Streetwise Professor

August 7, 2012

In Which I (Mainly) Agree With Felix Salmon. John Kemp, Not So Much

Filed under: Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 6:18 pm

I have crossed pixels with Felix on occasion, most notably over the issue of “empty creditors,” in which I took the Coasean position.  But today, I largely agree with his take on the Knight Capital implosion:

We’re seeing the same thing with the fiasco at Knight Capital, where a highly-sophisticated high-frequency stock-trading shop lost an enormous amount of money in a very small amount of time, and small investors lost absolutely nothing. On the grounds that we can’t present this as news without somehow determining that it’s bad for the little guy, it took no time at all for grandees to weigh in explaining why this really was bad for the little guy after all, and/or demonstrates the need for strong new regulation, in order to protect, um, someone, or something. It’s never really spelled out.

Knight lost $440 million.  That really stinks for its shareholders, but its loss is a windfall for those on the other side of its Hal moment.   Every dollar lost by Knight is a dollar gained by someone who entered an away from the market limit order that Knight triggered, or arbitrageuers that took advantage of the price anomalies.  You might argue that the temporary distortions in prices for dozens of stocks is a source of welfare loss, but I defy you to identify a real decision (e.g., the amount of investment by an affected firm, or its capital structure) that was affected by the very short lived fluctuations.

The final score: Knight -$440 million.  Others who bought and sold the affected stocks: +$440 million.  Third parties (not counting those who get the vapors when the markets don’t work as neatly and tidily as they think they should): $0.  Net result: $0.

Not quite, though, because of the pour encourager les autres aspect of Knight’s travails: to me this episode is an example of Darwinian selection in action.  Those who don’t adequately check their code are driven from the market (or almost are-Knight was rescued from bankruptcy on very harsh terms by a group of brokers and dealers).  Indeed, the outcome here is likely to be more efficient than a purely Darwinian one: here others can learn from Knight’s tale (“there but the grace of a geek go I: I’d better be extra vigilant”) whereas that learning mechanism doesn’t operate under pure natural selection.

Although I sometimes agree with Felix Salmon, the same cannot be said of me and John Kemp, another Reuters writer.  The correlation between our views pushes -1.

That’s true today, with respect to Kemp’s analysis (if that’s the right word) of ICE’s decision to relabel swaps as futures.  Kemp presents this as a smashing victory for Frankendodd.  Now it may seem churlish of me to criticize, given that Kemp did give my blog post extended play in his piece: I am aware of Brendan Behan’s dictum that there is no such thing as bad publicity, except where your obit is concerned.  But duty calls.

Kemp spends inordinate space in a disquisition on the Talmudic distinctions under the Commodity Exchange Act between contracts for future delivery and commodity forward contracts.  All of which is completely irrelevant because the ICE contracts transubstantiated from swaps to futures are definitely not commodity forward contracts exempt from CEA exchange trading requirements.  Kemp quotes my statement that nothing of economic substance changes as a result of the relabeling-and doesn’t disagree.  But he cavils:

Pirrong has been critical of Dodd-Frank and much of the CFTC’s rule-making. In this instance, he appears to argue that the sole outcome will be another round of regulatory arbitrage. (“A swap by any other name” Aug 2)

Arguably, however, ICE’s decision to re-label its cleared swaps as futures suggests regulators have won this round of the battle, ensuring that all contracts with an economically equivalent purpose will be treated in the same way, rather than subject to an artificial distinction.

Note the attempt to cast doubt on my analysis by pointing out my (unapologetic) criticism of Frankendodd, and Igor’s (i.e., the CFTC’s) implementation thereof. (“Distrust the skeptic!”)

Sorry, but I’m finding it hard to see the great regulatory victory here.  Nothing of economic substance has changed: Kemp does not dispute this, and in fact agrees with it (though he doesn’t go far enough, because the transactions are equivalent in form and substance as well as purpose).  The “artificial distinction” he criticizes is in fact a creation of the regulation: it is the direct result of Frankendodd’s establishment of a separate regime for swaps.  By revealed preference, the regulatory regime that ICE has chosen to operate under is less burdensome that the swap regime created by Frankendodd.  Since the economic substance of the transactions at issue hasn’t changed, this implies that either the swap regime is inefficiently costly (at least for some transactions), or the futures regime is inefficiently lax but a mere relabeling permits ICE and others to take advantage of that laxity.

I guess you have to take your victories where you find them, but that’s pushing it.

Print Friendly, PDF & Email


  1. Professor, what I cannot figure out (among other things) is why such glitches always happen with stock market players but not futures markets players, for example… Or are there such examples in futures and options markets as well? What is structurally/technologically so different in stock trading compared to futures that at the level of systems cause such havoc?

    Comment by MJ — August 7, 2012 @ 11:46 pm

  2. MJ, I thought the flash crash had something to do with Emini futures…

    Comment by Surya — August 8, 2012 @ 9:05 am

  3. Thanks for the note, Surya. But was the Flash Crash a technological glitch?

    The technological glitches I had in mind and have observed lately (BAT, RTS-MICEX)where specifically caused by abormalities in stock trading.

    Comment by MJ — August 8, 2012 @ 9:24 am

  4. @MJ-interesting question. Worthy of a separate post, which I will try to write up later. But a few quick points. First, there have been some issues like this in futures, not just the May 2010 Flash Crash, but mini-flash crashes in some commodity futures. Second, it is still the case that the problem is more acute in equities. That reflects the fact that equity trading is much more fragmented than futures, and that there are many more equity issues traded. The fragmentation creates opportunities for various algorithmic and HFT strategies to (a) exploit price deviations across trading venues, and (b) profit from idiosyncrasies in the various trading platforms. In contrast, futures markets are much less fragmented.

    This raises the question of why equities are more fragmented. That partly reflects the nature of equities: information asymmetries are more acute for equities, which provides a greater incentive for the uninformed to gravitate to dark pools and other venues to lower their trading costs. It also reflects a policy choice. RegNMS, which required electronic markets to route orders to other markets displaying better prices, socialized order flow and permitted the proliferation of linked electronic trading platforms. This works fine in normal times, but (a) encourages algos/hft for the reasons mentioned above, and (b) is prone to breakdown during times of stress. Note that post-NMS, NYSE market share fell from the mid-80 percent range to about 25-30 percent. In contrast, the lack of any such obligation in futures means that the attractive effect of liquidity tips all order flow to a single exchange and makes it very difficult for competitive exchanges to challenge the dominant incumbent.

    The ProfessorComment by The Professor — August 8, 2012 @ 9:49 am

  5. Professor, thanks for your clarifications. I understand that there have been mini-crashes in futures and in overlaping commodity markets. My impression is that one can attribute those crashes to structuralissues. However, it seems to me that more or less all of the problems of equity markets are being explained by technical or technological reasons – the codes and algorithms didn’t do what they were supposed to do.

    I am also inclined to think that variation of trading venues and trading platforms is more acute in equity markets, which leads me to a suspicion that indeed the order routing modules of those various platforms have some inherent problems.

    Comment by MJ — August 8, 2012 @ 9:30 pm

  6. “…Hal Moment” – Lovely! I do enjoy your missives.

    Nit-picking a bit, while Knight was indeed -440, the P&L on the other side is likely more subtlely and widely dispersed throughout the ecosystem with intermediators scalping along the way. It likely did trigger some other participants’ losses and whiplashing for those with less-than-economic stops and feedback-oriented strategies which were triggered, and then themmselves stopped out, though I reckon one shouldn’t shed tears for inherently parasitic pursuits.

    Comment by Cassandra — August 9, 2012 @ 4:54 am

  7. Professor, Larry Tabb has written a very insightful in my view article on the fragmentation of stock markets. I am sure you have seen it.

    As we discussed earlier most if not all market cataclysms of recent times have been associated with the stock market.

    And, indeed, we observe fragmentation (or segmentation) of stock markets more than of any other markets (except commodities).

    With some periodic frequency, as earlier discussed and reported in various venues, we witness technological failures, or so do they classify them, driving markets into wide swings. And as most of the time there is an army of people ready to blame HFT for these problems.

    My initial thought was that there is a technological problem with the order routing applications, which explains why the problem is more apparent in stock market rather than futures.

    Larry’s article has helped me to a further understand that the technological problem is just a consequence of non-recognition of structural problems.

    It appears that the issue is not much different from that of U.S. merchant power markets of late ‘90s and early ‘2000s. You sure remember when the price of electricity at the Cinergy hub reached almost $7,000 per MW while in neighboring hubs it was priced at about 100 times less. Similar effects were observed also in California and elsewhere throughout the next half a decade. We had occasional such cataclysms in US natural gas markets as well.

    When the same product, not meaning necessarily the same instrument, but perhaps meaning the same category of risk is traded in multiple venues, and many of the individual stocks might be viewed as belonging to the “same category” due to the very high correlation between them in our days – we live in a high beta economy – under such circumstances we deal with an additional risk, i.e. basis risk, which is a manifestation of “transmission” blockages between different trading venues, i.e. orders (aka distribution of risk). Orders do not flow freely between various venues to create equilibrium as not all of the market participants have equal access to all of these venues.

    Such fragmentation of markets can lead to dislocation of risks and generation of risk packets, and make the markets susceptible to instabilities, whereby small perturbations make them enter into a regime of wild swings.

    More than a decade ago, the unstable situation in power industry was generated by the violation of equilibrium between supply and demand of power due to the dislocated consumer and producer bases connected with each other with transmission lines which had limitations of transmission capacity.

    It looks to me that current technologies are developed without the understanding of the inherent, albeit implicit, instabilities in order routing processes (just when the industry is talking about smart order routing) due to the underestimation of basis risk between different risk venues resulted from “transmission” limitations and blockages.

    In this sense, the technological glitches we observe must probably be seen as signals of structural dislocation of risks between various venues.

    Surely, this implies that the technological solutions for smart order routing should accommodate for basis risk and its premium when writing smart order routing applications. Who could expect 5 years ago that the stock market is going to replicate some of the problems that were observed only in energy and some other commodity markets in the past…

    However, the fundamental solution of the problem will rest with the regulators – not in the sense of the creation of new barriers manifesting further blockages of order flow, but removal of these blockages. An efficient way off regulation of the market might be found through the proper pricing and trading of basis risk.

    In this sense, the experience and understanding accumulated from the energy industry might be very useful for the understanding of what really is going on in modern stock markets.

    Comment by MJ — August 11, 2012 @ 4:14 am

  8. @MJ-saw that Tabb article, and was going to incorporate that into the post I mentioned the other day. Will respond to your points as well.

    The ProfessorComment by The Professor — August 11, 2012 @ 10:08 am

RSS feed for comments on this post. TrackBack URI

Leave a comment

Powered by WordPress