Be Careful What You Ask For

The call for better regulatory oversight in financial markets rose to a cacophony after the sub-prime crisis and credit derivatives blowup, but I thought that it had been dying down of late. I was wrong. Senator Ted Kaufman from Delaware has charged the SEC to investigate seven practices: flash orders, high frequency trading, co-locating servers near exchanges, direct market sponsored access, liquidity rebates, dark pools, and retail order flow. Everyone in this business knows that Regulation NMS, although it was designed to level the playing field, actually benefited those with good technology. Investment banks, agency brokers, ECNs, ATSs and exchanges (finally) are all making 'new' money thanks to the new market structure. Kaufman and his fellow politicians probably do not fully understand the mechanics of the markets they are trying to regulate, which is one reason they are so suspicious. The industry and the general media have done a terrible job of educating and informing the regulators and other interested parties as the market has evolved. Only the specialist trade press (FT, Financial News, Securities Industry News, Traders, DWT, Wall Street & Technology) have covered these aspects of the business in depth. All have been warning of defects and loopholes in the new market structure that enable some fairly sharp practices. But sharp practices are what financial markets are all about. I would hate to see draconian rules coming down from above - it might signal the death knell of dozens of brokers and technology providers. Those asking for better regulation might wish they had never asked. And, keeping in mind that Delaware is the state that allows dodgy corporations to register there to avoid paying state corporate taxes and getting nailed with huge lawsuits, Kaufman may just be the pot calling the kettle black.

Unknown Knowns

Donald Rumsfeld famously said there are things we know that we know and there are things that we know we don't know. I would add there are things that we don't know that we know. Like whether the CFTC is going to increase position limits on commodities futures and remove the exemptions that the bulge bracket banks have enjoyed. I think we pretty much know that they will enforce limits, but officially we don't know. The reason I say this is because the FT today reiterated that the CFTC reiterated that it has doubts that banks should be exempted from position limits. Gary Gensler told the FT that he doesn't share the view that swap dealers (big banks) are 'passive mechanics in the marketplace.' Well, guess what? No one shares that view except the banks themselves. That the FT is reiterating the CFTC's opinion on this at this time sounds to me like the paper has a little birdie telling it something. One of my sources believes that the CFTC is probably already forcing the banks to cut back on their commodities futures positions to comply with the limits that are already in place by the exchanges. It would be hugely embarrassing for all parties if the extent of their current (and especially past) non-compliance were to be revealed. So once they have them cut down to size the CFTC will be able to unveil the new guidelines and - with a straight face - tell the world that the banks were already largely complaint. Face saving all around.

Singing from the Same Hymnbook

It seems while I've been away on holiday the regulators and exchanges are all holding hands and pledging their troth to each other. ICE has agreed to provide the CFTC with trade data. The CFTC has strong-armed the FSA into cooperating in trying to reign in oil speculation (even as the FSA continues to claim that the 2007 spike in prices was supply and demand). And now the SEC and the CFTC are joining hands and trying to find a page in the hymnbook that they can sing together. In the past it would seem the SEC was the experienced baritone while the CFTC was the squeeky young tenor. But since Gary Gensler's arrival, the CFTC has grown a pair and seems to be going in the right direction. The SEC remains unwieldy in size and still has too few ex-traders to help build better investigative practices. Plus it has not been given any sharper 'teeth' by the Obama administration, as far as I can see. Until it has the authority and manpower to actively investigate the dodgy goings on in our industry, little can be achieved. The administration and the regulators should heed President Obama's words and not waste this crisis.

Woodstock Redux

The Silly Season, la morte saison, the dog days of Summer - this is the time of year when everyone is on holiday and what little news there is is pretty silly. Thus on the 40th anniversary of Woodstock (news item #1 last week) I read that a new wave of protest is rearing its head. This one is not against health care reform, but against the prevention of climate change. The American Petroleum Institute (the last bastion supporting America's gas-guzzling habits and Sarah Palin's 'drill baby drill' policy) is organizing 'town hall' style protests across the US. Oil companies, their employees, and some of the US oil producing states are banding together to protest legislation that is designed to limit greenhouse gas emissions. I can envisage the protests now - obese people on ATVs and disabled-scooters wielding signs saying 'I heart my SUV'. Coal-burning utilities covering their buildings in banners proclaiming 'Soot is good for America'. Oil company CFOs waving placards that say 'Alaska doesn't need more wildlife'. I have a hard time understanding how people can be FOR air pollution. We may not have reached peak oil output yet (it depends who you listen to) but it will happen eventually. Oil is a limited resource. Exploration, production, refining and burning oil is bad for the environment. Whether this causes global climate change or not, we need to slow down our usage and find viable alternatives. How can you protest against that? It is almost as bad as protesting against people having health care.

Consumers Decide They Don't Need More Stuff

I was listening to Bloomberg on the radio this morning and I heard that there is real fear in the market about consumer spending for back-to-school and even this coming Christmas. The US economy, being so dependent upon consumer spending, is unlikely to recover, say the experts, until the spending increases to 'normal' levels. I get the feeling that American consumer spending may never recover to 'normal'. Finally people have realized that they don't really need to buy endless crap at the Christmas Tree Stores or home repair stuff at Lowes. The reason? The value of their homes is equal to or less than what they paid. Home equity is a thing of the past, and unlikely to rear its ugly head for quite some time. A friend who used to work for Fannie Mae, and now handles getting rid of foreclosures for banks, told me this weekend that the record foreclosures seen in July (360,149 - up 32% year on year)were just the beginning. She says that the real pain is still to come and that there is a veritable tsunami of foreclosures already in the pipeline. The end of the housing bust is not nigh, and prices will fall further still. This is not what the market wants to hear. But it might have to soon.

Monitoring Our Lives

I was surprised to see in today's news that market research company Nielsen is still using set-top boxes to monitor television viewing habits in just a few thousand homes. I would have thought that this antiquated technology went out with the Betamax. Newer technology exists for a Nielsen-type of company that would enable it to monitor anyone and everyone's viewing habits. This is particularly necessary now than a large number of people view TV via the Internet. Using complex event processing technology, market research firms could leap ahead of their competitors by analyzing these habits in real-time. Think how targeted and timely the advertisements could be. My old friend Stephen Bates, CEO of monitoring software provider ITRS in London, once told me he could monitor the temperature of the bath water in Bill Gates' bathtub (with Gates' permission surely). The UK's FSA is using event processing technology from Progress Apama to monitor the UK markets for abuse and possible insider trading. Information provider Genscape developed technology to monitor how much electricity is going over certain grids, and how much oil is in storage in Cushing, OK. Nielsen needs to speak to some of these firms. Either that or give up.

A Tax on Speculators

A proposed bill to tax oil futures and options speculation might be a lot easier to get through the House of Representatives than to actually implement. Representative Peter DeFazio from Oregon and another 29 reps are backing legislation that would add 0.2% to each oil futures contract and 0.5% to every options contract traded by 'non commercial' traders for non-hedging purposes. The idea is to use the tax to fund transportation projects. While I applaud the intention - provided the money is used not just for repairing the crumbling highway infrastructure but also for improving trains and other public transportation - the practice is likely to be downright impossible to implement and monitor. The CFTC can barely figure out who is commercial and who is non commercial, let alone try and separate out the activities of these participants. What if an investment bank acts as the counterparty to a commercial oil company buying futures, then turns that position around for profit? Position limits on the exchanges are a more logical solution. Accountability limits on Nymex have been sorely abused of late, and the exchanges already have a hard time figuring these out. Just last year oil trading firm Vitol was thought to have amassed 11% of the contracts traded on Nymex. The Commodity Markets Oversight Coalition goes as far as recommending to Congress that they stop allowing firms to trade consumer commodities as a US dollar hedge. There is a lot of noise around oil speculation currently, but a tax is probably the worst idea. Maybe regulators should force the investment banks to ring-fence all commodities trading within one subsidiary. In other words, Goldman Sachs could only trade and speculate within J. Aron, and Citi within Phibro. It's a thought.

Flash, Ping or Scrape, it is all Gaming

I was not surprised to see that Nasdaq and BATs (and probably soon Direct Edge?) have voluntarily quit allowing 'flash orders'. There are a number of strategies that are less than strictly kosher - flashing, pinging, scraping - all are a way of gaming displayed and dark liquidity. Algorithms are designed by clever people who know how to tease the teeniest margins out of high frequency trading. The convergence of electronic trading, ECNs, for-profit exchanges, NYSE's hybrid system and Regulation National Market System all contributed to enabling high frequency trading. This is generally a good thing because it bolsters liquidity and keeps the exchanges and ECNs in pocket money. But when it becomes too obvious that the HFTs (as the media seems to insist on labeling them now) are taking advantage of the rest of the investing public, the regulators have to step in. The SEC seems to have grown some cojones finally, thus the rush by Nasdaq and BATs to voluntarily ban flash orders. What the HFTs (and perhaps some of the ECNs, exchanges and dark pools) do not want is for the SEC to look under the rug and see the rest of the story. They are hoping that the ban on flash orders will satisfy the regulators temporarily, so their quants can find some new ways to game the market.