July 17, 2007
Is this the demise of Dow?
Like all things in the universe nothing is forever and an era that stretches out a hundred and eighteen years is about to come to closure. Dow has been so tied to that of markets, market risk and trading that I felt it worthy to pay homage to something that has been the very genius loci ('The Spirit') of the American markets for over a century.
To be precise Rupert Murdoch's News Corp is making a bid of USD $5Bn for the ownership of the Bancroft's Dow Jones business. While this occurred a couple of months ago, News Corp has been battling accusations that the paper won't remain independent. Tomorrow the Bacroft's family will hold a meeting to discuss the latest offer by Murdoch and the very future of Dow Jones is tied to that outcome. The directors of Dow Jones are of course searching for a bidder to rival the News Corp pitch and for many reasons however no-one has come forward with an offer that puts a lid on News Corp's $60 a share.
So you are probably wondering what has any of this got to do with risk ... Well a hundred or so years ago the very reason Dow Jones existed was because of risk, perhaps today that still is still the case.
In November 1882 Charles Dow and Eddie Jones, two aspiring journalists with an analytical bent clambered into bed with a banker of that time known as Charles Bergstrasser. It certainly does sound like a precarious bunch for a brokerage publishing business but within two years they had their own hand cranked printing press and the company had so many clients they updated their brokerage news feed into an electronic news ticker which was originally referred to as 'broad tape'.
Peter Bernstein's book Capital Ideas puts it this way:
'At heart Dow was a scholar rather than a speculator. He was more interested in interpreting the history of the stock market than in devising a system for predicting its future. The world has read his interpretation otherwise.'
This journalist Mr Dow was a market publisher that contributed to the world of risk by creating the Dow Jones Averages. In its essence it consisted of closing prices grouped by company type to provide an overall measure of the performance from trading activity throughout each day on the New York Stock Exchange.
As Dow was known to put it 'The industrial market is destined to be the great speculative market of the United States' and the embodiment of a mean for daily risk taking that Dow published day in day out became the auspicious paper for traders both in and out of the United States. The approach was eventually coined Dow Theory and it attempted to explain trends in stock prices by aggregating indicator variables within the market.
Now many market risk people of today run around with Gaussian copulas and complex netting systems to explain volatility in overall trades and they are likely to see this as really quite a primitive explanation of what goes on in the market place. Yet, it was a very first publication attempt to introduce central limit theorem to investors when back then speculation printed on carbon paper was all the rage.
Some months before Dow died his analytical publication business was sold to Clarence Barron for the sum of $130,000. Barron was so proud of the business he was quoted saying 'Savings in the United States may become investments, when guided by financial knowledge' and apparently passed away holding the posts of the Dow Jones and Wall Street Journal. The business was handed down to Barrons daughter and has remained in the Bancroft family till today, well perhaps Thursday this week. A successful bid by News Corp will bring Dow Jones publications and the Wall Street Journal into the same realm as News Corp's New York Post and The Times in the UK.
One does ponder what Dow would think of such a deal if he were here today?
Posted by CausalEvents at 10:28 PM
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July 12, 2007
Who is up for a trolley of Herstatt?
An interesting trend that is beginning to amuse me is the ever increasing segmentation of exposure types. Only a few years ago, perhaps one generation and well before ISO 9000 standards on quality existed, banks in general really only saw risk in a handful of domains. The first is an obvious play because it in itself is the merchandise of underwriting risk and is well known as the business of insurance. Staying in the domain of putting a value (dare I say a bet) on a threat would also take in the business of market based investment which is known to most as market risk and this is defined by the Basel committee as the risk of losses in on-and off-balance-sheet positions arising from movements in market prices. The pure domain of choosing to put funds at risk or not would also translate to lending and credit risk features very heavily in the Basel Accord. Today however I look up on some of the risk news sites and we have a whole shopping trolley of risk products including but not limited to interest rate risk, energy risk, weather risk, political risk, country risk, model risk and a new comer 'Corporate Defense Management'. The latter I personally see as an extension of operational risk, none the less people are talking about it even though one does have this real sense that some of the community out there are creating their own spins on an event to lobby their circumstances favorably. These people seem to wrap up a threat in risk classification propaganda to give it credibility and fear, then sell the world a panacea to such a pathogen.
Now if I were to ask you 'Do you know your Herstatt Risk'? You'd probably ask what are you going on about Martin and yet Herstatt risk is the very creature that kicked this whole risk regulation game over in the world of banking.
So what is this Herstatt thing?
The regulators certainly know what it is and to them it is one of the worst demons of all risks because it could result in a total melt down of the financial sector specifically where institutions owe each other payments but have not settled. So where did it first arise?
In 1974 a bank in Germany known as Herstatt was closed by the regulators leaving all its foreign-exchange positions open and unpaid, swiping an institution with an asset base of back then DM 2.07 billion in a matter of hours. Quite spectacular are the words the Bank For International Settlements now uses. Before Herstatt most threats created by banks were localised and manageable however Herstatt brought the world to a scary awakening through its foreign exchange business. In the end that foreign exchange business amounted to an unbelievable loss that was four times the size of the banks capital base.
Herstatts first mistake was to speculate on dollar appreciation and depreciation cycles which unfortunately for Herstatt moved in the opposite direction to their predictions. The problem was not so much in their strategy and for what its worth this is not the first or last investment strategy that fails on a market. The Herstatt case is unique in that the bank had 'borrowed' to finance their positions and they did this by taking foreign currency receipts in Europe and not making any of the US dollar payments.
Herstatt embodies a type of settlement risk which results from alternate layers of transaction settling in different time zones or perhaps where a banks netting system between segments of its clearing and settlement process is flawed in its workflow. Where foreign currency or asset backed swaps are involved Herstatt risk has a real potential to present itself especially with banks that have not mapped their clearing and settling procedures thus leaving pockets of fund catchment open. In the actual Herstatt bank case the institution was closed by the regulators sharply and even though the bank had taken payments for specific transactions and issued orders for more receipts, the US payment component did not clear because the US banking hours were behind that of Germany. The whole process was so convoluted that the three largest German banks that attempted to organise a joint bail out of Herstatt failed, there was simply a total lack of transparency about the magnitude of positions that had been taken and there were so many parties carrying the weight of the transactions it was extremely difficult to untangle. In the end a committee was formed to assist in the liquidation of Herstatt.
This committee and the potential magnitude of the event prompted many nations to also establish a central body for banking supervision which was passed into the Bank For International Settlements and just one year later that very committee adopted its 'Basel Concordat'. Basel Concordat put emphasis on host and home country authorities to share the supervisory responsibility for local banks entertaining foreign activities and was an outcome of Herstatt. So while so many risk analysts out there may never have heard of Herstatt, it very much affects their lives today. The Basel II accord is so globally impacting that it has been reckoned by many in the market as being the most impacting regulation pressed against financial institutions to date.
Posted by CausalEvents at 03:13 PM
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