Margin calls and Clearing Houses

If two investors are striking a deal to trade an asset in the future for a certain price, there are obvious risks. One of the investors can "disappear" or simply step back on his commitments in some way. Alternatively, the investor can be out of funds to honor the agreement. If the deal was agreed directly between two investors, on the Over The Counter (OTC) market, the both are carrying all these risks. Another, more secured option, is to strike the same deal on the organized exchange market, whose key role is to avoid defaults. Natural question would be, why don't we use the second option only? Even more surprising is the fact that the most of such trades are still done on the OTC market. Something goes wrong here, isn't it? In fact no, in order to secure trading, the exchange requires all participants to post a certain amount of money aside. So investors have to pay when the contract is signed on the organized exchange, while on the OTC market they have not to do that. For the most of investors "have to pay" means less money to invest elsewhere => less exciting. In this article we will examine the way how the deals on the organized exchange are regulated.

Daily Settlement and Margins

As usually we are going to take an example to illustrate how the things are fitting together. Let's consider an investor who calls its broker to buy 2 December oil futures contracts. Let current future price is 100 USD per barrel. To simplify we consider that contract size is 1 barrel. So our investor has contracted 2 barrels at this price for a total amount of 200 USD. To secure the transaction the broker will require to post an initial margin of 50 USD (25% of the contract amount). This amount will be deposited in a margin account, managed by the broker. So at the time contract is signed the investor have to pay 50 USD to its broker.

The price of the oil is fluctuating through trading days, so the price of the barrel tomorrow won't be the same as it is today. Obviously the price of the contract will follow this price change. At the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss. This practice is referred to as daily settlement or marking to market. If barrel price decreased by 4 USD then 4 x 2 = 8 USD will be withdrawn from the margin account and it will pass to 42 USD from initial 50 USD. If next day the price of the barrel would rebound of 3 USD, then the margin account would rise back to 48 USD.

But what would happen if the barrel price falls drastically? In this case we are facing a risk that the margin account could become negative and obviously it is not something that exchange would accept. To avoid such a situation maintenance margin comes into play. Maintenance margin is lower than initial margin and it serves to define some kind of red line to the investor. Once this red line is reached the broker asks investor to top up its margin account to bring it back to the initial margin level (50 USD in our example). Let's imagine that that broker defined a maintenance margin as 80% of the initial margin or 40 USD. So if barrel's price falls by 5 USD or more the broker will ask investor to top up his margin account by 10 USD (or more) to return back to 50 USD account. In this situation the investor has to pay again.

Basically that's it.... This is how the exchange is regulating future contract deals.

Clearing

All this process is pretty straightforward and hopefully is clear at this stage. Broker is strongly involved into the settlement process, but what happens if broker itself fails to meet its commitments ? Indeed broker is just a financial company that can be solid and strong but also weak and fragile. The latter characteristics are not acceptable for futures trading supervision. This is a reason why clearing houses where created. Clearing house is an intermediary in futures transactions. It has a number of clearing house members or clearing brokers, who must post funds with the clearing house. Brokers who are not members themselves must channel their business through a member. So we have some kind of chain where investor is required to maintain a margin account with a broker, broker - with a clearing house member and finally clearing house member - with the clearing house:

Investor => Broker => Clearing House Member => Clearing House

If investors deals with a broker who is already a member then this chain simplifies by one layer. As clearing house member maintain a margin account at the clearing house then clearing house can require to top up its account if it reaches some level considered as dangerous. This process is known as a clearing margin. This works in the same way as between investor and its broker; the only difference that there is no maintenance margin on this level. Indeed every day the account balance for each contract must be maintained at an amount equal to the original margin.

Netting

In determining clearance margins, the clearing house calculates the number of contracts outstanding on either gross or net basis. Suppose a clearing house member has 2 clients : one with a long position in 20 contracts, the other with a short position in 15 equivalent contracts. Gross margin would calculate clearing margin on the basis of 35 contracts; net margining would calculate on the basis of only 5 contracts. Basically long and short positions are mutually compensating. Most exchange currently use net margining.

Conclusion

The level of margin can sometimes be used as a tool to control futures market activity. Lower margin levels would allow speculators to to take larger positions with the same amount of money being put aside. On the other hand higher margin levels are likely to make debt based speculation less attractive. For example in mid-2008 the oil prices reached historical levels due to derivatives speculation. These prices were undermining the real economy and I don't still understand why regulators didn't use this tool to take control over the speculation wave.

Finance: From Business to Business

Today's large financial firms are hosting various and sometimes complex activities. They are rarely can be considered  as banks in a classic definition of the term. Indeed many financial institutions are involved in commercial and investment banking, capital management and sometimes even insurance business. Let's have a look into the structure of a typical financial institution and try to understand how all its parts are fitting together.

Commercial Banks

Commercial banks are the banks having the most traditional role of taking deposits and making loans while loans interest is greater than the interest paid on deposits. So the main source of revenues for a commercial bank is a spread between the cost of funds and the lending rate. Depending on the clients and amounts implied, commercial banking can be classified as retail banking or wholesale banking. Retail banking deals with private individuals and small businesses while wholesale banking provides banking services to medium and large corporations, investment funds and other financial institutions. Obviously the amounts of loans and deposits much higher in wholesale banking than in retail banking.

Investment Banking

This is probably the most obscure business in the banking sector. This obscurity is not necessary related to a lack of transparency but because the investment banking is holding a lot of various activities underneath. Public media are often presenting the investment banks as a group of conceited and insatiable traders who are capable to drive the world's economy to a collapse just to increase their own profits. Such persons certainly exist in the investment banking but fortunately this is not what the business is targeting for.

The main activity of investment banking is raising debt and equity financing for corporations or governments. The typical scenario is when a corporation approaches an investment bank when it needs to raise additional capital. This raise of capital can be achieved by issuing of a corporate debt, public offering of common stocks or some hybrid instruments such as convertible bonds. Basically investment bank can be seen as a mediator between a corporation which needs extra capital and investors who are happy to invest in it via capital markets.

Another important role of the investment bank is to offer advice to corporations in terms of merges and acquisitions, corporate restructuring etc. They will assist in finding mergers, takeovers, break down corporation into divisions to sell them separately to other corporations.

Investment banks can even design and sell to its clients custom financial products. These products can be standardized or not. The examples of these products are the warrants, options, ABS, CDO, CFD etc. Not standardized products are often called structured products and they are designed to address concrete client's needs, usually to hedge from some specific risks. Often investment banks are providing liquidity for these products in order to allow investors buying or selling them at any time. This liquidity management activity is often referred as market making.

Prop Trading

Proprietary trading refers to an activity when a bank takes a speculative position in the hope of making a profit. In other words it trades for its own account. The trading firm can trade stocks, bonds, currencies, commodities, their derivatives, or other financial instruments with the firm's own money. They may use a variety of strategies including very aggressive ones much like a hedge fund. Large investment banks often have this activity along with brokerage business. This is probably the most famous and contested activity that we can come across in various Hollywood movies about traders and large investment banks. For that many people have a wrong impression that this is the only activity of the investment banking business. The reason of criticism come from the definition of the "own account". For a large financial institution that has an investment banking activity the "own account" often means "depositors money"....

Brokerage

Brokerage firms are facilitating the buying and selling of financial securities between a buyer and a seller. Brokerage firms don't have any particular investment strategy, they are just processing client orders. Brokers can be considered as a middleman between client and the capital markets where clients can be asset managers, hedge funds, institutional investors, pension funds or individuals. Brokerage firms are taking profits from the commissions charged to their clients. In practice the real brokerage firm suggests many other services to its clients like researching the markets, recommendations of what to buy or sell etc.

Worth noting that brokerage firms are not just forwarding the orders to the market. It can be the case for some small orders. But the main chunk of the added value of the broker relies in the large orders and order baskets processing. Indeed very large orders cannot be directly sent to the market as they are likely to unbalance supply and demand (order book) and the price of the instrument will jump or fall drastically. This is where various trading algorithms are coming into play. Brokers are trying to provide a better price to its clients so they are usually splitting large orders into smaller parts and sending them to the market at an appropriate time defined by the strategy. Sometimes brokers are providing custom trading algorithms to their clients who are interested in some specific trading of their orders.

Asset Management

The objective of an asset manager is to invest client's money in the most efficient way. In the most of the cases asset managers suggest collective investment schemes like mutual funds, pension funds, exchange traded funds etc. to their clients. Asset managers are mainly targeting small and medium investors who are looking for broader diversification with a minimum costs. Indeed it can be difficult for a small investor to hold enough stocks to be well diversified and maintaining a well-diversified portfolio can lead to high transaction costs. As long as asset managers are mostly targeting small investors their business is pretty much standardized and overseen by financial regulators.

Usually asset managers have a benchmark that is clearly mentioned for each product being commercialized. This benchmark can be a broad index like S&P 600, Dow Jones, Dax, some bond or commodities index etc. Asset manager can commercialize funds with active management and/or index funds. Funds with active management are trying to beat the benchmark with respect of the fund's risk profile. Index funds and Exchange Traded Funds (ETF) are just following benchmark without applying any extra investment analysis. ETFs become more and more popular as they are traded on the market as usual common stocks while traditional mutual funds are not traded on the market and using subscription approach based on some fixed price per fund's share. Index funds and ETFs are much cheaper in terms of management fees than actively managed funds what partially explains their success. However actively managed funds allow investors benefiting of the manager's experience and knowledge.
Asset mangers earn money with management fees. Each year fund manager charges some percentage of assets to its clients. These fees are deduced from fund's overall performance. Some funds have extra entry fees and even exit fees but it becomes less and less. Actively managed funds can charge around 2%-5% per year while index funds and ETFs are usually charging around 0.2%-1.5% plus eventual leverage costs if fund is using leverage.

Criticism
There is a lot of criticism towards asset management in general and especially actively managed funds. Due to the strong regulation of the actively managed funds they are often constrained to implement the most efficient strategy. For example even if a fund manager is expecting stock market downturn, he can be forced to be invested at some level of its assets by regulators. This level can reach 90% in some cases! Another point of criticism is that asset manager always wins. Sounds funny but it is true. Even is the benchmark fell of 40% and the fund indexed on this benchmark fell "just" 30% the asset managers did a great job and they will still charge fees to their clients. Another VERY annoying point about actively managed funds is that subscription becomes valid in some period of time after client had requested it. Usually the subscription is validated next day for the next day price! With current market volatility it can be very risky to subscribe this way. Taking into account this criticism many investors consider that benefits of active management by professionals are offset by higher fees, regulatory constraints and funds subscription specific risks. Even worse statistic shows that actively managed funds are very rarely beating the broad market in the long term.
Index funds and especially ETFs are becoming more and more popular. They are widely used by investors implementing diversified strategies. The only criticism I'd mention that sometimes investors are buying several index funds holding same instruments. For instance both French CAC40 ETF and Eurostoxx 50 ETF are likely to hold Total and Sanofi stocks. So this is an example of the false diversification.

Hedge Funds (Alternative Investments)

Hedge funds are different from the asset managers in that they are subject to very little regulation as they are targeting financially sophisticated individuals and organizations. Hedge Funds can design their own strategies and take profits from both bullish and bearish markets. They don't have a strict benchmark but they can have a general investment direction like American stock market, commodities trading, fixed assets, currencies etc. But from the investor's perspective, even if a hedge fund is labeled American stock market fund, it doesn't mean that if market would fall the fund is likely to loose money. Hedge fund managers are expected to benefit from all opportunities even while market crash. Another difference between traditional asset manager and a hedge fund is that the latter is likely to use leverage. It means that hedge funds are often borrowing money to increase their performance.
Obviously hedge funds are much more expensive. They are charging fees to investors not only for usual management, entry/exit fees, but also they are taking a significant percentage of fund's performance. So hedge funds are always winning but after a good year they are winning even more! Investors giving their money to a hedge fund are strongly exposed to the manager's competencies and experience. Many hedge funds are going bankrupt every year especially during financial crisis. For this reason financial regulators are absolutely right in limiting the access to these sometimes very efficient investment schemes.

Private Banking

This is a special form of relationship between a bank and its client, usually a wealthy individual. This relationship includes premium services and a form of custom asset management designed to the specific client needs. For wealth management purposes, individuals have accrued far more wealth than the average person, and therefore have the means to access a larger variety of conventional and alternative investments. Private banks aim to match such individuals with the most appropriate options. In addition to providing exclusive investment-related advice, private banking goes beyond managing investments to address a client's entire financial situation. Services include: protecting and growing assets in the present, providing specialized financing solutions, planning retirement and passing wealth on to future generations. Private Banking business is very developed in Switzerland.

Private Equity Firms

A private equity firm is an investment manager that makes investments in the companies that are not traded on the stock exchange. Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity. Capital for private equity is raised from retail and institutional investors, and can be used to fund new technologies, expand working capital within an owned company, make acquisitions, or to strengthen a balance sheet. A private equity investment will generally be made by a private equity firm, a venture capital firm or an angel investor. Each of these categories of investor has its own set of goals, preferences and investment strategies; however, all provide working capital to a target company to nurture expansion, new-product development, or restructuring of the company’s operations, management, or ownership.

Inflation and Deflation

Looking few years back we often realize that for the same amount of money we were able to buy more things. Some people are complaining that even with a higher salary today they are poorer than earlier. Finally talking to our grand parents we can easily realize that when they were young they were living in a completely different price system than we do. These phenomenons can be explained by probably the most popular economic indicator called inflation. Inflation is very often mentioned by different people in various situations but often there is a lot of confusion around this term. Let's look inside the mechanisms affecting the prices we have to pay to buy goods and services we need.

Inflation refers to a persistent increase in the general price level of goods and services in an economy over a period of time. In other words during inflation times for the same amount of money we can buy less goods or we can also say that purchasing power of money reduces. The opposite process called deflation when prices are decreasing and the money's purchasing power increases.

Inflation

Rising inflation is something that people don't usually like to hear about. However in many developed countries today the low inflation is considered as an economic problem. I'm writing these words 2 days before ECB meeting where the president Mario Draghi will certainly try to suggest additional tools to fight "too low" euro zone's inflation. Something is wrong here, isn't it? Indeed inflation is quite complex phenomenon. Unlike deflation, which is almost always bad, inflation can be either bad or good depending on its pace.

As long as inflation refers to the higher prices it means that profits of the corporations increase, so they hire more workers, this sends wages up, so people can afford more goods, so demand increases, and the prices keep going up. This sequence sounds good, isn't it? Indeed inflation around 2%-3% is a characteristic if a healthy growing economy. The key point in the sequence presented above is wages that are supposed to go up a long with prices. If it is not the case inflation can become dangerous and in some extreme cases can cause an economic collapse.

One of types of dangerous inflation is hyperinflation when general price level within an economy increases rapidly as the currency quickly loses real value. Meanwhile, the real value of goods generally stays the same, and remain relatively stable in terms of foreign currencies. In such conditions usually the wages are not following the pace of the price rising and people can afford less and less of goods.

Another a bit less dangerous type of inflation is a stagflation. This is a situation when the inflation rate is high, the economic growth rate slows down, and unemployment remains steadily high. This situation is difficult to deal with as the governments are usually facing a dilemma for economic policy since actions designed to lower inflation may exacerbate unemployment, and vice versa.

Deflation

We are not talking very often about deflation but this is a natural economic process going closely along with progress. Indeed as technology improves we are now able to produce things cheaper and quicker, a lot of jobs were moved to Asia bringing production costs lower etc. So deflation is something constantly happening in the economy. But we don't really see prices falling. Indeed in the most common scenario deflation is offset by inflation. In other words these are parallel mutually compounding processes where inflation usually winning.
Why deflation is dangerous?

It sounds like a good news that things are becoming cheaper. But unfortunately these good news are hiding much worse consequences. As explained earlier, dynamic economy is likely to produce some inflation. If this healthy inflation is unable to offset deflation it means that country's economy is likely to slow down and probably there is a risk of recession. But probably even more dangerous effect of the deflation is an increase of the debt. Indeed in the developed countries both governments and households are heavily indebted and when money becomes more expensive then your net debt increases as well. This scenario is unacceptable for most of governments especially the United States having a huge debt.
Why deflation is unlikely?

As we are not living in the gold standard era, the purchasing power of the currencies can be easily manipulated by central banks and governments. As long as government doesn't want to see its debt rising it will always act whenever a risk of deflation appears. Indeed central banks usually have a monopoly on printing currency and increasing/decreasing money supply. So they are armed enough to fight deflation if needed.

2014 Forecast

THE BIG PICTURE

We've been in a bull market across all developed countries. In the United States this bull market was triggered by FED's asset buying program, called Quantitative Easing (QE), and in Europe by Mario Draghi's declarations of summer 2012. Ultra-aggressive FED's monetary policy allowed significantly improve american real estate market, generate GDP growth, bring stock market to historical highs and return confidence in the world's biggest economy. Europe has followed the same trend relying on a one single Mario Draghi's statement that "....ECB is ready to do whatever it takes to preserve the euro and believe me, it will be enough". Since then nothing has really been done but Europe believed that in the worst case scenario ECB will be here to support Europe and euro. PIIGS government bond rates fell, stock market rose and the broad economic sentiment improved. The similar declarations have been made in Japan where the prime minter is trying to fight deflation. As in Europe these declarations where not followed by actions but drove yen to its lowest levels. The emergent markets are performed poorly this year. The slowdown of the external demand makes Asian economies to cut their growth forecasts. A lot of investors are considering Europe more attractive changing investment flow direction from Asia to Europe and driving euro to its surprisingly high levels.

Analysis

Last years the most of economic improvements have been relying on the actions and/or promises of the central banks. In my opinion it has been the most important driver for all developed and (indirectly) emerging economies. Best economic indicators were reported by the countries where the central banks were the most aggressive. I have a mixed opinion on the FED's monetary policy as it allowed to avoid economic collapse and brought the rates lower. On the other hand it has pumped a new stock market bubble in the US and probably in some other US-dependent markets.

As many other investors I believe that FED will gradually taper the quantitative easing through 2014. This process will have a world wide economic impact. I also believe that american corporations are likely to miss more and more often the consensus and review their outlooks to more pessimistic. This can have an impact on the american stock market.

I'm still expecting an action from ECB in terms of monetary easing. I'm surprised that it didn't happen earlier regardless continuous euro's strengthening, deflation risks, unresolved debt problems, credit crunch for small the business and South Europe still struggling with a huge unemployment. I can explain this phenomena only by last year's election in Germany who is historically reluctant to the currency's devaluation approach. I'm repeating my concerns about France. Fortunately these concerns aren't shared by markets..... yet?

United Kingdom looks the most attractive so far. Ambitious reforms led by David Cameron are led to lower unemployment, even more attractive investment climate, very good visibility for businesses and safety for capital.

Japan's prime minister is keen on taking out the 3rd largest economy from 20 years deflation, so I believe that quantitative easing declarations and may be actions will multiply bringing the yen lower.

Emerging markets are very low but they are also very dependent on the developed economies. Russia looks particularly risky with a near-zero GDP growth and the risks of recession in the coming year.

STOCK MARKET

United States

As mentioned earlier I have a mixed opinion on FED's policy. I think that may be FED has gone too far with its quantitative easing and it should have stopped security buying earlier (for example in the beginning of 2013). Anyway were they wrong or not we have now a bubble on the american stock market. In my opinion it can burst at any moment and can be triggered by any event. I think that on January the 1st of 2014 the most of investors are realizing that the market needs to purge but none knows when it will happen. If speculations would continue through the beginning of 2014 the burst can be painful.

Positioning: I've taken a short S&P 500 position. I'll keep it until the market would purge at least of 10% from its current level.

Europe (Euro zone)

Technically Europe and the US are strongly correlated and I'm not expecting any rally in European stocks through 2014 unless ECB would take aggressive quantitative easing actions. In the latter scenario Europe is likely to outperform US but in case of bubble burst in the US stock market I'm struggling to imagine a profitable year in Europe.

Fundamentally Europe is still living with its old problems. EBC has reassured investors giving time to fix system drawbacks but nothing significant has been done so far on the political level. Spain is constantly reporting on "progress" achieved last year but the situation is still dramatic with 25% unemployment, very fragile banking system and huge sovereign debt. The only real improvement I can see is Ireland. But in my previous posts I have already mentioned that in my opinion Ireland has never been as fragile as other PIIGS because of its extremely liberal tax policy.
As last year I'm emphasizing attention on France. I have been wrong so far but still sticking to my opinion that it hides a huge risk for euro-zone. French economy is performing slightly better than its southern neighbors but economy is struggling of a very heavy social model impossible to finance without extending deficit gap already far beyond Europe required limits. French government, led by the most unpopular president of the 5th Republic, François Hollande, seems unable to overhaul heavy socialist system relying on overtaxed citizens and corporations. Latest UN statistics show that France has lost 77% of foreign investments last year. To reform the country the government has to take unpopular actions which could lead to social tensions and likely to give more and more influence to the euroscepticism.

But the main point about France is that any single doubt on the french debt would trigger broad sell off on the markets. The country is impossible to bail-out neither by European Union nor by IMF in case if it would struggle to refinance its debt on the market. Germany has clearly stated that it won't participate in such bail-outs with German tax payers money. So I keep praying that such a scenario will never happen.

Positioning: Except a short derivative to hedge my stock picking positions, I don't have any macro bets on the European market this year. I consider it as too dependent on the external events and political decisions that can be hardly foreseen. In case of any tension on the french debt I'll pass short quite aggressively.

Emerging Markets

Tapering of the FED's quantitative easing could lead investors to withdraw from the emerging markets. On the other hand the emerging markets are cheap and further down trend is likely to create a lot of opportunities. China is less dependent on the US than earlier and can partially rely on its own internal consumption.
Russia is struggling to generate growth with its commodities over exposed economy. Internal demand is satisfied by imported goods as domestic industry is very weak and uncompetitive. Foreign capital withdraw continues since the beginning of 2013 and is likely to accelerate along with FED's tapering. Country has a very bad outlook even with oil prices remaining high but in case of significant tensions on the oil market the consequences can become dramatic for Russia.

Positioning:

• Since the beginning of the last year I'm holding an ETF on China's stock market where I'm obviously loosing money. As long as I didn't allocate a lot to this position I prefer to keep it as I'm quite confident in China in the long run.
• I have an short position on the Russian market which I bought in the mid-2013. I'll definitely keep it as I expect a lot of bad news for Russia in the coming year.
• I'm currently buying Korean Stock Index. I'm not in position yet waiting for lower prices to enter.

INTEREST RATES

I'm expecting interest rates to increase on the US bonds for all maturities. The FED's tapering would reduce the demand on the US Treasuries driving rates higher. I'll change my opinion in case of severe stock market slump while investors are likely to move to the "safe-haven" and start buying US Treasuries and German Bunds.

Since mid-2012 I have been expecting higher rates on the french OAT but they are still remaining on the very low levels. My conviction is nevertheless the same - french debt is risky. So I'm betting on higher rates for the french government bonds.

I'm neutral on the German Bunds as in my opinion they are unlikely to raise especially in the context of higher market risks I'm expecting for the year 2014.

Positioning:

• I have a big short position on the US bonds as I'm expecting interest rates increase following FED's tapering. I'll close this position once the Treasury would reach 3.5% and I'll keep this position even in case of market slump accepting some lateral loses.
• I have a small short position on french OAT as I'm convinced that rates are too low but I'm not sure of timing when exactly they would rise.

CURRENCIES

Eur/Usd

This pair seems overpriced to me. ECB has been much less aggressive with its quantitative easing policy than the US and Japan. Many investors are expecting Draghi to take firm actions to ease financing in euro-zone and bring the currency rate lower to facilitate exporting. As mentioned earlier I don't understand why ECB didn't do it earlier but it might have some internal reasons may be related to German election. Anyway I don't see any reason why such a huge exchange rate would last in the long run. Another argument that FED's tapering is likely to increase the value of the US dollar against other currencies. In case of market crash dollar is quite secure as well as it is often considered as a "safe-haven" investment. For me there are enough arguments to short this pair.

Usd/Jpy

I'm expecting yen to weaken through 2014. The government gave clear indication of the policy it will implement and I don't see any reason why it would step back on it. In case of market crash, yen can be considered as a "safe-haven" investment what would strengthen this currency against others. However in this case the dollar is likely to get stronger too balancing pair's rate. To summarize I'm not expecting yen to fall in 2014.

Russian Ruble

Shorting of the Russian ruble is my strongest conviction since mid-2013. No growth, weak domestic industry, major part of GDP is in dollars and the social system became expensive while "good days" leaves no choice other than currency's devaluation. Devaluation may be smooth thanks to the currency reserves accumulated since beginning of the century. I'll write a separated article on the situation in Russia that I'm watching closely.

Positioning:

• EUR/USD: I have an aggressive short position.
• USD/JPY: I have a small long position that I'll increase but without taking excessive risks.
• USD/RUB and EUR/RUB: I have a huge long position as I'm expecting ruble to fall.

COMMODITIES

Oil

In my opinion the oil is on its long term down trend. My opinion is backed by slower oil demand from developed countries and China, Iran is likely to enter to the oil market in the coming years, developed countries are switching more and more to the alternative energy sources, exploration of the shale gas is developing in many countries, electric and hybrid cars are becoming more and more popular. Some political events can drive oil prices higher for some periods of time but I'll consider it as an opportunity to take a short position.

Gold

As I mentioned in other articles, I'm considering gold as a highly speculative asset that doesn't produce any return, and even generates saving fees. In my opinion it is incredibly difficult to define a "fair price" for the gold which is the main parameter for any fundamental investor. So for me there is no expensive or cheap gold as it has only market price defined by speculators.

I was shorting gold from 1400 USD per once levels and I sold my last short position by the end of 2013 at around 1200 USD. I'm not planning to speculate on the gold this year.

Positioning: Since the beginning of the 2014 I have started taking long term short positions on the oil.

Central Banks regulation and Interest Rates

Very often in financial media we hear people talking about Central Bank bringing Interest Rates higher or lower and the impact of these rates on the broad economy, mortgage rates, consumer loans etc. Let's look deeper into macro interest rates to better understand how do they affect our day to day life and the real economic sectors. Let's take a typical statement that we can come across reading through WSJ pages: "FED cuts rates by 0.25 point to reach record low of 0.50%". What does it mean? It may seem confusing as if tomorrow you would go to your local bank to apply for a mortgage your rates will be much higher. Let's try to understand what really happens and why this difference exists.

Government bonds

Bond Price vs Interest Rate

Governments to satisfy their budget needs as social security, defense, education etc. collect taxes and other state revenues which are usually not enough to cover all liabilities so they have to borrow money from investors. For that they issue Government Bonds with various maturities. In the United States they are called T-Bonds (Treasuries), in France - OAT, in Germany - Bunds etc. Bonds issued by highly rated countries are considered as an ultra-safe investment and their interest rates are close to risk-free rates. Government bonds are debt securities and are traded on the market. When any bond is traded it has a market price and interest rate. Both are linearly correlated, so when bond's price is going up the interest rate goes down. Therefore to bring the interest rate lower we need just start buying more bonds on the market increasing demand. To bring the rate lower we would obviously do the opposite it means sell bonds on the market. This is standard supply and demand rule. Remember well this relationship as it will be important later for understanding this article!

Commercial Banks

Walking down your city center you will certainly see several cash machines of well known local banks. Depending on the country you are living in examples can be City Group, Wells Fargo, Bank of America, HSBC, Barclays, BNP Paribas, Société Générale etc. All these banks are Commercial Banks operating in your country. Their traditional business is to finance individuals and corporations. To achieve this goal they are taking deposits from ones to give loans to others. Commercial bank lends money to an individual or corporation for a fixed or floating rate. In both cases this rate will be negotiated between the bank and its client within some interval of rates proposed by this concrete bank. Without going into details I'll just say that rate will be indirectly correlated to the current government bonds rate. It doesn't mean that it will be equal or close to this rate but when government bond rate increases the commercial bank's rates will increase too. I'll write an article explaining this relationship later.

Central Bank

Central Bank is a special type of bank that can be seen as a "bank of the banks". This definition may appear confusing as central bank's role goes far beyond of taking deposits and lending money out. Firstly central bank is an institution that manages a country's money supply, oversees the commercial banking system and acts as a lender of last resort to the commercial banks during financial crisis. As long as central bank possesses a monopoly of printing national currency its financing capacities are by definition unlimited. Thus the bankruptcy of the central bank is structurally impossible. In the most of developed countries the governments are controlling their central banks. The exception is United States where central bank (or Federal Reserve or FED) is a private company with a secret list of shareholders and the president of the bank is appointed by the president of the United States. In my opinion the word "bank" isn't applicable to the concept of the "central bank", as its primary role is regulation and not financing. Indeed it fulfills its financial role only in critical situations when regulation did not work properly.

Central Bank's regulation

As mentioned earlier one of the key roles of the central bank is to manage money supply. Money supply doesn't necessary mean "printing money" but more generally it refers to the amount of money available to the economy or amount of money available to the commercial banks financing this economy (individuals and corporations).

Typically central bank can increase money supply when GDP growth is slowing down, interest rates are too high, inflation is lower than its target level (creating a risk of deflation) or when currency rate is considered as unacceptable. On the other hand it can decrease money supply when there is a risk of a bubble on the real estate and/or capital market, interest rates are too low, inflation is far above its target level and/or again currency rates are considered unsatisfactory.

To regulate money supply central bank basically has 2 options:

1. Alter the reserve requirement.
2. Influence current interest rates on the market using OMO.

Reserve Requirement

Commercial banking system is very important and a bankruptcy of a significant commercial bank can have substantial consequences for the broad financial system. This is where central bank comes into play. To accomplish its regulatory role the central bank sets reserve requirement. Reserve requirement is an amount of capital that commercial banks have to put aside for each loan they are lending out. The required reserve ratio is sometimes used as a tool in monetary policy, influencing the country's money supply by changing the amount of funds available for commercial banks to make loans with.



Example:
Bank of America (BoA) lends out 100 000 USD and the reserve requirement set by the FED is of 10%, then 10 000 USD must be put to reserves and cannot be used for other loans. This amount can either be kept as cash or deposited to central bank.

Scenario 1: Increase reserve requirement to bring rates higher
FED brings reserve requirement to 20%. BoA would put 20 000$ aside for the same loan and this amount would "sleep" on the central bank's deposits producing a tiny interest rate. So BoA would have less money to lend out. As long as the reserve requirement affects all commercial banks then there will be less money available to the broad economy financed by these banks. When money supply decreases and the demand remain constant then, following supply and demand rule, the "price of money" will be higher. The "price of money" is Interest Rate. The objective of the central bank is achieved!
Scenario 2: Decrease reserve requirement to bring rates lower
FED brings reserve requirement to 5%. BoA would put only 5 000$ aside for the same loan. So BoA would have more money available to lend out. As consequence the broad economy would have more capital available too. When money supply increases and the demand remain constant then, following supply and demand rule, the "price of money" or Interest Rates will be lower. The objective of the central bank is achieved!

NOTE: Western central banks rarely alter the reserve requirements because it would cause immediate liquidity problems for banks with low excess reserves. They generally prefer to use Open Market Operations (buying and selling government-issued bonds) to implement their monetary policy (see below).

Open Market Operation (OMO)

Another option to alter money supply will be direct government bonds market intervention in order to technically affect the supply and demand. As mentioned earlier the rates paid on the government bonds indirectly affect loan rates proposed by commercial banks.

Scenario 1: Bring Interest Rates lower

Central bank will start buying government bonds on the market (probably with newly printed money if it wants to increase money in circulation) bringing the prices higher. As discussed earlier higher bond price means lower rate. The objective of the central bank is achieved!

Scenario 2: Bring Interest Rates higher

Just the opposite, central bank will start selling government bonds on the market bringing the prices lower and rates higher. The objective of the central bank is achieved!

CONCLUSION

Let's return to our original question what means the statement "FED cuts rates by 0.25 point to reach record low of 0.50%"? Usually the matter concerns target rate. Paradoxically this rate is the most often mentioned in the media but it is the less meaningful. Basically it refers to the rate to which the central bank will "push" short term government bonds on the market. We can also translate this statement that central bank is planning to increase money supply or inject liquidity.

Important to understand that such a statement doesn't mean that all commercial banks will now borrow money at central bank itself for a lower rate but that only means the intention of the central bank to push down interest rates proposed by commercial banks.

Bulle Immobilière Parisienne

Cette année les prix d’immobiliers dans la région parisienne ont continués leur flambée. A Paris les prix ont atteint un niveau historique de 8500€ pour m2 en moyenne. La question qui inquiète tout le monde jusqu'ou ou ça va aller...

On a une situation classique: les acheteurs potentiels disent "c'est la bulle, cela ne peut pas continuer comme ça!" et les propriétaires disent l'inverse "Pas de bulle ! C'est le marché, il fallait acheter avant !". C'est normal car souvent on voit uniquement ce qu'on a envie de voir.

Pour comprendre ce que se passe regardons d'abord la définition d'une bulle immobilière.

"Une bulle immobilière est une bulle spéculative qui apparaît à l'échelle locale d'une région voire sur l'ensemble du territoire d'un marché immobilier. Elle est caractérisée par une hausse rapide de la valeur des biens immobiliers". (source Wikipedia).

 

La première chose qu'on remarque dans cette définition - c'est le mot spéculation. Donc posons la question autrement: "Y-a-t il une spéculation sur le marché immobilier parisien?".

Une pré-condition obligatoire et incontournable pour la spéculation - c'est l'accès facile au crédit dans les meilleures conditions. En effet la majorité écrasante des spéculateurs utilisent le mécanisme du levier (ou tout simplement de crédit) pour effectuer les achats spéculatifs. C’est vrai non seulement pour l’immobilier mais aussi pour les marchés financiers. Dans l’immobilier le recours au crédit est presque inévitable due au montant des transactions.

Analysons donc les conditions de crédit en France durant ces dernières années. On va prendre en compte 2 choses : les taux d’intérêts et la volonté des banques de prêter. On peut observer que les taux évaluaient environ entre 3% et 5.5% sur cette période. Et la plupart de temps entre 3% et 4.5%. C’est en ligne avec l'inflation donc rien d'extraordinaire, n'est ce pas? Les taux étaient vraiment très bas juste 2 fois: entre 2005-2006 et 2009-2010. Notons que la période entre 2009-2010 était marquée par la crise majeure et le fameux "crédit crunch" quand les banques ne faisaient confiance à personne même entre elles mêmes. C’est peut être le seul moment quand il y avait vraiment la réticence des banques de prêter. Et même dans cette situation elles continuaient à prêter quand même.

La courbe des prix immobiliers ne va surprendre personne. Si on compare les deux courbes on voit que l’évolution des conditions du crédit a très peu d’impact sur les prix d’immobilier et le niveau de crédit a toujours été en ligne avec le besoin de financement en France (sauf la courte période de  "credit crunch" en 2008). En effet les banques françaises ont toujours été prudentes dans leur manière d’étudier les dossiers de crédit et dans leur gestion des risques des crédits. 

L’absence du "crédit facile", en étant une pré-condition majeure pour la spéculation, permet d’avoir des doutes sur la présence de la bulle immobilier en France. Il y a encore plus des doutes que les ménages français ont tellement de cash dans leur coffrets qu’ils soient capable de générer la bulle sans crédit. Ce n’est pas la peine de comparer les prix d’immobilier avec le pouvoir d’achat des ménages français. Ce dernier est peut être valable en province mais pas dans la région parisienne ou les prix sont tirés par la forte demande et insuffisance de l’offre. En plus dans les pays émergents la classe moyenne, qui commence à apparaître, rêve d’avoir les pieds sur terre à Paris en devenant de plus en plus présent sur le marché parisien et non seulement dans l’immobilier de luxe.

Pour confirmer cette idée on a un contre exemple de l’autre côté de l’Atlantique. En effet aux Etas Unies, ou la bulle immobilière est indiscutable, il y avait bien une spéculation. Cette spéculation a été encouragée par les taux bas, les subprimes et surtout par des organismes de rehaussement de crédit immobilier (Fannie Mae & Freddie Mac). La plupart des français ne sont pas familiers avec ce principe purement américain de rehaussement de crédit. Le principe est simple: si la banque A ne veut pas vous prêter de l’argent, vous allez chez Freddie Mac et eux ils vous donnent cet argent en empruntant dans la même banque A. Pour la banque A c’est très bien car le même prêt n’est plus garantie par vous-même mais par une énorme société comme Freddie Mac. Magnifique, n’est ce pas !? Vivement la gestion des risques ! Donc, contrairement à la France, aux Etats Unies toutes les conditions de la spéculation sont réunies.

Pour cela on peut faire une conclusion suivante : il n’y a pas de bulle immobilière dans la région parisienne. Les prix sont définis par l’offre et la demande uniquement. Donc celui qui attend "l’éclatement de la bulle" risque d’attendre longtemps. En effet les prix montent à cause d’un déséquilibre entre l’offre et la demande, mais pas à cause des méchants spéculateurs qu’ont débarqués sur Paris.

Pour celui qui attend vraiment la baisse des prix dans l’immobilier, j’aurais plutôt conseillé de faire attention aux programmes gouvernementaux de la construction. Une fois que notre magnifique gouvernement commence à regarder dans le fond des problèmes économiques, ils vont vite se rendre compte qu’il faut construire plus de logement au lieu de taxer les propriétaires qui encaisse des plus-values de plus en plus élevées. Cela serait un véritable "plan de relance". La solution parait très simple : Paris intra-muros va toujours rester la région chic accessible aux personnes avec des moyens financiers très importants. Dans les banlieues c’est là ou il faut construire plus et surtout des bâtiments de qualité avec plus d’étages. Cela ne va pas dégrader la vue classique de Paris et permettra améliorer l’offre de logement. Mais apparemment le gouvernement a des choses plus importante à faire…