Streetwise Professor

The FT reports a huge boom in rail in the Midcontinent, with oil shipments from the Bakken driving this growth.  And who is capturing the bulk of this traffic?

The exports have helped North Dakota become the second-biggest oil producing US state, behind only Texas. Customers of BNSF, the railway that handles 44 per cent of the region’s oil exports, have built terminals on its routes through the region capable of handling 1m barrels of oil a day.

. . . .

Mr Smith says BNSF should retain between 25 and 37 per cent of the Bakken Shale’s export market once pipelines arrive, and when the field is fully developed, that should provide more traffic than its current 44 per cent market share.

“As long as we can provide transportation services to markets that pay better than [the market served by] the pipeline, we’re going to maintain and retain our market share,” Mr Smith says.

And who owns BNSF?  Berkshire Hathaway, of course.

I’m sure that’s totally immaterial to the government’s failure to approve the building of the northern piece of the Keystone XL pipeline.

Speaking of Buffett, his most famous utterance is about derivatives being financial weapons of mass destruction.  That quote is recycled over and over and over again when anyone wants to warn about the dangers of derivatives.

But Buffett doesn’t take his own advice.  In 2007-well after his FWMD quote-Berkshire sold credit protection on municipal bonds.  $8.25 billion in notional, to be exact.  He exited that trade last month, but remember it whenever Buffett’s quote is used.  Also remember his big sale of S&P 500 put options right before the crisis.

It’s not as if I’m shocked that multi-billionaires are out to make money, and will use a variety of means (e.g., influencing government policy to benefit an investment from competition, taking risks that they damn in public-perhaps thereby scaring off competition, cornering markets) to make it.  Just saying don’t fall for the folksy shtick, and think that Buffett is a better brand of billionaire.

According to this Greg Meyer piece in the FT, Barclays estimates that $6 billion have flowed out of commodity index investments in 2012, and that many institutional investors are reducing exposure to commodities.

The anti-speculation frenzy that reached a peak in 2008, but has never gone away, is predicated on the belief that index investing-“massive passives” in the words of CFTC Commissioner Bart Chilton-exert a disproportionate influence on prices.  So, this outflow of indexing money should have led to a decline in commodity prices right?  But they have been up over 2012: one broad index, the UBS Bloomberg CMCI is up from 1520 at the end of 2011 to 1628 today, about a 7 percent increase.

But the anti-speculation folks have their story, and they’re sticking with it.  Sayeth Dennis Kelleher of “Better Markets”, “There’s excessive speculation in commodity markets which is driving up prices.”  QED.

Evidence? We don’t need no steekin’ evidence.

Ironically, I am in NY to speak at the CME Group’s First Annual Global Commodity Investment Roundtable, an event aimed precisely at fund managers, where I will be on a panel discussing the role of speculation.  Greg’s article tees that up very nicely.

Bloomberg’s Brad Keoun has out a long piece today highlighting the risks of collateral transformation, a development driven by Frankendodd’s clearing and collateral mandates:

Starting next year, new rules designed to prevent another meltdown will force traders to post U.S. Treasury bonds or other top-rated holdings to guarantee more of their bets. The change takes effect as the $10.8 trillion market for Treasuries is already stretched thin by banks rebuilding balance sheets and investors seeking safety, leaving fewer bonds available to backstop the $648 trillion derivatives market.

The solution: At least seven banks plan to let customers swap lower-rated securities that don’t meet standards in return for a loan of Treasuries or similar holdings that do qualify, a process dubbed “collateral transformation.” That’s raising concerns among investors, bank executives and academics that measures intended to avert risk are hiding it instead.

Keoun quotes Darrell Duffie and Anat Admati raising concerns about the systemic risk that collateral transformation creates.  And bully for them, because they’re right.  As I pointed out in this post from July, 2011, and in several others in the months since (as well as in a paper in the J. Applied Corporate Finance.)  Anat argues that clearing and collateral mandates are resulting in the shifting of risk, rather than its reduction as promised by Frank ‘N Dodd and Gigi and Timmy!:

The banks’ new lending business “smells like trouble,” said Anat Admati, a finance and economics professor at Stanford who studies markets and trading and advises bank regulators on systemically important firms.

“The point of the initiatives on derivatives was that derivatives can hide a lot of risk,” Admati said. “Now they’re going to just shuffle the risk around.”

I wrote that mandates would result in a substitution of new forms of credit exposure and leverage for the credit exposures and leverage eliminated from derivatives via collateral in this July, 2010 Cato Policy Analysis (see especially p. 25).

So although these consequences were unintended, they were foreseeable and foreseen.

But even though these developments have been in train for months, and although they are pregnant with systemic significance, regulators are ignorant of the potential risks.  In the most shocking but not really part of his piece, Keoun writes:

U.S. regulators implementing the rules haven’t said how the collateral demands for derivatives trades will be met. Nor have they run their own analyses of risks that might be created by the banks’ bond-lending programs, people with knowledge of the matter said. Steve Adamske, a spokesman for the U.S. Commodity Futures Trading Commission, and Barbara Hagenbaugh at the Federal Reserve declined to comment. [Emphasis added.]

But Congress and the regulators pinky swore that Frankendodd would make the system safer!  Trust us on this, they said.  We know what we’re doing!

Uhm, I don’t even think they slept in a Holiday Inn Express before taking on the wholesale reshaping of the vast derivatives markets.

Gensler and Geithner are particularly culpable here, because both pronounced repeatedly that Frankendodd, and specifically its collateral and clearing mandates, would reduce the interconnectivity of major financial institutions.

Not exactly.  Out with the old, in with the new: new interconnections, and arguably more fragile ones, are being forged to replace the old ones.  Again, predictable and predicted.

And they continue to assure the world that Frankendodd has made the world safer-even though the analysis necessary to support that claim has not even been done.

Think about it.  It is widely recognized that shadow banking, including quite specifically repo, was a major source of systemic risk that contributed to the severity of the financial crisis.  Collateral and clearing mandates have essentially resulted in the development of a new form of shadow banking.

This is an improvement?  Maybe it is.  But inasmuch as key regulators haven’t even acknowledged the development, and haven’t analyzed its systemic consequences, their pronouncements are not credible.

And make no mistake: this will not be the last big unintended consequence of Frankendodd that will tend to undermine the intent of the act.  And take fair warning: regulators are likely to be well behind the curve in understanding and reacting to these consequences.  Meaning that, to paraphrase Anat Admati, the systemic risk hasn’t gone away, it’s just been shuffled around.  That includes, mind you, the systemic risk resulting from the regulations and the regulators.

I’ve written about there being good HFT and bad HFT; HFT that enhances liquidity, and HFT that is predatory and attempts to exploit liquidity demanders (especially large traders).  Moreover, algorithmic trading (which may or may not be HFT, properly speaking) can potentially disrupt markets (e.g., the Knight Capital fiasco some weeks ago).

The question is: whatcha gonna do about the bad?  The knee-jerk response of many is to demand greater government regulation.  I have pointed out repeatedly, however, that this is an area where self-regulation is highly likely to be more efficient.  In particular, exchanges and other trading platforms have an incentive to design pricing structures and rules so as to reduce predatory trading, by HFT shops and others.  Predatory trading increases other market users’ trading costs, which reduces the derived demand for exchange services, thereby reducing the price the exchange can charge and the quantity of trading done on it.  Similarly, exchanges are hurt by disruptions caused by bad algos.

I’ve written a few posts on exchanges that have introduced pricing policies (e.g., charging high prices for “excessive” cancellations) with the specific purpose of reducing opportunistic trading.

Here is another example, this time from Forex:

Foreign exchange brokers are backing a series of changes unveiled by EBS, the world’s largest currency platform, designed to discourage predatory practices by high-frequency traders.

EBS, owned by interdealer broker ICAP, plans to widen the price spreads on its platform, raise targets on quote-to-buy ratios and set new quoting guidelines for Asian markets to discourage investors who exploit delays in technology to make money.

. . . .

Mr Mandelzis said that, while the changes were technical, they were aimed at encouraging genuine liquidity and discouraging disruptive behaviour, such as arbitraging prices.

With respect to dealing with the risk of runaway algos, CME and NYSE LIFFE are installing a kill switch functionality that permits FCMs to halt or limit trading activity by a malfunctioning algo:

Futures commissions merchants will be able to halt or limit trading activity at high speed on CME, operator of the world’s biggest futures exchange, and NYSE Liffe, one of the Europe’s dominant futures and options markets, if a computer begins to malfunction or a customer breaches risk limits.

Exchanges have an incentive to get these decisions right: they lose business if they basically provide hunting grounds for predatory HFTs or are unduly vulnerable to runaway algos.  Exchanges also have the information: they can observe what goes on on their systems, see who does what, and get feedback from customers.  Exchanges have a broad array of tools-outright bans on certain practices, and discriminating pricing policies. Exchanges are also able to move unilaterally and quickly.  In contrast, regulators have low powered incentives; poorer information; typically have blunt tools; and are less able to respond quickly and flexibly.  This is a clear case where self-regulation has advantages over government regulation.

This is particularly true in derivatives markets, where single platforms dominate a particular instrument.  Things may be more complex in equities, due to the potential spillovers across fragmented trading platforms.  But even there, the spillovers may be salutary.  A trading platform that clamps down (through pricing, for instance) on predatory arbs may push them to other platforms, but that just increases the incentive of those platforms to take action.  Moreover, different platforms have an incentive to compete to attract legitimate liquidity suppliers and liquidity demanders (especially the latter, since they are the ones that pay the freight), which means they have an incentive to compete to devise pricing schemes that penalize the predatory.

In brief, the task of reducing predatory computerized trading strategies should be left primarily to exchanges.  Predation will not disappear: it is almost never efficient to eliminate opportunistic/predatory conduct completely (because this would be too costly, primarily due to the fact that eliminating predatory conduct would almost certainly reduce some beneficial conduct), but exchanges have the strongest incentive, the best information, the most discriminating tools, and the greatest flexibility.  There will be an arms race between exchanges and predatory traders, but there would also be an arms race between government regulators and such traders.  Exchanges can run the race more efficiently and effectively.  Leave it up to them.

Reuters has a story in which several prominent economists lament the alleged Republican threat to Fed independence:

Increasing political encroachment on the Federal Reserve, particularly from the Republican Party, could threaten the central bank’s hard-won independence and undermine confidence in the nearly 100-year old institution.

That was the pervasive sentiment among economists gathered at the Fed’s annual monetary policy symposium in Jackson Hole, Wyoming. Against the dramatic backdrop of the Grand Teton mountain, many said a closely-contested presidential race has turned the monetary authority into a political football.

“I do fear for it a bit if the election comes out that way, especially if some of the more radical voices, that happen to be Republican voices nowadays, get reelected,” said Alan Blinder, Princeton economics professor and a former Fed vice chairman, adding that historically opposition to the U.S. central bank had come predominately from the left.

“Independence” is something of a red herring.  The key issue is the scope of the Fed’s discretion in which it can exert its independence.  And as John Cochrane notes in the WSJ, the Fed has greatly expanded its activities:

Momentous changes are under way in what central banks are and what they do. We are used to thinking that central banks’ main task is to guide the economy by setting interest rates. Central banks’ main tools used to be “open-market” operations, i.e. purchasing short-term Treasury debt, and short-term lending to banks.

Since the 2008 financial crisis, however, the Federal Reserve has intervened in a wide variety of markets, including commercial paper, mortgages and long-term Treasury debt. At the height of the crisis, the Fed lent directly to teetering nonbank institutions, such as insurance giant AIG, and participated in several shotgun marriages, most notably between Bank of America and Merrill Lynch.

These “nontraditional” interventions are not going away anytime soon. Many Fed officials, including Fed Chairman Ben Bernanke, see “credit constraints” and “segmented markets” throughout the economy, which the Fed’s standard tools don’t address. Moreover, interest rates near zero have rendered those tools nearly powerless, so the Fed will naturally search for bigger guns. In his speech Friday in Jackson Hole, Wyo., Mr. Bernanke made it clear that “we should not rule out the further use of such [nontraditional] policies if economic conditions warrant.”

But the Fed has crossed a bright line. Open-market operations do not have direct fiscal consequences, or directly allocate credit. That was the price of the Fed’s independence, allowing it to do one thing—conduct monetary policy—without short-term political pressure. But an agency that allocates credit to specific markets and institutions, or buys assets that expose taxpayers to risks, cannot stay independent of elected, and accountable, officials.

As Cochrane notes, it is utterly impossible for any entity to undertake such breathtakingly broad responsibilities without engendering a political reaction.

And can you really think that it is a good idea to have an institution exercise such incredible power without accountability?  The Fed, like any human institution, is fallible.  Look at the Great Depression.  Look at the 1970s stagflation.  Big mistakes that led to huge adverse consequences.

Yes, perhaps the Fed has learned from its past mistakes-but the markets have become much more complex too, and the Fed is dealing with different problems.  It is now going where no central bank has gone before: can you be confident that it is not going to commit new mistakes when dealing with new problems?  And given that its role is more all encompassing than ever, the consequences of such mistakes will be even weightier than ever.

Hayek’s dictum applies with special force to the Fed: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

You also cannot overlook the political economy angle.  Even now, the putatively independent Fed is subject to political pressures, from the White House, from Congress.  Moreover, it is an odd creature.  The regional Fed banks participate in policymaking, and private banks that “own” the regional Federal reserve branches select some of their directors.  In addition to these formal roles in governing the Federal Reserve System, banks also influence its operation in the way that other regulated industries influence their regulators: through the provision of information that the Fed uses to make decisions.  Fed decision making is therefore not Spock-like and disinterested, but human, and subject to interested influence.  Some form of accountability is necessary.

The current controversy over control of the Fed is a natural consequence of understandable fears that the Fed is out of control, and exercising powers that could be misused. The currency doesn’t say “In Ben We Trust.”  Not yet, anyways.

Yes, some of the proposals to rein in the Fed are crackbrained.  But the concerns that motivate these proposals are not crackbrained.  A degree of independence makes sense if that independence is exercised within a relatively well-defined and circumscribed set of responsibilities.  Independence-that is, vast discretion with attenuated accountability-is much more dangerous, and much more ominous, when it is exercised in a much broader realm, and when the Fed has considerable power in asserting its authority in new, unprecedented areas.

Norwegian state oil firm Statoil, which has considerable production in the Bakken, has announced plans to lease 1K railcars to ship oil from ND to refineries throughout eastern North America (h/t Greg L):

Statoil ASA said it is leasing more than 1,000 railroad cars to carry crude oil from fields in North Dakota to refiners across North America, in a bid to overcome pipeline bottlenecks that plague the booming oil-producing region.

The Norwegian oil giant’s railroad effort is a new sign of how the U.S. pipeline network is having a hard time keeping pace with the oil boom triggered by hydraulic fracturing, forcing companies to come up with creative workarounds.

Nowhere is the challenge more apparent than in North Dakota, which this year unseated Alaska as the country’s second-largest oil-producing state. In May the state produced 639,000 barrels per day, or about 10% of the oil produced in the U.S., up from 364,000 barrels per day in May 2011, according to the U.S. Energy Information Administration.

Beginning in early September, the trains that Statoil will have secured with long-term leases will have the capacity to move some 45,000 barrels of crude per day to refiners across North America, more than enough to cover the entirety of the company’s current net production there, company spokesman Ola Morten Aanestad said. Potential destinations include refineries in the East, West and Gulf Coasts and Canada, Mr. Aanestad said.

It would take 14 or 15 days for the trains to make a round trip to Canada, the U.S. East Coast or the Gulf of Mexico, including the loading and unloading of crude, Statoil said. The company didn’t disclose the party it was leasing rail cars from or the price it would pay.

Note what is missing from this story: a mention of the rail carrier that benefits most from all this traffic.  That would be BNSF.  You know, Rail Buffett.

If you don’t believe that fact has anything to do with the Obama administration’s decision to put Keystone XL pipeline running from Canada and the Bakken region to Cushing (and thence to the Gulf) on the regulatory siding, have I got a deal for you!:  Prime oceanfront real estate in the Badlands.

Corruptocrat Jon Corzine is whining about the MF Global Bankruptcy Trustee’s decision to assist customers who lost money as a result of the MFers in their attempts to recoup their losses by suing Corzine and other executives of the firm:

Corzine, along with other current and former MF executives, filed an objection in court on Wednesday arguing that their ability to defend themselves would be hurt if trustee James Giddens is allowed to assign his legal claims to plaintiffs in existing cases.

The executives are defendants in multiple lawsuits accusing them of mismanaging the firm and playing a role in its October 2011 collapse.

“Nothing in the Bankruptcy Code authorizes such limitations on the objectors’ rights and defenses or an enlargement of the trustee’s rights,” lawyers for Corzine and the other executives wrote in documents filed in U.S. Bankruptcy Court in Manhattan.

If allowed to join the customer cases, Giddens would have the right to limit the information and documents available to the executives through discovery, as well as dictate which documents the executives would turn over to plaintiffs, lawyers for Corzine and the other executives wrote.

Sorry.  I’m getting all choked up.   Hard to type through the tears.

JK.  MF him.

It looks like Corzine is going to skate on criminal charges, as in a reversal of usual procedure prosecutors appear to be focusing on low level employees, and not as a way of getting at bigger-and rotten-fish like Corzine.  (I’m sure that he’s a made man in the Democratic Party and a big fundraiser for Obama has absolutely nothing to do with that.)

Given that, one can only hope that he spends a good part of the rest of his life in civil legal torments, and ends up coughing up large sums to the injured customers who he victimized.  For regardless of his culpability in diverting segregated customer funds, his recklessness was the proximate cause of their losses: his ill-judged and ill-designed (i.e., improperly funded) bet on PIIGS debt put the firm in the straits that led someone to consider it necessary to take money that wasn’t the firm’s in a vain attempt to save it.  Moreover, even if he did not give the order to use seg funds, it happened under his watch: the choice is between scienter and negligence.  It still stuns me that a guy who was head of a major clearing firm claimed ignorance of the mechanics of the clearing process.  I guess he was too busy figuring out how to gamble his firm to resurrection.

So encroach away, Mr. Giddens!  Rough justice perhaps, but that’s exactly the kind Corzine deserves.

This article from Der Speigel is a fascinating article on many levels.  It describes how an environmental mandate-the German mandate to increase the power generated from renewables-is wreaking havoc on high tech German manufacturing:

Sudden fluctuations in Germany’s power grid are causing major damage to a number of industrial companies. While many of them have responded by getting their own power generators and regulators to help minimize the risks, they warn that companies might be forced to leave if the government doesn’t deal with the issues fast.

. . . .

Behind this worry stands the transition to renewable energy laid out by Chancellor Angela Merkel last year in the wake of the Fukushima nuclear disaster. Though the transition has been sluggish so far, Merkel set the ambitious goals of boosting renewable energy to 35 percent of total power consumption by 2020 and 80 percent by 2050 while phasing out all of Germany’s nuclear power reactors by 2022.

The problem is that wind and solar farms just don’t deliver the same amount of continuous electricity compared with nuclear and gas-fired power plants. To match traditional energy sources, grid operators must be able to exactly predict how strong the wind will blow or the sun will shine.

But such an exact prediction is difficult. Even when grid operators are off by just a few percentage points, voltage in the grid slackens. That has no affect on normal household appliances, such as vacuum cleaners and coffee machines. But for high-performance computers, for example, outages lasting even just a millisecond can quickly trigger system failures.

One reason the story is interesting is that it demonstrates-as if further demonstration were needed-that regulatory Sorcerer’s Apprentices take (allegedly) well-intentioned actions that have perverse unanticipated consequences.  Here the likely explanation is that said politicians and bureaucrats have a simplistic understanding of the industry they presume to regulate.  They perceive that the output of the power industry has a single dimension-megawatts produced.  They fail to understand that there are other economically crucial dimensions-such as voltage stability-so when they decree that Fraction X of Megawatts Shall Be Generated With Renewables, they fail to understand the implications of this decree for these other vital dimensions.  Meaning that they underestimate the costs of their lofty dictates.  (The electricity industry is particularly vulnerable to unintended consequences from attempts to structure it via legislation, cf. California.  I wrote a book chapter some years back about the difficulties in choosing the balance between the invisible hand and the visible hand in power.  The complexity of the power system, most notably the need to control its operation in real time, raises acute difficulties in relying solely on the invisible hand-the allocation of resources by price and contract-and makes it vulnerable to catastrophic consequences resulting from ill-considered interventions.)

The other source of interest to me is the Coasean aspect of the story.  Rather than a locomotive casting off sparks that sets farmers’ fields alight, here we have power generators producing random fluctuations in voltage that cause very sensitive-and expensive-machines to break down.  So who is liable for this?  That is a growing source of conflict in Germany:

Although the moves being made by companies are helpful, they don’t solve all the problems. It’s still unclear who is liable when emergency measures fail. So far, grid operators have only been required to shoulder up to €5,000 of related company losses. Hydro Aluminum is demanding that its grid operator pay for incidents in excess of that amount. “The damages have already reached such a magnitude that we won’t be able to bear them in the long term,” the company says.

Given the circumstances, Hydro Aluminum is asking the Federal Network Agency, whose responsibilities include regulating the electricity market, to set up a clearing house to mediate conflicts between companies and grid operators. Like a court, it would decide whether the company or the grid operator is financially liable for material damages and production losses.

But, for now, agency head Jochen Homann wants nothing to do with the idea. He first plans to discuss the problem with experts and associations in detail.

For companies like Hydro Aluminium, though, that process will probably take too long. It would just be too expensive for the company to build stand-alone emergency power supplies for all of its nine production sites in Germany, and its losses will be immense if a solution to the liability question cannot be found soon. “In the long run, if we can’t guarantee a stable grid, companies will leave (Germany),” says Pfeiffer, the CDU energy expert. “As a center of industry, we can’t afford that.”

In a Coasean zero transactions cost world, the liability assignment doesn’t matter.  So the situation in Germany raises the question of what are the transactions costs that preclude negotiations between power producers and power consumers that result in an efficient outcome.  (I should actually say “constrained efficient”, the constraint being the renewables mandate, which is almost certainly not efficient.)

There are only a few utilities to negotiate with, but there are many manufacturers adversely affected by the voltage variance.  Can these manufacturers engage in collective action (through an industry association, for instance) to negotiate?  Will free riders undercut these efforts?  Are the affected firms too heterogeneous to engage in effective collective action?  Does private information about value impede negotiation, either between the manufacturers and the utilities, or among the manufacturers in their attempt to organize collective action?

One factor that affects value is the cost of mitigation.  The article has some interesting detail about that:

At other industrial companies, executives at the highest levels are also thinking about freeing themselves from Germany’s electricity grid to cushion the consequences of the country’s transition to renewable energy.

Likewise, as more and more companies with sensitive control systems are securing production through batteries and generators, the companies that manufacture them are benefiting. “You can hardly find a company that isn’t worrying about its power supply,” said Joachim Pfeiffer, a parliamentarian and economic policy spokesman for the governing center-right Christian Democratic Union (CDU).

. . . .

Even August Wagner, head of a textile firm with roughly 180 employees in Bavaria, is taking precautions against feared power interruptions. A stop in production would be catastrophic for him. “When we dye our materials, there are thousands of meters in the dye factory,” he said. “If the power goes out, all of the goods are lost, and we have huge losses.”

Wagner now regulates the power supply of his production himself so that it doesn’t come to that point. What’s more, for a few months, he’s had an emergency power source standing in container next to the production facilities. Since then, other businesspeople in the area have been dropping by to take a look at his setup.

Aurubis, a major copper producer and recycler in Hamburg, has also spent about €2 million to protect against unwanted power emergencies. “If grid stability doesn’t markedly improve, we’ll have to rely on emergency power supplies this and the coming winter,” the company say

Presumably different companies, with different products and different technologies, incur different costs from a voltage fluctuation, and incur different costs to mitigate it.  Moreover, they almost certainly have private information about these costs.  Furthermore, utilities probably have private information about the costs they incur to address this problem.  All the resulting heterogeneity and private information, combined with the free riding problems inherent in collective action, present challenges to private solutions to this problem.

But they also present acute challenges to regulatory and legal solutions.  Given information about the costs of voltage fluctuations, and the costs of mitigating them, one could theoretically design the right liability rule.  But no one-not the politicians, not the regulators, and not the courts-have this information.

All meaning that the resolution of this issue will probably be time consuming, and beset with errors and false starts.  Especially when one considers the potential for political economy considerations to distort the process.

So this will be interesting to watch going forward.  A real world case study of how a big, heterogenous economy and polity deal with a (regulation-induced) technology shock that creates an “externality”.  Pay attention, PhD students.  There are thesis topics in there aplenty.  Another unintended consequence, to be sure.

The CME Group has announced plans to open a European exchange, following its earlier announcement of its launch of a European clearinghouse.

Just another unintended consequence of Frankendodd.  Another bucket emptied by the Sorcerer’s Apprentice’s regulatory broomsticks.

Why do I say that, pray tell?  Because that’s what CME Group is saying, quite clearly:

The Chicago-based exchange said that as policymakers overhaul the global market infrastructure, it was becoming increasingly important for market infrastructure providers to offer a choice of regulatory regimes. Derek Sammann, managing director of CME Group’s global interest rate and FX business, told Financial News immediately after the announcement: “Clients should not have to choose to trade with us in the US regulatory environment, or not to trade with us at all. That is not a real choice.

He added: “The more we have invested in our global infrastructure, the more we have realised that there are customer acquisition opportunities by creating regional access to our services.”

. . . .

Phupinder Gill, chief executive of CME Group, in June told an international derivatives conference IDX in London that the exchange group’s non-US clients had raised concerns that they would become ensnared by the Dodd-Frank rules if they traded with the US-regulated company – a phenomenon commonly known as extraterritoriality.

He said: “The question that many of our clients ask is if they are going to get ‘Dodd-Franked’.”

No, no, no, Gill!  It’s “going to get Frankendodded.”  Get with the program!  We need to feed the meme!

The reporting has been rather unclear on what the CME Group’s plans are going forward.  The new UK-based exchange will offer FX futures contracts.  The CME press release, and the reporting, do not say explicitly, but it looks like these would be new products, distinct from the CME’s FX contracts traded on Globex.  This means that liquidity and clearing would be fragmented, so that regulatory cost savings for European customers would be offset to some degree by higher trading and clearing costs.  Great!  And regulators note: the market will become more complex and difficult to oversee, with divided jurisdiction and the consequent need for regulators to coordinate in the event of market stress.  There will be arbitrageurs-including, no doubt, those HFT demons-buying and selling between the two markets, leading to more message traffic, more complexity, and more potential for breakdowns and technological glitches.  That is, the adverse technological consequences of fragmentation that have accompanied fragmentation in equity markets may rear their ugly heads in futures as well, with the added twist of fragmentation across international jurisdictions.

Given the difficulties associated with building liquidity, it is uncertain how the CME’s UK initiative will fare: it may be the case that Europeans decide that the liquidity and clearing costs savings exceed the regulatory burdens.  But it is relatively inexpensive for CME to put its toe in the water in the way it has.  It is a cheap way to buy an option on regulatory uncertainty.  If Frankendodd turns out to be the real monster that I think it will be, European customers will be willing to incur higher liquidity and clearing costs in order to avoid the monster’s grasp.  CME Group will add more contracts that mirror its US offerings.  The market will become more fragmented, and more complex.

Exactly what Frankendodd and Gigi and Timmy! intended, surely.

In the aftermath of Knight’s HAL moment, Larry Tab wrote a very good and succinct piece on the implications of fragmentation in equity markets:

Most think about fragmentation in terms of trading venues. And yes, the U.S. equity market has a number of trading venues. There are 13 exchanges, about 50 dark pools and many internalizing brokers that can match buyers and sellers. To ensure the best match, sophisticated order routers need to examine many trading venues. And without being in two places at once, the more venues checked, the greater the chance buyers and sellers miss each other.

While checking many venues complicates execution, markets also can fragment in other ways, including price and time. The more price points, the more missed trades. This is especially true as liquidity providers spread orders across more price points and venues. As fractions turn to pennies, and pennies to sub-pennies, through dark pools and the NYSE Retail Liquidity Program (RLP), trading volume becomes fragmented from 16 price points per dollar to 100, or 1,000.

The same problem exists with time. The quicker the quote timeframe, the more messages I need to produce and analyze. If I am quoting across 13 exchanges and 20 dark pools, then I need to manage my quotes across 33 venues. If my quoting frequency changes from seconds to tenths to tens of milliseconds to milliseconds, then my quoting rate increases from 33 to 330, 3,300, 33,000 quotes per second. Multiply that across 5,000 stocks trading at pennies or possibly sub-pennies and think about the massive technology and message infrastructure needed to trade.

Moreover, this dense web of linkages between venues raises the potential for algo errors.  More trading venues means more changes in the way the venues operate and their technologies, which means more changes in algos, which raises the odds of a programming glitch.  For instance, the catalyst for the Knight implosion was the NYSE’s introduction of its RLP program.  Another example that I just read (but can’t find a link to right now) is an HFT firm that had an algo go haywire because it hadn’t been informed of a change in the software at one of the trading venues it connected to: fortunately, this firm had measures in place that turned off the program after it had lost only $5K.  There is likely an externality across venues: a change by venue A increases the odds that the change will trigger a perverse algo response that will have adverse effects on venues B, C, D, etc.

So fragmentation has costs.  This raises the questions: why does fragmentation exist?, and, do the benefits exceed the costs?

It should first be noted that equity markets have always been fragmented to some degree.  Back in the day, substantial volumes of NYSE stocks were executed by “Third Market” dealers (notably, Bernie Madoff!) and in block trades negotiated away from the floor.

This fragmentation was driven by informational considerations.  (Relatively) uninformed order flow that could signal ignorance by some means (order size in the case of retail trades executed by Third Market dealers, or reputation and non-anonymous dealing in the case of blocks) reduced trading costs by trading in off-exchange venues.  If they traded in the anonymous NYSE marketplace, they could not be distinguished from informed order flow, and paid execution costs that reflected the adverse selection risks faced by liquidity suppliers in such a marketplace: by trading in another venue that had methods of screening out informed traders (imperfectly, but to some extent), the uninformed avoided paying this adverse selection premium.

This type of fragmentation exists today: Dark Pools have evolved to perform the same functions as Third Markets and block markets.  Dark pools use a variety of methods to attempt to screen out informed and opportunistic traders.  And some HFT/algo strategies (arguably opportunistic) are attempts to circumvent these screening technologies.

The proliferation of non-Dark Pool trading venues-anonymous, non-screening trading platforms-is relatively novel.  Until the mid-00s, such venues did not exist.  Virtually all informed order flow, and a good chunk of uninformed order flow, in NYSE stocks was executed on the NYSE.  The exchange had a market share of 85+ percent up through around 2005.

Since then, NYSE market share has plunged to around 30 percent.  Some of that volume has been snagged by Dark Pools, but the bulk has been taken by other exchanges.

This reflects an explicit policy choice by Congress, and the SEC.  Since the mid-1970s, Congress has pushed for the creation of a National Market System of competing exchanges.  That effort was moribund until 2005, when the SEC implemented RegNMS that obligated electronic markets to direct orders to other markets displaying better prices.

This effectively socialized order flow.  In the pre-RegNMS days, market participants had an incentive to direct their orders to the market that they expected to have the best price.  This created a self-reinforcing feedback loop.  The biggest market (the NYSE) tended to have the best price, so traders sent their orders there, thereby reinforcing the NYSE’s advantage.  With the mandated routing of orders to other markets, the NYSE no longer had a lock on order flow.  Other venues could compete for it effectively.

This had already been seen in options, which had been subject to order routing mandates much earlier.

From the SEC’s (and Congress’s) perspective, this was a feature, not a bug.  The whole idea behind NMS was to create a more competitive marketplace not dominated by a single exchange.

It worked, but it has had unintended consequences.  The adverse consequences of fragmentation Larry Tabb discusses are among them.

This points out a fundamental dilemma in securities market design.  If order flow is not socialized by order routing mandates, the liquidity network effect tends to lead to the dominance of a single exchange that exercises market power.  We see this in futures around the world.  Although electronic trading has taken over futures trading, we don’t see fragmentation like in the equity markets, which means that fragmentation is not an inevitable consequence of the computerization of trading.  Part of that is due to the fact that information asymmetries are less severe in futures than individual equities (e.g., because there is less private information about an equity index than an individual stock), and so there is no “dark pool” type fragmentation.  But most of it is due to the fact that there is no socialization of order flow in futures.  Perhaps because it was, historically, a more obscure corner of the financial world than the stock market,  Congress never caught the itch to create a National Futures Market System.  But regardless of the reason, the order flow feedback effect, where order flow attracts order flow, has led to the dominance of a single exchange in virtually every major futures contract.

This points out a fundamental dilemma.  Due to the nature of liquidity, policy makers have to pick their poison.  They can eliminate fragmentation, at the cost of market power.  They can eliminate market power, but only by living with the adverse consequences of fragmentation.

Those are the choices.  Period.  The economics of liquidity can’t be legislated or regulated away.  All that policy makers can do is affect how those economics will manifest themselves.  Don’t like exchange monopolies (or near monopolies)?  Socialize order flow a la RegNMS-and live with the consequences of fragmentation like we see today.  Don’t like the consequences of fragmentation? Abstain from requiring exchanges to direct order flows to markets displaying better prices-and live with the market power that will result when trading tips to a single venue of price discovery.

Not an easy choice.  I don’t know what the more efficient alternative is.  But it would be refreshing if debates over market structure would acknowledge that there are no Goldilocks, “just right”, choices.  Instead, there is more of a lady and the tiger like dilemma. Bewail the evil consequences of fragmentation if you will, but be prepared to show how those consequences are less malign than the costs of market power.  And vice versa.