Swaps enter brave new SEF world

The seven fat years in the run-up to the collapse of Lehman Brothers, when Deutsche Bank built its investment bank from bit-part player to the biggest show in town, are now a distant memory. For a business that once boasted a €2trn balance sheet, bigger than its rivals and more than the annual economic output of most countries, recent years have been humbling, with cuts – to the cost base, to personnel, to the balance sheet – the name of the game. At its height, the investment bank pulled in €21bn in revenues a year. But bosses will be lucky to tally €13bn this year, meaning 2014 will probably go down as the weakest since a calamitous 2008. Return-on-equity, which soared above 50% in some of the investment bank’s best quarters before the crisis, will struggle to get out of single figures. At the same time, its balance sheet has been slashed by more than 40% – or €840bn – since its peak. It’s a story repeated across the industry. In theory, banks should be doing well right now: debt issuance is at an all-time high, equity markets are breaking records on an almost daily basis and bond prices continue to soar. But regulations brought in after the industry virtually imploded have forced almost all banks, including Deutsche, into acute retrenchment in order to meet the dramatically increased levels of capital that they must now hold. “When there were few constraints on capital and leverage, everyone had the same strategy – revenue maximisation, which meant you were constantly looking for gaps in the market or gaps in your business that you could fill,” said Colin Fan, co-head of Deutsche’s investment bank. “But with the new rules, it is all about optimising your business to deliver the best returns within the new limits of what you can do. Everyone is working with fewer resources.” For Fan and his peers, that has meant figuring out how to work with far less leverage. Before the crisis, lax regulations and crafty interpretation of the rules allowed Deutsche to run its investment bank more than 100-times leveraged, meaning €100 of assets were backed by less than €1 of equity. Although still high, leverage at its investment bank has since fallen to 47 times. New capital rules have without a doubt made the system safer – but they have also reduced banks’ ability to make money. The prohibition of certain lucrative activities and the shift of some products to exchanges have also taken their toll: an industry that once earned US$300bn annually will bring in just US$230bn this year, according to Morgan Stanley. Revenues have in effect been pushed back a decade. Banks initially responded with deep cost cuts and tens of thousands of redundancies. But a subsequent decline in fixed-income trading has forced more fundamental overhauls, with most banks re-evaluating each line of what they do over the last two years.Efficiencies Some bankers say the need to find efficiencies and properly cost the balance sheet is a welcome change after the abundance of the 2000s. “Regulation is now forcing banks to examine the economics of each and every trade and relationship we have,” said Paco Ybarra, global head of markets at Citigroup. “After the years of abundant liquidity, we need to be very selective in what we offer and to which clients.” Tom King, the man who runs Barclays’ investment bank, shares that analysis. “The world has changed in a fundamental way since the crisis,” he said. “The whole industry has been forced to step back and make judgments in terms of how you generate returns for shareholders under these new rules. We have looked at every single line of our balance sheet and questioned whether it is a strategic use of our capital and whether it is something that can generate the required returns in the new world.” Barclays has certainly taken some tough decisions, reversing many of the expansionary moves made under the stewardship of Bob Diamond in the late 1990s and 2000s: cutting its presence in Continental Europe and Asia, exiting much of t

One record fine has barely earned its place in the history books before the next eye-popping settlement has supplanted it. Such has been the case of inflating penalties over the past two years. JP Morgan’s US$13bn fine for mortgage-linked misbehaviour held the record for just six months before a new record – a US$17bn penalty at Bank of America for similar wrongdoing – topped it. Wrongdoing linked to an array of offences from mis-selling to market manipulation and sanction breaches, and a new-found confidence from regulators in extracting big fines from a banking system no longer teetering on the brink of collapse, has been a lucrative business for regulators, which have reaped about US$150bn from banks – mainly US firms but also European ones. The size of the fines marks a step change, with Peter Henning, professor of law at Wayne State University Law School, saying that regulators now feel compelled to fine big if they want to get the attention of a large institution – many of which have more than US$250bn in assets, or a trillion dollars in some cases. “There was a time when a hundred million dollar fine would have been effective. Now, anything less than a US$1bn fine is considered chump change,” he said. So, even these days a billion dollar fine runs the risk of being called a slap on the wrist. When UBS was hit with a US$1.5bn fine from US, UK and Swiss regulators in 2012 after admitting its role in the Libor rate-rigging scandal, the US Department of Justice rather than being congratulated was criticised for not being more aggressive in the fine levied or in pursuing a criminal indictment. The US attorney leading the case, Lanny Breuer, said the Libor scandal was one of the most significant to ever hit the global banking industry. In doling out the fine he fired back at critics that the goal was “not to destroy a major financial institution”.Fine inflation But as banks have grown healthier post-crisis, the ability of regulators to impose bigger fines without threatening the stability of the firm has risen. That has boosted the confidence of regulators, which in addition to record fines have also forced banks that no longer feel they can fight their regulatory overlords as strongly into signing guilty pleas. In a US$2.9bn settlement with Credit Suisse over charges that it had conspired to aid tax evasion, the bank became the first financial institution in more than a decade to plead guilty to a crime. It wouldn’t be the last. BNP Paribas later agreed to settle up with the DoJ for US$8.9bn, pleading guilty to breaching US sanctions against Sudan, Iran and Cuba over a period of eight years. The potential for future bank fines was enough for at least one money manager, Neil Woodford, to cut bait. Woodford sold his stake in HSBC, citing the risk of “fine inflation”. The bank paid a US$1.9bn money laundering fine in 2012, another US$2.3bn for mis-selling financial products in the UK and could be on the hook for more after Belgian authorities charged the bank with tax evasion and money laundering. Banks were attracting fines as regulators and policy makers had cracked down on wrongdoings both old and ongoing, Woodford said, adding that the fines were increasingly sized on a bank’s ability to pay, rather than on the extent of the transgression. That is a concern that US analyst Dick Bove has been raising for years. “There’s no economic backing or sense of justice behind the fines,” he said. “If the Justice Department thinks they can get the fine, they go after it.” Bove argues that the fines have ballooned because banks themselves have been too willing to settle with regulators. Rather than face criminal prosecution of individuals or the institution, banks have been willing to open their cheque books. “You get a massive increase in the amount of fines when there is no opposition,” Bove said. Several attorneys involved in settlement talks have described negotiations as aimed at putting a cap on liabilities, ending investigations

Both regulation and the desire to cut costs have encouraged banks to review their equities businesses. But regulation has lent the issue extra urgency. In July, the European Securities and Markets Association published a consultation paper hinting that MiFID II (the latest set of rules that will govern trading in the EU) will force banks in Europe to unbundle their equities offering and charge separately for services, such as equities research, that they offer clients. “It is important that members, users and participants should face sufficiently granular tariffs that enable them to access and pay for only those services they need,” said ESMA in its consultation paper. “In particular, it should be possible to pay for trade data services without having to pay for other services that may not be wanted.” Typically with regulatory reform, the only certainty is that change is coming. Exactly what that change will entail remains unclear. The paper met with considerable resistance in consultation and is expected to see significant modifications before the next draft is published in coming months. Regulators are currently working towards a timetable that will see MiFID II rules in force from January 1 2017, though as ever there is scope for further delays. “We disagree with some of ESMA’s proposals and believe the current regulations, which highlight the distinction between trading commissions and investment advisory fees, are sufficient if they are enforced properly,” said Ian Burn, head of cash equity at Natixis. “The key to good regulation is transparency,” he added. “Banks and asset managers need to show clients what they are spending their money on – whether that is on the trading and execution side, or advisory. Indeed, this is what we, the regulators and clients want.” Complicating matters is the usual problem of inconsistency between the regulatory approaches in Europe and the US, and between the UK – where the Financial Conduct Authority has already forged ahead with its own version of the changes – and Europe. That may not only be a headache for banks. “It isn’t clear what impact geographical differences in regulatory approach will have on the buyside,” said Peter McGahan, deputy head of global equities at SG. “There is little sign of the US looking at similar regulation and Europe has also been lagging behind the UK. We will have to see what ESMA finally brings in for the MiFID ll reforms in 2017. An unintended consequence could be to put the UK asset management community at a competitive disadvantage.” As long as Europe does not go to the extreme end of its proposals, bankers expect this to be manageable for them and their clients. But if regulations stipulate that research be charged in a very specific way, it could end up creating logistical challenges for both sellside and buyside institutions. In the worst case scenario bankers fear it could encourage US buyside institutions to repatriate their European investment operations to the US.Not just MiFID At the same time, clients themselves are considering their relationships. The increasing popularity of ETFs, for example, has reduced the demand for services such as equity research. All this has encouraged banks to look at how they should price execution for their clients – and forced a rethink of the entire business. “Margins have been getting tighter for the sellside for a few years, even before the impact of further unbundling, and the whole community has been looking at ways to reverse the falling profitability in cash equities in particular,” said McGahan. This includes, for example, looking at where they have teams in different locations covering the same things. “Research is an obvious place to look for cost optimisation and changing regulation simply emphasises the need to make changes,” said McGahan. The unbundling of the equities offering into its component parts is going to shine a light on each individual business and force banks to justify their spending. But

The apparent success of holdout investors in the sovereign debt restructurings of Greece and Argentina has re-ignited talk about the need to reform the system, and to do so quickly. But advisers involved in the process say any changes will take years to take effect – and ultimately might have little impact on how restructurings are carried out anyway. Holders of some €6.5bn par value of Greek bonds managed to escape the estimated 70% haircut dished out in the country’s 2012 exchange – the biggest sovereign restructuring ever. And, thus far at least, holdouts that refused the terms of Argentina’s 2005 and 2010 restructurings have made a good go of it in court. While they have not been paid themselves, they have lately been able to block exchange holders from getting paid as well, while tying the sovereign up in years of legal battles. Those “victories” have underscored how difficult it is to make restructurings apply equally to all – and made it even less likely they will hold together down the road. “It emboldens people to hold out in the future,” said Yannis Manuelides, a partner at law firm Allen & Overy.New and old ideas When Argentina first defaulted 13 years ago, the IMF – the traditional lender of last resort for sovereigns – considered establishing a formal sovereign debt restructuring mechanism, similar to the US Chapter 11 corporate bankruptcy protection process. While pressure from the US blocked it, the IMF hinted at a milder version in a 2013 staff paper suggesting sovereigns would only get IMF funds if they extended the maturities of their outstanding debt. So-called re-profiling would save the IMF and the sovereigns both money and time. This has also been widely rejected, though many believe re-profiling, without an automatic element for all recipients of IMF funds, could still be a useful tool with which to address the problem. “This is precisely what was done dozens of times in the 1980s and early 1990s,” said Lee Buchheit, a partner at law firm Cleary Gottlieb. “No one pretends that it will solve a sovereign debt problem, but it will give the country and the IMF some time in which to assess the seriousness of the situation and the effectiveness of the programme.” Instead, the International Capital Markets Association received a warmer reception – including backing from the IMF board – for reforms to sovereign debt contracts. The ICMA wants it made explicit in future bond documents that use of “pari passu” language confers equal legal status on bonds – but does not entitle them all to the “rateable” payment that the US courts have adjudged applies to Argentina’s bonds. ICMA also urges collective action clauses (CACs) to aggregate votes across different series of bonds in exchange offers. Bondholders blocked 17 of 35 series of foreign law bonds in the Greek exchange, for example. But with an aggregation clause in its domestic law bonds, the sovereign got approval for the 2012 restructuring via one simple vote. “This approach is a standard tool in corporate bankruptcies in the US and elsewhere,” said Mark Walker, a partner at Millstein & Co who advised Greece on its restructuring when at Lazard. “Endorsement of the concept of aggregated CACs by ICMA and the backing of the IMF are extremely positive steps.” Just after the IMF blessed the contractual changes in September, Kazakhstan debuted in the international markets and incorporated the recommended clauses in its documents, after advice from law firm Morgan Lewis. Yet other sovereigns may be more cautious. The proposed clause has no option for holding a second vote with a lower quorum or reduced threshold, as is standard in most CACs. “Getting 75% of all bondholders to vote may be hard,” said Francis Fitzherbert-Brockholes, a partner at law firm White & Case. And this might mean that aggregated CACs end up being more investor-friendly than intended. This may not be the case for eurozone issuers, which have already had to include their own version of

On the face of it, many banks represent compelling investments. Certainly, their shares are cheap: price-to-earnings ratios at some of the world’s largest banks remain in the single digits, while on a price-to-book measure many are trading at less than one times book (and some at less than half their claimed book value). There are – of course – good reasons for that. Reasons that have convinced many equity investors simply to steer clear. Obvious bargains, they are not. “Do I think they [bank stocks] are bargains?” asked Ed Firth, head of European bank research at Macquarie. “No. They are heavily geared and have risks attached to them. You really have to proceed with caution. Anyone who says they know what will happen within weeks and months after the [European authorities’] asset quality review may not fully understand what is going on. There are lots of reasons why they are trading where they are.” What are those reasons? There are many. But let’s start with the litigation risks. In the fourth quarter, banks revealed in earnings reports that they have been setting aside billions of dollars in anticipation of fines and regulatory punishment. UBS, in quarterly results announced in October, set aside US$1.78bn for a host of issues, while in November HSBC provisioned US$1.69bn. A September report from Macquarie suggested that European banks had potential litigation liabilities of US$96.17bn, and had only provisioned for about a quarter of that amount. Dizzying as that estimate may be, it may not be far wrong as regulators are increasingly keen to punish banks, especially repeat offenders. This was most recently displayed with the US$3.4bn penalties imposed by authorities in Switzerland, the UK and US on five banks, including HSBC and UBS, in mid-November for failures to prohibit attempted FX market manipulation. The portion levied by the UK’s FCA was a record £1.1bn and the regulator specifically cited the failure to act despite earlier fines for Libor manipulation. Of course, litigation risk is just one of the many unknowns surrounding global banks. The regulatory picture is still evolving – and may evolve in a way that makes it harder for banks to make money. Investors also struggle to trust what they are told by banks. To take one example, the almost complete opacity of risk-weighted asset calculations – and other measures of risk that are becoming more important inputs into how banks are regulated – is enough to put off many.Captured And who would want to invest in an institution that has essentially been captured by its employees and used as a vehicle for their enrichment, rather than a money-making proposition for its actual owners? That is essentially the accusation made by Bank of England deputy governor Jon Cunliffe. In a speech in October he said that in 2013 global banks’ average return on assets was 0.3% and return on equity in the UK, the shareholders’ return, was also just 0.3%. He blamed this almost directly on banker pay, citing BoE figures showing that in the 10 years prior to 2007 bank pay bills grew at about the same rate as shareholder profits. But since the crisis, profits attributable to shareholders have fallen from about 60% of the wage bill to just 2% for the large UK banks. In other words, shareholders were getting just 2p for every pound paid to staff. “It is noticeable that since the crisis, for the industry as a whole, employees have received a larger share of a smaller pie relative to shareholders,” Cunliffe said.Days gone by And yet, for some analysts, it is not that banks are uninvestible, it is that investors must recalibrate their expectations. They argue that the days of pre-2007 financial crisis returns are over, but that investors looking for a reasonable return over the long run do have options available. “Some still want to make 20% returns, but I think those days are gone,” said Matt Spick, a banks analyst at Deutsche Bank. “But the sector is trading at one times price to book and makes a

In September, Chinese e-commerce company Alibaba toured major investment centres across the globe as it sought to drum up investor enthusiasm for its IPO on the New York Stock Exchange. In Asia, the company took in Hong Kong and Singapore. The only major Asian investor base it failed to try and woo was Japan’s. It was a notable absence, particularly given that 32.4% of Alibaba is owned by a Japanese citizen – Masayoshi Son, chief executive of SoftBank and Japan’s most dynamic entrepreneur. For Japan, the absence appears to confirm a slow but steady drop in the importance of the country’s retail investor base to foreign equity issuers. International companies are able to access the country’s retail investors (known colloquially as Mrs Watanabe) by using a unique format called public offering without listing. This lets a corporate or shareholder sell a predetermined portion of shares in an IPO to interested Japanese investors without having to list in the country, provided it offers the shares for a minimum of two weeks. Until a few years ago, 10 or more international equity issuers a year would include POWLs in their deals. China’s big privatisation wave of the mid-2000s included POWLs on several IPOs, including those of Bank of China and Agricultural Bank of China. However, the number of POWLs has declined of late to barely a trickle. There was just one between January and November 2014 and that barely counts. Accordia Golf Trust completed its Singapore IPO in July and placed most of the stock in Japan through a POWL, but the golf courses it runs are in Japan and it only floated in Singapore because business trusts cannot list on the Tokyo Stock Exchange. Bankers say a combination of retail investor choosiness and issuer reluctance amid sunnier equity conditions has served to stymie the number of deals that include the structure. Certainly, POWLs are seen as a defensive option, but IPOs have been extremely challenging for the past five years and only became easier in Europe in the past 18 months – a period that still includes moments when the market was closed – plus POWLs have not failed to deliver when used. So what else has happened since the financial crisis – an event that neatly coincides with the drop in POWLs? Well there are two banks with the reach into high-net worth individuals to make promises about what Japan can offer – Nomura and Daiwa. Nomura’s branch network and client base arguably puts it well ahead of its rival. But in the immediate aftermath of the crisis Nomura was reinventing itself – on the back of the acquisition of Lehman Brothers in Europe – into a global investment bank. The last thing the bank wanted was to undermine its ambitions by pitching a Japanese product that would typically account for somewhere between 3% and 25% of a transaction. Most banks pitch for the top global co-ordinator slot in any IPO syndicate and accept lower bookrunner positions if they are offered. A POWL-led pitch would be akin to aiming to be a lowly lead manager and if the issuer decided against the tranche, the bank could easily be excluded entirely. The situation has changed. Nomura has cut its cloth and, while it maintains global ambitions and is growing, most notably in the Americas, it is more willing to play the Japan card. Its investor base has seen the country slip back into recession and it may have to look overseas once again for returns. And it is not just Mrs Watanabe checking her purse. The country’s largest state pension fund, the Government Pension Investment Fund, is about to start spending tens of billions of US dollars accumulating equities both at home and abroad, as part of a massive re-weighting of its ¥127trn (US$1.08trn) portfolio. It is this asset shift that has brokers and banks rubbing their hands in anticipation. Could it also help to rekindle Japan’s love affair with offshore IPOs?Investor preferences While Japan’s investors have been active buyers of some foreign IPOs, analysts say local intere

In the old folk tale, only Ali Baba knew how to access the secret cave of treasure. But with the largest IPO in history, the real-world Alibaba has done a particularly good job of spreading the wealth around. The company’s New York Stock Exchange debut this year is already the stuff of legends; Alibaba shares have risen nearly 70% in less than two months. Yet the success of the US$25bn sale, one of the most eagerly awaited listings ever, was hardly pre-ordained. Chinese companies pursuing US listings have a decidedly mixed record. The e-commerce giant itself had already faced down one stock crisis in Hong Kong, where Alibaba.com was delisted in 2012. And founder Jack Ma was warned to pay heed to the troubles of previous mega-deal IPOs, such as Facebook’s disastrous debut two years earlier. At first, Ma considered doing another Hong Kong listing. But as it became clear that the regulatory changes he considered necessary would take months (at least) to push through, he set his sights on the US market instead. Chinese culture, it is said, values collective effort over individual achievement – and Ma seemed determined not to repeat the mistake of Mark Zuckerberg, whose stumbling Facebook IPO was dominated by just one bank. For its adviser, the company turned to Rothschild, where Alibaba’s head of corporate finance had earned his stripes. There, head of Asian equity advisory Claire Suddens-Spiers and head of North American equity advisory Matthew Sperling crafted engagement letters for a syndicate structure that omitted the lead-left role typical in most US IPOs. Instead, there would be a level playing field among the six joint bookrunners selected: Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan, Morgan Stanley and Citigroup. “It could have been incredibly combative,” said Anthony Kontoleon, head of global equity capital markets syndicate at Credit Suisse. “It could have been a client saying: ‘We are going to reward you at the end based on what we hear and create an incentive structure where [the banks involved] don’t collaborate’.” But it wasn’t going to be anything like that.New way to do it All the work was to be shared among teams of two banks – “Noah’s ark style”, as one participant put it – that would handle everything from prospectus drafting to legal documentation, roadshow materials preparation, offer structure, public relations, financial modelling and investor targeting. None of the bankers invited had been told in advance where the kick-off meeting in Hong Kong on March 25 would be held , and all had to wait with their cars for a call with the location 45 minutes before start time – the Aberdeen Marina Club, where Alibaba had booked using the fake name of a non-existent industry conference. Every single attendee had to stand and state his name, to assure all present there were no journalists on hand. Even JP Morgan vice-chairman Jimmy Lee had to do it, and he was one of the most well-known people in the room – at least until Ma himself turned up, halfway through, to rally the troops. With the deal now live, the most important task for the bookrunners was to reach consensus on the top 150 investors likely to participate. Each bank submitted a list, including the expected order size from each account. The data were cross-checked with each investor’s largest known previous IPO allocation, and everything was consolidated into one master spreadsheet. The process gave the syndicate further confidence that demand would be strong, even if market conditions were sour once the deal hit the road. “It was not the amalgamation of six banks’ best friends, which is sometimes what happens,” said a second senior banker on the deal. “There were pre-defined targets, pre-defined qualifications and really thoughtful approaches to how investors were bucketed. It was not your father’s allocation process. It was probably the most sophisticated allocation process we have ever seen.”Just following orders Still working in teams of two, th

Alibaba has had quite a year. In September, the Chinese internet-based business services company founded by Jack Ma in his bedroom in 1999 completed the largest IPO in history, raising US$25bn on the New York Stock Exchange. Investors ploughed into a stock that surged, paused, then rose again, hitting US$118.50 a share on November 7, up 68% in the seven weeks since its debut. That pushed the firm’s market capitalisation beyond the US$280bn mark, far outstripping the valuation of Walmart, the world’s largest bricks-and-mortar retailer. On November 5, the firm issued its first financial results since its listing, posting a 15% year-on-year rise in net income in the quarter to end-September, with revenues up more than 50% over the same period to US$2.74bn. The rapidity of Alibaba’s ascent to greatness and its control over its home market (where it accounts for four-fifths of all Chinese internet sales by volume) are certainly worthy of considerable attention, but there is another reason that the company is of interest to the geeky souls who examine the entrails of global capitalism: its curious and, some say, antediluvian governance structure – and how the wider world of finance has reacted to the way it has chosen to structure itself. The Hangzhou-based company has a board, just like most sizeable corporations, listed or not. Alibaba’s formal directors include Masayoshi Son, the founder and CEO of Japanese conglomerate SoftBank, Joseph Tsai, an executive vice-chairman who helped land a vital US$1bn investment from search firm Yahoo in 2005, and Ma himself. A quartet of independent directors that includes Tung Chee-hwa, the septuagenarian former chief executive of Hong Kong, and Yahoo co-founder Jerry Yang, complete the nine-man board.­Supergroup Yet there is another force at work, hovering above the fray: an elite band of 28 “partners” – carefully chosen individuals who guide and supervise Alibaba’s official board, and thus also the company’s thinking and strategy. These partners choose who is put forward for a majority of the board positions, then vote to approve those very nominations, creating a closed loop of governance that apes the way that the US Senate approves the president’s cabinet nominees. This “supergroup” of directors isn’t a new invention: it was formed by Ma in 2010 explicitly to speed up internal decision-making, while helping an increasingly bulky firm to operate with greater agility. The list of partners includes – again – Ma and Tsai, along with the likes of Alibaba’s chief financial officer Maggie Wu, and chief executive officer Jonathan Lu. To be elected (read: elevated) to the 28-person upper board, you have to be listed as an Alibaba employee for at least five years, and to have made a major impact on the firm’s bottom line – hence the addition of the likes of the SoftBank CEO. You then need to be nominated by three existing partners and vetted by the partnership committee, before securing the approval of at least 19 partners in a straight up-or-down vote. For those inside the fold, the structure makes good sense. Alibaba is in a growth phase. It wants to blaze its own trail, spending and investing as it sees fit, rather being guided by a quarterly need to generate dividends and hit earnings estimates. Indeed, in a famous 2009 speech, Ma made clear his reservations about short-termist fund managers, placing them last in a pecking order of importance behind customers and employees, and urging “Wall Street investors” to “curse [Alibaba as a result] if they wish”. For those outside this charmed circle, life is very different. Alibaba’s structure allows investors a limited say in how the company is run, whether they buy one share in the company or a million. Investors don’t buy securities in a company called Alibaba; rather, they acquire stock in a Cayman Islands-registered company called Alibaba Holdings, partly in order to circumvent strict Chinese capital controls. Common shareholders have some power. The