EU Parliament Passes New Benchmark Rules

This week the EU Parliament addressed the benchmark rate rigging scandals that have plagued financial markets for the past several years, including LIBOR, FX, gold and oil. The goal is to “clean up the benchmark-setting process, improve transparency and prevent conflicts of interest.”

While not yet implemented, new rules will affect benchmarks while breaking them into three categories based upon the size of the instruments and/or contracts influenced (over Euro 500 billion, over 50 billion or below 50 billion). Administrators of benchmark rates will need to create structures to prevent conflicts of interest, will be subject to controls, will have to be authorized or registered, and will need to publish their methodology and procedures for calculating each benchmark. As well, quality standards will have to be put in place for the data used to set benchmarks.

No More Junk Banks !!

Now Available:  Banking on Failure – Fixing the Fiasco of Junk Banks, Government Bailouts, and Fiat Money !  The authors propose simple but drastic changes to banking and bank regulation.  Banking on Failure explains how banks will be safer and have far less impact on economies and governments if and when they do fail.  No more bailouts!

I became fascinated with the challenge of “fixing banking” while spending a year as a lead investigator for the Bankruptcy Court to determine why Lehman Brothers failed in September 2008.  With additional consulting experience and independent study, I believe Laurel and I have found a comprehensive and pragmatic solution.  But it’s a big change!

Please see this link for the (short) Introduction.  I paste the Table of Contents below.  The Kindle E-Book version is best since it has more than 200 live links to news articles and other references that support our discussions.

Table of Contents:

1.    Introduction

2.   Business Failure

3.   Banking Business

4.   Banks Versus Non-Banks

5.    Analysis of Banking Risk

6.   History of Banking

7.   History of Money and Gold

8.   Central Banks

9.    Regulation of Banks

10.   Money, Lending, and Inflation

11.    Junk Banks

12.    Fixing Banking

13.    Summary

Deflation Risk !

(Adapted from Monetary Policy Risk?  Deflation! Industry Commentary of the Global Association of Risk Professionals)

Whenever one reads of global central bank activities beginning in 2008, one always finds the word “unprecedented.”  We continue to live through an “unprecedented experiment” in which central banks relentlessly print money to buy government and other debt securities to push base money (central bank reserves plus currency in circulation) higher.  The Federal Reserve in the U.S. has more than quadrupled its balance sheet since 2007 and is fearful even of reducing the rate of increase of its asset growth.  The reserve requirement for Eurozone banks is a minuscule 1% of liabilities and the European Central Bank must still impose a negative interest rate on bank reserves to encourage more lending.  One could launch a National Security Agency (NSA) data-gathering drone and it would hear G-20 central bankers targeting and wishing for positive inflation along the entire global circumnavigation route.

There’s huge risk here!  Stated less emotionally, there is great uncertainty of outcome – and that is precisely what “risk” is.  Evidently, the central bankers hope that global economies will soon show strong growth to permit them to whittle down the balance sheets and restore interest rates to pre-Crisis levels over the next five years or so.  Yet inflation could explode – or at least go trotting away from us faster than we can run to catch it.  Of the several glaring weaknesses of fiat money, one is the illusion of control.  The central bankers believe they have ultimate control over inflation, but such is not the case.

Individual investors have fretted for years over the ultra-low bond yields and prospects for runaway inflation.  Arguably the citizens at greatest risk are those nearing retirement who plan to live on the income of financial assets and pension annuities.  High inflation would decimate such plans.  Hence, these individual investors hedge with non-monetary assets such as gold that, of course, exacerbates the “low yield” problem.

What, if anything, should financial risk managers of banks and other corporate entities be thinking and doing right now?  Will such businesses suffer in a world of persistent, unbridled inflation?  As it happens, corporations are, relative to pensioners, fairly immune to inflation.  The corporate structure itself is a natural hedge.  Debt liabilities will lose value during inflationary years and that’s good for the debt issuers.  To the extent that a corporate’s balance sheet holds a mix of financial and non-financial assets, the fall in asset value may match or be less than the drop in debt value.  Further unlike the pensioners’ fixed revenue, both the revenue and the expenses of businesses tend to “float” with inflation.

Professional risk managers, therefore, need not dread the onset of inflation.  The corporate risk challenge is deflation!  In deflation, the debt liabilities gain value.  The assets of a non-financial corporate will likely “underperform the debt” in terms of the reaction to inflation.  While banks own predominantly financial assets that nominally appreciate during deflation, the corporate loans among such assets will fall in credit quality.  In addition, the “floating” aspect of income statement expenses can be sticky on the deflationary side.  For example, societies tend not to accept workers’ wage reductions as a reasonable consequence of deflation.  One alternative wage reduction action is to slash headcount with the obvious disadvantage of reducing capacity.  Perhaps it’s best for all employees, not just those in the financial sector, to have a variable (“bonus”) component to compensation that can move higher or lower with inflation and deflation, respectively.

We began this article noting all the inflationary measures of central bankers since 2008.  But the primary observations are “unprecedented” actions and “highly uncertain” environment.  It is entirely possible that the future will follow a deflationary, rather than inflationary, path.  Continued bank losses and several bank reform proposals could curtail lending and the money supply and trigger prolonged deflation.

Should corporates, then, hedge or otherwise prepare for possible deflation?  Our view is that executive management should make the deliberate choice.  Just as a financial firm would match asset-liability interest rate risk, it is also feasible to match asset-liability deflation risk.  Consider a large homebuilder leveraged with financial debt while holding (non-financial) real estate assets.  As it stands, this balance sheet is highly mis-matched in its deflation risk.  To improve the match and reduce risk, this company could short a real estate or other non-financial asset in appropriate size.

The U.S. has not experienced a deflationary two-year period since the Great Depression of the 1930’s.  Likely for this reason, corporate risk managers may not often think in terms of asset-liability balancing for deflation.  Let’s not forget, though, that the absence of national home price depreciation since the Depression was a comforting thought in the years before 2008.

Sovereign Suitability?

Bloomberg reports:  "Goldman Gets Ecuador Gold ...."

    Oh my gosh, this story looks familiar!  Channeling Mark Twain, History Rhymes.  This brief story has few details, so we'll need to make a few assumptions and guesses.  The deal between Ecuador, a sovereign entity that embraces the US dollar as its currency, and Goldman Sachs appears to be "gold lending" for a 3-year term in the amount of $580 million.  Just like "securities lending," Ecuador is entitled to receive cash as collateral.  The best interpretation is that Ecuador will use the cash to buy liquid USD securities from (surprise!) Goldman.

    The first alarming aspect is the statement of the Ecuadorean Central Bank that the gold "now becomes a productive asset that will generate profits."  Here we find the rhyme with the famous cases from the 1990's that created suitability laws!  The Treasury department at Procter & Gamble sought to become a profit center for the company - just like Ecuador's current Central Bank.

    A better analogy to Ecuador (a sovereign) is Hammersmith & Fulham London Borough Council (a UK municipality).  See this legal synopsis of the court judgment repudiating Hammersmith & Fulham derivative contracts as ultra vires.

    On its face, this Ecuadorean gold lending arrangement appears unsuitable for the sovereign.  We reach this view by noting that the central bank is pleased that it "will generate profits" of roughly 1% per year.  How does this happen?  It's leverage!!  It appears Ecuador will take the yield spread of the liquid securities as its profit.  But Ecuador will have, then, both the credit and market risk of the securities AND the market risk of the gold it has lent to Goldman.  Just like securities lending, this is the risk - the lender increases assets through leverage.

    For sophisticated investors with risk expertise, such leverage can be acceptable if fully disclosed.  But sovereigns don't fit this description.  How many central banks are there that gain leverage through off-balance sheet transactions?

    Good question!  Greece comes to mind!  See the February 2010 article "Wall Street Helped Greece to Mask Debt Fueling Europe's Crisis."  We don't recall anybody citing "suitability" concerns for these Greek derivative transactions, but that's how we see the story.  The Greek people were not well served by the delayed reckoning provided by the highly sophisticated Wall Street counterparties.

    Sovereigns and, really, all parties to financial transactions should keep their activities as simple as possible.  Ecuador would be better served simply by selling its gold if it needs the USD cash and near-cash instruments.  Why own gold anyway?  (The Fed itself owns essentially no gold.)  As a USD-based country, Ecuador should simply match the risks of its assets and liabilities.  Having a large, long gold position does not help such risk matching.

London Silver Daily Fixing to End August 14 After 117 Years

Reuters reports that Deutsche Bank has postponed to August 14 its decision to drop out of the London Silver Market Fixing.  In January Deutsche reported that as part of its retreat from much of the commodity business, it was going to sell its' memberships in the gold and silver fixes, run by five and three banks, respectively. They have not been able to sell either so far and announced that they will drop out of the processes on August 14.  The London Silver Market Fixing Ltd. said that the fix will cease at that date.  The possibility of another firm taking over the fix with replacement bank(s)  remains a possibility, although this might be a difficult time to attract anyone to establish benchmark prices.  The CFTC ended an investigation into the silver fix in 2013 without finding any wrongdoing.

Many lawsuits regarding the gold fix are currently in the process of being consolidated by the courts.  There do not appear to be any lawsuits regarding the silver benchmark.

UBS Announces Internal Investigation into Precious Metals Trading

The UBS annual report released Friday mentioned this as an outgrowth of their earlier begun FX investigation.  A couple of interesting points:

1) The mainstream reports over the last year have referred to alleged gold price fix manipulation.  Only 5 banks are involved in the benchmark rate setting process, and UBS is not one of them.  Goldbugs, on the other hand, have screamed market manipulation (by banks holding down the price of gold) for years.  While we are not gold market mavens, it appears difficult to believe that a long term strategy to hold down the market price of a commodity can be successful.  However, if any manipulation is found at all, we can expect many more conspiracy theories to see the light of day (and manipulation reports over the last few years will make them all a bit more believable).

2) Since the LIBOR scandal, UBS has developed a reputation of being the first bank to investigate allegations of wrongdoing and the first to approach regulators when anything untoward is found, trying to reduce or eliminate penalties.  Thus, this raises the question if once again, UBS is an early mover and additional precious metal trading investigations are to be begun.

Bitcoin is NOT Money !!

Yes, bitcoin is fun.  But it’s not money.  It fails the most critical and basic test of “money.”  Along with many other people, we wish it could be money.  The problem is NOT that bitcoin exists only in electronic (or virtual) form.  The problem is also NOT that bitcoin is independent of governments and banks.  In fact, we love these properties!  We’ll say it again:  Bitcoin fails the most critical test of money.  To explain, we digress.

Role of Money

Let’s start at the beginning.  Every adult must acquire the survival necessities of food, shelter, and clothing.  The most direct means of acquisition is to grow one’s own food, build one’s own shelter, and make one’s own clothing.  Free people, however, choose otherwise.  Just as baking two pies is little more effort than baking one, production of food, shelter, and clothing admits vast economies of scale.  A farmer can double the size of her “garden” to feed two families rather than one without doubling her labor or investment in tools.  By doubling her production, the farmer will exchange the excess crops, perhaps, for the clothing and firewood that her neighbor provides.

The superior efficiency of this exchange, or “barter,” system is indisputable.  All participants in this barter system earn their necessities with less time and effort.  Direct barter is potentially manageable in small communities but suffers from the complexity of innumerable “exchange rates” among the barter items (e.g., vegetables, meat, clothing, livestock, lumber, barn construction, medical services, et cetera).  The establishment of money simplifies the barter system tremendously.  People exchange their goods and services for money that they use, in turn, to exchange for items they need from others.  Money becomes the pre-eminent barter item but has meaning only in its ability to facilitate free market exchange of goods and services.

Money is an extraordinarily simple and elegant solution to the barter exchange rate problem.  Further, the size and scope of the barter market increases astronomically due to our ability to save money for future years, borrow money for future repayment, and transmit money easily over long distances.  All human societies invent money, just as they discover fire, in their pursuit of survival and advancement.

Yet what particular barter item could serve as money?  The requirements “to save money for future years” and “transmit money easily over long distances” eliminate most candidates.  Crops and cattle, for instance, are of great value and some historical accounts consider them as early forms of money.  But they are not well suited as money.  The dominant money of the thousands of years of recorded history has consisted of coins of metals and alloys such as copper, bronze, silver, and gold.

The requirement that trumps all others is the certainty people have that whatever serves as money has enduring value.  A man will agree to accept copper coins for his bushels of wheat only if he is confident in the value of other goods he can purchase with the same coins – whether now or next year or within the same village or many days’ travel away.

Gold and Silver through the Millennia

What substance or physical item could possibly inspire such confidence simultaneously in almost all people?  What would all people agree has value “now” and will have significant value at all future times?  There is nothing tangible on Earth that can provide this certainty of value.  Surprisingly and with no strong explanation, however, the metals gold and silver are history’s best answers to these questions.

Gold, and to a lesser extent silver, has smitten human beings through all of recorded history and across a wide range of cultures.  No society rejects gold.  (Lenin may have said “we will make public toilets out of gold,” but neither he nor his successors in the Soviet Union followed through on this promise.)

The history is clear.  Human beings have always regarded gold and silver as “valuable.”  This persistence and confidence are precisely what one needs for viable money.  But there’s a counter-argument:  why should this work?  If a society bases its money on gold or silver and then, suddenly, a large fraction of the society realizes one “cannot eat” gold or silver and that there is no evident value other than “shiny and pretty,” what happens then?  The monetary system would fail.  But it has never happened.  There is no certainty gold or silver will always work as money, but the world has thousands of years of good experience.

Fiat Money

Earlier we stated that the dominant requirement for money is the people’s certainty of “enduring value.”  Yet we then expressed the view that there is nothing tangible on Earth with this certainty.  Gold and silver are merely the best candidates.

Fiat money consists of tokens such as coins or paper certificates with little or no inherent value that a government decrees has stated value.  The enduring value of such money, then, stems from the people’s confidence in the government to maintain the value and validity of the money.  One critical aspect of maintaining value of the otherwise worthless money is that the government mandates that businesses and people accept the fiat money in all payments.

Like many ideas in life, fiat money can certainly work as intended in one’s imagination.  If our employer pays us for our labor with colorful pieces of paper and we know we can exchange this paper for immediate or future purchases, then the money is functioning.  An evident risk is counterfeiting of the colorful paper, so the government must take pains to produce the paper money in a manner that is difficult to emulate.  The government will also create and enforce laws to forbid the counterfeiting.

Since fiat money has no intrinsic value, the citizen implicitly relies on government to maintain the money’s value relative to goods and services in an economy.  We don’t like fiat money – we see it as a disaster waiting to happen.  But at least fiat money has a premise:  “trust government to create and supervise money.”

Bitcoin has No Enduring Value

The big problem with bitcoin is that there will never be widespread, popular certainty that it has enduring value.  We may be able to buy food or clothing or pay our college tuition today with bitcoin, but what about tomorrow?  Proponents of bitcoin might argue that there’s a plan to cap the total bitcoin supply and such fixed supply should maintain stable bitcoin prices.  But why trust that arrangement?  Why trust the unknown and unaccountable group of people that manage bitcoin?  While there may be arguments for trust, public behavior does not derive from carefully parsed arguments.  There’s no stability if people need to think about their money and wonder why it has value.

Perhaps the “easy fix” to this problem is to get government to enforce (or compel or otherwise support) bitcoin somehow.  Yet the existential point of bitcoin is to move away from government control of money.

We’re not economists here at Financial PESTs!!  This is not an argument from the musty library of “Economic Theory.”  Good economists know that they don’t build the theories first and then expect people to follow them.  It works the other way.  Observe how free people pursue their own self- and communal interests.

(We excerpted portions of this essay from J. M. Pimbley and L. E. McDevitt, Banking on Failure at Lehman, to be published in 2014.)

Why is Bitcoin sucking all the oxygen out of the room?

One of our other bloggers, Joe Pimbley, is currently working on a book that we expect will touch upon the topic of Bitcoin.  While he is Financial PEST's resident Bitcoin expert, I couldn't resist posting something about it.  The New York Times Dealbook features a critical piece by Edward Hadas about the virtual currency while Bloomberg Business Week recently published a feature story about the virtual currency and the economy that has erupted in pursuit of this "fool's gold." I wonder, however, whether Bitcoin fits into the classic definition of a "currency" and whether, perhaps, there may be more similarities to the Great Tulip Mania of 1633-37 in the Netherlands.

May a Bank "Tell-All" to Regulators Regarding FX Benchmark Rates?

This article discusses prior investigations by regulators and the incentives to the first mover to cooperate.
http://www.sfgate.com/business/bloomberg/article/Banks-Said-to-Snitch-on-FX-Competitors-in-Race-to-5080967.php