Follow up on high frequency trading

My last blog post on high frequency trading got a surprisingly wide reception – and was reprinted for several different audiences. The comments at Talking Points Memo were muted and did not touch the general angst about this issue. That is not surprising – that is a politics driven audience. The commentary at Business Insider was outright hostile with the general consensus being that I am an idiot. The reception on my own blog was balanced – with several people pointing out mistakes I made (and I made a few) and with most talking about the argument on its merits.

Still – one lesson – if you write an article that is not outright critical of Wall Street practice then you should expect to be called an idiot. I got endless emails asserting my stupidity.

All I wanted to really understand what the risks Goldman is taking to make all those trading profits. Sure I know most of them are fixed income – but the balance sheet is still in the trillion dollar range and this crisis has proved that ultimately these balance sheets get socialised. If taxpayers are ultimately on the hook then it is incumbent on taxpayers (at a minimum) to understand and manage the risks that they are taking through their regulatory agencies.

Anyway back to the hot-button issue which is electronic and high frequency trading.

First – let’s discuss front running.

I gave an example of a stock that was bid $129.50, sell $131.50. I bid $129.55 and immediately a computer bid $129.60 over me. I called this front running.

I stand corrected – if someone (even proprietary traders associated with my own broker) bids $129.60 over my bid of $129.55 they are not committing the crime of “front running” – but using the public information in my bid to make a different bid.

It would only be front running if they (a) worked for my broker and (b) organised to have their bid filled preferentially at $129.55.

Of course from my perspective it makes not a rats difference whether they got in front of me at $129.55 or $129.56. That difference is less than 0.01 percent and if you are in my business (strict fundamental investing for medium and long term) it makes no sense to be worried about that sort of percentage. Front running as a crime might have mattered when notional spreads were wide and we did not have 1c pricing. But now the issue is just pricing over me and my clients - not whether those orders are legal or otherwise.

The issue is not front-running per-se (except maybe using my broader – non-criminal use of the term). The issue is that more often than not, as a smallish institution, we are forced to go to the middle of the spread or often cross the spread to get filled. Traders – whether they be bots or the old fashioned screen addicted traders of yore make a good proportion of their profits simply by consistently earning spreads. One old Sydney Futures Exchange trader (open outcry) admitted that (unsurprisingly) was how he made his living. Traders make profits on their short term positions (and sometimes make surprisingly good returns on equity). Those profits come out of somewhere – and I am not averse to the notion that Bronte and its clients pay a small share of them. I am not averse to the notion that clever algorithmic traders effectively “tax” other market participants (and I am not particularly scared of that loaded word “tax”).

Nonetheless the tax is small and the issue is not and should not be a target for major reform. The attention played in the blogosphere – driven in part by Zero Hedge – is simply not warranted.

To quantify: these days the spreads are often 1c on $15 shares (say 0.07 percent) and I can easily get brokerage at a tenth of a percent. I can often buy more than enough stock at the high end of spreads. Even if I lose to the algorithmic traders every time (and I accept that I do a fair bit) then – hey – I am paying 0.15 percent for trading. That is a lot better than it was in the old days when brokerage fees were fixed, large and non-negotiable.

Moreover as a fundamental driven investor the turnover in my portfolio is low. Ideally we will turn over less than once per three years – but as market volatility is high we seem to be getting more opportunities for good switches than that. I can’t imagine how the switching costs for Bronte Capital’s portfolio are higher than they were before brokerage reform even with the “tax” that high frequency traders impose on the rest of the market. [Likewise we trade currency with spreads of 1 point (ie down to the hundredth of a US cent). Only a few years ago we traded with 5 points of spread.]

This issue is – as I suggested – a distraction. There are plenty of real issues for financial reform – and one of the most important in my view being the large and seemingly wholesale funded balance sheets of investment banks. Nobody really understands these balance sheets but ultimately we (though the tax base) are guaranteeing them. That is what the slogan “no more Lehmans” means.

Can we focus where it matters? HFT remains a distraction.

John

PS. Thomas Peterffy pointed out in the comments to my last post that fairly good algorithmic trading is available to small institutions like Bronte at very low fees. (He should know – he is probably the single most important driving force behind electronic trading globally. However he is selling his own service.) If anything these programs reduce the “tax” paid by ordinary institutions such as Bronte even further. Peterffy thinks his algorithm tends to beat the electronic traders. We have not experimented enough to back that conclusion.

PPS. A reasonable summary is that old-fashioned traders earnt big spreads with quite a deal of sweat and only a modest degree of certainty. New fangled high frequency traders earn small spreads with high frequency and ruthless efficiency. But they are still smaller spreads.

PPS. Quantifications of this as a $20 billion issue are insane. Felix Salmon once took umbrage at my assertion that the pre-tax pre-provision profits of the financial sector in the US were at least $300 billion. That looks like an underestimate. He however swallows this insane number without too much question.

High frequency traders – a phoney explanation when nobody seems to know the real explanation

There are a few changes to this post in italics. These come from the comments.

Goldman Sachs made 5.7 billion dollars of trading revenue in the last quarter. That run rate (over 22 billion per annum) is almost as much as the pre-crisis peak.

$22 billion per annum is roughly $200 per year per household in the United States.

If it is someone’s trading revenue it presumably comes out of someone else’s pocket so measuring it per household is appropriate.

The trading revenue of “Wall Street” major investment banks (including Barclays, the trading parts of Citibank and similar entities) peaked at over $500 per household in the Western world.

Revenue like this is usually paid for a service. Ultimately I thought the service was intermediation between savers in China, Japan and the Middle East (who want Treasuries) and dis-savers in the Anglo countries (who want to fund exotic credit card debt and mortgages). That remains the only service that looks large enough to justify that sort of revenue. [The real service having been finding suckers such as municipalities and insurance companies to hold the toxic waste such as CDO squared resecuritisation paper.]

That said, given almost nobody knows how to make $22 billion per annum trading and jealousy is a common trait, conspiracy theories abound. The current conspiracy theory is that this money comes from front-running clients in the market with very rapid trading. The New York Times recently promoted this view.

The idea is that by knowing client orders you can extract profits. Computers fleece clients by forcing clients to pay more when they buy and to receive less when they sell.

And it is clear this happens. We trade electronically at our fund. We were recently trading in a stock with a large spread. I have changed the numbers so as not to identify the stock – but the ratios are about right. The bid was about 129.50, offer was about 131.50. We did not want to cross the spread – so when we bid for the stock we bid $129.55. Within a second a computer (possibly at our own broker but it makes no difference which broker) bid $129.60 for a few hundred shares. We fiddled for a while changing our bid and watching the bot change theirs. We would have loved to think we were frustrating the computer – but alas it was just a machine – and we were people up late at night

Actually obtaining the stock required that we paid up – and when we did so it was probably a computer that sold the stock to us.

Inevitably we cross spreads and the computer earns spreads.

The computers make even more consistent profits with high volume low spread stocks. If you are buying or selling Citigroup it is almost certain that when you buy you will pay the offer price and when you sell you will receive the bid price. They are only 1 cent different – but in almost all cases it will be a computer that traded with you – and the computer will – through owning the “order flow” be getting the better end of that deal.

That said – these profits can’t add up to sufficient to explain Goldman’s trading profit.Interactive Brokers is (by far) the most electronic and lowest cost broking platform in the world.We use it extensively as do many others. Interactive Brokers has a 12 percent market share in option market making globally and probably a 10 percent share in all market making. Trading revenue was about 220 million. Moreover in the conference call the CEO/Founder (Thomas Peterffy) thought the influx of competition in the area had reduced market maker margins very substantially.

Anyway if 10 percent of global stock volume provides 220 million dollars revenue per quarter then there is no way that a substantial proportion of Goldman’s trading profit can come from high frequency trading. The numbers do not work.

When the New York Times quotes William Donaldson (a former CEO of the New York Stock Exchange) as that high frequency trading “is where all the money is getting made” they are quoting bunk – and they should know it.

This is a plea. Can we have a dispassionate and accurate view of where the (vast) trading profits of Wall Street in general (and Goldman Sachs in particular) come from? The last big boom in trading profits was followed by a bust which came at huge social costs. [Look what happened to Lehman.]

We cannot understand the risks “Wall Street” is taking and hence the economic downside if it all turns pear shaped, and the appropriate regulatory structure, unless we know what is happening.

Mindless articles such as the recent New York Times one – grossly inconsistent with facts are less than helpful. They are distracting.

One comment thought that this was algorithmic trading - someone really wanting to buy the stock - and bidding above our bid when we showed our bid. I wish that were true. If it were then if we were buying very illiquid wide spread things the bot would still be there. It is always there - even when buying defaulted debt that trades once per month. We simply ALWAYS find the bot.

Salary package includes sonic screwdriver and attractive assistant: Australian citizens only

The Australian Department of Defence is advertising for a TARDIS MANAGER.

Americans must be falling behind in defence equipment technology. They only have 67 F-22s.

Hat tip: Crikey.

Not buy and hold

Warren Buffett may – at least in part to make management comfortable – state regularly that his favourite holding period for a stock is forever. And he is a darn good buyer of shares. His name is used to promote "buy and hold".

What is less well recognised is that he is a fantastic seller. In 2000 he disposed of very large shareholdings in Fannie Mae and Freddie Mac. The stocks nearly doubled after he sold them – so for a while it looked like his timing was awry.

In 2001 – and almost without comment – he sold a huge stake in Citigroup he obtained by buying convertible notes in Salomon Brothers in the 1980s. You can find no reference to his sale in the letter – but the Citigroup convertible is in the 2000 annual and there is no reference to it in the 2001 annual. He simply converted and sold. He certainly did not advertise the fact - whereas most financial market guys would be boasting that they scored the all time high price.

The profits locked in were huge.

Buffett invested a very large proportion of Berkshire in financial shares. When the bust came he owned American Express, Wells Fargo and M&T Bank. These look like ex-post winners.

Why am I writing today? Because Warren is selling his stake in the Moodys rating agency. It looks like he is rather late. The franchise has already been seriously impaired. Moodys gave its blessed AAA to lots of things that defaulted. Indeed it seems the Moodys AAA is cursed.

Still plenty of people think that there will be a role for rating agencies - and that Moodys end position - backed by regulation - is solid.

Be warned. Buffett is a very canny buyer of equities. He is even more canny a seller.

How did the SEC get it this wrong? The judge throws out the Mark Cuban insider trading charges

I have not been a fan of the SEC – but on preliminary evidence I am forming a better opinion of Mary Schapiro than most. However as a tag-end of an era of grotesque incompetence the SEC has had the charges of insider trading it pushed against Mark Cuban thrown out of court.

The charges of insider trading against Mark Cuban were always stupid. I blogged about those charges here. I noted the (public) evidence was only that the CEO of a cash strapped company (Mamma.com) had phoned him and told him that he was cash strapped. Mark Cuban sold his shares. The SEC charged him with insider trading but did not present any evidence that he was an insider. I noted that:

To make him an insider he needs to have agreed to be an insider. He needs to have agreed with the CEO that he will take information confidentially. In other words the case hinges almost entirely on the contents of a phone call between the CEO of a failing dot.com and Mark Cuban – and the call is meant to have taken place in 2004. Nobody is going to credibly remember it. If it came to a criminal charge (which required absence of reasonable doubt) then you would have to acquit Cuban because at best this case will be two people saying “he said” and the other saying “no I did not” about a conversation years ago. As far as I know there is nothing in writing in which Mark Cuban agrees to be an insider (though something in writing is what is required). It is telling that there was no criminal charge filed with the civil charge. The criminal charge wouldn’t fly.

Well guess what – the Judge said that the SEC did not provide evidence that Mark Cuban had agreed to accept the information in confidence and hence did not provide evidence that he was an insider.

And that was obvious from the start. Unless the SEC had something in writing (which they did not) they were stuffed in this case and incompetent in bringing it.

The real issue now is how the SEC got this bad? I spot serious frauds at the rate of better than one per month – and they are rarely prosecuted. Madoff sat in front of the SEC’s face for years. However the SEC went on a wild-goose-chase against Mark Cuban on a case that was flimsy from a distance of 9000 miles (Atlanta to Sydney).

Getting trust in the financial system back is critical to economic recovery. With the SEC so far off its game that will be difficult. Mary Schapiro appears to be doing better than her predecessor. One day I hope to be blogging on SEC successes.

The ubiquity of Coca Cola

I was perusing the Post-Courier Online - a newspaper in Papua New Guinea. The cover story with picture is as follows:

Neighbouring tribes in South Wahgi district of Western Highlands Province exchanged food at the weekend as they started negotiation to restore peace among themselves and end hostilities in their area. The Ngenika and Kisu tribes have realised that there was an increase in illegal activities in their communities and after much discussion, starting in 2007, the Kisu tribe gave 21 cows, red pandanus fruits (marita), 200 coke cartons, scone packets, sugarcane and bananas to the Ngenika tribe. They also slaughtered 100 pigs for their neighbours. Last year the Ngenika tribe gave 10 cows with the same amount of food to the Kisu.

200 Coke Cartons is part of the tribal peace offering between tribes in the Western Highlands of PNG. And you read about it on the internet.

This modern world is very strange.

Australia – the lucky but unbalanced country

I get many emails asking for my opinion as to the Australian economy and the Australian banks in particular. That is not surprising because I am probably the best known Australian writing a global investment blog. Certainly I write the best known blog by any Australian fund manager.

Answering the question in one post makes about as much sense as answering the same question regarding say Canada or France. The country is too big for an easy answer. Moreover some of my correspondents are German or American and others are Australian and I can safely assume different levels of knowledge for each party. This is a post aimed at non-Australians. Nuance for locals is harder.

Australia’s macroeconomic miracle

You can’t understand why Australia works so well without a decent statement of the Australian macroeconomic miracle. Australia is one of the smallest and most indebted nations to be given the privilege of borrowing in their own currency and floating that currency. New Zealand (across the ditch) is the smallest country with the unlikely trifecta (has run large current account deficits for a very long time, borrows in its own currency, floats that currency).

This is incredibly useful. If you are highly indebted bad things can happen to you but they are far less severe if you are lucky enough to be able to borrow in your own currency and to float that currency.

Consider the situation when the macroeconomic environment moves sharply against a country – as might happen with a rapid terms of trade change – or also might happen with if people (say due to a global fear epidemic) think its possibly you can’t repay them.

• If your currency is fixed you will get a classic monetary recession. People will speculate against the currency (or withdraw their lending to you) and (due the central bank being forced to defend the currency) the local monetary supply will crash. The extreme version is what is happening to Latvia. It’s why Latvia should float their currency.
  
  
• If however your currency is floating and you are highly indebted in foreign currency then your currency collapse will bring into sharp relief and immediately the difficulty of repaying your debt. The lower currency increases the principal and interest repayment in domestic terms of your debt. In extrema it causes almost immediate default. This is what is stopping Latvia floating their currency.
  
  
• The Argentine solution is float the Peso in a crisis – but to rejig all old debts to new pesos at some new exchange rate and formalise the default. If you do that nobody trusts you again. If you are South American you do it a few times and you wind up looking like South America rather than Australia or the United States. In 1900 the three richest countries in the world per capita were Argentina, New Zealand and Australia (in order). Look how that worked out.

Now the Australian miracle (the trifecta) means that an external crisis can hit Australia and all that happens is that the Australian currency drops until our terms of trade improve again. The classic example was the 1997-99 Asian Economic Crisis: as we export mainly to Asia this was potentially devastating to our economy. But instead it was just devastating to the currency – which fell by about 50%. I remember travelling to the New York (for work) when the AUD was trading at 48c US. It was so expensive in New York as to be completely comical. The business hotel in New York cost more than a week’s average wages per night (it was a business hotel in the height of the dot.com bubble). But the fallen currency worked. It meant local export industries ticked up – the tourist industry did not collapse despite the lesser numbers of Asian visitors. The lower currency bailed out plenty of other industries as well.

When the crisis disappeared the currency went up again - more than doubling. Then China slowed a little and the currency fell.

If we did not have a floating currency and the ability to borrow in our own currency this would not have happened. We would have been just another case of macroeconomic road-kill.

This is a deal afforded Australia only because of 100 years of fairly good management. If you stuff up you lose our trifecta ... it is worth preserving. Fiscal rectitude – especially in good times – is worthwhile because it protects this privilege. And the reason why you want to run tight budgets in good times is precisely so the world does not force you to run fiscally contractionary policy during bad times.

General observation: whilst these conditions persist (which could be a long time), Australia will have the least trouble of any major OECD economy in adjusting to external economic shocks. The United States is pegged to China (although not by their own volition). Most of Europe is pegged to each other. [It will not help so much with domestic economic shocks. But governments of both persuasions are pretty good by global standards and they don’t look like stuffing it up. I am not so cheery about New Zealand – a country I think is very badly run by comparison with Australia.]

Anyway with the recent shock (China slowing commodity demand due to global economic conditions) we had the usual currency correction (currently reversed). Again and it looks like we have avoided the shock. The Australian economy seems indecently strong.

The unbalanced Australia

Unfortunately it is not quite as simple as all that. The Australian economy is very unbalanced. It has Sydney – a huge financial city in three big rings. Inner Sydney is a financial city of very high wealth. By repute owners of almost half of the wealth of Australia reside East of the Sydney Harbour Bridge. And it is only 4 km (3 miles) to the ocean! [The entire city of Brisbane is east of the bridge too, but the wealth is in Sydney.]

The financial sector is hurt but not badly as credit markets never closed here for longer than a few hours.

Beyond this Sydney has a service ring – mostly people who service the financial city (cleaners, plumbers, school teachers).

Outer Sydney (fully an hour drive from my home) is a manufacturing centre and it is hurting – but not as badly as I thought. Indeed a falling currency seemed to keep it quite well adjusted.

Almost all of Sydney is NOT resource dependent. It is the least resource dependent city in Australia. (In order Perth, Darwin, Brisbane, Adelaide, Melbourne, Hobart, Sydney.) Hence the recession is nastiest in New South Wales – and even then it is not bad. [Sydney is the capital of the state New South Wales.]

China has taken off again – or at least Chinese commodity demand has resumed. Australia is going to have to have a big internal adjustment – which will downplay the role of Sydney. However as there has not been a financial system crash here that will be an adjustment which for the moment looks manageable. As long as the adjustment happens at less than say 80 thousand jobs per year it will happen without great financial stress. For that we need China to keep on demanding our commodities.

The insane Sydney Housing Market

I am long Sydney Housing. I own a nice house. I would prefer bet against the price of my house (a nice but not large house without beach views in the fashionable suburb of Bronte worth about AUD3 million). I assure you it is not quite as glamorous as Sheila Bair’s recently advertised palace. Really it is solid upper middle class suburbia but with a silly price tag.

Indeed I would generally prefer bet against Sydney generally as it makes no sense. Both of us at Bronte Capital live East of the Harbour Bridge. Both of us are owners of insane real estate. Australian housing is amongst the most expensive in the world relative to the incomes of the people who live in them (see this report from Demographia).

It is that insane real estate which is the risk to Australian banks – which are loaded with mortgages on overpriced housing and overpriced commercial property. Unlike in America though these mortgages are largely recourse to the other assets of individuals (there is no jingle mail in Australia).

And they are insane loans within a country that makes a lot of sense and which has a government which has been so fiscally responsible as to allow us to run deficits of 6-8% of GDP during a financial crisis without any real risk to long term solvency. [Contrast this to America which was running insane deficits in good times – and which thus runs some risk of impinging the ability to run necessary deficits in bad times…]

An adjustment path from here is easier for Australia (because of our macroeconomic miracle). But it would help a lot if Chinese commodity demand does not wane - and hence allows us time to adjust.

Anyway in summary:

I don’t like unbalanced economies. The global problems we are now having is because the economy globally had been so unbalanced for a decade before that. However we are and remain unbalanced within Australia. However a relatively mobile labour market (compared to Europe but not to the US), increasing internal migration and a common currency and language should fix that over time.

Australia – I like it. I do not like the price. As an investment we are far more likely to be short Sydney consumption – and short Australian stocks – but it is not a bet against Australia – it’s a bet against the unbalanced bits of Sydney. And none of that should be unmanageable.

As for Australian banks other than our insane housing market the biggest problems are on the other side of the ditch. New Zealand is Australia's Eastern Europe - the over-indebted place without the historical advantages and with which we are not quite politically and economically integrated. When it comes to the crunch Australia will not guarantee New Zealand's debts - but the Australian banks will - which as Europeans are discovering comes down to the same thing.

John

Disclosure: I have worked for both Australian and New Zealand Treasuries. I have very strong views – perhaps little jaundiced by personal experience – about which is run better. The voting system in New Zealand is insane – whereas Australia’s parliamentary democracy is amongst the finest in the world. The Treasury has an easier time in Australia and is far more talented. For macroeconomic management this matters. But not as much as the resources that Australia has and New Zealand does not.

PS. I should link to this - which makes a fair point about just how far Australian and New Zealand housing prices have run - but without the necessary observations about recourse.

The second derivative is bad

I have been firmly in the “second derivative is good” camp for some time. Green shoots were few and far between – but the economy no longer appeared to be in free-fall. When the free-fall stopped it was time to buy equities – and whilst it was not time to ease up on the looser monetary and fiscal policies – it may have been sensible to limit them somewhere near the levels that they now are.

The data I considered most persuasive was the delinquency data at Fannie and Freddie. It gets worse every month, but until the last data point it was getting worse at a decreasing rate (especially if you adjusted for the foreclosure moratoriums they implemented).

Today I am more worried. My favourite data point (rate of increase of Freddie Mac delinquency) has deteriorated – especially in their insured portfolio. Its not sharp deterioration – and it is possible – even likely – that Freddie Mac will have end credit losses considerably lower than the bears anticipate. But as a second derivative bull I am feeling just that little bit less certain.

Contra: the usually bearish calculated risk has a fairly good data point here.

John

For the real masochists – here is the monthly data from Freddie Mac. The brilliant interest rate management I identified recently has continued albeit not with the panache of the previous month.

Finally BondInvestor has not contacted me as requested. I really would appreciate it.

Creation Science, oil drilling, naked shorts and constitutionally protected stock fraud

I once – unfairly perhaps – questioned what passes as mainstream conservative thinking as anti-scientific. The real target was greenhouse gas denial where the debate has gone (a) the greenhouse effect is not real to (b) yes – it is but it not caused by humans and then it will go to (c) but we can’t do anything about it anyway. I figured (fairly) that if you deny the science you wind up getting counted out of the debate. The “conservative” line was a fast-track to irrelevancy.

The reason why my criticism was unfair was that I used “creation science”, a realm of pure science denial, as a club to beat conservatives with. And I was rightly pulled up.

However I had what was – in my view – a market test of whether creation science was garbage. And that was that there were plenty of oil companies spending cumulatively billions of dollars on oil exploration using methods of finding oil (eg fossils of seeds and weeds) that were consistent with evolution and inconsistent with creation science. However I could find nobody who spent even a few million drilling for oil based on creation science.

This blog however corrects its mistakes. There is a serious oil company that does drill based on biblical texts and creation science. I was plain wrong.

So I give you one of the promotional websites of an oil company (Zion Oil and Gas) with a market cap of about $100 million.

www.OilInIsrael.net

And – just because these things should not go to waste – I give you one of their many YouTube promotional videos. In that video they got to ring a stock exchange opening bell. Creation Science is – it seems – at the heart of American Capitalism.

This ungodly liberal with his own creation myth (evolution) stands corrected.

John

PS. Don’t bother looking – you can’t short the stock. There are no securities available to borrow – and naked short selling – that just isn’t allowed.

If you need to know who is behind this then Mother Jones started the work, and Richard Bartholomew nailed it. It turns out that it is promoted in religious publications by the well known preacher and Christian Zionist Hal Lindsey who does not dislcose his family's substantial holdings.

I will refrain from again making a case for naked shorting because I can't see any real social benefit in aggressive hedge fund managers sharing when Hal Lindsey fleeces his flock. We can keep the losses in the fundamentalist family without any major social detriment.

And on this - I pity the SEC. If the promoters hold the belief in oil in Israel as true religious belief it will be very hard for the SEC to go after them. Even if this is as transparent a scam as Mother Jones thinks it will be hard to prove. Did the Founding Fathers mean to constitutionally protect stock fraud?

Request to BondInvestor from the comments

Can the person who comments under the name BondInvestor please contact me through the email on the blog.

Thanks in advance.

John