Streetwise Professor

This morning’s recon mission for derivatives-related stories turned up bumper crop of realizations that should have been painfully obvious, but were not made when it could have made a difference–meaning that the real pain is to come.

First, from the FT:

Quite simply, the regulators succumbed to the sheer volume of rulemakings and an avalanche of comments from the industry. There was not enough time to meet the deadline, and it became clear that implementing Dodd Frank was going to be far more complicated than initially thought.

Thought by whom, exactly?  We need to know, because anybody who admits to not foreseeing a train wreck should be disqualified from further comment or participation in these matters, (a) for not foreseeing the obvious, and (b) for copping to such cluelessness.

Next, from Financial News.  In response to the rhetorical question “Are clearing houses ‘too big to fail'”, Ben Wright writes (heh):

It is a real concern that not enough people have asked this question before now and even more worrying that no one has provide a satisfactory answer.  [The answer is almost certainly yes, though I guess that is unsatisfactory substantively.]  As the possibility of some form of huge sovereign credit event grows ever-more imminent, a solution need to be found, and fast.

It’s a little late to start thinking about packing a parachute when you’re already 30,000 feet up. But that’s Frank-n-Dodd in a nutshell (with an emphasis on the “nuts”).

Wright also recalls a speech by the BoE’s Paul Tucker (which I blogged about in June), in which this worthy

said clearing houses had to think of themselves as system risk managers and start behaving as such.  Clearing houses should, therefore, steer clear of procyclical margin practices, monitor the soundness of their members, and plan for their disappearance.

No disagreements here, except that it is insane to think that CCPs will think of themselves as “system risk managers.”  Because they aren’t “the system”, but only part of it.  They will act in their interest and the interest of their members.  That is quite different from–and often contrary to–acting in the interest of “the system.”  Clearing does not internalize most of the key externalities that create systemic risk, and all the wishing and should-ing in the world won’t change that fact.

And from Dow Jones:

Dealers and clearing experts have urged regulators to introduce so-called living wills for clearing houses, warning that a “credible” plan for unwinding critical pieces of market infrastructure is “vital to financial stability”. The comments come amid growing fears that the US government’s inability to raise its debt ceiling could prompt a global credit event.

. . . .

Roger Barton, founder and managing director at Financial Reform Consultancy, said: “It is arguable that the whole issue of clearing house resolution should have been addressed earlier.”

“Arguable”?  Go out on a limb there, Roger.

I wonder if it’s possible to fashion a parachute from the seat covers and a few stray blankets in the overhead bins.

Then there’s this article on portability in Risk.  It’s long (and gated), but the moral of the story is easily stated: this is a major issue, with systemic implications, but which is totally up in the air.  (Lot of company up there.)  There’s one on portability in the FT, coming to pretty much the same conclusion.

What, never heard of portability?  Apparently the Sorcerer’s Apprentices hadn’t either.

I could go on.  In recent days there have been numerous articles about myriad issues in clearing–collateral, margining, capital requirements, and on and on–all of which are (a) unresolved, and (b) of first order systemic importance.  All the important details were left to the end–most likely because those that demanded the system remade it, and wrote legislation demanding its remaking didn’t even know what the relevant details are.

An entire system that evolved organically with all of the complexity and interconnectedness that implies is being re-engineered on the fly.  Anyone even marginally cognizant of the complexity of the system would have been too humble to even contemplate remaking it root and branch.

But unfortunately, the marginally cognizant weren’t in charge.  The imperious, overconfident, ignorant, and foolish were–some were all of the above.

That never works out well.

The Exchange Formerly Known as the Chicago Mercantile Exchange–now dubbed the CME Group–has announced that the tax situation in its current corporate home of Illinois is “untenable“:

“Our tax situation is untenable,” [CEO Craig] Donohue told Reuters, noting that CME is taxed more heavily than any of its global competitors. The company is talking with at least three states — Texas, Florida and Tennessee — about relocating some of its business to take advantage of lower tax rates there, Donohue said.

Did he say Texas?  Well, come on down!  Plenty of room!  Might I suggest Houston?

I am a native Chicagoan, and a latter-day Texan. As someone who still identifies with Chicago, and who is deeply proud of the city’s history, I am truly saddened by the circumstances that led to the CME thinking seriously about pulling up stakes.  It is the company that arguably has the deepest, longest, and most emotional tie with the city.  Their destinies and identities have been linked for almost 160 years, if you include the CBT, and nearly 100 just looking at CME alone.  The exchanges have long been iconic symbols of the city.  When derivatives exchanges began to spring up around the world beginning in the 1980s, they all looked to emulate Chicago.   The futures exchanges were the city’s unique and enduring contribution to the world of finance.

But, as they say in Texas, bidness is bidness.  Illinois has become an unbelievably hostile environment for business.  As Walter Russell Mead has blogged about regularly, the Blue State model is broken beyond repair.  And Illinois is about the bluest and brokenest state in the country–in many senses of the word “broke.”  “The City That Works”–Chicago’s old-time motto–is no longer operative.  The state is well into the fiscal death spiral: bloated spending leading to high taxes that drives out business and people.  The writing was on the wall before the last election, but the new governor and the legislature refused to make fundamental changes in the way the state spends and operates, deciding instead just to ratchet up taxes.  When businesses and people can move, that never works.  Never.

So the mystic chords of memory only go so far, and the CME owes it to its shareholders to make a rational decision.  And a rational decision means start humming “Southbound.”  The tax environment is better, and the regulatory environment is too.  In Texas specifically, tort reform has made a big difference in the business environment.

And unlike Boeing (also a Chicago company, as of recently), CME Group won’t have to worry about the NLRB if–or should I say when?–it decides to move.

Like the bumper stickers say, I wasn’t born in Texas, but I got there as soon as I could.  And damned glad I did, for a variety of reasons.  Paradoxically, it is in many ways more like the US of a long time ago, but its future is a lot brighter than that of virtually any other “progressive” place in the US–including progressive Illinois and Chicago.

Though actually that’s not really a paradox, IMO.

Yes, today marks the one year anniversary of the day when The Monster slouched off of Capitol Hill (aka Frank-n-Dodd Castle) to begin its rampage of error and terror in the countryside.

Believe it or not, I’m not grateful, despite the never-ending source of material that it has provided in the past 12 months.

It is hard to pick the Worst of Frank-n-Dodd.  There is much to choose from, and the competition is intense.  There is one element, though, that is particularly indefensible, and which happens to be in the news now, so it will get special billing in this Special Anniversary Post: The Swaps Execution Facility (SEF) mandate.

It is indefensible for a variety of reasons.  For one thing, the ostensible purpose of Frank-n-Dodd is to reduce systemic risk, and it is very difficult to make a case that requiring trading of swaps on exchange-like platforms has anything to do with systemic risk.  It is particularly interesting to note that the Europeans, who are on board with the Dodd-Frank stuff that at least is related to systemic risk (like clearing and margining of derivatives) are deeply skeptical, not to say contemptuous, of the SEF requirement.  They show no signs of adopting anything even like it.

Moreover, the SEF requirement seems to reflect some extremely childish understanding of markets.  Exchanges– transparent and good.  OTC markets–dark and scary.

This cartoonish view of markets completely fails to recognize the tremendous diversity of transactors and instruments in the market place.  It is sensible that this diversity has given rise to a diversity of trading mechanisms adapted to the traders and instruments.  Shoving everything into a one-size-fits-all framework with intense pre-trade and post-trade transparency–and transactor anonymity–presumes that all traders and all traded instruments are effectively alike.

Wrong.  Gary Gensler regales everyone with tales of how the improved transparency is going to reduce transactions costs for the buy side and end-users, and these benefits will more than offset the other, uhm, inconveniences arising from Frank-n-Dodd.  Which is kind of weird, because the buy side and end-users have been largely critical of the SEF mandate, and comfortable with the current way of doing business.  As I’ve said before, Gensler’s Fairy Tale presumes that the supposed beneficiaries of the SEF mandate are suffering from some sort of battered spouse syndrome, and love and protect their bankers despite the abuse that the latter allegedly dish out on a daily basis.

It’s also weird because the OTC markets grew absolutely and relative to exchanges–by a large margin–pre-crisis.  Given the choice, the buy side and end-users more often than not chose to trade OTC. Absent mass ignorance of self-interest, this very strongly suggests that it was cheaper for the buy side and end users to trade on these markets.

Has Gensler, or any of the other SEF evangelists, provided a convincing explanation of these facts?

No,they haven’t.  They haven’t even tried.

A non-cartoonish analysis of transactions and transactors makes it perfectly clear why the OTC markets have flourished.  A big part of that is the very basic fact that for many traders exchanges with pre- and post-trade transparency but trader anonymity are more costly places to trade.  Uninformed traders (e.g., big hedgers or pension funds) trading in size typically trade more cheaply in face-to-face markets with negotiated prices, rather than in anonymous auction markets where their orders get lumped with the trades of the informed, and hence get filled at worse prices.  This is why dark markets, block markets, etc., have always been with us, and why OTC markets are frequently the venue of choice for big buy side and commercial traders.

The SEF mandate is bad enough, but as hard as it is to believe, the CFTC proposals are even worse.  Gensler and Chilton in particular clearly want to make OTC markets as exchange-like as possible, and are pushing SEF rules that would sharply constrain the diversity of execution platforms.  The CFTC is taking an even more extreme approach to this than is the SEC.

Which is why it is encouraging to see that this is one part of Frank-n-Dodd that is the target of a legislative effort for overhaul.  Representative Scott Garrett (R-NJ) has sponsored a bill that would sharply limit the kinds of requirements the CFTC or the SEC could impose on SEFS:

H.R. 2586 prohibits the CFTC and the SEC from interpreting the SEF definition to: 1.) require a minimum number of participants to receive or respond to quote requests, 2.) require a SEF to display or delay quotes for any specific period of time, 3.) limit the means of interstate commerce that market participants can use to execute swap transactions, or 4.) require one trading system (i.e. RFQ) to interact with another trading system (i.e. Limit Order Book) on the same SEF.  These prohibitions are necessary to preserve investor choice of execution, promote transparent price discovery for market participants, and decrease the costs of hedging for American businesses, farmers, and retirement plans, all of which contribute to economic growth and job creation.

I’d prefer no SEF requirement at all, but at least this bill would give market participants a lot more lee-way to develop systems that accommodate the diversity of trades and traders.

As to its prospects–I have no idea.  But hopefully this is a harbinger of efforts to chain The Monster and bring some relief from its depredations.  That would be a good thing–despite anything Timmy! says.

Betting the Business (i.e., John Parsons and Antonio Mello) notes that the Coalition of Derivatives End Users has backed off its more extreme claims about the effects of clearing and margin mandates.  John and Antonio have been correct to point out that Frank-n-Dodd requirements may just result in the credit implicitly bundled in derivatives deals being unbundled, by the extension of a loan or a credit line.  (This is something that I also pointed out in my Cato piece last year).  But they have not explicitly addressed an implication that I pointed out, and specifically asked them to analyze.  Specifically, if margin requirements merely result in making implicit credit explicit, how do these requirements affect the aggregate amount of credit in the system?   This is the crucial question because the amount of leverage in the system is the first-order driver of systemic risk.

The End User Coalition’s letter makes this point:

Margin lending facilities offered by banks (and especially if offered by [Swap Dealers] or [Major Swap Participants] [as will almost surely be the case], would merely re-allocate and re-label risk, but not materially reduce it.  What was formerly a derivatives exposure risk would be converted to a lending facility risk.  A counterparty default from a derivatives obligation would have the same impact on a bank as a default on a margin lending facility obligation.  In other words, changing the form of the risk does not eliminate the risk (p. 10).  [Emphasis in original.]

. . . .

Some have suggested that end-users that traditionally pledge non-cash collateral cold continue their operations by using a secured financing facility.  Like the margin lending facility discussed earlier in Section II.B.3., a secured financing facility does little or nothing to remove risks from the system.  Instead, it simply changes the name of the risk from derivatives exposure to financing facility exposure (pp. 11-12).

Exactly.  And exactly as I’ve pointed out for well over a year.

Revealed preference suggests that implicit and explicit credit are not perfect substitutes.  Indeed, the End User Coalition letter points out (on p. 12) why a secured lending facility may be an imperfect substitute for using non-cash collateral in a derivatives deal.   Thus, the imposition of the constraint will be costly for firms, and will lead to less hedging.

But the Parsons-Mello main point–and the important implication–remains unchanged: substitutions of one form of credit for another will limit, and perhaps sharply so, the effects of margin and clearing and capital mandates on the amount of leverage in the system.  Since leverage is the source of systemic risk–what’s the point?

I also think that P-M are too dismissive of contentions that the regulations as written will result in deadweight losses.  This is because the amount of margin required can be so large as to require firms to alter drastically their capital structures, and such alterations are costly and can result in some of the inefficiencies the Coalition laments.  As the Coalition letter points out, for non-cleared swaps, the margin requirement is quite onerous: the margin must be sufficient to cover 99 percent of 10 day price moves.  That’s a lot.  This will likely require firms to (a) hold far larger amounts of their assets in liquid instruments, and hence less in more productive assets, (b) reduce their derivatives usage, or (c) most likely, both.

Margins and liquidity are costly.  That’s why firms strive to manage liquidity tightly, and are quite sensitive to margin: the amount of collateral and the form in which it must be held are definitely not matters of indifference to them.  A big margin requirement, and a requirement that the margin be posted in liquid assets, will definitely be a binding constraint, and its shadow price will be non-trivial. I don’t know what it is, but I know it’s not zero–primarily because firms optimize with respect to margin costs.

All this means that, at best, the margin requirement and capital requirement rules on end users will merely lead to a relabeling of credit and will not alter the economic substance of end user’s balance sheets.  (Similar arguments hold for financial institutions too.)  At worst, the constraints will result in costly changes to these balance sheets: excessive holding of liquid assets (can you say financial repression?), deficient investments in higher returning illiquid assets (i.e., the productive assets that enhance productivity), and too little hedging.  I read M-P to mean that the margin requirements on end users will merely lead to a relabeling, and that the requirements will not alter balance sheets.  I think that is far too sanguine.

And for what, exactly?  Under the best circumstances (i.e., no change in the economic substance of balance sheets), systemic risk doesn’t change a whit.  Under the worst circumstances, capital is misallocted, risks are misallocated, and there is no reduction in systemic risk (because end users do not contribute to it in a material way).  So, in the best of outcomes: no gain and no pain; in the worse ones, all pain and no gain.

Such a deal.

One final quibble with Betting the Business.  They state:

But of course an implicit credit line embedded in the bid-ask spread has great advantages to dealer banks. It is hidden, bundled with the derivative contract sold and therefore difficult to figure out by client end-users, who never really know how much they are paying for the amount of credit extended. Welcome to the opaque world of OTC markets.

Who cares how the cost components of a derivatives deal break out?  The end user cares only about the all-in cost, and the bid or offer is sufficient for end users to figure that out.  They can solicit quotes from multiple dealers and choose the most favorable one.  They can compare the quotes to the prices of related, exchange traded instruments to evaluate the reasonableness of the prices they are quoted.

Do you really care how the cost of a gallon of gasoline breaks down between the price of the crude, refining margins, transportation, retailing margin, etc?  No: you care about what it costs you to fill up.  If one station quotes $4.60 and another $4.65 for gasoline of equivalent quality, do you care why?  Or, to use the famous example of a pencil: do you really care about what each step of the process of putting a pencil in your hands cost?  No: you care about the price of the pencil.

That’s the information economizing role of prices at work.  It works in OTC markets as it does in pencils and gasoline.

Back in the late-90s and early-00s I often remarked that it was interesting how exchanges had drawn so little anti-trust scrutiny, despite the fact that may were effectively monopolies.  I also predicted that they would get more scrutiny when they became for-profit, and more like conventional firms.

That prediction is being borne out today, and how.  Exchanges, particularly merging exchanges, are the subject of considerable attention from anti-trust authorities.  ICE CEO Jeffrey Sprecher–who ironically had hoped that anti-trust objections to the CME-CBT deal would open the door for an ICE-CBT merger–has seen the writing on the wall:

Exchanges will have to “rethink their global strategies” because of unexpectedly strong scrutiny of proposed bourse tie-ups from antitrust regulators, according to IntercontinentalExchange (ICE), one of the world’s biggest exchanges.

A string of proposed mergers has come unstuck in recent months, either through nationalist opposition in the home market of exchanges perceived as the targets of takeovers, or as antitrust authorities have moved to stymie combinations amid concerns they could reduce competition.

. . . .

Jeff Sprecher, ICE chief executive, said: “There’s been a marked change in the way regulators look at exchanges generally. The good news is that they are looking to exchanges to provide more transparency to prevent another meltdown.

“The bad news is that they want to ensure a lot more exchanges to ensure competition. So the impediments are now higher than they were a few years ago and I think it’s going to cause everyone to rethink their global strategies,” he told the Financial Times.

A major sticking point for anti-trust regulators has been vertical integration between execution and clearing.  The USDOJ Anti-trust Division’s Parthian shot at the CME from early-08 is one example of this.  Battles currently going on in Europe are another.

But the vertical silo wars have now gone beyond execution and clearing to encompass other vertical restrictions, including exclusive arrangements for use of data centers.  Last week, Swedish competition authorities raided the country’s stock exchange as part of an investigation of its deal with Verizon over exclusive access to a data center.

This area is fraught with potential for policy error, because as Sam Peltzman notes in his chapter on Aaron Director in Cohen and Wright’s Pioneers of Law and Economics, and as Posner notes in his Antitrust Law, anti-trust policy over vertical restrictions and vertical integration has long been a mess.

The brief against integration, particularly between execution and clearing venues, is that clearing is a natural monopoly, and that the operator of a clearing monopoly can thwart competition in execution by creating a vertical silo, and providing clearing services exclusively to its integrated execution arm. That is, that the clearing monopolist can leverage his market power into execution, which would otherwise be competitive.

As Peltzman notes, and as Director argued well over a half-century ago, this fear of leveraging one monopoly into two is commonsensical–and more often than not, wrong.   The essence of the Chicago critique is that the monopolist (in this case, the operator of the clearing service) can extract all of the monopoly rent by choosing the monopoly price for his product.  Keeping out potentially more efficient suppliers of complementary services (e.g., execution, which is highly complementary to clearing) just reduces the profit the monopolist could extract.  The monopolist wants complements sold for the lowest price possible, in order to push out the demand curve for the monopoly good as far as possible.  Thus, keeping out a more efficient supplier of the complementary good, or reducing competition in the sale of the complementary good, is counterproductive.

Chicagoans starting with Director explained vertical restrictions as a form of price discrimination (which has ambiguous welfare consequences) or as a means of addressing free rider problems (as in Telser’s model of resale price maintenance) or as a way to eliminate double-marginalization problems.  Transaction costs economists devised other efficiency-related explanations for vertical integration.

But the suspicion of vertical integration and ties and exclusive dealing and other vertical restraints lives on.  Hence the fighting over silos in the exchange space.

Post-Chicago, there have been several attempts to produce models which lead to anti-Chicago implications, i.e., to show that monopoly leveraging is possible.  In this post I will discuss those models, and show that they don’t apply to the facts of the exchange case.  In a future post, I will discuss the efficiency rationales for integration and exclusivity.

The most prominent post-Chicago leveraging model is by Whinston.  In his model, there is a monopoly good M.  Some customers want to consume that good along with another good C that could be produced by competitive firms.  But some customers don’t want to buy M.  They wish to consume C alone.

In Whinston’s model, the M monopolist may want to tie or vertically integrate into C (and not sell to other producers of C) if entry into C production requires payment of a fixed cost.  By tying/integrating, those who want to buy M have to buy C from the M producer too.  Thus, potential entrants into the C market can sell only to those who want to buy C alone.  If there are too few of those customers, or fixed costs are too high, it will be unprofitable to enter into the production of C.  Then the monopolist can sell C to the stand-alone customers at a monopoly price.

This model clearly doesn’t fit the facts in the clearing-execution case.  Those products are highly complementary.  Indeed, they are consumed in nearly fixed proportions–if you want to trade, you need to clear, and if you clear, you need to trade.  The whole point of the Whinston model is about monopolization of a product some customers do not find complementary to M. The monopolist uses his power over the customers who have strong complementarity to gain a monopoly over customers who do not experience any complementarity with M.   This is clearly at odds with the assertions of those who assert that clearing monopolies use their power to achieve execution monopolies, because those assertions rely heavily on the notion that clearing is an essential service–i.e., highly complementary to execution, and a service that all traders consume.  That’s completely at odds with the Whinston story, so it is of no help to the anti-silo crowd.

Carlton and Waldman have an interesting model that embeds complementarity, but arrives at similar conclusions to Whinston’s model.  But whereas Whinston argues that ties/integration can be used to extend a monopoly to a non-complementary good, Carlton-Waldman devise a model in which a monopolist ties a complementary good to protect his M monopoly.

C-W present a two-period model.  A firm has a monopoly over M.  It is guaranteed this monopoly for 1 period, but in the second period, a competitor can enter.  The M monopolist can also produce a good C, and a firm that can enter the M market in the second period can produce C in the first period.

In one model, the rival incurs a fixed cost to enter the C market.  By tying the complementary good in the first period, the M monopolist deprives the entrant of any sales in the first period.  The profits from producing C and M in the second period may not be sufficient to cover entry costs, meaning that with the tie entry may not occur in either market, thereby preserving the M monopoly.  In contrast, without a tie, the entrant can produce C in the first period, and make a profit that contributes towards covering fixed costs: he can make a profit because his C good is superior to that of the monopoly producer of M.  The profit from entering C production in the first period may cover fixed costs of entering the C market.  Then, in the second period, it may be profitable to enter the M market as well.  In this case, tying protects the M monopoly.

In the second model, there is customer lock in due to network effects.  By tying in the first period, the monopolist of M locks in a lot of consumers of C, and deprives the entrant of any sales in the first period.  The customer lock-in reduces the profitability of entry into M and C production in the second period, likely by enough to make such entry unprofitable.  Again, the tie protects the M monopoly.

These models work best to explain ties in highly technologically dynamic industries where monopolies are likely to be short-lived in any event.  That doesn’t seem to fit the exchange-clearing case.  Moreover, there is no legal or economic bar on entry into clearing and execution simultaneously: the necessity of sequential entry is the key driver of the C-W results.  Indeed, integrated exchanges have entered in competition with incumbents, and execution platforms have secured clearing services by contract, so simultaneous entry has occurred.

A third type of model relies on contracting externalities to explain how exclusive dealing and integration can impair competition.  One example of this is a model by Hart and Moore.  In H-M, an upstream monopolist can sell to multiple downstream retailers.  In the exchange case, the upstream firm would be the clearing monopoly, and the retailers execution venues.

In the H-M model, the upstream monopolist negotiates with the downstream firms individually and secretly.  Moreover, they negotiate over output–the quantity sold: this is a key assumption.  H-M show that under these conditions, the monopolist cannot credibly commit to sell the monopoly output Q_m.  For instance, if he sells .5Q_m to one firm, he has an incentive to sell more than .5Q_m to the other: he cannot credibly commit to selling .5Q_m to the second firm once he has sold that amount to the first firm.  Thus, total output exceeds the monopoly output and the monopolist’s profit is smaller.  Indeed, he can only achieve the Cournot duopoly profit.  If he sells to N retailers, he can get only the N-firm Cournot profit.

By integrating, or selling to only a single retailer, the monopolist effectively commits to the monopoly output.  This may come at a cost.  For example, there may be diseconomies of scale in retailing, or retailers may be differentiated and service different customer clienteles.  But the gains from eliminating the commitment problem may exceed the costs arising from diseconomies of scale or underproduction of variety/customization.

The monopolist obviously has incentives to avoid the commitment problem that drives the exclusionary result.  For instance, he could charge the monopoly price, post that price publicly, and let the downstream firms buy as much as they want–which would be .5Q_m.  This would require the avoidance of secret price discounts.  Reputation may ensure this in a repeated game.  The retailers could monitor competitors’ sales to see if the monopolist were cheating.

Moreover, this doesn’t seem to match up well with the mechanics of the exchange case.  “Output” is not the choice variable; prices are.  And trading volumes are readily observable, making it possible to detect whether a clearing monopolist were offering secret price cuts.

A similar model is one in which a downstream monopolist buys from two upstream suppliers who compete in an input market in which the supply curve for the input slopes up.  Similar commitment problems preclude achievement of the monopsony outcome in the input market.  This model has the same choice variable problem as the H-M model, and what’s more, it is difficult to imagine what the relevant input with the upward-sloping supply would be.  Computer programmers?  Servers?  Again, it doesn’t fit the exchange case well at all.

Another model of anti-competitive integration is by Ordover, Saloner, and Salop.  In that model, two downstream firms D1 and D2 compete, as do two upstream firms U1 and U2.  If D1 and U1 integrate, and the integrated firm refuses to sell to D2, D2 now has to buy an input from a monopoly supplier U1.  D2 pays a higher price for the input, which makes it a less formidable competitor for the integrated firm, which therefore becomes more profitable.

This model is quite fragile.  What’s more, an example in a related paper by Riordan and Salop makes it hard for me to take the theory seriously.  Their example of how this could work is that the purchase of Autolite–a spark plug maker–by Ford could raise the price of spark plugs to GM and Chrysler, thereby allowing Ford to raise the price of cars.  Really.  They couldn’t come up with a better example.  (Posner snarkily dismisses the applicability of this theory by pointing out the complete absence of credible examples.)

Moreover, it doesn’t fit at all the arguments of the anti-silo advocates.  Their premise is that clearing is a natural monopoly.  But the OSS model depends crucially on integration reducing competition upstream (i.e., in clearing).  That can’t happen if clearing is already a monopoly.  OSS is not a theory of monopoly leveraging.

In brief, there are a variety of rather special models that arrive at anti-Chicago conclusions, and which suggest that vertical restrictions and vertical integration can be anti-competitive.  None of these models, however, fit the facts of securities or derivatives trading.  Moreover, many are completely at odds with the arguments made by those who claim that integration between clearing and execution is monopoly leveraging.

Which means that the anti-silo forces are on very shaky intellectual ground.  There is no existing, rigorous, logically consistent theory that is (a) consistent with the facts of the exchange case, and (b) rationalizes their conclusion that integration is anti-competitive monopoly leveraging.

In his industrial Organization text, Tirole warns:

Few topics in industrial organization are as controversial as market foreclosure.  . . . Though market foreclosure is a “hot” issue among those concerned with anti-trust proceedings and with regulation, economists still have a very incomplete understanding of its motivation and effects.  Nor can they always explain successfully why a particular tool is employed to achieve foreclosure.  (Tirole, The Theory of Industrial Organization, p. 193).

True, that.  And given that Tirole is hardly a wild-eyed libertarian, those convinced that vertical silos in exchanges are anti-competitive foreclosure should take his words as cautionary.

Posner once upon a time was more of a libertarian than Tirole, but his words are also worth considering:

The general prohibition in section 2 of the Sherman Act against monopolizing is adequate to deal with the rare case in which a firm imposes a tie-in with the purpose or likely effect of monopolizing the market for the tied (or for that matte the tying) product.  A special tie-in doctrine, inevitably with a life of its own, is unnecessary and inappropriate.  (Antitrust Law, 2d. Ed., p. 207). [Emphasis added.]

Whinston recognizes that many of the models of vertical exclusion are quite special cases, limited primarily to “triangular” situations (i.e., two upstream firms and one downstream, or two downstream firms and one upstream).  Thus, like Tirole, he cautions against drawing strong conclusions on the basis of special models.

In his “Should Antitrust Be Modernized” (J. Econ. Perspectives, 2007), Dennis Carlton cautions that rules intended to identify anti-competitive exclusive acts “could potentially challenge a wide array of core competitive behaviors” and hence become “dangerous” (p. 170).   Peltzman, in the chapter on Director I alluded to earlier, takes a more benign view of the effects of errors in precluding certain types of vertical restrictions.  Sam explains courts’ hostility to vertical restrictions by a monopolist to the belief that it is unlikely that outlawing such restrictions is unlikely to have a serious detrimental impact on competition, that any benefits of the restriction are likely to be indirect, and that courts typically discount any such indirect effects.  Transaction costs economics suggest that these benefits may be large, however, so such discounting is problematic at best.

In sum, the existing models that demonstrate that vertical restrictions can leverage monopoly don’t fit the facts of the clearing-execution case and are so highly stylized that even their developers caution against taking them too seriously in practical situation.  Moreover, thoughtful analysts of anti-trust discount their applicability.

Based on this, antitrust authorities–and those who criticize integration between clearing and execution, or between exchanges and data centers, for that matter–should be much more circumspect in their attacks on silos: the cases in which integration or vertical restrictions are anti-competitive are the exception, rather than the rule.  This circumspection should be all the greater because there are compelling efficiency rationales for vertical integration and other vertical restrictions involving clearing and execution.  I’ve laid out some of those rationales in working papers, and will devote a future post to the subject.

The Bank of England’s Andrew Haldane gave a speech on high frequency trading that highlighted its risks.  He cites evidence that various measures of persistence in stock prices have risen since 2005, and attributes this to the advent of HFT.  Maybe.  But many other things have changed in the same time period, so giving privileged status to HFT as the cause is quite a stretch.  Short of a natural or controlled experiment (e.g., randomly assigning stocks that can and cannot be traded using HFT), attributing broad changes in pricing behavior to any single factor is highly conjectural.

His argument rests on the assertion that market making is more fickle during times of stress due to HFT.  I would say that market making is more fickle during times of stress, full stop.  Liquidity has always dried up during crashes and crises, no matter what the technology.  The floors in Chicago were depopulated during the ’87 Crash.  Many locals–liquidity suppliers–who didn’t leave voluntarily were pulled off the floors by their clearing firms.  And many those that remained stood with their hands concealing their badges lest somebody try to win the outtrade lottery by claiming that he had made a profitable trade.  NASDAQ market makers didn’t answer their phones during the Crash, and many specialists evaded their affirmative obligations to make markets (so much for one of Haldane’s suggested fixes).  No HFT, but no liquidity and a crash all the same.

I wrote about a lot of the proposals that Haldane mooted in the immediate aftermath of the Flash Crash.  Market making obligations are hard to enforce, as Haldane notes.  The argument for them, as I laid out last year, is that they could affect the time pattern of liquidity supply.  Such constraints necessarily reduce the return on capital, which will lead to an exit of market making capacity.  This will raise costs in tranquil times, in the hope that the obligations imposed on market makers will lead a larger proportion of a smaller population of market makers to remain active during turbulent times, thereby improving liquidity during those times.  Given the strong incentives to evade the obligations during turbulent times, and the difficulties of specifying and enforcing what those obligations are due to the high dimensionality of the services that market makers perform, this is quite a gamble: in more technical economic jargon, market making behavior is not contractible.  There is no guarantee that the greater participation rate will more than offset the loss in capacity, leading to a more desirable allocation of liquidity supply between stable and turbulent times.

Haldane also plumped for minimum order times.  Despite David of Deus Ex Machiatto’s best efforts, I remain wholly unconvinced of the wisdom of this.  Ditto Eric Hunsader of Nanex’s very nice and thoughtful comment.  David presents a calculation of the option value, and hence the cost, of mandating a one-second quote-in-force rule.  The calibration technique is a natural one, but I am skeptical of its applicability.  The price of an option with a maturity of a month that David is using to calibrate is based on private and public information flows over a period of days, which is fundamentally different than the market makers’ pricing problem, which is driven by private information flows over very short time scales.  The whole point about market microstructure theory is that price behavior is fundamentally different at small time scales, so in my view it is unlikely that a one month option can be scaled down to value an option granted on a far shorter time scale.

But quibbles about calibration and scaling aside, this begs a huge question: if it is so cheap to grant options under all market conditions, why doesn’t competition ensure that said options are in fact supplied at their allegedly negligible cost (fractions of a basis point, per DEM)?  After all, competition–as a graph in Haldane’s presentation shows–has driven down spreads to very low levels in normal times.  The wholesale exit of market making capacity during turbulent times–in many cases, the refusal to trade at any price–indicates that it is very costly, and for some prohibitively costly, to grant options under these circumstances.  It is a cost problem, and this cost problem is endemic to financial trading, regardless of the technology.

It has long been known that situations of extreme adverse selection–a problem completely abstracted from in the option calibration problem, by the way–can lead to a breakdown of trading, or at the very least, a sharp reduction in trading activity.  When lemons risk becomes too great, markets freeze up or shut down.

An old paper by Glosten in the Journal of Business suggests that this is a rationale for having a designated market maker or specialist: in his model, a monopoly specialist market is less vulnerable to breakdown than a competitive one.  But that’s a different solution than mandating quoting by competitive market participants.  In the Glosten model, competitive markets are subject to breakdown under conditions of extreme information asymmetry.  That’s true regardless of the technology.

Glosten’s paper, I might add, was published in 1985, before HFT was a gleam in a geek’s eye.  There is indeed little new under the sun, and the focus on technological novelty obscures the enduring nature of the fundamental economic problems of liquidity supply.

Indeed, I believe it to be almost certain that imposing a restriction on quoting times will not improve liquidity, and will usually make it worse.  Imposing a constraint increases costs, and increasing costs invariably reduces supply.  A quoting time rule says: “If you quote, your quote must be in force for x seconds.”  The “if” is the key thing here: a market maker can avoid the constraint by not quoting at all, and if the cost of extending the x-second option becomes too large due to severe lemons problems, that’s exactly what he will do–or will program his machine to do.  Not exactly the best way to induce liquidity supply.

So a quoting-time rule alone is extremely counterproductive.  Hence Haldane’s musing about market making obligations–which are noncontractible and hence not effectively enforceable, and hence not much use either.

In other words, if you want to encourage liquidity supply in the worst way, imposing constraints is that way!

Going back to basics, if you think that there is a market failure (e.g., a periodically occurring severe lemons problem), a natural way to address that failure is to subsidize what is being undersupplied, not to tax it.  Just how to subsidize is not obvious, but one thought would be to widen tick sizes.

Another more productive approach would be to constrain the kinds of trading strategies that can be destabilizing, most notably stop orders.  The CME’s stop order logic clearly helped put the brakes on the Emini Flash Crash.  Extending that logic to other markets would be salutary.

This is an area where fragmentation and the associated difficulties of coordination across linked platforms raises difficulties not present in a CLOB, as David emphasized.  But that’s where regulators could play a constructive coordinating function.  Haldane and other regulators have discussed coordinated circuit breakers–a coordinated stop order logic would be an excellent place to start.

Free associating  somewhat (for that’s what blogs are for!), I can envision a way to make such limits forward looking, rather than backward looking.  The Easley-O’Hara-Prado order flow toxicity measure could help identify times in which market breakdowns are more likely, and this could be used to trigger constraints on stop orders.  All circuit breakers under consideration are conditional on price movements, which often involves shutting the barn door after the horse has bolted.  Something forward looking based on real time monitoring of quoting behavior and the adverse selection risk of order flow would be preferable.  This would put computing technologies to work reducing the risk of flash crashes.

I also think it is worthwhile to explore measures directed at parasitic types of trading.  In particular I am still convinced that pricing of exchange capacity–e.g., charging prices for submitting and canceling orders, where said prices vary with system usage–is a promising avenue to explore.

One final note.  During his talk, Haldane mentions the importance of “moving from analysing market microstructure to market macrostructure.” Hear! Hear!  That’s what I’ve been on about for the last 15 plus years.

I claim credit for coining the term “macrostructure” in this context: maybe somebody used it first, but if so I wasn’t aware of it in ’98 or ’99 when I started describing my research using that term.*  I have a paper in the JLEO from 2002 titled “Securities Market Macrostructure,” and the title of my next book will be “Financial Market Macrostructure.”  I actually had to fight the editorial board at Cambridge UP to get them to sign on to that title; they wanted a more plain-spoken title and thought that “macrostructure” was not commonly enough used in economics to fit the bill.  Glad I prevailed–and glad Mr. Haldane is popularizing the phrase.

As I use it, macrostructure modeling involves deriving the implications of microstructural forces for the organization of securities and derivatives markets–the number of exchanges; how trading is divided between exchanges and OTC markets; fragmentation of trading; how exchanges are organized and governed, etc.  My perhaps heterodox views on fragmentation, dark markets, etc., are firmly rooted in this way of analyzing market structure.  Maybe Mr. Haldane and others often disagree with those heterodox views, but it is encouraging to see that the idea of building an understanding of market structure and regulation on firm microstructure foundations is gaining acceptance.

* I’d be interested to hear from anyone who can provide an example of the term “macrostructure” used in this way (which I describe more fully in the text below) that pre-dates 1998 or so, when the word popped into my head.  I wouldn’t want to deny the actual innovator the props he or she deserves.

As I’ve written repeatedly in the past years, the mandated move to central clearing will increase substantially demands for liquidity to fund variation margin payments, especially during periods of high volatility and high market stress.  By definition, variation margin payments total zero–every dollar paid is received by somebody else–thus they don’t affect aggregate liquidity, but economic frictions preclude the development of a perfect pooling mechanism.  As a result, market participants will need to pre-plan how to fund their margin payments.

Not surprisingly, banks are crafting funding mechanisms for their buy-side clients (“end users”).  FTAlphaville quotes from a Risk story by Matt Cameron which describes some of the solutions dealer banks are peddling to their clients [emphasis provided by FTA]:

Clearing members say they have a solution. Most buy-side firms will have to access clearing services through these members – typically the large banks – due to strict membership criteria set by the CCPs. These clearing members are responsible for collecting margin from their clients and posting it to the clearing house, charging a fee for the privilege. As an additional service, however, a number of clearing members are also planning to offer collateral transformation facilities – essentially, enabling the client to post non-eligible instruments with the dealer, which will be switched into cash via the repo market and then posted with the CCP. Given the frequency of margin calls – there could be several per day in volatile markets – some also plan to extend credit lines, where they would meet intra-day margin calls, with the customer settling up in one go at the end of the day or start of the next.

It sounds a perfect solution, but the numbers involved are huge, raising the question of whether there is enough capacity and appetite among dealers to offer this service to the entire universe of end-users. According to research published by Morgan Stanley and Oliver Wyman on February 16, as much as 40–50% of the total annual traded volume of OTC contracts could be cleared by 2012/13 … creating an additional collateral requirement of between $2 trillion and $2.5 trillion … Most dealers say they would only have capacity to extend credit lines and provide collateral transformation services on a fraction of that.

Diving into the Risk article reveals more details–troubling ones.  It notes that unlike dealers, whose books are typically close to matched, end users are likely to have one-way positions with commensurately greater exposure to margin calls.  Which just provides just another reminder that clearing would not have been a panacea for AIG, which had huge directional positions, and was brought down by the need to fund margin calls–and would have been brought down by the need to fund margin calls in a cleared environment.  Indeed, the expansion of clearing threatens to increase the population of potential AIGs.

The article also emphasizes that the contingent funding obligations on banks could be huge, and are likely to be huge precisely when funding market conditions are stressed.  The various solutions proposed by the banks rely very heavily on repo markets, and in particular repo markets for lower quality, less-liquid instruments.  In essence, banks will repo out lower quality assets and use the cash to fund margin calls.  But repo markets for lower quality assets are the ones that are the most problematic during periods of market stress.  Note that haircuts on everything but high quality sovereign paper increased dramatically when the financial crisis took hold.  Companies that depended on the repo market for funding found this source cut off.  The shadow banking system was built on repo, and runs on the repo market are what cratered that system.  The death knell for Lehman was the decision by JP Morgan and BNY Mellon–the clearing banks–to refuse to take low quality assets to collateralize tri-party repo.

So just why exactly is it a good idea to create a system that increases reliance on a fragile funding source?  This creates exactly the kind of feedback mechanism that generates crises.  Adverse shocks lead to price changes that result in big margin calls.  These shocks also impair liquidity of the funding markets that participants rely on to obtain the cash they need to pay the margin calls.  That’s how things spiral from bad to worse to worser yet.

And there are knock-on effects in the asset markets:

“We reserve the right not to fund clients on a unilateral basis.  If we fall short and can’t fund the variation margin call, we will demand the cash from the client.  If the client doesn’t have the cash, it will have to liquidate the assets it does have or we will be forced to close them out . . .” says one dealer.

Great.  This is a perfect example of how individually rational behavior by banks can exacerbate market stress.  The collateral liquidations and  derivatives liquidations will both cause prices to move–generating more margin calls and reducing the value of the collateral available to secure funding of those calls.  Positive feedback again.  And since by design a lot of the collateral that is liquidated will be lower quality stuff traded in illiquid markets the price impacts will be large–and this will make it more difficult for others to use these assets to fund their positions, thereby creating a serious negative externality.

These problems are endemic in financial markets, including uncleared OTC derivatives markets.  But clearing makes the mechanism more rigid and time sensitive.  It increases the tightness of the coupling in the financial markets, and that makes them more vulnerable to chaotic breakdown and cascading failure.

Cameron’s article discusses other alternatives.  One is that CCPs accept lower-quality collateral. But this merely passes the hot potato.  CCPs are simply conduits that transfer margin monies from the losers to the winners.  The winners won’t necessarily accept the collateral that the losers provide, or will place a lower value on it.  Much of the collateral will be hard to value, during periods of market stress particularly.  And if there is a delivery option on collateral, how do you even price collateralized derivatives trades?: the price of the collateralized trade depends on the value of the collateral, which adds an additional risk to the trade.

So if the CCP can’t just pass collateral along from loser to winner because the collateral isn’t fungible like cash, then the CCP has to fund the cash payments to the winners collateralized by the non-cash instruments posted by the losers.  That puts the CCP in the position of a bank, and raises the question: just who is going to lend against that collateral?

Moreover, this undermines one of the main potential benefits of clearing: fungibility of trades across counterparties.  Different counterparties may have different funding capabilities.  Some may have  access to high quality collateral, some may rely more heavily on low quality collateral.  In an OTC market, those counterparties would trade derivatives at different prices reflecting their differing risks and the quality of the collateral that backs the trade.  But in a cleared market in which all trades are fungible–with offsetting positions netted out, meaning that they are treated as perfect substitutes–this pricing mechanism doesn’t work.  Economically important differences are not priced, which distorts incentives.  This will tend to work to the advantage of low-quality counterparties and to the disadvantage of high-quality ones.

In other words, if the collateral really isn’t fungible–like cash is–how can the trades backed by this collateral be fungible?

One of the risks of clearing is that it treats the unequal equally.  Widening the range of collateral that CCPs must accept only exacerbates that risk.

It also puts CCPs in a delicate position–exactly the position that JP Morgan and BNY Mellon found themselves with Lehman.  A firm is in trouble, and is offering to post dodgy paper as collateral.  If the CCP refuses, the firm is likely to default.  That could jeopardize the CCP.  Even if the CCP can absorb the default, it is at risk of being accused by the defaulter’s bankruptcy administrator of violating the bankruptcy laws–which is the situation Morgan and BNY found themselves in post-Lehman.

So maybe the CCP will decide to play European Central Bank for a day–or a week, or a month–and pretend that junk collateral is as good as gold or cash, thereby gambling on the resurrection of the troubled firm.  That just increases the risk of the financial system–and may subject the CCP to a run by firms that are worried about the quality of the collateral it has taken on.

Contrary to the airy promises of their evangelists, clearing mandates therefore do not fundamentally alter the economic problem that must be addressed: how to fund variation margins in periods of market stress.  Indeed, in my view mandates actually exacerbate the problem because they increase the rigidity and time-sensitivity of the system, require the clearing of more instruments less suitable to accurate valuation in short time frames, and reduce the ability to price risk in a discriminating way (because unequal entities and instruments are treated as interchangeable).  What’s more, the mandates tie up vast amounts of high quality collateral in initial margin payments, forcing greater reliance on lower-quality collateral to keep the system running.  And yet more–depending on the scope of the mandates, buy-side entities that pose no real default risks (e.g., pension funds) but do pose potentially serious funding and liquidity risks will be forced to clear.  Since funding and liquidity risks are the Achilles heel of the clearing system, it is absolutely insane to increase funding needs.

No matter how many times you turn over this problem, I think you will conclude that clearing mandates will substantially increase the necessity of central banks to provide liquidity, and lend against dodgy collateral.  Whether the central banks provide cash to CCPs collateralized by non-cash collateral paid by customers, or provide cash to dealer banks collateralized by low-quality collateral, or provide the cash to end-users similarly backed by low-quality collateral (although this alternative is least likely), to fund the vast margin payments during periods of stress they will be lending a lot to somebody.

Savor the irony.  The rallying cry for clearing mandates was “No More Bailouts,” “bailouts” in this instance meaning central bank loans to troubled financial institutions, intended in part to prevent a meltdown in derivatives markets.  But clearing mandates will only increase the demands on central banks to provide extraordinary funding to keep the derivatives markets going.  The parable of the Indian village that brought in cats to rid itself of mice, dogs to rid itself of the cats, elephants to rid itself of the dogs, and then in the end mice to rid itself of the rampaging elephants is apt indeed.

In the Risk article, Matt Cameron notes that seven out of eight regulators he contacted about the story refused comment: “Most said not enough analysis had been conducted.”  Read that again: “Not enough analysis had been conducted.”  Pardon my French, but Jesus H. Christ, wouldn’t you want to do that analysis before embarking on this titanic reengineering of the largest, most complex financial markets the world has ever seen?  “Not enough analysis had been conducted.”  Really?  Really?

But I know it’s true–and you do too.  And that’s the tragedy of it all.

I sometimes try to think of a rational reason for undertaking this huge experiment on a live patient.  In my more cynical moments–pretty much all my moments are cynical, but some more than others–I wonder if this is just a part of the movement to “financial repression”, defined by Reinhart and Rogoff as follows:

Banks are vehicles that allow governments to squeeze more indirect tax revenue from citizens by monopolizing the entire savings and payment system. Governments force local residents to save in banks by giving them few, if any, other options.

They then stuff debt into the banks via reserve requirements and other devices. This allows the government to finance a part of its debt at a very low interest rate; financial repression thus constitutes a form of taxation. Governments frequently can and do make the financial repression tax even larger by maintaining interest rate caps while creating inflation.

Clearing mandates, mandates that non-cleared transactions be collateralized, limits on rehypothecation, segregation rules and on and are “other devices” that increase the demand for government paper.  And just coincidentally, I’m sure, we’re living in an age where governments are desperate for buyers.

Maybe the dots don’t connect.  But maybe they do.  But I guess financial repression is better than financial insanity, which is the only other explanation that comes to mind.

Cold comfort, that.

David at Deus ex Machiatto responded to my response to his post on HFT.  A brief surrebuttal, if I may.

First, regarding CLOBs.  I wrote in the Regulation piece “Thirty Years War” that I linked to in my reply that the SEC had a choice between mandating a CLOB, and an “information and linkages” approach, and chose the latter.  Its implementation of the information-and-links approach was flawed, however, because they didn’t go all the way: the limitation to top-of-book protection is the most obvious flaw.

Moreover, a linkage-based approach is problematic during periods of market stress.  Any tightly coupled system is prone to failure.  David mentions that a CLOB has a single off switch, but that coordinating a shut-down of  multiple linked markets is more difficult.  That’s definitely true.  Failures of linkages–which are prone to happen during periods of high traffic and high volatility–can propagate through a linked system in unpredictable, chaotic, and destructive ways.  All this argues for a CLOB.

But, linkages are inevitable even if all trading in a particular instrument (e.g., a particular stock) takes place on a single CLOB.  In equities, for instance, cash and futures and options and futures markets should be interrelated and interactive, but cannot be run through a single CLOB.  Thus, linkages between such markets are inevitable, these linkages can break, and this tightly coupled system is prone to destructive feedbacks during periods of market stress.  Now with the proliferation of cross-market/asset strategies, linkages are pervasive and there cannot be a true single off switch.

But this is not an artifact of computerization of the markets and HFT.  It was a problem in the Crash of ’87, for instance.  The years immediately following saw a lot of chin pulling about how to coordinate among interrelated markets.

With respect to dark markets, darkness is a mechanism for segmenting privately informed traders and those who are trading for reasons other than private information.  In the old days, with block markets, non-anonymity (counterparty transparency), reputation (“no bagging the street”), and repeat dealing were the mechanisms for doing this.  Similarly, payment for retail order flow and ex post evaluation of trading performance of various sources of order flow was a segmenting mechanism.  As long as you have some people that are trading for reasons other than private information, you will have mechanisms to help them signal their lack of information.  If you force dark markets to light up, you will see the evolution of a mechanism that performs the same functions.  As surely as the light follows the darkness.  Or something.

David and I will agree to disagree about forcing limits on order exposure.  My argument against a say 1 second minimum exposure time is based on the fact that quotes are like free options.  Forcibly extending time-in-force increases the cost of that option to the quoter.  This is especially the case during periods when order flow is toxic–as was clearly the case during the hours leading up to the Flash Crash–that cost can become appreciable.  Many quoters will decide not to quote or radically reduce size.

In other words, the supposed cure is likely to actually exacerbate the problem of liquidity supplier flight which was at the root of the Flash Crash.  Making something more expensive is not the way to get more of it.  Minimum exposure rules would raise dramatically liquidity supply costs during periods when order flow is toxic, so you will get even less liquidity then.

Remember on exchange floors the rule is that a quote is good only “as long as the breath is warm.”  That’s because locals wanted to limit the value of the options they were extending.

There’s no free lunch here.  If you impose a constraint, and the constraint binds–there is a cost associated with that.  Somebody is going to pay it.

The “warm breath” metaphor reminds me that many of the things you see in HFT have close analogies to floor trading.  Sharply limited quote exposure times is one.  Colocation gives HFT traders a time-and-space advantage like that that floor traders possessed.  Even flash trading has its parallels: it is just another time-space advantage for a subset of traders who specialize in liquidity supply.  (Though to the extent that flash trading is used primarily to exploit the lack of full book protection the analogy breaks down.)

I’m sure we haven’t reached the end of this discussion, but that’s all for now.  As the title of my Regulation piece suggested, these battles over market structure and trading rules have gone on a long, long time, and will continue for as long as asset and derivatives markets exist.

Free Exchange, one of the blogs at the Economist writes up one of my takedowns of the SPR release.

Deus ex Machiatto has an interesting post on high frequency trading.   His basic take:

I would argue that HFT has reduced trade sizes and decreased liquidity/increased costs for block trades, especially combined with the move to trading the VWAP rather than brokers taking on blocks as a risk trade, but (3) really gives me pause for thought. Is it true?

. . . .

My recipe for HFT is not to withdraw it, but to reduce the impact of its speed by (1) requiring all market participants to trade on a central order book – no dark pools and (2) requiring all quotes to be good for a minimum of half a second. This would affect real trading activity very little while completely wrecking the high frequency strategies that generate flash crash risk.

I am skeptical that requiring trading on a central order book (CLOB) will eliminate flash crashes.  Note that flash crashes have occurred on futures markets with CLOBs.  The eMini on 6 May 2010 is the most notable example, but even in markets without linkages to other markets–such as cocoa and natural gas–(a) have CLOBs, and (b) have experienced flash crashes.  I’m also skeptical that dark pools have anything to do with flash crashes, and am also not convinced that the dark pool structure–which as DEM notes, has effectively supplanted the block market for facilitating large trades–is detrimental to the interests of those who want to trade in size.  After all, a block positioner could still attempt to compete for the business of those who want to trade in blocks: the fact that dark pools have become the venue of choice suggests they outcompete the old way of trading blocks on cost.

That said, I have long been critical of the SEC rules that protect only the top of the book rather than the depth of book.  Top-of-book protection provides a way for HFTs to make money by exploiting fragmentation of liquidity.  Creating a real CLOB entails a whole set of issues (see the linked article above for a brief discussion), but these can be avoided through the creation of a virtual CLOB that protects the entire books of the various liquidity pools.

A related issue is flash quoting, in which the operator of a matching system gives those supplying liquidity on it a first chance to execute orders before they are routed to other venues.  This undermines time priority, which also precludes the creation of a virtual CLOB by integrating the books of multiple venues.  This can also affects the incentives to supply liquidity.

DEM also links to a presentation that notes that HFTs make money by collecting liquidity rebates.  He further quotes a Bank of Canada study:

Some HFT participants to overload exchanges with trade messaging activity; use their technological advantage to position themselves in front of incoming order flow, making it more difficult for participants to transact at posted prices; or withdraw activity during periods of pricing turbulence.

Both these issues relate to the subject of the very first substantive SWP post: exchange pricing.  That is, the prices that electronic exchanges charge their customers.  I wondered then, and I wonder now, why exchanges don’t charge users for causing congestion on their systems.  If quote stuffing and overloading is problematic, exchanges could penalize it through how they charge for message traffic.  You’d think they have the appropriate incentive to do so.  If it is parasitic on the customers who generate revenues for exchanges (because it is undertaken by those whom exchanges typically pay rebates–see below–and harms the people whom the exchanges charge positive prices), the exchanges would have a strong incentive to devise pricing strategies or quoting rules that would tend to deter this conduct.

Exchange pricing is also relevant for rebates.  It makes sense for exchanges to subsidize some activity (providing quotes) that increases the revenues they can realize from other activity (taking liquidity).  Again, exchanges should have the right incentives to balance the costs and benefits and come up with pricing schemes that encourage the right amount of liquidity supply.

It would certainly be odd, I should add, to want to discourage this kind of pricing if one of your concerns is the disappearance of liquidity.

And related to the disappearance of liquidity, I agree that contributes to crash risk–in both old school floor markets and newfangled electronic ones.  But restrictions on quoting–e.g., DEM’s suggestion that quotes be good for one second–could well be  counterproductive in that regard.  The current evidence suggests that order floor became much more toxic on 6 May 2010, and that’s why HFTs stopped supplying liquidity.  Forcing them to keep their quotes good for longer than they would choose to on their own in such circumstances makes it more likely they will not quote at all.  That is, establishing minimum times that quotes must be in effect is likely to accelerate the wholesale withdrawal of quotes altogether during circumstances in which flash crashes are most likely.

I think there are many issues implicated with HFT–not the least of which being whether there is even an approximate match between the social and private benefits of this activity.  Many of the issues associated with it, however, I think are only peripherally related to flash crashes.  HFT may have a role in flash crashes–though exactly what is hard to pin down, and it may also have a role in making them flashier, i.e., shorter.  But many of the controversies involving HFT don’t appear to be connected to flash crashes.  As in many issues involving financial infrastructure these days, many issues are getting mashed together.  This makes coherent analysis hard, and coherent responses even harder.