Streetwise Professor

January 27, 2015

Quiet, Please. Paranoids at Work.

Filed under: Economics,Exchanges,Military,Russia — The Professor @ 1:34 pm

The indictment in the Russian espionage* case is available online, and having had a chance to read the portion related to HFT, it’s now clear to me what the Russians were up to. Contrary to certain idiots desperate for attention who are breathlessly claiming that this was part of a plot to bring down Wall Street and the American financial system, this was all about Russian paranoia about the vulnerability of their own financial system to the devilishly clever HFT.

Here’s the relevant part of the indictment:

Screen Shot 2015-01-27 at 1.16.05 PM

ETFs on Russian stocks, including Market Vectors Russian Index ($RSX) are traded in the US, and HFT firms are major participants in ETF trading. What Badenov-sorry, I mean Buryakov-and his co-conspirators are worried about is that “trading robots”-why not trading drones?-could be used to trade Russian ETFs in a way that destabilized the Russian market. They are also curious about who trades ETFs on Russian stocks. Further, they want to gauge the NYSE’s interest in limiting these robots, presumably to learn whether the robots actually posed a threat to Russia.

In other words, this is Russian paranoia talking. More defensive than offensive. Still rather amusing.

Note that the Vnesheconombank employee, Buryakov, is the “expert” here, and the SVR agent operating under diplomatic cover, Igor Sporyshev, is the go between with the “news organization.”

As I noted yesterday, Russian cyber and hacking capabilities are formidable, and they don’t need a couple of disgruntled guys to garner secrets about the vulnerability of Wall Street. Instead, Bulyakov was just channeling fears about the vulnerability of the Russian financial markets.

That was in May, 2013. Just think of how paranoid they are today.

* Tellingly, these guys weren’t charged with committing espionage. Bulyakov was charged with failing to register as a foreign agent. Enough to put him in jail, and an excuse to fire this shot at Putin, but a charge that is likely easier to prove and which doesn’t require the government reveal too much about sources and methods.

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January 26, 2015

If the Russians Want to Know About HFT, They Don’t Need Spies

Filed under: Economics,Exchanges,Military,Politics,Russia — The Professor @ 8:08 pm

Attorney General Holder today announced espionage charges against three Russians, one of whom was arrested today in New York. Two were Russian diplomatic officials, and the third-the one arrested-was an employ of a Russian bank, reported to be Vneshekonombank. The FBI had the men under surveillance since 2012.

So just what were these agents after? Information about potential future sanctions targets for one thing. But they were also after information on high frequency trading of exchange traded funds, or in acronymspeak, HFT of ETFs:

According to the complaint, Sporyshev told Buryakov to tell an unnamed Russian state-owned news organization to ask about how the New York Stock Exchange used exchange-traded funds and potential limits on the use of high-frequency automated trading systems.

Why, pray tell, would this be of such great interest to the Russians? Economic sabotage? Or a money making opportunity?

And why the need for such cloak-and-dagger? There are Russians working in pretty much every HFT shop on and off Wall Street: remember Sergey Aleynikov in Flash Boys? Can’t they find one susceptible to blackmail, bribery, or appeals to patriotism?

Further, what really could be learned by having an “unnamed Russian state-owned news organization” (can you say “RT”? I knew you could) ask someone (presumably the NYSE itself) about “limits on the use of” HFT that couldn’t be obtained by reading public disclosures?

The best of all: it’s not as if the Russians couldn’t find out-and haven’t found out-pretty much anything about NYSE (or NASDAQ or any other exchange) operations without leaving home. They have been fingered for hacking many financial firms, including NASDAQ. (CME has also been hacked, although Russians have not been specifically implicated.) That would be a much more informative, and much less risky, way of divining HFT secrets.

And it’s not as if Russians in Russia aren’t aware of the details of HFT. The Moscow Exchange is actively trying to attract HFT firms (h/t @libertylynx), and has introduced capabilities such as co-location in order to do so. (But perhaps the Moscow Exchange rep is speaking in code. No doubt Fort Meade and Langley have their best men working on this.) Just Google “HFT Moscow Exchange” and you’ll find numerous links describing HFT activities there.

And if they want to learn about ETFs, why not just buy some books? Or do a little surfing? And there are Russian stock ETFs. (Note my clever insertion of the Market Vectors Russia ETF tag.)

You know that HFT and ETFs are hardly Russian espionage priorities. US intelligence and intelligence capabilities, defense technology, and even other types of economic espionage are of far greater interest. The triviality of the targets of this cell, compared to other things of much greater sensitivity, just reveals how pervasive Russian intelligence operations in the US likely are. So why go after this rather hapless group? And why now?

Viewed in context, it’s pretty clear. We rolled up what is likely the least important and sensitive operation the FBI is monitoring at this time and had the Attorney General announce it as a bit of Kabuki theater to communicate our displeasure with the Russians. We have had this group under surveillance since 2012, and could have netted them anytime. That time was now because of the escalating tensions with Russia. It is a signal that we can do things that would hurt the Russians much worse.

Will Putin listen? Doubtful. So what will we do next? That will be interesting to see.

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January 25, 2015

From Birth to Adulthood in a Few Short Years: HFT’s Predictable Convergence to Competitive Normalcy

Filed under: Commodities,Derivatives,Economics,Exchanges,HFT — The Professor @ 2:05 pm

Once upon a time, high frequency trading-HFT-was viewed to be a juggernaut, a money-making machine that would have Wall Street and LaSalle Street in its thrall. These dire predictions were based on the remarkable growth in HFT in 2009 and 2010 in particular, but the narrative outlived the heady growth.

In fact, HFT has followed the trajectory of any technological innovation in a highly competitive environment. At its inception, it was a dramatically innovative way of performing longstanding functions undertaken by intermediaries in financial markets: market making and arbitrage. It did so much more efficiently than incumbents did, and so rapidly it displaced the old-style intermediaries. During this transitional period, the first-movers earned supernormal profits because of cost and speed advantages over the old school intermediaries. HFT market share expanded dramatically, and the profits attracted expansion in the capital and capacity of the first-movers, and the entry of new firms. And as day follows night, this entry of new HFT capacity and the intensification of competition dissipated these profits. This is basic economics in action.

According to the Tabb Group, HFT profits declined from $7 billion in 2009 to only $1.3 billion today. Moreover, HFT market share in both has declined from its peak of 61 percent in equities in 2009 (to 48.4 percent today) and 64 percent in futures in 2011 (to 60 percent today). The profit decline and topping out of market share are both symptomatic of sector settling down into a steady state of normal competitive profits and growth commensurate with the increase in the size of the overall market in the aftermath of a technological shock. Fittingly, this convergence in the HFT sector has been notable for its rapidity, with the transition from birth to adulthood occurring within a mere handful of years.

A little perspective is in order too. Equity market volume in the US is on the order of $100 billion per day. HFT profits now represent on the order of 1/250th of one percent of equity turnover. Since HFT profits include profits from derivatives, their share of turnover of everything they trade overall is smaller still, meaning that although they trade a lot, their margins are razor thin. This is another sign of a highly competitive market.

We are now witnessing further evidence of the maturation of HFT. There is a pronounced trend to consolidation, with HFT pioneer Allston Trading exiting the market, and DRW purchasing Chopper Trading. Such consolidation is a normal phase in the evolution of a sector that has experienced a technological shock. Expect to see more departures and acquisitions as the industry (again predictably) turns its focus to cost containment as competition means that the days of easy money are fading in the rearview mirror.

It’s interesting in this context to think about Schumpeter’s argument in Capitalism, Socialism, and Democracy.  One motivation for the book was to examine whether there was, as Marx and earlier classical economists predicted, a tendency for profit to diminish to zero (where costs of capital are included in determining economic profit).  That may be true in a totally static setting, but as Schumpeter noted the development of new, disruptive technologies overturns these results.  The process of creative destruction can result in the introduction of a sequence of new technologies or products that displace the old, earn large profits for a while, but are then either displaced by new disruptive technologies, or see profits vanish due to classical/neoclassical competitive forces.

Whether it is by the entry of a new destructively creative technology, or the inexorable forces of entry and expansion in a technologically static setting, one expects profits earned by firms in one wave of creative destruction to decline.  That’s what we’re seeing in HFT.  It was definitely a disruptive technology that reaped substantial profits at the time of its introduction, but those profits are eroding.

That shouldn’t be a surprise.  But it no doubt is to many of those who have made apocalyptic predictions about the machines taking over the earth.  Or the markets, anyways.

Or, as Herb Stein famously said as a caution against extrapolating from current trends, “If something cannot go on forever, it will stop.” Those making dire predictions about HFT were largely extrapolating from the events of 2008-2010, and ignored the natural economic forces that constrain growth and dissipate profits. HFT is now a normal, competitive business earning normal, competitive profits.  And hopefully this reality will eventually sink in, and the hysteria surrounding HFT will fade away just as its profits did.

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November 4, 2014

This Cuts No ICE With Me

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 9:24 pm

I admire  Jeffrey Sprecher. ICE has been an amazing success story, and a lot of that has to do with his rather unique combination of vision and ability to execute.

But he is not above talking his book, and he delivered some self-serving, and in fact anti-competition, remarks in ICE’s earnings call held earlier today:

The head of Intercontinental Exchange, the world’s second-largest exchange group by market value, launched an unusually explicit criticism of its bigger competitor’s business strategy as he touted growth in his flagship oil contract.

Commercial customers such as refineries and airlines propelled this growth “as we see our competitors adopting incentives that attract the type of algorithm . . . trading that typically drives commercial users away,” Mr Sprecher said.

Mr Sprecher said “payment for order flow schemes” such as CME’s expanded the market by “attracting traders that really don’t want to hold the risk of your products but just want . . . to get paid to be there.”

If Mr. Sprecher actually believes that, he should be glad that CME (to speak of competitors plural is rather amusing) is implementing a program that per his telling drives away the paying customers, the commercial users.  That’s doubly true since those commercial users would presumably go to ICE. How is CME supposed to make money giving away trading incentives to traders whose presence those who repel those who pay full fare? If that’s what CME is doing, Mr. Sprecher should remember the old adage about not intervening when your enemy is intent on committing a blunder.

Sprecher was touting the fact that ICE’s Brent contract had now surpassed the older CME WTI contract in open interest. Well, this is good for ICE, certainly, but Sprecher and his exchange really have had very little to do with it: this is further proof that it’s usually better to be lucky, than good. Brent’s relative rise is the result of structural factors, most notably the prolonged logistical bottleneck that isolated WTI from waterborne crudes: that bottleneck is largely gone, replaced instead by a regulatory bottleneck, the US export ban.

ICE should not gloat for too long, though, because it is quite likely that the export ban will go, one way or another. What’s more, the resource base supporting the Brent contract is dwindling, and rapidly, whereas the Midcontinent of the US is experiencing a crisis of abundance, if it is experiencing a crisis at all. Logistical bottlenecks created by such crises tend to be transitory, and even regulatory bottlenecks can be overcome. In a few years, WTI will be deeply connected with the waterborne market, albeit in a non-traditional direction. And Brent will be at the mercy of inexorably declining production, and the ability of Platts and an often fractious community of producers and traders to figure out a contractual fix. (Adding Urals to the Brent basket? Really?) So Brent is riding high now, but over the medium to long term, CME will be one breaking out the shades, because WTI will have the brighter future.

As for incentives offered by upstart markets to unseat incumbents, as CME is attempting to do to ICE in Brent, this is a classic competitive tactic, and almost necessary in futures markets. The network effect of order flow means that (as I say in Gregory Meyer’s FT piece) bigger incumbent contracts have a big competitive advantage. The only way that  a competing contract can possibly build order flow and liquidity is to offer incentives, both to market makers (including HFT and algo traders!) who supply liquidity and to the hedgers and speculators that consume liquidity. (I wrote about this last year. Amusingly, I had forgotten about that post until Greg reminded me of it:-P)

Even that is a dicey proposition. Many have tried, and most have failed. But sometimes the upstart the succeeds, and at other times has forced the incumbent to meet the incentives to keep market share, and that can be expensive for the incumbent. That’s probably what Sprecher really doesn’t like. It’s not that incentives don’t work (as the criticism quoted above suggests): it’s that they just might. And if CME’s incentives work it could be an costly proposition for ICE to respond in kind.

In other words, Sprecher is really criticizing a reasonable competitive tactic, because like any dominant incumbent, he doesn’t like competition. That’s his job, but that kind of criticism cuts no ice with me. Or ICE, either, as much as I admire its achievement.

 

 

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October 28, 2014

Convergence to Agreement With Matt Levine

Filed under: Commodities,Derivatives,Economics,Exchanges,Regulation — The Professor @ 10:10 am

Matt Levine graciously led his daily linkwrap with a response to my post on his copper column:

It’s not that hard to manipulate copper.

Craig Pirrong, who knows a lot more about commodities markets than I do [aw, shucks], objects to my take on copper. My view is sort of efficient-markets-y: If one person buys up all the copper in the LME warehouses and then tries to raise the price, the much much greater supply of copper that’s not in those warehouses will flow into the warehouses and limit his ability to do that. And I still think that’s broadly true, but broadly true may not be the point. Pirrong quite rightly points out that there’s lots of friction along the way, and the frictions may matter more than the limits in actual fact.

. . . .

So there are limits to cornering, but they may not be binding on an actual economic actor: You can’t push prices up very much, or forvery long, but you may be able to push them up high enough and for long enough to make yourself a lot of money.

I agree fully there are limits to cornering. The supply curve isn’t completely inelastic. People can divert supplies (at some cost) into deliverable position. The cornerer presents the shorts with the choice: pay me to get out of your positions, or incur the cost of making delivery. Since those delivery costs are finite, the amount the cornerer can extract is limited too.

I agree as well that corners typically elevate prices temporarily: after all, the manipulator needs to liquidate his positions in order to cash out, and as soon as that happens price relationships snap back. But that temporary period can last for some time. Weeks, sometimes more.

What’s more, when the temporary price distortions happen matters a lot. Some squeezes occur at the very end of a contract. This is what happened in Indiana Farm Bureau in 1973. A more recent example is the expiry of the October, 2008 crude oil contract, in which prices spiked hugely in the last few minutes of trading.

The economic harm of these last minute squeezes isn’t that large. There are few players in the market, most hedgers have rolled or offset, and the time frame of the price distortion is too short to cause inefficient movements of the commodity.

But other corners are more protracted, and occur at precisely the wrong time.

Specifically, some corners start to distort prices well before expiration, and precisely when hedgers are looking to roll or offset. Short, out-of-position hedgers looking to roll or offset try to buy either spreads or outrights. The large long planning to corner the market doesn’t liquidate. So the hedgers bid up the expiring contract. Long still doesn’t budge. So the shorts bid it up some more. Eventually, the large long relents and sells when prices and spreads get substantially out of line, and the hedgers exit their positions but at a painfully artificial price. I have documented price distortions in some episodes of 10 percent or more. That’s a big deal, especially when one considers the very thin margins on which commodity trading is done. Combine that price distortion with the fact that a large number of shorts pay that distorted price to get out of their positions, and the dollar damages can be large. Depending on the size of the contract, and the magnitude of the distortion, nine or ten figures large.  (I analyze the liquidation/roll process theoretically in a paper titled “Squeeze Play” that appeared in the Journal of Alternative Investments a few years ago.)

But this is all paper trading, right, so real reapers of wheat and miners of copper aren’t damaged, right? Well, for the bigger, more protracted squeezes that’s not right.

Most hedgers are “out-of-position” they are using a futures contract to hedge something that isn’t deliverable. For example, shippers of Brazilian beans or holders of soybean inventories in Iowa use CBT soybean futures as a hedge. They are therefore long the basis. Corners distort the basis: the futures price rises to reflect the frictions and bottlenecks and technical features of the delivery mechanism, but the prices of the vastly larger quantities of the physical traded and held elsewhere may rise little, if at all. So the out-of-position hedgers don’t gain on their inventories, but they pay an inflated price to exit their futures.

This is why corners are a bad thing. They undermine  the most vital function of futures markets: hedging/risk transfer. Hedgers pay the biggest price for corners precisely because the delivery market is only a small sliver of the world market for a commodity, and because the network effects of liquidity cause all hedging activity to tip to a single market (with a very few exceptions). Thus, the very inside baseball details of the delivery process in a specific, localized market have global consequences. That’s why temporary and not very big and localized are not much comfort when it comes to the price distortions associated with market power manipulations.

 

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October 27, 2014

Matt Levine Passes Off a Bad Penny

Filed under: Commodities,Derivatives,Economics,Exchanges,Regulation — The Professor @ 5:36 pm

Bloomberg’s Matt Levine is usually very insightful about markets, and about financial skullduggery. Alas, in his article on developments in the copper market, Matt is passing off a bad penny.

The basic facts are these. A single firm, reportedly well-known (and arguably infamous) metals trading fund Red Kite, has accumulated upwards of 50 percent (and at times as much as 90 percent) of copper in LME warehouses that is deliverable against LME futures contracts. Such an accumulation can facilitate a corner of the market, or could be a symptom of a corner: a large long takes delivery of virtually the entire deliverable stock (and perhaps all of it) to execute a corner. So the developments in LME copper bear the hallmarks of a squeeze, or an impending one.

What’s more, the price relationships in the market are consistent with a squeeze: the market is in backwardation. I have not had time to determine whether the backwardation is large, controlling for stocks (as would occur during a corner), but the sharp spike in backwardation in recent days is symptomatic of a corner, or fears of a corner.

Put simply, there is smoke here. But Matt Levine seems intent on denying that. Weirdly, he focuses on the allegations involving Goldman’s actions in aluminum:

Loosely speaking, the problem of aluminum was that it was in deep contango: Prices for immediate delivery were low, prices for future delivery were high, and so buying aluminum and chucking it in a warehouse to deliver later was profitable. So people did, and the warehouses got pretty jammed up, and other people who wanted aluminum for immediate use found it all a bit unsporting.

. . . .

The LME warehouse system is an interesting abstract representation of a commodity market, but you can get into trouble if you confuse it with the actual commodity market. One example of the trouble: Goldman and its cronies were accused of manipulating aluminum prices up by putting too much aluminum in LME warehouses.

Well, yes. But the point is that there are many different kinds of manipulation. Many, many different kinds. An Appeals Court in the US opined in the Cargill case that they number of ways of manipulating was limited only by the imagination of man. Too true. The facts in aluminum and the facts in copper are totally different, and the alleged forms of manipulation are totally different, so the events in aluminum are a red herring (although it is copper that is the red metal)

Levine also makes a big, big deal out of the fact that the amount of copper in LME warehouses is trivial compared to the amount of copper produced in the world, let alone the amount of copper that remains in the earth’s crust. This matters hardly at all.

What matters is the steepness of the supply curve into warehouses. If that supply curve is upward sloping, a firm with a big enough futures position can corner the market, and distort prices, even if the amount of copper actually in the warehouses, or attracted to the warehouses by a cornerer’s artificial demand, is small relative to the size of the world copper market.

Case in point. In December 1995 Hamanaka/Sumitomo cornered the LME copper contract holding a position in LME warrants that was substantially smaller than what one firm now owns. Hamanaka’s/Sumitomo’s physical and futures positions were small relative to the size of the world copper market, measured by production and consumption. But they still had market power in the relevant market because it was uneconomic to attract additional copper into LME warehouses.

Another example. Ferruzzi cornered the CBT soybean contract in July, 1989, owning a mere 8 million bushels of beans in Chicago and Toledo. But since it was uneconomic to move additional supplies into those delivery points, it was profitable for, and possible for, Ferruzzi to corner the expiring contract.

World supply may have an effect on the slope of the supply curve into warehouses, but that slope can be positive (thereby creating the conditions necessary to corner) even if the share of metal in warehouses is small. The slope of the supply curve depends on the bottlenecks associated with getting metal into warehouses, and the costs of diverting metal that should go to consumers into warehouses. These bottlenecks and costs can be acute, even if the amount of warehoused metal is small. Diverting copper that should go to a fabricator or wire mill to an LME warehouse is inefficient, i.e., costly. It only happens, therefore, if the price is distorted sufficiently to offset this higher cost.

Levine ends his post thus:

One example of the trouble: Goldman and its cronies were accused of manipulating aluminum prices up by putting too much aluminum in LME warehouses.The worries about copper — that it could be cornered, pushing prices up — stem from there being too little copper in those warehouses. Both of those things can’t be true.

Yes they can, actually. Different commodities at different times with different fundamental conditions are vulnerable to different kinds of manipulation. It is perfectly possible for it to be true that aluminum was vulnerable to a manipulative scheme that exploited the bottlenecks of taking the white metal out of warehouses starting some years ago, and that copper is vulnerable to a manipulative scheme that exploits the bottlenecks of getting the red metal into warehouses now. No logical or factual contradiction whatsoever.

I know you are better than this, Matt. Don’t let your justifiable skepticism of allegations of manipulation make you a poster child for the Gresham’s Law of Internet Commentary.

 

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October 24, 2014

Someone Didn’t Get the Memo, and I Wouldn’t Want to be That Guy*

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 9:23 am

Due to the five year gap in 30 year bond issuance, in mid-September the CME revised the deliverable basket for the June 2015 T-bond contract. It deleted the 6.25 of May, 2015 because its delivery value would have been so far below the values of the other bonds in the deliverable set. This would have made the contract more susceptible to a squeeze because only that bond would effectively be available for delivery due to the way the contract works.

The CME issued a memo on the subject.

Somebody obviously didn’t get it:

It looks like a Treasury futures trader failed to do his or her homework.

The price of 30-year Treasury futures expiring in June traded for less than 145 for about two hours yesterday before shooting up to more than 150. The 7.3 percent surge in their price yesterday, on the first day these particular contracts were traded, was unprecedented for 30-year Treasury futures, according to data compiled by Bloomberg. Volume amounted to 1,639 contracts with a notional value of $164 million.

What sets these futures apart from others is they’re the first ones where the U.S. government’s decision to stop issuing 30-year bonds from 2001 to 2006 must be accounted for when valuing the derivatives. The size and speed of yesterday’s jump indicates the initial traders of the contracts hadn’t factored in the unusual rules governing these particular products, said Craig Pirrong, a finance professor at the University of Houston.

“That is humongous,” said Pirrong, referring to the 7.3 percent jump. “We’re talking about a move you might see over weeks or a month occur in a day.” Pirrong said he suspected it was an algorithmic trader using an outdated model. “I would not want to be that guy,” the professor said.

Here’s a quick and dirty explanation. Multiple bonds are eligible for delivery. Since they have different coupons and maturities, their prices can differ substantially. For instance, the 3.5 percent of Feb 39 sells for about $110, and the 6.25 of 2030 sells for about $146. If both bonds were deliverable at par, no one would ever deliver the 6.25 of 2030, and it would not contribute in any real way to deliverable supply. Therefore, the CME effectively handicaps the delivery race by assigning conversion factors to each bond. The conversion factor is essentially the bond’s price on the delivery date assuming it yields 6 percent to maturity. If all bonds yield 6 percent, their delivery values would be equal, and the deliverable supply would be the total amount of deliverable bonds outstanding. This would make it almost impossible to squeeze the market.

Since bonds differ in duration, and actual yields differ from 6 percent, the conversion factors narrow but do not eliminate disparities in the delivery values of bonds. One bond will be cheapest-to-deliver. Roughly speaking, the CTD bond will be the one with the lowest ratio of price to conversion factor.

That’s where the problem comes in. For the June contract, if the 6.25 of 2030 was eligible to deliver, its converted price would be around $142. Due to the issuance/maturity gap, the converted prices of all the other bonds is substantially higher, ranging between $154 and $159.

This is due a duration effect. When yields are below 6 percent, and they are now way below, at less than 3 percent, low duration bonds become CTD: the prices of low duration bonds rise less (in percentage terms) for a given decline in yields than the prices of high duration bonds, so they become relatively cheaper. The 6.25 of 2030 has a substantially lower duration than the other bonds in the deliverable basket because of its lower maturity (more than 5 years) and higher coupon. So it would have been cheapest to deliver by a huge margin had CME allowed it to remain in the basket. This would have shrunk the deliverable supply to the amount outstanding of that bond, making a squeeze more likely, and more profitable. (And squeezes in Treasuries do occur. They were rife in the mid-to-late-80s, and there was a squeeze of the Ten Year in June of 2005. The 2005 squeeze, which was pretty gross, occurred when there was less than a $1 difference in delivery values between the CTD and the next-cheapest. The squeezer distorted prices by about 15/32s.)

The futures contract prices the CTD bond. So if someone-or someone’s algo-believed that the 6.25 of 2030 was in the deliverable basket, they would have calculated the no-arb price as being around $142. But that bond isn’t in the basket, so the no-arb value of the contract is above $150. Apparently the guy* who didn’t get the memo merrily offered the June future at $142 in the mistaken belief that was near fair value.

Ruh-roh.

After selling quite a few contracts, the memo non-reader wised up, and the price jumped up to over $150, which reflected the real deliverable basket, not the imaginary one.

This price move was “humongous” given that implied vol is around 6 percent. That’s an annualized number, meaning that the move on a single day was more than a one-sigma annual move. I was being very cautious by saying this magnitude move would be expected to occur over weeks or months. But that’s what happens when the reporter catches me in the gym rather than at my computer.

This wasn’t a fat-finger error. This was a fat-head error. It cost somebody a good deal of money, and made some others very happy.

So word up, traders (and programmers): always read the memos from your friendly local exchange.

*Or gal, as Mary Childs pointed out on Twitter.

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October 13, 2014

You Might Have Read This Somewhere Before. Like Here.

The FT has a long article by John Dizard raising alarms about the systemic risks posed by CCPs. The solution, in other words, might be the problem.

Where have I read that before?

The article focuses on a couple of regulatory reports that have also raised the alarm:

No, I am referring to reports filed by the wiring and plumbing inspectors of the CCPs. For example, the International Organization for Securities Commissions (a name that could only be made duller by inserting the word “Canada”) issued a report this month on the “Securities Markets Risk Outlook 2014-2015”. I am not going to attempt to achieve the poetic effect of the volume read as a whole, so I will skip ahead to page 85 to the section on margin calls.

Talking (again) about the last crisis, the authors recount: “When the crisis materialised in 2008, deleveraging occurred, leading to a pro-cyclical margin spiral (see figure 99). Margin requirements also have the potential to cause pro-cyclical effects in the cleared markets.” The next page shows figure 99, an intriguing cartoon of a margin spiral, with haircuts leading to more haircuts leading to “liquidate position”, “further downward pressure” and “loss on open positions”. In short, do not read it to the children before bedtime.

This margin issue is exactly what I’ve been on about for six years now. Good that regulators are finally waking up to it, though it’s a little late in the day, isn’t it?

I chuckle at the children before bedtime line. I often say that I should give my presentations on the systemic risk of CCPs while sitting by a campfire holding a flashlight under my chin.

I don’t chuckle at the fact that other regulators seem rather oblivious to the dangers inherent in what they’ve created:

While supervisory institutions such as the Financial Stability Oversight Council are trying to fit boring old life insurers into their “systemic” regulatory frameworks, they seem to be ignoring the degree to which the much-expanded clearing houses are a threat, not a solution. Much attention has been paid, publicly, to how banks that become insolvent in the future will have their shareholders and creditors bailed in to the losses, their managements dismissed and their corporate forms put into liquidation. But what about the clearing houses? What happens to them when one or more of their participants fail?

I call myself the Clearing Cassandra precisely because I have been prophesying so for years, but the FSOC and others have largely ignored such concerns.

Dizard starts out his piece quoting Dallas Fed President Richard Fisher comparing macroprudential regulation to the Maginot Line. Dizard notes that others have made similar Maginot Line comparisons post-crisis, and says that this is unfair to the Maginot Line because it was never breached: the Germans went around it.

I am one person who has made this comparison specifically in the context of CCPs, most recently at Camp Alphaville in July. But my point was exactly that the creation of impregnable CCPs would result in the diversion of stresses to other parts of the financial system, just like the Maginot line diverted the Germans into the Ardennes, where French defenses were far more brittle. In particular, CCPs are intended to eliminate credit risk, but they do so by creating tremendous demands for liquidity, especially during crisis times. Since liquidity risk is, in my view, far more dangerous than credit risk, this is not obviously a good trade off. The main question becomes: During the next crisis, where will be the financial Sedan?

I take some grim satisfaction that arguments that I have made for years are becoming conventional wisdom, or at least widespread among those who haven’t imbibed the Clearing Kool Aid. Would that have happened before legislators and regulators around the world embarked on the vastest re-engineering of world financial markets ever attempted, and did so with their eyes wide shut.

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October 7, 2014

Manipulation Prosecutions: Going for the Capillaries, Ignoring the Jugular

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 7:32 pm

The USDOJ has filed criminal charges against a trader named Michael Coscia for “spoofing” CME and ICE futures markets. Frankendodd made spoofing a crime.

What is spoofing? It’s the futures market equivalent of Lucy and the football. A trader submits buy (sell) orders above (below) the inside market in the hope that this convinces other market participants that there is strong demand (supply) for (of) the futures contract. If others are so fooled, they will raise their bids (lower their offers). Right before they do this, the spoofer pulls his orders just like Lucy pulls the football away from Charlie Brown, and then hits (lifts) the higher (lower) bids (offers). If the pre-spoof prices are “right”, the post-spoof bids (offers) are too high (too low), which means the spoofer sells high and buys low.

Is this inefficient? Yeah, I guess. Is it a big deal? Color me skeptical, especially since the activity is self-correcting. The strategy works if those at the inside market, who these days are likely to be HFT firms, consider the away from the market spoofing orders to be informative. But they aren’t. The HFT firms at the inside market who respond to the spoof will lose money. They will soon figure this out, and won’t respond to the spoofs any more: they will deem away-from-the-market orders as uninformative. Problem solved.

But the CFTC (and now DOJ, apparently) are obsessed with this, and other games for ticks. They pursue these activities with Javert-like mania.

What makes this maddening to me is that while obsessing over ticks gained by spoofs or other HFT strategies, regulators have totally overlooked corners that have distorted prices by many, many ticks.

I know of two market operations in the last ten years plausibly involving major corners that have arguably imposed mid-nine figure losses on futures market participants, and in one of the case, possibly ten-figure losses. Yes, we are talking hundreds of millions and perhaps more than a billion. To put things in context, Coscia is alleged to have made a whopping $1.6 million. That is, two or three orders of magnitude less than the losses involved in these corners.

And what have CFTC and DOJ done in these cases? Exactly bupkus. Zip. Nada. Squat.

Why is that? Part of the explanation is that previous CFTC decisions in the 1980s were economically incoherent, and have posed substantial obstacles to winning a verdict: I wrote about this almost 20 years ago, in a Washington & Lee Law Review article. But I doubt that is the entire story, especially since one of the cases is post-Frankendodd, and hence the one of the legal obstacles that the CFTC complains about (relating to proving intent) has been eliminated.

The other part of the story is too big to jail. Both of the entities involved are very major players in their respective markets. Very major. One has been very much in the news lately.

In other words, the CFTC is likely intimidated by-and arguably captured by-those it is intended to police because they are very major players.

The only recent exception I can think of-and by recent, I mean within the last 10 years-is the DOJ’s prosecution of BP for manipulating the propane market. But BP was already in the DOJ’s sights because of the Texas City explosion. Somebody dropped the dime on BP for propane, and DOJ used that to turn up the heat on BP. BP eventually agreed to a deferred prosecution agreement, in which it paid a $100 million fine to the government, and paid $53 million into a restitution fund to compensate any private litigants.

The Commodity Exchange Act specifically proscribes corners. Corners occur. But the CFTC never goes after corners, even if they cost market participants hundreds of millions of dollars. Probably because corners that cost market participants nine or ten figures can only be carried out by firms that can hire very expensive lawyers and who have multiple congressmen and senators on speed dial.

Instead, the regulators go after much smaller fry so they can crow about how tough they are on wrongdoers. They go after shoplifters, and let axe murderers walk free. Going for the capillaries, ignoring the jugular.

All this said, I am not a fan of criminalizing manipulation. Monetary fines-or damages in private litigation-commensurate to the harm imposed will have the appropriate deterrent effect.

The timidity of regulators in going after manipulators is precisely why a private right of action in manipulation cases is extremely important. (Full disclosure: I have served as an expert in such cases.)

One last comment about criminal charges in manipulation cases. The DOJ prosecuted the individual traders in the propane corner. Judge Miller in the Houston Division of the  Southern District of Texas threw out the cases, on the grounds that the Commodity Exchange Act’s anti-manipulation provisions are unconstitutionally vague. Now this is only a district court decision, and the anti-spoofing case will be brought under new provisions of the CEA adopted as the result of Dodd-Frank. Nonetheless, I think it is highly likely that Coscia will raise the same defense (as well as some others). It will be interesting to see how this plays out.

But regardless of how it plays out, regulators’ obsession with HFT games stands in stark contrast with their conspicuous silence on major corner cases. Given that corners can cause major dislocations in markets, and completely undermine the purposes of futures markets-risk transfer and price discovery-this imbalance speaks very ill of the priorities-and the gumption (I cleaned that up)-of those charged with policing US futures markets.

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September 10, 2014

SEFs: The Damn Dogs Won’t Eat It!

Filed under: Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 8:37 pm

There’s an old joke about a pet food manufacturer that mounts an all out marketing campaign for its new brand of dog food. It pulls out all the stops. Celebrity endorsements. Super Bowl Ad. You name it. But sales tank. The CEO calls the head of marketing onto the carpet and demands an explanation for the appalling sales. The marketing guy  answers: “It’s those damn dogs. They just won’t eat the stuff.”

That joke came to mind when reading about the CFTC’s frustration at the failure of SEFs to get traction. Most market  participants avoid using central limit order books (CLOBs), and prefer to trade by voice or Requests for Quotes (RFQs):

“The biggest surprise for me is the lack of interest from the buyside for [central limit order books or CLOB],” Michael O’Brien, director of global trading at Eaton Vance, said at the International Swaps and Derivatives Association conference in New York. “The best way to break up the dual market structure and boost transparency is through using a CLOB and I’m surprised at how slow progress has been.”

About two dozen Sefs have been established in the past year, but already some of these venues are struggling to register a presence. Instead, incumbent market players who have always dominated the swaps market are winning under the new regulatory regime, with the bulk of trading being done through Bloomberg, Tradeweb and interdealer brokers including IcapBGC and Tradition.

“It’s still very early,” Mr Massad told the FT. “The fact that we’re getting a decent volume of trading is encouraging but we are also looking at various issues to see how we can facilitate more trading and transparency.”

Regulators are less concerned about having a specific numbers of Sefs since the market is still sorting out which firms can serve their clients the best under the new regulatory system. What officials are watching closely is the continued use of RFQ systems rather than the transparent central order booking structure.

Not to say I told you so, but I told you so. I knew the dogs, and I knew they wouldn’t like the food.

This is why I labeled the SEF mandate as The Worst of Dodd Frank. It was a solution in search of a non-existent problem. It took a one-sized fits all approach, predicated on the view that centralized order driven markets are the best way to execute all transactions. It obsessed on pre-trade and post-trade price transparency, and totally overlooked the importance of counterparty transparency.

There is a diversity of trading mechanisms in virtually every financial market. Some types of trades and traders are economically executed in anonymous, centralized auction markets with pre- and post-trade price transparency. Other types of trades and traders-namely, big wholesale trades involving those trading to hedge or to rebalance portfolios, rather than to take advantage of information advantages-are most efficiently negotiated and executed face-to-face, with little (or delayed) post-trade price disclosure. This is why upstairs block markets always existed in stocks, and why dark pools exist now. It is one reason why OTC derivatives markets operated side-by-side with futures markets offering similar products.

As I noted at the time, sophisticated buy siders in derivatives markets had the opportunity to trade in futures markets but chose to trade OTC. Moreover, the buy side was very resistant to the SEF mandate despite the fact that they were the supposed beneficiaries of a more transparent (in some dimensions!) and more competitive (allegedly) trading mechanism. The Frankendodd crowd argued that SEFs would break a cabal of dealers that exploited their customers and profited from the opacity of the market.

But the customers weren’t buying it. So you had to believe that either they knew what they were talking about, or were the victims of Stockholm Syndrome leaping to the defense of the dealers that held them captive.

My mantra was a diversity of mechanisms for a diversity of trades and traders.  Frankendodd attempts to create a monoculture and impose a standardized market structure for all participants. It says to the buy side: here’s your dinner, and you’ll like it, dammit! It’s good for you!

But the buy side knows what it likes, and is pushing away the bowl.

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