EMIR more Chuckle Brothers than Lehman Brothers!

I have recently,  through wrestling with the known unknowns of the Alternative Investment Fund Management Directive (AIFMD) revisited the European Market Infrastructure Regulations (EMIR) to ascertain how the two sets of regulations can be dovetailed where OTC contracts make up significant parts of Alternative Investment Funds (AIFs).

With my trusted tools of a large board and multi-coloured sticky notes I have made progress, well progress of sorts! I still come to a large ? at the end of the process.

While I was working for a Bank I attended several meetings trying to ascertain the impact of the first consultations seeking central clearing, transparency and collateral standards for the OTC derivative market places. As we worked through complex scenarios; parked controversial topics such as the need to build or buy new systems; clearly identify profit and loss (p&l) of each desk involved in a trade; and all of the divisional posturing and and denial that goes with such an exercise, I could only think about one thing, how do I explain this to a client?
I think it is therefore worth revisiting what went before the regulators started regulating, providing a tortured analogy and then concluding on the impact.

In the aftermath of the Lehman Brothers fall it became apparent that the Investment Banking dark arts had been very much in play in post-trade product management. Two plus two began life on the term sheets equaling four or near enough if you ignore amortizing p&l. Collateral would be posted and margin called within contractual parameters and established industry protocols. In the meantime all those otherwise redundant assets became inventory and indirect funding pools that could be re-hypothecated in the support of new contracts. All of a sudden two plus two became five, you could bet the p&l was being drip fed out of the price but it was far from certain that the assets were meeting the liabilities on the trading books and if they were, whether the internal trades between the exotic and security finance desks were booked correctly and stopping two plus two becoming three.

This may well be a jaundiced, generalised and simplistic view but for those of us involved in Investment Banking in the lead up to the Lehman's demise,whatever went on, the outcome is not a surprise. Structurers were constantly trying to identify efficiency to be competitive and maintain profit margins, in retrospect it is conceivable that the identified efficiency captured un-managed risks that so disastrously were realised to the detriment to all bank balance sheets. Whatever the truth and  the intent the G20 mobilised quickly and the trusted regulatory weapons of transparency and regulation were brought into play and draft regulations were agreed in principle as early as 2009. In Europe we eventually ended up with the European Market Infrastructure Regulations (EMIR) and now have an established time line albeit with need for clarification on material definitions.

So how do we make sense of these dark arts, simply call on Paul and Barry the "Chuckle Brothers". Even if you are unfamiliar with Paul and Barry it becomes very easy to establish their brand of pre-teen targeted situation comedy and apply it analogically to securities finance and collateralisation! Without further ado imagine the following scenario. Paul Chuckle wants a new battery put in his watch and asks his brother Barry to do it as he as a very good tool kit. Barry looks in the toolbox, only to find that the required screwdriver is missing. Paul remembers that he lent it to the Vicar and as he wants his watch fixed undertakes to get it back. The following dialogue then ensues:

Paul C: "Hello Vicar, I was wondering if I could have the screwdriver that I lent you back, please"
Vicar: Paul, forgive me but I have sinned, I lent it to Police Constable Grossman who needs it to fix his torch!" Paul C: "No problem, Vicar I'm off to the police station anyway so I'll ask him directly"

Now to save you from reading several pages of dialogue, I can summarise as follows, PC Grossman has lent the screwdriver to Terry Dogood the probation officer, who has in turn lent it to Tommy Tempted a rehabilitating petty thief. Tommy however lent the screwdriver to Sam Slippery the local wheeler dealer. Sam sold it to Mrs Pickle the Chuckle Brothers' landlady, for a pound.

While Paul is desperately following the screwdriver through the various transactions, Barry decides to ask Mrs Pickle if she has a screwdriver fit for purpose, which of course she has and Barry borrows it, and fixes Paul's watch. Paul returns with a pound having asked PC Grossman to intervene and force Sam Slippery to pass over his ill gotten gains. Paul gives Barry the pound, Barry gives Paul the screwdriver. Paul gives the screwdriver to Slippery Sam, who gives it to Tommy T, who passes it to Terry D, who of course gives it to PC Grossman who lets the Vicar have it back who then returns it to Paul who give it to Barry who now has the pound and the screwdriver, so he offers the pound to Mrs Pickle who accepts it under the circumstances.

There is a lot of the catch phrase "from me to you, to me , to you"......hilarious? Now of course this last transaction could have been undertaken by Paul giving Mrs Pickle a pound and the explanation, in this scenario he would have been fulfilling in conjunction with PC Grossman the role of a central clearer. What this situation does not take into account is the scenario where Mrs Pickle wants the screwdriver and doesn't accept the pound, and the cost of a replacement screwdriver to Barry is £1.20. In this scenario we let Barry and Paul argue who should pay the he extra 20p. Really we all know it should be Slippery Sam but he has run off to Malaga! The regulators have of course decided that nobody can run off to Malaga without leaving 20p, simple.

However rediculaous this anlaogy may seem some of the transactional flows I have anecdotally been made aware of are not far off, some I am reliably informed are as yet still unravelled, ie no one has decided who owes the 20p although someone has lost the it!.

This brings me to the ?.  How do I explain the requirements of EMIR to a client ? I'm not sure "it is collateralised" is going to help the Sales teams placate all those questions like, "what is the collateral, when is there a default, can collateral be re-hypothecated, is there margin in these transactions, can we have some of it off the price?

This is my point, the standard of transparency required for OTC transactions going forward, although laudable is significant. We do not expect a purchaser of a computer to understand how it works but what it does, with the safeguard that it will not kill you while it does it!  I believe that the complexities of the back office are irrelevant if the safe guards are inherent in the products and the enforcement robust. I'm not sure the latter details are anywhere near being pinned down as we still await in scope instruments and thresholds.

Back to the drawing board!

HRP April 2nd 2013 

What it says on the tin?

A short one today just to highlight a tortured irony rather than anything else! I would have thought that Lord Turner and Catherine Brown would not have been confused as Heads of the FSA. Lord Turner is probably welcoming the upcoming Twin Peaks just to clarify that his FSA will become the PRA and the FCA responsible for Prudential oversight of the big boys and conduct of everybody else in Financial services respectively. Its nice to see that the split is fairly accessible and each authority does what it says on the tin. As for Catherine Brown's FSA, I fear that food labelling may require far more work and the Foods Standard Agency may be struggling with consumer expectations more than than they thought they would have to.

At least any confusion between the two FSA's will be a thing of the past and there is no risk that Horse meat passed off as Beef will be compared to Endowments being passed off as Guaranteed returns, afterall we all want our products to do or at least be what they say on the tin,tray or packet whichever is applicable.

Huw Price February 2013

Unintended Consequences!

I admit it is easy to criticise the great and the good who are trying regulate the financial markets and the practitioners within them! see my last blog. I'm not certain that the route these bodies are taking is the most likely to get the desired results. The task to me is akin to Canute's self imposed challenge of turning back the tide but adds a couple more dimensions; firstly instead of setting a throne at the water's edge and commanding it to stop, the throne is set on a floating barge in the middle of the sea; secondly that sea is shark infested, a not too tortured analogy! The imposition of new rules and amendments to the old rules smacks of desperation to me. Whichever way you interpret it the legend of Canute is allegorical, either a self-effacing acknowledgement that Kings are mortal or a egotistical folly fuelled by the adoration of his subjects. The actions of the regulators are not allegorical they are real, imposed (admittedly after parsimonious consultation in some but not all areas) and real drivers of change. At the risk of the last sentence being interpreted as a positive it should be noted that change is not always benign it can be destructive or at least unintended and avoided at all costs just for it own sake.  Equally so, I would hope that the initial blame culture prevalent at the beginning of the crisis where governments blamed financial institutions,  regulators blamed distributors, journalists and consumers blamed everyone has been replaced by that most "illusive" of cultures, collective responsibility.

The following statements I would hope are not controversial and sum up the majority of the major issues that changes to the the regulatory environment are attempting to address.

1. The liabilities of major Financial institutions must be underwritten by assets with a surplus for sustained periods of stress.
2. Advice and remuneration for it must be transparent, fit for purpose and economically appropriate.
3. Retail consumers must be protected to a higher degree than Professionals and Institutions in their dealing in the financial markets.
4. Market practitioners must exhibit high standards of Professional integrity and accountability if they do not.
5. Consumers must be more educated in their understanding of the Financial markets and the relationship between risk and reward.

 I will be first to admit that the five statements are broad and the devil is in the detail, however if you could start again you would  not build the current models of Regulatory oversight that we see in the developed world. Stepping back my single biggest issue is that when you breakdown the value chain of most financial transactions you will identify a very real and material cost of regulation. Regulatory cost comes in various shapes and sizes whether it be Capital Adequacy ( the requirement to hold very liquid assets on balance sheet equal to a proportion of the liabilities of a business in the future, even if only to run down the business without client detriment; to the cost of armies of Compliance professionals tasked with keeping the business within the rules and the first line of protection for retail clients or the cost of reporting regularly to clients telling them how much they have made or lost in the experience. I am not advocating that the cost of regulation should be nil as this is clearly a nonsense, I am however concerned that the materiality of it is misunderstood. I work in a simple world where the measurement of the validity of a transaction or product can be assessed by the risk and reward profile inherent in the final return. Therefore if costs; manufacturing, distribution and regulatory are passed onto a client in the transaction they inevitably inhibit reward as a drag on return.

All to often the antidote to make the product or transaction more attractive will manifest itself as an increase in risk. Products and the underlying transactions in the whole are a provision of services, whether it be a combination of professional management aimed at growing or preserving wealth, matching an outcome to a need through advice or valuing, reporting and safekeeping. In the regulated world there is also an element of Fiduciary oversight and redress. As with any manufacturing industry the provision of such service comes at a cost which in turn covers the cost incurred by the service providers plus a realistic margin of profit. It is my contention that the regulatory cost and hurdles that exist before any product is launched creates a burden that influences the quality of the product and ultimately by extrapolation the choice of potential product available to the market.

Finally and at the risk of becoming a latter day Canute myself I am firmly becoming an advocate of a return to "Caveat Emptor", the principle of buyer beware! It is probably the wrong time to suggest that protection should be relaxed in Financial services given the relative excesses and failings exhibited over the last decade and frankly back to the late 80's when the regulatory framework as we know it began, however the very real cost of regulatory intervention will become prohibitive if it is not already for most consumers seeking choice. Leviathan funds may be the only choice for those seeking investment or savings products, since the sheer size does give the benefit of scale efficiencies accommodating costs at a relatively low ratio to  principal investment. All good you may think but only if the fund does what it says on the tin! As we know there is more than one FSA struggling with this issue and we certainly don't want retail investors seeking low volatility investment return and getting Horse meat instead!

HRP February 2013

If it is broken can we fix it!

I have to admit that when I posted my first Blog anticipating the Olympics I did not realise that the Games would actually contribute to to my failure to post a second Blog until now

I have to admit that the usual bile and vitriol that I call upon as my muse for my various Blogs has been hugely dissipated by watching London 2012 and a family holiday in the Basque country. Every time I have felt the need to wax lyrical on the failings of the global financial services industry I have only managed a Tweet in support or deriding the hard work of somebody else.

I have long since returned to a normality, the warm feeling of pride in the fact that we all managed to deliver a wonderful and uplifting spectacle has long since been replaced with huge personal cynicism by confronting the absurdity of the current financial services market.

Firstly and or a more positive note whether it be the often ridiculed organisation committee, the Mayoral office, the competitors, the volunteers or the spectators, all and I mean all deserve praise for delivering beyond expectation. I wish our politicians and lawmakers were not exhibiting the exact antithesis of these Olympian values!

I was recently looking at a PowerPoint slide originally produced by Pwc two or three years ago entitled the regulatory Tsunami ( see attached). I have since adapted it and in reaction to several commentators and retitled it the Regulatory Ice age. Tsunami is a misnomer because although destructive, tsunami's engulf but ultimately dissipate and things get back to normal with the obvious acknowledgement of the human and personal traumas that inevitably remain. Life however goes on. If the current set of regulatory developments, laws and directives are implemented as drafted or consulted on, God help us!

If the dinosaurs were wiped out by an Ice age caused by a huge meteorite strike somewhere in Mexico (bare with me if you don't subscribe to this particular theory as it matches a tortured analogy) then the same thing may happen to the leviathans of the financial services industry! This time the Ice age follows not a meteorite strike but a paper based onslaught of game changing laws and regulatory upheaval. It is not that any one individual text is flawed in its thinking or objectives (although some are and admittedly some I can't even bring myself to read the synopsis of, so could be anything) it is the interaction or lack of coordination whichever way you wish to look at it that gets me.

 I pride myself on trying to understand the objective behind the law or regulation before I get caught up in the individual clauses and detail. This allows me to take part in pre-implementation consultation and hopefully have influence on the eventual outcome. Even if it is only a clarification request, or more fundamental observation, in my experience the authors need practitioner help. Afterwards I get to grips with the detail.Therefore I get that; Solvency II and Basel III are about prudential standards and making sure the Dinosaurs have enough to stave off starvation; I know that MIFID II is looking to level the conduct of business playing field in European Markets; UCITS V and VI  are about saving the brand of the only truly pan-European regulated product; Volcker preventing poacher being gamekeeper in the Investment banks, and AIMFD ensuring that managers of Collective investment Schemes are subject to regulation and oversight by a third party. The UK's RDR wants to see transparency in charging for advice while challenging the advisory industry to show their worth. There's my favourite of all in FATCA which is probably the most ill conceived of the lot (forgive the simplification) whereby anybody investing in American financial instruments will have to prove to the US revenue that all Americans who have beneficial ownership of said instruments have been identified as such, the costs of this I only shudder to think. There you have it a series of single focus developments that create a barren wasteland of entrepreneurial opportunity. Outwardly there is no acknowledgement of the "law of unconsidered consequences". I am finding it difficult to believe that the large institutions are not caught in a web of regulatory impasse, having to consider structural change and adaptation at the expense of viability.

When the meteorite hit 65 million years ago it is estimated that half the species on earth were wiped out, only those that could adapt to the environmental paradigm shift did and then evolved into the present flora and fauna we have today (with the exception of the species hunted into extinction or denied environments in which they can survive). I obviously don't know that half the businesses in Financial services are going to disappear but I do know their chances are slimmer than they were now that we are entering the regulatory Ice age.

HRP 20th November 2012

Thirty-Metres in 9.5 seconds!

For my first "Tortured Analogy" I take the impossibility of my good self beating Usain Bolt in the London 2012 Olympics and compare it to the lack of realism in business strategy.

As an eternal optimist I have had to learn how to be cynical. Playing the Devil's Advocate is sometimes easy but not without value because the positive traits of optimism and unfettered entrepreneurial energy can often be broken on the rack of reality.  A belief that all can be achieved if you set your mind to it is a romantic maxim. I may have even reiterated to my children that all is possible in the countless "take every opportunity, live life to the full, the world is your oyster" cliche ridden motivational speeches that is the want of a father trying to guide but not dictate a life path for their offspring.

I do not however make my living as a motivator but as a strategy consultant and I would give up if ever I uttered anything as trite as "all is possible". Not only it is patronising and although my kids may appreciate the literal benefit in the future, I would not expect a client to pay for it. More importantly it is not true.

At this point if there is anybody deluded enough to disagree with me while bound by the accepted laws of physics and common understanding that Harry Potter is not real consider this; in about three weeks time Usain Bolt will attempt to cement himself as the face of the 2012 Olympics by winning the blue ribbon one hundred meters final.  I do not have a chance of beating him in the race!

There will undoubtedly be a pedant somewhere that will wish to challenge me on that one, siting that Bolt could be injured, a handicap system could be put in play or he could be disqualified. Absolute rubbish! Although the spectacle of Price versus Bolt will amuse those that know me it is not going to happen in the one hundred meters at London 2012. The important point here is whether or not it is possible not my relative ability against Bolt.

The mentioned scenario is impossible because of the restrictive nature of the deliverable. Beating Usain Bolt over one hundred meters is highly unlikely whoever you are, however Yohan Blake did beat Bolt in the Jamaican trials last week, therefore beating Bolt is not the issue in isolation. The issue is the race itself which is a final and follows two semi-finals, four quarter-finals, heats and pre-heat qualifying. It is restricted to three competitors from each country who have achieved a preordained qualification time of 10.24. Qualifying closed on the 8th of July. Forget that at the last recorded attempt back in 1984 I recorded 14.5 seconds for the hundred meters and certainly have not improved since then; forget I would have to beat all but seven other competitors to get into the final, forget there are at least three Britons more eligible than me. The simple fact is that I did not enter and I do not qualify for the race. If however Usain wants to take me on somewhere else at a different time I am open to offers, the handicap, injury and a multitude of other factors make my victory possible if somewhat improbable.

In stating the mind numbingly obvious that I will not be beating Usain in London 2012 I bring your attention to a common failing of business strategy; the failure to set realistic objectives. Whether it be a measurable achievement, the time period and budget in which to achieve it or a combination of these many business strategies are doomed to failure at outset because of a lack of realism. With the best people, an appropriate budget, common vision, achievable time frame and strong leadership business change and improvement can be massive. Failure to put any of these elements in place will compromise any goal. A common error I often come up against is that businesses put a relatively large budget in play to compensate for inadequacy in the other areas. Weak leadership is the most common source of failure and usually manifests itself in an inability to compromise. It is the first days of the project when the terms of reference are being drawn up that will dictate how the project is run and by definition its chances of success.

I welcome a vision that is ambitious, "number one in every market", why not!  However if any of the elements are unrealistic they must be challenged at the outset. Strategies are implemented by hitting a series of milestones on time and on budget, significant failure to hit these milestones will accrue and accumulate until the whole project is in danger, the staff will doubt feasibility of the objective, become demotivated or potentially leave. Project sponsors will blame everybody for the failure with the exception of themselves.

Therefore, if you want to be "number one in every market", show me the plan with ambitious but ultimately achievable objectives. I will ask, Over what time? By what measure? Define "Every Market". Who is delivering this? Are they qualified? What is the budget? How is it being spent? What is Plan B? A thorough tyre kicking exercise is warranted before any major strategy or project is implemented.

Finally in the absence of my participation at London 2012 I will attempt to run 30 meters in 9.5 seconds while Usain runs 100m. I will start just outside my front door and run down the street while Usain blasts out of the blocks in the Olympic stadium. If I finish first I will have achieved my objective!!

Huw
July 2012