Co-Locate and be Damned

I guess Essex girl jokes are totally out of date these days (what does an Essex girl use for protection during sex? A bus shelter!) but they do spring to mind when looking at today's Financial Times. While all the efforts are taking place in the US to ban flash orders, and regulate high frequency trading and dark pools, NYSE Euronext is building itself a giant co-location facility in Basildon, Essex (that is in England - near London - for my American readers). In a hangar-sized building the exchange is installing racks of computer space for its own trading engines and - next door - banks of space for the HFTs' servers. So, as the US says goodbye to HFTs and their sub-millisecond, fractional profit-snatching ways, Europe welcomes them with open arms. In the US Senator Ted Kaufman is hovering over the SEC to make sure they take a ground-up look at the new market structure. This seems to be working quite effectively. The SEC said to him in a letter that it would dig down and take a hard look at  Regulation ATS threshold levels, direct market access, high-frequency trading, and co-location. The FSA has yet to weigh in specifically on co-location and HFT but is adamant that an international approach be taken to policy-making. Otherwise any measures implemented by the UK alone could damage London’s competitiveness. But while the FSA and the SEC are trying to work together more closely, NYSE Euronext is building a hangar for co-location. Europe's new market structure is still too new for regulators to get a handle on it. The SEC had better jump in and advise the FSA before New York and Chicago lose their co-location domination.

In Defence of Conspiracy Theories

Financial journalism has changed more in the past year than anything else on the planet, including the credit markets. Traditional magazine or newspaper-style reporting is flying out the window and bare-knuckle, real-time blogging is taking over. If you ever doubted this take a look at Zero Hedge. It is an analytical yet tongue in cheek blog started early this year by an ex-hedgie. Zero Hedge digs into data, analyzes it and draws conclusions that most financial journos haven't the time or the aptitude for. I found it in my internet trawling a few months ago, loved it and followed it, and it is now becoming mainstream. Today's New York Magazine has a long diatribe about Zero Hedge and financial bloggers. It criticizes ZH's tendency towards conspiracy theories and its campaigns against high frequency trading, flash trading, dark pools and Goldman Sachs' market dominance - among other things. I think if you look carefully at financial blogs you will find many of the same arguments that ZH makes, though perhaps with less vigor. These blogs are trying to do you, the general public, a favor by pointing out things that may not be 100% good for you. You can take or leave our advice, but be aware that we try to tip you off before the banks - or the government - rip you off. And try to remember that where there is smoke there is often fire. If it walks like a conspiracy, talks like a conspiracy and acts like a conspiracy - it probably is one.

And so it Begins

The mere whiff of US regulators poking their noses into energy markets, those last bastions of government-sanctioned bribery and cowboy-style trading, has sent everyone scrambling offshore. S&P is considering an excluding-US GSCI style index, citing interest from investors to freely access commodities exposure. United States Commodity Funds (proud owners of the market-moving USO oil and USG natural gas ETFs), have already filed for permission to create a Brent-related one. Platt's is looking into setting up an index that would give investors exposure to physical commodities, according to Reuters. Presumably if an investor has a physical position then he can play around with futures willy-nilly. None of this news is good for those who want to stamp out oil speculation. Just because speculation may be curtailed on Nymex (and to a lesser extent on ICE) doesn't mean that prices of US futures won't be affected by speculators elsewhere going forward. Asian and Middle Eastern exchanges have been trying unsuccessfully to break into the oil futures markets for decades. But they have always been beaten down by the dominant US and UK ones. Their day in the sun may have arrived. I have said it before and I'll say it again: there was a good reason that Goldman Sachs and Vitol bought 20% of the Dubai Mercantile Exchange. And it wasn't because they like wadi-bashing.

Regulating the Dark Pool Palooza

The World Federation of exchanges has taken aim against dark pools, echoing the SEC's concern that they limit transparency. Yes and no. If an institutional buyer cannot execute large trades (which means hundreds of thousands of shares) on the quiet, then market volatility will soar. Transparency is only a good thing in that we know what has happened and when - which we do with dark pools because they have to report trades just like any other venue. Crossing internal and customer business - which is where dark pools started at the banks - is essential in order to save investors money on exchange fees. While it is probably true that there are too many dark pools - around 40 in the US alone at last count - I believe they are a necessary evil. Perhaps what is needed, ironically, is more transparency in dark pools. If more of them were integrated, or if regulators mandated that orders had to go to ALL pools rather than just one or two, then this might help to light them up a bit. Pool providers should be doing more to make their business more understandable to the regulators and the general public. Given the panic over flash orders and HFT, dark pools should be afraid. Very afraid.

Too Clever by Half

The noise over bankers' bonuses is growing into a virtual media cacophony in the run-up to the G20 meeting this week in Pittsburg. Everyone from economists to analysts to corporate lawyers are calling for a crackdown on the bonus culture. Nicolas Sarkozy (my new hero) is threatening to 'allez' the G20 if the group doesn't address the situation to his satisfaction (the G20 looks set to give regulators some increased authority in this area, so he will have to 'restez' instead). The SEC seems to be growing a larger pair after its courtroom drubbing in the BofA/Merrill Lynch bonus fiasco. BIS's Financial Stability Board is (of course)trying to tie bonus pools with capital requirements. Not a terrible idea, to be honest. But I worry about the ability of the global mishmash of regulators and central banks to monitor capital reserves, bonus pools and accounting standards as well as the usual fraud. I have heard many a tale where a firm will 'take profit' on future swaps or exchange deals in the current year in order to boost bonuses. It is common, not entirely illegal, and almost impossible for auditors to detect until it is too late. If the regulators work with some forensic accountants maybe they will stand a chance of outwitting the clever clogs at the banks. I won't hold my breath.

Nobody Loves me, Everybody Hates me...

High frequency traders are going to go eat worms next. At the Aite Group roundtable discussion on high frequency trading last week there were reportedly a few HFTs feeling unloved (WSJ Marketbeat). They believe that the high profile criticism over what they do and how they make money is unfair, because they also have to take risks which may not pay off. Oh boo-hoo. That is what traders do. These HFT firms were given the unbelievable gift of Reg NMS which made the equities markets more transparent and allowed routing between exchanges. (The fact that there is still arbitrage available between the venues is also unbelievable, but that's another blog.) That same transparency meant that regulators, retail investors and financial journalists alike could also see what was going on. This is what Reg NMS was all about. HFTs should take their money and run laughing all the way to the bank. Transparency means smaller and smaller margins, which means their days are numbered. Rather than complain, they should start looking at FX and commodities for further opportunities to exploit, while they wait for their quants to come up with some new ideas.

GDP and the Value of Happiness

France's President Nicolas Sarkozy and economist Joseph Stiglitz trying to start a new trend - using the value of happiness as a component of GDP. Stiglitz led a panel of economists - commissioned by Sarkozy - to look into GDP and whether it was a true measure of a society's health. Stiglitz maintains that GDP statistics often suggest that the economy is doing far better than most citizens' own perceptions. For example, before the credit crisis the US was reporting stellar GDP growth rates, but these were skewed by the massive amount of household debt Americans were taking on to fuel the growth. Sarkozy and Stiglitz argue that happiness, long holidays and a sense of well-being - partly down to having excellent health care - should be part of the measurement of a society's performance. I agree whole-heartedly. Americans live on a knife edge between good quality health insurance provided by their employers and having to use the emergency room and walk on the bill. That causes stress. In France the health care is excellent and paid for by their tax euros. The average American gets two weeks of vacation time each year. Most of them use it in the summer when their children are out of school; that leaves 10 months of the year with only a public holiday here and there. That causes stress too. In France, on the other hand, vacations are long and varied. Most Frenchmen get 6 weeks off plus public holidays. As far as happiness goes, I can't even bear to watch Fox News or CNN for all the vitriol and bile that is spilling out of Americans today. That is not happiness. In France their lifestyle is much the same today as it was 100 years ago - with a focus on good food, fine wines and arguing politics over the dinner table. They do not need the news media to feed them their opinions. In America property prices have fallen between 20-50%. In France property prices have barely dipped (I know this because I check Paris apartment prices weekly and a friend just came back from looking at houses in Provence). I think Sarkozy has something here.

Underwater Public Pension Funds

As Ben Bernanke and the Financial Times opine about the end of the recession and the miraculous recovery of financial firms after Lehman's collapse a year ago, spare a thought for one of the hardest hit sectors. Many public pension funds, those owned and managed by individual states (US) or federal governments (US and UK), are in mortal danger of collapsing. I am writing an article about the trend toward liability driven investment (LDI) in pension funds, where funds use interest rate futures and swaps to help manage their long-term risk. If people live 20 or more years after they retire, which is increasingly the case, the surplus risk to the underlying assets can be mitigated. Most pension funds do not employ this method, preferring instead the 'wait and hope' method of investing (which, as we have seen, worked pretty badly last year). A portfolio manager tells me that the worst problems are currently with the public pension funds, and that they are "horribly underfunded". Because we taxpayers fund the public pensions there is little incentive for public officials to tell us how bad the situation really is. We might just vote them out, and vote to stop giving state and federal workers pensions based on their final salaries. The MA state fund lost almost a quarter of its value in the year ended June 30th. California's CalPERS is so underwater that, rumor has it, the government is looking to see if there are legal ways to stop existing pensioners from getting the full amount agreed. (My source tells me that there are retired town managers in CA making $400k per year in benefits.) Until this mess is sorted out I find it hard to believe that the financial markets have truly recovered. This might just test their resilience.

There Will be Blood

Even as the ink dries on the newspapers analyzing President Obama's speech to Wall Street today bulge bracket banks are gearing up to circumvent new regulation. The President was right to tell Wall Street that it cannot resume taking risks without regard to consequences, but he is too late. The resumption of said risk-taking is already off and running. They have jumped back into bond markets, commodities, and derivatives with both feet. The CFTC's imminent clamp-down on oil speculation, arguably the straw that broke the economy's back last year, is already turning banks into oil trading firms. Massive hiring sprees have been reported as BofA, Credit Suisse, Standard Chartered and Deutsche Bank expand their commodities teams globally and plan to start trading spot oil markets. Most of these banks made huge layoffs in the same teams only a year ago when commodities prices went south. My sources tell me that any oil trader worth his or her salt is asking for a three-year minimum salary guarantee before going to work for one of the fly-by-night banks. Because even at $1 million a year (which some reports tout as 'the going rate' for experienced oil traders) they'd be lucky to get a year out of them. The million doesn't go far when you are out of work again for a couple of years. The thought of some of these banks trying to trade physical oil makes me smile, however. The reason Goldman Sachs and Citi and Morgan Stanley have made it in that world is because they bought experienced people and/or companies and stuck with it, year after year. Jumping in when oil and commodities prices rise and out again when they fall is hardly a long-term strategy. Like the title of the film modeled after the excellent Upton Sinclair book "Oil", there will be blood. Meanwhile CME is cracking down on its existing position limits for oil and commodities futures, as I predicted it would (The Wold Report, August 26, 2009). Now for ICE to do the same.

High Frequency Trading and Oil

The hand-wringing over high frequency trading is bleeding over into commodities markets - in particular oil futures. Transcripts released show that HFT Optiver, which has been charged with manipulating oil prices by the CFTC, actively spooked prices up and down to suit them. This makes the CFTC look pretty toothless. A report released yesterday by the Baker Institute at Rice University blamed the sharp price rises last year squarely on speculators, and says that the CFTC botched the investigation by using inadequate models. Amy Myers Jaffe, who co-authored the report and is a highly respected energy expert, went so far to tell the NY Times that the CFTC then played down the results. She told the paper the regulator didn't want the blame to fall on it for providing inadequate oversight. The CFTC has a lot to answer for, it's true, but I believe chairman Gary Gensler is doing his utmost to bring the agency up to speed. There is one huge problem waiting to bite them in the bum, however, and that is the proliferation of HFT in oil. I have heard anecdotal evidence that already 30% of trades going through Nymex and ICE are generated by algorithms. I know for a fact that the bulge bracket's quants have developed algos that trade the arbitrage between ETF prices and the underlying constituent elements. ETFs such as UNG, USO and DXO that become skewed away from their net asset value are offering rich pickings for these HFTs. As the algorithmic trading landscape becomes more sophisticated in oil futures, the CFTC will find it even more difficult to nail down the culprits.

You Read it Here First

Well, nearly. Last Wednesday I reported that there was something fishy about the FT reiterating that the CFTC was reiterating that banks might no longer be excluded from commodities futures trading limits. I said that the CFTC (probably with the cooperation of its faithful sidekick the FSA) was having a quiet word with the banks to get them to be at least somewhat compliant with existing exchange limits( the CFTC told the FT that it did not 'order' Nymex to enforce its own rules). Lo and behold, yesterday Deutsche Bank snatched its double long crude oil ETF (DXO) off the market when it bumped up to its Nymex limits. DXO is worth about $425 million, which shows just how pervasive these so-called index funds are in energy markets. Another niggling little problem by the name of United States Natural Gas Fund (UNG) has also raised some eyebrows. It seems the fund traded at 20% over its net asset value. It and its sister fund USO (crude oil) are both badly designed and have grown such that they can easily skew the futures markets. They will probably be the next to go. Many of these oil and gas ETFs came to market too quickly after the spike in 2007, and have grown far too large for what is a very limited underlying market. Around 1.2 billion barrels worth of crude oil futures trade on ICE and NYMEX every day. This about 50% more than the amount of actual crude oil produced globally (around 87 million b/d). Can you say 'manipulation'? Meanwhile I applaud BPs tenacity in the Gulf of Mexico. It has discovered another rich oil field that could have reserves of more than 3bn barrels. Maybe BP can help to stop the 'drill-baby-drill' in Alaska idiots in Congress.

Who will Pay for News?

Over $10 billion in advertising was wiped out of US media outlets in the first half of this year, according to today's FT. This helps to explain why financial journalists such as myself are currently under-employed. What is worrisome is that advertising in business-to-business magazines, the mainstay of the financial trade press, fell by nearly 32%. Newspapers are failing by the day as print media is replaced by real-time news on the internet. But the carnage in advertising budgets concerns me. What if this is a long-term trend and businesses find that they can do without advertising in local, national and trade publications? How do online news services make money if not with advertising? Even the mega-popular social media outlets such as Facebook and Twitter are struggling to squeeze money out of their subscribers, never mind advertisers. There are any number of free, real-time news feeds available over public sites including Yahoo! Reuters and Bloomberg now offer nearly-real-time news directly via their websites, this content used to make them a fortune. I have to hope that the public and businesses still recognize the value in good, accurate news that is politics-free. Especially since some of my journalist friends and I are bravely considering launching a locally-focused online business publication.