PrefBlog

Themis Trading will be known to Assiduous Readers due to its presence on the right-hand links panel. Sal L. Arnuk and Joseph Saluzzi write in Toxic Equity Trading Order Flow on Wall Street:

More than half of all institutional algo orders are “pegged” to the National Best Bid or Offer (NBBO). The problem is, if one trader jumps ahead of another in price, it can cause a second trader to go along side of the first one. Very quickly, every algo trading order in a given stock is following each other up or down (or down and up), creating huge, whip like price movements on relatively little volume.

This has led to the development of predatory algo trading strategies. These strategies are designed to cause institutional algo orders to buy or sell shares at prices higher or lower than where the stock had been trading, creating a situation where the predatory algo can lock in a profit from the artificial increase or decrease in the price.

To illustrate, let’s use an institutional algo order pegged to the NBBO with discretion to pay up to $20.10. First, the predatory algo uses methods similar to the liquidity rebate trader to spot this as an institutional algo order. Next, with a bid of $20.01, the predatory algo goes on the attack. The institutional algo immediately goes to $20.01. Then, the predatory algo goes $20.02, and the institutional algo follows. In similar fashion, the predatory algo runs up the institutional algo to its $20.10 limit. At that point, the predatory algo sells the stock short at $20.10 to the institutional algo, knowing it is highly likely that the price of the stock will fall. When it does, the predatory algo covers.
This is how a stock can move 10 or 15 cents on a handful of 100 or 500 share trades.

This is the type of behaviour considered desirable by Omega ATS in their response to the pegged order consultation.

So the question is: is such behaviour a Good Thing or a Bad Thing?

I suggest that this is a good thing. Intra-day volatility leads to a wider variety of entry- and exit-points for real-money players who have bothered to calculate entry- and exit-points. If I own Stock A and want to swap it into Stock B, I must definitely have a spread in mind: if I don’t, then I am grossly incompetent.

Themis’ example represents a bleeding of money from incompetent real-money players into those of the day traders and to competent real-money players; thus, it can be thought of as a Public Good, since it will serve to help differentiate between skill levels on the buy side.

The Federal Reserve Bank of New York has released a Staff Report by Gara Afonso, Anna Kovner, and Antoinette Schoar titled Stressed, Not Frozen: The Federal Funds Market in the Financial Crisis:

This paper examines the impact of the financial crisis of 2008, specifically the bankruptcy of Lehman Brothers, on the federal funds market. Rather than a complete collapse of lending in the presence of a market-wide shock, we see that banks became more restrictive in their choice of counterparties. Following the Lehman bankruptcy, we find that amounts and spreads became more sensitive to a borrowing bank’s characteristics. While the market did not contract dramatically, lending rates increased. Further, the market did not seem to expand to meet the increased demand predicted by the drop in other bank funding markets. We examine discount window borrowing as a proxy for unmet fed funds demand and find that the fed funds market is not indiscriminate. As expected, borrowers who access the discount window have a lower return on assets. On the lender side, we do not find that the characteristics of the lending bank significantly affect the amount of interbank loans it makes. In particular, we do not find that worse performing banks began hoarding liquidity and indiscriminately reducing their lending.

Normally, Fed Funds borrowers are allocated a line by their lender and rates are generic within that limit. After the Lehman bankruptcy, rate stratification was observed:

We use transaction level data of participants in the fed funds market to investigate the provision of credit in this market after the Lehman Brothers’ bankruptcy. We find a much more nuanced picture: Under “normal” or pre-crisis conditions the fed funds market functions via rationing of riskier borrowers rather than prices, e.g. adjustments of spreads.1 After Lehman we see a different picture emerge: In the days immediately after the Lehman Brothers’ bankruptcy the market seems to become sensitive to bank specific characteristics, not only in the amounts lent to borrowers but even in the cost of overnight funds. We see sharp differences between large and small banks in their access to credit: Large banks (especially those with high percentages of nonperforming loans) show drastically reduced daily borrowing amounts after Lehman and borrow from fewer counterparties. In fact, the interest rate spread at which large banks borrow in the fed funds market after Lehman falls below pre-crisis levels after September 16th, 2008. We interpret this initial response as an effect of credit rationing. In contrast, smaller banks were able to increase the amount borrowed from the interbank markets and even managed to add lending counterparties during the crisis; but to do so they faced higher interest rate spreads. Different from the predictions of many theoretical models of interbank lending, when faced with a market wide shock, we do not observe a complete cessation of lending but instead we see increased differentiation between borrowers of high versus low type.

Too-Big-to-Fail moral hazard had an immediate market effect:

After the AIG bailout is announced, spreads for the largest banks fall steeply, falling below the rate in the week before Lehman. We interpret the return to pre-crisis spreads as the effect of the government’s support for systematically important banks, because the same is not true for small banks: these banks continue to face higher spreads till well after the announcement of the CPP.

There was a high degree of differentiation shown by discount window usage:

Because of the high interest rate and potential for stigma, banks usually access the discount window only if they face severe unmet liquidity needs. Thus use of the discount window gives a lower bound for the unmet liquidity needs in the fed funds market. We find that even in the days after the Lehman Brothers’ bankruptcy only very poorly performing banks, those with low ROA, access the discount window. It seems reasonable to assume that these are banks which were rationed by private banks lending in the fed funds market. While again it is difficult to assess whether this means that interbank markets operated efficiently after the crisis, it is, however, reassuring that we do not observe that well performing banks are forced to turn to the discount window. This would have been a very alarming indication of dysfunction in the fed funds market.

Paul Krugman writes an op-ed piece in the New York Times today, titled An Irish Mirror:

So what can we learn from the way Ireland had a U.S.-type financial crisis with very different institutions? Mainly, that we have to focus as much on the regulators as on the regulations. By all means, let’s limit both leverage and the use of securitization — which were part of what Canada did right. But such measures won’t matter unless they’re enforced by people who see it as their duty to say no to powerful bankers.

That’s why we need an independent agency protecting financial consumers — again, something Canada did right — rather than leaving the job to agencies that have other priorities. And beyond that, we need a sea change in attitudes, a recognition that letting bankers do what they want is a recipe for disaster. If that doesn’t happen, we will have failed to learn from recent history — and we’ll be doomed to repeat it.

I find his insistence on the need for securitization to be limited somewhat puzzling: the authors of his source material go out of their way to stress that securitization was not a major factor in the Irish debacle.

The source paper is a paper by Gregory Connor, Thomas Flavin and Brian O’Kelly titled The U.S. and Irish Credit Crises: Their Distinctive Differences and Common Features:

Although the US credit crisis precipitated it, the Irish credit crisis is an identifiably separate one, which might have occurred in the absence of the U.S. crash. The distinctive differences between them are notable. Almost all the apparent causal factors of the U.S. crisis are missing in the Irish case; and the same applies vice-versa. At a deeper level, we identify four common features of the two credit crises: capital bonanzas, irrational exuberance, regulatory imprudence, and moral hazard. The particular manifestations of these four “deep” common features are quite different in the two cases.

There is some support for the IMF’s thesis that stability of the funding base is important for overall stability:

In the case of Ireland, the capital bonanza was mediated by the Irish commercial banks. In 1999, Irish banks were funded primarily from domestic sources; see Table 1. By 2008, Irish customer deposits provided just 22% of domestic bank funding. Over 37% of the funding was obtained in the form of deposits and securities from the international capital markets. Directly in response to this capital inflow, the balance sheets of the Irish banks increased more than six-fold in the period 1999 to 2008. Lending to the non-financial private sector had grown to more than 200% of GDP by end of the period, approximately twice the European average (see Figure 5).

It is becoming more and more compelling to believe that the Basel Accords’ insistence that inter-bank loans should be risk-weighted according to the credit rating of their sovereign is a major contributor to financial instability.

The authors also stress the relative looseness of monetary policy, as measured by the Taylor rule. This is food for Canadian thought, given the perpetual squawking over the Bank of Canada rate, which is by necessity applied nationally, over regions that can be performing very differently from each other.

After Ireland’s entry to the Euro zone, Irish banks funded much of their lending with short-term foreign borrowing. This allowed Irish financial institutions to extend much larger volumes of credit to borrowers at lower cost, as evidenced by Figure 6. As a small member of the Eurozone, Ireland does not have control of its interest rates, but Figure 7 shows an Irish target rate calculated from a standard Taylor rule. We set the target rate equal to 1/2 (GDP growth rate – 3%) + 1/2 (inflation rate – 2%) + 1%. Had Eurozone interest rates been set in accordance with a Taylor rule for Ireland, the interest rate would have been almost 6% higher on average during the period, and up to 12% higher in 2000.

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As always, concentration is at the root of the problem:

Woods (2007) reports that, as a proportion of lending to the private sector, property related lending grew from 38% in 2001 to over 62% in 2007. With the enormous growth in property- and construction-related lending, the loan books of the Irish domestic banks were becoming increasingly undiversified.

Dr. Krugman glosses over a major similarity between the pre-crash climates in the US and Ireland. He believes that Fannie & Freddie’s role are overemphasized in the current debate; but they simply represent one way for the government to over-stimulate the housing sector. In Ireland the mechanism was different, but the results the same:

In addition to the enormous credit inflow, the over-heating of the property markets was exacerbated by government legislation that encouraged people to invest in property through a series of tax-incentive schemes. For example, generous tax relief was available to investors in hotels as the government sought to increase the stock of hotel rooms and hence tourism; similar breaks were available to individuals who built houses in seaside towns and in rural areas.

On the retail end, we can see some support for the Canadian regulatory response, when the maximum insurable amortization period was decreased along with the maximum LTV ratio:

A considerable decline in lending standards occurred in the Irish mortgage market; an increasing proportion of lending was done at higher loan-to-value, higher income multiples, longer maturities, and with interest-only periods. The only step the regulator took to stem the sharp decline in lending standards was to increase to 100% the risk-weighting on the portion of a residential mortgage written above an 80% loan-to-value threshold. As Honohan (2009) notes, this was a weak and ineffective response.

The familiar weaknesses of the American securitization process are dutifully trotted out, but the authors point out:

Despite its centrality to the US crisis, this particular moral hazard problem has no relevance to the Irish credit crisis. Throughout the bubble period Irish banks used the originate-and-hold lending system, for both residential mortgage and business lending. Almost all the loans that the Irish banks generated remained on their own balance sheets. This crucial component of the US crisis is virtually absent in the Irish case.

I have often criticized the lack of recourse in US mortgages; there is some skepticism as to the effectiveness of recourse in Ireland:

The property loans issued by Irish banks were obtained by wealthy property developers, arguably well-informed, rational actors with considerable business acumen. It is not clear whether a moral hazard argument can explain their behaviour. Personal guarantees were a standard component of property development loan contracts in Ireland during the bubble period, so most of these developers did not have recourse to the trader put option. Irish property developers are legally liable for the “tail risk” in the net value of these loans, including de jure claims against their personal assets.

This brings us to another potential source of moral hazard: weak law enforcement. This was likely an important source of moral hazard in the Irish case. The legal framework for personal bankruptcy in Ireland is antiquated and rarely activated. Although property developers signed de jure claims against their personal assets as part of their bank loan contracts, many commentators believe that these claims are de facto unenforceable in Ireland. There is also the concern in Ireland that politically powerful agents have the ability to manipulate regulatory and legislative processes to their advantages. Most large property developers in Ireland have been very closely connected to the ruling political party, Fianna Fáil. Kelly (2009) uses the term “too connected to fail” for this feature of the Irish business environment.