PIMCO questions US financial focus

It's quite something when the managing director of PIMCO comes our and announces that the US has gone too far in seeking "wealth creation via financial assets," rather than boring things like science and manufacturing. Sean Paul Kelley at The Agonist points to this, which is worth a read.

(Corrupt) Lawmakers challenge derivatives rules

I'm not the least bit surprised by this story detailing the push back by well funded (by whom, do you think?) US senators and representatives against proposed rules to reign in derivatives. Here's some choice material:

The lawmakers, Republicans and Democrats alike, argue that some proposed rules could force Wall Street’s derivatives business overseas. They also say that regulators are ignoring a crucial exemption to the rules spelled out in the Dodd-Frank financial regulatory law.

The law excused airlines, oil companies and other nonfinancial firms known as end-users from new restrictions, including a rule that derivatives must be cleared and traded on regulated exchanges. The firms use derivatives to hedge against unforeseen market changes, say a rise in fuel costs or interest rates, rather than to speculate.

“We are concerned that recent rule proposals may undermine these exemptions, substantially increasing the cost of hedging for end-users, and needlessly tying up capital that would otherwise be used to create jobs and grow the economy,” Senator Debbie Stabenow, Democrat of Michigan and chairwoman of the Senate Agriculture Committee, and Representative Frank D. Lucas, her Republican counterpart in the House, said in a letter this week to regulators.

I particularly like the phrase "airlines, oil companies and other nonfinancial firms known as end-users" identifying those who have restrictions. Does anyone doubt that lawyers and accountants at Goldman Sachs, JP Morgan and virtually every other big bank are working overtime right now deciding how they can turn the bank, or some subsidiary in the Cayman Islands, into an airline, oil company or other nonfinancial firm? I would bet they're just looking for a new pathway through which to route all their high risk stuff - and they've counseled the lawmakers on how they can best carve out some useful routes.

The other thing that is simply precious is this (the likes of which we've heard many times already, of course):

The lawmakers, Republicans and Democrats alike, argue that some proposed rules could force Wall Street’s derivatives business overseas.

The proper response would be not worry, but GOOD, PLEASE HURRY UP! Let them take their financial engineering business overseas and blow up someone else's economy.

P.S. Here's a random string of letters and digits: W8ENHMJ8MBKD. Ponder it if you like, but I don't see that it holds any particular meaning or interest. I have to tuck it into one of my blog posts somewhere to get listed on Technorati.

The ticking CDS time-bomb

The looming mess in Europe, linked to financial distress in Greece, looks like a perfect if rather frightening illustration of the malign consequences of over-dense banking interdependence on global financial stability. In this case -- as with the crisis of 2007-2008 -- the root cause of the trouble is CDSs and other derivatives. No one in Europe is quite sure how many reckless gambles banks have made over Greek debt and potential default, and the European Central Bank appears to be deadly afraid that such gambles have the potential to bring down the entire financial house of cards.

What's happened to the CDS market over the past decade? It's exploded. Amazingly, the value of outstanding CDS linked to debt in Greece, Italy, Spain and Portugal has doubled in the past three years -- since 2008!! The New York Times today discusses what can only be described as a ridiculous situation -- Europe pushed to the brink of a financial disaster by the actions of a small number of people gambling with other peoples' money in the dark, and doing so in the direct aftermath of the greatest financial crisis since the Great Depression:

The uncertainty, financial analysts say, has led European officials to push for a “voluntary” Greek bond financing solution that may sidestep a default, rather than the forced deals of other eras. “There’s not any clarity here because people don’t know,” said Christopher Whalen, editor of The Institutional Risk Analyst. “This is why the Europeans came up with this ridiculous deal, because they don’t know what’s out there. They are afraid of a default. The industry is still refusing to provide the disclosure needed to understand this. They’re holding us hostage. The Street doesn’t want you to see what they’ve written.”

 Wonderful. We've known about this danger for at least several years and have done nothing about it. But in fact, we've actually known about such danger for far longer, and have only taken steps to make our problems worse. A couple of years ago CBS aired an examination of the CDS market, and it is still worth watching. One interesting comment from the program:

It would have been illegal [selling CDSs of any kind] during most of the 20th century under the gaming laws, but in 2000, Congress gave Wall Street an exemption and it has turned out to be a very bad idea.

Dirty little derivatives secrets...

The first dirty little secret of the derivatives industry -- probably not so secret to those in the financial industry, but unknown to most others who still think financial markets in some approximation are fair and efficient -- is that some of the big banks control the market and expressly inhibit competition to protect their profits. I just stumbled across this still highly relevant exposition by the New York Times of efforts to place derivatives trading within properly defined clearinghouses, and the banks' countervailing efforts to gain control over those clearing houses so as to block competition.

The banks (invoking some questionable claims of economic theory) like to argue that derivatives make markets more efficient because they make them more "complete." As Eugen Fama puts it: "Theoretically, derivatives increase the range of bets people can make, and this should help to wipe out potential inefficiencies." Available information, the idea goes, should flow more readily into the market. But the truth seems to be that derivatives make banks more profitable at everyone's collective expense, and not only because they make markets more unstable (see more on this below). From the New York Times article:

Two years ago, Kenneth C. Griffin, owner of the giant hedge fund Citadel Group, which is based in Chicago, proposed open pricing for commonly traded derivatives, by quoting their prices electronically. Citadel oversees $11 billion in assets, so saving even a few percentage points in costs on each trade could add up to tens or even hundreds of millions of dollars a year.

But Mr. Griffin’s proposal for an electronic exchange quickly ran into opposition, and what happened is a window into how banks have fiercely fought competition and open pricing.

To get a transparent exchange going, Citadel offered the use of its technological prowess for a joint venture with the Chicago Mercantile Exchange, which is best-known as a trading outpost for contracts on commodities like coffee and cotton. The goal was to set up a clearinghouse as well as an electronic trading system that would display prices for credit default swaps.

Big banks that handle most derivatives trades, including Citadel’s, didn’t like Citadel’s idea. Electronic trading might connect customers directly with each other, cutting out the banks as middlemen.

The article goes on to describe a host of maneuvers that Goldman Sachs, JP Morgan and other big banks used to block this idea, or at least to make sure they'd be locked into the gears of such an electronic exchange. Eventually the whole idea fell apart to the banks' relief. Guess who's paying the price?

Mr. Griffin said last week that customers have so far paid the price for not yet having electronic trading. He puts the toll, by a rough estimate, in the tens of billions of dollars, saying that electronic trading would remove much of this “economic rent the dealers enjoy from a market that is so opaque.”

"It’s a stunning amount of money,” Mr. Griffin said. “The key players today in the derivatives market are very apprehensive about whether or not they will be winners or losers as we move towards more transparent, fairer markets, and since they’re not sure if they’ll be winners or losers, their basic instinct is to resist change.”

But there's another dirty little secret about the derivatives industry, and this goes back to the question of whether these instruments really do have benefits, by making markets more efficient, perhaps, or if instead they might make them more unstable and prone to collapse. Warren Buffet was certainly clear in his opinion, expressed in his newsletter (excerpts here) to Berkshire Hathaway shareholders back in 2002: "I view derivatives as time bombs, both for the parties that deal in them and the economic system." But the disconcerting truth about derivatives emerges in more certain terms from new, fundamental analyses of how precisely they can stir up natural market instabilities.

I'm thinking primarily of two bits of research -- one very recent and the other a few years old -- both of which should be known by anyone interested in the impact that derivatives have on markets. Derivatives can obviously let people hedge risks -- locking in affordable fuel for the winter months in advance, for example. But they're used for risk taking as much as hedging, and can easily create collective market instability. These two studies show -- from within the framework of economic theory itself -- that adding derivatives to markets in pursuit of the nirvana of market completeness should indeed make those market less stable, not more.

I'm currently working on a post (it's taking a little time) that will explore these works in more detail. I hope to get this up very shortly. Meanwhile, these two examples of science on the topic might be something to keep in mind as the banks try hard to confuse the issue and obscure what ought to be the real aim of financial reform -- to return he markets to their proper role as semi-stable systems providing funds for creative and valuable enterprise. Markets should be a public good, not a rigged casino, benefiting the few, and guaranteed by the public.

The Grand Inquisitors of Rational Expectations

In this short snippet (two minutes and 23 seconds) of an interview, John Kay sums up quite succinctly the situation facing Rational Expectations theorists in the light of what has happened in the past several years. Reality just isn't respecting their (allegedly) beautiful mathematical theories.

In Bertold Brecht's play The Life of Galileo, Kay notes, there's a moment when the Grand Inquisitors of the Church refuse to look through Galileo's telescope. Why? Because the Catholic church had essentially deduced the motion of the planets from a set of axioms. They refused to look, as Kay puts it,

......on the grounds that the Church has decreed that we he sees cannot be there. This makes me think of the way some of the economists who believe in Rational Expectations have reacted to events of the past few years. [They're like the inquisitors with Galileo]. ...they refuse to look through the telescope because they know on a priori grounds that what he saw wasn't actually there.

Millisecond mayhem

The terrifying Flash Crash of 6 May 2010 has long dropped out of the news. The news cycle more of less ended with the release of the SEC's final report on the event in October of last year which concluded that...well... the event got kicked off by a big trade in E-Mini Futures by Waddell and Reed and played out in two subsequent liquidity crises exacerbated -- and crammed into a very short time-sale -- by high-frequency traders. In essence, the report concluded that A happened, then B happened, which caused C to happen, etc., and we had this Flash Crash. What it didn't explore is WHY this kind of this was possible, WHY the markets as currently configured should be prone to such instabilities, or WHY we should have any confidence similar things won't happen again.

I'm not sure what triggered my interest, but I had a quick look today to see if any similar events have taken place more recently. Back in November of last year the New York Times reported on about a dozen episodes it called "mini flash crashes" in which individual stocks plunged in value over a few seconds, before then recovering. In one episode, for example, stock for Progress Energy -- a company with 11,000 employees -- dropped 90% in a few seconds.  These mini whirlwinds are continuing to strike fear into the market today.

For example, this page at Nanex (a company that runs and tracks a whole-market datafeed) lists a number of particularly volatile events over previous months, events in which single stocks lost 5%, 17%, 95% over a second or five seconds before then recovering. According to Nanex, events of this kind are now simply endemic to the market -- the 6 May 2010 events simply seems larger than similar events taking place all the time:

The most recent data available are for the first month and three days of 2011. In that period, stocks showed perplexing moves in 139 cases, rising or falling about 1% or more in less than a second, only to recover, says Nanex. There were 1,818 such occurrences in 2010 and 2,715 in 2009, Nanex says.

 A few specific examples as reported on in this USA Today article:

•Jazz Pharmaceuticals' stock opened at $33.59 on April 27, fell to $23.50 for an instant, then recovered to close at $32.93. "There was no circuit break," says Joe Saluzzi, trader at Themis Trading, because Jazz did not qualify for rules the exchanges put in place after the flash crash for select stocks following extreme moves.

•RLJ Lodging Trust was an initial public offering on May 11. It opened at $17.25 its first day, then a number of trades at $0.0001 took place in less than a second before the stock recovered. The trades were later canceled, but it's an example of exactly what is not supposed to happen anymore, Hunsader says.

•Enstar, an insurer, fell from roughly $100 a share to $0 a share, then back to $100 in just a few seconds on May 13.

•Ten exchange traded funds offered by FocusShares short-circuited on March 31. One, the Focus Morningstar Health Care Index, opened at $25.32, fell to 6 cents, then recovered, says Richard Keary of Global ETF Advisors. The trades were canceled. "No one knows how frequently this is happening," he says.

•Health care firms Pfizer and Abbott Labs experienced the opposite of a flash crash on May 2 in after-hours trading. Abbott shares jumped from $50 to more than $250, and Pfizer shot from $27.60 to $88.71, both in less than a second, Nanex says. The trades were canceled.

 Apparently, according to the Financial Times, something similar happened just over a week ago, on 9 June, in natural gas futures.

I haven't seen anyone who has explained these events in some clear and natural way. I still see a lot of hand waving and vague talk about computer errors and fat fingers. But it seems unlikely these tiny explosions in the market are all driven by accidents. Much more likely it seems to me is that these events are somehow akin to those dust devils you see if driving through a desert -- completely natural if rather violent little storms whipped up by ordinary processes. The question is what are those processes? Also -- how dangerous are they?

The best hint at an explanation I've seen comes from this analysis by Michael Kearns of the University of Pennsylvania and colleagues. Their idea was to study the dynamics of the limit order mechanism which lies at the mechanical center of today's equity markets, and to see if it is perhaps prone to natural instabilities -- positive feed backs that would make it likely for whirlwind like movements in prices to take place quite frequently. In other words, are markets prone to the Butterfly Effect? Their abstract gives a pretty clear description of their study and results:

We study the stability properties of the dynamics of the standard continuous limit-order mechanism that is used in modern equity markets. We ask whether such mechanisms are susceptible to "Butterfly Effects" -- the infliction of large changes on common measures of market activity by only small perturbations of the order sequence. We show that the answer depends strongly on whether the market consists of "absolute" traders (who determine their prices independent of the current order book state) or "relative" traders (who determine their prices relative to the current bid and ask). We prove that while the absolute trader model enjoys provably strong stability properties, the relative trader model is vulnerable to great instability. Our theoretical results are supported by large-scale experiments using limit order data from INET, a large electronic exchange for NASDAQ stocks.

The "absolute" traders in this setting act more like fundamentalists who look to external information to make their trades, rather than the current state of the market. The "relative" traders are more akin, at least in spirit, to momentum traders -- they're responding to what just happened in the market a split second ago and changing their strategies on the fly. Without any question, there are indeed many high-frequency traders who are "relative" traders -- probably most. So mini-flash crashes -- perhaps -- are merely a sign of natural instability and chaos in the micro dynamics of the market.

Real steps on banking reform?

Don't want to get too wildly optimistic. When it comes to banking regulations, disappointment always lies just around the corner and everything important happens behind the scenes. But a couple things today give me some cautious hope that regulators interpreting the new Basel III banking rules may actually take some real steps to curb systemic risks -- they may even take the structure of banking network interactions into account.

First, Simon Johnson gives an excellent summary of recent developments in the US where banking lobbyists seem to have been caught flat-footed by recent steps taken by Federal Reserve governor Dan Tarullo. I hope this isn't just wishful thinking.

The banks are apparently pushing four key arguments to explain why it's a really horrific idea to make the banking system more stable, and why, especially, the world will probably end quite soon in a spectacular fiery cataclysm of the biggest and most well-connected banks are required to keep an additional few percentage points of capital. Johnson dissects these arguments quite effectively and suggests, encouragingly, that regulators at the Fed, charged with interpreting Basel III, aren't convinced either.

Elsewhere, this Bloomberg article suggests -- and this really surprises me -- that the measures under consideration would...

.. subject banks to a sliding scale depending on their size and links to other lenders.

Now this is an interesting development. Someone somewhere seems to be paying at least a little attention to what we're learning about banking networks, and how some risks are tied more directly to network linkages, rather than to the health of banks considered individually. The density of network linkages itself matters.

Research I've written about here suggests that there's essentially no way to safeguard a banking system unless we monitor the actual network of links connecting banks. It's certainly an encouraging step that someone is thinking about this and trying to find ways to bring density of linkages into the regulatory equation. I hope they're pondering the figure below from this study which shows how (in a model) the overall probability of a banking failure (the red line) at first falls with increasing diversification and linking between different banks, but then abruptly begins rising when the density gets too high.


The implication is that there's likely to be a sweet spot in network density (labeled in the figure as diversification, this being the number of links a bank has to other banks) from which we should not stray too far, whether the big banks like it or not.