Streetwise Professor

A few words about Garland.

First, the traffic cop who blew away two Islamist would-be mass murders is a total badass. He took out two guys who surprised him and were spraying him with assault weapon fire: pictures from the scene show dozens of evidence markers on the ground, most of which are likely indicating ejected brass from their assault weapons. His assailants were wearing body armor, which means he took them out with freaking head shots while taking rifle fire. With a service pistol. If that isn’t coolness and courage under fire, I don’t know what is.

I wonder if the guy has a military background, because most cops are not noted for their marksmanship. That was some serious shooting under the most disadvantageous and stressful conditions possible. He must spend a lot of time at the range, and must be thanking God that the freaks who attacked him apparently didn’t, going with the tried-and-true Muslim spray and pray thing. There are a lot of Salafists pushing up rocks in Iraq and Afghanistan because of that. I hope they keep it up.

Second, the American-born leader of this suicide mission had been convicted of a terrorism-related offense, and was on a watch list. So how the hell was he able to get his hands on weaponry that was fortunately too powerful for him and his Pakistani buddy to handle? The FBI watched this guy about as well as he watched Tamerlan Tsarnaev. (So yeah, Al Sharpton. Let’s federalize all law enforcement. Here’s a case-excuse me, another case-where the feds fucked up, and the local yokel saved the day.)

Third, this event has provoked the left into paroxysms of rage . . . at Pamela Geller and Geert Wilders, for having the audacity to engage in politically incorrect speech. As in the aftermath of Charlie Hebdo, I’ve lost count at the number of talking heads and pixel stained wretches who condemn the violence but . . . The “but” involves some variant on the theme that Geller engaged in hate speech, and had it coming, or at least the government should constrain such offensive speech to prevent such unfortunate events from recurring.  Indeed, the “buts” are more frequent and insistent here, because the Hebdo staff were hard core leftists, and Geller and Wilder are most definitely not.

As my father would say when I would try to talk my way out of something: No buts. Period.

I will not spend a millisecond discussing Pamela Geller’s words or beliefs, because they are utterly irrelevant. Utterly, completely irrelevant. The government’s powers to limit speech are extremely limited, and rightly so. Geller’s speech and actions are clearly within the protected zone, and for good reason, particularly for speech with political or religious content.

What is “hateful” or “offensive” is inherently subjective. Giving the government the power to censor or silence or punish speech because someone might be offended, or because he or she might deem words to be hateful, is to give it virtually unlimited power to oppress its political opponents. It is an instrument of social and political coercion and control.

As surely as day follows night, when being offended is grounds to call on the government to silence those who oppress those giving offense, the ranks of the offended and aggrieved will metastasize like the most virulent cancer. The ins will use “hate speech” as a club to bludgeon the outs. It will stifle all public discourse, as the circle of offensiveness will grow ever wider, like a drop of oil on still water. The most insistent and fanatical and politically driven-who are the most easily offended, and the most willing to opportunistically claim to be offended-will have a veto over what can be said, and will use it ruthlessly to enhance their power.

Cliff Asness asked on Twitter where the leftists who were die-hard advocates of free speech back in the ’60s and ’70s went. The answer to that question is almost trivial. When the left was seeking power, free speech served its interests as a way of undermining the establishment that it hated and wanted to displace. As its power grew, its interest in free speech contracted accordingly. What was a weapon that it could employ against the establishment became a threat as it became the establishment. Put differently: the left’s interest in free speech varies inversely with its power.

This can be seen in the time series, but particularly in the cross section. The institutions that the left dominates are the most hostile to free speech. Just look at any university if you doubt this. Conversely, they are most insistent about contrarian voice and speech in those institutions that they do not control, such as churches.

Insofar as those whom the left is rallying to defend in the Geller/Garland affair-that is, Muslims-are concerned, they outdo themselves. In defending Muslims, they infantilize and patronize them: apparently they believe Muslims are so incapable of self-control that they must be shielded from any hateful words, because they are liable to go on a murderous rampage if they hear them. And since when was the left so solicitous of the sensitivities of the religious? Well never, actually, including now. Muslims, and the phantom phenomenon of “Islamaphobia”, are merely battering rams that the left can use to attack its real enemies, i.e., anyone to their right, religious Christians (n.b., one of whom I am most definitely not) and Jews, Jacksonian Americans, traditionalists, libertarians, etc. (The left’s “other” is quite diverse.)

The fact that a local traffic cop was the only thing that saved hundreds from the homicidal plans of two Islamist fanatics (one of them a native born American citizen) is deeply concerning. But what is far more disturbing is that this isn’t what disturbs what I would wager is a clear majority of the chattering class. What disturbs them (or what they opportunistically claim disturbs them) is speech that they disagree with, and which they are hell-bent on limiting the rights to engage in such speech. They are not targeting hate speech: they are targeting speech and speakers that they hate.

Fine. As we say in Texas: Come and take it.

The frenzy over the Sarao spoofing indictment has led to the CME Group receiving considerable criticism about the adequacy of its oversight of its markets and trading system. One argument that has been advanced is that the CME’s for-profit status (and the for-profit status of other exchanges) is incompatible with its role as a self-regulatory organization. A piece by Brooke Masters titled “Exchanges Need to Balance Policing and Profitability” in the FT a few days ago puts it this way:

The Sarao case highlights the potential problems with the current US system of relying on “self-regulatory organisations”, including the exchanges, to do much of the frontline policing of markets. They are supposed to make sure traders abide by the rules and refer serious misbehaviour on to government regulators.

This system may have worked when exchanges were owned by their members, but now that they have to generate profits for shareholders, conflicts have emerged. A market that cracks down too hard or too quickly could drive away paying customers. The CME controls the futures market allegedly used by Mr Sarao, but the temptation to go soft could be far greater in areas where trading venues compete.

This is a straw man dining on red herring. The for-profit status of exchanges has little, if anything, to do with the incentives of an exchange to self-regulate. Indeed, for some types of conduct, investor ownership and for-profit status likely improves exchange policing efforts substantially.

I addressed these issues 21 years ago, and then again 15 years ago, in articles published in the Journal of Law and Economics, and 22 years ago in a piece in the Journal of Legal Studies. In the older JLE article, titled “The Self-Regulation of Commodity Exchanges: The Case of Market Manipulation,” I demonstrated incentives are crucial, and for some types of conduct the incentives to police were weak even for non-profit exchanges.

Exchanges (which were organized as non-profits) historically made little effort to combat corners, despite their manifest distorting effects, because the biggest costs of manipulation fell on inframarginal demanders of exchange services (namely, hedgers) or third parties (people who do not trade rely on exchange prices when making decisions), but exchange volume and member profitability depended on the marginal demanders (e.g., speculators) who were little affected. Therefore, exchanges didn’t internalize the cost of corners, so didn’t try very hard to stop them. For-profit exchanges would have faced the same problem.

In other cases, exchanges-be they for profit or non-profit-face strong incentives to police harmful conduct. For instance, securities exchanges have an incentive to reduce insider trading that reduces liquidity and hence raises trading costs leading to lower trading volume. Again, this incentive is largely independent of whether the exchange is for-profit or not-for-profit.

Exchange incentives to police a particular type of deleterious conduct depend crucially on how the costs of that conduct are distributed, and how it affects trading volume and trading costs. The effect on volume and trading costs determines whether and by how much the exchange’s owners (be they shareholders or members) internalize the cost of this conduct. This internalization depends primarily on the type of conduct, not on how the exchange is organized or who owns it or whether the exchange can pay its owners dividends.

In fact, for-profit exchanges have stronger incentives to adopt efficient rules relating to certain kinds of conduct than member-owned, not-for-profit ones. In particular, the members of mutual exchanges were intermediaries; brokers and market makers mainly. The intermediaries’  interests often conflicted with those of exchange users. In particular, self-regulation on member-owned exchanges often took the form of adopting rules and polices that were explicitly intended to benefit their members by restricting competition between them, thereby hurting exchange customers. For instance, member owned exchanges operated commissions cartels for decades: Only forty years ago last Friday (“May Day”) was the NYSE commission cartel that dated from its earliest days dismantled by the SEC. Even after the commission cartels were eliminated, member-owned exchanges adopted other anti-competitive rules that benefited members. Self-regulation was in large part an exercise in cartel management.

Further, powerful members, be they big individual traders or important firms, could often intimidate exchange managers and enforcement personnel. In addition, daily interaction between members contributed to a culture in which screwing a buddy was beyond the pale, but in which many a blind eye was turned when a customer got screwed. Not all the time, but enough, as the FBI sting in ’88-’89 and its aftermath made clear.

So no, there was no Eden of mutual, non-profit exchanges that rigorously enforced rules against abusive trading that was despoiled by the intrusion of the profit-seeking snake. The profit motive was there all along: exchange members were obviously highly profit-driven. It just was manifested in different ways, and not necessarily better ways, than in the current for-profit world.

This also raise the question: just who would own, control, and manage a neo-mutual, non-profit exchange? Big banks, either directly or through their brokerage units? Does anyone think that would solve more problems than it would create? Does anyone honestly believe that there would be fewer conflicts of interest and less potential for abuse in such a setup?

This all gets back to the issue of why exchanges demutualized in the first place. It had zero, zip, nada to do with self-regulation and rule enforcement. It was driven by a seismic technological change. I showed in my 2000 JLE article that non-profit form and mutual ownership economized on transactions costs on floor based exchanges, but were unnecessary in an electronic marketplace. I therefore predicted that exchanges would demutualize and become investor-owned as they shifted from open outcry to electronic trading. That’s exactly what happened over the next several years.

In sum, exchange ownership and organizational form are not the primary or even major determinants of the adequacy of exchange self-policing efforts. The incentives to self-regulate are driven more by economic factors common to both for-profit and not-for-profit exchanges, and the choice of organizational form is driven by transactions cost economizing (including the mitigation of rent seeking) rather than by self-regulatory considerations.  The tension between policing and profit existed even in non-profit exchanges. So those who fret about the adequacy of self-regulation need to get over the idea that going back to the future by re-mutualizing would make a damn bit of difference. If only it were that easy.

The US military’s credibility is at serious risk due to its don’t-worry-be-happy disclosures about the war against ISIS. Much independent reporting today strongly suggests that ISIS is in control of a substantial portion of the Baiji refinery, and that the small Iraqi garrison is in danger of being overrun: and you know what ISIS does when that happens. But the military’s Kevin Bacon-esque take couldn’t be more different:

 While Beiji and Ramadi in Iraq remain contested between Iraqi security forces and extremist Islamic State of Iraq and the Levant militants, ISIL is experiencing setbacks, a U.S. Central Command spokesman said Friday.

If things are going so swimmingly  in Baiji, why the relatively intense air activity there today?:

Near Bayji, eight airstrikes struck one large and five small ISIL tactical units, destroying five ISIL fighting positions, three ISIL buildings, an ISIL command and control facility, an ISIL mortar system, and an ISIL VBIED.

Remember Chairman of the Joint Chiefs Dempsey (who can’t leave soon enough to suit  me) declared that Baiji (in contrast to Ramadi) is strategically important. Then why are there only 200 Iraqi police and special forces there, hanging on for dear life?

Further, the military has been extremely slow in responding to accusations by the very dodgy Syrian Observatory for Human Rights (which appears to be one guy in a flat in London who is a conduit for Islamist agitprop) that US airstrikes had killed 64 civilians in a town near Kobani. All coverage of this event takes Syrian Observatory’s account as gospel. This is a very damaging charge, and the US should have responded quickly and authoritatively immediately, rather than letting this portrayal go around the world unchallenged. The military should also investigate the Syrian Observatory very closely and report what it learns about its sources, methods, and connections. If, as it appears, it is an information war outlet, it is unconscionable that we are letting it go unchallenged as the authoritative source on events in Syria that independent reporters cannot observe.

It’s not just me that is appalled by the Pentagon’s performance. The authoritative and respected analyst Anthony Cordesman rips the Pentagon’s recently released report on the progress of the “counter-ISIS” operation. This sentence suffices, but read the whole thing:

To put it bluntly, it seems to be far more of a public relations exercise than a serious attempt at reporting on nature and success of Operation Inherent Resolve.

We need to be honest and be real, and not repeat the self-defeating performance of the “Five-O’Clock Follies” of Vietnam infamy. Credibility is vital, and methinks it is being squandered to protect an administration that is only half-heartedly  (if that) committed to destroying ISIS. Reality will rear its ugly head sooner or later, and better to confront it now when something can be done about it.

Former CIA Deputy Director Michael Morell made a rather stunning admission that the US intelligence community believed that the Arab Spring would be the death knell of Al Qaeda:

“We thought and told policy-makers that this outburst of popular revolt would damage al-Qaeda by undermining the group’s narrative,” Morell wrote in the book, a copy of which was obtained by The Washington Post ahead of its release later this month.

Instead, “the Arab Spring was a boon to Islamic extremists across both the Middle East and North Africa,” he said. “From a counterterrorism perspective, the Arab Spring had turned to winter.”

Do they also believe in unicorns and faeries at the CIA? Revolutionaries exploit political turmoil: the vast majority of political upheavals in the developing world have empowered radicals, rather than neutered them. And since when did a revolutionary situation in the Middle East in particular result in the emergence of a stable, peaceful state? The region’s nations have see-sawed between anarchic strife and repressive regimes. The region’s history is fodder for cynicism and world weariness, not flights of political fancy.

Neocons were rightly savaged after the Iraq invasion for their naive belief that Saddam’s overthrow would lead to the creation of a stable, peaceful, and democratic Iraq, and that this in turn could provide the foundation for a democratic Middle East. We all know how that worked out, which makes the naiveté of the CIA almost a decade later astounding.

Arab societies are deeply broken, and as Iraq demonstrates, throwing off the shackles of an authoritarian regime is almost certain to result in chaos and anarchy that provides opportunities to Islamist radicals. Indeed, the failure of the CIA in 2011 is more damning than the neocon failure in 2003 because the former had the benefit of the sad example of Iraq, which should tempered greatly any temptation to indulge in flights of optimism.

And God spare us from anyone who bases policies on “narratives,” or believes that the roots of Salafism in the Middle East are so shallow that it will wither and die because a few aging dictators are overthrown. Islamism is deeply embedded in Arab societies, and to believe that the fall of a Mubarak or a Khaddafy will transform Islamists into Jeffersonians is delusional.

It must also be noted that this benign view of the effect of the Arab Spring on Al Qaeda was very politically convenient for the administration. Especially in the aftermath of the elimination Osama, it supported Obama’s campaign pitch that “Al Qaeda is on the run.” This raises the possibility that the CIA slanted its analysis to benefit its political masters.

In brief, this is an intellectual failure of the first order. What confidence can we have that the mindset that led to this failure is not still exerting a baleful influence on intelligence analysis today? The CIA’s intellectual failure is particularly troubling given the extremely fraught situation in the Middle East. We need all the penetrating analysis we can get, and the thought that those charged with providing such analysis have very recently have proved to be naive fantasists is deeply troubling.

During the Cold War, Reagan’s dissatisfaction with the analysis provided by the CIA led him to form a Team B to give an alternative viewpoint about the USSR. In light of Morell’s admission, something similar is desperately needed now. But we all know that the likelihood we will get it is somewhere between zero and nil.

I have read and re-read these remarks by Brett McGurk, “deputy special presidential envoy to the Global Coalition to Counter ISIL” (counter?-that tells you all you need to know) more times than I can count, and I still can hardly believe my eyes:

 Well, you certainly hope for such a tipping point, but our plan is for a long, steady, slow-burning campaign against Daish.

I have read more military history than I should have, and I cannot recall ever reading anything like this. I keep shaking my head. The closest thing that comes to mind is the Johnson-McNamara “gradual escalation” strategy, and if that’s the best comparison, it’s very bad news.

“Slow-burning” is the antithesis of pretty much every basic military principle. I remember one quote from Reef Points from my days at Navy, from Bull Halsey: “Hit hard, hit fast, hit often.” We are doing the reverse: hitting ineffectually, hitting slowly (by McGurk’s admission) and hitting infrequently. I further remember Napoleon: “The reason I beat the Austrians is that they did not know the value of five minutes.” Speed and initiative put the enemy on his heels. “Slow-burning” gives him the opportunity to prepare an dig in and marshal resources.

And that’s exactly what ISIS is doing, especially in Mosul. It is delusional to think that the Iraqi Army will be able to take Mosul, especially the way that ISIS has burrowed itself, literally and figuratively,  into every nook and cranny of the city. The Iraqis had a helluva time taking Tikrit, which was held by a few hundred ISIS fighters. Mosul will be orders of magnitude more difficult, no matter how many excavators we blow up.

The chance to keep ISIS out of Mosul was lost last June, when ISIS was exposed on the roads and deserts around the city. But Obama stayed his hand.

“Slow-burning” also allows ISIS to slaughter at its leisure, including hundreds of Yazidi prisoners who were massacred yesterday. By the time our slow-burning is over, will there be anyone alive left to save?

ISIS is actually on the offensive in places like Baiji and Ramadi. The US military is trying to spin that this is the last gasp of a force facing defeat:

While Beiji and Ramadi in Iraq remain contested between Iraqi security forces and extremist Islamic State of Iraq and the Levant militants, ISIL is experiencing setbacks, a U.S. Central Command spokesman said today.

Speaking to reporters in the Pentagon via teleconference, Air Force Col. Patrick Ryder provided a weekly update on Centcom’s operational highlights in the fight against ISIL in Iraq and Syria.

In central Iraq, Iraqi security forces continue to conduct operations to secure the city of Karmah, and they have retaken territory around the Tigris River canal, Ryder said.

“We’ve seen these efforts help isolate ISIL fighters who are in the town, and this has helped choke off their lines of communication,” he said, adding that from an operational perspective, such gains help to secure ISIL approaches to Baghdad.

Iraqi Forces Hold Ramadi

There have been no significant changes from last week’s operations in Ramadi, a city in western Iraq, where Iraqi forces continue to hold onto key ground while ISIL forces try to keep territory they captured in the eastern part of the city. “We expect Ramadi to remain contested,” Ryder said.

ISIL also continues to contest the Iraqi forces’ hold on Beiji’s oil refinery, he said.

“ISIL has shown that Beiji and Ramadi are strategically important to them, and they are committing a significant amount of limited resources to secure these locations,” Ryder said.

ISIL wants to “score a win” after suffering numerous recent setbacks, most notably in Tikrit, he added. “Because of this, both cities are expected to remain contested for some time,” he said.

Sorry. Not buying it. Most other information strongly suggests that the Iraqis are hanging on by their fingernails in both places. The initiative is with ISIS, not Iraq. At best, US airpower is keeping ISIS at bay and saving the Iraqis from another massacre. That’s not defeat, but it sure as hell ain’t victory. It’s sad to see the the military spinning so pathetically in defense of a campaign that you know deeply offends their professional and patriotic sensibilities.

In other embarrassments, the United States is telling citizens in Yemen: “Good luck! You’re on your own!”

That’s not true, exactly. The State Department is setting up the equivalent of a ride sharing program. Not exactly civis romanus sum, is it?

And there’s more! Iran seized a cargo ship in one of the most strategically important waterways in the world, the Straits of Hormuz, during a period of heightened tensions in the region: indeed there is an ongoing proxy war between Iran and the Saudis in Yemen. The Iranians are using some flimsy legal pretext to justify the seizure, but we all know that Iran is sending a message.

We also know that Obama is pretending not to hear. Again the Pentagon carried his water, issuing several mealy-mouthed statements to the effect that we aren’t sure whether the Maersk ship was in international waters, and that the US is under no obligation to defend a Marshall Islands flagged ship, despite the fact that the US has treaty obligations to that nation:

The Government of the United States has full authority and responsibility for security and defense matters in or relating to the Republic of the Marshall Islands. (b) This authority and responsibility includes: (1) the obligation to defend the Federated States of Micronesia and its people from attack or threats thereof as the United States and its citizens are defended;… (c) The Government of the United States confirms that it shall act in accordance with the principles of international law and the Charter of the United Nations in the exercise of this authority and responsibility

And even if the US had no treaty obligation, for centuries-and especially since WWII-it has been a stalwart defender of the freedom of navigation. Twice (in 1981 and 1986) Reagan dispatched carrier groups to the Gulf of Sidra when Khadaffy claimed that these waters were off-limits to foreign ships. When the Libyans insanely challenged the carriers, F-14s splashed several of their fighters. When the Iranians began attacking tankers in the Persian Gulf in 1987, foreign tankers were put under the US flag, and escorted by US ships. Later, the US shelled and destroyed oil platforms that the Iranians were using as command and control facilities to coordinate their attacks on tankers.

By the way, the Iranian seizure of the Maersk Tigris has to be viewed against the background of this history.

But Obama is hell-bent on doing a deal with Iran, and he will sacrifice pretty much any American policy principle and alliance to get it.

All of this has me doing a slow burn.

The CFTC released its civil complaint in the Sarao case yesterday, along with the affidavit of Cal-Berkeley’s Terrence Hendershott. Hendershott’s report makes for startling reading. Rather than supporting the lurid claims that Sarao’s actions had a large impact on E Mini prices, and indeed contributed to the Flash Crash, the very small price impacts that Hendershott quantifies undermine these claims.

In one analysis, Hendershott calculates the average return in a five second interval following the observation of an order book imbalance. (I have problems with this analysis because it aggregates all orders up to 10 price levels on each side of the book, rather than focusing on away-from-the market orders, but leave that aside for a moment.) For the biggest order imbalances-over 3000 contracts on the sell side, over 5000 on the buy side-the return impact is on the order of .06 basis points. Point zero six basis points. A basis point is one-one-hundredth of a percent, so we are talking about 6 ten-thousandths of one percent. On the day of the Flash Crash, the E Mini was trading around 1165. A .06 basis point return impact therefore translates into a price impact of .007, which is one-thirty-fifth of a tick. And that’s the biggest impact, mind you.

To put the comparison another way, during the Flash Crash, prices plunged about 9 percent, that is, 900 basis points. Hendershott’s biggest measured impact is therefore 4 orders of magnitude smaller than the size of the Crash.

This analysis does not take into account the overall cumulative impact of the entry of an away-from-the market order, nor does it account for the fact that orders can affect prices, prices can affect orders, and orders can affect orders. To address these issues, Hendershott carried out a vector autoregression (VAR) analysis. He estimates the cumulative impact of an order at levels 4-7 of the book, accounting for direct and indirect impacts, through an examination of the impulse response function (IRF) generated by the estimated VAR.* He estimates that the entry of a limit order to sell 1000 contracts at levels 4-7 “has a price impact of roughly .3 basis points.”

Point 3 basis points. Three one-thousandths of one percent. Given a price of 1165, this is a price impact of .035, or about one-seventh of a tick.

Note further that the DOJ, the CFTC, and Hendershott all state that Sarao see-sawed back and forth, turning the algorithm on and off, and that turning off the algorithm caused prices to rebound by approximately the same amount as turning it on caused prices to fall. So, as I conjectured originally, his activity-even based on the government’s theory and evidence-did not bias prices upwards or downwards systematically.

This is directly contrary to the consistent insinuation throughout the criminal and civil complaints that Sarao was driving down prices. For example, the criminal complaint states that during the period of time that Sarao was using the algorithm “the E-Mini price fell by 361 [price] basis points” (which corresponds to a negative return of about 31 basis points). This is two orders of magnitude bigger than the impact calculated based on Hendershott’s .3 return basis point estimate even assuming that the algorithm was working only one way during this interval.

Further, Sarao was buying and selling in about equal quantities. So based on the theory and evidence advanced by the government, Sarao was causing oscillations in the price of a magnitude of a fraction of a tick, even though the complaints repeatedly suggest his algorithm depressed prices. To the extent he made money, he was making it by trading large volumes and earning a small profit on each trade that he might have enhanced slightly by layering, not by having a big unidirectional impact on prices as the government alleges.

The small magnitudes are a big deal, given the way the complaints are written, in particular the insinuations that Sarao helped cause the Flash Crash. The magnitudes of market price movements dwarf the impacts that the CFTC’s own outside expert calculates. And the small magnitudes raise serious questions about the propriety of bringing such serious charges.

Hendershott repeatedly says his results are “statistically significant.” Maybe he should read Deirdre McCloskey’s evisceration of the Cult of Statistical Significance. It’s economic significance that matters, and his results are economically miniscule, compared to the impact alleged. Hendershott has a huge sample size, which can make even trivial economic impacts statistically significant. But it is the economic significance that is relevant. On this, Hendershott is completely silent.

The CFTC complaint has a section labeled “Example of the Layering Algorithm Causing an Artificial Price.” I read with interest, looking for, you know, actual evidence and stuff. There was none. Zero. Zip. There is no analysis of the market price at all. None! This is a piece of the other assertions of price artificiality, including most notably the effect of the activity on the Flash Crash: a series of conclusory statements either backed by no evidence, or evidence (in the form of the Hendershott affidavit) that demonstrates how laughable the assertions are.

CFTC enforcement routinely whines at the burdens it faces proving artificiality, causation and intent in a manipulation case. Here they have taken on a huge burden and are running a serious risk of getting hammered in court. I’ve already addressed the artificiality issue, so consider causation for a moment. If CFTC dares to try to prove that Sarao caused-or even contributed to-the Crash, it will face huge obstacles. Yes, as Chris Clearfield and James Weatherall rightly point out, financial markets are emergent, highly interconnected and tightly coupled. This creates non-linearities: small changes in initial conditions can lead to huge changes in the state of the system. A butterfly flapping its wings in the Amazon can cause a hurricane in the Gulf of Mexico: but tell me, exactly, which of the billions of butterflies in the Amazon caused a particular storm? And note, that it is the nature of these systems that changing the butterfly’s position slightly (or changing the position of other butterflies) can result in a completely different outcome (because such systems are highly sensitive to initial conditions). There were many actors in the markets on 6 May, 2010. Attributing the huge change in the system to the behavior of any one individual is clearly impossible. As a matter of theory, yes, it is possible that given the state of the system on 6 May that activity that Sarao undertook with no adverse consequences on myriad other days caused the market to crash on that particular day when it didn’t on other days: it is metaphysically impossible to prove it. The very nature of emergent orders makes it impossible to reverse engineer the cause out of the effect.

A few additional points.

I continue to be deeply disturbed by the “sample days” concept employed in the complaints and in Hendershott’s analysis. This smacks of cherry picking. Even if one uses a sample, it should be a random one. And yeah, right, it just so happened that the Flash Crash day and the two preceding days turned up in a random sample. Pure chance! This further feeds suspicions of cherry picking, and opportunistic and sensationalist cherry picking at that.

Further, Hendershott (in paragraph 22 of his affidavit) asserts that there was a statistically significant price decline after Sarao turned on the algorithm, and a statistically significant price increase when he turned it off. But he presents no numbers, whereas he does report impacts of non-Sarao-specific activity elsewhere in the affidavit. This is highly suspicious. Is he too embarrassed to report the magnitude? This is a major omission, because it is the impact of Sarao’s activity, not offering away from the market generally, that is at issue here.

Relatedly, why not run a VAR (and the associated IRF) using Sarao’s orders as one of the variables? After all, this is the variable of interest: what we want to know is how Sarao’s orders affected prices. Hendershott is implicitly imposing a restriction, namely, that Sarao’s orders have the same impact as other orders at the same level of the book. But that is testable.

Moreover, Hendershott’s concluding paragraph (paragraph 23) is incredibly weak, and smacks of post hoc, ergo propter hoc reasoning. He insinuates that Sarao contributed to the Crash, but oddly distances himself from responsibility for the claim, throwing it on regulators instead: “The layering algorithm contributed to the overall Order Book imbalances and market conditions that the regulators say led to the liquidity deterioration prior to the Flash Crash.” Uhm, Terrence, you are the expert here: it is incumbent on you to demonstrate that connection, using rigorous empirical methods.

In sum, the criminal and civil complaints make a Matterhorn out of a molehill, and a small molehill at that. And don’t take my word for it: take the “[declaration] under penalty of perjury” of the CFTC’s expert. This is a matter of magnitudes, and magnitudes matter. The CFTC’s own expert estimates very small impacts, and impacts that oscillate up and down with the activation and de-activation of the algorithm.

Yes, Sarao’s conduct was dodgy, clearly, and there is a colorable case that he did engage in spoofing and layering. But the disparity between the impact of his conduct as estimated by the government’s own expert and the legal consequences that could arise from his prosecution is so huge as to be outrageous.

Particularly so since over the years CFTC has responded to acts that have caused huge price distortions, and inflicted losses in nine and ten figures, with all of the situational awareness of Helen Keller. It is as if the enforcers see the world through a fun house mirror that grotesquely magnifies some things, and microscopically shrinks others.

In proceeding as they have, DOJ and the CFTC have set off a feeding frenzy that could have huge regulatory and political impacts that affect the exchanges, the markets, and all market participants. CFTC’s new anti-manipulation authority permits it to sanction reckless conduct. If it was held to that standard, the Sarao prosecution would earn it a long stretch of hard time.

*Hendershott’s affidavit says that Exhibit 4 reports the IRF analysis, but it does not.

The complaint against Sarao contains some interesting details. In particular, it reports his profits and quantities traded for nine days.

First, quantities bought and sold are almost always equal. That is characteristic of a scalper.

Second, for six of the days, he earned an average of .63 ticks per round turn. That is about profit that you’d expect a scalper to realize. Due to adverse selection, a market maker typically doesn’t earn the full quoted spread.  On only one of these days is the average profit per round turn more than a tick, and then just barely.

Third, there is one day (4 August, 2011) where he earned a whopping 19.6 ticks per round trip ($4 million profit on 16695 buy/sells). I find that hard to believe.

Fourth, there are two days that the government reports the profit but not the volume. One of these days is 6 May, 2010, the Flash Crash day. I find that omission highly suspicious, given that this is the most important day.

Fifth, I again find it odd, and potentially problematic for the government, that it charges him with fraud, manipulation, and spoofing on only 9 days when he allegedly used the layering strategy on about 250 days. How did the government establish that trading on some days was illegal, and on other days it wasn’t?

The most logical explanation of all this is that Sarao was basically scalping-market making-and if he spoofed, he did so to enhance the profitability of this activity, either by scaring off competition at the inside market, or inducing a greater flow of market orders, or both.

One implication of this is that scalping does not tend to cause prices to move one direction or the other. It is passive, and balances buys and sells. This will present great difficulties in pursuing the manipulation charges, though not the spoofing charges and perhaps not the fraud charges.

The United States has filed criminal charges against on Navinder Sarao, of London, for manipulation via “spoofing” (in the form of “layering”) and “flashing.” The most attention-grabbing aspect of the complaint is that Sarao engaged in this activity on 6 May, 2010-the day of the Flash Crash. Journalists have run wild with this allegation, concluding that he caused the Crash.

Sarao’s layering strategy involved placement of sell orders at various levels more than two ticks away from the best offer. At his request, “Trading Software Company #1” (I am dying to know who that would be) created an algorithm implemented in a spreadsheet that would cancel these orders if the inside market got close to these resting offers, and replace them with new orders multiple levels away from the new inside market. The algorithm would also cancel orders if the depth in the book at better prices fell below a certain level. Similarly, if the market moved away from his resting orders, those orders would be cancelled and reenetered at the designated distances from the new inside market level.

The complaint is mystifying on the issue of how Sarao made money (allegedly $40 million dollars between 2010 and 2014). To make money, you need to buy low, sell high (you read it here first!), which requires actual transactions. And although the complaint details how many contracts Sarao traded and how many trades (e.g., 10682 buys totaling 74380 lots and 8959 sells totaling 74380 lots on 5 May, 2010-big numbers), it doesn’t say how the trades were executed and what Sarao’s execution strategy was.

The complaint goes into great detail regarding the allegedly fraudulent orders that were never executed, it is maddeningly vague on the trades that were. It says only:

[W]hile the dynamic layering technique exerted downward pressure on the market SARAO typically executed a series of trades to exploit his own manipulative activity by repeatedly selling futures  only to buy them back at a slightly lower price. Conversely, when the market mved back upward as a result of SARAO’s ceasing the dynamic layering technique, SARAO typically did the opposite, that is he repeatedly bought contracts only to sell them at a slightly higher price.

But how were these buys and sells executed? Market orders? Limit orders? Since crossing the spread is expensive, I seriously doubt he used market orders: even if the strategy drove down both bids and offers, using aggressive orders would have forced Sarao to pay the spread, making it impossible to profit. What was the sequence? The complaint suggests that he sold (bought) after driving the price down (up). This seems weird: it would make more sense to do the reverse.

In previous cases, Moncada and Coscia (well-summarized here), the scheme allegedly worked by placing limit orders on both sides of the market in unbalanced quantities, and see-sawing back and forth. For instance, the schemers would allegedly place a small buy order at the prevailing bid, and then put big away from the market orders on the offer side. Once the schemer’s bid was hit, the contra side orders would be cancelled, and he would then switch sides: entering a sell order at the inside market and large away-from-market buys. This strategy is best seen as a way of earning the spread. Presumably its intent is to increase the likelihood of execution of the at-the-market order by using the big contra orders to induce others with orders at the inside market to cancel or reprice. This allowed the alleged manipulators to earn the spread more often than they would have without using this “artifice.”

But we don’t have that detail in Sarao. The complaint does describe the “flashing” strategy in similar terms as in Moncada and Coscia, (i.e., entering limit orders on both sides of the market) but it does not describe the execution strategy in the layering scheme, which the complaint calls “the most prominent manipulative technique he used.”

If, as I conjecture, he was using something like Moncada and Coscia were alleged to have employed, it is difficult to see how his activities would have caused prices to move systematically one direction or the other as the government alleges. Aggressive orders tend to move the market, and if my conjecture is correct, Sarao was using passive orders. Further, he was buying and selling in almost (and sometimes exactly) equal quantities. Trading involving lots of cancellations plus trades in equal quantities at the bid and offer shares similarities with classic market making strategies. This should not move price systematically one way or the other.

But both with regards to the Flash Crash, and 4 May, 2010, the complaint insinuates that Sarao moved the price down:

As the graph displays, SARAO successfully modified nearly all of his orders to stay between levels 4 and 7 of the sell side of the order book. What is more, Exhibit A shows the overall decline in the market price of the E-Minis during this period.

But on 4 May, Sarao bought and sold the exact same number of contracts (65,015). How did that cause price to decline?

Attributing the Flash Crash to his activity is also highly problematic. It smacks of post hoc, ergo propter hoc reasoning. Or look at it this way. The complaint alleges that Sarao employed the layering strategy about 250 days, meaning that he caused 250 out of the last one flash crashes. I can see the defense strategy. When the government expert is on the stand, the defense will go through every day. “You claim Sarao used layering on this day, correct?” “Yes.” “There was no Flash Crash on that day, was there?” “No.” Repeating this 250 times will make the causal connection between his trading and Flash Clash seem very problematic, at best. Yes, perhaps the market was unduly vulnerable to dislocation in response to layering on 6 May, 2010, and hence his strategy might have been the straw that broke the camels back, but that is a very, very, very hard case to make given the very complex conditions on that day.

There is also the issue of who this conduct harmed. Presumably HFTs were the target. But how did it harm them? If my conjecture about the strategy is correct, it increased the odds that Sarao earned the spread, and reduced the odds that HFTs earned the spread. Alternatively, it might have induced some people (HFTs, or others) to submit market orders that they wouldn’t have submitted otherwise. Further, HFT strategies are dynamic, and HFTs learn. One puzzle is why away from the market orders would be considered informative, particularly if they are used frequently in a fraudulent way (i.e., they do not communicate any information). HFTs mine huge amounts of data to detect patterns. The complaint alleges Sarao engaged in a pronounced pattern of trading that certainly HFTs would have picked up, especially since allegations of layering have been around ever since the markets went electronic. This makes it likely that there was a natural self-correcting mechanism that would tend to undermine the profitability of any manipulative strategy.

There are also some interesting legal issues. The government charges Sarao under the pre-Dodd-Frank Section 7 (anti-manipulation) of the Commodity Exchange Act. Proving this manipulation claim requires proof of price artificiality, causation, and intent. The customized software might make the intent easy to prove in this case. But price artificiality and causation will be real challenges, particularly if Sarao’s strategy was similar to Moncada’s and Coscia’s. Proving causation in the Flash Crash will be particularly challenging, given the complex circumstances of that day, and the fact that the government has already laid the blame elsewhere, namely on the Wardell-Reed trades. Causation and artificiality arguments will also be difficult to make given that the government is charging him only for a handful of days that he used the strategy. One suspects some cherry-picking. Then, of course, there is the issue of whether the statute is Constitutionally vague. Coscia recently lost on that issue, but Radley won on it in Houston. It’s an open question.

I am less familiar with Section 18 fraud claims, or the burden of proof regarding them. Even under my conjecture, it is plausible that HFTs were defrauded from earning the spread, or that some traders paid the spread on trades they wouldn’t have made. But if causation is an element here, there will be challenges. It will require showing how HFTs (or other limit order traders) responded to the spoofing. That won’t be easy, especially since HFTs are unlikely to want to reveal their algorithms.

The spoofing charge is based on the post-Frankendodd CEA, with its lower burden of proof (recklessness not intent, and no necessity of proving an artificial price). That will be easier for the government to make stick. That gives the government considerable leverage. But it is largely unexplored territory: this is almost a case of first impression, or at least it is proceeding in parallel with other cases based on this claim, and so there are no precedents.

There are other issues here, including most notably the role of CME and the CFTC. I will cover those in a future post. Suffice it to say that this will be a complex and challenging case going forward, and the government is going to have to do a lot more explaining before it is possible to understand exactly what Sarao did and the impact he had.

At a couple of conferences recently, people asked me what Gary Gensler is up to? I said “I don’t know. It’s not like GiGi and I are buddies.” (True fact: he had me banned from the CFTC building.) Well, now we all know what he’s up to: Gensler has landed as the CFO of Hillary’s presidential campaign.

When Gensler was CFTC chair, I surmised he had ambitions to replace Timmy! as Secretary of the Treasury. But that went to a Rubinoid, Jack Lew. There was also talk of Gensler running for the Senate from Maryland, and Mikulski has announced her retirement, but more well-known Dem pols in the state are poised to run, so that’s not an option.

Taking the campaign CFO job probably does give Gensler an inside track on the coveted SecTreas job. If Hillary wins. If.

Yes, I know she is the odds on favorite. But she was shopping for Oval Office curtains in 2008, and we know how that turned out.

Hillary’s problem is, well, Hillary. A lot of people like the idea of Hilllary. It’s the real person that is the problem.

This has been illustrated by her slow-motion-train-wreck of a campaign kickoff. There’s an old expression: if you can fake sincerity, you have it made. Hillary hasn’t quite mastered that yet. The launch and the comically contrived “spontaneous” road trip to Iowa were about as authentic as Velveeta. It was a remarkable act of will, because you can just tell how much Hillary hates to be with actual people. Further, she has operated in a bubble, protected by some Harry Potteresque charm that repels all serious questions from serious people.

Eventually, though, her personality will shine through. And that’s the problem. Playing word association, if you say “Hillary”, I say: shrill, angry, bitter, entitled, strident, rigid, ideological, dishonest, hyper-partisan, vengeful, arrogant, paranoid, and . . . I could go on. And on. And on. And she’s not that bright: whoever calls her “the smartest woman in the world” is a virulent misogynist, with an obviously low opinion of women. I on the other had, think so highly of women that I would prefer to select the next president by lot from America’s 150 million or so adult females, than by an election in which Hillary is the Democratic Party standard bearer. 150 million-to-one: I’ll take those odds over better than even any day.

She is also an awful politician. She has no political instincts whatsoever. You can see the gears grinding behind her phony grin, trying to figure out what would be the politically advantageous thing to say. Today’s persona is Class Warrior. She recently said the one percenters must be “toppled.” Actually, I could kinda go for that, because despite her past protestations of being as poor as a church mouse, she is definitely in that class now.

In other words, she’s no Bill, who was if nothing else, a natural politician that had a magnetism and suppleness that could overcome his other deficiencies.

Which brings up another issue: the psychodrama between Hillary and Bill. You would think that Bill is a major asset, but I wonder. She wants to win on her own, and has put up with decades of humiliation from him to advance her ambitions: will she put herself in a position where she has to accept his help to win? Nor are Bill’s incentives unmixed. Will he want to play second fiddle as the first First Husband? Hillary’s campaign in 2008 was a soap opera: will 2016 be any different?

Then there’s the old baggage, which Hillary has more of than the lost and found at JFK. (I contributed, in a modest way, to that collection, many years ago, as detailed in the Senate Whitewater Report and the Congressional Record.) It is quite a remarkable record, stretching into the distant past, when she was fired from the Watergate Committee staff, to Arkansas skullduggery, to various White House scandals, to her service as Secretary of State (Benghazi, preventing naming Boko Haram as a terrorist organization, the Reset), to the very present (the stench of cronyism and influence peddling at the Clinton Foundation, and the Immaculate Abortion of her private email server).

Further, she’s not getting any younger, and it shows.

So she has many liabilities. What about the assets? They are formidable, particularly a national media that may not like her, but hates Republicans more. They can be counted on to avoid criticizing her, to form a defensive phalanx around her, and to attack her Republican adversary relentlessly. That didn’t help her in the primaries in 2008, when the fickle press found someone even more attractive. But there is no Barack Obama on offer in 2015-2016.

She also has a relentless fundraising machine, a reliable and experienced party and campaign apparatus, union support, and a solid base who would vote for Godzilla over a Republican.

Thus, she has great institutional advantages that will go far in overcoming her severe personal deficiencies.

But her biggest asset is that you can’t beat somebody with nobody, and right now the Republicans are offering up national nobodies. Maybe a somebody will emerge, but I wouldn’t count on it.

All meaning that although Hillary is a flawed person, and a flawed candidate, she has many advantages. So, as much as it pains me to say so, GiGi’s wish may come true. And as bad as a Gensler Treasury would be, it pains me even more to say that it likely would be one of the best parts of a Hillary Clinton Administration.

The commodity trading sector is remarkable for the prevalence of private ownership, even among the largest firms. My recent white paper discusses this issue in some detail. In a nutshell, publicly-held equity is a risk sharing mechanism. The ability of commodity traders to share some of their largest risks-notably, commodity flat price risks-through the derivatives markets reduces the need to rely on public equity. Moreover, private ownership can mitigate agency problems between equity owners and managers: the equity owners are often the managers. As a consequence, private ownership is more viable in the commodity trading sector.

The biggest cost of this ownership structure is that it constrains the ability to fund large investments in fixed assets. Thus, private ownership can impede a firm’s ability to pursue asset heavy strategies. As I note in this white paper, and my earlier one, commodity firms have used various means to loosen this constraint, including perpetual debt, and spinoffs of equity from asset-heavy subsidiaries.

Another cost is that owners tend to be poorly diversified. But to the extent that the benefits of high powered incentives exceed this cost, private ownership remains viable.

Cargill is the oldest, and one of the largest, of the major privately held commodity traders. (Whether it is biggest depends on whether you want to consider Koch a commodity trader.) It is now commemorating its 150th anniversary: its history began as the American Civil War ended. Greg Meyer and Neil Hume have a nice piece in the FT that discusses some of Cargill’s challenges. Foremost among these is funding its ambitious plans in Indonesia and Brazil.

The article also details the tensions between Cargill management, and the members of the Cargill and McMillan families who still own 90 percent of the firm.

The last family member to serve as chief executive retired in 1995, and now only one family member works full time there. This raises questions about how long the company will remain private, despite management’s stated determination to keep it that way. The families are already chafing due to their inability to diversify. Further, at Cargill private ownership no longer serves to align the incentives of owners and managers, in contrast to firms like Trafigura, Vitol, and Gunvor: even though Cargill is private, the owners aren’t the managers. Thus, the negatives of private ownership are becoming more prominent, and the benefits are diminishing. There is separation of ownership and control, with its associated incentive problems, but there is no compensating benefit of diversification.

Indeed, it is arguable that the company remains private because of agency problems. Current management, which does not own a large fraction of the firm, is not incentivized to de-privatize: there would be no big payday for them from going public, because they own little equity, and they would give up the perquisites attendant to controlling a vast corporation. Moreover, as long as the families can be kept happy, management doesn’t have to worry about capital market discipline or nosy analysts. Thus, management may be well entrenched in the current private structure, and the number of family owners (about 100) could make it difficult to form a coalition that would force the company to go public, or to craft a package that would make it worth management’s while to pursue that option.

In sum, Cargill is a marvelous company, and has been amazingly successful over the years. Its longevity as a private company is remarkable. But there are grounds to wonder whether that structure is still efficient, or whether it persists because it benefits management.