Stocks Slide as Bond Selloff Panic Sets In

Shawn Lim

Companies such as Visa, Exxon, and Apple were amongst the biggest drops in the European and American stock markets that tumbled from record highs reached less than a month ago. On Tuesday 30th January, the pressure of the global bond market resonated across equity markets with US stocks sliding 0.8 percent in the first few minutes of trading. This was followed by Germany’s Dax index falling 0.9 percent, France’s CAC by 0.7 percent and the UK’s FTSE 100 dropping by 0.8 percent, followed by drops in Asia for Japan’s Topix Index, Hong Kong’s Hang Seng Index and South Korea’s Kospi.

Growing optimism over the potency of the world economy has buoyed equities, which enjoyed its best start to a year since 1987, but brought about concerns that inflation is finally making a comeback, forcing central banks to turn aggressive and tighten monetary policy this year.

However, the US Federal Reserve has currently kept interest rates unchanged, but did mention on Wednesday that inflation is likely to rise this year. This caused growing fears of a bond market rout as it sent the yield of the ten-year US government bond – a global benchmark – to a three-year high of 2.84 percent (as of the 2nd of February). To keep up with inflation, there is an expectancy of a Fed hike which could mean a sharp decrease in bond prices in the not-so-distant future.

Rising bond yields makes borrowing more expensive and may potentially put a strain on companies that have been relying on cheap capital to grow, and as such also make equities less attractive. This can be seen by the steady decrease of the S&P 500 index that has been slowly declining since Monday, dropping 3.71% to $2,762 –  its worst performance since May last year.

The potential of a bond and stock selloff happening right now is undoubtedly high. With stocks falling almost 4% and volatility coming crashing back in to the economy, it all comes as something unexpected with shares decreasing even as company earnings estimates are up. One cannot help but wonder if this is the start of a bearish turn in the market, with the S&P 500 up by almost 50 percent in less than two years, some might see it as the end of easy money that equities have churned out over the past 13 straight months.

Hong Kong Equity Markets 101

Jonathan Eng

With China seeking to establish itself as the next global hegemon and Trump’s ‘America First’ Policy continuing to rewind previous efforts for globalisation, perhaps it’s an opportune time to better understand what exactly is going on in the Oriental East. With China continually promoting its Belt and Road Initiative, the internationalisation of the Renminbi (RMB) is a key step in achieving its goals. And a key player in the internationalisation of the Renminbi is China’s offshore RMB market: Hong Kong.

Unlike other stock exchanges, Hong Kong’s stock market has a unique characteristic to it, in the form of access to China’s rather closed off, enigmatic stock markets. This is achieved through the Bond Connect Scheme, the Stock Connect Scheme and the issuance of H-shares­. H-Shares are shares of a company incorporated in Mainland China that list themselves on the HKSE. Whilst these shares are regulated by Chinese law, they are denominated in Hong Kong Dollars (HKD) and open to purchase from foreign investors. This contrasts with companies that list themselves in China, where they issue out A-Shares and B-Shares.

A-Shares are shares of a company that are listed in either the Shanghai Stock Exchange (SSE), or the Shen Zhen Stock Exchange (SZSE). These shares are typically only available to Mainland Citizens and select foreign institutions that purchase them through a ‘Qualified Foreign Institutional Investor System’. A-Shares were formerly only available to mainland citizens but have since been slowly deregulated as China takes steps to gradually open its financial markets. That being said, there is still a monthly 20% limit on the repatriation of funds to foreign countries for foreigners investing in A-shares.

B-Shares were initially China’s response to opening their markets to foreign investors. They are shares of a company that are quoted in foreign currencies: USD in the SSE and HKD in the SZSE. Although open to both domestic and foreign investors, access to Chinese investors is tricky due to the difficulty in converting the RMB to foreign currencies (China has strict controls on its currency in order to maintain its pegged value to the USD and take care of its Current Account). A Chinese firm can issue both A- and B-Shares on stock markets. However, A-shares demand a premium as they are more easily traded than B-shares, given their ease of access for domestic investors in A-shares and foreign investors in B-shares.

With the distinction in shares established, we now turn to the two aforementioned schemes that China has established with its offshore RMB market. Firstly, the Stock Connect is a scheme that allows investors trading in the HKSE to access stocks that are listed in the SZSE and SSE, i.e. they now have access to A-Shares. Although the exchange rate is strictly controlled by the Chinese authorities, this step opens foreign investors up to what has previously been a highly closed off market, promising prospects of new opportunities for profit as growth in US and EU markets stagnates.

The Bond Connect scheme was introduced in 2017, several years after the Stock Connect Scheme. The Bond Connect essentially allows foreign investors to tap into China’s USD9.0tn debt market without having to set up an onshore account. This will be particularly exciting for foreign investors as with interest rates set to rise in the coming year, the value of Western bonds will fall.

Of course, while foreign investors gain access to mainland markets, mainland investors will also gain access to foreign stocks, which offer far higher yields compared to the low-yielding investment opportunities that consumers are limited to in onshore markets (due to strict regulatory controls by Chinese authorities). This manifests as increased liquidity flowing into the HKSE as onshore consumers begin seeking higher returns, drawing firms to list in Hong Kong – in 2017, 90% of all IPOs on HKSE were oversubscribed.

China’s growth shows little sign of slowing down, and as it continues to grow its international presence and open its financial markets, there is little doubt that their offshore RMB market will continue flourishing and provide new opportunities and higher profits for investors.

Outlook for 2018

Jonathan Eng

This week’s article will focus on some market expectations and key themes to look out for in 2018. Bank of America Merrill Lynch Global Research predict a macro bullish year so much so that they are ultimately bearish as investors seek to rein in after a prolonged period of growth. Global economic growth looks robust at a predicted average growth of 3.8%, with the US equity markets set to strengthen into H1 2018 and US tax reform looking to pass. Expect tighter credit spreads as the USA and European Union look to taper off QE, signalling rising inflation and problems for secondary bond markets.

2017 has been underlined by steady economic growth, with little signs of any obvious bubbles forming in markets and the VIX volatility index staying consistently low. This has resulted in investors seeking higher-yielding equity returns with 2018 set to be ‘a year of euphoria’—as stated by Merrill Lynch market strategists.

These are some of the main themes to observe in 2018. Markets are still largely bullish but this may result in investors pulling back to prevent backlash and as such expect potential dips in H2 2018. But overall it is set to be a pretty good year.

S&P Index growth

The S&P is expected to reach 2800 by YE 2018, with earnings expected to grow by 6%. Trump’s highly anticipated tax reforms are looking to contribute almost 14% to S&P Earnings Per Share.

Global Economic Growth

US GDP growth is expected to be 2.4%, up from 2.2% in 2017. Eurozone growth is expected to be around 2%, with Japan and China expected to grow 1.5% and 6.6% respectively. Emerging markets are also estimated to grow on aggregate by 5%.

Higher Rates

With the Fed set to raise their rate once more in December, it is likely that there will be further rate hikes in 2018 should tax reforms pass and markets perform in 2018. Monetary tightening in the UK will largely be influenced by Brexit negotiations and reductions in inflationary pressure.

The Return of Inflation

With interest rates being near-historic lows for as long as they have, a rise in rates signals a return of central banks attempting to maintain their inflation targets. Whilst the Federal Reserve suggests that their inflation target will not be achieved in the short- to medium-term, an end of year rise indicates that the US economy is back on track with solid domestic figures and steady economic growth.

Debt Market  

Supply of bonds are likely to decline with the cost of issuing rising with rates and support from central banks falling away as money supply from QE continues to taper off. New issuance of US high-grade bonds could decline up to 17% while European supply falls 6%. Asia is set to remain constant with rates in Asia staying flat as well. If rates continue rising, existing bonds on the secondary market will start trading at a discount as the nominal value of the bond decreases due to depressed demand, lowering bond yields for the flush of bonds that have been issued in the market over the past years.

China

By increasing allowed-foreign ownership in a foreign company from 49% to 51%, effectively allowing foreign investors to retain control of their investments in China, and easing tariffs on certain luxury goods imports. China is slowly but surely opening its market more and more to the global economy. The extent of this might still be limited in the short-term while the RMB remains pegged to the USD. Furthermore, with promise of greater global economic integration from the 19th National Congress as well as a promise to deleverage, China is also looking to start focusing more on domestic-driven demand to drive the economy and rely less on export-driven growth. Perhaps a signal to takes its place on the global platform as a hegemon, or perhaps just another move to prop up economic growth and validate the CPC. Only time will tell what China’s true intentions are.

The Looming Menace of MiFID II

Guy Mitchell

While the New Year is set to be a joyous occasion for many, there’s an ominous shadow looming in the minds of Europe’s finance professionals. The second iteration of 2004’s Markets In Financial Instruments Directive (MiFID) rolls out on January 3rd 2018, much to the chagrin of a woefully underprepared financial services industry.

Just what does MiFID II prescribe exactly, and why is it set to be such a headache? MiFID I, officially in effect since 2007, only touched on stocks, resulting in a dizzying progeny of new trading methods such as dark pools and electronic trading platforms. Its successor’s intention is to drastically increase transparency and structure, lower costs and reduce conflicts of interest among banks, trading firms and investment managers. By the FCA’s definition, this includes any firms that provide services related to ‘financial instruments’. MiFID II affects everything to do with said firms, from trading, transaction reporting and client services to even IT and HR systems.

For many investment banks, MiFID II presents itself most clearly in the nightmare scenario of “unbundling” research costs. While this may on its face seem straightforward, its practical implications are anything but. These costs have essentially always been “bundled” into banks’ commissions and broker fees, meaning they have at times been hidden from buyers, and even secretly muted for favoured clients. New legislation will mean these costs are shown upfront and explicitly charged separately. Some have pledged to pass these on to clients, with According to consulting firm Coalition, European operations of global banks are predicted to lose up to $4.4bn (£3.3bn), with trading teams shouldering $2.5bn (£1.9bn) of the cost. This essentially amounts to an automatic 2.6% shedding of revenues. In a time where investment research has had its profit margins slashed razor thin, this extra squeeze on income is going to hurt more than ever. Financial advisor Capital Access Group estimates that the UK’s total fund management budget for research will fall from around £200m this year to £90m in 2018.

Such new measures hit traders just as hard as the enormous banks and fund managers. Restrictions on the trading of derivatives and bonds—still largely traded away from the big exchanges—will move them to more ordinary electronic trading platforms, transferring much of the power from trading shops to the general public. Price transparency ordained by MiFID II will cause even more of an issue, with pre- and post-trade prices needing to be published and sent to regulators for review. Policies need to be developed and implemented across the board by firms to ensure regulators that they are shopping at the fairest possible prices.

New regulation, while undoubtedly creating some losers, provides opportunities for the winners to reap both monetary and reputational rewards. Those fund managers ‘eating’ research costs rather than passing them on to clients (such as Vanguard, JPMorgan and Blackrock) are poised to attract even more business through good faith. Mark Davies, Global Head of RMS Data Services at Thomson Reuters, says, “MiFID II creates complex data management challenges for businesses, and this initiative presents a unique opportunity for firms to benchmark content alongside their peers before it is used in regulatory reporting.”

This all amounts to the fact that the global financial services industry is set for a turbulent time in the New Year. The sheer complexity of MiFID II has left many industry experts scratching their heads, and many top firms have meagre action plans in effect, if at all. With some reports stating “5 years’ worth of work will have to be done in the space of a few months,” for some firms to catch up, this turbulence is just the beginning.

Federal Reserve Rate Hike and its Implications on the Global Economy

Jonathan Eng

After the release of the Federal Open Market Committee (FOMC) minutes on the 22nd November, there has been a mixture of reactions to the signalling of an increase in the Federal Rate. The minutes reflect a more positive atmosphere in the US economy; with a strengthening labour market and a gradual increase in household spending and business investment. A streak of hurricanes drove up gasoline prices in September, fuelling short-term inflation. However, little has been done to impact medium- to long-term growth, with expected longer-term inflation targets remaining unaffected.

The FOMC expect that such economic activity will prevail, which warrants a gradual increase in the federal fund rate—henceforth, Rate—but will remain at levels lower than what is expected to prevail in the long-run. This sentiment has had several repercussions in the dollar, gold, Treasury Bonds and Foreign Exchange markets.

Theoretically, any rise in the Rate would result in the appreciation of the dollar as there becomes fewer dollars in the market due to a higher Rate. However, the dollar currently remains at one its weakest levels since mid-October and has fallen 0.9%. This is mainly due to the fact that markets have already priced in the potential hike in December into existing prices. However, beyond December 2017, the minutes appear vague and uncertain; compounding this with a flattening of US yield curves which only points to short-term Rate hikes and the result is a defensive dollar to protect domestic interests.

This uncertainty in the medium-to-long run in monetary policy has also been reflected in the price of gold and Treasury bonds. Gold went up 1% and traded at 0.8% higher and yield on 10-year Treasuries dipped slightly after the release of the FOMC minutes. Gold is generally perceived as a ‘safe-haven commodity’ whilst US treasury bonds are secure investments with sure-returns; essentially a ‘safe-haven investment’. The fact that gold and Treasury prices have risen reflect cautious investor confidence in the market. This attitude in investor confidence will result in 1 of 2 outcomes; either the price of gold continues to rise while treasury yields fall, or an influx of FDI will go towards China.

Attitudes across the Pacific contrast the defensive reaction in the West. The Yen and Australian dollar went up 0.3% against the dollar while the Dollar Index, which tracks the dollar against a basket of global peers, was down 0.2% in Asia. The index had moved down as much as 0.8% on the day, ahead of the release of the minutes. A weaker dollar remains favourable for China, which pegs the yuan against the dollar. Given China’s current appetite for exports and reputation for cheap labour, a lower dollar will relieve pressures on Chinese exports to the West for the time being.

Despite uncertainty in the medium-to-long term, what is clear in the short run is that the US economy is showing signs of being on track to recovery, with historic quantitative easing being rolled back and Rate hikes being back on the discussion table. What is less certain is how rates will change in the long run, as US inflation is expected to fail to meet its 2% target. How markets will price the dollar and yields accordingly is also undecided. For the time being however, China would almost certainly welcome a weaker dollar, as it continues to leverage cheap exports and extensive FDI to fuel its economic growth.

Ethical Investing: watching the triple bottom line has started to make real economic sense

Isabella Ferros

Be it Corporate Social Responsibly, Corporate Accountability, or Creating Shared Value, a plethora of terms have emerged and somewhat inconsequentially circulated the ranks of financial institutions over the last half century. Only recently have investment patterns actually begun to mirror these sentiments. Recent analysis shows that funds which have integrated environmental, social, and governance (ESG) standards in their strategy are now outperforming those who don’t by a significant margin. The rationale behind such investing is multifarious. These funds seek to claim a stake in future opportunities that will arise within the realm of clean technologies, such as renewable energy and electric vehicles. Furthermore, such investing will insulate portfolios against the downturn of the smokestack industries that comprised the “old economy.” This is an important consideration at a time when the green revolution continues to gain credence.

These new investing behaviours are evidenced globally. The world’s largest pension investment fund, the GPIF (which belongs to the Japanese Government), announced in July that it has selected three ESG indices to track. Norihiro Takahashi, president of the GPIF, has expressed that the organisation will entrust 1 trillion Yen ($9 billion US dollars) of Japanese equity investments against these benchmarks; an allocation which is likely to rise even higher in future. In a similar vein, one of Europe’s biggest insurers Swiss Re has also revealed plans to shift the entirety of its $130 billion-dollar portfolio away from traditional benchmarks and invest in a multitude of ESG aligned stocks instead. This shift, emboldened by the solid performance of current ESG indices, signifies the that the market has reached a pivotal point where ethical investing is no longer just “doing good” — it also makes economic sense.

There are clear social and environmental benefits accredited to ESG, such as that companies who show little regard towards workers’ welfare, act exploitatively towards their communities and fuel conflicts by funding corrupt parties, will be expunged. However, the deciding factor in a fund adopting a new strategy will always lie ultimately in protecting portfolios against downside risks. Spokespeople for global macro investment at BlackRock have articulated that ESG’s move to mainstream is “about not losing a tonne of money. [Funds who] invested in the US coal sector in June 2014 lost 85 per cent by the end of 2015.” On the flip side, inflows of capital into ESG index tracking funds on BlackRock’s iShares platform have brought in a total of $5.7 billion over the last eight years. Similarly, the four indices devised by one of the largest index providers, the FTSE Russell, which groups companies that are involved in green applications, have garnered superior returns in comparison to the FTSE Global All Cap Index.

However, despite the appearance that ESG investments are going from strength to strength, it’s not all plain sailing. The ambiguity surrounding classification of ESG factors has created a rift amongst industry players. Management at Swiss Re have expressed frustration around ESG benchmarking, citing that the lack of clear market standards and guidelines on accepted technologies and practices is dragging on the general acceptance of ESG. Sceptics also cite that the acceleration of “green” companies has been artificially enhanced by generous governmental subsidies divvied out en masse so governments meet the pledges they made under the UN Paris climate accord. Without these, iconoclasts state that the outperformance of ESG indices would be much slimmer, and that the capital flows propping up renewable energy, electric vehicles and all other green technologies would be insufficient.

Regardless, the Global Sustainable Investment Alliance has estimated that ESG integration reached $10.4 trillion dollars in 2016, which is an increase of 38% since 2014. With infrastructures such as policy, governance strategy and implementation reporting which will underpin future ESG investments being developed at speed by large fund managers, this trajectory doesn’t seem set to change any time soon. It can be considered that in order to make ESG investing truly mainstream, the private and public sector will have to work together to achieve stronger harmonisation regarding ESG guidelines. With infrastructure and acceptance of ESG proliferating, investors are now finding that if they do good for the people and planet, it tends to do good for their pockets, too.

Global Real Estate Concerns – The House Always Wins?

Benjamin Foster

Global real estate markets are facing increased concerns as the fundamentals of previously booming markets begin to scare regulators and institutional investors. The main target of this disquiet is China, with Beijing and Shanghai both well known for ballooning house prices and witnessing double-digit gains last year. Whilst this has prompted a degree of regulatory tightening in the main cities, Bloomberg’s recent investigation into the economic data of ten key Chinese cities highlights a large degree of fluctuation in the fundamentals behind property bubbles. These fundamentals (including population growth, income gains and the ratio between house prices and pay) and their fluctuation across the Chinese market are raising interesting concerns for those navigating the region’s real estate market.

A deep examination of the ten cities, selected out of the 70 that the government closely monitors, reveals a mixed picture. Shanghai and Beijing — facing lower population growth, moderate increases in wages and elevated home prices — appear increasingly vulnerable, especially when one factors in plans to cap their population and curb urban sprawl, traffic congestion and air pollution. Smaller cities also should be regarded as somewhat risky investments, with Haikou offering weak wage gains and lower population growth, raising concerns over the increased investment in the region. In contrast, Guangzhou and Shenzhen in the south may face less pressure, with far more favourable rates of population and income growth, as well as far more opportunities for development across the board.

A similarly troubled market is also clearly present across the Pacific, with the Australian housing market finally winding down. With almost half a decade of surging prices, the market value of the nation’s homes has exploded over $5 trillion, four times the country’s gross domestic product. Not even the U.S. and U.K. markets achieved such heady peaks a decade ago. Like the U.S. and the U.K. however, Australia’s obsession with home ownership is firmly entrenched in the nation’s economic focus. Record-low interest rates, tax breaks and increasing breadth, and depth of mortgage lending have pumped incredible amounts of debt into Australian homes.

The increasing treatment of housing as a financial commodity has seen a spike of borrowers tying themselves into a maze of mortgage-related products. Whilst this has been incredibly profitable in the short term for banks operating in the region, Daniel Blake, economist at Morgan Stanley, highlights that banks may find it harder to value their collateral if — or more likely when — the market falls dramatically as investors look to consolidate their portfolios of multiple homes. Indeed, the signs from some institutional investors are not particularly positive, with UBS economists declaring that “Australia’s world-record housing boom is officially over… The cooling may be happening a bit more quickly than even we expected.”

The world’s biggest sovereign wealth fund, however, says it has no intention of pulling back from real estate. Whilst Norway’s $1 trillion fund does note that gaps are opening between the noted valued of real estate and their value on the physical market, a potential sign that a correction could be looming, the fund is steadily growing its real estate empire (valued at $32 billion).

“It’s clearly a red flag in pricing if anything is too far off in any direction,” Karsten Kallevig, chief executive officer of Norges Bank Real Estate Management, said in an interview at his Oslo office on Wednesday. Yet perhaps the fund’s holistic approach to the sector, in its eyes, helps to mitigate these risks. Investing in a wide range of key global cities with prime office space, rather than domestic real estate being the backbone of their portfolio, the fund also holds an increasing amount of retail and logistics properties. With Amazon as one of its biggest tenants, the real estate unit is a close observer of the shift to online shopping.

“Retail is going through an evolution for sure, and it is something we are very focused on,” said Romain Veber, the London-based head of European markets. The fund is placing its bets on “high street retail,” which will “survive in the long term,” he said.

Stepping Up Scrutiny of Initial Coin Offerings

Isabella Ferros

Initial Coin Offerings (ICOs), a method of digitally raising funds from the public using cryptocurrencies, have become an increasing quandary amongst regulators in recent months.

Functionally, an ICO can be considered as a ‘coin sale’, whereby issuers accept cryptocurrencies such as Bitcoin or Ether in return for a proprietary ‘coin’ or ‘token’, which generally represents either a share in a firm or project or a prepayment voucher for future services.  The ICO’s issuer can keep the ether or bitcoin, and use the funds to develop its project.

Although they were as good as unknown a year ago, this method of raising funds has now become more celebrated that the initial public offering (IPO), which is the conventional way of floating a company. According to data provider Coinschedule, more than 3 billion US dollars has been raised in over 200 ICO’s over the last 12 months, compared to around $70 million in the previous annum. The velocity with which ICOs are increasing has in turn fuelled the rapid ascent in the value of all cryptocurrencies, from about $17 billion at the start of the year to a record high of close to $180 billion at the beginning of September.

As articulated by former New York securities regulator Benjamin Lawsky, “Regulators have never seen a new financial product explode with the speed and velocity,” and this unchartered growth is beginning to merit concern from those in charge of financial regulation.

For many, it seems that the crux of the quandary lies in determining what exactly ICOs and their tokens represent, and thus where they should fit into the regulatory framework. Champions of ICOs declare that, although they are initially used to raise funds, they also have a function in the projects they finance, and hence should be treated as utility tokens. It is proving difficult for regulators to be convinced of this, however. According to Lex Sokolin of Autonomous Research, being pieces of code, they can take on the form of any financial product. “They collapse all asset classes into one.” This is causing legal friction, particularly in America, where different asset classes are regulated by different agencies. Other jurisdictions are not proving easy to navigate, either.

At the end of September, Swiss financial regulator FINMA remarked upon the stark increase in initial coin offerings conducted in Switzerland, stating that it is “looking into a number of cases” that have been flagged for concern due to possible breaches of Swiss law.  Up to now, many crypto firms have based themselves in Zug, which has appropriately coined the name “Crypto-Valley,” where they have been less likely to be branded by authorities as a security (therefore saving on taxes).  However, in a similar vein to FINMA, the Crypto Valley Association has recently issued a statement in support of ICO regulation and said it was working with its members to develop an ICO code of conduct. This will likely spell out greater regulatory intervention for prominent blockchain projects operating out of the area.

The move to increase the oversight of projects puts Switzerland in line with other international authorities who have already cast a sharper eye over the new crowdfunding method. Whilst the Chinese and Korean authorities have outlawed ICOs under the premise that they are an extension of gambling culture, Wall Street’s main regulator has ruled that ICOs should be subject to the same safeguards as traditional securities. This is a sentiment shared by many regulators in other Western countries who have now voiced that they also consider at least some of the tokens distributed in an ICO to come under the classification of a security, thus needing to be regulated as such.

To avoid the heaviest regulation, issuers have been scrambling to keep the lawyers busy, but in early October JPMorgan Chief Executive Jamie Dimon declared that bitcoin, the original and largest cryptocurrency, is “a fraud” that will eventually “blow up” when regulators crack down. The coming months will be pivotal, but for the moment, the future of ICOs is mired in ambiguity.

Innovative Payments in FI: Block by (Sort of) Blockchain

Benjamin Foster

Financial innovation company R3 CEV and its 22 member banks have developed a new, blockchain-based platform to enable cost effective and near instantaneous cross-border payments, based upon Corda, a distributed ledger technology. At present, international transactions can take several days to be fully finalised, leading not only to delays, but the greater potential for fraud. With R3’s innovation Corda, however, banks and other financial institutions are approaching the capacity to execute payments almost instantly – building upon Goldman Sachs’ work on its Utility Settlement Coin from earlier this year (a system that envisions settling securities trades using a built-in cryptocurrency).

“International payments systems have struggled to keep pace with the explosion of global trade and the globalisation of the world’s markets,” said David E. Rutter, CEO of R3. “This marks a significant milestone for distributed ledger technology as we work alongside our bank members to harness its unique attributes to build the world’s first true international payments system.” The newly developed platform will sustain digitized versions of fiat currencies on a decentralized ledger and will look to also incorporate central bank-developed digital currencies in the future.

R3’s platform is not, however, a blockchain, with the company shifting away from its original research goal of developing an international payments blockchain, due to a number of key issues with the technology. The speed at which transactions can be processed, issues with the scalability of the technology (as Bitcoin’s ‘forking debate’ of the past year has demonstrated), and security concerns of irrevocably committing sensitive financial information to a public ledger have all forced R3 to shift towards the development of a Distributed Ledger Technology (DLT).

In addition to addressing many of the inherent obstacles for incorporating a blockchain system into international finance, R3’s DLT has also achieved API stability for the first time, allowing developers to build apps from within the ledger (CorDApps) that can be enabled without changing the core API or forcing the client to move its data outside of the secure platform. For instance, RegTech Accuity’s financial fraud screening capability has already been incorporated into Corda, with Accuity stating the feature is ready to use, but will likely only become accessible in 2018 when its licensing terms are finalized.

The integration is targeted at Corda’s financial institution users, including ING, BBVA, and HSBC, among others, and will allow Corda users to scan transactions using an “oracle node” (a key component of Corda that establishes a secure link between a DLT-based smart contract and external data sources), and cross-reference the transaction with regulations such as 4MLD and the US Patriot Act. Whilst Accuity’s integration into Corda is a key step in addressing major concerns of financial institutions regarding blockchain-based platforms – that is, ensuring processes are legally and regulatory compliant – Accuity has stated that it plans to strike similar deals with R3 competitors Hyperledger and Ethereum, suggesting that embedded compliance tools will soon become the standard among such providers and wiping away some of R3’s current, market-leading shine.

R3 is betting, however, that by leading the way in providing connectivity to existing networks, it will speed up the adoption of its open source applications and encourage banks to form coalitions with other network members to experiment with the technology. With R3 now working with over 100 banks, financial institutions, regulators, trade associations, professional services companies, including Barclays, Commerzbank, HSBC, Natixis, and U.S. Bank, the company’s vision for the future of its DLT will undeniably have a key impact on the development of blockchain-based FinTech.

This sector of the market is becoming increasingly key to innovation within both financial and technology giants, with Google and Goldman Sachs two of the most active corporate investors in blockchain companies according to latest reports. The number of corporate investors in blockchain companies hit a record high of 91 this year, just behind the 95 venture capital firms in the space, according to a report by data firm CB Insights published last Tuesday, with $327 million in equity investments made already this year and just trailing the $390 million for the whole of 2016.

Basel, (aisle) III

Jonathan Eng

With the start of 2018 mere weeks away, Basel III is set to be fully implemented across the EU and America. The roll-out has been gradual since its conception in 2010 to allow banks to restructure their balance sheets and capital structure. Basel III is a follow-up, voluntary, set of regulations from Basel II, which is aimed at improving bank liquidity, funding stability and capital structure, to better prepare banks for the next financial crisis. But are banks complying?

Basel III’s focus is mainly three areas: Capital, Liquidity and Leverage.  It specifies new capital target ratios and redefines what would constitute each tier of capital and ensures that firms have a strong enough financial base to weather another financial crisis. Basel III is analogous to a bitter medicine – nobody likes to take it but it’s good for you.

Capital

The new capital target ratio requires firms to hold 7% Common Equity Tier 1 (CET1) capital- which means that if they were to lend out $100, they had to be holding $7 capital (broken down into 4.5% CET1 and 2.5% capital conservation buffer). At a broader level, requirement for Tier 1 capital was set at 8.5%, including CET1 of 7%. Basel III also sets new standards for ST funding and sketches out requirements for LT funding.  An additional problem was with the rather complex redefinition of what would constitute Tier 1 or Tier 2 capital. Whilst it might seem quite complex, the principle behind it is quite straightforward; have enough in reserves to maintain bank credibility that enough cash can be returned to customers, preventing panic.

Liquidity

The ‘Liquidity Coverage Ratio’ is a requirement that banks hold enough liquid assets, or assets that they may liquidate at short notice, to cover net cash outflows over a period of 30 days. The intention behind it is much the same as requiring having to hold more top-tier capital. On top of this ratio, Basel III also put forth the ‘Net Stable Funding Ratio’ (NSFR), a policy that requires the available amount of stable funding a firm had, to be more than the amount the firm was required, over a one-year period of extended stress.

Compliance?

A lot of this was largely predicated on the redefinitions of capital. The Committee for European Bank Supervisors (EBS) estimated that the capital shortfall for top-tier banks would be between €53bn for the CET1 minimum requirement and €263bn for CET1 target level of 7%. Tier 2 Banks need €9bn for their minimum CET1 percentage and €28bn to achieve the target level of 7%. T1 capital ratios for Tier 1 Banks would, on average, decline from 10.3% to 5.6% whilst total capital ratios would decrease from 14.0% to 8.1%. Tier 2 Banks’ T1 capital ratios would decrease from 10.3% to 7.6% and total capital ratios would decline from 13.1% to 10.3%.

From this we can see that Basel III is already making a difference. And given the impact on high-tier firms, probably for the best. McKinsey estimate that pre-tax ROE will decrease between 3.7 – 4.3% from pre-crisis levels of 15%. There is no doubt that firms’ bottom lines would be affected in the midst of restructuring and reducing balance sheets, and since it’s voluntary, would anyone be interested in adopting such measures?

In one word, yes. There are signs that banks are adopting these new measures. As of the latest data from the EBS, the average LCR is already 134.2% and 170.1% respectively for Tier 1 and Tier 2 banks. 99.2% of banks show an LCR above 100%. This success can be attributed to the structural adjustments undertaken by firms and re-framing of the LCR framework. Furthermore, 87.5% of banks surveyed have met minimum NSFR requirement of 100%.

While the effectiveness of such safeguards will not be discernible until the next financial crisis, there is little doubt that adopting these new measures will better prepare firms for financial distress and also cushion the next big crisis – even though one can’t predict the next crisis. With so much uncertainty in today’s market, perhaps it is for the best that banks prepare for the next financial fall-out.