The Taiwan Banker

It has long been known that credit ratings agencies like Fitch, Moody’s, and S&P are independent market players, and that their power can even sometimes rival that of nation-states. In 1995, Thomas Friedman, a New York Times columnist, wrote “You could almost say that we live again in a two-superpower world. There is the U.S. and there is Moody's.” He noted that a visit of US President Clinton to Canada at the time was being overshadowed by a visit from the latter.Ratings were originally used as a tool for disintermediation in the bond market. Earlier, bonds were mostly funded by banks; the rise of these agencies gave ordinary investors more access to a previously closed market. By eliminating the banks, the markets produced even more powerful and centralized intermediaries. (Ratings have since however been incorporated back into bank regulation through the Basel Accords, among other measures).Now, with the rise of fintech and advent of passive investing, the same effect may be occurring again – this time with equity. Exchange-Traded Funds (ETFs) allow savers to invest in entire categories of stocks, such as the S&P 500, diversifying risks while avoiding both transaction costs and fund management fees. For these reasons, novice investors are now frequently advised to include ETFs in their portfolio, especially as actively managed funds have underperformed since the financial crisis.As a predictable result, ETFs are acquiring similar geopolitical significance. MSCI, an index provider specializing in emerging markets, has appeared in the news recently in relation to the US-China trade war. Index providers are also becoming increasingly important channels for corporate governance, a task that is seldom of interest to individual investors. Fintech advocates frequently claim that it will cause disintermediation, allowing savers to be matched directly to investment targets. New technologies will indeed challenge existing models, but the need for intermediation is fundamental, and not tied to any particular technological development level. Just as before, the elimination of banks will likely only serve to highlight the role of alternatives.Meet Your OverlordsAlthough there are several players in the ETF liquidity provision process, the most significant step is carried out by the index provider, which selects the securities to include based on its own criteria. Back when indices were solely statistical services, this was the only step; it was only later that they turned into dedicated investment strategies. The market for index providers has high barriers to entry, and is almost entirely controlled by three companies: MSCI, S&P Dow Jones Indices (DJI) and FTSE Russell. DJI runs the famous S&P 500 index, which was first launched in 1923 and is considered the best representation of the overall US stock market. The FTSE 100 is an equivalent for the UK, while the MSCI World index is more global. Many alternative indices exist, but they lack the clout of those provided by these firms.These three indices now guide US$ 20 trillion in equity investments. Their impact is not just limited to ETFs; even active investment managers refer to them to varying degrees.Some of the work index providers do is merely statistical in nature, adding little value, but many cases also require individual judgement calls. Indexes typically set inclusion requirements such as share classes and liquidity, besides just ‘financials’ like market cap and earnings. Governance is however an inherently ideological topic, and inclusion decisions based on these criteria often seem more political than financial. Indexes have sometimes been forced to balance their normative criteria with their own relevance, resulting in some decisions that could be questioned for being overly inclusive, and others for being under-inclusive.A particularly important example of such decisions has to do with entire whole-country designations for nations on the periphery of international finance. MSCI’s classifications of countries into the Emerging Markets and Frontier Markets indices are now important enough to get top government officials on the phone immediately, just as bond rating agencies might have done in the past. No such decision has attracted as much attention as MSCI’s recent decisions to gradually increase its weightings of mainland-listed stocks, following much delay. Platform PowerMSCI’s methodology still far underweights Chinese stocks relative to those of other countries, but its reweighting into China occurred just as the trade war was getting underway, which attracted negative attention. Florida Senator Rubio, who has been behind a number of initiatives to restrict Chinese business ties with the US, inquired publicly about the rationale for the move. Even though the US-based MSCI does not directly make any investments, US public pension funds hold Chinese stocks through ETFs tracking its indices, turning the company itself into a target of concern. Because of the authority of index providers, the negotiation process between them and Chinese regulators itself has been significant. These negotiations are now at the forefront of China’s opening-up process, with implications extending as far as the stability and internationalization of the RMB itself. Indices are apparently responsible for most of an increase in foreign holdings of Chinese equity from 2% to 3.3% of the market from 2017 to 2019. The objects of MSCI’s current demands include access to liquid hedging instruments and derivatives.In fact, China itself has long preferred to work through such intermediaries. Its 2009 proposal to the IMF for its basket of Special Drawing Rights (SDR) to include the RMB was one of its boldest moves on the international stage at the time, standing in contrast to its typical reluctance to engage in matters of international governance. The role it gives to portfolio builders internationally also mirrors the importance of technology platforms at home. Firms like WeChat and Alibaba have turned into regulators and even courts within their financial ecosystems, relieving the administrative burden on more formal government institutions.The government may yet stage a large-scale market rescue in response to the coronavirus, comparable to its response to the 2015 market crash. In that case, it will likely feel more confident imposing sales restrictions on intermediaries than on individual investors.Indices might not be intimidated by most governments, but it appears China is strong enough to attract their attention, making it the only country with that power besides the US. This turns the providers into inevitable pawns in the simmering rivalry between the two. In the first Cold War, the Korean War, Vietnam War, and Chinese Civil War became proxy wars between the two superpowers. In the new Cold War, that process may play out through financial intermediaries instead.The Value of StatisticsEven if market indices do help guide investments, their core function is still informational. How, then, do they acquire power which seems political in nature, in both domestic and international markets?In basic finance theory, two unitary factors are used to compute Net Present Value (NPV): the project itself, and a cost of capital based on alternative market investments. Macroeconomists have however known for some time that this framework is too simplistic. A 1995 paper by Ben Bernanke (who later become Chairman of the US Federal Reserve) and Mark Gertler demonstrated the existence of an “external finance premium.” The result of this difference between internal and external financing costs is that monetary policy acts through asset prices, rather than directly through financing costs. Their thesis has been largely borne out by subsequent developments. Central banks around the world have been working overtime to stimulate their economies, even exhausting their ammunition in ‘peacetime’ – but the main effect of these efforts has been valuation bubbles. Stimulus funds have gone to existing assets rather than new ones.Despite the success of this theory in explaining certain empirical trends, though, the definition of “internal” could use some clarification from a microeconomic perspective. It appears that it comes in part from the gradually increasing trust that arises from previous dividend payments and stock buybacks. A service that is only statistical in nature could also form another part of this process, allowing the companies it covers to obtain financing at a slightly lower costs than those outside the index.So intermediaries will never be entirely eliminated, but they may take a variety of forms. One new possibility that has arisen from the increased use of social trading platforms is “copy trades.” One investor may duplicate the entire trading strategy of another in exchange for a fee, turning the copied investor into an intermediary of sorts. This is a smaller-scale phenomenon, but it shows how platforms can create all new sorts of herd behavior. On a more abstract level, even algorithms themselves make assumptions which can always be challenged, yet which still feed into market behavior. Even if one decides to take an entirely “quantitative” approach, that is still an active decision and should not necessarily be seen as more objective than any other approach.This is not to say that the subjective and political nature of market intermediaries makes them undesirable, or an inherent threat. One positive aspect of the development of ETFs is to help popularize ESG investing strategies among the general public. What intermediaries are not, though, is neutral. China may be going too far by neglecting regulation of individual companies, but other countries will also have to carefully consider the role of new intermediaries created by technological changes in finance.