The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

>

Jim McTague explains why this is the unhappy anniversary of the flash crash:

From Jan. 1 through April 30, 2010, investors put $668 million into stock funds, says the Investment Company Institute, the mutual-fund trade group. By the end of 2010, they had withdrawn about $96 billion. In 2011, there were $135 billion in outflows. This year, there have been more than $15 billion in outflows.

The hazards posed by the new robots were detected not by the regulators but by Sal Arnuk and Joe Saluzzi, partners in a small proprietary trading company. They blew the whistle in December 2008, accusing some of the owners of these high-frequency trading machines of manipulating the market. (They tell all in a book out next month called Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence and Your Portfolio.)

Eric Hunsader of Nanex, a small data firm, uncovered real-time evidence of market manipulation and also showed up the regulators. His Twitter feed tracking machine misbehavior has become must-reading for investors.

Nothing has changed since May 6 2010. The odds of another co-located, algo-driven, dislocation remains as high as ever.

>

Source:
Happy Flash Crash
Jim McTague
Barron’s, MAY 5, 2012
http://online.barrons.com/article/SB50001424053111903935304577376060415615588.html

Joseph Saluzzi (jsaluzzi-at-ThemisTrading.com) and Sal L. Arnuk (sarnuk-at-ThemisTrading.com) are co-heads of the equity trading desk at Themis Trading LLC (www.themistrading.com), an independent, no conflict agency brokerage firm specializing in trading listed and OTC equities for institutions. Prior to founding Themis, Sal and Joe worked for more than 10 years at Instinet Corporation, pioneers in the field of electronic trading, and at Morgan Stanley.

~~~

This Sunday will mark the 2nd anniversary of the May 6th Flash Crash of 2010. As we all trade in this extremely low-volume environment, it is fitting that we recap where we stand today.

Listening to NYSE Euronext’s 1st quarter conference call yesterday, we shook our heads in dismay as management described a trading environment where volumes fell to a four and one half year low – the lowest levels since Reg NMS was implemented in late 2007, in fact.

NYSE’s Duncan Niederauer explained his 44% profit decline was due largely to a 25% decline in revenues from transactions from a year earlier. The culprit: An unfriendly environment for high frequency trading firms. From his point of view, regulators and folks in the media hyped the HFT bogey man too much, creating uncertainty, causing an HFT migration into other asset classes and geographies.

Niederauer doesn’t get it. He is mistaking the symptoms for the underlying problem. HFT volumes are down because investor volumes are down. Investor volumes are down because traditional retail and institutional buyers and sellers of stock have been steadily waking up to the dangers of drinking at the increasingly dangerous ”stock market watering hole.”

Like the animals on the Serengeti, who for years were accustomed to sipping long and heartily at their favorite spot, retail and institutional investors now see what’s beneath the surface. And they are deciding that the drink they crave is just not worth the risk.

More than $250 billion in long term equity funds has retreated from the markets since May 6th, 2010 – despite a slow but steady improvement in the economy and a stock market that has nearly doubled since the 2009 lows. It isn’t that these investors don’t have confidence in the economy. They don’t have confidence in our markets.

It isn’t hard to blame them. They have witnessed a radical transformation of the best capital allocation market system in the world, into one where:

- 13 stock exchanges cater to hyper traders who game the system, chasing exchange rebates, and leveraging speed for the purpose of a nanosecond scalping dance.
- More than 40 dark pools together trade more than 1/3rd of all shares.
- Conflicts of interest abound as exchanges own stakes in dark pools, and HFT firms own stakes in exchanges.
- Brokerage firm internalization of trades feeds the HFT financial modeling of investor orders.
- Exchange data feeds act as a veritable DVR of investor orders and behavior, the recording of which is then sold to HFTs.
- Rogue exchange traded products break down, trap unsophisticated investors, and only enrich the issuers, exchanges, and HFT firms that make markets in them.
- HFT firms in the last decade have achieved wondrous profitability (double-digit Sharpe ratios) while investors at best have clawed back to even.
- More than $1 billion in customer-segregated monies goes missing from MF Global, with not a single prosecution, nor a hope of redress.

As they witness all of the above, traditional retail and institutional investors see that our regulators must be having a challenging time acting as effective policemen in the marketplace:

- Flash orders, which give HFTs a quick peak at retail and institutional orders, are still alive and well, under many different names, despite a proposed banning of them in 2009.
- Dark pool regulation, also proposed years back, has not materialized.
- Internalizing brokerage/HFT firms, which clearly played a huge role in the market melt-down on May 6th (perhaps as well in the financial crisis in late 2008 and 2009) still practice the same way, with additional help from dark pools and exchanges who have all embraced “liquidity provider” programs.
- And finally, payment for order flow (PFOF) is alive and well on numerous levels throughout the system – from retail, to maker/taker exchange pricing, to free dark pool executions.

Investors know that the markets are broken. And they desperately want it fixed.

Our outrage over the transformation of the best capital markets in the world to this conflicted and fragmented web of chaos led us to write our book, Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence and Your Portfolio, which is being published by Financial Times Press.

When the book comes out June 3rd, it will find no shortage of critics from within our industry. However, we needed to write it. For years we have spoken about all of these issues in trade magazines and the financial media, and at industry conferences and panels, as well as with our regulators.

We wrote Broken Markets so that Main Street could understand what happened to our markets, to inspire change, so we can once again have the best capital markets in the world.

So, Happy Anniversary to everybody who made the Flash Crash happen. We hope you are enjoying yourself.

Because we, and millions and millions of other retail and institutional investors around the world, are not.

“When the crisis erupted, we realized we had stuck to a fairly basic rule, which was that the bulk of Tier 1 capital had to be in equity. That turned out to be very, very important.”

-Jamie Dickson, Superintendent, OSFI (Canada’s bank regulator)

>

Bloomberg Markets has a list of the world’s strongest banks — they are dominated by Canada and Singapore firms.

Why Canada? Regulators there set strict criteria on the quality of banks’ assets and reserves. Canadian banks don’t use a lot of leverage, and are required to hold 75% of their capital in equity.

Here is the top 10 list:

1. Oversea-Chinese Banking Corp OCBC (Singapore)
2. BOC Hong Kong Holdings Ltd. (Hong Kong)
3. Canadian Imperial Bank of Commerce CIBC (Canada)
4. Toronto-Dominion Bank TD (Canada)
5. National Bank of Canada (Canada)
6. Royal Bank of Canada (Canada)
7. United Overseas Bank Ltd. (Singapore)
8. DBS Group Holdings Ltd. (Singapore)
9. Hang Seng Bank
10. Svenska Handelsbanken (Sweden)

Other Canadian banks made the list, such as Bank of Nova Scotia ranked 18th, and Bank of Montreal was 22nd.

Only three U.S. banks — JPMorgan Chase (JPM) (No. 13), PNC Financial Services Group Inc. (PNC) (No. 17) and BB&T Corp. (BBT) (No. 20)  made the top 20.

>

Source:
Canadians Dominate World’s 10 Strongest Banks
Doug Alexander and Sean B. Pasternak
Bloomberg Markets Magazine, May 2, 2012  
http://www.bloomberg.com/news/2012-05-02/canadians-dominate-world-s-10-strongest-banks.html

Regulatory Reform since the Financial Crisis
Governor Daniel K. Tarullo
At the Council on Foreign Relations
New York, New York May 2, 2012

As everyone present today knows, the process of post-crisis financial regulatory reform has been elaborate and extended. Numerous rulemakings, most involving multiple agencies and many quite complex, are required to implement the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, as well as various international frameworks developed under the auspices of the Basel Committee on Banking Supervision. It is thus natural, and appropriate, that those of us involved in this process, both inside and outside government, have been focused on the details of one or another of these regulations. However, this necessary attention to details also places us at risk of losing sight of the broader reform picture. So this morning I would like to do some stocktaking: to review briefly the vulnerabilities in the financial system that contributed to the crisis and compel regulatory response, to outline some key reforms adopted to date, and to identify important tasks that remain.

The Origins of the Crisis
This is certainly not the occasion for an extended discussion of the origins of the crisis. But, in assessing the progress of reform, it is important to recall the basic problems we should be addressing. The New Deal reforms, engrafted onto preexisting restrictions in the National Bank Act and state banking laws, largely confined commercial banks to traditional lending activities within a circumscribed geographic area, while protecting them from runs and panics through the provision of federal deposit insurance and Federal Reserve discount window access. At the same time, investment banks and broker-dealers were essentially prohibited from affiliation with traditional banks. This approach fostered a system that was, for the better part of 40 years, very stable and reasonably profitable, though not particularly innovative in meeting the needs of savers, on the one hand, and of households and businesses wishing to borrow funds, on the other.

Beginning in the 1970s, the separation of traditional lending and capital markets activities began to break down under the weight of macroeconomic turbulence, technological and business innovation, and competition. The dominant trend of the next 30 years was the progressive integration of these activities, fueling the expansion of what has become known as the shadow banking system, including the explosive growth of securitization and derivative instruments in the first decade of this century.

This trend entailed two major, and related, changes. First, it diminished the importance of deposits as a source of funding for credit intermediation in favor of capital market instruments sold to institutional investors. Over time, these markets began to serve some of the same maturity transformation functions as the traditional banking systems, which in turn led to both an expansion and alteration of traditional money markets. Ultimately, there was a vast increase in the creation of so-called cash equivalent instruments, which were supposedly safe, short-term, and liquid. Second, this trend altered the structure of the industry, both transforming the activities of broker-dealers and fostering the emergence of large financial conglomerates.

Though motivated in part by regulatory arbitrage, these developments were driven by more than regulatory evasion: Such factors as the growth and deepening of capital markets and the rise of institutional investors as guardians of household savings accelerated the fracturing of the system established in 1933. Whatever the relative importance of these causal factors, however, one thing is clear: Neither the statutory framework for, nor supervisory oversight of, the financial system adapted to take account of the new risks posed by the broader trend. On the contrary, regulatory change for the 30 years preceding the crisis was largely a deregulatory program, designed at least in part to address the erosion of banks’ franchise value caused by the rapid growth of credit intermediation through capital markets.

The consequences of this neglect were dramatic. When questions arose about the quality of the assets on which the shadow banking system was based–notably, those tied to poorly underwritten subprime mortgages–a classic adverse feedback loop ensued. With lenders increasingly unwilling to extend credit against these assets, liquidity-strained institutions found themselves forced to sell positions, which placed additional downward pressure on asset prices, thereby accelerating margin calls for leveraged actors and amplifying mark-to-market losses for all holders of the assets. The margin calls and booked losses would start another round in the adverse feedback loop.

Read the rest of this entry »

Via Demonocracy, we see this basic take on derivatives:

A derivative is a legal bet (contract) that derives its value from another asset, such as the future or current value of oil, government bonds or anything else. Ex- A derivative buys you the option (but not obligation) to buy oil in 6 months for today’s price/any agreed price, hoping that oil will cost more in future. (I’ll bet you it’ll cost more in 6 months). Derivative can also be used as insurance, betting that a loan will or won’t default before a given date. So its a big betting system, like a Casino, but instead of betting on cards and roulette, you bet on future values and performance of practically anything that holds value. The system is not regulated what-so-ever, and you can buy a derivative on an existing derivative.”

Where things go mad is when we start to conceptualize the amount of exposure the major banks (and through them you the taxpayer) have. The scale of derivatives these days has becomes so immense as to be nearly unimaginable.

So Demonocracy helps us along with this giant infographic of the 9 biggest banks by their Derivative exposure, both individually and collectively.

Here for example is State Street Bank — note the $1.39 trillion dollar pile of derivatives next to their HQ — as well as Goldman Sachs and their $44.2 trillion dollar derivative pile:

>

click for giant graphic of largest banks and their derivative exposure

>

Compare that with Goldman Sachs

I have to admit to being stymied by this:

“The Securities and Exchange Commission voted Thursday in favor of bringing an administrative action against Egan-Jones, the firm said. In what would be an unprecedented move, the SEC could seek to punish the firm by stripping it of its ability to issue officially recognized ratings on securities tied to government debt and asset-backed deals. An SEC spokesman declined to comment.

The move stems from alleged “material misstatements” Egan-Jones made when it applied to regulators in 2008 to rate bonds issued by countries, U.S. states and local governments, and asset-backed securities, according to documents reviewed by The Wall Street Journal and people familiar with the matter.” (WSJ)

Here we have an allegation of a specific error, made in good faith by Egan Jones, over the course of doing business.

At the same time, we have a broad set of systemic errors made by the two much larger competitors, Moody’s and Standard & Poors. These two firms, by design, gave triple AAA ratings to piles of junk paper. They did so because that was what they were paid to do by the underwriters.

These were not good faith errors. They were instead a reflection of a wholly corrupted industry, designed to mislead investors and legitimize junk paper.  Consider what Nobel prize winning economist Joseph Stiglitz observed:

“I view the ratings agencies as one of the key culprits. They were the party that performed that alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the ratings agencies.” (Bloomberg)

Somehow, these two whales of corruption get a pass. I don’t get it . . .

>

Ratings Let Loose Subprime Scourge

Source: Bloomberg

>

Source:
Ratings Firm Is in SEC Sights
JEAN EAGLESHAM And JEANNETTE NEUMANN
WSJ, April 19, 2012, 7:38 p.m.
http://online.wsj.com/article/SB10001424052702303513404577354023825841812.html

Previously:
Ratings Agencies: Moodys, S&P, and Fitch (ORIGINAL) (February 10th, 2009)

How Can Securitization Lending Be Made Safer ? (February 6th, 2010)

Assessing Blame (January 26th, 2011)

Source: Fiscal Times

Bloomberg View published an op-ed today titled  “High-Speed Trading Is Progress, Not Piracy” written by Professor Bernard Donefer of Baruch College. As expected, this is the typical HFT defense piece (why does Fred Mishkin come to mind every time we read an academic piece like this). We’ll save you the trouble of reading it and summarize Prof. Donefer’s main points:

- Criticism of HFT is overblown
- Information-timing asymmetries have always existed
- Automated market makers are liquidity providers
- There is some bad HFT (momentum ignition, layering) and this needs to be identified but don’t blame all HFT.
- Credit Suisse (the largest dark pool provider) published a study that shows volatility is down and spreads are tight.

Does every HFT defender simply reference the same old tired talking points? There must be an app somewhere that spits out these standard lines. While Professor Donefer stuck to script and hit all the talking points that the FIA/PTG would have liked him to hit, he has overlooked most of the structural issues that allow HFT to extract near risk free rents from the markets. He does not address:

-the fact that there are two separate quotes (the fast one that HFT calculates, and the slow one that the SIP provides)
-why are there 13 different stock exchanges
-the maker/taker model and the payment for order flow which has distorted asset pricing
-the conflicted order types like hide/slide and Day ISO
-the conflicted smart order routers
-the IOI’s that dark pools send to each other
-the poorly crafted regulations like Reg ATS and Reg NMS which helped create today’s fragmented market

Professor, these are the real issues. We all know that you can’t stop technology and we have no intention of trying to do so. But please, it’s time for some new defenses.

We must give the professor some credit though. At the end of his pro-HFT piece, he does make some very good recommendations for structural reforms (Interesting that even though he thinks there is nothing wrong with HFT, he feels the need to call for structural reforms). He states:

“We should consider creating new trading venues exclusive to institutional block investors, and perhaps allowing block traders to opt out of the SEC’s trade-through rule, which requires buying shares at the best available price, even when that’s a hindrance to large trades. A new call market limited to small and mid-cap stocks might increase liquidity and tighten spreads for stocks with low average daily volume.”

These are all excellent recommendations that would help bring back trust and confidence to the equity market. Addressing the needs of small and mid-cap companies separately is also the right approach since their needs are much different from the mega cap companies.

We are not in favor of new regulations for the sake of regulation. We are in favor of having the stock market serve its original purpose of helping companies raise capital so that they can grow and create jobs to help our economy grow.

~~~

Joseph Saluzzi (jsaluzzi-at-ThemisTrading.com) and Sal L. Arnuk (sarnuk-at-ThemisTrading.com) are co-heads of the equity trading desk at Themis Trading LLC (www.themistrading.com), an independent, no conflict agency brokerage firm specializing in trading listed and OTC equities for institutions. Prior to founding Themis, Sal and Joe worked for more than 10 years at Instinet Corporation, pioneers in the field of electronic trading, and at Morgan Stanley.

~~~

Read the rest of this entry »

Dissenting Statement Regarding the Study on the Cross-Border Scope of the Private Right of Action Under Section 10(b) of the Securities Exchange Act of 1934 as required by Section 929Y of the Dodd-Frank Wall Street Reform and Consumer Protection Act

by Commissioner Luis A. Aguilar

U.S. Securities and Exchange Commission

Washington, D.C.
April 11, 2012

Today the Commission has authorized that a Study be sent to Congress expressing the views of the Staff on the cross-border scope of the private right of action under Section 10(b) of the Securities Exchange Act of 1934. However, my conscience compels me to write separately to record my views on the Study. I write to convey my strong disappointment that the Study fails to satisfactorily answer the Congressional request, contains no specific recommendations, and does not portray a complete picture of the immense and irreparable investor harm that has resulted, and will continue to result, due to Morrison v. National Australia Bank, Ltd.¹

In the United States we have a strong belief that, whether rich or poor, we are all entitled to our day in court. Sadly, for many American investors this is no longer true.

If American investors are defrauded by a company that they have invested in – and that company is listed on a foreign exchange – investors may be unable to have their day in court and seek redress against this company for its lies and misrepresentations. Thus, investors have been stripped of a traditional American right.

This was not always the case. For decades, federal courts applied the same standard to determine whether U.S. federal securities law applied to frauds that took place, in whole or in part, outside of the United States. Under that standard, Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and other antifraud provisions applied “when there was ‘significant U.S. fraudulent conduct that directly caused the plaintiffs losses’ (the conduct test) or when there were ‘significant effects’ on the U.S. securities markets (the effects test).” ²

Under the conduct test, an investor could bring a Section 10(b) claim if a sufficient level of conduct comprising the fraud occurred in the United States, even if the victims or the purchases and sales were overseas. ³

Under the effects test, an investor could bring a Section 10(b) claim in a transnational securities fraud when the conduct occurring in foreign countries caused foreseeable and substantial harm to U.S. interests. ⁴

As a result of the conduct and effects test, if an American investor was lied to or defrauded in a securities transaction, that investor had the ability to have his or her day in court and seek legal recourse, even if the securities transaction was overseas.

However, this dramatically changed when, in Morrison, the Supreme Court severely restricted the extraterritorial scope of Section 10(b) of the Exchange Act. After Morrison, investors are restricted to bringing Section 10(b) claims related to frauds in connection with the “purchase or sale of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States.”⁵ As a result of Morrison, investors have been stripped of the ability to seek redress against those who have harmed them in a transnational securities fraud.

The United States Congress, realizing the danger, immediately responded to mitigate the Supreme Court’s decision. The first step was to fully restore the ability of the Securities and Exchange Commission (“SEC” or “Commission”) and the Department of Justice (“DOJ”) to bring enforcement actions⁶ under Section 10(b) in cases involving transnational securities fraud pursuant to the pre-Morrison tests of conduct and effect.⁷ The second step was to request that the Commission conduct a Study on the Extraterritorial Scope of the Private Rights of Action under Section 10(b) of the Exchange Act (“Study”).⁸

Section 929Y of Title IX of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) requires that the Commission’s Study provide recommendations to Congress on whether private rights of action under the antifraud provisions of the Exchange Act should be extended to cover:

1. Conduct within the United States that constitutes a significant step in the furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors; and
2. Conduct occurring outside the United States that has a foreseeable substantial effect within the United States.⁹

The Study falls far short of providing Congress with an informed recommendation and falls far short in fulfilling the Commission’s mission to protect investors. I am particularly astonished that the Study states (at pages 58-59) that an option “would be for Congress to take no action” and, thus, would continue to deny American investors who have been harmed by fraud the ability to seek redress in court.

The evidence post-Morrison is stark and compelling. All of the predictions of the harm that the Morrison decision would inflict on investors have come to pass.¹⁰ It is clear that Morrison has deprived investors of their private rights of action under the Exchange Act with respect to a wide range of potentially fraudulent conduct that the United States has a compelling interest to regulate.

The answer to the Congressional query about whether to re-establish extraterritorial private rights of action under Section 10(b) of the Exchange Act through the application of the pre-Morrison tests of conduct and effect is an unequivocal yes.

The Study is incomplete in many ways, but I will just highlight the following:

• It Fails to Adequately Explain how Private Rights of Action are a Vital Complement to SEC Actions and Essential to Investor Protection;
• It Overstates the International Comity Concerns Associated with Restoring Investors’ Rights to Assert Private Claims Under Section 10(b);
• It Does Not Accurately Portray Investor Harm Resulting from Morrison and Fails to Convey a Sense of Urgency as to the Harm Being Suffered; and
• It Provides as an Option That Congress Take No Action at All Despite the Continuing Harm to Investors.

The Study should have recommended that Congress enact for private litigants a standard that is identical to the standard set forth in Section 929P of the Dodd-Frank Act – the standard for SEC and DOJ actions. The harm that has resulted and continues to result to investors is significant, and Congress should act to rectify this with haste.

Read the rest of this entry »

You’d think after such a calamitous economic fall, there’d be a strong consensus on reinforcing the protections that keep us out of harm’s way. But in some powerful corners, the opposite is happening. Business and political forces, including hordes of lobbyists, are working hard to diminish or destroy these protections. One of the biggest bull’s-eyes is on the Volcker Rule, a section of the Dodd-Frank Act that aims to keep the banks in which you deposit your money from gambling it on their own — sometimes risky — investments.

On this week’s Moyers & Company, Bill talks with the namesake of the Volcker Rule — Paul Volcker, who served two terms as Chairman of the Board of Governors of the Federal Reserve System from 1979-1987, and formerly headed President Obama’s Economic Recovery Advisory Board.

April 5, 2012

~~~

In this essay, Bill shares how several American cities, including Los Angeles, Kansas City, and New York City, are challenging big banks, and holding them accountable to their communities.

Restructuring Wall Street From the Bottom Up

April 5, 2012