Streetwise Professor

May 8, 2018

Libor Was a Crappy Wrench. Here–Use This Beautiful New Hammer Instead!

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Regulation — The Professor @ 8:02 pm

When discussing the 1864 election, Lincoln mused that it was unwise to swap horses in midstream.  (Lincoln used a variant of this phrase many times during the campaign.) The New York Fed and the Board of Governors are proposing to do that nonetheless when it comes to interest rates.  They want to transition from reliance on Libor to a new Secured Overnight Financing Rate (SOFR, because you can never have enough acronyms), despite the fact that there are trillions of dollars of notional in outstanding derivatives and more trillions in loans with payments tied to Libor.

There are at least two issues here.  The first is if Libor fades away, dies, or is murdered, what is to be done with the outstanding contracts that it is written into? Renegotiations of contracts (even if possible) would be intense, costly, and protracted, because any adjustment to contracts to replace Libor could result in the transfer of tens of billions of dollars among the parties to these contracts.  This is particularly like because of the stark differences between Libor and SOFR.  How would you value the difference between a stream of cash flows based on a flawed mechanism intended to reflect term rates on unsecured borrowings with a stream of cash flows based on overnight secured borrowings?  Apples to oranges doesn’t come close to describing the difference.

Seriously: how would you determine the value so that you could adjust contracts?  A conventional answer is to hold some sort of auction (such as that used to determine CDS payoffs in a default), and then settle all outstanding contracts based on the clearing price in the auction (again like a CDS auction).  But I can’t see how that would work here.

Let’s say you have a contract entitling you to receive a set of payoffs tied to Libor.  You participate in an auction where you bid an amount that you would be willing to pay/receive to give up that set of payoffs for a set of SOFR payoffs.  What would you bid?  Well, in a conventional auction your bid would be based on the value of holding onto the item you would give up (here, the Libor payments).  But if Libor is going to go away, how would you determine that opportunity cost?

Not to mention that there is an immense variety of payoff formulae based on Libor, meaning that there would have to be an immense variety of (impractical) auctions.

So it will come down to bruising negotiations, which given the amounts at stake, would consume large amounts of real resources.

The second issue is whether the SOFR rate will perform the same function as well as Libor did.  Market participants always had the choice to use some other rate to determine floating rates in swaps–T-bill rates, O/N repo rates, what have you.  They settled on Libor pretty quickly because Libor hedged the risks that swap users faced better than the alternatives.  A creditworthy bank that borrowed unsecured for 1, 3, 6, or 12 month terms could hedge its funding costs pretty well by using a Libor-based swap: a swap based on some alternative (like an O/N secured rate) would have been a dirtier hedge.  Similarly, another way that banks hedged interest rate risk was to lend at rates tied to their funding cost–which varied closely with Libor.  Well, the borrowers (e.g., corporates) could swap those floating rate loans into fixed by using Libor-based swaps.

That is, Libor-based swaps and other derivatives came to dominate because they were better hedges for interest rate risks faced by banks and corporates than alternatives would have been.  There was an element of reflexivity here too: the availability of Libor-based hedging instruments made it desirable to enter into borrowing and lending transactions based on Libor, because you could hedge them. This positive feedback mechanism created the vexing situation faced today, where there are immense sums of contracts that embed Libor in one way or another.

SOFR will not have this desirable feature–unless the Fed wants to drive banks to do all their funding secured overnight! That is, there will be a mismatch between the new rate that is intended replace Libor as a benchmark in derivatives and loan transactions, and the risks that that market participants want to hedge.

In essence, the Fed identified the problem with Libor–its vulnerability to manipulation because it was not based on transactions–and says that it has fixed it by creating a benchmark based on a lot of transactions.  The problem is that the benchmark that is “better” in some respects (less vulnerable to a certain kind of manipulation) is worse in others (matching the risk that market participants want to hedge).  In a near obsessive quest to fix one flaw, the Fed totally overlooked the purpose of the thing that they were trying to fix, and have created something of dubious utility because it does a poorer job of achieving that purpose.  In focusing on the details of the construction of the benchmark, they’ve lost sight of the big picture: what the benchmark is supposed to be used for.

It’s like the Fed has said: “Libor was one crappy wrench, so we’ve gone out and created this beautiful hammer. Use that instead!”

Or, to reprise an old standby, the Fed is like the drunk looking for his car keys under the lamppost, not because he lost them there, but because the light is better.  There is more light (transactions) in the O/N secured market, but that’s not where the market’s hedging keys are.

This is an object lesson in how governments and other large bureaucracies go astray.  The details of a particular problem receive outsized attention, and all efforts are focused on fixing that problem without considering the larger context, and the potential unintended consequences of the “fix.” Government is especially vulnerable to this given the tendency to focus on scandal and controversy and the inevitable narrative simplification and decontextualization that scandal creates.

The current ‘bor administrator–ICE–is striving to keep it alive.  These efforts deserve support.  Secured overnight rate-based benchmarks are ill-suited to serve as the basis for interest rate derivatives that are used to hedge the transactions that Libor-based derivatives do.

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May 1, 2018

Cuckoo for Cocoa Puffs: Round Up the Usual Suspects

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 10:39 am

Journalism on financial markets generally, and commodity markets in particular, often resorts to rounding up the usual suspects to explain anomalous price movements.  Nowadays, the usual suspect in commodity markets is computerized/algorithmic/high frequency trading.  For example, some time back HFT was blamed for higher volatility in the cattle market, even though such trading represents a smaller fraction of cattle trading than it does for other contracts, and especially since there is precious little in the way of a theoretical argument that would support such a connection.

Another case in point: a flipping of the relationship between London and New York cocoa prices is being blamed on computerized traders.

Computers are dominating the trading of cocoa in New York, sparking a dramatic divergence in the longstanding price relationship with the London market.

Speculative funds have driven the price of the commodity in New York up more than 50 per cent since the start of the year to just under $3,000 a tonne. The New York market, traded in dollars, has traditionally been the preferred market for financial players such as hedge funds.

The London market, historically favoured by traders and commercial players buying and selling physical cocoa, has only risen 34 per cent in the same timeframe.

The big shift triggered by the New York buying is that its benchmark, which normally trades at a discount to London, now sits at a record premium.

So, is the NY premium unjustified by physical market price relationships?  If so, that would be like hundred dollar bills lying on the sidewalk–and someone would pick them up, right?

Not according to this article:

The pronounced shift in price relationships comes as hedge fund managers with physical trading capabilities and merchant traders have exited the cocoa market.

In the past, such a large price difference would have encouraged a trader to buy physical cocoa in London and send it to New York, hence narrowing the relationship. However, current price movements reflected the absence of such players, said brokers.

Fewer does not mean zero.  Cargill, or Olam, or Barry Callebaut or Ecom and a handful of other traders certainly have the ability to execute a simple physical arb if one existed.  Indeed, given the recent trying times in physical commodity trading, such firms would be ravenous to exploit such opportunities.

What’s even more bizarre is that pairs/spread/convergence trading is about the most vanilla (not chocolate!) type of algorithmic trade there is, and indeed, has long been a staple of algorithmic firms that trade only paper.  Meaning that if the spread between this pair of closely related contracts was out of line, if physical traders didn’t bring it back into line, it would be the computerized traders who would.  Yes, there are some complexities here–different delivery locations, different currencies, different deliverable growths with different price differentials, different clearinghouses–but those are exactly the kinds of things that are amenable to systematic–and computerized–analysis.

Weirdly, the article recognizes this

Others use algorithms that exploit the shifts in price relationships between different markets or separate contracts of the same commodity. [Emphasis added.  I should mention that cocoa is one of the few examples of a commodity with separate active contracts for the same commodity.]

It then fails to grasp the implications of this.

One “authority” cited in the article is–get this–Anthony Ward of Armajaro infamy:

Anthony Ward, the commodities trader known in the cocoa market for his large bets, has been among the more well-known fund managers to close his hedge fund, exiting the market at the end of last year. Mr Ward, dubbed “Chocfinger” due to his influence over the cocoa price, blamed the rising power of algorithmic and systems-based trading for making position-taking based on “fundamental” supply and demand factors more difficult.

Methinks that the market isn’t treating Anthony well, and like many losing traders, can’t take the blame himself so he’s looking for a scapegoat. (I note that Ward sold out Armajaro’s cocoa trading business to Ecom for the grand sum of $1 in December, 2013.)

I am skeptical enough that computerized trading can distort flat prices, but those arguments are harder to refute because of the knowledge problem: the whole reason markets exist is that no one knows the “right” price, hence disagreements are inevitable.  But when it comes to something as basic as an intracommodity spread, I find allegations of computer-driven distortions completely implausible.  You can’t arb flat price distortions, but you can arb distorted spreads, and that business is the bread and butter for commodity traders.

So: release the suspect!

PS. For my Geneva students looking for a topic for a class paper, this would be ideal. Perform an analysis to explain the flipping of the spread.

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Begging the Question on VIX Manipulation

Filed under: Derivatives,Economics,Exchanges,Regulation — The Professor @ 9:29 am

Stung by yet another allegation of manipulation of the VIX, Cboe Chairman and CEO Ed Tilly and President and COO Chris Concannon fired off an open letter defending the exchange and VIX.  To say it begs the key questions is an understatement.

Here’s their explanation of the April 18 event:

During the opening auction on April 18th, a single market participant submitted orders to buy approximately 212,000 SPX options across a wide range of strike prices. Five additional market participants submitted buy orders totaling 20,000 options. The size and structure of these buy orders appeared consistent with the weights prescribed by the VIX Index formula. Offsetting this buy interest were sell orders submitted by nine participants for a total of 118,000 contracts. This left a buy order imbalance of 114,000 SPX options. This buy order imbalance contributed to the opening prices of the option series that were used to calculate the final VIX settlement value. Based on the orders that were submitted, we believe the auction process functioned as intended, notwithstanding that the final settlement value was higher than what market participants may have otherwise expected.

Although oddly disconnected from the discussion of the 18 April spike in the VIX, this statement ostensibly directed at the Griffin and Shams paper claiming to find frequent manipulations of the VIX strongly suggests that they are denying there was a manipulation on 18 April as well:

Finally, we would like to again address the claims of possible manipulation of the settlement process. We reiterate that we believe these claims are without merit, and that the academic paper’s analysis and conclusions are based upon a fundamental misunderstanding about how VIX derivatives are traded and settled. The trading behavior the author considered suspicious is
consistent with normal and legitimate trading behavior.

The explanation of what happened a couple of weeks ago begs the question because in no way does it disprove that a manipulation took place.  Indeed, what they describe is exactly how a large trader could and would “bang the auction” to influence the settlement price of VIX derivatives, in order to profit on positions in those derivatives.  What Tilly and Concannon describe involves a single large trader submitting a huge order on one side of a market with liquidity constraints.  That is almost certain to affect the auction price. That’s how that kind of manipulation works.

Note that the order–again, entered by a single participant–represented about 90 percent of the buy side interest, and more than 80 percent of the order imbalance.  Further, Tilly and Concannon’s touting of the Cboe’s efforts to improve liquidity at the auctions (perhaps inadvertently) concedes that the liquidity at the auctions is presently inadequate, which would mean that a huge order imbalance would almost certainly move prices–as occurred on the 18th–and be anticipated to move prices.  “There’s no problem (’the auction process functioned as intended’), but we’re fixing it!” hardly inspires confidence.

Any participant with the heft to enter such a large order would surely be sophisticated enough to know that it would be highly likely to move prices.  Note that non-manipulative traders would typically want to mitigate price impact, not trade in a way that exacerbates it.  So why do this?

Thus, there is evidence to support all of the elements of a manipulation case, but one.  There is evidence for artificial price, causation, and ability to cause.  The missing element is intent.  I’d be open to suggestions as to why this one market participant would enter such a large order but for an intent to distort prices.  Any such explanation would have to show how this was the most economical way of achieving some non-manipulative objective, such as hedging.

Addressing the issue of intent would require knowledge of the large trader’s positions in VIX-related instruments.  Tilly and Concannon are silent on that issue, which makes their confident disavowal of manipulation incomplete and hence unpersuasive.  Discussing the auction alone, disconnected from the VIX derivatives markets tied to the auction, is inadequate to dispel suspicions of manipulation.

Perhaps the exchange execs are right, and this “whale” (as the FT referred to the trader) was not manipulating.  But the information in the public record, including the information in their letter, is not sufficient to demonstrate this claim. The question-begging defense will therefore likely feed suspicions about VIX, rather than lay them to rest, as the letter’s authors intended.

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March 23, 2018

Will Chinese Oil Futures Transform the Oil Market? Highly Unlikely, and Like All Things China, They Will Be Hostage to Government Policy Whims

Filed under: China,Derivatives,Economics,Energy,Exchanges,Regulation,Russia — The Professor @ 11:08 am

After literally years of delays and false starts, the International Energy Exchange (a subsidiary of the Shanghai Futures Exchange) will launch its yuan-denominated, China-delivery crude oil futures contract on Monday.

Will it succeed?  Well, that depends on how you measure success.  No doubt it will generate heavy volume.  Speculative enthusiasm runs deep in China, and retail traders trade a lot.  They would probably make a guano futures contract a success, if it were launched: they will no doubt be attracted to crude.

Whether it will be a viable and successful contract for commercial market participants is far more doubtful.  Its potential to become an international benchmark is even more remote.

For one thing, most successful commodity futures contracts specify delivery in a major production area that is connected to multiple consumption regions, but the INE contract is at a major consumption location.  This will increase basis risk for non-Chinese commercials, even before taking into account the exchange rate issue.  Considering the cash basis (the cash-futures basis is more complicated), basis risk between a delivery location and a location supplied by that delivery point is driven by variability in transformation costs, most notably transportation costs.   The variance in the basis between two consumption locations supplied by a delivery point is equal to the variance in the difference between the transformation costs to the two locations, which is equal to the sum of the variances, minus 2x the covariance.  This is typically bigger than either of the variances.  Thus, non-Chinese hedgers will typically be worse off using the INE contract than the CME’s WTI or DME’s Oman or ICE’s Brent, even before liquidity is considered.

In this respect, the INE’s timing is particularly inauspicious, because the US crude oil export boom, which is seeing large volumes go to Asia and China specifically, has more tightly connected WTI prices with Asian prices.

I deliberately say “transformation costs” (rather than just transport costs) above because there can be disparities between international prices and prices in China due to regulations, currency conversion issues, and taxes.  I don’t know the details regarding the relevant tax and regulatory regime for oil specifically, but I do know that for cotton and other ags the tax and quota regime has and does lead to wide and variable differences between China prices and ICE prices, and that periodic changes in this regime create additional basis volatility.

Related to transformation costs, the INE has implemented one bizarre feature that is likely to undermine contract performance.  Specifically, it is setting a high storage rate on delivery warehouses.  The ostensible purpose of this is to restrain speculation and reduce price volatility:

One of its strategies to deter excessive price swings is to set related crude storage costs in China at levels that are at least twice the rate elsewhere. That’s seen discouraging speculators interested in conducting so-called cash and carry trades, which seek to take advantage of differences between the spot price and futures of a commodity.

This will be highly detrimental to the contract’s performance, and will actually contravene the intended purpose.  Discouraging storage will actually increase volatility.  It will also increase the volatility in the basis between the INE price and the prices of other oil in China.  The fact that discouraging storage will make the contract more vulnerable to corners and squeezes will further increase this basis volatility.  This will undermine the utility of the contract as a hedging mechanism.

Where will hedging interest for the contract come from?  Unlike in say the US, there will not be a large group of producers will big long positions that they need to hedge (in part because their banks insist on it).  Similarly, there is unlikely to be a large population of traders with inventory positions, as most of the Chinese crude is purchased by refiners.  The incentives of refiners to hedge crude costs are limited, because they have a natural hedge: although they are short crude, they are long products.  To the extent that refiners can pass on crude costs through products prices, their incentives to hedge are limited: this is why there is a big net short futures exposure (directly and indirectly) by producers, merchants and processors in WTI and Brent: sellers of crude (producers and merchants) have an incentive to hedge by going short futures because they have no natural internal hedge, and the big refiners’ natural hedge mutes their incentive to take long positions of commensurate size.

Ironically, regulation–price controls specifically–may provide the biggest incentive for refiners to hedge.  To the extent they cannot pass on crude cost increases through higher product prices, they have an incentive to hedge because then they have more of a true short exposure in crude.  Moreover, this hedging incentive is option-like: the incentive is greater the closer the price controls are to being binding.  I remember that refined product price restrictions have been a big deal in China in the past, resulting in periodic standoffs between the government and Sinopec in particular, which sometimes involved fuel shortages and protests by truckers.  I don’t know what the situation is now, but that really doesn’t matter: what matters is policy going forward, and Chinese policies are notoriously changeable, and often arbitrary.  So the interest of Chinese refiners in hedging will vary with government pricing policy whims.

If hedging interest does develop in China, it is likely to be the reverse of what you see in WTI and Brent, with hedgers net long instead of net short.  This would tend to lead to a “Keynesian contango” (the Canton Contango? Keynesian Cantongo?), with futures prices above expected future spot prices, although the vagaries of Chinese speculators make it difficult to make strong predictions.

Will the contract develop into an international benchmark? Left to its own devices, this is highly unlikely.  The factors discussed above that create basis risk undermine its utility as an international benchmark, even within Asia.  But we are talking about China here, and the government seldom leaves things to their own devices.  I would not be surprised if the government explicitly requires or strongly pressures domestic firms to buy crude basis Shanghai futures, rather than Brent or WTI.  This contract obviously involves national prestige, and being launched at a time of intense dispute on trade between the US and China I suspect that the government is highly motivated to ensure that it doesn’t flop.

Requiring domestic firms to buy basis Shanghai could also force foreign sellers to do some of their hedging on INE.

Another issue is one I raised in the past, when China peremptorily terminated trading in stock index futures.  The prospect of being forced out of a position at the government’s whim makes it very risky to hold positions, particularly in long-dated contracts.

All in all, I don’t consider the new contract to be transformative–something that will shake up the world oil market.  It will do better than the laughable Russian Urals oil futures contract (in which volume over six months was one-third of the projected daily volume), but I doubt that it will develop into much more than another venue for speculative churn.  But like all things China, government policy will have an outsized influence on its development. Refined product pricing policy will affect hedging demand.  Attempts to force firms to use it as a pricing mechanism in contracts will affect its use as a benchmark, which will also affect hedging demand.

If you are looking for a metric of success as a commercial tool (rather than of its success as a money making venture for the exchange) look at open interest, not volume.  And look in particular in open interest in the back months.  This will take some time to build, and in the meantime I imagine that there will be a lot of awed commentary about trading volume.  But that’s not the main indicator of the utility of a contract as a commercial risk management and price discovery tool.

Update. I had a moment to catch up on Chinese price regulations.  The really binding regulations, which resulted in shortages and the periodic battles between Sinopec and the government date from around 2007-8, when (a) oil prices were skyrocketing, and (b) I was in China teaching a course to Sinopec and CNPC execs, and so heard first-hand accounts.   These battles continued, but less intensely post-Crisis because the controls weren’t binding when prices collapsed.  Moreover, the government adopted a policy that effectively implemented a peg between crude and refined prices, but only adjusted the peg every 22 days and only if the crude price had moved 4 percent.  Subsequently, in 2013, Beijing revised the policy, and eliminated the 4 percent trigger and shortened the averaging period to 10 days. Then in 2015, after the collapse in oil prices, China suspended this program.  A few months later, it introduced a revised program that makes no adjustments to the price when crude falls below $40 or rises above $130.

Several takeaways.  First, at present the adjustment mechanism reduces the incentives of refiners to hedge crude prices.  Under the earlier adjustment system, the lags and thresholds would have created some bizarre optionality that would have made hedging decisions vary with prices in a highly non-linear way.  The system in effect from 2015 to 2016 would have created little incentive to hedge because the pricing system imposed hardly any constraints on margins that were allowed to vary with crude prices.

Second, the current system with the $40 floor and $130 ceiling actually increases the incentive to hedge (relative to the previous system) by buying futures when prices start to move up towards $130 (if that ever happens again).  That’s actually a perverse outcome (triggering buying in a rising price environment, and selling in a falling price environment–positive feedback loop).

Third, and most importantly, the policy changes often, in response to changing market conditions, which reinforces my point about the new futures contract being subject to government policy whims.  It also creates a motive for a perverse kind of speculation–speculation on policy, which can affect prices, which results in changes in policy.

One thing I should have mentioned in the post is the heterogeneity of refiners in China.  There are the big guys (Sinopec, CNPC, CNOOC), and there are the independents, often referred to as “teapot refineries.”  Teapots might have more of an incentive to hedge, given that they are in more tenuous financial straits–but those very tenuous straits might make it difficult for them to come up with the cash to pay margins.  And even they still have the natural hedge as long as price controls don’t bite.  It’s worth noting, however, that Chinese firms have a penchant for speculating too. I wouldn’t be surprised if some of the teapots turn plunger on INE.

Government policy towards the independents has been notoriously volatile–I know, right? In 2015, China granted the independents the right to import oil directly.  Then in late-2016 it thought that the independents were dizzy with success, and threatened to suspend their import quotas if they violated tax or environmental rules.  As always, there are competing and ever changing motives for Chinese policy.  They’ve lurched from wanting to protect the big three and drive consolidation of industry to wanting to provide competitive discipline for the big three to wanting to rein in the competition especially when the independents sparked a price war with the big firms.  These policy lurches will almost certainly affect the commercial utilization of the new futures market, even by Chinese firms.

Updated update. The thought that cash-and-carry trades are some dangerous speculative strategy puzzled me–it’s obviously not a directional play, so why would it affect price levels. But perhaps I foolishly took the official explanation at face value.  Chinese firms have been notorious for using various storage stratagems as ways of circumventing capital controls and obtaining shadow financing.  Perhaps the real reason for the high storage rate is to deter use of the futures market to play such games.  Or perhaps there is a tax angle.  Back in the day futures spreads were a favored tax strategy in the US (before the laws were changed and the IRS cracked down), and maybe cash-and-carry could facilitate similar games under the Chinese tax code.  Just spitballing here, but the stated rationale is so flimsy I have to think there is something else going on.

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February 22, 2018

VIX VapoRubOut

Filed under: Commodities,Derivatives,Economics,Exchanges — The Profesor 2 @ 12:28 pm

Bloomberg’s Odd Lots podcast from a few days ago discusses “How one of the Most Profitable Trades of the Last Few Years Blew Up in a Single Day.” Specifically, how did short volatility trades perform so well for so long, and then unravel so dramatically in a short period of time?

In fact, these two things are directly related. This trade performed well for a long time precisely because it was effectively selling insurance against an infrequent, severe event–in this case, a volatility spike. In essence, those who shorted volatility (primarily by selling VIX futures either directly or indirectly through exchange traded products like the XIV note) were providing insurance against a volatility spike, collected premiums for a long time, and then ended up paying out large amounts when a spike actually occurred. It is analogous to a company insuring against earthquakes: it’s rolling in the dough collecting premiums until a big earthquake actually happens, at which time the company has to pay out big time.

If you look at a graph of the VIX, you’ll see that the VIX can be well-described as a mean reverting process (i.e., it doesn’t behave like a random walk or a geometric random walk, but tends to return to a base level after it diverges from that level) subject to large upward shocks.  After the spikes, mean reversion kicks in, and the index returns roughly to its previous level.

 

 

So if you are short the VIX, you pay out during those spikes.

And that’s not all.  The VIX is strongly negatively correlated with the overall market.  That is, VIX tends to increase when the market goes down:

 

This means that providing insurance against volatility spikes is costly: the volatility short seller commits to making payouts in bad states of the world.  Thus, risk averse suppliers of volatility insurance will demand a premium to bear the risk inherent in that position.  Put crudely, a short VIX position has a large positive beta, meaning that the expected return (risk premium) on this position will be positive, and large.

The flip side of this is that those with a natural short volatility exposure incur a large cost to bear this risk, and might be willing to hedge (insure) against it.  Indeed, given the fact that such natural short exposures incur losses in bad states of the world, those facing them are willing to pay a premium to hedge them.

In equilibrium, this means that short volatility positions will earn a risk premium.  Since short sellers of volatility futures will have to earn a return to compensate them for the associated risks,  the VIX futures price will exceed the expected future value of VIX at futures expiration.  Thus, VIX futures will be in a Keynesian contango (with the futures above the expected future spot).  Given that VIX itself is a non-traded risk (one cannot buy or sell the actual VIX in the same way one can buy or sell a stock index), this means that the forward curve will also be in contango.*  Further, one would expect that long VIX futures positions lose money on average, and given the spikiness of realized VIX, lose money most of the time with the gains occurring infrequently and being relatively large when they do occur.

And of course, short positions have the exact opposite performance.  Shorts sell VIX futures at a premium over the price at which they expect to cover, and hence make money on average.  Furthermore, losses tend to be relatively infrequent, but when they occur they tend to be large.

And that’s exactly what happened in the period leading up to February 5.  During most of that period, VIX shorts were making money.  When the spike occurred on 2/5/18, however, they were hammered.

But this was not an indication of a badly performing market, or irrational trading.  Given the behavior of volatility and the existence of individuals and firms with a natural short volatility position that some wanted to hedge, this is exactly what you’d expect.  Participants (mainly institutional investors, including university endowments) were willing to take the opposite side of those hedges and receive a risk premium in return. Those short positions would earn positive returns most of the time, but when the returns go negative, they tend to do so in a big way. Again, just like earthquake insurance.

One of the inventors of VIX claims that he doesn’t understand why products such as VIX futures or ETPs that have long or short volatility exposures exist. Really? They exist because they facilitate the transfer of risk from those who bear it at a higher cost to those who bear it at a lower cost.  Absent these markets, the short volatility exposures wouldn’t go away: those with such natural exposures would continue to bear it, and would periodically incur large losses.  Those losses would not be as obvious as when volatility products are traded, but they would actually be more costly.  The pain that volatility short sellers incurred earlier this month might be bad, but it was less than the pain that would have existed if they weren’t there to absorb that risk.

One interesting question is whether technical factors actually exacerbated the size of the volatility spike.  Some sellers of volatility short ETPs (like the XIV exchange traded note that is basically a short position on the front two month VIX futures) hedge that exposure by going short VIX futures.  To the extent that the delta of the ETPs remains constant (i.e., the sensitivity of the value of the product to changes in forward volatility remains constant) that’s not an issue: the hedge positions are static.  However, the XIV in particular had a knock-out feature: payment of the note is accelerated when the value of the position falls to 20 percent of face amount.  The XIV experienced such an acceleration event on the 5th, and to the extent the issuer (UBS) had hedged its volatility exposure this could have caused it to buy a large number of futures, because as soon as the note was paid off, the short VIX position was unnecessary as a hedge, and UBS would have bought futures to close that hedge.  This would have been a discontinuous move in its position, moreover: oh, the joys of hedging barrier options (which is essentially what the acceleration feature created). This buying into a spike could have exacerbated the spike.  Whether UBS actually did this, or whether liquidating its hedge position was big enough to have an appreciable knock-on effect on prices is not known.  But it could have made the volatility event more severe than it would have been otherwise.

Bottom line. These markets exist for a reason–to transfer risk.  Moreover, they behaved exactly as expected, and those who participated got–and paid–in the expected way.  Insurance sellers (those short volatility futures) collected premiums to compensate for the risk incurred.  Most of the time the risk was not realized, because of its “spikey” nature, and those sellers realized positive returns.  When the spike happened, they paid out.  There is never a free lunch.  Yes, the insurance sellers dined out on somebody else most of the time, but when they had to pick up the tab, it was a big one.

*Keynes caused untold confusion by using “normal backwardation” to describe a situation where the futures price is below the expected spot price. In market parlance, backwardation occurs when the futures price is below the actual spot price.  Keynesian backwardation and contango refer to a risk premium, which is not directly observable in the market, whereas actual contango and backwardation are.  It is possible for a market to be in contango, but in a Keynesian backwardation.  Similarly, it is possible for a market to be in backwardation, but a Keynesian contango.  If interest rates exceed dividend yields, stock index futures are an example of the former situation.   No arbitrage forces the market into a contango, but long positions earn a risk premium (a normal backwardation).

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December 4, 2017

Bitcoin Futures: What? Me Worry?

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 9:53 pm

The biggest news in derivatives world is the impending launch of Bitcoin futures, first by CBOE, then shortly thereafter by CME.

Especially given the virtually free entry into cryptocurrencies I find it virtually impossible to justify the stratospheric price, and how the price has rocketed over the past year. This is especially true given that if cryptocurrencies do indeed begin to erode in a serious way the demand for fiat currencies (and therefore cause inflation in fiat currency terms) central banks and governments will (a) find ways to restrict their use, and (b) introduce their own substitutes. The operational and governance aspects of some cryptocurrencies are also nightmarish, as is their real resource cost (at least for proof-of-work cryptocurrencies like Bitcoin). The slow transaction times and relatively high transaction fees of Bitcoin mean that it sucks as a medium of exchange, especially for retail-sized transactions. And its price volatility relative to fiat currencies–which also means that its price volatility denominated in goods and services is also huge–undermines its utility as a store of value: that utility is based on the ability to convert the putative store into a relatively stable bundle of goods.

So I can find all sorts of reasons for a bearish case, and no plausible one for a bullish case even at substantially lower prices.

If I’m right, BTC is ripe for shorting. Traditional means of shorting (borrowing and selling) are extremely costly, if they are possible at all. As has been demonstrated theoretically and empirically in the academic literature, costly shorting can allow an asset’s price to remain excessively high for an extended period. This could be one thing that supports Bitcoin’s current price.

Thus, the creation of futures contracts that will make it easier to short–and make the cost of shorting effectively the same as the cost of buying–should be bearish for Bitcoin. Which is why I said this in Bloomberg today:

“The futures reduce the frictions of going short more than they do of going long, so it’s probably net bearish,” said Craig Pirrong, a business professor at the University of Houston. “Having this instrument that makes it easier to short might keep the bitcoin price a little closer to reality.”

Perhaps as an indication of how untethered from reality Bitcoin has become, the CME’s announcement of Bitcoin futures actually caused the price to spike. LOL.

Yes, shorting will be risky. But buying is risky too. So although I don’t expect hedge funds or others to jump in with both feet, I would anticipate that the balance of smart money will be on the short side, and this will put downward pressure on the price.

Concerns have been expressed about the systemic risk posed by clearing BTC futures. Most notably, Thomas Petterfy sat by the campfire, put a flashlight under his chin, and spun this horror story:

“If the Chicago Mercantile Exchange or any other clearing organization clears a cryptocurrency together with other products, then a large cryptocurrency price move that destabilizes members that clear cryptocurrencies will destabilize the clearing organization itself and its ability to satisfy its fundamental obligation to pay the winners and collect from the losers on the other products in the same clearing pool.”

Petterfy has expressed worries about weaker FCMs in particular:

“The weaker clearing members charge the least. They don’t have much money to lose anyway. For this reason, most bitcoin interest will accumulate on the books of weaker clearing members who will all fail in a large move,”

He has recommended clearing crypto separately from other instruments.

These concerns are overblown. In terms of protecting CCPs and FCMs, a clearinghouse like CME (which operates its own clearinghouse) or the OCC (which will clear CBOE’s contract) can set initial margins commensurate with the risk: the greater volatility, the greater the margin. Given the huge volatility, it is likely that Bitcoin margins will be ~5 times as large as for, say, oil or S&Ps. Bitcoin can be margined in a way that poses the same of loss to the clearinghouses and FCMs as any other product.

Now, I tell campfire horror stories too, and one of my staples over the years is how the real systemic risk in clearing arises from financing large cash flows to make variation margin payments. Here the main issue is scale. At least at the outset, Bitcoin futures open interest is likely to be relatively small compared to more mature instruments, meaning that this source of systemic risk is likely to be small for some time–even big price moves are unlikely to cause big variation margin cash flows. If the market gets big enough, let’s talk.

As for putting Bitcoin in its own clearing ghetto, that is a bad idea especially given the lack of correlation/dependence between Bitcoin prices and the prices of other things that are cleared. Clearing diversified portfolios makes it possible to achieve a given risk of CPP default with a lower level of capital (e.g., default fund contributions, CCP skin-in-the-game).

Right now I’d worry more about big markets, especially those that are likely to exhibit strong dependence in a stress scenario. Consider what would happen to oil, stock, bond, and gold prices if war broke out between Iran and Saudi Arabia–not an implausible situation. They would all move a lot, and exhibit a strong dependency. Oil prices would spike, stock prices would tank, and Treasury prices would probably jump (at least in the short run) due to a flight to safety. That kind of scenario (or other plausible ones) scares me a helluva lot more than a spike or crash in Bitcoin futures does while the market is relatively modest in size.

Where I do believe there is a serious issue with these contracts is the design. CME and CBOE are going with cash settlement. Moreover, the CME contract will be based on prices from several exchanges, but notably exclude the supposedly most liquid one. The cash settlement mechanism is only as good as the liquidity of the underlying markets used to determine the settlement price. Bang-the-settlement type manipulations are a major concern, especially when the underlying markets are illiquid: relatively small volumes of purchases or sales could move the price around substantially. (There is some academic research by John Griffen that provides evidence that the settlement mechanism of the VIX contracts are subject to this kind of manipulation.)  The Bitcoin cash markets are immature, and hardly seem the epitome of robustness. Behemoth futures contracts could be standing on spindly cash market legs.

This also makes me wonder about the CFTC’s line of sight into the Bitcoin exchanges. Will they really be able to monitor these exchanges effectively? Will CME and CBOE be able to?

(I have thought that the CFTC’s willingness to approve the futures contracts could be attributable to its belief that the existence of these contracts would strengthen the CFTC’s ability to assert authority over Bitcoin cash exchanges.)

What will be the outcome of the competition between the two Chicago exchanges? As I’ve written before, liquidity is king. Further, liquidity is maximized if trading takes place on a single platform. This means that trading activity tends to tip to a single exchange (if the exchanges are not required to respect price priority across markets). Competition in these contracts is of the winner-take-all variety. And if I had to bet on a winner, it would be CME, but that’s not guaranteed.

Given the intense interest in Bitcoin, and cryptocurrencies generally, it was inevitable that an exchange or two or three would list futures on it. Yes, the contracts are risky, but risk is actually what makes something attractive for an exchange to trade, and exchanges (and the CCPs that clear for them) have a lot of experience managing default risks. The market is unlikely to be big enough (at least for some time) to pose systemic risk, and it’s likely that trading Bitcoin on established exchanges in a way that makes it easier to short could well tame its wildness to a considerable degree.

All meaning that I’m not at all fussed about the introduction of Bitcoin futures, and as an academic matter, will observe how the market evolves with considerable fascination.

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October 12, 2017

Trump Treasury Channels SWP

SWP doesn’t work for the Trump Treasury Department, and is in fact neuralgic to the idea of working for any government agency. Yet the Treasury’s recent report on financial regulatory reform is very congenial to my thinking, on derivatives related issues anyways. (I haven’t delved into the other portions.)

A few of the greatest hits.

Position limits. The Report expresses skepticism about the existence of “excessive speculation.” Therefore, it recommends limiting the role of position limits to reducing manipulation during the delivery period. Along those lines, it recommends spot month on limits, because that is “where the risk of manipulation is greatest.” It also says that limits should be designed so as to not burden unduly hedgers. I made both of these points in my 2011 comment letter on position limits, and in the paper submitted in conjunction with ISDA’s comment letter in 2014. They are also reflected in the report on the deliberations of the Energy and Environmental Markets Advisory Committee that I penned (to accurately represent the consensus of the Committee) in 2016–much to Lizzie Warren’s chagrin.

The one problematic recommendation is that spot month position limits be based on “holistic” definitions of deliverable supply–e.g., the world gold market. This could have extremely mischievous effects in manipulation litigation: such expansive and economically illogical notions of deliverable supplies in CFTC decisions like Cox & Frey make it difficult to prosecute corners and squeezes.

CFTC-SEC Merger. I have ridiculed this idea for literally decades–starting when I was yet but a babe in arms 😉 It is a hardy perennial in DC, which I have called a solution in search of a problem. (I think I used the same language in regards to position limits–this is apparently a common thing in DC.) The Treasury thinks little of the idea either, and recommends against it.

SEFs. I called the SEF mandate “the worst of Frankendodd” immediately upon the passage of the law in July, 2010. The Treasury Report identifies many of the flaws I did, and recommends a much less restrictive requirement than GiGi imposed in the CFTC SEF rules. I also called out the Made Available For Trade rule the dumbest part of the worst of Frankendodd, and Treasury recommends eliminating these flaws as well. Finally, four years ago I blogged about the insanity of the dueling footnotes, and Treasury recommends “clarifying or eliminating” footnote 88, which threatened to greatly expand the scope of the SEF mandate.

CCPs. Although it does not address the main concern I have about the clearing mandate, Treasury does note that many issues regarding systemic risks relating to CCPs remain unresolved. I’ve been on about this since before DFA was passed, warning that the supposed solution to systemic risk originating in derivatives markets created its own risks.

Uncleared swap margin. I’ve written that uncleared swap margin rules were too rigid and posed risks. I have specifically written about the 10-day margining period rule as being too crude and poorly calibrated to risk: Treasury agrees. Similarly, it argues for easing affiliate margin rules, reducing the rigidity of the timing of margin payments (which will ease liquidity burdens), and overbroad application of the rule to include entities that do not impose systemic risks.

De minimis threshold for swap dealers. I’m on the record for saying using a notional amount to determine the de minimis threshold to determine who must register as a swap dealer made no sense, given the wide variation in riskiness of different swaps of the same notional value. I also am on the record that the $8 billion threshold sweeps in firms that do not pose systemic risks, and that a reduced threshold of $3 billion would be even more ridiculously over inclusive. Treasury largely agrees.

The impact of capital rules on clearing. One concern I’ve raised is that various capital rules, in particular those that include initial margin amounts in determining liquidity ratios for banks, and hence their capital requirements, make no economic sense, and and unnecessarily drive up the costs banks/FCMs incur to clear for clients. This is contrary to the purpose of clearing mandates, and moreover, has contributed to increased concentration among FCMs, which is in itself a systemic risk. Treasury recommends “the deduction of initial margin for centrally cleared derivatives from the SLR denominator.” Hear, hear.

I could go into more detail, but these are the biggies. All of these recommendations are very sensible, and with the one exception noted above, in the Title VII-related section I see no non-sensical recommendations. This is actually a very thoughtful piece of work that if followed, will  undo some of the most gratuitously burdensome parts of Frankendodd, and the Gensler CFTC’s embodiment (or attempts to embody) those parts in rules.

But, of course, on the Lizzie Warren left and in the chin pulling mainstream media, the report is viewed as a call to gut essential regulations. Gutting stupid is actually a good idea, and that’s what this report proposes. Alas, Lizzie et al are incapable of even conceiving that regulations could possibly be stupid.

Hamstrung by inane Russia investigations and a recalcitrant (and largely gutless and incompetent) Republican House and Senate, the Trump administration has accomplished basically zero on the legislative front. It’s only real achievement so far is to start–and just to start–the rationalization and in some cases termination (with extreme prejudice) of Obama-era regulation. If implemented, the recommendations in the Treasury Report (at least insofar as Title VII of DFA is concerned), would represent a real achievement. (As would rollbacks or elimination of the Clean Power Plan, Net Neutrality, and other 2009-2016 inanity.)

But of course this will require painstaking efforts by regulatory agencies, and will have to be accomplished in the face of an unrelentingly hostile media and the lawfare efforts of the regulatory class. But at least the administration has laid out a cogent plan of action, and is getting people in place who are dedicated to put that plan into action (e.g., Chris Giancarlo at CFTC). So let’s get on with it.

 

 

 

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July 1, 2017

All Flaws Great and Small, Frankendodd Edition

On Wednesday I had the privilege to deliver the keynote at the FOW Trading Chicago event. My theme was the fundamental flaws in Frankendodd–you’re shocked, I’m sure.

What I attempted to do was to categorize the errors. I identified four basic types.

Unintended consequences contrary to the objectives of DFA. This could also be called “counter-intended consequences”–not just unintended, but the precise opposite of the stated intent. The biggest example is, well, related to bigness. If you wanted to summarize a primary objective of DFA, it would be “to reduce the too big to fail problem.” Well, the very nature of DFA means that in some ways it exacerbates TBTF. Most notably, the resulting regulatory burdens actually favor scale, because they impose largely fixed costs. I didn’t mention this in my talk, but a related effect is that increasing regulation leads to greater influence activities by the regulated, and for a variety of reasons this tends to favor the big over the medium and small.

Perhaps the most telling example of the perverse effects of DFA is that it has dramatically increased concentration among FCMs. This exacerbates a variety of sources of systemic risk, including concentration risk at CCPs; difficulties in managing defaulted positions and porting the positions of the customers of troubled FCMs; and greater interconnections across CCPs. Concentration also fundamentally undermines the ability of CCPs to mutualize default risk. It can also create wrong-way risks as the big FCMs are in some cases also sources of liquidity support to CCPs.

I could go on.

Creation of new risks due to misdiagnoses of old risks. The most telling example here is the clearing and collateral mandates, which were predicated on the view that too much credit was extended via OTC derivatives transactions. Collateral and netting were expected to reduce this credit risk.

This is a category error. For one thing, it embodies a fallacy of composition: reducing credit in one piece of an interconnected financial system that possesses numerous ways to create credit exposures does not necessarily reduce credit risk in the system as a whole. For another, even to the extent that reducing credit extended via derivatives transactions reduces overall credit exposures in the financial system, it does so by creating another risk–liquidity risk. This risk is in my view more pernicious for many reasons. One reason is that it is inherently wrong-way in nature: the mandates increase demands for liquidity precisely during those periods in which liquidity supply typically contracts. Another is that it increases the tightness of coupling in the financial system. Tight coupling increases the risk of catastrophic failure, and makes the system more vulnerable to a variety of different disruptions (e.g., operational risks such as the temporary failure of a part of the payments system).

As the Clearing Cassandra I warned about this early and often, to little avail–and indeed, often to derision and scorn. Belatedly regulators are coming to an understanding of the importance of this issue. Fed governor Jerome Powell recently emphasized this issue in a speech, and recommended CCPs engage in liquidity stress testing. In a scathing report, the CFTC Inspector General criticized the agency’s cost-benefit analysis of its margin rules for non-cleared swaps, based largely on its failure to consider liquidity effects. (The IG report generously cited my work several times.

But these are at best palliatives. The fundamental problem is inherent in the super-sizing of clearing and margining, and that problem is here to stay.

Imposition of “solutions” to non-existent problems. The best examples of this are the SEF mandate and position limits. The mode of execution of OTC swaps was not a source of systemic risk, and was not problematic even for reasons unrelated to systemic risk. Mandating a change to the freely-chosen modes of transaction execution has imposed compliance costs, and has also resulted in a fragmented swaps market: those who can escape the mandate (e.g., European banks trading € swaps) have done so, leading to bifurcation of the market for € swaps, which (a) reduces competition (another counter-intended consequence), and (b) reduces liquidity (also counter-intended).

The non-existence of a problem that position limits could solve is best illustrated by the pathetically flimsy justification for the rule set out in the CFTC’s proposal: the main example the CFTC mentioned is the Hunt silver episode. As I said during my talk, this is ancient history: when do we get to the Trojan War? If anything, the Hunts are the exception that proves the rule. The CFTC also pointed to Amaranth, but (a) failed to show that Amaranth’s activities caused “unreasonable and unwarranted price fluctuations,” and (b) did not demonstrate that (unlike the Hunt case) that Amaranth’s financial distress posed any threat to the broader market or any systemic risk.

It is sickly amusing that the CFTC touts that based on historical data, the proposed limits would constrain few, if any market participants. In other words, an entire industry must bear the burden of complying with a rule that the CFTC itself says would seldom be binding. Makes total sense, and surely passes a rigorous cost-benefit test! Constraining positions is unlikely to affect materially the likelihood of “unreasonable and unwarranted price fluctuations”. Regardless, positions are not likely to be constrained. Meaning that the probability that the regulation reduces such price fluctuations is close to zero, if not exactly equal to zero. Yet there would be an onerous, and ongoing cost to compliance. Not to mention that when the regulation would in fact bind, it would potentially constrain efficient risk transfer.

The “comma and footnote” problem. Such a long and dense piece of legislation, and the long and detailed regulations that it has spawned, inevitably contain problems that can lead to protracted disputes, and/or unpleasant surprises. The comma I refer to is in the position limit language of the DFA itself: as noted in the court decision that stymied the original CFTC position limit rule, the placement of the comma affects whether the language in the statute requires the CFTC to impose limits, or merely gives it the discretionary authority to do so in the even that it makes an explicit finding that the limits are required to reduce unwarranted and unreasonable price fluctuations. The footnotes I am thinking of were in the SEF rule: footnote 88 dramatically increased the scope of the rule, while footnote 513 circumscribed it.

And new issues of this sort crop up regularly, almost 7 years after the passage of Dodd-Frank. Recently Risk highlighted the fact that in its proposal for capital requirements on swap dealers, the CFTC (inadvertently?) potentially made it far more costly for companies like BP and Shell to become swap dealers. Specifically, whereas the Fed defines a financial company as one in which more than 85 percent of its activities are financial in nature, the CFTC proposes that a company can take advantage of more favorable capital requirements if its financial activities are less than 15 percent of its overall activities. Meaning, for example, a company with 80 percent financial activity would not count as a financial company under Fed rules, but would under the proposed CFTC rule. This basically makes it impossible for predominately commodity companies like BP and Shell to take advantage of preferential capital treatment specifically included for them and their ilk in DFA. To the extent that these firms decide to incur costs (higher capital costs, or the cost of reorganizing their businesses to escape the rule’s bite) and become swap dealers nonetheless, that cost will not generate any benefit. To the extent that they decide that it is not worth the cost, the swaps market will be more concentrated and less competitive (more counter-intended effects).

The position limits proposed regs provide a further example of this devil-in-the-details problem. The idea of a hedging carveout is eminently sensible, but the specifics of the CFTC’s hedging exemptions were unduly restrictive.

I could probably add more categories to the list. Different taxonomies are possible. But I think the foregoing is a useful way of thinking about the fundamental flaws in Frankendodd.

I’ll close with something that could make you feel better–or worse! For all the flaws in Frankendodd, MiFID II and EMIR make it look like a model of legislative and regulatory wisdom. The Europeans have managed to make errors in all of these categories–only more of them, and more egregious ones. For instance, as bad as the the US position limit proposal is, it pales in comparison to the position limit regulations that the Europeans are poised to inflict on their firms and their markets.

 

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April 15, 2017

Is the Order Handling Rule Necessary to Ensure Intense Competition in Securities Markets?

Filed under: Commodities,Derivatives,Economics,Exchanges,Regulation — The Professor @ 2:01 pm

A couple of weeks back Acting SEC Chairman Mike Piwowar announced a new Special Study of the Securities Markets, a reprise of the 1963 Special Study. This is an excellent idea, given that RegNMS (adopted in 2005) has (as was inevitable) spawned many unintended and unexpected consequences. Revision of this regulation in light of experience is almost certainly warranted, and any such revision should be predicated on sound scholarship, lest it be merely a Trojan Horse for vested interests arguing their books.

I wrote about RegNMS in Regulation at the time of its adoption in a piece titled “The Thirty Years War” (an allusion to the fact that the establishment of the National Market System in 1975 had sparked a continuing clash over securities market structure). Overall, I think that piece stands up well, particularly my concluding paragraph:

Therefore, the proposed rules are not the final battle in a Thirty Years War. I fully expect that in 2075, some professor will write an article about the latest clash in an ongoing Hundred Years War over securities market structure regulation.

It is certainly the case that the controversies and conflicts over market structure have continued unabated since 2005, and show no signs of letting up. (Cf. Flash Boys.) Chairman Piwowar’s call for a new Special Study is testament to that.

More specifically, the major prediction of my article has been fully borne out. I predicted that the Order Protection Rule in particular would break the network effect that resulted in the dominance of the NYSE in the securities it listed. Since RegNMS was passed, the highly concentrated listed stock market (where virtually all price discovering transactions in NYSE stocks occurred on the NYSE) has been utterly transformed, with four exchanges now splitting most of the business, with no exchange doing more than a quarter of the volume.

I further predicted that this would result in the disintermediation of traditional intermediaries–like specialists–and the substantial erosion of economic rents. This too has happened. This is best illustrated by the trajectory of Goldman’s investment in specialist firm Spear, Leeds & Kellogg. Goldman paid $5.4 billion for it in 2000 (before RegNMS) and sold it for a pittance–$30 million–in 2014. I didn’t foresee exactly the nature or identity of the new intermediaries–HFT–but I was broadly aware that there would be entry into market making, and that this would reduce trading costs and undermine incumbents with market power. Further, as I’ve written about recently, the new intermediaries don’t appear to be making rents in the new equilibrium.

The years since RegNMS have seen a dramatic decline in trading costs for investors, and it is likely the case that this decline is largely attributable to the increase in competition. Much of the controversy that has raged since 2005 relates to disputes over trading practices that were an inevitable consequence of the breaking of the NYSE near-monopoly–a process pejoratively referred to as “fragmentation.” In particular, multiple markets necessitate arbitrageurs, who effectively enforce the law of one price. The strategies and tactics arbitraguers use often appear unsavory, and strike many as unfair: arbitrageurs get something even though they appear to do nothing substantive. Moreover, arbitrage uses up real resources. That’s costly, and it would be nice if this could be avoided, but that’s unlikely ever to be so. The trade-off between much greater competition (and reduced welfare losses due to the exercise of market power) and the expenditure of real resources to enforce the law of one price seems to be a great bargain.

Much of the criticism of RegNMS relates to the Order Protection Rule, which requires that no order can be executed on market X if a better price is displayed at market Y. The critics (e.g., the Principal Traders Association which ironically represents some of the biggest beneficiaries of RegNMS) argue that this rule (a) has led to a proliferation of order types intended to ensure compliance with the rule, which make the market far more complex, and (b) requires traders to maintain connections with and monitor all trading venues displaying quotes, no matter how small.

These complaints have some merit. The crucial question is whether the equity trading marketplace will be as competitive without the Order Handling Rule as it is with it. This is an open question, and one which should be the focus of the SEC’s inquiry. For if the Order Handling Rule is a necessary condition for robust competition, the costs that the PTA and others identify are likely well worth paying in order to realize the benefits of competition.

My prediction that competition would intensify post-RegNMS was based on my analysis of the effects of the Order Handling Rule, which was in turn based on my work on liquidity network effects done in the late-90s and early-00s. Specifically, in the formal models I derived (e.g., here), the self-reinforcing liquidity effect obtains when investors decide which trading venue to submit an order to on the basis of expected execution cost (i.e., bid-ask spread, price impact). The market with the bigger fraction of trading activity typically offers the lowest execution cost. Therefore, traders submit their orders to the bigger market. This creates a self-reinforcing feedback loop (and a self-fulling prophecy) in which trading activity “tips” to a single exchange. (There are some complexities here, relating to cream skimming of uninformed order flow. See the linked paper for a discussion of that issue.)

Mandating something akin to to the order handling rule forces order flow to the market offering the best price at a particular moment, not the one that offers the best price in expectation. As I phrased it in my Regulation paper, such a rule “socializes order flow”: even if an order is directed to a particular exchange, that exchange does not control that order flow and must direct to any other exchange offering a better price.

I think that both theory and the post-RegNMS experience show that the Order Handling Rule is sufficient to break the liquidity network effect because it socializes order flow. But is it necessary? Maybe not, but it is important to try to find out before jettisoning it.

Here’s a story which suggests that the rule is not necessary in the modern electronic trading environment. One reason why traders may choose to submit orders to where they expect to get the best execution is because of search costs. In a floor-based environment in particular, it is costly to verify which market is offering the best price at any time.  Moreover, since it takes time get quotes from two floor-based markets, by the time that you actually submit your order to the one giving the best quote, the market will have moved and you won’t get the price you thought you were going to get. So economize on search costs and the risks associated with delay by submitting the order to the market that usually offers the best price. Ironically, the inevitable result of this process is that there is only one market left standing.

Search is cheaper and faster–and arguably far cheaper and far faster–in the modern electronic environment. Based on feeds from multiple markets, an electronic trader (and in particular an automated trader) can rapidly compare quotes and send an order to the market offering the best quote, or by viewing depth (something pretty much impossible in the floor days, where much of the liquidity was in the hands of floor brokers) split an order among multiple venues to tap the liquidity in all of them.

In other words, the natural monopoly problem was far more likely in a floor-based environment where pre-trade transparency was so limited that search costs were very high: it was nigh on impossible to know precisely what trading opportunities were or to move fast enough to exploit the one that appeared best at any point in time, so traders submitted their orders to where they expected the opportunities to be the best. In contrast, electronification and automation have created such great pre-trade transparency and the ability to act on it that it is plausibly true that in this environment traders can and will submit their orders to whatever venue is offering the best trading opportunity at a point in time, regardless of whether it usually does so. In this story, technology eliminates the uncertainty and guesswork that created the liquidity network effect.

Maybe. Perhaps even likely. But I can’t be certain. Note that one complaint about the existing market structure is that even though everything has vastly speeded up, some traders are still faster than others. As a result, those who submit a market order in response to seeing a particular displayed price are often dismayed to learn that the market has moved before their order actually reaches the trading venue, and that their order is executed at a worse price than they had anticipated. Freed of the obligations of the Order Handling Rule, these traders may choose to submit their order to where they usually get the best price: if enough do this, the liquidity network effect will reemerge.

Further, the PTA and others have complained that it is costly to monitor and maintain connections with all trading venues as is necessary under the Order Handling Rule. If the Rule is relaxed or eliminated, one would expect that they will disconnect from some venues. If enough do this, the smaller venues will become unviable. After this happens, there will be fewer venues–and some traders may choose to disconnect from the smallest remaining one. This dynamic could result in another feedback loop that results in the survival of a single dominant exchange that exercises market power.

It is therefore not clear to me that elimination of the Order Handling Rule will result in traders having their cake (intense inter-exchange competition) and eating it too (less complexity, lower connection cost). Given the substantial benefits of greater competition that have been realized in the past dozen years, changes to the cornerstone of RegNMS should not be taken lightly. The Special Study, and the SEC, should pay close attention to how competition will evolve if the Order Handling Rule is eliminated. This analysis should take into account the existing technology, but also try to think of how technology will change in the aftermath of an elimination and how this technological change will affect competition.

Most importantly, any analysis must be predicated on an understanding that there are strong centripetal forces in securities trading. Any time traders have an incentive to direct order flow to the venue that is expected to offer the best price, the likely outcome is that only one venue will survive. The incentives of traders in a high speed, largely automated, and electronic market in the absence of an Order Handling Rule need to be considered carefully. It should not be assumed that technology alone will eliminate the incentive to direct orders to the market that is usually best, not the one that is best at any particular instant. This hypothesis should be probed vigorously and skeptically.

Experience in futures markets suggests that liquidity network effects can persist even in high speed, automated, electronic markets: futures contracts in a particular instrument exhibit a strong natural monopoly tendency, and strong tendencies towards tipping. It is arguable that the vertical integration of clearing, and the resulting non-fungibility of otherwise identical contracts traded on different venues, could contribute to this (though I am skeptical about that). But it could also mean that something like the Order Handling Rule (which is not present in futures markets) is necessary to create strong competition between multiple venues even in a highly computerized and automated trading environment.

This is the big issue in any revamping of RegNMS. It should be front and center of any analysis, including in the impending Special Study. The intense competition in the post-RegNMS world is a remarkable achievement, particularly in comparison with the near monopolistic market structure that existed before 2005. It would be a great shame if this were thrown away due to an incomplete analysis of what competition in a modern computerized market would be like in the absence of something like the Order Handing Rule.

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April 14, 2017

SWP Climbs The Hill

Filed under: Derivatives,Economics,Exchanges,Regulation — The Professor @ 10:40 am

I have become a regular contributor to The Hill. My inaugural column on the regulation of spoofing is here. The argument in a nutshell is that: (a) spoofing involves large numbers of cancellations, but so do legitimate market making strategies, so there is a risk that aggressive policing of spoofing will wrongly penalize market makers, thereby raising the costs of supplying liquidity; (b) the price impacts of spoofing are very, very small, and transitory; (c) enforcement authorities sometimes fail to pursue manipulations that have far larger price impacts; therefore (d) a focus on spoofing is a misdirection of scarce enforcement resources.

My contributions will focus on finance and regulatory issues. So those looking for my trenchant political commentary will have to keep coming here 😉

Click early! Click often!

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