Carrier Pigeon or Twitter Bird: The Evolution of Corporate Actions Messaging Efficiency

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A version of this blog post was originally published by Wall Street & Technology.

Virtually every industry in every corner of the world has undergone technological or process evolution in recent times. There are countless examples of innovations that have addressed a challenge – the process takes too long, the process costs too much, the process is too risky – and changed the game by helping organizations or individuals operate smarter through efficiency, automation, or simplification.

Let’s consider communication, or the transmission of messages, as just one area where evolution has occurred. There are ways to communicate that involve quite a bit of manual work, such as the use of a carrier pigeon. Not the quickest way to transmit a message, and not too efficient, as apparently a carrier pigeon typically only flew in one direction – home – and would need to be manually taken to a message’s original location to begin the process. Given the level of difficulty and manual intervention required, it’s no surprise we don’t see the skies full of email or text message pigeons today.

On the flip side, if we look at a more modern messaging bird, it is evident that technology has changed the game for how individuals, organizations, and governmental entities can communicate and discover information. Twitter offers its users a simplified and efficient way to communicate specific messages to an audience across the room or across the world – pointing to why the social network has amassed millions of users in just a few years.

A similar, albeit less feathery, evolution is taking place within the corporate actions space today.

Traditionally, when firms need to process a corporate action, they are faced with manual work along the way. While some firms have adopted automated corporate actions solutions to increase efficiency and reduce risk, there are still too many communication points within the corporate actions process that require manual intervention. In particular, when a firm is sending instructions for optional or voluntary events to The Depository Trust and Clearing Corporation (DTCC), those messages are still entered manually. Of course, this ups the risk and the cost of corporate actions processing for DTCC participants.

The industry is recognizing these challenges and the next evolution of corporate actions processing is now underway. The DTCC has begun a long-term, large-scale project called the DTCC Reengineering Initiative, a phased approach to automating the entire lifecycle of corporate actions for U.S, securities. In fact, successful testing of automated ISO 20022 message feeds between DTCC, SunGard’s XSP, and a select group of U.S. financial firms is already in progress.

The end goal? Evolve the corporate actions process to provide straight-through processing (STP) for industry participants, reducing the risks and costs associated with manual processes, while increasing efficiency through messaging automation. Industry utilities and vendors are hard at work to ensure their customers and participants don’t need to shoulder the burden of building bespoke solutions to keep up.

While the industry still has much work to do to get systems ramped up, new ISO 20022 message interfaces developed and testing completed, we are well on our way in this evolution of efficiency. Hopefully it won’t be too long before manual U.S. corporate action processing will also go the way of the birds.

vice president, SunGard’s capital markets business

Leveraging LSOC Opportunities

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This blog post was originally published on TabbFORUM.

New rules have recently come into effect that have substantively changed the customer collateral asset protections relevant to central clearing.

Specifically, the Dodd-Frank Act prescribed that the CFTC adopt rules that provide for enhanced protections of cleared swaps customer margin collateral. The mandate is known as “legal segregation with operational commingling,” or LSOC. LSOC provides a fundamental change in how futures commission merchants (FCMs), as members of central clearing counterparties (CCPs), must manage customer margin collateral.

As a result of these rules, there was an initial flurry of activity to automate compliant processes. For instance, the first phase simply provided a bridge whereby FCMs reported excess collateral without reaching individual-customer-level granularity.

In this instance, a complete compliance implementation is iterative, therefore, the industry is now moving into the next phase of implementation; which ultimately requires full disclosure of the customer’s portfolio of rights and obligations.

Portfolio of rights and obligations means that FCMs are required to report client-specific values and identifications to the relevant CCP. The portfolio of rights and obligations may be reported as: (I) belonging to a specific customer; (II) provided by the firm (the “firm contributed value,” sometimes called “firm contributed assets” or “residual value”); or, (III) unallocated client value.

The duties concerning the portfolio of rights and obligations have substantial implications for both FCMs and their customers. This is true because the general LSOC rule only prohibits an FCM from “permitting a lien on cleared swaps customer collateral held by the FCM.” However, consistent with generalized rules, often the exceptions provide the greatest value, and move to inspire innovation creation. LSOC falls within this category and is an example of leveraging the exception to create potential contractual-based opportunities and advantages for certain FCMs and their customers.

For example, LSOC does not expressly prohibit a cleared swaps customer from affirmatively granting a lien, or security interest on its own margin collateral held by the FCM. Nor does the rule prohibit the FCM from taking action to induce the cleared swaps customer’s grant of such a lien. Hence in this instance, contractual agreements concerning the use of the margin collateral may supersede the rules.

Simply put, customers may contractually opt out of the greater protections afforded under LSOC in favor of other ancillary value offered by their FCM by allowing a lien or security interest to be placed on their funds.

Although this is logically the other side of the same coin, the literal interpretation will likely inspire business opportunities for FCMs, as well as transaction efficacy for its customers, when asserted appropriately. Opportunities may consist of greater flexibility regarding FCM use of funds. Customer benefits may include lower transaction costs or certain netting efficacies.

It is certain that the migration to a contractual waiver of LSOC necessarily involves the requisite disclosures between FCMs and their customers that must be supported by automation.

For example, any process migration away from the general rule in favor of a loophole or exception requires robust permission-based workflows and quantitative tracking that adequately monitor specific actions such as rehypothecation or investments.

If implemented properly, the consent-based waiver reasonably seeks to alleviate the FCM’s burden of contributing to residual value and relieves FCMs of firm contribution that is generally required by the FCM to support its customers’ positions.

The key to leveraging this opportunity is capable automation.

senior product specialist, SunGard's capital markets business

Investor Protection Questions Your Firm Can’t Afford to Ignore

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A version of this blog post was originally published on the Chartis RiskTech Forum.

It’s 2007. Imagine a small-cap company, such as a family-run farm, and imagine the farmer needs to renew a loan he has with his bank. The bank salesman thinks in terms of rolling over a swap, and proposes a structured product protecting his client from rising interest rates. The downside is the collateral flow if interest rates hike south. The farmer, not as concerned about falling interest rates as he is about borrowing money, looks to the upside of protection if interest rates go up and perhaps doesn’t understand that a loan could carry risk if interest rates go down. He does not ask, and it’s pretty obvious he does not fully understand the product he is buying. But he trusts his banker. From the farmer’s viewpoint, the bank is a trusted institution with the best interests of its clients at heart.

Now, as we know, interest rates did fall, and remain low today. The hypothetical farmer has to fork over considerable sums on a monthly basis, and has a very expensive get-out clause that could bankrupt his small-cap organization.

This scenario inspires many questions. Should the farmer have understood what a swap is and have asked all the right questions to understand the risk he is taking? Is this acceptable behavior on the side of the bank? Did the decision makers of the bank understand that this type of structured product was being offered to small-cap organizations such as family-run farms?

The answers to these questions seem to point in the same direction. Capital markets firms will have to build up their functions and systems around investor protection to reduce the risk of miss-selling and being hit by the associated penalties from regulators.

The current picture is not pretty: For PPI (payment protection insurance sold to retail investors by banks and lenders), we are looking at some 34 million policies confirmed as miss-sold in the UK, with lenders have set aside some £14b for compensation, and the FSA/PRA (Financial Services Authority/Prudential Regulation Authority) recently estimated that a further £10b may be required.

Complex swaps products have been sold to small companies en masse, such as farms and small property developers. These often comprise commercial loans with embedded interest rate derivatives, which have a very complex structure to price properly and to fully understand the associated risks. Staggeringly, the FSA stated in January that potentially 90 percent of these complex interest rate derivatives sold to small businesses in the UK could have been miss-sold.

Lenders are now putting aside significant sums for compensation and penalties, and the total industry bill was estimated to £2b in February 2013. Some analysts speculate the total bill will rise to levels of as much as £12b.

Now, decision makers and board members should ask themselves what type of organization they want to represent and run. Do they want to profit on the type of situation befalling our farmer in the earlier scenario? Of course, commercial loans that contain embedded interest rate derivatives may well have their place to the right customer at the right time, but the onus is on the sales rep of the bank to manage product portfolios appropriately.

To invest in a suitable investor protection and sales rep monitoring tool that analyzes customer transactions from a suitability and fraud standpoint and reports sales rep activity from a due diligence and suitability perspective sounds like a simple decision. The upside of a tightly integrated customer on-boarding process with the KYC (know your counterparty) or CRM system, and with an investor and suitability compliance system is obvious: you reduce the risk of being involved in future miss-selling scandals that bring reputational and monetary damages to your company, not to mention a bad taste in your mouth. You also gain a much better view of what products your sales representatives and sales channels actually promote and what types of customers they are signing on.

If your compliance function can operate investor protection monitoring together with staff compliance, conflict management, and trader desk/DMA market abuse monitoring, you are looking at a very efficient compliance risk function that will provide decision makers with the tools to run a compliant and orderly business.

It boils down to one simple question: do you want to be compliant? If your answer is yes, (and why wouldn’t it be?), the tools and means are available, and you will find that the information and oversight they provide can support your business and easily justify the investment. The alternative – to “bet the farm” and do nothing – will ultimately cost much more.

global head of connectivity, SunGard’s global trading business

Come Trade with Me

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A version of this blog post was originally published by the Financial Times.

Recently, I traveled to Madrid. I booked a flight on British Airways and found myself flying… Iberia. Of course these days these two “national carriers” are part of the same company, listed primarily on the London Stock Exchange and Bolsa y Mercados Espanoles, the Madrid exchange.

The Madrid and London stock exchanges are both over 150 years old and fiercely independent. They used to be among scores of independent stock exchanges around the world, all existing to serve their local markets with listings of companies from their country or local area. But increasingly independence is the exception, not the norm, for stock markets.

Like airlines, when countries from Austria to Zimbabwe took pride in having “national carriers,” having your own stock market was a calling card for a nation, even a region. Just as the economics of airlines have prompted alliances no-one could have conceived of – Air France KLM, for example – the economics of stock markets are increasingly leading to a shake-out of the industry.

And just like with airlines, the traditional players are being challenged by low cost entrants who are shaking up the perceived business model by stripping it back to the basics of what traders want from a market. For every Easyjet or SouthWest Airlines, there are multilateral trading facilities (MTFs) such as BATS-Chi X or hungry new entrants, like the Intercontinental Exchange (ICE).

Hardly a week goes by without another deal or alliance being struck among exchanges. The partnerships change all the time creating the most unlikely bedfellows. But in reality all they are doing is following the money.

We are often told that we live in a global world. What happens in Sao Paulo can move markets in Shanghai. This means that traders can be in any location they choose – and these choices are dictated by the availability of skilled labor, the nature of the tax regime, regulations and probably where hedge fund managers want to send their kids to school. From that location they want to trade in any security anywhere in the world. Their choice of market is not predicated on any national loyalty – they will go where there is the best opportunity, the most liquidity, the lowest costs and the least hassle.

As a result you have seen an increasing flow of companies listing on stock markets outside their home territory – from Israeli technology companies on NASDAQ to Kazakh miners on the LSE and Manchester United, an English football club with a Scottish manager, listing in New York where “soccer” is at best a minority sport. Even when a company has its primary listing in its home country, you will often find that the investor community and the majority of trading happen in other places.

Like airlines, national exchanges have had to adapt from being near monopolies in their home markets to being relatively small players in an increasingly global marketplace. They have had to invest in systems and infrastructure to compete and yet still see a large amount of their business being taken by rivals. Against this background it is not surprising that they want to huddle together or face being picked off by global consolidators, worse- altogether forgotten and obsolete.

Over the last few years we have seen multiple alliances in other parts of the world come to fruition. Euronext in Western Europe should regain some autonomy following from the very likely takeover of its parent company by ICE, while NASDAQ OMX in the Nordics, ASEAN in South East Asia, CEESEG in Central & Eastern Europe, and MILA in Latin America have all emerged as important trading blocks, each operating with a subtly different market model.

A fresh crop of new entrants are emerging who reflect the financial strength of markets previously not considered to be worthy of consideration. Moscow shows how, with government backing and strong momentum, a fragmented market can be consolidated to create a credible emerging financial center, fighting for Russian stocks listings that previously would have gone to London or New York. Both the Warsaw and Istanbul exchanges are emerging with similar ambitions.

Where will it end? I can see a few major groupings of markets emerging over time. It is hard to see more than two or three exchange groups in Europe.  The lessons from the airline industry are there to see.

vice president, SunGard’s capital markets business

Regulatory Changes to Shadow Banking Bring Market Participants into the Light

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A version of this blog post originally appeared in Securities Lending Times (p 16).

The overarching mandate of financial reform is to mitigate the potential risks associated with systemically important financial activities and institutions. Statutory authority has purposely reserved an abundance of discretionary authority for the regulators to capture and reconfigure processes that have “an effect upon,” covered activities.

As a means of exercising this reservation of authority, rule-makers as well regulatory-framework-setting bodies now seek to target shadow banking.

For instance, the Financial Stability Board (FSB), which itself does not have rule-making authority yet is considered a persuasive advisory body concerning international standards within the financial system, seeks to “mitigate the spill-over effect between the regular banking system and the shadow banking system.”

Additionally, the Financial Stability Oversight Council (FSOC), which has rule-making authority under Section 120 of the Dodd-Frank Act, seeks to enhance and substantively modify the shadow banking space. The FSOC has concluded that the current state of shadow banking contributes to systemic risks. As a result, it now seeks to address the perceived bank-like activities that pose risks by subjecting shadow banking, and related activities such as money market mutual funds, (MMFs), and securitization activities to more onerous oversight.

Changes are coming to shadow banking

Shadow banking, which arguably provides a valuable funding conduit that supports real economic activity, broadly covers credit intermediation, liquidity optimization and maturity transformation involving entities and activities outside of the traditional banking system. Shadow banking may include securitization activities such as origination, or alternatively, wholesale funding through MMFs.

For example, MMFs, which had approximately $​3.​1 trillion in assets under management as of December 31, 2012, provide a substantial portion of the short-term funding available in the capital markets and are an integral part of shadow banking.

The regulators purport that MMFs generally lack loss-absorption capacity and are susceptible to runs. The FSOC and the Securities Exchange Commission (SEC) propose substantive rule changes that constitute the second regulatory enhancement since 2010. The present rule related to MMFs seeks to incorporate a variable value calculation that would replace the traditional fixed valuation.

Specifically, the proposed regulatory enhancements call for a mark-to-market (MTM) variable net asset value (NAV) as opposed to the fixed NAV used currently. The migration toward a variable NAV, which values the asset(s) at the current available market price, calls for supporting automation that would allow investors to monitor and contemplate risk and valuation changes in the MMF’s assets through a data-driven dashboard.

Additionally, the credit risk retention rule under Section 941 of the Dodd-Frank Act, which supplants Section 15G to the Securities Exchange Act of 1934, requires securitization sponsors to retain a portion of the credit risk and an economic interest in the assets they securitize.

According to the rule, securitization sponsors may retain credit risk in a number of ways. Since the manner and method in which risk retention is accomplished remains discretionary, based on certain limitations, firms are then faced with a technology challenge. That is, the flexibility of the rules in light of the heterogeneity of products and market participants provides a robust business case for automation. Accordingly, sponsors, or other market participants with independent technology processing capabilities, may achieve compliance with the risk retentions requirements in Section 941, or alternatively, may leverage the analytics in other ways.

Still, shadow banking will continue to evolve

Shadow banking takes a variety of forms, which are continuously evolving despite the regulatory scrutiny of these activities. From a regulatory monitoring perspective, authorities intend to cast a wide net, potentially subjecting all non-bank credit intermediation activities that might arise to new rules.

From a regulatory policy perspective, the proposed rules likely require enhanced automation processes for all covered shadow banking activities that involve credit intermediation, liquidity optimization and maturity transformation. This is true because enhanced transparency almost always requires connectivity reconfiguration and quantitative capabilities.

It is important to note that the FSOC and FSB regulatory objectives are not merely minor revisions to existing regulatory structures, but substantial changes in the ways that shadow banking will be regulated globally.

The ambiguity of these directives and outstanding reservations of authority given to regulators should prompt a call-to-action for shadow banking participants – including buy-side beneficiaries – regarding necessary automation advancements to support these industry changes.

When Every Penny Counts, Firms Must Operate Smarter Through Deeper Data Analysis

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The full version of this blog post originally appeared in Wall Street & Technology. It also appeared on Bank Systems & Technology.

Today’s economic environment has become increasingly difficult, forcing executives and managers to analyze expenditures and business practices with more scrutiny in an effort to remain profitable.

…

In addition to the expense of creating and maintaining an effective cost identification and management solution, broker-dealers are faced with the issue of the integrity of its results. Most financial services firms today are engaged in multiple businesses across global markets and with a magnitude of clients and business partners. Each new profit conduit is also an opportunity to add expense.

In order to identify profitability and cost savings, firms must manage large and disparate data sets housing transaction details, market timing and circumstances, and relationship details. The task of collecting, mapping and then parsing multiple data sources for accuracy is a big challenge. Even if a company has the ability to manage the data sets, there is a level of sophistication and depth that few market participants have achieved to date.

It is becoming increasingly important for firms to have access to a solution that can deliver a complete overview of costs via an integrated model across accounting and the front office. It should allow for a deep dive into disparate data sets to better handle alpha and cost attribution, and help improve trading decisions based on real-time analytics and granular data. This system should also then deliver the right information to buy-side clients to efficiently measure performance.

With the right access to and view of cost-related data, firms can give themselves a competitive advantage and operate smarter in today’s difficult markets where every penny counts.

While you’re here…

senior vice president, Astec Analytics, SunGard’s capital markets business

Lewis on Lending: A Bubble Fit to Burst?

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This blog post was taken from the Astec Analytics Securities Lending Focus for April 2013.

In the early 18th century, the bursting of what became known as the South Sea Bubble broke many fortunes. The East India Company, riding high on the global dominance of the British Empire, issued huge quantities of highly priced stock to hungry investors who believed the company’s monopoly on South American trade could not fail.

Unfortunately, they were wrong, and their clamor for the shares blinded them to the fundamental weaknesses of the company. A sudden realization burst the bubble, and the shares became worthless almost overnight. I am not, of course, directly comparing certain countries’ debt issuance with that of incompetent 18th century industrialists, but there is a certain similarity in the desperation of investors seeking safe places to put their money and the resultant bubbles in prices such actions create.

The price of debt issued by certain governments has been pushing at record highs recently, with the U.S. and Japan among them. Commonly, it is occurring where there are active “asset purchase” practices in place supporting demand for their debt, but there has to be a limit and at that point we will likely see a correction. The correction may of course be a slow deflation, with prices falling back steadily and corresponding yields rising to more normal levels. However, a more dramatic bursting of the bubble could have much worse implications for the markets and investors.

Securities lending volumes have certainly been on the rise in the debt of certain countries, which could indicate a movement of sentiment and the build-up of short positions poised to take advantage of a fall in prices if and when it comes. Shorting is, of course, not the only reason to borrow securities and government/sovereign debt of certain nations will attract greater demand as the need for high-quality collateral increases under new market regulations coming into force.

Over the coming weeks, we at SunGard’s Astec Analytics will be looking at these movements in greater depth to try and separate the demand to borrow high-quality collateral from those that may be borrowing debt that, possibly like the stock of the East India Company, is inflated beyond its true and fair value.

vice president, risk solutions, SunGard's capital markets business

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Risk Management: Making Sure the Tail Doesn’t Wag the Dog

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This blog post originally appeared on TabbFORUM.

Risk can and should be seen as the core of a financial institution. The management of risk has become an industry in itself, led in turn by regulatory drivers, technological advancement, trading floor developments and quantitative research. In this blur of evolution, it is easy to lose sight of exactly what is required of the risk department, and it is worth taking a step back to refocus on what is important.

There has always been a risk function. The key to that function is ensuring that the firm takes risks commensurate with the risk objectives as spelled out by the management of that firm, and that there is sufficient liquidity within the organization to withstand those losses that are reasonably foreseeable.

When risk management was primarily concerned with prudence in granting loans and investment diversification, there were challenges – but these were generally well understood, to the extent that many of the quantitative methods used by funds without derivative exposure are more than 30 years old. The use of derivatives, however, introduced the need for a new level of analytics, started as an offshoot of the trading desks themselves, and moving through being a trading strategy to becoming the central plank of the regulatory reporting requirements across the world. These requirements now include:

  • VaR (and various VaR derivative measures, such as VaR Shortfall)
  • Stress testing
  • Tail analysis
  • Sensitivity analysis
  • Liquidity stress testing
  • Potential future exposure
  • CVA

The essence of the risk management function though, remains the same, ensuring that risks are in line with what is now known as the “risk appetite” and that there is sufficient liquid capital available to mitigate losses that will inevitably occur as a result of taking those risks. This is fundamentally a human activity, a fact that can become lost within the overgrown architecture of many modern risk infrastructures. The first step to re-establishing the function as an efficient, people-led one is to understand how badly planned technological deployments hamper that intention.

The key barriers to risk efficiency are:

  • Too many disparate data sources leading to risk analysts spending much of their time ensuring that various systems have produced results and aggregating those results (a process that in itself often leads to significant loss of accuracy).
  • Black-box processes make the validation of the risk results difficult to check. This is a particularly thorny issue, as results indicating no issues do not attract the same level of attention as results pointing to potential breaches of risk limits. Given the potential impact to the business, these investigations are conducted in pressurized situations.
  • Regulatory reporting has increased in response to the crises that have hit the financial world, from Barings collapse to the recent credit crunch. As regulators seek to protect the system from individual firm failure, the amount of time spent complying with the rules has risen exponentially.

The dichotomy is that the need for technology has never been greater. The power and speed available now should enable risk systems that allow risk management to view, analyze, understand and communicate risk profiles in a way that promotes their function far above regulatory compliance and (back) into trading and portfolio strategy. To achieve this, the technological stack must enable certain core capabilities.

  • Processes that can be automated should be both automated and subject to audit and reporting – manual aggregation leads directly to operational risk. Communication systems and protocols now exist that enable almost any systems to speak to each other, with reporting and feedback available. As long as reporting on these systems exist and are available as standard daily outputs, there should be little to no human involvement in data aggregation.
  • Risk reporting should allow for “deep dive” investigation of the risk profile by risk analysts – this should be one of the core activities of the department and should allow sources of risk to be identified, whether those sources are related to the risk-generation process itself…
  • Trade representation
  • Market data
  • Risk methodology

…or actual trading positions affected by:

  • Individual, identifiable trades or positions
  • Risk factors impacting the portfolio as a whole
  • Risk management should be able to communicate both the risk position and the risk appetite across the organization – along with risk investigation; this should be the main activity for the risk department. It is exactly this communication that creates the platform for the chief risk officer and the board to determine the risk appetite itself, and to express that appetite in the terms and language of the risk reporting. It is equally important that the risk takers are kept informed of the same risk positioning in order that they use the risk system and its results as a critical input into decision making.
  • Risk management needs the ability to make trade corrections on an intraday basis. In order to achieve the level of credibility required for risk to become a strategic tool, when errors in the input data are discovered, they must be corrected and the risk made accurate. The correction capacity for the risk analysts has to be built, in a compliant way, into the risk architecture.

The current technology makes the above possible, with the recent increases in computation speed, data storage capacity and quantitative sophistication all available to complement online reporting and communication. In short, the technology has finally caught up with the needs of the industry – as long as existing, inefficient infrastructure and the regulatory pull on resources allow for what is available to be deployed intelligently across the organization.

Risk management, as a central financial function, has never enjoyed as high a profile as it does at the moment, but it also has never had the barrage of issue to deal with simultaneously. As long as the technical designers remember that the technology must empower the human activity that is risk management, then the outcome can and should be truly effective and credible risk structures acting as the nervous systems of the firms they exist within.

market analyst, Astec Analytics, SunGard's capital markets business

It Started with Tulips, but is the Bond Market the Next Big Bubble?

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A version of this blog post originally appeared on Forbes.

It started with tulips, went through corn and technology, and most recently hit property and cheap money. I am of course talking about bubbles. Not the type children play with and people write songs about, but the kind that, when they burst, can cause financial havoc.

The word “bubble” is bandied about all too often. There seems to be a constant fear that any price rise could become a short-sharp-shock. The latest in this long line up are bonds. Junk bonds, investment-grade corporates and even U.S. Treasuries – the classic ‘no-risk’ investment option – all seem to be reaching new heights.

Low interest rates and stimulus efforts from the U.S. government and Federal Reserve have brought U.S. yields to record lows. Add to this a fast flow of cash away from riskier equities and into the perceived safe haven of bonds, and maybe there is a case to be made that these fixed income securities are starting to get overheated.

Is this a bubble? If prices slowly retreat rather than burst, overheating like this isn’t usually defined as a bubble. So then, does this increase in demand for bonds look set to pop?

Looking and analyzing securities lending data from SunGard’s Astec Analytics may offer us some insight. If people have started to increase short positions in bonds, this at the very least represents growing concerns that prices may not rise forever, nor yields keep on falling. But could the accumulation of short positions actually precipitate the collapse of the bubble? If people are betting it will burst, could these positions represent the pin that will do the popping?

There has also been a growing sentiment that the U.S. Fed may start to rein in its stimulus efforts, when, and if the economy recovers. Any such move would likely see interest rates rise and demand for bonds, particularly Treasuries, fall. An unexpected announcement from Ben Bernanke, or even a European Central Bank or the UK’s MPC, would most likely act as a ‘pin.’

So what does the Astec Analytics securities lending data show? Are traders taking bets against bonds? Does this mean a burst is on the cards, or does it suggest selling pressure (both short and closing longs) may exert an influence at a more gradual pace?

Looking at the number of borrowed securities over the past year, we can see a distinct difference between implied shorting activity on U.S. corporate bonds, Treasuries and U.S. equities.

While the cash U.S. equity markets made steady gains during 2012 and early 2013, the number of shares borrowed saw only mild increases and generally held at fairly steady levels – a pattern we often observe when the short side of the market believes the price gains are ‘appropriate,’ or have the potential to continue.

The bond market on the other hands shows two fairly distinct patterns – corporates undergo increased borrowing in the first half of 2012, up around 25%, falling back and then bouncing once again in 2013; Treasuries see almost the exact reverse, with borrowing levels declining in the first months of last year, then climbing higher only to pull back again during the start of 2013.

Comparing corporate bonds and equities in the cash market, we have already observed a similar pattern. Both have been gaining over the past 12 months as some confidence surrounding the economy and prospects of individual firms has begun to build.

Companies have found it ever easier to issue debt at low interest rates as demand for their bonds has been strong. Likewise the very real threat of junk-graded companies defaulting on their debt has started to subside from the levels feared last year.

The one difference then is what has been happening recently; while both corporate bonds and equities have continued to climb in 2013, the increase in short interest in bonds has started to outstrip that of the stock market. An increase in short interest in line with climbing prices (when other factors are not an influence) is a pattern we see when short sellers are skeptical of the price move, and believe the securities to be overbought. Here, those on the short side seem to be making bets that corporate bonds will fall in a way shares will not. Is this a bubble?

Moving to Treasuries, their borrowing volumes seem to suggest a pattern all their own. As U.S. sovereign yields fell lower on bond buying and low interest rates, Astec Analytics’s data suggests short selling the bonds began to climb as early as May of 2012. Although at that point, the idea that Treasuries were in a bubble saw little speculation, the perceived pessimism probably began to surface thanks to an improving economic situation and increasing likelihood that the Fed would eventually curb its enthusiasm for stimulus measures.

In this case then, the lending data for the past few months suggest the exact opposite with regard to corporates – short positions may have been building over the previous year, but most recently those on the short side seem to be more skeptical that a bubble has formed, or at least that a bubble would pop any time soon.

Unlike corporates, this also fits in with the long side for U.S. sovereigns. While it is true that Treasuries are holding near record-low yield levels, the second half of last year saw rates creep slowly higher. The yield on the benchmark U.S. 10-year, for example, was as low as 1.4% in June 2012, and so it could be argued the current 2% level actually represents a fairly significant increase.

This easing of demand for Treasuries may be the key point. Rather than the short-sharp-shock needed to burst any bubble, Treasuries have seemingly been undergoing a slowing of demand, a release of air if you will, that may reduce the risk of any actual pop.

So then, is the bond market experiencing a bubble? This may be a matter of opinion, and depends mostly on what one defines as a bubble. A bubble is generally only called a bubble after it bursts, in which case the lending data seems to suggest that short sellers believe corporate bonds may be ready for such a hit.

With Treasuries on the other hand, the story may not be as clear cut. Although any move by the U.S. government to ease stimulus measures would certainly have a massive impact on sovereigns. Astec Analytics’s data seems to suggest much of this turnaround in policy is already being “priced in” to one extent or another.

One should also consider how far ‘ahead’ on the long side short sellers are. If each side is offering fair value, then the risk of the bubble bursting is reduced. If, however, the short side is overly cautious (or optimistic, depending on the perspective), then Treasuries may still be set for a deeper drop than one might think. As of yet, though, the lending data seems to suggest this may at least not lead to a burst to the extent many now fear.

product manager, Valdi, SunGard's capital markets business

Limit Up-Limit Down: Where’s the Limit?

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This blog post originally appeared on Advanced Trading and in the John Lothian Newsletter.

On April 8, 2013, the new Securities and Exchange Commission (SEC) rule Limit Up-Limit Down, aka Rule 608, will go into effect in the attempt to lessen volatility in the equities market. Limit Up-Limit Down was passed on May 31, 2012 to “address extraordinary market volatility market wide.”  At the time of the ruling, the Single Stock Circuit Breaker rule was in place to address market volatility, but was not consistent across the market. Limit Up-Limit Down will eventually replace the Single Stock Circuit Breaker in its entirety as it is rolled out in two phases over 2013 with the complete roll-out expected to be complete by September 2013.

To understand why this new rule has come about, one needs look no further than the events of May 6, 2010, known as the “Flash Crash.” During the Flash Crash, the market nose-dived at record rates in a very short time; within only 20 minutes, the market had dropped nearly 1000 points.  Almost as fast, the market gained back nearly 600 points.  This type of incident is ripe for conjecture and philanthropic thought about how to stop another Flash Crash event from taking place again.  Unfortunately, the ‘why’ is generally overlooked, as seems to be the case again today, where once again firms are sent scurrying to comply with a new regulation.

As technology has advanced, the markets have relied more and more on electronic trading, which coincidentally has led to some of the most significant market events in recent times.  This has put an unnecessary burden on a vast majority of firms, who, in an already fragmented market with withering profit margins, now must spend more on compliance.  The costs of running a business are becoming astronomical and firms are feeling that burden.

Now it seems obvious that the Flash Crash and similar instances before and after were accelerated by high-frequency trading (HFT) and rogue algorithms. High-frequency traders profit from the smallest arbitrage opportunities available. These arbitrage opportunities cannot be spotted quickly enough by humans, so these traders rely on technology, co-location hardware, and high-tech algorithms to find, analyze, and react to the information with little to no human interaction. There’s little regulation in place for monitoring and reacting to rogue algorithms today. This all begs the question: why has the SEC chosen to develop a rule that doesn’t necessarily address the root of potential market volatility issues?

What will happen as HFT firms migrate to other asset classes and instruments where the Limit Up-Limit Down Rule does not exist?

With the advent of this new Limit Up-Limit Down rule, the onus is on broker-dealers to have a system in place that will not allow executions to occur outside the set price bands nor quote outside the price bands, and will monitor for executions that might occur during a halt after a limit state has been enacted for more than 15 seconds.  Broker-dealers will also need to have access to this market data to truly understand the price band movements and how this may impact their resting limit orders.

In the end, it feels like this rule is a blanket oversight that fails to tackle the real issue around extraordinary market volatility, the rise of high frequency trading and rogue algorithms. When it comes to Limit Up-Limit Down, when will the regulators realize their limits?