Monday, May 17, 2010

Push-me Pull-you

Europe and the United States are locked in competition to see who can pass the strictest new financial regulations first. Each believes that if it is first, the other will have to harmonize their rules behind it. Both could be wrong about that, but it looks like Europe will win the blue ribbon for first place in the regulation race.    
Angela Merkel and Nicolas Sarkozy are throwing their weight behind the European Commission's hedge fund regulation known as the Alternative Investment Fund Managers directive. The AIFM is causing consternation from the US and other non-resident hedge funds which, if it passes, may not be allowed to do business in Europe. Many EU leaders actually believe that hedge funds are the reason their countries have become destabilized. And it looks like AIFM will pass on Tuesday, leaving US hedge funds to swing in the wind.
Meanwhile, the US Senate is debating the finer points of (read: pretending to understand) Chris Dodd's financial regulation bill. It rejected Ben Bernanke's and Wall Street's pleas to loosen derivatives trading rules, including keeping in there Sen. Blanche Lincoln's proposal to hive off swaps and derivatives from banks altogether.
And Paul Volcker is running around Europe touting the virtues of his prop trading rule, which he is absolutely convinced will pass. (I agree that the odds for the Volcker Rule passing are pretty good. The Volcker Rule makes its presence known in almost every discussion on how to regulate the TBTF banks. His reasoning is solid, saying that when commercial banks venture into capital markets functions their risks grow too high.)
So we have a regulatory first-mover stand-off, but the focus of these regulations makes me wonder if they are missing something. None of the immediately visible rules - regulating hedge funds, separating derivatives or prop trading from banking, clearing derivatives, smacking down credit ratings agencies - will do the first thing to prevent another market structure bump like the one on May 6th.
The US market has become so terribly fragmented that no one seems to know who is doing what and where, and under which rules. Regulators are running around like lunatics trying to figure out what happened on May 6th, while exchanges are tearing up their databases trying to see who did what and when. What is lacking is market-wide oversight, monitoring and - most importantly - transparency. I hope that some of the new rules and regulations we are about to have will help to pave the way toward this. The good news is that US exchanges, ECNs and regulators are experienced at cooperation.
These are still untested waters in Europe, which can barely deal with common currency issues. Fragmentation in European exchanges, ECNs, clearing houses, and regulators is becoming a major concern.  I fear a flash crash in European markets is the next shoe to drop, and it will be faster and more severe than anything we have seen in the US to date.

Friday, May 7, 2010

Tipping point for high frequency trading

Although a trading error may have been to blame for the domino effect that knocked the Dow Jones Industrial Average down by almost 1,000 points on Thursday, May 6 it highlighted the damage that high frequency trading can inflict in the blink of an eye. It also proved the fragility of the post-Reg NMS market framework, and proves the need for government mandated pre-trade risk management, market surveillance and monitoring.
'Greek Thursday' - as I have dubbed it - could be the tipping point for HFT. Regulators are poised to decide upon new controls for high speed markets, and Greek Thursday might just be the clarification they needed. Here are some of the lessons that could be learned from the experience.
1. Pre-trade risk management is a necessity. Fat fingered errors are absolutely avoidable. Using pre-trade risk management tools would prevent fat fingered errors and/or breaching trade limits. That trading firms do not use them is unbelievable.
2. Smart order routing can also be stupid order routing. Many algorithms are designed to 'find and nail' liquidity, no matter where it rests or what the price. You must monitor and manage your algorithms in real-time.
3. All exchanges and ECNs should have to take a break when markets are volatile.  If an exchange such as NYSE institutes a trading pause due to volatility, your order routing can go to a venue where liquidity is less than desirable, and prices are downright miserable.
4. Orders should be tagged. Whether an order comes through from an algorithm or a sales trader or broker, it should have an electronic tag so that when regulators/exchanges/ECNs see an error they know where it came from and can respond accordingly.
5. Real-time market monitoring is a necessity. Electronic trading means that crashes such as that on Greek Thursday can happen in an instant. If a trading anomaly is spotted in real-time, preventive measures could be taken.
Days like Greek Thursday could repel retail or institutional investment - the very money the industry has been trying to lure back into the stock markets.  When prices started to collapse on Thursday, it became all too clear that everyone was on the same side - bearish. Algorithmic players had their pants taken down and their positions exposed to the world yesterday. This hardly builds confidence.

Monday, May 3, 2010

Oil and Water

You would not think there was as much in common between the oil industry and the OTC derivatives markets; they look about as similar as oil and water. Oil is the substance upon which this country runs its cars (and trucks, SUVs, RVs, ATVs, speedboats....), heats its homes and runs its factories.  Derivatives are complex instruments that are (usually) derived from underlying trading instruments or exchange-traded contracts. Yet both have made the news lately for the same reason - they proved they can be dangerous weapons when in the wrong hands.
The oil leak offshore in the Gulf of Mexico is happening because the oil lobby is one of the most powerful in the US and has spent decades bribing politicians to allow more and more exploration. The mouthpiece of the oil industry, the American Petroleum Institute, is the official pooh-pooher when it comes to subjects such as over-consumption, pollution, global climate change. It spends millions every year saying how safe it is - how good for the economy - to drill, to refine, and to use oil.
The lobbyists for the financial services industry are also extremely powerful. There are reportedly four financial industry lobbyists for each politician in the house and the senate. The U.S. Chamber of Commerce, an anti-regulation group, reported spending $30.9 million on lobbying in the last three months, much of it on financial regulation, with major industrial and other corporations weighing in too, said the Global Association of Risk Professionals in an article. These lobbyists and the line that they feed the politicians ('regulation will kill this business') have helped to keep the lid on financial regulation since Glass-Steagall was abolished in 1999.
So, when you see the oil spill headed for the Gulf coast and wonder 'how can this happen?', picture a herd of lobbyists marshalled  to head for Washington, DC (beautiful image courtesy of Larry Tabb) armed with tens of millions of dollars. Picture the heads of these oil companies looking at their bottom line each year, trying to figure out how to make more for their shareholders. (There is really only one way - exploration and development, the rest is pocket change comparatively.) Remember hearing Sarah Palin screeching in her fingernails-on-a-blackboard voice that we need to 'drill, baby, drill.' Think of the pristine coastline of Norway and ask yourself whether that country would allow drilling if it did not have a disaster prevention/recovery plan in place. (It has an exhaustive plan.)
And when you hear anti-derivatives legislation voices raised from Washington (again with the 'regulation will kill this business', yeesh), remember where they are coming from. Wall Street's army of lawyers and lobbyists and even Warren Buffett. Yes, OTC derivatives regulation will cost them money. It will cost them capital. It will shrink profit margins. Boo hoo.
When you hear anti-regulation voices raised in the oil industry, much of the general public used to echo them. After all, who wants to pay $5.00 a gallon for gasoline? Why can't we drill and drill and drill until our oil is all-American, all the time (impossible, but hey why let the facts get in the way of a cause)? In the next couple of days you will see why we can't - when you turn on the TV. There will be birds and beaches and fish covered in oil, and livelihoods lost to the black gold.
Somehow in the pursuit of free markets, the interests of the few became paramount. The ones with the most lobbyists and the most money won, time and again. Because the politicians, who seemingly know nothing about anything, went along with it for their own self-interests (re-election). And now these same politicians are angry. They have been duped. They want blood. And both industries, oil and derivatives, will get their comeuppance in the form of draconian regulation. Free market proponents need to wake up and realize that free isn't always without cost.