PrefBlog

Scandal at the Fed!

Some investors may have gotten early word of changes to Federal Reserve policy between 1997 and 2013 and profited by trading before the policy shifts were publicly announced, according to Singapore-based researchers.

Trading records show abnormally large price movements and imbalances in buy and sell orders that are “statistically significant and in the direction of the subsequent policy surprise,” according to a paper by Gennaro Bernile, Jianfeng Hu and Yuehua Tang at Singapore Management University.

The moves occurred before and during the time that reporters were given the Federal Open Market Committee statement in so-called media lockups.

I wonder if this allegation will be investigated with as much hand-wringing and vigour as the LIBOR and FX pseudo-scandals.

Speaking of scandals…:

Ex-U.S. Treasury Secretary Timothy Geithner must comply with Standard & Poor’s demand that he provide documents related to its claim the U.S. sued the company in retaliation for downgrading government debt.

Harold W. McGraw III, chairman of S&P parent McGraw Hill Financial Inc. (MHFI), said in a court statement that Geithner called him days after S&P downgraded the U.S. debt in August 2011 and told him that the company would be held accountable for it. McGraw said Geithner told him there would be a “response” for the downgrade, which the government said was based on an error.

Geithner is the highest former government official S&P has pursued for information to support its allegations. S&P, the only credit rating company sued by the Justice Department for allegedly giving fraudulent ratings to mortgage-backed securities, has said it was singled out because of the downgrade.

The Justice Department and Geithner have denied there is a connection between the downgrade and the lawsuit filed last year. The government has said it may seek as much as $5 billion in civil penalties from S&P for losses to federally insured financial institutions that relied on its ratings for mortgage-backed securities and collateralized-debt obligations, or CDOs, that lost value after the housing market collapsed.

Here’s a step in the right direction!:

Wall Street’s bonus pool may rise as much as 10 percent this year for asset managers while fixed-income traders could see a 15 percent cut, according to compensation consultant Johnson Associates Inc.
…
“Many asset-management firms pay the same or better than the big banks, and this year that gap will get even bigger,” [founder of the consultancy Alan] Johnson said in the interview.

It was a day of modest gains for the Canadian preferred share market today, with PerpetualDiscounts winning 9bp, FixedResets gaining 1bp and DeemedRetractibles up 4bp. Volatility was modest. Volume was average.

Boyd Erman of the Globe comments on the HFT study that I reviewed yesterday:

The Bank of Canada has released a research paper on high-frequency trading that, unfortunately for those looking for a silver bullet that finally answers whether HFT is good or bad, provides ammunition for both sides.
…
In other words, it gets harder for those who had been in the market to read the new market, and it’s tougher to trade. That’s a tick in the column of the HFT opponents, who say HFT’s constant use of orders and cancellations to try to figure out the market’s direction creates noise that makes it difficult for other investors.

With respect to the “constant use of orders” point … that’s not what the study says. The study says:

Third, following entry by Aggressive HFT firms, those that mainly take liquidity, incumbents experience a loss in their ability to trade in the direction of future price movements.
…
In contrast, Aggressive HFT strategies are associated with informed trading, since they trade in the direction of future price movements (Biais, Foucault and Moinas 2013; Foucault, Hombert and Rosu 2012; Martinez and Rosu 2013). With more market participants monitoring for arbitrage opportunities, price predictability should decline. We study whether incumbent HFTs are less able to trade in the direction of future price changes.
…
Aggressive HFT entry decreases the price impact of the most informed incumbents’ trades. The average incumbent price impact decreases on average by 0.3 cents for a trade of $10,000. The first Aggressive entries decrease the incumbents’ price impact by a maximum of 1.3 cents.

Successive HFT entrants have a diminishing effect on incumbents’ informedness. In fact, there is no statistically significant impact after the second event. This suggests that HFTs are less able to predict future prices and that HFT trades are more reflective of short-term information.

The study does not address in any way the order fill-to-cancel ratio.

With respect to the claim that the actual point is “a tick in the column of the HFT opponents” … I don’t understand it. To the extent that directionality on a five-second time scale exists, what does it matter who gets the money? Is this some kind of argument that it’s better for ‘real money’ to make the profit, as opposed to HFT money? The paper itself refers only to incumbent HFT, not to who was exploiting the information beforehand.

I will make exactly the opposite point, that eliminating directionality on a five-second time horizon is actually a point in favour of HFT. We want markets to be efficient – HFT exploits, and eventually eliminates, the inefficiency on a five-second time-scale. Isn’t that good?

This also reduces the penalty for being poorly informed, which I understand is also a hobby-horse of the anti-HFT mob. In the extreme case, we have a single stock on the exchange, bid at say, 25.00-10, and a single ETF (which holds only the single stock). Ignoring frictional costs, we can then say that ideally the ETF will also be quoted at 25.00-10. But then somebody lifts the offer on the stock with a great big bid and the quote on the stock changes to 25.10-20. Then Granny Oakum puts in her market order to sell the ETF … she only gets 25.00 for it. Isn’t it an objective of market designers to assist Granny to get 25.10? Wouldn’t it be a good thing if somebody (an HFT, for instance) whipped an order to buy the ETF in between the big stock trade and Granny’s order, so that Granny makes an extra dime? Naturally, there will always be the chance that Granny’s order follows so swiftly behind the big stock trade that she doesn’t make that dime anyway. But reducing the time for which this obvious discrepancy is effective is a Good Thing for Granny.

The real problem that the anti-HFT crowd has is that the free dime used to be picked up by a big bank trader with a good pedigree and an expensive private school education. Now it’s going to some bum who nobody’s ever heard of, one of the geeks who was always screwing around with computers instead of attending the polo matches like a normal person. BooHooHoo.

My other complaint about today’s offerings from the Globe is Rob Carrick’s column GICs beat laddered bond ETFs, hands down:

A ladder of guaranteed investment certificates is better, as long as you don’t foresee the need to sell your holdings before maturity. Laddered bond ETFs can be bought and sold any time during the trading days, so they win decisively over GICs on liquidity.
…
If you invest equal amounts in these GICs, thereby creating a five-year ladder, your average yield would be 2.12 per cent.
…
The iShares 1-5 Year Laddered Government Bond Index Fund (CLF) … net yield of 1.22 per cent.
…
The iShares 1-5 Year Laddered Corporate Bond Index (CBO) … after-fee-yield of 1.6 per cent
…
The laddered bond ETF … also offers the possibility of capital gains if interest rates fall, or capital losses if rates rise. Given the flat to rising outlook for rates, losses seem more likely than gains.

So my first objection to this story is in the phrase “you don’t foresee the need to sell your holdings before maturity”. If you don’t foresee that, then why are you holding short-term instruments in the first place? That’s almost certainly just poor portfolio planning. It is possible that you hold the short-term instruments to counter-balance longer-term fixed income (such as the preferred shares that this blog is ostensibly about) – but then you’re frozen into your long-term position as well.

The other objection is “Given the flat to rising outlook for rates, losses seem more likely than gains”, a very common misconception. As I made clear in my article Bond ETFs demystified, there’s no real difference between the two vehicles; the only apparent difference is that an ETF makes visible the opportunity costs of a rise in interest rates that GIC holders like to ignore. Additionally, the objectionable phrase depends upon market timing for its validity and can be ignored solely on those grounds.

The Bank of Canada has released the Bank of Canada Review Spring 2014, with the following articles:

• The Canadian Dollar as a Reserve Currency
• Understanding Platform-Based Digital Currencies
• The Art and Science of Forecasting the Real Price of Oil
• Measuring Uncertainty in Monetary Policy Using Realized and Implied Volatility
• Beyond the Unemployment Rate: Assessing Canadian and U.S. Labour Markets Since the Great Recession

And at the Fed, they’re doing some work on the term premium.

Kevin Carmichael in the Globe comments on Tim Geithner’s book tour:

The European Union now is doing something similar [to the US public stress tests]. We can only wonder what the global economy would be like today if the Europeans had followed Mr. Geithner’s model sooner.
…
The Office of the Superintendent of Financial Institutions does one macro stress test a year and ad hoc tests on specific issues as necessary. But the results remain private, shared only with the Bank of Canada to help it with its twice-a-year assessments of the financial system.

Mr. Geithner would disapprove of the secrecy. I didn’t ask him to comment specifically on Canada, but I did ask how important it was that market participants be allowed to see the stress test results. “It’s central,” he said. “You need to let private investors, shareholders and creditors of banks, have enough information that they can better discriminate across institutions. You need to make the loss estimates transparent, you need to make the impact to individual markets transparent, if you are going to allow the markets to provide that form of triage.”

Well, the Europeans eventually did do stress tests, but they were fake, relaxed stress tests, as discussed on July 23, 2010. You only publicize stress tests if you know that the answer is going to be good.

It was a poor day for the Canadian preferred share market, with PerpetualDiscounts off 4bp, FixedResets down 13bp and DeemedRetractibles losing 27bp. The Performance Highlights table is lengthy by recent standards, but balanced with no clear pattern. Volume was above average, with GWO-group issues notable on the Volume Highlights table, presumably due to the GWO new issue.

SEC Commissioner Daniel M. Gallagher mused on the tangled web of supervisory responsibility:

And although securities firms have been generally increasing the amount of resources they devote to compliance matters, compliance budgets have increased in a linear manner while the demands faced by compliance officers have increased exponentially. A member of the House Financial Services Committee, citing a study issued by the Committee,[1] stated, “It will take over 24 million man hours to comply with Dodd-Frank rules per year. It took only 20 million to build the Panama Canal.”[2] On the plus side, at least Dodd-Frank has caused fewer deaths by malaria or yellow fever.
…
The Commission’s ability to impose sanctions for failures to supervise is a valuable part of our regulatory toolkit, encouraging a broker-dealer or investment adviser’s managers and executives to proactively monitor subordinate employees’ compliance with laws and regulations. We must make sure, however, that our rules establishing failure to supervise liability do not act as a deterrent to in-house legal and compliance officers, discouraging them from departing from their clearly delineated roles.

After all, we don’t want compliance officers or in-house attorneys spending their days drafting policies and sending out memoranda while avoiding interaction with the individuals governed by those policies or the recipients of those memos out of fear of being deemed a supervisor and subjecting themselves to liability. Indeed, we want to encourage such personnel to bring their expertise to bear in addressing important, real-world compliance issues and in providing real-time advice for concrete problems the firms and their employees face.

Clearly, what is necessary is a new department to be called “Compliance Compliance”, in which Compliance Compliance Professionals can ensue that Compliance Professionals are doing their jobs correctly. They can be regulated in the U.S. by the Securities and Exchange Commission Commission.

Remember the highly politicized SEC report on the Flash Crash? The regulator who wrote it thinks we should hire more regulators:

High-speed trading in U.S. futures markets is being dominated by a small number of firms that should be forced to register with regulators to ensure adequate oversight, the Commodity Futures Trading Commission’s former chief economist will tell lawmakers.

The firms, which can account for more than half of trading volume in some markets, should face new record-keeping rules and be required to have consistent policies and safeguards, according to Andrei Kirilenko, who left the CFTC in 2012 after he led a study of high-speed trading following the May 2010 flash crash.
…
Kirilenko is the co-author of a study that concludes high-frequency traders earn consistent profits, often at the expense of smaller and retail participants. The research, released again last month, was based on proprietary transaction-level data collected at the CFTC about trading in the E-mini S&P 500 futures contract from August 2010 through August 2012.

The researchers concluded that a small number of firms are consistently profitable and benefit by trading faster than their rivals. The small number of firms competing for ever-faster trades can lead to inefficient investments in technology by “driving an arms race” and warding off new participants in the market, according to Kirilenko, who said regulators should investigate why the industry is concentrated among so few firms while new participants struggle to compete.

The study referred to is by Matthew Baron, Jonathan Brogaard and Andrei Kirilenko, titled The Trading Profits of High Frequency Traders:

Small traders are defined as firms that trade less than a median of 20 contracts a day of all the days that firm is active. This is the majority of traders, with 21,761 participants in August 2010. … More precisely, for each trader, we calculate the end-of-day profits as the cumulative cash received from selling short positions minus the cash paid from buying long positions, plus the value of any outstanding positions at the end-of-day, marked to the market price at close: … Small traders in particular suffer the highest short-term losses to HFTs on a per contract basis: $3.49 per contract to Aggressive HFTs compared to $1.92 for Fundamental traders and $2.49 for Opportunistic traders, for a contract valued at approximately $50,000. … Retail investors are thought to be noise traders and so under the uninformed hypothesis we expect them to incur significant losses to HFTs (e.g. Hvidkjaer, 2008; Kaniel, Saar, and Titman, 2008; Barber, Odean, and Zhu, 2009). … The results also support the hypothesis that Small (retail) traders are noise traders who incur the largest effective transaction costs per contract.

So, yeah, the paper does indicate that HFTs make money from retail (as defined). What it does not do is estimate how much money retail would lose in the absence of HFT. Market making is a service; one generally pays for services.

The Bank of Canada has published a paper by Jonathan Brogaard, Corey Garriott and Anna Pomeranets titled High-Frequency Trading Competition:

When an HFT firm begins trading a stock, it disturbs the trading environment and leads incumbent HFT firms to change their behaviour. Part of the incumbents’ volume share is lost to the entrant. Competition in providing liquidity leads incumbents to tighten their spreads. Entry results indicate that incumbent HFT price predictability decreases, consistent with markets becoming more efficient. The culmination is that revenues fall with competition. The influence of both Passive and Aggressive entrants diminishes with each subsequent entry.

The approach in this paper helps to isolate the role of competition from the role of speed and aims to understand the channel by which competition affects markets. Our findings complement papers on HFT market quality. We show that competition among HFT firms, not just speed, plays a role in how they behave in the market and consequently may be partially responsible for the documented relationships between HFT and market quality.

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts up 10bp, FixedResets off 29bp and DeemedRetractibles gaining 1bp; it may be that the Enbridge new issue had an effect on the market! Or maybe it was profit taking. Possibly concerns over the Ukraine. How should I know? Enbridge issues certainly got whacked pretty hard; the Performance Highlights table is comprised entirely of Enbridge FixedReset losers. Could it be that the market is getting saturated with Enbridge and that investors are getting tired of their advisors passing gas all the time? Stay tuned! I won’t know next year, either! Enbridge issues also captured the top four spots on the Volume Highlights table on what was, overall, a day of average volume. Maybe a tad on the low side.