PrefBlog

Let’s all give three cheers for increased regulation:

New rules aimed at making the world safer from blowups in the $693 trillion derivatives market are poised to drive up costs so much for retirement funds and other users that bankers say they do just the opposite.

The toughened standards, hatched five years ago after derivative losses almost crashed the global economy, are meant to safeguard trades and bring more openness to a market whose secrecy and sheer size overwhelmed regulators in 2008. Where swaps had been one-on-one deals before, now they would be backstopped by third parties in clearinghouses that ensure everyone can pay, with the aim of avoiding emergency bailouts and panic.

Rules being finalized by the Basel Committee on Banking Supervision in Switzerland will require banks to set aside more money in the event the swaps go bad. And not just a little bit more — as much as 92 times, or 9,100 percent, more, according to calculations by three banks shared with Bloomberg News. The higher costs in turn may cause market participants to flee rather than take advantage of the clearinghouses, making it more difficult for those third-party guarantors.
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Since banks act as customers’ gatekeepers to the clearinghouses, the Basel committee wants them to protect themselves — and the global financial system — by matching every dollar they contribute to the default fund with a dollar of capital.

If the rules were adopted, swaps dealers say that only the wealthiest investors would be able to use clearinghouses. Fewer members would mean eroded financial support for the clearinghouses, which are the last backstop before losses are borne by taxpayers.
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Executives in a bank’s treasury department don’t allocate the firm’s money to trading desks without a guarantee that the profit on it will be about 10 percent to 15 percent a year after taxes, depending on the bank. In many cases, banks earn these returns by charging fees to clients.

In one bank’s internal model, a $100 million interest-rate swap between a dealer and its customer prior to the new Basel proposal would have meant that, before taxes, $14,750 in capital had to be set aside.

When the bank’s trading desk asks the firm’s treasury for $14,750 as part of the trade, the traders would have to earn $3,404 per year before taxes for as long as the swap was active. That’s in the old days.

The same $100 million swap would look different under the new proposal. As part of accepting that trade, the clearinghouse would require the bank to deposit $1.2 million into its default fund. Under the Basel committee proposal, the bank would have to have $1.2 million more capital.

According to the dealer bank, it would be required to generate more than $276,000 a year before taxes for that amount of capital. When charges such as the cost of funding and others are added to the trade, the tab balloons to $307,327 a year, the dealer said.

Fortunately, these new rules have been softened:

The Basel Committee on Banking Supervision’s final rule, released today, would require swaps dealers to hold less cash to protect against defaults than did a proposal published last year. The plan now applies a minimum 20 percent risk weighting to money deposited at clearinghouses, which are third parties that guarantee the transactions, down from 1,250 percent in the original proposal. The change takes effect on Jan. 1, 2017.

But central clearing is still a dumb idea.

Here’s yet another indicator that the HFT panic is a marketing gimmick:

Royal Bank has emerged as a leader against predatory high-frequency trading at a time of increasing scrutiny from both regulators and the public after the release of Lewis’s book, which claims the stock market is “rigged” against investors. The bank is described by Lewis as fostering an “RBC nice” culture with its “no asshole rule” on hiring.

High-frequency trading isn’t inherently good or bad, Mills said. The problem arises when certain market players use technology to take advantage of others.

“That’s what we need as an industry, to see regulation mature to the point where it can begin to eliminate those predatory practices, and that’s where we’ll level the playing field,” Mills said in a telephone interview yesterday.

Royal Bank, along with seven partners, owns a stake in and helped found Aequitas, a market with similar goals to IEX. The Toronto-based bank is Canada’s second-largest lender by assets.

“One thing that’s clear is that RBC is the common denominator between IEX and Aequitas,” said Jos Schmitt, chief executive officer at Toronto-based Aequitas, in an April 1 interview at the company’s headquarters in Royal Bank Plaza. “It tells you something about where they come from, what they stand for and what they seek to achieve. They translated that to being the spark in a change on Wall Street and on Bay Street.”

High-frequency trading firms have been accused of ripping off investors in the $22 trillion U.S. stock market by using tactics including paying for the right to trade in dark pools and placing their servers as close to the exchange as possible to speed up trading.

Royal Bank saw what its competitors were doing and decided to go in a different direction, Mills said.

I’ve been saying for a while that the economy’s still no good, and that while government yields are clearly unsustainable, there is not yet a clear trigger of impending doom. Looks like there’s some support for that idea:

Federal Reserve Chair Janet Yellen and her international counterparts are suffering from a case of what psychologists call confirmation bias: They keep insisting inflation will accelerate even as it continues to ebb.

That’s the diagnosis of Ethan Harris, co-head of global economics research at Bank of America Corp. in New York. He says central bankers are seeing what they want to see by blaming subpar inflation in their countries on temporary, partly home-grown forces. That risks ignoring more lasting, global influences ranging from weak worldwide demand and more emerging-market competition to cheap labor in developing nations, cooling commodity prices and technological breakthroughs.

“There is much lower-than-expected inflation showing up in too many places in the world to dismiss it as transitory,” said Allen Sinai, chief executive officer at consultant Decision Economics Inc. in New York.

Almost two-thirds of the 121 economies tracked by Bloomberg are experiencing smaller gains in consumer prices than a year ago, with many undershooting their goals. Global inflation was just 2 percent in February, the lowest since late 2009, when the world was struggling with recession, according to a tally by economists at JPMorgan Chase & Co.

Greece and Ireland were in the bond market today:

Italian bonds gained for a second day and Belgian, French and German securities also rallied. Greek bonds fell, pushing 10-year yields up from near the lowest level since February 2010, as the nation agreed to sell 3 billion euros ($4.17 billion) of five-year notes via banks. Greece received about 600 orders for a total of around 20 billion euros, a person familiar with the sale said. Ireland auctioned 1 billion euros of 10-year debt at a record-low yield.

“Bond markets have woken up on a positive note on the back of a dovish set of Fed minutes,” said Richard McGuire, a fixed-income strategist at Rabobank International in London. “This is a classic case of an improving liquidity outlook raising all boats. The strong demand for Greece’s five-year issue is symptomatic of a positive liquidity outlook trumping more fundamental concern.”

It was another positive day for the Canadian preferred share market, with PerpetualDiscounts winning 16bp, FixedResets up 5bp and DeemedRetractibles gaining 2bp. It is interesting to note that the median YTW on DeemedRetractibles remained negative for the second straight day and the fifth time on record, joining 2012-12-28, 2013-1-4 and 2013-1-10. Volatility was negligible. Volume was below average.

Nothing happened today.

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts off 3bp, FixedResets up 12bp and DeemedRetractibles gaining 11bp. Volatility was only technically existent. Volume was a little below average.

PerpetualDiscounts now yield 5.42%, equivalent to 7.05% interest at the standard equivalency factor of 1.3x. Long corporates now yield about 4.5%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 255bp, a slight (and perhaps spurious) decline from the 260bp reported April 2)
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This could get interesting:

Expectations are building that TMX is getting close to unveiling its plans for a network. TMX has acknowledged that microwaves are a priority but so far the company has not given any specifics.

“We do know that microwaves [are] an important opportunity out there and we have to bring that to this marketplace, we’re just trying to figure out how,” TMX chief executive officer Tom Kloet said in a recent interview.
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The speed advantage of microwaves is significant. Because of that, the owner would be able to charge speed-focused traders a high price for access. That’s especially true if there are only a small number of spots on the microwave network.

A microwave link between the TMX Group’s Toronto Stock Exchange data centre in suburban Toronto and the U.S. stock market data centres in New Jersey would be as much as 5 milliseconds faster than a fibre-optic link because microwaves travel more quickly and have a more direct route through the air, ITG Canada estimated in a report earlier this year.

Trial attorney Jim Kidney of the SEC is retiring … but he gave a farewell speech:

The revolving door is a very serious problem. I have had bosses, and bosses of my bosses, whose names we all know, who made little secret that they were here to punch their ticket. They mouthed serious regard for the mission of the Commission, but their actions were tentative and fearful in many instances. You can get back to Wall Street by acting tough, by using the SEC publicity apparatus to promote yourself as tough, and maybe even on a few occasions being tough, if you pick your targets carefully. But don’t appear to fail. Don’t take risks where risk would count. That is not the intended message from the ticket punchers, of course, but it is the one I got on the occasions when I was involved in a high profile case or two. The revolving door doesn’t push the agency’s enforcement envelope very often or very far.

The attitude trickles down the ranks. Combined with the negative views of the civil service promoted by politicians and the beatings we take from the public, it is no surprise that we lose our best and brightest as they see no place to go in the agency and eventually decide they are just going to get their own ticket to a law firm or corporate job punched.
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Please don’t tell me we account for other factors in our management of cases. We think about them, of course, but we all see cases frequently to which we offer a head scratching response. Really? The SEC spent time and money on that? These cases have no significant impact and the conduct is of minimal or no harm to the investing public. But the investigation has been intense and expensive. Could no one in management exercise judgment and call the investigation to a halt? Of course not! Bringing the case is a stat!

The metric [quantity] we have now is built into the soul of the Division. It has to be removed root and branch.

Jonathan Weil of Bloomberg wants to make Jim Kidney a commissioner [link now broken? What’s up with that?]; the speech has attracted some press notice:

The SEC also sued Fabrice Tourre, who was vice president on the team that put together the deal at issue in the SEC case, known as Abacus 2007-AC1. A federal jury found Tourre liable last year, and he was ordered in March to pay $825,000 in penalties and other costs.

Kidney, who was part of the initial team that was building the Goldman Sachs case, pressed his bosses in the enforcement division to go higher up the chain. He later took himself off the team after being given a lesser role, according to people familiar with the matter.

In particular, the people said, Kidney argued that the commission should sue Tourre’s boss, Jonathan Egol. Kidney also wanted to bring a case against Paulson & Co. or some executives at the hedge fund, which helped pick the portfolio of securities that were underlying the Abacus vehicle and then bet against it.

The SEC ultimately decided not to sue Egol, the Paulson firm or any individuals from the hedge fund.
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While Kidney declined to comment on the Goldman case in particular, much of his role is laid out in a September 2010 report by the agency’s inspector general’s office, which reviewed whether the SEC succumbed to political pressure in bringing the enforcement action. Kidney’s name is blacked out in the report.

He sounds like an honourable man. It seems clear that if there was in fact anything bad about the Abacus deal – Assiduous Readers will remember that I don’t think there was – then Fabrice Tourre should have been only a minor target.

It was a good day for the Canadian preferred share market, with PerpetualDiscounts winning 28bp, FixedResets gaining 8bp and DeemedRetractibles up 21bp. Volatility was minimal. Volume was below average.

There are some interesting statistics from electronic bond trading:

Traders trying to purchase investment-grade notes are failing about 46 percent of the time, close to the worst rate in more than four years as measured by activity on MarketAxess Holdings Inc.’s electronic platform. On the flip side, investors trying to sell the debt are having the easiest time on record, with an 85 percent success rate.

Bond buyers are showing an unwillingness to part with their holdings as a rally fueled by more than five years of unprecedented Federal Reserve stimulus refuses to die. Ironically, it’s harder than ever to find securities for sale even though the U.S. corporate-debt market has grown 53 percent since 2008, with companies selling $6.9 trillion of notes since then, according to data compiled by the Securities Industry and Financial Markets Association and Bloomberg.

“Right now, everyone’s a buyer,” said Edward Meigs, who manages $1.6 billion of debt assets at First Eagle Investment Management in Baltimore. “There’s a marked level of complacency.”

Traders will submit offers to buy or sell bonds on MarketAxess’s platform within a set period of time. The transaction is considered to fail when time runs out with no takers. New York-based MarketAxess is the most-active electronic venue for trading corporate bonds in the U.S.

And given the difficulty in buying bonds, guess what’s making a comeback?:

Commercial real-estate investor H/2 Capital Partners bundled a hodge podge of its holdings — from bonds tied to skyscrapers and malls to junk-rated bank loans — into about $400 million of securities. The deal, similar to the pre-crisis transactions known as collateralized debt obligations, included one portion that Moody’s Investors Service gave its highest rating of Aaa.

The investment firm is seizing on a revival of the types of transactions that fueled the property boom in 2006 and 2007, showing the lengths to which investors are going to bolster skimpy yields across credit markets. Such offerings are giving commercial-property investors a wider range of options to fund acquisitions, according to Richard Hill, a debt analyst at Morgan Stanley.

The war on markets continues:

U.S. Attorney General Eric Holder promised Congress a thorough investigation into whether high-frequency trading violates laws against insider trading.

Holder said he is responding to concerns being raised about whether the practice creates an uneven playing field for investors.

“The department is committed to ensuring the integrity of our financial markets, and we are determined to follow this investigation wherever the facts and the law may lead,” Holder said in testimony today at a hearing of the House Appropriations subcommittee that oversees the Justice Department.

With respect to my remarks about High Frequency Trading on April 3, Assiduous Reader PL writes in and says:

OK, I see your point. James you are like PT Barnum. But for you there is a sucker born every millisecond.

This is not strictly true. My objection to rules about spoofing and layering and all the other little tactical games that speculators play is twofold:

• They seek to protect speculators from the consequences of their own actions, and
• They are completely arbitrary

With respect to the first point – anybody who buys a stock at 20.55 simply because there’s a big bid at 20.50 is taking his chances. He is speculating and he knows he’s speculating. As a matter of public policy, there is no reason to worry over-much about the consequences that might befall speculators; speculators are of interest solely because they provide liquidity to real money players.

That big bid at 20.50 is valuable to real-money players seeking to sell – putting in a spoof order is a dangerous game and can easily blow up in the face of Mr. Clever if somebody else has a well timed pounce algorithm or otherwise hits that bid. Mr. Clever – whose actual goal is to sell a few shares at 20.55 – is now behind the eight-ball and has to sell more shares in order to break even. Mr. Clever has actually supplied liquidity to the market, which is exactly what speculators are supposed to do (although he might have to take some liquidity as he squares his books).

There will doubtless be a lot of whimpering about Granny and her purchase of 500 shares. I don’t really care much about Granny and her 500 shares, either. A stock exchange is life in the raw. If Granny wants professional management of her portfolio, she should hire a professional – last time I checked, there were still lots of them around. We do not insist that hospitals provide facilities and diagrams for amateur brain surgeons; why should we insist that stock exchanges provide a straight-forward and predictable environment for amateur stock traders? Granny’s best bet is an ETF, mutual fund or other arrangement to hire a professional to handle her investment needs.

The concern for Granny is all crocodile tears. It comes from incompetent institutional traders who simply aren’t very good at trading; who find themselves in a horrifying world where anybody – just anybody! – with a bit of capital and computer skills can eat their lunch. The controversy regarding HFT is fuelled by monopolists who are watching their monopoly erode and aren’t very happy about it.

The other point is regarding the arbitrary nature of the anti-spoofing, et cetera, rules and I will introduce that point by quoting again from the SEC press release I quoted on April 4:

“The fair and efficient functioning of the markets requires that prices of securities reflect genuine supply and demand,” said Sanjay Wadhwa, senior associate director of the SEC’s New York Regional Office. “Traders who pervert these natural forces by engaging in layering or some other form of manipulative trading invite close scrutiny from the SEC.”

This is total bullshit and reveals that Sanjay Wadhwa doesn’t have a clue about trading strategies (he’s only a lawyer-accountant – I see no evidence that he’s ever traded a single thing in his life. He is “nurturing” though, and golly, isn’t “nurturing” better than “competent” and “knowledgeable” nowadays?).

Genuine supply and demand? Spoofing works – when it does work! – because when there’s a big order on one side of the market, many speculators will back away from it, reasoning that whoever put that order in will end up moving the market (with more confidence, you can then take the orders that didn’t back away. It was exploitation of this behaviour that got Dondero into trouble – see April 4). So, for instance, if trader M. T. Head of Bozo Corp has an order to sell 10,000 shares of XYZ, the market may well evolve as follows:

• Market before Order: 21.50-60, 10×10
• Market immediately after order: 21.50-59, 10×100
• Market shortly after order: 21.40-59, 10×100

So after this happens a few times, Mr. Head wises up a little, and only puts in an order to sell 1,000 shares intending to feed the rest of his 10,000 shares into the market as he gets filled; so the market evolves like this:

• Market before Order: 21.50-60, 10×10
• Market immediately after order: 21.50-59, 10×10
• Market shortly after order: 21.50-59, 10×10

This has a couple of overall effects – spreads have narrowed (from a dime to nine cents) and execution sizes are reduced (since the 10,000 shares will be sold in pieces). In fact, this is exactly what we have seen in the market over the last twenty years.

But, to the chagrin of Sanjay Wadhwa of the SEC, the market prices no longer reflect genuine supply and demand! Oh, the horror! There is true supply of 10,000 shares, but only 1,000 shares are being advertised! Quick, to the lamp-posts! String up the social misfit of a trader who is keeping 9,000 shares secret! He is perverting the natural forces that Sanjay Wadhwa is sworn to defend!

The situation gets even more ridiculous when we remember that iceberg orders are institutionalized and available on many exchanges: M. T. Head could well have put in an iceberg order, giving the exchange an order for 10,000 shares with instructions to show only 1,000 shares at a time … and now it is the exchange that is perverting the natural forces of supply and demand. For some odd reason, Sanjay Wadhwa doesn’t seem particularly offended by this.

He does, however, have hysterics if M. T. Head takes another step to execute his client’s order at a good price, and puts in a spoof buy for 2,000 shares at 20.51, making the complete evolution of the market like this:

• Market before Order: 21.50-60, 10×10
• Market immediately after order: 21.50-59, 10×10
• Market shortly after order: 21.50-59, 10×10
• Market after spoof: 21.51-59, 20×10 ILLEGAL, ILLEGAL ILLEGAL!!! Call the gendarmes!

Mr. Head, as mentioned, is taking a bit of chance here, because his bid for 2,000 at 21.51 could get hit, and if it is he’s got 12,000 shares to sell instead of 10,000. But that’s his problem. But maybe it will work; somebody will see the big bid at 21.51 and consider this to be a good reason to buy 1,000 at 21.59; it’s the same principle as backing off on your orders when you see a big order on the other side. If M. T. Head’s good enough at the game his winnings will exceed his losses, he’ll get more clients and take home more money, which is exactly how the system should be working. In the mean-time, we observe that the spoof order increased market depth and decreased market spread. Why is this wrong? Regrettably, as discussed on April 4, this is exactly what got Joseph Dondero into trouble.

However, a good argument can be made that allowing spoofing will actually improve the market for naïve real money. As noted above, speculative bidders will drop their bids in the face of a large offer, believing that it is a naïve seller who will eventually execute at any price he can get (and vice versa for naïve buyers, of course). Along comes Granny, with her market order to sell 100 shares and hits one of those reduced bids and gets less money than she would have had there not been a large seller in the market at that time. If, however, spoofing is allowed, then there will be less certainty regarding the future course of prices, which should result in the speculative bidders not dropping their prices so much – or perhaps not dropping them at all. So the bid-offer spread is not so adversely impacted and Granny gets a better price. Isn’t that good? There’s no evidence that I know of that this will actually be the case; but there is no evidence I know of that it doesn’t, either; it would be interesting to see a few controlled experiments, but the SEC is more interested in grandstanding.

Another example of supply-and-demand uncertainty is a case where I have a client who has 10,000 shares of XYZ and 10,000 shares of ABC, both of which are trading around $20, which – as far as I can tell – is fair value. My client asks me to raise $20,000 because he wants to buy a car. So, wishing to do the best for my client, I put in two orders:

• Sell 1,000 XYZ at 20.10, and
• Sell 1,000 ABC at 20.10

Two orders! I’m trying to do the best for my client and get him the best price possible … if I get can sell 1,000 shares at 20.10, he’ll have $100 more than if he sold them at $20.00 … maybe $100 isn’t all that much, but given the choice between $100 in my client’s pocket and $100 in somebody else’s client’s pocket, I know what I like best – and it’s my job to get best execution for my client.

I’m taking a bit of a chance: maybe both offers will get lifted, I’ll have raised too much money, and I’ll have to reinvest the excess, possibly taking a loss on that part of the transaction. Well – that’s my problem. It’s my job to take calculated risks on behalf of my clients – isn’t that what investment is all about? – and in my judgement, for this package of transactions, given market conditions and my evaluation of fair value, this is a calculated risk worth taking.

“But”, shrieks Sanjay Wadhwa, spittle dribbling from his chin, “what about the Holy Supply and Demand? You are putting offers for 2,000 shares on the market when you really only wanting to supply 1,000 shares! Evil, evil, evil! To the lamp-posts!”

So I have to explain that there’s nothing actually illegal about my actions; they happen to be on the right side of an idiotic arbitrary line.

So the result of these precious little anti-spoofing rules are:

• increased spreads
• decreased depth
• lots of arbitrary rules for traders to remember
• lots of employment for lawyers, accountants, lawyer-accountants and other box-tickers to enforce these rules
• the occasional ‘Gotcha!’ when the authorities find a technical violation and decide to enforce these rules

You don’t believe in ‘Gotcha!’? Ask David Berry about ‘Gotcha!’. He only got off because (i) He had enough money to fight the case, and (ii) There was enough at stake to make it worthwhile fighting the case. Ask Fabulous Fab about ‘Gotcha!’.

It’s a pretty screwy system, if you ask me.

Rob Carrick of the Globe wrote an article recently titled Real estate or stocks – which will make you richer?, concluding that as an investment, stocks are better, based in part on the following figures:

He also notes that:

Property taxes, furnishings, maintenance, improvements, insurance and mortgage interest all have to be factored into calculations of how much money is being made on housing.

There’s also a cost to investing, of course. But it’s much more contained and predictable than a house, where costly repairs could be needed at any time. A do-it-yourself investor might pay 0.5 per cent of the value of her account assets in fees and commissions per year, while an investor with an adviser might pay 1 to 1.5 per cent. Even if you lower stock market returns by this amount, you still get a better result than housing.

He neglected to factor in taxes, but this was addressed in the comments. I’ll also point out that national average housing price figures are suspect due to quality improvements.

In the end, I take the view that a house is not an investment. It’s a place to live. All in, if owning makes sense for you – i.e, you can afford it, you have enough stability in your life that you can settle down, that sort of thing – you should own. Then you can paint when you feel like painting. In the long run, house prices aren’t going to appreciate more than people’s salaries improve, although one might get fancy and specify that the price of a house in your price bracket will appreciate according to the improvement in salaries of the people who can afford to buy it, which is a much different thing what with income inequality and all. I have a friend who bought an entry level condo ten years ago, visions of immense riches dancing in her eyes … she’s now sold it in disgust, as it has appreciated in price by about as much as the improvement in salaries of people who buy entry level condos, which ain’t much.

The big value to a house, as far as I can tell, is that the mortgage represents forced saving. Every month you pay $1,500 on your mortgage, $1,000 of that is reducing principal and represents saving; by the time you’ve done this for 25 years, you have something worth having, especially since you’ve kept pace with inflation – however defined – on the entire value. Mind you, that might be an old-fashioned thought, nowadays, what with people taking out lines of credit … it’s even easier than selling part of your portfolio when you need some cash for something important.

DBRS confirmed BCE at Pfd-3(high):

It should be noted that BCE’s ratings are based primarily on the ratings of Bell Canada and reflect the structural subordination of debt (currently none outstanding) and its preferred share obligations relative to Bell Canada.
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In terms of financial profile, DBRS expects Bell Canada’s leverage to be appropriate for the current rating category by mid-2015, following modest debt reduction and low-single-digit growth in EBITDA. DBRS expects Bell Canada to use the majority of its free cash flow and ~$700 million of proceeds from the Astral divestitures toward spectrum auction purchases and debt reduction. As such, DBRS forecasts Bell Canada’s gross debt-to-EBITDA will stand at approximately 2.1x at the end of 2014. DBRS continues to expect the Company to reduce its gross debt-to-EBITDA ratio to below 2.0x by mid-2015. DBRS notes that failure by Bell Canada to deleverage as expected could result in a negative rating action.

It was a positive day for the Canadian preferred share market, with PerpetualDiscounts up 8bp, FixedResets winning 11bp and DeemedRetractibles gaining 5bp. Volatility was modest. Volume was low.

I mentioned on April 4 that Charles Schwab, Inc., had come out against High Frequency Trading (HFT). Assiduous Readers have been on tenterhooks all day, wondering when Schwab will reveal the secrets of the universe and the golden key to riches through equity investment. Today, we got an answer:

“When you’re at record high levels, people start to get a little tentative going into weekends,” Randy Frederick, managing director of trading and derivatives at Charles Schwab Corp. which manages $2.2 trillion in client assets, said in a phone interview. “Taking a few profits off the table going into the weekend is probably not a bad strategy.”

What a thoroughly asinine remark, illustrative of Big Broker culture: ‘Go with the flow and avoid thinking’.

Meanwhile, another firm has been victimized for not being kind to stupid people:

The Securities and Exchange Commission today charged the owner of a Holmdel, N.J.-based brokerage firm with manipulative trading of publicly traded stocks through an illegal practice known as “layering” or “spoofing.”

The SEC also charged the owner and others for registration violations. Two firms and five individuals agreed to pay a combined total of nearly $3 million to settle the case.

In layering, the trader places orders with no intention of having them executed but rather to trick others into buying or selling a stock at an artificial price driven by the orders that the trader later cancels. An SEC investigation found that Joseph Dondero, a co-owner of Visionary Trading LLC, repeatedly used this strategy to induce other market participants to trade in a particular stock. By placing and then canceling layers of orders, Dondero created fluctuations in the national best bid or offer of a stock, increased order book depth, and used the non-bona fide orders to send false signals to other market participants who misinterpreted the layering as true demand for the stock.

“The fair and efficient functioning of the markets requires that prices of securities reflect genuine supply and demand,” said Sanjay Wadhwa, senior associate director of the SEC’s New York Regional Office. “Traders who pervert these natural forces by engaging in layering or some other form of manipulative trading invite close scrutiny from the SEC.”

Well, if technical analysts want to play around attempting to measure “true demand” for any particular stock, let them. But the fair and efficient functioning of the markets actually requires that the prices of securities reflect, to as close a degree as possible, the fundamental value of those securities. That’s how you get the best results in capital allocation, both by issuers getting clear signals about what their businesses are worth, and by investors being rewarded according to the accuracy of their estimates of fundamental value.

I will also point out that this spoofing strategy can get very expensive if somebody starts running a pounce algorithm.

By keeping markets safe for the stupid, the regulators are encouraging bubbles and hindering sustainable expansion of the economy.

There was a pretty good US jobs number today:

Companies powered the U.S. job market past a milestone in March as private employment exceeded the pre-recession peak for the first time, showing the kind of progress Federal Reserve officials look for to maintain their current policy course.

Payrolls excluding government agencies rose by 192,000 workers after a 188,000 gain in February that was larger than first estimated, the Labor Department reported today in Washington. That brought the job count to 116.1 million, beating the January 2008 high of 116 million. The jobless rate held at 6.7 percent even as almost half a million people entered the workforce.

… but Pew Research reminds us that there is a lot of catching up to do:

Because more people are entering the labor force each month, merely replacing all the jobs lost during the recession won’t bring employment back to its pre-crisis level.

Under the most optimistic scenario — the economy adds 472,000 jobs a month, the highest single-month rate in the 2000s — it would still take until October 2015 for employment to regain its pre-recession level. If the economy replicates its performance in 2005 (the best year since 2000) and adds about 208,000 jobs a month, it would take until September 2018. And if the economy continues to add jobs at the rate it has since late 2010 — an average of 182,000 a month — the employment gap won’t be closed till August 2019.

It was another positive day for the Canadian preferred share market, with PerpetualDiscounts up 5bp, FixedResets winning 10bp and DeemedRetractibles gaining 3bp. Volatility was minimal. Volume was well below average.

Assiduous Reader PL writes in and says:

I know that getting and correctly interpreting market reaction to information quicker whether one minute or one second than the other players will always be an advantage. And though I think there should be a small transaction tax on all of us to reduce this madness I know this may never happen in North America, even though it is happening in Europe I believe.

HOWEVER the one HFT practice that should be stopped is the fake orders. Any bid or offer should be required to stay in for one minute during trading hours. If they want to enter BS orders then let them do them before market opens.

I never buy or sell anything in the first half hour anyway. Your thoughts on eliminating fake deliberately deceptive orders.?

I disagree with your characterization of short-duration orders as “fake”. They may not be posted on the exchange for very long (as little as a few milliseconds), but for the entire time they’re up, they may be executed against.

This is a controversial subject – Panther Energy Trading LLC was victimized by the CFTC for spoofing:

According to the Order, Coscia and Panther made money by employing a computer algorithm that was designed to unlawfully place and quickly cancel orders in exchange-traded futures contracts. For example, Coscia and Panther would place a relatively small order to sell futures that they did want to execute, which they quickly followed with several large buy orders at successively higher prices that they intended to cancel. By placing the large buy orders, Coscia and Panther sought to give the market the impression that there was significant buying interest, which suggested that prices would soon rise, raising the likelihood that other market participants would buy from the small order Coscia and Panther were then offering to sell. Although Coscia and Panther wanted to give the impression of buy-side interest, they entered the large buy orders with the intent that they be canceled before these orders were actually executed. Once the small sell order was filled according to the plan, the buy orders would be cancelled, and the sequence would quickly repeat but in reverse – a small buy order followed by several large sell orders. With this back and forth, Coscia and Panther profited on the executions of the small orders many times over the period in question.

David Meister, the CFTC’s Enforcement Director, said, “While forms of algorithmic trading are of course lawful, using a computer program that is written to spoof the market is illegal and will not be tolerated. We will use the Dodd Frank anti-disruptive practices provision against schemes like this one to protect market participants and promote market integrity, particularly in the growing world of electronic trading platforms.”

I take the view that you can’t cheat an honest man. If somebody is spoofed into taking the ‘wrong’ side of the market in this way, he has only himself to blame. The markets exist for the formation and movement of long term capital – these short-term games are basically irrelevant to this purpose, but to the extent they do exist, they narrow spreads for real-money players. Speculators – such as HFT, traditional brokerages and fools – should be of interest to policy makers only to the extent that they provide liquidity to real money. We should not be doing a damn thing to protect traders whose Big Idea is ‘buy things when they start to go up’. As I said on May 7, 2010:

The way to eliminate stupid dumb trading is to ensure that stupid dumb traders lose all their money, go bankrupt and die.

The CFTC – under Dodd-Frank – takes the view that these are simply short-term versions of pump-and-dump, despite the fact that no execution actually occurred. If Panther had executed wash trades through separate accounts, giving rise to actual volume, they would have a better case for this … but with pump-and-dump, I also take the view that the law is merely molly-coddling of incompetent fools. If 21.50 is too much to pay for XZY stock … then don’t buy XZY at 21.50. It’s as simple as that.

I cancelled an order today within one minute of placing it. I’ll use fake numbers to illustrate: there was a bid for 500 shares at 21.50; the next bid was at 21.40. The offer was at about 21.60. I wanted to sell 1,000 shares and I thought 21.50 was a good price, so I hit the bid and got done for 500, which left me on the offer side of the market. But the offer behind me was at 21.60! Why should I improve the quote – using client money – by ten cents? So I modified the offer on the 500 shares remaining on my order to 21.58. Selling at 21.50 was good, but selling at 21.58 would be better. Selling at 21.50 with execution certainty is one thing; offering the entire world an option to buy them at 21.50 is another.

I don’t understand why you want to jail me for that.

It should also be noted that although Nanex is a firm I respect – they did excellent work on the Flash Crash – their conclusions regarding algorithmic behaviour have been challenged:

Nanex regularly misunderstands what it sees in market data and is fueling misconceptions that damage investor confidence, according to Manoj Narang, founder and chief executive officer of HFT firm Tradeworx Inc. in Red Bank, New Jersey. He compared Nanex to the “truthers” who doubt the official explanation of the Sept. 11 terrorist attacks.

There are usually benign explanations for what look to Nanex like attempts to manipulate prices through what it calls “quote stuffing,” he said. For example, he said, bursts of quotes could be trading algorithms reacting when the difference between the best bid to buy and the best offer to sell grows to more than a penny. The programs automatically cancel the orders after exchanges modify them to avoid markets where bids equal offers, according to Narang, resulting in “inadvertent repetitive behavior” by algorithms.

Assiduous Reader PL’s support for a Tobin Tax is one that keeps resurfacing like a lump of decomposing sewage:

Still, proponents of stricter regulation said they see the debate over the [Michael Lewis] book [Flash Boys] as a catalyst for possible future changes.

“The simplest approach and most direct approach is with a transaction tax,” said [ Democrat Representative Peter ] DeFazio, whose legislation would impose what he described as a “miniscule” 3-basis-point levy on the sell side of transactions.

However, it is quite apparent that Tobin taxes harm market quality. One possibility where the AR PL and I might have a meeting of minds is the potential for an exchange to impose a fee for the placement of an order – generally, once you’re permitted to place orders on the exchange, the only fees remaining are charged for executed transactions.

Schwab is upset about the number of orders:

High-frequency trading pumped out over 300,000 trade inquiries each second last year, up from just 50,000 only seven years earlier. Yet actual trade volume on the exchanges has remained relatively flat over that period. It’s an explosion of head-fake ephemeral orders – not to lock in real trades, but to skim pennies off the public markets by the billions.
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Added systems burdens, costs and distortions of rapid-fire quote activity: Ephemeral quotes, also called “quote stuffing,” that are cancelled and reposted in milliseconds distort the tape and present risk to the resiliency and integrity of critical market data and trading infrastructure. The tremendous added costs associated with the expanded capacity and bandwidth necessary to support this added data traffic is ultimately borne in part by individual investors.

There are solutions. Today there is no restriction to pumping out millions of orders in a matter of seconds, only to reverse the majority of them. It’s the life-blood of high-frequency trading. A simple solution would be to establish cancellation fees to discourage the practice of quote stuffing. The SEC and CFTC floated the idea last year. It has great merit. Make the fees high enough and they will eliminate high-frequency trading entirely.

However, I would support a charge for order entry (or simply order cancellation, assuming that executed orders get charged by other means) only to the extent that it is imposed by the exchanges to recover costs or as a source of competitive advantage. If, once you count amortization of all the required infrastructure, it costs $1 to process 1,000,000 orders, then by all means, charge $0.000001 to process an order. If you want to make a profit and the market will bear it, then by all means, charge $0.000002 to process an order. If your customers complain that they have to process all these orders too, then by all means offer them a kiddie feed at reduced price, transmitting orders only when they have been extant for 10 milliseconds.

But don’t start imposing fees with grandiose visions of Better Living Through Higher Taxation. We all know where that ends up.

In fact, I have learned from a paper by Charles M. Jones of Columbia Business School titled What do we know about high-frequency trading? that:

Order cancellation or excess message fees: If bandwidth and data processing requirements are overwhelming some trading venue customers, it may be appropriate for trading venues to set prices accordingly and charge the participants who are imposing those costs on others. Nasdaq is currently imposing these fees in the U.S.; it is too soon to measure the effects. However, order cancellation fees will almost certainly reduce liquidity provision away from the inside quote, reducing market depth. The current initiatives should be studied carefully before broader-based message fees are considered.

He also points out – bless the man – that:

Minimum order exposure times: Under these proposals, submitted orders could not be cancelled for at least some period of time, perhaps 50 milliseconds. This would force large changes in equity markets and could severely discourage liquidity provision. The economic rationale here is particularly suspect, as the overriding goal in market design should be to encourage liquidity provision.

Securities transaction taxes: The evidence indicates that these taxes reduce share prices, increase volatility, reduce price efficiency, worsen liquidity, increase trading costs, and cause trading to move offshore.

At the cost of severe personal trauma – which I hope you guys appreciate – I have actually gone to the extent of watching a video titled ‘Michael Lewis: Programmers have Replaced Traders’. My God, but I hate watching TV and listening to lectures! Anyway, the video makes it plain that the big thing that is really at issue is the replacement of the old time smiley-boys by geeks who can actually do things, like programme these here computer whatchamacallits. Brad Katsuyama, who was discussed on PrefBlog on April 2, was on it … just another smiley boy, having his lunch eaten by people who know what they’re doing. Yawn.

Meanwhile, Schneiderman wrote an op-ed for the Daily News titled The need for speed is costing billions:

Some high-frequency trading firms engage in a practice called “latency arbitrage” — a technical euphemism that hides a threat to the integrity of our markets.

This is what we should be talking about. This is what I am investigating.

Put simply, latency arbitrage describes the trading strategy whereby high-frequency traders gain access to market prices before regular investors.

Armed with what amounts to knowledge of the future, these traders execute tens of thousands of trades in milliseconds with essentially zero risk — driving up the cost for other purchasers of stock.

Here is how it works: When traditional investors buy or sell stocks, they often use what’s called the “consolidated feed” to gather market data and determine the best bid or offer in the nation. This is particularly so in private trading venues, where regular investors like pension funds often trade.

Because high-frequency trading firms receive market prices before traders relying on the consolidated feed, they are able to see the prices early, jump in and take the best one in the blink of an eye. Regular investors are left in the dark.

Well, BooHooHoo. OK, Schneiderman, make it a law that the only market data feed allowed is the Schneiderman Consolidated Feed. Fine. I’ll co-locate with the feed provider. If that’s illegal, I’ll rent a room across the street. You’re in an argument with physics here and you ain’t gonna win.

He goes on:

That is also why I am calling for market reforms like the one put forward by experts at the University of Chicago.

He is referring to frequent batch auctions, which were discussed on PrefBlog on March 19. It was also given a brief mention in the CFTC Concept Release on Risk Controls and System Safeguards for Automated Trading Environments, which also asked a question dear to Assiduous Reader PL’s heart:

96. Should exchanges impose a minimum time period for which orders must remain on the order book before they can be withdrawn? If so, should this minimum resting time requirement apply to orders of all sizes or be restricted to orders smaller than a specific threshold? If there should be a specific threshold, how should that threshold be determined?
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99. Would batched order processing increase the number of milliseconds that are necessary for correlations among related securities to be established? If so, what specific costs would result from this change and how do those costs compare to the potential benefits described in recent research?

The comment period on this concept release was extended to Valentine’s Day; fifty-seven comments have been published on the CFTC website. I simply do not have time to comb through all these things, especially since it would seem that this is viewed as simply a preliminary skirmish in a long war, but I did read a comment by Thomas McCabe of One Chicago LLC:

Market participants should be free to enter, cancel, or cancel/replace their orders at will, as they assume the risk of execution or non-execution. Exchanges are in a unique position to understand the strain on their systems caused by orders and should be allowed to independently govern throughput into those systems. Accordingly, we oppose the Commission mandating that exchanges impose minimum time periods for orders.

Well, yeah. I looked around a bit for critiques of batched order processing and found one on a blog by somebody claiming to have a good resume. The post is titled Beware Discrete Auctions:

But, I was intrigued by the idea of batch auctions, because I’ve heard people who think discrete auctions are better than continuous ones. I think they are not very good, and a simple example is an extreme of this, one can look at the performance of closing vs. opening prices. One is at the end of continuous trading, one where there’s no trading. What happens?

Well, I looked at over 1000 stocks, from 2000 to today. I excluded really small, low-priced stocks. The Open-Open returns have slightly higher volatility (2% higher), but more importantly, there’s a lot more ‘mean reversion’. The graph below shows the future returns(O-O or C-C), sorted each day into deciles by the immediate prior return (O-O or C-C, respectively), then averaged over all those days.

Basically, markets open at extremes that are quickly erased, allowing the market makers to pocket nice premiums for these temporary imbalances (you can’t make money off this if you aren’t a specialist). Continuous trading takes such trades away from monopolists, and allows competition to work.

Click for Big

… and a comment to that post …

Our U Chicago Colleagues are delusional: They are trying to solve a problem that doesn’t exist.

People just need to stop using “market” orders. Would you buy a house on the “market” price, by telling your Realtor that you’ll agree to ANY price the seller wants? Probably not. And there’s no reason to do that with stocks either.

Of course, one reason to use market trades is because the trader is too lazy to figure out limits. In that case, the trader pays for that convenience.

Regarding “clogging bandwidth” there is no evidence that flash orders are causing dissarray in the exchange. Even if they were, that would just be a technical issue of the exchange, and should be handled like any DOS attack.

Third, their solution won’t work. Batching by 1 second would lead to people timing the system, and figuring out how do direct orders into one auction or another to optimize trading. It would actually add complexity into the market that would give an advantage to the HFTs. The authors should try their proposed solution at Kovler Cafe, and see if it makes getting lunch more orderly.

One problem I see with batched processing is swap orders – or paired orders that have that intent. Say I want to sell A and buy B. In such a case, when I get one side filled, I want to execute the other as quickly as possible, so I can make or exceed my spread target. Batching interferes with that.

Another problem is when I’m spending or raising X dollars on behalf of a client. If I am a good little Portfolio Manager, genuinely trying to do the best for my client, I’ll put in a bunch of orders totalling (say) 2X. As some get filled, I’ll cancel others and – with no more than average luck – be able to raise or spend X dollars at good prices on the market. Again, batched processing will make that cancellation process a bit more chancy, causing me to reduce my over-ordering, reducing liquidity in the market place and making real-money trading more expensive.

Yet another problem is for dealers executing crosses, which may or may not be contingent on other stuff (e.g., pairs trades and, in the futures market, exchange for physicals). At present, there is a quote with a spread in continuous time, with executions in discrete time; therefore, there will always be a quote and the cross can be executed anywhere inside that quote. With batching, there’s the potential for the market to be locked at inconvenient prices for lengthy periods; another obstacle to trading by real-money traders.

The Australians had this to say about latency arbitrage:

We do not regard the fact that market participants can co-locate to obtain a speed advantage as inherently unfair. Speed of access to the market has always been contestable, from the days of physical proximity on the floor, when an open outcry system operated. We recognise that not all market operators choose to operate at the co-location site with the lowest latency, but for those who do, our concern is to ensure that the facilities for doing so are made available to them on a fair basis and on transparent terms.

Our assessment is that access to these services is fair. Market operators offer economically reasonable and transparent pricing, inclusive of ongoing fee costs, that is publicly available and access to these services is available on a non-discriminatory basis. Network connections within co-location facilities are precisely measured, and all participants within the facility receive their data feed with exactly the same latency as any other participant running the same options.
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However, market operators are required to provide market data on a fair, transparent and non-discriminatory basis. No trader is capable of detecting any submitted market message before acceptance by that operator. Many of the complaints about latency received and reviewed by ASIC appear to arise from the complainants’ misunderstanding of participant SORs.

390 Many market participants will find that the routing options and time taken by their SORs to break, and route, orders between operators is considerably longer than the reaction times of many highly automated traders. If this happens they may find that when an order reaches market A and, before the related order reaches market B, another system has generated an order for market B possibly in response to the order on market A. Market participants need to take this factor into account when programming decision logic for their SORs.

… but the Australians don’t like market rebates:

We have previously stated (e.g. in Report 237 Response to submissions on Consultation Paper 145 Australian equity market structure: Proposals (REP 237) and CP 168) that we would be concerned if pricing incentives influence behaviour in a way that is not in the best interests of clients and wider market integrity. We believe there is sufficient evidence to conclude that maker–taker models, where the market operator pays a rebate, do not promote market quality or market integrity.

Intriugingly:

Another sign of Australia’s success in limiting HFT is that fewer orders go unfilled due to a charge on orders. High-frequency strategies are usually defined by the use of computers to post and cancel orders in times measured in thousandths and even millionths of seconds. In the six years through the end of 2013, the average order-to-trade ratio in Australia was 4.2, less than half that of the NYSE, according to data compiled by Sydney-based research firm Capital Markets CRC Ltd.

I can’t find any more information on that.

So, Assiduous Reader PL, my conclusion is: You are being manipulated by the Smiley-Boys. Cancellations and resting times are simply not an issue to real money fundamental traders.

There is widespread frustration over Canada’s inadequate housing data:

The issue came to the forefront Thursday after Canadian Imperial Bank of Commerce economist Benjamin Tal released a strongly worded note, titled “Flying Blind,” in which he said “the gap between the importance of the real estate market to the economy and the lack of publicly available information on it is mind-boggling.”

His laundry list of information that’s missing includes the share of foreign investors in the condominium market, the distribution of mortgages by credit score and the average down-payment.
…
“It would be useful to have more information about personal debt and the mortgage market,” says Toronto-Dominion Bank chief economist Craig Alexander. “If we think that Canada has a problem with excessive personal debt, you need the data to actually assess the vulnerability and what the associated risks are. But the reality is we actually have quite limited information.”
…
“Because there is a bit of a void on housing data we do have a lot of ill-considered opinions on the real estate market, and it’s hard to completely refute some of the wild talk we’ve had in recent years because the data set is limited,” says BMO Nesbitt Burns chief economist Douglas Porter.

He cautions, however, that more information is not a panacea. Deeper U.S. data did not prevent a housing boom and crash in that country.

I think a good first step would be for the Bank of Canada to stop lying about 5-year mortgage rates, but I’m just a grouch.

Great-West Lifeco has announced a deal:

Great-West Lifeco Inc. today announced that its U.S. subsidiary Great-West Financial® has reached an agreement to acquire the J.P. Morgan Retirement Plan Services large-market recordkeeping business. Upon completion of the acquisition, Great-West Financial will become the second-largest retirement services provider by participants in the U.S. defined contribution market, with nearly 6.8 million participants and US$387 billion in recordkeeping assets. Terms of the transaction were not disclosed.

The J.P. Morgan Retirement Plan Services business comprises 200 clients with approximately 1.9 million participants and US$167 billion in retirement plan assets. As part of the transaction more than 1,000 staff and management affiliated with J.P. Morgan Retirement Plan Services will join Great-West Financial.

The transaction is scheduled to close in the third quarter of 2014, subject to regulatory approval in the U.S.

Jacqueline Nelson of the Globe reports:

“Great-West’s business has been more focused on the small to mid-sized market, so the JP Morgan transaction is highly complementary,” Mr. [Paul] Mahon [chief executive officer of Great-West Lifeco] said. The large market is classified as defined-contribution plans with more than $25-million (U.S.) in assets under administration, wrote analyst Peter Routledge. But JP Morgan’s plans are far larger, with average assets of $835-million, he noted.

Being in the larger market is helpful for two reasons, Mr. Mahon said. First, it lends credibility that a company can do business with the Fortune 100 employers. JP Morgan is the largest bank in the U.S. by assets, so it’s brand name has carried far with clients. If the deal boosts Great-West’s profile in the U.S. it could help the company sell other major products, such as asset management services and insurance products.

Second, and even more importantly to Mr. Mahon, different sized corporations have different requirements from plan managers. Large corporations often demand greater flexibility and technology capabilities. The acquisition allows Great-West to offer some of those advanced systems to its smaller clients.

DBRS comments:

DBRS views the transaction as a positive development and consistent with the Company’s strategy to grow its U.S. retirement services businesses. There are no changes to the ratings.
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There is some integration risk given the very large size of these DC plans. It will be important for GWF to manage client retention well. However, switching plan record keepers is costly and time consuming for plan sponsors, so there would need to be a very significant inducement, be it positive or negative, for a plan departure to occur. DBRS views favourably the potential for incremental profits and future product placement synergies with the rest of the Company and views the financial impact of this acquisition as diminutive compared to the overall size of GWL’s balance sheet.

It was a good day for the Canadian preferred share market, with PerpetualDiscounts winning 16bp, FixedResets gaining 4bp and DeemedRetractibles up 7bp. Volatility was minimal. Volume was very low.