January 5, 2013

At Cheverny we have two very simple businesses: firstly, advising on M&A and capital raising and, secondly, managing private equity investments. In both capacities our teams develop thoughtful, executable strategies to allow entrepreneurs and corporations to achieve their objectives.

Parallel advisory and investing activities are discouraged under the so-called “Volcker Rule”, which is designed to stop large banks deemed important to the financial system from using their balance sheets (and deposit bases) to engage in reckless trading for their own accounts. The goal, of course, is to ensure that no large bank (especially deposit taking ones) makes unwise “investments” and subsequently collapses, shocking the financial system a la Lehman Brothers.

Whilst Cheverny is far from being in a position to create risks that might help topple the financial system (though we are in an excellent position to assist entrepreneurs and solid businesses in their quest for growth and optimisation of capital structures), we nonetheless disagree with on specific element of the Volcker-inspired separation of investment banking and investing. Put another way, we fell that the Volcker Rule is more appropriately applied to trading businesses than to private equity.

In our view private equity investments, if they are made on an unleveraged basis and the capital is committed up front, pose less “systemic” risk than what one finds on the trading floors of global banks.

These departments, over time increasingly populated by mathematicians, physicists and other brilliant (if theoretically minded) people, had for years been making large, leveraged bets for the banks’ own accounts. Regulatory duress is now being applied against these activities, and high time. That said, these financial alchemists have taken their structured products expertise and, in many cases (when they have not formed hedge funds) deployed it in what is deemed to be “client-facing” business. In the view of many observers this has created as much (if not more, given the volumes involved) risk for financial markets and national economies.

The first business that deserves much greater scrutiny, regulation and control is the credit default swap (CDS) market. CDS are a form of insurance against a borrower failing to make bond payments or pay back the principal. Were there to be a 1:1 match of CDS against underlying loans then this would be a statistically significant, but systemically unthreatening, market. Unfortunately the financial wizardry of investment banks has allowed this market to balloon into one where directional bets are placed on many multiples of the underlying debts. A $100,000,000 bond issue by a troubled country may have billions of dollars of CDS bets written against it (in other words the banks are using one underlying transaction to support a much larger synthetic superstructure of directional market bets). Thanks to its size and underlying leverage, the CDS market, which responds to news much faster than the comparatively sluggish-seeming bond or equity markets, becomes a primary motivator of market sentiment and direction. Many of the writers of these CDS bets are aggressive hedge funds, prone to swift changes of sentiment (and potentially unable to fully cover losses should market moves and leverage conspire against them in a toxic mix of market pressures).

Another area of concern are synthetic exchange traded funds and products (ETFs and ETPs). Unlike the institutionally-focused CDS market, these potentially worrisome products are oft-times targeted at retail investors. After the made-in-Canada imbroglio of the asset backed commercial paper market (ABCP) one would think that the application of complex structure, derivatives and leverage in a product sold to retail investors would be deemed unwise. This does not seem to be the case. Whilst there are many high-quality exchange traded funds that provide simple and unleveraged exposure to a clearly defined asset class, others deliver hidden risk masked by misleadingly simple names. These hidden risks include derivatives exposure, counterparty exposure and liquidity risk, generally all in levels far above what the typical retail investor would likely want to bear.

At their conception ETFs were designed to provide a means of tracking the performance of stock market indices at low cost. This simple idea soon expanded to cover everything from natural resource commodities to currencies: the usual story of innovation in the financial sector running far ahead of the ability of regulators or senior management to understand it. Thousands of ETFs and ETPs now transact on global exchanges or (more worryingly) on an over the counter basis. The quoted value of these products exceeds a trillion and a half dollars.

What some find troubling is that a great many of these exchange traded products do not hold the underlying asset (basket of shares, the actual commodity or even the currency). Rather they replicate the performance of these assets with derivatives. The “Delta One” desks of banks (made infamous by UBS and the $2.3 billion losses that flowed, it is alleged, from ill-conceived and secret trades made by a rogue trader) are part of this increasingly risky scene. The coverage of the UBS scandal (which involved the CEO falling on his sword) focused on a debate regarding whether the bank ought to stay in “investment banking”, a catch all term that includes both the benign and traditional capital raising and M&A activities as well as the rather adventurous trading departments that spawned Delta One.

It was therefore encouraging to see the Financial Stability Board (an entity created and manned by central banks and regulators and, at the time of writing, likely to be headed up by Mark Carney, the Governor of the Bank of Canada) issue a warning about the potential risks associated with synthetic ETPs. The warning focused on whether these products were understood by investors, whether their promise matched their performance, and what would happen in the event derivatives counterparties failed to live up to their obligations during periods of severe market turmoil. Setting aside the first two concerns (fill in your answer here depending on your level of cynicism) one is hard-pressed not to agree that counterparty risk is worth discussing, especially given that many of these counterparties are the same hedge funds trading in CDS. There are also concerns about the quality of collateral posted by counterparties (be they banks or hedge funds).

Banks and industry associations are pushing back, but the movement, at least on ETFs and ETPs based on derivatives, seems to be towards an encouraging and (hopefully) appropriate level of regulation.