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Marketplace Lending – A High-Risk Investment? Too Soon to Tell

13 Jan


Where banks must make full disclosures of their capital adequacy ratios (under Basel 3) – and, in their annual report, the current market value of all their assets and liabilities including derivatives, – marketplace lenders have far less transparency obligations.

Key names such as Borrowize, Accion, Fundera, Multifunding and others are seemingly not financially significant enough to be required to publish annual reports on the SEC’s electronic filing system EDGAR. The information is not readily available on their websites. And they do not willingly give such information to journalists or inquisitive citizens.

For those of whom the majority of their investors are private institutional clients, they admittedly have no real public obligation. But those marketplace lenders whose primary stakeholders are retail investors arguably do have a duty to give some detail on how they manage the key risks of conducting their conducting their business.

Market Risk

This we will broadly define as the risk that an asset will decline in value due either to macro conditions, e.g. change in interest rates; or some underlying change in the asset class, e.g. a certain number of loans defaulting on payments.

Lending Club is typical of many marketplace lenders, in that it offsets its exposure to the loan pool by selling notes, equivalent at the time of issuance to the value of the loan, to its institutional partner. Lending Club collaborates with Utah-registered WebBank, partly to take advantage of Utah’s lax stance towards interest rate-capping. But many lenders have a wider range of institutional partners.

In its 2014 annual report, Lending Club explains away its market risk thus:

“Because balances, interest rates and maturities of loans are matched and offset by an equal balance of notes and certificates with the exact same interest rates and maturities, we believe that we do not have any material exposure to changes in the net fair value of the combined loan, note and certificate portfolios as a result of changes in interest rates. We do not hold or issue financial instruments for trading purposes.

 The fair values of loans and the related notes and certificates are determined using a discounted cash flow methodology. The fair value adjustments for loans are largely offset by the fair value adjustments of the notes and certificates due to the borrower payment dependent design of the notes and certificates and due to the total principal balances of the loans being very close to the combined principal balances of the notes and certificates.”

In order for the loans’ value to continue to equal that of the notes and certificates, the debt trading forum must ensure prompt resolution of any delinquent debts. But they do not generally have the right to forcible repossession of goods to the sum of what is owed. Fixed charges placed over assets owned by the debtor would make up part of the money owed.

But how many actively are the loan issuers ensuring collateral is posted?

Collateral Posted – A Mixed Bag

Intersect Fund and Copperline, in response to our inquiry, volunteered information about their policy on collateral, and on their credit checks. The contrasting policies of these two respondents clearly demonstrate that there is no fixed industry standard on either point.

When asked under what circumstances they would require an applicant to post collateral, Intersect Fund explained: “We use collateral as a compensatory factor for recent credit blemishes and overdrafts. We don’t have a LTV (loan to value) minimum and it depends on how strong the applicant is in other areas.”

Intersect Fund makes a policy of taking four character reference numbers, in addition to running a personal credit check through TransUnion. For Copperline, “Personal credit reports (from Experian) serve as character references”.

The ‘insurance policy’ of Copperline is also more relaxed, and typifies the more liberal end of the lending market. A spokesperson summarised, “We only require collateral if the client is purchasing equipment in which case we take the said equipment as collateral. We never take additional collateral.”

In sum

While all marketplace lenders take measures to counter the risk of delinquency and default, there are limits to the measures they can take to recover missed interest payments. Fortunately there is an ever-expanding supply of fresh loan applicants to keep their portfolios at full value.

Furthermore, the actual sums at stake seem to indicate this risk is for now fully under control. To draw again on Lending Club’s 2014 annual report – this time a detail from the auditor’s notes – we can see that its ‘loan loss contingency fund’ of $1,824,739 is more than sufficient to cover the losses in its three main portfolios over the preceding two years. In fact, the maximum sum deficient, in 2012, was $512,395.

So the management has just cause to consider the loan loss contingency fund “sufficient” to cover all potential future losses from its portfolios.





Back to the Future: Bitcoin, Blockchain and how Marketplace Lenders are Using Technology to Overtake Banks in the Race to Attract New Lenders.

13 Jan


Encumbent institutional investors themselves admit that they have a lot of catching up to do before they can compete with the ‘upstart’[1] marketplace lending providers. A Morgan Stanley research paper published in June discussed how banks were hampered both by their due diligence restrictions, and by the backwardness of their big data analysis techniques.

Because the new marketplace lenders have less operating costs, they are attractive to borrowers as they are able to offer lower commissions; their risk assessment criteria are less exacting than banks, and they incorporate demographic data into their analysis. Thus they are able to offer lower interest rates to interested investors.

Morgan Stanley analysts wrote: “Traditional banks excel at originating loans and underwriting credit, but are slowed by the batch process and portfolio approach to their deposit and loan legacy systems, which are the backbone of the US and global payments system, and by liquidity and capital rules.”

Disruptive Innovations

As well as raising the bar in big data analysis, both for existing users and in targeting potential loan seekers, many in the marketplace lending sector have enthusiastically adopted Bitcoin and the blockchain in their payments system.

BTCjam was among the first forums to facilitate lending in Bitcoin. Founded in late 2012, in 2013 it gained a wealth of sponsors in Ribbit Capital, 500 Startups, FundersClub and the Bitcoin Investment Trust. By the end of 2014, BTCjam had facilitated bitcoin loans of over of $10 million in value, with more than 100,000 users in over 200 countries. The fact that its due diligence procedure only goes so far as an “optional soft credit check” helps explain its popularity.

Bitcoin and BTCPOP both offer bitcoin-denominated loans, of the ‘instant’ and collateral-tied variety. Loanbase, formerly known as BitLendingClub, specialises in bitcoin loans to developing countries, where beneficiaries might not have a bank account.

Why Not Create A New Currency With Your Payments System?

Another start-up has created an entire new currency, LoanCoin, which appreciates as interest is paid on a loan. Once the interest and principal are paid off, the attached LoanCoin is destroyed and exchanged for a currency of the Coinholders’ choice, so the currency value is preserved.

Within the system created by the developers Lending DApp, aspiring loan issuers, or ‘officers’, can source and guarantee new loans for Coinholders and charge fees for their service. Financial institutions, marketplace lenders, and even individuals can act as loan officers; though their commission and the size of the credit or ‘Trust line’ extended to them is dependent on their credit record. Lending is also at the issuer’s own risk and in the event of default or missed payment, the loan officer loses their collateral.

The Trust line is calculated by applying an aggregate function to its collected weighted trust ratings. The network is thus able to draw on the accumulated knowledge of its participants when assessing a loan officer’s reputation and creditworthiness. Percentage of performance fees is dependent on the difference between the risk-adjusted performance of the loans selected by the loan officer, and the mean risk-adjusted loan performance of all loans in the network.

Lending DApp, with its innovative decentralised business model, which relies almost wholly on pre-programmed systems, is typical of the new hybrid marketplace lending product, where banks and what we loosely define as “P2P” lenders co-exist to mutual profit.

Smittipon Srethapramote, who covers the North American payments industry at Morgan Stanley, confirms this is a growing trend. He says “The fastest growing marketplace platforms are not really peer-to-peer but institutional investors partnering with tech platforms to cherry-pick borrowers, often with offline marketing.”

 What The Future Holds

Max Rangeley, who works for the Cobden Centre, a thinktank which has been charged with creating a Bitcoin exhibition for the European Parliament, explains how the Bitcoin transfer system, the ‘blockchain’, might be adapted for other purposes. One potential use is to allow users to better insure the asset they use as collateral on a loan.

“Transactions can be conditional on any event which can be programmed into the blockchain (or even other events, if there is third-party verification whether the event occurred or not). Smart property (property registered on the blockchain) can be used either as collateral or for repo loans, are when the “lender” effectively buys the property from the borrower and sells it back to them at the original price plus interest after a specified period of time.”










Trendwatch. What will impact equity prices in 2015?

13 May
man with telescope

Taking the long view

What are the possible storms on the horizon which might make waves in the UK market? Recent macroeconomic trends which will heavily impact the relative success of British equities are the strong pound, and the continuing low price of oil.

Invest in UK Buyers

Companies which depend heavily on exports might not do as well as those selling largely to a domestic market. Sterling is outperforming vs the dollar, with the 200-day moving average this Wednesday standing at 1.5632. The peak providing point of comparison was 1.5710 on December 16th. And the Euro, the currency of Britain’s other main export market, is also waning in comparison with the pound as GBP:EUR continued to increase today, to 1:1.39EUR, correct at time of publication.

The pound surged on the strength of news the Conservatives were back again, and was given an added boost after better than expected UK March industrial output data on Tuesday, which implied a moderate upside revision to Q1 GDP.

Labour market data released today are also positive: the 3-month moving average for earnings (including bonuses) is at 1.9% vs a predicted 1.7%. And unemployment rate is, as predicted, 5.5% though the number of claimants did not fall by nearly as many as expected.

Expert predictions for the Sterling Euro outlook were given to ( They include


“EUR/GBP has slid sharply after the decisive victory by the Conservatives but it has only unwound the election uncertainty premium built in just ahead of the election. Moreover, with Grexit risk on the rise GBP may benefit from some late safe haven flow. Bottom line EUR/GBP risks have flipped and wouldn’t be surprised to see the pair test 0.70 in the next week or two.”

Charles Stanley:

“Pre-election jitters drove the UK currency down to a three-month low of 1.34 last week but Friday’s result provoked a rebound that looks like it might have further to run in the short-term. Despite its recent choppy price action the chart is suggesting that a run back above 1.40 has become a realistic near-term expectation and that we have probably seen the bottom for now. “

And the Consumer Staples and Consumer Discretionary sectors catering to a UK market are likely to look increasingly attractive, as the Conservative electoral victory means an EU referendum is back on the agenda and Britain’s relationship with the Continent is clouded by uncertainty. The Guardian reported today that Cameron plans to bring the referendum forward, from 2017 to 2016.

Black Gold? Fool’s Gold…

And, while oil prices –taking Brent Crude Oil as an indicator – have recovered some ground over the past month, the long-term outlook is not great. Between April 14 and May 12, Brent Crude rose from 58 to 65GBP.

However, a recent OPEC assessment, as reported on by the Wall Street Journal, predicted that over the next ten years it was unlikely oil prices would rise above $100 barrel again. OPEC is allegedly considering re-introducing the quota system it dropped in 2011. The most positive scenario modelled by OPEC was that oil would retail for $76 a barrel in ten years’ time.

Clearly competition from rival energy sources like natural gas and renewables means that now is a time to avoid oil company stocks, unless you are confident in following a contrarian strategy. Green energy, on the other hand, keeps going up and up.

As a general proxy, look at the all-world Dow Jones Sustainability Index (DJSI), whose total return at the end of last month (April) was 1896.15, denominated in USD. The price return of the DJSI World Index, which is a better indicator of the value gains of its constituent parts, had increased to 1305.37 USD from 1264.41 at the end of March.

Historic data are not publicly accessible for beyond the three-month period, which is a shame because February was an unusually volatile period for markets in general so does not offer an accurate point of comparison: The Dow Jones went from around 17200 to 18500USD over the course of February, ending on a 6-month high.

So essentially, consider disinvesting from the big oil corporations which dominate the FTSE 100 and switch to any company which will benefit from cheaper oil prices – which is almost all of them, bar those providing services or equipment in some way to oil companies. Unless you are convinced your oil-producing asset has a strategy to ride out the new pricing norm.

Capital Markets Union – Breakdown of EU Roadmap (Part 2)

12 Apr

Share Offerings Will be Made Easier by Reducing Prospectus Requirements

As it stands, the threshold for share offers which must issue a prospectus stands at €5million; though the European regulation leaves leeway for individual states to legislate a lower threshold. The EU proposal is for a higher and universal threshold. This, it is hoped, would reduce onerous requirements for companies to shell out for a professional marketing sheen to give to their business plans and earnings forecasts.

The EC asks stakeholders if it would free smaller companies of some onerous obligations to remove the mandate for a prospectus for follow-on offerings. Instead it would allow them to point to existing info in the public domain, provided they were “released pursuant to the transparency and disclosure requirements to allow sufficient investor disclosure.”

A slightly less drastic solution would be to just raise the threshold required for follow-on prospectuses, from the existing level of 10%, to 20% of existing issued share capital.

Law firm Latham and Watkins makes the still more radical proposal that only “secondary offerings of, for example, up to 50 percent of the issued share capital of the company” would necessitate a prospectus being published.

This would not, however, require regulatory approval before permission was granted to list on Multilateral Trading Facilities (MTFs). As a mitigating measure, the firm posits that the threshold be raised for fully exempt offerings.

This last caveat links us on to the proposal that standard share prospectuses should be approved before trading on MTFs. There is some concern that these marketplaces do not provide the necessary due diligence on all of the securities listed, and an objective assessment is required by a regulator who, unlike the exchange operators, has no vested interest in securing transaction fees.

Some industry commentators, however, feel that increasing the barriers to listing new securities could check growth of the vibrant MTF market in Europe.

The Pan-European Corporate Private Placement Market Guide

This set of guidelines to the process of negotiating contract terms between borrowers and professional investors in large, unlisted bond and note issuances, has already been issued and should be starting to take effect.

Noteworthy considerations to observe from a legal perspective are, firstly, the possibility of a conflict of interests between private loan and note subscription, and trading in listed securities. The mandatory disclosures of non-public information, that full knowledge of the borrower’s debt burden requires, could leave the investor open to accusations of insider dealing, if they then trade in associated listed securities.

Institutional investors in unlisted debt placements should demand loans on equal terms with borrowers’ other debts, which is why disclosure of all information concerning the borrower’s existing debt is essential.

Details of, for example, the hierarchy of priority of repayment; actions in case of a breach in covenant or non-payment of an instalment; any assets that have already been pledged as securities; these are all necessary to ensure the comparability of loan contracts, and to ensure the borrower can meet any new obligations.

The guide provides four model documents by which best practice in this area can be followed:

As regards the ‘term sheet’, the list of terms each side agrees to include in the final contract, – subject to local law, – it is advised firstly that the borrower makes a ‘negative pledge’. This restricts the borrower’s ability to create security over its assets, and thereby enshrines the ranking of the new private placement.

It should also be requested that they disclose any restrictions on disposal of assets. Financial covenants with relevant ratios form another, obvious, clause. It might also be desirable to place restrictions on mergers and corporate restructuring and change of business.

In the event of a change in control, an option should be provided for early redemption or repayment, or even prepayment, of the interest and principal due on the loan. This measure is also advised to guard against a change in the borrower’s tax characteristics.

Finally, as insurance against the future, investors should consider a “more favourable terms” clause, such that if the Borrower grants more favourable financing terms to another creditor, it must also offer the same terms to the Investors.

Banks are tightening their belts on high-risk assets.

Banks are tightening their belts on high-risk assets.

Are Europe’s corporate debt and equity markets really in dire straits?

The ECB Statistics Bulletin for 2015 does show some cause for concern, in that holdings of debt securities issued by euro area residents (non-government securities), fell from €1,360.9 billion in 2013 to €1,275.9 billion in 2014. That is on the listed assets side. As regards liabilities, debt securities issued fell also, from €2,586.50 billion in 2013 to €2,476.3 billion in 2014.

Equity and non-money market investment fund shares fell too, partly as a result of, and due to anticipation of, the ECB’s €1.1trillion QE programme which substantially increased the demand for government securities. Between 2013 and 2014, equity holdings fell from €792.1 billion to €768.4 billion.

At the same time, banks and other financials’ deleveraging is very much in evidence, as the level of capital and reserves rose during the same period, from €2,340 billion in 2013 to €2,466.9 billion in 2014.

This is perhaps reflected in the downward trend in loans to non-financial corporations (seasonally adjusted), a metric which includes loans issued by non-MFIs (monetary financial institutions). The total value fell from 2013 to 2014, from €4,354.1 to €4,282.1billion, slightly recovering in the first two months of 2015 to an average of €2,177.5 billion. This pattern of recovery is mirrored when you break down the loan total into 1-5 year loans, and for loans over five years.

The only increase was in short-term loans (up to 1 year), showing some appetite for low-risk corporate debt.

Be a Smart Index Beater: track it with a Smart Beta!

26 Sep
Money Tree

A Passive ‘Smart Beta’ Fund acts a bit like a money tree – except with less watering required.



‘Smart beta’ funds, trackers with rules like ‘minimum volatility’ giving an ostensibly advantageous slant to the way they follow the securities in an index, have become a core part of many portfolios. Russell Investments’ survey in January 2014 found, of a sample of equity investment managers at around 200 asset owners in Europe and the Middle East, and North America, 32% have smart beta holdings. Of the average cross-region allocation, 40% of participants in Europe use smart beta (vs 24% in North America).

The weight of smart beta allocations is highest among the biggest asset owners. What’s more, most testified to their intention to evaluate the value added from smart beta within the following 18 months: 88% of survey participants with over $10billion in AUM, and for smaller funds of AUM between $1billion and $10billion, a healthy 77%. So the strategy is one being considered by the majority of the investor population.

Minimise Risk and Downside, Without Constantly Calculating Asset Correlation

There are numerous ‘smart’ beta methods to organising the assets in a fund. One of the most popular is low, or minimum volatility which selects the stocks with the lowest variance in a given index. Another tactic for minimising risk is equal risk weighting, where all constituents of the base index are weighted by their risk volatility contribution.

An example is the Compass EMP US 500 Enhanced Volatility Weighted Index ETF, a relative market newcomer which only arrived in July 2014. It tracks the CEMP US Large Cap 500 Long/Cash Volatility Weighted Index before expenses. The index takes the 500 largest US stocks by market capitalisation, after screening them to ensure four consecutive quarters of positive returns. All the 500 stocks are weighted according to their daily standard deviation (volatility) over the preceding 180 days compared to the universe average. The asset allocations are re-evaluated and adjusted every March and September.

The ‘enhanced’ factor of this particular fund, which justifies its slightly elevated expense ratio of 0.68%, is the built-in downside protection in its organisational structure. If the month-end price of the CEMP US Large Cap 500 Long/Cash Volatility Weighted Index has fallen 10% or more below its highest daily value (DHV), the ETF will liquidate 75% of its holdings. If the Index recovers 10% or more, all the securities would be reinvested.

But there are further conditions which guarantee re-entry on favourable terms to the ETF’s clients: if the Index declines 20% from its DHV, 25% will be reinvested back into the fund; a further 25% once the Index falls 30% from its DHV; and a final 25% if it drops below 40% of its DHV. After the equity market bottoms out, the fund would ride the curve up towards recovery. Not for nothing did it make’s ‘top ten’.

Min-volatility funds can be used as an alternative benchmark to the index itself for those with a more cautious investment strategy; the ploy has occasionally been used as a proxy for an active hedging strategy. Minimum variance allocations are more useful in market downturns, where they minimize downside, than expansive markets. They are also a safer way to gain exposure to asset classes perceived as a greater risk, like some emerging market, small-cap or high-yield bond indexes.


Why Weight Allocations by Market Cap? You’d do Better to Ignore Investor Sentiment

Then you have your alternative takes on capitalisation; many smart beta ETFs choose to do this through weighting stock allocations by fundamentals rather than market capitalisation. There are two competing products worth noting which use the Research Affiliates Fundamental Index (RAFI) methodology.

The Fundamental range by asset managers Charles Schwabb was launched last August 2013. The six new ETFs were based on a weighting methodology for market capitalisation using metrics like five-year average sales, five-year average cash flow, book value, and five-year average dividends. The pre-established PowerShares ETFs were also crafted around the Research Affiliates Fundamental Index (RAFI) methodology.

Research Affiliates describe the major selling point of their pioneering method: “Fundamental Index strategies have a value tilt and a slight small-cap tilt. These tilts, however, are dynamic: when value stocks are out of favour and thus are cheap, Fundamental Index strategies tend to increase their allocation to deep value stocks… When value is in favour, the value tilt is much milder because these stocks tend to be priced higher. Rebalancing into unloved stocks and out of the most popular stocks – which we call ‘contra-trading’ – provides the majority of RAFI strategies’ added value.”

A randomly selected example from Charles Schwabb’s six-suite ETF that would be expected to deliver solid performance is the Schwabb Fundamental International Large Company Index Fund. The FILCXF delivered total returns of 3.88% YTD for the periods ending 08/31/14. This is actually less than the Russell Fundamental Developed ex-US Large Company Index, which delivered 4.34% returns over the same period.

The index ranks companies in the Russell Dev ex-US Index (excluding the US), by fundamental measures of size, and then tracks the performance of all those companies whose fundamental scores (size, cash flows, book value and dividends) are in the top 87.5% of the Russell Dev. The index uses a partial quarterly reconstitution methodology in which the index is split into four equal segments at the annual reconstitution and each segment is then rebalanced on a rolling quarterly basis. Its bias towards the higher-valued stocks probably explains its superior performance; Charles Schwabb admits its methodology entails a time-lag while the under-valued mid-cap stocks it picks up at a discount start to appreciate to what should be their market value, according to their fundamentals.

An Option for the Dividend Investor

The final strategy to cover, and one almost guaranteed to provide a constant income, is dividend investing. It’s not complicated, but it works. Morningstar rates investment platform Hargreaves Lansdowne’s tax-efficient ISA smart beta funds fairly highly. It gave three stars to the iShares FTSE UK Dividend Plus product, which has a dividend yield of 4.16%, and provides quarterly payouts. This year the fund has grown just 1.44% in value, compared to its two-year performance of 20.2%. Nevertheless, Morningstar analyst Hortense Bioy calls it “a suitable tool to implement different strategies… This broadly diversified, large and mid cap-focused fund could easily serve as an alternative core UK equity holding for investors seeking a regular income stream. It could also be considered as a satellite holding,” rather than a major holding, as ISA accounts for 2014/5 are capped at £15,000.

EU proposes banning strategic acquisitions with less than 30% ‘effective control’

28 Aug

Legal Report – EC proposes changes to EU jurisdiction on merger approval


corporate acquisition cartoon

Do you consider yourself a big fish? There are plenty of sharks out there too.


The European Commission has issued a white paper outlining its proposed changes to its legal ability to approve or prohibit corporate mergers with a European dimension. Its dramatic new powers could widen the scope of acquisitions falling under its remit to those without the 30% share denoting effective control.

  • The emphasis now is on minority shareholdings which create a “competitively significant link” between investors. Such a condition requires both that
  • The acquisition is of a minority shareholding in a competitor or vertically related company (there is a commercial rivalry between acquirer and target)
  • The definition of “significant” entails that the acquired shareholding is either around 20%, or between 5% and 20% but coupled with additional factors. These include: rights that give the acquirer a “de facto” blocking minority, a seat on the board of directors, or access to commercially sensitive information of the target.

Acquisitions meeting the above criteria should be reported to the Commission, upon which they would be published on the website; however, it would not be necessary to make formal notification on Form CO, unless the Commission then deemed a full investigation was necessitated.

  • Another update posited would streamline case referrals, reducing the number of forms required from a merger participant from two to one; retaining Form CO and eliminating Form RS. National competition authorities would, though, still have the right to object to a domestic merger being referred upwards if they want to retain jurisdiction.

If national regulators oppose the referral, the EC will step back and let them take sole responsibility – there will no longer be shared legal cases, where some aspects of the case are referred to the EU authority for a second, alternative opinion.

  • Regarding Article 4(4), which allows the parties concerned to have their case transferred back from the Commission to a national competition authority: the justification used for such a move will change from the merger’s having a ‘significant impact’ on competition in a defined market in “one or more member states” to its having its “main impact” in a single market in the Member State.

Previously, requiring the offeror parties in a merger to argue that its successful conclusion would have a “significant impact” was seen as “self-incrimination” so they seldom made use of this contingency.


MiFID II’s extended price transparency requirements could make it impossible to pay anything but fair market value

4 Jul

Widened parameters for regular price updates by trading facilities


transparent piggy bank

Price transparency, a metaphor

Transparency on pricing of equities and equity-related instruments is one of the key components of the revised Markets in Financial Instruments Directive (MifID). Less experienced investors, it is asserted, must be better protected from being taken for a ride and paying more, or receiving less, for an investment product than what should constitute its market price.

Exchange forums are obliged to regularly publish price updates for all those instruments classed as ‘liquid’. A liquid market is defined as such using four criteria: firstly, that it is traded daily; secondly, the value of the total ‘free float’ of all the securities in issuance; thirdly, the average daily number of transactions; fourth, the average daily turnover. Exchanges calculate automated price updates using their systematic internalisers – the software behind the trading platform.

Where the rules for equity liquidity under MiFID I apply to shares traded on a regulated market, the wording of MiFID II suggests it could incorporate trading rules for dark pools. Under the revised regulations, the concept of a liquid market will be extended from just equities to equity-like instruments comprising ETFs, certificates and depositary receipts.

The same criteria for assessing the liquidity of the market in a given product were used under MiFID I, but shares only had to meet one of two set thresholds, e.g. have a daily turnover of less than €2million, as well as being daily traded and the free float of its shares in circulation. The other set threshold was that the average daily number of transactions in the share was 500 or more. However, there was a legal inconsistency in that Member States had, or have, autonomy to decide that both thresholds apply. MiFID II intends to simplify the process, so a financial product must meet all four criteria to be classed as ‘liquid’.

However, under various scenarios modelled on historical trading data it became clear that increasing the parameters to be met would mean less shares would be defined as ‘liquid’. ESMA trialled various alternative thresholds, and came up with the technical proposal of: a free float of €100,000,000; average daily number of transactions of 250; average daily turnover of not less than €100,000, as netting the largest percentage of the shares that had been traded over the trial period.

Depositary receipts, tradable securities linked to a share listed on an overseas exchange, are treated by ESMA as tantamount to equities. They are backed by a specific number of shares, or a fraction thereof. The requirements for depositary receipts to be considered liquid are the same as for equities, with one exception: the ‘free float’ would be set according to the number of shares issued in the issuer’s home market, as the overall free float for depositary receipts can be volatile; because they are often cancelled or issued somewhere else, depending on perceived investor demand in that country.

ETFS will be judged according to a ‘free float’ that consists of the number of units issued for trading, which stands at 100. The average daily number of transactions that mandates regular price reporting is 20, while the average daily turnover is €500,000.

There are only two types of instrument classed as ‘certificates’, according to the MiFIR definition. These are Spanish Preferentes and German Genussrechte/-scheine. Certificates are categorised as “those securities which are negotiable on the capital market and which in the case of a repayment by the issuer are ranked above shares but below unsecured bond instruments and other similar instruments.” After again modelling the historical trading data, ESMA set the free float (the issuance size in euros) at €1,000,000, the average daily number of transactions at 20, and the average daily turnover at €500,000.


Miffed at MiFID II’s Rigid Trading Guidelines? Know your Reporting Obligations

2 Jul

Surprising exceptions made for compliance with latest Markets in Financial Instruments Directive (MiFID II) for small firms

The European Securities and Markets Authority (ESMA) has graciously allowed stakeholders the opportunity to comment on its proposed legislative requirements under MiFID II. However, the consultation paper has a silver lining for smaller less complex firms which suffered with higher capital ratio requirements under Basel III.


Silver lining thinking

Key takeaways of the Markets in Financial Instruments Directive (II) concern transparency, reporting requirements and obligations to customers; the appropriateness of advice and products offered are stressed. It intervenes over the trading process, laying out the required reaction to orders significantly outside the market price, defining what constitutes ‘exceptional market circumstances’ and conditions for updating quotes. It also sets technical specifications for algorithmic and high-frequency trading.

To ensure compliance with the directive, it will be necessary for investment firms to appoint a compliance officer, who is to deliver regular reports on the risks of non-compliance and how they are met. Yes, compliance too must have its own risk assessment, though how this is to be quantified is uncertain: a ValueatRisk model would have to factor in the potential liability of punitive fines, which are set by the regulator case-by-case.

The Technical Standards further stipulate that the “compliance function should be required to report directly to the management body whenever it detects a significant compliance risk.” The same officer or team, it is proposed, should oversee the complaints process and in fact complaints should “be considered by the compliance function as a source of information.” This is in the unlikely event that traders prove reluctant to spend their working hours studiously documenting operational procedures that might put them at risk of non-compliance. Not that they have anything better to do.

Yet the somewhat anomalous outlier in this section is the exception made for firms whose low complexity and net resource level means they are unable to appoint a designated compliance officer who has no involvement in selling or marketing the services and products they monitor. These firms are also exempt from the stipulation that “the method of determining the renumeration of the relevant persons involved in the compliance function must not compromise their objectivity and must not be likely to do so.”

So… only small non-complex firms are allowed to pay their compliance officer a bonus? ESMA then seems to pass the baton entirely to the entities under its supervision, stating that it is left to the investment firm to assess the effectiveness of its own compliance measures. Still, they will face a costly fine if they knowingly flout the new rules.

Below is a table transcribed from the consultation paper laying out exactly all the individual reporting requirements now mandated, including ‘modification of orders’ and actions like ‘aggregated client orders’, where two clients’ accounts are altered under a single trade. ESMA stipulates that this list is not absolute and can be added to at any point. It also invites firms to add any factors they feel it has overlooked.

Type of record Summary of content
Identity and categorisation of each client The identity of each client and sufficient information to support categorisation as a retail client, professional client and/or eligible counterparty
Client agreements Records provided for under Article 25(5) of MiFID II.
Client details The information about the client’s or potential client’s knowledge and experience, financial situation and investment objectives, relevant to the specific product or service, obtained by the investment firm in complying with its obligation under Article 25(2) of MiFID II
Transactions The information required under Article 25(1) of MiFIR
Client order-handling – Aggregated transaction that includes two or more client orders, or one or more client orders and an own account order Identity of each client; whether transaction is in whole or in part for discretionary managed investment portfolio and any relevant proportions as well as the intended basis of allocation.
Client order-handling – Allocation of an aggregated transaction that includes the execution of a client order The date and time of allocation; relevant financial instrument; identity of each client and the amount allocated to each client
Client-order-handling – Re-allocation The basis and reason for any reallocation
Order received or arising from any decision to deal taken in providing the service of portfolio management The records provided for under Article 7 of the MiFID Implementing Regulation. Firms should record the date and hour that the order was sent by the investment firm for execution.
Orders executed on behalf of clients The records provided for under Article 8(1) of the MiFID Implementing Regulation
Orders and transactions effected for own account The records concerning own account orders and transactions.
Cancellations and modifications of orders The records concerning the cancellation and the modifications of orders on own account or executed on behalf of clients or in relation to decision to deal taken in providing the service of portfolio management.
Transmission of order received by the investment firm The records provided for under Article 7 and Article 8(2) of the MiFID Implementing Regulation
Periodic statements to clients Information to evidence the content and the sending of the periodic statement to the client in respect of services provided, either as a copy, or in a manner that would enable reconstruction.
Client financial instruments held by an investment firm The records required under Articles 16(8) of MiFID II and under Articles 16(1) of MiFID II and Article 19(2) subparagraph 2 of the MiFID Implementing Directive, where applicable.
Client funds Sufficient records to show and explain the investment firm’s transactions and commitments under Article 8 of the MiFID Implementing Regulation (note also the requirements under Articles 16(9) of MiFID II and under Articles 16(1)(a) and (b) of the MiFID Implementing Directive.
Marketing communications (except in oral forms) Sample of each marketing communication addressed by the investment firm to clients or potential clients
Investment research Each item of investment research, in accordance with Article 24(1) of the MiFID Implementing Directive issued by the investment firm in writing.
The firm’s business and internal organisation Records provided for under Article 5(1)(f) of the MiFID Implementing Directive.
Compliance procedures The investment firm’s essential compliance procedures, under Article 6(1) of the MiFID Implementing Directive
Services or activities giving rise to detrimental conflict of interest The services or activities under Article 23 of the MiFID Implementing Directive
Compliance reports Each compliance report to senior management, under Articles 6(3)(b) and 9(2) of the MiFID Implementing Directive
Risk management reports Each risk management report to senior management under Articles 7(2)(b) and 9(2) of the MiFID Implementing Directive
Internal audit reports Each internal audit report to senior management, under Articles 8(d) and 9(2) of the MiFID Implementing Directive
Complaints records Each complaint referred to in Article 10 of the MiFID Implementing Directive
Complaints-handling The measures taken for the resolution of each such complaint, according to Article 10 of the MiFID Implementing Directive
Records of prices quoted by systematic internalisers The quoted prices under Article 24(b) of the MiFID Implementing Regulation
Records of personal transactions The information required under Article 12(2)(c) of the MiFID Implementing Directive
Record of the information disclosed to clients regarding inducements The information disclosed to clients under Article 24(9) of MiFID II.
Investment advice to retail clients (i)The fact that investment advice was rendered and (ii) the financial instrument that was recommended.





EBA Disagrees with Banks’ Definition of ‘Immaterial’ Grounds for not Disclosing Assets

23 Jun



The European Banking Association (EBA) has issued guidelines, and invites feedback, on what should constitute ‘materiality’ when banks neglect to disclose certain capital assets on the ground they are ‘immaterial’.

The EBA recognises that an institution’s revealing its full roster of assets and securities positions, in declaring its capital adequacy under the CRD, could give its rivals a competitive advantage. For this reason it is possible to waive a declaration of specific assets.

But, it states, “this divergence in information… can, when combined with a lack of transparency, turn out to be sub-optimal and create uncertainty for stakeholders regarding the comprehensiveness of provided information.”

Under the proposed guidelines, European credit institutions and investment firms must state that the specific items of information are not provided, as well as explaining their decision to keep these assets’ properties a secret. This must be justified on one of three grounds: their immateriality, their proprietary nature or their confidentiality.

Currently, many companies “provide few details about how they use the waivers, making if difficult for users of information to know whether a missing piece of information is due to its immaterial, proprietary or confidential nature.”

The three concepts are defined in Article 432(1) and (2), with materiality delineated as being regarded as such “if its omission or misstatement could change or influence the assessment or decision of a user relying on that information for the purpose of making economic decisions.”

The new directions also address the regularity at which disclosures should be made: more systemically important financial institutions will have to make more frequent declarations. At present, the EBA states the majority of companies make quarterly declarations, though this is not required, but provide widely divergent levels of detail on aspects like instance capital, solvency and risk-weighted assets (RWAs).

In fact, one of the problems the EBA is suffering is “declaration overload,” and that there was “no transparency” behind the reasons for reporting some capital assets or risks, and not others.

For these reasons, it will now require institutions falling within certain defined groups to make more frequent declarations on items comprising capital structure, capital adequacy and ratios, leverage ratio and parameters of the Internal Ratings-Based models used to assess RWAs.

Those firms which have been targeted as needing to improve their capital reporting are those meeting one of the following criteria: being one of the three biggest institutions in a jurisdiction, having €30 billion consolidated total assets, having the four-year average of their total assets amounting to 20% of the four-year average GDP of their home member state, or having ‘consolidated exposures’ as defined in Article 429 of Regulation 575/2013 in excess of €200 billion.

EBA releases stress test results; to review comparability of risk-weighted assets

7 May
risk-weighted assets

Unsure if gold should be ‘risk-free’ if it’s no longer a currency peg, but…


The European Banking Association released the results of its capital and balance sheet stress test on Tuesday. Most findings about the integrity of the sampled banks’ holdings were positive, and indicated a move away from risk-weighted assets (RWAs), particularly credit risk.

The 2014 Q1 dashboard reports that banks with a coverage ratio of over 50% now hold almost 49% of total assets in the sample, relatively unchanged from earlier assessments; banks with a poor coverage ratio (under 25%) still account for roughly 13% of total assets reviewed.

Useful tools included in the reports were a heat map of Key Risk Indicators, and a summary of the directional trends in areas such as credit risk, market risk, operational risk, concentration risk, reputational and legal, and profitability. Margins were found to have suffered, partly due to legal and redress costs and smaller gains from lower interest rates. It cited heightened geopolitical tensions in Russia and Ukraine as contributing to heightened volatility, in addition to speculation over extra-European nations’ Central Bank policy, particularly that of the US Federal Reserve.

The integrity of banks’ loan portfolios continued to decline: the ratio of impaired loans and past due (over 90 days) loans to total loans peaked to 6.8%. However, the weighted average of delinquent loans was up by just 0.2 percentage points, so the EBA concluded “this trend is mainly driven by the decrease of the denominator since the amount of impaired loans and past due… loans has remained fairly stable over the last quarters.”

Overall, the weighted average of debt-to-equity ratio has sagged from 17 to 16.5, the lowest level in the last four years. Customer deposits now comprise around 48% of total liabilities, while holdings of credit and other liabilities with a greater risk profile have tapered.

The EBA has announced it will launch a review into the comparability of RWAs, prompted by the wide distribution of estimates as to the risk profile. This is assessed predominantly through an internal ratings-based IRB approach: a study into asset distribution, released December 2013, showed an IRB was used to assess 71% of risk-weighted assets, compared to 29% which used a Standardised Approach.

Each bank’s individual IRB approach involves its unilaterally calculating three input risk parameters: the probability of default (PD), the loss given default (LGD) and the exposure at default (EAD).

The regulator explained: “While differences in risk parameters and capital requirements between banks are not a sign of inconsistency per se, a substantial divergence may signal that the methodologies used for estimating risk parameters require, in some cases, further analysis.”

In its summary of the components of Pillar 1 bank risk, the EBA stated that asset quality would remain an issue of concern, but that “Upcoming review of assets should boost clarity on problem loans and level of impairments/provisions.”

It has not yet gone so far as to state the Committee of European Banking Supervisors (CEBS) EBA Guidelines might need updating.