Clearing, Settlement Services Highly Vulnerable as Cyberattacks Threaten Financial Institutions

Cyberattacks against financial institutions have become an increasingly important risk factor, and institutions that provide trade execution, clearing and settlement services are more vulnerable to attacks aiming for system disruption because of their interconnectivity with the financial system.

“Cyber risk is a growing threat that can adversely affect credit ratings as attacks can compromise customer data and disrupt websites, with detrimental financial or operational consequences for individual issuers and financial systems,” said Fitch Ratings analysts in a recent report. “Related reputational damage may weaken business and access to funding and capital markets.”

In the U.S., the chair of the Securities and Exchange Commission has said cyber-security poses the biggest risk to the financial system. Under the European Union’s General Data Protection Regulation, which takes effect in May next year, banks can face fines of up to 4% of their global turnover for security breaches; any organization that uses data from EU citizens has to comply with the rule. Fitch sees that some organizations, like The International Organization of Securities Commission’s Committee on Payments and Market Infrastructures, are seeking more coordination at the international level to combat the issue. The European Central Bank reports that the average lag until a breach is detected was 146 days in 2016, a drop from 205 days in 2014.

“As information is shared across firms, cyber risk detection and response plans could improve, but coordination does not ensure that risks can be fully contained,” Fitch notes.

The use of cyberinsurance to mitigate some of the damage from cyberattacks is on the rise, reaching about $1 billion in premiums in 2015 and expected to continue growing, though protection against reputational damage is more difficult to protect against, Fitch says.

– Nicholas Stern, senior editor

SWIFT Addresses Allegations of Service Bureau Hacking

SWIFT, the financial messaging service, has said in a press release that there is no indication that its network or core services have been compromised amid allegations that two services bureaus may have been targeted to gain unauthorized access to bank customers’ data.

As reported by Reuters, a hacking group calling itself the Shadow Brokers recently released allegations that service bureaus in the Middle East and Latin America may have been compromised by third parties. The allegations date back several years. Service bureaus are third-party providers that operate a connection to SWIFT for firms that wish to outsource their day-to-day operation of the SWIFT connection. In its release, SWIFT said that it is in close contact with the service bureaus in question to ensure that they are implementing appropriate preventive measures.

SWIFT recommends that customers pay close attention to their own security and keep in mind security issues when choosing a service bureau or other third-party provider. The effects of any vulnerabilities can be mitigated by immediately installing security updates and patches. SWIFT is working through its Customer Security Programme to provide tools and guidance about security to its customers and will keep customers updated through its Security Notification Service.

SWIFT said that there has been no impact on its infrastructure or data and that there is no evidence to suggest that unauthorized access has occurred to its network or messaging services.

Service bureaus must register under SWIFT’s Shared Infrastructure Programme (SIP), which outlines the legal, financial and operational requirements with which services bureaus must comply. The SIP should not be considered a substitute for customers to perform their own security checks and due diligence, the messaging service noted.

– Adam Fusco, associate editor

Small Fabricators and Manufacturers Optimistic about Future in New Survey

Many small- to medium-size job shops surveyed for the latest Fabricators and Manufacturers Association’s Forming and Fabricating Job Shop Consumption Report have an optimistic outlook lately and believe some significant impediments to business progress may be removed and that some of the stimulating efforts will bear fruit.

A whopping 61.9% of those surveyed see improving conditions for the coming quarter and another 34.3% expect things to be about as they are now. Only 3.7% expect things to get worse. This is the most confident the sector has been in a while.

Still, the survey found capacity utilization is on the low side, just short of 70%, which indicates slack in the system, though when looking at the anticipated capacity, there is a general sense that companies will be adding to it. That may mean more slack in the short term, but should mean less in the way of shortages and bottlenecks later. But generally, the survey respondents are staying connected to their capital equipment strategies as 57.4% indicate that nothing has altered their plans and they intend to buy what they had intended to buy. About 18% have delayed their original plans by a quarter or two and 24.6% have set their plans on the back burner indefinitely. There is tremendous variability between sectors, however. Those feeding into the agricultural community are seeing very low demand while medical manufacturing thrives. Automotive and aerospace are not as vibrant as they have been.

In the manufacturing community, the level of real confidence is reflected in data such as new orders. The survey this month shows that 44.7% of the respondents are reporting more in the way of new orders and another 41% are reporting that this activity has been stable. Only a little over 14% of the responses indicated a decline in new orders. That suggests that there is more expansion in the manufacturing sector overall and that it is expected to expand further into the year.

Hiring has also seen progress and stability, but there are some factors to take into consideration that affect these numbers and have for some time. The survey reports that over 27% expect to do additional hiring while just over 68% are staying right where they are as far as hiring is concerned. That means that only 4.5% of the respondents plan to reduce their workforce. This is as low a level as has been seen in the last few years. The wrinkle in all this is that most of the manufacturers are struggling to find qualified people to hire. The pipeline as far as talent is empty. Companies really have no alternative but to poach one another’s employees, which generally means that labor costs will rise steadily as companies try to lure the people they want and need.

Beyond hiring, the next biggest expense is raw material costs. Here, the key factors are generally the price of steel and aluminum. The survey reports that the vast majority of respondents see prices for both metals coming up. In general, the commodities suppliers have been trying to adjust to reduced demand over the last few years—they have limited output as a means to hike prices. The tactic has worked pretty well and the hope is that more production can be spurred when and if there is a boost in overall demand.

The cost of transportation and logistics has also been a factor when it comes to overall expenses, but there hasn’t been all that much movement. The percentage of respondents that report more logistics costs is 29.3% and most have indicated that these costs have been stable—over 70%. Not one respondent reported that these costs are going down. Rail costs have been more stable than trucking costs and there has been some reduction in the costs of ocean cargo due to the overcapacity issue facing maritime shipping. There is also a great deal of regionalism in logistics, in part due to the fluctuating costs of fuel and overall operating expenses. Just as with manufacturing, there has been a shortage of manpower in transportation. It is estimated trucking companies are short some 80,000 drivers this year alone.

– Chris Kuehl, Ph.D., NACM economist

Leveraged U.S. Corporates May Face Challenges from Rising Rates

Rising interest rates may translate into downside risk for some U.S. corporate sectors. The credit profiles of U.S. corporates are generally insulated from rising rates, but lower-rated issuers are more vulnerable, according to a new report from Fitch Ratings.

The ratings agency does not see significant interest rate risk across speculative-grade credit profiles, even in a severe stress scenario, but a rising rate environment may limit the margin of error available to corporates that are undergoing material acquisition or in the midst of adjusting their business models. This is particularly true for those that are highly leveraged. Poor execution of cost-saving programs and key initiatives, for example, may hamper a cash flow profile that is already weak if coupled with rising rates. Negative rating actions may result.

The retail sector, with high floating-rate debt exposure, is vulnerable to interest rate risk if the benefits of a growing economy are offset by secular challenges, Fitch said. Diversified manufacturing, which likewise has high floating-rate exposure, could see improved demand, though external factors such as an increase in trade restrictions could weigh on costs and hamper growth. Sectors with low floating-rate exposure like telecom face their own challenges from a competitive environment.

The stable outlook for U.S. corporates for this year supports the view that rates rise in response to increasing inflation during an economic recovery, Fitch said. Since companies have been proactively managing maturity profiles, modest rate increases, without an increase in spreads, would not impact interest rate expense in the near term. Investment-grade corporates are less vulnerable to rising rates. Fitch estimates that its portfolio of speculative-grade corporates has an average of 52% of floating-rate debt compared to 15% for investment grade.

– Adam Fusco, associate editor

China’s GDP Climbs in First Quarter with Strong Housing, Construction Sectors

Chinese GDP for the first quarter beat economists’ consensus forecast, buoyed by the nation’s secondary industry comprised of mining, manufacturing, construction and utilities production.
GDP in China grew 6.9% in the first quarter of the year, continuing a slight upward trend over the last three quarters, according to an analysis by Wells Fargo’s Jay Bryson, global economist, and E. Harry Pershing, economic analyst.

The country’s secondary industry climbed 6.4% year-over-year, following 6.1% the prior quarter, and accounts for about 40% of the value added in the Chinese economy, the analysts said. The nation’s primary industry, including the agriculture, forestry and fishing sectors, slowed to 3.0% in the first quarter from 3.3% the prior quarter. Growth in China’s service sector also decreased slightly to 7.7% from 7.8% the prior quarter.

“Strength in the secondary sector can partially be attributed to a rebound in overall investment spending, which increased 9.2% in March—its highest year-over-year rate of growth since May of last year,” the analysts said. Meanwhile, investment in the Chinese housing sector has similarly grown—by 8.9% in February. “The turnaround in housing investment has seemed to provide a boost to the construction sector, which is contained in the secondary industry. Although we do not expect housing investment growth rates to return to the 30% rates we witnessed during 2010–2011, continued government support for lending should buoy investment in the sector and for the foreseeable future.”

Also, China’s foreign exchange reserve woes, which saw reserves decline from nearly $4 trillion in mid-2014 to about $3 trillion today, have eased somewhat after modest increases in February and March, Wells said.

– Nicholas Stern, senior editor

Asian High-Yield Bond Issuance More than Doubles in Q1 2017

Asian high-yield bond issuance is at its highest level in four years. This has paved the way for “stronger liquidity profiles and manageable levels of refinancing risk,” according to Moody’s Investors Service. The first quarter of 2017 was more than double the last quarter of 2016, said the ratings agency.

There were 26 deals totaling $10 billion during the first quarter of this year, which is the highest level of issuance since the first quarter of 2013, when it was at more than $12 billion, said Annalisa DiChiara, a Moody's vice president and senior credit officer, in a news release. This was “driven by investor tolerance for lower credit quality and active refinancing by issuers," she added.

Refinancing risk will stay at a manageable level, “and the market is well positioned to absorb upcoming maturities which total [$127 billion] in rated and unrated bonds from now through to 2021," DiChiara said. The fourth quarter 2016 issuance was at $4.5 billion, and “50% of the [$10 billion] issued in Q1 2017 was rated at B3—a record amount of issuance at this level,” said the release.

The Asian nonfinancial high-yield corporate default rate will also stay low, according to Moody’s, at around 3% this year, while “most Asian high-yield corporates currently show good or adequate liquidity.”As of the last day of March, Moody’s covered 123 Asian companies in its high-yield portfolio with nearly $67 billion of rated debt outstanding.

The March Asian Liquidity Stress Index was at its lowest since September 2015, but the long-term average of the index shows “the ongoing weakness in liquidity for many issuers in Asia,” said Moody’s.

– Michael Miller, editorial associate

U.S. AAA Rating Affirmed by Fitch

With its financing flexibility and its prominence as having the most liquid capital markets in the world, the United States has earned an affirmation of its AAA rating and stable outlook from Fitch Ratings.

According to Fitch, the U.S. economy is one of the most productive and dynamic and is supported by strong institutions and a favorable business climate. The U.S. is the issuer of the world’s preeminent reserve currency, which accounts for nearly two-thirds of global reserves.

Uncertainty remains, however, over the short-term fiscal and borrowing outlook, but Fitch expects tax cuts to lead to a loosening in fiscal policy. The U.S. government debt burden is a relative credit weakness in comparison to other AAA-rated sovereigns, Fitch said. A tax reform proposal may lead to an increase in deficits over a 10-year time span, though the plan would aim at boosting investment and growth. Tax cuts are not likely to lead to a lasting boost in growth, however, Fitch believes.

The ratings agency has revised its real GDP growth forecast for the U.S. to 2.3% for next year and 2.6% for 2018. Trade protectionism and checks on immigration would be negative for growth in the medium term. Fitch expects the Federal Reserve to continue to raise interest rates, with two more 25 basis point increases in 2017 and four in 2018, with no major effects on credit growth.

Fitch does not anticipate any developments that would lead to a downgrade in the stable outlook for the United States. Developments that may lead to negative rating action, however, include 1) a significant increase in government deficits and the debt-to-GDP ratio, and 2) a deterioration in the credibility of economy policy or a shock that affects the U.S. dollar’s role as the foremost global currency.

– Adam Fusco, associate editor

New Chinese Bond-Tightening Rules Should Ease System Risks

A recent announcement by Chinese regulators to tighten the rules surrounding the use of corporate bonds as collateral should help reduce systemic risks, but it is also a credit negative for onshore issuers and borrowers. The rule changes effectively reduce the pool of bonds eligible to serve as collateral for repurchase agreements or repos, which should curb the growth in system-wide leverage that the rapid development of the repo market has helped engender, according to a new Moody’s Investors Service report.

“The new rules are aimed at controlling leverage in China's financial markets and should therefore reduce systemic risks,” said Nino Siu, a Moody's vice president and senior analyst. “And, by restricting the use of collateral to high-quality bonds, the new rules reduce the likelihood that defaults on lower-rated bonds could bring about a rapid contraction in the supply of credit, in the event that they cause lenders to reassess the risks of collateralized lending.”

On April 7, the China Securities Depository and Clearing Corporation Limited (CSDC) announced that, starting April 8, only newly issued corporate bonds with onshore issuer ratings/bond ratings of AA/AAA, AA+/AAA and AAA/AAA can be used as collateral in a repurchase agreement. Bonds issued or announced with a prospectus on or before April 7 are not affected by the new rules.

This change should enhance the regulation of the credit risks in the repo market that has more than doubled since March 2015 to about $3.25 billion by the end of this March, analysts said. About 34% of all corporate bonds in the onshore exchange-traded market in China are AAA-rated by onshore rating agencies. That means borrowing on the remaining lower-tier bonds available in the onshore market will become more difficult. Also, more borrowers tend to look for non-AAA-rated bonds at the short end of the duration curve. “The loss of repo eligibility for non-AAA-rated bonds will therefore boost the liquidity premium of such corporate bonds and result in a wider yield differentiation between AAA and non-AAA-rated bonds, raising funding costs for lower-rated issuers,” Moody’s said.

– Nicholas Stern, senior editor

Small Business Owners Remain Optimistic

A surge in small business optimism that started last November was continued in March, according to the National Federation of Independent Business’ (NFIB) Small Business Optimism Index. Though the index slipped slightly, it still posted a strong reading, with gains in actual earnings, capital expenditure plans and job-creation plans. Sales expectations, however, dropped eight points, signaling that the index could be moderating.

“Small business owners remain optimistic about the future of the economy and the direction of consumer confidence,” said NFIB President and CEO Juanita Duggan. “We are encouraged by signs that optimism is translating into economic activity, such as capital investment and job creation.”

The Uncertainty Index, which is a subset of data on how small business owners foresee the near term, saw a significant increase, the NFIB said. It reached its second-highest reading in the survey’s history in March. Most of the March data was collected before Congress failed to pass a bill repealing and replacing the Affordable Care Act, NFIB noted, adding that the optimism of the past five months was in part due to small business owners’ expectations of a reversal in some government policies. Duggan said that the index’s April data, due in May, will better indicate how owners are processing events in Washington.

“By historical standards, this is an excellent performance, with most of the components of the index holding their gains,” said NFIB Chief Economist Bill Dunkelberg. “The increases in capital expenditure plans and actual earnings are signs of a healthier economy, and we expect job creation to pick up in future months.”

Small business owners are having a hard time satisfactorily filling open positions, however, which will be a headwind to job growth, the NFIB said. The reports correlate with hard data on a tightening labor market and a gradual pickup in wage growth, Wells Fargo noted.

– Adam Fusco, associate editor

Supreme Court Summarily Vacates Fifth Circuit Decision Upholding Texas Surcharge Prohibition

On March 29, 2017, the United States Supreme Court issued its long-awaited decision in Expressions Hair Design, et al. v. Schneiderman, holding that New York’s prohibition against surcharging credit card transactions is a regulation of commercial speech and remanding the case to the Second Circuit Court of Appeals for further consideration as such.

On Monday, April 3, 2017, the Supreme Court ruled on petitions for certiorari in the two other surcharge-related cases that were pending before it.

In Rowell, et al. v. Pettijohn, a group of merchants sought review of a decision by the Fifth Circuit Court of Appeals, which, like the Second Circuit in Expressions, held in early 2016 that the Texas surcharge ban is a constitutionally permissible regulation of pricing.  On Monday, the Supreme Court granted the merchants’ petition, summarily (i.e., immediately and with no further briefing or argument by the parties) vacated the Fifth Circuit’s decision and remanded the case back to the Fifth Circuit for further consideration in light of the Supreme Court’s holding in Expressions.

In Bondi v. Dana’s Railroad Supply, et al., the Florida attorney general sought review of a decision by the Eleventh Circuit Court of Appeals, which held in late 2015 that Florida’s surcharge ban is a facially unconstitutional regulation of merchants’ speech.  The Supreme Court denied the state’s petition for a writ of certiorari, leaving the Eleventh Circuit’s ruling intact.  As a result, the Florida surcharge ban has effectively been overturned in its entirety.

Denial of certiorari in Dana’s means the Supreme Court will not have an opportunity to provide further guidance on the application of the commercial speech doctrine to credit card surcharge bans unless and until another case—possibly even Expressions or Rowell, depending upon the outcome in those cases on remand—comes up from the courts of appeals.  However, the Dana’s decision at least suggests that the Supreme Court is receptive to the Eleventh Circuit’s reasoning, and is a knockout punch for Florida merchants, whose surcharging fight is now over unless and until the Florida legislature decides to craft a new surcharge ban.

– Bruce Nathan, Esq., and Andrew Behlmann, Esq., of Lowenstein Sandler LLP