a structural review of capital market operators

A STRUCTURAL REVIEW OF CAPITAL MARKET OPERATORS

22

INTRODUCTION

Let me first start by commending the Securities & Exchange Commission and the Central Bank of Nigeria under the vision 2020 work done in time passed under the Money & Capital Markets Committee in its bold accomplishment of ending the concept of universal banking and hence, the final separation of commercial and merchant/investment banking.

However, this major accomplishment has led to a major financial exclusion of the key players in this very important intermediation sector of the economy

FMD DISCUSSION PAPER

33

1. There are two types of intermediation;• Bank based intermediation and • Capital market based intermediation –

• In Nigeria, only bank based intermediation works - Our inability to provide a full platter of services to our clients and fulfill our role as intermediaries is a testimony…

2. Why? capital market based intermediation is cut out of the wholesale funding markets hence, no ability to fund any part of the capital market business, it has no repo markets for liquidity, and therefore (except for commercial bank treasuries) generally has inefficient sales & trading operations or maturity transformation activities.

3. There is therefore no real added value from a liquidity stand point, as the equity trading business is generally also mainly brokerage hence, market making which is meant to significantly increase liquidity is highly inefficient.

We are not investment banks – we call We are not investment banks – we call ourselves that ourselves that but, we are not.but, we are not.

3FMD DISCUSSION PAPER

Even from the corporate finance origination stand point;

• Underwriting financing (if you can get it) is extremely high,

• No ability to execute bought deals for sell down,

• No real leverage at the client’s table - lack of balance sheet generally (application to stand-alone institutions).

We are We are notnot investment banks – we call investment banks – we call ourselves ourselves that but, we are not….cont’dthat but, we are not….cont’d


The question is: •How long can these businesses continue to mal-function due to their inability to operate as intermediaries across the financial markets with No wholesale funding access? •As is, capital market operators currently operate in “silos” with no access to the money markets and therefore totally cut off from the life blood or base liquidity of all financial markets.

We are We are notnot investment banks – we call investment banks – we call ourselves ourselves that but, we are not…..cont’dthat but, we are not…..cont’d


NIGERIA AND MALAYSIA COMPARISON


Malaysia and Nigeria – A factual Comparison of capital Malaysia and Nigeria – A factual Comparison of capital requirements - 1requirements - 1


Malaysian Bank Capital Requirements RM Current GDP/Capital

2012 RM NGN

Investment Bank 500,000,000.00 USD 10,432.06 0.31 $155,000,000.00 74,529,862.75 3,741,458,973.39

Universal Broker 100,000,000.00 USD 10,432.06 0.31 $31,000,000.00 14,905,972.55 748,291,794.68

Stockbroker (Broker/Market Maker ) 20,000,000.00 USD 10,432.06 0.31 $6,200,000.00 2,981,194.51 149,658,358.94

Issuing House 2,000,000.00 USD 10,432.06 0.31 $620,000.00 298,119.45 14,965,835.89

NGN Current GDP/Capital

2012 NGN

Investment Bank 15,000,000,000.00 $1,555.00 3,741,458,973.39 4.01x

Universal Broker 1,300,000,000.00 $1,555.00 748,291,794.68 1.74x




2012

Domestic Bank 2,000,000,000.00 0.31 $620,000,000.00 $10,432.06

Investment Bank 500,000,000.00 0.31 $155,000,000.00 $10,432.06

Universal Broker (Marker Maker) 100,000,000.00 0.31 $31,000,000.00 $10,432.06

Stockbroker (Broker/Dealer) 20,000,000.00 0.31 $6,200,000.00 $10,432.06

Issuing House 2,000,000.00 0.31 $620,000.00 $10,432.06

Nigerian Banks Capital Requirments NGN Current GDP/Capital

2012GDP/ Capital required

for current capitalCapital required at current GDP levels In Local currency

Domestic Bank National 25,000,000,000.00 165 $151,515,151.52 $1,555.36 $2,549.38 $92,438,425.39 15,252,340,189.76 1.64x

Investment Bank 15,000,000,000.00 165 $90,909,090.91 $1,555.36 $6,118.51 $23,109,606.35 3,813,085,047.44 3.93x

Domestic Islamic Bank (National) 10,000,000,000.00 165 $60,606,060.61 $1,555.36 $1,019.75 $92,438,425.39 15,252,340,189.76 0.66x

Market Maker (Fixed Income & Equities)+Broker Dealer 1,300,000,000.00 165 $7,878,787.88 $1,555.36 $2,651.35 $4,621,921.27 762,617,009.49 1.70x




2005 RM NGN

Investment Bank 500,000,000.00 $5,553.94 0.38 $190,000,000.00 139,990,709.30 7,027,646,049.11

Universal Broker 100,000,000.00 $5,553.94 0.38 $38,000,000.00 27,998,141.86 1,405,529,209.82

Stockbroker (Broker/Market Maker ) 20,000,000.00 $5,553.94 0.38 $7,600,000.00 5,599,628.37 281,105,841.96

Issuing House 2,000,000.00 $5,553.94 0.38 $760,000.00 559,962.84 28,110,584.20

Current GDP/Capital

2012

NGN NGN

Investment Bank 15,000,000,000.00 $1,555.00 7,027,646,049.11 2.13x

Market Maker (Fixed Income & Equities)+Broker Dealer 1,300,000,000.00 $1,555.00 1,405,529,209.82 0.92x

Malaysia and Nigeria – A Comparison –Key Malaysia and Nigeria – A Comparison –Key TakeawaysTakeaways

10

• The new SEC capital requirements are adequate for the current size of the economy

` BUT • The capital requirements for a

Merchant Bank by CBN is clearly in excess for the size of our economy

FMD DISCUSSION PAPER

Malaysia and Nigeria – A Comparison – Key take Malaysia and Nigeria – A Comparison – Key take aways..cont’daways..cont’d


• This has not been possible. As to date (26th of March, 2014) there remains only one fully owned Nigerian merchant bank after c4years!!

• This means we require a new way or approach to our operations and markets – not in regulatory and operational silos but across the full curve from the shortest end to the longest (permanent capital or equities)…see fig 2

• We therefore require a new paradigm shift in thinking and make some major changes to the way we operate and regulate our markets

• The first being - like other liquid markets (Malaysia included)……..

….THE CENTRAL BANK MUST JOINTLY WORK WITH THE SECURITIES EXCHANGE TO GROW AND REQULATE THE INDUSTRY - WHY?

Approach to our Operations and RegulationsApproach to our Operations and Regulations


• ALL IMPORTANT LIQUIDITY

• “The tri-party repo market is the most important source of funding for investment banks and securities broker-dealers as they can obtain short-term liquidity to finance their securities portfolios. Liquidity providers are usually money markets, investment funds, asset managers or public authorities with surplus liquidity” - Deutsche Bundesbank Monthly Report Dec 2013.

• TODAY in Nigeria 2014 – this resides ONLY at the short end of the curve (Money and Interbank Markets plus the discount window – Lender of last resort – comfort to all investors)

• No Broker/Dealer/Market Maker has access to this and therefore the business is severely illiquid, fragile, small, viewed as high risk and can NEVER grow into real institutions

Addressing the NEED for a WHOLESALE Addressing the NEED for a WHOLESALE FUNDING MARKETFUNDING MARKET


• We therefore suggest one or a combination of the following options :-

1. Adopt the Malaysian model of a Universal Broker2. A Financial Market Dealer licence that will support

financial market intermediation to act as a stop-gap measure to operators becoming a full fledged Merchant Bank (jointly regulated by SEC and CBN)

3. A two-tier Merchant Bank Licence• International Merchant Bank License • National Merchant Bank License

• Each position is discussed in-turn in exposition to follow...

Possible SuggestionsPossible Suggestions


BACKGROUND TO OUR MARKET

The Nigerian capital market operates in silos of its own, cut off from the rest of the financial markets. We currently have a market that looks as follows:-

Money Markets

DMB

D.H

D.M.B

D.HNBFI* brokers I.HNBFI

Broker/DealerIssuing houses

Bond Markets

Equity Markets

Short Term Capital

Medium Term Capital

Permanent Capital

Fig 1


BACKGROUND

If we plot these markets in risk/return/duration space, we should get:-

Money Markets

Bond Markets

Equity Markets

Risk Premium

Risk Premium

Risk Premium

Fig 2


BACKGROUND

In effect, for the same credit risk, the cost of shorter term money should by all definition be cheaper than longer term capital or permanent capital. “A normal yield curve”

So, whose responsibility is it to price the entire financial markets as depicted in fig 2 appropriately?

Different parts of the market are concentrated in silos and there is no one institution that can design/create, price and trade across instruments across the curve

Our competitive ability should be to fully serve our clients, and market across the curve and hence have a real impact on our economy


BACKGROUND

How do you promote innovation across markets where each participant is confined to only one part of the market? More importantly, how do you efficiently price across all asset classes in one continuous price curve, intermediating across all markets?

We believe we require a major shift in our thinking to allow an institution intermediate the short, medium and long term securities across the entire financial markets.

This is the only way the deficient issues mentioned above can be addressed and the market begin to see real growth


THE IMPORTANCE OF INTERMEDIATION Users of financial intermediation will

include governments, large institutions, medium sized corporations, institutions, high net worth individuals; in addition to short, medium and long term investors

Financial intermediation firms will generally advise companies on buying and selling businesses and assist them in managing risks

They will generally work with businesses, local, state and national governments to finance their operations through debt and equity offerings


THE IMPORTANCE OF INTERMEDIATION

They will buy and sell equities, bonds, currencies, commodities primarily to facilitate transactions by their clients in all of the key sectors of the financial markets

They will manage assets for institutions, including mutual funds, pensions and foundations as well as for individuals

They may also invest capital together with their clients in growing businesses which help to create jobs

Finally and importantly, they will create and manage liquidity across the financial markets by acting as dealers / market makers of traded securities


OPTION 1 – UNIVERSAL SECURITIES BROKER


THE CASE FOR A UNIVERSAL SECURITIES DEALER

This is defined herein as a firm that is SEC and NSE approved and regulated:-

Capital 1.Fixed Income Market Maker – N500m2.Equities Market Maker – N500m3.Broker /Dealer – N300m

N1,300m

This level of capital for our market size MUST give access to the wholesale funding market


THE CASE FOR A ADOPTING THE MALAYSIAN UNIVERSAL BROKER MODEL

In Malaysia, the Universal Broker - means a brokerage firm that has merged or acquired at least 3 other brokerage firms (To meet Capital requirements) and has satisfied all conditions and requirements stipulated by the Securities Commission under the Policy frame work for the brokerage industry consolidation

Minimum Paid-up capital of RM100m ($31m). Minimum shareholders funds of RM100m ($31m) to be maintained at all timesMinimum Capital Adequacy ratio of 1.2x

NOTE: these parameters operate in economies c4.5x the size of the Nigerian economy and we can be clever by scaling the requirements to suite our market size – this was previously depicted



The Universal Broker - Why is this important?As part of measures to strengthen capacity & competitiveness of universal brokers, brokers that meet the eligibility criteria were allowed to access the interbank market to undertake borrowing or lending

•Minimum shareholders funds of RM100m•Strong capital position as measured by capital adequacy ratio (CAR) imposed by the Malaysian bursa (stock exchange)•Satisfactory conduct of current credit facilities obtained from banking institutions•Compliance with prudential and financial regulators imposed by the securities exchange and stock exchange•Limit on aggregate interbank borrowings not to exceed 2x shareholder funds unimpaired by losses



• A robust and effective risk management framework to identidy, measure and monitor risks and

• A sound liquidity management framework that encompass strategies to manage funds, ability to match near and short term liquidity requirements and maintain sufficient credit lines, liquefiable assets in managing potential liquidity shortfalls

Universal brokers are allowed to borrow securities from the central bank via repo arrangements to enhance their securities broking activity and will be subject to examination by the central bank and the securities commission where appropriate.


THE CASE FOR A UNIVERSAL SECURITIES DEALER

Purchase Securities

INTERMEDIATION Sell Securities

BUYERS SELLERS

Fig 3


OPTION 2 – A FINANCIAL DEALER LICENCE


THE CASE FOR A FINANCIAL MARKET DEALER LICENCE

A Financial Market Dealer (FMD) licence will provide a very essential intermediation function by ensuring that our financial markets across the curve (see fig 2) remain liquid.

This will be achieved where such licence and skills give the holder the ability to fund and trade securities across the financial markets from say a 7day note issued under a commercial paper program or medium term note program to permanent capital (equities).



Going forward, with such a licence, we would expect financial market dealers to provide liquidity and begin to create new products for companies, institutions and governments like interest rate swaps, currency swaps etc. for improved risk management for the institutions and the financial markets



Graphical depiction of how a combined Issuing House and Broker Dealer (regulated by SEC) and a FMD (regulated by CBN) can now perform

Originate Securities

Distribute Securities

Trade Securities

BORROWERS INVESTORS

Fig 3



The additional licence should encourage a new paradigm shift to allow for the combined entity to have an evenly spread business model as depicted above.

The financial market dealer/Issuing house/Broker/Dealer will therefore be able to function across the entire sphere of the market as shown in fig 2


ADVANTAGES OF THE PROPOSED MODEL TO REGULATORS

Equity/MM1

Fixed Income

PDMM/MMBroker/DealerFund

Portfolio Manageme

ntCommodity

Dealers F

MD

Reg

ula

ted

by

CB

N

Reg

ula

ted

By

SE

C

In – Time

Issuing Houses

Financial Advisory

Underwriting

1Jointly regulated by SEC/NSE with oversight from the CBN

Fig 4


ADVANTAGES OF THE PROPOSED MODEL TO REGULATORS

Allows for each regulator to still focus on their core areas of competence whilst being able to have an oversight on the other areas of this important financial market intermediary

This leads to greater scrutiny and therefore less probability of systemic risk to the system

Allows for sharing of information, stricter regulation as these firms will be jointly regulated with formalised shared information for all procedures

It also allows for the regulators to grow with these institutions learning from lessons where capital is still relatively small and risks are very manageable.


ADVANTAGES TO MARKET

Wider product coverage Origination, distribution and trading of

securities should become seamless Product development, increased knowledge

on pricing across the financial markets leading to deeper liquidity in all markets

Deeper liquidity reduces costs to the end user

Creation of new jobs as sales and trading operations become much bigger, more sophisticated and less risky to manage due to significantly improved information technology infrastructure and risk management systems. 34FMD DISCUSSION PAPER

ADVANTAGES TO MARKET

The users of financial intermediaries will strongly benefit from lower costs across all markets, efficient pricing, and an ability for firms to now create products for their clients across the entire sphere of the financial markets

To build resilience in the domestic financial markets to withstand shocks by increased participants in the financial intermediation market


WHAT SHOULD A FINANCIAL MARKET DEALER LICENCE HOLDER BE ALLOWED TO DO?SOURCE OF FUNDS -

Equity - paid up capital plus reserves

Liabilities Call Money and short term borrowings A FMD that is short of funds must be able to:

• Obtain from the CBN an overnight advance against acceptable collateral

• Sell short term AAA rated assets to the CBN for the CBN to provide rediscounting facilities for treasury and other eligible securities

• Enter into repurchase transactions with CBN using eligible securities

Have a CBN account Access to the interbank market (as discount

houses have for alternative short-term funding purposes) 36FMD DISCUSSION PAPER


Types of AssetsThe short to medium term nature of its funding sources and liabilities should require that the assets it funds are generally also short – medium term assets. (Asset/liability matching)

The aim of such combined entities is to create and sell down good assets to real money managers – pension funds and other asset managers.


38


Therefore the assets it can hold should be as follows:-Treasury BillsTreasury CertificatesNegotiable certificates of depositsBankers AcceptanceCommercial PaperAsset Backed Commercial PaperAsset Backed and Mortgage Backed SecuritiesCorporate Bonds and NotesFederal Government BondsState and Municipal BondsEquities for NOT more than 5 days (Trading Purposes ONLY)Any other securities that may be from time to time approved by the CBN/SEC/NSE. 38FMD DISCUSSION PAPER

PROPOSED CAPITAL COMPUTATION

Beginning in 2008, many observers remarked that the 2004 change to the United States SEC's net capital rule permitted investment banks to increase their leverage and this played a central role in the financial crisis of 2007-2009.

This position appears to have been first described by Lee A. Pickard, Director of the SEC's Division of Market Regulation (the former name of the current Division of Trading and Markets) at the time the SEC's uniform net capital rule was adopted in 1975. In an August 8, 2008, commentary, Mr. Pickard wrote that before the 2004 rule change, broker-dealers were limited in the amount of debt they could incur, to a ratio of about 12 times their net capital, but that they operated at significantly lower ratios.


http://en.wikipedia.org/wiki/Financial_crisis_of_2007-2009


He concluded that, if they had been subject to the net capital rule as it existed before the 2004 rule change, broker-dealers would not have been able to incur their high debt levels without first having increased their capital bases.[10]

In what became a widely cited September 18, 2008, New York Sun article (the "2008 NY Sun Article"), Mr. Pickard was quoted as stating the SEC's 2004 rule change was the primary reason large losses were incurred at investment banks.



In late 2008 and early 2009, prominent scholars such as Alan Blinder, John Coffee, Niall Ferguson, and Joseph Stiglitz explained (1) the old net capital rule limited investment bank leverage (defined as the ratio of debt to equity) to 12 (or 15) to 1 and (2) following the 2004 rule change, which relaxed or eliminated this restriction, investment bank leverage increased dramatically to 30 and even 40 to 1 or more.

The investment bank leverage cited by these scholars was the leverage reported by the Consolidated Supervised Entity Holding Companies in their financial repoPrts filed with the SEC.[13] 41FMD DISCUSSION PAPER


As noted from the last financial crisis, having excessive capital does not make an institution immune to an insolvency, bankruptcy or liquidity crisis

We therefore advocate for a rather medium level of capital requirement as a head start but with a very strict and much improved monitoring/reporting/regulation on the amount of leverage currently applied by the firm, the assets, tenors, funding, governance structure, market values, asset concentrations etc

Firms should be mandated to have very robust risk management systems and high level risk management personnel.


Credit rating

Maximum Leverage

Maximum Assets

30,000,000,000.00

Est. ReturnsMaximum buckets

AAA12,000,000,00

0.00 12.75% 40.00%

AA7,200,000,000.

00 13.50% 24.00%

A6,000,000,000.

00 14.50% 20.00%

BBB3,000,000,000.

00 16.00% 10.00%

N/R1,800,000,000.

00 20.00% 6.00%Capit

al2,000,000,00

0.00 14.01%100.00

%4,212,000,00

0.00

Funding Costs 10.00%3,000,000,00

0.00Net Spread( turnover not included 4.04%

1,212,000,000.00

Credit protection <BBB 111.10%Credit protection =>BBB 7.09%

Credit rating

Single Obligor Limit Single Obligator Amount Capital protection

Coverage

AAA 25.00% 3,000,000,000.002,000,000,00

0.00 67%

AA 20.00% 1,440,000,000.002,000,000,00

0.00 139%

A 15.00% 900,000,000.002,000,000,00

0.00 222%

BBB 12.50% 375,000,000.002,000,000,00

0.00 533%

Mainly Equities N/R 2.50% 45,000,000.002,000,000,00

0.00 4444% 10% 518,427,95

0.00 0.92%

MD CEO:MaximumLoss per day

MD CEO:Number ofDays held

MD CEO:Loss % of capital


OTHER REASONS FOR A LOWER CAPITAL THRESHOLD

Non deposit taking institution Does not trade currencies Cannot advance loans as risk assets

(illiquidity) No trade finance business Purely institutional funding.



FINALLY,The financial market dealer licence is intended to serve as a stepping stone for issuing houses, underwriters, broker/dealers, market makers etc to one day become fully fledged Merchant Bank

This also allows for financial inclusion from the institutional level

It also allows for the regulators to grow with these institutions learning from lessons where capital is still relatively small and risks are very manageable.


OPTION 3 – A TWO TIER MERCHANT BANKING LICENSE


THE CASE FOR A CREATING A TWO TIER MERCHANT BANK STRUCTURE

A two tier structure is proposed as follows:

1.International Merchant Banking License• Can bid for international issues for

the government• Can have operations offshore

2.National Merchant Banking License• Can only operate within Nigeria• Cannot bid for international issues



FINALLY,

Financial intermediation remains a very crucial part of the workings of any financial market. Moreso, where the development of infrastructure in the economy is weak and requires a multitude of funding propositions or its middle class requires a viable primary and secondary mortgage markets to function relying on liquid financial markets



FINALLY,

We believe the case to have new institutions that are jointly regulated by SEC and CBN that can originate, distribute and trade all asset classes across the financial market spectrum is long over-due.

The process for achieving this has little or no hitch to current regulatory practices and will be seen by domestic and foreign observers of the Nigerian financial markets as a major step in the right direction



FINALLY,

We have shown the model to be sustainably profitable and that the risks associated can be strictly contained and managed

We therefore believe that the newly created Universal Brokers or originators (Issuing Houses), distributors and traders (Financial Market Dealers) or National Merchant Banks will become major engines of growth for the development of our financial markets going forward


THANK YOUAND

GOD BLESS THE FEDERAL REPUBLIC OF

NIGERIA.

a structural review of capital market operators

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