Streetwise Professor

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.

Michael Lewis’s new book on HFT, Flash Boys, has been released, and has unleashed a huge controversy. Or put more accurately, it has added fuel to a controversy that has been burning for some time.

I have bought the book, but haven’t had time to read it. But I read a variety of accounts of what is in the book, so I can make a few comments based on that.

First, as many have pointed out, although this has been framed as evil computer geniuses taking money from small investors, this isn’t at all the case. If anyone benefits from the tightening of spreads, especially for small trade sizes, it is small investors. Many of them (most, in fact) trade at the bid-ask midpoint via internalization programs with their brokers or through payment-for-order-flow arrangements. (Those raise other issues for another day, but have been around for years and don’t relate directly to HFT.)

Instead, the battle is mainly part of the struggle between large institutional investors and HFT. Large traders want to conceal their trading intentions to avoid price impact. Other traders from time immemorial have attempted to determine those trading intentions, and profit by trading before and against the institutional traders.  Nowadays, some HFT traders attempt to sniff out institutional orders, and profit from that information.  Information about order flow is the lifeblood of those who make markets.

This relates to the second issue. This has been characterized as “front running.” This terminology is problematic in this context. Front running is usually used to describe a broker in an agency relationship with a customer trading in advance of the customer’s order, or disclosing the order to another trader who then trades on that information. This is a violation of the agency relationship between the client and the broker.

In contrast, HFT firms use a variety of means-pinging dark pools, accessing trading and quoting information that is more extensive and obtained more quickly than via the public data feeds-to detect the presence of institutional orders. They are not in an agency relationship with the institution, and have no legal obligation to it.

And this is nothing new. Traders on the floor were always trying to figure out when big orders were coming, and who was submitting them. Sometimes they obtained this information when they shouldn’t have, because a broker violated his obligation. But usually it was from watching what brokers were trading, knowing what brokers served what customers, looking at how anxious the broker appeared, etc.  To throw the floor of the track, big traders would use many brokers. Indeed, one argument for dual trading was that it made it harder for the floor to know the origin of an order if the executing broker dual traded, and might be active because he was trading on his own account rather than for a customer.

This relates too to the third issue: reports that the FBI is investigating for possible criminal violations. Seriously? I remember how the FBI covered itself in glory during the sting on the floors in Chicago in ’89. Not really. The press reports say that the the FBI is investigating whether HFT trades on “non-public information.”  Well, “non-public information” is not necessarily “inside information” which is illegal to trade on:  inside information typically relates to that obtained from someone with a fiduciary duty to shareholders. Indeed, ferreting out non-public information contributes to price discovery: raising the risk of prosecution for trading on information obtained through research or other means, but which is not obtained from someone with a fiduciary relationship to a company, is a dangerous slippery slope that could severely interfere with the operation of the market.

Moreover, it’s not so clear that order flow information is “non-public”.  No, not everyone has it: HFT has to expend resources to get it, but anybody could in theory do that. Anybody can make the investment necessary to ping a dark pool. Anybody can pay to get a faster data feed that allows them to get information that everyone has access to more quickly. Anybody can pay to get quicker access to the data, either through co-location, or the purchase of a private data feed. There is no theft or misappropriation involved. If firms trade on the basis of such information that can be obtained for a price that not everyone is willing to pay, and that is deemed illegal, how would trading on the basis of what’s on a Bloomberg terminal be any different?

Fourth, one reason for the development of dark pools, and the rules that dark pools establish, are to protect order flow information, or to make it less profitable to trade on that information. The heroes of Lewis’s book, the IEX team, specifically designed their system (which is now a dark pool, but which will transition to an ECN and then an exchange in the future) to protect institutional traders against opportunistic HFT. (Note: not all HFT is opportunistic, even if some is.)

That’s great. An example of how technological and institutional innovation can address an economic problem. I would emphasize again that this is not a new issue: just a new institutional response. Once upon a time institutional investors relied on block trading in the upstairs market to prevent information leakage and mitigate price impact. Now they use dark pools. And dark pools are competing to find technologies and rules and protocols that help institutional investors do the same thing.

I also find it very, very ironic that a dark pool is now the big hero in a trading morality tale. Just weeks ago, dark pools were criticized heavily in a Congressional hearing.  They are routinely demonized, especially by the exchanges. The Europeans have slapped very restrictive rules on them in an attempt to constrain the share of trading done in the dark. Which almost certainly will increase institutional trading costs: if institutions could trade more cheaply in the light, they would do so. It will also almost certainly make them more vulnerable to predatory HFT because they will be deprived of the (imperfect) protections that dark pools provide.

Fifth, and perhaps most importantly from a policy perspective, as I’ve written often, much of the problem with HFT in equities is directly the result of the fragmented market structure, which in turn is directly the result of RegNMS. For instance, latency arbitrage based on the slowness of the SIP results from the fact that there is a SIP, and there is a SIP because it is necessary to connect the multiple execution venues. The ability to use trades or quotes on one market to make inferences about institutional trades that might be directed to other markets is also a consequence of fragmentation. As I’ve discussed before, much of the proliferation of order types that Lewis (and others) argue advantage HFT is directly attributable to fragmentation, and rules relating to locked and crossed markets that are also a consequence of RegNMS-driven fragmentation.

Though HFT has spurred some controversy in futures markets, these controversies are quite different, and much less intense. This is due to the fact that many of the problematic features of HFT in equities are the direct consequence of RegNMS and the SEC’s decision (and Congress’s before that) to encourage competition between multiple execution venues.

And as I’ve also said repeatedly, these problems inhere in the nature of financial trading. You have to pick your poison. The old way of doing business, in which order flow was not socialized as in the aftermath of RegNMS, resulted in the domination of a single major execution venue (e.g., the NYSE). And for those with a limited historical memory, please know that these execution venues were owned by their members who adopted rules-rigged the game if you will-that benefited them. They profited accordingly.

Other news from today brings this point home. Goldman is about to sell its NYSE specialist unit, the former Spear, Leeds, which it bought for $6.5 billion (with a B) only 14 years ago.  It is selling it for $30 million (with an M).  That’s a 99.5 decline in market value, folks. Why was the price so high back in 2000? Because under the rules of the time, a monopoly specialist franchise on a near monopoly exchange generated substantial economic rents. Rents that came out of the pockets of investors, including small investors.  Electronic trading, and the socialization of order flow and the resultant competition between execution venues, ruthlessly destroyed those rents.

So it’s not like the markets have moved from a pre-electronic golden age into a technological dystopia where investors are the prey of computerized super-raptors. And although sorting out cause and effect is complicated, the decline in trading costs strongly suggests that the new system, for all its flaws, has been a boon for investors. Until regulators or legislators find the Goldilocks “just right” set of regulations that facilitates competition without the pernicious effects of fragmentation (and in many ways, “fragmentation” is just a synonym for “competition”), we have to choose one or the other. My view is that messy competition is usually preferable to tidy monopoly.

The catch phrase from Lewis’s book is that the markets are rigged. As I tweeted after the 60 Minutes segment on the book, by his definition of rigging, all markets have always been rigged. A group of specialized intermediaries has always exercised substantial influence over the rules and practices of the markets, and has earned rents at the expense of investors. And I daresay it would be foolish to believe this will ever change. My view is that the competition that prevails in current markets has dissipated a lot of those rents (although some of that dissipation has been inefficient, due to arms race effects).

In sum, there doesn’t appear to be a lot new in Lewis’s book. Moreover, the morality tale doesn’t capture the true complexity of the markets generally, or HFT specifically. It has certainly resulted in the release of a lot of heat, but I don’t see a lot of light. Which is kind of fitting for a book in which a dark pool is the hero.