Transcript of Question & Answer Session Benchmarks

Good morning everyone my name is Candice Zacharias I cover FX and bonds for Bloomberg from Sydney. Thank you Guy very much for starting us off on discussion about improved functioning in markets and benchmarks in the FX and weight space. And I’m sure we’re going to circle back to questions about this a little bit, I thought maybe to start us off and to sort of set the background for where we are today, maybe I can get your thoughts on what might be the most important question facing market participants today as what happens in December if the Fed raises interest rates for the first time in a decade at the same time as the European Central Bank might be changing policy as well, what’s the potential for disorderly market activity and what do you think is going to happen?

So I have no idea as to what’s going to happen in December, or at least no particular insight. Let me say a few things – so the Fed rate rise, should it actually occur, would be the most telegraphed rate rise in the history of rate rises, and for anyone to not be prepared for its eventuality, they really have no excuse and if they suffer as a consequence it’s probably warranted.

As I said, this has been coming for a long time, possibly more than Godot, but hopefully we won’t be still waiting for Godot this time next year. So as I said you’ve been warned, you can’t say that you haven’t been. So that said, I’m sure there are products out there which are still hoping that they get out just in time and they’re predicated on zero funding costs and they won’t work when funding costs are no longer zero, at least in the US. What they are? Not sure. Where they are? I don’t think they’re on the books of the core part of the banking system, but I would be surprised if they’re not out there.

I think one thing which is interesting is, and like I mentioned Simon Potter earlier when he gave a talk about this sometime in the past 24 hours, the Fed’s balance sheet is four times larger than it was when rates last went up, which actually reminds me of another fact is it’s 10 years ago – 10 years since the Fed last raised interest rates. That means there’s a decently large chunk of people in the financial markets who have never known what happens when the Fed actually raises interest rates so we’ll see how that goes. But as Simon said, the Fed is operating with a balance sheet which is considerably larger than it’s been in the past, they’ve got a bunch of new tools which they haven’t tested –they’ve tested them but they don’t really know how they’re going to operate, so there will be a bit of ‘learning by doing’, so learning by doing in general entails a bit of volatility.

On top of that, I think it will be interesting because we will hit December 31 soon after the Fed raises interest rates and we had saw a reasonable amount of interesting market functioning activity around on September 30 this year in a number of markets, and there’s some chance – and part of there are some balance sheet constraints at quarter end. So if you overlay that on top of an environment where the Fed’s trying out some new tools, you know December 31 in particular could be interesting.

But as you said and at the same time as you said the ECB possibly going the other way. As much as the Fed’s interest rate rise has been telegraphed, the ensuing volatility has also been talked about ad nauseam. But we’ve been also waiting for that for a long period of time, but we may actually get there this December if the Fed does actually raise the rates.

I was going to ask is it concerning that you know all this we saw quite a big up tick and monitored, and obviously there were other things going on but there was a September Fed meeting to look forward too. We’re not really seeing spikes in volatility right now, why is that? Are we seeing a calm before the storm or are people on holiday?

No they’re not on holiday. That was possibly true in August but not true now. I mean even the volatility we saw in August was high in some markets, wasn’t high in others. In fact it’s still so, by and large, the most interesting story is that volatility as being reasonably benign throughout this whole period. And again partly coming back to the length of experience of people in financial markets, if you look at some of the volatility that people have been remarking on lately, in the greater scheme of things it’s not all that high. It may well get higher. I mean one thing we don’t know – the one thing if you look at experience, is that when the Fed has raised interest rates - we don’t have that many interest rate cycles - things tend to happen afterwards and beyond. It would be surprising if that wasn’t the case this time around and one of the things which does seem to happen is volatility spikes or shifts to a higher level. But as I said people are being warned about this for a long time, one of the things that most people are expecting as a consequence is the volatility will be high so I would assume that people have at least positioned themselves to deal with it when it actually arrives.

I’m going to be move on a little bit and I’m going to ask you that some people are calling the unintended consequences of regulation, you’ve talked about benchmark changes, in the FX space for example people we talk to say that you know bid offer spreads are widening in some smaller duty and currencies and the New Zealand had a very good example in August where it sort of tanked for about 10 minutes and then recovered. We’re seeing similar things happening in Norway, Sweden, sometimes in Australia before RBA decisions. Do we now have issues with pockets of liquidity in the FX market and is that going to come to a head in December?

Are there pockets of illiquidity in FX? Yes there are on occasion. I mean you mention ahead of, so if you look at what happens ahead of our rate announcements now the bid offer goes from one or two pips a few minutes prior to 40, 50 points in the minute prior, so that’s a lot, that’s a wide bid offer in FX.

More generally though – and this is true in FX, it’s true in fixed income, it’s true in equity – so for most of the time and particularly more benign times, top of book liquidity is probably as good as it has ever been, bid offer is as low as it’s ever been. The question is more around market depth and you mentioned the New Zealand dollar episode back in September I think it was. One that happened in the middle of the night in New Zealand – so no one actually trading in New Zealand – missed it. And I made this comment about the bond market, the flash rally on October 15 last year in Treasuries, if you went out for a well-timed cup of coffee you missed the whole episode. That raises the interesting question: do these liquidity events matter – illiquidity events matter? I think the concern people have is that we don’t understanding what’s driving them. So if it’s the case that you can always be confident there’s a liquidity blip and then the market returns to where it was a few minutes prior you can pretty much ignore it, that’s okay, but the concern I think seems to be that we’ll have this illiquidity pocket and then the market will continue to gap lower.

One thing again which is interesting in terms of the October 15 Treasury episode there was no price gapping, there was continuous pricing throughout that whole episode, one basis point at a time with a large amount of volume behind it, so it’s often referred to inappropriately as a flash crash, (a) it was a rally not a crash, and (b) there was no price gapping; it was smooth price action. That wasn’t true of the FX episodes you were talking about, but they were fairly short-lived and as I said, if you’re a person with slightly more medium term perspective; i.e longer than a minute, then you know it’s not something you necessarily need to get – it’s not going to affect the way you operate. As I said, the concern we have, and this was expressed particularly around the Treasury episode, we just don’t understand why, arguably in the most liquid market in the world, these sort of price movements can actually happen. And the lack of understanding means you’re concerned that if you don’t understand what’s going to happen then – so far all these episodes have resolved in a fairly benign manner – but we can’t be confident that’s going to be the case in the future.

Can we sort of blame some of the automated trading that you were talking about creating the illusion of liquidity in-depth and sort of acting like a bad friend and going away when you really need it?

They would say no, that’s a very controversial question in the whole liquidity provision discussion is that so the people who are providing the liquidity at the moment are different from those who are providing liquidity in the past and so a lot of them are, so you don’t call them high frequency traders any more, you call them proprietary trading firms that’s the way to refer to them. But they are providing liquidity. The question is when an event happens, do they get out of the way, but that’s still very much an open question. If you talk to them about the October 15 episode, they will say they were there the whole time and indeed they were.

The other question which is relevant to this is the more traditional market makers, the investment banks of the world. They were pretty good at getting out of the way of large price movements in the past as well, so the traditional way of not providing liquidity to the market was (a) I don’t answer my phone, or (b) my bid offer suddenly widens considerably, so I am technically still in the market, but could you actually transact with me? Possibly not.

That said, I think what we’re seeing at the moment is actually an evolutionary process, so a lot of these new participants in the market in terms of liquidity provision; there is no customer relationship in the market, they don’t have visibility or relationship with the customer. It’s not clear that’s always going to be the case. As their presence in the market continues to evolve then they actually start to care about reputation and customer relationships in the way that the current market makers or the traditional market makers have.

That’s not necessarily going to be the case, but as I said we’re in this evolutionary phase and we’re not quite sure where it’s going to end up. Wherever it’s going to end up is not going to be back to where we were, and you talked about the words unintended consequences, which is the phrase I think is the most abused phrase around regulation in financial markets. Most, if not all, but probably most, of the consequences are intended. You may not like them and the people who don’t like them say that they’re unintended, but actually they’re intended. And the idea was if you look at liquidity provision for instance it was clearly under-priced prior to 2007, now it costs. Has the price gone up too much? Maybe. But whatever it is – as I said it’s not going back to where it was, and you can complain all you like about it – but it’s not going to go back there any time soon and so you might as well just accept that that’s the way it’s going to be for the time being and adjust.

Doesn’t mean that we’re in the right spot and that conversation is still worth having, but it’s not going to turn around and go back to where it was any time in a hurry and so I think market participants do need to adjust to the current environment regardless of whether it’s actually right or not.

Okay I want to move on to other people who have been liquidity providers in a different sense; the large reserve managers. We’ve seen some of them change the way that they behave recently I’m wondering how much of an impact that’s having on market activity and whether people are sort of discouraging it a little bit.

I sort of think that – with some exceptions – but I think that’s been somewhat neglected. If you think about it there’s one very – the largest, I keep on saying they’re the largest asset manager in the world and then Simon Potter reminds that the Fed’s balance sheet is larger – but anyway the reserves in China have gone from $4 trillion to $3.5 trillion; that’s a half a trillion dollar portfolio shift in 12 months. That’s a big number. So if you think we don’t know exactly what they’re holding – probably some Treasuries, because they seem to be holding a bit less of them now than they did a year ago – but if you think about the size of that flow, that has to have a material effect on whatever markets they’re actually in.

On top of that you’ve got some of the large oil related sovereign wealth funds who are now running down some of their holdings because of the fall in the oil price, and you know if you take the Saudis for instance, they’re running a budget deficit of about 25 per cent of GDP – 10 times larger than our budget deficit – which they’re funding by running down some of their accumulated earnings in their sovereign wealth fund. So again if you think about those sort of flows they’re large. And as I said on the one side in China we’ve had 500 billion dollar fall in the Chinese reserves holdings, on the other side of that there’s been $500 billion capital outflow from the private sector in China, also a big number, over the past 12 months. These things have surely got to be having an impact on markets and where some of these entities who are participating in markets and they’re not anymore, it’s probably also contributing to some of the dislocation that we’re seeing in pricing.

So in the sense that if you think about it – take the Treasury market for a number of years, we’ve had the Fed buying bonds, we’ve had SAFE buying bonds, we’ve had other Asian reserve managers buying bonds – none of those are buying and two of those are at least selling now. That’s a different dynamic than what we’re seeing for much of the past of decade or so.

And do you think we’re seeing this in the bond market? In the swap market? Where do you think we’re seeing the biggest impacts?

I think it’s clearly in the bond market and I think it’s also potentially in the swap market as well, and contributing to some of the developments we’re seeing. The other thing I think which we’re seeing particularly in something like the swap market, you talked about the consequences of regulation, so one of the consequences of regulation has increased the cost of providing a lot of balance sheet services. It’s taken quite a long time for some of that repricing to flow through to other market segments and I think we’ve only just started to see that in repo, we’re only just starting to see that in the swap market, and so there’s this digestion phase as people start to work out what the consequences are.

So if you take swap spreads at the moment – which are an interesting position here, same in the US, same in Canada and the UK – it seems to be very much an Anglo phenomenon, it’s not happening in Europe. Anyway one of the reasons is people who had previously had arbitraged those movements away aren’t doing that this time around because they haven’t got the balance sheet capacity to do it. I’ll give you guys a free plug. So there’s piece on this on Bloomberg in the last 24 hours. There’s a change in the way that a lot of the markets are actually functioning, and some market participants haven’t quite adjusted to that change. And as I said some traditional arbitrageurs in the past aren’t there at the moment, doesn’t mean that what we’re seeing at the moment is a problem, it’s just different and as I said earlier to some extent, so hedging strategies which may have been effective in the past may not be so effective in the future. The price of a lot of services which was very low in the past isn’t going to be quite so cheap in the future; that’s something you need to take account of.

I want to keep it on China and then I’ll open up if there are any questions. Just one last question, China recently – or we imagine the yuan is going to be included in the IMF’s SDR basket and I was wondering – some people have commented about what that means for Australia or it saps demand for Aussie debt, perhaps the currency – is that something you think is going to happen?

Not any time soon. So for sovereign wealth funds or central bank reserve managers like ourselves we’ve had access to the RMB for a while now; I mean we have 5 per cent of our reserves in RMB so you always had that option. Some of the announcements the Chinese have made particularly over the last couple of months have increased the liquidity around those reserve holdings more than was the case in the past. But by and large, if you wanted to hold RMB you could, and people have. But at the same time they’ve made a number of changes to increase the liquidity. I don’t think people are holding Aussie as a proxy for RMB holdings in their reserve portfolio. Rather as a diversification strategy away from, basically I would say, the G3 in terms of reserves – I don’t see the RMB as sort of cannibalising that demand. I think people are holding Aussie for other reasons in their portfolio, not as a sort of RMB substitute so that once the RMB becomes more available they switch out. I wouldn’t be holding my breath for that sort of change to occur and if we look at the reserve managers who hold Aussie in their portfolio we have seen no evidence of any behaviour change.

Okay I’m going to open up. David do we have any questions from the audience?

Paul Dales from Capital Economics – actually he was asking a question with you before any of us arrived this morning so he’s long overdue. He was pointing out that the forecast for underlying inflation in Australia, has it fallen below the bottom of the 2-3 per cent target range and staying below that for a while. It’s obvious we’ve seen a lot of economies which are experiencing stubbornly low core inflation, how would the Bank react if that did happen?

Well I think we have a reasonable well-articulated reaction function, that’s not our forecast though. Let me turn that around and refer it back to the US. The one thing which I think is interesting at the moment is I still believe that supply curves slope upwards – radical concept that that is – so that if you think about as unemployment rates continue to fall, and the best example would be the US, at some point you will actually hit the point where the labour supply curve actually slopes upwards and you might actually start to see some wage pressure actually emerge. So I think the actual question is why is underlying inflation structure low everywhere in the world? (In the US it’s only about half a percentage point below where they actually want it.)

It basically boils back to a global demand story. If global demand or US demand is adequate enough to generate increased employment of the size of the increase that we’re seeing particularly in the US over the past year or so, you get that again in the next year or so and the unemployment rate’s got a 4 in front of it. I’m guessing that you’re going to get to the point where the labour supply curve slopes upwards, you’ll get domestic wage pressure that puts a floor under any of your domestic inflation developments. So as I say the surprise to some extent, and what are the reasons for this aren’t fully understood as to why, particularly in the US where you’ve had this marked improvement in the labour market, you haven’t got any particularly strong increase in wage pressure. But I said if you delivered the same sort of improvement you’ve had in the labour market and the US over the next 12 months and you didn’t get that I would find that incredibly surprising.

There is another one in from John Fildes again, Chi-X is very active today, makes interesting question, possibly talking about his own book a little bit here, but he says isn’t the solution for Forex markets to bring more trading onto lit exchanges rather than allowing it to trade in a multitude of dark pools.

I don’t think it does, that’s not the correct characterisation of a state of the market. So one thing which is interesting, so it’s in the FSB report on benchmarks, it was on high frequency trading in FX is something I have some idea about. One thing which is interesting – so we did a decent amount of work on this five or six years ago and HFT had really penetrated the foreign exchange market over the five years prior to that, having come from the equity space and now they’re moving into fixed income as the market structure changes there. But if you look at what’s happened in the FX space, some of the core parts of the FX market on some of the platforms – like that provided by this institution (Bloomberg), but also by Reuters and EBS – they’ve changed some of the trading rules to deal with various participants in the market including randomised pricing, minimum order fills and the like. And so you’ve actually seen the market structure change so that the high frequency part of the world is sort of off on the frontiers of the market where they pick each other off, whereas in some of the core parts of the market, the market structure is slightly different. So the market structure has actually evolved over the last little while. And actually a decent chunk of it is actually in lit exchanges.

What has changed though is there’s been a lot more internalisation of trading flows by some of the large sell-side participants which is matching off order flow – you see a lot of that happen through the fix – so different people have different views as to how good that is, but a lot of this comes back to the relationship between the sell side and the buy side and the transparency around that. So I would agree him in terms of – I wouldn’t use the word lit – but it’s more about the transparency and post trade reporting which is important, not the exchange itself on which it actually happens. It may happen internally and the bank’s internal matching engine may happen on a platform like Reuters or EBS, it may happen through a non-bank liquidity provider – what really matters is the post trade transparency around that and the degree to which people –the other problem I’ve seen is people will get that information and then have no idea what they’re actually supposed to do with it. But I think the understanding around that has also increased quite a lot over the last few years.

And a final point, I notice what’s interesting in the FX market – as best as I can tell – so we reached peak HFT about two or three years ago so the share of high frequency traders on the market has basically plateaued over the last few years, it hasn’t kept on going up. What we’re seeing now is a lot of them have shifted to fixed income and part of the reason for that is it’s just less profitable. What we’re seeing now is they’re now shifting into fixed income and that’s leading to some of these – we’re hearing the same debate now on fixed income that occurred in FX five years ago and occurred in equity sort of five years prior to that.

Okay well thank you very much for that, unfortunately we’re out of time I’m sorry if there were any questions from the floor we weren’t able to address, but thank you Guy and thank you for being such a good audience.

Thanks.