Financial market regulators come in for quite a lot of criticism, very often well deserved, but on occasion they are not actually the ones who have made the errors; or at least, not all of the errors
On Monday of this week, the London ‘Times’ carried a story - billed as an exclusive - reporting the demise of a small bond broker/trader by the name of Invexstar Capital Management. Apparently, the company was caught in the spike of German Bund yields in May and the collapse has cost a group of major international banks around £100 million, with a guesstimate of the final bill being as much as £250 million.
Now, I’m not a bond trading expert, but the operation that led to the failure seems to have been pretty obvious. The capital base of Invexstar was in the region of £650000, yet they were running securities positions worth several thousand times that. In other words, they held positions which were totally out of line with their financial resources. The preferred trade was to buy new issues in the grey market, with the intention of selling them before settlement was due - punting on the likelihood that new issues would increase in value when they were fully tradable. Just to help things along, they also managed to persuade at least some of the banks with whom they dealt to allow them to extend the settlement period from the fixed-interest-market norm of two days to five and in some cases even ten days. Call me over-cautious, but to me that looks like an accident waiting to happen. And happen it did when bund yields spiked sharply. (I should point out here that there were several banks who declined the opportunity to trade with Invexstar, but those who did were by no means at the smaller end of the market - they were big names.)
It seems to me that that is not actually a regulatory failing; rather, it would appear to be an internal failing, specifically a lack of awareness in the compliance and credit control areas. Obviously, we can’t know what internal debate went on before the particular agreement in this case was reached between client and bank, but despite that, it’s fair to conclude that the decision reached was faulty on two grounds. First, as events proved when the market moved, the trading limits were out of proportion to the client’s equity and secondly, in those circumstances, why would you effectively lend the client money by varying the standard settlement period (since the bank would have settled in the normal way). But I really don’t think this one can be landed at the feet of the regulators.
LME Historic Prices
Looking at that made me think of the way the LME community got to grips with the issue of historic price trades, which is somewhat similar, in the way it effectively lent money to clients. Younger readers of this may find it difficult to credit, but there was a time when historic price trades - and particularly carries - were a regular, day-to-day part of an LME traders business. There were all sorts of reasons given for the client to need them - ‘it helps with our records’, 'it matches our hedge and physical more precisely’, 'it’s easier for our accounting’ and so on. The reality, of course, was much more simple; somebody had a loss-making position and rather than pay up, they wanted the broker or bank to fund the loss for the time being. Isn’t it always ‘easier for our accounting’ if someone else finances a loss? Actually, from the brokers' point of view, it wasn’t necessarily all bad; the interest rate applied to the deal could be marked up to produce a better return on free cash than regular deposits. Nevertheless, the consensus understanding between regulator, market and trader of the systemic danger of increasingly out-of-the-money positions being allowed to build up over a period of time squeezed those trades almost totally out of the business. Now I doubt there would be any responsible market participants prepared to make the case for the way it used to be. Understanding the implications of credit and cash flow would preclude it.
Regulation and Responsibility
But in the case of Invexstar and its banks, it would appear that, although the regulations have seemingly - and I accept that further information coming out may modify this - not been infringed, the common sense understanding of the issue has somehow not been applied. Could it be that the default position is dubious? Have we perhaps - for whatever reason - reached an environment where as long as the letter of the regulation is obeyed, then other considerations do not come into play? We live in a world of pretty prescriptive financial regulation; we all understand why, given the errors and excesses that have plagued the financial services industry in the past. Are we allowing rules to squeeze responsibility out of the game? From what one can see so far, that seems to have been the case with Invexstar and its banks.
On a different subject, David Bowie has just died. For pretty much everyone growing up after the mid-1960s, his music was part of the soundtrack of our lives, whether or not we were particular fans. But his cultural impact is for the arts correspondents, not me. However, he was prescient in another way, directly of relevance to the finance business. In 1997, he sold the future rights to royalties from the albums he had made up until then, in return for an upfront payment against a ten year bond paying something like seven or eight percent. It was a classic piece of securitisation, but why do I say it was prescient? Well (and of course I have no way of knowing whether or not he actually foresaw this), the rise of file-sharing music sites like Napster blew the value of those bonds away, because the royalty stream suddenly dried up. But Bowie had already taken his reward for his creativity up front. Bit like selling the equity of your trading company at the top of the market………