| This is cool: A growing number of hedge funds are helping banks recycle the risks stemming from deal contingent trades, a risky type of derivative that banks sell to corporates and private equity firms looking to hedge financial market moves ahead of the completion of major mergers and acquisitions. At least four hedge funds are active in helping banks offset deal contingent risks, according to industry experts, compared with just one a few years ago. That is helping create a secondary market for the risks stemming from these complex trades and enabling banks to underwrite more – and larger – deal contingent transactions than ever before. “We are regularly facing a lot larger [deal contingent hedging] opportunities than in the past,” said the global head of foreign exchange structuring at a major dealer. “The fact that banks’ appetite [for deal contingent risk] has increased is linked to the fact that there’s now an ability to distribute that risk in the market to hedge funds, allowing us to take on larger deals through risk recycling.”
The idea of a deal-contingent hedge is that, if a company signs a deal to acquire another company, that deal won’t close for a few months, and when it does, the buyer will need to come up with the money. This might involve borrowing the money and/or converting it from the buyer’s currency into the target’s. This creates risk: Between signing and closing, the exchange rate might move against the buyer, or interest rates might go up. The buyer might want to hedge this risk by locking in an interest rate or an exchange rate at the time of signing. That’s generally pretty simple to do: You buy a bunch of foreign currency today (or do a forward) to lock in your exchange rate, or you borrow a bunch of money today (or do an interest rate swap) to lock in your interest rate. But there is another risk: The deal might not close. (Regulators might block it, the target’s shareholders might vote no, another bidder might emerge, etc.) And if that happens, the buyer will not want to be stuck with a bunch of foreign currency and/or borrowed money that it doesn’t need. And so there is a market for the buyer’s banks to say “we’ll do a trade where you lock in an exchange rate and/or interest rate today, and you get that rate when the deal closes, but if the deal doesn’t close we’ll tear it up, never mind.” That’s a good product for the buyer, a good hedge to its actual risks. (And so the buyer will pay the bank a premium for it.) It’s a tough product for the bank to manufacture, though, because it puts the risk of deal closing on the bank. The bank needs to correctly estimate the likelihood of the deal closing to hedge the derivative, and if it gets it wrong it could lose a lot of money. In an earlier era you’d say “yes, the job of an investment bank is to use its balance sheet to facilitate risk management trades for clients, and to be smart and good about managing the risks of those trades.” In 2024 that is not quite right. In 2024 it is the job of a big hedge fund to use its balance sheet to facilitate risk management trades; it is the job of an investment bank to bring the hedge funds those trades. The investment bank has the client relationship; the hedge fund takes the risk: Hedge funds are comfortable holding these chunky exposures because they don’t face the same regulatory and risk constraints as banks. It can also be a lucrative business as banks are often willing to pay handsomely to offload deal contingents on public transactions that can involve billions of dollars of risk. It’s these riskier, public M&A deals that hedge funds are most interested in taking off banks' hands, in part because there's often a higher chance of failure, meaning the hedge will be more expensive. There also tends to be more information around the proposed transaction to scrutinise.
This relates to two stories that I write about from time to time around here. One is about the retreat of banks (and investment banks) from many sorts of balance-sheet risk, and the rise of other firms — hedge funds, proprietary trading firms, private credit firms, etc. — to replace them. Banks have risky funding models and a lot of regulation, so it is tougher than it used to be for them to take big proprietary risks on mergers closing. But hedge funds are less regulated and happy to take over that business, for a price. The other is about the economic function of hedge funds. You can sort of tell two stories about what it is that a hedge fund does: - One story is “a hedge fund is full of smart people who have some advantage at predicting financial asset prices, so they buy things that will go up.” Hedge funds find uncorrelated sources of returns and then bet on them. They are essentially making bets in a casino, and they are smart bettors.
- The other story is “a hedge fund is a financial intermediary that provides a set of services to long-term fundamental investors and other participants in the real economy, though it usually provides those services indirectly: It is on the other side of some trade that people want to do for fundamental reasons, and it gets paid, in expectation, for that service.” So we have talked about the basis trade, which is arguably “hedge funds bet that Treasury bond prices will converge with Treasury futures prices” — a pure smart-betting story — but which is more sensibly described as “pension funds want to get their duration via Treasury futures, and Treasury wants to sell bonds, so hedge funds intermediate that trade by buying the bonds, using them to manufacture futures, and collecting a spread.” Or yesterday I mentioned the index arbitrage trade, which is “index funds want to buy stocks the day they are included in the index, so hedge funds buy them up ahead of time to deliver to the index funds, and collect a spread for their trouble.”
Here, you can tell both stories. The hedge funds have smart people who can analyze whether a merger will close — they have a merger arbitrage desk, for instance, that bets directly on whether deals will close — and they have smart people who can price foreign-exchange and interest-rate derivatives, so they think they can do a good job of pricing deal-contingent derivative risk, and they can get paid for being right. On the other hand, they are also obviously providing a service to real companies, mitigating risks and making it easier for mergers to happen in the real economy. They are providing, essentially, a banking service. They get paid for being right, and lose money if they’re wrong, but in expectation they should mostly get paid, because they are doing something useful. In May, the US stock market transitioned to T+1 settlement. Before the transition, if you bought stock on a Monday, the trade settled — you got the stock and delivered the money — on Wednesday (T+2). After the transition, if you bought stock on a Monday, it settled on Tuesday. Ahead of the transition, people were worried, and I suggested that there were three ways it could go: - Smoothly,
- Disastrously, or
- Smoothly enough that the US stock market would not crash, no big financial institutions would be bankrupted, and I wouldn’t have to think about it much anymore, but disastrously enough that stock settlement professionals would moan about how many problems it caused.
That was a few months ago, and I am now pretty sure that the T+1 transition was not a visible-to-the-naked-eye disaster. But are settlement professionals moaning about it? Yes: This year’s seemingly smooth transition to a faster settlement regime for US stocks turns out to have been far from plain sailing for many industry players, according to Citigroup Inc. From overhauling arcane funding processes to relocating traders across oceans, the late-May switch to the system known as T+1 proved tougher than expected, the bank found in a survey of market participants. The scale of the changes required — which affected multiple divisions including funding, FX and securities lending — caught out many in the industry, the poll shows. Meanwhile, the impacts of the switch appear to have been felt unevenly, with the likes of asset managers hit with higher funding costs as banks and other intermediaries see expenses drop. “Every area appears to have been more impacted than originally anticipated, from funding to headcounts, securities lending and fail rates,” the Wall Street bank’s securities services arm said in a report released Wednesday. “Investment budgets have been diverted, non-critical projects delayed and essential resources borrowed.”
The basic intuition here is that if settlement takes two days, then brokers take two days of risk that their customers will not deliver securities or cash and the trade will fail. This risk is expressed in things like clearinghouse margin, where the broker posts some cash to a clearinghouse to cover the risk of client failures. If settlement takes one day, that risk is substantially reduced, so the broker doesn’t need to post as much cash. Meanwhile, if settlement takes two days, then the customer can do a trade and take two days to line up funding for the trade. If settlement takes one day, the customer has less time to line up funding. In fact, because of various mismatches (you might be in a different time zone, foreign exchange markets might be quiet, your bank might be closed, etc.), the customer might have to line up funding before agreeing to the trade, keeping cash lying around in the US to be able to trade stocks. And so T+1 settlement reduces systemic risk and broker costs, while increasing customers’ funding costs and headaches: The single biggest impact for brokers and custodians has been a roughly 30% reduction in clearing margin, with some 80% of the sellside calling the development strongly impactful to their business. In contrast, 46% of buyside respondents say they’re having to cover significant funding gaps during the settlement process as they navigate between T+1 and T+2 regimes (the latter is still standard in Europe and in the global currency market).
This does seem mostly like T+1 working as intended. Here’s a business model: - Write insurance on some essential part of the economy.
- Underprice the insurance: Charge $60 for insurance that will predictably pay out $100 in a few years.
- Win a lot of market share: Your insurance is cheaper than everyone else’s, so customers will prefer you.
- Invest the float and pay yourself nice bonuses.
- Eventually, you will get insurance claims, you won’t have enough money to pay them, and you’ll be insolvent.
- Oops! It’s fine, though. The thing you are insuring is so essential that the government will probably bail you out.
This is … you know, this is such an obviously good business model that it’s kind of the whole point of insurance regulation to prevent it? Of course if you could undercharge for insurance, keep the money, and not pay out claims, that would be a good business, so insurance regulation is designed to make sure that insurance companies actually keep enough money to pay their claims. It’s not perfect though: American Transit, also known as ATIC, insures roughly 60% of New York City’s more than 117,000 commercial taxis, livery cabs, black cars and rideshare vehicles. It’s also insolvent. Run by Ralph Bisceglia, ATIC has for decades been the dominant player in New York City’s commercial car insurance market, the largest in the country, offering cabbies premiums far lower than other insurers. In the second quarter, it posted more than $700 million in net losses, according to a filing with the National Association of Insurance Commissioners. ... “There is a perception that they are too big to fail,” said Andrew Don, chief operating officer of Research Underwriters, a transportation insurance broker. If that happened, “there would be a large void in the ability to get a taxi or an Uber or a Lyft or a limo in New York as all of these vehicles would suddenly be without insurance.” … “[The New York Department of Financial Services] has to step in and do something,” said Matthew Daus, a partner at law firm Windels Marx and the former chairman and commissioner of New York City’s Taxi and Limousine Commission. The company’s latest financial filing paints a picture so dire that it’s “creating unrest in the industry,” said Daus, who founded Windels Marx’s Transportation Practice Group. ATIC has been underpricing insurance for decades, snapping up business from competitors, Daus and other transit and insurance industry officials told Bloomberg. “The premiums that they were charging were not commensurate with the risk they were taking on,” Research Underwriters’s Don said.
Apparently. I like that, in New York, the too-big-to-fail industry is taxis and Ubers. This story is a little reminiscent of an amazing working paper titled “When Insurers Exit: Climate Losses, Fragile Insurers, and Mortgage Markets,” by Parinitha Sastry, Ishita Sen and Ana-Maria Tenekedjieva, about the Florida home insurance market. (Bloomberg’s Leslie Kaufman wrote about it in April.) The basic story is that there are a lot of parts of Florida where it is very risky to insure a home, and in response to that fact (1) traditional insurers don’t insure homes there, (2) new, riskier insurers step in to sell underpriced insurance and (3) this is all allowed because the new insurers get somewhat dubious credit ratings: Using Florida as a case study, we show that traditional insurers are exiting high risk areas, and new lower quality insurers are entering and filling the gap. These new insurers service the riskiest areas, are less diversified, hold less capital, and 20 percent of them become insolvent. We trace their growth to a lax insurance regulatory environment. Yet, despite their low quality, these insurers secure high financial stability ratings, not from traditional rating agencies, but from emerging rating agencies.
Sort of a traditional bad story: underpriced insurance, risky insurers and regulatory gaps. But there’s a second part to the story: Importantly, these ratings are high enough to meet the minimum rating requirements set by government-sponsored enterprises (GSEs). We find that these new insurers would not meet GSE eligibility thresholds if subjected to traditional rating agencies’ methodologies. We then examine the implications of these dynamics for mortgage markets. We show that lenders respond to the decline in insurance quality by selling a large portion of exposed loans to the GSEs.
If you are a mortgage lender in Florida, you care about homeowner’s insurance: If the home gets washed away in a hurricane, the insurance had better pay out, or else you’re not getting paid back on your mortgage. If you suspect that some insurers will also get washed away in a hurricane, you won’t want to hold mortgages against houses that they insure. Fortunately (for you), there is a profit-maximizing solution: You make the mortgage, but then you sell it to Fannie Mae or Freddie Mac, so that the credit risk is their problem. (And Fannie and Freddie are insensitive to this risk.) Instead of the government having to bail out the insurers after the fact, it can do it in advance using the GSEs. One person with a fascinating job is whoever runs the US Securities and Exchange Commission’s Task Force for Fining Everyone for Texting About Work on Personal Cell Phones. In the beginning, that was a creative, risky job. When you first went to the chair of the SEC and said “I want to start fining everyone for texting about work on their personal cell phones,” there was a possibility that he would say “what, no, it’s not illegal to text about work on your personal cell phone.” Maybe that was not that big a risk — the SEC chair is Gary Gensler — but maybe other people would say that. Maybe you’d go to the big banks and say “we think you have employees who text about work on their personal phones” and the banks would say “yeah probably” and you’d say “okay we’re fining you a billion dollars for that” and they’d say “what, no, that’s not illegal, we’ll see you in court,” and you’d go to court and a judge would conclude that it’s not illegal to text about work on your personal cell phone. And then the whole Task Force for Fining Everyone for Texting About Work on Personal Cell Phones would shut down ignominiously without extracting any fines. But that is in fact not what happened: The SEC extracted a $200 million cell phone settlement from JPMorgan Chase & Co. in 2021, and that got the ball rolling for a couple of billion dollars of bank fines, and at that point the task force was off to the races. And then the job probably got more boring. Coming up with the theory — that texting about work on your personal cell phone violates a 1948 SEC regulation requiring every broker to keep “originals of all communications received and copies of all communications sent by such member, broker or dealer (including inter-office memoranda and communications) relating to its business as such” — and persuading banks that it was correct was an impressive creative leap, but after that it’s all pretty cookie-cutter. You come into work each day and ask yourself “what other sorts of financial services firms could we fine for texting about business on their cell phones,” and you go down the list. You started with the biggest banks and extracted the biggest fines, but three years into the program you’re rounding up the cats and dogs. For instance, you might eventually get around to the awkward fact that SEC employees, like everyone else, also sometimes discuss work on their personal cell phones. On the other hand eventually someone might push back — none of these cases have been litigated; they all settle — and that might be exciting. Anyway, ratings agencies: The Securities and Exchange Commission [yesterday] announced charges against six nationally recognized statistical rating organizations, or NRSROs, for significant failures by the firms and their personnel to maintain and preserve electronic communications. The firms admitted the facts set forth in their respective SEC orders; acknowledged that their conduct violated recordkeeping provisions of the federal securities laws; agreed to pay combined civil penalties of more than $49 million, as detailed below; and have begun implementing improvements to their compliance policies and procedures to address these violations.
Okay. Here’s the one against Moody’s Investor Service Inc., which is paying $20 million: Moody’s Ratings employees, including those at senior levels, have communicated using personal mobile devices by text message and other messaging platforms, such as WhatsApp, since at least January 2020 (“off-channel communications”). The messages included discussions of initiating, determining, maintaining, monitoring, changing, or withdrawing a credit rating (“Credit Rating Activities”).
Probably. You can’t do that, apparently. We talked yesterday about the problems with triple-leveraged exchange-traded funds. Basically: Those ETFs try to match three times the daily returns of some stock (or index, etc.). If that’s what you want, you get it (minus fees). But if you want three times the long-term return of the stock — or even, like, three times the monthly return — you might be disappointed. If the underlying stock is volatile, tripling its daily returns will not get you triple its long-term returns. In particular, we talked about a 3x levered single-stock ETF on MicroStrategy Inc.: MicroStrategy was up about 110% year-to-date, with a ton of volatility; the ETF was down about 80%. If a stock is up 8% one day, down 7% the next, etc., it will go up a lot over the long term, but if it is up 24% one day and down 21% the next, it will go down over the long term. (Here is a 2010 article titled “Leveraged ETFs: All You Wanted to Know but Were Afraid to Ask,” which goes through the math for how far a leveraged ETF will deviate from its underlying, given the volatility of returns.) I pointed out that this is not an inherent feature of leveraged ETFs. You could imagine an ETF that is like “we give you 3x the annual returns on Stock XYZ.” The problem is that ETFs trade every day, and they advertise some experience (“3x the returns on a stock”), and people want that experience whenever they trade. A triple-annual-return ETF would work perfectly for someone who bought it on the launch day, but after that, if the stock is up or down and you buy the ETF, you will not get exactly three times the returns on the stock from the point at which you buy it. The daily rebalancing is a requirement to make the ETF work every day. But you could just give up that goal and get an arguably more sensible longer-term product. Coincidentally, also yesterday, someone launched that: Tradr ETFs, a provider of ETFs designed for sophisticated investors and professional traders, [yesterday] announced the launch of eight leveraged ETFs as part of its new series of "Calendar Reset Leveraged ETFs." Tradr's new products reset their performance target on a calendar week or calendar month, providing an alternative to the daily resets offered by today's leveraged ETFs. The launch represents a profound advancement in the world of leveraged trading that will significantly expand the possible uses of leverage for a variety of investment purposes. The six new ETFs below seek 200% exposure to the weekly or monthly performance of the SPY ETF and the Invesco QQQ ETF for broad U.S. equity exposure, and to the SOXX ETF for semiconductor industry exposure. … Weekly ETFs reset performance each calendar week on the last trading day of the week, while monthly ETFs reset on the last trading day of the calendar month. Tradr also plans to launch several ETFs with calendar quarter resets on October 1. … Calendar Reset Leveraged ETFs provide a practical alternative to daily leveraged ETFs, which are specifically designed to generate an amplified return for one day only and are best suited for day traders. Years of data show that many investors hold dailies for several days, weeks or even months, leading to several challenges. The first is the erosion of returns, or "volatility drag," caused by day-to-day price movements in the underlying security, which in turn compounds over time making it difficult to achieve the targeted leverage multiple. In addition, use of daily ETFs usually requires frequent position monitoring and rebalancing, which is time consuming and potentially generates unnecessary trading costs.
If you buy the calendar month ETF on the 10th of the month, you will not get exactly 200% of the index’s performance for the rest of the month. But if you buy it on the first of the month and hold it until the end of the month, you will, which is nice. One other clarification of yesterday’s column. In writing about the problem of volatility — if you triple the returns of a volatile stock that goes up a lot over the long term, your tripled product might go down over the long term — I wrote that it was only a problem of volatility, and that “if the stock goes steadily up (or down), 3x the daily return will end up getting you roughly 3x the long-term return.” That’s approximately true if by “steadily up” you mean “with limited volatility.” But if you mean it literally, I mean, if the stock goes up 1% per day for a month, then at the end of the month it will be up about 23%; if it goes up 3% per day, it will be up 86%, which is more than triple. This is an arithmetic point but it is also a practical one. If you buy a triple-levered ETF thinking “this stock is going to go up every day for the next week,” and you’re right, then it’s great, better than getting triple the weekly returns. You just have to know what bet you’re making. This is a long-running piece of advice (though not legal advice) around here, so I feel like I have to point out the duck bribes. Here’s a US Department of Justice case against Linda Sun, a former New York government official, for allegedly working as an agent of the Chinese government: Acting at the request of PRC government officials and the CCP representatives, Sun engaged in numerous political activities in the interests of the PRC and the CCP, including blocking representatives of the Taiwanese government from having access to high-level New York State officers; changing high-level New York State officers’ messaging regarding issues of importance to the PRC and the CCP; obtaining official New York State proclamations for PRC government representatives without proper authorization; attempting to facilitate a trip to the PRC by a high-level New York State politician; and arranging meetings for visiting delegations from the PRC government with New York State government officials. … In return for these and other actions, Sun received substantial economic and other benefits from representatives of the PRC government and the CCP, including the facilitation of millions of dollars in transactions for the PRC-based business activities of Hu; travel benefits; tickets to events; promotion of a close family friend’s business; employment for Sun’s cousin in the PRC; and Nanjing-style salted ducks prepared by a PRC government official’s personal chef that were delivered to the residence of Sun’s parents.
She allegedly got a lot of other, more obviously monetarily valuable stuff, but I kind of respect a person who would work as a spy and get paid in salted ducks. I bet the ducks were really good? Nvidia Gets DOJ Subpoena in Escalating Antitrust Probe. Nordstrom Family Offers to Take Chain Private for $3.8 Billion. Companies Approved $107 Billion in Buybacks Ahead of Latest Rout. SPACs are back. Rise of the Pint-Size Startup Is Reshaping the U.S. Economy. High Rates Expose Global Banking’s Multi-Trillion-Dollar Weak Spot. Russia built covert trade channel with India, leaks reveal. Uber Kicks Off Its First Bond Sale as Investment-Grade Company. Trump Media stock keeps sinking as Donald Trump's share dump nears. Elon Musk’s Starlink agrees to block X in Brazil. America Must Free Itself from the Tyranny of the Penny. If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks! | 
