Streetwise Professor

November 4, 2015

I’m Not Spoofing You About Judicial Overkill

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 11:02 pm

Yesterday in a federal court in Chicago, Michael Coscia of Panther Energy Trading was convicted of six counts each of commodity manipulation and fraud for “spoofing.” Coscia faces decades in prison.

I haven’t seen the evidence, so I cannot judge whether Coscia did manipulate. For the purposes of this post I will stipulate that he did. But even given that stipulation, this entire exercise was judicial overkill and a travesty that can do serious damage to the markets.

What is spoofing? A trader puts in a large order (an offer, say) several ticks away from the best price in the market. He also places a small limit order on the other side of the market (a bid, in this example). If the market moves towards the large order, the spoofer cancels and replaces the order several ticks away from the new inside market. It is this cancellation that attracts all the attention. Much of the coverage says that the spoofer submits orders with the intent of canceling them.

That’s not the whole story though. The point of spoofing is to increase the odds that the small order is executed. After all, what would be the point of submitting orders that are never executed?

In the example, the large sell order is intended to convince others that the current price is too high. This may induce some bidders to cancel their bids, and others to cross the market and hit the bid. Both of these actions increase the odds that the spoofer’s small order will be executed.

So how does he make money? It can’t be by driving down the price persistently. The spoofer has bought: to profit, prices must rise subsequently. So, often the spoofer will reverse direction, putting in a big bid away from the market, and a small offer.

If spoofing works, the spoofer will repeatedly buy at the bid and sell at the offer, making the dealer’s turn. This will not cause the price to diverge persistently from where it would be, absent this conduct.

That’s apparently what happened with Coscia. He made a whopping $1K on the six episodes for which he was charged and convicted. He was just making a tick here and a tick there. And crucially, unlike the kinds of manipulation that cause real damage-corners, in particularly-he is not causing the price to be persistently inflated or depressed.

So who is hurt? Some people may be induced to trade when they wouldn’t have absent the spoofing. Their losses are approximately equal to the spoofers gains, on the order of a tick. And since some might have hit the spoofer’s bid even absent the spoofing, only a fraction of those with whom the spoofer trades are damaged.

Others who might be damaged are those who are fooled into canceling orders, and see the spoofer execute a trade they would have liked to if they hadn’t been fooled. The spoofer takes some of the profit they would have earned.

I find it hard to believe that these damages are are all that large. (They would also be hard to estimate because it is virtually impossible to identify who traded because of the spoofing, and who pulled a quote because of the spoofing, and gave up the opportunity to trade.) And regardless, this is exactly the kind of conduct that can be deterred using monetary fines.

This brings me to another bizarre aspect of these spoofing cases. Many of those who scream loudest about spoofing, like Eric Hunsader of Nanex, say: “SPOOFING IS SO OBVIOUS!!!! JUST LOOK AT THE DATA!”

As another case in point, I saw a Tweet embedding a .gif of someone’s TT trading screen, in which the quoted depth a couple of ticks above the inside market would rise and fall by 800 contracts or so. The Tweeter (I can’t find the Tweet) said something to the effect “look at this obvious spoofing.”

Well, I agree with the obviousness of it, but the implication of that is exactly the opposite of what Hunsader, the Tweeter, and presumably the DOJ and CFTC believe: If it so obvious, nobody is fooled. If nobody is fooled, it can’t affect trading behavior or prices. If it doesn’t affect trading behavior or prices, there is no economic harm. If there is no economic harm, it shouldn’t be prosecuted.

There is a law and economics take on this too. Classic Gary Becker analysis shows that draconian penalties-like 25 years per fraud charge and 10 years per manipulation charge-are justifiable if the probability of detection of a harm/crime is small. This is necessary to make the expected cost paid by the offender equal to the cost of the harm. But if the conduct is obvious, even only ex post, the probability of detection should be high, so penalties far greater than any harm are excessive. In this case, grotesquely excessive. (Furthermore, again pace Gary Becker, incarceration of a defendant who can pay the monetary value of the harm caused is a social waste, in the form of the cost of imprisonment, and the lost output of the convict.)

But it gets worse. The Coscia prosecution-and the popular condemnation of spoofing-focuses obsessively on the large rate of order cancellation. But perfectly legitimate market making strategies involve large rates of order cancellation, especially in volatile markets. They also involve buying frequently at the bid and selling at the offer. Given the Javert-like zeal of prosecutors, their dim understanding of trading, and the difficulty of explaining market making to a jury create the very real risk that a market maker could be charged, and convicted, and be punished severely, because he cancelled a lot of orders, and made the dealer’s turn all day long. This huge and very real risk will no doubt lead to less aggressive quoting (a market maker is less willing to quote aggressively if he is reluctant to cancel too often for fear of being accused of spoofing).

And who pays for that? Market users, including both institutional and retail traders, who take the liquidity market makers supply. Thus, you and me are harmed by overzealous prosecution of spoofing that threatens to demoralize legitimate, efficiency-enhancing trading.

This raises the very real possibility that the prosecution of actions that produce little economic harm will inflict a far larger harm. That is perverse.

What is particularly infuriating is that enforcement authorities are apparently incapable of prosecuting much truly damaging market conduct. Federal prosecutors are crowing over getting Coscia’s scalp, and the Chairman of the CFTC is using the verdict to intimidate would-be spoofers, but 6 years ago Federal prosecutors in Houston utterly botched the BP propane corner case (US v. Radley). That was a real manipulation that caused real damage. But the prosecutors totally flubbed the case, and the perps walked. Then there are those obvious manipulations that the Feds haven’t even bothered to prosecute (perhaps to spare themselves the embarrassment of flubbing another one.)

It reminds me of the old joke about the lawyer who said: “I lost the cases I should have won, and won the cases I should have lost. Therefore, on average, justice was done.”

No, actually, Mr. Lawyer: justice is never done if the guilty walk free and the innocent are punished. And sad to say, US manipulation law is perilously close to embodying that cynical joke.



Print Friendly

July 21, 2015

The Fifth Year of the Frankendodd Life Sentence

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 7:52 pm

Today is Frankendodd’s fifth birthday. Hardly time for celebration. It is probably more appropriate to say that this is the fifth year in the Frankendodd life sentence.

So where do we stand?

The clearing mandate is in force, and a large fraction of derivatives, especially interest rate and credit index derivatives are cleared. This was intended to reduce systemic risk, and as I’ve written since before the law was passed and signed, this was a chimerical goal. Indeed, in my view the systemic risk effects of the mandate are at best a push (merely shifting around the source of systemic risk), and at worse the net effects of the mandate are negative.

Belatedly regulators are coming around to the recognition of the risks posed by CCPs. They understand that CCPs have concentrated risk, and hence the failure of one of these entities would be catastrophic. So there is a frenzy of activity to try to make CCPs less likely to fail, and to ensure their rapid recovery in the event of problems. Janet Yellen has spoken on the subject, as has the head of the Office of Financial Research, Robert Dudley of the NY Fed, and numerous European regulators. Efforts are underway in the US, Europe, and Asia to increase CCP resources, and craft recovery and resolution procedures.

This is an improvement, I guess, over the KoolAid quaffing enthusiasm for the curative effects of CCPs that virtually all regulators indulged in post-crisis. But it distinctly reminds me of people madly sewing parachutes after the rather dodgy plane has taken off.

Further, these efforts miss a very major point. The main source of systemic risk from the clearing mandate derives from the huge liquidity strains that clearing (notably variation margin on a rigid time schedule) will create when the market is stressed. There has been some attention to ensuring CCPs have access to liquidity in the event of a default, but that’s not the real issue either. The real issue is funding large margin calls during a crisis.

Moreover, as I’ve also discussed, efforts to make CCPs more resilient can increase pressures elsewhere in the financial system (the “levee effect.”) Relatedly, regulators have not fully come to grips with the redistributive aspects of clearing–including in particular how netting, which they adore, can just relocate systemic risks.

I therefore stand by my prediction that a regulation-inflated clearing system will the source of the next systemic crisis.

Moving on, I called the SEF mandate the worst of Dodd-Frank. In the US, the majority of swap trades are done on SEFs, though mainly through RFQs rather than the central limit order books that Barney and Co. dreamed about in 2010.

There was never a remotely plausible systemic risk reducing rationale for the SEF mandate. Hence, if SEFs are inefficient ways to execute transactions, the mandate is all pain, no gain. As an indication of that this is indeed the case, note that virtually all European banks and end users stopped trading Euro-denominated swaps with US counterparties exactly when the mandate kicked in. The swaps mandate was too onerous, and anyone who could escape it did.

In a piece in Risk, I referred to the Made Available to Trade part of the SEF mandate the worst of the worst of Dodd-Frank. It made no sense to force all market participants to trade a particular kind of swap on SEFs just because one SEF decided to list it. Apparently that realization is slowly sinking in. The CFTC recently held a meeting on the MAT issue, and it seems as if there is a good chance that the CFTC will eventually determine what has to be traded on SEFs.

It is an indication of my loathing for MAT as it currently exists that I consider that an improvement.

Still moving on, Frankendodd was intended to reduce concentration and interconnectedness in the financial system. The actual result cannot really be called a mere unintended consequence: it was the exact opposite of the intended effect. Completely predictably (and predicted) the huge regulatory overhead increased concentration rather than reduced it. This is particularly true with respect to clearing. Gary Gensler’s dream of letting a thousand clearing firms bloom has turned into a nightmare, in which the clearing business is concentrated in a handful of big financial institutions, exacerbating too big to fail problems. And clearing has turned out to be the Mother of All Interconnections, because every big financial institution is connected to all big CCPs, and because pretty much everyone has to funnel the bulk of their derivatives trades through clearinghouses.

I could go on. Let me just re-iterate another risk of Frankendodd: standardization–the regulators’ fetish–is  a major source of systemic risk. Monocultures are particularly vulnerable to catastrophic failure, and the international regulatory standardization that was birthed in Pittsburg in 2009, and enacted in Frankendodd and MiFID and Emir, has created a regulatory monoculture. Some are grasping the implications of this. But too few, and not the right people.

I’ve focused here on the sins of commission. But there are also the sins of omission. Frankendodd did nothing about the Fannie and Freddie monster, which is coming back from the dead. F&F was a real systemic risk, but the same political dynamic that fed it in the 1990s and pre-2008 is at work again. Get ready for a repeat.

Frankendodd should have just focused on raising capital requirements for banks and other financial institutions with liquidity and maturity mismatches, and driven a stake through Fannie and Freddie. Instead, it sought to impose a detailed engineered solution on an emergent order. This inevitably ends badly.

So maybe it would be more accurate to say that we’re in our fifth year on death row. Someday the warden will come knocking.

Print Friendly

July 8, 2015

Monkeys Fly in China

Filed under: China,Economics,Exchanges,Regulation — The Professor @ 5:56 pm

In the very early days of this blog, I told the story about what Chief Economic Advisor Beryl Sprinkel said on Black Monday, 1987, when a panicked Treasury Secretary James Baker wanted to close the stock market: “We’ll close these markets when monkeys fly out of my ass.” No monkeys flew, and the markets stayed open, eventually stabilized, and then recovered.

But many monkeys are flying out of many asses in China. Although the authorities have not closed the stock markets, individual companies have halted trading in their stocks: trading in more than one-half of the listings in China is currently suspended.

Halting trading more than for a short interval in order to resolve information asymmetries and permit the flow of liquidity to stocks that have just experienced an information event (as during a temporary stock halt in the US) is in general a bad idea. (Post-87, Greenwald and Stein wrote a paper published in the JOB laying out this argument.) An uncoordinated and extended halt of many stocks is a really horrible idea, because of the negative externalities. That is, uncoordinated flying monkeys wreak even more havoc than coordinated ones.

Halting trading in a large number of stocks increases selling pressure on stocks that are still trading. This happens for at least a couple of reasons. First, individuals who need to raise cash (e.g., to meet margin calls) are forced to concentrate their sales in the stocks that keep trading. This tends to concentrate selling pressure, rather than diffuse it. Second, individuals who want to rebalance their portfolios away from equity into cash or bonds have to concentrate their sales in the stocks that continue to trade. Again, this concentrates selling pressure.

This creates a vicious feedback loop. A number of companies halt trading, which forces selling pressure to spill over with greater force on other stocks, which leads some of these companies to halt trading, which intensifies selling pressure on other companies, and so on. The ultimate likely outcome is a protracted lockdown of the entire market. Protracted because who is going to be the firm to restart trading first, and risk having everyone sell the hell out of them?

The vaunted Chinese economic managers (ha!) have well and truly bungled this one. They should have prevented open-ended trading halts, or had a coordinated stoppage and restarting of trading. The coordination failure at work now is manifest.

Again, I believe that the sharp selloff is more of a symptom of a deeper economic problem than a potential direct cause of such a problem. The main adverse spillover that the stock selloff could cause is through the margin debt channel. Margin calls could lead to fire sales of illiquid assets. Again, the more stocks that are not trading, the more severe these fire sales in non-equity assets will be: this is another adverse consequence of uncoordinated monkey launches. Moreover, failures to meet margin calls will saddle the lenders (themselves often highly leveraged) with losses. Both of these channels could have adverse consequences in the brokerage, banking and shadow banking sectors. Their balance sheets are not that hale and hearty to begin with, and this kind of shock could spark broader financial distress throughout the sector.*

In other words, the stock market decline is less of a crisis in itself, than a potential catalyst to a crisis via informational and fire sale channels. And perversely, uncoordinated trading halts in the stock market are more likely to intensify than mitigate any such catalytic effect.

But the Mandarins know everything, so I’m sure it will turn out swell.

In the meantime, the Mandarins have a message for all investors in China. Good luck with that!

* Perhaps one could argue, as Michael Brennan did when trying to explain price limits in futures markets in the JFE in 1986, that halting trading could ease pressure on margin credit. I am skeptical though. Even if stocks stop trading, margin lenders are likely to demand additional security in current conditions. Indeed, trading halts that reduce the informational content of stock prices create a source of uncertainty to margin lenders which they are likely to compensate for by demanding additional margin based on their estimate of the stock price once trading recommences, plus a premium to compensate for the uncertainty.

Print Friendly

July 2, 2015

See You In the Funny Papers

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges — The Professor @ 6:01 pm

Here’s a first. I appear in a comic strip history of the CME-ICE rivalry in Bloomberg Markets Magazine. Quite the likeness!

Other than the fact that I appeared at all, the most amusing part of the, er, article, is the panel depicting CME’s Terry Duffy getting the news that ICE was making a rival bid for CBOT via a note slipped under his hotel room door at the FIA at Boca at 0600. I had eaten dinner with Duffy and CME CEO Craig Donohue the night before. They were in a little better mood then than they were the next day.

Bloomberg’s Matt Leising called me at about 0630 to ask me about the development. That led to an appearance on Bloomberg TV, where I was interviewed right before Jeff Sprecher. He watched me give the interview, and was not pleased with my prediction that CME would eventually prevail, but have to pay a lot more: I saw him say to the woman next to him (who I later found out was his wife, Kelly Loeffler) “who is this guy?” That was exactly how it worked out though, and apparently there were no hard feelings because Sprecher spoke at a conference I organized at UH a couple of years later. Either that, or he didn’t connect me with “this guy.”

Evenhanded guy that I am, I invited Craig Donohue to speak at a conference a year or two after that. His speech was interrupted by some Occupy types (remember them?), whom my tiger of an assistant Avani and I bodily shoved out of the room while the rest of the audience sat in stunned silence (not knowing what was going on).

So yeah. My involvement with CME and ICE sometimes does sound like something out of the funny pages. Now it’s official.

Print Friendly

April 22, 2015

Spoofing: Scalping Steroids?

Filed under: Derivatives,Economics,Exchanges,HFT,Regulation — The Professor @ 5:35 pm

The complaint against Sarao contains some interesting details. In particular, it reports his profits and quantities traded for nine days.

First, quantities bought and sold are almost always equal. That is characteristic of a scalper.

Second, for six of the days, he earned an average of .63 ticks per round turn. That is about profit that you’d expect a scalper to realize. Due to adverse selection, a market maker typically doesn’t earn the full quoted spread.  On only one of these days is the average profit per round turn more than a tick, and then just barely.

Third, there is one day (4 August, 2011) where he earned a whopping 19.6 ticks per round trip ($4 million profit on 16695 buy/sells). I find that hard to believe.

Fourth, there are two days that the government reports the profit but not the volume. One of these days is 6 May, 2010, the Flash Crash day. I find that omission highly suspicious, given that this is the most important day.

Fifth, I again find it odd, and potentially problematic for the government, that it charges him with fraud, manipulation, and spoofing on only 9 days when he allegedly used the layering strategy on about 250 days. How did the government establish that trading on some days was illegal, and on other days it wasn’t?

The most logical explanation of all this is that Sarao was basically scalping-market making-and if he spoofed, he did so to enhance the profitability of this activity, either by scaring off competition at the inside market, or inducing a greater flow of market orders, or both.

One implication of this is that scalping does not tend to cause prices to move one direction or the other. It is passive, and balances buys and sells. This will present great difficulties in pursuing the manipulation charges, though not the spoofing charges and perhaps not the fraud charges.


Print Friendly

April 4, 2015

The IECA Libels Me: I Am Oddly Flattered

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 10:22 am

The Industrial Energy Consumers of America has submitted a comment letter on the CFTC’s position limit rule making. The letter contains this libel:

If one looks at the agenda from the February 26, 2015 meeting (see below), other than CFTC presenters, every presenter has views that are not consistent with CFTC action to set speculative position limits. Professor Pirrong has a long history of client paid studies in this area and will need to identify who paid for the underlying data and study for his results to be credible on this subject.

If “this area” is the subject of speculation and position limits, this statement is categorically false. I have not done one “client paid study” on these issues. Period.

In fact, most of my writing on speculation has either been in my academic work (as in my 2011 book), or here on the blog. I have been arguing this issue on my own time.

Actually, I did do one client paid study on these issues about 11 or 12 years ago. For the IECA, in fact, which was just certain that the NYMEX’s expanded accountability limits for natural gas had caused volatility to increase. They hired me to study this issue. I did, using methods that I had employed in peer reviewed research, and found that IECA’s firm beliefs were flatly contradicted by the data: data that IECA paid for, analyzed using methods that were disclosed to it. IECA decided not to release the study. Surprise, surprise. So IECA knows from direct experience that my opinions are not for sale.

So just who here is hiding something? Hint: it ain’t me.

I could provide other examples. The GFMA study on commodity traders is a well known case: it was written up in the Financial Times. Another example that is not as well known was my work on a project for the Board of Trade in 1991-1992, in which I studied the delivery mechanism for corn and soybeans. (The resulting report was published as Grain Futures Markets: An Economic Appraisal.) I concluded that the delivery mechanism was subject to manipulation, and recommended the addition of delivery points at economic par differentials to Chicago. This was not the desired answer. On the day I presented my results to the committee of the CBT that commissioned the study, the chief economist of the exchange pressured me to change my recommendations. I refused. The meeting that followed became heated. So heated, in fact, that the head of the committee and I almost literally came to blows when I refused to back down: committee members from Cargill and ADM actually took the guy bodily from the room until he calmed down.

So the track record is abundantly clear: I call them like I see them, even if it isn’t what the client wants to hear.

In fact, it is IECA’s ad hominem that lacks credibility. My white papers for Trafigura are not related to the issue of speculation at all. To the contrary, they are related to the issue of physical commodity trading. I did a study for CME in 2009 on the performance of the WTI futures contract. Nothing related to speculation. Data sources disclosed, and the methodologies are clearly set out. Again, if IECA has specific critiques of any of these analyses, bring it on. Anytime. Anywhere. And they can leave their libelous insinuations behind.

Perhaps IECA head Paul Cicio is still sore over how I smacked him around at a House Ag committee hearing in July 2008. Cicio said it was obvious that speculation had inflated energy prices. He used the metaphor of a swimming pool: if a bunch of speculators jump in, it has to raise the water level. I retorted that this shows the exact opposite, because all the speculators get out of the pool before contracts go spot. Long speculators are sellers of futures as delivery approaches, meaning they are out of the pool (the physical market) as delivery approaches, and hence can’t be inflating spot prices.

If Cicio is still sore, all I have to say is: Get over it.

To reiterate: IECA’s statement in a document submitted to a government regulatory agency is categorically false, and libelous.

And oddly flattering. You don’t go out of your way to libel the irrelevant. The fact that this organization feels compelled to slur me by name and attack my credibility (even though the attack is false) means that they must believe that I pose a threat to them. I sure as hell hope so.

Word to the wise. Don’t bring a wet noodle to a gunfight. (I cleaned that up.) You’re going to lose.


Print Friendly

April 3, 2015

BATS in the OCC’s Belfry?, or The Perils of Natural Monopoly Regulation, CCP Edition

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Regulation — The Professor @ 11:13 am

The Options Clearing Corporation (“OCC”) and the exchanges that own it (Chicago Board Options Exchange, Incorporated, International Securities Exchange, LLC, NASDAQ OMX PHLX LLC, NYSE MKT LLC, and NYSE Arca) are embroiled in a dispute with virtually everyone else in the options business regarding its new capital plan. Pursuant to its designation as a “Systemically Important Financial Market Utility” (“SIFMU”) under Frankendodd, OCC was required to boost capital from $25 million to nearly $250 million. Part of this will be obtained through retained earnings, with an additional $150 million via a capital injection from the four owner-exchanges. In addition, CBOE et al promise to inject up to $117 million in the event of “unexpected losses”, which would be most likely to occur during a financial crisis.

In return, the owner-exchanges receive in essence preferred stock, which pays a dividend in perpetuity. The exact amount of the dividend is not known publicly, but those objecting to the plan (including BATS and KCG) claim that it could be as much as 16-19 pct, at least in the first few years of the plan’s operation.

Non-owner exchanges like BATS and market users like KCG are furious, claiming that the the capital plan allows OCC’s owners to “monetize” the rents accruing to its status as the monopoly clearer for options transactions in the US. They believe that OCC will pay for the dividend by charging super competitive fees that will impair competition among exchanges (advantaging the owner exchanges over the non-owners) and will burden market users.

This is a difficult issue, the nature of OCC. Here are some thoughts:

1. OCC is a regulated monopoly, and arguably a natural monopoly.This creates the traditional conflict between the owners of the utility and its customers, which include other exchanges that aren’t owners (like BATS) and clearing firms and market users (like KCG). This is in many ways very similar to a dispute between a traditional electric utility and its ratepayers heard before a state utility commission, with the exception that this is before the SEC.

2. Like a traditional are case involving a regulated utility, the dispute here is over what is a fair rate of return on capital. BATS and KCG are objecting to the rate of return the 4 exchange owners of OCC are being promised for their capital contribution, and the process by which the SEC approved this rate of return.

3. It is particularly challenging to determine a “fair” rate of return on this capital because of the unique risks that the OCC exchanges are assuming. This capital is at risk of taking a big hit, and the owner-exchanges are potentially obligated to make additional capital contributions, during periods of financial crisis (the “dire circumstances”) referred to in BATS’s letter to the SEC. This tends to make this capital very expensive, and it should therefore earn a relatively high rate of return (high dividend). Capital that has bad returns when the market is doing poorly overall-“high beta”, if you will-is expensive capital. The type of capital being provided is fraught with wrong-way risk: it is likely to take a hit precisely when the capital suppliers are least able to afford it. Determining how much of a risk premium is warranted is a challenge, because of the exceptional nature of the risk. In essence, the exchanges are assuming tail risk, i.e., the risk of exceptional events, and it is inherently difficult to evaluate and price these risks.

4. The other exchanges and firms like KCG benefit from the risk bearing capital supplied by the owner exchanges. Otherwise, they would have to bear the risk. But of course they would like to underpay for this benefit, just as the owner exchanges might want to overcharge for it.

5. In other words, this situation is tailor made for disputes. Monopoly rate setting to determine fair rates and a fair rate of return on capital with very unusual and hard to evaluate risks.

6. The fears about the effects of pricing on inter-exchange competition in execution service are misdirected. Yes, it is possible that the owner exchanges will capture monopoly rents accruing to the OCC’s dominant position, but traditional “one monopoly rent” analysis implies that they don’t have an incentive to use OCC pricing power to advantage their competitive position in execution services. Indeed, the opposite is true.

This also highlights some organization, ownership and governance issues that I addressed in my research on exchanges that culminated in my 2000 JLE piece. Exchanges (and clearinghouses) have market power, and serve disparate and heterogeneous interests. They can use pricing to redistribute rents (which accrue in part due to market power) from one group of intermediaries to another. Not-for-profit status and mutual ownership (having the exchange or CCP operate as a non-profit “utility” serving disparate intermediary-owners is a way of reducing rent seeking and mitigating the use of pricing to redistribute rents.

But non-profit, mutual organization comes at a cost. It requires highly participative, committee-heavy governance that slows decision making and often creates gridlock that makes it difficult for the exchanges/CCPs to respond to technology, regulatory, or market shocks. (Look at the CBT in the 1990s and early-2000s if you want an example.) If everybody has a voice and a vote, it is very difficult to get things done.

In sum, “financial market utility” pricing and governance is inherently messy and controversial.  It has all of the problems associated with public utility regulation, and then some. The problems are particularly daunting when it comes to capitalizing, allocating and pricing the systemic and wrong way risks that CCPs bear. Given these complexities, I won’t venture an opinion here, except to say that (a) I can see both sides of the argument here, and (b) this ain’t going away anytime soon.

Print Friendly

March 10, 2015

Chinese Chutzpah: Using IP to Ice Cotton Competition

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

China is notorious for flouting intellectual property rights. From stolen technology (including notably military gear) to designer knock-offs, China pirates everything and everyone. It is therefore a rather jaw-dropping act of chutzpah for to Chinese Zhengzhou Commodities Exchange to send a nasty cease-and-desist letter to the Singapore subsidiary of ICE demanding that ICE not copy ZCE’s cotton and sugar contracts:

Intercontinental Exchange has been forced to delay the launch of its new Singapore platform after a Chinese exchange threatened legal action to stop the US group launching two commodity futures that are copies of contracts offered in China.

The move by the Zhengzhou Commodity Exchange is likely to send shockwaves through the global futures industry because it signals that China will not tolerate foreign exchanges copying its futures contracts, and comes despite the practice of offering “lookalike” contracts being accepted around the world for years.

The ICE contracts are not copies, exactly. Similar to its “NYMEX lookalike” contracts, which cash settle against the expiring NYMEX future, the ICE Singapore commodity contracts are to be cash settled based on the settlement price of the expiring ZCE future. The ZCE future is delivery-settled. Meaning that the delivery mechanism ensures convergence between physical and futures prices, and the lookalike contract can ensure convergence by cash-settling against the delivery-settled contract.

The issues here are common to all intellectual property controversies. Strong intellectual property rights impede competition. Against that, free riding off the creativity or investment of others can impede innovation.

There isn’t a one-size-fits-all answer to this trade-off. In the case of exchange traded contracts, I tend to lean towards weak intellectual property rights.  The network effects of liquidity tend to weaken competition, and to give incumbents a strong advantage over entrants. There is already a substantial stream of rents to being first that gives strong (and maybe overly-strong) incentives to innovate, making strong intellectual property rights superfluous, and indeed damaging because they place another burden on already weak competition.

The US courts arrived at a similar conclusion, ruling that NYMEX did not have property rights over its settlement prices that it could use to preclude ICE from using them to cash settle its contracts. This is one factor that has encouraged a relatively robust competition in energy derivatives, which is the exception rather than the rule.

In sum, I hope ICE is able to prevail in its battle with ZCE. In part on economic grounds, and in part on the grounds that it burns me to see IP pirates protect their turf by asserting IP, especially over something for which IP is unwarranted.

Print Friendly

March 1, 2015

The Clayton Rule on Speed

Filed under: Commodities,Derivatives,Economics,Exchanges,HFT,Politics,Regulation — The Professor @ 1:12 pm

I have written often of the Clayton Rule of Manipulation, named after a cotton broker who, in testimony before Congress, uttered these wise words:

“The word ‘manipulation’ . . . in its use is so broad as to include any operation of the cotton market that does not suit the gentleman who is speaking at the moment.”

High Frequency Trading has created the possibility of the promiscuous application of the Clayton Rule, because there is a lot of things about HFT that do not suit a lot of gentlemen at this moment, and a lot of ladies for that matter. The CFTC’s Frankendodd-based Disruptive Practices Rule, plus the fraud based manipulation Rule 180.1 (also a product of Dodd-Frank) provide the agency’s enforcement staff with the tools to pursue a pretty much anything that does not suit them at any particular moment.

At present, the thing that least suits government enforcers-including not just CFTC but the Department of Justice as well-is spoofing. As I discussed late last year, the DOJ has filed criminal charges in a spoofing case.

Here’s my description of spoofing:

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.

Order cancellation is a crucial component of the spoofing strategy, and this has created widespread suspicion about the legitimacy of order cancellation generally. Whatever you think about spoofing, if such futures market rule enforcers (exchanges, the CFTC, or the dreaded DOJ) begin to believe that traders who cancel orders at a high rate are doing something nefarious, and begin applying the Clayton Rule to such traders, the potential for mischief-and far worse-is great.

Many legitimate strategies involve high rates of order cancellation. In particular, market making strategies, including market making strategies pursued by HFT firms, typically involve high cancellation rates, especially in markets with small ticks, narrow spreads, and high volatility. Market makers can quote tighter spreads if they can adjust their quotes rapidly in response to new information. High volatility essentially means a high rate of information flow, and a need to adjust quotes frequently. Moreover, HFT traders can condition their quotes in a given market based on information (e.g., trades or quote changes) in other markets. Thus, to be able to quote tight markets in these conditions, market makers need to be able to adjust quotes frequently, and this in turn requires frequent order cancellations.

Order cancellation is also a means of protecting market making HFTs from being picked off by traders with better information. HFTs attempt to identify when order flow becomes “toxic” (i.e., is characterized by a large proportion of better-informed traders) and rationally cancel orders when this occurs. This reduces the cost of making markets.

This creates a considerable tension if order cancellation rates are used as a metric to detect potential manipulative conduct. Tweaking strategies to reduce cancellation rates to reduce the probability of getting caught in an enforcement dragnet increases the frequency that a trader is picked off and thereby raises trading costs: the rational response is to quote less aggressively, which reduces market liquidity. But not doing so raises the risk of a torturous investigation, or worse.

What’s more, the complexity of HFT strategies will make ex post forensic analyses of traders’ activities fraught with potential error. There is likely to be a high rate of false positives-the identification of legitimate strategies as manipulative. This is particularly true for firms that trade intensively in multiple markets. With some frequency, such firms will quote one side of the market, cancel, and then take liquidity from the other side of the market (the pattern that is symptomatic of spoofing). They will do that because that can be the rational response to some patterns of information arrival. But try explaining that to a suspicious regulator.

The problem here inheres in large part in the inductive nature of legal reasoning, which generalizes from specific cases and relies heavily on analogy. With such reasoning there is always a danger that a necessary condition (“all spoofing strategies involve high rates of order cancellation”) morphs into a sufficient condition (“high rates of order cancellation indicate manipulation”). This danger is particularly acute in complex environments in which subtle differences in strategies that are difficult for laymen to grasp (and may even be difficult for the strategist or experts to explain) can lead to very different conclusions about their legitimacy.

The potential for a regulatory dragnet directed against spoofing catching legitimate strategies by mistake is probably the greatest near-term concern that traders should have, because such a dragnet is underway. But the widespread misunderstanding and suspicion of HFT more generally means that over the medium to long term, the scope of the Clayton Rule may expand dramatically.

This is particularly worrisome given that suspected offenders are at risk to criminal charges. This dramatic escalation in the stakes raises compliance costs because every inquiry, even from an exchange, demands a fully-lawyered response. Moreover, it will make firms avoid some perfectly rational strategies that reduce the costs of making markets, thereby reducing liquidity and inflating trading costs for everyone.

The vagueness of the statute and the regulations that derive from it pose a huge risk to HFT firms. The only saving grace is that this vagueness may result in the law being declared unconstitutional and preventing it from being used in criminal prosecutions.

Although he wrote in a non-official capacity, an article by CFTC attorney Gregory Scopino illustrates how expansive regulators may become in their criminalization of HFT strategies. In a Connecticut Law Review article, Scopino questions the legality of “high-speed ‘pinging’ and ‘front running’ in futures markets.” It’s frightening to watch him stretch the concepts of fraud and “deceptive contrivance or device” to cover a variety of defensible practices which he seems not to understand.

In particular, he is very exercised by “pinging”, that is, the submission of small orders in an attempt to detect large orders. As remarkable as it might sound, his understanding of this seems to be even more limited than Michael Lewis’s: see Peter Kovac’s demolition of Lewis in his Not so Fast.

When there is hidden liquidity (due to non-displayed orders or iceberg orders), it makes perfect sense for traders to attempt to learn about market depth. This can be valuable information for liquidity providers, who get to know about competitive conditions in the market and can gauge better the potential profitability of supply ing liquidity. It can also be valuable to informed strategic traders, whose optimal trading strategy depends on market depth (as Pete Kyle showed more than 30 years ago): see a nice paper by Clark-Joseph on such “exploratory trading”, which sadly has been misrepresented by many (including Lewis and Scopino) to mean that HFT firms front run, a conclusion that Clark-Joseph explicitly denies. To call either of these strategies front running, or deem them deceptive or fraudulent is disturbing, to say the least.

Scopino and other critics of HFT also criticize the alleged practice of order anticipation, whereby a trader infers the existence of a large order being executed in pieces as soon as the first pieces trade. I say alleged, because as Kovac points out, the noisiness of order flow sharply limits the ability to detect a large latent order on the basis of a few trades.

What’s more, as I wrote in some posts on HFT just about a year ago, and in a piece in the Journal of Applied Corporate Finance, it’s by no means clear that order anticipation is inefficient, due to the equivocal nature of informed trading. Informed trading reduces liquidity, making it particularly perverse that Scopino wants to treat order anticipation as a form of insider trading (i.e., trading on non-public information). Talk about getting things totally backwards: this would criminalize a type of trading that actually impedes liquidity-reducing informed trading. Maybe there’s a planet on which that makes sense, but its sky ain’t blue.

Fortunately, these are now just gleams in an ambitious attorney’s eye. But from such gleams often come regulatory progeny. Indeed, since there is a strong and vocal constituency to impede HFT, the political economy of regulation tends to favor such an outcome. Regulators gonna regulate, especially when importuned by interested parties. Look no further than the net neutrality debacle.

In sum, the Clayton Rule has been around for the good part of a century, but I fear we ain’t seen nothing yet. HFT doesn’t suit a lot of people, often because of ignorance or self-interest, and as Mr. Clayton observed so long ago, it’s a short step from that to an accusation of manipulation. Regulators armed with broad, vague, and elastic authority (and things don’t get much broader, vaguer, or more elastic than “deceptive contrivance or device”) pose a great danger of running amok and impairing market performance in the name of improving it.

Print Friendly

February 4, 2015

Turn Out the Lights, The Party’s Over

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,History — The Professor @ 8:12 pm

What party, you ask? The one with the mosh pit at LaSalle and Jackson in Chicago.  The one held in the building that’s in the background image of this page.

That’s right. Today the CME Group announced it was ending floor trading of futures (with the exception of the S&P 500) in Chicago and New York. Floor trading of options will continue.

As a Chicagoan who knew the floor in its glory days, this is a sad day. The floor was an amazing place. (Even though the floors will remain open until July, the past tense is appropriate in that sentence.)  A seemingly chaotic place full of shouting and gesticulating men (and yes, it was an overwhelmingly male place). Despite the chaos, it was an extraordinarily efficient way to buy and sell futures. In the bond pit in the 80s and 90s, $100,000,000 notional could be bought in sold with a shout and a wave. Over and over and over.

The economics of the pits were fascinating, but the sociology was as well. They were truly little societies. There were the exchange rules that were in the book, and there were the rules not written in any book that you adhered to, or else. Face-to-face interactions day after day over periods of years created a unique dynamic and a unique culture with its own norms and hierarchies and rituals. And soon it will be but a memory.

Even though I am wistful at the passing of this remarkable institution, I was ahead of the curve in predicting its eventual demise. I worked at an FCM in 1986, when the CME, CBT, and Reuters announced the initial Globex initiative. This got me interested in electronic trading, and when I became an academic a few years later, I researched the subject. In 1994 I wrote one of the early papers documenting that electronic markets could be as liquid and deep as floor-based markets, and I conjectured that parity in liquidity and superiority in speed and cost of access would result in the ultimate victory of computers over the floor. The collective response in the industry was scorn: everyone knew the floor was more liquid, and always would be. The information environment on the floor could never be duplicated on the screen, they said. This view was epitomized by the CEO of LIFFE, Daniel Hodgson, who ridiculed me in the FT as an ivory tower academic.

The first sign that the floor’s days were numbered occurred in 1998, when computerized Eurex wrested the Bund futures contract from LIFFE. (Eurex used my research as part of its marketing push.) LIFFE suffered a near death experience, barely surviving by shutting the floor and going fully electronic. (Mr. Hodgson was shown the door, and I resisted the temptation of sending him a certain FT clipping.)

Computerized trading was only slowly making inroads in the US at the time, in part because the incumbent exchanges resisted its operation during regular floor trading hours. But the fear of the machines was palpable by the mid-1990s. The CBT built its massive trading floor in 1997 in part because the members believed that if it spent so much on a new building the exchange couldn’t afford to render it useless by going electronic. Ironic that a group of traders who lived and breathed real world economics would fall victim to the sunk cost fallacy, and be blind to the gales of competition and creative destruction.

The floor continued to thrive, but inexorably the machines gained on it. By the early-2000s electronic volumes exceeded floor volumes for most contracts, especially in the financials. By the end of the first decade of the millennium, the floors were almost vacant. I remember going to the crude oil pit in NY in early-2009, and where once well over 100 traders stood, engaged in frenzied buying and selling, now a handful of guys sat on the steps of the pit, reading the Post and the Daily News.

When the CME demutualized, and when it acquired CBT and NYMEX, it made commitments to keep the floors open for some period of time. But the commitments were not in perpetuity, and declining floor volumes made it evident that eventually the day would come that the CME would shut down the floors.

Today was that day.

This was inevitable, but in the 80s and 90s the floor trading community, and the futures business generally, couldn’t possibly imagine that machines could ever do what they did. But the technology of the floor was essentially static. Yes, the technology of getting orders to the pit evolved along with telecommunications, but once the orders got there, they were executed in the same way that they had been since 1864 or so.* That execution technology was highly evolved and efficient, but static. In the meantime, Moore’s Law and innovation in hardware, software, and communications technology made electronic trading faster and smarter. Electronic trading lacked some of the information that could be gleaned looking in the eyes of the guy standing across the pit, or knowing who was bidding or offering, but it made accessible to traders vast sources of disparate information that was impossible to absorb on the floor. By the late-00s, HFT essentially computerized what was in locals’ heads, and did it faster with more information and fewer errors and less emotion. Guys that were all about competition were displaced by the competition of a more efficient technology.

Floor trading will live on for a while, in the options pits. Combination trades in options are complex in ways that there are efficiencies in doing them on the floor. But eventually machines will master that too. ICE closed its options pits a couple of years ago (four years after it closed its futures pits), and one day the CME will do so too.

The news of the CME announcement reminded me of something that happened almost exactly 10 years ago, 21 February 2005. Around that time, the management of  the International Petroleum Exchange was discussing the closure of the floor. (It decided to do so on 7 March.) Floor traders were very anxious about their future. Totally oblivious to this, Greenpeace decided to mount a protest on the IPE floor to commemorate the Kyoto Protocol. Bad decision. Bad timing. The barrow boys of the London floors, already in a sour mood, didn’t take kindly to this invasion, and mayhem ensued. Punches were thrown. Bones were broken. Furniture was thrown. There was much comedy:

“The violence was instant,” reported one aggrieved recipient of a rain of blows to the head. “I’ve never seen anyone less amenable to listening to our point of view.”

You can’t make that up.

From what I understand, the response was much more subdued in Chicago and New York today. But then again, Occupy or GMO protesters didn’t attempt to sally onto the floor to flog their causes. If they had, they just might have caught a flogging like the enviros did in London a decade back.

Being of a historical bent, I will look back on the floors with fascination. I am grateful to have known them personally, and to have known many who trod the boards in the pit in their colorful jackets, shouting themselves hoarse and at constant risk of being stabbed in the neck with a pencil wielded by a hyperactive peer.

Today is a good day to watch Floored or The Pit. Or even play a game of Pit. The films will give you something of a feel, but just a bit.

2015. The year Chicago lost Ernie Banks and the floor. But life moves on. Machines do not have the color of the floor, but they perform the markets’ vital functions more efficiently now. And not everything has changed in Chicago. The Cubs are still horrible.

*The exact beginning of floor trading on the CBT is unknown. The Board of Trade of the City of Chicago was formed in 1848, but futures trading proper probably did not begin until the Civil War. Sometime in the 1862-1864 period floor trading as we know it today-or should I say knew it?-developed. The first formal trading rules were promulgated in 1867. If you look at pictures from the 19th century or early-20th century, other than the clothes things don’t look much different than they did in the 1980s or 1990s. Electronic boards replaced chalk boards, but other than that, things look very similar.

Print Friendly

Next Page »

Powered by WordPress