Streetwise Professor

April 23, 2014

File Under “Dog Bites Man”: Exchange Monopolies and Dark Pools

Filed under: Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 2:13 pm

An exchange chairman believes that all trading should take place on exchanges. In commenting on securities market structure, CME Group Chairman Terry Duffy criticizes fragmentation-especially the existence of dark pools-and touts the lack of fragmentation in futures trading.

The concentration of trading activity on futures exchanges, as opposed to the fragmentation across different exchanges (as well as off-exchange venues) in equities is due to a major difference in the treatment of orders. In futures markets, exchanges own their order flow: hypothetically, if there was another exchange posting a better price in a particular product, CME would not be obligated to direct an order to that better-priced market. When exchanges own their order flow in this way, traders direct orders to the exchange where they expect to get the best price. This is typically the market where most traders are. This creates a centripetal force that causes all activity to tip to a single dominant exchange. That is why CME, Eurex, ICE, etc., have monopolies or near monopolies in the products they trade. (And yes, Terry, even though no one is stopping anyone from competing with you, this order flow effect means that no one can do so effectively, leaving you a de facto monopoly. Only LIFFE’s idiocy in its battle with Eurex in 1998 allowed the Germans to get trading in the Bund futures to tip their way.)

This is the way it used to be in equities too. Prior to the late-2000s, the NYSE effectively owned its order flow, and 80-85 percent of trading volume in NYSE listings took place on the NYSE. The remainder occurred on “third markets” that catered to the verifiably uninformed (more on this below).  But in 2005 the SEC changed the rules in a fundamental way. It passed RegNMS, which socialized order flow by requiring exchanges to route orders to others displaying better prices. Within a very short period, a handful of exchanges executing between 8-20 percent of volume competed fiercely with one another. The NYSE’s effective monopoly had been broken.  This is why Goldman paid $6.5 billion for a specialist unit in 2000, and sold it for $30 million this year. The 2000 price capitalized monopoly rents: there are none to capitalize in 2014.

Duffy says he’s fine with this kind of fragmentation  of trading across exchanges with the associated intense competition (though that’s very easy for him to say because he doesn’t have to worry about that outcome given the lack of a RegNMS-type rule in futures markets), but he thinks dark pools should be shut down.

To evaluate this position, you need to understand what role dark pools play. Just like third markets and block markets of the pre-RegNMS era, dark pools (and internalization of retail order flow) are a ways of screening out informed traders. This reduces the costs of the uninformed who can trade on dark pools be reducing their vulnerability to adverse selection. This is good for them, but the overall effects are much harder to understand. Order flow on exchanges becomes more toxic (i.e., a higher proportion of the order flow is informed) which raises adverse selection costs on exchanges, and thereby raises trading costs there.

The net effect of this is very difficult to determine. This is another application of the second best. Since exchanges may have market power, the additional competition from off-exchange venues can improve efficiency even if it raises adverse selection costs for some traders. Moreover, as I’ve argued in my HFT posts recently, since some informed trading is of the rent seeking variety, by reducing the returns to informed trading dark pools can reduce wasteful investments in information.

This means that Duffy’s criticism of dark pools might be right. But it might be wrong.

One thing is definitely true. Market structure has huge distributive effects. Although the rules on dark pools have very uncertain efficiency effects, there is no doubt that these rules affect the distribution of costs and benefits across different types of traders. It is precisely these distributive effects which make the battles over market structure so divisive and protracted.

I’d also note that Duffy ignoring some features of futures markets, and derivatives markets generally, that perform functions similar to dark pools. For instance, CME allows block trading. Indeed, it is engaged in a tussle with the CFTC, which wants to reduce the amount of block trading in order to force more volume into the order book.

But block trades are a way that less-informed large traders can reduce adverse selection costs. They have long performed this function in equity markets, and are now doing so in futures. And by stripping out that order flow from the order book, block trades have the same effects as dark pools.  Blocks are a form of fragmentation.

Block markets are non-anonymous: that’s how they screen out the informed. Block traders won’t deal with those they believe likely to be informed, and by trading face-to-face traders can develop reputations for not being informed and profiting systematically at the expense of their counterparties.

Well, wouldn’t you know it, but this is how OTC derivatives markets work too. The lack of price transparency in OTC markets is often bewailed, but OTC markets are transparent in another important way that exchanges are not: they offer counterparty transparency, whereas exchanges are counterparty opaque. This benefits, say, firms that are trading to hedge in large volume (who are likely to be uninformed). It’s not a surprise that trading activity migrated from OTC to blocks on CME and ICE after Frankendodd made swaps trading more expensive. Both futures blocks and swaps are ways of reducing the execution costs of large, likely uninformed traders.

Put differently: blocks (and swaps) are a form of fragmentation, in the sense that they divert trading activity away from the limit order book. So Duffy shouldn’t be quite so sure about the superiority of the futures market model. It is fragmented in its own way, and has a lot more market power. But of course Duffy likes the last part, though he would never admit it.



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April 20, 2014

May the Farce Be With You, Geneva Edition

Filed under: Military,Politics,Russia — The Professor @ 4:46 pm

Marx said that history repeats itself, first as tragedy, then as farce.

Perhaps the best interpretation of Geneva, 2014, is that it is the farcical doppelgänger of Munich, 1938.

It was apparent to anyone not willfully blind that Geneva was doomed to failure. There was no enforcement mechanism. And within hours, it became clear that the Russians intended to use the agreement as a reason to ratchet up its offensive against the Kiev government, and had no intention to force evacuation of any buildings by its forces in eastern Ukraine. The Russians are demanding that the Kiev government go after any group that Moscow does not like.

And you know what will happen. The Russians will use the failure of Kiev  to bend to their will as a pretext for refusing to do anything in Donestk, and for invading or supporting separatists.

I have to conclude that Kerry enjoys getting punked by Lavrov in Geneva. If he doesn’t, why does he do it so regularly?

Insofar as enforcement is concerned, the Geneva agreement lays out a special role for the OSCE. But check out this organizations description of its activities in Ukraine. Totally passive. Merely an observer. I’ve heard of alpha males. I’ve heard of beta males. OSCE comes off as omega males. Who have been eunuched.

And not surprisingly, the Russian forces in eastern Ukraine are totally blowing them off.

But don’t worry, OSCE is going to persuade them with sweet reason!:

After a meeting in Kiev on Saturday with diplomats from the four parties to the Geneva accord, Swiss envoy Christian Schoenenberger, whose country is chair of the OSCE, said its monitors had already spoken to the separatists: “For the time being the political will is not there to move out,” he said.

“That’s the task of the monitors, to create this political will, inform the people, so eventually they will understand that the best option for them is to move out,” he told reporters.

I don’t know whether to laugh, cry, or pound my head against the wall.

The article I linked to is titled “Surrender talks set with separatists in Ukraine.” It is beyond obvious that it is OSCE whose surrender is being negotiated.

But the farce does not end with Geneva. Perhaps stung by the criticism of his dancing to organ grinder Vladimir’s tune, Eddie Snowden penned a defense of his conduct that ran in the Guardian. Never fear, people, the article had its allotted content of narcissistic Snowden gasbaggery. (Just how many times do you have to mention risking your life, Ed.) But the best (and by best, I mean worst) part was this:

Moreover, I hoped that Putin’s answer – whatever it was – would provide opportunities for serious journalists and civil society to push the discussion further.

When this event comes around next year, I hope we’ll see more questions on surveillance programs and other controversial policies. But we don’t have to wait until then. For example, journalists might ask for clarification as to how millions of individuals’ communications are not being intercepted, analysed or stored, when, at least on a technical level, the systems that are in place must do precisely that in order to function.

I have to say it. What planet does this guy live on?

Journalists? You mean the ones that are beaten or killed if they challenge Putin? (The name Politkovskaya ring a bell, Ed?) Civil society? You mean the individuals and organizations that Putin and the Russian state have relentlessly ground into the dust over the past several years?

And just what answer would Snowden expect Putin to deliver to any journalist-with-a-death-wish who poses these questions?

Snowden’s Guardian piece comes off as more of a taunt than serious defense. He was only allowed to ask his question because the FSB approved it, and set up the entire apparatus for him to ask it. The Guardian article means nothing, because the Russians have to at least attempt to maintain the pretense that Snowden is not the organ grinder’s monkey that he actually is.

To show how farcical this is, check out Kucherena’s explanation of the situation:

Mr. Snowden’s Russian lawyer, Anatoly Kucherena, denied his client had been pressured to participate.

“He decided to do this himself. There was no negotiation with the Kremlin,” he said. “Edward had the opportunity, so he asked the question.” Questions could be submitted ahead of the event in writing or in video form via a website or mobile application.

Um, just how did this “opportunity” magically appear?

Kucherena’s risible attempt to claim that this was not an FSB-arranged performance is the most telling proof that it was an FSB-arranged circus.

One more item in the farcical chronicles.  German FM Frank-Walter Steinmeier is pimping for Putin harder than ever:

German Foreign Minister Frank-Walter Steinmeier said he wished as much emphasis would be placed on preventing an escalation of tensions with Russia over Ukraine as there is at the moment in threatening economic sanctions.

In an interview to appear in Germany’s Bild am Sonntag newspaper on Sunday, Steinmeier appeared to be referring to threats from the United States as well as from within Germany about the need for economic sanctions against Russia.

“I sometimes wish that the same engagement being used for the debate about sanctions would also exist when it comes to avoiding a further escalation,” Steinmeier told the Sunday newspaper, according to excerpts released before publication.

Yeah, because Putin is putting so much effort into avoiding escalation.

Steinmeier is a snake at the bosom of the western alliance. Germany is totally compromised, and the US must accept that when crafting its own actions, such as they are. Germany is giving more proof by the day that whatever resources NSA devoted to spying on it, it was not enough.

One piece of news is that the US is considering going after Putin’s billions. I’ll believe it when I see it. For now, that appears to be just another part of the FUD campaign that the US is waging in place of actually doing something. But FUD doesn’t work unless the threats are credible, and the threats aren’t credible unless you carry through on them. Obama has repeatedly failed to do so, and as a result, these whispered and leaked threats will have zero effect whatsoever.

I fear the farce will be with us, for many years to come. The current farce stems from a fatal lack of will in the west, and that is not going away anytime soon.

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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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April 17, 2014

Ukraine Update: Charlie Brown, Lucy, the Organ Grinder and His Monkey

Filed under: Military,Politics,Russia,Snowden — The Professor @ 10:05 pm

The farce involving Ukraine continues. Today John “Charlie Brown” Kerry and Sergei “Lucy” Lavrov met in Geneva, the scene of many previous Kerry pratfalls, mostly involving Syria. (Yeah, the Euros were there. Like that matters. Well, I guess someone has to make sure the places are set properly, with the forks in the right spot and all that stuff.)

Even after having Lucy pull the ball away time and again, Charlie Brown had another go at “diplomacy,” which in Russian means “war continued by other means.” In military terms, the Russians treat diplomacy with the US as a delaying action, knowing the US won’t do anything meaningful as the “process” is “working.” In Syria, Assad has used Russian diplomatic cover to turn the tide of war decisively in his favor.

Kerry and Obama have apparently never heard Einstein’s definition of insanity: doing the same thing over and over, and expecting different results. Maybe Kerry should hop the train to Bern and visit the Einstein museum. Maybe he’ll collect a clue.

This time around, Putin and the Russians are using the diplomatic pause to delay the implementation of meaningful sanctions. UST is continuing the FUD game, holding meetings with hedge funds and money managers to inquire about their Russian investments, knowing that the inquiries would be leaked, and perhaps spook the markets. But truly throttling sanctions will remain in abeyance as long as the jaw jaw continues. Putin is also using the diplomatic pause to continue infiltration and subversion in Ukraine. The Ukrainians are constrained by their own divisions, and incompetence, but the US is also restraining them while talks continue.

The meetings produced this paean to the passive voice:

All illegal armed groups must be disarmed; all illegally seized buildings must be returned to legitimate owners; all illegally occupied streets, squares and other public places in Ukrainian cities and towns must be vacated.

Who is going to do the disarming? The returning? The vacating? The GRU and the 45th Airborne and the locals are just going to say “my bad” and walk away? Really? I see objects here, but no subjects.

This hardly inspires confidence:

It was agreed [more passivity!] that the OSCE Special Monitoring Mission should play a leading role in assisting Ukrainian authorities and local communities in the immediate implementation of these deescalation measures wherever they are needed most, beginning in the coming days.

The OSCE? You mean the guys who were prevented from entering Crimea? My confidence is not inspired! (Damn, this passive voice thing is contagious!)

The Russians deny anyone in eastern Ukraine is theirs, so they can disclaim any responsibility. The Ukrainian military is too intimidated to take them on. The OSCE has no army to back it up. So I doubt much disarming, vacating, etc. will actually, you know, be happening.

But I forgot. “Local communities” are going to do it! This is a job for Community Organizer Man! Obama can follow his true calling!

Just one problem. Those “local communities” in large part support the “Pro-Russian” (or “pro-federalist”) forces, to the point of surrounding Ukrainian APCs so that the “local militias” could seize six of them. (As an aside, let’s give the “pro-Russian” bullshit a rest. It is more accurate to say “Russian pros.”) (Actually, the active supporters are few, but characteristic Russian apathy in the vast majority means that a few can achieve their objectives.)

All meaning that this plan will work out about as swell as the plan to eliminate Assad’s chemical weapons that Lucy used to entice Charlie into taking a big kick at the Syrian football, winding up flat on his back as always.

But as hard as it is to believe, the comedy in Geneva pales in comparison to the total farce in Moscow, where Putin held one of his call in shows. The whole thing was a carnival of mendacity, all too familiar to discuss in detail. But the banal absurdity of a VVP presser was excelled by a new high (or is it low) in farcicality: Snowden (in another Wizard of Oz appearance on a large screen) asked Putin whether Russia, that paragon of privacy and individual liberty, engaged in mass surveillance against its citizens. “Nous? Nous? Jamais!” responded Vladimir Vladimirovich. Even worse, Putin answered only after acknowledging Snowden as a fellow Chekist, and hence a man he could understand and respect. The pair posed for a photo after the event (Eddie is on the left):


There may be some uncertainty as to whether Snowden was Putin’s monkey before he decamped to Sheremetyovo, but there is no doubt now. Eddie is now totally owned and operated by Putin and the FSB.

But despite all this Obama and Kerry think that Putin and Lavrov are legitimate interlocutors, interested in reaching mutually beneficial deals.

David Ignatius had a column in the WaPo yesterday describing the administration as being “flummoxed” by Putin’s refusal to see reality the same way Obama does. Believe me, “flummoxed” is never a good thing.

I swear to God, mirror imaging is going to be the death of the west. Distressingly, good little mouthpiece that he is, Ignatius reports that Obama’s strategy is “to make Putin pay for his adventurism, long term. Unless the Russian leader moves quickly to de-escalate the crisis, the United States will push for measures that could make Russia significantly weaker over the next few years.”

Excuse me while I go bang my forehead on the corner of my desk. In the long term we are all dead. At least a lot of Ukrainians may be.

And the point of this is what, exactly? Just how will this deter Putin? And note that the administration will just be “push[ing] for measures that could make” Russia weaker. Not implementing. Pushing for: what happened to Mr. Executive Order? (Sounds like more community organizing is involved.) Not measures that will make Russia weaker, but “could.” And Putin cares about tomorrow. The long term-whatever.

To give you an idea of Putin’s mindset, and how little he cares about Obama’s incredible threats to push for some measures that could impose some costs at some ill-defined future date, the Russian president used the term Novarossiya to refer to parts of Ukraine. Meaning that his irredentist goals remain, undeterred. (And does anybody else notice that the only thing that Putin criticizes the leaders of the USSR for is their penchant for redrawing borders in ways that put traditional Russian territories outside of the Russian Soviet Socialist Federative Republic?)

Russia is weak economically, demographically, and militarily. The US is none of those things. It is weak by choice, and letting Putin proceed in his irredentist and revanchist mission.

We are so screwed.

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April 14, 2014

Men Without Chests: The Pusillanimity Riot

Filed under: Military,Politics,Russia,Uncategorized — The Professor @ 8:33 pm

The egregious pusillanimity, fecklessness, and cravenness in the US, Europe, and Ukraine, metastasizes day by day.

Today Obama, at Putin’s request, spoke with the Russian president.

That’s problem one. Obama should have said: we have nothing to talk about until you call off your dogs in eastern Ukraine, move your troops away from the border, and cease all economic pressure on Ukraine.

And yeah, all the previous five talks made such a big freaking difference. Hasn’t Obama heard about Einstein’s definition of insanity? Or maybe he is a glutton for punishment, and gets some perverse pleasure out of being Putin’s bitch.

Why do you think Putin asked for the call? The most likely explanation is that he gets off on having Obama being his supplicant, and then telling him to sod off.

Obama expressed “grave concern.” Judas Priest, if I hear “grave concern” or “deep concern” or “great concern” one more time I am  going to have a stroke. The most vacuous phrase in the English language, because this airy “concern” is never transformed into action.

It gets worse, if you can believe that’s possible:

[Obama] urged President Putin to use his influence with these armed, pro-Russian groups to convince them to depart the buildings they have seized.

“Use his influence”? Seriously? Barry-they are under Putin’s orders, as anyone with two eyes and a room temperature IQ can understand.

But it gets even worse!

Obama to reassure Putin: Won’t provide lethal aid to Ukraine

The White House on Monday said President Barack Obama would speak to Russian President Vladimir Putin soon, perhaps later in the day, and made clear the United States was not considering lethal aid for Ukraine.

“We are looking at a variety of ways to demonstrate our strong support for Ukraine including diplomatically and economically,” White House spokesman Jay Carney told reporters.

“We’re not actively considering lethal aid but we are reviewing the kinds of assistance we can provide,” he said

Reassure Putin? Huh? So he can, after being suitably reassured, proceed to gobble up Ukraine with no fear of humiliating defeat, or even breaking a nail?

Here’s a thought: “Hey, Vlad. Remember those Kornet ATGMs that wound up in Hezbollah hands and caused the Israelis huge problems in Lebanon in 2006? Good times, good times. Well, anyways, since one good turn deserves another, we’re supplying  Javelins and TOWs out the wazoo to Ukraine. And we have all these Dragons that we’ve phased out laying around, but they were designed specifically to take out T-72s, and it would be a shame to have them sit around going to waste.  The C-130s and C-5s are winging their way as we speak. We’re nothing if not generous, and I hope you appreciate the spirit in which these are given. Have a nice day!”

If you can handle more, there’s this:

The President noted Russia’s growing political and economic isolation as a result of its actions in Ukraine and made clear that the costs Russia already has incurred will increase if those actions persist.

Obviously our genius president hasn’t figured out that Putin wants to isolate Russia: isolation is a feature, not a bug. He has made it quite clear that he views the west as a malign force, and fears that western ideas and influence threaten his control over Russia. But Obama so believes that everyone views the world the same way as he and the Harvard faculty and the Euros do, and would  just die! at the thought of being cut off from their wine and cheese parties. Mirror imaging will be the death of us.

And insofar as costs are concerned, even the seriously mentally challenged will have concluded that the “costs” that have been imposed heretofore have not checked Putin in the slightest. This implies that if Obama is serious about deterring Putin, he must dramatically ratchet up the pressure. Dramatically: the costs must be increased by orders of magnitude. The additional sanctions announced last week just convinced Putin of Obama’s lack of seriousness: yeah, like Putin could give a damn about the Crimean oil and gas company. Rosneft and Gazprom, and Sberbank and VTB: maybe that would get his attention.  But instead of stabbing brutally at the jugular, Obama gingerly pricks the capillaries.

Sadly, Obama has plenty of company in his pusillanimity riot.

The Euros have announced that they might have a meeting in a week or so to discuss the “emergency” in Ukraine. If it can wait a week, it ain’t an emergency. Disgusting. The Euros give every impression of someone who hopes that Putin will prevail in the next couple of days, so they can throw up their hands and say “Too bad! There’s nothing we can do now!”

But the Ukrainian “leadership” gives Obama and the Euros a run for their money for the Craven Cup. It is obviously paralyzed at the thought of exercising control over its own territory, and this paralysis just spurs on Putin. Acting President Turchynov declared that the military would undertake an “anti-terrorist” operation against those who have seized government buildings and facilities (including air bases) throughout eastern Ukraine. But as of yet, nothing serious has happened. This is stoking popular anger at the new government: Maidan may very well reconstitute itself to demand ouster of this government out of outrage at the abject failure to defend Ukraine from invasion by Russia.

If the World War II cohort was “the greatest generation,” we are its antithesis. We are the living personification of what C.S. Lewis called “men without chests.” Denatured humans, enervated by a smug rationalism that is profoundly irrational because it fails to take the world as it is, populated by people who see things much, much differently, and who act accordingly.

“We make men without chests and expect from them virtue and enterprise. We laugh at honor and are shocked to find traitors in our midst.”

That is where we are now.


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April 12, 2014

Putin Loops the West’s OODA Loop

Filed under: History,Military,Politics,Russia — The Professor @ 6:35 pm

Russia has commenced its invasion of eastern Ukraine. No, tanks have not rolled over the border, and Sukhois are not dropping bombs on Kharkov or Donetsk. But the invasion has begun, with the seizure of government buildings in several eastern cities by armed men. Men dressed in combat garb carrying advanced automatic weapons (including AK-100s with grenade launchers).

No, these troops have not declared that they are Russian soldiers. But that just adds to the outrageousness. What’s more, this is exactly the Crimea MO. Exactly. Recall that the Russians swore up and down that those who took over Crimea weren’t theirs. Until Putin let the cat out of the bag and bragged how the Crimean operation had demonstrated the tremendous progress that had been made in reforming the Russian military.

Post-Crimea, Occam’s Razor tells you that Little Green Men popping up anywhere in the Near Abroad are taking orders from Putin. This is an invasion.

And why shouldn’t he take another slice of Ukraine? The US and EU have said that they might maybe could ramp up sanctions a little bit if Putin’s tanks roll into Kyiv. But they let him take a slice-Crimea-with virtually no consequence. So why shouldn’t he take another slice? And once he digests this one, another? And another?

It is beyond obvious that the US and EU are desperate to avoid facing hard realities. They don’t want to confront Putin. The bleat about diplomacy and off-ramps and de-escalation, which Putin translates into “surrender.” And rightly so. So he will advance inexorably.

The Ukrainian government is paralyzed. It realizes that if it exercises force against the intruders that Putin will use that as a pretext to unleash the forces massed on the border. It knows that it is unlikely that the US/Nato will provide any meaningful assistance in that event. So it goes fetal.

These are the wages of fecklessness. Yet again.

We are governed by-I will not say led by-craven midgets. Obama played golf today. He spent last week making scurrilous charges of racism against his real enemies: the Republicans. That’s when he wasn’t hyping Obamacare while defenestrating the cabinet secretary charged with its implementation. Biden will be traveling to Ukraine Tuesday. Not this Tuesday, silly:  next Tuesday, the 22d.  Joe is probably still working on his taxes, and has plenty of fundraisers to attend to in the interim. So first things first. It’s the weekend, so Europe is, um, unavailable.

Clausewitz called “the offensive” the first principle of warfare. By this, he meant that the combatant with the initiative has a decisive advantage. He can choose the time and place to attack, and do so in a way that exploits his advantages and his enemy’s disadvantages.

Putin has the initiative. In part this is due to the fact that his adversary-Nato-is a coalition, and decision making in coalitions is inherently slow, and its councils divided. (I recall a story of Napoleon rejoicing to learn that another country had joined a coalition against him.)

But the United States in particular has the ability to act unilaterally, and drag Nato along with it. The US could unilaterally impose crippling costs on Russia, by effectively cutting off its access to the world banking system. Yes, this would cause the Germans and the Brits to squeal. But so be it. Leadership must sometimes be exercised with the flat of the sword laid to the backs of necks.

Putin has the initiative because Obama has conceded it to him.

The western OODA loop-observe, orient, decide, act-is pitifully slow. It is slow because of an intense desire to avoid conflict and to deny the reality of Putin’s behavior. It is slow because of a conscious choice of the US to abdicate leadership, and to defer to countries like Germany that have a deeply compromised relationship with Russia.

This means that Putin can easily keep the initiative because the US has deliberately chosen to cede the initiative to him. He can get inside our OODA loop over and over again. He can present us with faits accompli.

Until Obama-and no one else-bestirs himself to confront Putin, the Russians will continue to take slice after slice of Ukraine. Perhaps some parts will be incorporated into Russia, and other parts set up as formally independent Russian satrapies. But the formalities are irrelevant. Unless Putin is confronted, before long all of Ukraine will be subordinate to Russia.

And once that is accomplished, why should you think that Putin’s thirst to restore the USSR will be slaked? And it is not just about Putin and Russia. Once the idea that irredentism and revanchism will not be confronted takes hold, it will not be limited to the FSU. Obama is sowing the wind. His successors-and you and me-will reap the whirlwind.


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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 10, 2014

Germany & Russia: Psychology, Ideology, Economics–and Romanticism

Filed under: History,Politics,Russia,Snowden — The Professor @ 7:11 pm

In a sign of the impending apocalypse, Der Spiegel has run several articles that evaluate critically Germany’s all too accepting and “understanding” approach to Russia, including during the Ukraine and Crimea crises. The articles argue that there is a volatile brew of psychology (neuroses, actually), philosophy, and ideology, which when combined with the economic interests of German industry, makes Germany ambivalent at worst about Russia.

World War II of course plays a central role in this. One of the articles notes that the Germans are acutely conscious of the horrific things they did in the East, and that despite that, the Russians do not really hold that over the Germans. This impels the Germans to make amends, and makes them somewhat grateful to the Russians. In contrast American moralism about German actions during the war rankles the Germans deeply: this helps explain why the Germans revel in shrieking about American transgressions, notably Viet Nam and more lately, Snowden. If the Americans are morally tainted, Germans can feel less guilty about their past. (Similar considerations apply with force to German attitudes towards Israel.)

One point that the articles all make is the deep anti-western streak in German thought and attitudes. The similar anti-westernism in Russia, which is central to Putin’s new ideology, therefore resonates deeply in Germany and makes Germans think that Russians are kindred spirits.  These attitudes are particularly pronounced in the former GDR.

More specifically, there is a strong element of anti-Anglo Saxon-ism in both German and Russian thought.

This anti-westernism is rooted in Romanticism. Five years ago, I wrote a post drawing the parallels between the Romantic elements in German and Russian culture and thought.  Here’s a taste:

Following on Pauli, Viereck hypothesizes that German Romanticism was the product of the division of Germany between the Latinized West and the Barbarian East.  That Germany was on the divide between two civilizations with wildly different mental and moral universes.  Romanticism was a revolt of the East against the West.

Russia, too, has a very uneasy, conflicted relationship with the Latinized West.  Indeed, although the dividing line did not run directly through Russia, as it did Germany (thanks to Hermann/Arminius), post-Peter I’s introduction of Western ideas into Muscovy, the same conflict has rent Russia, with many of the same consequences, political and psychological.  The Slavophiles and latterly, the Eurasianists (new and old), are in essence Russia’s indigenous Romantics.  (It is well known that German Romanticism was quite influential in Russia.  I think that this is primarily a matter that the doctrine found very fertile soil waiting for it there.)

In brief, Russia’s conflicted relationship with the West, and the psychological complexes associated therewith, bear uncanny similarities to Germany’s.  Both Germany and Russia lie on civilizational fault lines, and Russia and the non-Romanized parts of Germany were not all that dissimilar in terms of economy and social organization.  It should not be too surprising that each reacted similarly to the onslaught of modernity and the hegemony of the Latinized West, though each of course exhibits its own distinct characteristics.

Similarly, my post On Russophobia I noted the deep anti-liberal strains in Russian thought: similar strains exist in Germany.

If you combine economic interest, latent (and not so latent) guilt, and deep anti-western (and specifically anti-American) sentiments rooted in Romanticism, Germany is entirely unreliable in opposing Putin.

And don’t doubt that Putin hasn’t figured that out, and is planning accordingly. And also don’t doubt that he is playing this for all it is worth. Exhibit A: Snowden.

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April 9, 2014

The Great White Swims, the Capital Flies

Filed under: Economics,Politics,Russia — The Professor @ 8:04 pm

Sometimes it’s hard to keep up. Yesterday, the Russian Central Bank reported that capital outflows from Russia totaled $50 billion in the first quarter, nearly equal to last year’s total of $60 billion (which was already a high number). Check that: today the RCB updated the number to $63.7 billion. What will it be tomorrow?

Last ruble/dollar to leave: please turn out the lights.

No wonder Putin is soliciting donations to the comment box on how to arrange a quick turnaround of the Russian economy. Too bad he doesn’t understand he is the biggest money repellent in Russia (with the exception of the dirty money that sticks to him like glue.)

Given this, it is rather remarkable that Russia is urging companies that have listed abroad to delist and trade on the Moscow exchange exclusively instead.  Deputy PM Igor Shuvalov promises that Russia will create “attractive” conditions for Russian companies that come home.

Good luck with that.

It is ironic, given that in the mid-2000s in particular Putin’s Russia was encouraging its companies to list abroad.

No doubt that this is driven in large part by fears that this capital is vulnerable in the event of a pronounced escalation of tensions (or conflict) between the West and Russia.

So we are observing a process of the reversal of Russia’s integration into the world financial system. A sort of push me-pull you process. Money is being pulled out of Russia, and Russia is taking actions that will push foreign investors out of big Russian companies.

These processes will get even worse if the Ukraine situation deteriorates. Or if there is a Latvia/Lithuania/Estonia/Finland/Poland situation.

And a worsening geopolitical situation is likely. Putin reminds me of a great white shark. If he doesn’t keep moving, he will die. Crimea boosted him, but that effect will dissipate. He’ll need another boost, and that will almost certainly not come from some domestic achievement, particularly an economic one. So another foreign confrontation seems necessary for the shark to survive.

And so much for the notion that financial ties will soften and westernize Russia. Putin will sacrifice these ties to his civilizational mission, domestic political considerations and the the corruption imperative.

Actually, I have the tense wrong there. He is sacrificing them. He has been sacrificing them.

The great white will keep swimming, and the capital will keep flying.


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