Streetwise Professor

This week’s big derivatives story was about a public workshop at the CFTC on the issue of futurization.  I was one of the first people to comment on this issue, last year when ICE announced it was converting all of its energy swaps into energy futures.

That was Futurization 1.0. The conversion merely consisted of renaming “swaps” “futures”.  In all economic dimensions (contract specs, execution, clearing) the contracts remained identical.  But the renaming allowed some energy swap users to escape the dreaded Swap Dealer designation.

Futurization 1.1 was the CME’s conversion.  This illustrates some of the silly impacts of Frankendodd.  The CME has cleared energy swaps for going on 10 years now.  The parties would execute a swap, and submit the swap for clearing through an Exchange of Futures for Swaps (EFS) trade.  So the originally executed swap existed only until it was submitted for clearing, when it was replaced with economically equivalent futures contracts.  But no matter how short the swap’s life, the fact that it was born a swap meant that it counted towards the volume of swaps activity used to determine whether someone was a swap dealer.  So the process has now changed, and market participants use (mainly) block trades of futures to create the positions they want, thereby cutting out the interim swap step.

The transformation of the energy derivatives landscape, and the launch of swap futures by CME and Eris are now raising the question of whether futurization will spread beyond energy.

One motive to eschew swaps in favor of futures is unlikely to exist in interest rates, credit and other financial derivatives: the biggest market participants are likely to trade enough bespoke swaps for which there are no futures equivalents, meaning that they will be treated as swap dealers regardless: this reduces their incentive to substitute futures for swaps.

The main driver of futurization outside of energy will be CFTC regulatory treatment of futures and swaps.  Differential treatment will affect the economics of futures vis a vis swaps, and the prospect of such differential treatment was the center of controversy at the CFTC meeting, and in the larger debate in the industry.

The main sources of differential treatment are execution and margining.  Swaps will have to be executed subject to (allegedly) soon-to-be announced SEF rules, and are subject to immediate reporting.  Most market participants who will substitute futures for swaps will execute these deals via privately negotiated block trades subject to exchange rules.  Crucially, reporting of block futures trades is delayed 15 minutes, a concession to fears that immediate reporting would impair liquidity because block positioners (those supplying liquidity to the block futures market) could find it difficult to lay off their risk if the fact they had just done a big trade was announced immediately.  This would induce them to require larger price concessions for doing block trades.

Which raises the question: why the difference between the futures goose and the swaps gander?  Similar considerations obtain for swaps.

Thus, this rule difference is likely to favor futures executed via block trades as opposed to swaps executed via traditional means (but with immediate post-trade transparency) or via SEFs.  (Economically material differences between the rules governing block trades and SEF trades could also affect the relative costs of trading in these disparate ways, and hence affect the choice between them.)

Margining will be different for swaps and futures.  Futures will be margined assuming a one- or two-day liquidation period (i.e., margins will be based on something analogous to a one- or two-day value at risk).  However, swaps-even cleared swaps-will require a minimum liquidation period of 5 days for calculating initial margin.

This substantially higher margin for swaps results in a substantial economic disadvantage to these contracts compared to futures contracts that generate the exact same cash flows (in the absence of default).   This will likely be another factor pushing the market towards futures-which is a major reason for the fury of swaps dealers.

This differential treatment of economically equivalent contracts just because one is called a “swap” (BAD!) and the other is called a “future” (GOOD!) makes little-or no-economic sense-and reflects the swap-o-phobia that pervades DC, and which was an animating principle behind Frankendodd.

The reason to set margins based on a liquidation period reflects the purchase of IM: it is intended to cover potential losses on a defaulted position before that position can be liquidated by the clearinghouse (i.e., the position can be assumed by another solvent market participant).  The less liquid an instrument,  the longer it takes the CCP to work out of the position, the more it is exposed to potential adverse price moves and hence the more margin cover it needs.

This liquidation period depends on the economic characteristics of the contract, how widely it is traded in the marketplace, the identity, number and capitalization of the firms that trade it, and market conditions at the time of liquidation. All of these conditions should be pretty much the same for two contracts that specify the same contingent cash flows, one of which is called a swap and the other a future.  Consider say a 10 year vanilla IRS and economically equivalent futures contracts that offer the same contingent cash flows.  Abstracting from margining differences, these contracts have identical price risks, and should attract the same kinds of users.  Why should liquidity of one differ from the liquidity of the other in the event of the default of the holder of a big position?

And don’t tell me that futures are traded in light markets and swaps are traded in dark ones.  As already noted, futures traded as substitutes for swaps are and will be typically traded in blocks outside the limit order book.

More importantly: in the event of the default of a big FCM or dealer that should be the reason to be concerned, the CCP is going to try to get rid of the defaulted portfolio in big chunks through some sort of auction process.  The firm winning the auction will then trade out of the position, likely using the central market and block trades.

This isn’t much different than how a swap CCP will handle the default process.  Indeed, LCH obligates its members to assume portions of a defaulted portfolio, and one reason for having stringent CCP membership requirements is to ensure that the members have the capital and trading expertise to manage big pieces of defaulted portfolios.

We actually have a case study of futures and swap default management processes.  When Lehman defaulted, CME auctioned off its interest rate, equity, currency, commodity, and energy positions.  These trades were done at differentials from market prices, to reflect the risk that those taking over the positions would assume and have to work off.  A couple of the positions were under-margined: the firms taking over the positions required the CME to provide more funds than the Lehman margin it had against those positions.  As it turned out, the other positions were over-margined, and across all positions the over-margining exceeded the under-margining, meaning that the CME clearinghouse did not suffer any loss as the result of the default.  But this illustrates the possibility that futures can be under-margined, and that even the putatively more liquid futures contracts can require substantial price concessions to get someone to assume them.

LCH.Clearnet handled the default of the Lehman IRS positions. These totaled $9 trillion in notional-bigger than the Lehman futures positions at CME, and arguably far larger in terms of risk.  ($1 trillion in notional of a 10 year IRS poses substantially more risk than $1 trillion in notional of Eurodollar futures.)  90 percent of the position was hedged within a week.  According to LCH.Clearnet, the costs of trading out of the defaulted position were “well within” the Lehman margins it held.

It’s hard to see much of an economic difference between the CME and LCH experiences.  It doesn’t appear that it was materially more difficult to manage the default of “swaps” than it was “futures.”   The Lehman default does not provide any evidence that swap-o-phobia is anything but a mental illness.

Further, this case study illustrates that there is no reason to believe that absent government regulation, swaps will be under-margined and futures will not.  Indeed, had the Lehman positions been held at 5 separate CCPs, two of them would have been under margined.

Indeed, there are serious reasons to be concerned that government regulations of the margining of economically similar (and in some respects identical) contracts will create systemic risks, rather than mitigate them.

The margin regulations-with larger IM imposed on swaps than futures-are a form of price control, in this case default risk price control.  And we know that price controls work out swell, especially when applied by regulators in a two-sizes-fits-all fashion across all different kinds of instruments posing different risks and cleared by CCPs with potentially disparate financial strength.

Moreover, this price control will tend to induce activity to move towards futures CCPs.  Whereas in the absence of the margin differential clearing activity in, say, interest rate derivatives would be split between futures CCPs and swap CCPs, under the differential regulation, business will tend to tip to the futures CCPs-most notably, CME.  This will tend to lead to greater concentration of credit risk.

Wasn’t the whole point of Frankendodd to reduce concentration? Just asking.

The whole conceit that regulators can set risk prices is quite dangerous, and is likely to be a source of systemic risk because these prices are set on the basis of highly limited information in a politicized process, and because mistakes in setting risk prices (especially price differences between similar products) tend to lead to crowded trades and risk concentration that is highly destabilizing during crisis periods (cf. Basel II).

The case for setting different margins (default risk prices) on very similar-and in some cases identical-derivatives contracts is particularly weak.  It is the characteristics of the products and those who trade them that will drive liquidity and liquidation periods: products called “futures” that share the same economic characteristics as products called “swaps” will pose virtually the same challenges to liquidate in the event of a large default.  Given this, the economics suggest that imposing differential margins based on a name difference-rather than economic differences-can’t make things better, and could well make them worse.

But the Sorcerer’s Apprentices know better. So futures are likely to get an artificial advantage, and swaps an artificial burden. Such distortions are quite dangerous.  My conclusion? Futurize in haste, repent at leisure.

More indications that Frankendodd, Basel III, and other measures intended to reduce the risk in the banking system, and to address the too big to fail problem, are leading to greater consolidation of the banking sector:

Investment banks must take further actions to improve returns and more will follow firms like UBS AG (UBSN) and Royal Bank of Scotland Plc  that have exited businesses, McKinsey & Co. said.

Only five or six companies will remain “bulge bracket” firms that offer all investment banking and trading products worldwide, the consulting firm said today in a report titled “After the Reckoning.” Others will step back from some businesses to focus on areas where they have a competitive advantage, according to the report.

. . . .

The top three firms in each asset class account for about two-thirds of trading volume in that product, according to the report. Banks that lack such scale or face higher funding costs will probably focus on businesses such as foreign exchange or structured rates and credit, McKinsey said.

So: increased concentration and reduced competition as some banks exit certain businesses.  The sector overall will almost certainly shrink, but the remaining bulge bracket firms will account for a greater fraction of business, and may grow absolutely.  It is also likely that these remaining firms will be as interconnected, or more interconnected, than was previously the case.

One of the themes of my writing on clearing mandates and other aspects of post-Crisis derivatives regulation has been that although these initiatives have been sold as ways of reducing risk in the financial markets, in reality, they shift many risks, transform others, and create new ones.  It is by no means clear that these new laws and regulations have reduced the overall vulnerability of the financial system.

For instance, clearing and collateral mandates are intended to reduce the amount of credit embedded in derivative trades.  But market participants can respond to this by substituting other forms of leverage.  The effects on credit risk and leverage overall are far more equivocal than the advocates of the mandates claim.  As another example, making derivatives more expensive means that some will eschew using them to manage risk.  Risk that was passed to others able to bear it at lower cost will remain with those who bear it at a high cost.  As yet another example-and the one that worries me most-is that clearing and collateral mandates have transformed credit risk to liquidity risk.  Since true crises are usually liquidity crises, this is highly disturbing.

The CFO of Rolls Royce made similar arguments forcefully at a conference a few days back:

European regulatory measures designed to make the financial system safer don’t actually eliminate risk, they simply move it to nonfinancial companies, warns Mark Morris, the finance chief for Rolls-Royce, the British aero-engine maker. And there could be a negative impact on the economy, he says.

Speaking at a conference organized by The Economist Group (a minority owner of CFO), Morris criticized European regulators for seeking to deal with over-the-counter derivatives risk in the financial sector by requiring some contracts to be centrally cleared or to have collateral posted.

The European market infrastructure regulation, known as EMIR, took effect last August but requires the European Commission to enact a series of technical standards before the rules can be fully implemented. Most are expected to be finalized by mid-2013.

“In essence, you can’t destroy risk,” Morris said. “It morphs into something else. If you take market risk and go into a foreign exchange [hedging] transaction with a bank, you’re replacing it with counterparty risk. If you try to replace the counterparty risk by using central clearing or some form of posting of collateral, what you’re doing is you’re replacing counterparty risk with liquidity risk.”

Morris makes some other good points in the article, so I recommend you read the whole thing.

It seems that the Europeans are more sensitive to these concerns than was the case in the US.  The European Parliament may demand changes in EMIR. Apparently they are aware of the legislate/regulate in haste, repent at leisure problem.  Unfortunately, with Frankendodd dismissed such concerns.  Methinks that the repentance stage will come soon.

There is an I-told-you-so tizzy going on about the revelation of the BATS exchange that a system (or programming) error had resulted in the execution of about 450,000 orders at prices worse than the best bid/offer (BBO).  Oh, the humanity!

A little perspective here.  According to BATS, the total loss (which is a wealth transfer, mind you) totaled . . . brace yourselves now . . . $420,000.  Excuse me.  $420,360.

There seems to be some presumption that there was a Golden Era of trading, before the invasion of the dreaded machines, when intermediaries had hearts of gold rather than a hunger for it.  When bids and offers were never violated.  When there were never trading errors.

Wrong.  There was no Golden Age.  Nirvana is still just a band.

Think that the BBO was never violated on exchange floors?  Think again.  Sometimes this was inadvertent in the chaos of the pits/trading posts during active markets.  Sometimes it was very advertent (is that a word?)  May I remind everyone of the FBI sting on the CME and CBT, which discovered that some brokers would collude with locals to execute customer orders at off-market prices, and split the proceeds, sometimes delivered by bagmen-literally, guys passing paper bags of bills.   Given the relatively crude time stamping of trading cards, it was very difficult to construct an accurate audit trail.  Trades couldn’t even be sequenced with precision, and since the bid/offer were not recorded continuously or time stamped, it was impossible to see whether  a trade violated the BBO.  There were pit monitors who tried to keep an eye on things, but no human monitoring was capable of detecting all violations.  Indeed, the sociology of the floor and the member domination of exchanges (a subject I’ll turn to shortly) meant that social pressure discouraged cracking down too aggressively, particularly on the most powerful.

Enforcing the BBO on the floor was in many ways constrained by a lack of data.  If anything, current market monitors have the exact opposite problem: they are drowning in a sea of data.  But as BATS shows, it is possible to go back through years of this data and pick up mistakes that cost customers about $1 per error.

Then shall we discuss out-trades?  Out-trades-trading errors, where trade terms submitted by the buyer and seller didn’t match-were common on the floor.  Brokers were on the hook for errors, and there were stories of brokers writing six figure checks to make a customer whole for a loss.  I would not be surprised that on an inflation adjusted basis, a single broker wrote a check to a customer that exceeded $420,000 in 2013 dollars.

But this reality of the way things were doesn’t stop the hue and cry about the fallen state of today’s computerized markets.  The biggest huer-and-crier (emphasis on the crying) is Jackass Joe Saluzzi of Themis Trading.  Here Joe outdoes himself, by suggesting that we need to go back to the days of non-profit exchanges in order to restore public confidence in broken markets. (h/t Blivy.)

JJ apparently believes the old mutual non-profit exchanges were freaking charities, like the March of Dimes or something.  Uhm, no.

Let’s look at the facts.  The old mutual exchanges were cartels of intermediaries.  They restricted membership in order to enhance the rents of those members.  For decades, most of them ran brokerage cartels that fixed commissions.  Some created monopoly privileges for some members (e.g., NYSE specialists).  Others (NASDAQ comes to mind) had order handling rules that basically precluded public customers from competing with member market makers in supplying liquidity: NASDAQ was also the nexus of a flagrant conspiracy among market makers to fix spreads at supercompetitive levels.

Non-profit status had nothing whatever to do with the charitable urges of old time brokers and market makers.  As I showed in research done just as the transition from non-profit to for-profit status was occurring, exchanges chose the non-profit form because the non-distribution constraint inherent in that form prevented the exchange from choosing pricing policies that transferred wealth among heterogeneous members with very specialized human capital.  (An abbreviated version of the argument is here.  The full version was published in J. Law & Econ. in 2000.)  Electronic trading undermined the rents and the specialized assets that drove the choice of non-profit form, so the move to electronic trading in turn impelled the transformation of exchanges to for-profit entities.

In other words, non-profit form was chosen by very greedy, profit-driven individuals to protect their profits.  And a good chunk of those profits resulted from the exercise of market power and the adoption of collusive arrangements by exchanges.

So spare me nostalgia.  Indeed, methinks that a good deal of the nostalgia-and the related criticism of modern electronic markets-is a shriek of rage by those who profited under the old system, and are furious that someone ruined their racket.

Joe does get one thing right (cf. blind hog, acorn).  He attributes the specific BATS problem, and the increased complexity of the equity markets, to RegNMS.  This is correct.  The information-and-linkages approach chosen by the SEC led it to adopt regulations that socialized order flow.  This was done with the explicit goal of encouraging competition among trading platforms.

Another example of “be careful what you ask for: you might get it.”  Pre-RegNMS, NYSE executed about 85 percent of the trades in its listed stocks, and the bulk of the remainder was executed in Third Markets which did not contribute to price discovery.  NYSE was essentially the natural monopoly supplier of price discovery.  Now, NYSE market share is in the low-20s, and executions are shared pretty much equally among a handful of platforms.

But this socialized order flow model requires linkages between the execution venues.  It is that necessity that accounts for the complexity of the current equity markets.  The interconnection imperative is directly responsible for the proliferation of order types that many find so vexing, and which indeed give advantages to specialized electronic traders.  Note that the BATS error was in an order type designed to ensure compliance with RegNMS rules relating to the BBO.

You can criticize this market structure.  But if you do so, you have to grasp the nettle of the fundamental trade-off.  The choice is binary.  You can choose to socialize order flow, or not.   If you do, you get something like the current equity market structure, with intense competition among execution venues linked by a complex web of fragile connections and a proliferation of order types.  If you don’t, you get something like the pre-RegNMS market structure, or futures market structure past and present.  A market that tips to a single execution venue that exercises market power, either by restricting access (the old mutual model) or by charging supercompetitive prices (the new for-profit exchange model).

Those are the choices.  But the debate is almost never framed that way.  Instead, bat sh*t crazy people like Saluzzi (enabled by folks like the CNBC talking head in the BATS Hit video) take up all the oxygen screaming about how bad the current market structure is and retailing myths about some Golden Age that never was.

Political economy considerations almost certainly ensure that the SEC is not going to go back on RegNMS, and it is truly invested in the information-and-linkages approach it chose.  So we are likely to see a continued series of controversies over problems that are inherent in the socialized order flow model.  The SEC will pull its chin, and deal with each problem as it appears in an ad hoc way, just adding to the complexity as the new games are devised to exploit the new rules implemented to stop the old games that exploited the old rules.  This will make for never ending media appearances for the likes of Joe Saluzzi, but  don’t buy his line about the good old days.  The good old days that existed when regulation effectively opted for the other binary choice (no socialization of order flow) weren’t all that great.  There was a different set of problems, and a different set of people and firms profiting off the inefficiencies that inhere in the network nature of financial trading.

One of the predictable though unintended consequences of Frankendodd (and its European cousins) will be to increase concentration in the banking sector.  Not just predictable: predicted, including by me (notably at the JP Morgan Commodity Conference in October 2011, and here on SWP).

The logic is fairly straightforward.  Frankendodd creates a huge regulatory overhead that in turn leads to scale economies.  Smaller-to-medium-sized entities will not be able to afford these overhead costs, and will exit the business, and the bigger firms will get bigger.  The overall level of activity is likely to go down as a result of the exit and expansion, but the biggest firms are likely to get bigger even if the market overall gets smaller.  Moreover, the capital and collateral requirements in Frankendodd, including in the derivatives title, have disparate impacts on different market participants  Since the smaller entities typically have higher capital costs than the bigger ones, this increase in capital needs to support trading businesses in particular will lead the smaller market participants to contract more than the bigger ones; this increase in their capital costs may also induce them to exit altogether, especially when taken in conjunction with the increase in regulatory overhead associated with trading businesses in particular

Given that Frankendodd was allegedly intended to address the too big to fail problem, it is perverse that one of its predictable consequences is to increase concentration, and likely increase the size of the biggest firms in the market.

We may be seeing the first major move in this direction, just as Frankendodd’s big boot is starting to kick in.  Morgan Stanley announced deep job cuts, and rumors are flying that it will exit the fixed income trading business:

Now the storied company — whose take-no-prisoners trading desks have at times been rivaled only by firms like Goldman Sachs — is cutting even deeper, raising questions among some on Wall Street about whether it should spin off or ditch much of its trading business as its Swiss rival UBS has, a suggestion the firm eschews.

. . . .

Morgan Stanley’s board, said people briefed on the matter, has discussed closing its fixed-income department. Instead, the firm is shrinking the unit, arguing that it is important to offer its customers those trading services. By cutting jobs and costs and exiting lines like structured products and other complex financial investments and focusing on less risky, less capital-intensive businesses like the trading of interest rates, executives contended that the division can generate a healthy return.

So they’ve discussed it, but decided to keep it in a shrunken state.  But it may have to revisit the more drastic measure:

In recent years, the fixed-income department has not been able to make enough money to cover the cost to Morgan Stanley of this capital, according to people briefed on the matter but not authorized to speak on the record

If it hasn’t covered its cost of capital pre-Frankendodd, lotsa luck with covering it afterwards.

Frankendodd will cause a contraction of the financial sector, which isn’t necessarily a bad thing.  But the contraction will be uneven, and the fundamental nature of Frankendodd favors a relative expansion, and perhaps an absolute expansion, in the biggest-the JP Morgans and Goldmans and Deutsche Banks.

Hardly what was intended.  But that’s different to say it wasn’t predictable.

The US Senate s sometimes called the World’s Greatest Deliberative Body.  At times-most times, in fact-it seems that it would be more apt to call it the Deliberative Body With the World’s Greatest Proportion of Room Temperature IQs.  Many notable dimwits come to mind-Barbara Boxer, for instance. But the dearly departed (from the Senate, anyways) Blanche Lincoln was oh-so-special in her dimness.

As a sort of parting gift prior to her electoral rout in 2010, Blanche succeeded in inserting the eponymous Lincoln Amendment into Frankendodd.  This was the “swaps push out” provision, which precluded any “swaps entity” from receiving assistance from the Federal Reserve.  This requires banks to “push out” dealing in derivatives to separately capitalized subsidiaries that have no access to the Fed discount window, or other sources of federal support.

Crucially, the Lincoln Amendment was limited: basically, only equity derivatives, some credit derivatives, and commodity derivatives (with the exception of gold) were pushed out.  Banks were allowed to maintain their bread-and-butter rates derivatives business, as well as some of their credit trading businesses.  I guess the theory was that commodities are scary risky, but banks can’t jeopardize themselves by playing in interest rates.  Or something.

Well, that’s true of US banks, anyways.  But due to the meticulous drafting that characterizes Frankendodd, branches of foreign banks cannot avail themselves of the same exemptions.  This includes behemoths like Barclays and Deutsche Bank.

So now the Fed is trying to clean up after Congress, endeavoring to find ways to blunt the effects the provisions of the Lincoln Amendment on foreign banks.  Easier said than done, because despite the fact that “Ms Lincoln called her amendment’s treatment of foreign banks’ uninsured US branches a ‘significant oversight’ that was “unfortunate and clearly unintended. . . . the language of the legislation is clear, regulators are unable to use [Lincoln’s] statements on the Senate floor to unilaterally change the implementation of the law. ”

Good times.  Good times. Just another of the land mines lurking in Frankendodd.  Think of how many more are to be found.  And how many are buried in Obamacare.

Like I said.  Good times.

I laughed out loud, and very hard, watching this video (from RT, no less, though via Tabb Group) about HFT.  It is an interview with David Greenberg, who spent 25 years trading CL on the floor of the NYMEX.

What made me laugh?  The part (starting around the 1:30 mark) where Greenberg notes that when public news comes out, HFT traders pull their quotes “in nanoseconds.”  But back on the floor, there would be brokers who would be quoting customer limit orders, and “before his clerk could grab him on his neck, I could go ‘SOLD!'”

Let me translate.  Floor traders had a speed advantage over customers off the floor who were trading by limit order.  When market-moving news came out, floor traders like Greenberg could exploit their speed advantage, and trade against stale customer limit orders that were entered before the information was released. In so doing, the locals, due to their time-and-space advantage, took money from customers.

Yeah, it didn’t happen in a nanosecond, but that doesn’t mean jack.  What matters is that even on the floor, the faster took money from the slower: seconds, nanoseconds, whatever.  This was true in 1990, 1890, and hell, in 1790 or 1690 in the Osaka rice market.  Locals on the floor had a speed advantage over those off the floor, which they exploited ruthlessly .  And this inevitably resulted in wider markets, as off-floor traders quoted wider spreads precisely because of their vulnerability to being picked off.

Not to go all Einstein on you (as if), but speed is relative.  The stale quote problem is not a function of the absolute speed with which some traders can react, but the relative speed.  Humanoid locals in the pit were pitifully slow, compared to robot traders-especially customers who had to play telephone (literally) to yank their orders.  But that doesn’t mean that predatory trading-taking advantage of the slowest gnu in the herd-was less severe on the floor than in an electronic market.  What drives the losses from stale quotes is relative speed.  And I would argue that relative speed differences were even greater in the floor days than now.

And what ticks off old-timers like Greenberg is that the easy pickings aren’t there for the taking anymore.  HFT traders, through their tremendous speed, and their ability to scrape numerous sources of electronic information, can pull their quotes in an instant when market-moving news comes out.  They thereby protect themselves from being picked off.

Which is precisely why they can quote very tight markets.  And which is precisely why guys like Greenberg hate them.  They have ruined a total racket.  How dare they?!?!

Greenberg also talks about how in the floor days prices would move in stages to a new level after information was released.  Now the movement is much faster.  That’s bad how, exactly?

One could argue that if HFT completely withdraw their quotes, that the market will overshoot.  Prices move a lot because HFT traders totally pull their quotes.   Once the information has been digested, they quote again, and presumably the new quote level is between the pre-information release price and the quote/price immediately following the pulling of HFT quotes.

This has a testable prediction: price reversals should be larger in electronic markets than floor markets.  Or to refine the test: price reversals in the aftermath of big price moves (in response to the release of particularly salient information) should be bigger in electronic than floor markets.  To refine the test: the magnitude of price reversals should vary directly with the prevalence of HFT.

This all brings to mind two conversations, held more than 10 years apart, with a legendary trader.  A guy who made 100s of millions of dollars.  In about 2000, this trader told me he was ecstatic about the advent of electronic trading because he was “tired of getting raped by the floor.”  (Exact quote.)  In 2012, he was lamenting the advent of electronic trading because he couldn’t keep up with HFT.

Keep this in mind when you hear laments about HFT, especially from market veterans.  It’s all about whose gnu is gored, or about how the gnus have become so fast that it’s hard to gore them anymore.

A paper on HFT by Baron, Brogaard and Kirilenko is attracting a lot of attention.  They provide shocking evidence: HFT traders make money.  Who knew?

What is garnering the most attention is their analysis of profit by counterparty.  For instance, Bart Chilton was shocked to find that passive HFT traders earned a $5 per contract profit on average when trading with small traders.

The numbers are interesting and all very nice, but the interpretation is far more equivocal than the authors-and HFT critics like Chilton-would have you believe.

One issue is “how big is big?” or “big compared to what?”  Is the per contract profit supposed to be zero?

The paper reports eye-popping Sharp ratios, which suggests that HFT earns abnormal profits.  But great caution is required.  This Sharp ratio only takes into account the authors’ estimate of the capital required to support the HFT positions: given the rapid mean reversion of positions (especially for “passive” HFTs), this capital can be quite modest.  But HFT also requires a substantial investment in systems, software and human capital.  And data! A huge cost.  Arguably the trading capital is the smallest portion of the capital required to setup an HFT and keep it running.  Leaving those investments out of a Sharp ratio calculation renders the number utterly meaningless.  The fact that these are numbers from a single market and HFT traders usually trade in many markets also makes it impossible to know what the profitability of HFT firms is.

Indeed, given that there is free entry into HFT, why wouldn’t we expect the marginal entrant to just earn the market rate of return on all capital employed?  If a study that takes all the relevant costs and investments into account finds that the marginal HFT trader earns abnormal returns, the appropriate response would be to identify  the source of the entry barrier that gives rise to this rent, and attack that.

Another issue of interpretation relates to defining the but-for.  That is, what is the alternative to which HFT is being compared?  An electronic market without HFT?  Floor markets?  Consider the latter.  There is no doubt that floor traders-locals-reaped profits in the same way as the HFT traders in the Baron et al analysis.  Some were “passive”-quoting bids and asks, and supplying liquidity and trading against order flow.  Others were “active”-speculating on price movements, and always alive to picking off stale limit customer limit orders.   Some did both.  Given that the per contract profits reported in the Baron et al paper are fractions of a tick, it’s almost certain that floor traders earned profits as large or larger than they report for HFT, particularly if you leave out important cost/capital components (e.g., the opportunity cost of a seat).

When it comes to floor trading, we know that the marginal trader was earning a rent.  Know as in metaphysically certain.  How do we know that: seat prices were positive, and frequently very large. (A paper I published in 1999 shows that Q-ratios for exchanges calculated using seat prices were astronomical.  This provides clear evidence of rents.)  The seat price is the capitalized value of the abnormal profits earned by the marginal floor trader.  And we know the entry barrier that gave rise to these abnormal profits: exchange limitations on the number of memberships.

So that would be an interesting comparison.  The (appropriately calculated) profit of the marginal HFT firm vs. the marginal profit of floor traders (as measured using seat prices).

The paper also reports substantial skewness in the profitability in HFT.  But there was substantial skewness in profit on the floor too.  The Tom Baldwins and Harris Brumfelds made huge money, a lot of other traders did quite well, and a very large fraction-arguably a majority-were on breaking even and at risk of getting blown out.    And this isn’t a recent phenomenon.  In the 19th and early 20th centuries, titans like Old Hutch made substantially more money than the run of the mill pit trader.

Which brings me back to my constant refrain: what’s really all that different about HFT?  The functions and behaviors of market participants are pretty much static.  We have uninformed traders and informed traders.  We have liquidity suppliers and liquidity demanders.  We have opportunistic traders looking to take advantage of a time-and-space advantage, and the ability to respond sooner than others (thereby profiting at the expense of the slow).  The functions haven’t changed: just the technology for carrying out those functions has changed.

I’d wager that an analysis based on exchange street books from the floor days (which report price, volume, and trader type by CTI indicator) would produce very similar results to the HFT study’s, although the inability to observe the bid-ask on the floor makes it difficult or impossible to break down members trading on their own account (CTI1s) into “active” and “passive” categories in the same way Baron et al do.  I am highly confident that such a study would find that: CTI1s made per contract profits as large or larger than HFT traders; CTI1s profited primarily in trades with CTI4s (customers), and that there was variation in the per contract profit depending on whether the CTI4 was big or small; that floor trader Sharp ratios based only on the capital required to support their positions would be very large; and that there was substantial skewness in the profitability of CTI1s.

Perhaps the most interesting aspect of the study is the distinction between aggressive and passive HFT traders.  It is very hard to criticize passive HFT, because they are clearly providing liquidity (although no doubt Bart will find bad things to say).  The activities of aggressive HFT-HFT firms that are almost always hitting bids and lifting offers-could well be less salutary and perhaps inefficient.

Aggressive firms could be creating adverse selection.  One aggressive strategy could be to invest substantial real resources into scooping up huge amounts of public data, analyzing it faster than anybody else, and trading faster on it than anybody else when they recognize that quotes don’t reflect the information.  Some of this information could be obtained by scraping news and social media sites.  Some of it could be generated by statistical arbitrage: analyzing vast quantities of data to identify pricing relationships across multiple instruments; identifying times when prevailing quotes across these markets deviate from these relationships; and buying cheap and selling rich when such deviations are found.  To the extent quote submitters-including passive HFT firms-do not have this information, the aggressive firms will be better informed, profit at the expense of quote setters, and thereby cause liquidity suppliers to widen their quotes.

If that’s all there is to it, aggressive HFT would be inefficient.  Real resources are devoted to earning a rent, and this rent seeking distorts prices (notably the price of liquidity), thereby inducing others trading for risk-related reasons to trade too little.

But price discovery is the flip side of adverse selection.  Informed trading drives the price discovery process.  The question becomes what is the value of the price discovery provided by aggressive HFT.  Impossible to answer quantitatively.  I would surmise that the conventional wisdom is that the value is small.  Why do we need to have prices adjust by a fraction of a cent to reflect information a fraction of a second sooner?  What real decision (e.g., investment decision, planting decision) is going to change if a price embeds slightly more information a blink of an eye sooner?  I am similarly skeptical about the value of speeding up price discovery, and therefore am quite willing to accept that some aggressive HFT is opportunistic rent seeking, and hence inefficient.

But even granting that, what are you going to do about it?  Is there a way of restricting rent seeking HFT that does not also burden beneficial HFT, for instance by imposing costs on passive HFTs that supply liquidity?

It’s not obvious that there are discriminating ways of pricing trading services in ways that reduce opportunistic trading without also reducing liquidity supply and trading for risk shifting reasons.  Tinkering with maker-taker fee structures, or tinkering with price schedules more generally seems to be the most sensible way to do it.  The question becomes: who should do the tinkering?  Exchanges presumably have the strongest incentives to drive out the opportunistic wolves that feed on the sheep, and the best information to do it.  I therefore don’t see a strong case for external regulation intended to reduce rent seeking HFT.  Let the exchanges handle it.

It is obvious that some of the regulations that have been proposed would make things far worse, rather than better.  Time-in-force rules are probably the best-or worst-example of that.  Requiring quote submitters-including passive HFT firms-to keep quotes in force for some minimum time period makes them incredibly vulnerable to the opportunistic HFT firms.  The aggressive HFT firms feed off of quotes that aren’t adjusted to reflect the information they produce by stat arb or whatever.  Time-in-force rules make it harder to adjust quotes, giving more targets of opportunity to aggressive HFT traders.  Prediction: TIF rules will increase aggressive HFT trading; reduce passive HFT trading; lead to aggressive HFT representing a higher proportion of HFT overall; and lead to wider spreads.

And ironically, these effects will increase the profits HFT firms earn at the expense of non-HFT traders. So, Bart: if you think the profits that HFT earns off the little guys are unconscionable now, be careful what you ask for.  Some of the restrictions on the “cheetah traders” that you advocate will make those profits even more unconscionable.

Put differently: Time-in-force rules don’t constrain aggressive traders who are taking quotes instead of making them.  They only constrain those making quotes and thereby make them vulnerable to the takers.  This makes sense how, exactly?

In almost any human endeavor, there is opportunism and rent seeking and inefficient behavior that goes on side-by-side with beneficial, wealth increasing conduct.  We don’t have the information or sufficiently discriminating and cheap deterrents to eliminate bad conduct altogether.

When it comes to any financial trading-old school floor trading or HFT-dominated electronic trading-rent seeking trading will occur.  When evaluating HFT generally, and restrictions on HFT that do not discriminate between the virtuous and vicious forms of the activity, you have to take the good with the bad and see which predominates.  The vast bulk of the existing empirical evidence shows that HFT is associated with better market quality in terms of spreads and depth.  So even though some HFT is almost certainly predatory, the effects of the predatory trading are more than offset by the efficient, wealth-increasing kinds.   Indiscriminate regulations that constrain both types of HFT are therefore highly objectionable.  Not a good idea to shoot a prize bull in the head because it has a parasite that available drugs won’t kill.  But that’s what those who get all hot and bothered about aggressive-and arguably parasitical-HFT threaten to do with indiscriminate regulations that would impede all HFT.

I’m sure you would never peg me as a green type, but I have decided to join the recycling movement!

I am doing so in response to the call by Barney Frank (the Frank of Frankendodd) to merge the SEC and the CFTC.  This idea has itself been recycled many times, dating back to the 1980s and the birth of stock index futures.

One of the recycling efforts was by Hank Paulson, in the spring of 2008, in his proposal to reform the financial markets.  A centerpiece of this proposal was the org chart shuffling.  What I said then holds true today, so I’ll conserve scarce resources (mainly my time), and merely recycle:

The biggest headline was that the recommendation for the merger of the SEC and the CFTC. This puts in me in mind of two quotes. The first is by Churchill: “A fanatic is one who can’t change his mind and won’t change the subject.” Whenever anything happens in the financial markets, the cry immediately goes up to merge the SEC and the CFTC. Many people are apparently fanatical, because they never change about their minds about the desirability of the merger, and the subject always seems to return to it.

The second quote is by somebody slightly–well, a lot actually–less famous; that would be me. In a 2001 Regulation Magazine piece on the Clinton regulatory legacy, I wrote that the SEC-CFTC combination was a solution in search of a problem.

I am always somewhat mystified by the substance of the arguments for the merger. The most commonly mentioned benefit is a harmonization of margins between stocks and stock index futures. What, it’s not possible to harmonize without going merging the two bodies? Moreover, given the myriad other more important issues facing the two agencies, this seems like a very thin reed on which to rest a major reshaping of the regulatory structure.

In reality, there is very little overlap between the regulatory responsibilities of the two agencies. What’s more, there are huge swathes of the trading landscape that fall outside the jurisdiction of either agency. So merger will hardly reduce that much duplicative or contradictory regulation, and will not fill any regulatory gaps. So what’s the point?

Indeed, there are many sources of potential danger in a merger. One, very underappreciated in my view, is that it sacrifices the advantages of specialization. There are issues unique to securities markets and derivatives markets. Specialized agencies can develop the expertise needed for each market space. Of course the staff at a merged agency could specialize, but major policy, rulemaking, and interpretive decisions are made at the commissioner level. Right now SEC commissioners, for example, need to deal with arcane issues of accounting, disclosure, securities intermediation, and securities trading practices in stock, option, and fixed income markets. This is an already daunting task. Adding new areas of responsibility involving different markets and different instruments with different issues will further tax the already limited expertise of the commissioners of the merged agency.

The inevitable outcome of this dilution of expertise and specialization will be to enhance the power of staff, and degrade the quality of commission decision making. Neither outcome is desirable.

Indeed, I would argue that the SEC is already underspecialized. The agency operates subject to three statutes, the Securities Act of 1933, the Exchange Act of 1934, which focus on primary and secondary markets for securities, respectively; and the Investment Company Act of 1940, which focuses on mutual funds and the like. The agency has responsibility over the issuers of securities, and the markets and intermediaries that trade securities. There is little overlap between these areas. Issues of disclosure and accounting can be conceptually and operationally distinguished from issues of market structure and organization.

A second area of concern is that a unified agency will provide a mechanism to reduce and distort competition between different sectors of the financial markets. There are many on Wall Street that would love to throttle the futures exchanges in order to reduce competition for the securities business. (The margin issue is a perfect example of this. The securities firms would love to force an increase in margins on futures to drive some business from the futures exchanges to the stock market.) The regulatory autonomy of the CFTC has largely precluded such an outcome. The SEC has indeed tried in the past to impede the development and introduction of futures products that compete closely with securities markets but has largely failed in these endeavors because it does not have the necessary authority or jurisdiction.

Now, of course, a merger would change agency politics. Under the current framework, the SEC is largely responsive to securities firms and exchanges, and the CFTC is responsive to the futures exchanges and the FCMs. A merged entity would be responsive to the interests of all of these parties. But that is not necessarily a good thing, as one very likely outcome is that the merged entity would implement regulations that would reduce competition between the varying constituencies.

A more sensible, but still problematic, regulatory reorganization would involve (1) stripping out the primary market, accounting, and disclosure responsibilities from the SEC and putting them in a separate agency focusing on these corporate finance issues, and (2) creating a separate agency responsible for trading and market structure issues in securities and derivatives markets. This second agency, call it the “Commission for Financial Trading and Markets” (“CFTM”) would focus on issues relating to manipulation; fraud; the financial adequacy of intermediaries (securities and derivatives brokerages); and facilitating competitive market structures in financial markets. Arguably the manipulation, fraud and competition responsibilities should give the CFTM some authority in the OTC markets.

This approach would be far preferable to mashing together two disparate agencies with very different histories and cultures in the hope that something beneficial will come out of the unnatural coupling. It would permit the development of some specialization, and many issues of fraud, manipulation, and market structure are common across securities and derivatives markets, so the specialization could be applied to a variety of related markets. This alternative is still problematic, however, because the CFTM could easily become a mechanism for stifling competition between different methods of allocating risks and discovering prices.

All that said, there is little likelihood that the merger (or the creation of a CFTM) will come to pass in any event. The idea has been around for decades, and has never even come close to implementation. This is no surprise. There are powerful political forces in the way. Most notably, the futures exchanges, their members, and the FCMs have fought the SEC’s loving embrace vociferously, and found vocal support in Congress. Moreover, whereas the SEC falls under the congressional banking committees (e.g., the Senate Banking Committee and the Securities, Insurance and Investment Subcomittee), the CFTC is under the ag committees. Neither is about to readily cede jurisdiction over a large, well-heeled, and generous industry.

What he, er I, said.

Expecting miracles from mashing together org charts is insane.  At best, it has no effect.  The more likely outcome is to make things worse.  (Want an example?  Look at the effects of the reorganization of the intelligence community post-911.)   The point about specialization is particularly apposite, IMO (naturally, since I brought it up!)  The five commissioners of the CFTC and the five commissioners of the SEC are already overwhelmed by their complex responsibilities, and can devote relatively little time to becoming expert in any one particular area.  Extending the scope of the commissioners’ responsibilities is supposed to make that problem better?

In the end, nothing is likely to happen.  This is a lame duck kerfuffle.  The people who will have skin in the game in the next Congress will want nothing to do with this, as has been the case for about the last 15 Congresses.

November saw a mini-drama involving the CME, CFTC, and DTCC about the issue of SDRs.  (Acronym overload!)  SDRs being Swap Data Repositories, a spawn of Frankendodd-arguably the only good thing in the Title VII litter.

CME had filed to become an SDR, and wanted to require anyone who cleared swaps through CME to report the trade to its SDR.  The CFTC didn’t like the idea of tying clearing and reporting, and held things up: it had stated that the choice of SDR should be up to the customer.  So CME sued.  DTCC-which has its own SDR and would benefit if some CME swap deals were reported to it-filed as an intervenor in the suit.

Lo and behold, the CFTC approved the CME application, including the provision that tied clearing and reporting.  CME dropped its suit, and DTCC is stomping its little feet:

“The Commission’s action late yesterday was an unexplained and an abrupt reversal of course,” the DTCC, which runs a rival swaps data repository, said in a statement.

“This action is inconsistent with the Commission’s previous actions, and will cause market participants to question the finality of any Commission rule or interpretation.”

Two comments.

First, issues of tying and vertical integration are cropping up all over in trading and exchanges.  I just presented a paper at a conference honoring Oliver Williamson that looks at vertical integration between execution and clearing and settlement.  But the issues are also present in things like data centers and reporting and likely will be present in any service exchanges offer.  Regulators are hostile to these sorts of arrangements.  The lesson of my paper is that there can be-and in my view, typically are-good, transactions cost economics-based reasons for these sorts of vertical arrangements.  Regulators should take a deep dive into TCE and learn something about the potential benefits of vertical restrictions or vertical integration rather than continuing to indulge in their reflexive hostility to it.  What’s the transaction at issue?  What are the potential contractual hazards?  Are the contracting and governance methods chosen to implement the transaction well-adapted to the contracting hazards?

IOW, as if (40 plus years after Coase made an observation on the subject) it is rather astounding that regulators look at every vertical restriction with a jaundiced eye.

Second, in some respects this is like Groundhog Day for me.  I’ve seen this before.  I came across a similar controversy in my failed attempt to create a predecessor to SDRs-an “energy data hub”-back in 2003.  It was obvious then, and is obvious now, that there are substantial scale and scope economies in creating and operating an SDR, and that an SDR is a natural, multi-product monopoly.  It is highly likely that the efficient form of organization would be an industry utility/cooperative, likely a non-profit.

But as I experienced in ’03, industry players see this as a great commercial opportunity, and there is intense competition to establish for-profit data hubs and regulators will not mandate the creation of a single hub or pick a winner.  Hence, it is likely that in the end, in each jurisdiction there will be one dominant hub that could be quite lucrative.  Hence the intense competition to be the winner in a winner-take-all contest.  This competition is typically dissipative.  Moreover, if multiple SDRs do survive (because, for instance, the firms play some sort of oligopoly pricing game), there will be excessive costs due to incomplete exploitation of scale and scope economies (i.e., fragmentation is costly).

Which all means that although mandatory reporting to a data hub/SDR is a good idea, as a result of political economy considerations it will be implemented in a highly inefficient way.

Go figure.