Streetwise Professor

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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April 8, 2014

Tales From the Crypt of Corruption

Filed under: Economics,Military,Politics,Russia — The Professor @ 7:58 pm

The vicissitudes of life have prevented me from writing-or even reading much-for the last few days. But a few Russia-related things caught my eye.

Most notably: Putin calls for swift action to improve Russia’s business climate.

Talk about low hanging fruit! Give me a hard problem, Vladimir Vladimirovich! If you resign, and take your judo clique and Sechin and the rest of the St. Petersburg gang with you, Russia’s business climate would improve dramatically and swiftly!

No charge for this sure-fire advice. It’s on the house.

The Russian economy is sputtering, but it would be quite easy to crater it. As I’ve discussed before, the US could squash the Russian economy like an overripe grape, but the markets have decided that the US and the west are all bark, no bite. The initial post-Crimea selloff has been largely reversed:

President Vladimir Putin’s pledge not to expand beyond the Crimea peninsula in Ukraine is driving short sellers out of the Russian stock market.

Traders have scaled back bets on declines in theMarket Vectors Russia (RSX) exchange-traded fund to 5 percent of outstanding shares from a record-high 21 percent on March 3. That’s the largest drop for a comparable period since June, according to data compiled by Bloomberg and Markit.

As short sellers retreat, the market is rebounding, with the Bloomberg Index of Russia’s most-traded stocks in New York posting the longest stretch of weekly gains since October. Foreign Minister Sergei Lavrov said at the end of last month that there’s no intention to go beyond Crimea, fueling speculation that tensions with the U.S. and the EU are abating. Putin told lawmakers in Moscow on March 18 that Russia isn’t about to occupy Eastern Ukraine.

Let me put it this way. The article is wrong. The market isn’t taking Putin at his word that Russia won’t invade Ukraine. The market just believes that even if he does, nothing will happen. The west will wuss out. Again.

Yeah. I’m looking at you, Germany. And you, Obama.

Believe me. Putin is drawing the exact same conclusion.

Make sure you are sitting down for this last one. Sophisticated Russian hackers were responsible for mounting a massive attack on Nieman Marcus. But that’s not the shocking part. The US approached the Russian government for help and . . . nothing. Crickets:

Attempts to shut down the criminal network have failed despite international sting operations and secret meetings with Russian intelligence officials, according to two former U.S. officials who asked not to be named because they weren’t authorized to discuss the activities. Federal Bureau of Investigation officials visited their Russian counterparts in 2008 and 2009 to share information that could help locate and stop hackers, one of the former officials said.

“The FBI has tried to get cooperation, the State Department has asked for help and nothing happens, so law enforcement options under the current circumstances are pretty negligible,” said Richard Clarke, special adviser for cybersecurity under George W. Bush.

Law enforcement officials describe Russian stonewalling as just one obstacle as they try to curb the burgeoning theft of credit-card data that has sparked a Congressional inquiry and left banks and retail chains blaming each other for the failures of outdated credit-card technology.

This, no doubt, is because the FSB received a cut of the hackers’ take.  I am sure you are standing there, mouth agape, in shock at this stunning news.

But this corrupt, criminal colossus is twisting the far wealthier, far more powerful west around its little finger. There is a pronounced asymmetry in power, but an even greater asymmetry in the will to use it.

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April 5, 2014

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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April 4, 2014

Not Willing to Sacrifice the Bonus of a Single Frankfurt Banker

Filed under: History,Military,Politics,Russia — The Professor @ 7:52 pm

Few things I’ve read recently are more depressing than this WSJ article about European, and specifically German, enabling of Putin’s and Russia’s aggression:

Opposition to economic sanctions as a way to penalize Russia runs from 36% in Germany to 23% in Great Britain, to 15% in Denmark, Sweden, and Norway, according to a YouGov poll taken across Europe from March 21 to 27.

In an interview with the weekly newspaper Die Zeit, former German Chancellor Helmut Schmidt said he found Mr. Putin’s actions “absolutely understandable” and urged Germans to reflect on history before condemning the Kremlin.

“More important than appealing to international law is the historical development of Crimea,” Mr. Schmidt said. “Historians are divided over whether there is even such a thing as a Ukrainian nation.”

Gerhard Schröder, who as chancellor until 2005 developed a close friendship with Mr. Putin, has expressed his understanding for Russia’s “fear of encirclement” by the West.

Mr. Schröder’s pro-Russian leanings are well known in Germany. The ex-chancellor, now chairman of a gas-pipeline venture majority-owned by Russian state energy giant Gazprom, once deemed Mr. Putin a “flawless democrat.”

While not condoning the Crimea annexation, Mr. Schröder has made light of Russia’s violation of international law, saying that Germany and NATO also broke international law when they bombed Serbia without U.N. authorization—a precedent that Mr. Putin also cites.

Ms. Merkel has used tough rhetoric against Mr. Putin and warned the crisis could inflict “massive damage” on Russia. Much of the German press panned Mr. Schröder, Mr. Schmidt, and other “Putin-understanders” and “Russia-understanders” for excusing 19th-century-style military aggression.

But the sympathetic tone strikes a chord with the German public and some elites. Siemens  AG   chief executive Joe Kaeser cited the two former chancellors’ remarks in justifying his controversial visit to Mr. Putin last week.

Among Germans polled on March 31 and April 1, 49% said the country’s foreign policy should represent a “middle position between the West and Russia,” whereas 46% said Germany should stick to a firm alliance with the West, according to polling company infratest dimap. In another poll taken in mid-March, half of Germans said the EU should simply accept Russia’s annexation of Crimea.

“People who say ‘Russia-understander’ never understand what they are talking about—it’s either black or white for them,” said former German Ambassador to Russia Ernst-Jörg von Studnitz. “Many people call me that, and I don’t mind at all.”

Germany appears dead set on making the French look grateful.

This whinging about Russia being “surrounded by enemies” and having “defenseless borders”  and being threatened by Nato expansion is so much bologna. Nato has neither offensive capability or intent. Russia has more strategic depth than any nation in the world. Just ask Charles XII, Napoleon or Hitler. As they all found out to their bitter chagrin, you can cross Russia’s borders, only to get lost in the trackless wastes that lie beyond.

And if Putin is so worried about Nato moving closer to Russia’s borders, why is he making moves in Ukraine that would move Russia’s borders closer to Nato?

Russian “fears” about a Nato invasion threat are not based in reality: they are either paranoid delusions, or contrived, or both.

Germans whine about not wanting another Cold War. Sorry, Fritz: this isn’t your choice. Putin has a vote too. Or to paraphrase Trotsky: you might not be interested in another Cold War, but another Cold War is interested in you. Courtesy of Vladimir Vladimirovich.

In large part due to the heavy burden of its horrific past, Germany wants a vacation from history and civilizational conflict. But Putin is on a civilizational mission, and if he is not stopped now, he will continue to push until some confrontation occurs in the future.

But to achieve this, Germany is not willing to sacrifice the bonus of one Frankfurt banker, let alone the bones of a single Pomeranian grenadier. And indeed, it appears that mercenary considerations are paramount. German business leaders, notably from Siemens (one of the world’s technology leaders-as well as a leader in bribery and corruption), are bleating about the economic costs of even mild economic measures against Russia.

Looking over the past several years, it becomes clear that such commercial considerations are paramount in Berlin. Germany abjures any leadership role when it comes to Russia, rationalizing this choice by harking to its bad experience with Führers. But when it comes to German money in Greece or Spain, Germany was quite willing to throw its weight around and push policies that advance German economic interests. That is, it’s not about historical burdens making Germans shirk from leadership. It’s about German commercial interests causing it to conduct a passive foreign policy sometimes, and a very heavy-handed one at others.

In other words: le perfide Allemagne. The common denominator in German policy towards Europe and Russia is what benefits German industry and German banks. Germany’s foreign policy is ultimately corporatist, and the country is quite willing to sell the rope that hangs some poor Eastern Europeans.

Germany has never hesitated to preen about its moral superiority, and to attack the US in particular for doing the dirty work that has kept Germany free and prosperous for going on 70 years. The pretense is beyond annoying.

Germany is enabling Putin, and for the most crass commercial reasons. Its policy is due neither deference nor respect.

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