Streetwise Professor

Back in Houston after a long trip to Turkey, France, Switzerland, and the Netherlands speaking about various commodity and clearing related issues, plus some R&R. Last stop on the tour was Chicago, where the Chicago Fed put on a great event on Law and Finance. Clearing was at the center of the discussion. Trying to be objective as possible, I think I can say that my critiques of clearing have had an influence on how scholars and practitioners (both groups being well-represented in Chicago) view clearing, and clearing mandates in particular. There is a deep  skepticism, and a growing awareness that CCPs are not the systemic risk safeguard that most had believed in the period surrounding the adoption of Frankendodd. Ruben Lee’s lunch talk summarized the skeptical view well, and recognized my role in making the skeptic’s case. His remarks were echoed by others at the workshop. If only this had penetrated the skulls of legislators and regulators when it could have made a major difference.

And the hits keep on coming. Since about April 2010 in particular, the focus of my criticism of clearing mandates has been on the destabilizing effects of rigid marking-to-market and variation margin by CCPs. I emphasized this in several SWP posts, and also my forthcoming article (in the Journal of Financial Market Infrastructure, a Risk publication) titled “A Bill of Goods.” So it was gratifying to read today that two scholars at the LSE, Ron Anderson and Karin Joeveer, used my analysis as the springboard for a more formal analysis of the issue.

The Anderson-Joeveer paper investigates collateral generally. It concludes that the liquidity implications of increased need for initial margin resulting from clearing mandates are not as concerning as the liquidity implications of greater variation margin flows that will result from a dramatic expansion of clearing.

Some of their conclusions are worth quoting in detail:

In addition, our analysis shows that moving toward central clearing with product specialized CCPs can greatly increase the numbers of margin movements which will place greater demands on a participant’s operational capacity and liquidity. This can be interpreted as tipping the balance of benefits and costs in favor of retaining bilateral OTC markets for a wider range of products and participants. Alternatively, assuming a full commitment to centralized clearing, it points out the importance of achieving consolidation and effective integration across infrastructures for a wider range of financial products. [Emphasis added.]

Europe and the US have diverged in significant ways on post-crisis financial regulation. This has had myriad consequences, including fragmentation of liquidity (especially in the swaps market), which in turn leads to less competition as it is harder for US banks to compete for the business of European clients and vice versa; greater cost; and greater complexity.

One area where there was some prospect of a unified global framework was capital rules for banks, where it was hoped that the US would adopt Basel III. But evidently the Fed is resisting that, and will move forward with its own stress test-based framework, rather than the Basel III framework which permits banks to utilize their own models to evaluate risk and hence capital.

Not that Basel III is perfect, by any means, but this approach creates the problems mentioned above, plus some more in the bargain. One is mentioned in the article: a one-model-fits all approach creates a monoculture problem that is vulnerable to catastrophic failure. I wrote about this problem quite a bit in 2009.

There is another problem as well. Although the stress test has some merits as a way of periodically evaluating capital adequacy, it  is not immediately clear how banks can evaluate the capital implications of particular transactions on a day-to-day basis in this system. If you can’t do that, you can’t price deals right or make capital allocation decisions. This is especially true if the details of the Fed model are kept secret, as will almost certainly be the case.

If you have a Basel III compliant capital model you can calculate the impact on capital due to an incremental change in a portfolio, and can hence price deals rationally and structure portfolios to achieve capital efficiency. This will be harder to do in a black-box stress test model. Not impossible but not easy either.

Several clearing related stories, each of which gives me a sense of deja vu. Or deja dit, to be more accurate.

The Bank of England just released a paper warning about the potential pro-cyclicality of CCP initial margin methodologies. I have expressed concern about this for some time.

BofE expresses concern that pro-cyclicality threatens to cause a measure intended to reduce credit risk create liquidity risk instead. This is another Clearing Cassandra theme. (Speaking of Cassandra, I will be returning to the old stomping grounds of Troy next week. And I don’t mean a city in upstate NY.)

BofE recommends that CCPs make public their margin methodologies, something that sends the clearinghouses into paroxysms of rage. But it makes sense to do that. And not just to reveal to the marketplace the potential liquidity demands that these methodologies can create, thereby allowing them to prepare accordingly. But to permit clearing participants to estimate their exposure to CCPs.

Clearing member exposure to CCPs depends on the likelihood that initial margins are sufficient to cover losses. Estimation of this exposure requires CMs to be able to evaluate margin calculations under a variety of market scenarios. If CCPs keep their methodologies secret, this is not possible. Discriminating choice among CCPs also requires market participants to understand margin costs and exposure under different scenarios. Such choice is not possible if CCPs keep secret their calculations.

CCPs are the beneficiaries of clearing mandates. Due to margin spirals and other feedback effects, margin calculations have external effects. There is therefore a strong efficiency case favoring disclosure to mitigate the externality, and any commercial/competitive inconvenience CCPs suffer as a result is more than compensated for by the fact that government mandates force huge quantities of business their way.

Another story that has come to my attention is that RBS is cutting back its rate clearing business, in large part due to the substantial capital commitment required, and the operational overhead.

This is another long-time SWP theme. The regulatory burdens of being a clearing member create scale economies that will result-and is resulting-in substantial consolidation of the clearing business. Thus, the systemic risks associated with clearing arise not only because of concentration of risk in CCPs, but in concentration of risks in a dwindling number of clearing firms who participate in multiple CCPs. Concentration of risks in a small number of CMs is, in my view, actually more systemically worrisome than concentration of risks in a small number of CCPs. Indeed, it is precisely the concentration of risks in CMs that makes failure of a systemically important CCP more likely.

Recall the good old days, when Gensler fought to reduce the minimum capital requirement for CMs to $25 million in order to spur competition in the supply of clearing services? Good times, good times. Little did he recognize that the other myriad burdens of Franendodd and Emir would inevitably lead to consolidation, making the minimum capital requirement irrelevant.

But this was only one of Gensler’s delusions (or was it lies?) about clearing. I was therefore pleased, and admittedly somewhat shocked, to see his (interim) replacement, Mark Wetjen, (implicitly) call bull on Gensler’s Panglossian propaganda on clearing:

He made an interesting and refreshingly blunt departure from the superseded Gensler script, by referring to Clearing Houses as potential sources of systemic risk.

“A clearinghouse’s failure to adhere to rigorous risk management practices established by the Commission’s regulations, now more than ever, could have significant economic consequences.”

His predecessor’s evangelical belief in CCPs as universal risk-mitigants, refused to countenance the heresy that central clearing may at best merely transfer credit risk, and may actually result in concentration of and increase in systemic risk. Fundamentalism should have no place in regulation, especially the more fundamental reforms; Wetjen’s implied recognition that a central pillar of the Dodd-Frank reforms is open for objective discussion, represents an important and consequential change in the Agency’s culture and governance.

That last part is the opinion of Nick Railton-Edwards (a somewhat Pythonesque handle, eh?), who wrote the piece, rather than Wetjen. (He sounds like a like-minded, not to say right-minded, bloke.) But it is a realistic characterization of the implications of Wetjen’s remarks. I would add that this evangelism is exactly what I hammered Gensler for repeatedly in 2009-2013: Indeed, I repeatedly used the term evangelist to refer to Gensler and his allies. (And that hammering is why he banned me from the CFTC building-something that I have on unimpeachable authority.)

The sad thing about all this is that all of these things were foreseeable before legislators and regulators* went all in on clearing as The Solution. Certain Cassandras did foresee it. But now this is where we are, and some adults like the BofE and Wetjen are trying to mitigate the dangers that this rash and thoughtless plunge created.

Would that this had occurred at the front end of the process rather than the back. Better late than never, perhaps. But better early than late.

*Timmah! was Gensler’s partner in crime on this. Geithner has just released his memoirs, and is flogging the book. I will give him another flogging in due course. For old times’ sake.

There was another fiery derailment of a train carrying crude oil, this one in Lynchburg, Virginia. Some of the cars plunged into the James River, spilling oil into the stream that runs through Virginia via Richmond to the Chesapeake.

This is just the latest of a spate of such accidents. This is, to some extent, the inevitable consequence of the oil boom in the Bakken and Texas. The boom means that more oil has to move, and rail can adjust most rapidly to accommodate that need. Pipelines are cheaper and safer, but they take a while to build. Unfortunately, regulatory obstacles had impeded the more rapid buildout of pipelines.

To give an idea of how unexpected the oil-by-rail movement is, note that the US government (namely the Energy Information Agency) does not collect data on the volume of rail shipments. It tracks shipments by barge and pipeline, but not rail. Because oil by rail volumes were basically rounding error until the shale oil boom.

The recent spate of accidents has led Warren Buffett to call for stronger regulation, most notably, a requirement for safer rail cars.  Buffett’s Berkshire Hathaway of course owns the nation’s second largest rail carrier, BNSF.

That Warren, always looking out for the public interest, and willing to sacrifice the interests of one of his major holdings to benefit us hoi polloi.

Not.

First, it’s long been known that some firms in an industry can benefit from the imposition of more stringent safety regulations. Yes, these regulations raise everybody’s costs, but some firms’ costs rise more than others. The less-impacted firms have an incentive to press for the regulations in order to raise their rivals’ costs. This raises market price. The effect on price more than offsets the effect on cost for the less cost-impacted firms.

Which means: always look askance at people like Buffett who are calling for regulation of their industry.

And this goes double for Buffett. For in addition to BNSF, Berkshire Hathaway owns the Union Tank Car Company, one of the largest manufacturers of oil tanker railcars. Meaning that some of the costs from requiring the purchase of more robust railcars goes from Buffett’s BNSF pocket into his UTLX pocket. He is, effectively, hedged against the rise in BNSF’s costs that would result from regulations requiring the use of safer cars. What’s more, his UTLX also pockets some of the costs incurred by his rivals. That’s a double win for Buffett. His rivals’ costs go up, raising prices for rail freight which benefits BNSF, and Buffett also books as profit (at UTLX) some of the higher costs his rivals incur.

Great work if you can get it.

So yeah, Buffett’s call for more stringent regulation of oil carrying railcars is totally altruistic. Totally.

It never ceases to amaze me how Buffett’s kindly grandfather shtick fools the world. He is utterly cynical in his actions and public statements. He demonizes derivatives, but engages in some huge exotic options trades. He claims he supports the estate tax out of interest of fairness and equity, not mentioning that his insurance businesses profit immensely from the estate tax (and that he can of course largely circumvent the tax). He has manipulated the silver market. And he poses as a defender of public safety, not mentioning his very strong economic interests in such regulation.

It’s not surprising that Buffett conceals his interests. What’s more surprising, and more discouraging, is that none of the media stories on his calls for tougher regulation that I have seen mention his economic interest. Reporters are either intimidated,  gulled by his shtick, or shockingly ignorant of how Buffett would benefit from rules requiring railroads to upgrade their car fleets.

Just because reporters are credulous dupes doesn’t mean you have to be. Don’t fall for the Buffett shtick. Don’t pay attention to what he says. Evaluate the costs and benefits of increased safety standards on oil-by-rail shipments on the merits.

And don’t limit your analysis to rail shipments alone. Consider too the effects of expediting the approval and building of oil pipelines. Pipelines aren’t perfect, but they have a much better safety record than rail. Not that Grandpa Warren will tell you that.

I have been working since last year on a whitepaper (sponsored by Trafigura) on The Economics of Commodity Trading Firms. After about a month of limited theatrical release, the paper is now publicly available at the link.

Even if I do say so myself, the paper provides a pretty thorough overview of commodity trading firms, ranging from their economic function as “agents of transformation” (of commodities in space, time, and form), to risks and risk management, to corporate structure (private vs. public), to capital structure, to asset ownership, to the systemic risks (or lack thereof) of commodity trading.

One of the main takeaways for me was the diversity of commodity trading firms. Making generalizations is difficult. Another takeaway (related, in a way) is that some of the conventional wisdom about these firms (e.g., there is a general trend to asset ownership and vertical integration) is not correct.

But rather than discuss the report extensively here, I leave it to you all to read it. Comments welcome.

An exchange chairman believes that all trading should take place on exchanges. In commenting on securities market structure, CME Group Chairman Terry Duffy criticizes fragmentation-especially the existence of dark pools-and touts the lack of fragmentation in futures trading.

The concentration of trading activity on futures exchanges, as opposed to the fragmentation across different exchanges (as well as off-exchange venues) in equities is due to a major difference in the treatment of orders. In futures markets, exchanges own their order flow: hypothetically, if there was another exchange posting a better price in a particular product, CME would not be obligated to direct an order to that better-priced market. When exchanges own their order flow in this way, traders direct orders to the exchange where they expect to get the best price. This is typically the market where most traders are. This creates a centripetal force that causes all activity to tip to a single dominant exchange. That is why CME, Eurex, ICE, etc., have monopolies or near monopolies in the products they trade. (And yes, Terry, even though no one is stopping anyone from competing with you, this order flow effect means that no one can do so effectively, leaving you a de facto monopoly. Only LIFFE’s idiocy in its battle with Eurex in 1998 allowed the Germans to get trading in the Bund futures to tip their way.)

This is the way it used to be in equities too. Prior to the late-2000s, the NYSE effectively owned its order flow, and 80-85 percent of trading volume in NYSE listings took place on the NYSE. The remainder occurred on “third markets” that catered to the verifiably uninformed (more on this below).  But in 2005 the SEC changed the rules in a fundamental way. It passed RegNMS, which socialized order flow by requiring exchanges to route orders to others displaying better prices. Within a very short period, a handful of exchanges executing between 8-20 percent of volume competed fiercely with one another. The NYSE’s effective monopoly had been broken.  This is why Goldman paid $6.5 billion for a specialist unit in 2000, and sold it for $30 million this year. The 2000 price capitalized monopoly rents: there are none to capitalize in 2014.

Duffy says he’s fine with this kind of fragmentation  of trading across exchanges with the associated intense competition (though that’s very easy for him to say because he doesn’t have to worry about that outcome given the lack of a RegNMS-type rule in futures markets), but he thinks dark pools should be shut down.

To evaluate this position, you need to understand what role dark pools play. Just like third markets and block markets of the pre-RegNMS era, dark pools (and internalization of retail order flow) are a ways of screening out informed traders. This reduces the costs of the uninformed who can trade on dark pools be reducing their vulnerability to adverse selection. This is good for them, but the overall effects are much harder to understand. Order flow on exchanges becomes more toxic (i.e., a higher proportion of the order flow is informed) which raises adverse selection costs on exchanges, and thereby raises trading costs there.

The net effect of this is very difficult to determine. This is another application of the second best. Since exchanges may have market power, the additional competition from off-exchange venues can improve efficiency even if it raises adverse selection costs for some traders. Moreover, as I’ve argued in my HFT posts recently, since some informed trading is of the rent seeking variety, by reducing the returns to informed trading dark pools can reduce wasteful investments in information.

This means that Duffy’s criticism of dark pools might be right. But it might be wrong.

One thing is definitely true. Market structure has huge distributive effects. Although the rules on dark pools have very uncertain efficiency effects, there is no doubt that these rules affect the distribution of costs and benefits across different types of traders. It is precisely these distributive effects which make the battles over market structure so divisive and protracted.

I’d also note that Duffy ignoring some features of futures markets, and derivatives markets generally, that perform functions similar to dark pools. For instance, CME allows block trading. Indeed, it is engaged in a tussle with the CFTC, which wants to reduce the amount of block trading in order to force more volume into the order book.

But block trades are a way that less-informed large traders can reduce adverse selection costs. They have long performed this function in equity markets, and are now doing so in futures. And by stripping out that order flow from the order book, block trades have the same effects as dark pools.  Blocks are a form of fragmentation.

Block markets are non-anonymous: that’s how they screen out the informed. Block traders won’t deal with those they believe likely to be informed, and by trading face-to-face traders can develop reputations for not being informed and profiting systematically at the expense of their counterparties.

Well, wouldn’t you know it, but this is how OTC derivatives markets work too. The lack of price transparency in OTC markets is often bewailed, but OTC markets are transparent in another important way that exchanges are not: they offer counterparty transparency, whereas exchanges are counterparty opaque. This benefits, say, firms that are trading to hedge in large volume (who are likely to be uninformed). It’s not a surprise that trading activity migrated from OTC to blocks on CME and ICE after Frankendodd made swaps trading more expensive. Both futures blocks and swaps are ways of reducing the execution costs of large, likely uninformed traders.

Put differently: blocks (and swaps) are a form of fragmentation, in the sense that they divert trading activity away from the limit order book. So Duffy shouldn’t be quite so sure about the superiority of the futures market model. It is fragmented in its own way, and has a lot more market power. But of course Duffy likes the last part, though he would never admit it.

In his Atlanta Fed paper, Stiglitz uses second best considerations in his argument against HFT. My basic response is that second best considerations cut both ways.

Put simply, second best considerations mean that if one optimality condition is violated, then it may be efficiency enhancing to violate another optimality condition: or, one “market failure” can mitigate another. A simple example would be that it might be better for a polluting industry to be monopolistic or oligopolistic instead of competitive.  The monopolist’s reduction of output offsets the incentive to produce too much that occurs when there is an externality.

In the context of HFT, my second best argument is that since informed trading can be rent seeking, things that might otherwise be inefficient, such as anticipating orders or engaging in “arms races” to enhance trading speed, can be efficiency enhancing.

This is not a new theme with me. In fact, it’s quite old. I wrote a paper in 1998 titled “Third Markets and the Second Best” that applied this argument to off-exchange trading, and the free riding off of price discovery on exchanges. I discussed this further in my 2002 JLEO paper, “Securities Market Macrostructure: Property Rights and the Efficiency of Securities Trading“.

In these papers, I showed that off exchange trading venues-third markets-that free ride off of the prices produced by exchanges and limit trading to the verifiably uninformed can be efficiency enhancing even if this exacerbates adverse selection problems on the exchange because this free riding mitigates two problems: the market power of dominant exchanges (where the market power arises from the liquidity network effect) and rent seeking informed trading (i.e., the expenditure of real resources to obtain information in order to extract profits by trading with the less-informed who buy and sell for portfolio balance or risk management reasons).

Similar arguments can be applied to dark pools today. Indeed, many dark pools (and internalization) perform a similar function to third markets back in the day: they are venues that use various means to screen out informed traders, in order to reduce execution costs for the verifiably less-informed. This loss of uninformed order flow on “lit” exchanges tends to increase adverse selection costs there, but the same competition and rent seeking informed trading second best considerations arise here, meaning that the costs of lower liquidity on exchanges may be more than offset by other benefits.

And many of the very same considerations apply to HFT. Thus, contra Stiglitz, second best considerations do not unambiguously favor the adoption of restrictions on HFT.

Indeed, the thing that is most striking about the trading of financial instruments is that there are so many potential violations of optimality conditions that the entire analysis of market structure becomes an exercise in the theory of the second best.

Which can be a problem. For as George Stigler said, “Well, there are second best considerations” is a conversation stopper. But the conversation about market structure isn’t going to stop anytime soon, so we have to grasp the nettle of the second best if that conversation is going to shed more light than heat. It is good that Stiglitz makes the second best issue explicity. If only he had applied this reasoning more consistently, and recognized that informed trading can be a deviation from optimality which can be addressed by things that seem in isolation to be inefficient.

The battle over bank participation in physical commodities is reaching a climax. The deadline for commenting on potential Federal Reserve regulation of this activity is approaching, and many letters from groups representing banks (‘natch) but also from energy and commodity industry groups plead with the Fed to permit continued bank involvement in the markets. However, on Capitol Hill the sentiment largely runs the other way, and Senators Sherrod Brown and Elizabeth Warren submitted a letter demanding that the Fed defenestrate banks’ commodities businesses.

Most of the Brown-Warren letter is stuff I’ve written about before, so I won’t comment more on it now. But this part stood out to me, and deserves a rebuttal:

Commodities activities present risks that are different from financial-market risks, are idiosyncratic, and have the potential to disrupt more than just the financial system. Global supply chain disruptions can affect industries in the broader economy that rely upon raw materials.

First, from a systemic risk perspective, the fact that commodities risks are idiosyncratic, and different (i.e., less correlated) with other risks in the banking system is a good thing. Diversification is beneficial in this regard.

I have looked at some evidence that speaks directly to this issue. Over the period of the crisis, the profits of the biggest physical commodity trading firms (the Glencores, Cargills, Vitols, etc.) did not suffer the same extreme drop as bank profits. Indeed, with a few exceptions (Bunge) profits of the major commodity trading firms rose from 2008 to 2009, when bank profits were in freefall.

This lack of cyclicality in trading firm profits, which is in stark contrast to the extreme cyclicality in prices (especially for energy and metals) is readily understood. Physical trading is a margin and volume business: these factors, not flat prices, drive profits. Due to the inelasticity of supply and demand for commodities, margins and volumes tend to be much more stable than flat prices. Prices, rather than quantities, tend to bear the bulk of the burden of responding to demand shocks. Moreover, some commodity trading activities-notably storage-tend to be countercyclical, providing a source of profit to physical commodity traders during recessions.

Commodity trading firms actually had more issues when prices spiked in 2008, because it was difficult for them to finance inventories at very high prices, and the low prices of 2009 eased these financing constraints.

The lack of cyclicality, which contrasts starkly to the pronounced cyclicality of earnings in traditional banking and capital market activities, means that physical commodity trading could reduce the systemic risk posed by banks. The effect will not be large, because even for the biggest banks  commodity trading revenues are small relative to those generated by the more traditional activities. But directionally, this lack of cyclicality in physical trading profitability makes it an attractive part of a bank’s portfolio, especially from a systemic risk perspective.

Second, the Brown-Warren warning about disruptions beyond the financial system are vastly overblown. Presumably what they mean is that if a large bank or several large banks with commodity trading operations were to run into financial trouble, this could disrupt global supply chains. But especially for the commodities that banks tend to focus on (particularly energy), they represent a small fraction of total physical market trading activity. If they disappeared overnight, others could step in and handle most of the business at a slightly higher cost. (Not to mention that it is kind of strange to justify driving banks out of the business by saying that if they leave the business it could disrupt global supply chains.)

But even more importantly, we know that even major disruptions in global supply chains are likely to have only trivial impacts on the global economy. Look at the Japanese earthquake and tsunami of 2011. It devastated supply chains throughout Asia, far more than the loss of even several major commodity trading firms could have. Yet the effects on global growth were minimal. Several central banks examined the issue, and found that the catastrophe reduced global growth by around .1 percent for a couple of quarters. Even in Asia, the effect was minor.

As another example, the implosion of the merchant energy sector in the US in 2002 had no marked effect on US economic activity.

Another concern raised about bank participation in physical markets is environmental risk. This is potentially a serious concern, but even there legal protections (notably dealing through subsidiaries that protect a bank or bank holding company from liability) and insurance can sharply reduce the risk that legal exposure arising from an oil spill or the like could threaten the viability of a large financial institution. Also, since different commodity trading activities pose different environmental risks, a blanket restriction on commodity trading activities, some of which are not particularly environmentally risky, is not warranted.

In sum, the Brown-Warren arguments are not persuasive. Financially, the nature of physical commodity trading tends to reduce the cyclicality of of bank profits, which tends to reduce systemic risk. The fears about threats to global supply chains from the failure of any major commodity trader leading to adverse macroeconomic consequences are vastly overblown. Finally, the environmental/legal risk issues can be allocated away from banks through organizational structure and insurance. Since there also complementarities between traditional banking activities and commodity trading (which I discussed in posts from last summer) some commodity producers and consumers would pay higher costs if they could not enter into physical trading deals with banks: this is one reason why some of these producers and consumers object to limitations on bank participation in these markets. It’s hard to see the benefits of a ban (or restriction), but some costs are evident.

I doubt that will matter much in the end though. Commodities are a politically sensitive issue. Banks are a politically sensitive issue. Put them together, and the sensitivities are acute. Meaning that politics will largely drive the outcome.

Update. One other amusing part of the Brown-Warren letter. They say:

Some have argued it is preferable to allow commodities activities and physical asset ownership within the regulated banking system, rather than at the more lightly regulated commodity trading houses. As a general matter, the CFTC maintains authority to police fraud and manipulation in the commodities markets, regardless of the party engaging in such behavior.

So are banks somehow less subject to deterrence by the threat of CFTC action? If the objective  is to reduce the amount of manipulation and fraud, to justify forcing banks to eschew commodity trading it is necessary to argue that banks are  somehow less responsive to CFTC action than commodity trading houses. Maybe, but it’s not obviously true and I’ve seen no evidence that would support my view.

This relates to a point I made in earlier posts, namely, that if the economics are such that banks find it tempting to manipulate, non-banks will also find it tempting. Meaning that moving a business (e.g., metal warehousing) from a bank to a non-bank is unlikely to reduce the amount of manipulation.

One other thing needs to be said in this context. The Brown-Warren point is correct to the extent that it demonstrates that the term “lightly regulated” is used far too sloppily. Yes, trading houses are less subject to less of some kinds of regulation than banks, but they are subject to anti-fraud and anti-manipulation rules just as banks are. Similarly,  environmental laws and anti-trust laws and many other laws apply to these firms. “Lightly regulated” does not apply uniformly to all forms of bad conduct. The fact that commodity traders are not subject to some regulations that banks are (e.g., capital requirements) makes sense, given the differences between them.

Whenever anyone says “unregulated” or “lightly regulated”, I get suspicious and skeptical. Often those using these phrases are playing a shell game.

Joe Stiglitz presented a paper on HFT at the Atlanta Fed conference earlier this week that has received a lot of attention. The paper is worth reading, but I actually recommend Felix Salmon’s synopsis, which breaks out the issues nicely.

I agree with Stiglitz in part, and disagree in part. The agreement is that Stiglitz hits many of the themes of my recent posts on HFT, notably that when there is private information, financial markets are unlikely to reach first best outcomes, and that making welfare comparisons is very difficult: I would say nigh-on to impossible, actually. Stiglitz also recognizes that HFT affects the incentives to collect information, which is another theme that I’ve emphasized.

Where I disagree is that Stiglitz (like DeLong) concludes from these insights that HFT is wasteful and should be restricted. This conclusion does not follow at all, and can be traced to some implicit assumptions about the nature of informed trading by non-HFT traders.

Stiglitz says “HFT discourages the acquisition of information which would make the market more informative in a relevant sense.” And by “relevant sense” he means fundamental information about the real economy. He laments that HFT “can be thought of as stealing the information rents that otherwise would have gone to those who had invested in information.” Further, he criticizes that much of what HFT does is merely accelerate the revelation of this information, and this acceleration is so small that it cannot improve any decision on any margin, and hence the resources used by HFT are wasted.

But this implicitly assumes that the information produced by non-HFT traders, the collection of which is reduced by the “stealing of information rents”, is in fact fundamental information that would improve decisions. But as I’ve noted repeatedly, many of the informed traders who HFT firms sniff out are producing information that does not improve any economic decision on any margin. Getting better information about an impending earnings report can be very profitable, but revelation of this information doesn’t improve decision making.

By assuming that non-HFT informed traders are producing information that invariably improves decisions, Stiglitz misunderstands what a great deal of informed trading is about, and thereby ignores a benefit of HFT order anticipation-based trading, and crucially, of HFT quote adjustments that cause markets to run away from big traders and thereby limits their ability to profit on their information.

One way to think about it is that there is cash flow relevant information, and decision relevant information. Pretty much all decision relevant information is cash flow relevant, but not all cash flow information is decision relevant. One major example is what Stiglitz emphasizes: the slight acceleration of revelation of information. But I claim that a lot of the information produced by institutional traders is of exactly this type. Stiglitz (and DeLong) ignore this, which leads them to biased appraisals of the efficiency of HFT.

That is, once one recognizes that some informed trading is rent seeking, and socially wasteful, “stealing of information rents” by HFT can be a feature, not a bug.

Stiglitz also ignores that even if HFT reduces the amount of decision relevant information produced and incorporated into prices, reducing this source of private information still reduces the adverse selection costs incurred by uninformed investors trading for portfolio rebalancing or hedging reasons. This reduction in adverse selection costs tends to improve the allocation of risk. This benefit must be weighed against any cost arising from the reduction in the production of decision relevant information.

In brief, Stiglitz and I agree that HFT reduces the incentive to collect information. Where we differ is that Stiglitz believes this is an unmitigated bad, whereas I strongly believe that this is totally wrong, because Stiglitz’s characterization of informed trading is very unrealistic. My point is that non-HFT informed trading can be parasitic, but Stiglitz does not recognize this or account for it in his analysis.

Stiglitz also complains that HFT liquidity is junk liquidity. In particular, prices move before large orders can be executed.

This is a variant on the criticism that HFT reduces information rents. Moreover, Stiglitz fails to make comparisons between realistic alternatives. The ability to adjust quotes faster reduces adverse selection costs, and allows HFT to quote tighter markets. Restricting HFT in some way will lead to wider spreads and lower quoted depth. Either way, big orders will have a price impact.

Stiglitz also claims that HFT reduces other, better forms of liquidity. Salmon actually explains this point more clearly:

HFT does not improve the important type of liquidity.

If you’re a small retail investor, you have access to more stock market liquidity than ever. Whatever stock you want to buy or sell, you can do so immediately, at the best market price. But that’s not the kind of liquidity which is most valuable, societally speaking. That kind of liquidity is what you see when market makers step in with relatively patient balance sheets, willing to take a position off somebody else’s book and wait until they can find a counterparty to whom they can willingly offset it. Those market makers may or may not have been important in the past, but they’re certainly few and far between today.

HFT also reduces natural liquidity.

Let’s say I do a lot of homework on a stock, and I determine that it’s a good buy at $35 per share. So I put in a large order at $35 per share. If the stock ever drops to that price, I’ll be willing to buy there. I’m providing natural liquidity to the market at the $35 level. In the age of HFT, however, it’s silly to just post a big order and keep it there, since it’s likely that your entire order will be filled — within a blink of an eye, much faster than you can react — if and only if some information comes out which would be likely to change your fair-value calculation. As a result, you only place your order for a tiny fraction of a second yourself. And in turn, the market becomes less liquid.

These points are pretty dubious. The kinds of market makers that HFT displaces (locals on futures exchanges, specialists, day traders) were hardly characterized by “relatively patient balance sheets.” Their holding periods were also quite short. Indeed, one of the filters academics use to identify HFT traders is firms that end the day flat: this exactly what most locals and specialists strove to do. And most traders that “do a lot of homework on a stock” were not doing so to supply liquidity through limit orders that they did not adjust frequently. Those who do a lot of homework are usually liquidity takers, not liquidity suppliers.

In sum, although Stiglitz’s analytical framework and broad conclusions are correct, his specific conclusions about HFT are not. They are not correct primarily because he has a very unrealistic view of the nature of informed trading. Once one recognizes that much informed trading is a form of rent seeking-the point that Hirshleifer made over 40 years ago-most of Stiglitz’s objections to HFT dissolve. Put differently, Stiglitz is right to believe that the financial sector may be too big, in part because there can be excessively strong incentives to collect information and trade on it, but he fails to take this point to its logical conclusion when evaluating HFT.

I do find it rather odd that strongly left-leaning economists like Stiglitz and DeLong who are broadly skeptical of financial markets focus their criticism on one new feature of those markets-HFT-without considering the implications of their broader critiques of the financial sector. At root, their criticism is that much financial market activity is rent seeking. If you believe that, you have to consider how HFT affects these rent seeking activities. Once you do that, it is impossible to sustain the critiques of HFT, because even if there are rent seeking aspects to HFT, it also can reduce other forms of rent seeking.

This is totally serious. 100 percent snark free. The answer (and more importantly, the explanation) will help make explicit assumptions and logic, and thereby advance the discussion.

So here it is:

Do you oppose or support laws prohibiting trading by corporate insiders on material, non-public information? (Alternative formulation: Do you support the expenditure of resources to enforce laws prohibiting trading by corporate insiders on material, non-public information?) Explain your reasoning.

The explanation is more important than the answer.