The HSBC scandal is big news the world over and yesterday I spoke on the BBC about it (you can listen to the interview here, I’m on at about the 24min30second mark).

A large part of the current reporting on HSBC is quality journalism, but there are two things that are being missed out on in all the reports I have seen so far.

1.   Lack of historical perspective
2.   Lack of understanding of banking secrecy legislation and culture

Here, with my first post in a three part series during this week, I will begin to fill you in so you will have a better understanding of why and how it all happened. This way you’ll be better informed than the majority of those following the story.

It’s important to first understand how banking secrecy works within a multinational bank that has banking operations in a banking secrecy country. Please note that this is not just an HSBC issue, it affects every single bank that has had a subsidiary in a banking secrecy location. For the purposes of this blog post however, I will stick to just HSBC.

HSBC got into the Swiss private banking business in 1999 by acquiring the Republic New York Corporation and Safra Republic Holdings, even though the acquired bank became part of HSBC, carrying its name, its Swiss subsidiary will have been completely separate from all the rest of HSBC. The subsidiary in Switzerland was, from a legal perspective, a Swiss bank, coming in under Swiss legislation. This means that HSBC Switzerland will have had no information sharing within the HSBC group. For example, if you were a client with HSBC and had accounts with them in both the UK and in Switzerland, the UK arm will have had no knowledge (unless you informed them otherwise) that you had an account with the Swiss arm.

Much has been discussed about Lord Green who was the chairman of HSBC at the time. Lord Green is facing a barrage of accusation for either being complicit in tax evasion or ignorant of it. Just because he was Chairman of HSBC group doesn’t mean he would have had access to information regarding the clients of HSBC Switzerland. The only way he could have had access is IF he sat on the board of HSBC Switzerland at the time the "tax evasion" was happening. (I will come to that just a little bit later).

This is purely my own personal speculation, but it is unlikely that matters of tax evasion would have come up on board level in HSBC Switzerland prior to 2008 because tax evasion was not a problematic issue until then. Pre 2008 there was a general laissez faire culture within the offshore banking sector regarding clients and their taxes. Banks in banking secrecy countries at the time saw tax as an issue that was of no concern to the banks themselves, it was the seen as the clients’ problem to deal with. 

The reason that 2008 is such a pivotal year is because that was the year the UBS tax scandal story regarding US clients with assets in Switzerland became public. This was the first really public story involving Switzerland and tax evasion, with juicy (and fresh and minty) stuff like the smuggling of diamonds in tubes of toothpaste. This would have been the first time that Swiss banks and banks in other banking secrecy jurisdictions would have had their initial contact with the possible reputational risks regarding tax evasion by their clients. It is therefore likely that the subject of tax avoidance was discussed in 2008 at board level in Switzerland, how seriously and how extensively, is something that only those who sat on the board of HSBC Switzerland at the time could answer.

With the above in mind, I'll end this post with an interesting bit of information: Lord Green was still mentioned as chairman of the Swiss arm of HSBC in the group annual report of 2007, but no longer in 2008. What could possibly be the reason? Coincidence?




In tomorrow's blog post I'll delve into why so few have been convicted of tax evasion on the back of the HSBC leaks.

It’s been a busy few weeks since the release of my book Dark Pools and High Frequency Trading for Dummies in the UK  (release date for the US is 23rd of February). What with other writing obligations eating into my time, blogging has had to take a bit of a step back.

Subscriber Winners 

Thank you to all of you who subscribe to the Banker’s Umbrella blog by email. I have now placed all the names of the subscribers into an Excel sheet and pressed the RANDBETWEEN function, twice. The lucky people to be awarded a signed copy are Jeroen from Germany and Holly from - of all places - beautiful Alaska in the US of A. 


Out of the hundreds and hundreds of subscribers it was both spooky and appropriate that one of the books goes to Holly, an academic scholar, who has herself written extensively and with great expertise on high frequency trading.

Congratulations to both of you. The books will be in the mail next Monday.

In Other News

Don’t miss my latest article in Professional Adviser on some of the risks with passive index investing.

Also, my Author Page in Amazon UK is now up and running, which is my sly way of saying “buy my book if you haven’t already”.

Have a good weekend all!

In my latest editorial for Management Today I make the case for stronger shareholder participation as a way to improve corporate governance. I cite academic research and give real life examples. Read the article by clicking on the logo below.

Don't forget! If you haven't yet subscribed to the blog, please do so before Friday to get the chance to win a signed copy of my new book Dark Pools and High Frequency Trading for Dummies, published by John Wiley & Sons.

Last week the gnomes in the Swiss National Bank (SNB) gave everyone a terrible fright. As a result the Swiss franc took a rocket ship to the stars and at one point during the day was up around 40% against the Euro.

Shock, horror and what, what, what, what?

As the resulting carnage in the FX markets was still taking hold, pundits were coming out of the woodwork pontificating about how this was bound to happen and the SNB must’ve known what the results of its actions would be.

Let’s be very clear. First, you! Yes, you, the reader! If you believe the rubbish these pundits are spouting you can go right off to that corner over there and stand there for a bit and ponder upon your own gullibility.

As for the pundits. Come hither, I’m about to give you all a proper slap around the ears. How dare you talk such rubbish, you complete and utter numpties! Now go over there and stand in the corner with that gullible fellow. On second thoughts, come back, I’m not done, I want to smack you again.

Let’s be very clear about this: No one knew this shock was coming, no one expected this shock was coming, no one foresaw this shock coming. It wouldn't have been a shock otherwise, would it?

From a purely technical perspective the market reaction to the SNB qualifies as a Black Swan event. It was a standard deviation move of the magnitude that come about every few billion years or so. This of course is an absurd statement (as this article correctly states). When you are using data going back a few years, about a currency that has been around for over a hundred years, to make statements predicting probabilities over billions of years, everyone, except a Microsoft Excel jockey financial analyst, should be belly laughing with gusto.

Predictions of billion year event anomalies are a waste of time. The fact is that market shocks come at us from unexpected angles and then the dominoes begin to fall. Simple. These shocks are regular, they happen in about every decade or so.

To put it in American English: S#*t happen regularly. Deal with it.

Point here is that there’s nothing unusual happening now. Just as in every other financial shock, an unexpected event kicks off an expected set of repercussions. Something tips over the first domino and then the all too familiar rat-tat-tat-tat sound of dominoes falling begins. In other words: A lot of major players end up losing their shirts.  

We are now seeing those expected repercussions work themselves through the markets. Whether the events kicked off by the SNB end up as a ripple or a tsunami remains to be seen. 

What are the ramifications?

1. CHF denominated loans across the globe. As an example, Poland has an estimated 46% of total home loans denominated in CHF. Lovely. When the mortgage borrowers of a nation (the middle class) see their overall debt jump, it can’t but have an effect on the national economy. What will the knock on effect be? (Here's a differing opinion on the subject from FT Alphaville)
   
   
2. Currency trading has grown in popularity in the last years, just look at the amount of web advertising from firms offering FX transaction services. The business model run by many of these companies are based on leverage taken by the firm and leverage taken by the clients. We are already seeing the effects of this with the insolvency of the West Ham sponsors Alpari and Global Brokers from New Zealand. Banks are also declaring large losses. What will the knock on effect be?
   
   
3. Hedge funds, those investment vehicles loved by the rich, which so often and inevitably end up being shown for what they are: Overly leveraged, gambling ideas, based on an Excel whim of some young chap with an oversized ego.  The main hedge fund of Everest Capital Global was wiped out. Their bet on a weakening Swiss Franc had made the fund a 0.6% profit last month. Last week, the $830 million fund, was wiped out in one day. Sounds like they had it all under control. What will the knock on effect be?
   
   
4. The Chinese stock market plunged 8% on Monday after curbs where placed on margin trading after brokers had broken the rules in regards to leveraged accounts. Sounds like a trustworthy bunch. What will the knock on effect be?
   

The point in all the above is that the events mentioned are all linked. One is not enough to destroy the global economy, but they are all knock on effects that may well have other knock on effects. Rat-tat-tat-tat

None of these events are happening in a vacuum. The global market is interconnected in a way that no risk manager can possibly calculate and the global market is immensely fragile, much more so than we would like to admit to ourselves.

Strap yourselves in folks, because this could get a worse, a lot worse.




Remember! By subscribing to the Banker's Umbrella this week you have a chance to win a signed copy of my new book Dark Pools and High Frequency Trading for Dummies. An excellent primer into how the modern equity markets work. Honestly, it is. Trust me, I'm a banker.

Subscribe now by clicking the link below.

My first book was published yesterday and is now available in bookshops all over the UK, it will be available in the US in a week or so. As for the rest of the world, it'll get there when it gets there.

The book is titled Dark Pools and High Frequency Trading for Dummies and is part of the global For Dummies brand published by Wiley. In the book I shine a light on what is currently one of the most interesting and important subjects affecting the global equity markets.

True to the For Dummies brand the book is easy to understand and not overly technical.

MoneyScience interviewed me prior to release of the book, which you can read in full at the MoneyScience Blog.

For those of you who want to get your hands on the book, you can buy it from Amazon.

Competition

I will be giving out 2 signed copies to subscribers of this blog. The lucky winners will be decided by random lottery on the 23.1.2015. The lottery will be done using an Excel formula. Hey, this is a finance blog after all! So if you're not a subscriber yet, now's a good reason to get on the band wagon. You can subscribe below. As all existing subscribers know: This blog does not spam anyone. Ever.

In my previous blog post I touched on Credit Default Swaps (CDS), which are a form of gambling chips in the financial markets.

CDSs, like so many things in the world of finance, involve risks. There are two types of risk in particular that you need to understand if you are to understand what’s going on in the world of finance and how these risks could blow the whole economic system we know and love sky high.

The two types of risk are counterparty risk and third-party risk.

The Story

You and your new colleague Dave, who works in the compliance department, have decided to go for a drink. You pay for the first round of drinks, but when it comes time for Dave to buy the drinks he notices that he has left his wallet at the office. You’re both having a fine and dandy time of it, so you agree to pay for a few more drinks and Dave agrees to pay you back when you see him in the office the next day.

As you order another round of drinks you think to yourself ‘No problem, Dave works in the compliance department, he’s as honest as the day is long’. You both have a few more drinks and then go your separate ways. You, comfortable in the knowledge that the next day you’ll get your money back from honest Dave.

Counterparty Risk

Unbeknownst to you Dave is a degenerate gambler. While you were in the bathroom Dave had called his bookie and placed a rather large bet on one of those silly games they like so much across the pond in the land of the free and the home of the hamburger, that game they call basketball.

In his infinite wisdom Dave had bet on his favourite team The New York Knicks. Unsurprisingly, just like 32 times prior this season, the Knikcerbockers of New York lose and Dave is out of pocket.

The next day Dave is not in the office. He’s jumped on the first EasyJet flight to Mallorca to escape his bookie and drink himself into oblivion. No money for you.

You, my friend, have just been on the receiving end of counterparty risk. You (party A) had made an agreement with Dave (party B) concerning a debt (based on the price of drinks consumed) to be repaid at a future date (the next day). Party A believed party B would be able to make good on its debt, but when time of payment arrived party B was not forthcoming with the necessary funds. Result: A realised counterparty risk.

Third-Party Risk

Let’s go back to our example of you and Dave, but this time Dave is not a degenerate gambler. In fact he has inherited a fortune from his aunt and despite being a millionaire he remains frugal in his ways with no secret vices, unless you call enjoying a few drinks in intellectually stimulating company a vice.

The next day you go into your office and there’s Dave standing by your desk looking pale, rubbing his palms together nervously and shifting from foot to foot.

“Good morning Dave, you’re not looking too good. Hangover?”
“It’s the bank" Answers Dave
“Bank?” You query
“My bank” replies Dave
“Your bank?” you clarify your original question
“Yes, my bank” retorts Dave
“What about your bank?”
“Gone”
“Gone bank?”
“Busted”
“Bank busted?” 
“Busted bank”

You get frustrated at the lack of progress and clarity with this conversation and try a new tack.
“Dave, I’m not sure I quite follow you. Can you just come out and say it, please?”
“My bank has gone bust. Thy diversified into bitcoin, oil and did some acquisitions in Russia, it’s all gone!”

The result is that you, my friend, have been on the receiving end of third-party risk. Despite having been flush with cash, Dave had (understandably) trusted his money to a third-party (a bank), which Dave had been dependent on to carry out his obligations.

Third-party risk is one of the most difficult to calculate. In any financial transaction, when you look at the complete chain of entities involved, it can become impossible to calculate the overall risk. In any future financial crisis, third-party risk is likely to play a significant role. A role we will only work out, after the fact.

There’s a strange game afoot in the financial markets. It’s all gone a bit Twilight Zone actually, as all the laws of science have been turned upside down and it is now the tail that wags the dog. So hard in fact that the dog might actually die with all the shakin' goin' on.

The problem concerns Credit Default Swaps also known as CDSs. Now, before you lose interest and click on to the next thing, please bear with me for just a bit longer because this will interest you. I guarantee it, trust me, I’m a banker.

Despite their technical and serious sounding name, in principal, the purpose of a CDS is rather simple. The idea is that you can buy insurance against a default. It works like this:

Sounds lovely, right? All apples and peaches and happy smiles.

Well nope. Unfortunately it has the possibility of going pear shaped.

Let's look at an example:

According to the New York Times Radio Shack’s total debt came to $1.4 billion but swaps outstanding on its debt were $ 23.5 billion. Think about that for a moment, because it wasn’t a typo. $1.4 billion in total debt, with contracts insuring against default standing at $23.5 billion. That’s 17 times more!

What does this mean? It means that the CDS market isn’t about insuring against default, it’s about gambling like Las Vegas, just without the strippers and Blackjack tables. Those dealing in CDSs are taking a gambler's punt on Radio Shack, nothing more, nothing less.

The problem here is that there are tens of billions betting on Radio Shack either going bust or not. This money has nothing to do with the actual business viability of the company. We are in a tail wagging the dog scenario where it is in the interest of certain parties for Radio Shack to default even if Radio Shack is in a solvent position and able to pay its debts.

Compounding this problem is that CDSs are an over the counter (OTC) product. What this means is that they are not traded on a transparent exchange. They are created by banks and bought and sold by speculators/investors/traders, call them what you like, and there is very little transparency on the size of the positions held by these entities.

With tens of billions on the line, you should by now see the possibility and the strong temptation for manipulation and corruption to bring about a default scenario.

This is a serious problem that doesn’t just concern one firm, CDS contracts are all over the place and with the current several year long bull market in bonds, one can only imagine the size of the CDS mountain behind all the outstanding debt.

When it goes pop. You're going to hear it.



Tomorrow I’ll come back to this subject and dive a little deeper into CDS contracts.

Tax the rich. Oui, oui mon cher! Make zem pay. Give ze filthy riche ze Guillotine! This was the wave of anti-rich sentiment that ended up washing Francois Hollande ashore at the steps of the Élysée Palace as the President of France.

Hollande's rallying cry was a promise to place a 75% tax on earnings above EUR 1 000 000, a 'rich tax'. The law came in to force in 2012 and kicked off a furore of speculation, all of which turned out to be completely wrong.

Basically the debate came down to two predictions.

1. The government would make truckloads of money
2. All the wealthy French would move abroad
   

Now - in a silent retreat - the French are bidding an Adieu to the rich tax.

Here’s why

According to Reuters the rich tax netted France 260 million euros in the first year and 160 million euros in the second year. This in a country with a deficit of 84.7 billion euros. 

Look, I’ve even drawn you a chart to give you some perspective as to the dent this new tax made on France’s deficit.

Here you go:

Woopsie. You can’t even see the tax on that, can you? let’s try a pie chart instead, shall we?

There you go. I think we can all agree that the tax has been an unmitigated…. Flop.

So, what about the other argument, claiming that all the rich French people would leave the country? When the tax plan came out I received only a few calls from concerned wealthy French residents. The simple reason is this (and you would do well to keep this in mind): Whenever the wealthy rise up in droves to say “we are moving country” it’s simply not true. Why? Because they are just like you and everyone else. They’ve got their own lives, families, routines, (multiple) homes etc. etc. Upping sticks and moving to another country will always, always, always be the choice of the minority.

Allow me to get out my pen and the back-of-an-envelope and make a quick calculation for you.

In 2010 Switzerland had about 5 500 people in their forfait system (basically a special tax regime for rich immigrants) of which around 30% were French nationals. That makes for 1 650 croissant consuming, café-au-lait drinking rich immigrants in Switzerland. Assuming that of all the 66 million French people 1% are rich, we come up with a figure of 660 000 wealthy French people in total. Scribbling these figures on the back-of-an-envelope brings us to the result that a miniscule minority of 0.25% of wealthy French people live in tax exile in Switzerland. With numbers like that before the rich tax was implemented, is it really any surprise that there has been no mass exodus?

Yes, there have always been tax exiles and yes, changes in taxation will have some effect on immigration of the wealthy, but those effects, barring a Cuban style revolution, will always be minimal.