The Volcker Rule and Commodities Trading

The Financial Times and Reuters both ran reports today about the possible impact of the Volcker rule on commodities trading. The FT says that commodities trading houses will "slip under" the Volcker net - this would benefit trading companies like Glencore and Vitol because the banks would cut back on physical trading. Reuters says the plan to stop banks speculating in financial markets on their own account may "spawn a host of new independent commodities houses as banks sell trading units and as dealers leave to set up on their own." They are both right. The trading houses of this world will always benefit from the banks' misfortune. It happens regularly. Commodities are a highly cyclical market, with volatile downward periods in what - as Jim Rogers claims - is an inexorable long term move upward. When the markets are on an upward romp, the banks pile in with prop trading in energy, agriculturals, metals and soft commodities. When the inevitable 'correction' happens it is almost always severe, and the banks pile out again leaving traders standing on the pavement scratching their heads. Then they call Vitol or Glencore or Trafigura for a job.
Given the current return-to-bubble feel of the commodities markets, it is likely that those getting the push from the banks will head to the established houses, or even try to start their own as the FT suggests. There is one problem with this. Credit. The trading houses have established lines of credit, of course, but many lines were pulled out from under them during the crisis. Credit remains limited for such a high-capital, high-risk type of trading business. Start-up hedge funds have been waiting in the wings for financing for over a year now, and most do not see venture capitalists or banks rushing to take on the risk. Banks have always been more willing to extend credit to oil or commodities traders if they themselves are trading. That way they have a feel for the market, and the players. They have a sense of who is solvent and who is struggling. They know each others' positions (to a degree) and can often tell when someone has made a serious loss.
Ultimately, the banks and the trading houses could be losers in the Volcker plan.

One Down - Maybe - While Another Issue Looms

The mood on Capitol Hill is pretty sour towards banks and insurance companies that trade on their own account, with good cause. Tim Geithner today finally voiced something I have wondered about since I moved here - that American insurance companies have no national oversight. I imagine that is because when they started they were all in Nebraska or Connecticut and the federal government thought these states could manage them well enough. Wrong. AIG has been playing away for years, and it is unbelievable to me that it didn't get caught by someone - anyone. Some of its forays into energy trading were world renowned - and not because they made money. A national regulator would have had some idea what AIG was up to, I would hope. (Although the SEC and CFTC have not exactly been proactive before or during this crisis.) There is now a move afoot by the House and the Senate to create a national insurance office, but these bills do not go so far as to create a regulator. The National Association of Insurance Commissioners has gone further and has proposed federal legislation of its own that would establish a National Insurance Supervisory Commission (NISC), to be created by the states under federal law, to establish and enforce uniform standards across state lines, according to law firm Wiley Rein LLP. So,perhaps after years of state-by-state 'oversight' insurance companies will have to learn to toe the line.
In the meantime, financial markets players are opening a new can of worms for regulators to get their heads around. Exchanges and high frequency trading firms are lobbying hard to be allowed to trade in sub-penny increments on equities. The markets have barely absorbed the impact of penny increments, which enabled automated and high frequency trading. And the regulators have yet to get to grips with HFT and algorithmic trading. Allowing sub-penny increments is folly at this stage. Joe Saluzzi, as always, said it best and he believes it will force more order flow into dark pools (something else the regulators have yet to figure out). Themis Trading's Saluzzi said: "HFT players want sub-penny pricing, not because the extra sub-penny executions would pad their margins, but rather because the sub penny pricing will allow HFT shops more ways to step in front of traditional institutional hedge and mutual fund orders." Ouch.

Honest, Mr. President - We Won't do it Again

The Financial Times says this morning that bankers are going to head to Davos to lobby regulators for 'softer reforms'. No surprise there. The thing that caused me to laugh out loud was one banker and Alistair Darling's claims that "inter-connectivity" would solve the problems. Darling says that breaking up the banks and creating separate entities, like President Obama has strongly recommended, is not the point. "The point is the connectivity between them in relation to their financial transactions." Ummm, no that is not the point Mr. Darling. Bankers saying they will use connectivity in future to prevent any further pesky risk issues between departments is akin to your teenaged son saying he promises to use a condom after he got half the Junior class pregnant. You know you can't just lop it off, but surely you would do something fairly draconian to prevent further expensive mistakes.
Preventive measures in the banking industry - the so-called 'connectivity' - have been there for a long time. When I started reporting this technology lark in 1998 there was a massive push for removing product silos using straight through processing and enterprise-wide technology. These solutions have come a long, long way and it is now possible to monitor and control risk on a sub-millisecond basis. Risk across departments can be accessed, measured, monitored. Senior management only has to look at a web page and then say - "Hey, we might be betting the farm here, let's slow down." But they won't. Because moral hazard risk - the biggest risk of all and the one that got us into all this mess - cannot be measured or monitored. Greed is stronger than prudence. Always has been, always will be. Until greed is reined in, moral hazard remains far too tempting. The only way to rein in greed is by tackling the compensation culture of trading firms. Making them stop trading on their own behalf, or at least containing it, is a start. Publicly owned and government regulated banks should not be giving away half of their profits to the traders and management. They should not be betting the farm to make sure those bonus pools stay comfortably bloated. Only when this is under control can the regulators gain control.

Prop Desks are the Tip of the Iceberg

I'm already tired of hearing the bleating from financial markets pundits that 'prop trading was not to blame' for the credit crisis. Prop desks are the tip of the iceberg that was once called an investment bank. Prop traders gauge the mood of the client trading going on in their own banks (Chinese Walls don't mean a lot between the prop and client facing desks - they are usually in the same room) and in others, take the trends and run with them, using a bucketload of the bank's money. Their interest and highly visible movements create demand for the products they favor - such as buying energy or commodities or taking short positions in banks that are about to fail. The client desks then get requests from their customers for instruments that they too can trade to get on board. ETFs and derivatives are created and securitized to enable this. The prop desks now have even more to play with - they can take the arbitrage between the underlying instruments and the ETF or derivatives and scrape off profit. They can employ high frequency trading tools to take the froth off the top of the more liquid markets. They know when their own interest in something is fading - the market is oversold or something is about to crack(cue CDOs) and short them while the bank still sells them to unwitting clients. There is no law against this. But the prop desks and client desks and market makers and internal hedge funds and private equity funds feed off of each other. It wouldn't work very well otherwise. When the LIFFE floor close in London in 2005 the dealers and floor traders lost their trading mojo, trading on the screen did not allow them to 'feel' the market. Trading floors today are the same. Most of the business is now electronic, but there is a buzz and a 'feeling' that comes from being in the same busy room. That can't be hidden with Chinese Walls or technology.
The proliferation of internal prop trading and hedge funds etc. came about due to pressure from outside forces. When stacks of traders were laid off after the dot com bust they started their own firms - HFT, hedge funds that could short client money, agency brokers with high speed platforms. The banks had to compete with this, which they did by building their own versions of them. And, although, prop trading did not kill the golden goose it was almost certainly what helped take the banks to the too-big-to-fail level.
I agree with President Obama (and since when is it OK to call him 'Barack' on TV? Bush was never called 'George' by the talking heads on CNBC). It is time to unscramble the eggs that are investment/commercial banks today. This is not politics, it is common sense.

Banks to Separate 'Church' and 'State'

Today's Financial Times says that President Obama is about to crack down on proprietary trading in investment banks. Let me be the first to bet that this will happen sooner rather than later. There will be much criticism of this, with bankers asking if it is really necessary to separate 'church' from 'state' as it were. The 'state' being core banking activities such as lenders and depositories. And 'church' being the lofty prop desks full of guys making bets and praying that they win (and that their bonuses are not taken away by nosy non-believers).
It has started already. The CFTC just separated out the believers (real oil companies) from the non-believers (swaps dealers and speculators), in a bid to control speculative bubbles. Oil companies that supply oil and speculate may have to divide themselves in two in order to avoid trading limits. So is it feasible for large banks to do the same? It could be a little like unscrambling eggs. The prop desks are usually linked in with activities from the sales trading desks (netting what the brokers bring in), internal hedge funds and general hedging. Some say too closely linked.
But I will make a bet that this is going to happen. The reason I say this is because I happen to know that Paul Volcker wants it to happen. Volcker, who is the former chairman of the Federal Reserve Board, is now chairman of President Obama's Economic Recover Advisory Board. And Volcker has been banging the drum about this for some months now. He told the Wall Street Journal in December that "extraneous" activities such as hedge funds, equity funds, commodities and securities trading are secondary in terms of banks' direct responsibilities as lenders and depositors. He believes that these extraneous activities should be sloughed off into separate companies outside the banks where they would have the freedom to contribute to a fluid market without creating systemic risk. He said that this idea has a lot of support.
My bet is placed. By this time next year there will be legislation that banks separate out 'risky' trading activities and focus on what they are supposed to be doing. Anyone care to take the other side?

Strengthening Regulation Must not Falter

Reuters reports today that, because of Scott Brown's Massachusetts special election win, it will be more difficult than ever for Democrats to win Senate passage of their proposals to tighten bank and capital market oversight. The definitive election of Republican Scott Brown in the election yesterday has given right wing talk show hosts reason to gloat. But just because the backlash over health care reform handed them a victory does not mean the government should waver in its determination to reform the regulation of financial markets. The Financial Crisis Inquiry Commission, which included FDIC's Sheila Bair and SEC's Mary Schapiro, told Congress only Monday that regulation needed to be tightened. Schapiro fingered lax regulation of asset-backed securities, an excessive reliance on credit rating agencies, executive compensation that encouraged unhealthy risk-taking and a failure to oversee hedge funds and private equity funds as the culprits, according to the New York Times. The regulation of OTC derivatives is still high on the list of those in charge, even as the use of them is again on the increase. Derivatives pricing service SuperDerivatives expects volumes for FX, interest rates, energy, and commodity derivatives to soar this year. Unless the excesses of the past ten years or so are curtailed, the banks will head straight back to their old ways and securitize the Hell out of things that should not be securitized. Foreclosures in the US continue to skyrocket as a direct result of securitizing sub-prime mortgages. The pain in the housing market has not yet even subsided, and yet Republicans call for a return to the free-wheeling ways of the the past. It must not be allowed. Markets can and will be better monitored and controlled in ways that leave players free to innovate. Regulation should not be a political football.

They're Watching.....

After a year and a bit of listening to the public wailing and gnashing its teeth over the financial crisis, regulators and governments are finally responding.  The UK acted first with its 50% tax on bonuses, and now the FSA's not-so-gentle hints to banks that liquidity risk had better be under control. The Obama Administration dug deep into the pockets of both US and foreign banks with a US presence and said it will tax them to claw back 'every penny' that the taxpayers spent on TARP. A surreptitious move to tax bonuses over $100,000 by 50% is also underway by some Congressmen. The SEC banned brokers from providing naked direct market access to exchanges and ECNs (they were very lucky to have ever gotten away with this to be honest, so brokers should just suck it up and put the required risk controls in place. And keep an eye on their customers.) And on the same day, the CFTC finally came out with its proposed position limits on energy markets. Pundits and traders are calling the limits 'fair' and 'sensible', which means they won't suffer unduly from them. The limits, which are linked to the prevailing size of the market, are a little loose for my liking, but at least they are - finally - there. The CFTC never took another stand on oil market speculation - whether it happened or not - probably because it is happening again. Best not to rock the cradle. Reuters says that the CFTC made a mistake in allowing high single-month limits, that this could possibly lead to too-high of an all-month concentration. But the fact that the CFTC is looking at and monitoring these limits at all is encouraging. (The FSA should take notice.) Swaps dealers will now be limited from exemptions, which is good. This may impact large swaps/physical/hedging outfits such as Glencore, Vitol and Trafigura, but they can figure out a way around it. Separating speculative activity into a different entity is one way.
All in all, a good week for those who are pro-regulation. Everyone so far has employed a light touch, a thoughtful approach and pleased the general public. As outrage over the bonus culture grows louder, they will need to keep cool heads.

Stock Market Bulls and Treasury Bears

Something doesn't smell right. The bullish stock market trend of late in the face of reality seems overheated. Trim Tabs Investment Research, a firm that tracks liquidity flows in the market, says that December was the fifth month in a row where mutual fund investors pulled more money out of domestic equity mutual funds than they put in. According to a Bloomberg survey investors are the most bearish on Treasuries that they have been in over two years. I have friends asking me if they should take their money out of stocks and put it into bonds. But 10-year Treasuries are yielding 3.7% - only slightly more than my one-year CD.  (A word of caution - I am not an independent financial adviser. Not that they know what they are talking about...) So where is the money? And who is supporting this stock market rally? One possibility is that the US government is. Charles Biderman, CEO of Trim Tabs has theorized that the Federal Reserve and the Treasury, with the help of the bulge bracket Wall Street banks, are supporting the stock market. The approximately $600 billion of net new cash that is needed to lift the market's overall capitalization by $6 trillion last year could not be identified, Biderman said. The money, he said, didn't come from traditional players such as companies, retail investors, foreign investors, hedge funds or pension funds. Hmmm. Not only that, the bulk of the bullish activity over the past year has come in after hours trading on the futures markets. Hmmm. The idea that there is a 'plunge protection team' out there is not new. I proposed this possibility last year. The Wall Street banks were not bailed out with gazillions of dollars in taxpayers money without promising something in return. Using algorithms and high frequency trading strategies, it is really quite simple to gently goose a market. Expecially when the goosing in in lockstep with other banks. If you look at it, the stock market movements resemble trying to sink a life preserver. Disappointing employment figures? The market dumps... then gently resurfaces. Cue sighs of relief from the 401K-crowd. Ahhh. Maybe the economy IS recovering. Maybe we ARE invincible. Maybe my house will be worth a million dollars by next year and I can retire. And this is why the theory is so plausible. What better way to keep the public happy/quiet/complacent than by supporting the stock market? As conspiracy theories go, this is a doozy. Let's just hope the money doesn't run out.

Charge of the Bubble Brigade

I haven't paid much attention to the commodities markets over the past few months. The prices were high-ish but range bound for the most part, and China was slowly stockpiling all the stuff it might need to survive a nuclear holocaust. But something struck me when listening to Bloomberg on the radio last week. A pundit was talking about peak oil and said that this might be the least of our problems if the emerging nations keep growing. We could reach peak copper, peak iron, peak uranium, peak gold - all of the earth's natural resources could be tapped out. It is clear that investors think they will - at the very least - be more expensive. The buying spree of late signals another bubble, which can only be burst if another recession strikes or if China implodes. James Chanos, the prophetic hedge fund manager and president of Kynikos Associates, predicts that it will. Jim Rogers, the commodities perma-bull, scoffed at Chanos' logic and expertise, inferring that Chanos couldn't even spell China 10 years ago. Ouch. But wasn't it Chanos who shorted Enron all the way down from $90 to $1.00? I am not an analyst, but I can spell Bubble. And my spelling got a little better after hearing that the CFTC would set "generous" limits on energy speculation.
A trader friend wrote the following poem (crediting Lord Tennyson) to explain to management why prices of oil and commodities were rising after Jan.1:

Half a league, half a league,
Half a league onward,
All into the valley of oil
Rode the world's funds
Forward the fund Brigade
Load your guns ! he said.
Into the valley of oil
Theirs not to make reply,
Theirs but to buy and buy
Into the valley of oil.

He said to remind everyone that the Light Brigade got slaughtered.
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Regulating Moral Hazard

The seemingly toothless SEC has called a Sunshine Act meeting next Wednesday to get feedback on high frequency trading, dark pools and sponsored access. It is unlikely that the agency wonks have done any homework on these subjects, and will merely ask the 'public' for feedback. Cue reams of 'proof' from JP Morgan, Goldman Sachs, Credit Suisse, etc. that none of these practices are damaging to the general public. Whether you agree with this or not, the fact is that many of these strategies have arisen due to the new market structure. High frequency trading, for example, has really only been prevalent for the past couple of years. (Note to Mary Schapiro: can you ask the banks if HFT works better in an up market than it does in a down market? I'd really like to know.) Dark pools have been around longer, but just recently proliferated into a virtual dark tank farm of pools. The SEC is right and justified in looking into them, if only to be able to recognize where future problems might lie. All of these activities involve layers of risk that have yet to be properly analyzed.
In the meantime, the Bank for International Settlements is growing a bigger pair, and has called some of the largest players together to discuss 'excessive risk taking'. This a deliberate slap on the hand by BIS, who bravely tried to take on the captains of the finance industry before the crisis. Had the banks maintained the BIS-recommended capital reserves, the crisis would surely have been lessened, with less taxpayer money needed. BlackRock, Citi and Wells Fargo have reportedly accepted the invitation, according to the FT. (Not surprisingly, Goldman Sachs and JP Morgan have cried off.)
But for all the posturing by the regulators, little has changed in our world of finance. Moral hazard remains the largest risk of all, and no one seems to be strong enough to address that. Only this morning, again in the FT, did I see that Citi delayed paying severance to some of its top executives last year. The bank claimed that it wanted to wait until the furor over outsized paychecks and bonuses died down. But here is how it looks to me - it looks like Citi kept those millions in its 2008 P&L to boost the bonus pool and keep shareholders sweet. I wonder of BIS or the SEC can ever have the power to stop the greed.

Terrorism and Technology

I write about technology. Therefore it is in my interest to mentally solve problems using financial markets technology that I know about and (peripherally) understand. This gives me ideas for stories that I can pitch to publications, and thereby make money. This morning I was struck by an idea that has nothing to do with financial markets, but everything to do with its technology. I am not a techie. But I know that there are a few geeks who read my blog (you know who you are) who might be able to answer this question for me. Why can't governments coordinate their anti-terrorist groups and databases using algorithms? If a bank's algo can hunt down and nail liquidity and find the best price among 40-odd exchanges and ECNs, why can't governments hunt down terrorists the same way?
Here is my thought. This Umar Farouq Abdulmutallab who tried to set his pants on fire on Xmas Day was either listed by or known about at over a dozen US and foreign agencies. None of them seemed to be bothered about telling the others what they knew, so Umar slipped through the - very wide - cracks. If these agencies had to note down every known or suspected terrorist or their movements or a plot into a central database, which I believe they do, then an algorithm could be programmed to find patterns and similarities between the data in them. The TSA, CIA, FBI, MI5 and whoever else is supposed to be in charge, could therefore communicate without any egos or lobbyists getting involved. The quant brains over at Goldman Sachs and Credit Suisse could earn their 2010 bonuses by helping to design the algos. Am I wrong? Or could technology really help to control terrorism?