Rate Risks and Bank Blockchains

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Sometimes rates go up.

I mean, I don't know about tomorrow, but sometime in our lifetimes. The prospect spooked the Treasuries market yesterday, "lifting the two-year note yield to the highest since April 2011," when the Fed Funds rate was also zero. It was last above zero in December 2008; it was last increased in June 2006. Whole generations of traders have arrived and grown up and become disillusioned and left to run food trucks in that time. Which is a problem:

At Barclays PLC, executives last year started reviewing which traders had never been through a rate hike. They discovered even some people in relatively senior positions will be in uncharted territory.

“You could have a vice president who is now considered an expert trader who has never seen a rate hike,” said Mike Yarian, head of rates trading for the Americas and Europe.

Various older folks have tips for them ("Buy bonds that are undervalued, and sell bonds that are overvalued"; "properly hedging interest-rate risk is crucial"; learn "to calculate the break-even price of a bond for a particular investment horizon"), but you can't really know how you'd handle a rate hike until you experience one. It is like combat, except conducted in perfect safety in air-conditioned offices. Good luck out there everyone; your shareholders are counting on you.

Also don't miss the article's picture comparing a circa-2006 trader (suit, Blackberry, worrying about credit -- which is possibly a bit ahistorical?) and a circa-2015 one (Citibike, Apple Watch, worrying about bond market liquidity, Paul Volcker peering grimly over his shoulder).

Banks.

Besides the Citibikes and the Apple Watches, one distinguishing feature of hip bank employees in 2015 is that they're super into the blockchain. And so "Nine of the largest investment banks, including Goldman Sachs, JPMorgan and Credit Suisse, are planning to develop common standards for blockchain technology in an effort to broaden its use across financial services." The particular entity here is called R3CEV, and you might reasonably wonder how it compares and competes with Symbiont's Smart Securities platform, ItBit's BankChain, Overstock.com's t0, Citi Ventures' Citicoin, and Blythe Masters's Digital Asset Holdings, all of which are other banking blockchain efforts. The blockchain for finance is mostly a good clever way for banks to coordinate on settlement and trading practices. But sometimes -- like in the credit-default swap market, apparently -- banks' coordination on trading practices might make it hard for competitors to break in with cheaper ways of doing things that are less favorable to the banks.

Elsewhere, "Europe's biggest banks are on track for a fifth straight year of cutting staff at their securities units." And "a former Jefferies Group saleswoman sued the investment bank for 3.5 million pounds ($5.4 million)" for sexual harassment, and anyone who has worked on a trading floor for a minute will find this credible:

Alaoui Belghiti said male colleagues would be openly derogatory about women suggesting that if someone was attractive "they had a ‘bid’ for her, whilst to denote unattractiveness they would say ‘offer only,’” according to her witness statement.

Get it? The one joke in finance is basically applying trading terms to sex. 

And here is a story about banks criticizing the Basel Committee on Banking Supervision over proposed Basel "rules on interest-rate risk in banking books, including possible binding standards on how banks should measure their resilience to shock changes in benchmark borrowing costs." There is sort of a deep tension in modern banking wrapped up in this story. The core purpose of a bank -- as opposed to a bond market -- is to borrow short-term, lend long-term, and experience interest-rate risk as a rise or fall in profits rather than as a mark-to-market change in asset prices. But it is very tempting for regulators to think about banks' risks in rigorous, quantifiable, mark-to-market ways imported from bond markets. That might make banks safer, but it sort of ignores what they are for.

Credit markets.

Here is the amazing story of Neighborly, which is raising "a $5.5 million round of funding from Joe Lonsdale’s Formation 8 and Ashton Kutcher’s Sound Ventures" and pivoting from "crowdfunding civic projects, kind of like a Kickstarter for your neighborhood" to being "a platform for retail investors to invest in municipal debt that actually affects where they live." Its millennial founder has this to say:

“There are a lot of inefficiencies that software can solve in the market as it operates today,” he said. “The market fundamentally fails to connect people our age with the debt that goes toward funding projects in their neighborhoods.”

Millennials, or at least the people marketing financial products to them, seem really determined to un-learn all of the financial lessons that previous generations have absorbed through hard experience. (Consider Vest, which teaches millennials to avoid diversification and put their money in single-stock derivatives.) The market "fundamentally fails to connect" young people to municipal bonds because young people with long time horizons should probably be taking more investment risks (and because young people investing in tax-advantaged 401k's have less use for tax-free bonds). And most people don't invest all their money in the debt of one neighborhood, particularly not the one where they also live, because they have learned of the advantages of diversification. These are not ... for the love of everything that is holy these are not software problems, come on, come on. 

Elsewhere in municipal bonds, "Puerto Rico officials have overestimated the U.S. territory’s anticipated budget deficit over the next five years by about 60 percent, according to an analysis by Morgan Stanley’s debt-trading team." And in corporate credit, "Junk-bond investors are bracing for a surge in corporate defaults," and people are worried about covenant-lite bonds

Hedge funds.

Here is my Bloomberg View colleague Noah Smith on why you shouldn't compare the performance of everything to the S&P 500 index. This is relevant to Donald Trump, but it is especially, constantly, exhaustingly relevant to hedge funds. If you run a more-or-less long-only diversified equity "hedge fund," sure, you should probably be benchmarked to the S&P. Otherwise the S&P comparison might not be apt.

On the other hand if you call your hedge fund the "All Weather" fund and it does badly when the S&P is down, that is going to be a bit embarrassing for you. So Ray Dalio's Bridgewater Associates was moved to "defend its approach as a solid strategy in good markets and bad" in a client note yesterday. This seems to be less about the fund's performance and more about the alleged risks that "risk parity" funds might pose for the rest of the market:

They have drawn public criticism in recent weeks, as some analysts and hedge-fund manager Leon Cooperman of Omega Advisors Inc. blamed firms that employ risk-parity strategies for putting extra pressure on stocks by using automated trading programs that increase the selling of already-beaten-down assets. They didn’t cite Bridgewater in those critiques.

The billionaire Mr. Dalio fired back in his Tuesday note, which was reviewed by The Wall Street Journal, saying his style “would tend to smooth market movements rather than exacerbate them.” 

Elsewhere, some big hedge fund managers invest their own money in smaller personalized hedge funds.

Pyramid schemes.

Pershing Square put out a press release and a big presentation saying that Herbalife (the multilevel marketing company that Pershing Square thinks is an illegal pyramid scheme) is just like Vemma (the multilevel marketing company that the Federal Trade Commission thinks is a pyramid scheme). Obviously Herbalife disagrees. Pershing Square seems to think that its comparison proves that the FTC will go after Herbalife next, but the best evidence against that theory is that the FTC hasn't gone after Herbalife yet. Pershing Square announced that Herbalife is a pyramid scheme almost three years ago. The FTC has been investigating for 17 months. If it was an obvious pyramid scheme, it would have been obvious by now. 

But of course Pershing Square is not wrong that there are lots of points of comparison between Vemma and Herbalife. Any multilevel marketing company in which people at higher levels are rewarded for the sales of people at lower levels, and where the high-level people get rich while the low-level people don't, does kind of look like a pyramid. Like, just geometrically. The difficulty is distinguishing between legal and illegal pyramids, and, as Joe Nocera points out, that distinction is murky and the FTC is not helping:

William Keep, dean of the College of New Jersey’s School of Business, and a pyramid scheme critic, told Bloomberg earlier this year that “in terms of sending clear signals to the industry, the F.T.C. has done worse than nothing since 1979. It sends confusing signals that have in no way helped us understand how to identify a multilevel marketing company that may be a pyramid scheme.”

People are worried about bond market liquidity.

One of my secret tricks in this newsletter is that when I am hard up for ideas, all I have to do is hint that I might retire "people are worried about bond market liquidity," and then I am immediately flooded with fascinating worries about bond market liquidity. L'homme propose, l'Internet dispose. Here is Guy Debelle, the assistant governor for financial markets at the Reserve Bank of Australia:

Matt Levine devotes a section of his column to ‘people are worried about bond market liquidity’. Notwithstanding the fact that his column is published daily, he has little problem in finding material to write about on this issue.

So today, I would like to provide Matt Levine with some more material and throw my hat into this crowded ring. 

Much obliged! He diagnoses the problem as the decline of "risk-warehousing capacity" in the banks, making them "less able to be nimble buyers of assets whose prices they believe have overshot":

Many real money investors are not able to move so quickly to take advantage of overshooting prices. The degree of discretion is generally not as large. Mandates often impose the constraint of not straying too far from benchmarks, and it takes a long time to change mandates to respond to changes in market circumstances. Are there other participants in the market who are able to move so rapidly and agilely to perform that function today? I'm sure they exist but I'm not so sure that there are enough of them. I suspect we will soon find out.

If there is less capacity to do this, then prices will move by larger amounts and remain away from equilibrium values for longer. Volatility will be higher. In itself, this is not necessarily a bad thing. It is what it is. But with higher volatility, the distribution of price movements will have fatter tails. Overshooting will be more likely and that can have long-lasting and more deleterious consequences.

It does seem like if you were designing a financial system from scratch you might not put the capital-markets risk-warehousing capacity in the same place as the insured-deposit-funded banks? But maybe you would; I mean, that's where the money is, and the government backstop. And, as we're finding out, where else would you put it? Debelle notes that there are calls for central banks to "step in and play the role of market-maker of last resort," but that "In a dislocated market, with most of the trading one-way, the central bank would only be buying, it wouldn't be selling the asset to anyone else anytime soon," so it wouldn't really be a market maker but a sink for risk. But the banks are (were?) just market makers. It's not like they have a track record of just buying everything all the way down in previous dislocated markets.

Elsewhere, I find the European MiFIR rules baffling, right down to the acronym, but "U.K. bond investors are asking for more time to consider and implement proposed transparency rules because plans to make bond traders publicly disclose prices before they buy and sell securities could increase costs and sap liquidity." Here is the statement from the Investment Association, saying that "The plans could damage already-strained levels of liquidity in the bond market." The interaction of pre-trade transparency and liquidity is complex. If you have an order-book-based market with pre-trade transparency, it might be easier for buyers and sellers to find each other and be confident that they're transacting at market prices. But if you have pre-trade transparency in a market without that many trades, it might be very hard for an investor to get out of a big position without tipping its hand.

Things happen.

AB InBev Approaches SABMiller in Record Industry Combination. IRS Raises Red Flag on Real-Estate Spinoffs. S&P cut Japan's credit rating to from AA- to A+. Matt Yglesias on the case for financing deficits by printing money. Steve Randy Waldman on the case for a universal basic income. Quit your job. Ta-Nehisi Coates on mass incarceration. Steven Brill on Johnson & Johnson's Risperdal case. Horndog CEO can’t get a fair trial because he’s a horndog: lawyer. What is Nicolas Berggruen up to these days? The Pilatespocalypse. Reminder That Australia’s New Prime Minister Has A Blog About Dogs. Robert Shiller ate cat food. "Molecular gastronomy is in, in case you mist it." Get drunk at the Taco Bell.

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
Zara Kessler at zkessler@bloomberg.net