August 27, 2010

Regulators are seeking to ensure that their post-regulatory employment options include non-competitive alternative exchanges:

The fine shows regulators are getting serious about demanding that brokerage firms hook up to all the alternative trading systems in Canada to ensure they are shopping around for investors to get the best price on trade orders.

BMO Nesbitt dallied in hooking up to Omega, long the smallest ATS, and it wasn’t alone. Sources say regulators are also looking at firms like RBC Dominion Securities and have put them on notice that there have been too many so-called trade-throughs taking place in the market.

Trade-throughs in industry parlance are trades that don’t take place at the best price available in the marketplace.

The industry has griped that some marketplaces are too small to warrant the expense of a hookup.

Regulators clearly aren’t buying that. They have been sending long lists of trade-throughs spotted by market surveillance systems to offending desks. BMO got two warnings, IIROC said, in December, 2008, and February, 2009 “that it was responsible for a larger-than-average number of ‘trade through’ alerts.”

The focus on trade-throughs puts pressure on not only the big firms, but tiny shops that are already stretched thin for resources in a tough market. However, given that the end result is supposed to be protection for investors, it’s hard for regulators to look the other way.

The settlement notice specifies:

Pursuant to the Settlement Agreement, BMONB admitted to the following misconduct:

  • Between October 2008 and October 2009, it failed to make reasonable efforts to connect to the Omega ATS protected marketplace, contrary to UMIR 5.2 and UMIR Policy 5.2.

Pursuant to the Settlement Agreement, BMONB agreed to pay a fine in the amount of $250,000 and costs of $15,000.

Fortunately, however, no individual was disciplined or even named by IIROC. This serious misconduct, worth a quarter of a million bucks, did not occur as a result of a decision, or negligence, or human behaviour of any kind, in fact … it just happened.

I think it fair to say that Omega ATS is not a particularly important exchange:

In terms of market share, Omega ATS is still relatively small, says Eric Stoop, chairman of Omega ATS, “We’re around 1% of the market this year,” he explained.

It is interesting to consider how this might tie in with sub-pennying; I speculated in a post about Alpha Trading Systems that the extant exchanges might be introducing order types to forestall the big brokers from setting up captive dark pools.

I would be quite happy with a statement from any brokerage house with whom I might deal as to just which exchanges they belonged to; if the regulators want some busy-work, they could always specify that this disclosure should include statistics on trade-throughs. But such a system would involve consumer choice and competition; anathema to the regulatory mind.

Terence Corcoran gave bank capital regulation another try, but assumes that an increase in global capital requirements will be matched in Canada. This is not necessarily the case, since Canadian banks are capitalized well above the current minimum.

I have previously remarked that a good deal of all the whining regarding overwhelming message traffic generated by High Frequency Traders could be eliminated through a novel proposal – charging for message traffic. I am pleased to see that a variant of this idea has been proposed by BMOCM’s Quantitative Execution Services team in a paper titled Drowning in Data:

We have suggested in the past that the street’s regulatory bill be split into two portions – human resources and technology. The HR cost, that is the cost of having regulatory staff, should be divided amongst the street based on either volume of shares traded, or number of trades. This reflects the fact that staff time is spent looking at actual trades. The technology portion should then be allocated based on share of message traffic. This reflects the fact that technology costs are driven by message traffic not traded volume. This type of allocation system would result in inefficient strategies having to pay a higher portion of the total bill. This would be true of any inefficient strategy, whether it be an agency pairs trading algorithm or a passive rebate HFT strategy. (Currently the total cost is allocated to trading venues based on volume traded market share, which they then charge back to the dealers using the same metric).

They also talked about trade-through protection:

Canada is the only developed marketplace that enforces full depth of book trade-through as opposed to top of book for each marketplace venue. This implies that the Smart Order Routers in Canada have to process the entire depth of book in all markets in order to satisfy trade-through obligations. The order changes on the entire depth of book dwarf the order changes on just top of book and thus force the Canadian market participants to be consumers of this glut of data. We feel the regulators need to review the trade-through obligations from a technology lens.

The BMOCM idea regarding charging has been picked up by Senator Edward Kaufman, who has written to the SEC suggesting:

Accordingly, the Commission should require trading venues to allocate system costs at least partially based on message traffic rather than traded volume. A similar framework should be applied to pay for the consolidated audit trail and other technology and surveillance costs that regulatory agencies incur.

Sen. Kaufman also suggests:

It may seem counterintuitive, but the Commission should even examine whether regulation should aim not to facilitate narrow spreads with little size or depth of orders, but instead promote deep order books -and if necessary -wider markets with large protected quote size. Wider spreads with a large protected quote size on both sides may facilitate certainty of execution with predictable transparent costs. Narrow fluctuating spreads, on the other hand, with small protected size and thin markets, can mean just the opposite -and actual trading costs can be high, hidden and uncertain. Deep stable markets will bring back confidence, facilitate the capital formation function of the markets and diminish the current dependence on the dark pool concept. At a minimum, the Commission must carefully scrutinize and empirically challenge the mantra that investors are best served by narrow spreads. In reality, narrow spreads of small order size may be an illusion that masks a very “thin crust” of liquidity (which leave markets vulnerable to another flash crash when markets fail their price discovery function only next time . within the bounds of circuit breakers) and difficult-to-measure price impacts (that might be harmful to average investors and which diminish investor confidence), both of which the Commission must examine and possibly address.

This leads to an interesting conundrum: there is lots of academic evidence (e.g., from TRACE and from the Toronto Exchange’s changes to limit book transparency in the early nineties) that increasing transparency results in thinner books with tighter spreads. I suspect, however, that prohibiting dissemination of Level 2 – or Level 1 – pricing information will prove to be unpopular should anybody have the guts to make the suggestion.

ProPublica has published a good investigative piece on CDO Tranche Retention (otherwise known as self-dealing) titled Banks’ Self-Dealing Super-Charged Financial Crisis:

Faced with increasing difficulty in selling the mortgage-backed securities that had been among their most lucrative products, the banks hit on a solution that preserved their quarterly earnings and huge bonuses:

They created fake demand.

A ProPublica analysis shows for the first time the extent to which banks — primarily Merrill Lynch, but also Citigroup, UBS and others — bought their own products and cranked up an assembly line that otherwise should have flagged.

Independent manager? Independent schmanager!:

There were supposed to be protections against this sort of abuse. While banks provided the blueprint for the CDOs and marketed them, they typically selected independent managers who chose the specific bonds to go inside them. The managers had a legal obligation to do what was best for the CDO. They were paid by the CDO, not the bank, and were supposed to serve as a bulwark against self-dealing by the banks, which had the fullest understanding of the complex and lightly regulated mortgage bonds.

It rarely worked out that way. The managers were beholden to the banks that sent them the business. On a billion-dollar deal, managers could earn a million dollars in fees, with little risk. Some small firms did several billion dollars of CDOs in a matter of months.

“All these banks for years were spawning trading partners,” says a former executive from Financial Guaranty Insurance Company, a major insurer of the CDO market. “You don’t have a trading partner? Create one.”

It remains unclear whether any of this violated laws. The SEC has said [5] that it is actively looking at as many as 50 CDO managers as part of its broad examination of the CDO business’ role in the financial crisis. In particular, the agency is focusing on the relationship between the banks and the managers. The SEC is exploring how deals were structured, if any quid pro quo arrangements existed, and whether banks pressured managers to take bad assets.

A Wall Street Journal article [9] ($) from late 2007, one of the first of its kind, described how Margolis worked with one inexperienced CDO manager called NIR on a CDO named Norma, in the spring of that year. The Long Island-based NIR made about $1.5 million a year for managing Norma, a CDO that imploded.

“NIR’s collateral management business had arisen from efforts by Merrill Lynch to assemble a stable of captive small firms to manage its CDOs that would be beholden to Merrill Lynch on account of the business it funneled to them,” alleged a lawsuit filed in New York state court against Merrill over Norma that was settled quietly after the plaintiffs received internal Merrill documents.

“I would go to Merrill and tell them that I wanted to buy, say, a Citi bond,” recalls a CDO manager. “They would say ‘no.’ I would suggest a UBS bond, they would say ‘no.’ Eventually, you got the joke.” Managers could choose assets to put into their CDOs but they had to come from Merrill CDOs. One rival investment banker says Merrill treated CDO managers the way Henry Ford treated his Model T customers: You can have any color you want, as long as it’s black.

Once, Merrill’s Ken Margolis pushed a manager to buy a CDO slice for a Merrill-produced CDO called Port Jackson that was completed in the beginning of 2007: “‘You don’t have to buy the deal but you are crazy if you don’t because of your business,'” an executive at the management firm recalls Margolis telling him. “‘We have a big pipeline and only so many more mandates to give you.’ You got the message.” In other words: Take our stuff and we’ll send you more business. If not, forget it.’

And that, boys and girls, is the way the investment business works. Which is why you should always check the performance track record of a manager and ignore the “experience” so beloved of the regulators.

On an unrelated note, I will leave you with a weekend thought: it is striking just how many people urgently tell me how friendly their dogs are, as if I care. Hardly anybody ever says “My dog is aggressive and obnoxious. I’m too stupid and lazy to train it”.

It was a very nice day for the Canadian preferred share market today, with PerpetualDiscounts up 11bp and FixedResets gaining 15bp, on continued elevated volume.

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 0.00 % 0.00 % 0 0.00 0 -0.3050 % 2,043.3
FixedFloater 0.00 % 0.00 % 0 0.00 0 -0.3050 % 3,095.3
Floater 2.56 % 2.17 % 34,618 21.92 4 -0.3050 % 2,206.2
OpRet 4.90 % 3.51 % 95,245 0.26 9 -0.1977 % 2,348.2
SplitShare 6.07 % -29.60 % 63,996 0.09 2 0.2096 % 2,320.9
Interest-Bearing 0.00 % 0.00 % 0 0.00 0 -0.1977 % 2,147.2
Perpetual-Premium 5.77 % 5.30 % 96,268 5.55 7 0.1633 % 1,961.5
Perpetual-Discount 5.72 % 5.75 % 191,483 14.12 71 0.1051 % 1,898.2
FixedReset 5.28 % 3.17 % 273,484 3.36 47 0.1489 % 2,250.9
Performance Highlights
Issue Index Change Notes
Maturity Type : Call
Maturity Date : 2011-07-30
Maturity Price : 25.25
Evaluated at bid price : 25.61
Bid-YTW : 4.85 %
CM.PR.H Perpetual-Discount -1.21 % YTW SCENARIO
Maturity Type : Limit Maturity
Maturity Date : 2040-08-27
Maturity Price : 21.28
Evaluated at bid price : 21.28
Bid-YTW : 5.71 %
MFC.PR.B Perpetual-Discount 2.47 % YTW SCENARIO
Maturity Type : Limit Maturity
Maturity Date : 2040-08-27
Maturity Price : 19.12
Evaluated at bid price : 19.12
Bid-YTW : 6.10 %
Volume Highlights
Issue Index Shares
CM.PR.H Perpetual-Discount 92,096 RBC crossed blocks of 37,000 and 10,800, both at 21.50.
Maturity Type : Limit Maturity
Maturity Date : 2040-08-27
Maturity Price : 21.28
Evaluated at bid price : 21.28
Bid-YTW : 5.71 %
TRP.PR.C FixedReset 78,951 RBC bought 11,200 from anonymous at 25.30 and crossed 48,400 at 25.45.
Maturity Type : Limit Maturity
Maturity Date : 2040-08-27
Maturity Price : 23.27
Evaluated at bid price : 25.44
Bid-YTW : 3.67 %
BNS.PR.K Perpetual-Discount 67,995 TD crossed 44,900 at 22.15.
Maturity Type : Limit Maturity
Maturity Date : 2040-08-27
Maturity Price : 21.75
Evaluated at bid price : 22.07
Bid-YTW : 5.48 %
BNS.PR.Q FixedReset 61,500 TD crossed two blocks of 25,000, the first at 26.55, the second at 26.60.
Maturity Type : Call
Maturity Date : 2013-11-24
Maturity Price : 25.00
Evaluated at bid price : 26.50
Bid-YTW : 3.10 %
RY.PR.R FixedReset 59,160 RBC crossed 50,000 at 27.75.
Maturity Type : Call
Maturity Date : 2014-03-26
Maturity Price : 25.00
Evaluated at bid price : 27.75
Bid-YTW : 3.04 %
MFC.PR.D FixedReset 58,517 RBC crossed blocks of 15,000 and 10,000, both at 26.50.
Maturity Type : Call
Maturity Date : 2014-07-19
Maturity Price : 25.00
Evaluated at bid price : 26.43
Bid-YTW : 4.90 %
There were 42 other index-included issues trading in excess of 10,000 shares.

One Response to “August 27, 2010”

  1. […] The issue of trade-throughs was discussed on August 27. […]

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