KGB Interview: Elmer Funke Kupper

The ASX's managing director divulges his views on the level of high frequency trading in Australia and the potential for mergers across the Asian exchanges.

Chief executive and managing director of the Australian Securities Exchange, Elmer Funke Kupper, tells Business Spectator's Alan Kohler and Robert Gottliebsen:

-- A violent sell-off in fixed income markets will pose challenges for emerging markets, where a lot of money has flowed in from investors chasing yield

-- The derivatives market has grown 7 per cent over the past 10 years, but volumes have levelled off 

-- Why it's important to capitalise and collateralise the risk for some markets in Australia, rather than abroad

-- Why the ASX bought into over-the-counter platform Yieldbroker

-- The level of high frequency trading in Australia

-- His view on the potential for mergers across the Asian exchanges

Alan Kohler: Elmer, welcome to Business Spectator again. It’s great to have you.

Elmer Funke Kupper: Thank you.

AK: Now this week the assistant governor of the Reserve Bank, Guy Debelle, warned that we may be in for a violent sell-off because liquidity in the markets isn’t what everyone thinks it is. Do you agree?

EF: I agree very much with the sentiment. And I’d say I particularly agree in fixed income markets around the world.

AK: I think he was mostly talking about fixed income.

EF: We’ve been in a long period of record low interest rates, a long period of quantitative easing and it acts like a drug in the financial system, doesn’t it. You get used to being on the drug and as people start to chase yield, they by definition go onto riskier assets. The combination of low interest rates and liquidity from quantitative easing makes that look attractive.

So, the question is: what happens when that dries up and interest rates start to rise? My fear is that two things would happen. The first is that there will be a value correction, so as interest rates go up, those higher risk assets don’t look so attractive anymore, so their value starts falling. But at the same time, liquidity might dry up. So, what looks like a highly active market today might be much more difficult to trade at that point in time.

The combination of values going down and liquidity going down can create a spiral and I think he calls that a ‘violent correction’. I think there’s every chance that that might happen.

Robert Gottliebsen: When do you think this is likely to happen? What’s your best guess?

EF: If I knew, I wouldn’t be sitting here having this conversation. Markets have been expecting the US to raise interest rates for some time now and it hasn’t done it. The expectation for Australia if we talk to the economists is that it’s something like 15-18 months out before we start to see a rise in rates.

In some ways, it’s not about interest rates actually rising that matters; it’s the expectation that matters. So, the moment Janet Yellen starts to talk about tightening, the market will start to respond.

AK: Well, they are talking about it now.

EF: They are, but they’re also talking about continuing to be accommodative to growth and liquidity, so it’s a slow boat to that moment, but it will come sometime in the next 12-18 months.

You can see why central bankers are worried about it. The reason they’re talking about this being a sharper correction in the fixed income markets is that they’d quite like to take the heat out of it before it starts to boil.

AK: But the implication of what Guy Debelle was saying was that in some way, the markets have changed in fixed income, in some way there are fewer market-makers than there used to be, the market has changed in such a way that the next time there’s a correction, it will be more violent because something has changed. Is that right? You’re right in the middle of it.

EF: Our markets in Australia are not as exposed to those forces as they are overseas. I think this is a particular challenge for emerging markets, where a lot of money has flowed in since the GFC, chasing yield. He would have better insights into that than I would, but I think he’s right.

AK: But the derivatives, particularly the fixed income derivatives markets, are enormous now. In fact, they are dominant. You know, ICE has taken over the New York stock exchange, like it’s the derivatives markets that are now on top, so it feels like the liquidity in those things is absolutely almost bottomless.

EF: I think we’re looking at two different types of risk or two different types of liquidity. I think the risk that I would worry about most is real investment risk, so it’s the value of the real securities and the liquidity to trade the real securities. That’s where people might get stung.

The derivatives markets in Australia, which is largely interest rate derivatives traded for real demand, people trying to hedge their risk in interest rates and by professional traders in the investment banks. So, I have no concerns about the quality and the soundness of our derivatives market.

I think the concern is much more about what happens in the world when capital starts to move in very large quantities from one geography to another geography and prices start to adjust because interest rates all rise, which one day they will. Those forces are almost bigger than any market maker or liquidity provider or even sometimes central bank can provide. And I think that’s where the concern is and that will reverberate around the world, so it will affect us indirectly more than directly.

RG: There was only one line in his speech, but Guy Debelle says a number of institutions that are inexperienced in the risk protection market are taking punts: either the market will keep rising or it will fall. He says they’re going to accept that market, they’ll have some losses and they’ll go out. Do you think Australian institutions that are inexperienced in this area -- I’m not talking about your Goldman Sachs and Citibanks -- the Australian institutions, perhaps superannuation funds, big superannuation funds are playing this market and doing what Guy says they’re doing?

EF: I’m not so concerned about that. Relative to the impact of a general correction like we’re now seeing in the equity markets or falling asset prices because of the state of the world, I’m not so concerned about that. I don’t see that as a big risk.

RG: Do you think our funds aren’t playing?

EF: If they’re in the market, they’re mostly there to manage actual risks of the balance sheets and the investments that they run as opposed to speculation. It’s all relative because if people are long on equities, a 6-10 per cent correction in the equity market -- down six and a bit over the last two months -- that’s a much bigger impact than any of this. Super funds are still highly conservative in the way they manage these things.

AK: It’s interesting. Since the GFC, not only has debt continued to increase unexpectedly perhaps, so has the trading of derivatives on the debt, interest rate swaps, interest rate futures and so on, to the point where it’s now a third of your business. Is it the case that a stock exchange these days and trading platforms such as yours is as much about gambling as about trading investments? Most of the derivatives trading is not actual people hedging their real securities; they’re trading, which is punting.

EF: Well…

AK: It’s the TAB, which you used to run. Now we know why they hired you, right?

EF: I can assure that it’s a little different. If you look at the derivatives business, the vast majority is interest rate futures. Yes, that market trades many times the underlying amount. Of course, it needs to be trading multiple times the underlying amount because that creates the liquidity that allows investors to be there. It’s an important function of it.

There are three customer groups there. There are professional traders. These are well established firms who have been around for a long time and who trade that market. You call it punting. I’ll tell you they’re a lot more scientific and deliberate about that. You have the house accounts of the investment banks and the major banks, so these are highly professional traders. And you’ve got the underlying real customers, fund managers, corporations and others who use the market to manage risk.

The structure of that market hasn’t changed very much. It has grown over the last ten years, probably around 7 per cent per annum. We had a record year in the last two years. Volumes have now levelled off a bit. And why have volumes levelled off? Because interest rates have been very stable and it doesn’t look like it’s going to change for a while.

That market trades on the back of interest rate movements of up or down and in the shape of the yield curve. That’s what traders are looking for and that’s the risk real customers are trying to manage. We don’t have a big concern about that. And remember, the risk management systems we have are absolutely state-of-the-art to manage that risk every single day in real time. We monitor the capital position of our clients in real time. Every single day we take several billion dollars’ worth of collateral to manage the risk in these markets. Because remember, the risk is centralised in the exchange, so our job is to make sure we manage this. I don’t have a big concern about the risk.

RG: Is our risk totally managed in Australia or are we part of London?

EF: The Reserve Bank had come up with some guidance earlier this year that says that the risk of the markets that are systemically important to Australia -- in other words, if the market fails, we have a serious economic problem -- that the risk of those markets has to be managed here. There are two in particular that matter: the equities market and the interest rate futures market.You can imagine why those are so important to our country.

That’s very helpful and very sound guidance to the marketplace. It doesn’t mean people can’t compete in the interest rate futures market, but it’s got to be capitalised and collateralised in Australia. That’s very important. In the over-the-counter interest rate market, interest rate swaps, they haven’t said that. Our advice was to do it there as well, but the Reserve Bank concluded that that market is already heavily globally traded and that they are very happy for the risk for that market to be managed in other places, be it, you know, Singapore or London or Chicago. London probably is the centre of excellence for that.

RG: To what extent do our regulations in these marketplaces differ from the global regulations and where do you think that should be changed?

EF: In the derivatives market there is now very strong global alignment, so our financial stability standards which we have to live with are aligned with the standards of Europe and the United States. This is part of the pact between global regulators to make sure the global derivatives markets are well managed.

We have some differences because of the peculiarities of our market, but by and large they’re the same.You may recall that last year we raised over half a billion in capital and that was to comply with the European capital standards that our regulators have adopted. That’s very well aligned and so it should be.

In the equity market there are very, very clear differences for all the reasons we’ve previously discussed around high frequency trading and dark pools. I think our regulators have very smartly not copied markets like the United States and as a result, we’re better regulated in the equity market than the United States.

AK: A month ago you bought into a business called Yieldbroker, which is part owned by a large number of the investment banks. And in the press release you said: “ASX sees an opportunity for ASX and Yieldbroker to work together to deliver the next generation of Australia’s financial market trading infrastructure”. What does that mean?

EF: Well, right now we have an exchange-traded derivatives market and we have an over-the-counter fixed income and derivatives market. Global regulations are bringing these markets closer together and we see an opportunity to work with our clients, hence that’s only 49 per cent of this business. And, by the way, the transaction hasn’t completed yet, as we sit here, so we hope it gets completed soon. And our clients own 51 per cent. So, by working together we believe we can invest in the next generation of platforms that starts to integrate these products in a more meaningful way and it can create efficiencies for our clients. So, examples would be the convergence between exchange-traded interest rate products and over-the-counter interest rate products.

AK: So, Yieldbroker’s an over-the-counter platform?

EF: It’s an over-the-counter platform that trades over-the-counter securities. We are an exchange-trade platform.

AK: So, is this an example of Muhammad going to the mountain rather than expecting the mountain to go do Muhammad? I mean the expectation has been that over-the-counter derivatives trading needs to move on to the exchange. As an exchange, you seem to be going to participating in over-the-counter.

EF: I think those markets will be separate, but will be getting closer together over the next decade. Exactly how that’s going to play out, nobody knows. So, a simple example of this is something called swap futures, so we have an interest rate swap and we have an interest rate future, over-the-counter, exchange-traded. Exchanges are now launching something called deliverable swap futures, which is an exchange-traded product but delivered into an over-the-counter swap.

And this is because regulators are forcing these markets closer together. As they get closer together, our clients will demand integration of the risk management, integration of the platform, integration of the front end or at least delivery in a very efficient way. So, we thought it was natural to partner up with Yieldbroker, who is the leading electronic platform for this, and see over the next decade if we can deliver this to the marketplace.

AK: So, is there also an element in this of remutualisation, of you now seeking part-ownership of the trading platform by the clients, the investment banks?

EF: Yes. Someone asked me once if I would have liked to buy all of Yieldbroker, and the answer is no. I think it’s really important this is a partnership with our clients because it’s really working together if we can deliver the efficiencies to the marketplace and to them and to the end investors, so I wouldn’t want to own more than half of it. It turns out to be 49 per cent. In other parts of our business we’ve also been giving our clients much greater input into our investment program. So, we have forums for almost every market that we run that brings our clients and the exchange together regularly to talk about what they want from us in terms of product development and innovation. Because the world is accelerating, regulations are accelerating, innovation is accelerating. And we need to be right at the forefront. The good news is in a number of markets, we are.

RG: But about six of those clients have these dreadful cables which basically rip off the smaller investor because they get first go at it. You promised us that you’d cut those if we couldn’t get it right. You haven’t cut them. Is that due to just sopping up to the big institutions?

EF: We said we should cut them if we didn’t get it right, so perhaps we got it right, so we didn’t have to cut them.

RG: They’re still there.

EF: You’re nothing if not persistent on this point. Most of the intermediaries, certainly larger ones, are now located in our data centre, so they all have access to the exact same technology and exactly the same length cable. In that sense, if you think that 90 per cent of the market goes through that data centre today, it is probably the closest thing you can get to democracy because everybody gets the same technology, the same access, so I think that’s very important. At the same time, our regulators have done a very good job in not copying the regulations from overseas. And there are some very important differences between the US market, in particular, where high frequency trading is very significant, and the Australian marketplace. Some of the practices that are allowed in the US are explicitly not allowed in Australia.

RG: Do you have an example?

EF: An example is something called maker-taker pricing. So, in the US an exchange is allowed to pay people to trade. In Australia we charge buyers and sellers. So someone takes liquidity, someone posts liquidity, we charge both sides. In America they charge the people who take the liquidity, usually real investors, more than they do in Australia and they pay the high frequency traders to sit on the other end. So, while in our case, everybody pays, in the US, real investors pay more and high frequency traders get paid. We think paying people to provide liquidity, paying people for order flow in the equity markets, is a highly dysfunctional way of operating. We’ve advocated very strongly for it to be banned in Australia and today it is banned. That’s a very important difference because remember high frequency traders are nothing if not rational. They don’t care about what the company does. They only care about the mathematics and the algorithms and the opportunity. So, if you take economic opportunity away or limit economic opportunity, you limit the trading opportunity, you limit the void that they do. And as a consequence, high frequency trading in Australia is less than half of what it is in the US.

RG: What would it be as a percentage?

EF: Well, it’s probably in the lower 20s percentage points, but more importantly what people call predatory high frequency trading is very, very small in Australia, if it exists at all, and it is because the economic opportunity isn’t there. Now, there is high frequency trading. There is intermediation in transactions that is not necessary, but of course once you’ve got two exchanges, you’ve given up on a single queue of orders, haven’t you? So, once you fragment, that’s where it all starts. Once you’ve got two exchanges, you’ve fragmented the market, you’ve given up.

AK: So, it would be all okay if you had a monopoly?

EF: Well, let’s put it this way, it wouldn’t have been much of an issue if we had a single exchange. That’s true. But that ship has sailed. Now, what we have done over the last couple of years is we’ve tried to give control back to the end investors, particularly the super funds and the fund managers, so that they have control again over the way their orders get executed. So, they get liquidity and control over their order flow and that’s been very successful, so we’ve actually done okay out of that journey.

AK: So, is the idea of a merger between Singapore Stock Exchange and Australian Stock Exchange completely finished now or is it likely to come back on the table?

EF: We’re completely finished unless you’re looking at it from a very long timeframe. I think it’s hard for us to look, you know, very far away on this. Right now, there’s nothing to talk about. I think that’s the most important message. I think my chairman, Rick Holliday-Smith, put it very well at our AGM when he was asked the same question. He said our world is shrinking, consolidation in the exchange industry is happening again and it’s likely to continue, so we’d be foolish not to be aware of what’s happening, being on top of the trends, even when there’s nothing to talk about.

The most important thing for us is to make sure that we’re in the strongest possible position, so that if and when something happens with anyone – and I’m not picking any particular exchange, then we’re in the strongest possible position to do things on our terms. But today, there’s absolutely nothing to talk about on it.

AK: Do you think that at some point in the future there’s a combination of the Asian exchanges, Hong Kong, Shanghai, Singapore, Australia? Does that make some sort of sense?

EF: Well, clearly Singapore and Australia have had an attempt. I wasn’t there at the time, but people must have felt that that made sense.

AK: I’m asking if you think it makes sense.

EF: I can’t say too much about this, as you might appreciate. I think exchange consolidation will continue and we can’t be an island forever, but we also should be patient and we should only do things that make sense for our shareholders and for our long-term strategy. Right now, we’re in a very strong position; we’re doing many of the right things and therefore we’re not in a hurry here at all.

In Greater China you can see some very interesting things happening, I think in two ways. One is that Hong Kong and Shanghai are getting closer together. You know, they’ve just set up a trading link which allows mainland Chinese investors to buy directly into the Hong Kong market. Now, that’s a first. So, Hong Kong and Shanghai are getting closer together.

And of course China itself is trying to play a much greater role in the global commodities trade. They’ve set up the free trade zone, Hong Kong with the metals exchange. So, you can see commodities trading over the next decade drifting towards the Asian time zone, since Asia is the main client of commodities globally. If the main buyer of commodities wants to take control of the trade, why shouldn’t they?

RG: Chicago would not like that.

EF: Well, Chicago wouldn’t like it, but what Chicago is doing is setting up businesses in Asia. ICE, one of the big commodities exchanges and derivatives exchanges in the world, has set up a business or has bought a business in Singapore. The Chicago Mercantile Exchange is looking at Asia. Eurex is looking at Asia. We are already in Asia.

RG: Just briefly, who do you see as your main rival globally?

EF: Well, we’ve got of course domestic competition with Chi-X in equity markets. The equity market is not our biggest business; it’s 5 per cent of our revenues. I think global regulations are creating global competition. So, in derivatives and particularly the clearing side of it, I’d say London is probably our number one competitor today. And when I say we, I mean Australia’s competitor because whether you like it or not, today ASX and Australia are the same thing.

I think the work that our regulators have done on this has been very helpful to clarify where risk has to be managed, so we believe we can be highly successful based in Australia in the current regulatory environment. And that’s been very important to us, because remember we need to make very serious investments to be globally competitive.

Our business model gives us the balance sheet and the revenues and the profit to do it and the regulations that are now in play give us a certain investment environment, so we’re quite happy to put our money where our mouth is and invest very heavily in our infrastructure to be globally competitive.

RG: Do you see us then as the major hub in equities and interest rate derivatives in the region?

EF: Well, we are the Australian dollar interest rate market today, which is $40 trillion in notional turnover. It’s a very big business. Our equities business is largely domestic and that’s not a surprise. We have the third largest portfolio of investable assets.

If anything, our equities market is not big enough to deal with the funds that are flowing into the superannuation system. So, what we would like to do is have a broader set of assets listed on the exchange to get the corporate bond market going. We would like to start quoting international equity so we bring the world to Australia because of the phenomenal amount of funds that we have in our superannuation system.

It’s a terrific asset, but the money has to go somewhere. We have $1.8 trillion worth of assets. Our entire equities market is $1.5 trillion, and that will be $2 trillion next year, by the way, and then it goes to $3 trillion and so forth. So, by definition, we need to have a broader set of investment opportunities for those funds and our mission is to build that in Australia and for the rest of the money flowing overseas.

AK: Thanks for joining us, Elmer.

EF: Thank you.

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