Dominic Hobson Opinion

Anyone conversant with basic economic theory knows that supply and demand are inextricably linked. With demand for quality collateral on the rise and supply drying up, Dominic Hobson wonders why custodians seem reluctant to step up and plug the gap.

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Amid the din of praise for the size and liquidity of the global foreign exchange market, it is easy to forget that the need to exchange currencies at all is a defeat for human progress. Money, unlike manufactured goods or commodities, is useful primarily for its exchange-value. Its exchange-value is maximised where it facilitates the maximum number of transactions. Every time money has to be exchanged for another currency, its usefulness declines.

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Agent lenders have taken in recent years to describing securities lending as an investment management discipline. This has numerous advantages. For agent lenders, it distances their trade from its origins in settlement inefficiency and tax arbitrage. A cynic familiar with how investment management works might say it also signals to the asset owners lending portfolios that scale is more important than profitability, loss of asset value is only to be expected, and intermediaries need ample rewards for the risks they run on behalf of their clients and the complex and demanding work they undertake to identify opportunities.

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The foreign exchange market is commonly described as the most liquid financial market in the world. Indeed, it is often portrayed as the closest approximation in real market conditions to perfect competition, in which the barriers to entry are negligible, the products being exchanged are indistinguishable, and no one provider is large enough to set the price.

Since the 1990s, trading of the major currency pairs has moved on to electronic platforms, which are also thought to have contributed to the surge in liquidity, by broadening participation in the markets by non-banks, and especially mutual funds, money market funds, insurance companies, pension funds, hedge funds and even retail investors and traders.

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Ours is the age of collateral. Nothing is more important now to the workings of the global financial system than a plenteous supply of collateral, for collateral eligible for discounting at a central bank has become the key to access to liquidity. Collateral is the means by which banks fund themselves at central banks, and by which broker-dealers fund themselves at banks, and by which hedge fund managers fund themselves at broker-dealers. Indeed, the great financial crisis that started in 2007, and which continues to this day, could with good reason be described as the first great collateral crisis instead. What ultimately sank Bear Stearns and Lehman Brothers was not the closure of the commercial paper market, though that was bad enough, but the disappearance of the repo counterparties they had relied on every morning to fund tens of billions of dollars of collateral belonging to themselves and their clients. The availability of collateral to use – and, as importantly, to re-use, and more than once – is the chief lubricant of the global financial system of the modern world. Collateral has become, in a sense, a form of money: a substitute for the cash and bank deposits captured by the usual monetary aggregates.

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When is a default not a default? When the institutions hurt the most decide that they cannot afford one. Ever since it became clear that holders of Greek government bonds would be obliged to accept a severe haircut as part of the restructuring of the obligations of the indebted southern European nation, politicians and central bankers have worried that it would trigger payments on credit default swap contracts (CDS) bought by shrewder investors to protect themselves against loss on their Greek investments, and so precipitate an unstoppable crisis that reverberates through Ireland, Italy, Portugal and Spain.

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Whether or not its inventions are socially useless, it is hard to disagree that the investment banking industry has an extraordinary facility for innovating its way to disaster. The publication last week of a consultation paper on ETFs by the European Securities and Markets Authority (ESMA) is a further reminder of mounting regulatory and central bank concern that ETFs are becoming a case in point. They were invented as an even-lower-cost, open-ended alternative to the indexed mutual fund, with the additional benefit of stock exchange levels of continuous liquidity, no subscription or redemption charges, and (especially in the United States) greater tax-efficiency. Now regulators and central bankers are worried that, in the hands of over-inventive financial engineers, ETFs are in danger of degenerating into a yet another leveraged synthetic-cum-derivative financial instrument with no utility beyond the ability to be devised, sold, valued and traded by investment bankers and their clients.

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A tax on financial transactions is no longer the pipedream of an unreconstructed Keynesian economist of the 1970s called James Tobin. Celebrities such as George Soros and Bill Gates have declared themselves in favour. The Archbishop of Canterbury wants a transactions tax. So does the Vatican, a recent paper advocating “taxation measures on financial transactions through fair but modulated rates with charges proportionate to the complexity of the operations, especially those made on the secondary market” to fund a new global reserve fund to replenish the depleted firepower of the IMF. Less predictably, a financial transactions tax (FTT) has even attracted the support of a hedge fund manager, in the shape of David Harding, CEO of Winton Capital, provided the proceeds were invested in a better system of international financial regulation.

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There was some excitement last week at press reports that the Her Majesty’s Treasury was considering the establishment of a United Kingdom sovereign wealth fund to support public sector pensions. Naturally, custodians shared the excitement. Though not yet as large as pension funds, insurers, mutual funds or even central bank reserves, sovereign wealth funds are nevertheless highly desirable custodial clients. Their collective means greatly exceed the much-vaunted hedge fund industry, and they are conspicuous participants in major transactions. Indeed, they were among the earliest targets of ailing banks seeking a capital uplift in the early stages of the banking crisis of 2007-09. A Congressional report estimated that foreign sovereign wealth funds and other large investors sunk $37.9 billion into US financial institutions in 2007.

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The crisis which began in the Spring of 2007 is still with us. Neither the printing of trillions of dollars, nor the maintenance of interest rates at record low levels, has managed to re-start the credit cycle. There is a dawning realization, among bankers as well as central bankers and finance ministers, that hosing the financial services industry with more money is not going to work. The industry has a large, innate and institutionalized structural problem which repeated infusions of money can conceal for a surprisingly long time, but not forever. Policy has now reached the stage at which, to borrow a phrase from Maynard Keynes, low rates of interest and quantitative easing are tantamount to pushing on a piece of string. It is time to face reality, and adopt a new approach that fixes the disease, rather than treats the symptoms. As Boston University economics professor Larry Kotlikoff has described in a series of articles and a book published last year, mutual funds point to a compelling potential solution.

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The mutual fund industry has remained remarkably immune to the moral as well as the material effects of the financial crisis. Despite shedding $5.7 trillion of assets in the second half of 2008, money market funds are the only section of the global mutual fund industry to exhibit any signs of permanent damage, or to have attracted any moral opprobrium. Indeed, the industry as a whole is managing more now ($25.6 trillion) than it did when Lehman Brothers collapsed in 2008 ($24.6 trillion). So a degree of complacency is more understandable in the mutual fund industry than it is in, say, investment banking. Yet it is obvious to any disinterested observer that the mutual fund industry cannot go on like this. There are still too many funds, and too few of them create any value at all for investors. Indeed, a great many funds guarantee the destruction of value through the transaction costs they incur. Despite apparently abundant competition, and high levels of investment in labour-saving digital and telecommunications technology, those transaction charges remain embarrassingly high.

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The European Union has developed a reputation for boring its opponents into submission. With today marking the fifth anniversary of the unexpected decision by the Governing Council of the European Central Bank (ECB) to build a single central securities depository for Europe, nothing scheduled to go live for another three years, and the payback period stretching out to 2022, the TARGET2-Securities (T2S) project is shaping up to become a classic of the genre.

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The securities services industry has an astonishing capacity to absorb punishment without complaint. Custodian banks and their fund management clients have now effectively agreed to spend a fortune to speed up the European settlement timetable by one day no later than the first half of 2013. That means, at a time when it is already wrestling with nearly two dozen other regulatory initiatives, the securities industry has only two years to prepare for a substantial acceleration of the speed at which cash and securities must be exchanged.

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Institutional investors will warm instinctively to the European Commission proposal to increase disclosure of short positions as another blow to greedy investment bankers and hedge funds. They should also consider the consequences for themselves.

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Central bankers have much in common with generals, those other models of public sector profligacy and incompetence. Both are immune to repeated evidence of their own failure. Like the butchers of the battlefield, central bankers are disinclined to question either their strategy or their tactics, and tend instead to call only for the application of the existing methodology with still greater force. This is how our highly sophisticated commercial civilization has ended up being asked to believe that increasing the equity ratio of banks from 2 per cent of risk-weighted (under Basel II) to 4½ per cent of risk-weighted assets (Under Basel II) by 2015 will prevent a financial crisis like that of 2007-08 ever occurring again.

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Nobody would describe the average global custodian CEO as a visionary. It is not easy for the seers and the mavericks and the explorers to rise to the top of any organization, and hardest of all at a bank, where an excess of conventionality is the necessary mask of an outrageously dangerous activity. In fact, the last CEO to visualise the future of the custody industry and then act upon it was probably Bill Edgerly, and he retired from the top job at State Street at the end of 1992. Yet an industry which has undergone as great a trauma as the securities services industry in the last three years needs leaders with a lot more strategic imagination and ambition than shareholders, clients and staff have seen so far.

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Like the rest of the banking industry, securities services has undergone a great shock in the last two years. But if the banking industry has experienced a shock in the last two years, the securities services industry has experienced something closer to anaphylactic shock. This was because it went into the crisis with a business model that was almost perfectly designed to maximize the impact of the shock. Over the last 20 years, the custodian banks evolved a highly risky business model.

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