An email from a legal academic in response to yesterday’s post spurred a few additional thoughts re spoofing.
One of my theories of spoofing is that is a way to improve one’s position in the queue at the best bid or offer. Why does one stand in a queue? Why does one want to be closer to the front?
Simple: because there is a rent there to capture. Where does the rent come from? When what you are queuing for is underpriced, likely due to some price control. Think of gas lines, or queues for sausage in the USSR.
In market making, the rent exists because the benefit from executing at the bid or offer exceeds the cost. The cost arises from (a) adverse selection costs, and (b) inventory cost/risk and other costs of participation. What is the source of the price control?: the tick size.
Exchanges set a minimum price increment–the “tick.” When the tick size exceeds the costs of making a market, there is a rent. This makes it beneficial to increase the probability of execution of an at-the-market limit order, i.e., if the tick size exceeds the cost of executing a passive order, it pays to game to move up in the queue. Spoofing is one way of gaming.
This has a variety of implications.
One implication is in the cross section: spoofing should be more prevalent, when the non-adverse selection component of the spread (which is measured by temporary price movements in response to trades) is large. Relatedly, this implies that spoofing should be more likely, the more negatively autocorrelated are transaction prices, i.e., the bigger the bid-ask bounce.
Another implication is in the time series. Adverse selection costs can vary over time. Spoofing should be more prevalent during periods when adverse selection costs are low. These should also be periods of unusually large negative autocorrelations in transaction prices.
Another implication is that if you want to reduce spoofing . . . reduce the tick size. Given what I just discussed, tick size reductions should be focused on instruments with a bigger bid/ask bounce/larger non-adverse selection driven spread component.
That is, why police the markets and throw people in jail? Mitigate the problem by reducing the incentive to commit the offense.
This story also has implications for the political economy of spoofing prosecution (which was the main thrust of the email I received). HFT/algo traders who desire to capture the rent created by a tick>adverse selection cost should complain the loudest about spoofing–and are most likely to drop the dime on spoofers. Casual empiricism supports at least the first of these predictions.
That is, as my correspondent suggested to me, not only are spoofing prosecutions driven by ambitious prosecutors looking for easy and unsympathetic targets, they generate political support from potentially politically influential firms.
One way to test this theory would be to cut tick sizes–and see who squeals the loudest. Three guesses as to whom this might be, and the first two don’t count.
Market participants that traded futures contracts in these three markets while the spoof orders distorted market prices incurred market losses of over $60 million.
$60 million in market losses–big number! For spoofing! How did they come up with that?
The answer is embarrassing, and actually rather disgusting.
So the defendants traded futures contracts with a notional value of approximately $60+ million. For the DOJ to say that anyone “incurred market losses of over $60 million” based on this calculation is complete and utter bollocks. Indeed, if someone touted that their trading system earned market profits of $60 million based on such a calculation in order to get business from the gullible, I daresay the DOJ and SEC would prosecute them for fraud.
This exaggeration is of a piece with the Sarao indictment, which claimed that his spoofing caused the Flash Crash.
And of course the financial press credulously regurgitated the number the DOJ put out.
I know why DOJ does this–it makes the crime look big and important, and likely matters in sentencing. But quite frankly, it is a lie to claim that this number accurately represents in any way, shape, or form the economic harm caused by spoofing.
This gets to the entire issue of who is damaged by spoofing, and how. Does spoofing induce someone to cross the spread and incur the bid/ask, who would otherwise not have entered an aggressive order? Does it cause someone to cancel a limit order, and therefore lose the opportunity to trade against an aggressive order and thereby earn the spread (the realized spread, not the quoted spread, in order to account for losses to better-informed traders)?
Those are realistic theories of harm, and they imply that the economic harm per contract is on the order of a tick in a liquid market like the ES. That is, per contract executed as a result of the spoof, the damage is .25 (the tick size) times $50 (the value of an S&P point). That is, a whopping $12.50. So, pace the DOJ, the ~800 “fraudulent orders placed caused economic harm of about 10,000 bucks, not 60 mil. Maybe $20,000, under the theory that in a particular spoof, someone lost from crossing the spread, and someone else lost out on the opportunity to earn the spread. (Though interestingly, from a social perspective, that is a transfer not a true loss.)
But $10,000 or $20,000 looks rather pathetic, compared to say $60 million, doesn’t it? What’s three orders of magnitude between friends, eh?
Yes, maybe the DOJ just included a few episodes in the indictment, because that is sufficient for a criminal prosecution and conviction. But even a lot more of such episodes does not add up to a lot of money.
This is precisely why I find the expenditure of substantial resources to prosecute spoofing to be so dubious. There is other financial market wrongdoing that is far more harmful, which often escapes prosecution. Furthermore, efficient punishment should be sized to the harm. People pay huge fines, and go to jail–for years–for spoofing. That punishment is hugely disproportionate to the loss, under the theory of harm that I advance here. So spoofing is over-deterred.
Perhaps there are other theories of harm that justify the severe punishments for spoofing. If so, I’d like to hear them–I haven’t yet.
These spoofing prosecutions appear to be a case of the drunk looking for his wallet (or a scalp) under the lamppost, because the light is better there. In the electronic trading era, spoofing is possible–and relatively cheap to detect ex post. So just trawl through the trading data for evidence of spoofing, and voila!–a criminal prosecution is likely to appear. A lot easier than prosecuting market power manipulations that can cause nine and ten figure market losses. (For an example of the DOJ’s haplessness in a prosecution of that kind of case, see US v. Radley.)
Spoofing is the kind of activity that is well within the competence of exchanges to detect and punish using their ordinary disciplinary procedures. There’s no need to make a federal case out of it–literally.
The time should fit the crime. The Department of Justice wildly exaggerates the crime of spoofing in order to rationalize the time. This is inefficient, and well, just plain unjust.
In a world that corresponds to economists’ assumptions of perfect competition and rational actors, we would not need net neutrality rules. But until that happy day arrives and goodwill, peace, and free chocolate ice-cream descend upon the earth, then we should defend this necessary principle.
And a bit later:
It is better to enforce equal access with some exemptions, as in India, than to allow a handful of ISPs to discriminate between users in far-from-perfect markets. [Emphasis added.]
There’s a name for this particular foolishness–“the Nirvana fallacy”–coined by the great Harold Demsetz almost 50 years ago:
The view that now pervades much public policy economics implicitly presents the relevant choice as between an ideal norm and an existing “imperfect” institutional arrangement. This nirvana approach differs considerably from a comparative institution approach in which the relevant choice is between alternative real institutional arrangements.
Perhaps there was an excuse for falling for the fallacy in 1969. But decades post-Demsetz, it is embarrassing to see someone proudly flaunting the fallacy on the pink pages of the FT.
Perfection is not an option in this fallen world. One has to make choices between flawed alternatives–that’s what Harold meant by “a comparative institution approach.” What is particular bizarre is that in the paragraph just preceding what I quoted, Thornhill seems to understand this:
In truth, the arguments over net neutrality involve complex trade-offs and are a matter of broader societal choice. But that public debate is often based on partial information, corrupted by corporate lobbying, and mangled by dysfunctional political systems.
But never mind that! This particular regulation–which is certainly based on “based on partial information, corrupted by corporate lobbying [e.g., by those paragons of virtue Facebook, Google, Twitter, Netflix] and mangled by dysfunctional political systems”–is preferred to alternatives, because the alternatives are imperfect. To call this a non sequitur hardly does it justice.
It is also amusing to see India–which has a dismal history of regulatory failure–held up as some paragon. Absent some assertion that this is the exception that proves the rule, India’s adoption of net neutrality should be taken as more of a warning than an exemplar.
This is all twaddle. And supercilious twaddle at that.
As most of you probably know by now, Elon Musk settled with the SEC. Though, perhaps it would be more accurate to say that the SEC settled with Elon Musk. The settlement over last weekend was apparently on the very same terms that he rejected at the end of the week. Uhm, who leaves a rejected offer on the table, especially when that offer was a gift because the case against Musk was extremely strong.
Apparently it is because Elon is deemed the Indispensable Man. SEC Chair Jay Clayton said that the settlement was best for Tesla shareholders. Musk supposedly threatened to quit as CEO unless the board backed him to the hilt. So apparently both caved to the legend of Elon.
The board’s action is somewhat expected–after all, they are Elon’s co-dependents and enablers. The SEC’s actions are rather more disappointing. My best explanation is that the SEC filed suit against Musk only because if they hadn’t they would have been a laughingstock given the outrageousness of Musk’s actions. Their heart wasn’t in it, however, and they were willing to capitulate rather than bear responsibility for Tesla’s fate. The fundamentals haven’t changed, and Tesla’s future is still fraught.
And Elon hasn’t changed either. Even a mild settlement spurred his narcissistic rage, which he expressed in a tweet scorning the SEC as the “Shortseller Enrichment Commission.” Still obsessed with shorts, still unable to handle any criticism, still unable to count his blessings.
This is the man whom the SEC apparently deems indispensable, and believes is the best guardian of Tesla shareholders’ interests.
Perhaps the judge who must approve the settlement will find the SEC’s arguments unpersuasive. She has asked for each side to file briefs defending the settlement. This briefing is pro forma, but in past years–in dealing with big banks and brokers like BofA and Merrill, anyways–judges have rejected SEC settlements. Perhaps that will happen here. Tesla stock sank today on the news of the judge’s request, and sank more post-close after Elon’s tweeter tantrum.
Even if the judge blesses the settlement, Tesla still faces its chronic cash flow issues. The settlement may make it somewhat easier to go to the capital market–although that would potentially–and should–trigger another investigation and perhaps suit given Elon’s adamant denials of the need to do so. But even with a settlement, recent events have no doubt made it harder–and costlier–for the firm to sell more stocks and bonds. Elon got off easy once. Given that he clearly hasn’t changed–and what 47 year olds do, really?–there is a serious risk that (a) he won’t get off so easy next time, and (b) there will be a next time. That will affect the receptiveness of the capital markets to Tesla’s voracious cash needs.
In sum, by the grace of the SEC, Nemesis has been stayed for now. But Hubris remains. Meaning that Nemesis may well return, more vengeful than before.
Soon after the news of the SEC securities fraud lawsuit against Elon Musk, Tim Newman tweeted “Finally says @streetwiseprof.” Indeed I did.
I am mildly surprised, but presumably Musk’s actions were so outrageous that the SEC couldn’t avoid taking action.
Although it shouldn’t be an issue, because Musk had to have known that his going private tweets were false, the law forecloses any “it was secured in my own mind” defense: recklessness–that he should have known the tweets were materially false–satisfies the scienter requirement. At least that’s the case for the civil action: I’m not sure about any criminal action by the DOJ.
Several people emailed me soon after the announcement, and my response was (in addition to “It’s about time”): Is this just the first step? Will the SEC (and perhaps DOJ) expand its investigation, and eventually legal action, to include Musk’s myriad previous dodgy statements? SolarCity came to mind. This SeekingAlpha post has a nice summary of some(!) of the others:
There’s been plenty of talk regarding SEC action since the day Elon Musk issued the go private tweet. With the news out Thursday, many would argue that a substantial overhang has been lifted from the stock, but of course, it brings up a lot of other issues that I’ve detailed above. Unfortunately, investors should consider the possibility that more shoes will drop.
There already have been many lawsuits filed from investors who have lost money during this whole fiasco. Additionally, there may be even more action from a number of government bodies. Who knows if the SEC is looking at other items like the Model 3 production ramp or the mysterious solar roof product? Perhaps they might even take a look at this blog post where Elon Musk talked about discussions for going private going back two years. He’s bought tens of millions in Tesla shares since, so would that be trading on material non-public information (insider trading)? Perhaps an investigation is started related to end of quarter sales tactics, where it seems Tesla is holding back deliveries of vehicles despite consumers paying for them. Some say this would be an effort to add much needed cash to the balance sheet or book unearned revenues for quarter’s end.
Not to mention missed production deadlines, the supercharger rollout, and on and on and on. And what could a deep dive into Tesla’s accounting reveal?
Elon’s co-dependents, AKA the Tesla Board of Directors, came out in his support.
Good luck with that! Though truth be told, they are so deeply connected to Elon that it would be pointless to try to cut loose from him now: their best bet is to go to the mattresses with him. Not a good bet, but their best one.
A friend has repeatedly asked me why haven’t there been class action lawsuits. My reply: not until there is a big break in the stock price. That is occurring now. So I wouldn’t stand in front of federal courthouses in the SDNY or NDCal for fear of being trampled by class action attorneys rushing to file.
The knock-on effects of this are many. As I’ve written repeatedly, despite Elon’s denials (another possible legal vulnerability!) Tesla needs cash. I don’t see a public equity or debt raise being remotely possible now, which would cripple the company’s ability to grow–and fulfill Elon’s grandiose promises. Moreover, Elon has borrowed extensively against Tesla stock. Margin call, anyone? And if that happens, what will he do and how will that impact the stock?
It was only a matter of time before Elon’s words–and his tweets–came back to haunt him. The only surprise is that it took such a long time. But his aura as a visionary protected him.
There is an element of Greek tragedy here. Hubris brings nemesis. To say that Elon exhibited hubris is the understatement of the century. If nemesis is even remotely proportional to hubris, he is in for hellish torments.
This Bloomberg piece from last month claims that the International Maritime Organization’s looming 2020 caps on sulfur emissions from ships “could lift crude prices by $4 a barrel when the measures come into effect in 2020.”
The IMO regulation will have different impacts on different crudes. It will no doubt cause the spread between sweet and sour crudes to widen. This happened in 2008, when European regulation mandating low sulfur diesel kicked in: this regulation contributed to the spike in benchmark Brent and WTI prices, and wide spreads in crude prices. During this time, (if memory serves) 10 VLCCs full of Iranian crude were swinging at anchor while WTI and Brent prices were screaming higher and sweet crude inventories were plunging precisely due to the fact that the regulation increased the demand for sweet crude and depressed demand for heavier, more sour varieties.
The IMO regulation will definitely reduce the demand for crude oil overall. The demand for crude is derived from the demand for fuels, notably transportation fuels. The regulation increases the cost of some transportation fuels, which decreases the (derived) demand for crude. This change will not be distributed evenly, with demand for light, sweet crudes actually increasing, but demand for sour crudes falling, with the fall being bigger, the more sour the crude.
The regulation will hit ship operators hard, and they will pass on the higher cost to shippers. In the short run, carriers will eat some of the cost–perhaps the bulk of it. But the long run supply elasticity of shipping is large (arguably close to perfectly elastic), meaning after fleet size adjusts shippers will bear the brunt.
The burden will fall heaviest on commodities, for which shipping cost is large relative to value. Therefore, farmers and miners will receive lower prices, and consumers will pay higher prices for commodity-intensive goods. Further, this regulatory tax will be highly regressive, falling on relatively low income individuals, who pay a higher share of their income on such goods.
This seems to be a case of almost all pain, little gain. The ostensible purpose of the regulation is to reduce pollution from sulfur emissions. Yes, ships will produce less such emissions, but due to the joint product nature of refined petroleum, overall sulfur emissions will fall far less.
Many ships currently use “bottom of the barrel” fuel oil that tend to be higher in sulfur. Many will achieve compliance by shifting to middle distillates. But the bottom of the barrel won’t go away. Over the medium to longer term, refineries will make investments that allow them to squeeze more middle distillates out of a barrel of crude, or to remove some sulfur, but inevitably refineries will produce some low-quality, high sulfur products: the sulfur has to go somewhere. This is inherent in the joint nature of fuel production.
And yes, there will be some adjustments on the crude supply side, with the differential between sweet and sour crude favoring production of the former over the latter. But sour crudes will be produced, and new discoveries of sour crude will be developed.
Meaning that although consumption of high sulfur fuels by ships will go down, since (a) in equilibrium consumption equals production, and (b) due to the joint nature of production the output of high sulfur fuels will go down less than its consumption by ships does, someone will consume most of the fuel oil that ships no longer used. And since someone is consuming it, they will emit the sulfur.
The ultimate result will be a regulation that basically shifts who produces the sulfur emissions, with a far smaller impact on the total amount of emissions.
This represents a tragic–and classic–example of a regulation imposed on a segment of a larger market. The pernicious effects of such a narrow regulation are particularly acute in oil, due to the joint nature of production.
Given the efficiency and distributive effects of the IMO, it is almost certainly not a second best policy. Indeed, it is more likely to be a second worst policy. Or maybe a first worst policy: doing nothing at all is arguably better.
Some other power traders–this time in the US–blowed up real good. Actually preceding the Aas Nasdaq default by some months, but just getting attention in the mainstream press today, a Houston-based power trading company–GreenHat–defaulted on long-term financial transmission rights contracts in PJM. FTRs are financial contracts that have cash-flows derived from the spread between prices at different locations in PJM. Locational spreads in power markets arise due to transmission congestion, so FTRs can be used to hedge the risk of congestion–or to speculate on it. FTRs are auctioned regularly. In 2015 GreenHat bought at auction FTRs for 2018. These positions were profitable in 2015 and 2016, but improvements in PJM transmission caused them to go underwater substantially in 2018. In June, GreenHat defaulted, and now PJM is dealing with the mess.
PJM members are on the hook for the defaulted positions. The positions were underwater to the tune of $110 million as of June–and presumably this was based on market prices, meaning that the cost of liquidating these positions would be multiples of that. In other words, this blow up could put Aas to shame.
PJM operates the market on a credit system, and market participants can be required to post additional collateral. However, long-term FTR credit is determined only on an annual basis: “In conjunction with the annual update of historical activity that is used in FTR credit requirement calculations, PJM will recalculate the credit requirement for long-term FTRs annually, and will adjust the Participant’s credit requirement accordingly. This may result in collateral calls if requirements increase.” Credit on shorter-dated positions are calculated more frequently: what triggered the GreenHat default was a failure to make its payment on its June FTR obligation.
This event is resulting in calls for a re-examination of PJM’s FTR credit scheme. As well it should! However, as the Aas episode demonstrates, it is a fraught exercise to determine the exposure in electricity spread transactions. This is especially true for long-dated positions like the ones GreenHat bought.
The PJM episode reinforces the Aas episode’s lessons the challenges of handling defaults–especially of big positions in illiquid instruments. Any auction is very likely to turn into a fire sale that exacerbates the losses that caused the default in the first place. Moral of the story: mutualizing default risk (either through a CCP, or a membership organization like PJM) can impose big losses on the participants in risk pool.
The dilemma is that the instruments in question can provide valuable benefits, and that speculators can be necessary to achieve these benefits. FTRs are important because they allow hedging of congestion risk, which can be substantial for both generation and load: locational spreads can be very volatile due to a variety of factors, including the lack of storability of power, non-convexities in generation (which can make it very costly to reduce generation behind a constraint), and generation capacity constraints and inelastic demand (which make it very costly to increase generation or reduce consumption on the other side of the constraint). So FTRs play a valuable hedging role, and in most markets financial players are needed to absorb the risk. But that creates the potential for default, and the very factors that make FTRs valuable hedging tools can make defaults very costly.
FTR liquidity is also challenged by the fact that unlike hedging say oil price risk or corn price risk, where a standard contract like Brent or CBT corn can provide a pretty good hedge for everyone, every pair of locations is a unique product that is not hedged effectively by an FTR based on another pair of locations. The market is therefore inherently fragmented, which is inimical to liquidity. This lack of liquidity is especially devastating during defaults.
So PJM (and other RTOs) faces a dilemma. As the Nasdaq event shows, even daily marking to market and variation margining can’t prevent defaults. Furthermore, moving to a no-credit system (like a CCP) isn’t foolproof, and is likely to be so expensive that it could seriously impair the FTR market.
We’ve seen two default examples in electricity this past summer. They won’t be the last, due the inherent nature of electricity.
Mr. Jackson has a just-so story that, well, just ain’t so. In his story, once upon a time US stock markets were faithful guardians of the public interest. Then, the SEC let them become for-profit firms, and it all went wrong:
Given power and a profit motive, even the most storied institutions will do what they must to maximize their wealth. And nowhere has this been more true than in our stock markets.
For over a century, exchanges were collectively owned not-for-profits, overseeing and organizing trading in America’s best-known companies. But about a decade ago, exchanges became private corporations, designed—perhaps even obligated—to maximize profits. Yet we at the SEC have far too often continued to treat the exchanges with the same kid gloves we applied to their not-for-profit ancestors. The result is that, even while one our fundamental mandates is to encourage competition, the SEC has stood on the sidelines while enormous market power has become concentrated in just a few players. That’s a key reason why among our 13 public stock exchanges, 12 are owned by just three corporations. And that’s how the stock exchanges that are a symbol of American capitalism have developed puzzling practices that look nothing like the competitive marketplaces investors deserve.
. . .
First, one might wonder how our stock markets got here. The answer is that stock exchanges have been better at extracting rents than regulators have been at stopping them. As you all know, in 1934, the Nation struck a bargain with our stock exchanges: the Commission was created to oversee the markets, and in turn the exchanges were given wide latitude in organizing their affairs. For generations, this system served investors well. But then the world changed, and the SEC allowed exchanges to become for-profit corporations with both regulatory and profit-seeking mandates.
At the time, the Commission didn’t sufficiently contemplate the effects that decision might have; we simply said that we saw no reason to think that exchanges couldn’t play the role of regulator and pursue profit at the same time. Maybe we were wrong. Whatever one thinks about the benefits or drawbacks of those events, we should all agree that for-profit companies can be counted on to do one thing: pursue profit. And in for-profit hands, SEC oversight designed for not-for-profit exchanges can be dangerous.
Where to begin?
Well, I guess I should begin by saying for probably the billionth time (here’s one of them) that stock markets were not non-profits out of some charitable motive, or to ensure that they acted in the public interest by self-regulating markets free of conflict of interest and mercenary motive. In fact, stock exchanges (and derivatives exchanges) adopted the not-for-profit form to protect the rents of their members. Furthermore, the exchanges self-regulated in ways that maximized the profits of their members: it is beyond a joke to say that exchanges are better at extracting rents today than during the halcyon non-profit years. Non-profit exchanges just extracted rents in different ways, and the rents did not flow through the exchange coffers. These different ways included naked collusion–which the SEC tolerated for years, kid gloves indeed!–as well as entry restrictions (the number of members remaining fixed since the 19th century) and various rules advantaging intermediaries (especially specialists, but also brokers).
As for conflicts of interest–they were rife in Commissioner Jackson’s good old days. The exchanges, as agents for their intermediary member-owners, had structural conflicts with the investing public.
Mr. Jackson argues that “modern exchanges tax ordinary investors.” The implicit claim is that old time exchanges didn’t. Ha! They just did it in different ways, and arguably levied far greater taxes then than now.
Why were the taxes arguably greater then? The answer relates to another fundamental error in Jackson’s just so story: “enormous market power has become concentrated in just a few players. That’s a key reason why among our 13 public stock exchanges, 12 are owned by just three corporations.” Er, prior to RegNMS, a little over a decade ago, and for the entire life of the SEC prior to that time, and prior to the formation of the SEC, the NYSE had a far more dominant position than any exchange does today. Due to network effects, it basically had a lock on order flow for its listings. Its market share was routinely above 85 percent, and that other 15 percent was basically cream skimming competition that the SEC only grudgingly accepted.
Again, the NYSE did not capture rents from this market power by charging higher prices and passing the revenues through to owners in the form of dividends. But through broker cartels, and after the SEC finally bestirred itself to end the broker cartels, through entry limits and rules that advantaged members, it permitted its members to earn rents by charging higher prices for their services.
Indeed, the great benefit of RegNMS is that it undermined the liquidity network effect that largely immunized the NYSE against competition, and unleashed competition for order flow unprecedented in the history of US stock markets–or stock markets anywhere, for that matter. Three (granting arguendo that 3 rather than 13 is the right number) is a helluva lot more competitive than one.
But Commissioner Jackson cannot see the glass is at least 90 percent full: he frets over the 10 percent (or less) that is empty. He laments “fragmentation.”
Yes. As I have written, the “fragmentation” (aka “competition”) that has occurred post-RegNMS has its costs–some of which are the result of problematic features in RegNMS. Others are inherent in any multi-market system. Fragmentation creates arbitrage opportunities that some participants capture through spending real resources: this is probably socially wasteful. Commissioner Jackson notes that these opportunities exist in part due to the lack of incentive of exchanges to invest in the public data feed: well, I’ve noted this public goods problem in the past (note the date–almost 5 years ago). Yes, some have information advantages due now mainly to speed: well, back in the day, people on the floor had information advantages–and speed advantages–due to their proximity to where price discovery was taking place. Take it as a law: there will always be a class of traders with information, access and speed advantages over the hoi polloi.
Some of these problems could be remedied by better regulation. But despite the deficiencies of RegNMS, there is no doubt that it made US equity markets far more competitive, and that this has redounded to the benefit of ordinary investors–and pretty much the entire buy side, including institutions. RegNMS dramatically reduced the “tax” that stock markets levied on investors, not increased it as Mr. Jackson apparently believes.
Commissioner Jackson questions whether the limited exposure to lawsuits that exchanges currently enjoy is justified. That is a legitimate question, but Mr. Jackson’s motivation for asking it is completely off-base. His fixation on for-profit again shines through: “Finally, we should take a hard look at whether it makes sense to allow for-profit exchanges to write the rules of the game for their customers and competitors while also enjoying immunity from civil liability.” Mr. Jackson: it is equally questionable whether it makes sense “to allow non-profit exchanges to write the rules of the game for their customers and competitors while also enjoying immunity from civil liability.”
Commissioner Jackson also questions pricing practices: “Finally, SEC and FINRA rules for best execution have clearly left open opportunities for conflicts of interest that hurt investors. The reason is that exchanges offer controversial payments—they call them rebates—to brokers based on the volume of customer orders that broker sends to that exchange.” This is a form of price competition. Yes, there are agency issues involved here, but if anything these rebates reduce the rents that exchanges earn that exercise Commissioner Jackson so greatly. Perhaps brokers don’t pass 100 percent of the rebates to their customers–but this is a distributive issue not an efficiency one, and competition between brokers mitigates this problem.
Perhaps in the category of “rebates” Commissioner Jackson is including maker-taker payments. But the interpretation of these payments–and the more prosaic order flow incentives Mr. Jackson describes–is greatly complicated by the fact that exchanges are multi-sided platforms. It is well-known that the pricing policies of multi-sided platformsoften involve cross-subsidies among customer groups (e.g., liquidity suppliers and liquidity demanders), and that these pricing strategies can be economically efficient.
US securities market structure could certainly be improved. But reasonable improvements must be grounded in a reasonable understanding of the economics of exchanges. Alas, one individual responsible for improving market structure is clearly operating from a seriously defective understanding. Commissioner Jackson’s bugbear–for-profit exchanges–have to a first approximation nothing to do with whatever ails US markets. He pines for an era that not only never existed, but which was in reality worse on almost every dimension that he criticizes modern markets for–competition, rent seeking, and conflicts of interest.
The SEC actually performed a public service–something not to be taken for granted for a public agency!–by breaking the liquidity network effect and opening stock markets to competition through the adoption of RegNMS. Tweak RegNMS to improve market performance, Commissioner Jackson, rather than advocating proposals based on just so stories that just ain’t–and weren’t–so.
The most important point: Nasdaq uses SPAN to calculate IM. SPAN was a major innovation back in the day, but it is VERY long in the tooth now (2018 is its 30th birthday!). Moreover, the most problematic part of SPAN is the ad hoc way it handles dependence risk:
Intra-commodity spreading parameters – rates and rules for evaluating risk among portfolios of closely related products, for example products with particular patterns of calendar spreads
Inter-commodity spreading parameters – rates and rules for evaluating risk offsets between related product
The CME SPAN methodology divides the instruments in each portfolio into groupings called combined commodities. Each combined commodity represents all instruments on the same ultimate underlying – for example, all futures and all options ultimately related to the S&P 500 index.
For each combined commodity in the portfolio, the CME SPAN methodology evaluates the risk factors described above, and then takes the sum of the scan risk, the intra-commodity spread charge, and the delivery risk, before subtracting the inter-commodity spread credit. The CME SPAN methodology next compares the resulting value with the short option minimum; whichever value is larger is called the CME SPAN methodology risk requirement. The resulting values across the portfolio are then converted to a common currency and summed to yield the total risk for the portfolio.
I would not be surprised if the handling of Nordic-German spread risk was woefully inadequate to capture the true risk exposure. Electricity spreads are strange beasts, and “rules for evaluating risk offsets” are unlikely to capture this strangeness correctly especially given the fact that electricity markets have idiosyncrasies that one-size-fits all rules are unlikely to capture. I also conjecture that Aas knew this, and loaded the boat with this spread trade because he knew that the risk was grossly underpriced.
There are reports that the Nasdaq margin breach at the time of default (based on mark-to-market prices) was not nearly as large as the €140 million hit to the default fund. In these accounts, the bulk of the hit was due to the fact that the price at which Aas’ portfolio was auctioned off included a substantial haircut to prevailing market prices.
Back in the day, I argued that one of the real advantages to central clearing was a more orderly handling of defaulted portfolios than the devil-take-the-hindmost process in OTC bilateral markets (cf., the outcome of the LTCM disaster almost exactly 20 years ago–with the Fed midwifed deal being completed on 23 September, 1998). (Ironically spread trades were the cause of LTCM’s demise too.)
But the devil is in the details of the auction, and in market conditions at the time of the default–which are almost certainly unsettled, hence the default. The CME was criticized for its auction of the defaulted Lehman positions: the bankruptcy trustee argued that the price CME obtained was too low, thereby harming the creditors. The sell-off of the Amaranth NG positions in September, 2006 (what is it about September?!?) to JP Morgan and Citadel (if memory serves) was also at a huge discount.
Nasdaq has been criticized for allowing only 4 firms to bid: narrow participation was also the criticism leveled at CME and NYMEX clearing in the Lehman and Amaranth episodes, respectively. Nasdaq argues that telling the world could have sparked panic.
But this episode, like Lehman and Amaranth before it, demonstrate the challenges to auctioning big positions. Only a small number of market participants are likely to have the capital, or the risk appetite, to take on a big defaulted position in its entirety. Thus, limited participation is almost inevitable, and even if Nasdaq had invited more bidders, there is room to doubt whether the fifth or sixth or seventh bidder would have been able to compete seriously with the four who actually participated. Those who have the capital and risk appetite to bid seriously for big positions will almost certainly demand a big discount to compensate for the risk of holding the position until they can work it off. Moreover, limited participation limits competition, which should exacerbate the underpricing problem.
Thus, even with a structured auction process, disposing of a big defaulted portfolio is almost inevitably something of a fire sale. This is a risk borne by the participants in the default fund. Although the exposure via the default fund is sometimes argued to be an incentive for the default fund participants to bid aggressively, this is unlikely because there are externalities: the aggressive bidder bears all the risks and costs, and provides benefits to the rest of the other members. Free riding is a big problem.
In theory, equitizing the risk might improve outcomes. By selling shares in the defaulted portfolio, no single or two bidders would have to absorb the entire position and risk could be spread more efficiently: this could reduce the risk discount in the price. But who would manage the portfolio? What are the mechanics of contributing to IM and VM? Would it be like a bad bank, existing as a zombie until the positions rolled off?
Another follow-up from my previous post relates to the issue of self-clearing. On Twitter and elsewhere, some have suggested that clearing through a 3d party would have been an additional check. Surely an FCM would be less likely to fall in love with a position than the trader who puts it on, but the effectiveness of the FCM as a check depends on its evaluation of risk, and it may be no smarter than the CCP that sets margins. Furthermore, there are examples of FCMs having the same trade in their house account as one of their big customers–perhaps because they think the client is really smart and they want to free ride off his genius. As a historical example, Griffin Trading had a big trade in the same instrument and direction as its biggest client. The trade went pear-shaped, the client defaulted, and Griffin did too.
I also need to look to see whether Nasdaq Commodities uses the US futures clearing model, which does not segregate positions. If it does, and if Aas had cleared through an FCM, it is possible that the FCM’s clients could have lost money as a result of his default. This model has fellow-customer risk: by clearing for himself, Aas did not create such a risk.
I also note that the desire to expand clearing post-Crisis has made it difficult and more costly for firms to find FCMs. This problem has been exacerbated by the Supplementary Leverage Ratio. Perhaps the cost of clearing through an FCM appeared excessive to Aas, relative to the alternative of self-clearing. Thus, if regulators blanch at the thought of self-clearing (not saying that they should), they should get serious about addressing the FCM cost issue, and regulations that inflate these costs but generate little offsetting benefit.
Again, this episode should spark (no pun intended!) a more thorough reconsideration of clearing generally. The inherent limitations of margin models, especially for more complex products or markets. The adverse selection problems that crude risk models can create. The challenges of auctioning defaulted portfolios, and the likelihood that the auctions will become fire sales. The FCM capacity issue.
The supersizing of clearing in the post-Crisis world has also supersized all of these concerns. The Aas blowup demonstrates all of them. Will CCPs and regulators take heed? Or will some future September bring us the mother of all blowups?
This was bound to happen. In a way, it was good that it happened in a relatively small market. But it provides a sobering demonstration of what I’ve said for years: clearing doesn’t eliminate losses, but affects the distribution of losses. Further, financial institutions that back CCPs–the members–are the ultimate backstops. Thus, clearing does not eliminate contagion or interconnections in the financial network: it just changes the topology of the network, and the channels by which losses can hit the balance sheets of big players.
Happening in the Nordic/European power markets, this is an interesting curiosity. If it happens in the interest rate or equity markets, it could be a disaster.
We actually know very little about what happened, beyond the broad details. We know Aas was long Nordic power and short German power, and that the spread widened due to wet weather in Norway (which depresses the price of hydro and reduces demand) and an increase in European prices due to increases in CO2 prices. But Nasdaq trades daily, weekly, monthly, quarterly, and annual power products: we don’t know which blew up Aas. Daily spreads are more volatile, and exhibit more extremes (kurtosis), but since margins are scaled to risk (at least theoretically–more on this below) what matters is the market move relative to the estimated risk. Reports indicate that the spread moved 17x the typical move, but we don’t know what measure of “typical” is used here. Standard deviation? Not a very good measure when there is a lot of kurtosis (or skewness).
I also haven’t seen how big Aas’ initial margins were. The total loss he suffered was bigger than the hit taken by the default fund, because under the loser-pays model, the initial margins would have been in the first loss position.
The big question in my mind relates to Nasdaq’s margin model. Power price distributions deviate substantially from the Gaussian, and estimating those distributions is challenging in part because they are also conditional on day of the year and hour of the day, and on fundamental supply-demand conditions: one model doesn’t fit every day, every hour, every season, or every weather enviornment. Moreover, a spread trade has correlation risk–dependence risk would be a better word, given that correlation is a linear measure of dependence and dependencies in power prices are not linear. How did Nasdaq model this dependence and how did that impact margins?
One possibility is that Nasdaq’s risk/margin model was good, but this was just one of those things. Margins are set on the basis of the tails, and tail events occur with some probability.
Given the nature of the tails in power prices (and spreads) reliance on a VaR-type model would be especially dangerous here. Setting margin based on something like expected shortfall would likely be superior here. Which model does Nasdaq use?
I can also see the possibility that Nasdaq’s margin model was faulty, and that Aas had figured this out. He then put on trades that he knew were undermargined because Nasdaq’s model was defective, which allowed him to take on more risk than Nasdaq intended.
In my early work on clearing I indicted that this adverse selection problem was a concern in clearing, and would lead CCPs–and those who believe that CCPs make the financial system safer–to underestimate risk and be falsely complacent. Indeed, I argued that one reason clearing could be a bad idea is that it was more vulnerable to adverse selection problems because the need to model the distribution of gains/losses on cleared positions requires detailed knowledge, especially for more exotic products. Traders who specialize in these products are likely to have MUCH better understanding about risks than a non-specialist CCP.
Aas cleared for himself, and this has caused some to get the vapors and conclude that Nasdaq was negligent in allowing him to do so. Self-clearing is just an FCM with a house account, but with no client business: in some respects that’s less risky than a traditional FCM with client business as well as its own trading book.
Nasdaq required Aas to have €70 million in capital to self-clear. Presumably Nasdaq will get some of that capital in an insolvency proceeding, and use it to repay default fund members–meaning that the €114 million loss is likely an overestimate of the ultimate cost borne by Nasdaq and the clearing members.
Further, that’s probably similar to the amount of capital that an FCM would have had to have to carry a client position as big as Aas’. That’s not inherently more risky (to the clearinghouse and its default fund) than if Aas had cleared through another firm (or firms). Again, the issue is whether Nasdaq is assessing risks accurately so as to allow it to set clearing member capital appropriately.
But the point is that Aas had to have skin in the game to self-clear, just as an FCM would have had to clear for him.
Holding Aas’ positions constant, whether he cleared himself or through an FCM really only affected the distribution of losses, but not the magnitude. If Aas had cleared through someone else, that someone else’s capital would have taken the hit, and the default fund would have been at risk only if that FCM had defaulted. But the total loss suffered by FCMs would have been exactly the same, just distributed more unevenly.
Indeed, the more even distribution that occurred due to mutualization which spread the default loss among multiple FCMs might actually be preferable to having one FCM bear the brunt.
The real issue here is incentives. My statement was that holding Aas’ positions constant, who he cleared through or whether he cleared at all affected only the distribution of losses. Perhaps under different structures Aas might not have been able to take on this much risk. But that’s an open question.
If he had cleared through another FCM, that FCM would have had an incentive to limit its positions because its capital was at risk. But Aas’ capital was at risk–he had skin in the game too, and this was necessary for him to self-clear. It’s by no means obvious that an FCM would have arrived at a different conclusion than Aas, and decided that his position represented a reasonable risk to its capital.
Here again a key issue is information asymmetry: would the FCM know more about the risk of Aas’ position, or less? Given Aas’ allegedly obsessive behavior, and his long-time success as a trader, I’m pretty sure that Aas knew more about the risk than any FCM would have, and that requiring him to clear through another firm would not have necessarily constrained his position. He would have also had an incentive to put his business at the dumbest FCM.
Another incentive issue is Nasdaq’s skin in the game–an issue that has exercised FCMs generally, not just on Nasdaq. The exchange’s/CCP’s relatively thin contribution to the default fund arguably reduces its incentive to get its margin model right. Evaluating whether Nasdaq’s relatively minor exposure to default risk led it to undermargin requires a more thorough analysis of its margin model, which is a very complex exercise which is impossible to do given what we know about the model.
But this all brings me back to themes I flogged to the collective shrug of many–indeed almost all–of the regulatory and legislative community back in the aftermath of the Crisis, when clearing was the silver bullet for future crises. Clearing is all about the allocation and pricing of counterparty credit risk. Evaluation of counterparty credit risk in a derivatives context requires a detailed understanding of the price risks of the cleared products, and dependencies between these price risks and the balance sheet risks of participants in cleared markets. Classic information problems–adverse selection and moral hazard (too little skin in the game)–make risk sharing costly, and can lead to the mispricing of risk.
The forensics about Aas blowing up real good, and the lessons learned from that experience, should focus on those issues. Alas, I see little recognition of that in the media coverage of the episode, and betting on form, I would wager that the same is true of regulators as well.
The Aas blow up should be a salutary lesson in how clearing really works, what it can do, and what it can’t. Cynic that I am, I’m guessing that it won’t be. And if I’m right, the next time could be far, far worse.
