Streetwise Professor

April 19, 2014

HFT, Dark Pools, Third Markets, and the Second Best

Filed under: Economics,HFT,Regulation — The Professor @ 12:05 pm

In his Atlanta Fed paper, Stiglitz uses second best considerations in his argument against HFT. My basic response is that second best considerations cut both ways.

Put simply, second best considerations mean that if one optimality condition is violated, then it may be efficiency enhancing to violate another optimality condition: or, one “market failure” can mitigate another. A simple example would be that it might be better for a polluting industry to be monopolistic or oligopolistic instead of competitive.  The monopolist’s reduction of output offsets the incentive to produce too much that occurs when there is an externality.

In the context of HFT, my second best argument is that since informed trading can be rent seeking, things that might otherwise be inefficient, such as anticipating orders or engaging in “arms races” to enhance trading speed, can be efficiency enhancing.

This is not a new theme with me. In fact, it’s quite old. I wrote a paper in 1998 titled “Third Markets and the Second Best” that applied this argument to off-exchange trading, and the free riding off of price discovery on exchanges. I discussed this further in my 2002 JLEO paper, “Securities Market Macrostructure: Property Rights and the Efficiency of Securities Trading“.

In these papers, I showed that off exchange trading venues-third markets-that free ride off of the prices produced by exchanges and limit trading to the verifiably uninformed can be efficiency enhancing even if this exacerbates adverse selection problems on the exchange because this free riding mitigates two problems: the market power of dominant exchanges (where the market power arises from the liquidity network effect) and rent seeking informed trading (i.e., the expenditure of real resources to obtain information in order to extract profits by trading with the less-informed who buy and sell for portfolio balance or risk management reasons).

Similar arguments can be applied to dark pools today. Indeed, many dark pools (and internalization) perform a similar function to third markets back in the day: they are venues that use various means to screen out informed traders, in order to reduce execution costs for the verifiably less-informed. This loss of uninformed order flow on “lit” exchanges tends to increase adverse selection costs there, but the same competition and rent seeking informed trading second best considerations arise here, meaning that the costs of lower liquidity on exchanges may be more than offset by other benefits.

And many of the very same considerations apply to HFT. Thus, contra Stiglitz, second best considerations do not unambiguously favor the adoption of restrictions on HFT.

Indeed, the thing that is most striking about the trading of financial instruments is that there are so many potential violations of optimality conditions that the entire analysis of market structure becomes an exercise in the theory of the second best.

Which can be a problem. For as George Stigler said, “Well, there are second best considerations” is a conversation stopper. But the conversation about market structure isn’t going to stop anytime soon, so we have to grasp the nettle of the second best if that conversation is going to shed more light than heat. It is good that Stiglitz makes the second best issue explicity. If only he had applied this reasoning more consistently, and recognized that informed trading can be a deviation from optimality which can be addressed by things that seem in isolation to be inefficient.

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April 18, 2014

Banning Banks From Physical Commodity Trading: The Battle Continues

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 3:33 pm

The battle over bank participation in physical commodities is reaching a climax. The deadline for commenting on potential Federal Reserve regulation of this activity is approaching, and many letters from groups representing banks (‘natch) but also from energy and commodity industry groups plead with the Fed to permit continued bank involvement in the markets. However, on Capitol Hill the sentiment largely runs the other way, and Senators Sherrod Brown and Elizabeth Warren submitted a letter demanding that the Fed defenestrate banks’ commodities businesses.

Most of the Brown-Warren letter is stuff I’ve written about before, so I won’t comment more on it now. But this part stood out to me, and deserves a rebuttal:

Commodities activities present risks that are different from financial-market risks, are idiosyncratic, and have the potential to disrupt more than just the financial system. Global supply chain disruptions can affect industries in the broader economy that rely upon raw materials.

First, from a systemic risk perspective, the fact that commodities risks are idiosyncratic, and different (i.e., less correlated) with other risks in the banking system is a good thing. Diversification is beneficial in this regard.

I have looked at some evidence that speaks directly to this issue. Over the period of the crisis, the profits of the biggest physical commodity trading firms (the Glencores, Cargills, Vitols, etc.) did not suffer the same extreme drop as bank profits. Indeed, with a few exceptions (Bunge) profits of the major commodity trading firms rose from 2008 to 2009, when bank profits were in freefall.

This lack of cyclicality in trading firm profits, which is in stark contrast to the extreme cyclicality in prices (especially for energy and metals) is readily understood. Physical trading is a margin and volume business: these factors, not flat prices, drive profits. Due to the inelasticity of supply and demand for commodities, margins and volumes tend to be much more stable than flat prices. Prices, rather than quantities, tend to bear the bulk of the burden of responding to demand shocks. Moreover, some commodity trading activities-notably storage-tend to be countercyclical, providing a source of profit to physical commodity traders during recessions.

Commodity trading firms actually had more issues when prices spiked in 2008, because it was difficult for them to finance inventories at very high prices, and the low prices of 2009 eased these financing constraints.

The lack of cyclicality, which contrasts starkly to the pronounced cyclicality of earnings in traditional banking and capital market activities, means that physical commodity trading could reduce the systemic risk posed by banks. The effect will not be large, because even for the biggest banks  commodity trading revenues are small relative to those generated by the more traditional activities. But directionally, this lack of cyclicality in physical trading profitability makes it an attractive part of a bank’s portfolio, especially from a systemic risk perspective.

Second, the Brown-Warren warning about disruptions beyond the financial system are vastly overblown. Presumably what they mean is that if a large bank or several large banks with commodity trading operations were to run into financial trouble, this could disrupt global supply chains. But especially for the commodities that banks tend to focus on (particularly energy), they represent a small fraction of total physical market trading activity. If they disappeared overnight, others could step in and handle most of the business at a slightly higher cost. (Not to mention that it is kind of strange to justify driving banks out of the business by saying that if they leave the business it could disrupt global supply chains.)

But even more importantly, we know that even major disruptions in global supply chains are likely to have only trivial impacts on the global economy. Look at the Japanese earthquake and tsunami of 2011. It devastated supply chains throughout Asia, far more than the loss of even several major commodity trading firms could have. Yet the effects on global growth were minimal. Several central banks examined the issue, and found that the catastrophe reduced global growth by around .1 percent for a couple of quarters. Even in Asia, the effect was minor.

As another example, the implosion of the merchant energy sector in the US in 2002 had no marked effect on US economic activity.

Another concern raised about bank participation in physical markets is environmental risk. This is potentially a serious concern, but even there legal protections (notably dealing through subsidiaries that protect a bank or bank holding company from liability) and insurance can sharply reduce the risk that legal exposure arising from an oil spill or the like could threaten the viability of a large financial institution. Also, since different commodity trading activities pose different environmental risks, a blanket restriction on commodity trading activities, some of which are not particularly environmentally risky, is not warranted.

In sum, the Brown-Warren arguments are not persuasive. Financially, the nature of physical commodity trading tends to reduce the cyclicality of of bank profits, which tends to reduce systemic risk. The fears about threats to global supply chains from the failure of any major commodity trader leading to adverse macroeconomic consequences are vastly overblown. Finally, the environmental/legal risk issues can be allocated away from banks through organizational structure and insurance. Since there also complementarities between traditional banking activities and commodity trading (which I discussed in posts from last summer) some commodity producers and consumers would pay higher costs if they could not enter into physical trading deals with banks: this is one reason why some of these producers and consumers object to limitations on bank participation in these markets. It’s hard to see the benefits of a ban (or restriction), but some costs are evident.

I doubt that will matter much in the end though. Commodities are a politically sensitive issue. Banks are a politically sensitive issue. Put them together, and the sensitivities are acute. Meaning that politics will largely drive the outcome.

Update. One other amusing part of the Brown-Warren letter. They say:

Some have argued it is preferable to allow commodities activities and physical asset ownership within the regulated banking system, rather than at the more lightly regulated commodity trading houses. As a general matter, the CFTC maintains authority to police fraud and manipulation in the commodities markets, regardless of the party engaging in such behavior.

So are banks somehow less subject to deterrence by the threat of CFTC action? If the objective  is to reduce the amount of manipulation and fraud, to justify forcing banks to eschew commodity trading it is necessary to argue that banks are  somehow less responsive to CFTC action than commodity trading houses. Maybe, but it’s not obviously true and I’ve seen no evidence that would support my view.

This relates to a point I made in earlier posts, namely, that if the economics are such that banks find it tempting to manipulate, non-banks will also find it tempting. Meaning that moving a business (e.g., metal warehousing) from a bank to a non-bank is unlikely to reduce the amount of manipulation.

One other thing needs to be said in this context. The Brown-Warren point is correct to the extent that it demonstrates that the term “lightly regulated” is used far too sloppily. Yes, trading houses are less subject to less of some kinds of regulation than banks, but they are subject to anti-fraud and anti-manipulation rules just as banks are. Similarly,  environmental laws and anti-trust laws and many other laws apply to these firms. “Lightly regulated” does not apply uniformly to all forms of bad conduct. The fact that commodity traders are not subject to some regulations that banks are (e.g., capital requirements) makes sense, given the differences between them.

Whenever anyone says “unregulated” or “lightly regulated”, I get suspicious and skeptical. Often those using these phrases are playing a shell game.

 

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Stiglitz on HFT

Filed under: Derivatives,Economics,Exchanges,HFT,Regulation — The Professor @ 11:39 am

Joe Stiglitz presented a paper on HFT at the Atlanta Fed conference earlier this week that has received a lot of attention. The paper is worth reading, but I actually recommend Felix Salmon’s synopsis, which breaks out the issues nicely.

I agree with Stiglitz in part, and disagree in part. The agreement is that Stiglitz hits many of the themes of my recent posts on HFT, notably that when there is private information, financial markets are unlikely to reach first best outcomes, and that making welfare comparisons is very difficult: I would say nigh-on to impossible, actually. Stiglitz also recognizes that HFT affects the incentives to collect information, which is another theme that I’ve emphasized.

Where I disagree is that Stiglitz (like DeLong) concludes from these insights that HFT is wasteful and should be restricted. This conclusion does not follow at all, and can be traced to some implicit assumptions about the nature of informed trading by non-HFT traders.

Stiglitz says “HFT discourages the acquisition of information which would make the market more informative in a relevant sense.” And by “relevant sense” he means fundamental information about the real economy. He laments that HFT “can be thought of as stealing the information rents that otherwise would have gone to those who had invested in information.” Further, he criticizes that much of what HFT does is merely accelerate the revelation of this information, and this acceleration is so small that it cannot improve any decision on any margin, and hence the resources used by HFT are wasted.

But this implicitly assumes that the information produced by non-HFT traders, the collection of which is reduced by the “stealing of information rents”, is in fact fundamental information that would improve decisions. But as I’ve noted repeatedly, many of the informed traders who HFT firms sniff out are producing information that does not improve any economic decision on any margin. Getting better information about an impending earnings report can be very profitable, but revelation of this information doesn’t improve decision making.

By assuming that non-HFT informed traders are producing information that invariably improves decisions, Stiglitz misunderstands what a great deal of informed trading is about, and thereby ignores a benefit of HFT order anticipation-based trading, and crucially, of HFT quote adjustments that cause markets to run away from big traders and thereby limits their ability to profit on their information.

One way to think about it is that there is cash flow relevant information, and decision relevant information. Pretty much all decision relevant information is cash flow relevant, but not all cash flow information is decision relevant. One major example is what Stiglitz emphasizes: the slight acceleration of revelation of information. But I claim that a lot of the information produced by institutional traders is of exactly this type. Stiglitz (and DeLong) ignore this, which leads them to biased appraisals of the efficiency of HFT.

That is, once one recognizes that some informed trading is rent seeking, and socially wasteful, “stealing of information rents” by HFT can be a feature, not a bug.

Stiglitz also ignores that even if HFT reduces the amount of decision relevant information produced and incorporated into prices, reducing this source of private information still reduces the adverse selection costs incurred by uninformed investors trading for portfolio rebalancing or hedging reasons. This reduction in adverse selection costs tends to improve the allocation of risk. This benefit must be weighed against any cost arising from the reduction in the production of decision relevant information.

In brief, Stiglitz and I agree that HFT reduces the incentive to collect information. Where we differ is that Stiglitz believes this is an unmitigated bad, whereas I strongly believe that this is totally wrong, because Stiglitz’s characterization of informed trading is very unrealistic. My point is that non-HFT informed trading can be parasitic, but Stiglitz does not recognize this or account for it in his analysis.

Stiglitz also complains that HFT liquidity is junk liquidity. In particular, prices move before large orders can be executed.

This is a variant on the criticism that HFT reduces information rents. Moreover, Stiglitz fails to make comparisons between realistic alternatives. The ability to adjust quotes faster reduces adverse selection costs, and allows HFT to quote tighter markets. Restricting HFT in some way will lead to wider spreads and lower quoted depth. Either way, big orders will have a price impact.

Stiglitz also claims that HFT reduces other, better forms of liquidity. Salmon actually explains this point more clearly:

HFT does not improve the important type of liquidity.

If you’re a small retail investor, you have access to more stock market liquidity than ever. Whatever stock you want to buy or sell, you can do so immediately, at the best market price. But that’s not the kind of liquidity which is most valuable, societally speaking. That kind of liquidity is what you see when market makers step in with relatively patient balance sheets, willing to take a position off somebody else’s book and wait until they can find a counterparty to whom they can willingly offset it. Those market makers may or may not have been important in the past, but they’re certainly few and far between today.

HFT also reduces natural liquidity.

Let’s say I do a lot of homework on a stock, and I determine that it’s a good buy at $35 per share. So I put in a large order at $35 per share. If the stock ever drops to that price, I’ll be willing to buy there. I’m providing natural liquidity to the market at the $35 level. In the age of HFT, however, it’s silly to just post a big order and keep it there, since it’s likely that your entire order will be filled — within a blink of an eye, much faster than you can react — if and only if some information comes out which would be likely to change your fair-value calculation. As a result, you only place your order for a tiny fraction of a second yourself. And in turn, the market becomes less liquid.

These points are pretty dubious. The kinds of market makers that HFT displaces (locals on futures exchanges, specialists, day traders) were hardly characterized by “relatively patient balance sheets.” Their holding periods were also quite short. Indeed, one of the filters academics use to identify HFT traders is firms that end the day flat: this exactly what most locals and specialists strove to do. And most traders that “do a lot of homework on a stock” were not doing so to supply liquidity through limit orders that they did not adjust frequently. Those who do a lot of homework are usually liquidity takers, not liquidity suppliers.

In sum, although Stiglitz’s analytical framework and broad conclusions are correct, his specific conclusions about HFT are not. They are not correct primarily because he has a very unrealistic view of the nature of informed trading. Once one recognizes that much informed trading is a form of rent seeking-the point that Hirshleifer made over 40 years ago-most of Stiglitz’s objections to HFT dissolve. Put differently, Stiglitz is right to believe that the financial sector may be too big, in part because there can be excessively strong incentives to collect information and trade on it, but he fails to take this point to its logical conclusion when evaluating HFT.

I do find it rather odd that strongly left-leaning economists like Stiglitz and DeLong who are broadly skeptical of financial markets focus their criticism on one new feature of those markets-HFT-without considering the implications of their broader critiques of the financial sector. At root, their criticism is that much financial market activity is rent seeking. If you believe that, you have to consider how HFT affects these rent seeking activities. Once you do that, it is impossible to sustain the critiques of HFT, because even if there are rent seeking aspects to HFT, it also can reduce other forms of rent seeking.

 

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April 12, 2014

A Serious Question For Brad DeLong

Filed under: Economics,Exchanges,HFT,Politics,Regulation — The Professor @ 4:39 pm

This is totally serious. 100 percent snark free. The answer (and more importantly, the explanation) will help make explicit assumptions and logic, and thereby advance the discussion.

So here it is:

Do you oppose or support laws prohibiting trading by corporate insiders on material, non-public information? (Alternative formulation: Do you support the expenditure of resources to enforce laws prohibiting trading by corporate insiders on material, non-public information?) Explain your reasoning.

The explanation is more important than the answer.

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Yes, Brad, It’s Just You (And Others Who Oversimplify and Ignore Salient Facts)

Filed under: Derivatives,Economics,Exchanges,HFT,Politics,Regulation,Uncategorized — The Professor @ 2:48 pm

Brad DeLong takes issue with my Predator/Prey HFT post. He criticizes me for not taking a stand on HFT, and for not concluding that HFT should be banned because it is a parasitic. Color me unpersuaded. De Long’s analysis is seriously incomplete, and some of his conclusions are incorrect.

At root, this is a dispute about the social benefits of informed trading. De Long takes the view that there is too little informed trading:

In a “rational” financial market without noise traders in which liquidity, rebalancing, and control/incentive traders can tag their trades, it is impossible to make money via (4). Counterparties to (4) will ask the American question: If this is a good trade for you, how can it be a good trade for me? The answer: it cannot be. And so the economy underestimates in fundamental information, and markets will be inefficient–prices will be away from fundamentals, and so bad real economic decisions will be made based on prices that are not in fact the appropriate Lagrangian-multiplier shadow values–because of free riding on the information contained in informed order flow and visible market prices. [Note to Brad: I quote completely, without extensive ellipses. Pixels are free.]

Free riding on the information in prices leading to underinvestment in information is indeed a potential problem. And I am quite familiar with this issue, thank you very much. I used similar logic in my ’94 JLE paper on self-regulation by exchanges to argue that exchanges may exert too little effort to deter manipulation because they didn’t internalize the benefits of reducing the price distortions caused by corners. My ’92 JLS paper applied this reasoning to an evaluation of exchange rules regarding the disclosure of information about the quantity and quality of grain in store. It’s a legitimate argument.

But it’s not the only argument relating to the incentives to collect information, and the social benefits and costs and private benefits and costs of trading on that information. My post focused on something that De Long ignores altogether, and certainly did not respond to: the possibility that privately informed trading can be rent seeking activity that dissipates resources.

This is not a new idea either. Jack Hirshleifer wrote a famous paper about it over 40 years ago. Hirsleifer emphasizes that trading on information has distributive effects, and that people have an incentive to invest real resources in order to distribute wealth in their direction. The term rent seeking wasn’t even coined then (Ann Kreuger first used it in 1974) but that is exactly what Hirshleifer described.

The example I have in my post is related to such rent seeking behavior. Collecting information that allows a superior forecast of corporate earnings shortly before an announcement can permit profitable trading, but (as in one of Hirshleifer’s examples) does not affect decisions on any margin. The cost of collecting this information is therefore a social waste.

De Long says that the idea that there is too little informed trading “does not seem to me to scan.” If it doesn’t it is because he has ignored important strands of the literature dating back to the early-1970s.

Both the free riding effects and the rent seeking effects of informed trading certainly exist in the real world. Too little of some information is collected, and too much of other types is collected. And that was basically my point: due to the nature of information, true costs and benefits aren’t internalized, and as a result, evaluating the welfare effects of informed trading and things that affect the amount of informed trading is impossible.

One of the things that affects the incentives to engage in informed trading is market microstructure, and in particular the strategies followed by market makers and how those strategies depend on technology, market rules, and regulation. Since many HFT are engaging in market making, HFT affects the incentives surrounding informed trading. My post focused on how HFT reduced adverse selection costs-losses to informed traders-by ferreting out informed order flow. This reduces the losses to informed traders, which is the same as saying it reduces the gains to informed traders. Thus there is less informed trading of all varieties: good, bad, and ugly.

Again the effects of this are equivocal, precisely because the effects of informed trading are equivocal. To the extent that rent seeking informed trading is reduced, any reduction in adverse selection cost is an unmitigated gain. However, even if collection of some decision improving information is eliminated, reducing adverse selection costs has some offsetting benefits. De Long even mentions the sources of the benefits, but doesn’t trace through the logic to the appropriate conclusion.

Specifically, De Long notes that by trading people can improve the allocation of risk and mitigate agency costs. These trades are not undertaken to profit on information, and they are generally welfare-enhancing. By creating adverse selection, informed trading-even trading that improves price informativeness in ways that leads to better real investment decisions-raises the cost of these welfare-improving risk shifting trades. Just as adverse selection in insurance markets leads to under provision of insurance (relative to the first best), adverse selection in equity or derivatives markets leads to a sub optimally small amount of hedging, diversification, etc.

So again, things are complicated. Reducing adverse selection costs through more efficient market making may involve a trade-off between improved risk sharing and better decisions involving investment, etc., because prices are more informative. Contrary to De Long, who denies the existence of such a trade off.

And this was the entire point of my post. That evaluating the welfare effects of market making innovations that mitigate adverse selection is extremely difficult. This shouldn’t be news to a good economist: it has long been known that asymmetric information bedevils welfare analysis in myriad ways.

De Long can reach his anti-HFT conclusion only by concluding that the net social benefits of privately informed trading are positive, and by ignoring the fact that any kind of privately informed trading serves as a tax on beneficial risk sharing transactions. To play turnabout (which is fair!): there is “insufficient proof” for the first proposition. And he is flatly wrong to ignore the second consideration. Indeed, it is rather shocking that he does so.*

Although De Long concludes an HFT ban would be welfare-improving, his arguments are not logically limited to HFT alone. They basically apply to any market making activity. Market makers employ real resources to do things to mitigate adverse selection costs. This reduces the amount of informed trading. In De Long’s world, this is an unmitigated bad.

So, if he is logical De Long should also want to ban all exchanges in which intermediaries make markets. He should also want to ban OTC market making. Locals were bad. Specialists were bad. Dealers were bad. Off with their heads!

Which raises the question: why has every set of institutions for trading financial instruments that has existed everywhere and always had specialized intermediaries who make markets? The burden of proof would seem to be on De Long to demonstrate that such a ubiquitous practice has been able to survive despite its allegedly obvious inefficiencies.

This relates to a point I’ve made time and again. HFT is NOT unique. It is just the manifestation, in a particular technological environment, of economic forces that have expressed/manifested themselves in different ways under different technologies. Everything that HFT firms do-market making, arbitrage activities, and even some predatory actions (e.g., momentum ignition)-have direct analogs in every financial trading system known to mankind. HFT market makers basically put into code what resides in the grey matter of locals on the floor. Arbitrage is arbitrage. Gunning the stops is gunning the stops, regardless of whether it is done on the floor or on a computer.

One implication of this is that even if HFT is banned, it is inevitable-inevitable-that some alternative way of performing the same functions would arise. And this alternative would pose all of the same conundrums and complexities and ambiguities as HFT.

In sum, Brad De Long reaches strong conclusions because he vastly oversimplifies. He ignores that some informed trading is rent seeking, and that there can be a trade-off between more informative prices (and higher adverse selection costs) and risk sharing.

The complexities and trade-offs are exactly why debates over speculation and market structure have been so fierce, and so protracted. There are no easy answers. This isn’t like a debate over tariffs, where answers are much more clean-cut. Welfare analyses are always devilish hard when there is asymmetric information.

Although a free-market guy, I acknowledge such difficulties, even though that means that implies that I know the outcome is not first best. Brad De Long, not a free market guy, well, not so much. So yes, Brad, it is just you-and other people who oversimplify and ignore salient considerations that are present in any set of mechanisms for trading financial instruments, regardless of the technology.

* De Long incorrectly asserts that informed trading cannot occur in the absence of “noise trading,” where from the context De Long defines noise traders as randomizing idiots: “In a ‘rational’ financial market without noise traders in which liquidity, rebalancing, and control/incentive traders can tag their trades, it is impossible to make money via [informed trading].” Noise trading (e.g., in a Kyle model) is a modeling artifice that treats “liquidity, rebalancing and control/incentive” trades-trades that are not information-driven-in a reduced form fashion.  Randomizing idiots don’t trade on information. But neither do rational portfolio diversifiers subject to endowment shocks.

It is possible-and has been done many, many times-to produce a structural model with, say, rebalancing traders subject to random endowment shocks who trade even though they lose systematically to informed traders. (De Long qualifies his statement by referring to traders who can “tag their trades.” No idea what this means. Regardless, completely rational individuals who benefit from trading because it improves their risk exposure (e.g., by permitting diversification) will trade even though they are subject to adverse selection.) They will trade less, however, which is the crucial point, and which is a cost of informed trading, regardless of whether that informed trading improves other decisions, or is purely rent-seeking.

 

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April 9, 2014

Smith and Bodek on Equity Market Reforms: Good, Bad, and Ugly

Filed under: Economics,HFT,Regulation — The Professor @ 1:44 pm

Fellow Houstonian Cameron Smith (of HFT shop Quantlab) and HFT gadfly Haim Bodek have an oped in the FT that makes recommendations on how to fix the US equity markets. (That’s a key right there. There’s HFT in futures, but it doesn’t generate near the heartburn as it does in equities.)

The recommendations are a mixture of good, bad, and ugly. The good are recommendations to fix RegNMS, specifically by allowing locked markets, and moving away from one-size-fits-all tick sizes.  The bad/ugly are their recommendations on dark pools and especially on exchange policies regarding data access and pricing.

All of this is too much for one post, so I will defer discussions of RegNMS reform and dark pools. I will focus here on the data issues.

Here’s what they say about data access and pricing:

Make market data free
Free market data would eliminate the disparity between professionals and investors. It would also cut the $400m of revenues divided among exchanges – which essentially subsidises the creation of otherwise useless markets. At the same time, we must ensure that data disseminated by the public consolidator is synchronised with the private exchange data feeds so that all the data are received by investors at the same time, eliminating the perception of unfairness. A technology company should be dedicated to this task.

This is bad/ugly because overlooks the basic microeconomics of entry and investment into HFT. Let’s think through the implications of this recommendation.

The fundamental error is in the first sentence: making data free would not eliminate the disparity between professionals and investors. Nor would making it possible for all participants to access the data simultaneously by synchronizing the data feeds.  To understand where Smith and Bodek err, it is necessary to think through the equilibrium effects of their recommendation.

There would still be disparities because access to data is a necessary but not sufficient condition to eliminate them. HFT firms take the private data feed they get from exchanges, and also make additional investments in hardware and software in order to use that data to drive their trading strategies. Without these complementary investments, the data is useless in implementing HFT-type strategies. Given the cost of private data feeds, there is investment in hardware and software and other supporting resources to implement HFT. In a reasonably competitive market, entry and investment in these other resources will proceed to the point where for the marginal HFT firm, risk adjusted profits cover its cost of capital. We’ve seen that process in action: HFT profits were high in 2008-2009, but have subsequently fallen substantially as entry and investment into this business has occurred.  This is the way that competitive markets work.

Note that not everybody decides to make the investments in the resources necessary to implement HFT. Even many big institutional investors eschew doing so. Certainly individual investors do. This is because the returns on the investment in hardware and software (where returns depend on the costs of data) do not cover the related capital costs. This is why disparities exist. The disparities in speed and strategies are the result of maximizing choices made by myriad market participants, and these maximizing decisions reflect the costs of engaging in various market activities.

Understanding this, let’s consider the economic effects of mandating free access to data and synchronizing access. To a first approximation, data charges are a fixed cost. Therefore, making data free would reduce the fixed costs of becoming an HFT firm. Reducing fixed costs will induce entry into HFT: costs are just covered by the marginal firm when data must be paid for, meaning that when data is free all existing firms at existing scale will earn profits above the cost of capital.  This economic profit induces entry. Entry means there will be more HFT activity when data is free. (If lowering data charges also reduce the marginal costs of HFT, existing HFT firms will expand, reinforcing this effect.)

Again, entry will occur to the point where the profits of the marginal HFT firm cover the cost of capital.  Moreover, many market participants will choose not to make the additional investments required to engage in HFT. There will still be disparities. Some firms will be faster than others (i.e., the firms that make the investments necessary to engage in HFT will be faster than “investors” who don’t make the investments in hardware and software and people necessary to engage in HFT.) Moreover, there will be more HFT activity, for the simple reason that the cost of engaging in HFT has gone down.

In other words: if you want to want to reduce disparities and discourage entry into HFT, don’t make data free, tax it. Smith and Bodek’s policy recommendation will have the exact opposite effect from what they intend.

There are other things to consider here. Data revenues represent a substantial source of income for exchanges. Forcing them to forego these revenues will affect their economics. It is conceivable that the loss in revenue will induce some exchanges to exit, reducing competition which would tend to result in an increase in fees paid by investors. Even if exit doesn’t happen, the loss of revenue may affect exchange decisions on other margins: they may choose, for instance, to invest less in systems or technology. I just raise this as a possibility: the effects of the loss of data revenues on these other decision margins are likely to be complex and subtle, and I don’t pretend to understand them, and to do so would require considerable research and thought. (Moreover, given my agnosticism about the welfare effects of financial trading generally, the effects of adjustments on these other margins on welfare are even more complex and mysterious.)

This analysis brings out a general point. You need to think through the equilibrium implications of policy changes, taking into account how market participants will respond on all margins. Making data free reduces the costs of engaging in HFT. This induces entry into HFT, and leads to more of it, not less.

In other words, in analyzing HFT and market structure generally, not just microstructure is important. Microeconomics 101 is too.

 

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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 29, 2014

Margin Sharing: Dealer Legerdermain, or, That’s Capital, Not Collateral.

Concerns about the burdens of posting margins on OTC derivatives, especially posting by clients who tend to have directional positions, have led banks to propose “margin sharing.”  This is actually something of a scam.  I can understand the belief that margin requirements resulting from Frankendodd and Emir are burdensome, and need to be palliated, but margin sharing is being touted in an intellectually dishonest way.

The basic idea is that under DFA and Emir, both parties have to post margin.  Let’s say A and B trade, and both have to post $50mm in initial margins.  The level of margins is chosen so that the “defaulter (or loser) pays”: that is, under almost all circumstances, the losses on a defaulted position will be less than $50mm, and the defaulter’s collateral is sufficient to cover the loss.  Since either party may default, each needs to post the $50mm margin to cover losses in the event it turns out to be the loser.

But the advocates of margin sharing say this is wasteful, because only one party will default.  So the $50mm posted by the firm that doesn’t end up defaulting is superfluous.  Instead, just have the parties post $25mm each, leaving $50mm in total, which according to the advocates of margin sharing, is what is needed to cover the cost of default.  Problem solved!

But notice the sleight of hand here.  Under the loser pays model, all the $50mm comes out of the defaulter’s margin: the defaulter pays,  the non-defaulter receives all that it is owed, and makes no contribution from its own funds.  Under the margin sharing model, the defaulter may pay only a fraction of the loss, and the non-defaulter may use some of its $25mm contribution to make up the difference.   Both defaulter and non-defaulter pay.

This is fundamentally different from the loser pays model.  In essence, the shared margin is a combination of collateral and capital.  Collateral is meant to cover a defaulter’s market losses.  Capital permits the non-defaulter to absorb a counterparty credit loss.  Margin sharing essentially results in the holding of segregated capital dedicated to a particular counterparty.

I am not a fan of defaulter pays.  Or to put it more exactly, I am not a fan of mandated defaulter pays.  But it is better to confront the problems with the defaulter pays model head on, rather than try to circumvent it with financial doubletalk.

Counterparty credit issues are all about the mix between defaulter pays and non-defaulter pays.  Between collateral and capital.  DFA and Emir mandate a corner solution: defaulter pays.  It is highly debatable (but lamentably under-debated) whether this corner solution is best.  But it is better to have an open discussion of this issue, with a detailed comparison of the costs and benefits of the alternatives.  The margin sharing proposal blurs the distinctions, and therefore obfuscates rather than clarifies.

Call a spade a spade. Argue that there is a better mix of collateral and capital.  Argue that segregated counterparty-specific capital is appropriate.  Or not: the counterparty-specific, segregated nature of the capital in margin sharing seems for all the world to be a backhanded, sneaky way to undermine defaulter pays and move away from the corner solution.  Maybe counterparty-specific, segregated capital isn’t best: but maybe just a requirement based on a  firm’s aggregate counterparty exposures, and which doesn’t silo capital for each counterparty, is better.

Even if the end mix of capital and collateral that would result from collateral sharing  is better than the mandated solution, such ends achieved by sneaky means lead to trouble down the road.  It opens the door for further sneaky, ad hoc, and hence poorly understood, adjustments to the system down the line.  This increases the potential for rent seeking, and for the abuse of regulator discretion, because there is less accountability when policies are changed by stealth.  (Obamacare, anyone?)  Moreover, a series of ad hoc fixes to individual problems tends to lead to an incoherent system that needs reform down the road-and which creates its own systemic risks.  (Again: Obamacare, anyone?)  Furthermore, the information produced in an honest debate is a public good that can improve future policy.

In other words, a rethink on capital vs. collateral is a capital idea.  Let’s have that rethink openly and honestly, rather than pretending that things like margin sharing are consistent with the laws and regulations that mandate margins, when in fact they are fundamentally different.

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March 24, 2014

Abbot and Costello Do Manipulation Enforcement

Filed under: Commodities,Economics,Energy,Politics,Regulation — The Professor @ 7:36 pm

I heard a hilarious story the other day about an incident that occurred when European Commission investigators raided a trading shop in connection with the Brent investigation.  While going through trader emails and documents, one of the crack investigative team came across numerous documents about trading on ICE.  The investigator was puzzled, so he asked the a lawyer for the trading company: “You trade ice?”  Lawyer: “Yes, we trade on ICE.”  Investigator: “You mean you really trade ice?  Frozen water?”  Lawyer: This is my please-tell-me-you’re-sh*tting-me face.

No prizes for figuring out which was Abbot, and which was Costello.

We are in the best of hands.  The best of hands.

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