Streetwise Professor

I’ve written about there being good HFT and bad HFT; HFT that enhances liquidity, and HFT that is predatory and attempts to exploit liquidity demanders (especially large traders).  Moreover, algorithmic trading (which may or may not be HFT, properly speaking) can potentially disrupt markets (e.g., the Knight Capital fiasco some weeks ago).

The question is: whatcha gonna do about the bad?  The knee-jerk response of many is to demand greater government regulation.  I have pointed out repeatedly, however, that this is an area where self-regulation is highly likely to be more efficient.  In particular, exchanges and other trading platforms have an incentive to design pricing structures and rules so as to reduce predatory trading, by HFT shops and others.  Predatory trading increases other market users’ trading costs, which reduces the derived demand for exchange services, thereby reducing the price the exchange can charge and the quantity of trading done on it.  Similarly, exchanges are hurt by disruptions caused by bad algos.

I’ve written a few posts on exchanges that have introduced pricing policies (e.g., charging high prices for “excessive” cancellations) with the specific purpose of reducing opportunistic trading.

Here is another example, this time from Forex:

Foreign exchange brokers are backing a series of changes unveiled by EBS, the world’s largest currency platform, designed to discourage predatory practices by high-frequency traders.

EBS, owned by interdealer broker ICAP, plans to widen the price spreads on its platform, raise targets on quote-to-buy ratios and set new quoting guidelines for Asian markets to discourage investors who exploit delays in technology to make money.

. . . .

Mr Mandelzis said that, while the changes were technical, they were aimed at encouraging genuine liquidity and discouraging disruptive behaviour, such as arbitraging prices.

With respect to dealing with the risk of runaway algos, CME and NYSE LIFFE are installing a kill switch functionality that permits FCMs to halt or limit trading activity by a malfunctioning algo:

Futures commissions merchants will be able to halt or limit trading activity at high speed on CME, operator of the world’s biggest futures exchange, and NYSE Liffe, one of the Europe’s dominant futures and options markets, if a computer begins to malfunction or a customer breaches risk limits.

Exchanges have an incentive to get these decisions right: they lose business if they basically provide hunting grounds for predatory HFTs or are unduly vulnerable to runaway algos.  Exchanges also have the information: they can observe what goes on on their systems, see who does what, and get feedback from customers.  Exchanges have a broad array of tools-outright bans on certain practices, and discriminating pricing policies. Exchanges are also able to move unilaterally and quickly.  In contrast, regulators have low powered incentives; poorer information; typically have blunt tools; and are less able to respond quickly and flexibly.  This is a clear case where self-regulation has advantages over government regulation.

This is particularly true in derivatives markets, where single platforms dominate a particular instrument.  Things may be more complex in equities, due to the potential spillovers across fragmented trading platforms.  But even there, the spillovers may be salutary.  A trading platform that clamps down (through pricing, for instance) on predatory arbs may push them to other platforms, but that just increases the incentive of those platforms to take action.  Moreover, different platforms have an incentive to compete to attract legitimate liquidity suppliers and liquidity demanders (especially the latter, since they are the ones that pay the freight), which means they have an incentive to compete to devise pricing schemes that penalize the predatory.

In brief, the task of reducing predatory computerized trading strategies should be left primarily to exchanges.  Predation will not disappear: it is almost never efficient to eliminate opportunistic/predatory conduct completely (because this would be too costly, primarily due to the fact that eliminating predatory conduct would almost certainly reduce some beneficial conduct), but exchanges have the strongest incentive, the best information, the most discriminating tools, and the greatest flexibility.  There will be an arms race between exchanges and predatory traders, but there would also be an arms race between government regulators and such traders.  Exchanges can run the race more efficiently and effectively.  Leave it up to them.

Corruptocrat Jon Corzine is whining about the MF Global Bankruptcy Trustee’s decision to assist customers who lost money as a result of the MFers in their attempts to recoup their losses by suing Corzine and other executives of the firm:

Corzine, along with other current and former MF executives, filed an objection in court on Wednesday arguing that their ability to defend themselves would be hurt if trustee James Giddens is allowed to assign his legal claims to plaintiffs in existing cases.

The executives are defendants in multiple lawsuits accusing them of mismanaging the firm and playing a role in its October 2011 collapse.

“Nothing in the Bankruptcy Code authorizes such limitations on the objectors’ rights and defenses or an enlargement of the trustee’s rights,” lawyers for Corzine and the other executives wrote in documents filed in U.S. Bankruptcy Court in Manhattan.

If allowed to join the customer cases, Giddens would have the right to limit the information and documents available to the executives through discovery, as well as dictate which documents the executives would turn over to plaintiffs, lawyers for Corzine and the other executives wrote.

Sorry.  I’m getting all choked up.   Hard to type through the tears.

JK.  MF him.

It looks like Corzine is going to skate on criminal charges, as in a reversal of usual procedure prosecutors appear to be focusing on low level employees, and not as a way of getting at bigger-and rotten-fish like Corzine.  (I’m sure that he’s a made man in the Democratic Party and a big fundraiser for Obama has absolutely nothing to do with that.)

Given that, one can only hope that he spends a good part of the rest of his life in civil legal torments, and ends up coughing up large sums to the injured customers who he victimized.  For regardless of his culpability in diverting segregated customer funds, his recklessness was the proximate cause of their losses: his ill-judged and ill-designed (i.e., improperly funded) bet on PIIGS debt put the firm in the straits that led someone to consider it necessary to take money that wasn’t the firm’s in a vain attempt to save it.  Moreover, even if he did not give the order to use seg funds, it happened under his watch: the choice is between scienter and negligence.  It still stuns me that a guy who was head of a major clearing firm claimed ignorance of the mechanics of the clearing process.  I guess he was too busy figuring out how to gamble his firm to resurrection.

So encroach away, Mr. Giddens!  Rough justice perhaps, but that’s exactly the kind Corzine deserves.

The CME Group has announced plans to open a European exchange, following its earlier announcement of its launch of a European clearinghouse.

Just another unintended consequence of Frankendodd.  Another bucket emptied by the Sorcerer’s Apprentice’s regulatory broomsticks.

Why do I say that, pray tell?  Because that’s what CME Group is saying, quite clearly:

The Chicago-based exchange said that as policymakers overhaul the global market infrastructure, it was becoming increasingly important for market infrastructure providers to offer a choice of regulatory regimes. Derek Sammann, managing director of CME Group’s global interest rate and FX business, told Financial News immediately after the announcement: “Clients should not have to choose to trade with us in the US regulatory environment, or not to trade with us at all. That is not a real choice.

He added: “The more we have invested in our global infrastructure, the more we have realised that there are customer acquisition opportunities by creating regional access to our services.”

. . . .

Phupinder Gill, chief executive of CME Group, in June told an international derivatives conference IDX in London that the exchange group’s non-US clients had raised concerns that they would become ensnared by the Dodd-Frank rules if they traded with the US-regulated company – a phenomenon commonly known as extraterritoriality.

He said: “The question that many of our clients ask is if they are going to get ‘Dodd-Franked’.”

No, no, no, Gill!  It’s “going to get Frankendodded.”  Get with the program!  We need to feed the meme!

The reporting has been rather unclear on what the CME Group’s plans are going forward.  The new UK-based exchange will offer FX futures contracts.  The CME press release, and the reporting, do not say explicitly, but it looks like these would be new products, distinct from the CME’s FX contracts traded on Globex.  This means that liquidity and clearing would be fragmented, so that regulatory cost savings for European customers would be offset to some degree by higher trading and clearing costs.  Great!  And regulators note: the market will become more complex and difficult to oversee, with divided jurisdiction and the consequent need for regulators to coordinate in the event of market stress.  There will be arbitrageurs-including, no doubt, those HFT demons-buying and selling between the two markets, leading to more message traffic, more complexity, and more potential for breakdowns and technological glitches.  That is, the adverse technological consequences of fragmentation that have accompanied fragmentation in equity markets may rear their ugly heads in futures as well, with the added twist of fragmentation across international jurisdictions.

Given the difficulties associated with building liquidity, it is uncertain how the CME’s UK initiative will fare: it may be the case that Europeans decide that the liquidity and clearing costs savings exceed the regulatory burdens.  But it is relatively inexpensive for CME to put its toe in the water in the way it has.  It is a cheap way to buy an option on regulatory uncertainty.  If Frankendodd turns out to be the real monster that I think it will be, European customers will be willing to incur higher liquidity and clearing costs in order to avoid the monster’s grasp.  CME Group will add more contracts that mirror its US offerings.  The market will become more fragmented, and more complex.

Exactly what Frankendodd and Gigi and Timmy! intended, surely.

In the aftermath of Knight’s HAL moment, Larry Tab wrote a very good and succinct piece on the implications of fragmentation in equity markets:

Most think about fragmentation in terms of trading venues. And yes, the U.S. equity market has a number of trading venues. There are 13 exchanges, about 50 dark pools and many internalizing brokers that can match buyers and sellers. To ensure the best match, sophisticated order routers need to examine many trading venues. And without being in two places at once, the more venues checked, the greater the chance buyers and sellers miss each other.

While checking many venues complicates execution, markets also can fragment in other ways, including price and time. The more price points, the more missed trades. This is especially true as liquidity providers spread orders across more price points and venues. As fractions turn to pennies, and pennies to sub-pennies, through dark pools and the NYSE Retail Liquidity Program (RLP), trading volume becomes fragmented from 16 price points per dollar to 100, or 1,000.

The same problem exists with time. The quicker the quote timeframe, the more messages I need to produce and analyze. If I am quoting across 13 exchanges and 20 dark pools, then I need to manage my quotes across 33 venues. If my quoting frequency changes from seconds to tenths to tens of milliseconds to milliseconds, then my quoting rate increases from 33 to 330, 3,300, 33,000 quotes per second. Multiply that across 5,000 stocks trading at pennies or possibly sub-pennies and think about the massive technology and message infrastructure needed to trade.

Moreover, this dense web of linkages between venues raises the potential for algo errors.  More trading venues means more changes in the way the venues operate and their technologies, which means more changes in algos, which raises the odds of a programming glitch.  For instance, the catalyst for the Knight implosion was the NYSE’s introduction of its RLP program.  Another example that I just read (but can’t find a link to right now) is an HFT firm that had an algo go haywire because it hadn’t been informed of a change in the software at one of the trading venues it connected to: fortunately, this firm had measures in place that turned off the program after it had lost only $5K.  There is likely an externality across venues: a change by venue A increases the odds that the change will trigger a perverse algo response that will have adverse effects on venues B, C, D, etc.

So fragmentation has costs.  This raises the questions: why does fragmentation exist?, and, do the benefits exceed the costs?

It should first be noted that equity markets have always been fragmented to some degree.  Back in the day, substantial volumes of NYSE stocks were executed by “Third Market” dealers (notably, Bernie Madoff!) and in block trades negotiated away from the floor.

This fragmentation was driven by informational considerations.  (Relatively) uninformed order flow that could signal ignorance by some means (order size in the case of retail trades executed by Third Market dealers, or reputation and non-anonymous dealing in the case of blocks) reduced trading costs by trading in off-exchange venues.  If they traded in the anonymous NYSE marketplace, they could not be distinguished from informed order flow, and paid execution costs that reflected the adverse selection risks faced by liquidity suppliers in such a marketplace: by trading in another venue that had methods of screening out informed traders (imperfectly, but to some extent), the uninformed avoided paying this adverse selection premium.

This type of fragmentation exists today: Dark Pools have evolved to perform the same functions as Third Markets and block markets.  Dark pools use a variety of methods to attempt to screen out informed and opportunistic traders.  And some HFT/algo strategies (arguably opportunistic) are attempts to circumvent these screening technologies.

The proliferation of non-Dark Pool trading venues-anonymous, non-screening trading platforms-is relatively novel.  Until the mid-00s, such venues did not exist.  Virtually all informed order flow, and a good chunk of uninformed order flow, in NYSE stocks was executed on the NYSE.  The exchange had a market share of 85+ percent up through around 2005.

Since then, NYSE market share has plunged to around 30 percent.  Some of that volume has been snagged by Dark Pools, but the bulk has been taken by other exchanges.

This reflects an explicit policy choice by Congress, and the SEC.  Since the mid-1970s, Congress has pushed for the creation of a National Market System of competing exchanges.  That effort was moribund until 2005, when the SEC implemented RegNMS that obligated electronic markets to direct orders to other markets displaying better prices.

This effectively socialized order flow.  In the pre-RegNMS days, market participants had an incentive to direct their orders to the market that they expected to have the best price.  This created a self-reinforcing feedback loop.  The biggest market (the NYSE) tended to have the best price, so traders sent their orders there, thereby reinforcing the NYSE’s advantage.  With the mandated routing of orders to other markets, the NYSE no longer had a lock on order flow.  Other venues could compete for it effectively.

This had already been seen in options, which had been subject to order routing mandates much earlier.

From the SEC’s (and Congress’s) perspective, this was a feature, not a bug.  The whole idea behind NMS was to create a more competitive marketplace not dominated by a single exchange.

It worked, but it has had unintended consequences.  The adverse consequences of fragmentation Larry Tabb discusses are among them.

This points out a fundamental dilemma in securities market design.  If order flow is not socialized by order routing mandates, the liquidity network effect tends to lead to the dominance of a single exchange that exercises market power.  We see this in futures around the world.  Although electronic trading has taken over futures trading, we don’t see fragmentation like in the equity markets, which means that fragmentation is not an inevitable consequence of the computerization of trading.  Part of that is due to the fact that information asymmetries are less severe in futures than individual equities (e.g., because there is less private information about an equity index than an individual stock), and so there is no “dark pool” type fragmentation.  But most of it is due to the fact that there is no socialization of order flow in futures.  Perhaps because it was, historically, a more obscure corner of the financial world than the stock market,  Congress never caught the itch to create a National Futures Market System.  But regardless of the reason, the order flow feedback effect, where order flow attracts order flow, has led to the dominance of a single exchange in virtually every major futures contract.

This points out a fundamental dilemma.  Due to the nature of liquidity, policy makers have to pick their poison.  They can eliminate fragmentation, at the cost of market power.  They can eliminate market power, but only by living with the adverse consequences of fragmentation.

Those are the choices.  Period.  The economics of liquidity can’t be legislated or regulated away.  All that policy makers can do is affect how those economics will manifest themselves.  Don’t like exchange monopolies (or near monopolies)?  Socialize order flow a la RegNMS-and live with the consequences of fragmentation like we see today.  Don’t like the consequences of fragmentation? Abstain from requiring exchanges to direct order flows to markets displaying better prices-and live with the market power that will result when trading tips to a single venue of price discovery.

Not an easy choice.  I don’t know what the more efficient alternative is.  But it would be refreshing if debates over market structure would acknowledge that there are no Goldilocks, “just right”, choices.  Instead, there is more of a lady and the tiger like dilemma. Bewail the evil consequences of fragmentation if you will, but be prepared to show how those consequences are less malign than the costs of market power.  And vice versa.

Maybe that’s a disturbing mental image, but the title is more than apt given Gensler’s recent NYT oped, “Libor, Naked and Exposed.”  As is his wont, demonstrated repeatedly on Frankendodd-related issues such as clearing and SEF mandates, Gensler presents a misleading and distorted analysis to advance some regulatory or political agenda.

Gensler questions the integrity of Libor.  This is certainly understandable in the light of the deluge of revelations in the past couple of months.  But the “evidence” that Gensler uses to justify his skepticism is completely off point, and certainly grossly overstates the impact of any manipulation on this important benchmark rate.

The first comparison Gensler makes is between Libor and Euribor.  He notes that dollar Euribor is about double dollar Libor.  But what Gensler omits to say is that this is an apples to horse apples comparison, given the major differences between the banks in the Libor and Euribor panels.  The former includes major banks (crucially, TBTF banks that benefit from the implicit and explicit support of governments and central banks), and most notably major US banks with ready access to dollar funding.  The latter includes something of a dog’s breakfast of foreign banks.  It has two Spanish and one Portuguese cajas and five German landesbanken, for crissakes.  And Dexia! The Euribor panel banks are all weaker, and don’t benefit from the same safety net as the banks in the Libor panel.  Moreover, since the beginning of the crisis, foreign banks have much greater difficulty in securing dollar funding than US banks.  Even big European banks (such as French giants like Paribas)  have faced acute dollar funding problems.  This is one reason why they have been deleveraging, and selling off dollar assets.  The Euribor banks almost certainly have even worse problems.

This issue of fragmentation of funding markets also bears on Gensler’s second piece of evidence: the divergence between Libor and the dollar rate implicit in FX swap prices. Gensler treats the violation of the interest rate parity relation as an indicia of manipulation.

But again, this reflects the acute problems European banks have faced in securing dollar funding.  They can borrow in Euros, but have to swap it into dollars to fund their dollar assets.  They are willing to, and the market is making them, pay a premium to execute this transaction.

Gensler claims “this divergence between theory and practice has yet to be adequately explained.”  Really?  It is well-understood.  Don’t believe me?  How about some economists from the New York Fed?  They investigated this issue in detail in 2009, and concluded that the divergence in the basis between the FX swap implied USD rate and USD Libor was caused by the dislocations associated with the financial crisis.

Indeed, Gensler’s oped implicitly recognizes this: he notes that implied and Libor rates have not been aligned “since 2008.”  Hmm.  What happened in 2008?  Think, think, think.  A financial crisis maybe?  Could that be it?  I’m thinkin’.

One key piece of evidence that FRBNY economists  Coffey, Hrung, Nguyen, and Sakar present is that the basis blowout was not limited to Libor.  It was also present when they used the New York Funding Rate produced by ICAP.  It was also present when they used Eurodollar deposit rates.

Look, anybody who has followed this knows that basis relationships that had been steady as a rock for years went haywire starting in August, 2007.  (Happy Anniversary!)  The CDS-cash bond basis went haywire.  Interest rate spreads (e.g., OIS-Libor) went haywire.  Spreads between borrowing rates across banks have become much more dispersed and become much more volatile.  (This relates directly to the Euribor-Libor comparison: banks are much more heterogeneous now than in, say, 2006, making comparisons between averages across different groups of banks much less meaningful now than then.)

This pertains to another piece of evidence: the lack of comovement between bank CDS spreads and their Libor submissions.  This could be informative, particularly in normal times, but it is problematic during crisis times.  CDS spreads and yields on the underlying cash bonds diverged dramatically, and often exhibited little comovement, during the period of the crisis.  CDS spreads were being driven by liquidity and risk aversion issues.  If the CDS-cash bond basis became much more volatile, it’s not at all surprising that the CDS-Libor spread also became much more variable, given that CDS and cash bonds have closer kinship than CDS and unsecured short term borrowings.

Noticing a pattern here? Basis relationships of every sort became much more volatile during the crisis period, and hence are far less reliable evidence of manipulation in Libor than would have been the case more than 5 years ago.  In essence, Gensler is trying to tell time with a broken watch.

Recall that Gensler mentions “the divergence between theory and practice.”  Anybody who has been paying attention understands why that’s true.  The theory is predicated on an assumption of frictionless financial markets.  Financial markets where capital and liquidity constraints are not binding, thereby permitting arbitrageurs to eliminate swiftly divergences in prices across related markets.  That was a reasonable approximation of reality in say, July, 2007: certainly in July, 2005.  It is completely unreasonable post-August, 2007.

Or as the FRBNY economists put it:

The widening of the basis illustrates the breakdown in arbitrage relationships that has afflicted many markets during the financial crisis. For example, eurodollar interest rates in New York and London diverged during the crisis-as did yields on corporate bonds and credit default swaps, which are closely related securities.  The element common to all of these phenomena was increased funding costs, which impeded arbitrageurs from shrinking the basis between these types of securities.  In addition, counterparty credit risk became prominent, and previously risk-free arbitrage trades suddenly became risky . . . funding constraints and counterparty risk explain the rise in the basis and the relative importance of each factor changed as the crisis evolved. [Emphasis added].

Since then, the coefficient of financial friction has reached record levels.  Capital and liquidity and funding constraints are binding everywhere, and binding hard.  In particular funding markets-and Libor is a measure of a funding costs for some banks-have been dysfunctional for 5 years.  Severely dysfunctional.  Most of the European banking system relies on the ECB for funding.  Markets across regions that were once highly integrated are now fragmented as never before.

This is particularly important for dollars.  Having access to dollar funding via deposits and access to the Fed (like major US banks) is completely different than having to raise dollars through wholesale markets, like most European banks that have been hit hard by the flight of US money market funds and other sources of dollar liquidity.  This is what drives things like the Euribor-Libor differential, and the swap-Libor basis.

Hell, there is fragmentation of funding even within currency areas, in particular, the Eurozone.  European subsidiaries are attempting to fund their local lending with local deposits, especially in countries where conversion risk (i.e., the risk that a country will leave the Euro) is acute.  For instance, Italian subsidiaries of French banks are funding their loans to Italian businesses with local deposits, rather than money from the parent banks.

In other words, Gensler is relying on a textbook model that presumes a frictionless world.  That ain’t our world, today.  The textbook needs to be thrown out.  But Gensler uses it as his bible.

There are two explanations of this, both quite frightening.

The first is that he really doesn’t understand this.  That he doesn’t understand that the financial system has suffered cataclysmic shocks and doesn’t work the way it used to.   It would inspire confidence, wouldn’t it, that an individual playing a crucial role in reshaping that financial system through the promulgation of rules under Frankendodd doesn’t understand why things are working-or not working-the way they are?

The second is that he is a fan of the band Say Anything.  That he knows that his “evidence” has nothing to do with Libor manipulation, but he is saying it to advance some regulatory or political agenda.

I’m betting on the second alternative, because Gensler is a serial offender in this: look back at my posts from 2009 and 2010 and you will see numerous times where I called BS on the former Goldman managing director for making ludicrous statements about financial markets-all of which were calculated to justify Frankendodd and a massive expansion of Federal regulation of derivatives markets.

Regardless of the reason, one thing is clear: Gensler’s misleading analysis lies naked and exposed. This is not to say that Libor was not manipulated.  It is to say that what Gensler hypes is not evidence of the existence of manipulation, or the magnitude of its effect.

It is unfortunate that he penned such a distorted oped, given that his agency provided a very rational proposal to reform the Libor fixing process in its Barclay’s settlement order.   Gensler should limit himself to promoting that proposal, rather than writing pieces that sow confusion and promote misunderstanding about a highly contentious issue that could have huge and costly impacts on banks-and hence on the world financial system, stressed as it already is.  That is not constructive.  It is irresponsible and dangerous.

I have crossed pixels with Felix on occasion, most notably over the issue of “empty creditors,” in which I took the Coasean position.  But today, I largely agree with his take on the Knight Capital implosion:

We’re seeing the same thing with the fiasco at Knight Capital, where a highly-sophisticated high-frequency stock-trading shop lost an enormous amount of money in a very small amount of time, and small investors lost absolutely nothing. On the grounds that we can’t present this as news without somehow determining that it’s bad for the little guy, it took no time at all for grandees to weigh in explaining why this really was bad for the little guy after all, and/or demonstrates the need for strong new regulation, in order to protect, um, someone, or something. It’s never really spelled out.

Knight lost $440 million.  That really stinks for its shareholders, but its loss is a windfall for those on the other side of its Hal moment.   Every dollar lost by Knight is a dollar gained by someone who entered an away from the market limit order that Knight triggered, or arbitrageuers that took advantage of the price anomalies.  You might argue that the temporary distortions in prices for dozens of stocks is a source of welfare loss, but I defy you to identify a real decision (e.g., the amount of investment by an affected firm, or its capital structure) that was affected by the very short lived fluctuations.

The final score: Knight -$440 million.  Others who bought and sold the affected stocks: +$440 million.  Third parties (not counting those who get the vapors when the markets don’t work as neatly and tidily as they think they should): $0.  Net result: $0.

Not quite, though, because of the pour encourager les autres aspect of Knight’s travails: to me this episode is an example of Darwinian selection in action.  Those who don’t adequately check their code are driven from the market (or almost are-Knight was rescued from bankruptcy on very harsh terms by a group of brokers and dealers).  Indeed, the outcome here is likely to be more efficient than a purely Darwinian one: here others can learn from Knight’s tale (“there but the grace of a geek go I: I’d better be extra vigilant”) whereas that learning mechanism doesn’t operate under pure natural selection.

Although I sometimes agree with Felix Salmon, the same cannot be said of me and John Kemp, another Reuters writer.  The correlation between our views pushes -1.

That’s true today, with respect to Kemp’s analysis (if that’s the right word) of ICE’s decision to relabel swaps as futures.  Kemp presents this as a smashing victory for Frankendodd.  Now it may seem churlish of me to criticize, given that Kemp did give my blog post extended play in his piece: I am aware of Brendan Behan’s dictum that there is no such thing as bad publicity, except where your obit is concerned.  But duty calls.

Kemp spends inordinate space in a disquisition on the Talmudic distinctions under the Commodity Exchange Act between contracts for future delivery and commodity forward contracts.  All of which is completely irrelevant because the ICE contracts transubstantiated from swaps to futures are definitely not commodity forward contracts exempt from CEA exchange trading requirements.  Kemp quotes my statement that nothing of economic substance changes as a result of the relabeling-and doesn’t disagree.  But he cavils:

Pirrong has been critical of Dodd-Frank and much of the CFTC’s rule-making. In this instance, he appears to argue that the sole outcome will be another round of regulatory arbitrage. (“A swap by any other name” Aug 2)

Arguably, however, ICE’s decision to re-label its cleared swaps as futures suggests regulators have won this round of the battle, ensuring that all contracts with an economically equivalent purpose will be treated in the same way, rather than subject to an artificial distinction.

Note the attempt to cast doubt on my analysis by pointing out my (unapologetic) criticism of Frankendodd, and Igor’s (i.e., the CFTC’s) implementation thereof. (“Distrust the skeptic!”)

Sorry, but I’m finding it hard to see the great regulatory victory here.  Nothing of economic substance has changed: Kemp does not dispute this, and in fact agrees with it (though he doesn’t go far enough, because the transactions are equivalent in form and substance as well as purpose).  The “artificial distinction” he criticizes is in fact a creation of the regulation: it is the direct result of Frankendodd’s establishment of a separate regime for swaps.  By revealed preference, the regulatory regime that ICE has chosen to operate under is less burdensome that the swap regime created by Frankendodd.  Since the economic substance of the transactions at issue hasn’t changed, this implies that either the swap regime is inefficiently costly (at least for some transactions), or the futures regime is inefficiently lax but a mere relabeling permits ICE and others to take advantage of that laxity.

I guess you have to take your victories where you find them, but that’s pushing it.

ICE has created something of a kerfuffle by its announcement that it will convert its cleared energy swaps contracts to futures.  Despite a lot of breathless reporting, there is less here than meets the eye.

ICE has merely relabeled its cleared energy swaps as futures in order to avoid burdening its customers with the costs that Frankendodd imposes on swaps.  Futures and swaps are subject to different regulatory regimes.  Firms with sufficiently large swap positions are considered swap dealers under Frankendodd, and must meet a variety of requirements that those not blessed with this designation can avoid: holders of equivalent futures positions need not meet the same requirements.  Swaps trades also involve additional reporting obligations not imposed on futures trades.

So what ICE will do effective in January is change the name of its contracts, thereby reducing the regulatory burden on its customers, without changing their economic substance one iota.  Note that these are cleared swaps, so the change doesn’t create a new clearing obligation on those trading them.  The central counterparty for the futures will be the same as for the swaps: ICE Clear Europe. The contracts will have identical settlement terms.  They will have identical cash flows.  They will trade on the exact same ICE platform.  The economic substance of every aspect of the old “swap” transaction and the new “futures” transaction remains the same, from execution to clearing to settlement.  Nothing changes but the name.

And the regulatory burden.

Which points out the potential for absurd outcomes under Frankendodd.  The CFTC has labored mightily to craft definitions of a swap and swap dealers and major swap market participants.  Where one falls under these definitions matters a lot.  Firms will endeavor to take measures that minimize the regulatory burden they face. ICE is basically picking the low hanging fruit, and taking note of Congress’s morbid obsession with “OTC swaps” and idealization of futures by magically transforming the former into the latter, and thereby making life easier-and cheaper-for its clients.

The incentive to label or structure transactions to achieve the same economic outcome at lower regulatory cost will be quite strong in the Frankendodd era.  This will initiate a regulatory dialectic in which regulators will attempt to adjust regulations in order to limit such attempts to escape regulatory burdens by relabeling or restructuring; the regulated will adjust to the adjustments; the regulators will adjust some more; and on and on.*

The lawyers will rejoice.

Much of the reporting on the ICE move has been pretty far off base, such as this from the WSJ:

Derivatives exchange IntercontinentalExchange said it plans to overhaul trading in trillions of dollars of energy contracts starting in January, becoming the first exchange to take such a step ahead of new financial regulations.

ICE is pushing trading of certain energy contracts onto its exchange, a move that would likely diminish the more-opaque world of over-the-counter derivatives trading. The plan will likely appease lawmakers who have decried the lack of transparency in such portions of the financial markets.

Derivatives exchange IntercontinentalExchange said it plans to overhaul trading in trillions of dollars of energy contracts starting in January, becoming the first exchange to take such a step ahead of new financial regulations.

ICE is pushing trading of certain energy contracts onto its exchange, a move that would likely diminish the more-opaque world of over-the-counter derivatives trading. The plan will likely appease lawmakers who have decried the lack of transparency in such portions of the financial markets.

. . . .

Many energy producers and users generally have preferred swaps contracts because each contract can be written up individually and to a company’s own specifications. That has enabled them to be more targeted in their hedging. Futures contracts, by contrast, are generally standard contracts covering the price of a specific energy grade to be delivered at a certain time.

Pretty much none of that is true.  All of it suggests a change in the way these instruments are designed, traded, and cleared, none of which is in fact changing. The contracts are already standardized, traded on an electronic platform, and cleared.  This is not a movement of bespoke, uncleared, bilateral contracts onto an exchange.

Look.  It’s long been known that the economic substance of swaps and futures are effectively identical, especially when the former are cleared.  Changing the label-hell, call them bananas-doesn’t change the economics.  If the CFTC had even less burdensome regulations for bananas, ICE would launch ICE Bananas.

Which illustrates that Frankendodd is quite often and in many ways truly bananas.

* Relabeling of derivatives contracts was employed in the 19th century to avoid legal restrictions.  When Illinois banned options trading, traders bought and sold the same things, but started calling them privileges.

The Intercontinental Exchange (not to be confused with the Intercontinental Railroad!) has announced the end of cotton, coffee, sugar, cocoa and OJ options floor trading.  The futures floor was closed some time ago.

The decision was spurred by the movement of options trading to ICE’s computerized trading system.  This is significant, and is likely the beginning of the end of floor trading.  Options have been the last major bastion of open outcry.  Many options trades involve more complicated multi-leg strategies (including spreads of various sorts) that are more difficult to computerize than simple outright futures trades, or simple futures strategies like calendar spreads, but which can be done efficiently on the floor: locals on the floors quote many of the common spreads.   If options can be done on the screens, there’s nothing really left for the floor to do.

Thus, we are witnessing the culmination of a process that began about 20 years ago.  I first did some research on electronic trading in the early-1990s, and remember the disdain with which the futures and options communities looked on computerized markets.  In 1995, I wrote a study comparing the electronic DTB and the open outcry LIFFE market which found that the former was as liquid, or more liquid than the latter: this study was met with much derision by LIFFE, and by most people in Chicago.  The derision of electronic trading died down substantially in 1998, when volume in the Bund futures market tipped completely to DTB’s successor (Eurex), and LIFFE suffered a near death experience.

The floor held out in the US for sometime longer, but by the early-2000s the writing was on the wall here as well.  By the mid-2000s options trading was keeping the floors going.  But that’s no longer true of ICE, and it is likely a matter of time before it is no longer true on CME/CBT or NYMEX.

Timmy! is deeply offended by SIGTARP Barofsky’s assertion that he was too close to Wall Street while he was head of FRBNY. In related news, Geithner defended himself against allegations that he had not been sufficiently aggressive in his handling of the LIBOR situation:

“We, at least I, first learned about those concerns in the early parts of spring of 2008 and we acted very quickly at that stage. At that time, this is in the spring of 2008, we took a very careful look at these concerns, we thought those concerns were justified,” Geithner said.

“And we took the initiative to bring those concerns to the attention of the broader U.S. regulatory community, including all the agencies that have responsibility for market manipulation and abuse,” he said, citing a specific meeting of the president’s working group on financial markets.

Note this:

The first trove of documents from the New York Fed showed that Barclays had flagged concerns as early as 2007 and Geithner sent the email to Bank of England Governor Mervyn King in June 2008 with the Libor recommendations.

So let’s review the timeline:

• In August, 2007 Barclays admits to FRBNY personnel that it submitted misleading LIBOR quotes, and claims that this practice is widespread.
• In April 2008 the WSJ runs an article providing evidence that banks were systematically underreporting LIBOR rates.
• In June 2008-AFTER the WSJ article-FRBNY sends a letter to the BOE suggesting procedural and governance changes to LIBOR in order to reduce the incentive to misreport.  This letter says nothing about Barclay’s admission that it had in fact misreported LIBOR 10 months earlier.
• BOE does nothing.  FRBNY does nothing.  FRBNY does not follow up when BOE does nothing.

So I guess we now now what “all I could” means in Timmyspeak.

I would have more respect for Geithner had he said: “Given the state of the banking system it would have been catastrophic to pursue aggressively misreporting of LIBOR.” The weaseling-not so much.  That is truly offensive.  (The “We, at least I, first learned” weaseling is particularly offensive.  Just where did the buck stop at FRBNY?)

Incidentally, the NYT has turned on Geithner for his role-or lack thereof-in cracking down on the misreporting.  Moreover, it has come out in support of Gary Gensler as a replacement for Geithner, in the event of a 2d Obama term:

And when the time comes to choose a new Treasury secretary — Mr. Geithner has said he does not expect to remain if President Obama is re-elected — the next president would do well to look for candidates among the regulators who have distinguished themselves by their willingness to confront the banking system’s manifest problems. One such person is Gary Gensler, the chairman of the Commodity Futures Trading Commission, which pursued the rate-rigging allegations against Barclays, securing a record fine and referring the matter to the Justice Department for criminal investigation.

A couple of things.  First, the CFTC acted almost five years after the initial information came to light: that’s confrontation?  Second, has the NYT maybe like heard of MF Global?  Peregrine?

Admittedly, a Gensler Treasury would probably be well down on the list of debacles in the event of Obama’s reelection.  But a debacle it would be, and the LIBOR case-in which the CFTC worked with DOJ and the BOE-is hardly sufficient grounds to justify Genlser’s elevation, especially in light of the two confidence-shattering, and unprecedented, breaches of customer fund segregation that occurred on his watch.

But then again, DC has always been a living, breathing, pulsating embodiment of the Peter Principle, so it just might happen.

Near zero interest rates are wreaking havoc among FCMs. I recall reading something about that.  Heck, I remember writing something about that about a week ago.

There is a puzzle here, though.  Why don’t commissions vary inversely with interest rates?  The FCM business is pretty competitive, meaning that FCMs should earn the competitive rate of return, i.e., roughly speaking revenues should equal costs plus a fair return on capital.  If interest rates rise, generating more revenues for FCMs, competition should lead them to cut commissions in order to attract customers.  Conversely, if interest rates fall, reducing FCM revenues, competitive pressures should induce them to raise commissions.  Why have commissions remained at rock bottom levels despite the loss of revenues from interest on customer funds that the FCMs hold and invest?

One possible explanation is that due to technological change (e.g., the expansion of electronic trading) there is excess capacity in the FCM industry, and some firms should exit.  The excess capacity keeps downward pressure on commissions, which will not rise until there is a significant shakeout.

Perhaps MF Global, or Peregrine, or both, were unwilling to concede that they were no longer economically viable and should exit.  Frequently the need to secure external funds to keep operating is what forces unviable businesses to exit even though individual managers or owners may want to try to gamble or cheat for resurrection.  Financial firms’ (including FCMs’) ready access to cash (even if it isn’t really theirs) can permit them to engage in these sorts of actions without securing external funds.  This is why financial sectors under stress are particularly vulnerable to fraud and excessive risk taking: not only do stressed firms have the incentive to engage in this kind of conduct (which is true of stressed firms in other industries too), but they have opportunities that stressed firms dependent on external finance do not.