May 10, 2010

We can expect regulators, polititicans and the media to trumpet the latest Economist piece on Canada … but how many will quote from the last two paragraphs?

How much of the Canadian model can, or should, be exported? Critics of the Canadian banks reckon that their conservatism was the flip side of a cosy oligopoly. The big five were barred from merging and partly protected from foreign interlopers. They shared out a profitable domestic market and gave up competing on price. And keeping tabs on the banks is much easier when all are relatively small by international standards and are based within a few hundred yards of each other and of regulators in Toronto.

The result is that Canadians pay more for financial services than others and there is little innovation. Even so, as taxpayers elsewhere dig deep to pay for their bankers’ wheezes they might think that Canadians got a bargain. Replicating Canadian banking elsewhere would be hard. But when Americans and Europeans press Mr Harper at the G20 meeting to accept a tax on banks to curb their riskiness, he has reason to retort that Canadian-style regulation does the job better.

Good article on High Frequency / Algorithmic trading and risk control from the Chicago Fed (hat tip: Financial Webring Forum):

Sometimes, these trading errors have been the result of the removal of pre-trade risk controls to decrease latency. For example, futures broker MF Global suffered $141.5 million in losses in February 2008, when a rogue trader initiated transactions during off hours using a terminal intended for the business of major customers. One breakdown in MF Global’s internal risk systems was the removal of trade limits, which had been done to increase trading speeds.

A well-built algorithm contains risk controls, such as price and quantity limits.

The Themis Trading blog has some good commentary on the May 6 Bungee Jump:

The story is a failed market structure. The market failed today.

The market melted down and “liquidity providers” quickly pulled all bids. According to today’s Wall Street Journal, high frequency firm, Tradebot, closed down its computer systems completely, as did New Jersey’s own Tradeworx, who was so critical of our silly market structure comments in their SEC comment letter. By the way, if you don’t know who or what Tradebot is, it is the proprietary trading engine that used to be part of the BATS exchange. In fact the reason BATS was rolled out as an exchange to begin with was to lower costs and facilitate trades for Tradebot (Tradebot’s 1251 NW Briarcliff Pkwy Kansas City address is next door to BATS’s North Mulberry Drive address fyi). In the WSJ article Mr. Cummings said his Tradebot system was designed to stop trading when the market becomes too volatile, because he “doesn’t want to compound the problem.” Too bad he doesn’t understand that that was and is the problem. To make matters worse, while some high frequency firms shut down yesterday and pulled their bids, as we warned they would do for over a year and a half, other high frequency firms turned from being liquidity providers to liquidity demanders, as they turned around and indiscriminately hit bids like Randolph and Mortimer Duke.

Today’s price swings in a great number of stocks highlight the inherent and systemic risk of our automated stock market, which has few checks and balances in place. Once the market sensed stress, the bids were cancelled and market sell orders chased prices down to the lowest possible point. Investors who thought they were protecting themselves with the prudent use of stop orders were left with fills that were far away from the closing price. In some stocks like our SAM example above, this was $0.01. We warned of the potential for HFT to behave this way when we met with and showed our regulators the NY Fed study that highlighted HFT’s vanishing act around stressful news announcements in the currency markets.

We read this in a recent comment letter to the SEC about HFT and couldn’t agree more: “When markets are in equilibrium these new participants increase available liquidity and tighten spreads. When markets face liquidity demands these new participants increase spreads and price volatility and savage investor confidence.”

The market action of May 6th has demonstrated that our equity market has major systemic risks built into it. There was a time today when folks didn’t know the true price and value of a stock. The price discovery process ceased to exist. High frequency firms have always insisted that their mini-scalping activities stabilized markets and provided liquidity, and on May 6th they just shut down. They pulled the plug, as we always said they would, and they even admit it in the papers this morning. We need a new mousetrap. This is not an isolated incident, and it will happen again.

Significant Movers This Morning:

It doesn’t matter; earnings don’t matter. Our regulators have decreed that stock valuation shall be determined by the whims of “liquidity providing” HFT firms armed by our new breed of exchanges.

Earnings Today:

It doesn’t matter; earnings don’t matter. Our regulators have decreed that stock valuation shall be determined by the whims of “liquidity providing” HFT firms armed by our new breed of exchanges.

Expected Earnings Later:

It doesn’t matter; earnings don’t matter. Our regulators have decreed that stock valuation shall be determined by the whims of “liquidity providing” HFT firms armed by our new breed of exchanges.

Significant Upgrades and Downgrades:

It doesn’t matter; earnings don’t matter. Our regulators have decreed that stock valuation shall be determined by the whims of “liquidity providing” HFT firms armed by our new breed of exchanges.

While I have not dealt with Themis Trading, I do have a certain amount of respect for them as traders – they have clearly studied market microstructure quite intensively and if I were putting together a major US equity trading operation, I would certainly take the time to find out more about them and what they might be able to do for me.

However, trading is not investing and their closing comments betray their bias. Even after allowing for a fair amount of hyperbole, earnings matter and valuations matter. Accenture pays a semi-annual dividend of $0.375 and made $0.60 per share in 2Q10 (note: I have not actually analyzed Accenture and have no idea of its value. It’s just an example, and I’m assuming the quoted figures are sustainable). If some idiot wants to sell me shares at $0.01 each, I have no problem buying them all day long … and if the value is good, why should I care what the price is? Increased volatility brings a lovely range of potential entry and exit points – an actual investor can make quite a bit of extra money punishing the bozos.

The SEC release of public comments on the Equity Market Structure concept release included the Themis Trading response. There is no public comment from Tradeworx – they just had a meeting.

In the Themis response, they note:

Traditionally, exchanges have competed for revenues in three different areas: listings, transaction fees and market data revenue. A recent study by Grant Thornton details what the firm refers to as “The Great Delisting Machine Timeline.” They detail how a progression of regulation (including order handling, decimalization and Sarbanes-Oxley) has destroyed the economic incentive for traditional market making, investment banking and research.

It is interesting to compare this (claimed) equity market structure effect with the corporate bond market, in which the greater transparency provided by TRACE has led to a market that is tighter but with significantly less depth.

All in all though, I will be most interested to learn what the SEC finds in their investigation of the bungee jump – the data will be very good, I’m sure, although it may be presented in such a way as to provide support for whatever conclusions they wish to draw.

I suspect that there will be a certain amount of evidence that stop-loss orders will be implicated to at least some degree. Stop loss orders are the most idiotic order type known to man (if you’re willing to sell something at $45, why the hell aren’t you selling at $50? It makes no sense!) but have immense popularity. There are so popular, in fact, that even if the evidence shows they were 100% responsible for the bungee jump (it won’t: ain’t nuthin in the markets ever so clear cut; but just say), there will be no talk of banning them.

James Hamilton of Econbrowser mentions stop-loss orders in his discussion of the bungee jump:

… if momentum-chasing algorithms come to rule the financial world, those who try to follow them will be the biggest losers.

Another notion that’s popular with many financial gurus these days is the claim that you can eliminate certain risks to your portfolio with the right strategy of automatic trading and stop-loss sell orders. Again that claim invites an economic question– if you are getting an insurance policy, who is selling it to you? I believe the implicit answer is, you are counting on the market-maker to insure you by taking the other side of your escape transactions. But the curious thing about such an insurance policy is that the market-maker gets to decide what premium to charge you after you ask to collect on the policy. You just might find that the state of the world when you and your buddies all most desperately want to cash in on your insurance is exactly the time when the premium proves to be ruinously expensive.

The SEC has held a meeting about the bungee jump:

This morning, SEC Chairman Mary Schapiro had a constructive meeting with the leaders of six exchanges — the New York Stock Exchange, NASDAQ, BATS, Direct Edge, ISE and CBOE — and the Financial Industry Regulatory Authority to discuss the causes of Thursday’s market events, the potential contributing factors, and possible market reforms.

“As a first step, the parties agreed on a structural framework, to be refined over the next day, for strengthening circuit breakers and handling erroneous trades.

Too bad investors weren’t represented at the meeting; but then, investor scum would only get in the way.

The Greek crisis is now worse than the Lehman crisis – at least by one measure:

The cost of insuring against losses on European bank bonds soared to a record, surpassing levels triggered by the collapse of Lehman Brothers Holdings Inc., as the sovereign debt crisis deepened.

The Markit iTraxx Financial Index of credit-default swaps on 25 banks and insurers soared as much as 40 basis points to 223, according to JPMorgan Chase & Co. The index closed at 212 basis points March 9, 2009. Swaps on Greece, Portugal, Spain and Italy rose to or near all-time high levels.

The spread between the three-month dollar London interbank offered rate and the overnight indexed swap rate, a barometer of the reluctance of banks to lend that’s known as the Libor-OIS spread, is at 18 basis points, up from 6 basis points on March 15 and near the highest level in more than five months. It’s still far from the record 364 basis points in October 2008, almost a month after Lehman’s bankruptcy.

Funny, isn’t it, that we are told that the Lehman crisis arose because of incompetent decision makers, while the Greek crisis is due to speculators and hedge funds. However, funding is sufficiently tight that the dollar swap line has been re-established:

In response to the re-emergence of strains in U.S. dollar short-term funding markets in Europe, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing the re-establishment of temporary U.S. dollar liquidity swap facilities. These facilities are designed to help improve liquidity conditions in U.S. dollar funding markets and to prevent the spread of strains to other markets and financial centers. The Bank of Japan will be considering similar measures soon. Central banks will continue to work together closely as needed to address pressures in funding markets.

The Federal Open Market Committee has authorized temporary reciprocal currency arrangements (swap lines) with the Bank of Canada, the Bank of England, the European Central Bank (ECB), and the Swiss National Bank. The arrangements with the Bank of England, the ECB, and the Swiss National Bank will provide these central banks with the capacity to conduct tenders of U.S. dollars in their local markets at fixed rates for full allotment, similar to arrangements that had been in place previously. The arrangement with the Bank of Canada would support drawings of up to $30 billion, as was the case previously.

These swap arrangements have been authorized through January 2011. Further details on these arrangements will be available shortly.

The Bank of Canada states:

The Bank of Canada and the Federal Reserve have agreed to re-establishment of the US$30 billion swap facility (reciprocal currency arrangement) that had expired 1 February 2010. This facility would be accessed, should the need arise, to provide U.S.-dollar liquidity in Canada. If drawn on by the Bank of Canada, the swap would provide liquidity facilities for use by financial institutions in Canada that are similar in nature to those being announced today by the other central banks. This swap facility expires in January 2011.

This agreement provides the Bank of Canada with flexibility to address rapidly evolving developments in financial markets. The Bank judges that it is not necessary for it to draw on this swap facility at this time, but that it is prudent to have the agreement in place. Should the swap be drawn on, the details of the liquidity facilities provided would depend on the specific market circumstances at the time.

Additionally, the Fed has approved a practice session with the Term Deposit Facility, whereby banks can deposit free Fed Funds with the Fed on a competitive basis.

The EU was able to agree on a bail-out:

European policy makers unveiled an unprecedented loan package worth nearly $1 trillion and a program of securities purchases as they spearheaded a drive to stop a sovereign-debt crisis that threatened to shatter confidence in the euro. Jolted into action by last week’s slide in the currency to a 14-month low and soaring bond yields in Portugal and Spain, governments of the 16 euro nations agreed to make loans of as much as 750 billion euros ($962 billion) available to countries under attack from speculators.

The “attack from speculators” line means the reporter has drunk the Kool-aid. The fund is all very well and good, but it is not as simple a matter as providing funding for a solvent but illiquid financial firm until such time as markets recover and its assets mature. Unless Club Med takes credible actions, not just to reduce their deficits to 3%, not just to balance the budget, but to pay down some of their debt … it’s only delaying the inevitable.

Continued heavy volume today, with PerpetualDiscounts continuing their slide and finishing down 3bp, while FixedResets continued their recovery, gainng 12bp.

HIMIPref™ Preferred Indices
These values reflect the December 2008 revision of the HIMIPref™ Indices

Values are provisional and are finalized monthly
Index Mean
(at bid)
Mod Dur
Issues Day’s Perf. Index Value
Ratchet 2.58 % 2.66 % 45,121 20.92 1 0.0000 % 2,143.0
FixedFloater 5.06 % 3.12 % 43,008 20.20 1 -2.2273 % 3,165.8
Floater 2.07 % 2.33 % 104,115 21.52 3 -0.1051 % 2,344.5
OpRet 4.92 % 4.25 % 92,490 2.88 11 0.1214 % 2,293.9
SplitShare 6.50 % 6.95 % 128,045 3.53 2 -0.1789 % 2,100.8
Interest-Bearing 0.00 % 0.00 % 0 0.00 0 0.1214 % 2,097.6
Perpetual-Premium 5.53 % 4.77 % 23,758 15.83 1 0.0399 % 1,824.2
Perpetual-Discount 6.32 % 6.39 % 217,019 13.31 77 -0.0259 % 1,691.2
FixedReset 5.53 % 4.44 % 518,216 3.58 44 0.1151 % 2,141.1
Performance Highlights
Issue Index Change Notes
BAM.PR.G FixedFloater -2.23 % YTW SCENARIO
Maturity Type : Limit Maturity
Maturity Date : 2040-05-10
Maturity Price : 25.00
Evaluated at bid price : 21.51
Bid-YTW : 3.12 %
W.PR.H Perpetual-Discount -1.28 % YTW SCENARIO
Maturity Type : Limit Maturity
Maturity Date : 2040-05-10
Maturity Price : 20.90
Evaluated at bid price : 20.90
Bid-YTW : 6.67 %
GWO.PR.M Perpetual-Discount 1.46 % YTW SCENARIO
Maturity Type : Limit Maturity
Maturity Date : 2040-05-10
Maturity Price : 22.77
Evaluated at bid price : 22.90
Bid-YTW : 6.46 %
Maturity Type : Soft Maturity
Maturity Date : 2013-12-30
Maturity Price : 25.00
Evaluated at bid price : 25.25
Bid-YTW : 5.41 %
GWO.PR.H Perpetual-Discount 4.00 % YTW SCENARIO
Maturity Type : Limit Maturity
Maturity Date : 2040-05-10
Maturity Price : 19.23
Evaluated at bid price : 19.23
Bid-YTW : 6.41 %
Volume Highlights
Issue Index Shares
TRP.PR.A FixedReset 552,065 RBC crossed blocks of 100,000 and 300,000 at 25.25. Nesbitt crossed 100,000 at 25.25 and RBC crossed 13,900 at the same price.
Maturity Type : Call
Maturity Date : 2015-01-30
Maturity Price : 25.00
Evaluated at bid price : 25.20
Bid-YTW : 4.55 %
PWF.PR.H Perpetual-Discount 74,520 RBC crossed blocks of 36,900 and 20,000 at 22.00.
Maturity Type : Limit Maturity
Maturity Date : 2040-05-10
Maturity Price : 21.95
Evaluated at bid price : 21.95
Bid-YTW : 6.62 %
BMO.PR.M FixedReset 55,825 TD crossed 50,000 at 25.81.
Maturity Type : Call
Maturity Date : 2013-09-24
Maturity Price : 25.00
Evaluated at bid price : 25.80
Bid-YTW : 3.89 %
BMO.PR.P FixedReset 41,054 RBC crossed 25,000 at 26.30.
Maturity Type : Call
Maturity Date : 2015-03-27
Maturity Price : 25.00
Evaluated at bid price : 26.23
Bid-YTW : 4.23 %
CM.PR.H Perpetual-Discount 38,247 Desjardins crossed 12,400 at 18.80.
Maturity Type : Limit Maturity
Maturity Date : 2040-05-10
Maturity Price : 18.82
Evaluated at bid price : 18.82
Bid-YTW : 6.44 %
BNS.PR.K Perpetual-Discount 33,971 YTW SCENARIO
Maturity Type : Limit Maturity
Maturity Date : 2040-05-10
Maturity Price : 19.44
Evaluated at bid price : 19.44
Bid-YTW : 6.24 %
There were 48 other index-included issues trading in excess of 10,000 shares.

One Response to “May 10, 2010”

  1. […] This is why the Fed has restarted the dollar swap lines, as noted May 10. […]

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