Outreach Blog

Tuesday, September 6, 2016

Surprise! Market Theories Fail in Real-World Tests!!

Single-vector studies miss the full picture


Author: Ed Blount

“There is nothing less practical than a bad theory,” wrote CEO Paul Shott Stevens of the Investment Company Institute (ICI) in a July 2016 blog.  Mr. Stevens introduced a series of recent findings that the ICI suggests may present a rebuttal to their members of the “first-mover” hypothesis. What is that, one may ask, and why should I care?

Under the first-mover hypothesis, cited favorably in an update on the asset management review being conducted by the Financial Stability Oversight Council of the U.S. Treasury, sophisticated investors are said to redeem their shares in a poorly performing fund at full value before others can appreciate the increasing risks. According to the theory, the other investors suddenly follow, creating a cascade of redemptions and forced sales of fund assets. The Treasury is considering new rules to limit the risk of fire sales or prevent these first-mover-driven sell-offs.

However, in contravention to that theory, the ICI reported that, shortly after the UK’s shocking Brexit vote, investors redeemed just 1% of the more than $300 billion now held in U.S. investment-grade and high-yield bond funds. The first-mover theorists would have expected massive outflows from these funds after the shock. But that didn't happen.

According to ICI, the data suggests that the effect of redemptions to any one fund after Brexit may well have been offset by reinvestments in more balances or better protected funds. Simply put, sales were followed by buys, and that allowed the fund sector to reach equilibrium -- perhaps with lower asset values but without a selling panic at fire-sale prices.

ICI argues that academics whose fire-sale research focuses only on sales tend to miss that equilibrating dynamic. In fact, we would agree and add that it would not be the first time that academic studies with a distorted viewpoint were used to influence investor behavior.

In the late 1990s, the JPMorgan Chase Bank, in a series of collaborative studies with ASTEC Consulting, sought to respond to research theorists who alleged short sellers drove down prices for those investors who lent their securities to the shorts. Just as with the recent ICI analysis, the Chase-ASTEC rebuttal presented real world data in a multi-vector context to show that some preconceptions that drive academic theories, while intuitively appealing, are often quite wrong.

In the Chase-ASTEC study, any negative affect on prices from short-selling was shown to have been neutralized by the price support arising from reinvestment of the proceeds. For example, many short sellers immediately reinvested their sale proceeds into purchases of the second leg of a pairs trade. And even if the cash wasn't immediately reinvested, the short sellers eventually had to return the shares they had borrowed -- through purchases which offset the earlier downward pressure.

In a 2007 update to that study, the Center for the Study of Financial Market Evolution (CSFME) used global securities finance data to show attendees at an IMF-World Bank conference in Moscow that prices for Russian securities were actually being supported by short sellers. In other words, the dynamics held even for emerging markets. 

In an even more recent empirical study, the CSFME employed data provided by members of the Risk Management Association in a robust rebuttal to allegations that hedge funds were borrowing equity shares in the securities finance markets for the express purpose of manipulating the outcome of corporate annual meetings. CSFME found that the spike in borrowings that academics had noted before the record date was not an attempt by hedge funds to take control of shares they didn’t own, and then manipulate the vote. Rather it was the result of loan recalls by the original fund investors in order to vote their own shares. The RMA-CSFME study used a much deeper pool of data to explain the spike, provided by eight lending agents, while the original academic study focused on borrowings, not returns, and used only two data providers.

In all of these cases, the academic studies did not go far enough, in part because their single-vector models did not have access to a sufficiently complete set of data upon which to base their conclusions. In many cases, similarly incomplete models are being used today to argue in favor of stringent reform regulations. It's not too surprising that the latest market data have shown that there is a growing tendency toward unintended adverse results from those regulations, as noted in my September, 2016 article in the RMA Journal.

Going forward, regulators may well find that multi-vector studies with robust data will conclude that, instead of the possibility that the market infrastructure is fragile, the opposite is true; that is, that markets are sufficiently resilient to absorb the sales by certain investor groups without damage to the overall market system. And perhaps academics will also find that the rebalancing of investor accounts within bond sectors is just one of many unanticipated beneficial consequences from come from otherwise stressed markets.

In any event, the take-away from all of these studies is that one vector of market activity, whether it's asset sales or security loans, is just not sufficient to model the real world. In each of the multi-vector cases, analysts used not just sales or borrows, but also buys and repayments to estimate “net flows” and show that the effect was not as bad as that anticipated by the single-vector theorists.

In his blog, the ICI's Mr. Stevens echoed Mr. William Dudley, the president of the New York Federal Reserve Bank, who, in September 2015, to invite new research into the dynamics of the market system. We hope that the results will be made available in the near term, before regulators have to conclude their final rules.

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The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



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