Challenges of a New Supervisory Architect in Europe.
Jaksa Kristo, University of Zagreb, Faculty of Economics and Business, Croatia
Jaksa Kristo is a research and teaching assistant at the Department of Finance at Faculty of Economics and Business in Zagreb, Croatia. His main fields of research are risk management and regulatory issues of institutional investors.
Introductory notes
The financial crisis has revealed that the financial sector has a single core with strong mutual influences and spill-over effects both domestically and internationally. The importance of ‘looking at the big picture’, instead of focusing only on supervision of single institutions, has been highlighted during the financial crisis, as well as in recovery interventions. New regulatory changes have led to the development of institutions, procedures and committees for macro-prudential supervision, to ensure the future stability of the financial sector.
In previous years, regulators and supervisors were too focused on the micro-prudential supervision of individual financial institutions and did not monitor the macro-systemic risks in the global financial market. It was assumed that if supervisors ensured individual financial institutions were safe, systemic stability would look after itself. Yet, in a recent report, The Fundamental Principles of Financial Regulation, a group of prominent bankers and academics points out that this view ‘sounds like a truism, but, in practice, it represents a fallacy of composition’ (meaning, in trying to make themselves safer in a crisis, financial institutions can behave in a way that collectively undermines the system). It may be prudent, for example, for an individual bank to sell assets when the price of risk increases. However, if many banks and financial institutions do the same, the asset price will collapse, causing financial institutions to take further steps that can lead to a vicious, self-reinforcing downward spiral in asset prices.1
Financial stability, before and during the financial crisis, has been ensured through central bank policy and supervisory authorities in charge of micro-prudential supervision. Various supervision models exist in national economies, from prudential and conduct-of-business supervision — integrated in one institution, usually a central bank, or ‘one peak’ — to the ‘twin peaks’ model, meaning the existence of various institutions in charge of the supervision of different financial institutions.
The effectiveness of macro-prudential regulation, emphasised during the financial crisis, is a core assumption behind the new capital proposals and regulatory/supervisory reform in 2009 (espeically in the US Treasury, A New Foundation: Rebuilding Financial Regulation and Supervision, the De Larosière Report in the EU, and The Turner Review in the UK).
Rebuilding financial regulation in the US
In the US, the proposal for a regulatory reform intends to consolidate several federal banking regulators and give the Federal Reserve new power to regulate systemic risk, supplemented with a council of regulators from other agencies. Additionally, there is a proposal to create a consumer financial protection agency to regulate credit cards and mortgages, and the requirement that hedge funds are registered, and the central clearing for many derivatives.
The financial regulatory reform in the US is intended to meet five key objectives, to:
1. promote robust supervision and regulation of financial firms;
2. establish comprehensive supervision of financial markets;
3. protect consumers and investors from financial abuse;
4. provide the government with the tools it needs to manage financial crises; and
5. raise international regulatory standards and improve international co-operation.
The US Treasury’s report, A New Foundation: Rebuilding Financial Regulation and Supervision proposes demanding reforms of the existing authorities, and practices of regulation and supervision, as well as establishing various new authorities and councils. They have proposed the creation of a Financial Services Oversight Council, chaired by the Treasury, which would include the heads of the principal federal financial regulators as members. Its purpose would be to identify emerging systemic risks and improve inter-agency co-operation. The proposal’s hope is that the US would combine comprehensive supervision of financial markets with enhanced regulation of securitisation markets, market transparency, stronger regulation of credit rating agencies and over-the-counter derivatives. The Consumer Financial Protection Agency would be an independent entity dedicated to consumer protection in credit, savings and payments markets. The report also proposed the creation of the National Bank Supervisor, a single agency with separate status in the Treasury, with responsibility for federally-chartered depository institutions. To promote national co-ordination in the insurance sector, an Office of National Insurance within the Treasury would also be created.
One of the key initiatives in the US is to strengthen the Financial Stability Board and institutionalise its new mandate to promote global financial stability.2
Regulatory and supervisory changes in the EU
In November 2008, the European Commission mandated a High Level Group (chaired by Mr. Jacques de Larosière) to propose recommendations to the Commission on how to strengthen European supervisory arrangements to better protect its citizens, and rebuild trust in the financial system. As one of the two largest financial markets in the world, the EU also has a responsibility to promote global financial stability and security — a role that it can only perform if it has a strong supervisory and regulatory framework itself.
The final report presented by the De Larosière Group on 25 February 2009, set out a balanced and pragmatic vision for a new system of European financial supervision. At the core of this vision are proposals to strengthen co-operation and co-ordination between national super visors, including the creation of new European Supervisory Authorities and, for the first time, a European-level body in charge of overseeing risk in the financial system as a whole.
The DeLarosiere Report consists of 3 1 recommendations structured into four chapters: (1) the causes of the financial crisis; (2) policy and regulatory repair; (3) EU supervisory repair; and (4) global repair. The Report outlines the Group’s views on the priority areas that need regulatory change, including:
• stronger macro-economic policy and macro-prudential analysis;
• reforming Basel II;
• supervision of credit rating agencies;
• accounting, regulation and supervision of hedge funds, private equity funds, securitised products/derivative markets; and
• common EU rules for investment funds.3
Based on the conclusions of the De Larosière Report, the European Commission has adopted a package of draft legislation to strengthen the supervision of the financial sector on 23 September and 26 October 2009 respectively. The aim of these enhanced co-operative arrangements is to sustainably reinforce financial stability throughout the EU; to ensure that the same basic technical rules are applied and enforced consistently; to identify risks in the system at an early stage; and to be able to act more effectively in emergency situations, and in resolving disagreements among supervisors. The legislation will create a new European Systemic Risk Board (ESRB) to detect risks to the financial system as a whole, with a critical function to issue early risk warnings to be rapidly acted on. It will also establish a European System of Financial Supervisors (ESFS), composed of national supervisors and three new European Supervisory Authorities for the banking, securities, and insurance and occupational pensions sectors.4
The ESRB will monitor and assess potential threats to financial stability that arise from macro-economic developments and from developments within the financial system as a whole (macro-prudential supervision). To this end, the ESRB would provide an early warning of system-wide risks that may be building up and, where necessary, issue recommendations for action to deal with these risks. The creation of the ESRB will address one of the fundamental weaknesses highlighted by the crisis, which is the vulnerability of the financial system to interconnected, complex, sectoral and cross-sectoral systemic risks.
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The Performance of the SFA Score vs Traditional Risk-adjusted Performance Measures
Peter Urbani, Infiniti Capital, Hong Kong
Peter Urbani is Chief Investment Officer of Infiniti Capital, a Hong-Kong-based hedge fund of funds group.
Ever since the seminal work on Portfolio Theory by Harry Markowitz (1959) and the subsequent work of William Sharpe, the measurement of portfolio returns has been inextricably linked to the level of risk associated with achieving those returns.
This has led to the introduction of a number of risk-adjusted performance measures (RAPMs), most famously the reward-to-variability, or Sharpe Ratio.
Typically calculated as the portfolio returns in excess of those of the risk-free rate over the standard deviation of portfolio returns, the Sharpe Ratio embeds the concept of the variance, standard deviation squared, or volatility as the appropriate measure of ‘risk’ to use.
Over time, practitioners and academics alike have realised that this poses a number of problems for the accurate measurement of ‘risk’. In fact, the use of variance was largely an act of convenience to simplify the math in the days before computers. Markowitz himself has said that for some investors semi-variance might be a more appropriate measure to use.
The reason for this is simply that variance, or standard deviation as is more commonly used (the square root of the variance), is not a measure of ‘risk’ at all, but rather a measure of uncertainty. Standard deviation suffers from a number of well known deficiencies, most particularly the fact that it does not differentiate between good (upside) ‘risk’ and bad (downside) ‘risk’. Moreover, it is a symmetric measure that assumes both upside- and downside-variance are the same.
In recognition of these deficiencies, a number of other RAPMs have been developed to better address these issues. Probably the best known of these is the Sortino Ratio which replaces the standard deviation with the downside deviation or second lower partial moment (LPM2) as the denominator in the Sharpe Ratio.
Still others include the modified Sharpe Ratio where the denominator of risk is represented by the Cornish Fisher expanded or ‘modified’ Value at Risk (VaR).
More recently, Shadwick and Keating pioneered the use of the Omega Function, sometimes also used as the Omega Ratio. In this formula, the area under the probability curve in excess of some threshold return is taken over the area under the curve of the downside part of the distribution. This can be calculated in either a discrete form using empirical data, or a continuous form by fitting a distribution.
From a practitioner’s perspective, what we care most about is how well these measures predict the relative ranking from one period to the next and whether or not using one particular method produces superior returns to another. Although these RAPMs are typically used for calculating the relative ranking of funds they can also be, and often are, used as the objective function in direct portfolio optimisations. For instance, maximising the value of your portfolio’s Sharpe Ratio is the same as minimising its variance and gives the same set of weights as the classical Markowitz mean variance optimisation formulation. Minimising your ‘normal’ VaR will give the same solution. However, as mentioned previously, measures based on standard deviation such as Sharpe and the normal VaR calculation do not consider the asymmetry of returns.
In this article, we examine the performance of a new risk-adjusted performance measure called the Single Fund Analysis (SFA) score, developed by Infiniti Capital. This measure is a weighted average of a number of underlying statistics that has also been standardised to a reference data set making it both a relative and conditional measure. The SFA score can further be decomposed into risk, return and persistence sub-scores.
The study referenced below, compares the outof- sample performance of a portfolio built using the SFA score as its objective function versus the performance of portfolios built from the same data set using the Sharpe, Sortino and Omega measures. For reference we also include a naive benchmark made up of an equally weighted continuously rebalanced portfolio of all of the 36 underlying hedge funds in the selection universe. The portfolios are re-optimised to the objective function and rebalanced on a quarterly basis.
The results of the study suggest that the SFA score is capable of generating annualised rates of returns (CAGR) of around 15% versus those of around 11.5% for the Sharpe Ratio, 13% for the Omega Ratio, and just 10% for the Sortino Ratio.
More importantly, although the Sharpe Ratio of the resultant time series remains better for both the Sharpe and Omega portfolios, the ratio of the annualised return to the absolute drawdown over the period, which is arguably a better measure of realised risk to return, remains highest for the SFA score portfolio.
The reason for the superior performance of the SFA scores is due to it not being a simple point estimate, but being calibrated relative to a reference data set of other hedge funds. This improves the predictive power of the method because it responds dynamically to market conditions. In order to ensure the availability of data for the SFA reference scores, the portfolios are also optimised with a one-month data lag. This means that January SFA scores which only become available in February are used to obtain the March opening portfolio weights.
Unlike traditional performance measures, the SFA score is both conditional on the time period being used and relative to a large reference data set of other hedge funds. Where other methods typically standardise everything back to a normal or Gaussian distribution, the IAS uses the best fitting distributions throughout. This has the effect of calibrating the range of scores more closely to real-world data.
Of course, the method is not perfect. The SFA scores will not provide the best returns over each and every single time period, however, over any meaningful length of time they will tend to out-perform.
We were somewhat surprised by the poor performance of the Sortino Ratio portfolio relative to that of the Sharpe Ratio portfolio. We believe this may have been due to the fact that the quality of the 36 underlying hedge funds used was very good. This enabled the computer to select portfolio weights that gave a portfolio with zero downside deviation in the in-sample optimisation periods. The low variance of these portfolios did not persist out-of-sample in the subsequent periods causing this portfolio to underperform.
This is a classical problem of over-fitting your data which results in there being little relationship between the in-sample period and the performance in the next period. The Sharpe Ratio suffers from a similar problem, but more because it is capturing only the linear effects of the portfolio whereas we know there are significant non-linear effects present in hedge funds.
The SFA score is able to capture some of these non-linear artifacts because of the statistics used in its calculation and the best-fitting non-normal distributions it uses. These have the effect both of improving the predictive power of the method and ensuring the resultant pay-off is positively skewed, or as close to positively skewed as possible. This translates into more upside risk than downside risk.
Of course, the method is not perfect. The SFA scores will not provide the best returns over each and every single time period, however, over any meaningful length of time they will tend to out-perform.
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The Top Ten Rules Hedge Fund Managers Should Follow to Attract and Keep Great Investors
Jeff Banfield, JMO Research, Toronto
Mr Banfield founded and was Chief Investment Officer of a Canadian hedge fund from 1997 until 2002. During this time, the fund generated a compound annual return of 34%, never had a negative year, never a negative quarter. Prior to running the hedge fund, Mr Banfield worked for 10 years in proprietary trading at two Canadian investment banks.
An important point hedge fund managers should keep in mind is that the best investors don’t want to micromanage their managers. Integrating the following points into the framework of a hedge fund will greatly improve a fund’s appeal to institutional and high-net-worth investors. These points are often given equal or greater consideration to performance, as these guidelines will help to prevent problems in the future.
1. Liquidity and integrity
If your fund accepts money monthly, then it should provide liquidity monthly. Not all requests for redemption are based on unsatisfactory performance. Giving investors the opportunity adjust their exposure to a fund within a reasonable timeframe is essential for managers trying to convey the message that they are able to manage liquidity risk in the portfolio. Most funds these days have market disruption clauses that provide the manager with the option to restrict redemptions during times of severe market duress. Investors want this clause, as it helps to reduce volatility. However, for a manager to need more than 20 days to generate 10%, or even 15%, cash during properly-functioning markets is absurd. A long notice of redemption period is a huge red flag to investors. It says a large proportion of the fund’s investments are illiquid and, therefore, carry an elevated level of risk. In today’s world, a hedge fund manager definitely wants to avoid being labeled illiquid at all costs.
2. Information on a timely basis
Hedge funds should provide investors with timely month-end net asset value (NAV). Estimates within seven days of month-end are no longer a challenge, and are becoming an indicator of how strong a fund’s internal controls are. Providing investors enough time to make informed decisions as to whether any changes to their holdings are warranted is essential to attracting good investors. Today, prime brokers provide their clients
with overnight valuations that are accurate. Almost all managers know their fund’s NAV (within a hundred basis points), within three days of their month-end. If a manager doesn’t have this information, or isn’t sure of
its accuracy, the message being conveyed to the investor is either the managers back office and accounting are not well organised, or the portfolio is too illiquid to value on a timely basis.
3. Fairness for all
In business, it is common to have penalties levied when commitments are broken. Investors agree to invest their capital based on the terms provided in the offering documents. The terms will often stipulate a minimum hold period. The same material often provides a targeted return and volatility the fund will generate. If the hold period is violated, a penalty is imposed by way of a redemption charge. This is acceptable, as long as the manager has also upheld their commitment to generate the targeted return and volatility. Simply put, from the perspective of the investor, if the funds performance is negative over a reasonable period of time (eg, six to eight months), or the fund experiences abnormal volatility swings relative to its historical relationship to general market volatility over a similar time frame, then the investor should be entitled to redeem without penalty, as the manager has failed to uphold their commitment.
4A. Alignment of interests
It doesn’t get much simpler than this; an individual confident enough in their investing skills to tie their compensation to the performance of a fund should be confident enough to leave the majority of the compensation in the fund going forward. Investors have been outraged by managers who received huge amounts of money as the value of their fund went up, but lost little of that money when the same fund dropped substantially in value. If it’s ok for hedge fund managers to be partners in the gains of a fund, then they must be willing to maintain that relationship during times the fund suffers losses. In order to accomplish this, managers should only be paid a portion of the performance fees annually, and the remainder paid when either an investor’s capital is redeemed, or the partnership is dissolved entirely. If the manager feels that under this structure, his capital is excessively exposed to risk during the life of the fund and wishes to reduce the exposure, they can return a portion of the capital under management back to investors and receive the unpaid performance fees on that capital. Alternatively, if a manager is concerned about the level of risk their wealth is exposed to in a certain market environment, then they can move capital to cash, therefore, reducing the risk to all investors. Managers that align their interests with investors by paying out all fees but reinvesting a portion of the after-tax proceeds of their compensation in the fund are not exposed to the same level of risk, and any graduate of sixth grade math knows this. To imply otherwise is insulting to the investor.
4B. The good investors want their managers to be properly paid
Good investors don’t want money management decisions influenced by the manager’s need to pay bills. It is important that a manager be paid enough to meet overhead and be provided with a reasonable income. As a rough guide, performance fees on assets in excess of $50 million should be deferred as explained above. A firm that has $50 million under management and generates 16% net to investors per annum will generate $3 million in revenue a year. This is sufficient to satisfy overhead for a small firm. By deferring just the performance fees on assets above $50 million, the manager is aligning their interests with those of their investors, and providing investors with a sense of equality. As an added benefit, it allows the manager to compound their own earnings pretax thus increasing their wealth more quickly. The best managers will leap at the chance to do this. As a consequence of this approach, investors will have to pay tax on the deferred returns (a small price to ensure alignment of interests), which will be recouped on redemption. Resistance by a manager to accept deferred compensation is a huge red flag to excessive greed and a lack of confidence by the manager in their own skills.
5. Compare apples with apples
Comparing a fund’s performance to a benchmark that has little or no bearing on the fund’s returns is blatant misrepresentation, and investors see this. If a manager runs a long/short fund in resource stocks, then it should be compared with a long/short fund benchmark and a resource index, not the Morgan Stanly Global EAFE Index or the Standard and Poor’s 500 Index. If you’re a 500-pound gorilla, don’t try to hide behind a twig. Smart investors know what kind of manager they are investing in and if your monthly reports provide bogus comparisons, investors will notice the 500-pound gorilla behind the twig.
6. Time is money
Given that a manager should know within 100 basis points the NAV within three days of month-end, it seems more than reasonable to pay out 90% of redemption proceeds on the fourth or fifth day after month-end. Following a redemption date, an investor is forced to cash after the month-end. The opportunity to reinvest is gone until the following month-end. Investors suffer opportunity costs of one and, in some cases, two months’ return while waiting for their redemption proceeds. Not providing the proceeds from redemption on a timely basis is like imposing a redemption charge indirectly to the investor. At a minimum, 90% of monies should be paid to the investor within five day’s following month-end. The faster the money is sent to the investor, the more likely the investor will convey a positive experience to other investors if asked in the future.
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Financial Services Regulation in Australia
Scott Charaneka, Norton Rose, Australia and Michelle Asimus, Pinsent Masons LLP, London
Scott Charaneka is a partner at Norton Rose, Sydney, where he practices financial services law. Scott is a regular speaker at conferences, is the editor and author of many texts and articles and is an active member of industry associations. Michelle Asimus has worked as an investment funds lawyer in Australia and the United Kingdom.
An overview of the financial services regulatory environment in Australia
The framework for the regulation of Australia’s financial services industry is set out in Chapter 7 of the Corporations Act and its regulations.1 These provisions were introduced with effect from 11 March 2002, following a lengthy industry consultation period. They are built on the philosophical concepts of competition, neutrality, cost-effectiveness, transparency, flexibility and accountability, and are designed to promote:
• confident and informed decision-making by consumers of financial products and services;
• efficiency, flexibility and innovation in the provision of financial products and services;
• fairness, honesty and professionalism by the providers of financial services;
• fair, orderly and transparent markets for financial products; and
• the reduction of systemic risk in, and the provision of fair and effective services by, clearing and settlement facilities.
Chapter 7 of the Corporations Act provides for a uniform licensing and disclosure regime for financial services businesses operating in Australia, together with general compliance obligations, reporting and record-keeping obligations and prohibitions on certain types of conduct including unconscionable, dishonest and misleading
and deceptive conduct. The aim is to ensure that minimum standards of competence, capital holdings, reporting and disclosure are met by participants in this industry on an ongoing basis, in order to protect the interests of consumers. It is, at its heart, a consumer protection law.
In addition to this legislative framework, a person in this industry will also need to observe the various policies, guides and information releases issued by Australian regulators that are relevant to their conduct in the industry. These policies build on the legislative framework by providing, among other things, an explanation of the regulator’s interpretation of the law as well as guidance on how, in the regulator’s opinion, financial organisations can meet their obligations on an ongoing basis.
The Australian Securities and Investments Commission (ASIC) is the primary regulator of investment funds and fund managers in Australia, however, a fund manager may also be subject to the policies of other Australian regulators, depending on their operations in Australia.
Australia's financial services laws
As already mentioned, Chapter 7 of the Corporations Act is Australia's principal piece of legislation that regulates the provision of financial services and products in Australia. This Chapter of the Corporations Act (among other things) provides for:
• the licensing of financial services providers including the rules on when a person must obtain an Australian Financial Services (AFS) licence, the exemptions that apply, and the
ongoing obligations of an AFS licensee;
• financial services and product disclosure (both up-front and ongoing disclosure);
• obligations in relation to dealing with client money;
• obligations relating to financial recordkeeping, financial statements and audit; and
• the prohibition on certain conduct relating to financial services and products, including market misconduct, misleading and deceptive conduct, and unconscionable conduct.
The regulation of conduct in Australia’s financial services industry is not limited to the provisions of Chapter 7 of the Corporations Act. The concept of ‘financial services law’2 in the Corporations Act also includes provisions in the Act relating to the operation of registered managed investment schemes, takeovers, fund-raising activities, compulsory acquisition and buy outs, ownership of listed companies and managed investment schemes together with ‘any other Commonwealth, State or Territory legislation that covers conduct relating to the provision of financial services (whether or not it also covers other conduct), but only in so far as it covers conduct relating to the provision of financial
services’.
In conjunction with this regime, certain organisations are also subject to Australia’s prudential regulatory regime operating under various Australian statutes, a brief summary of which is set out in the following table:
Australian regulators and supervisors
There are several bodies that are charged with specific regulatory and supervisory oversight powers within Australia’s financial services industry. As previously mentioned, each regulator has issued policies that outline their interpretation of the laws they are charged with overseeing and provide general guidance or clarification on how an organisation that is subject to such laws can comply with their obligations.
Although, a fund manager operating in Australia will be primarily regulated by ASIC, it may also need to be familiar with the policies of other regulators, depending on what activities the fund manager is seeking to carry out in this jurisdiction.
Despite each regulatory body having a specific mandate to perform designated supervisory and regulatory duties and to administer certain Australian laws, they generally operate under Memoranda of Understandings (MoUs) with each other that allow for, firstly, the exchange of information between regulators that are parties to such agreements and, secondly, co-operation during investigations of financial services businesses. To date, ASIC has signed a Memorandum of Understanding with the Australian Prudential Regulation Authority (APRA),3 the Australian Taxation Office (ATO),4 the Australian Securities Exchange (ASX),5 as well as other Australian institutions such as the Director of Public Prosecutions, and the Reserve Bank of Australia.
A brief description of each regulator and their responsibilities within Australia’s financial services regulatory framework is set out below.
ASIC
ASIC is the financial services, markets and corporate regulator in Australia. ASIC is an independent government body that was constituted under statue.6
In addition to its financial services regulatory and supervisory duties, ASIC is also responsible for overseeing the authorised financial markets in Australia to ensure they are operated in a fair, orderly and transparent manner.
ASIC is also the corporate regulator in Australia, and is involved in registering and de-registering companies as well as monitoring their compliance with the Corporations Act (which includes provisions relating to fund-raising activities, takeovers, financial reporting and directors’ duties).
APRA
APRA is responsible for the prudential supervision of banks, superannuation trustees, life insurers, general insurers and friendly societies operating in Australia.7 Similar to ASIC, APRA is an independent government body that was constituted under statute8 and is responsible for implementing prudential standards, practice guides and guidance notes for these entities, together with monitoring compliance with such standards.
These prudential standards provide minimum standards and general guidance (based on APRA’s interpretation of the legislation it administers) and cover issues such as capital adequacy requirements, outsourcing, fit and proper (for senior management and the board), risk management, adequacy of resources, governance and a standard for managing investments and investment selection (for superannuation trustees), to name a few.
ATO
ATO is responsible for the administration of Australia’s taxation legislation. It is the principal revenue collection agency of the Australian Government.
The head of ATO, the Commissioner of Taxation (Commissioner), from time to time, issues public rulings and determinations that outline the Commissioner’s views on how a particular section of Australia’s tax legislation applies to a category of people or class of arrangements. In addition, a person may apply to the Commissioner for a private ruling which, if granted, outlines the Commissioner's opinion on how a particular provision of the tax law applies to the applicant.
The Commissioner also has certain powers to issue legislative determinations on particular provisions of taxation law (which are legally binding). To date, the Commissioner has issued legislative determinations relating to superannuation as well as income, excise and goods and services tax. Interpretative decisions are also issued that outline the Commissioner’s interpretation of a particular matter in Australia’s tax laws.
ATO also issues various other guidelines, bulletins, policies and case decision summaries, which can be found on its website, www.ato.gov.au.
Endnotes:
Please note that this article is an excerpt from the new book, Establishing a Funds Management Business in Australia, written by Scott Charaneka and Michelle Asimus. This is a new title published by ISI Publications and is scheduled for release in April 2010. To order a copy of this new title, please click here.
1. In addition to setting out Australia’s financial services regulatory framework, the Corporations Act also includes provisions for regulating basic corporate affairs (including
registration, general operation and deregistration of a company), together with provisions for the registration of managed investment schemes and their operation, as well as fund-raising and takeover provisions.
2. Pursuant to the definition of ‘financial services law’ in Section 761A of the Corporations Act.
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The Oil Markets: Let the Data Speak for Itself1
Hilary Till, Premia Capital Management, LLC, Chicago; and Research Associate, EDHEC-Risk Institute, Nice (France)
Hilary Till is co-founder and principal of Premia Capital, a proprietary investment and research firm in Chicago. She is also the co-editor of the book, Intelligent Commodity Investing; a member of the North American Advisory Board of the London School of Economics, and is a Research Associate at the EDHEC-Risk Institute in Nice, France.
Please note: Due to length, this article will run in two parts over two consecutive issues of Alternative Intelligence Quotient; this is the first section of the article and the second half will run in the upcoming issue.
Crude oil prices increased from $19.84 per barrel at the end of 2001 to the lofty level of $124.08 at the end of July 2008, before plummeting to $44.60 per barrel by the end of 2008. Was this oil-price rally yet another speculative bubble like the late 1990s technology-stock boom; or, more topically, will history see this rally as similar to the bubble in US residential real estate values? Specifically,
was the oil rally based on speculative excess rather than fundamental supply-and-demand factors?
We will argue that the answer to this question is a qualified ‘no’, but we acknowledge:
• that many areas of data uncertainty exist in the oil markets, which need to be resolved, given how critical oil is to the global economy; and
• that, in the short-term, it is fully plausible for the activity of market participants to have a strong influence on price.
In the first section of this article, we will explain how futures traders view the role of price, followed by an examination of data and public statements from the International Energy Agency (IEA) on the state of the oil markets during the summer of 2008. We will then discuss how useful petroleum-complex futures markets are in their price-discovery function: even when fundamental data on the oil markets are sparse or opaque, large-scale supply-and-demand shifts leave footprints in futures-price relationships, from which one can
potentially infer the oil market’s fundamentals. In the presence of active futures markets, an observer need not be a member of a cartel or a large corporation to gain insights into the oil market.
We will also discuss how the actions of traders and their algorithmic strategies can impact price, in the shortterm, particularly in a commodity that is exhibiting scarcity.
We will conclude our first section by stating that it would be extremely unfortunate if the oil markets were made even more opaque, which could occur if this became public policy, particularly in the US, to limit oil futures trading (beyond what is needed to prohibit actual or attempted market manipulation).
In our final section, we will explain how an analysis of oil-price drivers is made more complicated by trends in currency values; and that, objectively, one should not exclude this factor in policy debates on what caused the oil-price rally. We will then
conclude with a discussion on the debate surrounding oil as a store-of-value.
The role of price and oil supply-and demand data
The role of price
A sensitive political question has been: in the oil markets, did the fundamentals justify the oil-price rally?
For an oil futures trader, even the premise of this question is perplexing. Instead, a veteran oil futures trader always asks the opposite question: what is the price telling me about fundamentals? The reason
for this difference in outlook is simple. The market imposes sufficient discipline to prevent a trader from ignoring price for anything but a very short space of time. We do not expect that commodity
futures traders will ever have the benefit of a termlending facility, or become the beneficiaries of other large-scale government bail-outs for unwise (or unlucky) financial participants. Commodity futures
traders are instead forced to rely on disciplined risk management, which, ultimately, is based on an in-depth understanding of price and its statistical characteristics.
A futures trader also interprets a commodity’s price as part of a dynamic process. A commodity’s price moves in whatever direction is needed in order to elicit a supply or demand response that will balance a commodity market. It may be useful to review the
technical aspects of this interplay.
For a number of commodities, either storage is impossible, prohibitively expensive, or producers decide it is much cheaper to leave the commodity in the ground than store it above ground.
The existence of plentiful, cheap storage can act as a dampener on price volatility since it provides an additional lever with which to balance supply and demand. If there is too much of a commodity relative to demand, it can be stored. In that case, one does not need to rely solely on the adjustment of price to encourage the placement of the commodity. If too little of a commodity is produced, one can draw on storage; price does not need to ration demand.
Now, for commodities with difficult storage situations, price has to do a lot (or all) of the work of equilibrating supply and demand, leading to very volatile spot commodity prices. A defining feature of a number of commodities is the long lead-time between deciding on a production decision and the actual production of the commodity. It is impossible
to exactly foresee what demand will be by the time a commodity is produced. This is why supply and demand will frequently not be in balance, leading to large price volatility for some commodities.
In the case of oil, it is prohibitively expensive to store more than several months worth of global consumption. Rowland (1997) explained the situation as follows:
‘From wellheads around the globe to burner tips, the world’s oil stocks tie up enormous amounts of oil and capital. The volume of oil has been estimated at some seven to eight billion barrels of inventory, which is the equivalent of over 100 days of global oil output or two and a half years of production from Saudi Arabia, the world’s largest producer and exporter of crude oil. Even at today’s low interest rates, annual financial carrying costs tied up in holding these stocks amount to… more than the entire net income of the Royal Dutch/Shell Group.’
One can look at the aftermath of Hurricane Katrina in the US in 2005 for a good concrete example of the dynamic interplay between an oil product’s price and its supply and demand situation. With the onset of Hurricane Katrina, the price of gasoline (petrol) rallied 18% in four days before falling back about the same amount 15 days later, this is illustrated in Figure 1 below.
Were the markets irrational in rallying so much in four days, given how short-lived these price increases were?
According to a Dow Jones Newswire report (2005) of the time, ‘[Hurricane] Katrina shut in nearly all of oil and gas production in the Gulf of Mexico… The large scale supply disruption and fear of an economic shock triggered a massive government response. The outages prompted the Bush administration to release Strategic Petroleum Reserve Oil, waive air-pollution rules on fuels, and ease restrictions on use of foreign-flagged vessels to carry fuel in US waters.’ Further, ‘Members of the Organisation of Economic Co-operation and Development [OECD] agreed… to [release] two million barrels a day of crude oil and petroleum products from their strategic stocks for 30 days.’
One could argue that this unprecedented government response caused gasoline prices to decline from their post-Katrina peak. Further, and as also illustrated in Figure 1, with that response, fears of an economic slump diminished, which, in turn, caused deferred interest rate contracts to also decline, as the market resumed pricing in the expectation that the Federal Reserve Board could continue tightening interest rates at the time.
With this brief example, we see how the dynamic change in the price of gasoline induced an international and domestic response to increase supplies and that, once achieved, the price responded by quickly decreasing. Quite simply: price did its job.
The fundamentals: Oil supply-and-demand data
We admit that the way that an oil futures trader analyses a commodity market by granting primacy to the role of price may not be satisfactory to those outside the profession. Therefore, let us turn to an objective examination of oil supply and demand data.
Surowiecki (2008) succintly summarised the fundamental supply and demand backdrop: ‘Between 2000 and 2007, world demand for petroleum rose by nearly nine million barrels a day, but the Organization of Petroleum Exporting Countries [OPEC] has been consistently unable, or unwilling, to significantly increase supply, and production by non-OPEC members has only risen by just four million barrels per day.’2
For further fundamental information on the oil markets, we are fortunate to be able to mine the wealth of data provided by the IEA.3 The IEA 4, in turn, is an autonomous agency linked with the OECD and is based in Paris.
The IEA estimated global oil product demand for 2008 at 86.9 million barrels per day, and global oil supply was estimated at 87.8 million barrels per day, according to its 12 August 2008 report.
As of August 2008, the IEA predicted that on the supply side, ‘Oil production in non-OPEC countries is set to peak within the next two years, leaving the world increasingly dependent on supplies from…’ OPEC. Dr. Fatih Birol, chief economist for the IEA, explained the situation, which prevailed as of July 2008, to Pagnamenta of The Times [of London] (2008): ‘The days of the international [Western] oil companies are coming to a glorious end because their reserves are declining and they will have difficulty accessing new reserves.