PrefBlog

Hal Weitzman of the Financial Times highlights a purported Need for consistent market structure to avoid ‘flash crash’:

Gary Katz, head of the International Securities Exchange, owned by Deutsche Boerse, dismissed the suggestion that US regulators should focus on creating incentives for market-makers.

“When the market begins to fall like that, there are no incentives big enough to persuade market-makers to catch a falling knife,” Mr Katz said.

Tom Whittman, president of Nasdaq OMX, which operates one of the biggest US options-trading platforms, agreed. “Market-makers wouldn’t have stayed in the market on May 6,” he said. “They’d rather pull out and pay a fine.”

Ed Boyle, who runs NYSE Euronext’s options business, said the “flash crash” indicated there were bigger and more serious structural issues for regulators, such as the existence of “dark pools” for share trading.

“There has to be a more consistent market structure than simply incentives for market-makers,” Mr Boyle said.

Bill Brodsky, chief executive of the Chicago Board Options Exchange, said the Securities and Exchange Commission’s report on the “flash crash”, which pinpointed a single trade by Waddell and Reed, a Kansas City-based firm, was suspect.

“The SEC never figured out what happened on May 6,” Mr Brodsky said. “The SEC report just doesn’t add up in my view.”

In the absence of any argument to support the idea that structural issues were at the root of the crash, I’ll have to dismiss Ed Boyle’s remarks as self-serving.

Brodsky’s remarks were also reported by Reuters:

“We went on for months and months and still didn’t know what happened,” William Brodsky, chief executive of Chicago Board Options Exchange parent CBOE Holdings Inc (CBOE.O), told a Futures Industry Association conference.

The report’s explanation of the May 6 crash “just doesn’t add up in my view,” he said on Thursday
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Brodsky, who recently headed up the World Federation of Exchanges, criticized the report’s “vague reference to a Kansas City firm (Waddell),” adding, “we need to know what happened across all markets” that day.

“We failed because it took so long to figure out what happened, and they never figured out what happened,” he said of the CFTC and the SEC, which is expected to make further changes to the marketplace to avoid a repetition of the crash.

The Wall Street Journal continues to tout “order toxicity”:

“Complementary to circuit breakers based on price action, they could have circuit breakers based on our metric,” said Marcos Lopez de Prado, one of the authors of the study released last month and head of high frequency futures at hedge fund Tudor Investment Corp.

The study has already caught the attention of regulators as they look for ways to avoid another flash crash, especially given that Maureen O’Hara, one of the Cornell professors that co-authored the study, is a member of the Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues. The committee’s first task after it was formed in mid-May was to review the market events of May 6, when stock prices fell dramatically before staging a rapid rebound, and make recommendations related to market structure issues that may have contributed to that day’s volatility.

Richard Ketchum, chairman and chief executive of the Financial Industry Regulatory Authority, mentioned the study Friday during a meeting of the Joint CFTC-SEC Advisory Committee. Ketchum noted that a way for market participants to predict toxicity and hedge accordingly “could be really valuable.” The question, he said, is “how do you create an environment where people can offload some of that toxicity risk?”

That ain’t the question, Ketchum. The question is “is it possible to predict future toxicity?”. As has been noted on PrefBlog there is not a shred of evidence in the paper regarding predictive power of “Order Toxicity” – it’s just another piece of Technical Analytical gargage (fifty year old technical analytical garbage, at that) that explains everything and predicts nothing. But one of the authors has good political connections, so we haven’t heard the last of it.

Meanwhile, an executive with the CME has flatly contradicted a central element of the SEC report’s conclusions:

An algorithm-powered order to sell 75,000 futures contracts linked to the S&P 500 stock index, entered by a mutual fund as the session’s volatility ramped up, did take into account price and time parameters, according to Scot Warren, managing director of equity indexes for CME.

“This was a sophisticated algorithm that took time and price into consideration,” said Warren, contesting descriptions of the trade as an emergency bet that helped spark a rout in stock prices.

Warren said the session’s activity revealed a “fundamental supply and demand imbalance” that spooked buyers from the market.

The second paragraph above is a bit puzzling, because the part that says he is “contesting descriptions” is not a direct quote – it might very well be the reporter’s interpretation. If somebody really, really, needed to unload 75,000 contracts, then I am prepared to believe that the algorithm executed this task in an efficient manner – the same way I would unload 100,000 horribly illiquid preferred shares in a day if the client insisted on it (after acknowledging in writing that I considered it a really stupid idea!).

The question is, was it really in Waddell Reed’s clients’ best interests to unload 75,000 contracts as quickly as possible? With no limit price? That’s a $4.6-billion trade, which Waddell Reed has defended as being a highly astute hedge based on a keen awareness of risk. You mean to tell me they were $4.6-billion worried about the market in the afternoon of May 6 and were $0.00 worried in the morning? I’m prepared to listen, but to me the whole Flash Crash story is just another tale of a cowboy vaporizing his clients’ money.

The SEC report was discussed on PrefBlog in the post Flash Crash: Incompetence, Position Limits, Retail.

Nanex has released its May 6’th 2010 Flash Crash Analysis Final Conclusion:

First of all, the Waddell & Reed trades were not the cause, nor the trigger. The algorithm was very well behaved; it was careful not to impact the market by selling at the bid, for example. And when prices moved down sharply, it would stop completely.

The buyer of those contracts, however, was not so careful when it came to selling what they had accumulated. Rather than making sure the sale would not impact the market, they did quite the opposite: they slammed the market with 2,000 or more contracts as fast as they could. The sale was so furious, it would often clear out the entire 10 levels of depth before the offer price could adjust downward. As time passed, the aggressiveness only increased, with these violent selling events occurring more often, until finally the e-Mini circuit breaker kicked in and paused trading for 5 seconds, ending the market slide.
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The first large e-Mini sale slammed the market at approximately 14:42:44.075, which caused an explosion of quotes and trades in ETFs, equities, indexes and options — all occurring about 20 milliseconds later (about the time it takes information to travel from Chicago to New York). This surge in activity almost immediately saturated or slowed down every system that processes this information; some more than others. The next sell event came just 4 seconds later at 14:42:48, which was not enough time for many systems to recover from the shock of the first event. This was the beginning of the freak sell-off which became known as the flash crash.

In summary, the buyers of the Waddell & Reed e-Mini contracts, transformed a passive, low impact event, into a series of large, intense bursts of market impacting events which overloaded the system. The SEC report uses an analogy of a game of hot-potato. We think it was more like a game of dodge-ball among first-graders, with a few eighth-graders mixed in. When the eighth-graders got the ball, everyone cleared the deck out of panic and fear.

Zero Hedge reports the latest in an ongoing series of mini-flash crashes – Verifone on October 15:

Well, none really, suffice to say that we have just had approximately the 20th flash crash in the past 2 months (all in rehearsal for when Apple goes bidless). Don’t worry though – the SEC is all over it. And, after all this is to be expected when trading in a computerized, roboticized, broken market. But a point to consider: the NYSE decided to cancel all trades below $27.44, so to the unlucky human who bought at $27.43 tough luck. Of course, robotic readers who sold at that price: congratulations, the NYSE and SEC has your robotic back. We are now eagerly awaiting Monday’s ongoing flash crashes.

Click for Big

Zero Hedge‘s take on the SEC report was:

NO ONE MUST BE ALLOWED TO SELL MORE THAN ONE SHARE OF STOCK AT A TIME EVER!!! YOU WILL OVERLOAD THE MARKET, FLOOD THE NYSE’S LRP, CAUSE A LIQUIDITY CRISIS, DESTROY THE MARKET AND END CIVILIZATION AS WE KNOW IT

aiCIO notes that the SEC report whitewashes the Exchange’s role in the Flash Crash, in a post titled The Saga Continues: Flash Crash Controversy:

Still, the report has brought a lot of this criticism on itself. The recommendations it does make, and even many of the conclusions it comes to, seem incommensurate to the problems of the crash. The fact that the NYSE’s computer systems couldn’t keep up with trading volume and printed delayed and inaccurate stock quotes? A couple brief references buried in footnotes and deep in the report saying things like, “we do not believe significant market data delays were the primary factor in causing the events of May 6.” And no harsh words for the exchanges or demands that they fix the problems.

What to do about the lightning-fast reselling of futures that certainly contributed to (and in Nanex’s analysis, caused) the Crash? It doesn’t say much. What about the upside of high-frequency trading, firms who actually stayed in the jittery market and provided liquidity during the Crash, only to have exchanges like the NYSE cancel their trades and cost them millions? The report codifies a byzantine set of standards for canceling future trades, but they seem too complex for most trader to take into account during real-time trading, and are fairly moot, since an exchange has the right to cancel any trade it wants to. So in the unfortunate event of a repeat crash, many traders might be so afraid of having their trades canceled again that they’ll simply pull out of the market entirely.

And finally there’s the the bigger question of What This All Means. “Despite the knee-jerk reaction on part of anybody who wanted to get on TV,” says Illinois Institute of Technology professor Ben van Vliet, a high-frequency trading expert who works with the Chicago Mercantile Exchange and CFTC, the report shows “that automated systems had nothing to do with it….There’s actually a much better argument that the reason the market came back so fast is automated trading systems. Automated systems, because they don’t trade on emotion, calculated the probabilities, [bought the undervalued securities] and that’s why things came back so quickly.”

Nanex has published a very important post titled May 6’th 2010 Flash Crash Analysis; Continuing Developments; Sell Algo Trades:

We have obtained the Waddell & Reed (W&R) May 6, 2010 trade executions from the executing broker in the June 2010 eMini futures contract. There were 6,438 trades totalling 75,000 contracts. We matched them by time, price and size to the 147,577 trades (844,513 contracts) in the CME time and sales data between 14:32 and 14:52 (they matched exactly). One-second resolution charts of the W&R trades along with other eMini trades are shown below in various time frames.

The SEC report identified a Sell Algorithm selling 75,000 contracts as the cause of the flash crash. If the “Sell Algorithm” in the SEC report refers to the Waddell & Reed trades, then there is a problem. A big one. Looking at the trades in context with the other trades during that time, they do not appear to be significant. The W&R trades also do not occur near the ignition point (14:42:44.075) we identified earlier. Furthermore, the W&R trades are practically absent during the torrential sell-off that began at 14:44:20. The bulk of the W&R trades occurred after the market bottomed and was rocketing higher — a point in time that the SEC report tells us the market was out of liquidity. Finally, the data makes it clear that the algorithm does take price into consideration; you can see it stops selling if the price moves down over a short period of time.

Something is very wrong here.

There are some charts of great interest.

I quite agree that something is very wrong here. The SEC stated quite explicitly:

This large fundamental trader chose to execute this sell program via an automated execution algorithm (“Sell Algorithm”) that was programmed to feed orders into the June 2010 E-Mini market to target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time.

Let’s play lawyer. “Target” does not necessarily mean that the execution rate was achieved. It only means it was targetted, and it is possible that other considerations adjusted this target. “Without regard to price” is formally consistent with Nanex’s observations regarding the appearence of pauses in algo execution, since the pauses are triggered by the rate of price decline; it might be that “without regard to price” means simply that once the market price has flattened out it starts executing again, regardless of what level prices reached during the pause period.

But that’s just hair-splitting. I will be most disappointed if this SEC report turns out to have been an exercise in legalistic hairsplitting.

Now, it is not necessarily the case that the SEC report and conclusion is completely wrong, even given the execution pause; it is entirely possible that Waddell Reed soaked up all the available liquidity and the price decline triggered other things. In that case the SEC report is not wrong, per se, but it has missed the point of the affair which (assuming that the hypothesis is correct) is far different from the stated conclusions.

After all, if I put in a market order to sell 100,000 shares; execution of this order takes the market price down a buck; the decline in market price triggers stop loss orders of 200,000 shares which take the market price down another two bucks; and this decline in market price causes the momentum players to jump in with both feet while all potential buyers sit on their hands and the maret price declines another four bucks … what’s the cause of the seven dollar decline? Me, I would say “mainly bozo price-based technical traders”, but maybe the SEC would blame me for the whole thing.

The SEC needs to clarify this.

The story has been picked up by the New York Times:

The findings are based on the actual private trading data from the afternoon of May 6 given to Nanex by Waddell & Reed — presumably because Waddell & Reed wants the data to be made public to clear its name as the cause of the crash.

The data was verified for Nanex by Barclays Capital, at the request of Waddell & Reed.
Barclays Capital supplied the computer algorithm used by Waddell & Reed to make the sale.

In a statement, Waddell & Reed said, “Following the recent release of the regulatory report on the ‘flash crash,’ many market observers have noted that the events of May 6 involve multiple issues that transcend the actions of any single market participant. We agree with those observations.”

A spokesman said, “After discussion, we granted permission to use the data, which was supplied to us by the executing broker.”

Roubine Global Economics has published an alarmist blog post titled The Flash Crash and Financial Terrorism: Could the Nineteenth Street NW Scenario Come True?:

But the SEC’s explanation is scarcely reassuring, and the incident is surely symptomatic of the pervasive market uncertainty.[1] That a single trade could wreak such havoc also raises the intriguing (and frightening) possibility of a deliberately engineered financial crash.
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A recent account, Nineteenth Street, NW, describes one possible scenario in which the terrorists use an off-shore hedge fund to launch a series of speculative attacks. The terrorists start with already weak currencies or markets—perhaps an overvalued currency or an under-financed sovereign[2]—and as they succeed in their initial speculative attacks, not only do they gain additional capital to launch their next attack, they also induce other (profit, not politically, motivated) investors to join the bandwagon of the next round of speculative attacks. In the story, the terrorists are also able to learn of the central banks’ FX intervention strategies (an issue of growing salience once more)—and plan a nasty surprise at a meeting of central bank governors and ministers to really spook markets. Eventually, given the interconnectedness of the global financial system, these cascading crises culminate in a global financial crash—costing trillions of dollars, and millions their jobs, homes, and life-savings.

The account is purely fictional, of course, but as George Soros proved when he helped oust the UK pound from the European Exchange Rate Mechanism in 1992, weak fundamentals and jittery markets make for successful speculative attacks against even major central banks. And as the flash crash has amply demonstrated, markets are plenty jittery these days.

There’s so much here that is completely off-base I scarcely know where to begin. Terrorists launching speculative attacks via a hedge fund? Well, if they were that smart they wouldn’t be terrorists.

The Flash Crash caused 20 minutes of chaos, as the $4.1-billion market order swamped available liquidity, but the market quickly recovered. Dave Cummings estimates the cost of that adventure to be $100-million … and you can bet that the next twenty minutes would have cost more, given the lack of fundamental justification. Chaos inducing trades of this magnitude can only be done by sovereigns – China, say, the day before invading Taiwan. And in that event, you can bet the Fed would be involved, buying up Treasuries with fiat money as fast as the Chinese could sell.

Soros making a “successful speculative attack” in 1992? The UK owes Soros its heartfelt gratitude that he assisted in taking the pound out of the ERM. The attack was speculative, certainly, in the sense that there was no way of knowing for sure what was going to happen. But it would not have been successful had it been fundamentally unsound. What the events of September 1992 showed was that it was sterling’s position in the ERM that was unsound. Had they remained, the distortions would have spread from the financial economy to the real economy and things would have been, ultimately, much worse.

Which is the role of hedge funds and the role of short-trading: to yell that the emperor has no clothes. Politicians and global bureaucrats heartily dislike the entire process, because they’re the tailors. However, most of these attacks are unsuccessful because they are not based in fundamentals – they’re just chatter by wannabes.

The funny part about the essay is that the author acknowledges this:

Because the specific trigger is almost impossible to predict, crisis prevention efforts are better directed at addressing the underlying vulnerabilities. Quite simply, if there are no vulnerabilities, then a “triggering event” (deliberate or accidental) will have nothing to ignite, and will just fizzle out instead.

So who are the wise people who are going to make the system invulnerable, carefully ensuring that nothing bad can ever happen to anybody anywhere?

Starting from this premise, the Early Warning Exercise draws on a wide range of analytical tools, market information, and expert opinions. A key goal is to “connect the dots”—that is, understand how shocks in one country or market could spread across the global financial system. The findings are communicated confidentially to finance ministers and central bank governors at the IMF Spring and Fall meetings in order that they may take prompt preventive and corrective actions, especially those that require international cooperation and coordination.

Ah, yes, the IMF, perpetually on the prowl to expand its bureaucracy.

And who, you may ask, is raising the bogeyman of financial terrorism (as described in the novel Nineteenth Street NW) and pointing to the IMF as the saviour of the world? Funny you should ask:

Rex Ghosh is an economist with the International Monetary Fund and the author of Nineteenth Street NW (www.nineteenthstreetnw.com), a thriller about financial terrorism and a global market crash.

Roubini has demeaned himself by publishing this claptrap.

RWE AG, a German utility sold some hybrids:

RWE AG, Germany’s second-biggest utility, sold 1.75 billion euros ($2.3 billion) of hybrid bonds in the biggest offering of the equity-like securities in Europe since 2006.

RWE’s perpetual notes were priced to yield 265 basis points more than the five-year benchmark swap rate, according to a banker involved in the sale. The Essen-based company can redeem the fixed-rate notes in 2015 and 2020. If the notes aren’t called within 10 years, the coupon changes to a floating rate equal to the initial spread plus 100 basis points more than the euro interbank offered rate.

In another Euro deal Scottish and Southern Energy plc issued a big whack of similar instruments:

The Euro Securities will bear interest from (and including) the Issue Date to (but excluding) 1 October 2015 at a rate of 5.025 per cent. per annum, payable annually in arrear on 1 October in each year. The first payment of interest, to be made on 1 October 2011, will be in respect of the period from (and including) the Issue Date to (but excluding) 1 October 2011 and will amount to A51.76 per A1,000 in principal amount of the Euro Securities. Thereafter, unless previously redeemed, the Euro Securities will bear interest from (and including) 1 October 2015 to (but excluding) 1 October 2020 at a rate per annum which shall be 3.150 per cent. above the then prevailing euro 5 year Swap Rate, payable annually in arrear on 1 October in each year. From (and including) 1 October 2020, the Euro Securities will bear interest at a rate reset annually of 4.150 per cent. per annum above the Euro interbank offered rate for 12-month deposits in euro, payable annually in arrear on the Interest Payment Date falling in October in each year, all as more particularly described in ‘‘Terms and Conditions of the Euro Securities — Interest Payments’’.
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The Issuer may redeem all, but not some only, of the relevant Securities on the First Call Date, the Second Call Date or any Interest Payment Date thereafter at their principal amount together with any accrued and unpaid interest up to (but excluding) the redemption date and any outstanding Arrears of Interest.

Moody’s has released a report on Canadian banks’ risk exposure due to investment banking activities:

While the Canadian banking system outperformed most developed country banking systems during the 2007–2009 credit crisis, the Canadian banks’ expansion of their capital markets platforms, particularly outside Canada, is not without risk, Moody’s Investors Service says in its new report.

The banks’ performance, coupled with the oligopolistic structure of the Canadian system, has allowed them to maintain very high ratings. Nevertheless, the mature domestic market raises a strategic challenge with regards to growth, and the void left by the retrenchment of many global investment banks represents one avenue for growth and revenue diversification. Therefore, several Canadian banks are now expanding their wholesale investment banking (WIB) activities.

Golly, not a word about the beneficial, if not to say brilliant and incisive, supervision by OSFI! I guess they forgot that bit.

Moody’s has previously cited the risks associated with WIB business and noted that even the most well-managed WIBs can suffer from unusual earnings volatility, and when serious risk-management failures occur, significant ratings transitions are possible.

The report is titled, “Capital Markets Activities of Canadian Banks: A Growing Risk”

A few tid-bits are disclosed in a Globe story on the report, Banks take $21.5-billion hit on risk:

Ratings agency Moody’s Investor Services has tallied up the hit Canadian banks took through their capital markets divisions from the start of 2007 to the end of 2009, and the toll has reached nearly $21.5-billion.

That is the amount Moody’s figures the banks would have recorded as profit if not for the writeoffs they took due to their exposure to the markets.

Canadian Imperial Bank of Commerce topped the list with a $10.5-billion hit during those three years, largely because of bets on U.S. structured debt products that went sour, followed by Royal Bank of Canada at $4.3-billion. Bank of Montreal ($2.9-billion), Bank of Nova Scotia ($2.2-billion) and National Bank of Canada ($1.1-billion) came next. Toronto Dominion Bank took the smallest hit at $727-million, the report says.

Moody’s has raised flags about this exposure in the past, notably when downgrading BMO prefs an extra notch last spring.

Alpha Group has announced:

that, subject to regulatory approval, Alpha ATS will implement a new trading facility – the Alpha IntraSpread™ facility, during the 4th Quarter of 2010. The Alpha IntraSpread™ facility, a set of new orders offered by Alpha ATS, allows dealers to seek matches within their firm without pre-trade transparency and with guaranteed price improvement upon the National Best Bid and Offer (NBBO) at the moment of the trade. The Alpha IntraSpread™ facility will be available to all dealers that are Subscribers of Alpha and for all symbols traded on Alpha ATS.

Some of the specifics are:

• Dark orders have no pre-trade transparency as information on Dark orders is not disseminated on any public data feeds.
• Price of a Dark order is calculated as an offset of the NBBO by adding the price offset to the national best bid for a buy order and subtracting it from the national best offer for a sell order.
• Price of the Dark order can optionally be capped.
• Price offset is calculated as a percentage of the NBBO spread with value expressed as 10%, 20%, 30% … 90%, but capped to one standard price increment. If either side of the NBBO is not set, or the NBBO is locked or crossed, Dark orders will not trade.
• Dark orders trade only with incoming SDL™ orders that are tradable at the calculated price of the Dark order. Dark orders do not trade with each other.

… while SDL orders:

• SDL™ orders are “immediate-or-cancel” – they trade with eligible Dark orders to the extent possible, and any residual is cancelled. Price can be market or limit.
• SDL™ orders only trade with Dark orders and do not interact with other transparent orders in the Alpha CLOB. In the first phase of the Alpha IntraSpread™ facility, SDL™ orders only match with Dark orders from the same Subscriber

I do not profess to be an expert on ATS marketting practices, but this appears to be an attempt by Alpha Group to forestall the creation of internal dark pools by its members (or pool the cost of such systems; Alpha is owned by the major dealers) by offering a sub-pennying mechanism in a manner that is smoothly integrated with extant trading systems.

Sub-pennying is a controversial element of the current market microstructure debate. There is an excellent comment letter from Bright Trading Systems that explains how it works (in the States!):

Statistics from the Commission’s Concept Release on Equity Market Structure, state that 17.5% of all trades are internalized by broker-dealers. A more alarming statistic from page 21 of the release states that, “a review of the order routing disclosures required by Rule 606 of Regulation NMS of eight broker-dealers with significant retail customer accounts reveals that nearly 100% of their customer market orders are routed to OTC market makers.” This means that almost every single market order placed in these retail brokerage accounts, is checked by the brokerdealer’s OTC market maker to decide if they can make money by trading against their customer. They can legally trade against their customers as long as they match or beat the National Best Bid and Offer (“NBBO”).
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The only time the displayed order on the NBBO is filled from an incoming retail market order, is when the OTC market maker of the broker-dealer passes on the chance to trade against its customer’s order, and there are no undisplayed orders hiding in dark pools in front of the NBBO order. As a result the only retail orders getting through to the publicly displayed NBBO, are the orders that the first two market participants have passed on. If the first two participants have passed on the opportunity to trade against the order, there is a good chance that the incoming market order is on the right side of the market (in the short-term). Hence, the only NBBO orders that are filled are those that are more likely wrong (in the short-term). The displayed liquidity provider is “sub-pennied” when they’re right, filled when they’re wrong. As liquidity providers become discouraged, they will place fewer passive limit orders in the short term and ultimately leave the trading markets. This will lead to less depth in the market and larger spreads, both increasing the cost to investors in the long term.

In their recent update of the status of the market microstructure review the Canadian Securities Administrators stated:

Forum participants discussed the idea of price improvement in dark pools, as well as the concept of sub-penny pricing. Questions were raised whether dark pools should always be required to offer price improvement, how much price improvement is meaningful, and whether sub-penny price improvement is desired or even relevant. It was noted that sub-penny price improvement may only be meaningful for dark pools achieving block sized execution, but is of questionable benefit to the overall market or to the investors for small orders. Participants also discussed the fairness of allowing dark pools to offer sub-penny price improvement while transparent markets are not allowed to offer the same execution opportunities. Some participants felt that sub-penny quoting on visible exchanges would not be desirable, one reason being the impact of increased messaging due to sub-penny pricing and marketplaces’ technology infrastructure costs. We will examine the issue of sub-penny pricing with the goal of assessing how any changes in either printing or quoting in subpennies would impact both the market as a whole, and the individual participants. Additionally, we will consider both transparent and dark markets, and whether principles of fairness would allow both types of venues to offer sub-penny price improvement and printing or execution, or whether different market structure models necessitate different treatment.

Cost concerns are a red herring. If it costs more, charge more. Idiots.

Sub-pennying is annoying, but not a major issue. As previously noted, a value investor has a cost-of-capital advantage on the order of 12% over a high-frequency-trader … if you can’t kick-ass with an advantage like that, you deserve to be hungry, naked and homeless.

I am scheduled to appear on BNN Monday, June 21, shortly before 9am.

Topics to be discussed will include preferred shares and contingent capital.

Barry Critchley wrote a column in the Financial Post on April 1 titled Is this the end for rate resets?

The trigger for his column was (besides the obligation to bang out another 750 words, I mean!) the BNS 3.85%+100 new issue. Mr. Critchley believes that such skimpy yields will have the effect of pushing income investors back into common shares.

He concludes with a quote from John Nagel:

So what’s the outlook? John Nagel, a vice-president and director at Desjardins Securities and one of the architects of rate-reset pref shares, said that despite the low yield, there is still a market for the security, in part because investors continue to demonstrate that they don’t want to purchase “straight perpetual pref shares,” or securities that offer no chance of a change of dividend.

“The straight pref share marker is doing nothing but going straight down because investors are very nervous about higher interest rates,” he said, noting that more than $15.5-billion of rate-reset pref shares have been issued over the past two years. Accordingly that sector of the market is larger than the straight pref share market.

Despite the low yields, Nagel says the regulatory authorities have given their approval for rate resets to continue to count as Tier 1 capital. But he said the authorities have not been as kind for continued issues of so-called innovative Tier 1 securities.

It’s my understanding that the BNS issue sold out just as fast as all the other ones, despite its extreme richness vs. BNS Straights.

What do I think? Well, first of all, I think that forecasting investor tastes in new issues has much the same chance of success as forecasting young women’s tastes in new outfits. Some shops, who spend a lot of money on market research and take an intelligent approach to interpreting the data, can be right just often enough to pay for the times their wrong and make a great deal of money – but they’re still left holding the bag every now and then.

Second, I think that FixedResets have been grossly overemphasized in the marketplace through the course of their existence. The banks have been driven to inflate their Tier 1 capital at a time when bank money is pretty expensive. The allure of FixedReset issuance hasn’t been so much the reset provision (although that’s the hook for retail) as the five year call; which fixed income investors in most other markets will simply not allow.

Third, I don’t think the acid test of FixedResets continued existence is low issue yield – which is surely more a sign of fashionability rather than otherwise. I can think of two critical tests:

• The first wave of redemptions: It is not entirely clear that investors have really thought through the implications of the five-year call and will be most upset when such a call lands most secondary market buyers with a big capital loss and the need to reinvest in a (probably) lower yield environment.
• The first few downgrades & defaults: Nortel & Quebecor World defaulted on their FixedFloaters; BCE and Bombardier were downgraded. All remaining issues are trading well below par. How will the FixedReset market react when it becomes apparent that interest rate risk is only one of the problems facing fixed income investors?

Straights will always be the little black dress of the preferred share world, but FixedResets have the advantage of allowing the issuer to assume the inflation risk, just like RRBs; there will always be a significant number of new issue investors eager to accept low yields for the chance of offloading that risk. FixedResets have the chance of becoming a permanent feature of the new issue shop.