Best Foreign Exchange Trading Platform: The Nominees
The 2017 winners will be announced at a gala event on May 25 in London at the V&A Museum
By Joel Clark
Updated: April 3, 2017 4:14 p.m. GMT
The 2017 winners will be announced at a gala event on May 25 in London at the V&A Museum.
Here are the nominees for: Best Foreign Exchange Trading Platform
360T has been a reliable FX platform for institutional asset managers and corporates since inception in 2000, but its acquisition by Deutsche Börse in 2015 has given it increased firepower. With offices in Frankfurt, New York, Singapore, India and Dubai, the platform has 1,600 users globally and sources liquidity from 200 providers. The business is managed by long-time chief executive Carlo Kölzer, now also Deutsche Börse’s head of FX. It made several senior hires in 2016 to strengthen its sales effort in the US and Nordics. Most recently, industry veteran Simon Jones joined as chief growth officer and board member.
Part of Michael Spencer’s NEX Group, EBS’s average daily volume in 2016 was $85.8 billion, down nearly 10% year-on-year, but it bounced to $93.2 billion in January 2017. The pace of change may have slowed after chief executive Gil Mandelzis left in 2016, but EBS remains the market’s primary trading platform for major currencies. Under new CEO Seth Johnson, it introduced EBS Live Ultra, a faster data feed that updates price at intervals of either 100 milliseconds or 20 milliseconds. An upgrade in February offers a five millisecond feed, reducing reliance on the controversial practice of “last look”.
FastMatch, which was founded in 2012, aims to provide the fastest access to reliable FX liquidity using the same technology that underpins Credit Suisse’s Crossfinder matching engine. Average daily volume reached $12.7 billion in 2016, up from $8.4 billion in 2015. FastMatch traded $39.8 billion on June 24 and $38.0 billion on November 9, following the Brexit vote and US elections respectively, putting it on a par with established platforms that often see a spike in volume at times of market stress. The platform made its proprietary algorithmic and transaction cost analysis services available to all subscribers last year.
The State Street owned business has existed since 1996 and sources liquidity from more than 60 firms, including both top-tier banks and regional specialists. Of the largest 50 global asset management firms, State Street estimates that 47 use FX Connect. The platform saw a peak day on June 30, 2016, in the aftermath of the Brexit vote, when FX trading volumes exceeded $400 billion, with more than 47,000 transactions processed. FX Connect supports a range of execution methods, including relationship-based request-for-quote, request-for-stream, voice trading and algo execution services.
Led by chief executive Alan Schwarz, bank-owned FXSpotStream has become an enduring presence in the rapidly changing FX market. With an average daily volume of $18.2 billion in 2016, and significant year-on-year growth reported in seven out of 12 months, the platform is attracting a growing pool of liquidity. FXSpotStream does not charge brokerage fees to either clients or liquidity providers. With liquidity provided by 12 global banks – double the number it had had when it started out in 2011 – the business now has offices in London, New York and Tokyo.
Turnover on institutional FX platform Hotspot has remained resilient in the past year, with an average daily volume fluctuating between $29.4 billion in the first quarter of 2016, $25.7 billion in Q3 and $26.7 billion in Q4. Since its acquisition by Bats Global Markets in 2015, Hotspot has launched a UK matching engine, developed trading in outright deliverable forwards and launched Hotspot Link, which allows clients to design their own relationship-based liquidity pools. The platform grew its market share from 11.5% to 12.5% last year, according to Bats. Hotspot recently hired Matt Vickerman from Sun Trading and Rahul Bowry from Markit.
JP Morgan Markets
While some of its competitors have pulled back, JP Morgan has continued to invest heavily in its electronic platform and has achieved significant growth in activity on eXecute, the FX and commodities trading platform on JP Morgan Markets. By December 2016, the average number of daily users trading on eXecute had increased 43% year-on-year. Mobile usage had increased by 23% year-on-year, while the biggest trade on a mobile device stands at $100 million. JP Morgan has set aside $100 million to further develop its electronic offerings this year.
Thomson Reuters’ FX platforms support a combined average daily trading volume of $350 billion, representing a substantial chunk of global market turnover. FXall, the dealer-to-client platform acquired by Thomson Reuters in 2012, has 1,700 institutional clients and 160 market makers. The company’s interbank platform, Thomson Reuters Matching, is a key trading venue for commonwealth currencies, and average daily spot volume across venues averaged $100 billion in 2016. Thomson Reuters introduced a new high-speed data feed in 2016 to deliver faster price updates and is partnering with analytics provider BestX to deliver independent trade analysis to clients.
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Best Foreign Exchange Trading Platform 2018: The Nominees
The winners of FN’s Trading and Technology Awards will be announced at the V&A Museum in London on May 15
Our awards are independent and fee-free. The Financial News editorial team compiles a shortlist of five nominees in each category following extensive research, taking soundings from industry contacts, and reviewing data and industry information.
The winners will be announced at the 16th annual awards gala dinner to be held at the V&A Museum in London on Tuesday, May 15.
Here are the nominees for: BEST FOREIGN EXCHANGE TRADING PLATFORM
In spite of multiple changes of ownership over the past three years – from KCG to Bats Global Markets to Cboe – the platform formerly known as Hotspot has gone from strength to strength, with an average daily volume of $29.5bn in 2017, up nearly 10% year-on-year. In the fourth quarter, its market share averaged 14.9%, up from 12% in 2016. Given the fragmentation of liquidity, that is a sizeable chunk of the global FX market. In May 2017, Hotspot launched outright deliverable forwards on the platform while non-deliverable forwards were launched on Cboe SEF, the exchange’s registered swap execution facility, in December. The Hotspot business has now been rebranded as Cboe FX and is led by Bryan Harkins, Cboe’s head of US equities and global FX, while Jon Weinberg was hired from UBS last year as head of FX liquidity analysis.
Ten years after buying Currenex in a landmark deal for the sector, State Street has continued to invest in the platform and it remains a leading liquidity pool in the FX market. In readiness for the EU’s revised trading rulebook under the Markets in Financial Instruments Directive, State Street last year launched the Currenex Multilateral Trading Facility to enable clients to use a disclosed request-for-quote model for FX spot, swaps, forwards and non-deliverable forwards. The platform’s trading volume are not disclosed, but Currenex remains a significant pool of FX liquidity. It is supported by a range of market data services, including streaming tick data on 40 currency pairs as well as well as a 100-millisecond snapshot of aggregated top of book price data. Last year, State Street hired James Reilly from Cantor Fitzgerald as global head of Currenex.
Amidst a spate of FX platform launches in recent years, FastMatch has emerged as one of the most successful, achieving an average daily volume of $18.4bn in 2017, up from $12.7bn in 2016. Average daily volumes spiked to a record of $22.5bn in May 2017, putting FastMatch firmly into competition with more entrenched players. In August 2017, exchange operator Euronext acquired the platform as a means of expanding into the FX market, which has in turn allowed FastMatch to push into the real money space in Europe. Additional highlights of 2017 included the opening of a sales office in Connecticut to complement its offices in New York, London and Moscow, and the launch of FX Tape, a market data service intended to act as a central reference point for transacted prices in spot FX.
NEX Markets, previously EBS BrokerTec before Icap sold its voice broking unit and rebranded as NEX Group, recorded average daily FX volumes of $82.6bn last year. This may be a far cry from its heyday in 2008 when EBS hit an average of $214bn, but the FX market has changed since then and liquidity is now far more fragmented. With 2,800 customers in 50 countries, EBS remains the benchmark in major currency pairs such as EUR/USD and USD/JPY. The EBS Live Ultra data feed was enhanced last year to deliver spot FX data at five-millisecond intervals in response to client demand, while NEX Quant Analytics, a newly launched service that allows clients to analyse their performance and conduct regular reviews has proven particularly popular. EBS revenue for the half year ending September 30 2017 was £75m, up 12% year-on-year, highlighting the success of its diversified product offering.
This year got off to a flying start, with trading volume across the Thomson Reuters Matching and FXall platforms reaching record highs in January 2018, suggesting not only that FX volatility had picked up, but also that diligent preparations for Mifid II had paid off. Average daily volume for all products reached $432bn, including $107bn for spot only – a level not surpassed since June 2016. Enhancements were completed in July 2017 to allow European clients to continue using the platforms for FX products under Mifid II and further changes were made to the company’s multilateral trading facility in December to support FX derivatives. In January, Thomson Reuters hired Jill Sigelbaum from NEX Traiana to head FXall, the ever popular institutional platform that it acquired in 2012.
Methodology Financial News’s awards are independent and fee-free. Nominees in each category are voted on by a distinguished, independent panel of industry practitioners who cast their vote electronically. Each judge awards a score out of five to each nominee. The results are then vetted by FN editors for conflicts of interest. The highest adjusted average score out of five is the winner.
BATS increases its institutional platform portfolio
Just who is forging ahead in the very competitive institutional ECN sector? It is a very close battle of the…
Just who is forging ahead in the very competitive institutional ECN sector? It is a very close battle of the titans….
Yesterday, exchange operator BATS Global Markets announced it was buying ETF.com, without disclosing the financial terms of the transaction, in a deal which is expected to close in April 1st.
The ETF.com website which generated 875,572 page views and attracted 291,191 unique visitors in February 2016 will become an independent media subsidiary of BATS Global Markets.
David Lichtblau, CEO of ETF.com, will remain in that role and report directly to Bats Executive Vice President and Head of U.S. Markets Bryan Harkins.”, said the press release, underscoring “our commitment to the ETF industry and our focus on providing unique, value-added content for issuers, brokers, financial advisors, market professionals and investors.”
Bats has been expanding its ETF business, doubling the number of ETFs listed on the US market to 56 as the Kansas-based firm offered to pay ETF providers as much as $400,000 to list on its exchange, since 2015.
On Monday, the company announced it would provide Money.com with Bats One Feed, a market data product that handled 26.2% of all ETF trading in February 2016.
In 2015, BATS Global Markets, Inc. Class A Common Stock (BATS:BATS) decided to expand into the foreign exchange market by buying currency-trading venue Hotspot FX from KCG Holdings Inc. in a $365 million deal in cash and additional payments under a tax sharing arrangement of $63 million, apparently valuing the company 14 times the EBITDA in 2014. HospotFX has a network of more than 30 prime brokers and an average daily volume over $30,000 billion in 2016.
Multi-asset institutional platforms have been dominated by EBS (ICAP) and Thomson Reuters who compete at almost level pegging volume wise for 3 years.
Thomson Reuters bought FXall for $625 million in 2012, having published its average daily spot volume at $111 billion in a total volume of $356 million in February. At the time, FXall CEO Phil Weisberg became Global Head of eFX for Thomson Reuters, a position he continues to hold today.
Electronic Broking Services (EBS) which is the institutional ECN division of British interdealer broker ICAP Plc (LON:IAP) and is one of the largest dealing platforms, continues to hold its level pegging with FXall on a monthly basis, with average daily volumes in February 2016 coming in at $102 billion, and daily average of $107 billion in 2015, down from $274 million in 2008.
ICAP’s decision to bring EBS under the same roof in late 2014, combining its EBS foreign exchange and BrokerTec fixed income electronic trading platforms into one business unit, might have been the force behind Bats buying Hotspot FX, in a business environment where mergers and acquisitions are in fashion. Consolidation is the new big thing among institutional giants, now the other “big four”: Thomson Reuters, ICAP, BATS and KCG.
No.2 US exchange operator by volume, BATS expanded beyond equities and into foreign exchange and ETFs, aggressively trying to win market share. After a failed attempt to file an IPO in 2012, due to a glitch in the company’s trading systems, BATS is planning to file one in 2016, valuing the firm at $2 billion despite equity’s valuation at $1.5 billion.
This acquisition, when looking at the closely-contended institutional ECN sector, is a case of BATS Global Markets sharpening its bow as the battle for supremacy in this particular sector continues not only to be a four horse race, but a very marginal one at that.
Photograph: Time Square, New York. Copyright FinanceFeeds
Exchanges and the over-the-counter (OTC) market might have moved a little closer in recent years, but it is far from inevitable that demand for greater trading clarity will push a sizeable chunk of the market away from OTC.
The acquisition of trading platforms Hotspot and 360T by Bats Global Markets and Deutsche Börse respectively last year were bold statements of intent by exchange operators to grab a larger chunk of the trillions of dollars traded in FX every day.
However, while consolidation in the venues supporting FX trading can be expected to result in exchanges becoming more involved in the FX space, any actual market structure change is likely to take a long time to materialize, according to FXSpotStream CEO Alan Schwarz.
“The FX market continues to do a good job of addressing regulatory requirements and meeting the demands of market participants,” he says.
“We have seen a shift in the FX market looking to trade more on a disclosed basis. Our business has continued to see year-on-year growth because there is a move taking place from exchange-like anonymous trading to bilateral, fully disclosed trading between counterparties.
“Unlike trading on an exchange, the relationship via FXSpotStream is transparent and trading with the liquidity providing banks is on a fully disclosed basis.”
Kevin McPartland, head of market structure and technology research at Greenwich Associates, believes that discussion of migration from OTC to exchange fails to take account of some of the nuances of the FX market and that the future lies in venues that support multiple trading models.
“There are a host of non-exchange electronic trading venues that allow clients to trade with each other in a variety of ways,” he says.
On the question of whether there is a discernible shift towards fully disclosed trading, McPartland refers to both central limit order book (CLOB) and request-for-quote (RFQ) having their merits.
Despite observations made by the likes of TeraExchange – that order book platforms offer a democratic marketplace through transparent, firm and executable prices – corporates have remained reluctant to abandon the RFQ model.
The key question for CLOB platform providers continues to be not why market participants have migrated to alternative models but rather when they will be in a position to win new business for products that are most suited for order books, such as the benchmarks and plain vanilla products.
“RGQ offers liquidity on demand and identification of counterparties, whereas CLOB is faster and its anonymity can be helpful,” says McPartland.
“But we are now seeing demand for a solution that provides the best of both worlds by enabling trading in an order book format while maintaining a bilateral relationship with counterparties.”
He refers to CME FX options as an example, noting they are effectively options on futures.
“However, the situation in the spot market is more complicated – some aspects are becoming closer to an exchange, others are moving further away,” he says. “FX has its own market structure that is hard to fit into the OTC/exchange paradigm.”
One of the fundamental reasons why the market does not become centrally cleared, says Sinclair, is that a cleared model carries the cost of insurance against both settlement and market risk.
“CLS insures you against settlement risk but not the market risk,” he adds. “Counterparts still find it cheaper to self-insure against market risk in case of a counterparty default than to pay the extra cost of a fully cleared solution.”
A senior platform source observes that growth in exchange-traded products has largely come from futures traders who have looked for diversification and added FX as another asset class.
“Very little business has moved from OTC – some banks have added exchanges as additional liquidity sources to cover risk, but that is really the only business that has crossed the divide,” the source says.
OTC has become more exchange-like in that the largest banks have continued to extend their internalization of flow, so each now runs an order book trading structure internally.
However, our source also points out that the tightening of credit has reduced the number of prime brokers in FX and costs have risen “so the nearest thing that the FX OTC market has to centralized clearing has actually reduced its volume and capacity”, he concludes.
Pressure builds to move more FX trading onto exchanges
LONDON, Feb 16 (Reuters) – International regulators struggling to rein in the $5 trillion-a-day global foreign exchange market are finally finding some support from asset managers warming to the idea of moving more trading onto exchanges.
The juggernaut forex market operates 24 hours a day across all time zones, but unlike with shares or commodities, trading is not centralised, potentially leaving space for malpractices.
This has gone largely unremarked for years. But a global investigation into market-rigging, allied to post-2008 regulation which has raised trading costs, has prompted more fund managers to ask if they are getting a fair deal from banks.
Advocates say putting forex trading on to exchanges would increase transparency, limit the scope for manipulation and benefit consumers. That would all come at a cost that now looks less of an issue than it did even two years ago.
“We are talking to people who are planning to shift 10-20 percent of their portfolios to some form of exchange-based or cleared trading if only to see how it goes,” said Peter Jerrom, who has launched a new broking operation matching orders for certain types of derivatives at London-based Sigma Broking.
“There is a shift that is a reflection of how much people have become tired of a variety of issues with the banks.”
BATS Global Markets’ purchase of FX trading platform Hotspot last month and moves by NASDAQ and Eurex into the sector, as well as the growing role of commodities and futures exchange CME Group in FX dealing suggest the move is gathering momentum.
Straightforward spot trading, worth roughly $2 trillion a day, will almost certainly continue to be done ‘over the counter’, with participants dealing directly with one another by phone or electronically.
But the growing costs of trading derivatives and options means anything from 20 to 60 percent of the market will be up for grabs in the next few years.
“All of the big exchanges are looking at this space now,” said David Mercer, chief executive officer of LMAX, a “multilateral trading facility” (MTF), to all intents and purposes the world’s only regulated currency trading exchange.
The head of business development with another major exchange added: “It is clear to us that our clients want trading on exchanges. But they do not want all trading on exchanges.”
DON’T BANK ON IT
Alfred Schorno, managing director of FX trading platform 360 Trading Networks said the critical issue was increasing transparency rather than necessarily moving to exchanges.
Calls for clearer structures reached a crescendo last November, when a year-long global investigation into allegations of collusion and rigging culminated in multi-billion dollar fines for six of the world’s biggest banks.
The threat of further fines for the banks from the European Union remains, while the U.S. Department of Justice and Britain’s Serious Fraud Office are still pursuing criminal investigations.
One issue is that forex dealing is concentrated in relatively few hands, with just five banks accounting for more than half of all the trade. Understandably, they are reluctant to loosen that grip.
“The big platforms have a difficult choice to make. Faced with more regulation, if they favoured a move to exchanges, they might well be the biggest players – or at least from a manager’s point of view might be bought well by one of them,” a senior industry source said.
WTO warns of global trade slowdown as indicator hits 9-year low
“But the banks would go mad if they said that publicly so they have to keep quiet,” he said.
Britain’s Conservative-led coalition government has pushed the bigger issues of the structure of the FX market back until after May’s general election.
But with some 40 percent of global currency trading flowing through London every day, the Bank of England’s Fair and Effective Market Review recommendations, not expected out until June, will be an important sign of things to come.
The industry contact panel for the review is, notably, chaired by the head of one of the world’s biggest asset managers, Allianz IG’s Elizabeth Corley. She declined to comment for this article.
ROUBLE RUCTIONS, FRANC FALLOUT
One driver for the move to more regulation is the market’s sheer size. It is by far the world’s largest single financial market, backed by central bank balance sheets that have swollen by some $10 trillion since the 2007-08 crisis and global foreign exchange reserves that now stand at $12 trillion.
Switzerland’s shock removal of its cap on the Swiss franc on Jan. 15 helped drive a record 2.26 million transactions, worth $9.2 trillion that day. On Dec. 17, as Russia’s rouble crumbled along with oil prices, volumes hit a record $10.67 trillion.
While various financial centres have developed voluntary codes of conduct for FX trading, they are not legally binding. In FX, unlike on the stock market, short-selling or betting on a fall in the price of an asset is virtually unrestricted.
Spot trading is hardly regulated at all. Traders dealing tens of billions of dollars a day are not required to be on the UK Financial Conduct Authority’s register of approved persons.
But that leaves some $3 trillion of FX options, swaps and derivatives trading, which regulators have moved to push towards formal clearing. (Editing by Hugh Lawson)
In international finance, derivative instruments imply contracts based on which you can purchase or sell currency at a future date. The three major types of foreign exchange (FX) derivatives: forward contracts, futures contracts, and options. They have important differences, which changes their attractiveness to a specific FX market participant.
FX derivatives are contracts to buy or sell foreign currencies at a future date. The table summarizes the relevant characteristics of three types of FX derivatives: forward contracts, futures contracts, and options. Because the types of FX derivatives closely correspond to the identity of the FX market participant, the table is based on the derivative type-market participant relationship.
An Overview of the Relevant FX Derivatives
Standardized regarding the amount of currency
Obligation to engage in the transaction on the specified
No, but premium must be paid
CME Group GLOBEX
Useful for MNCs
Useful for speculators
CME Group: the leading derivative exchange formed by the (2007) merger of the Chicago Mercantile Exchange (CME) and Chicago Board Options Exchange (CBOT); GLOBEX: an international, automated trading platform for futures and options at CME; ISE: International Security Exchange, a subsidiary of EUREX, a European derivative exchange; OTC: over-the-counter.
CLSClearedFX is the first payment-versus-payment settlement service specifically designed for over the counter (OTC) cleared FX derivatives. The service enables central counterparties (CCPs) and their clearing members to safely and effectively mitigate settlement risk when settling cleared FX products.
The service delivers capital, margin, leverage, liquidity and operational benefits for industry participants, and is consistent with goals set by the G20 in response to the global financial crisis to mitigate systemic risk through the clearing of standardized OTC derivatives.
LCH ForexClear continues to dominate the cleared NDF market.
CME have recently announced that 7 market participants intend to clear NDFs across their service next year.
We look at the CME’s existing volumes in FX futures.
FX NDF Clearing Update
When we last looked at NDF Clearing in June 2017, we saw that LCH were dominating volumes. Open Interest had risen to $600bn+ and monthly volumes were up over $400bn, with March 2017 pushing $500bn. Has anything changed since? Amir provided an update for September, and bringing this up-to-date via CCPView shows:
LCH ForexClear continues to dominate NDF clearing. 92% of notional outstanding is at LCH.
Total Notional Outstanding of cleared NDFs has now surpassed $750bn – both in total and at ForexClear alone.
Growth since the beginning of 2017 has been impressive, with Open Interest basically doubling (it is 1.88 times higher now than end of December 2016).
And in terms of monthly volumes, October 2017 was near to the records set in September. The weekly time-series of volumes shows a steady upwards trend:
The biggest week was the end of September, when $184bn cleared in total.
There have now been four weeks when total clearing volumes have topped $150bn.
Our disclosures data shows that the number of participants at LCH ForexClear have increased over the past year. We started at 25 in Dec 2016 (23 of whom were banks), and we were up to 27 as at end June 2017 (our latest data point).
As a reminder, this move to NDF Clearing appears to be a post-trade process. We still see less than 4% of volumes reported to SDRs flagged as “Cleared”. Actual market take-up is much larger than this (about 20% of the total market is cleared and 35% of D2D markets according to our last estimates) – but the trades are novated to clearing after trading, and hence do not appear to be cleared in public trade reports.
This obviously piqued our interest at Clarus – we like innovation, we are keen followers of the FX market and we are continually looking at ways that volumes may move across OTC and Futures products. This new product ticks a lot of those boxes!
Add in the fact that EMIR brings VM to FX Forwards next year, and this product is one we will watch closely. If counterparties can bring in multilateral netting benefits of clearing to any of their OTC business, it may lessen the funding impacts from having to post VM on FX.
In terms of the product itself, I understand this to be the concurrent buy and sell of OTC Spot versus an FX Future at CME. As well as managing VM in a UMR world, this product offers the same exposures to risk factors as an OTC FX Forward – interest rate differentials between two currencies, very short dated cross currency basis exposure – but could allow users to manage OTC credit and settlement exposures by using a future for the long-leg.
For CME, I imagine transferring as much liquidity as possible from the OTC space to the futures space is important. Therefore, using Quandl, I had a look at FX futures volumes recently:
Number of contracts traded in the front EURUSD FX Futures contract every day since June.
Volumes have been very stable.
The rolling ten-day average (the orange line) shows anything between 150-250,000 contracts trade each day. Multiply by EUR125,000 notional value tells us we have a notional equivalent volume of around €25bn.
In that BIS survey, we see an average daily volume for EURUSD spot of ~$500bn. If we treat the CME future as a spot-like product (because it trades on an outright basis and I imagine is largely used for price risk transfer) then about 5% of spot-market equivalent volume occurs in futures markets.
It will be an interesting one to watch. Our chart suggests volumes in FX Futures have been fairly static recently. Will this new product shake things up?
I’ve not got too much to add to the press release apart from;
Cross-margining versus Non Deliverable IRS will be offered. This is interesting as I do not think that LCH cross-margin ForexClear versus SwapClear (let me know if you think different in the comments). On the LCH 2017 roadmap, non deliverable swaps should soon be available at SwapClear (Q4 2017).
It is not clear if these members are new members or are existing clearing members at CME. Our Disclosures data (identified as “CME IRS” ) shows that CME had 23 clearing participants at end June 2017.
We will be keeping a keen eye in Q1 2018 for these volumes coming through into the CME service. Make sure to subscribe to stay on top of these market trends.
Open Interest in Cleared NDFs has surpassed the $750bn mark.
LCH dominate NDF clearing at the moment, with up to $150bn in notional volumes trading each week.
CME will be bringing more competition to NDF clearing in 2018 with seven participants intending to clear.
CME already have a successful FX franchise, with EURUSD FX Futures accounting for around 5% of spot market volumes.
CME are introducing an FX Link product in 2018 which will combine OTC spot and Futures contracts into a single executable spread.
Clarus data helps market participants stay on top of these trends by showing where volumes are traded.
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Eurex will look to open up competition for clearing OTC FX derivatives in Europe.
Eurex will begin clearing OTC FX derivatives following the launch of new systems changes to clearing swaps, as it looks to compete in new asset classes with LCH.
Eurex Clearing is cooperating with 360T to introduce clearing on OTC FX swaps, spots and forwards in EUR/USD and GDP/USD, with CLS acting as the settlement agent.
According to a circular from the Frankfurt-based exchange group, it plans to launch the service after it goes live with a series of changes to EurexOTC Clear on 15 May. It currently provides clearing for FX futures and listed options.
The move will open up competition in the FX swaps market, with London-based LCH currently operating the only clearing service for OTC FX derivatives in Europe. So far this year LCH has cleared over 128,000 contracts with a notional volume of $2.9 trillion.
According to data from ClarusFT, over a third of dealer-to-dealer volumes were cleared in the non-deliverable forwards market at the end of last year.
Previous reports have suggested LCH is looking to launch an OTC FX options clearing service. Meanwhile CME Group has said it will expand its cleared FX suite this year by offering FX options on seven main currency pairings.
THE FUTURE OF FX: EXCHANGE TRADED AND OTC LIQUIDITY?
Best Execution talks to David Holcombe, Product Lead for FX Futures and Clearing, 360T
Is the FX market really heading towards being an exchange traded and centrally cleared market?
This isn’t an all or nothing point in either direction. One size does not fit all in the FX market. The Deutsche Boerse Group FX strategy is actually a good view of the end state of the FX landscape – where informed clients will establish whether to clear any given trade, then use the right tools to achieve that.
When will that be? Cleared and exchange traded FX is still a small fragment of the overall FX market, so surely that “end state” view is still many years away?
My role is to ensure 360T exploits tight integration between 360T, the Eurex Exchange, Eurex Clearing and other group entities to create a truly front-to back FX offering for our clients that covers Exchange and OTC FX liquidity. We haven’t made a public song and dance about this, but this integration really is very well advanced, and you will see FX futures traded via 360T in the first quarter of 2018.
Beyond tools to let our clients choose the right FX product for the trade they need to do, using the right execution model, and the right credit and clearing model to exploit all the benefits available, the challenge the industry faces right now is to understand what clearing means, and what it can do for them.
OK, so if clearing is the start point for all of this, how do I know whether to clear something?
It’s actually a complex consideration. We’ve had a specialist consultancy in to prepare analysis to quantify the benefits of central clearing for FX, as in the absence of clearing mandates, the decision process to clear needs to consider multiple attributes for any given scenario. With so many moving parts as variables in the model, we are now going through these results with clients individually, offering to put their sample portfolios through our modelling tool to see where they will gain.
Ultimately though, one has to understand what the real drivers for each trade are, and also to consider the full impact that the trade will have on the portfolio in each form it could take, in order to then make an informed decision of how and where to get the best trade done with the best outcome.
So, once you need to clear, how do you choose between OTC executed flow or exchange products?
While the use of exchange listed products amplifies the benefits of clearing, the answer is still pretty much down to product access and liquidity.
It’s understandable that OTC execution is a place many start when considering clearing, because exchange-traded FX has never really been centre stage in the FX market. The majority of our clients being real FX participants state that a market built on the foundations of “how much and who’s asking”, with a myriad of ways in which LPs and clients can meet to bilaterally negotiate and trade OTC FX, have meant the US-focused exchange offerings, with limited value dates and product flexibility, have always been too far away from being a good fit for their needs.
Also, it is fair to say that trading on an exchange platform doesn’t suit everyone, and clients with strong relationships that have historically served them very well, particularly in bilateral disclosed models, are understandably inclined to favour those routes to interact with the market. This is the execution model you will see in our 360T Block and EFP network: access to FX futures, while trading using familiar OTC models and tools.
When OTC products are the right route though, the availability of a clearing service for the product you need is the first obvious consideration. While interdealer NDF clearing is pretty much routine now, no CCP has yet been able to satisfy the regulators that they are effectively managing the settlement risk they concentrate between members for deliverable OTC FX products, in order to address the bulk of the market’s ADV – deliverable Spot, Forward and FX Swaps. Deliverable OTC FX clearing will become a reality in 2018 though, as we are one of two major CCPs currently finalising a deliverable FX clearing service, with the Deutsche Boerse Group’s Eurex Clearing service being the only one focused on letting you clear FX Spot, Forward, FX Swap, alongside cross currency swaps.
Once you have determined the position is going to be cleared, then your focus should be whether listed or OTC products give you the best route to get that position into the clearing house, considering all liquidity available: in the exchange orderbook and off-book – exactly the model 360T has with support for OTC alongside exchange listed FX products.
Well that’s clear – the customer gets the choice of using an OTC or exchange FX product, and accessing those exchange products on or off the exchange orderbook, but surely the problem with listed FX remains – the products are not a particularly good fit for OTC users?
The uptake of FX futures will be helped by next generation products that evolve FX futures from the US contracts with a small number of infrequent value dates, to something closer resembling the flexibility of OTC products.
We do have classic shaped FX futures contracts, albeit with OTC characteristics like having the currency pair quoted the right way around for OTC users, but a perfect example of next generation FX is the Eurex Rolling Spot Future. This is the simplest way to get FX spot exposure into the CCP, using an exchange listed product designed with a focus on removing incumbent costs in OTC rolls, with multiple liquidity providers considering the exchange orderbook and also how they can use the 360T block and EFP functionality to increase their distribution.
With all of these points aligning, the future of FX is here. Giving the customer true choice of product, execution type, and credit/clearing model so they can exploit the benefits that clearing can bring is certainly a challenge, but all of the foundations are already there for this client choice to become a reality in 2018 within 360T and the Deutsche Boerse Group.
CME Group is making another run at the OTC FX market. The Chicago-based market operator recently unveiled an agreement with seven leading liquidity providers to begin using its clearing service for non-deliverable forwards and redoubled its efforts to promote the capital efficiencies that clearing can provide for FX traders. But with LCH currently dominating NDF clearing, is there really enough demand for the CME solution?
Over the last two years, NDF clearing has exploded as margin requirements for uncleared derivatives have come into effect around the world. Banks seeking to avoid those margin requirements have mainly turned to LCH’s ForexClear service, which provides clearing for NDFs in 12 emerging market currencies as well as several G-10 currencies. The service has 30 clearing members and has signed up an additional 3,000 client accounts this year alone. In the third quarter, the London-based clearinghouse processed NDFs worth $1.5 trillion in notional value, up more than 400% from the third quarter of 2016.
NDF Clearing Surges Monthly Notional Value Cleared at LCH (Billions USD)
Note: Monthly clearing volumes include a small amount of NDFs in major currencies such as EUR, GBP, JPY and CHF. These NDFs make up less than 0.1% of total NDF clearing volume.
Virtually all interdealer activity resides on the LCH platform, explained John O’Hara, Americas head of prime brokerage and clearing at Société Générale Corporate and Investment Banking. But he said there is demand for a CME solution as well. One reason is the potential synergy with CME’s well-established foreign exchange futures market, which boasts more than $91 billion in average daily volume and more than $260 billion in open interest. “People gravitate toward what is most familiar to them, and for those actively clearing futures on CME, OTC FX clearing is a natural progression,” O’Hara explained.
CME has offered NDF clearing for several years but with minimal success. As of early December, across the 12 emerging market NDFs that CME clears, the only one with any activity was the Colombian peso NDF. The open interest in all of the others was exactly zero.
CME sees an opportunity for a second chance, however. So far most of the NDF clearing has been for interbank trades, but fund managers and other buyside institutions are poised to take up clearing as margin requirements for uncleared derivatives come into effect. CME is hoping that it can capture a share of this business by offering a clearing solution that combines OTC FX products with listed futures and options. Portfolio margining of OTC FX NDFs and listed FX futures is not available yet, but CME is working on getting regulatory approval and is hoping to bring that live in 2018.
Getting Market Makers on Board
The deeper challenge is pricing. Market sources said because ForexClear has been so widely adopted, liquidity in NDFs that are cleared at LCH are quoted with a tighter bid-ask spread than NDFs cleared at CME. CME is hoping to address that issue with its November announcement that seven leading NDF liquidity providers intend to start clearing with the service by the end of the first quarter of 2018. The seven liquidity providers are BBVA, Citi, Itau Unibanco, NatWest Markets, Santander, Standard Chartered and XTX Markets.
It is no accident that three of the liquidity providers—BBVA, Itau Unibanco, and Santander—are specialists in Latin American markets. Many of the most heavily traded NDFs are based on Latin currencies such as the Brazilian real and the Colombian peso. The other big center for NDFs is in Asia. That is one of the strengths of Standard Chartered, one of the top liquidity providers in Asian forex markets.
XTX is the only one of the seven that is not a bank, but the London-based electronic trading firm has emerged over the last three years as a major liquidity providers in the FX market. In last year’s Euromoney survey, which calculates market share across the top forex market-makers, XTX took third place in electronic spot trading in last year’s Euromoney survey of market share across the top FX market makers, and first place in this year’s FX Week awards for best liquidity provider.
All Under One Roof
CME also argues that its solution has a structural advantage. At LCH, the ForexClear service has its own default fund that is separate from its clearing services for other asset classes such as interest rate swaps. At CME, NDFs are under the same umbrella as a range of related products, including listed FX futures and options as well as interest rate swaps. That opens the door for margin offsets that LCH cannot offer. For example, CME estimates that the margin offsets between NDFs and non-deliverable interest rate swaps denominated in currencies such as the Brazilian real and the Korean won could go as high as 51%. The single default fund structure also offers capital savings for clearing firms. Rather than having to commit their capital to multiple default funds, the clearing firms only need to make one commitment that covers all the asset classes that they clear.
“Our NDF clearing solution leverages the same guaranty fund as the entire CME Group-listed futures and options complex, enabling material capital savings for our NDF clearing members and lower fees for customers clearing via an FCM,” Sean Tully, CME’s senior managing director of financials and OTC products, said in November when the agreement with the seven liquidity providers was announced.
Buyside Interest on the Rise
One of the key drivers behind the rise in demand for NDF clearing is the implementation of uncleared margin rules, which are still in the early stages of being phased in. Paddy Boyle, global head of ForexClear, explained that bilateral initial margin was initially required from all participants with at least $3 trillion of notional outstanding. That limit has now fallen to $2.25 trillion and will continue to fall to lower and lower thresholds. By September 2020, nearly all market participants will be subject to the rules.
“When we reach the final threshold in 2020, NDFs that are bilaterally traded and uncleared will become significantly more expensive and will provide all types of institutions with obvious greater incentive to clear,” Boyle said. Although most buyside firms are not yet subject to the margin requirements, Boyle said there is a “small but active group” of buyside firms voluntarily clearing NDFs at LCH now. “We expect buy-side clearing to grow substantially over the next few years, particularly as most buy-side firms will be caught as the thresholds continue to fall in 2019 and 2020,” he added.
“We expect buy-side clearing to grow substantially over the next few years, particularly as most buy-side firms will be caught as the thresholds continue to fall in 2019 and 2020.”
– Paddy Boyle, LCH
Basu Choudhury, head of business intelligence at NEX Traiana, also predicted that the buy side will soon have to start clearing more. Choudhury, who worked at ForexClear before joining Traiana in August 2016, explained that the first two waves of margin rules created an upturn in demand from tier one and tier two banks for NDF clearing. “Come January 2018, buy-side firms globally will also start to be impacted, so what CME are looking to do on the NDF side makes sense,” he said.
There is an added attraction for mutual funds in the U.S., according to SocGen’s O’Hara. “Since these fund structures have leverage and cash retention requirements measured on a gross notional basis when trading deliverable forwards, they have been seeking ways to ensure that there is no chance of delivery so their exposure can be assessed purely on a mark-to-market basis,” he explained. Since the CCPs have a mechanism wherein they can disallow delivery, they should be able to provide this relief, he said.
Bringing liquidity providers on board is only one part of a renewed focus on the OTC FX market at CME. The company also is preparing to roll out a new service in the first quarter that will give OTC market participants better access to the liquidity in CME’s FX futures. Starting on Feb. 18, CME’s Globex electronic trading platform will support a central limit order book for trades that track the basis between spot FX and FX futures. This service, called FX Link, will enable the trading of an OTC spot FX contract and an FX futures contract via a single spread trade.
CME is partnering with Citi, one of the largest liquidity providers in the FX market, to act as central prime broker for the spot FX transactions resulting from the spread. The benefit of this arrangement, according to CME, is that it will allow participants to tap into their existing OTC FX interbank credit relationships and the established OTC FX prime brokerage network.
“By strengthening the integration between futures and the OTC FX marketplace, CME FX Link will enhance access to our deeply liquid FX futures market,” Paul Houston, CME’s global head of FX products, said in September when the initiative was announced. “OTC FX market participants will benefit from the capital and regulatory advantages of listed futures as well as optimizing credit lines through facing a central counterparty.”
“There will continue to be a convergence of sorts as OTC becomes more futures-like and futures assume some characteristics of OTC.”
– John O’Hara, Société Générale
In addition, both CME and ForexClear are preparing to launch OTC FX options clearing. CME said it is working with major FX options dealers to deliver a cash-settled clearing solution later this year, with the expectation of volumes beginning in early 2018. In contrast, ForexClear’s solution will offer physical settlement of OTC FX options in partnership with CLS, the widely used settlement service. ForexClear is currently seeking regulatory approval and plans to start by offering clearing in eight major currency pairs.
SocGen’s O’Hara explained that the options market has historically been characterized by physical settlement and many firms’ operational infrastructures have been built with this in mind. CME’s view, however, is that physical-settlement had become the standard simply as a consequence of how the market evolved and that cash settled would be the norm if it were starting today.
Ultimately the FX market is big enough to support both clearinghouses, according to Choudhury. “In IRS clearing we saw the buyside use CME initially while big dealers used LCH and it will be interesting to see if the same occurs with FX clearing,” he said. “CME do offer risk offsets between FX futures and OTC FX. For the buyside this may be attractive due to arbitrage opportunities, but dealers may prefer the LCH model due to larger netting pool.”
O’Hara commented that all of these moves are part of a larger trend that is blurring the lines between different sectors of the FX marketplace. “There will continue to be a convergence of sorts as OTC becomes more futures-like and futures assume some characteristics of OTC,” he said.
Low Interest Rates and Bank’s Profitability – Update May 2019
My last post on this important topic was in 2017. Since then several new articles and research papers have been published. I have compiled them in this post. Please see references.
In my posts I have shown how many trends in economics for the last thirty years can be explained by unintendend consequences of US Federal Researve monetary policy of lowering interest rates to boost economic growth.
Rise of Shadow Banking – MMMF
Rise of International capital flows in USA
Growth of Consumer credit – Credit Cards and Housing Loans
Decline in Net Interest Margins of the Banks
Risk taking by banks to maintain and increase their profits
Rise of Non interest income of Banks
Rise of Non core business of banks
Rise of Mergers/Acquisitions/Consolidation in Banking sector
Related to these are:
Business Investments by Production side of economy
Increase in Market concentration of Products
Increase in Mergers and Acquisitions/consolidation among Product market businesses
Decreasing monitory policy effectiveness
Wrong economic growth forecasts
Secular Stagnation Hypothesis
Rise of Outsourcing and global value chains
Free Trade agreements
Increase in Ineqality of wealth and Income
Increase in corporate profits and equities market
Increase in corporate savings
Increase in share buybacks, and dividends payouts
I have yet to see an effort by economists and policy makers to analyze these trends in an integrated manner.
To be prepared for any future crisis in economic/financial system, collective efforts have to be made to understand non linear sources of complexity and fragility.
Increasing Market Concentration in USA: Update April 2019
In this post, I have compiled recent articles and papers on the issues of:
Increased Market Power
Increased Market Concentration
Increased Corporate Profits
Anti Trust Laws and Competition policy
Interest rates and Business Investments
Interest rates and Mergers and Acquisitions
Stock Buybacks, Dividends, and Business Investments
Outsourcing, and Global Value Chains
Corporate Savings Glut
Slower Economic Growth
From Low Interest Rates, Market Power, and Productivity Growth
How does the production side of the economy respond to a low interest rate environment? This study provides a new theoretical result that low interest rates encourage market concentration by giving industry leaders a strategic advantage over followers, and this effect strengthens as the interest rate approaches zero. The model provides a unified explanation for why the fall in long-term interest rates has been associated with rising market concentration, reduced dynamism, a widening productivity-gap between industry leaders and followers, and slower productivity growth. Support for the model’s key mechanism is established by showing that a decline in the ten year Treasury yield generates positive excess returns for industry leaders, and the magnitude of the excess returns rises as the Treasury yield approaches zero.
Competition, Concentration, and Anti-Trust Laws in the USA
Currently the US FTC has been having hearings on concentration, competition, and anti-trust laws in the USA. Several conferences are organized starting with September 2018. I present links to hearings details and videos of the sessions. As of now, two hearings have already taken place. I have given the links to the third hearing below. Economists Joe Stiglitz and Jason Furman have given speeches and presentations during first and second hearings.
Key Sources of Research:
Hearings on Competition and Consumer Protection in the 21st Century
The Federal Trade Commission will hold a series of public hearings during the fall and winter 2018 examining whether broad-based changes in the economy, evolving business practices, new technologies, or international developments might require adjustments to competition and consumer protection law, enforcement priorities, and policy. The PDF version of this content includes footnotes and sources. All the hearings will be webcast live.
Public traded companies are always under pressure to show earnings growth and sales revenue growth to enhance shareholder value.
How do they do it when markets have matured and economy has slowed?
Increase Market Share
Find New Markets
Create New products and servicces
How do then companies lower their costs?
Vertical Mergers and Acquisitions
Outsourcing (Sourcing parts and components / Intermediate Goods / Inputs from cross border)
Offshoring (Shifting Production cross border)
How do then companies increase their market share?
Horizontal Mergers and Acquisitions
Cross Border Markets Share (Sales in other countries)
In the last thirty years, this is exactly what has happened in US economy.
Macro Trends of increase in Outsourcing/Offshoring, Increase in Market Concentration, Increase in Inequality, Increase in Corporate Profits, Rising Equity Prices, Slower Productivity Growth, Lower Interest Rates, Low Labor Share, and Capital Share.
Please see my other posts expanding on these issues.
Please note that these forces are continuing and trends will remain on current trajectory.
Stakeholder vs Shareholder Capitalism
Slow Productivity Growth
Rising Market Concentration
Rising Equities Market
Dupont Ratio Analysis
Financial Planning (Micro – Firm Level)
Economic Planning (Macro- Aggregate Level)
From SHAREHOLDER CAPITALISM: A SYSTEM IN CRISIS
Our current, highly financialised, form of shareholder capitalism is not just failing to provide new capital for investment, it is actively undermining the ability of listed companies to reinvest their own profits. The stock market has become a vehicle for extracting value from companies, not for injecting it.
No wonder that Andy Haldane, Chief Economist of the Bank of England, recently suggested that shareholder capitalism is ‘eating itself.’1 Corporate governance has become dominated by the need to maximise short-term shareholder returns. At the same time, financial markets have grown more complex, highly intermediated, and similarly shorttermist, with shares increasingly seen as paper assets to be traded rather than long term investments in sound businesses.
This kind of trading is a zero-sum game with no new wealth, let alone social value, created. For one person to win, another must lose – and increasingly, the only real winners appear to be the army of financial intermediaries who control and perpetuate the merry-goround. There is nothing natural or inevitable about the shareholder-owned corporation as it currently exists. Like all economic institutions, it is a product of political and economic choices which can and should be remade if they no longer serve our economy, society, or environment.
Here’s the impact this shareholder model is currently having:
• Economy: Shareholder capitalism is holding back productive investment. Even the Chief Executive of BlackRock, the world’s largest asset manager, has admitted that pressure to keep the share price high means corporate leaders are ‘underinvesting in innovation, skilled workforces or essential capital expenditures.’ 2
• Society: Shareholder capitalism is driving inequality. There is growing evidence that attempts to align executive pay with shareholder value are largely responsible for the ballooning of salaries at the top. The prioritisation of shareholder interests has also contributed to a dramatic decline in UK wages relative to profits, helping to explain the failure of ordinary people’s living standards to rise in line with economic growth.
• Environment: Shareholder capitalism helps to drive environmental destruction. It does this by driving risky shortterm behaviour, such as fossil fuel extraction, which ignores long-term environmental risks.
The idea that shareholder capitalism is the most efficient way to mobilise large amounts of capital is no longer tenable.
We need both to create new models of companies, and implement new ways of organising investment that are fit for building an inclusive, equal, and sustainable economy.
Companies should be explicitly accountable to a mission and a set of interests beyond shareholder returns. Equally, investment must provide long-term capital for socially and environmentally useful projects, and damaging forms of speculation must be restricted.
For most people, our economy simply is not working, and the damaging aspects of shareholder capitalism are at least in part responsible. Reforming shareholder capitalism must not be dismissed as too difficult – the crisis is too urgent for that. We can take the first steps towards a better economic model right now. It’s time to act.
A Crash Course in Dupont Financial Ratio Analysis
What happens when economic growth slows ?
What happens when profit margins decline ?
What happens when Sales growth is limited ?
What does lead to Mergers and Acquisitions ?
What is the impact of Cost of Capital ?
What is EVA (Economic Value Added) ?
What is impact of Outsourcing/Offshoring on Financial Ratios ?
What is impact of Mergers and Acquisitions on Financial Ratios ?
What is impact of Stock Buy Backs on Financial Ratios ?
What is impact of Dividends on Financial Ratios ?
ROS (Return on Sales)
ROE (Return on Equities)
ROA (Return on Assets)
ROIC (Return on Invested Capital)
EVA (Economic Value Added)
MVA (Market Value Added)
From The DuPont Equation, ROE, ROA, and Growth
The DuPont Equation
The DuPont equation is an expression which breaks return on equity down into three parts: profit margin, asset turnover, and leverage.
Explain why splitting the return on equity calculation into its component parts may be helpful to an analyst
By splitting ROE into three parts, companies can more easily understand changes in their returns on equity over time.
As profit margin increases, every sale will bring more money to a company’s bottom line, resulting in a higher overall return on equity.
As asset turnover increases, a company will generate more sales per asset owned, resulting in a higher overall return on equity.
Increased financial leverage will also lead to an increase in return on equity, since using more debt financing brings on higher interest payments, which are tax deductible.
competitive advantage: something that places a company or a person above the competition
The DuPont Equation
The DuPont equation is an expression which breaks return on equity down into three parts. The name comes from the DuPont Corporation, which created and implemented this formula into their business operations in the 1920s. This formula is known by many other names, including DuPont analysis, DuPont identity, the DuPont model, the DuPont method, or the strategic profit model.
The DuPont Equation: In the DuPont equation, ROE is equal to profit margin multiplied by asset turnover multiplied by financial leverage.
Under DuPont analysis, return on equity is equal to the profit margin multiplied by asset turnover multiplied by financial leverage. By splitting ROE (return on equity) into three parts, companies can more easily understand changes in their ROE over time.
Components of the DuPont Equation: Profit Margin
Profit margin is a measure of profitability. It is an indicator of a company’s pricing strategies and how well the company controls costs. Profit margin is calculated by finding the net profit as a percentage of the total revenue. As one feature of the DuPont equation, if the profit margin of a company increases, every sale will bring more money to a company’s bottom line, resulting in a higher overall return on equity.
Components of the DuPont Equation: Asset Turnover
Asset turnover is a financial ratio that measures how efficiently a company uses its assets to generate sales revenue or sales income for the company. Companies with low profit margins tend to have high asset turnover, while those with high profit margins tend to have low asset turnover. Similar to profit margin, if asset turnover increases, a company will generate more sales per asset owned, once again resulting in a higher overall return on equity.
Components of the DuPont Equation: Financial Leverage
Financial leverage refers to the amount of debt that a company utilizes to finance its operations, as compared with the amount of equity that the company utilizes. As was the case with asset turnover and profit margin, Increased financial leverage will also lead to an increase in return on equity. This is because the increased use of debt as financing will cause a company to have higher interest payments, which are tax deductible. Because dividend payments are not tax deductible, maintaining a high proportion of debt in a company’s capital structure leads to a higher return on equity.
The DuPont Equation in Relation to Industries
The DuPont equation is less useful for some industries, that do not use certain concepts or for which the concepts are less meaningful. On the other hand, some industries may rely on a single factor of the DuPont equation more than others. Thus, the equation allows analysts to determine which of the factors is dominant in relation to a company’s return on equity. For example, certain types of high turnover industries, such as retail stores, may have very low profit margins on sales and relatively low financial leverage. In industries such as these, the measure of asset turnover is much more important.
High margin industries, on the other hand, such as fashion, may derive a substantial portion of their competitive advantage from selling at a higher margin. For high end fashion and other luxury brands, increasing sales without sacrificing margin may be critical. Finally, some industries, such as those in the financial sector, chiefly rely on high leverage to generate an acceptable return on equity. While a high level of leverage could be seen as too risky from some perspectives, DuPont analysis enables third parties to compare that leverage with other financial elements that can determine a company’s return on equity.
ROE and Potential Limitations
Return on equity measures the rate of return on the ownership interest of a business and is irrelevant if earnings are not reinvested or distributed.
Calculate a company’s return on equity
Return on equity is an indication of how well a company uses investment funds to generate earnings growth.
Returns on equity between 15% and 20% are generally considered to be acceptable.
Return on equity is equal to net income (after preferred stock dividends but before common stock dividends) divided by total shareholder equity (excluding preferred shares ).
Stock prices are most strongly determined by earnings per share (EPS) as opposed to return on equity.
fundamental analysis: An analysis of a business with the goal of financial projections in terms of income statement, financial statements and health, management and competitive advantages, and competitors and markets.
Return On Equity
Return on equity (ROE) measures the rate of return on the ownership interest or shareholders’ equity of the common stock owners. It is a measure of a company’s efficiency at generating profits using the shareholders’ stake of equity in the business. In other words, return on equity is an indication of how well a company uses investment funds to generate earnings growth. It is also commonly used as a target for executive compensation, since ratios such as ROE tend to give management an incentive to perform better. Returns on equity between 15% and 20% are generally considered to be acceptable.
Return on equity is equal to net income, after preferred stock dividends but before common stock dividends, divided by total shareholder equity and excluding preferred shares.
Return On Equity: ROE is equal to after-tax net income divided by total shareholder equity.
Expressed as a percentage, return on equity is best used to compare companies in the same industry. The decomposition of return on equity into its various factors presents various ratios useful to companies in fundamental analysis.
ROE Broken Down: This is an expression of return on equity decomposed into its various factors.
The practice of decomposing return on equity is sometimes referred to as the “DuPont System. ”
Potential Limitations of ROE
Just because a high return on equity is calculated does not mean that a company will see immediate benefits. Stock prices are most strongly determined by earnings per share (EPS) as opposed to return on equity. Earnings per share is the amount of earnings per each outstanding share of a company’s stock. EPS is equal to profit divided by the weighted average of common shares.
Earnings Per Share: EPS is equal to profit divided by the weighted average of common shares.
The true benefit of a high return on equity comes from a company’s earnings being reinvested into the business or distributed as a dividend. In fact, return on equity is presumably irrelevant if earnings are not reinvested or distributed.
Assessing Internal Growth and Sustainability
Sustainable– as opposed to internal– growth gives a company a better idea of its growth rate while keeping in line with financial policy.
Calculate a company’s internal growth and sustainability ratios
The internal growth rate is a formula for calculating the maximum growth rate a firm can achieve without resorting to external financing.
Sustainable growth is defined as the annual percentage of increase in sales that is consistent with a defined financial policy.
Another measure of growth, the optimal growth rate, assesses sustainable growth from a total shareholder return creation and profitability perspective, independent of a given financial strategy.
retention: The act of retaining; something retained
retention ratio: retained earnings divided by net income
sustainable growth rate: the optimal growth from a financial perspective assuming a given strategy with clear defined financial frame conditions/ limitations
Internal Growth and Sustainability
The true benefit of a high return on equity arises when retained earnings are reinvested into the company’s operations. Such reinvestment should, in turn, lead to a high rate of growth for the company. The internal growth rate is a formula for calculating maximum growth rate that a firm can achieve without resorting to external financing. It’s essentially the growth that a firm can supply by reinvesting its earnings. This can be described as (retained earnings)/(total assets ), or conceptually as the total amount of internal capital available compared to the current size of the organization.
We find the internal growth rate by dividing net income by the amount of total assets (or finding return on assets ) and subtracting the rate of earnings retention. However, growth is not necessarily favorable. Expansion may strain managers’ capacity to monitor and handle the company’s operations. Therefore, a more commonly used measure is the sustainable growth rate.
Sustainable growth is defined as the annual percentage of increase in sales that is consistent with a defined financial policy, such as target debt to equity ratio, target dividend payout ratio, target profit margin, or target ratio of total assets to net sales.
We find the sustainable growth rate by dividing net income by shareholder equity (or finding return on equity) and subtracting the rate of earnings retention. While the internal growth rate assumes no financing, the sustainable growth rate assumes you will make some use of outside financing that will be consistent with whatever financial policy being followed. In fact, in order to achieve a higher growth rate, the company would have to invest more equity capital, increase its financial leverage, or increase the target profit margin.
Optimal Growth Rate
Another measure of growth, the optimal growth rate, assesses sustainable growth from a total shareholder return creation and profitability perspective, independent of a given financial strategy. The concept of optimal growth rate was originally studied by Martin Handschuh, Hannes Lösch, and Björn Heyden. Their study was based on assessments on the performance of more than 3,500 stock-listed companies with an initial revenue of greater than 250 million Euro globally, across industries, over a period of 12 years from 1997 to 2009.
Due to the span of time included in the study, the authors considered their findings to be, for the most part, independent of specific economic cycles. The study found that return on assets, return on sales and return on equity do in fact rise with increasing revenue growth of between 10% to 25%, and then fall with further increasing revenue growth rates. Furthermore, the authors attributed this profitability increase to the following facts:
Companies with substantial profitability have the opportunity to invest more in additional growth, and
Substantial growth may be a driver for additional profitability, whether by attracting high performing young professionals, providing motivation for current employees, attracting better business partners, or simply leading to more self-confidence.
However, according to the study, growth rates beyond the “profitability maximum” rate could bring about circumstances that reduce overall profitability because of the efforts necessary to handle additional growth (i.e., integrating new staff, controlling quality, etc).
Dividend Payments and Earnings Retention
The dividend payout and retention ratios offer insight into how much of a firm’s profit is distributed to shareholders versus retained.
Calculate a company’s dividend payout and retention ratios
Many corporations retain a portion of their earnings and pay the remainder as a dividend.
Dividends are usually paid in the form of cash, store credits, or shares in the company.
Cash dividends are a form of investment income and are usually taxable to the recipient in the year that they are paid.
Dividend payout ratio is the fraction of net income a firm pays to its stockholders in dividends.
Retained earnings can be expressed in the retention ratio.
stock split: To issue a higher number of new shares to replace old shares. This effectively increases the number of shares outstanding without changing the market capitalization of the company.
Dividend Payments and Earnings Retention
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. On the other hand, retained earnings refers to the portion of net income which is retained by the corporation rather than distributed to its owners as dividends. Similarly, if the corporation takes a loss, then that loss is retained and called variously retained losses, accumulated losses or accumulated deficit. Retained earnings and losses are cumulative from year to year with losses offsetting earnings. Many corporations retain a portion of their earnings and pay the remainder as a dividend.
A dividend is allocated as a fixed amount per share. Therefore, a shareholder receives a dividend in proportion to their shareholding. Retained earnings are shown in the shareholder equity section in the company’s balance sheet –the same as its issued share capital.
Public companies usually pay dividends on a fixed schedule, but may declare a dividend at any time, sometimes called a “special dividend” to distinguish it from the fixed schedule dividends. Dividends are usually paid in the form of cash, store credits (common among retail consumers’ cooperatives), or shares in the company (either newly created shares or existing shares bought in the market). Further, many public companies offer dividend reinvestment plans, which automatically use the cash dividend to purchase additional shares for the shareholder.
Cash dividends (most common) are those paid out in currency, usually via electronic funds transfer or a printed paper check. Such dividends are a form of investment income and are usually taxable to the recipient in the year they are paid. This is the most common method of sharing corporate profits with the shareholders of the company. For each share owned, a declared amount of money is distributed. Thus, if a person owns 100 shares and the cash dividend is $0.50 per share, the holder of the stock will be paid $50. Dividends paid are not classified as an expense but rather a deduction of retained earnings. Dividends paid do not show up on an income statement but do appear on the balance sheet.
Stock dividends are those paid out in the form of additional stock shares of the issuing corporation or another corporation (such as its subsidiary corporation). They are usually issued in proportion to shares owned (for example, for every 100 shares of stock owned, a 5% stock dividend will yield five extra shares). If the payment involves the issue of new shares, it is similar to a stock split in that it increases the total number of shares while lowering the price of each share without changing the market capitalization, or total value, of the shares held.
Dividend Payout and Retention Ratios
Dividend payout ratio is the fraction of net income a firm pays to its stockholders in dividends:
The part of the earnings not paid to investors is left for investment to provide for future earnings growth. These retained earnings can be expressed in the retention ratio. Retention ratio can be found by subtracting the dividend payout ratio from one, or by dividing retained earnings by net income.
Dividend Payout Ratio: The dividend payout ratio is equal to dividend payments divided by net income for the same period.
Relationships between ROA, ROE, and Growth
Return on assets is a component of return on equity, both of which can be used to calculate a company’s rate of growth.
Discuss the different uses of the Return on Assets and Return on Assets ratios
Return on equity measures the rate of return on the shareholders ‘ equity of common stockholders.
Return on assets shows how profitable a company’s assets are in generating revenue.
In other words, return on assets makes up two-thirds of the DuPont equation measuring return on equity.
Capital intensity is the term for the amount of fixed or real capital present in relation to other factors of production. Rising capital intensity pushes up the productivity of labor.
return on common stockholders’ equity: a fiscal year’s net income (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage
quantitatively: With respect to quantity rather than quality.
Return On Assets Versus Return On Equity
In review, return on equity measures the rate of return on the ownership interest (shareholders’ equity) of common stockholders. Therefore, it shows how well a company uses investment funds to generate earnings growth. Return on assets shows how profitable a company’s assets are in generating revenue. Return on assets is equal to net income divided by total assets.
Return On Assets: Return on assets is equal to net income divided by total assets.
This percentage shows what the company can do with what it has (i.e., how many dollars of earnings they derive from each dollar of assets they control). This is in contrast to return on equity, which measures a firm’s efficiency at generating profits from every unit of shareholders’ equity. Return on assets is, however, a vital component of return on equity, being an indicator of how profitable a company is before leverage is considered. In other words, return on assets makes up two-thirds of the DuPont equation measuring return on equity.
ROA, ROE, and Growth
In terms of growth rates, we use the value known as return on assets to determine a company’s internal growth rate. This is the maximum growth rate a firm can achieve without resorting to external financing. We use the value for return on equity, however, in determining a company’s sustainable growth rate, which is the maximum growth rate a firm can achieve without issuing new equity or changing its debt-to-equity ratio.
Capital Intensity and Growth
Return on assets gives us an indication of the capital intensity of the company. “Capital intensity” is the term for the amount of fixed or real capital present in relation to other factors of production, especially labor. The underlying concept here is how much output can be procured from a given input (assets!). The formula for capital intensity is below:
Capital Intensity=Total AssetsSales
The use of tools and machinery makes labor more effective, so rising capital intensity pushes up the productivity of labor. While companies that require large initial investments will generally have lower return on assets, it is possible that increased productivity will provide a higher growth rate for the company. Capital intensity can be stated quantitatively as the ratio of the total money value of capital equipment to the total potential output. However, when we adjust capital intensity for real market situations, such as the discounting of future cash flows, we find that it is not independent of the distribution of income. In other words, changes in the retention or dividend payout ratios can lead to changes in measured capital intensity.
This document was prepared by the OECD Secretariat to serve as an issues paper for the hearing on market concentration taking place at the 129th meeting of the OECD Competition Committee on 6-8 June 2018
Rising Market Concentration and Declining Business Investments in the USA – Update June 2018
Since my last posts in August/September 2017 on the subject of
Declining Business Investments
several new studies have been published. In addition, several important hearings and conferences have been organized by OECD, Brookings Institution, Boston University School of Law. Please see my list of references for details of each one of them.
This topic now is getting good attention in media also.
The Peterson Institute for International Economics (PIIE) held a major research conference on the “Policy Implications of Sustained Low Productivity Growth” on November 9, 2017. Jeromin Zettelmeyer, PIIE, moderates panel 4, “Wages and Inequality.” Presenters include Jason Furman, Harvard University and PIIE, and Lawrence H. Summers, Harvard University. I have given the link to Video of the session 4 in the references.
OECD on June 7-8, 2018 held hearings on Market Concentration at Paris, France. Several presentations were given by experts in the field. I have given link to the conference webpage in the references.
The Hamilton Project/Brookings Institution had a Conference on June 13, 2018 in Washington DC on the subject of Market Concentration. Please see the link to the conference video and papers in the references below.
From The State of Competition and Dynamism: Facts about Concentration, Start-Ups, and Related Policies
From The State of Competition and Dynamism: Facts about Concentration, Start-Ups, and Related Policies
On Inequality of Wealth and Income – Causes and Consequences
Disparity in Wealth and Income of American workers/household is a hot public policy/economic/social/political issue.
what are the causes and consequences of Inequality on economics and society?
From TRENDS IN INCOME INEQUALITY AND ITS IMPACT ON ECONOMIC GROWTH (OECD)
The disparity in the distribution of household incomes has been rising over the past three decades in a vast majority of OECD countries and such long-term trend was interrupted only temporarily in the first years of the Great Recession. Addressing these trends has moved to the top of the policy agenda in many countries. This is partly due to worries that a persistently unbalanced sharing of the growth dividend will result in social resentment, fuelling populist and protectionist sentiments, and leading to political instability. Recent discussions, particularly in the US, about increased inequality being one possible cause of the 2008 financial crisis also contributed to its relevance for policy making. But another growing reason for the strong interest of policy makers in inequality is concern about whether the cumulatively large and sometimes rapid increase in inequality might have an effect on economic growth and on the pace of exit from the current recession. Is inequality a pre-requisite for growth? Or does a greater dispersion of incomes across individuals rather undermine growth? And which are the short and long-term consequences of redistributive policies on growth?
From Causes and Consequences of Income Inequality: A Global Perspective (IMF)
Widening income inequality is the defining challenge of our time. In advanced economies, the gap between the rich and poor is at its highest level in decades. Inequality trends have been more mixed in emerging markets and developing countries (EMDCs), with some countries experiencing declining inequality, but pervasive inequities in access to education, health care, and finance remain. Not surprisingly then, the extent of inequality, its drivers, and what to do about it have become some of the most hotly debated issues by policymakers and researchers alike. Against this background, the objective of this paper is two-fold.
First, we show why policymakers need to focus on the poor and the middle class. Earlier IMF work has shown that income inequality matters for growth and its sustainability. Our analysis suggests that the income distribution itself matters for growth as well. Specifically, if the income share of the top 20 percent (the rich) increases, then GDP growth actually declines over the medium term, suggesting that the benefits do not trickle down. In contrast, an increase in the income share of the bottom 20 percent (the poor) is associated with higher GDP growth. The poor and the middle class matter the most for growth via a number of interrelated economic, social, and political channels.
Second, we investigate what explains the divergent trends in inequality developments across advanced economies and EMDCs, with a particular focus on the poor and the middle class. While most existing studies have focused on advanced countries and looked at the drivers of the Gini coefficient and the income of the rich, this study explores a more diverse group of countries and pays particular attention to the income shares of the poor and the middle class—the main engines of growth. Our analysis suggests that
Technological progress and the resulting rise in the skill premium (positives for growth and productivity) and the decline of some labor market institutions have contributed to inequality in both advanced economies and EMDCs. Globalization has played a smaller but reinforcing role. Interestingly, we find that rising skill premium is associated with widening income disparities in advanced countries, while financial deepening is associated with rising inequality in EMDCs, suggesting scope for policies that promote financial inclusion.
Policies that focus on the poor and the middle class can mitigate inequality. Irrespective of the level of economic development, better access to education and health care and well-targeted social policies, while ensuring that labor market institutions do not excessively penalize the poor, can help raise the income share for the poor and the middle class.
There is no one-size-fits-all approach to tackling inequality. The nature of appropriate policies depends on the underlying drivers and country-specific policy and institutional settings. In advanced economies, policies should focus on reforms to increase human capital and skills, coupled with making tax systems more progressive. In EMDCs, ensuring financial deepening is accompanied with greater financial inclusion and creating incentives for lowering informality would be important. More generally, complementarities between growth and income equalityobjectives suggest that policies aimed at raising average living standards can also influence the distribution of income and ensure a more inclusive prosperity.
From World changes in inequality: an overview of facts, causes, consequences and policies (BIS)
Public concern about inequality has grown substantially in recent years. Politicians and journalists descant with increasing frequency on the increase in inequality as a threat to social stability, laying the blame on globalisation and its attendant so-called neo-liberal policies. There is certainly much truth in such views. However, the lack of rigour in the public debate is striking, and one may doubt whether a constructive discussion of inequality, its causes and its economic, social and political consequences can take place without more clarity. Is it really the case that inequality is everywhere increasing more or less continuously, as actually seems to be happening in the United States? What type of inequality are we talking about: earnings, market income, household disposable income per consumption unit, wealth? What matters most: the inequality of opportunity or the inequality of economic outcome, including income? What kind of measure should be used? The recently highly publicised share of the top 5, 1.1% taken from tax data may not evolve in the same way as the familiar Gini coefficient defined on disposable incomes. And, then, what is known about the nature of the unequalising forces that seem to affect our economies and what tools might be available to counteract them?
In an international survey conducted in 2010, people were asked how they thought inequality had changed over the previous 10 years.1 In few countries was the perception of inequality trends in agreement with what could be observed from standard statistical sources about inequality. US citizens felt inequality had remained the same, whereas it was surging by most accounts, Brazilians found it was also increasing despite the fact that, for the first time in over 40 years, inequality was declining, while French and Dutch people thought that inequality had increased although the usual inequality coefficients were remarkably stable.
Good policies must rely on precise diagnostics. It is the purpose of this paper to take stock of what is known at this stage about the evolution of inequality around the world. In so doing, it will be shown that an ever-increasing degree of inequality at all times and everywhere over the last 30 years is far from the reality, and that there is a high degree of specificity across countries. In turn, this suggests that the combination of equalising and unequalising forces may be quite different from one country to another. Some factors may be common and truly global but others may be country-specific, the outcome being quite variable across countries. It also follows that tools to correct inequality, if need be, may have to differ in nature depending on the causes of increased inequality.
Tackling all these issues in depth is beyond the scope of this paper. My aim is only to offer an overview of what is observed and the main ideas being debated in the field of economic inequality. The paper is organised as follows. It starts with a quick “tour d‘horizon“ of the evidence for the evolution of various dimensions of economic inequality. It then tackles the issue of the potential causes, identifying what may be seen as common to most countries and what may be specific. Finally, it touches upon the consequences of excessive inequality and the tools available to counter it, emphasising the rising constraints imposed by globalisation.
Causes of Inequality
Focus on Cost Minimization
Focus on ROIC and Economic Value Added (EVA)
Consolidation – Mergers and Acquisitions
Free Trade Agreements – NAFTA
Global Commodity Chains
Global Production Networks
Global Value Chains
Lack of Educated Workforce
Lack of protection for Low income earners
Compensation for Executives vs Labor
Value of High Skilled Technical Workers
Consequences of Inequality
Impact on Effective Demand
Slows Economic Growth
Decreased Economic Mobility
Health and Social effects
Living Standards at the Bottom (Poverty)
Democratic Process and Social Justice
Hampers Poverty reduction
Access to Health services
Access to Financial Services
Access to Education
Key Sources of Research:
The Age of Inequality
Edited by Jeremy Gantz
The Price of Inequality
A Firm-Level Perspective on the Role of Rents in the Rise in Inequality
The possible connection between inequality and market concentration, however, has been relatively understudied for many years—until recent years, that is, when a sheafof new studies examining the interactions between concentration, market power, and inequality began to appear.
A 2015 paper by Jonathan Baker and Steven Salop, for instance, examined the connection between inequality and market power and argued that “because the creation and exercise of market power tend to raise the return to capital, market power contributes to the development and perpetuation of inequality.” Harvard Law School’s Einer Elhauge also found that horizontal shareholding likely leads to anti-competitive price raises and has regressive effects. Daniel Crane of the University of Michigan, however, contends that the connection between antitrust and wealth inequality has been grossly oversimplified by advocates of tougher antitrust enforcement.
Asked if there was a connection between concentration and inequality, Chicago Booth professors Austan Goolsbee, Steven Kaplan, and Sam Peltzman pointed to data being inconclusive. Goolsbee said: “Probably [there is a connection]. But we don’treally know more than correlations at this point.” Kaplan said his own research “suggests that winner-take-all markets (driven by technology and scale) play a rolein inequality. However, they may not play the most important role.” And Peltzmansaid that “The timing suggests so, but there are a lot of unconnected dots in this question.”
Is rising inequality connected to monopolies, rent-seeking, and concentration, or is it a result of larger forces like globalization and technology? Can antitrust be used effectively to mitigate inequality, or is concentration a sign of greater efficiency? These questions, and others, were debated by economists and legal scholars during a panel at the recent Stigler Center conference on concentration in America.
The panel featured Peter Orszag, Vice Chairman and Managing Director of the financial advisory and asset management firm Lazard Freres; Justin Pierce, a Senior Economist at the Board of Governors of the Federal Reserve; Lina Khan, a fellow at Open Markets program at New America; Sabeel Rahman, an Assistant Professor of Law at Brooklyn Law School; Simcha Barkai, a PhD Candidate at the University of Chicago Booth School of Business; and German Gutierrez, a PhD Candidate at the New York University Stern School of Business. The panel was moderated by Matt Stoller of the Open Markets program at New America, who opened by observing that “a new kind of Brandeis School of antitrust is emerging, in terms of thinking about political economy.”
Much of the panel focused on the dramatic rise in corporate profits. A recent, much-discussed Stigler Center working paper by Simcha Barkai found that over the past 30 years, as labor’s share of output fell by 10 percent, the capital share declined even further. This finding goes against the argument that the labor share went down due to technological changes, or as Barkai put it: “We used to spend money on people, today we’re spending money on robots.”
Barkai’s paper finds no evidence to support the technological argument. “We’re spending less on all inputs. If you think of this from the perspective of a firm, this is terrific. After accounting for all of my costs—material inputs, workers, capital—I am left with a large amount of money, much more so than in the past.” What Barkai does find, however, is that profits have gone way up. From 1984 to 2014, the profit share increased from 2.5 percent of GDP to 15 percent.
“To give you a sense of how large these profits are, if you look over the past 30 years and you ask, ‘How much have profits increased?’ you can give a number in dollars. A better way to think about that is, “Per worker, how much have these dollars increased?” It’s about $14,000 per worker. That’s a really large number because, in 2014, personal median income was just over $28,000. It’s about half of personal median income,” said Barkai.
Barkai went on to say that these findings were more pronounced in industries that experienced an increase in concentration. “Those industries that have a large increase in concentration also have larger declines in the labor share,” he said. Barkai’s conclusions were echoed by a separate study that was recently published by David Autor, David Dorn, Lawrence Katz, Christina Patterson, and John Van Reenen, in which they found that higher concentration is connected to the fall in the labor share.
One way to consider the question of concentration and inequality, said Pierce, is to look at what happens to firms’ efficiency and markups as a result of a merger. In a recent paper with Bruce Blonigen, Pierce was able to utilize new techniques in order to isolate the effects of mergers in the manufacturing sector. Comparing data from factories that were acquired during mergers to similar factories that weren’t, and to factories where an acquisition has been announced but not yet completed, Pierce and Blonigen found no evidence of the standard argument that mergers benefit consumers by increasing efficiency, reducing production costs, and, in turn, lowering prices. Quite the opposite: they found evidence that mergers increase market power, allowing firms to generate higher profits by raising prices.
“What we find when we do this is that mergers on average are associated with increases in markups in a magnitude of 15 to 50 percent. When we look at the effect on productivity, we actually don’t find a statistically significant effect on productivity associated with mergers,” said Pierce.
Gutierrez, meanwhile, spoke about his 2016 paper with Thomas Philippon, in which the two found that concentrated industries with less entry and more concentration invest less. Before 2000, he explained, firms funneled about 20 cents of every dollar of surplus into investments. Since 2000, however, investments dropped by half—to 10 cents on the dollar.
Their findings, he said, rule out the argument that the drop in investments is related to control by the stock market. The data also rule out other theories, such as financial constraints, safety premiums, or globalization. “What we’re left with is competition, or lack of competition and governance,” said Gutierrez.
“What we find is that most industries have become more concentrated. That leads to a decrease in investment. It means less investment by leaders in particular, and at the industry as a whole. Some manufacturing industries have seen increased competition from China. For the U.S. in particular, we see that leaders invest more. They try and hold onto their position, but the overall effect is somewhat negative on aggregate investment in the U.S.”
How is this drop in investments connected to an increase in concentration? Gutierrez offered two hypotheses: one, that superstar firms, such as digital platforms, are more productive and are therefore capturing more market share. The second, he said, is increased regulation: “In particular, if you look at the cross section of industries, industries where regulation has increased have also tended to become more concentrated and have invested less.”
Orszag, the former head of the Office of Management and Budget and former Director of the Congressional Budget Office, co-authored a 2015 paper with former Obama economic adviser Jason Furman that explored the rise in “supernormal returns on capital” among firms that have limited competition. In the panel, he spoke about what he described as a “dramatic rise” in dispersion among firms in productivity and wages as an understudied driver of inequality.
“In general, if you look at most textbooks on economics and most discussions of public policy, firms are seen as this uninteresting thing that you have to deal with but don’t want to really get into the innards of. Why do some firms behave differently than others? Having now spent a bunch of time in the private sector, the culture in firms really is quite different. Firms do behave differently from one to another beyond just market structure. Within the same market in the same field, Firm A is not the same as Firm B, as people who work inside those firms know.”
Orszag pointed to OECD data that showed that top global firms have been largely exempted from the decline in productivity that advanced economies experienced over the last 10-15 years. “If there’s a structural explanation for that, whether it’s polarization or market structure or innovation, why is it affecting only the laggards in the industry and not those at the frontier? Secondly, why aren’t there more spillovers from the frontier firms within each sector to others? What is happening to the flow of information or the flow of technique or what have you that’s causing this broad, significant rise in productivity deltas across firms, even within the same sector?” he asked.
Orszag also suggested that contrary to media narratives that present growing gaps between CEO wages and median workers within each firm as a prominent driver of inequality, the bulk of the rise in wage gaps is happening between firms, and not within the firms themselves. Studies, he said, show a dramatic increase in between-firm wage inequality “and very little movement except at the very, very largest firms in within-firm inequality.”
Orszag added: “We don’t know exactly what’s causing this. This may be a sorting of workers. It may be sharing of rents in the form of wages for the top firms. It may be a whole variety of different things. What I do suggest is the vast majority of the discussion on income-and-wage inequality seems to just glide over this whole thing as if it doesn’t exist.”
A holistic approach to inequality and concentration
Khan, who in a recent paper with Sandeep Vaheesan explored the role of monopoly and oligopoly power in perpetuating inequality, argued that the way to understand the connection between market concentration and inequality is to take a more holistic approach.
The connection between excessive market concentration and inequality, she said, has been understudied for a long time. “We were really surprised to see that at the time, in 2014, there really wasn’t much research on this connection at all. The most comprehensive paper that we found was from 1975 by William Comanor and Robert Smiley, which found that monopoly power did in fact transfer wealth to the most affluent members of society and suggested that a more competitive economy would have more progressive redistributive effects,” said Kahn. “One way to understand why this connection between market concentration and inequality has been understudied is that the law decided that it wasn’t really important. Once we shifted from an antitrust approach that took a more holistic and multidimensional view of the effect of market power to an approach that privilege means prices, the research on these effects also took a hit.”
In their paper, Khan and Vaheesan argue that inequality not only harms efficiency, but also that firms use their market power to raise prices “above competitive levels to consumers and push prices below competitive levels for small producers.” The paper makes a case for more rigorous enforcement of antitrust laws, arguing that reinvigorating antitrust could be one possible remedy for the regressive redistributive effects of concentration and the political power of monopolies.
“I think at a very basic level, our current political economy reflects 30 years of doing antitrust in a very particular way,” said Khan, who listed several industries such as airlines, healthcare, pharmaceuticals, and telecom, where prices have risen following mergers and industry consolidation.
“New business creation and growth have been on a secular decline. It’s worth recalling that in an earlier era, owning one’s own business was a form of asset building for the middle class, a way of passing on wealth to one’s children. This is especially still true in immigrant communities, where owning your own bodega or your own dry-cleaning service is a path of upward mobility. You can imagine how markets that shut out independent businesses are also effectively closing off that path of asset building,” said Khan.
Khan went on to discuss the political implications of excessive market power and how they can further entrench inequality. “Big firms and concentrated industries enjoy a level of political power that they can use to further entrench their economic dominance. Politics is another vessel by which we see this,” she said.
Rahman, author of the book Democracy Against Domination (Oxford University Press, 2016), also advocated for a wider view of the issue. “When we’re worried about the problem of concentration, I think it goes much broader than the specific areas of mergers and firm size, although that’s a big part of it,” he said.
“When we think about the good things that we want from the economy, we want it to be dynamic, we want it to be innovative, we want it to enable mobility. These things are not natural products. They are a property of the underlying structure of firms, of labor markets, of financial markets, and of policies, including antitrust,” said Rahman, who went on to discuss two aspects of the rise in concentration: digital platforms and the “Uber-ization” of more and more economic sectors, and what he described as a “growing geographic concentration of wealth, income, and opportunity between rural and urban.”
Rahman suggested that other tools, not just antitrust, could be used to combat excessive market power—particularly when it comes to the power of digital platforms. “The way I want to frame this is as a problem of concentration and inequality that warps the structure of opportunity in our economy,” said Rahman. “You have antitrust and public utility law, corporate governance, and labor law as three parts of the larger ecosystem of law and regulation that, coming out of that Progressive era debate about power, were the three complements that together, it was hoped, would produce a high-opportunity, a high-mobility economy that was open to all.”