where should it come from? Should it be tied to profits of the CCP or management compensation? Doing so will change the model, and as one panellist stated it could lead to moral hazard if you place more risk on them which could lead to a change in operating methodology. I thought this was an important point and one well made, CCPs have to operate with a limited contribution to risk capital to provide the services and operating model they do. All agreed that a CCP could fail, and some have accessed the reserve clearing fund in the past but not in any significant way. There is a risk that CCPs will become too big to fail and regulators are looking at that, particularly in the US. It was noted that the ability of a CCP to fail must be maintained. The last default in Europe was in 1974. On the subject of integrity of the platforms, cyber-attack was named as the greatest risk threat and all participants spend a lot of time stress-testing their Business Continuity Plans. The OCC has increased its security team from 5 to 20 to constantly test the integrity of the system. All agreed that such an attack would disrupt the financial services of the country in question rather than to defraud it.
Current and Future Trends in Collateral Management
This panel started with stating that Non-cash collateral in EMEA stands at $3tn of collateralised transaction and $6tn globally. The technology servicing this requires deep intellectual commitments from the industry. The municipal finance market is growing in the US and the collateral generated will find its way to triparty services. BNYM mentioned they are in the middle of delivering a new collateral management platform. Interoperability within an institution or eternally on a global basis is vital as will be the standardisation of legal governance.
The discussion on Fintech’s centred on whether there are too many. BNYM described a Fintech day they held recently with over 100 in attendance and many looking at collateral management, adding he was impressed by the knowledge of the participants. BNYM has a formal method to engage with a Fintech. They aren’t keen on small firms that may disappear and are very aware of the liability that all clients insist on when engaged with a third party for any operational function. Part of their new collateral management system was built by a fintech firm. On ESG they see tremendous pace in investment management but very little request in collateral management to be compliant. I believe this will change quickly given what we hear from the market in Europe. However, I found it very interesting that one panellist explained that when building a service or product offering, they include ESG compliance as part of their decision. They are developing a climate impact analysis with recommendations and then a set of metrics to measure it. This is very progressive and will undoubtedly be an approach adopted by others.
A timely and relevant point was made about UMR in that whereas classic repo activity operates with huge volumes and a limited number of accounts, UMR will create a huge number of accounts that will maintain relatively small balances. The panel envisaged a rise in post-trade services for UMR. If buy-side firms lend, that activity will need to efficiently co-exist with UMR collateral management requirements to avoid friction between the two goals.
The CEO of the Luxembourg House of Financial Technology (LHoFT) which is a facilitator of Fintech’s looking to have space in an environment where they can exchange ideas. It was interesting to listen to this very eloquent speaker reflect on his time in the city and that the job he initially held some 25 years ago no longer exists and that change is inevitable. Technical developments are being employed in a host of industries from bots in medicine, the powerful uses of 3D printing, water harvesting in the Middle East by making it rain, driverless cars and big data from cameras that will attempt to predict where crime will take place. (Minority Report 2?) He had also heard that in five years it may be possible to “talk” to his dog but was unsure what on earth his dog would tell him. While all this development is taking place, financial services appear to be lagging and haven’t changed that much. Regulation is cited as an explanation for the lack of change but it was pointed out that the Pharmaceutical Industry is more regulated than finance ever will be and yet they manage to bring products to market. Merck has appointed their Chief of Data Science to their board, such is the importance and use of progressive technology in their processes.
A wealth of data points to financial institutions producing a historical average 6% return on equity and that longer-term, this is no longer a reasonable expectation. To address this, most institutions do what they always do: slash headcount and reduce expenses, but it was argued that what they should be doing is investing in technology. The looming pension deficit crisis that is growing by €30 bn per day is set to become a major issue with increased rates of longevity, peak “baby boomer “retirements and fewer younger workers supporting them, is an area in which technology has to be applied to create real value to address and solve for viable solutions. The audience was reminded that the first people to live to 150 have likely already been born.
The good news is that the best brains in the world are involved in finance but that to date, the industry has failed to harness the real power of new technology and it needs to do better and get over the perception that robots and machine learning are something to fear.
A Fintech conference in Singapore in 2019 had 80,000 attendees from all walks of life and was represented by 5,000 fintech firms. This is a remarkable number and it was encouraging to hear that bank CIOs wanted to talk about digital ledger technology and the use of blockchain technology.
The speech ended with a rhetorical question asking, "What are the greatest businesses on the planet? The answer is tech firms, because 15 years ago their founders had a vision of the future and are now seeing the results of that vision”. Where are the financial services in this mix?
The next panel was entitled a “fireside chat” between the CEO of Clearstream Holding and the head of rates and credit research from Commerzbank. The picture in the eurozone isn’t pretty with 50% of the fixed income assets in the entire trading bloc trading below zero. There are structural factors that keep it low but it was recognised that Quantitative Easing failed to create inflation but here is an interesting point of note about its calculation. In Europe, the ECB, in the basket of goods it measures applies a 6.5% weighting to housing cost. The equivalent in the US is 30% and if one applied that to the ECB calculation, inflation would be closer to above 2%. On the subject of trade tariffs, it was commented that given some Chinese trade practices, it is of no surprise that the US has levied them on China, but to also expect the US to do the same this year for European car exports.
The discussion turned to Germany which is experiencing an erosion of competitiveness and is already in recession with a 25% reduction in car output and a lack of skilled labour. With full employment and a rise in domestic spending, it's proving harder to stimulate the economy. This led to a discussion about the future of the euro as asked from the audience via an app (from me in reality) and it was acknowledged that longer-term, the project is at risk. The formation of the EU has kept peace in Europe for the past 75 years and yet even this as a project could falter given that in the final analysis, it is difficult to dictate to members of differing countries how to run their lives, in particular with a single interest rate policy.
Innovative Solutions Panel
This panel was well placed after the comments from the keynote speech and was made up of a mix of practitioners from banks and founders of new products that have harnessed new technology in their offering. It is always interesting to hear the journey a start-up company makes and the pain points along the way. A common experience is the reluctance of corporations to be an early adopter and that most tend to want to “feel and touch” a finished product after someone else has got involved first. The panel argued that the products developed have to address a common pain point the markets are dealing with and demonstrate it has a real value not just for now but for the future. Convincing a decision-maker, even when they see the value in a proposition to commit, is a formidable challenge. One panellist commented that the ideal conditions to develop a product are by forming a strategic partnership, a collegiate approach, developed by and for the market and lastly, luck helps. Despite this, one has to ensure particular attention is taken in defining the problem one is trying to solve. The question has to be why good ideas and products fail; it was cited as saying that delays in development can frustrate early adopters who end up building something themselves, as without a solid, finished product they can lose sight of their initial vision. In the new order of change, some enemies benefit from the old who benefit from the old order and its persistence so if the new product support is only lukewarm from those that see the benefit, it won’t be enough to effect change.
The panel was asked what advice they would give someone considering a start-up and all agreed that first and foremost it was to discuss with a partner and/or family to warn them what was about to happen. It costs 4 times as much and 4 times as long to bring a product to market and while the business to business space is the right environment, action by clients is slow and requires patience. The “how to fund discussion” included one participant relating how they had spent a lot of time with others who had considered the same issue, while ranging as far as venture capital and strategic partnership with a deal to “borrow “developers to assist in production. One quote that stuck with me came from the moderator who had been told early in the development of his own business, “it’s not enough to be right, you have to be right at the right time.” Wise words indeed.
Thoughts about short-selling airlines while waiting to board a flight!
I had to leave at this point so I missed that last panel with regret. At Luxembourg airport, I read the following headline in the Financial Times “Hedge funds bet against airline stocks as coronavirus spreads” My initial thoughts were that it’s such headlines that fuel the negative debate over short-selling in the public eye, confirms the bias held by some asset managers and lastly made me think it’s quite cynical to take advantage of a situation that is beyond the fundamental economics of the airlines involved by shorting them further.
Then I checked myself. The hedge funds referred to were already short of those airlines with high levels of routes to China, so were adding to existing positions. Their investors expect them to transact in their best interests and the economic health of a company is not the only consideration in taking a view on whether to short, numerous other factors can and do influence the direction of share prices. Cuts in corporation tax, changes to regulation, severe weather and warfare are examples of factors that can influence share prices that fall outside the direct influence or control of a company. The outbreak of a deadly virus is another such factor, and as it continues, the global effect on a range of industries has become evident, and a long investor closing out an airline, auto parts manufacturer or hotel chain related stock is exercising an investment decision to protect its investors.