Streetwise Professor

April 24, 2014

What You’ve All Been Waiting For: The Commodity Trading White Paper

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 3:13 pm

I have been working since last year on a whitepaper (sponsored by Trafigura) on The Economics of Commodity Trading Firms. After about a month of limited theatrical release, the paper is now publicly available at the link.

Even if I do say so myself, the paper provides a pretty thorough overview of commodity trading firms, ranging from their economic function as “agents of transformation” (of commodities in space, time, and form), to risks and risk management, to corporate structure (private vs. public), to capital structure, to asset ownership, to the systemic risks (or lack thereof) of commodity trading.

One of the main takeaways for me was the diversity of commodity trading firms. Making generalizations is difficult. Another takeaway (related, in a way) is that some of the conventional wisdom about these firms (e.g., there is a general trend to asset ownership and vertical integration) is not correct.

But rather than discuss the report extensively here, I leave it to you all to read it. Comments welcome.


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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 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 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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