Streetwise Professor

April 5, 2014

Pinging: Who is the Predator, and Who Is the Prey?

Filed under: Economics,Exchanges,HFT,Politics,Regulation — The Professor @ 11:59 am

The debate over Lewis’s Flash Boys is generating more informed commentary than the book itself. One thing that is emerging in the debate is the identity of the main contending parties: HFT vs. the Buy Side, mainly big institutional traders.

One of the criticisms of HFT is that it engages in various strategies to attempt to ferret out institutional order flows, which upsets the buy side. But the issue is not nearly so clearcut as the buy side would have you believe.

The main issue is that not all institutional orders are alike. In particular, there is considerable variation in the informativeness of institutional order flow. Some (e.g., index fund order flow) is unlikely to be informed. Other order flow is more informed: some may even be informed by inside information.

Informed order flow is toxic for market makers. They lose on average when trading against it. So they try to determine what order flow is informed, and what order flow isn’t.

Informed order flow must hide in order to profit on its information. Informed order flow uses various strategies based on order types, order submission strategies, choice of trading venues, etc., to attempt to become indistinguishable from uninformed order flow. Uninformed order flow tries to devise in strategies to signal that it is indeed uninformed, but that encourages the informed traders to alter their strategies to mimic the uninformed.

To the extent that market makers-be they humans or machines-can get signals about the informativeness of order flow, and  in particular about undisclosed flow that may be hitting the market soon, they can adjust their quotes accordingly and mitigate adverse selection problems. The ability to adjust quotes quickly in response to information about pending informed orders allows them to quote narrower markets. By pinging dark pools or engage in other strategies that allow them to make inferences about latent informed order flow, HFT can enhance liquidity.

Informed traders of course are furious at this. They hate being sniffed out and seeing prices change before their latent orders are executed. They excoriate “junk liquidity”-quotes that disappear before they can execute. Because the mitigation of adverse selection reduces the profits they generate from their information.

It can be frustrating for uninformed institutional investors too, because to the extent that HFT can’t distinguish perfectly between uninformed and informed order flow,  the uninformed will often see prices move against them before they trade too.  This creates a commercial opportunity for new trading venues, dark pools, mainly, to devise ways to do a better way of screening out informed order flow.

But even if uninformed order flow often finds quotes running away from them, their trading costs will be lower on average the better that market makers, including HFT, are able to detect more accurately impending informed orders. Pooling equilibria hurt the uninformed: separating equilibria help them. The opposite is true of informed traders. Market makers that can evaluate more accurately the informativeness of order flow induce more separation and less pooling.

Ultimately, then, the driver of this dynamic is the informed traders. They may well be the true predators, and the uninformed (or lesser informed) and the market makers are their prey. The prey attempt to take measures to protect themselves, and ironically are often condemned for it: informed traders’ anger at market makers that anticipate their orders is no different that the anger of a cat that sees the mouse flee before it can pounce. The criticisms of both dark pools and HFT (and particularly HFT strategies that attempt to uncover information about trading interest and impending order flow) are prominent examples.

The welfare impacts of all this are unknown, and likely unknowable. To the extent that HFT or dark pools reduce the returns to informed trading, there will be less investment in the collection of private information. Prices will be less informative, but trading will be less costly and risk allocation improved. The latter effects are beneficial, but hard to quantify. The benefits of more informative prices are impossible to quantify, and the social benefits of more informed prices may be larger, perhaps substantially so, than the private benefits, meaning that excessive resources are devoted to gathering private information.

More informative prices can improve the allocation of capital. But not all improvements in price efficiency improve the allocation of capital by anything near the cost of acquiring the information that results in these improvements, or the costs imposed on uninformed traders due to adverse selection. For instance, developing information that permits a better forecast of a company’s next earnings report may have very little effect on the investment decisions of that company, or any other company. The company has the information already, and other companies for which this information may be valuable (e.g., firms in the same industry, competitors) are going to get it well within their normal decision making cycle.  In this case, incurring costs to acquire the information is a pure waste. No decision is improved, risk allocation is impaired (because those trading for risk allocation reasons bear higher costs), and resources are consumed.

In other words, it is impossible to know how the social benefits of private information about securities values relate to the private benefits. It is quite possible (and in my view, likely) that the private benefits exceed the social benefits. If so, traders who are able to uncover and anticipate informed trading and take measures that reduce the private returns to informed trading are enhancing welfare, even if prices are less informative as a result.

I cannot see any way of evaluating the welfare effects of financial trading, and in particular informed trading. The social benefits (how do more informative prices improve the allocation of real resources) are impossible to quantify: they are often difficult even to identify, except in the most general way (“capital allocation is improved”). Unlike the trade for most goods and services, there is no reason to believe that social and private benefits align. My intuition-and it is no more than that-is that the bulk of informed trading is rent seeking, and a tax on the risk allocation functions of financial markets.

It is therefore at least strongly arguable that the development of trading technologies that reduce the returns to informed trading are a good thing. To the extent that one of the charges against HFT-that it is better able to detect and anticipate (I will not say front-run) informed order flow-is true, that is a feature, not a bug.

I don’t know and I am pretty sure nobody knows or even can know the answers to these questions. Which means that strongly moralistic treatments of HFT or any other financial market technology or structure that affects the returns to informed trading is theology, not economics/finance. Agnosticism is a defensible position. Certitude is not.

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April 2, 2014

Michael Lewis’s HFT Book: More of a Dark Market Than a Lit One

Filed under: Derivatives,Economics,Exchanges,HFT,Politics,Regulation,Uncategorized — The Professor @ 2:35 pm

Michael Lewis’s new book on HFT, Flash Boys, has been released, and has unleashed a huge controversy. Or put more accurately, it has added fuel to a controversy that has been burning for some time.

I have bought the book, but haven’t had time to read it. But I read a variety of accounts of what is in the book, so I can make a few comments based on that.

First, as many have pointed out, although this has been framed as evil computer geniuses taking money from small investors, this isn’t at all the case. If anyone benefits from the tightening of spreads, especially for small trade sizes, it is small investors. Many of them (most, in fact) trade at the bid-ask midpoint via internalization programs with their brokers or through payment-for-order-flow arrangements. (Those raise other issues for another day, but have been around for years and don’t relate directly to HFT.)

Instead, the battle is mainly part of the struggle between large institutional investors and HFT. Large traders want to conceal their trading intentions to avoid price impact. Other traders from time immemorial have attempted to determine those trading intentions, and profit by trading before and against the institutional traders.  Nowadays, some HFT traders attempt to sniff out institutional orders, and profit from that information.  Information about order flow is the lifeblood of those who make markets.

This relates to the second issue. This has been characterized as “front running.” This terminology is problematic in this context. Front running is usually used to describe a broker in an agency relationship with a customer trading in advance of the customer’s order, or disclosing the order to another trader who then trades on that information. This is a violation of the agency relationship between the client and the broker.

In contrast, HFT firms use a variety of means-pinging dark pools, accessing trading and quoting information that is more extensive and obtained more quickly than via the public data feeds-to detect the presence of institutional orders. They are not in an agency relationship with the institution, and have no legal obligation to it.

And this is nothing new. Traders on the floor were always trying to figure out when big orders were coming, and who was submitting them. Sometimes they obtained this information when they shouldn’t have, because a broker violated his obligation. But usually it was from watching what brokers were trading, knowing what brokers served what customers, looking at how anxious the broker appeared, etc.  To throw the floor of the track, big traders would use many brokers. Indeed, one argument for dual trading was that it made it harder for the floor to know the origin of an order if the executing broker dual traded, and might be active because he was trading on his own account rather than for a customer.

This relates too to the third issue: reports that the FBI is investigating for possible criminal violations. Seriously? I remember how the FBI covered itself in glory during the sting on the floors in Chicago in ’89. Not really. The press reports say that the the FBI is investigating whether HFT trades on “non-public information.”  Well, “non-public information” is not necessarily “inside information” which is illegal to trade on:  inside information typically relates to that obtained from someone with a fiduciary duty to shareholders. Indeed, ferreting out non-public information contributes to price discovery: raising the risk of prosecution for trading on information obtained through research or other means, but which is not obtained from someone with a fiduciary relationship to a company, is a dangerous slippery slope that could severely interfere with the operation of the market.

Moreover, it’s not so clear that order flow information is “non-public”.  No, not everyone has it: HFT has to expend resources to get it, but anybody could in theory do that. Anybody can make the investment necessary to ping a dark pool. Anybody can pay to get a faster data feed that allows them to get information that everyone has access to more quickly. Anybody can pay to get quicker access to the data, either through co-location, or the purchase of a private data feed. There is no theft or misappropriation involved. If firms trade on the basis of such information that can be obtained for a price that not everyone is willing to pay, and that is deemed illegal, how would trading on the basis of what’s on a Bloomberg terminal be any different?

Fourth, one reason for the development of dark pools, and the rules that dark pools establish, are to protect order flow information, or to make it less profitable to trade on that information. The heroes of Lewis’s book, the IEX team, specifically designed their system (which is now a dark pool, but which will transition to an ECN and then an exchange in the future) to protect institutional traders against opportunistic HFT. (Note: not all HFT is opportunistic, even if some is.)

That’s great. An example of how technological and institutional innovation can address an economic problem. I would emphasize again that this is not a new issue: just a new institutional response. Once upon a time institutional investors relied on block trading in the upstairs market to prevent information leakage and mitigate price impact. Now they use dark pools. And dark pools are competing to find technologies and rules and protocols that help institutional investors do the same thing.

I also find it very, very ironic that a dark pool is now the big hero in a trading morality tale. Just weeks ago, dark pools were criticized heavily in a Congressional hearing.  They are routinely demonized, especially by the exchanges. The Europeans have slapped very restrictive rules on them in an attempt to constrain the share of trading done in the dark. Which almost certainly will increase institutional trading costs: if institutions could trade more cheaply in the light, they would do so. It will also almost certainly make them more vulnerable to predatory HFT because they will be deprived of the (imperfect) protections that dark pools provide.

Fifth, and perhaps most importantly from a policy perspective, as I’ve written often, much of the problem with HFT in equities is directly the result of the fragmented market structure, which in turn is directly the result of RegNMS. For instance, latency arbitrage based on the slowness of the SIP results from the fact that there is a SIP, and there is a SIP because it is necessary to connect the multiple execution venues. The ability to use trades or quotes on one market to make inferences about institutional trades that might be directed to other markets is also a consequence of fragmentation. As I’ve discussed before, much of the proliferation of order types that Lewis (and others) argue advantage HFT is directly attributable to fragmentation, and rules relating to locked and crossed markets that are also a consequence of RegNMS-driven fragmentation.

Though HFT has spurred some controversy in futures markets, these controversies are quite different, and much less intense. This is due to the fact that many of the problematic features of HFT in equities are the direct consequence of RegNMS and the SEC’s decision (and Congress’s before that) to encourage competition between multiple execution venues.

And as I’ve also said repeatedly, these problems inhere in the nature of financial trading. You have to pick your poison. The old way of doing business, in which order flow was not socialized as in the aftermath of RegNMS, resulted in the domination of a single major execution venue (e.g., the NYSE). And for those with a limited historical memory, please know that these execution venues were owned by their members who adopted rules-rigged the game if you will-that benefited them. They profited accordingly.

Other news from today brings this point home. Goldman is about to sell its NYSE specialist unit, the former Spear, Leeds, which it bought for $6.5 billion (with a B) only 14 years ago.  It is selling it for $30 million (with an M).  That’s a 99.5 decline in market value, folks. Why was the price so high back in 2000? Because under the rules of the time, a monopoly specialist franchise on a near monopoly exchange generated substantial economic rents. Rents that came out of the pockets of investors, including small investors.  Electronic trading, and the socialization of order flow and the resultant competition between execution venues, ruthlessly destroyed those rents.

So it’s not like the markets have moved from a pre-electronic golden age into a technological dystopia where investors are the prey of computerized super-raptors. And although sorting out cause and effect is complicated, the decline in trading costs strongly suggests that the new system, for all its flaws, has been a boon for investors. Until regulators or legislators find the Goldilocks “just right” set of regulations that facilitates competition without the pernicious effects of fragmentation (and in many ways, “fragmentation” is just a synonym for “competition”), we have to choose one or the other. My view is that messy competition is usually preferable to tidy monopoly.

The catch phrase from Lewis’s book is that the markets are rigged. As I tweeted after the 60 Minutes segment on the book, by his definition of rigging, all markets have always been rigged. A group of specialized intermediaries has always exercised substantial influence over the rules and practices of the markets, and has earned rents at the expense of investors. And I daresay it would be foolish to believe this will ever change. My view is that the competition that prevails in current markets has dissipated a lot of those rents (although some of that dissipation has been inefficient, due to arms race effects).

In sum, there doesn’t appear to be a lot new in Lewis’s book. Moreover, the morality tale doesn’t capture the true complexity of the markets generally, or HFT specifically. It has certainly resulted in the release of a lot of heat, but I don’t see a lot of light. Which is kind of fitting for a book in which a dark pool is the hero.

 

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March 24, 2014

The Vertical (Silo) Bop: A Reprise

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 7:26 pm

With all the Ukraine stuff, and Gunvor, and travel, some things got lost in my spindle.  Time to catch up.

One story is this article about a debate between NASDAQ OMX’s Robert Greifeld and CME Group’s Phupinder Gill.  The “vertical silo” in which an exchange owns both an execution venue and a clearinghouse was a matter of contention:

Nasdaq OMX Group Inc. CEO Robert Greifeld was asked yesterday about the vertical silo and whether it hurts investors.

“Monopolies are great if you own one,” he said during a panel discussion at the annual Futures Industry Association conference in Boca Raton, Florida, paraphrasing a quote he recalled hearing from an investor. His exchanges don’t use this system. “We have yet to find a customer who is in favor of the vertical model,” he said.

A very retro topic here on SWP.  I blogged about it quite a bit in 2006-2007.  Despite that, it’s still a misunderstood subject :-P

Presumably Greifeld believes that eliminating the vertical silo would open up competition in execution.  Yes, there would be competition, but the outcome would likely still be a monopoly in execution given the rules in futures markets.  Under current futures market regulations, there is nothing analogous to RegNMS which effectively socializes order flow by requiring each execution venue to direct orders to any other venue displaying a better price.  Under current futures market regulations, there is no linkage between different execution venues, and no obligation to direct orders to a better priced market.  This leads traders to submit orders to the venue that they expect will be offering the best price.   In this environment, liquidity attracts liquidity, and order flow tips exclusively to a single market.

So opening up clearing would still result in a monopoly execution venue.  There would be competition to be the monopoly, but at the end of the day only one market would remain standing.  Most likely the incumbent (CME in most cases, ICE in some others.)

It is precisely the fact that competition in clearing and execution would lead to bilateral monopolies that drives the formation of a vertical silo.  This eliminates double marginalization problems and reduces the transactions costs arising from opportunism and bargaining that are inherent to bilateral monopoly situations.

Breaking up the vertical silo primarily affects who earns the monopoly rent, and in what form. These outcomes depend on how the silo is broken up.

One alternative is to require the integrated exchange to offer access to its clearinghouse on non-discriminatory terms.  In this case, the one monopoly rent theorem implies that the clearing natural monopoly could extract the entire monopoly rent via its clearing fee.  Indeed, it would have an incentive to encourage competition in execution because this would maximize the derived demand for clearing, and hence maximize the monopoly price.  (This would also allow the integrated exchange to be compensated for its investment in the creation of new contracts, a point Gill emphasizes.  In my opinion, this is a minor consideration.)

Another alternative (which seems to be what Greifeld is advocating) would be to create a utility CCP (a la DTCC) that provides clearing services at cost.  In this case, the winning execution venue will capture the monopoly rent.

To a first approximation, market users would pay the same cost to trade under either alternative. And most likely, the dominant incumbent (CME) would capture the monopoly rent, either in execution fees, or clearing fees, or a combination of the two.  Crucially, however, total costs would arguably be higher with the utility clearer-monopoly execution venue setup, due to the transactions costs associated with coordination, bargaining, and opportunism between separate clearing and execution venues.  (Unfortunately, the phrase “transactions costs” does double duty in this context.  There are the costs that traders incur to transact, and the costs of operating and governing the trading and clearing venues.)

A third alternative would be to move to a structure like that in the US equity market, with a utility clearer and a RegNMS-type socialization of order flow.  Which would result in all the integration and fragmentation nightmares that are currently the subject of so much angst in the equity world.  Do we really want to inflict that on the futures markets?

As I’ve written ad nauseum over the years, there is no Nirvana in trading market structure.  You have a choice between inefficiencies arising from monopoly, or inefficiencies arising from fragmentation.   Not an easy choice, and I don’t know the right answer.

What I do know is that the vertical silo per se is not the problem.  The silo is an economizing response to the natural monopoly tendencies in clearing and execution (when there is no obligation to direct order flow to venues displaying better prices).  The sooner we get away from assuming differently (and the Boca debate is yet another example of our failure to do so) the sooner we will have realistic discussions of the real trade-offs in trading market structure.

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March 11, 2014

CCP Insurance for Armageddon Time

Matt Leising has an interesting story in Bloomberg about a consortium of insurance companies that will offer an insurance policy to clearinghouses that will address one of the most troublesome issues CCPs face: what to do when the waterfall runs dry.  That is, who bears any remaining losses after the defaulters’ margins, defaulters’ default fund contributions, CCP capital, and non-defaulters’ default fund contributions (including any top-up obligation) are all exhausted.

Proposals include variation margin haircuts, and initial margin haircuts.  Variation margin haircuts would essentially reduce the amount that those owed money on defaulted contracts would receive, thereby mutualizing default losses among “winners.”  Initial margin haircuts would share the losses among both winners and losers.

Given that the “winners” include many hedgers who would have suffered losses on other positions, I’ve always found variation margin haircutting problematic: it would reduce payoffs precisely in those states of the world in which the marginal utility of those payoffs is particularly high.  But that has been the industry’s preferred approach to this problem, though it has definitely not been universally popular, to say the least.  Distributive battles are never popularity contests.

This is where the insurance concept steps in.  The insurers will cover up to $6 to $10 billion in losses (across multiple CCPs) once all other elements of the default waterfall-including non-defaulters’ default fund contributions and CCP equity-are exhausted.  This will sharply limit, and eliminate in all but the most horrific scenarios, the necessity of mutualizing losses among non-clearing members via variation or initial margin haircutting.

Of course this sounds great in concept.  But one thing not discussed in the article is price.  How expensive will the coverage be?  Will CCPs find it sufficiently affordable to buy, or will they decide to haircut margins in some way instead because that is cheaper?

As I say in Matt’s article, although this proposal addresses one big headache regarding CCPs in extremis, it does not address another major concern: the wrong way risk inherent in CCPs.  Losses are likely to hit the default fund in crisis scenarios, which is precisely when the CCP member firms (banks mainly) are least able to take the hit.

It would have been truly interesting if insurers would have been willing to share losses with CCP members.  That would have mitigated the wrong way risk problem.  But the insurers were evidently not willing to do that.   This is likely because they are concerned about the moral hazard problems.  Members would have less incentive to mitigate risk if some of that risk is offloaded onto insurers who don’t influence CCP risk management and margining the way member firms do.

In sum, the insurers are taking on the risk in the extreme tail.  This of course raises the question of whether they are able to bear such risk, as it is likely to crystalize precisely during Armageddon Time. The consortium attempts to allay those concerns by pointing out that they have no derivatives positions (translation: We are not AIG!!!)  But there is still reason to ponder whether these companies will be solvent during the wrenching conditions that will exist when potentially multiple CCPs blow through their entire waterfalls.

Right now this is just a proposal and only the bare outlines have been disclosed.  It will be fascinating to see whether the concept actually sells, or whether CCPs will figure it is cheaper to offload the risk in the extreme tail on their customers rather than on insurance companies in exchange for a premium.

I’m also curious: will Buffett participate.  He’s the tail risk provider of last resort, and his (hypocritical) anti-derivatives rhetoric aside, this seems like it’s right down his alley.

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January 28, 2014

Were the Biggest Banks Playing Brer Rabbit on the Clearing Mandate, and Was Gensler Brer Fox?

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 10:25 pm

One interesting part of the Cœuré speech was his warning that the clearing business was coming to be dominated by a few large banks, that are members of multiple CCPs:

Moreover, it appears that for many banks, indirect access is their preferred way to get access to clearing services so as to comply with the clearing obligation. Client clearing seems thus to be dominated by a few large global intermediaries. A factor contributing to this concentration may be higher compliance burdens, where only the very largest of firms are capable of taking on cross-border activity. This concentration creates a higher degree of dependency on this small group of firms.

There are also concerns about client access to this limited number of firms offering client clearing services. For example, there is some evidence of clearing firms “cherry picking” clients, while other end-users are commercially unattractive customers and hence unable to access centrally cleared markets.

These are all developments that I believe the international regulatory community may wish to carefully monitor and act on as and when needed.

And wouldn’t you know.  He supports a longstanding SWP theme: That Frankendodd and EMIR and Basel create a huge regulatory burden that is essentially a fixed cost.  This increase in fixed costs raises scale economies, and this inevitably leads to an increase in concentration-and arguably a reduction in competition, in the provision of clearing services.

It now seems rather quaint that there was a debate over whether CCPs should be required to lower the minimum capital threshold for membership to $50 million.  That’s not the barrier to entry/participation.  It’s the regulatory overhead.

It’s actually an old story.  I remember a Maloney and McCormick paper from the 80s-hell, maybe even the late 70s-about the effects of the regulation of particulates in textile factories (if I recall).  The cost of complying with the regulation was essentially fixed, and the law essentially favored big firms and they profited from it.  It raised the costs of their smaller rivals, led to their exit, and resulted in higher prices and the big firms profited.  Similarly, I recall that  several papers by the late Peter Pashigian (a member of my PhD committee) found that environmental regulations favored large firms.

The Cœuré speech suggests this may be happening here: note the part about client access to a “limited number of clearing firms.”

And it’s not just pipsqueaks that are exiting the clearing business.  The largest custodian bank-BNY Mellon-is closing up shop:

More banks are expected to follow BNY Mellon’s lead and pull out of client clearing, as flows have concentrated among half a dozen major players following the roll-out of mandatory clearing in the US last year.

The decision of the world’s largest custodian bank to shutter its US clearing unit was the first real indication of how much institutions are struggling with spiralling costs and complexity associated with clearing clients’ swaps trades – a business once viewed as the cash cow of the new regulatory regime.

You might recall that BNY Mellon was one of the firms that complained loudest about the high capital requirements of becoming a member of ICE Trust and LCH.  Again: it’s not the CCP capital requirements that are the issue.  It’s the other substantial cost of providing client clearing services, and regulatory/compliance costs are a big part of that.

Ah yes, another Gensler argument down in flames.  Remember how he constantly told us-lectured us, actually-that Frankendodd would dramatically increase competition in derivatives?  That it would break the dealer hammerlock on the OTC market?

Remember how I called bull?

Whose call looks better now?  Sometimes I wonder if JP Morgan, Goldman, Barclays, etc., weren’t playing the role of Brer Rabbit, and Gensler was playing Brer Fox. For he done trown dem into dat brer patch, sure ’nuff.

Though it must be said that this was not Gensler’s biggest contribution to reducing competition in derivatives markets in the name of increasing competition.  His insane extraterritoriality decisions have fragmented the OTC derivatives markets, with Europeans reluctant to trade with Americans.  The fragmentation of the markets reduces counterparty choice in both Europe and the US, thereby limiting competition.

This is not just a matter of competition.  There are systemic issues involved as well, and these also make a mockery of the Frankendodd evangelists.  They assured the world that Frankendodd and clearing mandates would reduce reliance on a few large, highly interconnected intermediaries in the derivatives markets. That is proving to be another lie, on the order of “if you like your health plan, you can keep your health plan.”  The old system relied on a baker’s dozen or so large, highly interconnected dealers.  The new system will rely on probably a handful or two large, highly interconnected clearing firms.

The most important elements in the clearing system are a small number of major banks that are clearing members at several global CCPs.  The failure or financial distress of any one of these would wreak havoc in the derivatives markets and the clearing mechanism, just as the failure of a major dealer firm would shake the bilateral OTC markets to the core.

Just think about one issue: portability.  If there are only a small number of huge clearing firms, is it really feasible to port the clients of one of them to the few remaining CMs, especially during times of market stress when these might not have the capital to take on a large number of new clients?

What happens then?

I don’t want to think about it: there’s only so much I can handle.

But Cœuré assures us the regulators are on top of it.  Or at least they are thinking about getting on top of it: “the international regulatory community may wish to carefully monitor and act on as and when needed.”  “May wish to act as needed.”  Sure. Take your time! What’s the hurry? What’s the worry?

I won’t dwell on the  irony of those who advocated the measures that got us into this situation pulling their chins and telling us this might be a matter of concern, especially since they were deaf to warnings made back when they could have avoided leading us down the path that led us to this oh-so-predictable destination.

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January 20, 2014

Day of the Mifid, or, To Stupidity and Beyond!

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Russia — The Professor @ 7:03 pm

After years of wending through to what is to an American an incomprehensible legislative process that involves a three body problem (the trialogue of the Commission, the EU Parliament, and member states), Europe has agreed on its version of the trade execution portion of Frankendodd: Mifid II.  (The clearing and OTC collateralization equivalents are covered under a different law, EMIR.)  A good summary is here.

It contains many of the objectionable features of Frankendodd, namely, a mandate that swaps be executed on SEF-like entities (Organized Trading Facilities, or OTFs, in Euro parlance), and commodity position limits.  The former were pretty much a done deal after the Pittsburgh G20 meeting, the latter a reflection of the global suspicions of “speculation” in commodities, but intensified by European NGO convictions that speculation in food is evil.  (The shade of Adam Smith is shaking his head, noting that his observation about the equivalence between the popular terrors and suspicions against speculation and  the popular terrors and suspicions involving witchcraft is as apt today as it was in 1776.  Except that witchcraft is probably much more socially acceptable these days.)

But the EU has added its own idiosyncratic idiocies to its law.  Two things stand out.

First, the EU has mandated open access to derivatives exchange CCPs, in an attempt to demolish the vertical silo model.  Yes, the mandate is delayed-by as much as 5 years-but “I will wait 5 years to be stupid” hardly seems to be much of  a defense.  As I’ve written for years-a year or two before SWP began, in point of fact-the vertical silo makes economic sense (from a transactions cost economics perspective), and the pro-competition justification for it (namely, to encourage competition in execution) is inconsistent with what economists have known since the 1960s (the “one monopoly rent” theorem).

Second, and even more inanely, Mifid II caps the dark pool share in the trading of any individual equity at 8 percent.  Overlooking the operational difficulties of enforcing a collective constraint on volume across multiple venues, this reflects a suspicion of dark pools (a pejorative name in itself) that is again not grounded in good economics.  In a second best world, where competition between exchanges is imperfect, off-exchange venues (block markets in the old days, internalization, dark pools) can be welfare enhancing.  The fact that many market participants find them the lowest-cost venue to transact in should at least give pause to regulators, and ask them to inquire why this is true, and do the appropriate cost-benefit analysis of the trade-offs involved.  But no, fools rush in.

It strikes me that the  Euros have created a new Pixar character.  Buzz Darkpool: “To stupidity and beyond!” Derivatives trading mandates and position limits are stupid, but they’ve decided to go beyond that.

Meaning that the US can perhaps adopt what I’ve often said is the Russophile motto: “Not the worst!”

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Why History is Useful: Some Perspective on Liquidity Supply in Floor and Electronic Markets

Filed under: Derivatives,Economics,Exchanges,HFT,Regulation — The Professor @ 11:37 am

One of the annoying things about the debate over HFT, particularly related to the quality of liquidity supplied by HFT traders, is the lack of any historical context.  HFT firms are criticized for pulling liquidity suddenly, particularly when volatility ticks up, thereby exacerbating price moves and the impact of order flow on prices.

The thing is, that market makers/liquidity suppliers have been doing this since time immemorial. Liquidity suppliers have always chosen flight over fight.

I’ve written about that in the past (focusing, for instance, on Black Monday).  This recent blog post provides some excellent historical color that illustrates the point quite well.

Having traded the markets since 1985, I would like to explain what market liquidity actually meant in the pre-electronic days and what it means in the world of electronic trading.

During the 1987 October crash, Black Monday, I was a junior trader in government bonds and futures. Black Monday was not a crash which was over in seconds or minutes; no, the world stopped turning actually for days. The mini crash of 1989 had a similar pattern. Chernobyl 1986, Gorbachev crisis in 1991 and UK election day in 1992, were all similar liquidity gap events seen by market traders.

The beauty of those days (the late 80s) for a trader, was that markets were very often in a ‘fast market’ condition. This meant that one was able to trade at any price and all rules were thrown overboard until the board officials were able to control the pit again. Without computers, we simply could not deal with the enormous amount of activity in the markets at those times and simply stopped (or delayed) sending price information out, not just for seconds, but minutes and even (during the week of Black Monday) days. Clearers had backlogs to clients for days.

What investors, customers, institutions looked at in those days were screen prices on systems like Reuters or Bloomberg: feeds fed by the voice of the official. If the official did not yell a price in the mic, the data group would not enter a price, and the world would never see this price. Under fast markets no prices were entered and the screen would just read ‘fast’ (if you were lucky). Future and option prices on screen were seen as tradeable prices and in slow markets they may have been pretty close to the truth. In fast markets they were inaccurate and it was not possible to trade the price indicated on the Reuters screen. Yet the world still thought this was the correct price.

Being in the pit, one cannot keep buying or selling an instrument, so traders would hedge their positions. Hundreds of times I have been in situations where there was simply no bid or offer in the instrument to hedge in. The signal from a broker out of the futures pit simply stated, ‘no bid, no bid’, yet all the screens where showing a bid or an offer. Was this liquidity? The world clearly thought it was, but we all knew there was panic on the floor and you were lucky to trade one lot.

Yes, I know Mr. Spanbroek is talking his book.  (The EPTA represents HFT firms.)  But what he writes about the good old days on the floor are accurate.  They were good days mainly for the guys on the floor, who would supply liquidity when it was profitable, but would head for the exits when the order flow was toxic.  Ditto traders upstairs in the OTC markets.  This is a characteristic of liquidity supply and liquidity suppliers pretty much everywhere and always.

This subject always brings to mind a legendary-and I mean legendary-trader, who told me in the early-00s he was all in favor of the markets going electronic because he was “sick of getting raped by the floor.”  About 2 years ago he told me that he couldn’t compete with HFT.  I guess there was a Goldilocks “just right” era in between, say 2002-2007 or so, but the criticisms of liquidity suppliers is a hardy perennial.  And there is some justice to the charges.  The point is that it is not new, and it is not unique to HFT.  It is inherent in the economics of liquidity supply.

And there is no easy policy solution.  A policy intended to fix one problem will just create others.  Again, the problems inhere in the economics of liquidity supply.

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January 15, 2014

The Clayton Rule on Manipulation Lives On

Filed under: Commodities,Derivatives,Economics,Exchanges,History,Regulation — The Professor @ 10:41 am

I have studied manipulation for going on 25 years now, and one of my pet peeves is the promiscuous and imprecise use of the term.  I often quote a cotton broker, William Clayton, who in Congressional testimony said “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.”

Case in point: a story from a couple days ago about the FBI investigating the trading of interest rate swaps:

Wall Street traders may be manipulating a key derivatives market and front running Fannie Mae and Freddie Mac, hurting the US-owned mortgage giants in the process, according to an FBI intelligence bulletin reviewed by Reuters.

. . . .

Disclosure of the suspected manipulation and front running came in an FBI intelligence bulletin that was distributed last week by the bureau’s field office in Charlotte, North Carolina, to security officers at financial services firms.

Front running  is not manipulation.  Manipulation distorts prices, and causes them to move away from where they should be (at least temporarily, although the effects can be highly persistent).  If anything, front running causes prices to move where they were going to go anyways, but faster.   Front-running is a source of information leakage.

Front running raises the trading costs of the entity that is front run–allegedly Fannie and Freddie in this case.  It results in a redistribution of wealth away from those who are front run to the front runner.  But these effects are notably different from real manipulations, like corners and squeezes, or banging the close/settle, or the release of false information.

In the stock and futures markets, front running by a broker or specialist is a violation of the agency relationship with the client.  In securities markets in the US it is a violation of Section 10(b) of the 1934 Securities Exchange Act.  I don’t know, and don’t have time to research at the moment, whether front running of interest rate swaps falls afoul of any law or regulation.

But it ain’t manipulation, as the term should be construed as conduct that distorts prices.  Although everything that is manipulative is bad, not everything that is bad is manipulative.  But as William Clayton noted 80 odd years ago, that distinction is almost universally overlooked.  Especially now, in media coverage of financial markets.

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January 13, 2014

Scott Irwin Answers Kocieniewski

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 9:04 pm

Scott Irwin has provided his responses to David Kocieniewski.  Read the whole thing.

It’s My Turn

The responses to the recent NYT article by David Kocieniewksi certainly make interesting reading.   I don’t want to belabor points already made so well by others in response to the numerous problems with the article (especially Craig).  Instead, I want to offer some additional points that I think merit further consideration or elaboration:

  1. To start, it is important to clarify that the heart of the controversy is the trading activities of a new type of participant in commodity futures markets—financial index investors—during the 2007-2008 commodity price spikes.  The concern was that unprecedented buying pressure from index investors created massive bubbles in commodity futures prices, and these bubbles were transmitted to spot prices through arbitrage linkages between futures and spot prices.  The end result was that commodity prices far exceeded fundamental values during the spikes.  Dwight Sanders and I labeled this the “Masters Hypothesis” in honor (dishonor?) of the central role that hedge fund manager Michael W. Masters played in pushing this line of thinking.   It is crucial to understand the key features of the Masters Hypothesis.  First, it implies that index buying in commodity futures markets created massive price bubbles—20, 30, 50% overvaluations (take your pick).  Second, it implies the price bubbles were long-lived, measured in months if not years.  These features have driven the acrimonious debate about “speculation” in commodity markets that first erupted in 2008.  Without the charge of massive and long-lasting bubbles the intense public policy debate about speculation limits would not have taken place.
  2. My position on the validity of the Masters Hypothesis has been consistent from the earliest days of the controversy.   In fact, in an ironic twist, one of my earliest publications on the controversy was an op-ed that Dwight Sanders and I jointly authored—drum roll please—yes, in the NYT in July 2008.   A few quotes:  “Over all, there is limited evidence that anything other than economic fundamentals is driving the recent run-up in commodity prices…The complex interplay of these factors and how they affect commodity prices is often difficult to grasp immediately, and speculators are a convenient scapegoat for the public’s frustration with rising prices. That’s unfortunate because curbing speculation — and hobbling the ability of businesses that rely on futures markets to reduce their risk — is counterproductive.{
  3. If my work was somehow tainted by associations with “Wall Street,” then why the editorial endorsement by the Paper of Record in 2008?   It also seems convenient that this little fact was omitted in Mr. Kocieniewksi’s recent article.   I made sure he was aware of my previous NYT op-ed article when he interviewed me. I suspect he was already aware of it given his exhaustive background research on the two of us.
  4. The academic research pertaining to the Masters Hypothesis since 2008 has been overwhelmingly negative.  I submit that there is very little credible academic research that is consistent with the basic tenets of the Masters Hypothesis.  That is, index buying is not associated with massive and long-lasting price bubbles in commodity futures markets.  There are no “accidental Hunt Brothers.”   Some unnamed persons (one has the initials GG) like to characterize academic research on the subject as being roughly equally divided between studies that find a positive impact of index positions on prices and studies that fail to find an impact.  This characterization is misleading.  Yes, some studies find evidence of a positive impact but the impacts are invariably small and fleeting or do not line up with the spikes of 2007-2008.  This type of evidence does not support the Masters Hypothesis.  So, when properly interpreted the evidence to date is not divided equally, but instead overwhelmingly rejects the Masters Hypothesis.  And this is what is important from a public policy perspective—small impacts do not provide much justification for costly new regulation of commodity futures markets.
  5. My approach to research on the market impact of index investment has always been to go where the data lead.  My co-authors and I have sliced and diced the available data many different ways and we cannot find a smoking gun (a full list can be found here).  As I like to put it, if the Masters Hypothesis is true then the relationship between index positions and commodity futures prices should literally jump off the page.  It does not.  Importantly, there is also limited evidence of bubbles in commodity futures markets independent of whether or not they are associated with index investment.   My co-authors and I could not find evidence that bubbles have become larger or longer-lasting since index investment came on the scene.  If anything they have become smaller and less frequent.
  6. If my research on speculation is slanted/biased/tainted then it sure has fooled a whole bunch of academics who serve as journal editors and reviewers.  I have published 13 papers since 2009 dealing directly with the speculation controversy in 9 different academic journals.  And several more are currently under review.  Yes, under review.  This means the articles don’t get published unless they first pass muster with reviewers and then a journal editor.  I don’t know exactly how many editors and reviewers I have dealt with on these papers (several were invited submissions but still subject to peer-review), but it is safe to say that it must be at least 20-30 people.  So, we are to believe that my biased research ran this gauntlet of editors and reviewers and the bias managed to go undetected the entire time?  Give me a break.
  7. Just for the record, I want to state in public that I did not even know about the Chicago Mercantile Exchange (CME) donations to the business school here at the University of Illinois when the donations were made.  I only became aware of them in the last year or so through conversations with our development staff.   (OK, I should actually be a little embarrassed by that last statement given my work on commodity futures markets.)   In any event, to draw an inference between the gifts to the business school from the CME and my research really is ridiculous.  I made this clear in my interviews with Mr. Kocieniewksi.
  8. I do have a long working relationship with the CME, and before that, with the Chicago Board of Trade (CBOT).  This after all is my research area.   The CME has not funded any of my research since 2007.  However, I did work on a commissioned white paper for the CME in 2005 when the grain contract convergence problems first erupted.  My co-authors (Phil Garcia and Darrel Good) and I were paid a total of $15,000 for the work, which we split equally.   I did accept a position on a new Agricultural Advisory Council that the CME started in late 2013.  The council will meet three times a year at various locations around the country and serve as a sounding board for various issues that come up with regard to agricultural futures markets.  I will receive the same $10,000 annual stipend for this position as the other members of the council.   That is the sum total of my financial ties to the CME.
  9. I have had numerous interactions with CME staff in recent years on a host of issues related to commodity futures markets, including, of course speculation.  Sometimes I have reached out to them and sometimes they reach out to me.  Most of the time it is the former and involves pretty obscure questions about things like how the grain delivery process works or help in getting some data.  My research would be far less interesting and useful without this help.  I have the utmost respect for the professionalism of the CME staff and I have never been asked for any type of quid pro quo.  Never.  When I have agreed to participate in presentations, write blogs, etc. I have done so because I believed my research and analysis contributed to better understanding of the issues.
  10. My other research on commodity market speculation has been funded from three main sources.  First, the Laurence J. Norton Chair that I hold here at the University of Illinois provides earnings each year that go to support my research program (thank you U of I!).  Second, I have had two grants from the Economic Research Service of the USDA on commodity speculation related topics since 2008.  The first one included work directly on speculation while the second focused on convergence in grain futures contracts. Both have been completed.  Third, Dwight Sanders and I did a commissioned study for the OECD in 2010.  I lost track of the emails with the exact amount we were paid but I know it was only a few thousand dollars.
  11. Yieldcast is a product of T-Storm Weather that I helped develop with a former graduate student, Mike Tannura, and Darrel Good.  Yieldcast provides “real-time” U.S. corn and soybean yield forecasts for subscribers.  My main role is to build the statistical models that form the basis of the forecasts and to prepare the weekly forecasts during the growing season.  As indicated in the NYT article I do not have direct contact with Yieldcast subscribers.  I am fortunate that side of the business is ably handled by Mike Tannura through T-Storm.  It is really laughable to think that I have somehow been rewarded through this channel by Wall Street as a payoff for my speculation research.  I know how hard Mike has worked to build the base of subscribers for this product, and if it only were that easy!  I have never seen one email, one voice mail, or absolutely anything that connects my research on speculation to taking out a subscription for Yieldcast.
  12. As the NYT article indicated, Dwight Sanders and I did conduct a study in 2012 for Gresham Investment LLC on the market impact of index investment.   Given the political sensitivities surrounding the speculation issue, I gave considerable thought as to whether I ought to pursue the consulting project.  I knew some would see taking any funding from a commodity firm as being a conflict of interest.  But, the project provided access to detailed firm level position data that has previously been unavailable to researchers and this made it worthwhile in my mind.  Sure, I didn’t mind getting paid as well.  The NYT article got it wrong when it said I was paid the full $50,000.  Dwight and I split that equally so I was actually only paid $25,000.  We are working on several interesting papers based on this new dataset.
  13. If the charges (really, innuendoes) in the NYT article are baseless, then readers might reasonably ask what does motivate my “defense of Wall Street”?  Good question.   I am indeed a “freshwater” economist that became convinced early in my career that commodity futures markets were an invaluable market institution that improved the discovery of prices and the ability of market participants to shift risks.  While these markets are by no means perfect (as Craig’s work on manipulation highlights), on balance, the good vastly outweighs the bad.  So, when the current speculation controversy erupted in 2008 I was struck by the similarity of the present controversy and those that have buffeted the industry in the past.  Change only the names and dates and not all that much is different.  This has been a reoccurring theme in my own writings since 2008 (including the July 2008 NYT article…could not resist).  And I admit that I made an intentional decision early on to play a more public role in the present controversy.  Three of my professional heroes are Holbrook Working, Tom Hieronymus, and Roger Gray, who spent much of their illustrious academic careers defending futures markets.  All the motivation I needed.

Scott Irwin

University of Illinois

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What is the World Coming To, When SWP Shares Headlines With the Dodd of Frankendodd?

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 7:08 pm

Risk Magazine’s annual review issue includes a set of short contributions on the progress that has been made on the G-20 OTC derivative reforms.  (If you run into paywall problems: there are ways.  There are ways.)  The contribution by yours truly is under the category Academics (plural) even though I am the only academic in the piece.  I guess I count for double, or something.
But that’s not the best part.  The best part is the headline:

Progress and peril: Davie, Dodd, Maijoor, Pirrong and more on the G-20 reforms.

Sharing top billing with Chris Dodd!  What is the world coming to?  I guess it could be better (or worse): it could have been Barney.  Or Gary.  Or Bart.

To spare you having to scroll through all of the contributions by politicians, lawyers and people who actually work in these markets, here’s my two cents:

When the Dodd-Frank Act was passed, I thought the Sef mandate was its worst part. It has nothing to do with the act’s ostensible purpose – reducing systemic risk – and imposes a one-size-fits-all model for trading swaps that will likely decrease the efficiency of the market. The made-available-for-trade provision of the Sef rule merits the title ‘worst of the worst’. This says if a Sef applies to the CFTC to trade a particular type of swap, and it approves the application, all trading of that type of swap must occur on a Sef. This turns the ordinary competitive process on its head. In most markets, a firm introduces new products, and if it is desirable to consumers, it sells. If the product is flawed, it doesn’t. Under this rule, a firm that introduces a flawed execution method imposes this bad choice on all consumers.

The CFTC could prevent such a perverse outcome by not approving an application. However, the agency’s animus to the traditional dealer-centric trading model and its fetish for transparency means the CFTC sets very low standards for approval. It also demonstrates the CFTC’s bizarre interpretation of cost-benefit analysis: it considers only the trivial cost of filing an application, and totally ignores the massive costs that would result if traders are forced to execute in an inefficient way.

Swap market participants and transactions are diverse. There is no execution model to fit all – counterparties themselves are best placed to determine how to execute their trades. Sef mandates already constrain choice, and made-available-for-trade puts the execution decision in the hands of third parties whose interests are not aligned with those actually trading. Given the size of these markets, if the untried Sefs don’t work as hoped – even for a modest subset of traders – the dislocations and inefficiencies will be immense.

The Risk editors chopped my last line, which was: “I fear that the epitaph of the OTC swap market will be: ‘Died of a Theory.'”  (A line lifted from Jefferson Davis’s epitaph on the Confederacy.)  The Theory, of course, is that traditional means of executing OTC derivatives trades are flawed, if not evil, and that Gary Knows Best in imposing a simulacrum of a centralized, order driven market that has worked well for futures on swaps, which are different in many ways.

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