Streetwise Professor

May 29, 2007

Russia Roundup

Filed under: Energy,Russia — The Professor @ 10:13 am

A few quickies on Russia.

It appears that BP-TNK will soon lose its license to the Kovykta gas project. No surprise. It also goes to show that, as I wrote on April Fool’s Day, dancing to Vlad’s tune won’t save you if you have something he really wants. Hopefully, other western energy companies will finally answer the clue phone and realize that playing go along to get along in Russia is futile. Lord Browne bent over backwards to appease Russia, and it did him and his company no good whatsoever. Going forward, these companies will have to develop a new legal structure to protect their investments in Russia. This will require an exchange of hostages, and a mechanism for adjudicating disputes that is not dependent on Russian courts. But most importantly, they have to learn to Just Say No and walk away if Russia doesn’t want to play by these rules.

I know the arguments–you gotta go where the resources are. But what’s the point of making investments in those resources unless you can protect them against expropriation once you’ve sunk billions into the ground (literally)?

Speaking of BP, one of my sources tells me that in years past, the company worked against the Transcaspian pipeline to protect other gas deals in the region from competition from lower priced gas from Turkmenistan. Turkmenbashi wanted to proceed, but BP (and Turkey) worked against him. When they had a change of heart, Turkmenbashi told them to pound sand. Further evidence of how the divided (and time varying) interests and agendas of western energy companies advance Russian interests and ultimately undercut their own.

And speaking of the Transcaspian, commenter James notes that Iran is likely to veto this project. Yes, James, the Transcaspian is a geopolitical minefield, and there are many obstacles and pitfalls. I didn’t mean to suggest in my original post that getting a deal done would be a diplomatic cakewalk–to the contrary. The very complexity means that getting a deal will be an arduous and complex task–and that the US and Europe don’t seem to be doing the heavy lifting required to get it done.

Money does make the world go round, though. The spread between the price that Gazprom pays Turkmenistan and the price they charge the Europeans represents a valuable rent that can be distributed to attract the necessary support for the venture.

Two major obstacles the US and Europe face in getting things to go their way are moral scruples and legal constraints on how–and to whom–that rent is distributed. According to this article in This is London, Gazprom has employed massive bribes to advance its interests:

Key to this triumph has been Alisher Usmanov and his Gazprominvest Holdings. This [Gazprom] subsidiary is the channel for massive slush funds. In November 2004, for example, a payment of £44million to Gulnara, the daughter of President Karimov of Uzbekistan, secured that country’s gas contracts for Gazprom from under the noses of the US.

In return for the cash, Putin instructed Karimov to kick out a US military base that dominated Central Asia, and Gazprom secured the strategic kingpin to dominate the Central Asian and Caucasus gas reserves.

To reiterate, the struggle will not be an easy one, but it is vital, and requires more assiduous–and creative–efforts than the US and Europe have undertaken heretofore. And the short-sighted actions of some companies–as in the BP example discussed above–don’t help one bit.

In this vein, James also points out that Chevron will benefit from the deal to ship Kazakh oil via Russia. Given the state of play, this is no doubt the rational thing for Chevron to do, but this is just another example of the negative contracting externalities that undermine American and European interests in the region. Friday I wrote about Whinston’s Lectures on Antitrust, and noted that I can think of few practical examples of his models of vertical restrictions (which are driven by contracting externalities) in a commercial context. However, some of these models describe Russian actions in energy to a “T.” Specifically, Whinston discusses models that show that bilateral contracts can have externalities, and can be used as part of a “divide and conquer” strategy. That is exactly what Russia is doing in the energy field; by offering relatively attractive deals to selected parties early on, they reduce the bargaining power of other customers later in the game.

Contracting externalities can best be eliminated by a coordinated, cooperative strategy among customers. It is just this coordinated approach that is lacking in energy. German, French, and Italian firms (often with the enthusiastic support of their governments) have been the worst offenders so far.

These companies and nations would do well to remember what Ben Franklin said at the signing of the Declaration of Independence: “We must, indeed, all hang together or, most assuredly, we shall all hang separately. ” Europe is going to the gallows one at a time; hopefully they will come to their senses soon before they all swing on Gazprom’s rope. After all, isn’t it things like this for which a European Union is truly useful? But no, Brussels bureaucrats seem to be too involved in enforcing politically correct speech and standardizing sausage ingredients to be bothered with such trivialities.

Oh, and one last thing. Make sure you read these two Edward Lucas posts.

May 26, 2007

Swiss Silos

Filed under: Exchanges — The Professor @ 10:47 am

The Swiss exchange SWX and the Swiss clearing group SIS have announced their intention to merge. (The data and financial transaction services provider Telekurs will be part of the merger too.) The merging firms state that the pressure to innovate, regulatory changes, and customer demands for new services are driving the need to merge. These challenges require efficient coordinated response by the clearing and execution venues, and the firms have concluded that vertical integration will facilitate this coordination. This echoes an argument that I made in my working paper on clearing silos. I also made this argument in my presentation at the CME InformationXchange in Boca Raton in March. Charley Carey of the CBOT (whom I sat next to) asked if he could, er, “borrow” this argument when defending the integration of clearing and execution in a merged CME-CBT. (This was the day before the ICE bombshell.)

It is interesting that the Swiss have moved towards the silo model at the same time that integration of clearing and execution is under assault elsewhere in Europe and in the US. It provides a clear illustration that there are strong efficiency arguments in favor of integration. Hopefully this will induce some reflection among those who only see (or purport to see) insidious anticompetitive motivations for integration. But somehow I doubt it.

Along these lines, I just read Doug Whinston’s Lectures on Antitrust Economics. Whinston’s book provides a very readable overview of the potential anticompetitive effects of tying and other vertical restraints. Even Whinston admits that these arguments are merely statements of “possibilities” that would contradict the Chicago School view that such restraints seldom have anticompetitive motivations. As such, it is very difficult to think of practical examples of these models of “possibilities.” It is also abundantly clear that these models have no bearing on the tying of clearing and execution. The only model that is even remotely relevant is that of Carlton and Waldman, and my aforementioned working paper shows that an adaptation of this model to the exchange context does not support the view that integration and tying are anticompetitive. Instead, formalizing and extending ideas first propounded on SWP, the paper concludes that integration can enhance efficiency in numerous ways–and the Swiss announcement provides a timely and powerful endorsement of that conclusion.

For Only Pennies a Trade!

Filed under: Exchanges — The Professor @ 10:19 am

LSE CEO Clara Furse writes to the FT defending exchange pricing. She notes that exchange fees represent a small fraction of total trading costs–which as I have noted is exactly what gives exchanges pricing power, though Ms. Furse doesn’t make that point.

The relation between elasticity and expenditure share reminds me of a story I use to illustrate this point to my students. I am a big history buff, and in the early 1990s I made a trek to the coast of the Cape Breton Island in Nova Scotia to visit the old French fortifications at Louisburg. (I highly recommend this to all military history buffs.) In any event, in the entryway to the Visitors’ Center was a sign saying that the museum was facing financial difficulties, and requesting donations to allow it to continue operating. I went inside, and paid my admission–C$8.50. I gladly paid this sum, and thoroughly enjoyed my visit.

When I returned home to Michigan, I sat down and wrote Parks Canada a letter. I explained that Cape Breton is very isolated, and as a result it is quite expensive to take a trip there. Flying was very expensive, and the typical auto traveler would spend several days to get there, thereby incurring several days lodging expense, plus the cost of gas, mileage, etc., not to mention the opportunity cost of time. Hence, the $C8.50 visitors’ fee was a small fraction of the cost of a trip to visit Louisburg, and doubling or trebling it would increase the cost of a visit by only a couple of percent, making the demand for admissions very inelastic. I told Parks Canada that as a result, they could raise the price substantially without reducing the number of visitors proportionally, thereby raising revenue–and solving the site’s financial difficulties.

A couple of weeks later I received a letter from Parks Canada. They thanked me very much for my letter. They also said I was the only person that had ever written them suggesting that they raise fees;-)

May 24, 2007

Well Put

Filed under: Climate Change — The Professor @ 9:19 am

Roger Pielke Sr. has a very illuminating blog entry on climate modeling vs. weather modeling. A common objection to long range climate prediction is “If we can’t predict next week’s weather, how can we predict the next century’s climate?” The stock climate modeler response is that climate is stationary, so we can predict future averages (where averages are taken over relatively long periods) with considerable accuracy. The short run vicissitudes of weather around long run means are effectively averaged out when forecasting climate.

Pielke notes, however, that this is only part of the story, and arguably not a very important part. The “stationary” part of climate models is in the basic physics, but this represents only a fraction of the forces that affect climate. Climate also depends on numerous other processes and feedbacks. Climate models “parameterize” these processes. Unfortunately, some of these processes are very poorly understood (e.g., clouds, just to name one), so the parameterizations are crude. Moreover, these factors can interact in complex–and poorly understood–ways. Even if the climate system is indeed stationary, the relevant model may be badly misspecified due to incorrect parameterizations. This can lead to biased projections. Even if the vicissitudes in weather indeed average out, the models may be waaaaay off, because the estimate of the mean can be biased due to biased parameterizations. That is, in the presence of potentially large uncertainty in the parameterizations, it is a non sequitur to assert that stationarity implies that climate forecasts are more accurate than weather forecasts. Large model errors can swamp the effects of stationarity.

Dr. Pielke deserves plaudits for pointing this out. He does so in an evenhanded, thoughtful, and fairminded way. (In stark contrast to many in the climate sciences–at least many of those who have a high public profile.) He seems to be a serious scientist–one who acknowledges anthropomorphic effects on climate, but who skeptically evaluates competing claims and evidence. Would that more were like him.

Color Me Skeptical

Filed under: Derivatives,Exchanges — The Professor @ 8:57 am

The FT comes out foursquare for “fungibility” in futures clearing. [Is it just me, or do you get a sense of deja vu when reading that article? Is it just me, or do you get a sense of deja vu when reading that article? FT must be really impressed with its reasoning, as it repeats it word for word three times.]

In a nutshell, the FT believes that open access into clearing is a sufficient condition for competition in trade execution. Its case is a weak one. It asserts that there is “cutthroat competition” in US equities, and attributes that to the industry’s clearing cooperative, the DTCC. Well after the creation of the DTCC, competition in listed equities was very weak. The NYSE was dominant. Most of the off-exchange execution was of the cream-skimming variety. That’s better than no competition at all, but it’s hardly cutthroat. The NYSE members earned substantial rents as a result. In Europe, clearing fungibility didn’t allow the LSE to gain any headway in its foray into Dutch equities. In US futures, Eurex and EuronextLIFFE offered both execution and clearing when they attempted to go after CBOT and CME, respectively, and both failed miserably.

Competition is arguably heating up in US equities, but that is attributable to RegNMS, which effectively socializes order flow and undermines the liquidity network effect that gives a dominant exchange considerable shelter from entry. Although open access clearing probably facilitates competition in this environment, it is not a sufficient condition; additional measures are necessary to reduce market power in execution.

The strongest evidence for the FT case is US options, where the OCC operates a fungible clearing mechanism, and trading in individual options is split among several exchanges; tipping has yet to occur. This example needs further study to prove whether it is the exception that proves the rule that competition in execution is highly imperfect, or whether it shows that execution in fact can be highly competitive.

A key issue here is payment for order flow. Option exchanges pay for order flow. This may reflect underlying factors that make the US options market unrepresentative of what might happen if clearing fungibility is extended to futures.

Payment for order flow can arise from excessive tick sizes. Too large a tick can impede competition for liquidity. It can serve as a price floor that supports more trading venues than would exist in its absence. That is, it can dull the tipping effect. The move to pennies will provide an interesting test of this hypothesis.

Payment for order flow can also arise when some order flow is uninformed. Payment for order flow can serve as a cream skimming mechanism; market makers rationally pay for order flow that is verifiably uninformed Basic microstructure theory shows that multiple cream skimming trading venues can exist. Thus, although theory suggests that order flow that is not verifiably uninformed will tip to one trading venue, verifiably uninformed order flow will not tip, and may be served by multiple venues.

There needs to be more detailed study of the US options example before it is used as the basis of regulatory and anti-trust intervention into the organization of futures trading.

There is one major reason to doubt that competition in futures execution is likely to be cutthroat even given open access to clearing. If clearing is truly a natural monopoly (as the FT argument implicitly assumes), then a dominant clearinghouse (such as the CME) would like to encourage competition in execution, not discourage it–this would allow it to make more money from its monopoly clearing operation. Clearing and execution are complements. The derived demand for the putative clearing monopolist is higher, the lower the cost of execution. Competition and entry in execution reduce execution costs, so the clearing monopoly would encourage it. However, if execution is not highly competitive, integration between the clearing and execution venue can improve efficiency. Thus, if the FT is correct, the CME would have no incentive to tie clearing and execution–but the CME is a diehard defender of tying. Either the CME is stupid, or the FT is wrong. Any guesses where I place my bet?

This is the old Chicago School argument that vertical restrictions are likely to have an efficiency rationale, rather than an anticompetitive one. I still have not seen a convincing refutation of the relevance of this argument to futures trading.

I should also note that although “non-profit cooperatives” sound like wonderful things, they can often be an effective way of exercising market power. After all, the NYSE was a non-profit cooperative for years–and ran a restricted entry cartel. My working paper on clearing shows that a user-owned clearing cooperative can be efficiency enhancing, or it can be an incredibly effective way of cartelizing the brokerage business. Moreover, even if the clearing cooperative avoids the dark side, and prices services at cost, if my surmise is correct that competition in execution is highly imperfect, all this will do is transfer rents to the dominant execution venue. The LSE–which gets clearing services from a user-owned entity, but which has the highest margins of any equity exchange in the world–is a great example of that.

So, all in all, I am less than persuaded by the FT’s argument–no matter how many times they repeat it. The case for remaking the futures business with the blunt tool of antitrust is far from made.

May 17, 2007

Good for Thee, But Not For Me

Filed under: Energy,Russia — The Professor @ 9:10 am

While reading Vladimir Socor’s dispiriting account of Putin’s successes in Turkmenistan and Kazakhstan, I came across this:

During the summit, Putin underscored with satisfaction that Russian companies will receive production-sharing agreements (PSAs) in Turkmenistan. This seems ironic as the Kremlin is now refusing to sign PSAs with Western energy companies in Russia and is tearing up existing PSAs.

Ironic, indeed. Ironic doesn’t quite do justice to this. Chutzpah doesn’t even do it justice. In their attempts to justify expropriations (e.g., Sakhalin II), the Russians whine that production sharing agreements were foisted upon a desperate and helpless Russia; that they were an example of western economic imperialism; that they are fundamentally unfair and unjust.

But when the shoe is on the other foot, the Russians do their best Emily Litella imitation. “Never Mind.” Or maybe they just agree with Emerson that a foolish consistency is the hobgoblin of little minds. Or maybe they are truly consistent in their belief that PSAs are an unfair, imperialistic instrument that the strong use to exploit the weak, but it just so happens in this case that the Russians are strong, and are not in the least bit troubled by moral qualms in exploiting that strength.

Apropos my remarks last night, this is the kind of thing that should give the US and an EU some leverage in the region. If the Russia-Turkmenistan PSAs are truly tilted in favor of the Russians, there should be an opportunity to trump their offer with a more favorable arrangement. How ’bout it, folks?

May 16, 2007

Get in the (Great) Game

Filed under: Energy,Politics,Russia — The Professor @ 9:21 am

Not long ago (April Fool’s Day, in fact) I wrote that “the most important thing” that could be done vis-a-vis Russian energy imperialism is to court aggressively the Transcaspian states, especially Turkmenistan and Kazakhstan. These states could be the Russian Achilles Heel, as Gazprom is acutely dependent on cheap gas from these countries. A Transcaspian pipeline would provide a competitive alternative for gas from east of the Caspian, resulting in an increase in prices for the producers, lower prices for consumers–and much slimmer margins for Gazprom.

Apparently the US and the EU don’t take this seriously enough. Last week Putin waltzed into Kazakhstan and Turkmenistan, and secured deals to move gas out of these countries via Russia on a to-be-built pipeline on the east side of the Caspian. Kazakhstan and Russia also approached a deal on transporting Kazakh oil via Russia, although Kazakh president Nazarbayev is apparently driving a hard bargain.

While Putin spent a week in the area, the US and EU apparently can’t be bothered to send high-powered delegations to Kazakhstan and Turkmenistan. My sources in the region tell me that US and EU diplomacy has been ineffectual, not to say incompetent. Specifically, the US and EU have merely announced their support for a Transcaspian pipeline without adequately consulting the Turkmen and Kazakh governments, and without a serious effort to woo them to support the endeavor. This has given the Russians an opening that Putin has exploited brilliantly. While the Americans and Europeans engage in long distance happy talk, they are not doing the face-to-face horse trading (almost literally–Putin left Kazakhstan with a beautiful stallion) needed to do business in that part of the world.

Not to say that it is easy. The governments in the region are authoritarian and corrupt. Moreover, Russia is next door, while the US and Europe are far, far way; like I said many months ago, Turkmenistan is so close to Russia, so far from God. These governments fear color (color revolutions, that is)–as does Russia; Turkmenistan and Kazakhstan fear that US/EU support will be tied to demands for reform, demands that the Russians will never make. Moreover, Kazakhstan has a large Russian population. It is surely paying close attention to how Russian nationalists are making trouble in Estonia. Indeed, I would not be surprised to learn that the FSB is stirring up the Nashiniks in Estonia in part to send a message to other countries with a large Russian population.

It is one thing to lose when the odds are against you. It is something else altogether not to get in the game at all. The Russians have some strategic advantages in this region, but we certainly have some arrows in our quiver as well, but we are not even forcing Putin to break a sweat. The matter should be particularly pressing for the Europeans, but they can’t seem to get their energy act together.

The Transcaspian is still the most important theater of energy geopolitics. Putin has recently gained some major victories in that theater, but the game is not over–if we decide to play. So jock it up, folks. If you can’t, one has to wonder why we have a State Department in the first place.

May 10, 2007

Chekist Chutzpah

Filed under: Politics,Russia — The Professor @ 9:45 am

There are days that I think maybe I’m to hard on Vladimir Putin. And then he does something that brings me to my senses.

His Victory Day speech represents another new low in Putin’s limbo routine. He quite clearly equated the United States and Nazi Germany:

We have a duty to remember that the causes of any war lie above all in the mistakes and miscalculations of peacetime, and that these causes have their roots in an ideology of confrontation and extremism. It is all the more important that we remember this today, because these threats are not becoming fewer but are only transforming and changing their appearance. These new threats, just as under the Third Reich, show the same contempt for human life and the same aspiration to establish an exclusive dictate over the world.

To those who have followed Putin’s recent spewings (notably his Munich speech) the line “contempt for human life and the same aspiration to establish an exclusive dictate over the world” is clearly aimed at the US.

This is truly disgusting. It is particularly disgusting coming from a man who grew up in the bosom of one of the most tyrannical and bloody regimes in human history, a regime that truly showed “contempt for human life” and aspired to “establish an exclusive dictate over the world.” A regime that killed tens of millions. Putin has publicly mourned the passing of this monstrous state as the century’s greatest geopolitical tragedy. And Putin was a proud member of the “security services” that were, from the time of the Cheka, the regime’s executioners. And he is a proud member still.

As outrageous as these remarks are, his paean to the “unity” of the former USSR is even more offensive:

Victory Day not only unites the people of Russia but also unites our neighbors in the countries of the Commonwealth of Independent States. We are deeply grateful to the generation of people whose difficult fate it was to face this war. They have passed on to us their traditions of fraternity and solidarity and their truly hard-won experience of unity and mutual aid. We will preserve this sacred memory and historical legacy. Those who attempt today to belittle this invaluable experience and defile the monuments to the heroes of this war are insulting their own people and spreading enmity and new distrust between countries and peoples.

Hate to break this to you Vlad, but your “neighbors” didn’t exactly view the USSR as a fraternal organization, hence their haste to depart it at the first opportunity. They viewed the Soviet system of “mutual aid” in the same way the web caught fly perceives a spider. The Estonians (the clear referent in Putin’s paragraph just quoted) are not “defiling” a monument to heroes of WWII, insulting themselves, or spreading enmity. To them, the monument to which Putin refers is a painful reminder of their subjugation by a regime that showed utter disdain for human life and dignity, and which imposed “comradeship” at the barrel of a gun.

If Putin had any interest in allaying distrust between countries and peoples, he would acknowledge the gaping physical and psychic wounds inflicted by the regime he so clearly misses, and express understanding at how monuments to that regime just might be painful reminders of those wounds. Instead, by refusing to concede the USSR’s awful legacy, it is Putin who exacerbates historical distrust. The Estonian move seems a reasonable compromise; the monument will stand and the dead will be buried in a place where those who wish to mourn and honor the fallen may do so, but where the statue does not serve as a daily reminder of Estonia’s subjugation and the USSR’s crime. A crime, by the way, that grew out of a conspiracy between the Soviet Union and Nazi Germany to divide eastern Europe between them. Yes, no state suffered more than USSR from the depredations of the Nazis–but no state did more to make those depredations possible.

But that’s just the problem, methinks–Putin (and the ultranationalist Nashiniks who are his most vocal constituency) want that daily reminder. And they really want to return to those days when the uppity Estonians, Latvians, Lithuanians, Ukrainians, Georgians, and myriad others knew their place.

But maybe all Vlad is doing in this speech, with its implicit equation of Bush with Hitler, is auditioning for some post-Presidential political position. Like the mayorship of Berkeley.

May 6, 2007

Ridgeway, Abrams, Patraeus.

Filed under: Military,Politics — The Professor @ 9:57 am

General David Patraeus faces a Herculean task in Iraq, but he is not the first post-WWII American general to confront such a challenge. In Korea, Matthew C. Ridgeway assumed command of a battered American Eighth Army reeling from Chinese attacks. In Vietnam, Creighton Abrams succeeded William Westmoreland in the aftermath of the Tet Offensive and political turmoil at home. Both Ridgeway and Abrams succeeded admirably in trying circumstances. Both took command in unpopular wars under politically damaged Presidents. Both introduced new tactics and operational methods better adapted to the conditions on the ground than those of their predecessors. Both stabilized the military situation–all that could be realistically expected–and provided the breathing space necessary for shaky governments to take halting steps forward. By achieving stalemate, Ridgeway and Abrams created the conditions for tenuous peaces. Both redeemed military and political situations that pessimists–and political opportunists–had written off as lost. So, although Petraeus’s challenge is a daunting one, the feats of his illustrious predecessors demonstrate that the dark omens of political Cassandras are not foreordained.

Ridgeway’s legacy survives to this day, in a free and prosperous South Korea. Abrams’ achievements were thrown away when the US Congress abandoned South Vietnam to a conventional North Vietnamese attack by depriving it of material support and the backing of US airpower (which had shattered the NVA’s Easter Offensive in 1972).

In many ways, Petraeus’s problem resembles Abrams’ more than Ridgeway’s. Although the political atmosphere in Washington in 1950-1951 was rancorous (this was the beginning of the McCarthy era) it was nothing compared to that of the Vietnam era, especially post-Tet. Sadly, today’s political environment evokes comparisons to that of Abrams’ time (although mass demonstrations are notably lacking.) Ridgeway’s military problem was primarily a conventional one. Although the havoc wreaked on the Viet Cong in Tet had reduced the insurgency threat, it still existed. Ridgeway’s theater of operations was well-defined, and although he could not operate against targets north of the Yalu River, his enemy could not readily infiltrate from and exfiltrate to safe zones. In contrast, the VC and the NVA that Abrams fought could receive support from, and withdraw to, sanctuaries in North Vietnam, Laos, and Cambodia. Similarly, Patraeus must deal with a guerrilla threat supported politically and logistically by hostile regimes in Iran and Syria that are off limits to American arms. Like Abrams, Patraeus must also deal with a hostile and defeatist Congress that views the war as a front in domestic political battles.

Patraeus’s surge strategy is largely an application of well-established counterinsurgency tactics. The previous strategy of withdrawing to large bases was misguided, ceded the initiative to Al Qaeda and Shiite militias and extremists, and was at odds with the ways that insurgencies have been defeated since time immemorial. Insurgencies must be strangled, denied of safe havens, and pressured into narrower and narrower areas, as Edward I did against the Welsh, for example. By establishing a presence in ever widening areas in Iraq, the surge pressures the insurgents, wrests the initiative from them, forces them to attack on unfavorable terms to protect their bases, and dislodges them from the network of sympathizers that is essential for their survival. It will not be rapid. It will not be easy. But the instrument at his command–the American Army and Marine Corps, with support from the Air Force and Navy Air–is far superior to that wielded by Ridgeway and Abrams, as effective as their forces were. With adequate political backing, Patraeus has an excellent chance of surpassing the achievements of his distinguished predecessors. Given the consequences of failure–which are arguably far more dangerous to the US than in Korea or Vietnam–let us hope that he is given that chance.

May 4, 2007

Ticked Off

Filed under: Derivatives,Exchanges — The Professor @ 10:06 am

In FI magazine, Galen Burghardt makes a good point:

This may be a good time to reflect on the influence that the electronic revolution has had on the costs of trading, and consider asking the exchanges to make drastic reductions in their minimum tick sizes. Now that the locals have been taken out of the equation of exchange decision-making, all major stakeholders— traders, hedgers, exchange shareholders, and brokers—would stand to gain enormously from such reductions. It would be a win/win/win situation.

It is indeed something of a puzzle that demutalized exchanges have not reduced tick size. As I have noted before, the demand for exchange services is a derived demand. The higher the price/cost of complementary services, such as liquidity supply, the lower the demand curve for exchange services–and hence the lower the fee that the exchange can charge. By reducing tick size, an exchange will reduce the price that liquidity suppliers charge; if the tick size is currently binding, the marginal cost of liquidity provision equals the tick size, and competition between potential liquidity suppliers dissipates any profit they could earn by resulting in queuing of orders and a commensurately lower probability of execution of a limit order. By reducing the tick size, the exchange reduces the marginal cost of liquidity, and raises the derived demand for its services. It can profit from this by raising its fee.

Thus, it is not quite the win-win-win Burghardt suggests; any decline in liquidity costs that results from a reduction in tick size will be offset in part by an increase in exchange fees. There is also a cost issue–lower tick size is likely to lead to more message traffic as more orders are entered and canceled. So exchanges will have to bulk up capacity to deal with a lowered tick.

Given the pressure on exchanges to generate earnings, it is surprising that they have not been more aggressive in exploiting this strategy. Perhaps the penny tick experiment in equity options will convince futures exchanges to take the plunge and reduce tick size. Message traffic has not overwhelmed the options exchanges, and the penny experiment seems to be generating a big uptick (no pun intended) in volume.

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