Tag Archives: U.S. Securities and Exchange Commission

Evolving Use of Leverage and Derivatives

Many US closed-end funds (CEFs) continue to utilize traditional forms of cash-funded leverage such as bank loans, debt or preferred stock in order to enhance yields and returns for their common shareholders.

“Fitch expects that use of cash-funded leverage and derivatives by CEFs will continue to evolve and, as such, will remain an important consideration for investors in CEFs, affecting their return and risk profiles.”

Fitch Ratings


Additionally, CEFs may also utilize various types of derivatives to meet their investment objectives, either for purposes of hedging or as means to more efficiently achieve return and leverage targets, according to a special report published by Fitch Ratings, Monday.

As of July 30, 2010, 416 leveraged CEFs in the U.S. had issued $55.4 billion of cash-funded leverage against $180.4 billion in assets under management, according to the statement.

Additionally, 71 Fitch-rated CEFs had utilized $4.7 billion in notional of derivatives as an alternative to cash-funded leverage (termed “economic leverage”) and, to a lesser extent, for hedging purposes.

While leverage strategies enhance equity returns in favorable markets with rising asset returns and positively-sloped yield curves, leverage may also amplify the downside risk to debt, preferred stock and common stock investors in less favorable markets.

The report, entitled “Closed-End Funds: Evolving Use of Leverage and Derivative” discusses the extent to which different forms of leverage and derivatives are utilized by US CEFs, contrasts derivatives used for hedging purposes from those used for economic leverage purposes, highlights the Securities and Exchange Commission‘s (SEC) current and evolving regulatory treatment of derivatives, and summarizes Fitch’s treatment of derivatives when rating CEF debt and preferred stock issues.

“Current regulatory requirements for derivatives vary, however, and may not appropriately capture the potential for increased off-balance sheet leverage in excess of that allowed for more traditional forms of cash-funded borrowings,” the rating agency says.

Recognizing the evolution of derivatives usage by investment companies (including CEFs), both the SEC and American Bar Association continue to examine the issue to determine appropriate methods of measuring and reporting derivatives activity by applying a risk-based approach.

“Fitch believes that derivatives can be an effective tool for CEFs to manage existing risks and/or take on new risk exposures, provided that the marginal risk contribution is appropriately identified and measured.”

Further, Fitch expects that use of cash-funded leverage and derivatives by CEFs will continue to evolve and, as such, will remain an important consideration for investors in CEFs, affecting their return and risk profiles.”

“Regardless of the form that fund leverage takes (cash or derivatives), Fitch seeks to account for the risk to fund investors.”

For derivatives, Fitch seeks to recognize any additional economic leverage by ‘grossing up’ the CEF balance sheet, while also taking into account potential differences in the price volatility of the reference assets, the agency says.

“Conversely, hedges are viewed as a reduction in the overall risk profile of CEFs, to the extent the hedge is well-matched.”

The special report entitled “Closed-End Funds: Evolving Use of Leverage and Derivatives” was published on Sept. 27, 2010 and is available at http://www.fitchratings.com.

Additional research: Closed-End Fund Debt and Preferred Stock Rating Criteria

Example of use, Direct Market Access (DMA):

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Ex-Physicist Leads Flash Crash Inquiry

As a doctoral candidate in physics two decades ago, Gregg E. Berman spent most of his time in a laboratory searching through subatomic data for an elusive particle called the heavy neutrino. Today, from his office at the Securities and Exchange Commission, the former physicist is supervising a team of more than 20 investigators who have spent the last five months scrutinizing stock-trading data interview transcripts in an effort to figure out why stock prices went into free fall for 20 terrifying minutes on May 6th.                       

“What everybody would love to hear from the SEC is that XYZ trader blew up the market and made a gazillion dollars and is now in jail.”                       

Larry Tabb                 

Gregg E. Berman, head of an inquiry into the crash, said he will show how conditions and events led to an abrupt drop. (Photo: The New York Times).

 

Their long-awaited report on the so-called flash crash, in partnership with the Commodity Futures Trading Commission, is due to be published in the next two weeks, the New York Times reports.                

Mr. Berman (44) will not say exactly what will be in the report, but he says that it will not simply restate what regulators have already said — that markets were volatile because of worries over the debt crisis in Europe, causing some computerized trading programs to stop trading, and finally causing computers on other exchanges to misread the pullback as a rapid bidding down of stock prices.                       

Instead, he says, the report will focus on a specific sequence of events that preceded the crash.                       

He says it will tell a clear story about what happened in the markets on that stomach-churning day, beyond simply pointing a finger at the perils of the kind of high-speed computer trading that dominates today’s markets.                       

“The report will clearly demonstrate how  market conditions and events prior to the flash crash led to the extreme price moves.”                       

Some blame the high frequency trading for the so-called "flash crash" on May 6th.

 

When pressed, he adds, notably, that he had found no evidence of a deliberate attempt by anybody to disrupt markets.                   

The implications of the report are not merely academic.                       

Ordinary investors, shaken by the brief stock plunge and the lack of an official explanation, have withdrawn money from stock mutual funds every week since the crash.                       

The Berman report will not be the final word on the matter. Its findings will be used by a group of advisers to the S.E.C. and the commodity futures commission, which will make policy recommendations.                       

Still, some analysts question whether the report can deliver a simple answer that will satisfy everyone eager for reassurance.                       

“What everybody would love to hear from the S.E.C. is XYZ trader blew up the market and made a gazillion dollars and is now in jail,” says Larry Tabb, chief executive of the Tabb Group, a specialist on the markets.                       

“The answer, I think, is much more complicated and nuanced and has to do with a lot of different things. I am not sure that everybody outside the industry is going to have the patience to understand that.”                       

Market analysts say investors want to be reassured about the integrity of the nation’s markets so they can be confident that a nose dive will not happen again.                       

Visit The Swapper to read the rest of this story.                       

Related by the Econotwist.                       

May 6. 2010: “The Black Thursday”                       

SEC Expand Single Stock Circuit Breakers for Russell 1000 Index And Others                       

Wall Street Collapse: Did Somebody See It Coming?                       

David Rosenberg: “The Weirdest 20 Minutes Of My Life”                       

U.S. Stock Crash Compels Further Investigation of Wall Street Scam                       

Testimony Of A High Frequency Trader                       

The Ultimate Trading Weapon                       

The Rise Of The New Market Makers                       

US Stock Markets Infected By Malicious Software?                       

Update: Day Traders Crack The Timber Hill Trading System                       

Living In A Derivative World                    

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Filed under International Econnomic Politics, National Economic Politics

Ex-Physicist Leads Flash Crash Inquiry

As a doctoral candidate in physics two decades ago, Gregg E. Berman spent most of his time in a laboratory searching through subatomic data for an elusive particle called the heavy neutrino. Today, from his office at the Securities and Exchange Commission, the former physicist is supervising a team of more than 20 investigators who have spent the last five months scrutinizing stock-trading data interview transcripts in an effort to figure out why stock prices went into free fall for 20 terrifying minutes on May 6th.

“What everybody would love to hear from the SEC is that XYZ trader blew up the market and made a gazillion dollars and is now in jail.”

Larry Tabb

Gregg E. Berman, head of an inquiry into the crash, said he will show how conditions and events led to an abrupt drop. (Photo: The New York Times).

Their long-awaited report on the so-called flash crash, in partnership with the Commodity Futures Trading Commission, is due to be published in the next two weeks, the New York Times reports.

Mr. Berman (44) will not say exactly what will be in the report, but he says that it will not simply restate what regulators have already said — that markets were volatile because of worries over the debt crisis in Europe, causing some computerized trading programs to stop trading, and finally causing computers on other exchanges to misread the pullback as a rapid bidding down of stock prices.

Instead, he says, the report will focus on a specific sequence of events that preceded the crash.

He says it will tell a clear story about what happened in the markets on that stomach-churning day, beyond simply pointing a finger at the perils of the kind of high-speed computer trading that dominates today’s markets.

“The report will clearly demonstrate how market conditions and events prior to the flash crash led to the extreme price moves.”

Some blame the high frequency trading for the so-called "flash crash" on May 6th.

When pressed, he adds, notably, that he had found no evidence of a deliberate attempt by anybody to disrupt markets.

The implications of the report are not merely academic.

Ordinary investors, shaken by the brief stock plunge and the lack of an official explanation, have withdrawn money from stock mutual funds every week since the crash.

Market analysts say investors want to be reassured about the integrity of the nation’s markets so they can be confident that a nose dive will not happen again.

The Berman report will not be the final word on the matter. Its findings will be used by a group of advisers to the S.E.C. and the commodity futures commission, which will make policy recommendations.

Still, some analysts question whether the report can deliver a simple answer that will satisfy everyone eager for reassurance.

“What everybody would love to hear from the S.E.C. is XYZ trader blew up the market and made a gazillion dollars and is now in jail,” says Larry Tabb, chief executive of the Tabb Group, a specialist on the markets.

“The answer, I think, is much more complicated and nuanced and has to do with a lot of different things. I am not sure that everybody outside the industry is going to have the patience to understand that.”

Mr. Berman acknowledges that his team’s explanation will involve a number of things happening at once.

.

It may strike many people as painfully complex, but that is an undeniable result of the byzantine nature of today’s disparate electronic markets and the many players who take part in them.

The report’s conclusions will involve “market participants doing very different things and for very, very different reasons,” Berman says.

Central to all of this is the fact that stock trading is no longer centralized but instead takes place on dozens of exchanges, all with varying policies and procedures.

For example, the New York Stock Exchange has circuit breakers that prevent stocks from rising or falling so quickly that they disrupt the broader market.

Trading was slowed on several listings on that exchange on May 6, while other markets kept trading lower.

That lack of coordination created confusion during the flash crash.

Since then, the SEC has extended circuit breakers for individual stocks across all markets.

In investigating the crash, Mr. Berman says he finds himself in a position similar to his physics work 20 years ago, when he was collecting huge amounts of data and comparing the competing views of many laboratories on a question dividing particle physics — whether the neutrino, one of the least known and most common elementary particles, actually had mass.

Today he finds himself in familiar territory, sifting through huge amounts of messy and disjointed data, and at the same time reading blogs and e-mails from a wide range of observers, each with a theory about what happened on May 6th.

Read the rest of the article at The New York Times.

Related by The Swapper:

May 6. 2010: “The Black Thursday”

SEC Expand Single Stock Circuit Breakers for Russell 1000 Index And Others

Wall Street Collapse: Did Somebody See It Coming?

David Rosenberg: “The Weirdest 20 Minutes Of My Life”

U.S. Stock Crash Compels Further Investigation of Wall Street Scam

Testimony Of A High Frequency Trader

The Ultimate Trading Weapon

The Rise Of The New Market Makers

US Stock Markets Infected By Malicious Software?

Update: Day Traders Crack The Timber Hill Trading System

Living In A Derivative World

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