Category / Markets

Silver linings February 2, 2014 at 9:12 am

2014 Cocoa

I mean not just to clouds, but to Kit Kats too. In January the cocoa price went up precipitously, driven partly by increased demand from emerging markets, as the Nymex cocoa future price plot shows. This is profound implications for the cost of what’s inside those foil wrappers.

A global emerging market crisis could of course plunge the financial system back into crisis and cause untold harm – as it did with Russia/LTCM in recent memory – but it will at least reduce the pressure on cocoa prices. Instead of messing around with those troublesome credit indices, perhaps JPMorgan should have hedged their loan book with rolling cocoa puts…

Bubble me do January 17, 2014 at 11:17 am

‘Bubbles’ are much in debate – by Gavyn Davies here and here, Daoud & Diaz here, Fama here, Stein here, and so on.

A key issue, obviously, is what is a bubble. The Brunnermaier definition is

Bubbles are typically associated with dramatic asset price increases followed by a collapse. Bubbles arise if the price exceeds the asset’s fundamental value. This can occur if investors hold the asset because they believe that they can sell it at a higher price to some other investor even though the asset’s price exceeds its fundamental value.

I think this is a terrible definition. There are two big things wrong with it:

  • It implies that an asset price rise is only a bubble if it is followed by a collapse, in other words that, by definition, slow bubble deflation is impossible.
  • It assumes that there is a single ‘fundamental’ price which we can measure deviations from. In reality of course ‘fundamentals’ are just as socially constructed as market prices, and just as arbitrary. (I have used the catchphrase ‘prices are a Schelling points’ in the past.)

We can’t reasonably hope to address the financial stability implications of bubbles until we have a better definition of what a bubble is.

US M/A activity to plummet? December 10, 2013 at 7:58 pm

Bloomberg gives use what might unkindly be called a sell signal:

Nomura Holdings Inc., Japan’s biggest brokerage, plans to hire about 20 bankers in the U.S., part of efforts to regain lost share of the world’s largest mergers and acquisitions advisory market.

Make of that what you will, but anyone who is convinced that the Japanese show universally good timing in these matters might be accused of mis-reading history…

The problem with bond market power November 9, 2013 at 2:06 pm

Peter Lee in Euromoney points out that while dealers’ bond inventory has been going down, the big funds have got bigger.

Liquidity is drying up across the bond markets. Regulations designed to curtail banks’ leverage have had the unintended consequence of also sharply reducing their ability and willingness to make markets in corporate and even government debt.

Felix Salmon picks up the story and reposts this chart from Citi as evidence:


As the title hints, what is at stake here is the declining ability of the markets to absorb risk. Twenty years ago, dealers would make ‘risk’ prices for big blocks, committing their balance sheets to take on customer blocks in exchange for a return. That’s rare now, and become rarer. Dealer inventory has declined too as it becomes more costly in capital to hold. The net result is not just a market with wider spreads and less certainty of execution; it is also one that is becoming more and more vulnerable to even mild selling from the two buy-side leviathans, Pimco and Blackrock. It is no one’s interest that these firms are now so big that they cannot change their positions meaningfully without causing market disruption.

Knight check October 24, 2013 at 8:43 am

Amusing details from the SEC proceeding against HFT firm Knight:

To enable its customers’ participation in the Retail Liquidity Program (“RLP”) at the New York Stock Exchange, which was scheduled to commence on August 1, 2012, Knight made a number of changes to its systems and software code related to its order handling processes. These changes included developing and deploying new software code in [the firm’s system] SMARS. SMARS is an automated, high speed, algorithmic router that sends orders into the market for execution. A core function of SMARS is to receive orders passed from other components of Knight’s trading platform (“parent” orders) and then, as needed based on the available liquidity, send one or more representative (or “child”) orders to external venues for execution.

Upon deployment, the new RLP code in SMARS was intended to replace unused code in the relevant portion of the order router. This unused code previously had been used for functionality called “Power Peg,” which Knight had discontinued using many years earlier. Despite the lack of use, the Power Peg functionality remained present and callable at the time of the RLP deployment. The new RLP code also repurposed a flag that was formerly used to activate the Power Peg code. Knight intended to delete the Power Peg code so that when this flag was set to “yes,” the new RLP functionality—rather than Power Peg—would be engaged.

This is like the nubile teens kissing in a horror movie: you just know it is going to end badly.

The baddie with the knife appears soon enough:

When Knight used the Power Peg code previously, as child orders were executed, a cumulative quantity function counted the number of shares of the parent order that had been executed. This feature instructed the code to stop routing child orders after the parent order had been filled completely… Beginning on July 27, 2012, Knight deployed the new RLP code in SMARS in stages by placing it on a limited number of servers in SMARS on successive days. During the deployment of the new code, however, one of Knight’s technicians did not copy the new code to one of the eight SMARS computer servers. Knight did not have a second technician review this deployment and no one at Knight realized that the Power Peg code had not been removed from the eighth server, nor the new RLP code added. Knight had no written procedures that required such a review.

On August 1, Knight received orders from broker-dealers whose customers were eligible to participate in the RLP. The seven servers that received the new code processed these orders correctly. However, orders sent with the repurposed flag to the eighth server triggered the defective Power Peg code still present on that server. As a result, this server began sending child orders to certain trading centers for execution.

And that, ladies and gentlemen, is one way to lose $460M in a few hours.

The CDS market vs. Paddypower October 6, 2013 at 6:16 pm

From the Paddypower website:


From the CDS market:


Wot, an arbitrage? Well, OK, there might be an issue in doing big enough size on PaddyPower, I agree, but hey, I do like the idea of buying cheap CDS protection then hedging by selling on a political betting website.

Mary Jo addresses the oxymoron October 4, 2013 at 11:06 pm

From SEC chair, Mary Jo White:

Equity exchanges today operate fully electronic, high-speed trading systems using a business model that mostly was developed by electronic communications networks, or ECNs… Exchanges differ from ECNs, however, in significant respects. Exchanges, for example, continue to exercise self-regulatory functions, even as they operate as for-profit entities.

This model for exchanges has encountered challenges. As I noted earlier, for example, the “lit” exchanges no longer attract even one-half of long-term investor orders.

From time to time, equity exchanges have adopted trading models that use different fee structures or attempt to focus on different priorities, such as order size or retail investor participation. These models have been met with mixed success, which raises the question as to whether exchanges have a real opportunity to develop different trading models that preserve pricing transparency and are more attractive to investors.

As is true for all important aspects of our current market structure, the current nature of exchange competition and the self-regulatory model should be fully evaluated in light of the evolving market structure and trading practices. This evaluation should include whether the current exchange regulatory structure continues to meet the needs of investors and public companies. Does it provide sufficient flexibility for exchanges to implement transparent trading models that can effectively compete for investor orders? Does the current approach to self-regulation limit or support exchange trading models?

This evaluation should also assess how trading venues can better balance their commercial incentives and regulatory responsibilities. For example, is there an appropriate balance for exchanges in key areas, such as the maintenance of critical market infrastructure? And are off-exchange venues subject to appropriate regulatory requirements for the types of business they today conduct?

I have in the past, probably unkindly, described the self regulatory model for US exchanges as oxymoronic. What is true, hyperbole aside, is that it is hard to be both a for profit exchange and a regulator of the market you provide, especially as execution mechanisms evolve in ways that potentially advantage one class of market user above another. It is really nice to see the SEC’s chair acknowledging this issue.

Getting out of three trillion August 27, 2013 at 7:32 pm

What do you do if, in round terms, your balance sheet is three trillion dollars bigger than you want it to be? (Or two. Whatever.) Get into the reverse repo market in a big way, of course. Which is exactly what the FED is doing, as the WSJ spotted:

In the July minutes of the Fed meeting released Wednesday, officials discussed a proposal to introduce a so-called reverse repurchase program

That would be a fixed-rate, full-allotment reverse repo programme, to flesh out the details and correct the WSJ’s lamentable spelling. The idea is to give the FED better control over that key monetary policy transmission mechanism, the repo market, by allowing them to dribble out collateral as needed to meet their target repo rate (or more precisely spread of repo rate over FED funds).

Just one question. If Barclays are right about the impact of recent regulatory proposals on the repo market, might the FED be picking up a new tool just when it is about to become less effective?

SLOBs and CLOBs August 14, 2013 at 10:22 pm

The Streetwise Professor, reviewing Haim Bodek’s The Problem of HFT, makes an important point about true central limit order book markets (CLOB markets) vs. those where a poor simulacrum of a central limit order book (SLOB) is created via market linkages:

I call what the SEC wrought a “simulacrum” order book because although it incorporates some aspects of a central limit order book, specifically price priority across exchanges for the top of book, it lacks several crucial features of a true CLOB. Price priority is for top of book only. Time priority (or other secondary priorities) are not enforced across trading venues. Markets can cross or lock-which can’t happen in a CLOB, where locked or crossed orders execute automatically. Moreover, latencies, particularly in the public feed of the NBBO create behaviors and incentives that diverge from a CLOB.

Because it links multiple execution venues, the SLOB has many seams. And one thing we know is that traders traders look for and exploit seams like Tom Brady looks for and exploits the seams in a zone defense…Socializing order flows by requiring exchanges to route orders to other markets displaying better prices encourages competition, and seemingly avoids the problems posed by private CLOBs and utility CLOBs, but raises its own difficulties. Indeed, these are the problems that we are experiencing today, and which Bodek identifies… The trade off is therefore pretty stark: it’s a pick-your-poison kind of thing. Don’t socialize order flow and live with market power, or socialize order flow to facilitate competition, and grapple with the technological challenges of creating a virtual CLOB, and fighting the never ending battle against attempts to exploit the seams.

He’s right: there is no easy answer here. My predilection is towards socializing order flow but that does have consequences for the power of the exchange, and pushes you pretty strongly towards a mutual exchange model with wide participation in governance and strong regulation. If you think (as you reasonably might) that such models tend to slide towards dominance by the big users at the expense of the little guy, and that exchange competition is the answer to that (perhaps a more dubious proposition), then you have to live with the SLOB model and its exploitable inefficiencies.

Peak HFT? June 13, 2013 at 8:12 pm

As Phil Albinus rightly says, if your trading strategy is destroyed by a 5c increase in trading costs, then you may have an issue:

And now high-frequency trading is taking a long look at itself in the mirror. In the cold light of day, traders are rethinking their once favorite way to execute deals in the blink of an eye… Even calls for a nickel fee on every HFT trade or cancelled order, which is a hallmark of HFT, are gaining momentum. If enacted, traders will have to ask themselves if they really needed to trade that fast.

Survival of the slowest June 2, 2013 at 4:33 pm

From Goldman research, via Reuters:

Most banks remain hesitant to announce outsized cost cuts in client facing businesses before peers; their concern being that banks that cut expenses first will see outsized pressure on their revenue… Using history as a guide shows this fear is justified, as historically banks that have cut expenses more than peers have seen outsized pressure on their revenue. This is creating a type of ‘reverse Darwinism,’ where banks are waiting for their competitors to leave certain businesses first, hoping their exit allows for share gains and more expense leverage for the banks that remain committed to the business.

Good luck with that. Evolutionary pressure is slow, but it is relentless.

Morgan Stanley bows to the inevitable May 31, 2013 at 9:05 pm

Or so it seems. The WSJ tells us:

Morgan Stanley has told investors that its under-performing fixed-income unit will have to be a lot smaller than rivals’ businesses in order to earn decent profits.

The shift, disclosed by a senior executive at a dinner earlier this month, marks a twist in Morgan Stanley’s decade-long struggle to become a force in the trading of bonds, currencies and commodities

Six weeks ago, or thereabouts, I suggested that the Tier 2 derivatives players, including Morgan Stanley needed to grasp the nettle and downsize. I doubted that they had the courage: it seems that I was wrong, at least in MS’s case.

Update. Apparently, MS bought correlation books from CS, RBS and Natixis from 2010 to 2012. The key point, of course, is that the EU had implemented CRM models at that point and the US hadn’t, so those books were worth more the US players who were able to exploit their carry for longer before the capital associated with them came in. Such books often had quite a short weighted average life, so even two years of minimal capital requirements were worth having if you could get the book cheaply enough. Now of course the capital is kicking in in the US, and Gorman’s goal of getting below $18B capital requirements for FICC by 2016 is looking problematic.

Going loopy with the SEC May 30, 2013 at 8:19 pm

Thanks to Matt Levine, I have this lovely story of the Facebook IPO on Nasdaq. Matt points us at the SEC account of that dismal day for NASDAQ here. The first few pages are hilarious:

In a typical IPO on NASDAQ, shares of the issuer are sold by the IPO’s underwriters to participating purchasers at approximately midnight and secondary market trading begins later that morning. Secondary trading begins after a designated period – called the ‘Display Only Period’ or ‘DOP’ – during which members can specify the price and quantity of shares that they are willing to buy or sell (along with various other order characteristics), and can also cancel and/or replace previous orders. The DOP usually lasts 15 minutes…

At the end of the DOP, NASDAQ’s “IPO Cross Application” analyzes all of the buy and sell orders to determine the price at which the largest number of shares will trade and then NASDAQ’s matching engine matches buy and sell orders at that price…

NASDAQ’s systems run a ‘validation check’ which confirms that the orders in the IPO Cross Application are identical to those in NASDAQ’s matching engine. One reason that the orders might not match is because NASDAQ allowed orders to be cancelled at any time up until the end of the DOP – including the very brief interval during which the IPO Cross Application was calculating the price and volume of the cross. If any of the orders used to calculate the price and volume of the cross had been cancelled during the IPO Cross Application’s calculation process, the validation check would fail and the system would cause the IPO Cross Application to recalculate the price and volume of the cross.

This second calculation by the IPO Cross Application, if necessary, incorporated only the first cancellation received during the first calculation, as well as any new orders that were received between the beginning of the first calculation and the receipt of that first cancellation. Thus, if there were multiple orders cancelled during the first IPO Cross Application’s calculation, the validation check performed after the second calculation would fail again and the IPO Cross Application would need to be run a third time in order to include the second cancellation, as well as any orders received between the first and second cancellations.

Because the share and volume calculations and validation checks occur in a matter of milliseconds it was usually possible for the system to incorporate multiple cancellations (and intervening orders) and produce a calculation that satisfies the validation check after a few cycles of calculation and validation. However, the design of the system created the risk that if orders continued to be cancelled during each recalculation, a repeated cycle of validation checks and re-calculations – known as a ‘loop’ – would occur, preventing NASDAQ’s system from: (i) completing the cross; (ii) reporting the price and volume of the executions in the cross (a report known as the “bulk print”); and (iii) commencing normal secondary market trading.

This is precious in so many ways: and I am sure that you can guess what happened next. Don’t you love the SEC telling us what a loop is? But lolz aside, it does suggest that IT systems written for the pre-HFT era are not necessarily fit for purpose today.

The second phase of asset price bubbles… May 9, 2013 at 8:02 pm

…is often buying on margin. So we can worry a little when Pragmatic Capitalism shows us this, courtesy of Orcam:

NYSE margin debt

I’ll take a 1 please, Bob April 13, 2013 at 1:10 pm

JP’s recent research report into investment banking has generated a lot of comment (see for instance here for a nice piece from Matt Levine); Citi came out with their version the day before.

Let’s take (some of) JP’s handy cut-out-and-keep classification, add them into the mix (as they don’t appear on their own chart), and use some of Citi’s insights:


The tier 1 banks have a clear franchise. They have profitable IB businesses, global reach, and, – while challenged by regulatory change, – they clearly will stick around in this space. If you want to own an IB, you have to buy one or more of them*.

The tier 2 agency banks similarly have a clear role in life. They make money from flow, don’t have as high a compensation cost, or as volatile earnings. They are investable from an IB perspective.

The tier 2 institutional banks are where the problems are. They don’t have a strategy that makes sense, and likely won’t make enough money to pay for the costs of competing directly with Tier 1. UBS and RBS have already announced that they are exiting this space, presumably keeping a limited agency franchise. Jefferies could certainly follow the agency model, too. For the rest, there is a stark challenge. It isn’t clear that being an asset class champion (e.g. the French banks in equity derivatives or CS in credit) is viable. There isn’t clearly room for all of these banks to move to the agency box: in particular France doesn’t need all of BNP, Soc Gen and CASA in this space. MS, too, doesn’t have a strategic option that looks very attractive, and no tier 1 player needs what it does have enough to buy it. The political support for IB in Switzerland has waned, so CS might have a hard job pretending to be American in IB but Swiss in private client, especially with a niche IB model.

The play of the day is therefore long Barc, BofA, Citi, JPM, GS; short CS, BNP, Soc Gen, MS, RBC‡. This isn’t JP’s argument: they suggest that the tier 1 players can’t afford to exit a business with regulatory uncertainty and volatile ROEs, while the tier 2 players can. I agree with that, but critically that argument depends on the tier 2 players actually seizing the moment rather than wasting two years pretending to be top tier IBs when they are not, and wasting a lot of money in the process. I don’t believe that all of the players in red will have the guts to cut aggressively, hence the call.

*DB is perhaps the exception due to their need for capital to support the US businesss. Note while we are here that 4 out of 6 of these tier 1 firms are American.

‡Any banking trade that doesn’t have a UCG short in it does feel a little incomplete, though.

The curious case of the 2s of 2023 April 12, 2013 at 8:05 pm

The overnight repo rate on the 2% T bond of February 2023 bond did some odd things in March, as Real Clear Markets reports:

[The repo rate] had been about 20 basis points in the week prior, but fell negative on Monday, March 11. By the close on Wednesday, March 13, the overnight repo rate was -2.95%. That day the Treasury sold $21 billion in a 10-year reopened auction that seems to have abated the negative repo after settlement… Such a negative repo rate indicated a sharp and acute shortage of collateral.

RCM suggests that the withdrawal of deposit insurance above $250K and QE caused a collateral squeeze. I don’t have a clear opinion on that, but I do know that negative repo rates that size are a cause for concern.

Downing Drysdale April 9, 2013 at 12:18 am

Scott Skyrm helpfully reminds us of an historic failure, that of Drysdale. The origin of the failure was a glaring arbitrage between the US repo market in the 80s and the treasury market. The former did not account for accured interest on repo’d t-bills, while the latter did. Drysdale’s head trader

started short-selling U.S. Treasurys outright, where he received the price plus the accrued interest. Then he borrowed the securities to cover his shorts in the Repo market, paying only the market price. He was getting the full use of the accrued interest on the bonds at no cost. In order to maximize to amount of cash he was collecting, he concentrated on shorting Treasurys about half way between the semi-annual coupon payment dates. With years of declining bond markets, he had made a lot of money shorting the Treasury market and by February 1982 his trades reached $4.5 billion in short positions and $2.5 billion in long positions… Overall, it was not a bad trading strategy since he won under two out of three possible market scenarios. If the bond market went down, he made a lot of money. If the market stayed the same, he earned free interest on the cash the trade generated. [But] If the Treasury market rallied, he risked a significant amount of money.

The problem, then, was that he was exposed to rising prices which would kill his short. Needless to say, that happened in spring 1982, and Drysdale collapsed. What happened next is insightful.

Drysdale had conducted their Repo trading mostly through Chase’s Securities Lending Department and Drysdale’s counterparties believed they were facing Chase and not Drysdale. Chase believed they were acting “as agent” for Drysdale, so they would not accept responsibility for the $160 million in coupon interest payments on that Monday, but the problem grew even worse. Up until then, the government securities market had operated under the assumption that the buyer in a Repo trade was entitled to liquidate the trade in the event of a default by the seller. There was no law on books differentiating a Repo from a collateralized loan and there had never been a case in court to set a precedent. The market was unsure whether they could liquidate the Drysdale/Chase Repo trades.

The lack of clarity as to the bankruptcy status of a Repo left Chase with a major dilemma. If the bank refused to pay the coupon interest to the Street and that contributed to any of those securities dealers going bankrupt, a future court ruling against Chase could expose them to liability for the damage they caused. However, if Chase made the coupon interest payments for Drysdale, they were clearly taking a loss and would line up as a creditor of Drysdale in the bankruptcy. It was a lose/lose situation.

On Wednesday, the Fed intervened and called together the heads of the 20 largest banks and securities dealers for a meeting at the Fed’s New York office. Not only was there pressure put on Chase from the dealer community, but also by the Fed itself. Though the Fed would later announce that their only involvement was hosting a meeting, quite similar to the future meetings for Long Term Capital Management in 1998 and Lehman Brothers in 2008. The next day Chase relented and, as they say, the rest is history.

The FED, then, prevented a market failure by leaning on Chase in the way central banks do. There were profound financial stability reasons for doing this, not least because of the uncertainty in the legal status of repo. Without knowing if a repo was a collateralised loan or a sale/buyback, no one knew what the exposure was. The law was subsequently clarified in favour of the latter interpretation (thanks to another bankruptcy Scott discussed, that of Lombard-Wall), but the lesson is clear: don’t engage in lots of transaction of uncertain legal status.

On no longer washing April 8, 2013 at 9:05 am

The stock loan business is, paradoxically getting less dirty because it is no longer washing. No longer washing dividends, that is, in tax arb trades. That is because ESMA has acted. The FT reports:

The profitability of lending programmes has been eroded by new guidelines from the European Securities and Markets Authority, which came into force in February, requiring asset managers to return all the revenues from stock lending, net of costs… New tax harmonisation rules in France, forcing domestic funds to pay the same rate of dividend tax as foreign funds holding French equities, are also expected to damp demand for stock lending during the spring “dividend season”. Dividend arbitrage strategies account for 80 per cent of European stock lending revenues, according to BNP Paribas Securities Services.

Step back for a moment. 80%? Surely that an activity is pretty close to being completely socially useless if four fifths of it is tax-driven? European stock loan is down two thirds from the 2008 peak. This is surely a very good thing. I have no problem with stock loan facilitating shorting, but clearly that useful part of the business wasn’t a big part of it.

Closing out Kweku March 28, 2013 at 8:03 pm

Reuters, in between telling a interesting story of the impact of Kweku Adoboli’s losses on UBS, gives us some insightful information on the close out of his position:

The call that would eventually spell the end for [UBS boss Oswald] Gruebel came at 4 p.m. on Wednesday, September 14… [Gruebel] ordered a small taskforce — dubbed “Project Bronze” by those involved — to immediately close Adoboli’s open positions…

The Swiss stock exchange had to be informed by 7.30 a.m. With two-thirds of Adoboli’s open positions closed out overnight, the scale of the losses was clear and executives agreed they would have to say something…

Bankers said Adoboli’s positions were completely closed out by Friday lunchtime.

That would be a little less than two days, then, to get out of exchange traded positions (including ETFs).

The Lehman recovery advances… March 27, 2013 at 4:40 pm

…a little.

From Reuters:

Lehman Brothers Holdings Inc said on Wednesday it plans to distribute about $14.2 billion to creditors early next month… [this] will increase total distributions to about $47.2 billion, with two-thirds going to third parties.

The company has said it hopes to distribute more than $65 billion, on average about 21 cents on the dollar for allowed claims…

Following the distribution, holders of senior unsecured claims against the parent company will have received about 14.8 cents on the dollar on their claims

So, five years on, more or less, we are up to 15% recovery, with 20% in sight. Hmmm.