Streetwise Professor

There is an I-told-you-so tizzy going on about the revelation of the BATS exchange that a system (or programming) error had resulted in the execution of about 450,000 orders at prices worse than the best bid/offer (BBO).  Oh, the humanity!

A little perspective here.  According to BATS, the total loss (which is a wealth transfer, mind you) totaled . . . brace yourselves now . . . $420,000.  Excuse me.  $420,360.

There seems to be some presumption that there was a Golden Era of trading, before the invasion of the dreaded machines, when intermediaries had hearts of gold rather than a hunger for it.  When bids and offers were never violated.  When there were never trading errors.

Wrong.  There was no Golden Age.  Nirvana is still just a band.

Think that the BBO was never violated on exchange floors?  Think again.  Sometimes this was inadvertent in the chaos of the pits/trading posts during active markets.  Sometimes it was very advertent (is that a word?)  May I remind everyone of the FBI sting on the CME and CBT, which discovered that some brokers would collude with locals to execute customer orders at off-market prices, and split the proceeds, sometimes delivered by bagmen-literally, guys passing paper bags of bills.   Given the relatively crude time stamping of trading cards, it was very difficult to construct an accurate audit trail.  Trades couldn’t even be sequenced with precision, and since the bid/offer were not recorded continuously or time stamped, it was impossible to see whether  a trade violated the BBO.  There were pit monitors who tried to keep an eye on things, but no human monitoring was capable of detecting all violations.  Indeed, the sociology of the floor and the member domination of exchanges (a subject I’ll turn to shortly) meant that social pressure discouraged cracking down too aggressively, particularly on the most powerful.

Enforcing the BBO on the floor was in many ways constrained by a lack of data.  If anything, current market monitors have the exact opposite problem: they are drowning in a sea of data.  But as BATS shows, it is possible to go back through years of this data and pick up mistakes that cost customers about $1 per error.

Then shall we discuss out-trades?  Out-trades-trading errors, where trade terms submitted by the buyer and seller didn’t match-were common on the floor.  Brokers were on the hook for errors, and there were stories of brokers writing six figure checks to make a customer whole for a loss.  I would not be surprised that on an inflation adjusted basis, a single broker wrote a check to a customer that exceeded $420,000 in 2013 dollars.

But this reality of the way things were doesn’t stop the hue and cry about the fallen state of today’s computerized markets.  The biggest huer-and-crier (emphasis on the crying) is Jackass Joe Saluzzi of Themis Trading.  Here Joe outdoes himself, by suggesting that we need to go back to the days of non-profit exchanges in order to restore public confidence in broken markets. (h/t Blivy.)

JJ apparently believes the old mutual non-profit exchanges were freaking charities, like the March of Dimes or something.  Uhm, no.

Let’s look at the facts.  The old mutual exchanges were cartels of intermediaries.  They restricted membership in order to enhance the rents of those members.  For decades, most of them ran brokerage cartels that fixed commissions.  Some created monopoly privileges for some members (e.g., NYSE specialists).  Others (NASDAQ comes to mind) had order handling rules that basically precluded public customers from competing with member market makers in supplying liquidity: NASDAQ was also the nexus of a flagrant conspiracy among market makers to fix spreads at supercompetitive levels.

Non-profit status had nothing whatever to do with the charitable urges of old time brokers and market makers.  As I showed in research done just as the transition from non-profit to for-profit status was occurring, exchanges chose the non-profit form because the non-distribution constraint inherent in that form prevented the exchange from choosing pricing policies that transferred wealth among heterogeneous members with very specialized human capital.  (An abbreviated version of the argument is here.  The full version was published in J. Law & Econ. in 2000.)  Electronic trading undermined the rents and the specialized assets that drove the choice of non-profit form, so the move to electronic trading in turn impelled the transformation of exchanges to for-profit entities.

In other words, non-profit form was chosen by very greedy, profit-driven individuals to protect their profits.  And a good chunk of those profits resulted from the exercise of market power and the adoption of collusive arrangements by exchanges.

So spare me nostalgia.  Indeed, methinks that a good deal of the nostalgia-and the related criticism of modern electronic markets-is a shriek of rage by those who profited under the old system, and are furious that someone ruined their racket.

Joe does get one thing right (cf. blind hog, acorn).  He attributes the specific BATS problem, and the increased complexity of the equity markets, to RegNMS.  This is correct.  The information-and-linkages approach chosen by the SEC led it to adopt regulations that socialized order flow.  This was done with the explicit goal of encouraging competition among trading platforms.

Another example of “be careful what you ask for: you might get it.”  Pre-RegNMS, NYSE executed about 85 percent of the trades in its listed stocks, and the bulk of the remainder was executed in Third Markets which did not contribute to price discovery.  NYSE was essentially the natural monopoly supplier of price discovery.  Now, NYSE market share is in the low-20s, and executions are shared pretty much equally among a handful of platforms.

But this socialized order flow model requires linkages between the execution venues.  It is that necessity that accounts for the complexity of the current equity markets.  The interconnection imperative is directly responsible for the proliferation of order types that many find so vexing, and which indeed give advantages to specialized electronic traders.  Note that the BATS error was in an order type designed to ensure compliance with RegNMS rules relating to the BBO.

You can criticize this market structure.  But if you do so, you have to grasp the nettle of the fundamental trade-off.  The choice is binary.  You can choose to socialize order flow, or not.   If you do, you get something like the current equity market structure, with intense competition among execution venues linked by a complex web of fragile connections and a proliferation of order types.  If you don’t, you get something like the pre-RegNMS market structure, or futures market structure past and present.  A market that tips to a single execution venue that exercises market power, either by restricting access (the old mutual model) or by charging supercompetitive prices (the new for-profit exchange model).

Those are the choices.  But the debate is almost never framed that way.  Instead, bat sh*t crazy people like Saluzzi (enabled by folks like the CNBC talking head in the BATS Hit video) take up all the oxygen screaming about how bad the current market structure is and retailing myths about some Golden Age that never was.

Political economy considerations almost certainly ensure that the SEC is not going to go back on RegNMS, and it is truly invested in the information-and-linkages approach it chose.  So we are likely to see a continued series of controversies over problems that are inherent in the socialized order flow model.  The SEC will pull its chin, and deal with each problem as it appears in an ad hoc way, just adding to the complexity as the new games are devised to exploit the new rules implemented to stop the old games that exploited the old rules.  This will make for never ending media appearances for the likes of Joe Saluzzi, but  don’t buy his line about the good old days.  The good old days that existed when regulation effectively opted for the other binary choice (no socialization of order flow) weren’t all that great.  There was a different set of problems, and a different set of people and firms profiting off the inefficiencies that inhere in the network nature of financial trading.

One of the predictable though unintended consequences of Frankendodd (and its European cousins) will be to increase concentration in the banking sector.  Not just predictable: predicted, including by me (notably at the JP Morgan Commodity Conference in October 2011, and here on SWP).

The logic is fairly straightforward.  Frankendodd creates a huge regulatory overhead that in turn leads to scale economies.  Smaller-to-medium-sized entities will not be able to afford these overhead costs, and will exit the business, and the bigger firms will get bigger.  The overall level of activity is likely to go down as a result of the exit and expansion, but the biggest firms are likely to get bigger even if the market overall gets smaller.  Moreover, the capital and collateral requirements in Frankendodd, including in the derivatives title, have disparate impacts on different market participants  Since the smaller entities typically have higher capital costs than the bigger ones, this increase in capital needs to support trading businesses in particular will lead the smaller market participants to contract more than the bigger ones; this increase in their capital costs may also induce them to exit altogether, especially when taken in conjunction with the increase in regulatory overhead associated with trading businesses in particular

Given that Frankendodd was allegedly intended to address the too big to fail problem, it is perverse that one of its predictable consequences is to increase concentration, and likely increase the size of the biggest firms in the market.

We may be seeing the first major move in this direction, just as Frankendodd’s big boot is starting to kick in.  Morgan Stanley announced deep job cuts, and rumors are flying that it will exit the fixed income trading business:

Now the storied company — whose take-no-prisoners trading desks have at times been rivaled only by firms like Goldman Sachs — is cutting even deeper, raising questions among some on Wall Street about whether it should spin off or ditch much of its trading business as its Swiss rival UBS has, a suggestion the firm eschews.

. . . .

Morgan Stanley’s board, said people briefed on the matter, has discussed closing its fixed-income department. Instead, the firm is shrinking the unit, arguing that it is important to offer its customers those trading services. By cutting jobs and costs and exiting lines like structured products and other complex financial investments and focusing on less risky, less capital-intensive businesses like the trading of interest rates, executives contended that the division can generate a healthy return.

So they’ve discussed it, but decided to keep it in a shrunken state.  But it may have to revisit the more drastic measure:

In recent years, the fixed-income department has not been able to make enough money to cover the cost to Morgan Stanley of this capital, according to people briefed on the matter but not authorized to speak on the record

If it hasn’t covered its cost of capital pre-Frankendodd, lotsa luck with covering it afterwards.

Frankendodd will cause a contraction of the financial sector, which isn’t necessarily a bad thing.  But the contraction will be uneven, and the fundamental nature of Frankendodd favors a relative expansion, and perhaps an absolute expansion, in the biggest-the JP Morgans and Goldmans and Deutsche Banks.

Hardly what was intended.  But that’s different to say it wasn’t predictable.

Stephen Bainbridge, an eminent UCLA law prof of my (slight) acquaintance, has been rocking on the Ace Greenberg suit against the federal government.  He brutally eviscerates those in Congress and the media that exhibited their high dudgeon at the temerity of AIG’s board in even considering joining the Greenberg suit.  But more importantly, he reinforces and complements the point in my previous post on the subject.  Specifically, he argues that there are serious issues at stake here.  That the fact that the government provided “assistance” to AIG during crisis conditions does not give the government carte blanche to dictate the price of that assistance, if in so doing (a) it tramples on the legal rights of AIG shareholders, and (b) expropriates wealth from those shareholders by exploiting AIG’s financial distress to impose punitive conditions on that assistance.

During the crisis, the government asserted that the gravity of the emergency justified extraordinary measures that trampled well-established legal protections and procedures.  The terms of the Chrysler bailout are one clearcut example.  The AIG case is plausibly another.

This turns things on their head.  If particular measures-like protecting AIG’s derivatives counterparties-are so important that they create a substantial amount of wealth, paying fair compensation shouldn’t be a problem. Moreover, doing that reduces fears that the government will expropriate wealth in the future, and that limits the chilling effects on investment that expropriation threats engender.  In contrast, the attitude that property and legal rights are forfeit when the government in its wisdom deems that emergency conditions justify it, has an extremely corrosive effect.

Put differently, a government that creates a reputation for protecting property and legal rights even during extreme circumstances also creates an environment that is conducive to growth.  In contrast, one that creates a reputation for opportunistically exploiting crisis situations by transferring wealth to itself, or to favored constituencies (like Chrysler’s unions), creates an environment that is hostile to investment and growth.

Sort of like Russia, in other words.

The US Senate s sometimes called the World’s Greatest Deliberative Body.  At times-most times, in fact-it seems that it would be more apt to call it the Deliberative Body With the World’s Greatest Proportion of Room Temperature IQs.  Many notable dimwits come to mind-Barbara Boxer, for instance. But the dearly departed (from the Senate, anyways) Blanche Lincoln was oh-so-special in her dimness.

As a sort of parting gift prior to her electoral rout in 2010, Blanche succeeded in inserting the eponymous Lincoln Amendment into Frankendodd.  This was the “swaps push out” provision, which precluded any “swaps entity” from receiving assistance from the Federal Reserve.  This requires banks to “push out” dealing in derivatives to separately capitalized subsidiaries that have no access to the Fed discount window, or other sources of federal support.

Crucially, the Lincoln Amendment was limited: basically, only equity derivatives, some credit derivatives, and commodity derivatives (with the exception of gold) were pushed out.  Banks were allowed to maintain their bread-and-butter rates derivatives business, as well as some of their credit trading businesses.  I guess the theory was that commodities are scary risky, but banks can’t jeopardize themselves by playing in interest rates.  Or something.

Well, that’s true of US banks, anyways.  But due to the meticulous drafting that characterizes Frankendodd, branches of foreign banks cannot avail themselves of the same exemptions.  This includes behemoths like Barclays and Deutsche Bank.

So now the Fed is trying to clean up after Congress, endeavoring to find ways to blunt the effects the provisions of the Lincoln Amendment on foreign banks.  Easier said than done, because despite the fact that “Ms Lincoln called her amendment’s treatment of foreign banks’ uninsured US branches a ‘significant oversight’ that was “unfortunate and clearly unintended. . . . the language of the legislation is clear, regulators are unable to use [Lincoln’s] statements on the Senate floor to unilaterally change the implementation of the law. ”

Good times.  Good times. Just another of the land mines lurking in Frankendodd.  Think of how many more are to be found.  And how many are buried in Obamacare.

Like I said.  Good times.

It’s been known for centuries that comparative advantage and relative factor endowments should drive trade patterns.   The fracking revolution has led to a dramatic change in US comparative advantage and factor endowments.  Basic economics tells us that this should drive a change in trading patterns, and in particular, it makes it efficient for the US to export natural gas, once the requisite infrastructure is in place.

Prices tell the story.  There is a a yawning gap between prices in Europe and Asia, and prices in the US.  Price signals are screaming: invest in export infrastructure, and export gas.

But politicians are deaf to basic economics, and to policies that promote efficiency.  They listen to the importuning of organized interests, and these interests are often diametrically opposed to economic efficiency.

Natural gas is a case in point.  Rep. Ed Markey (D-MA) has long been beating the drum to restrict natural gas exports.  And now he has company, Senator Ron Wyden (D-OR):

New discoveries of natural gas are beginning to transform the U.S. economy, and energy companies say exporting it is the next logical step. But a call for restraint is coming from Sen. Ron Wyden.

The Oregon Democrat, who will have a powerful perch in Congress to influence the debate, has been fielding substantial home-state opposition to such exports. The brewing fight illustrates how energy abundance can be just as divisive in Washington as a shortage, a theme likely to play out in coming years as the U.S. deals with growing energy supplies.

. . . .

Hours after the report came out, Mr. Wyden was sitting at Bistro Cacao, a French restaurant a few blocks from the Capitol, with Andrew Liveris, chief executive of Dow Chemical Co.,  one of the largest natural-gas-consuming companies in the U.S.

. . . .

“I want to make sure we look for the opportunities…to the greatest extent possible, to export value-added products rather than the raw material,” the senator said in a recent interview.

“Natural gas is a strategic American advantage,” he added. “We’ve got it. The whole world wants it.”

And the market is the best way to determine the most efficient way to exploit that advantage. But Sen. Wyden, thinks he is Goldilocks, and knows the price that is just right:

That is one reason Mr. Wyden hasn’t proposed an outright energy export ban. Instead, he suggests softer restrictions such as a cap. “How can policy makers look to find a sweet spot where you can allow exports to keep wells in production without letting exports drive prices so high that they hurt the American manufacturers?” he said.

This is an illustration of the Peltzman-Becker theory of regulation in action.  Politicians buy political support by balancing between competing interests.  Wyden is trying to buy support from domestic gas consumers by proposing to restrict exports, thereby keeping prices lower.  But he doesn’t want prices too low, because that would lead to fierce opposition from energy producers.  So he is looking for “softer restrictions.” He wants to take, but not too much.

How generous of him.  But it’s not generosity, really.  It is the logic of the stationary bandit, and the optimizing politician balancing support and opposition.

Distributive effects drive politics and regulation, not efficiency.  Efficiency is not irrelevant, because politicians like to have a bigger pie to divvy out, but they are willing to incur substantial efficiency penalties in order to achieve distributive goals.  Here, Wyden is proposing to deliver a big gift to Dow and other chemical producers (and other major industrial consumers of gas).  But for every dollar Dow gets, somebody else loses a dollar, and crucially, some cents are destroyed.  There will be deadweight losses.   Too little gas will be produced.  Too little gas will be exported.  Too much will be consumed domestically.

This is just one example of how politics and regulation destroys wealth.  Multiply this thousands of time over, in just about every good and service you can think of.  Everything from haircuts to energy to medicine.  These things kill income and growth, by a thousand cuts.

The amazing-and disturbing-thing about the Wyden article is the very matter-of-fact treatment Wyden’s threatened intervention gets in the article.  It’s the natural order of things that a senator can just arrogate to himself the power to shift around billions at a whim.

And the whim part is important.  Any investment, and plan, is vulnerable to the whims of politicians looking to redistribute wealth to favored interests.  You do something that creates a substantial amount of wealth, you attract those who believe it is their God given right to redistribute it.  In essence, politicians have an option on innovation and the fruits of hard work: tails you lose, heads you share .   This uncertainty, this risk, and the innovators’ short option position are drags on investment and hence growth.  Moreover, management of this risk involves the direction of valuable resources-including the time of top management-into rent seeking activities.  More waste, another drag on growth.

All the yammering over the “fiscal cliff” is a distraction, a near irrelevance.  All the fear mongering is predicated on Keynesian mumbo jumbo, so it will be more of a pothole than a cliff.  The real threat is the accumulation of interventions like those that Wyden is proposing, that collectively serve to reduce wealth and income, and sap growth.   That is the real cliff we have to worry about.  All of the budgetary and fiscal issues become far more more intractable, the lower is growth.   The sclerosis that results from the overbearing interventions in matters large and small will make a fiscal crisis far more likely, because our ability to create wealth will not be able to accommodate the insatiable demands of the entitlement state.

I laughed out loud, and very hard, watching this video (from RT, no less, though via Tabb Group) about HFT.  It is an interview with David Greenberg, who spent 25 years trading CL on the floor of the NYMEX.

What made me laugh?  The part (starting around the 1:30 mark) where Greenberg notes that when public news comes out, HFT traders pull their quotes “in nanoseconds.”  But back on the floor, there would be brokers who would be quoting customer limit orders, and “before his clerk could grab him on his neck, I could go ‘SOLD!'”

Let me translate.  Floor traders had a speed advantage over customers off the floor who were trading by limit order.  When market-moving news came out, floor traders like Greenberg could exploit their speed advantage, and trade against stale customer limit orders that were entered before the information was released. In so doing, the locals, due to their time-and-space advantage, took money from customers.

Yeah, it didn’t happen in a nanosecond, but that doesn’t mean jack.  What matters is that even on the floor, the faster took money from the slower: seconds, nanoseconds, whatever.  This was true in 1990, 1890, and hell, in 1790 or 1690 in the Osaka rice market.  Locals on the floor had a speed advantage over those off the floor, which they exploited ruthlessly .  And this inevitably resulted in wider markets, as off-floor traders quoted wider spreads precisely because of their vulnerability to being picked off.

Not to go all Einstein on you (as if), but speed is relative.  The stale quote problem is not a function of the absolute speed with which some traders can react, but the relative speed.  Humanoid locals in the pit were pitifully slow, compared to robot traders-especially customers who had to play telephone (literally) to yank their orders.  But that doesn’t mean that predatory trading-taking advantage of the slowest gnu in the herd-was less severe on the floor than in an electronic market.  What drives the losses from stale quotes is relative speed.  And I would argue that relative speed differences were even greater in the floor days than now.

And what ticks off old-timers like Greenberg is that the easy pickings aren’t there for the taking anymore.  HFT traders, through their tremendous speed, and their ability to scrape numerous sources of electronic information, can pull their quotes in an instant when market-moving news comes out.  They thereby protect themselves from being picked off.

Which is precisely why they can quote very tight markets.  And which is precisely why guys like Greenberg hate them.  They have ruined a total racket.  How dare they?!?!

Greenberg also talks about how in the floor days prices would move in stages to a new level after information was released.  Now the movement is much faster.  That’s bad how, exactly?

One could argue that if HFT completely withdraw their quotes, that the market will overshoot.  Prices move a lot because HFT traders totally pull their quotes.   Once the information has been digested, they quote again, and presumably the new quote level is between the pre-information release price and the quote/price immediately following the pulling of HFT quotes.

This has a testable prediction: price reversals should be larger in electronic markets than floor markets.  Or to refine the test: price reversals in the aftermath of big price moves (in response to the release of particularly salient information) should be bigger in electronic than floor markets.  To refine the test: the magnitude of price reversals should vary directly with the prevalence of HFT.

This all brings to mind two conversations, held more than 10 years apart, with a legendary trader.  A guy who made 100s of millions of dollars.  In about 2000, this trader told me he was ecstatic about the advent of electronic trading because he was “tired of getting raped by the floor.”  (Exact quote.)  In 2012, he was lamenting the advent of electronic trading because he couldn’t keep up with HFT.

Keep this in mind when you hear laments about HFT, especially from market veterans.  It’s all about whose gnu is gored, or about how the gnus have become so fast that it’s hard to gore them anymore.

A paper on HFT by Baron, Brogaard and Kirilenko is attracting a lot of attention.  They provide shocking evidence: HFT traders make money.  Who knew?

What is garnering the most attention is their analysis of profit by counterparty.  For instance, Bart Chilton was shocked to find that passive HFT traders earned a $5 per contract profit on average when trading with small traders.

The numbers are interesting and all very nice, but the interpretation is far more equivocal than the authors-and HFT critics like Chilton-would have you believe.

One issue is “how big is big?” or “big compared to what?”  Is the per contract profit supposed to be zero?

The paper reports eye-popping Sharp ratios, which suggests that HFT earns abnormal profits.  But great caution is required.  This Sharp ratio only takes into account the authors’ estimate of the capital required to support the HFT positions: given the rapid mean reversion of positions (especially for “passive” HFTs), this capital can be quite modest.  But HFT also requires a substantial investment in systems, software and human capital.  And data! A huge cost.  Arguably the trading capital is the smallest portion of the capital required to setup an HFT and keep it running.  Leaving those investments out of a Sharp ratio calculation renders the number utterly meaningless.  The fact that these are numbers from a single market and HFT traders usually trade in many markets also makes it impossible to know what the profitability of HFT firms is.

Indeed, given that there is free entry into HFT, why wouldn’t we expect the marginal entrant to just earn the market rate of return on all capital employed?  If a study that takes all the relevant costs and investments into account finds that the marginal HFT trader earns abnormal returns, the appropriate response would be to identify  the source of the entry barrier that gives rise to this rent, and attack that.

Another issue of interpretation relates to defining the but-for.  That is, what is the alternative to which HFT is being compared?  An electronic market without HFT?  Floor markets?  Consider the latter.  There is no doubt that floor traders-locals-reaped profits in the same way as the HFT traders in the Baron et al analysis.  Some were “passive”-quoting bids and asks, and supplying liquidity and trading against order flow.  Others were “active”-speculating on price movements, and always alive to picking off stale limit customer limit orders.   Some did both.  Given that the per contract profits reported in the Baron et al paper are fractions of a tick, it’s almost certain that floor traders earned profits as large or larger than they report for HFT, particularly if you leave out important cost/capital components (e.g., the opportunity cost of a seat).

When it comes to floor trading, we know that the marginal trader was earning a rent.  Know as in metaphysically certain.  How do we know that: seat prices were positive, and frequently very large. (A paper I published in 1999 shows that Q-ratios for exchanges calculated using seat prices were astronomical.  This provides clear evidence of rents.)  The seat price is the capitalized value of the abnormal profits earned by the marginal floor trader.  And we know the entry barrier that gave rise to these abnormal profits: exchange limitations on the number of memberships.

So that would be an interesting comparison.  The (appropriately calculated) profit of the marginal HFT firm vs. the marginal profit of floor traders (as measured using seat prices).

The paper also reports substantial skewness in the profitability in HFT.  But there was substantial skewness in profit on the floor too.  The Tom Baldwins and Harris Brumfelds made huge money, a lot of other traders did quite well, and a very large fraction-arguably a majority-were on breaking even and at risk of getting blown out.    And this isn’t a recent phenomenon.  In the 19th and early 20th centuries, titans like Old Hutch made substantially more money than the run of the mill pit trader.

Which brings me back to my constant refrain: what’s really all that different about HFT?  The functions and behaviors of market participants are pretty much static.  We have uninformed traders and informed traders.  We have liquidity suppliers and liquidity demanders.  We have opportunistic traders looking to take advantage of a time-and-space advantage, and the ability to respond sooner than others (thereby profiting at the expense of the slow).  The functions haven’t changed: just the technology for carrying out those functions has changed.

I’d wager that an analysis based on exchange street books from the floor days (which report price, volume, and trader type by CTI indicator) would produce very similar results to the HFT study’s, although the inability to observe the bid-ask on the floor makes it difficult or impossible to break down members trading on their own account (CTI1s) into “active” and “passive” categories in the same way Baron et al do.  I am highly confident that such a study would find that: CTI1s made per contract profits as large or larger than HFT traders; CTI1s profited primarily in trades with CTI4s (customers), and that there was variation in the per contract profit depending on whether the CTI4 was big or small; that floor trader Sharp ratios based only on the capital required to support their positions would be very large; and that there was substantial skewness in the profitability of CTI1s.

Perhaps the most interesting aspect of the study is the distinction between aggressive and passive HFT traders.  It is very hard to criticize passive HFT, because they are clearly providing liquidity (although no doubt Bart will find bad things to say).  The activities of aggressive HFT-HFT firms that are almost always hitting bids and lifting offers-could well be less salutary and perhaps inefficient.

Aggressive firms could be creating adverse selection.  One aggressive strategy could be to invest substantial real resources into scooping up huge amounts of public data, analyzing it faster than anybody else, and trading faster on it than anybody else when they recognize that quotes don’t reflect the information.  Some of this information could be obtained by scraping news and social media sites.  Some of it could be generated by statistical arbitrage: analyzing vast quantities of data to identify pricing relationships across multiple instruments; identifying times when prevailing quotes across these markets deviate from these relationships; and buying cheap and selling rich when such deviations are found.  To the extent quote submitters-including passive HFT firms-do not have this information, the aggressive firms will be better informed, profit at the expense of quote setters, and thereby cause liquidity suppliers to widen their quotes.

If that’s all there is to it, aggressive HFT would be inefficient.  Real resources are devoted to earning a rent, and this rent seeking distorts prices (notably the price of liquidity), thereby inducing others trading for risk-related reasons to trade too little.

But price discovery is the flip side of adverse selection.  Informed trading drives the price discovery process.  The question becomes what is the value of the price discovery provided by aggressive HFT.  Impossible to answer quantitatively.  I would surmise that the conventional wisdom is that the value is small.  Why do we need to have prices adjust by a fraction of a cent to reflect information a fraction of a second sooner?  What real decision (e.g., investment decision, planting decision) is going to change if a price embeds slightly more information a blink of an eye sooner?  I am similarly skeptical about the value of speeding up price discovery, and therefore am quite willing to accept that some aggressive HFT is opportunistic rent seeking, and hence inefficient.

But even granting that, what are you going to do about it?  Is there a way of restricting rent seeking HFT that does not also burden beneficial HFT, for instance by imposing costs on passive HFTs that supply liquidity?

It’s not obvious that there are discriminating ways of pricing trading services in ways that reduce opportunistic trading without also reducing liquidity supply and trading for risk shifting reasons.  Tinkering with maker-taker fee structures, or tinkering with price schedules more generally seems to be the most sensible way to do it.  The question becomes: who should do the tinkering?  Exchanges presumably have the strongest incentives to drive out the opportunistic wolves that feed on the sheep, and the best information to do it.  I therefore don’t see a strong case for external regulation intended to reduce rent seeking HFT.  Let the exchanges handle it.

It is obvious that some of the regulations that have been proposed would make things far worse, rather than better.  Time-in-force rules are probably the best-or worst-example of that.  Requiring quote submitters-including passive HFT firms-to keep quotes in force for some minimum time period makes them incredibly vulnerable to the opportunistic HFT firms.  The aggressive HFT firms feed off of quotes that aren’t adjusted to reflect the information they produce by stat arb or whatever.  Time-in-force rules make it harder to adjust quotes, giving more targets of opportunity to aggressive HFT traders.  Prediction: TIF rules will increase aggressive HFT trading; reduce passive HFT trading; lead to aggressive HFT representing a higher proportion of HFT overall; and lead to wider spreads.

And ironically, these effects will increase the profits HFT firms earn at the expense of non-HFT traders. So, Bart: if you think the profits that HFT earns off the little guys are unconscionable now, be careful what you ask for.  Some of the restrictions on the “cheetah traders” that you advocate will make those profits even more unconscionable.

Put differently: Time-in-force rules don’t constrain aggressive traders who are taking quotes instead of making them.  They only constrain those making quotes and thereby make them vulnerable to the takers.  This makes sense how, exactly?

In almost any human endeavor, there is opportunism and rent seeking and inefficient behavior that goes on side-by-side with beneficial, wealth increasing conduct.  We don’t have the information or sufficiently discriminating and cheap deterrents to eliminate bad conduct altogether.

When it comes to any financial trading-old school floor trading or HFT-dominated electronic trading-rent seeking trading will occur.  When evaluating HFT generally, and restrictions on HFT that do not discriminate between the virtuous and vicious forms of the activity, you have to take the good with the bad and see which predominates.  The vast bulk of the existing empirical evidence shows that HFT is associated with better market quality in terms of spreads and depth.  So even though some HFT is almost certainly predatory, the effects of the predatory trading are more than offset by the efficient, wealth-increasing kinds.   Indiscriminate regulations that constrain both types of HFT are therefore highly objectionable.  Not a good idea to shoot a prize bull in the head because it has a parasite that available drugs won’t kill.  But that’s what those who get all hot and bothered about aggressive-and arguably parasitical-HFT threaten to do with indiscriminate regulations that would impede all HFT.

The SEC would have totally nailed them.  Totally.

The absurdity is so obvious no further comment is required.  Bureaucracy in action, or inaction as the case may be.

I’m sure you would never peg me as a green type, but I have decided to join the recycling movement!

I am doing so in response to the call by Barney Frank (the Frank of Frankendodd) to merge the SEC and the CFTC.  This idea has itself been recycled many times, dating back to the 1980s and the birth of stock index futures.

One of the recycling efforts was by Hank Paulson, in the spring of 2008, in his proposal to reform the financial markets.  A centerpiece of this proposal was the org chart shuffling.  What I said then holds true today, so I’ll conserve scarce resources (mainly my time), and merely recycle:

The biggest headline was that the recommendation for the merger of the SEC and the CFTC. This puts in me in mind of two quotes. The first is by Churchill: “A fanatic is one who can’t change his mind and won’t change the subject.” Whenever anything happens in the financial markets, the cry immediately goes up to merge the SEC and the CFTC. Many people are apparently fanatical, because they never change about their minds about the desirability of the merger, and the subject always seems to return to it.

The second quote is by somebody slightly–well, a lot actually–less famous; that would be me. In a 2001 Regulation Magazine piece on the Clinton regulatory legacy, I wrote that the SEC-CFTC combination was a solution in search of a problem.

I am always somewhat mystified by the substance of the arguments for the merger. The most commonly mentioned benefit is a harmonization of margins between stocks and stock index futures. What, it’s not possible to harmonize without going merging the two bodies? Moreover, given the myriad other more important issues facing the two agencies, this seems like a very thin reed on which to rest a major reshaping of the regulatory structure.

In reality, there is very little overlap between the regulatory responsibilities of the two agencies. What’s more, there are huge swathes of the trading landscape that fall outside the jurisdiction of either agency. So merger will hardly reduce that much duplicative or contradictory regulation, and will not fill any regulatory gaps. So what’s the point?

Indeed, there are many sources of potential danger in a merger. One, very underappreciated in my view, is that it sacrifices the advantages of specialization. There are issues unique to securities markets and derivatives markets. Specialized agencies can develop the expertise needed for each market space. Of course the staff at a merged agency could specialize, but major policy, rulemaking, and interpretive decisions are made at the commissioner level. Right now SEC commissioners, for example, need to deal with arcane issues of accounting, disclosure, securities intermediation, and securities trading practices in stock, option, and fixed income markets. This is an already daunting task. Adding new areas of responsibility involving different markets and different instruments with different issues will further tax the already limited expertise of the commissioners of the merged agency.

The inevitable outcome of this dilution of expertise and specialization will be to enhance the power of staff, and degrade the quality of commission decision making. Neither outcome is desirable.

Indeed, I would argue that the SEC is already underspecialized. The agency operates subject to three statutes, the Securities Act of 1933, the Exchange Act of 1934, which focus on primary and secondary markets for securities, respectively; and the Investment Company Act of 1940, which focuses on mutual funds and the like. The agency has responsibility over the issuers of securities, and the markets and intermediaries that trade securities. There is little overlap between these areas. Issues of disclosure and accounting can be conceptually and operationally distinguished from issues of market structure and organization.

A second area of concern is that a unified agency will provide a mechanism to reduce and distort competition between different sectors of the financial markets. There are many on Wall Street that would love to throttle the futures exchanges in order to reduce competition for the securities business. (The margin issue is a perfect example of this. The securities firms would love to force an increase in margins on futures to drive some business from the futures exchanges to the stock market.) The regulatory autonomy of the CFTC has largely precluded such an outcome. The SEC has indeed tried in the past to impede the development and introduction of futures products that compete closely with securities markets but has largely failed in these endeavors because it does not have the necessary authority or jurisdiction.

Now, of course, a merger would change agency politics. Under the current framework, the SEC is largely responsive to securities firms and exchanges, and the CFTC is responsive to the futures exchanges and the FCMs. A merged entity would be responsive to the interests of all of these parties. But that is not necessarily a good thing, as one very likely outcome is that the merged entity would implement regulations that would reduce competition between the varying constituencies.

A more sensible, but still problematic, regulatory reorganization would involve (1) stripping out the primary market, accounting, and disclosure responsibilities from the SEC and putting them in a separate agency focusing on these corporate finance issues, and (2) creating a separate agency responsible for trading and market structure issues in securities and derivatives markets. This second agency, call it the “Commission for Financial Trading and Markets” (“CFTM”) would focus on issues relating to manipulation; fraud; the financial adequacy of intermediaries (securities and derivatives brokerages); and facilitating competitive market structures in financial markets. Arguably the manipulation, fraud and competition responsibilities should give the CFTM some authority in the OTC markets.

This approach would be far preferable to mashing together two disparate agencies with very different histories and cultures in the hope that something beneficial will come out of the unnatural coupling. It would permit the development of some specialization, and many issues of fraud, manipulation, and market structure are common across securities and derivatives markets, so the specialization could be applied to a variety of related markets. This alternative is still problematic, however, because the CFTM could easily become a mechanism for stifling competition between different methods of allocating risks and discovering prices.

All that said, there is little likelihood that the merger (or the creation of a CFTM) will come to pass in any event. The idea has been around for decades, and has never even come close to implementation. This is no surprise. There are powerful political forces in the way. Most notably, the futures exchanges, their members, and the FCMs have fought the SEC’s loving embrace vociferously, and found vocal support in Congress. Moreover, whereas the SEC falls under the congressional banking committees (e.g., the Senate Banking Committee and the Securities, Insurance and Investment Subcomittee), the CFTC is under the ag committees. Neither is about to readily cede jurisdiction over a large, well-heeled, and generous industry.

What he, er I, said.

Expecting miracles from mashing together org charts is insane.  At best, it has no effect.  The more likely outcome is to make things worse.  (Want an example?  Look at the effects of the reorganization of the intelligence community post-911.)   The point about specialization is particularly apposite, IMO (naturally, since I brought it up!)  The five commissioners of the CFTC and the five commissioners of the SEC are already overwhelmed by their complex responsibilities, and can devote relatively little time to becoming expert in any one particular area.  Extending the scope of the commissioners’ responsibilities is supposed to make that problem better?

In the end, nothing is likely to happen.  This is a lame duck kerfuffle.  The people who will have skin in the game in the next Congress will want nothing to do with this, as has been the case for about the last 15 Congresses.

November saw a mini-drama involving the CME, CFTC, and DTCC about the issue of SDRs.  (Acronym overload!)  SDRs being Swap Data Repositories, a spawn of Frankendodd-arguably the only good thing in the Title VII litter.

CME had filed to become an SDR, and wanted to require anyone who cleared swaps through CME to report the trade to its SDR.  The CFTC didn’t like the idea of tying clearing and reporting, and held things up: it had stated that the choice of SDR should be up to the customer.  So CME sued.  DTCC-which has its own SDR and would benefit if some CME swap deals were reported to it-filed as an intervenor in the suit.

Lo and behold, the CFTC approved the CME application, including the provision that tied clearing and reporting.  CME dropped its suit, and DTCC is stomping its little feet:

“The Commission’s action late yesterday was an unexplained and an abrupt reversal of course,” the DTCC, which runs a rival swaps data repository, said in a statement.

“This action is inconsistent with the Commission’s previous actions, and will cause market participants to question the finality of any Commission rule or interpretation.”

Two comments.

First, issues of tying and vertical integration are cropping up all over in trading and exchanges.  I just presented a paper at a conference honoring Oliver Williamson that looks at vertical integration between execution and clearing and settlement.  But the issues are also present in things like data centers and reporting and likely will be present in any service exchanges offer.  Regulators are hostile to these sorts of arrangements.  The lesson of my paper is that there can be-and in my view, typically are-good, transactions cost economics-based reasons for these sorts of vertical arrangements.  Regulators should take a deep dive into TCE and learn something about the potential benefits of vertical restrictions or vertical integration rather than continuing to indulge in their reflexive hostility to it.  What’s the transaction at issue?  What are the potential contractual hazards?  Are the contracting and governance methods chosen to implement the transaction well-adapted to the contracting hazards?

IOW, as if (40 plus years after Coase made an observation on the subject) it is rather astounding that regulators look at every vertical restriction with a jaundiced eye.

Second, in some respects this is like Groundhog Day for me.  I’ve seen this before.  I came across a similar controversy in my failed attempt to create a predecessor to SDRs-an “energy data hub”-back in 2003.  It was obvious then, and is obvious now, that there are substantial scale and scope economies in creating and operating an SDR, and that an SDR is a natural, multi-product monopoly.  It is highly likely that the efficient form of organization would be an industry utility/cooperative, likely a non-profit.

But as I experienced in ’03, industry players see this as a great commercial opportunity, and there is intense competition to establish for-profit data hubs and regulators will not mandate the creation of a single hub or pick a winner.  Hence, it is likely that in the end, in each jurisdiction there will be one dominant hub that could be quite lucrative.  Hence the intense competition to be the winner in a winner-take-all contest.  This competition is typically dissipative.  Moreover, if multiple SDRs do survive (because, for instance, the firms play some sort of oligopoly pricing game), there will be excessive costs due to incomplete exploitation of scale and scope economies (i.e., fragmentation is costly).

Which all means that although mandatory reporting to a data hub/SDR is a good idea, as a result of political economy considerations it will be implemented in a highly inefficient way.

Go figure.