Streetwise Professor

Dark pools are under a regulatory and legislative assault, in Europe, Canada, and the US.  Scott Patterson wrote a long piece in the WSJ about FINRA’s scrutiny of Dark Pools:

The Financial Industry Regulatory Authority, Wall Street’s self-regulatory body, last month sent 15 examination letters to operators of “dark pools”—lightly regulated, off-exchange trading venues that have been a rising concern for regulators and some investors as more activity shifts away from exchanges.

Finra is seeking details about how the increasingly popular venues operate, what they disclose to clients and whether they adequately police trades. It could bring enforcement action against dark-pool operators or issue recommendations for tighter oversight, depending on the answers it receives and additional examinations, said John Malitzis, executive vice president of market regulation at Finra. The letters are a follow-up to an initial round of questions the regulator circulated last fall.

“We want to understand whether [dark pools] are disclosing to their customers how their orders work [and] whether customers are informed who their orders will interact with,” Mr. Malitzis said in an interview. “A big part of this is to get an understanding of practices that may or may not be problematic.”

Here’s an interesting bit:

Dark pools don’t disclose traders’ buy or sell orders and only publish trade data after transactions occur. About 13% of all stock-market action takes place on dark pools, up from about 4% five years ago, according to Tabb Group, a market-research firm. Most dark pools are run by broker-dealers—firms overseen by Finra that buy and sell assets on behalf of customers as well as trade for their own accounts.

While dark pools command an expanding slice of trading volume, regulators still have little idea about how they operate since, unlike exchanges, they aren’t required to regularly disclose detailed information about their trading systems.

I see.  “more activity shifts away from exchanges”; dark pools “command an expanding slice of trading volume”; their volume has more than tripled in 5 years.  Growing volume! Growing market share!  That sounds sinister, doesn’t it?

Note that the possible nefarious practices under investigation, if they occur, would result in the users of dark pools are getting screwed.  If that’s true, why are they flocking to the pools in increasing numbers?  The most plausible explanation for a growing market share is that dark pools offer better value-not worse-to those who have the opportunity to choose where to trade.

I am particularly skeptical about the idea that dark pools are hugely exploitive because sophisticated buy side firms are among the most extensive and loyal users of dark pools.  Buy side firms analyze their execution costs with considerable detail.  They evaluate execution costs in lit and dark markets, and slice and dice the data in sophisticated ways, uncovering the circumstances under which it is cheaper to execute in one venue or another, and allocate their trades accordingly.

In other words, if they decide to execute more in dark markets, it’s because they have decided after thorough analysis that they are more likely to get screwed in broad daylight on exchanges.

This isn’t rocket science.

There is a potentially more intellectually reputable case against off-exchange trading.  Dark pools utilize a variety of techniques that are designed to screen out informed, or opportunistic, traders.  Uninformed traders-firms or individuals trading for portfolio balance or cash flow or hedging reasons-suffer losses when dealing with the informed.  They can reduce execution costs by trading in venues where there is a lower likelihood of dealing with a better-informed trader.

But this “cream skimming” of uninformed order flow by dark pools that screen out the informed increases the trading costs of those uninformed traders who for whatever reason cannot avail themselves of dark markets: those left behind have a higher likelihood of dealing with someone with better information, and incur higher trading costs (due to adverse selection).

Dark pools free ride off the price discovery in lit markets, and cream skimming impairs price discovery.  Thus it is possible-possible-that this externality reduces welfare.

Possible, but not necessarily so.  The free riding externality reduces welfare if there is no other inefficiency in the lit markets.  But that is not necessarily the case.  As I pointed out about 15 years ago, there are other sources of inefficiency on exchanges.  For instance, exchanges may exercise market power.  In this case, second best considerations imply that the free riding externality may improve welfare because the benefit of increased competition for order flow from the dark market may more than offset the cost of degraded price discovery.  I have produced formal models that show that this can occur under conditions that have existed in securities and derivatives markets.

As another example, much informed trading can be a form of rent seeking.  Market participants expend real resources to produce information because this allows them to profit at the expense of the uninformed.   This profit is a transfer from the uninformed, and unless there is some external benefit arising from more informative securities prices, the real resources expended to gain this transfer are a pure waste.  By reducing the profitability of informed trading, dark pools reduce this rent seeking and improve welfare.

Both of these analyses are applications of the theory of the second best, which says if there are multiple departures from “perfect” conditions (perfect competition, no externalities), eliminating one imperfection may actually make things worse, not better. In the dark pool case specifically, if there are other imperfections (imperfect competition on and between lit markets, rent seeking informed trading), dark pools’ ability to free ride on exchange price discovery may improve welfare because it mitigates these other inefficiencies.

Determining the welfare impacts of dark pools in the presence of these various departures from first-best conditions is devilish hard.  For instance, it is arguably impossible to determine the costs and benefits of informed trading.  It is also difficult to determine the degree of imperfect competition in lit markets, and the costs of this market power.

But what can be said is that the kinds of things FINRA is looking at are totally irrelevant to addressing these issues.  FINRA is focusing on activities that would be agency problems, or fraud.  But it is hard to square the proposition that these problems are widespread with the observation that dark markets are growing relative to lit ones, especially given that most of the patrons of dark markets are quite sophisticated, and devote considerable attention to evaluating the cost and quality of the services that they obtain.

So what is going on here?  Quite likely political economy, capture, and rent seeking.  For the past couple of months exchanges have been importuning regulators to do something about dark pools, precisely because they are bleeding business.  This headline from Bloomberg says it all:

Stock exchanges seek curbs on dark pools to curb exodus.

In other words: exchanges are losing a competitive battle, and are recruiting regulators and legislatures to hamstring the competitors that are eating their lunch.  A very, very, very old story.

I have to give the exchanges credit.  They have done a marvelous job of shaping the narrative, playing skillfully on the quite different connotations of light and dark.  The exchanges are like a Scout master telling a ghost story beside a campfire, his face scarily illuminated by a flashlight.  They have proven masterful at scaring regulators into action against the evils lurking in the dark

My bottom line?  It is possible that dark pools are, on net, inefficient, but the case has not been made.  Moreover, their commercial success should be considered as evidence that they actually enhance welfare.  Indeed, their commercial success is almost impossible to reconcile with claims that dark pools are somehow deceiving or defrauding those who trade on them, especially given that these traders are often quite sophisticated, and quite on guard against getting screwed.

So don’t be afraid of the dark.  Be especially skeptical about stories detailing the horrors allegedly stemming from the activities of entities that are gaining market share.  And always remember that incumbents are past masters at inducing regulators to crack down on inconvenient competitors.  Be afraid of what regulators do in the light, not what goes on in the dark.

Headed off in a while to see Social Distortion at the Orange Peel in Asheville.  Hopefully this time I won’t have to give first aid to the <a href=”http://streetwiseprofessor.com/?p=4519″>casualty of a motorcycle accident, </a> like I did when I saw them here in 2010.

I’ll post a review in the next couple of days.

A recurring pattern since Putin’s reelection has been for him to issue some ukase, which results in . . . nothing happening.  Then he vents, and rants and raves, sometimes in public, and . . . nothing happens.

Today’s example, his command to Russian state companies to increase dividends:

Most of Russia’s state-controlled companies have refused President Vladimir Putin’s appeal to raise dividends, providing a fresh reason for investors to avoid the cheapest emerging-market stocks.

Russian stocks’ discount to the MSCI Emerging Markets gauge grew to 2.1 times net assets in May, the highest in four years, as 11 of 17 Kremlin-backed companies included in the benchmark Micex Index (INDEXCF) ignored the government’s November rule mandating a payout equal to at least 25 percent of net income. The Micex is down 9 percent this year, the worst performance of the BRIC markets after Brazil’s Ibovespa. (IBOV) State-controlled OAO Rosneft and OAO Inter RAO UES both fell more than 20 percent.

“The unrealized dividend promises have a negative impact on the market, especially since this was one of the key growth triggers,” Victor Bark, who oversees about $2.8 billion as the head of asset management at Alfa Capital in Moscow, said by phone on May 27. “This is bad news in a situation when there are no sources for economic growth.”

Putin has targeted dividends in a drive to boost budget revenue and lure foreign and domestic investors wary of an economy that grew at the slowest pace since 2009 in the first quarter. Capital outflows amounted to as much as $4 billion in April, according to the Economy Ministry.

Putin wants more of the money from state companies to go into state coffers so he can meet the promises he’d made to increase state spending on everything from pensions to weapons.  The management of these companies, of course, would much rather tunnel out the money using lavish investment expenditures.  Or in Gazprom’s case, pipe out the money-with a good chunk of the money going into the pockets of Putin’s judo buddies, and pipe manufacturers, the Rotenbergs.  So Putin will command, and rant, but he shouldn’t wait by the mailbox for the dividend checks to start rolling in.

This quote from the article is priceless:

“The Russian corporate sector would do almost anything on earth to be seen as modern and transparent,” Eric Kraus, a managing director at Nikitsky Capital in Moscow, where he manages about $200 million in assets, said by e-mail on May 28. “Anything but pay fair dividends, respect minority interests in corporate transactions, or allow truly independent directors. There is a disconnect between the rhetoric and the reality.”

Couldn’t have said it better myself.

In other news of Russian state corporation hijinks, consider this Reuters item:

Banks that helped Russian oil company Rosneft finance its $55 billion buyout of rival TNK-BP have been left waiting for their payback – a share in $15 billion in asset sales expected to follow the deal, sources familiar with matter said.

State oil company Rosneft’s takeover of TNK-BP this year aimed to create a major oil group producing more oil than Exxon Mobil, but it also tightened the Russian government’s grip on the country’s energy sector.

The asset sales promised by Rosneft Chief Executive Igor Sechin would offload less-profitable businesses to turn the company into the major oil player the CEO has said he wants it to be. The delay shows Rosneft has a lot on its plate integrating TNK-BP and that the sales are on the back burner.

Rosneft had dangled the juicy divestment mandates at the banks in exchange for a $29.8 billion loan – the largest in Russia’s history – on good terms, three out of four sources with direct knowledge of the loan talks said.

“All the lending banks are waiting,” said one of the bankers who asked not to be named because the talks are private.

And they’ll probably be waiting a very long time.

I really don’t blame Sechin here.  He is just doing what he does.  But because he’s doing what he does, that should have been perfectly predictable, I do blame the banks for being so gullible-no, make that stupid-for falling for his bait-and-switch.  (And to reprise a theme from above, Sechin has little incentive to unload bad assets because even bad assets can create good tunneling opportunities.)

Perhaps you’ve been asking yourself: Who trusts a grown man with a mullet when billions of dollars are at stake?  (Seriously: have you checked out Sechin’s ‘do lately? Hockey Hair hardly does it justice.)

Well, now you know: executives from the world’s biggest banks.  They think that Sechin is thinking like a western CEO who at least faces some pressure to maximize shareholder value.  In reality, Sechin’s objective function is quite different.  Mirror imaging is a very bad idea when western managers and financiers deal with Russians.  The Russians are marching to a very different drummer.  But Sechin apparently realized that the banks were mirror imaging, and used that to get them to offer attractive financing terms in exchange for future business he had no intention of sending their way.

Of late the news has been full of stories of the stagnating Russian economy, faltering investment, and continued capital flight.  These two stories illustrate a big part of the reason for those headlines: a colossally corrupt and inefficient state corporate sector.

And again, the irony here is too rich.  I noted the other day that Putin’s rant against defense contractors was ironic because he created the behemoth state enterprises that he now rages against.  He has also been a proponent of the huge state enterprises that he now fulminates about because they won’t pay dividends.

There’s an old expression: be careful what you ask for, because you just might get it.  I’m sure Putin could relate to that right now, if he’s capable of honest self-appraisal.

Commenter Michael brought up an excellent question: what about the Turkish army?  From the beginnings of the Turkish Republic in 1923, the army was the final arbiter of Turkish politics, and viewed itself as the defender of the Kemalist secular state.   Erdogan and Gul recognized this, and after the AKP ascended to power they went after the military, primarily through judicial means.  It has largely neutered military opposition.  At present, something like 20 percent of Turkey’s flag officers are in jail on a variety of charges, from plotting coups to far more sordid crimes.

As a result, the military is back on its heels, and poses far less of a threat to Erdogan’s government.

But the protests might change everything, because it changes the game and the players’ beliefs.  No doubt the military is nursing its hurts, but heretofore has been unwilling to act because the government appeared popular and on the march.  The protests demonstrate that there is serious opposition to Erdogan, and protests can be self-feeding: as protests gain mass, others who disagree with the government learn that more people than they had believed also disagree, which makes them more likely to oppose the government publicly.

This also provides information to the military, telling the officers in particular that Erdogan is more vulnerable than they had believed.  This makes them more likely to become emboldened to challenge him.  Military opposition, even if scattered, can in turn embolden the civilian opposition.

The military can also use any excesses by Erdogan’s government to justify intervention, saying that they are acting on behalf of the people, protecting them from oppression.  They can wrap self-interested intervention in patriotic and populist justifications.

This is now a plausible scenario.  Though not the only one.  The opposition has a varied agenda, and inherently faces coordination problems that the government can exploit.

But the military can potentially determine the balance of power.  Whereas it was reluctant to act independently after Erdogan’s purge, its calculus is now likely to change, because it now knows that there is widespread public opposition to Erdogan: this increases its estimate of the odds that it can prevail if it challenges the government.  It can serve as a power broker, either by throwing its support to the opposition, or by threatening to do so, and negotiating with Erdogan to restore its dominant position in the Turkish state.

It surprises me that little of the commentary has considered the military’s role going forward: the coverage has focused on the turmoil in the streets.  (I plead guilty too-Michael’s comment snapped me out of it.)  This reflects a Romanticism that dominates popular perceptions of revolution.  But in revolutions, the military typically plays the decisive role.  This is likely to be true in Turkey too, especially given the military’s role in the Turkish Republic for the last 80 years. A new Kemal, or a Turkish Franco, is a very real possibility.

So keep an eye on the Turkish military.  Hopefully the media will figure out it should be watching it more closely too.

It’s a damned good thing I went to Istanbul two plus weeks ago rather than now.  I was in most of the locations where the rioting has taken place over the last couple of days: when I was there, the place was crowded as hell but peaceful.

The epicenter of the protests is Taksim Square.  Funny story about that.  I took a boat tour of the Bosporus, during which I was on the bridge where some protests took place.  Afterwards, the tour went to Dolmabache Palace.  The tour operator was supposed to take me from Dolmabache back to my hotel, but she said: “It will take us two hours to get there through traffic.  We’re dropping you off at the Metro  station.”  So I was unceremoniously plopped down at Taksim Square, where I picked up the Metro to go Sishli.  It all worked out well . . . but I doubt that would have been the case this week.

My admittedly superficial impression from my visit was that there is substantial tension between Erdogan and his relentless efforts to move towards a Islam-dominated Turkish state and more secular elements of Turkish society.  It’s hard to explain, but I did pick up uncomfortable vibes in conversations.  For instance, when I was in an office with a TV playing Erdogan giving his weekly speech to the Turkish parliament: I sensed that my hosts were probing to learn my opinions of Erdogan before revealing anything, and felt that they were expressing disapproval, but tacitly.

These articles from the Economist and the FT support that interpretation, with the added twist of Erdogan’s symbiotic relationship with property developers and contractor (which reminds me of Houston).

Erdogan is not backing down, and in fact is doubling down.  For instance, he has said that he will demolish the Ataturk Cultural Center, and replace it with an opera house.  That is highly symbolic because Ataturk, aka Mustafa Kermal, was as relentless in his efforts to secularize Turkey as Erdogan is to Islamize it.

Twitter accounts suggest that the opposition in Taksim and elsewhere is rather disorganized and lacking in leadership.  On the one hand, that suggests that a highly disciplined force like Erdogan’s government and party and security forces should be able to control it.  But on the other, it suggests that it is spontaneous, genuine, and taps into deeply felt resentments.  And given the way that falsified/suppressed preferences work, the revelation of widespread discontent can lead to a positive feedback loop, as people who were upset by Erdogan but kept silent because they believed they were in the distinct minority may feel emboldened by the public expression of opposition.  This is why leaders like Putin-and, presumably Erdogan-live in fear of color revolutions, and take extensive measures to quash any expression of public protest.  By the time things reach the pitch observed in Taksim, though, it can be too late.

Just what the world needs.  More instability in the Middle East.  Particularly in a country that was widely considered to be the potential foundation for a new order in that region.  It is clear that there are deep fault lines in Turkish society, and seismic changes may occur, and quickly.

I have a tentative invitation to return to Istanbul in September.  Who knows what things will be like then?  Although I sensed some tension during mid-May, I never anticipated that things would boil over within mere days.  Three months is a lifetime.

Tech writers are supposed to be clued into what’s on the cutting edge, but Mike Butcher writing on Skolkovo for Techcrunch is so far behind the wave it’s hilarious.  His piece reads like a 2009 press release:

So, in a typically Russian approach to the problem, it’s come up with Skolkovo, a vast new science-based city, to catapult its economy into a new era of technology and innovation. The Skolkovo Innovation Center will be a planned high technology business area with its own set of laws, designed to encourage science and technology companies. The 400 hectare site is predicted to house over 20,000 people permanently, with another 10,000 commuting in to work. In other words, this is a massive project on a typically Russian scale. But in an untypical breakwith the past the whole project is being run by a specially created non-profit, the Skolkovo Foundation.

Skolkovo was a joke from the get-go, as I wrote about at its inception: a government-directed Silicon Valley is a contradiction in terms, but oh-so-Russian.  But even overlooking the fundamental defects in the concept, anyone paying the slightest bit of attention-which is a group which obviously does not include Mike Butcher-knows that Skolkovo is under an unrelenting attack from the siloviki, and most notably from Alexander Bastrykin’s Investigative Committee, which is leading the campaign against anything remotely liberal or viewed in paranoid siloviki minds as connected with the opposition.  The war against Skolkovo is a war on Medvedev by proxy, and is a rather prominent indicator of Russia’s political trajectory.

Not that you’d learn that reading Techcrunch.

In response to the furor over the AP and Rosen investigations, Obama noted the threat that leaks pose to national security:

“As commander-in-chief, I believe we must keep information secret that protects our operations and our people in the field. To do so, we must enforce consequences for those who break the law and breach their commitment to protect classified information. But a free press is also essential for our democracy. “

In a rational world, he would be referring to things like this:

It was the Obama administration that sealed the fate of the Pakistani doctor jailed for helping nail Usama Bin Laden, by divulging key details after the fact and dooming any chance Shakil Afridi’s cover story could win his freedom, according to a confidential Pakistani report.

When former Secretary of Defense and ex-CIA Director Leon Panetta publicly acknowledged Afridi’s role in the ruse which helped the CIA pinpoint Bin Laden’s presence in an Abbottabad compound, any chance that Pakistani authorities could help him get out of the country vanished, according to what some have called Pakistan’s version of the 9/11 Commission, a 357-page report from an independent body set up to probe the aftermath of the 2011 raid by Navy SEALs in which the Al Qaeda leader was killed.

“The statement by the U.S. Defense Secretary Leon Panetta, who was the CIA Director when May 2 happened, confirming the role of Dr. Afridi in making the U.S. assassination mission a success, rendered much of what Afridi told the Commission very questionable if not outright lies,” states the report, which has not been released, but which FoxNews.com has viewed.

As I wrote about a year ago, this administration leaks furiously information that makes it look good, even though these leaks (like the one involving Afridi, or the apprehension of the would-be junk bomber in Yemen, or the US involvement in Stuxnet) are deeply damaging.

In every administration there has been a considerable amount of for-me-but-not-for-thee hypocrisy when it comes to leaking about national security.  But nothing like what we’ve seen in the Age of Obama.

A group of senators from western states, led by Diane Feinstein, have sent Gary Gensler a missive accusing the CFTC of violating the letter and spirit of Frankendodd by failing to register major energy companies (e.g., BP, Shell) as swap dealers.  Each paragraph of the letter is more risible than the one before.

They set the scene by recounting the western electricity crisis of 2000-2001.  This is utterly irrelevant to the swap dealer designation, because swaps had nothing to do with what happened then and there.  Indeed, at its core the crisis was driven by a combination of fundamentals and flawed market design, and even the suspect trading strategies involved physical market transactions rather than swaps.  For instance, none of the Enron strategies like “Fat Boy” or “Ricochet” involved swaps or OTC derivatives generally in any way, shape, or form.  (It’s also rather ironic that one of the things that wreaked havoc with California utilities was that they were precluded by law from engaging in forward transactions to hedge the short position forced upon them by the retail price caps in the restructuring legislation.)

Parts of the letter made me laugh.  Most notably, the senators attack the $8 billion de minimus exemption from the registration requirement.  Their “logic” is that since commodity swaps represent a small fraction (less than one percent) of total OTC derivatives activities, the de minimus level for energy swaps activity should be lower than for financial swaps. Not just lower: “vastly lower.”

They say this “stands to reason.”  Whenever anyone says something “stands to reason” s/he really means: “I can’t give you an actual reason, so I’ll just assert that my conclusion is obvious.”

This gets to the issue of just what the swap dealing designation is intended to achieve.  That’s always been somewhat hazy, but the most charitable interpretation is that swaps dealers are deemed potential sources of systemic risk that require extraordinary regulatory scrutiny.  The risk a particular firm poses to the financial system as a whole depends on its size relative to the entire financial system, rather than to any particular market, so even accepted the premises of Frankendodd the swap dealing designation should not vary by market.  (Indeed, from a systemic perspective, even $8 billion/year on a flow basis is ridiculously small.)

The senators also fret over the possibility that allowing the Shells and BPs of the world to escape the designation will limit the CFTC’s ability to deter manipulation and fraud.  Hardly.  Those things are still illegal, and swap dealing designation will have no impact whatsoever on the CFTC’s ability to detect and deter.  (Which may not be saying much, because all too often the CFTC wouldn’t know a manipulation if it hit the CFTC in the face with a waffle iron.)  (I consider it ironic that these Solons refer to the BP propane manipulation, which was discovered, prosecuted, and punished when the swap dealer designation was not even a twinkle in Barney Frank’s eye.  Bad mental image, I know.)

Relatedly, the senators worry about “transparency”, but all swaps trades will still be reported to central repositories.  The only way the dealer designation matters in this regard is it affects/determines who has to report.  (I shall pass over in silence the fact that the CFTC is at present utterly incapable of utilizing the data reported to the repositories, as Commissioner Scott O’Malia has repeatedly pointed out.)

But most importantly, the senators miss the elephant in the room.  No major energy firm has registered as a swaps dealer because energy firms have shifted trading from swaps to futures.  Another premise (flawed, but there  it is) behind Frankendodd is that swaps are somehow more dangerous to the system than futures.  The legislation and the rules under it imposed more onerous requirements on swaps than futures, in large part to encourage the movement of trading to futures markets.

So if these senators actually applied reason, rather than just hiding behind a stand-in for it, they should be overjoyed that no major energy firm has applied to be a swap dealer.  This should be a feature, not a bug.  It means that market activity has shifted to the venue that these very same senators and others who voted for Frankendodd considered to be the preferred model for trading derivatives: open, transparent, and subject to a rigorous regulatory regime.  Most notably, from a systemic risk perspective, futures are cleared, and one of the major requirements imposed on swap dealers is a clearing requirement.  So the specter of the swap dealing designation, with its associated burdens, has actually led firms to transfer trading activity from the satanic swaps markets to the sainted futures exchanges.  Yay!

But arriving at this understanding would require actual, you know, reasoning.  Not much, but some.

And that is a bridge too far when it comes to the World’s Greatest Deliberative Body.  Which may be a correct description: if so, God save the world.