Trading While Intoxicated

Oil traders in London have a richly deserved reputation for boozy, three-hour lunches from which they return to the office for a few hours of TWI - Trading While Intoxicated. As it has been the norm for more than 30 years, rarely did anyone get in trouble for it. Today, however, drunken cowboy traders are about as welcome as a fart in an elevator. Financial News has a great story up about a trader at Morgan Stanley - David Connor Redmond - who took a large short position in WTI after an alcoholic lunch. He then buried it in a colleague's book, because he knew he had breached the firm's risk limits. An oil trader friend of mine said: "This shows the downside of electronic trading. If he had been on the phone doing the business someone would have noticed." I pointed out that if it had been done by voice it would have taken the bank longer to find out. He said the damage done by electronic trading can be much more "instantaneous". True enough. But how is one trader able to put on such a large position in the first place? There should be risk limit controls on each trader and certainly firm-wide. The fact that he could hide it in another colleague's book shows that there were no such controls in place. Morgan Stanley and others like it should be a lot more concerned about their risk controls than over how much their traders had to drink at lunchtime.

Is Program Trading Enabling a Conspiracy?

I love conspiracy theories. The latest one to catch my fancy is that the US government is using Goldman Sachs and its massive capacity for program trading to prop up the stock market. Essentially, Goldman Sachs is using taxpayers' bailout money to fuel buy-sell program trading to support (what should be) an ailing stock market. Fact: Goldman Sachs currently trades almost half of the program trading volume on the NYSE. Fact: 25% of the volume on NYSE is from program trading. Fact: Goldman Sachs proprietary trading (nearly 1bn shares a day)and agency brokerage volume is FIVE TIMES its customer facilitation volume. Fact: Timothy Geithner, Stephen Friedman and Hank Paulson all worked for Goldman Sachs.
The mysterious Tyler Durden said in his Zero Hedge blog last month: "The implication is that Goldman Sachs, due to its preeminent position not only as one of the world's largest broker/dealers (pardon, Bank Holding Companies), but also as being on the top of the high-frequency trading/liquidity provision "food chain", trades much more often for its own (principal) benefit, likely in tandem with the other top dogs on the list: RenTec, Highbridge (JP Morgan), and GETCO. In this light, the program trading spike over the past week could be perceived as much more sinister. For conspiracy lovers, long searching for any circumstantial evidence to catch the mysterious "plunge protection team" in action, you should look no further than this."
See? A great conspiracy theory if I ever heard one.

More Fallout on the Journalism Front

Three of my ex-colleagues got laid off from Financial News this month, on top of all the freelancers that were ousted last month. It seems that even Rupert Murdoch, for whom I inadvertently worked (his News Corporation bought Dow Jones which owned Financial News), is feeling the pinch. The financial freelance field is rapidly becoming overcrowded, with few publications showing signs of growth or even recovery. (I, of course, intend to make a million on my best-selling yet-to-be-released novel. After which I will give selective, Dan Brown-like interviews when people question my theory about Brent squeezes.) But I still have oil market reporting to fall back on if I am desperate. I am one of the lucky ones, I guess. It is very difficult to write about refinery feedstock utilization if all you have ever written about is the stock market. The other way around is easier.
I am very concerned about the quality of financial journalism post-recession. If all of the seasoned experts are either freelancing or have found greener pastures, that leaves us with the general press and television reporters covering markets they can't possibly understand. A year ago none of them would have known a credit derivative if it bit them in the backside. While we had been writing about the dangers in that marketplace for several years. Having said that, it seems no one really listened. They were making too much money. Moral hazard risk is alive and kicking.

Research: Not What it is Cracked up to be

The FT said today that research analysts' buy or sell recommendations have almost no effect on a stock's price. Investment banks have been forced to provide independent research to their clients for the last five years. This was because regulators suspected the banks were too closely linking recommendations with other, more lucrative deals they were working with the same companies they were recommending. (Remember, they rarely advised selling anything until last year when the manure hit the proverbial fan.) This research pact is about to end, but as the U. Pittsburgh and Tulane study showed there is little to fear. Analysts' recommendations only impacted prices by about 0.03 percent either way.
I have said before that sentiment is running the markets. Therefore it is more important to know what the masses think than what a company's current P/E ratio is. There is a service gaining momentum out there called the Trade Ideas Monitor from technology company youDevise. TIM is technology that enables institutional brokers to send trading ideas to their customers. Then it tells us what they did. Given these brokers and their clients - hedge funds, funds, asset managers - are pretty big fish, what they do tends to move markets. In the past few weeks the brokers have been advising their clients to take their profits and run. Last week the stock markets tumbled. I think I'll stick to TIM and let everyone else look at traditional research.

Playing Silly Buggers with Pay Packets

MPs in London yesterday slammed the bonus system for British bankers, saying it had led to "lethal" risk taking. It did, and it will continue to do so until they revamp the bonus system and link reward with longer-term benchmarks. A little better risk management and stress testing would also help. The bonuses in the City of London were something to behold, making Wall Street almost pale in comparison. Real estate prices got so stupid I had to move to America to afford another bedroom. In 1997 I bought a flat in Notting Hill Gate for 205,000 pounds. Within 4 years it had doubled in value and before the credit crunch slashed London prices it was on the market for 695,000 pounds. This was a two-bedroom flat (one bedroom was so small it fit only a specially made double bed) with one bathroom and a tiny balcony. On one of the less desirable, non-leafy streets I might add. When City bonuses started taking off in the early noughts, every banker and his brother wanted to be in Kensington - the Central Line dumped them directly into Liverpool Street station. Traders who made bonuses in the millions were buying multi-million pound flats with 90% mortgages. Mothers were dropping off their precious little cargoes in financed BMW and Mercedes SUVs that could barely fit on the back streets. The bankers were, of course, in their Ferraris and Porsches - because even though they lived on the Central Line, they couldn't be seen TAKING the Central Line. The whole thing got way out of hand. And it is important to note that Brits were abusing credit just as enthusiastically as the Americans were. I hope the politicians and the regulators in the UK get a handle on this. Because the bonus culture made London unaffordable and unpleasant. And it used to be such a nice place...

OTC Derivs Regulation Not as Easy as it Sounds

US Treasury Secretary Tim Geithner has finally laid down the law on over the counter (OTC) derivatives. He is going to push for them to be listed on exchanges, or cleared through registered clearing houses, or posted into a trade repository. But the most important thing Geithner is insisting upon is that they are traded electronically. Only by using electronic trading can there be transparency. Deals concluded over the phone, by fax and instant messaging should be things of the past. But the temptation by traders to rip someone else's face off through OTC dealings is too great. Traders are not in the game for any other reason than to make money. And none of Geithner's efforts can stop trading firms from inventing new and different derivatives, most of which - no matter how well regulated - will be beyond the scope of regulators' understanding. Transparency does not tend to make traders as much money as does opacity. As my friend and ex-boss Gerald Ashley said in his new book Financial Speculation*: "Many market players have an almost schizophrenic relationship with the market; wanting to know all that is going on, alternating between secrecy and publicity over own their positions and being constantly influenced by the opinions and actions of those around him. Now we can start to see why trading is a hard way to make money." And we can see why the regulators will have a hard time seeing through OTC derivatives.

*Financial Speculation is published by Harriman House. It is currently Number 2 on Amazon UK's Hot Future Releases List (www.financialspeculation.co.uk). Gerald Ashley has over thirty years experience in international financial markets, having worked for Baring Brothers in London and Hong Kong, and the Bank for International Settlements in Basel, Switzerland. He is now Managing Director of St. Mawgan & Co which he co-founded in 2001, a London-based consultancy specialising in risk management, strategy consulting, and behavioural finance modelling in finance, business and risk-taking.

Making the Case for Carbon Trading

Trading carbon emissions is the next big thing in financial markets. Despite opposition from some Republican camps (citing it will 'cost businesses money') the U.S. looks set to pass climate change legislation any day now. As with most things that are good for us or good for the environment, the government has to tell us to do it or else. Without government intervention, few U.S. utilities or manufacturing plants would willingly move from using fuels that pollute and produce carbon dioxide to fuels that are cleaner. Texas is already complaining that carbon allowance costs will add $10bn per year to the cost of producing electricity. This means an extra $27 per month on the average electricity bill, according to Reuters. What this will do is encourage utilities to use less polluting sources of power such as wind turbines (which Texas has plenty of room for, unlike Cape Cod) and solar. Eventually those electric bills will come down.
Meantime the CFTC is preparing to regulate and monitor carbon trading if legislation passes. It has formed and expanded a panel called the Energy and Environmental Markets Advisory Committee to prepare the government for carbon trading. The CFTC said that the panel will help it to prevent 'fraud, abuse and manipulation' of carbon markets. Given the CFTC's dire track record of preventing these things in energy futures, I have my doubts. But the fact that Dr. Richard Sandor and Bob Pickel are on the panel gives me hope.

Regulators Should Mandate Risk Management

Ben Bernanke is giving a clear signal to banks that the government stress tests were just the tip of the iceberg. The 19 banks that were tested 'passed' the stress tests, which measured trading and market risk, but they now have more work to do. Bernanke told a group of Federal Reserve Bankers at a conference this week that these banks will have to take internal measures to test liquidity, operational and reputational risk. He said this was 'important' and that regulators would be watching to make sure it happened. I have long been a believer that risk management has to be better regulated. Most investment banks put disaster recovery plans into effect after September 11, 2001 when they lost buildings and people in New York City. But few have been willing to really test what would happen if liquidity dried up - like it did in fixed income derivatives last year. Or what would happen if they couldn't meet capital requirements at any given time - ditto. Stress testing should be done using the most extreme, even unlikely, circumstances. Risk managers need the support of the board and of the trading department - which generally tends to push them away. A good dose of curiosity would also help - a risk manager who actually enjoys testing extreme scenarios and dissecting the consequences. And has the stones to stand up to management to tell them what needs to be done to better protect the firm's downside.

High Frequency Traders Dominate

The stock market is increasingly dominated by high frequency trading firms - they get in and out fast, making minuscule amounts on millions of trades. I wrote an article for Financial News in January that pointed out how the new market structure - electronic trading, multiple destinations - benefits high frequency traders. Often to the detriment of more traditional buy-and-hold investors.
Joe Saluzzi, an outspoken source of mine who is co-CEO of Themis Trading, said in his blog last week that just because volumes are increasing doesn't mean more investors are coming into the market. On the contrary, the increase in volumes is mainly down to the high frequency stat-arb traders who are goosing the market in order to increase volatility. Only in a volatile market can they make money. This trading pattern is misleading ordinary investors to think that the current market trend is real. If the buy-and-hold crown jumps back into the market and it turns out to be a Fool's Rally, they will not come back again for a very long time.
I'd buy shares in the high frequency trading firms, personally.

Oil Prices Could Cause 'Double Dip'

There has been increasing talk of a 'double dip' recession. One where we recover this year and next year all Hell breaks loose again. This theory is being reinforced by renewed enthusiasm over oil prices. Speculators are again driving up futures even while the world is awash in oil. The photograph left shows oil tankers floating off of Singapore. All are laden with oil, and none have anywhere to take it. This is called floating storage. It does not show up on countries' inventories, therefore does not register with speculators. If the speculators drive prices up and US gasoline again breeches $4.00 per gallon, this fragile 'recovery' will go pop.

Short Selling Curbs Won't Create a Bull Market

Curbing or ending short selling will not turn a bear market into a bull market. Calls by short-sighted and market ignorant politicians to ban short selling, bring back the uptick rule or introduce 'cooling off periods' when the markets are dumping are very bad knee-jerk reactions.
Americans (in particular) have a deep-seated need to hear only good news. Bad news is to be avoided at all costs. Witness the stock market of late. The news reports say that banks need more capital or they are in danger of collapse, like Bear Stearns and Lehman Brothers did, remember? And what happens? The stock market rallies. CNBC trumpets the end of the bear market. The nation breathes a sigh of relief and goes after those scoundrels that caused this mess - the short sellers.
Studies have already proven that the outright banning of short selling throttled liquidity. And exchanges, ECNs, brokers and investment banks need liquidity in order to get their fees. The uptick rule didn't work before. That leaves the cooling off period. I wrote about this in Financial News in October last year. The consensus from designers of trading algorithms was that an algorithm can smell a time-out coming a mile off. Which means panic buying or selling will INCREASE during times of volatility. Making volatility GREATER. And the short selling could dump prices even faster and further than would have happened before. You can't beat the algos. My advice is to leave short selling alone, and let the market recover of its own volition.

The Wall Street Shuffle

It just gets better and better. The FT reports today that Wall Street banks owned the lion's share of the sub-prime mortgage providers who spent $370m bribing (oops, I mean lobbying) the government to fight off regulation. Basically, for a mere $370m investment the Wall Street banks got back $700bn from the US taxpayers. Nice return on investment. Meanwhile, the chairman of the NY Federal Reserve, Stephen Friedman - who once ran Goldman Sachs - still sits on the board and owns a gigantic number of shares in the investment bank. The NY Times reports that Friedman bought a further 37,300 shares of Goldmans in December which have already risen by almost $2m.
Is it any wonder the nation is sceptical about Wall Street's good intentions? Now it seems the bank stress tests ordered by the Obama administration are finished, the results are in. But we still don't know what the results are. Why? Because the administration doesn't want any 'bad news' to spoil the recovery party. I feel sorry for the regulators, the power remains on the Street and there is nothing they can do about it.

Roubini and Me, Sitting in a Tree

O frabjous day! Nouriel Roubini - that most outspoken and clever economist also known as Doctor Doom - agrees with me. Roubini is one of my financial heroes (along with Tim Geithner, who is admittedly not making the best impression right now), and I usually agree with everything he says. This time Roubini is supporting my argument that the banks need to shore up their capital reserves. And without getting the dosh from the government. His op-ed piece in today's Wall Street Journal, co-written with his NYU Stern colleague Matthew Richardson, says many banks will fail the ongoing stress tests. And that they are as close to insolvency as banks can get, especially if you remove the taxpayers' funds that are currently supporting them. He wants Congress to float and pass a law that gives the US government more power to control the banks, and to guide them through bankruptcy if necessary. Other financial pundits are calling this 'nationalization'. I disagree. It is called leverage. Wall Street still has the upper hand, and can walk all over the US government and the taxpayers if it so pleases. And - believe me - it pleases.

Oil and Commodities Speculation Begins Anew

Speculation by funds, proprietary trading firms and investment banks led to a massive bubble in crude oil prices in 2008, when US crude oil rose to just over $147 a barrel. Commodities went along for the ride, high on the prospect of unlimited Chinese and Indian demand. The huge spikes in these prices may have been the straw that broke the economy's back. Energy-gobbling Americans started to feel the pinch of $4 plus gallon gasoline. Foodstuffs got more and more expensive. When consumption dove, prices went with it.
But the so-called rapid recovery from the recession is sending the speculators back into the ring. Credit markets are loosening up. Equities are buoyant. Spring has sprung and everybody feels good. Crude oil started the year at around $44 per barrel and has already gained about $10.00. Demand is still in the toilet, so one can only imagine that the speculators are once again running these markets. If they manage to drive oil prices up again, and gasoline approaches $4, the rapid recovery will be over. (Still, this plays right into my hands. The novel I am writing is about corruption and speculation in the oil markets!)

US Car Companies and Disaster Recovery

This is the last time you will see anything from me about the state of American car companies. I don't care about them - I have always thought that they built crap - and I don't live in the Midwest (nor will I). But this morning I heard a car 'expert' talking about how Ford and GM were restructuring themselves to be profitable at current demand levels. Which are pretty low. This incensed me. If they can be PROFITABLE at these levels, then why were they not prepared for the possibility of these levels? Disaster recover (business continuity is what they like to call it these days) is more than being able to use your computers after a hurricane strikes the office. It is about being prepared for ANYTHING from Swine flu to a bad economy. The fact that these firms were only prepared for business to improve and increase going forward shows that they really are not worth saving. The CEOs clearly had their heads up their collective jacksies. Buy Foreign Cars.

Market Turning on Sentiment Alone?

Some 'irrational exhuberance' appears to be leading the stock market up a garden path, despite a flurry of bad news. Consumer sentiment - the index rose 12 points to 39.2 in April - is a powerful thing, and perhaps the long-awaited Spring weather is helping to fuel the optimism.
But I can't help but wonder what impact low volumes are having on this bullish trend. NYSE Euronext revenues fell 55% last quarter, largely due to sharply lower trading volumes. Nasdaq is offering rebates, BATS is paying liquidity takers - anything to grab some of the all-important trading volume. Retail investors have yet to come back into the market, and there is the distinct possibility that when they do it won't be to the extent that they did before the crash. When you have less money to spend, you don't usually spend it on stocks and shares. This leaves hedge funds, investment banks and proprietary trading firms doing the lion's share of business. And as more quant traders enter the market, newer and more sophisticated algorithms come along. Smaller spreads, higher frequency trading and lower overall volumes - sounds like volatility will remain high.