Streetwise Professor

July 1, 2017

All Flaws Great and Small, Frankendodd Edition

On Wednesday I had the privilege to deliver the keynote at the FOW Trading Chicago event. My theme was the fundamental flaws in Frankendodd–you’re shocked, I’m sure.

What I attempted to do was to categorize the errors. I identified four basic types.

Unintended consequences contrary to the objectives of DFA. This could also be called “counter-intended consequences”–not just unintended, but the precise opposite of the stated intent. The biggest example is, well, related to bigness. If you wanted to summarize a primary objective of DFA, it would be “to reduce the too big to fail problem.” Well, the very nature of DFA means that in some ways it exacerbates TBTF. Most notably, the resulting regulatory burdens actually favor scale, because they impose largely fixed costs. I didn’t mention this in my talk, but a related effect is that increasing regulation leads to greater influence activities by the regulated, and for a variety of reasons this tends to favor the big over the medium and small.

Perhaps the most telling example of the perverse effects of DFA is that it has dramatically increased concentration among FCMs. This exacerbates a variety of sources of systemic risk, including concentration risk at CCPs; difficulties in managing defaulted positions and porting the positions of the customers of troubled FCMs; and greater interconnections across CCPs. Concentration also fundamentally undermines the ability of CCPs to mutualize default risk. It can also create wrong-way risks as the big FCMs are in some cases also sources of liquidity support to CCPs.

I could go on.

Creation of new risks due to misdiagnoses of old risks. The most telling example here is the clearing and collateral mandates, which were predicated on the view that too much credit was extended via OTC derivatives transactions. Collateral and netting were expected to reduce this credit risk.

This is a category error. For one thing, it embodies a fallacy of composition: reducing credit in one piece of an interconnected financial system that possesses numerous ways to create credit exposures does not necessarily reduce credit risk in the system as a whole. For another, even to the extent that reducing credit extended via derivatives transactions reduces overall credit exposures in the financial system, it does so by creating another risk–liquidity risk. This risk is in my view more pernicious for many reasons. One reason is that it is inherently wrong-way in nature: the mandates increase demands for liquidity precisely during those periods in which liquidity supply typically contracts. Another is that it increases the tightness of coupling in the financial system. Tight coupling increases the risk of catastrophic failure, and makes the system more vulnerable to a variety of different disruptions (e.g., operational risks such as the temporary failure of a part of the payments system).

As the Clearing Cassandra I warned about this early and often, to little avail–and indeed, often to derision and scorn. Belatedly regulators are coming to an understanding of the importance of this issue. Fed governor Jerome Powell recently emphasized this issue in a speech, and recommended CCPs engage in liquidity stress testing. In a scathing report, the CFTC Inspector General criticized the agency’s cost-benefit analysis of its margin rules for non-cleared swaps, based largely on its failure to consider liquidity effects. (The IG report generously cited my work several times.

But these are at best palliatives. The fundamental problem is inherent in the super-sizing of clearing and margining, and that problem is here to stay.

Imposition of “solutions” to non-existent problems. The best examples of this are the SEF mandate and position limits. The mode of execution of OTC swaps was not a source of systemic risk, and was not problematic even for reasons unrelated to systemic risk. Mandating a change to the freely-chosen modes of transaction execution has imposed compliance costs, and has also resulted in a fragmented swaps market: those who can escape the mandate (e.g., European banks trading € swaps) have done so, leading to bifurcation of the market for € swaps, which (a) reduces competition (another counter-intended consequence), and (b) reduces liquidity (also counter-intended).

The non-existence of a problem that position limits could solve is best illustrated by the pathetically flimsy justification for the rule set out in the CFTC’s proposal: the main example the CFTC mentioned is the Hunt silver episode. As I said during my talk, this is ancient history: when do we get to the Trojan War? If anything, the Hunts are the exception that proves the rule. The CFTC also pointed to Amaranth, but (a) failed to show that Amaranth’s activities caused “unreasonable and unwarranted price fluctuations,” and (b) did not demonstrate that (unlike the Hunt case) that Amaranth’s financial distress posed any threat to the broader market or any systemic risk.

It is sickly amusing that the CFTC touts that based on historical data, the proposed limits would constrain few, if any market participants. In other words, an entire industry must bear the burden of complying with a rule that the CFTC itself says would seldom be binding. Makes total sense, and surely passes a rigorous cost-benefit test! Constraining positions is unlikely to affect materially the likelihood of “unreasonable and unwarranted price fluctuations”. Regardless, positions are not likely to be constrained. Meaning that the probability that the regulation reduces such price fluctuations is close to zero, if not exactly equal to zero. Yet there would be an onerous, and ongoing cost to compliance. Not to mention that when the regulation would in fact bind, it would potentially constrain efficient risk transfer.

The “comma and footnote” problem. Such a long and dense piece of legislation, and the long and detailed regulations that it has spawned, inevitably contain problems that can lead to protracted disputes, and/or unpleasant surprises. The comma I refer to is in the position limit language of the DFA itself: as noted in the court decision that stymied the original CFTC position limit rule, the placement of the comma affects whether the language in the statute requires the CFTC to impose limits, or merely gives it the discretionary authority to do so in the even that it makes an explicit finding that the limits are required to reduce unwarranted and unreasonable price fluctuations. The footnotes I am thinking of were in the SEF rule: footnote 88 dramatically increased the scope of the rule, while footnote 513 circumscribed it.

And new issues of this sort crop up regularly, almost 7 years after the passage of Dodd-Frank. Recently Risk highlighted the fact that in its proposal for capital requirements on swap dealers, the CFTC (inadvertently?) potentially made it far more costly for companies like BP and Shell to become swap dealers. Specifically, whereas the Fed defines a financial company as one in which more than 85 percent of its activities are financial in nature, the CFTC proposes that a company can take advantage of more favorable capital requirements if its financial activities are less than 15 percent of its overall activities. Meaning, for example, a company with 80 percent financial activity would not count as a financial company under Fed rules, but would under the proposed CFTC rule. This basically makes it impossible for predominately commodity companies like BP and Shell to take advantage of preferential capital treatment specifically included for them and their ilk in DFA. To the extent that these firms decide to incur costs (higher capital costs, or the cost of reorganizing their businesses to escape the rule’s bite) and become swap dealers nonetheless, that cost will not generate any benefit. To the extent that they decide that it is not worth the cost, the swaps market will be more concentrated and less competitive (more counter-intended effects).

The position limits proposed regs provide a further example of this devil-in-the-details problem. The idea of a hedging carveout is eminently sensible, but the specifics of the CFTC’s hedging exemptions were unduly restrictive.

I could probably add more categories to the list. Different taxonomies are possible. But I think the foregoing is a useful way of thinking about the fundamental flaws in Frankendodd.

I’ll close with something that could make you feel better–or worse! For all the flaws in Frankendodd, MiFID II and EMIR make it look like a model of legislative and regulatory wisdom. The Europeans have managed to make errors in all of these categories–only more of them, and more egregious ones. For instance, as bad as the the US position limit proposal is, it pales in comparison to the position limit regulations that the Europeans are poised to inflict on their firms and their markets.

 

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April 15, 2017

Is the Order Handling Rule Necessary to Ensure Intense Competition in Securities Markets?

Filed under: Commodities,Derivatives,Economics,Exchanges,Regulation — The Professor @ 2:01 pm

A couple of weeks back Acting SEC Chairman Mike Piwowar announced a new Special Study of the Securities Markets, a reprise of the 1963 Special Study. This is an excellent idea, given that RegNMS (adopted in 2005) has (as was inevitable) spawned many unintended and unexpected consequences. Revision of this regulation in light of experience is almost certainly warranted, and any such revision should be predicated on sound scholarship, lest it be merely a Trojan Horse for vested interests arguing their books.

I wrote about RegNMS in Regulation at the time of its adoption in a piece titled “The Thirty Years War” (an allusion to the fact that the establishment of the National Market System in 1975 had sparked a continuing clash over securities market structure). Overall, I think that piece stands up well, particularly my concluding paragraph:

Therefore, the proposed rules are not the final battle in a Thirty Years War. I fully expect that in 2075, some professor will write an article about the latest clash in an ongoing Hundred Years War over securities market structure regulation.

It is certainly the case that the controversies and conflicts over market structure have continued unabated since 2005, and show no signs of letting up. (Cf. Flash Boys.) Chairman Piwowar’s call for a new Special Study is testament to that.

More specifically, the major prediction of my article has been fully borne out. I predicted that the Order Protection Rule in particular would break the network effect that resulted in the dominance of the NYSE in the securities it listed. Since RegNMS was passed, the highly concentrated listed stock market (where virtually all price discovering transactions in NYSE stocks occurred on the NYSE) has been utterly transformed, with four exchanges now splitting most of the business, with no exchange doing more than a quarter of the volume.

I further predicted that this would result in the disintermediation of traditional intermediaries–like specialists–and the substantial erosion of economic rents. This too has happened. This is best illustrated by the trajectory of Goldman’s investment in specialist firm Spear, Leeds & Kellogg. Goldman paid $5.4 billion for it in 2000 (before RegNMS) and sold it for a pittance–$30 million–in 2014. I didn’t foresee exactly the nature or identity of the new intermediaries–HFT–but I was broadly aware that there would be entry into market making, and that this would reduce trading costs and undermine incumbents with market power. Further, as I’ve written about recently, the new intermediaries don’t appear to be making rents in the new equilibrium.

The years since RegNMS have seen a dramatic decline in trading costs for investors, and it is likely the case that this decline is largely attributable to the increase in competition. Much of the controversy that has raged since 2005 relates to disputes over trading practices that were an inevitable consequence of the breaking of the NYSE near-monopoly–a process pejoratively referred to as “fragmentation.” In particular, multiple markets necessitate arbitrageurs, who effectively enforce the law of one price. The strategies and tactics arbitraguers use often appear unsavory, and strike many as unfair: arbitrageurs get something even though they appear to do nothing substantive. Moreover, arbitrage uses up real resources. That’s costly, and it would be nice if this could be avoided, but that’s unlikely ever to be so. The trade-off between much greater competition (and reduced welfare losses due to the exercise of market power) and the expenditure of real resources to enforce the law of one price seems to be a great bargain.

Much of the criticism of RegNMS relates to the Order Protection Rule, which requires that no order can be executed on market X if a better price is displayed at market Y. The critics (e.g., the Principal Traders Association which ironically represents some of the biggest beneficiaries of RegNMS) argue that this rule (a) has led to a proliferation of order types intended to ensure compliance with the rule, which make the market far more complex, and (b) requires traders to maintain connections with and monitor all trading venues displaying quotes, no matter how small.

These complaints have some merit. The crucial question is whether the equity trading marketplace will be as competitive without the Order Handling Rule as it is with it. This is an open question, and one which should be the focus of the SEC’s inquiry. For if the Order Handling Rule is a necessary condition for robust competition, the costs that the PTA and others identify are likely well worth paying in order to realize the benefits of competition.

My prediction that competition would intensify post-RegNMS was based on my analysis of the effects of the Order Handling Rule, which was in turn based on my work on liquidity network effects done in the late-90s and early-00s. Specifically, in the formal models I derived (e.g., here), the self-reinforcing liquidity effect obtains when investors decide which trading venue to submit an order to on the basis of expected execution cost (i.e., bid-ask spread, price impact). The market with the bigger fraction of trading activity typically offers the lowest execution cost. Therefore, traders submit their orders to the bigger market. This creates a self-reinforcing feedback loop (and a self-fulling prophecy) in which trading activity “tips” to a single exchange. (There are some complexities here, relating to cream skimming of uninformed order flow. See the linked paper for a discussion of that issue.)

Mandating something akin to to the order handling rule forces order flow to the market offering the best price at a particular moment, not the one that offers the best price in expectation. As I phrased it in my Regulation paper, such a rule “socializes order flow”: even if an order is directed to a particular exchange, that exchange does not control that order flow and must direct to any other exchange offering a better price.

I think that both theory and the post-RegNMS experience show that the Order Handling Rule is sufficient to break the liquidity network effect because it socializes order flow. But is it necessary? Maybe not, but it is important to try to find out before jettisoning it.

Here’s a story which suggests that the rule is not necessary in the modern electronic trading environment. One reason why traders may choose to submit orders to where they expect to get the best execution is because of search costs. In a floor-based environment in particular, it is costly to verify which market is offering the best price at any time.  Moreover, since it takes time get quotes from two floor-based markets, by the time that you actually submit your order to the one giving the best quote, the market will have moved and you won’t get the price you thought you were going to get. So economize on search costs and the risks associated with delay by submitting the order to the market that usually offers the best price. Ironically, the inevitable result of this process is that there is only one market left standing.

Search is cheaper and faster–and arguably far cheaper and far faster–in the modern electronic environment. Based on feeds from multiple markets, an electronic trader (and in particular an automated trader) can rapidly compare quotes and send an order to the market offering the best quote, or by viewing depth (something pretty much impossible in the floor days, where much of the liquidity was in the hands of floor brokers) split an order among multiple venues to tap the liquidity in all of them.

In other words, the natural monopoly problem was far more likely in a floor-based environment where pre-trade transparency was so limited that search costs were very high: it was nigh on impossible to know precisely what trading opportunities were or to move fast enough to exploit the one that appeared best at any point in time, so traders submitted their orders to where they expected the opportunities to be the best. In contrast, electronification and automation have created such great pre-trade transparency and the ability to act on it that it is plausibly true that in this environment traders can and will submit their orders to whatever venue is offering the best trading opportunity at a point in time, regardless of whether it usually does so. In this story, technology eliminates the uncertainty and guesswork that created the liquidity network effect.

Maybe. Perhaps even likely. But I can’t be certain. Note that one complaint about the existing market structure is that even though everything has vastly speeded up, some traders are still faster than others. As a result, those who submit a market order in response to seeing a particular displayed price are often dismayed to learn that the market has moved before their order actually reaches the trading venue, and that their order is executed at a worse price than they had anticipated. Freed of the obligations of the Order Handling Rule, these traders may choose to submit their order to where they usually get the best price: if enough do this, the liquidity network effect will reemerge.

Further, the PTA and others have complained that it is costly to monitor and maintain connections with all trading venues as is necessary under the Order Handling Rule. If the Rule is relaxed or eliminated, one would expect that they will disconnect from some venues. If enough do this, the smaller venues will become unviable. After this happens, there will be fewer venues–and some traders may choose to disconnect from the smallest remaining one. This dynamic could result in another feedback loop that results in the survival of a single dominant exchange that exercises market power.

It is therefore not clear to me that elimination of the Order Handling Rule will result in traders having their cake (intense inter-exchange competition) and eating it too (less complexity, lower connection cost). Given the substantial benefits of greater competition that have been realized in the past dozen years, changes to the cornerstone of RegNMS should not be taken lightly. The Special Study, and the SEC, should pay close attention to how competition will evolve if the Order Handling Rule is eliminated. This analysis should take into account the existing technology, but also try to think of how technology will change in the aftermath of an elimination and how this technological change will affect competition.

Most importantly, any analysis must be predicated on an understanding that there are strong centripetal forces in securities trading. Any time traders have an incentive to direct order flow to the venue that is expected to offer the best price, the likely outcome is that only one venue will survive. The incentives of traders in a high speed, largely automated, and electronic market in the absence of an Order Handling Rule need to be considered carefully. It should not be assumed that technology alone will eliminate the incentive to direct orders to the market that is usually best, not the one that is best at any particular instant. This hypothesis should be probed vigorously and skeptically.

Experience in futures markets suggests that liquidity network effects can persist even in high speed, automated, electronic markets: futures contracts in a particular instrument exhibit a strong natural monopoly tendency, and strong tendencies towards tipping. It is arguable that the vertical integration of clearing, and the resulting non-fungibility of otherwise identical contracts traded on different venues, could contribute to this (though I am skeptical about that). But it could also mean that something like the Order Handling Rule (which is not present in futures markets) is necessary to create strong competition between multiple venues even in a highly computerized and automated trading environment.

This is the big issue in any revamping of RegNMS. It should be front and center of any analysis, including in the impending Special Study. The intense competition in the post-RegNMS world is a remarkable achievement, particularly in comparison with the near monopolistic market structure that existed before 2005. It would be a great shame if this were thrown away due to an incomplete analysis of what competition in a modern computerized market would be like in the absence of something like the Order Handing Rule.

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April 14, 2017

SWP Climbs The Hill

Filed under: Derivatives,Economics,Exchanges,Regulation — The Professor @ 10:40 am

I have become a regular contributor to The Hill. My inaugural column on the regulation of spoofing is here. The argument in a nutshell is that: (a) spoofing involves large numbers of cancellations, but so do legitimate market making strategies, so there is a risk that aggressive policing of spoofing will wrongly penalize market makers, thereby raising the costs of supplying liquidity; (b) the price impacts of spoofing are very, very small, and transitory; (c) enforcement authorities sometimes fail to pursue manipulations that have far larger price impacts; therefore (d) a focus on spoofing is a misdirection of scarce enforcement resources.

My contributions will focus on finance and regulatory issues. So those looking for my trenchant political commentary will have to keep coming here 😉

Click early! Click often!

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March 24, 2017

Creative Destruction and Industry Life Cycles, HFT Edition

Filed under: Derivatives,Economics,Exchanges,Regulation — The Professor @ 11:56 am

No worries, folks: I’m not dead! Just a little hiatus while in Geneva for my annual teaching gig at Université de Genève, followed by a side trip for a seminar (to be released as a webinar) at ESSEC. The world didn’t collapse without my close attention, but at times it looked like a close run thing. But then again, I was restricted to watching CNN so my perception may be a little bit warped. Well, not a little bit: I have to say that I knew CNN was bad, but I didn’t know how bad until I watched a bit while on the road. Appalling doesn’t even come close to describing it. Strident, tendentious, unrelentingly biased, snide. I switched over to RT to get more reasonable coverage. Yes. It was that bad.

There are so many allegations regarding surveillance swirling about that only fools would rush in to comment on that now. I’ll be an angel for once in the hope that some actual verifiable facts come out.

So for my return, I’ll just comment on a set of HFT-related stories that came out during my trip. One is Alex Osipovich’s story on HFT traders falling on hard times. Another is that Virtu is bidding for KCG. A third one is that Quantlabs (a Houston outfit) is buying one-time HFT high flyer Teza. And finally, one that pre-dates my trip, but fits the theme: Thomas Peterffy’s Interactive Brokers Group is exiting options market making.

Alex’s story repeats Tabb Group data documenting a roughly 85 percent drop in HFT revenues in US equity trading. The Virtu-KCG proposed tie-up and the Quantlabs-Teza consummated one are indications of consolidation that is typical of maturing industries, and a shift it the business model of these firms. The Quantlabs-Teza story is particularly interesting. It suggests that it is no longer possible (or at least remunerative) to get a competitive edge via speed alone. Instead, the focus is shifting to extracting information from the vast flow of data generated in modern markets. Speed will matter here–he who analyzes faster, all else equal, will have an edge. But the margin for innovation will shift from hardware to data analytics software (presumably paired with specialized hardware optimized to use it).

None of these developments is surprising. They are part of the natural life cycle of a new industry. Indeed, I discussed this over two years ago:

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.

. . . .

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.

The rise and fall of Peterffy/Interactive illustrates Schumpeterian creative destruction in action. Interactive was part of a wave of innovation that displaced the floor. Now it can’t compete against HFT. And as the other articles show, HFT is in the maturation stage during which profits are competed away (ironically, a phenomenon that was central to Marx’s analysis, and which Schumpeter’s theory was specifically intended to address).

This reminds me of a set of conversations I had with a very prominent trader. In the 1990s he said he was glad to see that the markets were becoming computerized because he was “tired of being fucked by the floor.” About 10 years later, he lamented to me how he was being “fucked by HFT.” Now HFT is an industry earning “normal” profits (in the economics lexicon) due to intensifying competition and technological maturation: the fuckers are fucking each other now, I guess.

One interesting public policy issue in the Peterffy story is the role played by internalization of order flow in undermining the economics of Interactive: there is also an internalization angle to the Virtu-KCG story, because one reason for Virtu to buy KCG is to obtain the latter’s juicy retail order flow. I’ve been writing about this (and related) subjects for going on 20 years, and it’s complicated.

Internalization (and other trading in non-lit/exchange venues) reduces liquidity on exchanges, which raises trading costs there and reduces the informativeness of prices. Those factors are usually cited as criticism of off-exchange execution, but there are other considerations. Retail order flow (likely uninformed) gets executed more cheaply, as it should because it it less costly (due to the fact that it poses less of an adverse selection risk). (Who benefits from this cheaper execution is a matter of controversy.) Furthermore, as I pointed out in a 2002 Journal of Law, Economics and Organization paper, off-exchange venues provide competition for exchanges that often have market power (though this is less likely to be the case in post-RegNMS which made inter-exchange competition much more intense). Finally, some (and arguably a lot of) informed trading is rent seeking: by reducing the ability of informed traders to extract rents from uninformed traders, internalization (and dark markets) reduce the incentives to invest excessively in information collection (an incentive Hirshleifer the Elder noted in the 1970s).

Securities and derivatives market structure is fascinating, and it presents many interesting analytical challenges. But these markets, and the firms that operate in them, are not immune to the basic forces of innovation, imitation, and entry that economists have understood for a long time (but which too many have forgotten, alas). We are seeing those forces at work in real time, and the fates of firms like Interactive and Teza, and the HFT sector overall, are living illustrations.

 

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January 24, 2017

Two Contracts With No Future

Filed under: China,Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 7:14 pm

Over the past couple of days two major futures exchanges have pulled the plug on contracts. I predicted these outcomes when the contracts were first announced, and the reasons I gave turned out to be the reasons given for the decisions.

First, the CME announced that it is suspending trading in its new cocoa contract, due to lack of volume/liquidity. I analyzed that contract here. This is just another example of failed entry by a futures contract. Not really news.

Second, the Shanghai Futures Exchange has quietly shelved plans to launch a China-based oil contract. When it was first mooted, I expressed extreme skepticism, due mainly to China’s overwhelming tendency to intervene in markets sending the wrong signal–wrong from the government’s perspective that is:

Then the crash happened, and China thrashed around looking for scapegoats, and rounded up the usual suspects: Speculators! And it suspected that the CSI 300 Index and CSI 500 Index futures contracts were the speculators’ weapons of mass destruction of choice. So it labeled trades of bigger than 10 (!) contracts “abnormal”–and we know what happens to people in China who engage in unnatural financial practices! It also increased fees four-fold, and bumped up margin requirements.

The end result? Success! Trading volumes declined 99 percent. You read that right. 99 percent. Speculation problem solved! I’m guessing that the fear of prosecution for financial crimes was by far the biggest contributor to that drop.

. . . .

And the crushing of the CSI300 and CSI500 contracts will impede development of a robust oil futures market. The brutal killing of these contracts will make market participants think twice about entering positions in a new oil futures contract, especially long dated ones (which are an important part of the CME/NYMEX and ICE markets). Who wants to get into a position in a market that may be all but shut down when the market sends the wrong message? This could be the ultimate roach motel: traders can check in, but they can’t check out. Or the Chinese equivalent of Hotel California: traders can check in, but they can never leave. So traders will be reluctant to check in in the first place. Ironically, moreover, this will encourage the in-and-out day trading that the Chinese authorities say that they condemn: you can’t get stuck in a position if you don’t hold a position.

In other words, China has a choice. It can choose to allow markets to operate in fair economic weather or foul, and thereby encourage the growth of robust contracts in oil or equities. Or it can choose to squash markets during economic storms, and impede their development even in good times.

I do not see how, given the absence of the rule of law and the just-demonstrated willingness to intervene ruthlessly, that China can credibly commit to a policy of non-intervention going forward. And because of this, it will stunt the development of its financial markets, and its economic growth. Unfettered power and control have a price. [Emphasis added.]

And that’s exactly what has happened. Per Reuters’ Clyde Russell:

The quiet demise of China’s plans to launch a new crude oil futures contract shows the innate conflict of wanting the financial clout that comes with being the world’s biggest commodity buyer, but also seeking to control the market.

. . . .

The main issues were concerns by international players about trading in yuan, given issues surrounding convertibility back to dollars, and also the risks associated with regulation in China.

The authorities in Beijing have established a track record of clamping down on commodity trading when they feel the market pricing is driven by speculation and has become divorced from supply and demand fundamentals.

On several occasions last year, the authorities took steps to crack down on trading in then hot commodities such as iron ore, steel and coal.

While these measures did have some success in cooling markets, they are generally anathema to international traders, who prefer to accept the risk of rapid reversals in order to enjoy the benefits of strong rallies.

It’s likely that while the INE could design a crude futures contract that would on paper tick all the right boxes, it would battle to overcome the trust deficit that exists between the global financial community and China.

What international banks and trading houses will want to see before they throw their weight behind a new futures contract is evidence that Beijing won’t interfere in the market to achieve outcomes in line with its policy goals.

It will be hard, but not impossible, to guarantee this, with the most plausible solution being the establishment of some sort of free trade zone in which the futures contract could be legally housed.

Don’t hold your breath.

It is also quite interesting to contemplate this after all the slobbering over Xi’s Davos speech. China is protectionist and has an overwhelming predilection to intervene in markets when they don’t give the outcomes desired by the government/Party. It is not going to be a leader in openness and markets. Anybody whose obsession with Trump leads them to ignore this fundamental fact is truly a moron.

 

 

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December 30, 2016

For Whom the (Trading) Bell Tolls

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Exchanges,History — The Professor @ 7:40 pm

It tolls for the NYMEX floor, which went dark for the final time with the close of trading today. It follows all the other New York futures exchange floors which ICE closed in 2012. This leaves the CME and CBOE floors in Chicago, and the NYSE floor, all of which are shadows of shadows of their former selves.

Next week I will participate in a conference in Chicago. I’ll be talking about clearing, but one of the other speakers will discuss regulating latency arbitrage in the electronic markets that displaced the floors. In some ways, all the hyperventilating over latency arbitrages due to speed advantages measured in microseconds and milliseconds in computerized markets is amusing, because the floors were all about latency arbitrage. Latency arbitrage basically means that some traders have a time and space advantage, and that’s what the floors provided to those who traded there. Why else would traders pay hundreds of thousands of dollars to buy a membership? Because that price capitalized the rent that the marginal trader obtained by being on the floor, and seeing prices and order flow before anybody off the floor did. That was the price of the time and space advantage of being on the floor.  It’s no different than co-location. Not in the least. It’s just meatware co-lo, rather than hardware co-lo.

In a paper written around 2001 or 2002, “Upstairs, Downstairs”, I presented a model predicting that electronic trading would largely annihilate time and space advantages, and that liquidity would improve as a result because it would reduce the cost of off-floor traders to offer liquidity. The latter implication has certainly been borne out. And although time and space differences still exist, I would argue that they pale in comparison to those that existed in the floor era. Ironically, however, complaints about fairness seem more heated and pronounced now than they did during the heyday of the floors.  Perhaps that’s because machines and quant geeks are less sympathetic figures than colorful floor traders. Perhaps it’s because being beaten by a sliver of a second is more infuriating than being pipped by many seconds by some guy screaming and waving on the CBT or NYMEX. Dunno for sure, but I do find the obsessing over HFT time and space advantages today to be somewhat amusing, given the differences that existed in the “good old days” of floor trading.

This is not to say that no one complained about the advantages of floor traders, and how they exploited them. I vividly recall a very famous trader (one of the most famous, actually) telling me that he welcomed electronic trading because he was “tired of being fucked by the floor.” (He had made his reputation, and his first many millions on the floor, by the way.) A few years later he bemoaned how unfair the electronic markets were, because HFT firms could react faster than he could.

It will always be so, regardless of the technology.

All that said, the passing of the floors does deserve a moment of silence–another irony, given their cacophony.

I first saw the NYMEX floor in 1992, when it was still at the World Trade Center, along with the floors of the other NY exchanges (COMEX; Coffee, Sugar & Cocoa; Cotton). That space was the location for the climax of the plot of the iconic futures market movie, Trading Places. Serendipitously, that was the movie that Izabella Kaminska of FT Alphaville featured in the most recent Alphachat movie review episode. I was a guest on the show, and discussed the economic, sociological, and anthropological aspects of the floor, as well as some of the broader social issues lurking behind the film’s comedy. You can listen here.

 

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November 8, 2016

WTI Gains on Brent: You Read It Here First!

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 8:22 pm

Streetwiseprofessor, August 2011:

WTI’s problems arise from the consequences of too much supply at the delivery point, which is a good problem for a contract to have.  The price signals are leading to the kind of response that will eliminate the supply overhang, leaving the WTI contract with prices that are highly interconnected with those of seaborne crude, and with enough deliverable supply to mitigate the potential for squeezes and other technical disruptions.

. . . .

Which means that those who are crowing about Brent today, and heaping scorn on WTI, will be begging for WTI’s problems in a few years.  For by then, WTI’s issues will be fixed, and it will be sitting astride a robust flow of oil tightly interconnected with the nexus of world oil trading.

Bloomberg, November 2016:

In the battle for supremacy between the world’s two largest oil exchanges, one of them is enjoying a turbo charge from the U.S. government.

Traders bought and sold an average of almost 1.1 billion barrels of West Texas Intermediate crude futures each day in 2016, a surge of 35 percent from a year earlier. The scale of the gain was partly because of the U.S. government lifting decades-old export limits last year, pushing barrels all over the world, according to CME Group Inc., whose Nymex exchange handles the contracts. By comparison, ICE Futures Europe’s Brent contract climbed by 13 percent.

WTI and Brent have been the oil industry’s two main futures contracts for decades. In the past, the American grade’s global popularity was restrained by the fact that exports were heavily restricted. Now, record U.S. shipments are heading overseas, meaning WTI’s appeal as a hedging instrument is rising, particularly in Asia, where CME has expanded its footprint.

“You have turbo-charged WTI as a truly waterborne global benchmark,” Derek Sammann global head of commodities and options products at CME Group, said in a phone interview regarding the lifting of the ban. “You’re seeing the global market reach out and use WTI — whether that’s traders in Europe, Asia and the U.S.”

This should surprise no one–but the conventional wisdom had largely written off WTI in 2011. Given that economic price signals were providing a strong incentive to invest in infrastructure to ease the bottleneck between the Midcon and the sea, it was inevitable that WTI would become reconnected with the waterborne market.

Once the physical bottleneck was eased, the only remaining bottleneck was the export ban. But whereas the export ban was costless prior to the shale boom (because it banned something that wasn’t happening anyways), it became very costly when US supply (especially of light, sweet crude) ballooned. As Peltzman, Becker and others pointed out long ago, politicians do take deadweight costs into account. In a situation like the US oil market, which pitted two large and concentrated interests (upstream producers and refiners) against one another, reducing deadweight costs probably made the difference (as the distributive politics were basically a push).  Thus, the export ban went the way of the dodo, and the tie between WTI and the seaborne market became all that much tighter.

This all means that it’s not quite right to say that CME’s WTI contract has been “turbocharged by the federal government.” Shale it what has turbocharged everything. The US government just accommodated policy to a new economic reality. It was along for the ride, as are CME and ICE.

ICE’s response was kind of amusing:

“ICE Brent Crude remains the leading global benchmark for oil,” the exchange said in an e-mailed response to questions. “With up to two-thirds of the world’s oil priced off the Brent complex, the Brent crude futures contract is a key hedging mechanism for oil market participants.”

Whatever it takes to get them through the day, I guess. Reading that brought to mind statements that LIFFE made about the loss of market share to Eurex in early-1998.

The fact is that there is hysteresis in the choice of the pricing benchmark. As exiting contracts mature and new contracts are entered, market participants will have an opportunity to revisit their choice of pricing benchmark. With the high volume and liquidity of WTI, and the increasingly tight connection between WTI and world oil flows, more participants will shift to WTI pricing.

Further, as I noted in the 2011 post (and several that preceded it) Brent’s structural problems are far more severe. Brent production is declining, and this decline will likely accelerate in a persistent low oil price environment: not only has shale boosted North American supply, it has contributed to the decline in North Sea supply. Brent’s pricing mechanism is already extremely baroque, and will only become more so as Platts scrambles to find more imaginative ways to tie the contract to new supply sources. It is not hard to imagine that in the medium term Brent will be Brent in name only.

Since WTI will likely rest on a strong and perhaps increasing supply base, Brent’s physical underpinning will become progressively shakier, and more Rube Goldberg-like. These different physical market trajectories will benefit WTI derivatives relative to Brent, and will also induce a shift towards using WTI as a benchmark in physical trades. Meaning that ICE is whistling past the graveyard. Or maybe they are just taking Satchel Paige’s advice: “Don’t look back. Something might be gaining on you.” And in ICE Brent’s case, that’s definitely true, and the gap is closing quickly.

 

 

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June 29, 2016

Will the EU Cut Off Its Nose to Spite Its Face on Clearing, Banking & Finance?

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 7:45 pm

French President Francois Hollande is demanding that clearing of Euro derivatives take place in the Eurozone. Last year the European Central Bank had attempted to require this, claiming that it could not be expected to provide liquidity to a non-Eurozone CCP like London-based LCH.

The ECB lost that case in a European court, but now sees an opportunity to prevail post-Brexit, when London will be not just non-Eurozone, but non-EU. Hollande is cheerleading that effort.

It is rather remarkable to see the ECB, which was only able to rescue European banks desperate for dollar funding during the crisis because of the provision of $300 billion in swap lines from the Fed, claiming that it can’t supply € liquidity to a non-Eurozone entity. How about swap lines with the BoE, which could then provide support to LCH if necessary. Or is the ECB all take, and no give?

Hollande (and other Europeans) are likely acting partly out of protectionist motives, to steal business for continental entities from London (and perhaps the US). But Hollande was also quite upfront about the punitive, retaliatory, and exemplary nature of this move:

“The City, which thanks to the EU, was able to handle clearing operations for the eurozone, will not be able to do them,” he said. “It can serve as an example for those who seek the end of Europe . . . It can serve as a lesson.” [Emphasis added.]

That will teach perfidious Albion for daring to leave the EU! Anyone else harboring such thoughts, take note!

The FT article does not indicate the location of M. Hollande’s nose, for he obviously just cut it off to spite his face.

In a more serious vein, this is no doubt part of the posturing that we will see ad nauseum in the next two plus years while the terms of the UK’s departure are negotiated. Stock up with supplies, because this is going to take a while, since (1) everything is negotiable, (2) almost all negotiations go to the brink of the deadline, or beyond, and (3) these negotiations will be particularly complicated because the Eurogarchs will be conducting them with an eye on how the outcome affects the calculations of other EU members contemplating following Britain out the door–and because immigration issues will loom over the negotiations.

When evaluating a negotiation, it’s best to start with the optimal, surplus maximizing “Coasean bargain” (a term which Coase actually didn’t like, but it is widely used). This, as Elon Musk would say, is a no brainer: allow € clearing in London, through LCH. That is, a maintenance of the status quo.

What are the alternatives? One would be that € clearing for those subject to EU regulation and some non-EU firms would take place in the Eurozone (say Paris or Frankfurt), some € clearing might take place in London or the US, and most dollar and other non-€ clearing would take place in London and the US.  This would require the EU to permit its banks to clear economically in the UK or US, by granting equivalence to non-EU CCPs for non-€ trades, or something similar.

There are several inefficiencies here. First, it would fragment netting sets and increase the probability that one CCP goes bust. For instance, if a bank that is a member of an EU and a non-EU CCP (as would almost certainly be the case of the large European banks that do business in all major currencies) defaulted, it is possible that it could have a loss on its € deals and a gain on its non-€ deals (or vice versa). If those were cleared in a single CCP, the gain and loss could be offset, thereby reducing the CCP’s loss, and perhaps resulting in no loss to the CCP at all: this is what happened with Lehman at the CME, where losses on some of its positions were greater than collateral, but losses on others were smaller, and the total loss was less than total collateral. However, if the business was split, one of the CCPs could suffer a loss that could potentially put it in jeopardy, or force members to stump up additional contributions to the default fund during a time when they are financially stressed.

Second, default management would be more difficult, risky and costly if split across two or more CCPs. It would be easier to put in place dirty hedges for a broader portfolio than two narrower ones, and to allocate or auction off a combined portfolio than fragmented ones. Moreover, it would be necessary to coordinate default management across CCPs in a situation where their interests are not completely aligned, and indeed, where interests may be strongly in conflict. Furthermore, there would be duplication of personnel, as CCP members would be required to dispatch people to two different CCPs to manage the default.

Third, even during “peacetime,” fragmented clearing would sacrifice collateral and capital efficiencies and increase operational costs and complexity.

But it could be worse! Maybe the Europeans will cut off their noses and ears (and maybe some other parts lower down), and deny a UK CCP equivalence for any transaction undertaken by an EU bank. The outcome would be EU banks clearing in Europe, and most everybody else clearing outside of Europe. This would result in multiple inefficiently small CCPs clearing in all currencies that would exacerbate all of the negative consequences just outlined: netting set inefficiencies would be even worse, default risk management even more difficult, and peacetime collateral, capital, and operational efficiencies would be even worse.

Oh, and this alternative would require the ECB to obtain dollar and sterling (and other currency) liquidity lines to allow it to provide non-€ liquidity to its precious little CCP. How hypocritical is that? (Not that hypocrisy would cost Hollande et al any sleep. It hasn’t yet.)

The fact is that CCPs exhibit strong economies of scale and scope, and although mega-CCPs concentrate risk, fragmentation creates its own special problems.

So the wealth-maximizing outcome would be for the EU to come to an accommodation on central clearing that would effectively perpetuate the pre-Brexit status quo. Wealth maximization exercises a strong pull, meaning that this is the most likely outcome, although there will likely be a lot of posturing, bluffing, threatening, etc., before this outcome is achieved (and at the last minute).

I would expect that EU banks would support the Coasean bargain, further increasing its political viability. Yes, Deutsche Borse would be pushing for a EU-centric outcome, and some Europols would take pride at having their own (sub-scale and/or sub-scope) CCP, but the greater cost and risk imposed on banks would almost certainly induce them to put heavy pressure behind a status quo-preserving deal.

This raises the issue of negotiation of banking and capital market issues more generally. There has been a lot of attention paid to the fact that British banks would probably lose passporting rights into the EU post-exit, and this would be costly for them. But European banks actually rely even more on passporting to get access to London. Since London is still almost certain to remain the dominant financial center (especially since the UK government will have a tremendous incentive to facilitate that), European banks would suffer as much or more than UK ones if the passporting system was eliminated (and a close substitute was not created).

Thus, if the negotiations were only about clearing, banking, and capital markets, mutual self-interest (and political economy, given the huge influence of the finance sector on policymakers) would strongly favor a deal that would largely maintain the status quo. But of course the negotiations are not about these issues alone. As I’ve already noted, the EU may try to punish the British even if it also takes a hit because of the effect this might have on the calculations of others who might bolt from the Union.

Furthermore, the most contentious issue–immigration–is very much in play. Merkel, Hollande, and others have said that to obtain a Norway-style relationship with the EU, the UK would have to agree to unlimited movement of people. But that issue is the one that drove the Leave vote, and agreeing to this would be viewed as a gutting of the referendum, and a betrayal. It will be hard for the UK to agree to that.

Perhaps even this could be finessed if the EU secured its borders, but Merkel’s insanity on this issue (and the insanity of other Eurogarchs) makes this unlikely, short of a populist political explosion within the EU. But if that happens, negotiations between the EU and the UK will likely be moot, because there won’t be much of the EU left to negotiate with, or worth negotiating with.

In sum, if it were only about banking and clearing, economic self-interest would lead all parties to avoid mutually destructive protectionism in these areas. But highly emotional issues, political power, and personal pride are also present, and in spades. Thus, I am reluctant to bet much on the consummation of the economically efficient deal on financial issues. The financial sector is just one bargaining chip in a very big game.

 

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June 15, 2016

Where’s the CFTC’s Head AT?: Fools Rush in Where Angels Fear to Tread

Filed under: Commodities,Derivatives,Economics,Exchanges,Financial crisis,HFT,Regulation — The Professor @ 1:07 pm

The CFTC is currently considering Regulation AT (for Automated Trading). It is the Commission’s attempt to get a handle on HFT and algorithmic trading.

By far the most controversial aspect of the proposed regulation is the CFTC’s demand that algo traders provide the Commission with their source code. Given the sensitivity of this information, algo/HFT firms are understandably freaking out over this demand.

Those concerns are certainly legitimate. But what I want to ask is: what’s the point? What can the Commission actually accomplish?

The Commission argues that by reviewing source code, it can identify possible coding errors that could lead to “disruptive events” like the 2013 Knight Capital fiasco. Color me skeptical, for at least two reasons.

First, I seriously doubt that the CFTC can attract people with the coding skill necessary to track down errors in trading algorithms, or can devote the time necessary. Reviewing the code of others is a difficult task, usually harder than writing the code in the first place; the code involved here is very complex and changes frequently; and the CFTC is unlikely to be able devote the resources necessary for a truly effective review. Further, who has the stronger incentive? A firm that can be destroyed by a coding error, or some GS-something? (The prospect of numerous individuals perusing code creates the potential for a misappropriation of intellectual property which is what really has the industry exercised.) Not to mention that if you really have the chops to code trading algos, you’ll work for a prop shop or Citadel or Goldman or whomever and make much more than a government salary.

Second, and more substantively, reviewing individual trading algorithms in isolation is of limited value in determining their potentially disruptive effects. These individual algorithms are part of a complex system, in the technical/scientific meaning of the term. These individual pieces interact with one another, and create feedback mechanisms. Algo A takes inputs from market data that is produced in part by Algos B, C, D, E, etc. Based on these inputs, Algo A takes actions (e.g., enters or cancels orders), and Algos B, C, D, E, etc., react. Algo A reacts to those reactions, and on and on.

These feedbacks can be non-linear. Furthermore, the dimensionality of this problem is immense. Basically, an algo says if the state of the market is X, do Y. Evaluating algos in toto, the state of the market can include the current and past order books of every product, as well as the past order books (both explicitly as a condition in some algorithms, or implicitly through the empirical analysis that the developers use to find profitable trading rules based on historical market information), as well as market news. This state changes continuously.

Given this dimensionality and feedback-driven complexity, evaluating trading algorithms in isolation is a fools errand. Stability depends on how the algorithms interact. You cannot determine the stability of an emergent order, or its vulnerability to disruption, by looking at the individual components.

And since humans are still part of the trading ecosystem, how software interacts with meatware matters too. Fat finger problems are one example, but just normal human reactions to market developments can be destabilizing. This is true when all of the actors are human: it’s also true when some are human and some are algorithmic.

Look at the Flash Crash. Even in retrospect it has proven impossible to establish definitively the chain of events that precipitated it and caused it to unfold the way that it did. How is it possible to evaluate prospectively the stability of a system under a vastly larger set of possible states than those that existed on the day of the Flash Crash?

These considerations mean that  the CFTC–or any regulator–has little ability to improve system stability even if given access to the complete details of important parts of that system. But it’s potentially worse than that. Ill-advised changes to pieces of the system can make it less stable.

This is because in complex systems, attempts to improve the safety of individual components of the system can actually increase the probability of system failure.

In sum, markets are complex systems/emergent orders. The effects of changes to parts of these systems are highly unpredictable. Furthermore, it is difficult, and arguably impossible, to predict how changes to individual pieces of the system will affect the behavior of the system as a whole under all possible contingencies, especially given the vastness of the set of contingencies.

Based on this reality, we should be very chary about letting any regulator attempt to micromanage pieces of this complex system. Indeed, any regulator should be reluctant to undertake this task. But regulators frequently overestimate their competence, and financial regulators have proven time and again that they really don’t understand that they are dealing with a complex system/emergent order that does not respond to their interventions in the way that they intend. But fools rush in where angels fear to tread, and if the Commission persists in its efforts to become the Commissar of Code, it will be playing the fool–and it will not just be algo traders that pay the price.

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June 12, 2016

Squeezing Dr. Copper

Filed under: Commodities,Derivatives,Economics,Exchanges,Regulation — The Professor @ 2:21 pm

Andy Home has an interesting piece in Reuters. He provides information that strongly suggests that the LME copper contract has been squeezed. All of the tell-tale signs are there:

What the exchange terms a dominant long position emerged on the copper market last week.

This player controlled 50-80 percent of all LME open stocks, excluding metal earmarked for physical load-out, and had bulked this up with cash positions to the point that its overall position represented in excess of 90 percent of all available stocks.

That position was being rolled forward daily, forcing shorts to pay the backwardation price as they too rolled their positions.

The cash premium over three-month metal, the backwardation, had flexed out as wide as $27.75 per ton the previous week as the long tightened its grip on the London market’s nearby date structure.

Someone, it seems, was not prepared to pay the roll price and decided to deliver physical metal against their position. [LME stocks rose almost 40 percent in a few days.]

And they did so in a way to generate the maximum bang for their buck.

It seems to have worked.

That cash premium has evaporated. As of Thursday’s close, the cash-to-three-months spread was valued at $15 per ton contango.

The ripple effects have spread down the curve, LME broker Marex Spectron noting that the July-December spread eased $10 to $35 per ton contango over the course of Thursday.

The latest positioning reports, denoting the state of play as of Wednesday’s close, show the dominant long still holding 50-80 percent of stocks <0#LME-WHL> but with no equivalent cash position <0#LME-WHC>.

All the signs are there: a large long position, here both in physical metal and prompt LME contracts; a spike in the backwardation; a movement of metal into deliverable position; followed by a collapse in the backwardation. Also, the large long apparently liquidated the bulk of his position in LME contracts, as is necessary to profit. Right out of the book.

These episodes are chronic in the commodity markets, and on the LME in particular. They impose real deadweight losses (the costly movement of copper into LME warehouses being an example), and undermine the effectiveness of derivatives contracts as a hedging mechanism. Would that regulators pursued this conduct more vigorously, rather than obsessing over spoofing games, or chasing the “excessive speculation” will-o-the-wisp.

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