Category: Interesting External Papers

Interesting External Papers

BoE Financial Stability Report, June 2011

The Bank of England has released its Financial Stability Report, June 2011.

Unfortunately, the Bank has taken action to ensure that the information published in this report does not fall into the wrong hands. The PDF document is secured (at the 128 bit level, no less!) in a manner which prohibits copying of extracts. Hah! That will teach Al Qaeda to quote from the Bank of England Financial Stability Report!

My attention was immediately caught by the fact that BIS concerns regarding synthetic ETFs have been given a prominent place in the threat list. Box 1 (on pages 16-17 of the PDF) points out that:

Because the collateral does not need to match the assets of the index being tracked, the bank might have incentives to use the synthetic ETF structure as a source of collateralised borrowing to fund illiquid portfolios

I’m not going to report on this any more because, quite frankly, I’m too pissed off at the moronic at worst and picayune at best restrictions on fair use imposed by the Bank’s encryption of the document. But read it; the research is quite good, which is presumably why it is being kept secret.

Update: Chart 1.4 has an interesting reference to Panigirtzoglou, N and Scammell, R (2002) ‘Analysts’ earnings forecasts and equity valuations’, Bank of England Quarterly Bulletin, Spring, pages 59-66

Interesting External Papers

Exchange Traded Bonds?

Bruno Biais and Richard C. Green, The Microstructure of the Bond Market in the 20th Century:

Bonds are traded in over-the-counter markets, where opacity and fragmentation imply large transaction costs for retail investors. Is there something special about bonds, in contrast to stocks, precluding transparent limit-order markets? Historical experience suggests this is not the case. Before WWII, there was an active market in corporate and municipal bonds on the NYSE. Activity dropped dramatically, in the late 1920s for municipals and in the mid 1940s for corporate, as trading migrated to the over-the-counter market. The erosion of liquidity on the exchange occurred simultaneously with increases in the relative importance of institutional investors, who fare better in OTC market. Based on current and historical high frequency data, we find that average trading costs in municipal bonds on the NYSE were half as large in 1926-1927 as they are today over the counter. Trading costs in corporate bonds for small investors in the 1940s were as low or lower in the 1940s than they are now. The difference in transactions costs are likely to reflect the differences in market structures, since the underlying technological changes have likely reduced costs of matching buyers and sellers.

The authors point out the central question:

Perhaps corporate and municipal bonds have low liquidity and high trading costs because they are traded in opaque and decentralized dealer markets. Alternatively, perhaps they trade over the counter because the infrequent need for trade, and sophistication of the traders involved, renders the continuous maintenance of a widely disseminated, centralized limit-order book wasteful and costly.

What is often ignored is the fact that exchange trading of bonds has been tried before:

Until 1946, there was an active market in corporate bonds on the NYSE. In the 1930s, on the Exchange, the trading volume in bonds was between one fifth and one third of the trading volume in stocks. In earlier periods, there was also an active market for municipal bonds and government bonds…Municipal bond trading largely migrated from the exchange in the late 1920s, and volume in corporate bonds dropped dramatically in the late 1940s.(footnote) Since this collapse, bond trading on the Exchange has been limited.

Footnote: The historical evolution of trading volume in municipal and corporate bonds is documented in the present paper. The Treasury and Federal Study of the Government Securities Market, published in July 1959, mentions (Part I, page 95) that trading volume in Treasury securities migrated from the NYSE to the OTC market during the first half of the 1920s.

Two possible explanations for the collapse of the exchange market are dismissed:

First, we ask whether decreases in liquidity could have been associated with changes in the role of bond financing generally. Based on data assembled from different sources (Federal Reserve, NBER and Guthman (1950)) we show that bond financing actually grew during the periods when trading volume collapsed on the Exchange.

Second, we ask whether the drop in liquidity could have resulted from SEC regulations increasing the cost of listing on the Exchange. We show that the decline in liquidity was not correlated with a decline in listings. Furthermore, while Exchange trading disappeared in securities that were exempt from the 1933 and 1934 acts (such as municipal bonds), it remained active in securities which were subject to this regulation (most notably stocks).

The third possibility is due to the interaction of groups with differing objectives in a heterogeneous market:

Different equilibria will vary in terms of their attractiveness for different categories of market participants. Intermediaries benefit when liquidity concentrates in venues where they earn rents, such as opaque and fragmented markets. For reasons we will show were quite evident to observers at the time, large institutional investors fare better than retail investors in a dealership market. This was especially t ue on the NYSE until 1975, because commissions were regulated by the Constitution of the Exchange, while intermediary compensation was fully negotiable on the OTC market. We find that liquidity migrated from the exchange to the OTC market at times when institutional investors and dealers became more important relative to retail investors. As institutions and dealers became more prevalent in bond trading, they tipped the balance in favor of the over-the-counter markets.

TRACE, of course, has had an impact:

In their studies of the corporate bond market, Edwards, Harris and Piwowar (2007), Goldstein, Hotchkiss and Sirri (2007) and Bessembinder, Maxwell, and Venkataraman (2007) show that the lack of transparency in the corporate bond market led to large transactions costs, while the recent improvement in post-trade transparency associated with the implementation of the TRACE system lowered these costs for the bonds included in the TRACE system.

A later paper by Bessembinder & Maxwell has been reviewed on PrefBlog, in the post TRACE and Corporate Bond Market Transparency. The referenced paper, by Bessembinder, Maxwell and Venkataraman, is titled Market Transparency, Liquidity Externalities, And Institutional Trading Costs in Corporate Bonds:

We develop a simple model of the effect of transaction reporting on trade execution costs and test it using a sample of institutional trades in corporate bonds, before and after the initiation of public transaction reporting through the TRACE system. The results indicate a reduction of approximately 50% in trade execution costs for bonds eligible for TRACE transaction reporting, and consistent with the model’s implications, also indicate the presence of a “liquidity externality” that results in a 20% reduction in execution costs for bonds not eligible for TRACE reporting. The key results are robust to allowances for changes in variables, such as interest rate volatility and trading activity, which might also affect execution costs. We also document decreased market shares for large dealers and a smaller cost advantage to large dealers post-TRACE, suggesting that the corporate bond market has become more competitive after TRACE implementation. These results reinforce that market design can have first-order effects, even for sophisticated institutional customers.

The paper by AMY K. EDWARDS, LAWRENCE E. HARRIS, MICHAEL S. PIWOWAR is titled Corporate Bond Market Transaction Costs and Transparency:

Using a complete record of U.S. OTC secondary trades in corporate bonds, we estimate average transaction costs as a function of trade size for each bond that traded more than nine times between January 2003 and January 2005. We find that transaction costs decrease significantly with trade size. Highly rated bonds, recently issued bonds, and bonds close to maturity have lower transaction costs than do other bonds. Costs are lower for bonds with transparent trade prices, and they drop when the TRACE system starts to publicly disseminate their prices. The results suggest that public traders benefit significantly from price transparency.

The paper by Michael A. Goldstein, Edith S. Hotchkiss and Erik R. Sirri is titled Transparency and Liquidity: A Controlled Experiment on Corporate Bonds:

This article reports the results of an experiment designed to assess the impact of lastsale trade reporting on the liquidity of BBB corporate bonds. Overall, adding transparency has either a neutral or a positive effect on liquidity. Increased transparency is not associated with greater trading volume. Except for very large trades, spreads on newly transparent bonds decline relative to bonds that experience no transparency change. However, we find no effect on spreads for very infrequently traded bonds. The observed decrease in transaction costs is consistent with investors’ ability to negotiate better terms of trade once they have access to broader bond-pricing data.

The Biais and Green paper makes a hiliarious point about trading frequency:

Table 6 shows the number of trades and average trade size on the NYSE by year for the six corporate issues in our sample. In 1943 and 1944, trading activity was relatively high. There were around 800 trades per bond issue each year, which is over two transactions per trading day. The trading frequency observed in the modern OTC corporate bond market has been documented in modern studies. Using TRACE data Goldstein, Hotchkiss and Sirri (2007) observe on average 1.1 trade per day, and Edwards, Harris and Piwowar (2007) around 2.0 trades per day.

More Biais & Green:

Furthermore, the professionalized management and relatively frequent presence in the market of institutions makes transparency less important to them than to less sophisticated small investors who trade infrequently. The repeated interaction that dealers and institutions have with each other renders them less vulnerable to the opportunities which a lack of transparency affords other participants to profit at their expense on a one-time basis. Smaller institutions and individuals, for the opposite reasons, will tend to fare better in an exchange-based trading regime. Indeed, the theoretical model of Bernhardt et al (2005) shows that, in a dealer market, large institutions will trade more frequently and in larger amounts than retail investors, and incur lower transactions costs.(footnote)

Footnote: Bernhardt et al (2005) also offer an interesting empirical illustration of these effects in the case of the London Stock Exchange.

The paper by Dan Bernhardt, Vladimir Dvoracek, Eric Hughson & Ingrid M. Werner is titled Why Do Larger Orders Receive Discounts on the London Stock Exchange?:

We argue that competition between dealers in a classic dealer market is intertemporal: A trader identifies a particular dealer and negotiates a final price with only the intertemporal threat to switch dealers imposing pricing discipline on the dealer. In this kind of market structure, we show that dealers will offer greater price improvement to more regular customers, and, in turn, these customers optimally choose to submit larger orders. Hence price improvement and trade size should be negatively correlated in a dealer market. We confirm our model’s predictions using unique data from the London Stock Exchange during 1991.

Biais & Green also make the point:

Over-the-counter and exchange-based bond trading coexisted for decades in the 20th century with viable levels of activity in each setting. What upset this balance? Was the migration to the OTC market triggered by changes in the structure of the population of bond investors? Combining Guthman (1950) and data from the Fed, we present in Figure 5 the evolution of bond ownership between 1920 and 2004.13 As can be seen in Panel A, there was a dramatic increase in institutional ownership in corporate bonds between 1940 and 1960. In the 1940s the weight and importance of institutional investors in the bond market grew tremendously. These investors came to amount for the majority of the trading activity in the bond market. Naturally, they chose to direct their trades to the OTC market, where they could effectively exploit their bargaining power, without being hindered by reporting and price priority constraints, and where they could avoid the regulated commissions which prevailed on the Exchange. Thus, the liquidity of the corporate bond market migrated to the dealer market.

Biais & Green also make an important point, which may be relevant to the debate on High Frequency Trading:

An obvious question is why exchange trading remained predominant in the stock market, in such a stark contrast with the bond market. One important difference between bond and stock trading on the Exchange is that, while the bond market has always been purely order driven, specialists have traditionally supplied liquidity in the stock market. It is possible that the presence of the specialist anchored the liquidity on the exchange. Because it was common knowledge that the specialist would be there to supply liquidity, small and medium sized trades could continue to be directed to the exchange. Because liquidity attracts liquidity, the larger traders also found it attractive to trade there, in line with the logic of Admati and Pfleiderer (1988).

Interesting External Papers

BoC Releases Spring, 2011, Review

The Bank of Canada has released the Bank of Canada Review, Spring 2011, a Special Issue devoted to Lessons from the Financial Crisis with articles:

  • Understanding and Measuring Liquidity Risk: A Selection of Recent Research
  • Unconventional Monetary Policy: The International Experience with Central Bank Asset Purchases
  • Lessons from the Use of Extraordinary Central Bank Liquidity Facilities
  • Central Bank Collateral Policy: Insights from Recent Experience

Sadly, despite the promising focus of the special issue, I found nothing of particular interest in the material.

Interesting External Papers

Swiss "Too Big to Fail" Project Nearing Completion

Thomas J Jordan, Vice Chairman of the Governing Board of the Swiss National Bank, gave a speech at the International Center for Monetary and Banking Studies, Geneva, 17 May 2011 titled Approaching the finishing line – the too big to fail
project in Switzerland

A central component of the Swiss approach is that systemically important banks should markedly improve their capital base and liquidity positions, both qualitatively and quantitatively, and reduce their risk exposure to other banks.(footnote)

Footnote: The new capital adequacy regulations for systemically important banks are to apply to risk-weighted capital and to the leverage ratio. Furthermore, they are designed to be progressive. In other words, the bigger the bank, the higher the requirement. Given the current size of Switzerland’s two big banks, the requirement would be 19% total capital of the risk-weighted assets, of which 9% can be held in convertible capital (cocos) and 10% must be held in common equity.

I am very pleased to see that the capital adequacy requirements are progressive and that the exposure to other banks is being addressed.

I can’t say I’m similarly impressed by the trigger for the cocos (I would prefer a trigger based on market price of the common)

If common equity falls below the threshold of 5%, the cocos will be converted and the emergency planning for separating the systemically important functions from the rest of the bank will be initiated.

… but you can’t have everything!

He takes a little dig at the US solution of banning prop-trading by the banks:

Firstly, regulation is never free of charge for every participant. However, analysis of the possible costs of regulation must always differentiate between the private and the social costs: in practice, regulation is bound to lead to additional costs for those regulated. This is part of the plan and makes economic sense provided that these additional costs are smaller than the benefits that regulation brings to the entire economy. If regulation leads to the elimination or reduction of market distortions – such as subsidies, for example – then an economically more efficient result is obtained.

Secondly, regulation can be formulated in a more or less cost-efficient manner. Particular attention was paid to this element in Switzerland. For instance, the additional capital required here by systemically important banks can largely be held in the form of more cost-efficient convertible capital. Other, far more drastic measures, such as a strict ban on certain business activities or the introduction of a bank tax – as discussed in other countries – were firmly rejected, partly for cost reasons.

He then provides an economic rationale for CoCos:

an increase in capital should not have any effect on a bank’s overall financing costs. Owing in part to the preferential tax treatment of borrowed funds, the Modigliani-Miller theorem referred to here, cannot be applied directly in practice, which means that overall financing costs would rise if capital increases. However, this is exactly what the proposed measures on convertible capital take into account. They create better conditions, so that capital structure will have less influence on a bank’s financing costs.

I liked Chart 2:


Click for big

But Chart 8 was pretty good to:


Click for Big

And there’s a handy scoresheet!


Click for big
Interesting External Papers

Some Good Papers on Regulatory Capture

Nicholas Dorn, Erasmus University Rotterdam – Erasmus School of Law, Ponzi Finance, Regulatory Capture and the Credit Crunch:

The unfolding financial market instability provokes questions about the safety of all financial investments and, in doing so, reveals some large investment frauds, which can flourish only in buoyant markets. More broadly, as is now recognized by market regulators, there has been insufficient attention to fraudulent practices, conflicts of interest and evasion of regulatory controls, notably in relation to promotion of sub-prime mortgages, the role of ratings agencies, the packaging and selling on of the resulting debt instruments to investors worldwide, and circumvention of risk controls. So, where were the regulators? This paper proposes that institutional capture of the regulators by the market – in terms of adoption by the regulators of technical assumptions, ‘models’ and data defined as relevant by the private sector – provides a narrative on ‘what went wrong’. Moving towards a vision of the way forward for regulatory reform, the paper argues against the exclusionary notion of regulation that makes it a matter of coordination between those possessing technical expertise, separated off from moral questions, public politics and debate amongst citizens. The literature on security governance and ‘public goods’ is explored as one way of opening up the debate on financial regulation, reversing regulatory capture.

Daniel C. Hardy, Monetary and Financial Systems Department, International Monetary Fund, Regulatory Capture in Banking:

Banks will want to influence the bank regulator to favor their interests, and they typically have the means to do so. It is shown that such “regulatory capture” in banking does not imply ineffectual regulation; a “captured” regulator may impose very tight, costly prudential requirements to reduce negative spillovers of risk-taking by weaker banks. In these circumstances, differences in the regulatory regime across jurisdictions may persist because each adapts its regulations to suit its dominant incumbent institutions.

The Report of the Second Warwick Commission, The Warwick Commission on International Financial Reform: In Praise of Unlevel Playing Fields:

Capture was helped by the emergent view that public agencies ought to be independent of politics. As part of this process, a policy role for the private sector was legitimised. Intellectual capture, in turn, also relates to the ‘group-think’ that has taken hold in the making of financial policy. Regulatory and supervisory arrangements are discussed and agreed in expert and apolitical terms, bringing like-minded individuals who, whether in the official, private or academic sphere, can reach common understandings based on shared training, practice and access to economic ideas. Both in the national arena and, increasingly, in the international fora around the Basel process, such networks are technocratic, informal, politically unaccountable and have a narrowly defined understanding of financial policy. They are also often de-coupled from other economic considerations or broader questions about the role of finance.

It is important to break ‘group-think’ and introduce new voices and interests to debates about financial regulation.

Independent Evaluation Office of the International Monetary Fund, IMF Performance in the Run-Up to the Financial and Economic Crisis IMF Surveillance in 2004–07:

On the other side, the report ultimately ascribes the failure to warn about the crisis to “groupthink,” which is as much a description as an explanation. The report could have looked more at the extent to which staff considered contrarian views (arguably, they did) and how they judged these positions against the much larger evidence marshaled by the mainstream (clearly, they judged incorrectly). This also speaks to the IEO recommendation to increase financial expertise and staff diversity—which undoubtedly is correct, and indeed a goal of the institution, but does not follow from the pre-crisis experience: the vast majority of financial experts, from a diversity of countries and backgrounds, also failed to see the crisis coming. (Ironically, the prescient individuals cited by the report are from remarkably undiverse backgrounds—i.e., macroeconomists with PhDs from U.S.-U.K. universities.) That said, the recommendation to access thoughtful and diverse opinion is a very important one, and one that we return to below.

Interesting External Papers

Synthetic ETFs a Threat to Financial Stability?

The Bank for International Settlements has released a working paper by Srichander Ramaswamy titled Market structures and systemic risks of exchange-traded funds:

Crisis experience has shown that as the financial intermediation chain lengthens, it becomes complicated to assess the risks of financial products due to a lack of transparency as to how risks are managed at different levels of the intermediation chain. Exchange-traded funds, which have become popular among investors seeking exposure to a diversified portfolio of assets, share this characteristic, especially when their returns are replicated using derivative products. As the volume of such products grows, such replication strategies can lead to a build-up of systemic risks in the financial system. This article examines the operational frameworks of exchange-traded funds and identifies potential channels through which risks to financial stability can materialise.

The part I found most interesting was:

Some of the product innovation might also be driven by dealer incentives to seek alternative funding sources to comply with the liquidity coverage ratio (LCR) standard under Basel III.2 For example, certain product structures might facilitate run-off rates on liabilities to be reduced despite keeping the maturity of liabilities short. As a result, ETFs have moved away from being a plain vanilla cost- and tax-efficient alternative to mutual funds to being a much more complex and diverse array of products and replication schemes (Russell Investments (2009)).

Liquidity regulation, such as the standards now proposed under Basel III, may also create incentives to use synthetic replication schemes. For example, under the proposed LCR standard, unsecured wholesale funding provided by many legal entity customers (banks, securities firms, insurance companies, fiduciaries, etc) as well as secured funding backed by lower credit quality collateral assets or equities maturing within 30 days will receive a 100% run-off rate in determining net cash outflows. By employing equities and lower credit quality assets to collateralise the swap transaction with the ETF sponsor that might typically have a maturity greater than one year, the bank engaging in this swap transaction will be able to reduce the run-off rate substantially on the collateral posted. Yet, the collateral substitution option allows banks to effectively keep the maturity of the funding short. The bank will still face a cash outflow run-off rate of 20% for valuation changes on the collateral posted,7 but this is far lower than the 100% run-off rate that it might otherwise face. When significant volumes of such transactions are done, this may result in a substantial improvement in the banks’ LCR, which would make compliance with the LCR standard less expensive.

Synthetic replication schemes, by contrast, transfer the underperformance risk to the swap counterparty. Within investment banking, the risk of underperformance or tracking error might be co-mingled with the rest of the trading book risk. This could potentially undermine the oversight function and compromise sound risk management. Moreover, the capacity of the swap counterparty to bear the tracking error risk while providing the market liquidity needed when there is sudden and large liquidation of ETFs is untested. Hedge funds often manage the liquidity risk through techniques such as “gating”, ie by restricting investor withdrawals

In Canada, there is the Horizons S&P/TSX 60™ Index ETF (HXT) that operates in this way. There may be others.

This may be just another instance of the regulators not thinking things through. Yes, the swap transaction may have a term of greater than one year. But if investors can redeem at any time, then it’s just another wholesale demand deposit, and should be treated accordingly.

Interesting External Papers

SEC Market Structure Report a Disappointment

On February 18 – sorry, I’ve been busy – the SEC released the RECOMMENDATIONS REGARDING REGULATORY RESPONSES
TO THE MARKET EVENTS OF MAY 6, 2010
, which is the Summary Report of the Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues.

I found it rather disappointing, but this is unsurprising. On February 7 I passed on a Reuters report in which it was stated:

While “Sunshine” laws have prevented the committee from regularly meeting, [Nobel Prize-winning finance professor at New York University Robert] Engle said the subcommittee has discussed a bevy of sometimes esoteric market structure issues

In other words, they knew that their process wouldn’t withstand scrutiny, so they hashed it all out in the back rooms instead.

The report in Bloomberg harshly criticized the recommendation for the “trade-at” rule:

Individual investors could be hurt should regulators alter an equities-trading rule limiting the prices at which brokers can execute orders away from public markets, an executive at TD Ameritrade Holding Corp. said.

An eight-member committee urged the Securities and Exchange Commission in a report yesterday to adopt a restriction called a trade-at rule. It would prevent venues and brokerages from executing orders within their walls unless they improve pricing by a specified amount versus the market’s best level.

“I was disappointed,” Nagy, a managing director for order routing, sales and strategy at the third-largest retail brokerage by client assets, said in an interview. “The report appears to be a politically motivated stalking horse to implement the trade-at rule. A trade-at would serve to increase costs for retail investors by creating an inconsistent trading experience.”

We never see TD criticizing the regulators so heartily in Canada. The regulatory-industry complex in Canada is way too cosy, as discussed on March 15.

Be that as it may, the committee was good enough to state the purpose of the report quite clearly:

One additional, specific point of background is appropriate to mention at the outset. The broad, visible, and often controversial, topic of High Frequency Trading (HFT)— including the definition of the practice, its impact on May 6, and potentially systemic benefits and problems that arise from the growing volume of HFT participants in all of our markets—has been pervasive in our discussions and in comments received from others. Rather than detail specific recommendations about HFT in this report, steps to address issues associated with this practice are evident throughout our report.

In other words, the committee was set up to do a hatchet job on HFT and eagerly went about its task of pleasing the established players, who are most upset that arrivistes are introducing competition to their comfortable lives. This serves – unsurprisingly – as a continuation of the intellectually dishonest Flash Crash report.

Anyway, back to the report – while skipping over the recommendations that don’t interest me! – which makes a point of telling the committee’s paymasters what an excellent job they’re doing:

The Committee supports the SEC’s “naked access” rulemaking and urges the SEC to work closely with FINRA and other Exchanges with examination responsibilities to develop effective testing of sponsoring broker-dealer risk management controls and supervisory procedures.

So what’s wrong with naked access? I mean, really? The official line:

According to the SEC: “The new rule prohibits broker-dealers from providing customers with ‘unfiltered’ or ‘naked’ access to an Exchange or ATS. It also requires brokers with market access – including those who sponsor customers’ access to an Exchange or ATS – to put in place risk management controls and supervisory procedures to help prevent erroneous orders, ensure compliance with regulatory requirements, and enforce pre-set credit and capital thresholds.”

I would like to see a lot more discussion of access as an economic transaction. Say we’ve got a small firm trading its own capital (call it $10-million) as principal. Why can’t the exchanges and marketplaces offer them direct access themselves? I have no idea what the requirements are for gaining such access, but I’ll bet it involves a lot of regulatory expense and rigamarole that is completely unnecessary in such a case.

Why isn’t it happening? What are the risks? What controls can be justified? And how would it interact with the rest of regulation?

Say, for instance, I am the risk manager at Very Big Brokerage Corp. (and I mean the real risk manager, not the clown with the title). And say, there is a marketplace (“Sleazy Trading Inc.”) that I’m not happy with, in terms of counterparty risk. I’ve looked at their controls and their access requirements and come to the conclusion that if I execute a big trade that makes a lot of money for me prior to settlement, I’m taking on too much exposure to the notion that the trade won’t settle. Or maybe I have made a decision on how much exposure I’m willing to take with Sleazy, and they’re currently over the limit.

Now, I’ve got a client order to sell 10-million shares of IBM and wouldn’t you know it, there’s a good bid – the best bid – for 10-million shares at Sleazy Trading. Will the regulations allow me to ignore it? I don’t believe so. And that is a problem.

In Canada, there are strong inducements that say that each “protected marketplace” is as good as any other protected marketplace.

We also applaud the CFTC requesting comment regarding whether it is appropriate to restrict large order execution design that results in disruptive trading. In particular, we believe there are questions whether it is ever appropriate to permit large order algorithms that employ unlimited use of market orders or that permit executions at prices which are a dramatic percentage below the present market price without a pause for human review.

Accordingly:
7. The Committee recommends that the CFTC use its rulemaking authority to impose strict supervisory requirements on DCMs or FCMs that employ or sponsor firms implementing algorithmic order routing strategies and that the CFTC and the SEC carefully review the benefits and costs of directly restricting “disruptive trading activities “with respect to extremely large orders or strategies.

Note how careful they are in restricting their concerns to “large orders”. In other words Stop-Loss orders, beloved of the brokerage community because they’re so insanely profitable, are not in the scope of this recommendation.

But, as I argued in the November, 2010, edition of PrefLetter, Stop-Loss orders appear to have been the exacerbating cause that turned a sharp decline into a rout. But the sheer size of the Stop-Loss avalanche only made it into one insignificant speech – never into any official report of any kind. Ms. Schapiro’s speech was reported on PrefBlog in an update to the post The Flash Crash: The Impact of High Frequency Trading on an Electronic Market.

Perhaps the committee’s most laughable recommendation is:

We therefore believe that the Commission should consider encouraging, through incentives or regulation, persons who regularly implement marker maker strategies to maintain best buy and sell quotations which are “reasonably related to the market.”

We recognize that many High Frequency Traders are not even broker-dealers and therefore their compliance with quoting requirements would have to be addressed primarily through pricing incentives. We note that these incentives might be effectively interconnected with the peak load pricing discussed above.
Accordingly:
9. The Committee recommends that the SEC evaluate whether incentives or regulations can be developed to encourage persons who engage in market making strategies to regularly provide buy and sell quotations that are “reasonably related to the market.”

Earth to Committee: Market Making loses money in a directional market. There is no amount of exchange pricing incentive that can possibly counteract this fact.

The original Flash Crash report makes some useful classifications of market participants:

In order to examine what may have triggered the dynamics in the E-Mini on May 6, over 15,000 trading accounts that participated in transactions on that day were classified into six categories: Intermediaries, HFTs, Fundamental Buyers, Fundamental Sellers, Noise Traders, and Opportunistic Traders.

Opportunistic Traders are defined as those traders who do not fall in the other five categories. Traders in this category sometimes behave like the intermediaries (both buying and selling around a target position) and at other times behave like fundamental traders (accumulating a directional long or short position). This trading behavior is consistent with a number of trading strategies, including momentum trading, cross-market arbitrage, and other arbitrage strategies.

It seems to me that if you want to encourage tranquility of market prices, you should be concentrating on the potential for getting contra-flow orders from Opportunistic Traders, rather than market makers; and the only way I can see that being done by regulators is encouraging the development and execution of opportunistic algorithms by “real money” accounts, rather than discouraging this process.

The committee has another recommendation good for not much more than a laugh:

Accordingly:
10. The Committee recommends that the SEC and CFTC explore ways to fairly allocate the costs imposed by high levels of order cancellations, including perhaps requiring a uniform fee across all Exchange markets that is assessed based on the average of order cancellations to actual transactions effected by a market participant.

Central planning at its finest, complete with the implicit assertion that prices can only be fair if they are both uniform and approved by the central planners. If data flow from order cancellations gets to be a problem, it’s easy enough to sever connection with the offending marketplace – which should be sufficient to ensure that fees are put in place to charge the cancellers and rebate the other participants. But, oops, sorry, not possible to sever connections. One market’s as good as any other – just ask the regulators.

The “Trade-At” recommendation is number 11; the committee’s justification is:

We believe, however, that the impact of the substantial growth of internalizing and preferencing activity on the incentives to submit priced order flow to public exchange limit order books deserves further examination. While the SEC has properly concluded in the past that permitting internalization and preferencing, even accompanied by payment for order flow agreements, increases competition and potentially reduces transaction costs, we believe the dramatic growth argues for further analysis. Notable in the trading activity of May 6 was the redirection of order flow by internalizing and preferencing firms to Exchange markets during the most volatile periods of trading. While these firms provide significant liquidity during normal trading periods, they provided little to none at the peak of volatility.

The last sentence is simply so much horseshit. The original Flash Crash report makes it quite clear that orders were routed to the public exchanges only when the internalizers has provided so much liquidity that they were up to their position limits.

The recommendation simply shows the committee’s total lack of comprehension of the market maker’s role; additionally, they didn’t waste their precious Nobel Prize-winning brain power discussing – or even considering – the possibility that such requirements will make internalization less profitable, therefore (surprise!) leading to a lower allocation of capital and therefore (surprise!) increasing the odds that another market break will exhaust that capital.

Update: Public comments are available.

Update: The CME comment letter recommends that regulators keep their cotton-picking hands off algorithms:

Large orders represent demand for liquidity and that demand necessarily informs price discovery. Participants typically rely on algorithms to execute large orders today precisely because sophisticated algorithms can employ intelligent real time analytics that allow traders to significantly reduce the market impact of their orders and enhance the quality of their execution. As discussed in our previously referenced letter on this topic, we do not believe the Commissions are equipped or should be involved in regulating the design of algorithms, and should instead focus on regulating conduct that is shown to be harmful to the market.

It also points out:

CME Group does not believe that high frequency traders, however such traders are in fact defined, should be required by third parties to put their own capital at risk when it is unprofitable to do so. High frequency traders, like other independent traders who are uncompensated by the trading venue, should quote responsibly based upon their ability to responsibly manage the risks associated with the orders they place. It would be extremely irresponsible for a high frequency trader, or any other trader, to continue to operate an algorithm under conditions in which it was not designed to operate or when the inputs to the algorithm are not reliable. Doing so could potentially put the firm itself at risk and arguably subject the firm to regulatory exposure if their algorithm malfunctioned and created or exacerbated a disruption in the market.

Rules that would undermine a trading firm’s own risk management processes by creating affirmative trading obligations in highly volatile periods are misguided. Assuming participants in fact complied with such obligations, which they likely would not, this “cure” would simply lead to the depletion of market making capital and result in less liquid and more volatile markets.

With respect to cancellation fees:

As an initial matter, the Committee has not identified how the market will be served by this proposal or how it will enhance the stability of markets. Other than apparently seeking to impose a tax on a high frequency trading, the objective is unclear.

CME Group additionally employs a CME Globex Messaging Policy that is broadly designed to encourage responsible messaging practices and ensure that the trading system maintains the responsiveness and reliability that supports efficient trading. Under this policy, CME Group establishes messaging benchmarks based on a per-product volume ratio which measures the number of messages submitted to the volume executed in a given product. These benchmarks are tailored to the liquidity profile of the contract to ensure that contract liquidity is not compromised. CME Group works with firms who exceed the benchmarks to refine their messaging practices and failure to correct excessive messaging results in a surcharge billed to the clearing firm.

Knight Capital’s letter commits lese majeste by asking for data:

Many have posed the following question time and again:

“What is the quantitative and qualitative justification for taking steps to change or slow internalization?”

To date, there has been no answer offered and no credible data presented to support such a dramatic shift in market structure.

and with respect to Trade-At:

In short, there has been no qualitative or quantitative data offered to suggest that such shift in market structure is warranted. Rather, the evidence offered in support has been anecdotal at best. As a result, we strongly encourage the SEC to proceed with the same thoughtful consideration that has guided its decisions in the past. It should demand empirical data, and thoroughly vet that data before making any determination to propose such a rule.

Interesting External Papers

BoE Quarterly Bulletin, 2011Q1

The Bank of England has released its 2011 Quarterly Bulletin, filled with the usual high quality analysis.

In addition to the Markets and Operations review, there are articles on:

  • Understanding the recent weakness in broad money growth
  • Understanding labour force participation in the United Kingdom
  • China’s changing growth pattern
  • Summaries of recent Bank of England working papers
    • Wage rigidities in an estimated DSGE model of the UK labour market
    • The contractual approach to sovereign debt restructuring
    • Are EME indicators of vulnerability to financial crises decoupling from global factors?
    • Low interest rates and housing booms: the role of capital inflows, monetary policy
      and financial innovation

    • Mapping systemic risk in the international banking network
    • A Bayesian approach to optimal monetary policy with parameter and model uncertainty

In the United Kingdom, despite the reduction in sterling corporate bond spreads, the cost of corporate bond finance for investment-grade non-financial companies increased slightly, on account of the rise in government bond yields. An indicative measure of the nominal cost of equity finance for UK companies had also risen slightly (Chart 13).


Click for big
Interesting External Papers

BIS Quarterly Review, March 2011, Released

The Bank for International Settlements has released the March 2011 BIS Quarterly Review. The cover story is “Inflation pressures rise with commodity prices”, with special features:

  • Systemic importance: some simple indicators
  • Inflation expectations and the great recession
  • The use of reserve requirements as a policy instrument in Latin America
  • Foreign exchange trading in emerging currencies: more financial, more
    offshore

and the usual “Highlights of the BIS international statistics”.

There was a great table:

As of the end of the third quarter of 2010, the total consolidated foreign exposures (on an ultimate risk basis) of BIS reporting banks to Greece, Ireland, Portugal and Spain stood at $2,512 billion (Table 1). At $1,756 billion, foreign claims were equal to approximately 70% of that amount. The remaining $756 billion was accounted for by other exposures (ie the positive market value of derivatives contracts, guarantees extended and credit commitments).

Interesting External Papers

FRBNY Assesses Economic Cost of Higher Bank Capital Ratios

The New York Fed has released a staff report by Paolo Angelini, Laurent Clerc, Vasco Cúrdia, Leonardo Gambacorta, Andrea Gerali, Alberto Locarno, Roberto Motto, Werner Roeger, Skander Van den Heuvel, and Jan Vlček titled BASEL III: Long-Term Impact on
Economic Performance and Fluctuations
:

We assess the long-term economic impact of the new regulatory standards (the Basel III reform), answering the following questions: 1) What is the impact of the reform on long-term economic performance? 2) What is the impact of the reform on economic fluctuations? 3) What is the impact of the adoption of countercyclical capital buffers on economic fluctuations? The main results are the following: 1) Each percentage point increase in the capital ratio causes a median 0.09 percent decline in the level of steady-state output, relative to the baseline. The impact of the new liquidity regulation is of a similar order of magnitude, at 0.08 percent. This paper does not estimate the benefits of the new regulation in terms of reduced frequency and severity of financial crisis, analyzed in Basel Committee on Banking Supervision (2010b). 2) The reform should dampen output volatility; the magnitude of the effect is heterogeneous across models; the median effect is modest. 3) The adoption of countercyclical capital buffers could have a more sizable dampening effect on output volatility. These conclusions are fully consistent with those of reports by the Long-term Economic Impact Group (Basel Committee on Banking Supervision 2010b) and the Macroeconomic Assessment Group (2010b).

The results are also consistent with the Bank of Canada report (discussed in the post BoC Studies Capital Ratio Cost/Benefits, which stated:

The results of this analysis are reported in Table 4, which summarizes the results for both Canada and the LEI study of the long-run impact of tighter capital standards. The range of the results on long-run output loss for the Canadian economy is similar to that observed in the LEI report. The average is similar to the median of the international results—i.e., about 0.1 per cent of GDP for a 1-percentage-point rise in bank capital requirements. Note that a high degree of uncertainty accompanies the calculation of long-run estimates, as evidenced by the wide range of model outcomes. Thus, the focus is on the median results of the Canadian models.