Investors need to be cautious of possible black holes in the world’s financial system, van Eyk’s Head of Research John O’Brien told the van Eyk annual conference in Sydney on Wednesday.
“Like the universe, there are at least three black holes in the world’s financial system whose nature and impact is not fully understood and have the potential to severely affect financial markets,” he told delegates.
O’Brien nominated three black holes: computer-based high speed trading, inter-bank asset pledges and unfathomable valuations on developed market and emerging market banks.
High speed trading already forms a substantial share of all turnover on the Australian Securities Exchange. The ASX’s annual report for the 2010-11 financial year reported there were 144 million trades that year, far higher than the number of human traders in the Australian market would suggest. “It’s the equivalent of everyone in the financial services industry each making 250 trades a day,” O’Brien said.
“Investors need to be careful that they don’t suffer any adverse effects as prices move under the impact of such large and fast trading.”
A second black hole is the potential for adverse effects from the use of hypothecated collateral, or the transfer of assets backing financial transactions, especially those by large banks acting as prime brokers.
Such practises have been curtailed in the United States, but remain available to banks in Europe, where the financial system is under severe strain in the aftermath of the global financial crisis.
O’Brien told the conference the IMF recently estimated that the value of trades worldwide using such assets had fallen from $US30 trillion to $US25 trillion from 2007 to 2008 – “a huge drop in the value of the system that simply disappeared”.
Bank valuations in recent years are also concerning. The market valuation of emerging market banks remains consistently higher than those of developed nations. This is despite their relatively small size and the fact that emerging market equities have traditionally traded at a valuation risk premium.
“In Australia, Bendigo Bank for example has more assets than those of the four biggest banks in Indonesia combined. Yet those banks trade at higher price to earnings valuations,” he said.
How the valuations adjust should remain of interest to investors because it is an apparent anomaly that has persisted for years.”
