In a recent episode, the ever-brilliant Planet Money podcast looked at the arcane world of high-frequency trading. The usual clarity of exposition was further enhanced by something of a Mule theme. It seems that Planet Money host Chana Joffe-Walt is, like me, a Tom Waits enthusiast and she found a way to fuse “Whats He Building in There?” from the Mule Variations album with the otherwise non-musical subject of the podcast. An inspired choice.

So, what is high-frequency trading? Here is how Planet Money describes it.

In high-frequency trading, people program computers to buy and sell stocks in quick succession under certain, pre-defined circumstances. The idea is to profit from fleeting changes in the price of a stock.

This type of trading is made possible by the increased use of electronic trading platforms for financial markets around the world and is a special case of so-called “algorithmic trading” (or “algos”). It has been estimated that as much as 75% of the trades on the New York stock exchange were generated by algos and perhaps 50% on some European markets.

High-frequency trading has been generating some controversy in recent years:

High-frequency traders often confound other investors by issuing and then canceling orders almost simultaneously. Loopholes in market rules give high-speed investors an early glance at how others are trading. And their computers can essentially bully slower investors into giving up profits — and then disappear before anyone even knows they were there.

Critics of high-frequency trading argue that it is a form of front-running, a practice which is illegal in most jurisdictions. The counter-argument in defence of the algos is that it increases the efficiency of the market. As Steve Rubinow of NYSE Euronext explains to Planet Money:

Every innovation of this type makes the market more efficient. … The faster we trade, and the more people you have trading, any aberrations that exist in the market are taken out of the market really really quickly, which makes for a fairer market for all participants … Those prices are about as fair as they could be.

Efficient markets are a good thing and I have used a similar argument here on the blog to defend short-selling. Nevertheless, there has always been something about high-frequency trading that makes me uneasy. In an interview with Edge, Emanuel Derman seems to put the finger on the source of this unease:

Also, people who benefit from it tend to over-accentuate the need for efficiency. Everybody who makes money out of something to do with trading tends to say, oh, we’re got to do this because it makes the market more efficient. But a lot of the people who provide this so-called liquidity and efficiency are not there when you really need it. It’s only liquidity when the world is running smoothly. When the world is running roughly, they can withdraw their liquidity. There is no terrible need to be allowed to trade large amounts in fractions of a second. It’s kind of a self-serving argument. Maybe a tax on trading to insert some friction isn’t a bad idea, just as long term capital gains are taxed lower than short term gains.

Derman started working as a “quant” in financial market around 25 years ago and had a long stint at Goldman Sachs. His response is not likely to be one of knee-jerk suspicion, but rather the considered voice of experience.

Joffe-Wolt’s reinterpretation of Waits conjured up an atmosphere of mystery and fear when exploring NYSE Euronext’s new data centre. Perhaps a bit of fear of high-frequency trading is healthy.

Image Source: Discogs

Following on from the interest generated by his last post, Mule Stable regular Zebra (James Glover) returns to the subject of the Resources Super Profits Tax in another guest post.

In a previous post I explained how the formula for the RSPT (Resource Super Profits Tax) was derived by considering the Government to be a 40% silent investor in any mining project. I showed that the correct deduction from the return on investments is indeed GBR (Government Bond Rate), as proposed, not a higher rate that includes a “price of risk”. One important thing I missed in this analysis, however, was whether the investment amount (I) was the correct basis for valuing the Government’s new 40% “investment”. I aim to show that the correct variable should actually be the Market Value of Assets (MVA) and as such the appropriate deduction from profits is several times (maybe as much as 4 times) higher for established mines.In the example given based on the mining industry “price to earnings ratio” of 14 the RSPT would only be 9% of earnings. I should emphasise this is not about having separate formulas for new and existing mines but correctly taking into account the fair, market based, price the Govt should pay for it’s 40% share of the earnings.

For new mines MVA = I (where all “=” signs should be taken to mean “approximately equal” to head off the pedants) so the proposed tax is correct in this case.

The Government says that in return for this tax take they are taking downside risk as well as upside benefit. One of the criticisms of the RSPT is that the Government is effectively nationalising 40% of ongoing mines and the GBR deduction is irrelevant as there is no serious downside risk. In the framework I propose the Government is not currently proposing to pay a fair price for this “nationalisation”. If the fair price of the Government’s stake is taken into account then the tax from existing mines is considerably lower than proposed. It may be as low as 9% of earnings. This does not require a backdown by either the miners or the Government, although the Government’s tax take might be less than forecast

If the Government is going to nationalise 40% of a mine – at a fair price – then it needs to effectively pay 40% of the Market Value of Assets (or MVA) for the mine. For new mines the Investment = Equity + Debt is pretty much set at this value. The Government RSPT tax is then:

Tax = 40% x (Earnings – GBR x MVA)

The first term is the Government’s 40% share of the earnings (here taken as Earnings before Tax). The second term is the deduction for the interest that recognizes that the funding of the Government’s share is undertaken by the mine at the Government Bond Rate or GBR. There is no good reason for the Government to pay less than the market value of this asset or MVA. For a new mine just starting up MVA = I, the investment amount, so

Tax = 40% x (Earnings – GBR x I)

If ROI = Return on Investment = Earnings/I then we can write this as:

Tax = 40% x (ROI – GBR) x I

which is the proposed RSPT formula.
For an ongoing mining operation with established operations and contracts, the market value will exceed the book value several times over. I am going to take the very simple assumption that MVA = Price ie the market value of the assets is the market value of the equity. This ignores leverage and is probably too simplistic. Price is based on share price and the number of outstanding shares. In terms of PE-ratio (the ratio of Price to Earnings as determined by the share price) we can write

Tax = 40% x Earnings x (1 – GBR x PE-ratio)

Compared to the original formula the deduction is  40% x GBR x PE-ratio x Earnings. Alternatively we can write this as 40% x GBR x I x MBR where MBR is the Market to Book ratio = MVA/I. So the original Govt funding deduction is just multiplied by MBR. The current formula assumes implicitly that MBR = 1. For existing businesses eg. banks MVA/BVA can be as high as 4 (which is BHPs current value). This gives a very simple deduction in terms of % of earnings, rather than Investment/I, of 40% x GBR x PE-ratio. Note that this is really the same formula for new and existing mines; it just makes proper allowance for the true value of established mines.

So what is the fair deduction for existing mines? It obviously varies with share price and hence market conditions. For mines which are privately held we need a proxy based on publicly traded stocks. The PE-ratio for traded mining stocks is currently about 14. So now, using GBR=5.5%, the  fair deduction for the Govt’s nationalised share for existing mines is not 5.5% (as many erroneously claim) or 22% (allowing for a 25% ROI) but 31%! Note this deduction is off the 40% so the total RSPT tax on earnings would be 9%.

So under a scheme based on a fair deduction for existing mining assets the tax should be:

RSPT = 40% x  Earnings x (1 – 5.5% x 14) = 9% x Earnings.

After 30% company tax this represent a total tax of 38%. Even if we don’t know what the PE-ratio would be for mines which aren’t publicly traded we can use an industry based proxy for the mines whose stocks are publicly traded. Currently this is in the range 13-14. If I was the miners I’d be pretty happy with that. Maybe they should have taken a closer look at the RSPT before opposing it. All the miners have to do is get the Govt to accept it should pay a fair value for its stake and the framework I propose makes that transparent.

Over recent months there have been a few informal polls on the Mule Stable on whether or not the Reserve Bank of Australia (RBA) would be moving interest rates. There will be another monthly policy decision tomorrow and this time I decided to make poll a bit more structured, courtesy of the PollDaddy website. If you come across this post before early Tuesday afternoon, you will still have a chance to chip in with your prediction.


Polls like this will start to be a regular feature on the Mule Stable and I will publish some of them here on the blog too. This one is a gentle start: there is a strong consensus as to what will happen tomorrow (the blog title is a giveaway!). Next time, I will aim for a more controversial question!

UPDATE: In the end, 83% of poll respondents picked no change, which is indeed what happened.

Today’s “Chart of the Day” from Business Insider’s Clusterstock blog presents an alarming picture of the US economy viewed through the prism of bank business lending. The chart, which I have reproduced below, shows a precipitous collapse in lending*, described in dramatic language as “falling like a knife”. There is no doubt that the US economy remains in very poor health, but should we be getting as excited as Clusterstock?

Annual Change in US Commercial and Industrial Loans

Closer examination of the chart reveals that it is in fact quite misleading.

For a start, it makes the very common mistake of plotting a long series of data without adjusting for the fact that over time the value of the dollar has declined through inflation and the US economy has grown. As a result, more recent movements in the data take on an exaggerated scale.

Also, the chart shows annual changes without providing any sense of the base level of lending. Not only that, while attention is drawn to the US $300 billion annual decline in lending, the increase of close to US $300 billion just over a year earlier is ignored, when in fact the two largely offset one another. Certainly lending has declined, but rather than taking us into historically unprecedented territory, as the Clusterstock chart suggests, it actually means loan volumes are back to where they were in late 2007.

Both shortcomings are addressed in the chart below, which shows the history of loan volumes themselves rather than annual changes and overlays a series scaled by the gross domestic product (GDP) of the US to represent lending in “2010 equivalent” dollars.

US Commercial and Industrial Loans

Changes in lending do provide a useful reading of an economy’s health. But, it is important to be careful when using annual changes to read its current state. The change from January 2009 to January 2010 is affected just as much by what happened a year ago as by what happened last month. Since monthly data is available, we can in fact look at changes over a shorter period. The charts below show monthly changes, which are probably a little too volatile, and quarterly changes which are probably the best compromise. Since these charts extend only over a five year period, it is not as important to adjust for changes in the value of the dollar and the size of the economy.

Monthly Changes in US Commercial and Industrial Loans

Quarterly Changes in US Commercial and Industrial Loans

Both of these charts reveal an economy that certainly remains unhealthy and lending volumes are still declining. However, the declines of the last couple of years evidently reflect an unwinding of the enormous increases of a few years earlier. So rather than fretting that lending is “falling like a knife”, we can take some comfort from the fact that the rate of decline is diminishing from the worst point of the third quarter of 2009. The moral of the story is that charts can mislead as easily as words and should always be treated with caution.

* The data is sourced from the St Louis Fed “FRED” economic database.

The shadow finance minister, Barnaby Joyce, has been waxing hysterical of late about Australia’s “unsustainable” public debt. This is not a new line to take in Australian politics. Last year when the then leader of the opposition, Malcolm Turnbull, began attacking the government’s stimulus package, I argued in “Park the Debt Truck” that there was very little reason to be worried about Australia’s public debt.

This phobia of government debt is not unique to Australia. In the US, national debt is one of the primary bug-bears of the “Tea Party movement” that emerged in 2009. Widespread concern about government borrowing is helped along by the sort of simplistic fear-mongering evident in the so-called “debt clock” (and yes, I am aggrieved to say, there is an Australian version of the debt clock).

The catalyst for the current focus on sovereign debt is the crisis faced by Greece. Stimulus spending to combat the economic fall-out of the global financial crisis has led to significant growth in government debt around the world, prompting fears that Spain, Portugal, Ireland or even the United Kingdom or the United States will be the “next Greece”. This week, Business Insider published what it dubbed “the real list of countries on the verge of sovereign default”. Sourcing its information from a Credit Suisse paper via the FT Alphaville blog, they rank United States government debt as riskier than Estonian debt. That alone should raise eyebrows and suggests that Credit Suisse needs to join Barnaby Joyce in some remedial lessons in economics.

The basis of Credit Suisse’s sovereign risk ranking is mysterious. It supposedly takes into account, amongst other things, the market pricing of credit default swaps (CDS). However, they are clearly not listening too closely to the market, otherwise Argentina would be at the top of their list and the United States at the bottom (the chart below shows the actual Credit Suisse ranking). Of course, the market is not always right: just look at the tech bubble or the US housing bubble. Indeed, I know of one person working in the markets who refers to sovereign credit default swaps as a device for “taking money from stupid people and giving it to smart people”, so perhaps Credit Suisse are right not to put too much weight on these prices.

Credit Suisse Sovereign Risk Ranking*

It would appear that Credit Suisse is primarily concerned about the amount of public debt each country has (although if this was the sole criterion, Italy would rank above Greece).

Many who fret about the risk of government debt appeal to an analogy with a household budget. Just as you and I should not live beyond our means and put more on the credit card than we can afford to repay, so the government should not spend more than it earns in the form of tax. This analogy is simple and compelling. However, just as H. L. Mencken once wrote, “For every problem, there is one solution which is simple, neat and wrong,” this analogy is simple neat and wrong. The circumstances of the government are fundamentally different from yours or mine.

In “How Money Works” I explained the difference between money which derives its value from being convertible to something else, such as gold or US dollars, and “fiat money” for which there is no convertibility commitment. As I wrote in that post,

However, in a country with fiat money, the central bank makes no convertibility commitments…It has monopoly power in the creation of currency. So, the government simply cannot run out of money.

The United States, United Kingdom and Australia are all examples of countries with fiat money with floating exchange rates. None of these countries can ever be forced into default. Contrary to the alarmists, none of these countries are reliant on China (or anywhere else) for their money. Here is a simple thought experiment: when China “lends” the US government money by buying Treasury bonds, where does that money come from to buy the bonds? From US dollar mines by the Yangtzee river? No. All of the money comes from China taking US dollars as payment for their exports. So China is “lending” the US government money that was all created in the United States in the first place. While any of these countries could decide for political reasons not to repay their debt, that is extremely unlikely in current circumstances. So the United States, United Kingdom and Australia and indeed many other countries with fiat money and free-floating exchange rates should all be considered to pose an extremely remote risk of sovereign default.

But what about Greece? Unfortunately for the Greek government, ever since they joined the European monetary union and adopted the euro as their currency, they lost the power to create their own money. While the US government cannot run out of dollars, the Greek government certainly can run out of euros. To make matters worse, they are subject to the tight controls of the Growth and Stability Pact as part of the Maastricht Treaty which severely restricts their ability to use the sorts of stimulus measures Australia, the United States and others have turned to in the face of economic downturn. In fact, their national debt levels are already well over the Pact maximum of 60% of their gross domestic product.

Like the other members of the monetary union, Greece is effectively operating on a gold standard only substituting euros for gold. In A Tract on Monetary Reform, John Maynard Keynes referred to the gold standard as a “barbarous relic” and the European Union is now learning how right he was. They adopted a common currency with an eye on the benefits of streamlining commerce between member countries, but without understanding the implications for times of economic crisis. The Union is now in a bind: do they allow Greece to fail, only to see Portugal, Spain and others tumble in its wake? Or do they ignore the rules of the Pact and bail Greece out, a course of action which would doubtless leave Ireland feeling that their fiscal austerity measures were an unnecessary hardship? In all likelihood, they will find a way to dress up a rescue package with all sorts of tough language and pretend that the union is as strong as ever. The fact remains, that the euro is the real reason Greece finds itself facing a debt crisis.

But what of Estonia being less risky than the United States? The Estonian kroon is pegged to the euro, so despite not yet being part of the European currency union, Estonia has chosen to give up sovereign control of its currency. As long it goes down this path, Estonian government debt has to be considered a far riskier proposition than US government debt. Clearly Credit Suisse’s sovereign risk analyst does not understand this. Little wonder it is lost on Barnaby Joyce.

* India, which ranks between Egypt and Italy, is not shown in the chart because no CDS data is provided. The “CDS spread” represents the annual cost of buying protection against an event of default. This cost is measured in basis points (1 basis point = 1/100th of a percentage point). For example, in the chart above, the CDS Spread for Australia is reported as 50 basis points (i.e. 0.5%). This means that to buy protection against default on $100 million of Australian government bonds would cost $500,000 each year. A typical credit default swap runs for five years.

One misconception about the mechanics of money that I mentioned in my last post is the idea that banks can hoard their reserves at the central bank* rather than lending them out.

Here I will explain why this idea simply does not make sense, but no more casinos and gaming chips. No more senior croupiers and casino cashiers. I will dispense with the metaphor and instead stick to a more prosaic explanation, looking at interactions between banks and central banks.

All banks have their own accounts with the central bank. Often these are called “reserve accounts”, although in Australia they are called “exchange settlement accounts” (ESAs). As the Australian terminology suggests, the primary function of these accounts is to facilitate settlement of transactions that take place between banks. To keep it simple here, I will stick to the terminology of “reserve accounts”.

To see how this works, imagine I make a $100 purchase from a shop on my credit card. If the shop banks with the same bank as I do, all that happens is that our bank increases the balance of my credit card by $100 and also increases the balance in the shop’s bank account by $100. With a couple of simple accounting entries and no movement of any physical currency, the transaction is complete. In fact, as was discussed in the casino money post, this simultaneous $100 loan advance to me and $100 deposit raising for the shop has effectively “created” an additional $100 of money in the economy that was not there before.

Things are slightly more complicated if the shop banks with a different bank. In that case, my bank (let’s call it “Bank C”) will still debit $100 from by credit card, but it now has to make a $100 payment to the shop’s bank (“Bank W”). The way this is done is through the two banks’ reserve accounts: my bank will have its balance with the central bank reduced by $100 and the shop’s bank will have its balance increased by $100. In practice, this does not happen for every individual transaction. On any given day, there will be a large number of payments to and from every bank. So, banks will net all of these transaction each day and then transfer money between their reserve accounts to cover the net amount owed one way or another.

One problem that can then arise is that a bank may not have a sufficient balance in its reserve account to make the settlement payments. The typical solution is for the bank to borrow what it needs from another bank. Sticking with the simple example of the $100 purchase and ignoring the fact that the figures involved here are unrealistically small, my bank may only have $50 in its reserve account and may therefore choose to borrow $50 from another bank. This loan results in $50 being transferred into its reserve account, bringing the balance up to $100 which it can then transfer to Bank W’s reserve account. It may even be that Bank C could borrow from Bank W, in which case it is effectively making good on the payment of the $100 by a combination of a $50 reserve account transfer and a $50 loan. As a last resort, if Bank C is unable to borrow from another bank, it will have to borrow from the central bank. Acting as a lender of last resort in this way is part of the function of a central bank.

Looking at all of these scenarios, purely internal account entries at Bank C, reserve balance transfers between Bank C and Bank W and combinations of reserve transfers and inter-bank loans, there is one very important point to note. At no point did the aggregate balance across the reserve accounts of all banks change. All that happened was that balances were shuffled from one bank to another. In fact, contrary to the view of certain financial commentators, it is impossible for a bank to lend its reserves to the private sector. Banks can certainly make loans, but these loans never take money from a bank’s reserve account and give it to an individual or a business (who, after all, do not have accounts with the central bank). If anything, these loans may move some of their reserve balances to the reserve account of another bank and so the actions of one bank can affect that bank’s reserve balance, but not the total amount of bank reserves.

So, how can aggregate reserve balances change? The only way this can happen is through the transactions of entities, other than banks, which deal directly with the central bank. This means the central bank itself or the government treasury, which also banks with the central bank. In its management of monetary policy, the central bank will routinely conduct “market operations” which involve lending to banks (which increases aggregate reserve balances) or borrowing from banks (which decreases aggregate balances). Similarly, the execution of fiscal policy by the treasury will also involve government spending (which increases aggregate balances), debt issuance or taxation (both of which reduce aggregate balances). To give an example of the mechanics behind one of these processes, imagine you are due a tax refund and you receive a cheque from the tax office. Once you deposit this cheque at your bank, the bank will increase your account balance by the amount on the cheque and then put a claim in to the tax office for that amount. This claim will be met by means of a transfer into the bank’s reserve account. For accounting clarity, there will also be a debit of the account with the central bank associated with the tax office, but in a modern economy with fiat money the government is effectively the monopoly issuer of currency (just like the casino is the monopoly issuer of chips in the last post) and so there is no sense in which the amount credited to the bank’s reserve account actually has to come from anywhere. It is simply a matter of the central bank saying that the bank’s balance has increased.

So, treating the central bank and the treasury as part of a broad “government sector”, the only way aggregate reserve balances can change is through the actions of the government sector, not through the dealings of banks with the private sector. Reflecting on what governments have done through the financial crisis can then solve the supposed riddle of the large reserves, particularly in the US and the UK. Governments around the world have made extensive use of fiscal stimulus packages, putting their budgets into deficit. Where has all of this stimulus spending ended up? In the reserve accounts of banks. Furthermore, some central banks have conducted extensive “quantitative easing” programs, which is just a fancy name for buying large volumes of bonds of various types (including corporate bonds and mortgage-backed securities). Without going into the reasons or the efficacy of quantitative easing, the relevant point here is that the process of central banks buying bonds directly results in increases in bank reserve balances. Are banks then hoarding these balances? Of course not. There is nothing they can do to reduce reserve balances by lending. The balances will not go down again until governments run surpluses or central banks start selling down their bond holdings again (or both). Does it matter that these reserve balances are so high? Not in the least.

There is one last point to clarify in dispelling the myth of reserve hoarding and that is the notion of “excess reserves”. In some countries, including the US, banks are required to have a minimum balance in their reserve accounts as a percentage of their total deposits. In the US, this minimum percentage is 10%. So, a bank with $1 billion in deposits must maintain at least $100 million in reserves with the US Federal Reserve (the US central bank). Any balances in excess of this amount constitute “excess reserves”. So, a bank with $1 billion in deposits and $150 million in reserves has $50 million in excess reserves. Unlike aggregate reserve balances, the actions of individual banks can affect aggregate excess reserves. Recall that bank lending effectively creates new money in the form of deposits. Now imagine that this bank with $1 billion in deposits writes a whole lot of new loans totalling $200 million. For simplicity imagine that all of the money is spent at businesses which bank with the same bank (much like the first $100 shopping scenario above), so this bank now has $1.2 billion in deposits and a minimum reserve requirement of $120 million. It still has $150 million in reserves, but its excess reserves have now dropped from $50 million to $30 million. Of course, it is not the case that the bank has spent the $20 million difference, it’s just that this $20 million is no longer considered “excess”.

Before we start getting too generous and conclude that commentators bemoaning reserve hoarding were actually talking about excess reserves, there are a couple of points to note. First, many countries, including the Australia and the UK, do not have minimum reserve requirements (and the article I linked to at the top refers to banks in the UK). Second, the relationship between excess reserves and bank lending is not straightforward. Many banks have reacted to the crisis by making greater use of the bond market. The reason for this is that, deposits can be withdrawn at call and so poses risks for the bank (so-called “liquidity risk”), just like the risk the casino runs that too many people will cash in their chips at the same time. Bonds on the other hand do not have to be repaid for a specified period of time, typically three to five years and so help to reduce the bank’s liquidity risk. For the same reason, banks have been tempting depositors with attractive interest rates to switch to term deposits. These term deposits are not subject to reserve requirements in the US and other countries that have minimum reserve requirements. So this shift in liquidity can increase the banks excess reserves whether or not they continue to lend.

So while finance commentators can reasonably ask whether bank lending has been swung too far from the easy money days of lending too freely to excessively tight lending practices, worrying about banks “hoarding reserves” is to completely misunderstand the workings of the banking system.

* I originally linked to this article but, as has been pointed out to me, not only does that article misunderstand the mechanics of central bank reserve accounts, but the writing was rather impenetrable. I have therefore replaced the link with another that is equally misguided, but easier to read.

Last week, the Australian Financial Review was doing its best to spruik the ongoing prospects for the Australian share market in their front page article “Cashed-up funds have $70bn to invest”. The article is only available online to subscribers, but this quotation sums it up:

analysts cite the volume of cash stockpiled as a reason for stocks to keep rising

Mostly consisting of quotations from people in the equity business (who all arguably stand to benefit from talking up the market), the authors do include some data to support the proposition as well:

The latest data released by the Australian Bureau of Statistics shows that fund managers have increased their cash holdings to about 18 per cent of the $880 billion they manage, or about $160 billion. If managers were to return their cash holdings to more normal levels, there would be about $70 billion available for investment, with the local sharemarket receiving up to $30 billion.

The image of a wall of cash on the sidelines waiting to spill over into equity markets is compelling, but does it make sense? The power of this commonly used image arises from the idea that cash is somehow transforming into shares, when of course for every buyer there is a seller who gets the cash, so share trading never changes the total amount of cash in the system (note that aggregate money supply can change through central bank operations and banking deposit creation, but that is a whole other story beyond the sharemarket and is not part of the standard “cash on the sidelines” argument). Of course, this does not stop share prices from going up or down.

So, if the cash in the system does not change, what is going on?

For a start, most commentators who consider cash on the sidelines to be a driver of stock prices look at the percentage of total assets held in cash; this post on the Market Thoughts blog is a good example.  The problem with this approach is that, while it creates an apparent correlation, it is trivial and has no predictive power. This is because a fall in the value of shares (or indeed any risky asset class) will reduce the aggregate value of investment assets and, with the total amount of cash staying constant, the percentage in cash automatically increases. It will then decrease again when shares increase in value again. But of course, this means that the move in cash percentages is coincident with movements in share prices and provides no better prediction than simply saying “shares have fallen and eventually they will go back up”.

A more sophisticated interpretation is to say that “cash on the sidelines” does not mean aggregate cash in the system, but refers specifically to cash held by a segment of the market, namely investors in money market funds (the figure most often measured). The argument could go something like this: many investors target asset allocation mixes and if their cash holdings become too high, they would be forced to buy more shares, thereby adding to demand for shares, shifting the demand curve and pushing prices higher. I have a few problems with this argument.

First, if this phenomenon is significant, why would the cash imbalance have arisen in the first place? Presumably because investors became more risk averse and demand for shares decreased. If so, I would argue that what would push share prices up is sentiment: investors become less risk averse and increase their demand for shares once more. This may, as a consequence, push the cash in the segment back down if investors’ net buying was from participants outside their segment. If so, I would see that the change in cash is a consequence of a change in demand, not the cause.

Second, by segmenting you need to consider not only the demand side, but the supply side. Investors cannot simply trade among themselves, otherwise the cash in their segment would not change. Their increased holding of cash would have to be offset by a reduced holding in cash by other segments, such as the corporate segment, which may affect the supply curve. A plausible scenario would be that corporates, starved of cash, begin issuing shares to raise cash, possibly at a discount to market prices. In the process, they channel the cash back from the investor segment and push share prices down. While I am not saying this would happen, I don’t think it is much less plausible than the explanation that excess cash shifts the demand curve for investors.

A related point is that the segment of investors with money in money market funds is bigger than asset allocators. While asset allocators may feel the pressure of their cash holdings increasing relative to their target, other investors may be becoming more risk averse, offsetting the effect of the asset allocators.

So much for theoretical arguments. Since this is the Stubborn Mule, I really should look at what the data says. The AFR article refers to Australian Bureau of Statistics data on the cash holdings of fund managers. Looking at the history of cash and deposits held by fund managers and comparing it to the Australian All Ordinaries share price index, there is no obvious pattern of increases in cash holdings leading to rises in share prices.

Fund Managers’ Cash and the Share Market (1988-2009)

In case there is a hidden pattern in these time series charts, we can also look at a plot of quarterly changes in the share price index against changes in cash holdings of fund managers.

Cash versus Share Prices (1988-2009)

There are a few outliers in this chart, but certainly nothing to support the claim that cash on the sidelines can push the market up. Of course, it may be that there is a lag before the effect on share prices takes effect, so here is a plot where changes in the All Ordinaries index are lagged by six months.

Cash versus Lagged Share Prices (1988-2009)

Even with the lag, there are a couple of occasions where an increase in cash was followed by share market rises, but the biggest cash build-up was followed by share market declines and for more modest changes in cash levels, the change in the share price index is distributed across gains and losses.

So, neither theory nor data supports the cash on the sidelines argument. And finally, I’ll just note if you believed in the argument back when the article I linked to above was published, you would have gone long stocks in June 2008! So, the next time you hear someone talking about all the “cash on the sidelines”, tell them they are talking nonsense.

UPDATE: Commenting on this post, James suggested calculating the correlation between changes in cash balances and changes in share prices for a variety of time lags. The chart below takes up this suggestion. The correlations are quite variable, which is consistent with my contention that build-ups of cash do not drive share prices. But it is also interesting to note that, if there is a pattern to be found, it is that the correlations are mostly negative, suggesting that increases in cash are  more often followed by share price declines not rallies.

Correlation of Cash and Lagged Share Prices (1988-2009)

I should concede that this chart, which stretches out five years (20 quarters), ends up looking for correlations far beyond where even the most hopeful “cash on the sidelines” advocates would expect to see a relationship.

As the G20 starts to get serious about curbing executive bonuses, we can expect banking lobbyists to get more strident in their attempts to resist these incursions into their cosy remuneration practices. This has, in fact, already begun. In a recent example, Deutsche Bank Chief Executive Josef Ackermann was resorting to cliché, claiming that “the war for talent is in full swing” (we can blame McKinsey & Co for unleashing these weasel words on an unsuspecting world). Expect to hear more.

Whether it is bankers defending bonuses or politicians frowning that bonuses contributed to excess risk-taking, what rarely seems to be questioned is whether or not bonuses actually work. That is, used as an incentive for employees, do they actually result in better performance. In most discussions, it is taken for granted that they do work, but that unwelcome side-effects can also emerge, in the form of excessive risk-taking.

However, writer Dan Pink recently challenged this basic assumption in a TED talk in August this year. He pointed to years of experimental research which suggest that while financial incentives may be very good in maximising productivity for simple tasks, they can actually result in worse performance for more complex tasks that require problem-solving or creativity. Rather than “extrinsic” motivators like financial rewards, Pink and others argue that “intrinsic” motivators like autonomy (being in control of what you do in your work environment), mastery (being good at what you do and wanting to get better) and purpose (feeling that what you are doing is worthwhile) are far better motivators.

The talk itself is under 20 minutes long and is well worth a watch (as are so many of the TED talks).

Of course, some may argue that the simplified environment of the social science laboratory does not translate to the complexities of the real business world. However, this research shows that the implicit assumption that bonuses are required in banking and finance to deliver better outcomes should not be quietly accepted. And, if the G20 are successful in initiating a change to the practices in the financial sector, it may not actually hinder staff performance. In fact, it might even help.

Regular readers of the Mule will know that I am a bit of a data-mining junkie. Whenever I come across an interesting chart I start Googling for the underlying data. But, even with well-honed Google skills, it’s not always possible to find the data. Sometimes it is simply not publically available. I ran into just this problem recently. The recent Australian Federal budget triggered countless alarmist opinion pieces despairing that Australia would be “mired in debt” and this prompted me to do some research of my own. In the process, I came across a handy primer on the subject entitled “A history of public debt in Australia”. Written by a number of Australian Treasury employees in the Budget Policy Division, it included the chart below which shows the history of net Government debt (combining Commonwealth and State debt) over almost 40 years. The chart also includes forecasts for the next few years.

Australian Government Net Debt to Gross Domestic Product

While the paper is clearly quite recent (it has no publication date), the forecasts pre-date those included in the May budget, so I was interested in updating the chart with the latest Treasury forecasts. The underlying data does not appear to be published online and, since I do not work with the authors in the Budget Policy Division, I had to resort to special measures. I turned to a handy (and free, open source) little piece of software I have used a number of times to pinch data from charts. The software is called Engauge Digitizer and it allows you to import an image of a chart and extract the underlying data.

Engauge Digitizer Screenshot

For charts with points or curve segments, Engauge generally does a great job of automatically finding the data. For a column chart like the one I had found, the process is a little bit more manual, but with a bit of clicking on the tips of each of the columns in the image, I had my data. The chart below shows the data I obtained. One indication of the accuracy of the results is that the authors of the history paper noted that net debt had averaged 5.7% of gross domestic product (GDP) since 1970. Satisfyingly, the average of my extracted data over this period was also 5.7%.

Australian Government Net Debt to GDP (imported data)

Having obtained the data, I was then able to replace the forecasts with the more recent Treasury figures included in Budget Paper No. 1.

Australian Government Net Debt to GDP (updated forecasts)

For the alarmists who are worried about this growing debt, it is useful to put these forecasts in a global perspective. The chart below puts these Treasury forecasts alongside IMF forecasts for a number of other developed countries.

Global Debt to GDP Forecasts

Compared to the rest of the developed world, the global financial crisis is still not looking quite so scary for Australia. When it comes to the United Kingdom, rating agency Standard and Poor’s is even more pessimistic than the IMF and is concerned that their net debt could reach 100% of GDP and have accordingly changed the credit rating outlook for the UK to negative.

UPDATE: For anyone interested in getting hold of the data without resorting to scraping it from the images, I have uploaded it to Swivel. This dataset includes the most recent Treasury forecasts.

]]> http://www.stubbornmule.net/2009/05/pinching-data/feed/ 14 http://www.stubbornmule.net/2009/04/brisconnections/ http://www.stubbornmule.net/2009/04/brisconnections/#comments Fri, 17 Apr 2009 12:59:32 +0000 Stubborn Mule http://www.stubbornmule.net/?p=1676

In the latest instalment of the ongoing debacle that is BrisConnections, Nicholas Bolton shrugged off the mantle of hero to mum and dad shareholders in exchange for a secretly arranged $4.5 million dollars. I have to admit I would have enjoyed the Schadenfreude of seeing Bolton continue to stick it to Macquarie Bank, but whatever his shortcomings (which include a striking resemblance to the One.Tel dude—thanks to the friend who pointed this out to me and to Crikey!), and however tempting it is to blame him for not finishing the job, it was never his job to protect shareholders.

When it comes to assigning blame, it should fall fair and square on the ASX. If they were doing their job properly, they should never have allowed BrisConnections to be listed in the first place.

To explain why requires a (relatively) brief explanation of instalment receipts. Also known as partly paid shares, they are a means a of issuing shares in a company in stages. If a company was estimated to be worth around $200 million, rather than issuing 100 million shares at $2 each, this approach involves selling 100 million “instalment receipts” (rather than fully paid shares) at $1 each. At some point in the future, holders of these receipts would pay a further $1 and their receipts convert into ordinary shares. This means of raising capital is very well suited to construction projects where the company does not require all of the capital upfront and was, for example, used to finance the construction of the Sydney Olypmic Stadium prior to the 2000 Olympics.

So, using instalment receipts was a natural approach to raising capital for the construction of Brisbane’s Airport Link. However, there is a crucial difference between the approach Macquarie Bank used with BrisConnections and most previous projects such as the Olympic Stadium and the Telstra privatisation. In the earlier examples, payment of later instalments was optional. Holders of instalment receipts had the choice of paying the next instalment and converting their holdings to fully paid shares or simply walking away with nothing. However, in the case of BrisConnections, paying the instalment is not optional and this makes a big difference.

To see why, I’ll go back to the hypothetical example of the $200 million company. Imagine that, for some reason (project problems, global financial crisis, or whatever), the value of the company fell to $150 million and then to $100 million and finally to $60 million. If they had originally raised capital by issuing 100 million $2 shares, then the share price would fall to $1.50, then to $1 and finally to $0.60. Obviously investors would be disappointed to see their investment fall in value, but these things happen on the share market.

Now imagine that they had issued 100 million $1 instalment receipts with a compulsory instalment payment of $1 in the future. So, even though the original investors had only invested $1, they had effectively committed $2. Initially worth $1, these instalment receipts would fall in value to around $0.50 when the company fell to $150 million. This is because the overall value of a fully paid share is $1.50 and instalment receipt holders have committed to paying the final $1, so the balance is $0.50. It gets messier as the value of the company continues to fall. When the company is worth $100 million, the instalment receipts are essentially worth $0 and with the company worth $60 million they should be worth negative $0.40! What this means is that a holder of one of these receipts should be prepared to pay someone $0.40 per receipt to take them off their hands. Since a “buyer” of the receipts considers the company to be worth $0.60 per share but knows there is a commitment to pay $1, they would want to be compensated $0.40 per share to take on the commitment of paying the instalment.

This is where is gets problematic for the ASX. The way the stock exchange system is set up, it is impossible to trade on the exchange with negative prices. So, even though these hypothetical receipts have a negative value, they would have to trade at a positive price. And they are not worth that! This is exactly what happened with BrisConnections. It got to the point where it was trading at price of a fraction of a cent when the value of the instalments were in fact negative. As a result, investors unaware of the future instalment obligation thought they were snapping up large numbers of shares at a bargain price and instead are now faced with enormous liabilities that many will simply be unable to pay.

The ASX has responded by announcing new rules requiring better disclosure from brokers. This misses the point. No amount of disclosure will change the fact that BrisConnections instalments could not be traded at real, negative prices. Even if everyone had full disclosure and (assuming no-one was trying anything tricky like Bolton) so no-one bought any units at near zero prices, this would leave the problem that existing investors would be unable to sell their holdings at all.

When the BrisConnections receipts were first listed, everyone might have expected the value of the company to go up not down, but the possibility that it could have gone down was always there and this should have raised alarm bells with the ASX right from the start.

Put simply, if the ASX cannot cope with negative prices, they should never allow anything to be listed on the exchange that has the slightest chance of having a negative value.

Since instalment receipts are hardly new, why has this only come up now? The secret lies in the fact that the instalments for Telstra, the Olympic Stadium and so many others were optional. Since there would never be a committed liability for instalment holders, the prices of the receipts could certainly go down to very close to zero, but they could never be negative. Of course, if no-one paid the instalment this would create some difficulties for the company and they would have to raise fresh capital, but a debacle like BrisConnections could never happen. Why was BrisConnections structured with a committed instalment? I can only guess the certainty of future cashflows for BrisConnections made it much easier for Macquarie Bank to pull out fatter fees for structuring the deal in the first place, which is why I would not have been sorry to see it all collapse for them (and it still might). Even if I am right in my suspicions, this would hardly be surprising news about Macquarie. So, I don’t really blame them, I blame the ASX.