Monday, December 22, 2014

FINMA - “We regulate more intensively, especially where products and innovations are concerned.”

What does a financial regulator do? Here is an example, describing what the Swiss financial regulator FINMA (“Eidgenössische Finanzmarktaufsicht”) does.

FINMA Essentials

FINMA is an institution under public law that has its own legal personality. The own legal personality underlines the regulator’s independence from political interferences. The independence is also financial in that FINMA’s funding stems from fees and duties paid by supervised entities instead of public Government funds.

Two main bodies govern FINMA:

  • The Board of Directors decides on matters of substantial importance, issues ordinances and circulars, and is responsible for FINMA’s budget.

  • The Executive Board is namely responsible for audit, risk, and nominations.

Employing roughly 500 people (14 % of which are non-Swiss nationals), the Swiss regulator is a rather small organization.

What should FINMA achieve?

FINMA has vocation to

  • protect the (collective, not individual!) interests of creditors, investors, and insurance policyholders;

  • ensure the proper functioning of financial markets and the overall stability of the financial system.

FINMA’s goals translate into which concrete activities?

FINMA carries out four principal sets of activities:

  • Licensing: The authority grants and publishes licenses to individuals and legal entities active in regulated financial markets. We are essentially talking about banks, insurance companies, stock exchanges, securities dealers, collective investment schemes, distributors, and insurance intermediaries.

  • Regulation: FINMA can issue ordinances and circulars where it is authorized to do so. However, regulation only takes place at the lowest level, in order to make supervisory practices transparent.

  • Supervision: This is a core task. The administration takes a risk-oriented approach and deliberately monitors less risky areas less intensively than riskier areas.

  • Enforcement: On the one hand, FINMA investigates possible breaches of financial market legislation and takes corrective action vis-à-vis regulated entities. On the other hand, the agency has no authority to impose administrative fines.

Supplementary activities relate to participating in national and international rule-setting bodies:

  • In Switzerland, FINMA advises the Parliament, the Federal Council, and other authorities on technical issues of financial legislation.

  • Internationally, it participates in setting regulatory principles globally within the Financial Stability Board (FSB), the Basel Committee on Banking Supervision (BCBS), the International Association of Insurance Supervisors (IAIS), and the International Organization of Securities Commissions (IOSCO).

However, FINMA is not an institution that directly boosts the Swiss economy. In its own words, “credible supervision and direct promotion of the economy by the supervisory authority are mutually exclusive.”


Monday, December 15, 2014

BIS Annual Report 2013 – How to tackle a balance sheet recession

In its annual report for 2013, the Bank for International Settlements writes that we are in a balance sheet recession. It also proposes ways how we should tackle it. Here are the essentials.

What is a balance sheet recession?

The last financial cycle ended in 2009 and gave birth to a balance sheet recession. The BIS explains what a balance sheet recession is, using three key features:

  • A balance sheet recession is very costly and tends to be deeper, gives way to weaker recoveries, and results in permanent output losses, i.e. output may return to its previous long-term growth rate but hardly to its previous growth path.
  • It is less responsive to traditional demand management measures because banks need to repair their balance sheets. As long as asset quality is poor and capital meager, banks will tend to restrict overall credit supply and, more importantly, misallocate it.
  • Overly indebted agents will pay down debt and save more instead of spending. As one agent’s spending is another’s income, a balance sheet repair logically depresses income and value of asset holdings.

How can we tackle a balance sheet recession?

The first priority is to repair balance sheets by reducing debt. In the BIS' view, many countries have not completed this task yet. As a matter of fact, private and public sector debt levels remain high in many countries.

Second, countries should implement structural reforms, allowing resources to transfer from unprofitable to profitable sectors and, thus, raising the economy's productivity and growth potential.

Unless productivity growth picks up, the prospects for output growth are dim.”

More specifically, structural reforms can consist of

  • deregulating protected sectors, such as services;
  • improving labor market flexibility;
  • trimming public sector bloat; and
  • putting the fiscal house in order.

Which role plays monetary policy when it comes to balance sheet recoveries?

In short, extraordinary monetary policy is not the right tool for achieving a balance sheet recovery. Even though it is the first means to combat a financial crisis, it does, at the same time, encourage bad debt taking, through keeping interest rates low. Therefore, central banks need to pay attention to the risks of exiting too late and too gradually.

Low interest rates do not solve the problem of high debt. They may keep service costs low for some time, but by encouraging rather than discouraging the accumulation of debt they amplify the effect of the eventual normalization.”

After so many years of an exceptional monetary expansion, the risk of normalizing too slowly and too late deserves special attention.”


Tuesday, December 9, 2014

Extreme Money – A provoking book about the finance industry

Back in 2006, Satyajit Das has written a book about the financial derivatives industry called “Traders, Guns & Money”. I really liked reading this book. It was, therefore, logic that I got also interested in reading his book “Extreme Money: The Masters of the Universe & The Cult of Risk”, published in 2011. “Extreme Money” is a pretty provocative story about the finance industry. In fact, the title fits pretty well the overarching idea of the book: Satyajit’s view is simply “extreme”. In my view, many of his thoughts reveal some truth about the industry; however, they certainly are over-exaggerated and overlook many people and organizations simply doing a good job in finance.

Here are some of Satyajit’s provoking statements that I found most interesting:

Modern economies don't make anything anymore; their major activity is investing, borrowing, and trading money. Money has become the main way to make money.”

A long time ago, money simply served as a means to pay for real goods and services. However, in the second half of the twentieth century, money became something important in its own right. It became, in itself, a way to create wealth.

Satyajit describes a three step evolution resulting in today’s “business of business”:

  • The industry consisted of making things.
  • The industry then became a business, meaning making money from producing things.
  • Ultimately, increasing financialization lead to the “speculation economy” which consists of making money from things not necessarily linked to producing things. The typical example is trading goods that you don’t produce or consume.

Why did financial engineering replace real engineering? The author’s answer is that real engineering means innovation, which is, by definition, a very risky business, contrary to pure financial engineering.

“Rather than making things, trained engineers joined banks to provide turbo-charged financial structures for companies.”

Examples of this financialization include the developments of General Motors, General Electric, and Enron.

“Dealmaking beats working, dealmaking is exciting and fun, and working is grubby. Running anything is primarily an enormous amount of grubby detail work… Dealmaking is romatic, sexy. That’s why you have deals that make no sense.”
Peter Drucker

“Finance had become the panacea for arresting America’s industrial decline.”

The study of money is a field in which complexity is used to disguise truth or to evade truth, not to reveal it.”

A good example for how complexity can evade truth is the tranching of securitized assets:

“Tranching is like buying a place to live in a flood-prone area. To protect yourself from the one-in-10,000-year flood, you buy an apartment in a tower above previous known flood levels, with a large margin of safety. However, when the flood hits, your higher situated apartment doesn’t help you because the foundations of the tower itself and the surrounding infrastructure are also hit.”

Another aspect of complexity that the author pinpoints to is the lack of responsibility of individual actors to understand complex finance products. Satyajit writes, “Everyone relied on someone else to do their job”.

Finally, complexity generates high profit margins: “Opaque and inefficiently priced financial products produced high profit margins.”

Why is complexity bad? Because it creates financial instruments disconnected from the real world and capable of damaging it: “If correlation between two loans in a normal portfolio was an educated guess, then the correlation input into a structured finance CDO, CDO2, or CDO3 was fantasy.”

“There is a strong correlation between the complexity of an instrument, its remoteness from the real economy and its likelihood to spread contagion.”

In my view, complexity in finance is, indeed, often artificial and home-made. On the other hand: Isn’t everything easy once you have understood it?

A propos complexity, the author doesn’t seem to like Alan Greenspan. Satyajit makes particularly fun of the following quote:

“I know you believe you understand what you think I said, but I am not sure you realize that what you heard is not what I meant.”
Alan Greenspan

In modern economics and finance, until something is said mathematically, it isn’t said at all.”

Today’s math based risk management techniques don’t work, because markets are not efficient and price changes not normally distributed.

“Exceptions and anomalies increasingly undermined the theory of efficient markets.”

“Risk management assumes that price changes are normally distributed. But normal distributions do not exist in practice. Unpredictable extremes of price movement, known as fat tails, were more common than theory implied.

Hedge funds are courtesans, high-class prostitutes whose clients come from the wealthy. Banks are the pimps and bordello keepers.”

Here is how Satyajit sees the culture in the finance industry:

“All successful financiers have selective amnesia, remembering what fits their current world view.”

“Wall Street and the City are bad judges of value. Having enjoyed the milk, in a moment of confusion they tend to over pay for the cow.”

“In risk management, you learn that you are irrelevant, despite everybody saying you are vital. In the back office, you are chained to the oars of the banking trireme, processing an avalanche of paper.”

“Banks take smart people and plug them into their dull, trivial culture where they waste their lives on the hamster wheel of corporate life. There is a mismatch between expectations and the reality of banking.”

“Banks have no strategy, only hustle. One bank decided its strategy was to have no strategy. Imitation is the only real strategy.”

“In the culture of the deal, banks endlessly copy each other’s strategies or products, chasing the same customers, competing on price and the ability to take risk.”

“Happy employees mean that you have paid them too much. Disgusted employees mean that you have paid them so little that they will leave. The optimal point is between satisfied and dissatisfied – enough to keep you but not enough to make you complacent or diminish the manager’s own bonus.”

“The financial elite is narrow and limited, too smart, too fast, wanting too much, lacking any sense of history, and reinforcing each other’s opinion.”

“In finance, flexibility and split personalities are important.”

“Empty words like governance and oversight masked a lack of adult supervision of business and markets. A culture of benign neglect presided over increasing debt, greater leverage, higher risk, lower capital, and accounting fudges.”

As I wrote above, the book is extreme…

There is no simple, painless solution: The world has to reduce debt, shrink the financial part of the economy, and change the destructive incentive structures in finance. Individuals in developed countries have to save more and spend less.”

Satyajit describes in his book how the importance of debt kept rising in the global economy over the last decades.

He defines debt as a Darwinian scheme in which only those players survive who can withstand the highest debt levels. If interest cannot be paid back, more borrowing is needed until the player, ultimately, collapses under the weight of debt. From the point of view of the entire economy, this leads to a constant cycle of credit booms and bust.

“Debt became the essential part of the modern lifestyle. Even wealthy people borrow to increase their return.”

But why is debt so attractive? The author’s answer is that the debt’s attractiveness lies in its capacity to provide instant gratification as it borrows from tomorrow to pay for today. However, this only works as long as the debt level is sustainable. Sustainable means that debt is invested productively, i.e. in a way that generates the necessary revenue to repay debt and interest. Spending debt simply to finance consumption or larger houses, to the contrary, does not generate any revenue and then ultimately must result in a financial bust.

“The best loans are made during the worst times, the worst loans are made during the best times.”

The financial system was a case of financial groupthink, the madness of crowds.”

Das criticizes more or less every institution of the finance industry:

  • “Financial journalism is superficial.” The BRIC symbol (Brazil, Russia, India, and China) that expressed the raising power of emerging countries in the global economy in the years after 2000 may serve as an example.
  • “Financial TV never bothered with plot, dialogue, or production values, focusing only on the action. Occasional outside shots on the steps of a stock exchange or outside some monumental bank headquarters interrupt the visual monotony and interviews are never longer than 5 to 10 minutes.”
  • “At Davos the diverse mix is confusing – celebrities wanting to be intellectuals, intellectuals wanting to be celebrities, and bankers wanting to be both celebrities and intellectuals.”
  • Regulators seem to be powerless: “When things were going well, regulators favored self-regulation, which bears the same relationship to regulation that self-importance does to importance.” If ever banks could not obtain self-regulation, they always ended up avoiding regulation by imposing exclusions and exemptions.

Botox economics

Let’s finish with the concept of botox economics that Satyajit uses to highlight the inefficiency of central bank / central government financial support for the economy:

“Botox is a toxin, commonly used to improve a person’s appearance by removing signs of ageing. However, the effect is only temporary, with significant side effects. As the global financial crisis rolled on, financial botox, a flood of money from central banks and governments, covered up unresolved and deep-seated problems. Tax cuts, investment incentives, and subsidies all boosted activity. Low or zero interest rate policies engineered a recovery in stocks and financial markets.”

This debate is still vivid today. Let’s wait and see…


Satyajit Das – Extreme Money

Monday, December 1, 2014

FOREX Manipulation - „Call me legend!! Front run legend.“

Earlier this month, on November 12, 2014, U.S., U.K., and Swiss regulators have fined several investment banks for manipulating FOREX markets.

The Fines

Let’s first have a closer look at the fines:

Fines are pretty evenly distributed among the banks. UBS stands out because it not only settled with U.S. and U.K. regulators but also with its home regulator FINMA.

As FOREX trading desks are mainly situated in London and New York, these were also the main regulators involved. It stands out that U.K.’s Financial Conduct Authority (FCA) was even more severe than its U.S. counterpart, the Commodities Futures Trading Commission (CFTC). FINMA, the Swiss financial markets regulator, however, didn’t actually impose a fine in a narrow sense. It rather asks UBS to pay back illegally obtained return and avoided costs.

In total, fines amount to 3.3 bn USD. As a comparison, this represents the fines of 28,000 aggravated thefts in France or 8 % of the combined 2013 net income of the fined banks.

On the merits

In contrast to other financial litigation, this one is, in my view, rather easy to understand.

On the merits, there is one notable difference between CFTC’s approach on the one hand and FCA’s / FINMA’s approach on the other hand: Whereas in the U.S., there exists specific legislation forbidding any willful manipulation of commodities’ (including FOREX) prices, the U.K. and Swiss regulators did not invoke such legislation. Rather, the latter sanctioned the banks on the grounds of violations of general prudential requirements such as insufficient control systems and negligence of client information confidentiality.

The facts

Obviously, the tedious work of regulators was here to establish the facts. In the end, they gathered ample evidence from private electronic chat rooms to show that traders manipulated, between 2008 and 2013, FOREX fixings by sharing client information on upcoming trades and coordinating trading strategies.

A USB trader even wrote “Call me legend!! Front run legend.“ and „Das Ding ist wir dürfen nicht mehr front runnen, compliance sitzt uns am Arsch.“ (which I don’t want translate here…).

As a reminder, front running means trading ahead of your client: If you know that you will execute a huge order on behalf of your client soon, you know that this higher demand will increase prices. It would then obviously be interesting for you to buy before and sell, at a higher price, once you have executed your client’s transaction.

But traders did not only practice front running. They also shared information about (upcoming) FX transactions and trading strategies to drive certain benchmark exchange rates up or down. They namely tweaked the 4 p.m. World Markets/Reuters Closing Spot Rates, most widely used in U.S. and global foreign exchange markets, and the 1:15 p.m. ECB fix. The Reuters fix is based on actual trades and calculates the median of bids and offers extracted from a certain electronic trading system during a one-minute window. Given this small sample, you can easily understand that traders were motivated to alter the benchmark.

The chat conversations that the regulators provide are indeed striking and show that traders placed their personal interest beyond those of their employers and clients.

What do regulators say?

The FCA does not tolerate conduct which imperils market integrity or the wider UK financial system. Today’s record fines mark the gravity of the failings we found and firms need to take responsibility for putting it right. They must make sure their traders do not game the system to boost profits or leave the ethics of their conduct to compliance to worry about. Senior management commitments to change need to become a reality in every area of their business. But this is not just about enforcement action. It is about a combination of actions aimed at driving up market standards across the industry. All firms need to work with us to deliver real and lasting change to the culture of the trading floor. This is essential to restoring the public’s trust in financial services and London maintaining its position as a strong and competitive financial centre.”
Martin Wheatley, FCA, November 12, 2014

This is not about having armies of compliance staff ticking boxes. It is about firms understanding, and managing, the risks their conduct might pose to markets. Where problems are identified we expect firms to deal with those quickly, decisively and effectively and to make sure they apply the lessons across their business. If they fail to do so they will continue to face significant regulatory and reputational costs.”
Tracey Mc Dermott, FCA, November 12, 2014

The setting of a benchmark rate is not simply another opportunity for banks to earn a profit. Countless individuals and companies around the world rely on these rates to settle financial contracts, and this reliance is premised on faith in the fundamental integrity of these benchmarks. The market only works if people have confidence that the process of setting these benchmarks is fair, not corrupted by manipulation by some of the biggest banks in the world.”
Aitan Goelman, CFTC, November 12, 2014

What do banks say?

The RBS Board fully accepts the criticisms within today’s announcements and condemns the actions of those employees responsible for this misconduct. Today is a stark reminder of the importance of culture and integrity in banking and we will rightly be judged on the strength of our response.”
Philip Hampton, Royal Bank of Scotland, November 12, 2014

Since becoming Chief Executive, I have worked to ensure that everyone within the bank understands the importance of regaining the trust of our customers. In order to achieve that trust we must set ourselves the highest standards of integrity and professionalism, both individually and collectively - this episode has clearly shown us to have fallen well short of that. Now, it’s up to us to show that we can learn the lessons of these mistakes and can be worthy of earning trust in the future.”
Ross Mc Ewan, Royal Bank of Scotland, November 12, 2014

If felt pain for our stuff and customers again [referring to FOREX fines against RBS].”
Ross Mc Ewan, Royal Bank of Scotland, November 12, 2014

Citi acted quickly upon becoming aware of issues in our foreign exchange business and we have already made changes to our systems, controls and monitoring processes to better guard against improper behavior. While today’s settlements resolve significant investigations into Citi’s foreign exchange business, as we have previously disclosed, several additional regulatory agencies and enforcement bodies are conducting investigations and making inquiries into this business. We continue to fully cooperate with these investigations and inquiries.”
Citibank Press Release, November 12, 2014

"Today's resolutions are an important step in our transformation process and towards closing this industry-wide matter for UBS. We continue to cooperate with related ongoing investigations."
Sergio P. Ermotti, UBS, November 12, 2014

Last, but not least: What do (or rather did) FX traders say?

Bank R Trader: 4:00:35 pm: ”well done gents”
Bank W Trader 1: 4:01:56 pm: “hooray nice team work”
Bank U Trader: 4:02:22 pm: “nice one mate”

What’s next?

More control of chat rooms, more compliance, more whistle blowing, a change of culture, and automation of FX trading are to come. As said a UBS FX trader, back in 2012: „It’s a new world out there“.


The CFTC orders can be found here.

FINMA’s investigation documents can be found here.

FCA’s final notices on the fines are available for download here.