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The spread of the arbitrage economy

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Deliveroo, Greensill, Coinbase, Archegos. Apart from their shared proclivity to dominate the headlines, these high and low flying outfits are an exceptionally disparate bunch.

Yet one thing they have in common is a dependence on regulatory arbitrage to attempt to extract value – successfully or otherwise – from pedestrian core businesses in which fancy technology plays a purely ancillary role.

At the risk of inflicting a taxonomy, here are some basic thoughts. Deliveroo, the lossmaking food delivery company which was a notable flop in its recent flotation, is all about labour market arbitrage and the legal definition of employment.

Yes, it uses artificial intelligence to manage its casual gig economy workers. But what it is really about is transferring food from A to B, just as Uber transfers people from A to B. It does so more efficiently than the old non-gig economy could manage but it will transform no one’s life in the way electricity or the internal combustion engine succeeded in doing.

Greensill, the supply chain finance business whose collapse has rocked Sanjeev Gupta’s steel empire and embarrassed David Cameron, the former UK prime minister who advised it, proudly trumpeted that its success in finance was driven by the technology underneath.

Yet the core of this fintech concern was the age old practice of factoring whereby invoices are turned into cash. It was, in effect, a shadow bank that largely escaped the regulatory watchdogs’ radar. Thankfully, it appears not to have posed a systemic threat.

In this quartet, newly floated Coinbase does not at first sight fit the arbitrage template because it provides an exchange for trading in digital currencies, where a majority of net revenues come from transactions in just bitcoin and ethereum. This brings a degree of transparency to a wildly volatile and otherwise opaque business.

It is hard, reading the prospectus, to grasp precisely how it is regulated, but it is certainly not immune from oversight because the US Commodity Futures Trading Commission accused it last month of undermining the integrity of digital asset pricing and fined it $6.5m, for “reckless, false, misleading or inaccurate reporting”. 

That said, it is facilitating a market in unregulated shadow currencies. While those currencies owe their existence to blockchain technology they perform the same portfolio function in the investment world as gold. They do so without the yellow metal’s thousand-plus year pedigree as a safe bolt hole in chaotic times, but in a form that is more convenient for channelling criminal funds.

A family office is neither a bank nor a hedge fund. Most people will not have heard of Bill Hwang, a former fund manager at the fabled Tiger Management hedge fund, or his low profile family office Archegos, before it blew up, inflicting billions of losses on Credit Suisse, Nomura and other big international banks.

Archegos took billion-dollar bets on a handful of stocks via derivatives known as equity total return swaps. A trader in these swaps does not have to disclose big positions as they would if they owned the stocks directly. And Bill Hwang entered into similar swaps with a number of banks without their having an inkling of his overall exposure.

Family offices are under no regulatory requirement to back their positions with a given cushion of capital. As my colleague Robert Armstrong explained in the Financial Times on April 1, the extraordinarily rapid growth of the equity total return swaps market owes a great deal to the fact that the swaps are not required to appear in the filings banks make to comply with the Basel III rules for risk-weighted assets, leverage and credit risk.

The debacle at Archegos bears a remarkable resemblance to the near-collapse of the Long-Term Capital Management hedge fund in 1998, which foundered because of overleveraged positions in risky derivative instruments. Despite frenetic regulatory activity since then this experience raises the worrying possibility that we are in a vicious circle where financial crises breed rafts of new regulations which in turn breed more financial arbitrage which precipitate further, bigger crises.

Regulatory arbitrage was, after all, a key instigator of the great financial crisis of 2007-08 as banks economised on capital by shovelling assets off-balance sheet or into trading accounts with lighter capital requirements than for bank lending.

Meantime, it is curious that investors are prepared to put such tech-frothy valuations on companies with business models that are more about regulatory arbitrage than life enhancing innovation. When political climates change, regulation changes. In a post-Trump world it will be about more regulation not less.

John.Plender@ft.com

 



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European stocks stabilise ahead of US inflation data

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European equities stabilised on Wednesday after a US central banker soothed concerns about inflation and an eventual tightening of monetary policy that had driven global stock markets lower in the previous session.

The Stoxx 600 index gained 0.4 per cent and the UK’s FTSE 100 rose 0.6 per cent. Asian bourses mostly dropped, with Japan’s Nikkei 225 and South Korea’s Kospi 200 each losing more than 1.5 per cent for the second consecutive session.

The yield on the 10-year US Treasury bond, which has dropped in price this year as traders anticipated higher inflation that erodes the returns from the fixed interest securities, added 0.01 percentage points to 1.613 per cent.

Global markets had ended Tuesday in the red as concerns mounted that US inflation data released later on Wednesday could pressure the Federal Reserve to start reducing its $120bn of monthly bond purchases that have boosted asset prices throughout the Covid-19 pandemic.

Analysts expect headline consumer prices in the US to have risen 3.6 per cent in April over the same month last year, which would be the biggest increase since 2011. Core CPI is expected to advance 2.3 per cent. Data on Tuesday also showed Chinese factory gate prices rose at their strongest level in three years last month.

Late on Tuesday, however, Fed governor Lael Brainard stepped in to urge a “patient” approach that looks through price rises as economies emerge from lockdown restrictions.

The world’s most powerful central bank has regularly repeated that it will wait for several months or more of persistent inflation before withdrawing its monetary support programmes, which have been followed by most other major global rate setters since last March. Investors are increasingly speculating about when the Fed will step on the brake pedal.

“Markets are intensely focused on inflation because if it really does accelerate into this time near year, that will force central banks into removing accommodation,” said David Stubbs, global head of market strategy at JPMorgan Private Bank.

Stubbs added that investors should look more closely at the month-by-month inflation figure instead of the comparison with April last year, which was “distorted” by pandemic effects such as the price of international oil benchmark Brent crude falling briefly below zero. Brent on Wednesday gained 0.5 per cent to $69.06 a barrel.

“If you get two or three back-to-back inflation reports that are very high and above expectations” that would show “we are later into the economic recovery cycle,” said Emiel van den Heiligenberg, head of asset allocation at Legal & General Investment Management.

He added that the pandemic had sped up deflationary forces that would moderate cost pressures over time, such as the growth of online shopping that economists believe constrains retailers’ abilities to raise prices. Widespread working from home would also encourage more parents and carers into full-time work, he said, “increasing the labour supply” and keeping a lid on wage growth.

In currency markets on Wednesday, sterling was flat against the dollar, purchasing $1.141. The euro was also steady at $1.214. The dollar index, which measures the greenback against a group of trading partners’ currencies, dipped 0.1 per cent to stay around its lowest since late February.



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Potash/grains: prices out of sync with fundamentals

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The rising tide of commodity prices is lifting the ricketiest of boats. High prices for fertiliser mean that heavily indebted potash producer K+S was able to report an unusually strong first quarter on Tuesday. Some €60m has been added to the German group’s full year ebitda expectations to reach €600m. Its share price has gone back above pre-pandemic levels.

Demand for agricultural commodities has pushed prices for corn and soyabeans from decade lows to near decade highs in less than a year. Chinese grain consumption is at a record as the country rebuilds its pork herd. Meanwhile, the slowest Brazilian soyabean harvest in a decade, according to S&P Global, has led to supply disruptions. Fertiliser prices have risen sharply as a result.

But commodity traders have positioned themselves for the rally to continue for some time to come. Record speculative positions in agricultural commodities appear out of sync even with a bullish supply and demand outlook. US commodity traders have not held so much corn since at least 1994. There are $48bn worth of net speculative long positions in agricultural commodities, according to Saxo Bank.

Agricultural suppliers may continue to benefit in the short term but fundamentals for fertiliser producers suggest high product prices cannot last long. The debt overhang at K+S, almost eight times forward ebitda, has swelled in recent years after hefty capacity additions in 2017. Meanwhile, utilisation rates for potash producers are expected to fall towards 75 per cent over the next five years as new supply arrives, partly from Russia. 

Yet K+S’s debt swollen enterprise value is still nine times the most bullish analyst’s ebitda estimate, and 12 times consensus, this year. Both are a substantial premium to its North American rivals Mosaic and Nutrien, and OCI of the Netherlands, even after their own share prices have rallied.

Any further price rises in agricultural commodities will depend on the success of harvests being planted in the US and Europe. Beyond restocking there is little that supports sustained demand.

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Amazon sets records in $18.5bn bond issue

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Amazon set a record in the corporate bond market on Monday, getting closer to the level of interest paid by the US government than any US company has previously managed in a fundraising. 

The ecommerce group raised $18.5bn of debt across bonds of eight different maturities, ranging from two to 40 years, according to people familiar with the deal. On its $1bn two-year bond, it paid just 0.1 percentage points more than the yield on equivalent US Treasury debt, a record according to data from Refinitiv.

The additional yield above Treasuries paid by companies, or spread, is an indication of investors’ perception of the risk of lending to a company versus the supposedly risk-free rate on US government debt.

Amazon, one of the pandemic’s runaway winners, last week posted its second consecutive quarter of $100bn-plus revenue and said its net income tripled in the first quarter from the same period a year ago, to $8.1bn.

The company had $33.8bn in cash and cash equivalents on hand at the end of March, according to a recent filing, a high for the period.

“They don’t need the cash but money is cheap,” said Monica Erickson, head of the investment-grade corporate team at DoubleLine Capital in Los Angeles.

Spreads have fallen dramatically since the Federal Reserve stepped in to shore up the corporate bond market in the face of a severe sell-off caused by the pandemic, and now average levels below those from before coronavirus struck.

That means it is a very attractive time for companies to borrow cash from investors, even if they do not have an urgent need to.

Amazon also set a record for the lowest spread on a 20-year corporate bond, 0.7 percentage points, breaking through Alphabet’s borrowing cost record from last year, according to Refinitiv data. It also matched the 0.2 percentage point spread first paid by Apple for a three-year bond in 2013 and fell just shy of the 0.47 percentage points paid by Procter & Gamble for a 10-year bond last year.

Investor orders for Amazon’s fundraising fell just short of $50bn, according to the people, in a sign of the rampant demand from investors for US corporate debt, even as rising interest rates have eroded the value of higher-quality fixed-rate bonds.

Highly rated US corporate bonds still offer interest rates above much of the rest of the world.

Amazon’s two-year bond also carried a sustainability label that has become increasingly attractive to investors. The company said the money would be used to fund projects in five areas, including renewable energy, clean transport and sustainable housing. 

It listed a number of other potential uses for the rest of the debt including buying back stock, acquisitions and capital expenditure. 

In a recent investor call, Brian Olsavsky, chief financial officer, said the company would be “investing heavily” in the “middle mile” of delivery, which includes air cargo and road haulage, on top of expanding its “last mile” network of vans and home delivery drivers.



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