High-frequency trading surges across the globe

Geeks trump alpha males as algos dominate Wall St

Who’s afraid of high-frequency trading?

We are no strangers to the world of ETFs, but the following observation took us by surprise.  A single fund, the iShares MSCI Emerging Markets Index Fund (EEM) generates some $240 million in revenue per annum for its sponsor.  Ian Salisbury at WSJ goes on to note how lower trading costs have kept EEM on top against its much thriftier competitor the Vanguard Emerging Markets Stock ETF (VWO).  In short, size matters in the ETF industry.  And by industry, we mean industry.

There certainly are benefits to size in the ETF world, but there is a downside as well. Funds that were originally thought to be niche products have in some cases have seen explosive growth.  This growth has put pressure on their ability to produce the returns they set out to generate.  Therefore owning an ETF that invests in gold, commodities, or junk bonds is not the same thing as holding the underlying asset(s).

In some of these cases the ETF industry has tried to take something that is complex and make it seem simple.  Unfortunately something can get lost in the translation.  In addition the issuance of an ETF can change the dynamics of a market, something not always contemplated prior to a fund launch.

That is not to say that being too small in world of ETFs is not a problem as well.  We have written about the risks of so-called orphan or “zombie ETFs” that are too small and illiquid.  One need not look far to see that a broad swath of the ETF industry is potentially on the chopping block.

…ETFs can be a wonderful tool for investors, but ETFs are also a business.  A big business.  If you want to continue playing in the ETF sandbox make sure you know the distinction between a good ETF and a bad ETF.  Because the ETF sponsors are not going to tell you which is which.

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The boom in securitization was based on investors’ willingness to believe what investment banks and credit rating agencies said about these securities. Buying a mortgage-backed security is making a loan. Ordinarily you don’t loan money to someone without proving to yourself that he is going to pay you back (or that the interest rate you are getting will compensate you for the risk that he won’t pay you back). The securitization bubble happened because investors were willing to outsource that decision to other people — banks and credit rating agencies — who had different incentives from them.

Are investors going to go back to that mindset? Do we want them to? It seems to me the rational investor response is this: “I have no idea what is in those securitization trusts. I don’t trust the banks, since they are taking fees out of each deal. I don’t trust the credit rating agencies, since they are being paid by the banks, and don’t have enough staff and expertise to do the job properly. I don’t trust the models, because they’re wrong. There’s no way I can do the analysis myself. So I’m not buying.”

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Bedlam Asset Management takes a look at exchange traded funds in its latest market commentary. Specifically, at how — largely because of greed — a sound concept has once again potentially been bastardised by the financial industry.

As Bedlam notes, ETFs started off as a simple and good idea. They were convenient for investors, easy to understand, affordable, the natural successor of earlier market structures  like futures.

But then — unhappy with the ETFs’ solid but low returns — the industry turned to financial rocket scientists to try and beef up the ETF game. Or as Bedlam observes:

Like alcoholics, investment bankers can never have enough, but in the ETF markets they had made a mistake. For the annual management charges and the dealing commissions were set at a low, thus fair, price to make them attractive.

Having established these precedents, it proved hard to raise the profitability for their managers and thus skin the investor. Banks really dislike steady, recurrent low fee income from low-risk products as they can never cover their bloated overheads; so they consulted their rocket scientists.

They invented the ‘Almost as Safe ETF’, but with a much higher fee base. Some started using derivatives and other opaque financial instruments to offer an increase in value twice that of the price gain of the underlying gold or other commodity. These attracted more trading and higher fees too.

The next phase, as Bedlam notes, was similar to the development of asset-backed mortgage securities. The industry thinking appeared to be:

Why not have gold ETFs not backed by gold at all but say by gold shares, with price differences smoothed out through ever-liquid derivatives and hedges?

And the risk (and fees) just kept getting greater:

The ability to play around globally in multiple types of listed paper generated even more commissions; and because these vehicles were far more complex — but still very safe — management fees charged could be higher for enhancing the rise or fall relative to the underlying commodity. The die was cast. As it worked so well, and profitably, for bullion and then hard commodities why not apply it to others such as sugar, cocoa or coffee? Why not to anything not nailed down? So ETFs spread like a virus; the market went fissile. Having dredged most commodities — yes, there are even lean hog ETFs over which you can buy an OTC put — investment bankers took the final leap of taking it back into actual listed companies.

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According to some estimates, high-frequency trading by investment banks, hedge funds and other players accounts for 60% to 70% of all trades in U.S. stocks, explaining the enormous increase in trading volume over the past few years. Profits were estimated at between $8 billion and $21 billion in 2008.

Some market observers, members of Congress and regulators are worried. Are those profits coming out of ordinary investors’ pockets? Is Wall Street’s latest qet-rich-quick scheme going to harm innocent bystanders? “I don’t think it would hurt people to become educated as to the intent of these strategies,” says Wharton finance professor Robert F. Stambaugh. “What is their effect on the markets? There is a little sense of 2001: A Space Odyssey [in that it] does kind of create an air of mistrust.”

Its defenders say high-frequency trading improves market liquidity, helping to insure there is always a buyer or seller available when one wants to trade. And so far, high-frequency trading doesn’t look threatening, according to several Wharton faculty members. Indeed, it may well provide benefits to mutual fund investors and other market participants by reducing trading costs. But at the same time, several note that not enough is known about how trading at light-speed works, whether it can be used to manipulate markets or whether benign-looking moves by different players could interact to produce a new financial crisis.

“High-frequency trading involves investors with good computers taking advantage of small discrepancies in prices,” says Wharton finance professor Marshall E. Blume. “Generally, economists think that drives prices back to where they should be…. If they bring liquidity to the market and make prices more accurate, then that’s good. Now a concern, which is hard to document, is that somehow these traders manipulate the market, which would be bad.”

Turning decision-making over to machines has not always benefited humans, notes Wharton finance professor Itay Goldstein. “People believe the crash of ’87 was caused by this kind of computer-based trading.” In that case, a vicious cycle swirled out of control as computerized trading programs dumped stocks in response to falling prices, causing other programs to do the same.

Traveling at Light Speed

High-frequency trading refers to computerized trades seeking to profit from conditions too ephemeral for a human to exploit, like a miniscule increase in the spread between bid and ask prices for a given security, or a slight price difference for a stock traded on various exchanges. Trading is so fast that some firms locate their server farms near the exchange’s computers, to shorten the distance orders must travel through cables at light speed.

Aside from being made possible by the proliferation of high-speed computers, high-frequency trading has evolved out of several regulatory changes. In 1998, the Securities and Exchange Commission’s Regulation Alternative Trading Systems opened the door to electronic trading platforms to compete with the major exchanges. A couple of years later, the exchanges started quoting prices to the nearest penny rather than 16^th of a dollar, causing spreads between bid and ask prices to narrow and forcing traders who made money on those price differences to look for alternatives. Finally, the SEC’s Regulation National Market System of 2005 required that trade orders be posted nationally instead of only at individual exchanges. This allowed quick-moving traders to profit when a stock traded at a slightly different price at one exchange versus another.

With the effects of the subprime crisis still being felt, regulators and lawmakers are especially alert to any dangers that might lurk in unfamiliar Wall Street products and strategies. Alarm bells started going off with news accounts this summer about “flash orders,” a subset of high-frequency trading that exploits regulatory loopholes to give favored traders notice of orders a fraction of a second before they are transmitted to everyone else. Flash trading has been widely condemned as giving a favored few an unfair advantage.

“Some people are getting advantages that others aren’t, and that may lead to abuse,” says Wharton finance professor Franklin Allen. “It is a form of front running.” Front running, which is generally illegal, means improperly profiting by using advance information to jump ahead of someone else’s trade. In the textbook example, a broker receives a customer’s order to buy a stock for up to $10 a share. The broker buys the shares at the market price of $9.75 and sells them to his customer at $10, cheating the customer out of 25 cents a share. Flash orders can do the same thing, much faster and more often.

Flash trading now appears to be on the way out. In mid-September, the SEC proposed a ban, and the Nasdaq market quickly moved to prohibit the practice. A number of firms that had offered flash trading to clients have exited the business. The SEC ban requires a second vote by commissioners to become final.

Because many people have been unclear about the distinction, the flash-trading controversy has triggered worries about high-frequency trading, which involves strategies that appear to be perfectly legal. In some cases, high-frequency traders test prices by issuing buy or sell orders that are withdrawn in milliseconds, giving those traders insight into investors’ willingness to trade at specific prices. High-frequency traders can also earn tiny profits, millions of times over, from “rebates” provided by exchanges to players willing to buy and sell when there is a shortage of other traders.

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The problem is that financial breakdowns come with low frequency. Since flaws in the financial system may appear decades apart, it is hard to figure out how some new financial device will behave. Moreover, because of the low frequency of crises, people who use financial instruments often have little or no personal experience with the crises and so trust is harder to establish.

When people invest for their children’s education or their retirement, they are concerned about risks that will not become visible for years. They may not be able to rebound from mistaken purchases of faulty financial devices and they may suffer if circumstances develop that create risks that could have been protected against.

Thus, to facilitate financial progress, we need regulators who ensure trust in sophisticated products. They must work towards clearing the way to widespread use of better products, concerning themselves with both safety and creative ideas. They must not simply be law enforcers against the shenanigans of cynical promoters, but also be open to making complex ideas work that have the potential to improve public welfare. Unfortunately, the crisis has sharply reduced trust in our financial system.

…Unfortunately, people do not trust some good innovations that could protect them better. The innovations in mortgages in recent years (involving such things as option-adjustable rate mortgages) are not products of sophisticated financial theory. I have proposed the idea of “continuous workout mortgages”, motivated by basic principles of risk management. The privately issued mortgage would protect against exigencies such as recessions or drops in home prices. Had such mortgages been offered before this crisis, we would not have the rash of foreclosures. Yet, even after the crisis, regulators seem to be assuming a plain vanilla mortgage is just what we need for the future.

Another example of a potentially useful innovation is the target-date fund (also called life-cycle fund) that invests money for people’s retirement in a way that is specifically tailored for people their age. Such a fund plans for young people to take greater risks and for older people to invest more conservatively. Target-date funds, first introduced by Wells Fargo and BGI in the 1990s, are growing in importance, but few people commit the bulk of their portfolio to such funds, or make use of target-date funds that might make adjustments for their other investments. It appears that people do not fully trust that these funds are designed correctly, or would protect them from crises.

…It is critical that we take the opportunity of the crisis to promote innovation-enhancing financial regulation and not let this be eclipsed by superficially popular issues. Despite the apparent improvement in the economy, the crisis is not over and so the public continues to support government-led interventions. Doing this means encouraging better dialogue between private-sector innovators and regulators. My experience with regulators suggests that they are intelligent and well-meaning but often bogged down in bureaucracy. Regulatory agencies need to be given a stronger mission of encouraging innovation. They must hire enough qualified staff to understand the complexity of the innovative process and talk to innovators with less of a disapprove-by-the-rules stance and more that of a contributor to a complex creative process.

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Leave it to Wall Street to give innovation a bad name. Americans prize out-of-the-box thinking in technology and culture, but they fear it in finance—understandably, thanks to innovative disasters like credit default swaps, collateralized debt obligations, and “negatively amortizing” mortgages whose principal grows instead of shrinking.

In spite of the public’s mistrust, entrepreneurs and academics are plunging ahead. They’re working on ideas they hope will help the consumer borrow more safely and build wealth more reliably. Some are ambitious, like reducing homeowners’ exposure to declines in local housing prices. Others are fanciful, like an electronically rigged wallet that becomes harder to open when your bank account is low, an idea from the Massachusetts Institute of Technology.

The big problem: It’s hard to tell the beneficial ideas from the ones that are self-serving or dangerous. Many top economists, including former Federal Reserve Chairman Alan Greenspan, once lauded subprime mortgages as a fantastic innovation. With this fresh in mind, there’s a risk that government will overreact and suppress good ideas along with bad ones.

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The Securities and Exchange Commission has proposed halting high frequency and flash trading.

In response, Nasdaq (and others) are now prohibiting flash orders. Supposedly, the NYSE is also considering banning the practice.

This was a given. The real question that remains unanswered and demands a thorough investigation is this: WHAT EXCHANGE OFFICIALS APPROVED THIS? WHO BELIEVED THAT ALLOWING FAVORED FIRMS TO FRONT RUN OTHER INVESTORS WAS OK?

Quite bluntly, the clueless dolts who allowed this to occur need to be publicly excoriated, fired from their job as exchange officials, and driven out of town on a rail. Oh, and, all the gains from this organized theft should be clawed back from all the front-running firms that stole this money — THAT’S RIGHT, ITS THEFT — one quarter cent at a time. Put the recovered ill-gotten gains into the SIPIC fund that compensates investors who have been defrauded by their stock brokers.

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Bloomberg: Flash Trade Halt Backed for Nasdaq, Bats as SEC Vote

IN the aftermath of the great meltdown of 2008, Wall Street’s quants have been cast as the financial engineers of profit-driven innovation run amok. They, after all, invented the exotic securities that proved so troublesome.

But the real failure, according to finance experts and economists, was in the quants’ mathematical models of risk that suggested the arcane stuff was safe.

The risk models proved myopic, they say, because they were too simple-minded. They focused mainly on figures like the expected returns and the default risk of financial instruments. What they didn’t sufficiently take into account was human behavior, specifically the potential for widespread panic. When lots of investors got too scared to buy or sell, markets seized up and the models failed.

That failure suggests new frontiers for financial engineering and risk management, including trying to model the mechanics of panic and the patterns of human behavior.

“What wasn’t recognized was the importance of a different species of risk — liquidity risk,” said Stephen Figlewski, a professor of finance at the Leonard N. Stern School of Business at New York University. “When trust in counterparties is lost, and markets freeze up so there are no prices,” he said, it “really showed how different the real world was from our models.”

In the future, experts say, models need to be opened up to accommodate more variables and more dimensions of uncertainty.

The drive to measure, model and perhaps even predict waves of group behavior is an emerging field of research that can be applied in fields well beyond finance.

Financial markets, like online communities, are social networks. Researchers are looking at whether the mechanisms and models being developed to explore collective behavior on the Web can be applied to financial markets. A team of six economists, finance experts and computer scientists at Cornell was recently awarded a grant from the National Science Foundation to pursue that goal.

“The hope is to take this understanding of contagion and use it as a perspective on how rapid changes of behavior can spread through complex networks at work in financial markets,” explained Jon M. Kleinberg, a computer scientist and social network researcher at Cornell.

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Simon Johnson and James Kwak have an important article on financial innovation in the latest issue of Democracy. The broad thrust of the article I agree with — as you might expect, given that after listening to my last debate on the subject, James Kwak came to the conclusion that “obviously I agree most with Salmon”. (Thanks, James!)

That said, there are significant chunks of the Johnson and Kwak article that I disagree with, and I feel that it’s probably long past time that the “financial innovation: good or bad?” debate allow itself to make some nicer distinctions than have generally been made until now. So with the clear proviso that I’m on the “financial innovation: bad” side of the broader debate, here’s where I take issue with Johnson and Kwak.

First, they address securitization:

Securitization—the transformation of large, chunky loans into small pieces that can be easily distributed among many investors—was a beneficial innovation, because it expanded the pool of money available for lending. And securitization on its own, before the new products of the late 1990s and 2000s, did not produce the colossal boom and bust we have just lived through.

Sure, nothing, on its own, produced the colossal boom and bust we’ve just lived through. But securitization is as much to blame as anything else, if not more so. Securitization absolved lenders from sensible underwriting, since they knew they were just going on onsell that debt anyway. And it made bond investors comfortable with the idea of buying structured products tested only by models, as opposed to actual analyzable liabilities of real-world entities. You can’t phone up the CFO of a special-purpose entity and ask him how things are going. And lending in general works when there’s a relationship between the borrower and the lender. Securitization severs that relationship, which is harmful.

I’d also take issue with the idea that anything which expands the pool of money available for lending is, ipso facto, a good thing. To the contrary, things which expand the pool of money available for lending can serve only to inflate credit bubbles. In general, lending shouldn’t be easy to come by; and it should in principle always be just as easy to issue equity as it is to issue debt. We’re nowhere near that point right now, and securitization only serves to drag us further away from it.

Johnson and Kwak then attack the credit default swap:

Another paradigmatic product was the credit default swap, which insured a security (like a CDO) against the risk of default. But by underpricing that risk, it essentially tricked investors into buying securities that they would not otherwise have bought. The losses were borne by the companies that underpriced the credit default swaps, such as A.I.G., and by the government, which had to bail out A.I.G.—leading to the misallocation of capital to value-destroying investments.

The CDS, pace financial innovation, did not in and of itself underprice credit risk: it was simply a measure of credit risk. And indeed for most of the history of the CDS market, the basis on CDS was positive: as you’d intuitively expect, the cost of insuring a certain credit against default was higher than the spread on that credit’s bonds. You couldn’t lock in a risk-free return by simply buying a security and insuring it against default. So if the CDS market was underpricing risk, the bond market was underpricing risk even more. It was only after the credit market imploded that the negative-basis trade started becoming possible. So you can’t really blame a negative CDS basis for any part of the crisis.

Yes, it’s clear, in hindsight, that AIG, in particular, was underpricing credit risk. But that has nothing to do with the structure of the CDS market more generally. Instead, the problems with AIG surrounded the fact that it only ever sold credit protection, and never bought it; and that once it had sold protection, it used its triple-A credit rating to avoid having to put up any collateral against those positions or otherwise be forced to protect itself against loss. AIG in general, and AIG Financial Products in particular, did a lot of things wrong. But that’s not the fault of the CDS market.

Johnson and Kwak are right that regulators should be inherently suspicious of financial innovation; they’re possibly too polite to mention that this is largely because most financial innovation comprises, at its heart, some kind of regulatory arbitrage. (Securitization being no exception.) I agree also with the idea of standardizing CDS documentation, although it should be said that that is already happening to a large extent. I’m not at all sure, however, that standardized CDS will be much easier to regulate than the customized CDS of old. It’s not the customization which is the problem, it’s trying to get a grip on net positions, in a market which is constantly in flux. The way to solve that problem is to simply let the market continue down the road of the past six months, where CDS are increasingly being shunned as an asset class in favor of good old-fashioned bonds.

Johnson and Kwak then finish with a list of good financial innovations we might encourage: banking the underserved (a no-brainer), reforming health insurance (yes, but let’s not debate that here), and finally this:

We need innovation in financial education. A large part of our regulatory system relies on consumers being able to make intelligent choices when faced by an ever increasing and ever more complex set of financial choices. The recent crisis has shown that even large and supposedly sophisticated investors, such as municipalities and pension funds, did not fully understand the products they were buying. Economist Robert Shiller has proposed government-subsidized financial advice; this may not be a sufficient solution, but it is a start. Obama’s proposed Consumer Financial Protection Agency (first proposed by Elizabeth Warren in Democracy, Issue #5, “Unsafe At Any Rate”) could also go far in improving consumers’ understanding of their financial options.

This I’m much less sure about. You can be sure that no matter how good the financial education provided, the consumers of that education won’t end up being better educated about financial affairs than large and supposedly sophisticated investors, such as municipalities and pension funds. The problem with investors who made bad choices during the boom wasn’t that they were insufficiently educated: it was rather that they were educated too much. Financial education breeds overconfidence, and overconfidence was a much more important cause of the crisis than insufficient education was. If a strong CFPA prevents truly harmful products being sold to consumers, that’s the best we can hope for: a mass education program isn’t practicable and wouldn’t work even if it were implemented. The last thing I want is Robert Shiller being unleashed on the public, telling them that they can hedge the value of the equity in their houses by buying derivatives on house prices.

So thank you, Simon and James, for fighting the good fight. But this clearly isn’t the last word on the subject.