Monday, October 25, 2021

Assembling the Market Posse

The Case for a Cross-Border Stock Loan Registry, Part I

Author: Ed Blount

We’ve all been there, having drinks after work with an important client visiting from overseas. My most memorable time was at the very beginning of my career on Wall Street. The client was a trader from the South African branch of Jos. Sebag & Co., a London firm more than 100 years old when he and I met in 1975 at the upscale bar, Michael II. The firm and the restaurant have long since vanished, but at the time Sebag was the most active account for First National City Bank’s (FNCB) American Depositary Receipt (ADR) business. The firm was far more active than Merrill Lynch, Goldman Sachs, or any other cross-border trading outfit. Most of the trades were for the issuance of ADRs in South African mining stocks, such as Anglo-American Gold.

“How is it that you are so active?”, I remember asking, naturally enough (I thought). After all, as the ADR global operations head in FNCB’s 111 Wall Street back office, I was in the best position to see their issuance volumes.

“Most of my clients are plantation owners,” he answered, “who are funding the purchase of weapons to protect their farms and families after the end of Apartheid.”

We only learned their motives by accident.

He went on to explain how his customers bought stocks for deposit in our local FNCB Johannesburg sub-custodian. Their banque wires directed our issuance of ADRs for the benefit of an American broker’s account in DTC, the new central securities depository in New York. After settlement, funds were wired to a Sebag private banking account in London. My trader client told me that the private account was owned by an arms dealer in yet another African country. Sebag issued a draft to the arms dealer's account who then arranged delivery of his products to Sebag’s customers in Rhodesia and South Africa. The transaction chain thus evaded the contemporaneous Anti-Apartheid weapons embargo of the U.S., as well as South Africa’s capital controls on Securities Rand and the UK’s currency restrictions for Sterling Area transfers.

My client, unbeknownst to me, was a gun runner.

Of course, I couldn’t know that until the account info was disclosed to me through the sheer carelessness of trader chutzpah and a third martini. (At the time, internal data sharing at banks was limited by Glass-Steagall era rules that maintained “Chinese Walls” between departmental recordkeeping systems. The laws are gone, too, but many banks still have impenetrable barriers to sharing in their siloed information technology systems.)

Over the years, I’ve seen a lot of interesting trades flow through the cross-border markets. The vast majority are legitimate arbitrage trades, exploiting differences in market intelligence, taxes, forex or other asymmetries. A lot of services have sprung up to support those trades. And a few rogues, like my gun-running client, have also cropped up along the way.

KYC is the sine qua non of finance.

In most cases, it was the insight into certain aspects of their policy tolerances and trading risk profiles (or stupidity) that tripped up the rogues. In the 1970s, “Know Your Customer” (KYC) rules were just starting to insure trading legitimacy through the due diligence standards evolving in developed countries. (The global KYC process is not yet complete: inadequate databases and disclosure rules still hinder enforcement throughout the chain of cross-border transactions.)

It was an early version of the KYC rules that obligated my FNCB superiors to report the chain of transactions to regulators once we learned that the policies and practices of the private Sebag account in FNCB’s London subsidiary allowed for a) offshore settlement in unrestricted currencies and the b) acquisition of weapons stockpiles as alternative assets. (In 1981, the SEC’s censure of Sebag forced the US branch of the firm into liquidation, citing violations of Section 15(c), e.g., undisclosed roguish activities.)

Anti-social trades don't fit with ESG.

Most service providers still don’t have all the information needed to identify antisocial transactions, even though such trades would surely get harsh ratings in today’s market from the ESG consultants. Without knowledge of the controlling policies and practices at the account level, however, the chain of transactions is meaningless to outside auditors, then and now.

The need for policy-level disclosures remains relevant for a new set of anti-social transactions. Once again, regulators are on edge – and scrambling to catch up with the cross-border fraudsters.

Critics question Social Compliance in Cross-Border Financings.

As published online last Friday, a charge of systemic tax fraud has been levied against the ADR and cross-border securities finance markets by a team of investigative reporters, aided by Professor Christoph Spengler from the University of Mannheim in Germany. "Between 2000 and 2020," it is claimed, "an estimated €150 billion in tax revenue was lost across 12 countries due to cum-ex trades, including ADRs."

In general, Spengler and the reporters charge that a network of bad actors has used a variety of dividend capture and swap strategies to evade income taxes or to create claims for repayment of withholding taxes that were never actually paid.

As described, these are essentially legal dividend capture trades that have been turbocharged for illegal purposes and for which the proceeds have been laundered through unsuspecting service providers, e.g., me in 1975. (More on their assumptions later.)

Policy-level data can validate the loan chain.

Critics will challenge Prof. Spengler’s assumptions, but his model will stand until a better one can be used to unweave the tangled web of the loan chain and prove the legitimacy of transactors at both ends. However, better models will need validation algorithms linked to policy-level data, as we learned in 1975, that have never been made available to academics. (Commercial data vendors are blocked from using policy-level data without buy-side releases to their service providers from non-disclosure agreements.) Even the regulators cannot police cross-border loans because the scope of their enforcement authority ends at their borders.

Only the principals can direct their providers to share confidential data. Still, there are many hurdles to overcome before the collective insights of stakeholders can be used to refine risk tolerances and reduce the opportunities for bad actors to game the system. We will call those stakeholders the “Market Posse”.

The Market Posse formed itself during the LTCM crisis.

It is often said that no securities lenders reported credit losses from Lehman’s defaults after its September 2008 bankruptcy. It may be true. That same month, the Risk Management Association published my article praising the stellar risk management skills of a group of creditors who had been able to avoid direct losses when Bear Stearns rolled over six months earlier, and ten years before that, when Long Term Capital Management (LTCM) failed. Those were the schooling events for the counterparty risk managers protecting their clients from Lehman’s possible failure.

Traders in the pits know the body language of desperation. Just so, the Rolodex networks of operations managers can spot signals in trading data to position their defenses against potential events of defaults. Of course, I did not realize while writing in the summer of 2008 that Lehman Brothers Holdings Inc. would soon create an even bigger wave in the pond with respect to their counterparty and funding defaults. But I would have expected the same group to again avoid losses. And they did. The managers each shared their suspicions, then lifted their initial margin and counterparty collateral requirements for Lehman, just as they earlier had for both Bear and LTCM in advance of their failures. In April, 2008, the signals from trading desks were saying that, ‘Bear’s two internal hedge fund accounts may be illiquid.’ A passive run-on-the-bank was being engineered because it was well known that the two accounts were paying unusually high fees for credit extensions after counterparties had failed to renew their lines in the funding markets.

Some also suspected that Lehman was hiding leverage by overcollateralizing its repo trades, a notorious strategy called “Repo 105” in the bankruptcy examiner’s report. In effect, the Market Posse roped in the culprits by depleting Lehman’s cash reserves.

In January, 2009, the New York Fed published an explanation by two Yale/NBER economists: "as lenders began to fear for the stability of the banks and the possibility that they might need to seize and sell collateral, the borrowers were forced to raise repo rates and haircuts. Both of these increases occurred in the crisis. In Section IV.C, we find that these increases were correlated with changes in the LIB-OIS (for repo rates) and changes in the volatility of the underlying collateral (for repo haircuts). It is the rise in haircuts that constitutes the run on repo." [1]

Similar metrics will be used to inform today's Market Posse.

Today's Market Posse will have better gear.

In a speech two weeks ago, Natasha Cazenave, newly appointed Director of the European Securities & Markets Authority, called for “firms to take a company-wide, rather than a regime-specific approach to reporting.” That might help to identify rogues at the periphery (and would surely have alerted us in 1975), but Ms. Cazenave went even further. She also endorsed the use of “DLT-based market infrastructures [so that] authorities, like ESMA, could have direct access to the distributed ledgers and could monitor transactions data in real-time. This would reduce the compliance cost for market participants and, at the same time, give more flexibility for the authorities with respect to what data and when they would like to see it.”

The Market Posse could also benefit if those distributed applications also helped lending agents and other service providers to monitor their market exposures, as I explained for the RMA Journal in 2008:

“As useful as credit models and rating systems have become over the last decade or so, the bank still needs its frontline lending officers to understand the markets that their customers depend on for their ability to repay their obligations. One more, underappreciated key to understanding customer markets is a keener appreciation of the wisdom and value of the ‘market posse.’”

A voluntary, encrypted Loan Registry will please regulators -- and ESG lenders.

With the prior approval of beneficial owners, DLT-based infrastructures could allow their regulators and service providers to use a new set of collaborative tools, such as blockchains and smart contracts, to create a cross-border loan registry. That could be used to validate a trader’s counterparty risks as well as a loan’s legitimacy, thereby extending the insights of seasoned risk managers for the benefit of a much wider network of Market Posse members.

Just as in 1998 and 2008, any insight into a counterparty’s need for liquidity, inferred in the fees and rates that its accounts are willing to pay, will be a critical insight. The benefits for a Cross-border Loan Registry could also include a visa as a form of cross-border tax validation, granted for demonstrably benign securities funding trades. (More on that later.) If effective, counterparty risk metrics could reinforce the limited default warranties that lending agent banks provide.  There’s even a chance that the cost of such a service would be borne by the banks as a premium upgrade to their global custodial services. (More later.)   


PART 2: Exposing the Rogue Traders - The Case for a Cross-Border Stock Loan Registry, Part II



1. Gary Gorton and Andrew Metrick, "Securitized Banking and the Run on Repo," Jan/Nov, 2009, New York Federal Reserve Bank, p.6