Rob Park at SFI

"Logic and Intent: Shaping Today's Financial Markets"

  • Started program trading with a spread algo between Deere and Caterpillar, under the assumption that fundamental drivers were similar and spreads will revert to mean. 
    • In executing this algo, felt orders were being copied by someone else.
  • Today, 70% of total US volume is algos.
  • How do algos introduce risks?
    • Problems occur when you can’t predict.
  • The algo ecosystem: the number of possibilities grow exponentially when algos interact with other algos.
    • 1 runaway algo problem. Example-on Amazon there was a $1 million book. Someone raised the price in marketplaces of another ever so slightly and that triggered a cascade where this book ended up listed for $20 million (the story of how this happened is fascinating and told here)
    • 2 Flash crash – unpredictable interaction of algos
  • What is an algorithm? It is a sequence of logic statements. All algos are created by humans. They do what people intend them to do. Intent=important. Humans are driven by incentives, algorithms are driven by human intent.
    • The technologist needs to understand the human goal, or else risk is introduced into the system.
  • IEX introduced a 350 microsecond delay on an order reaching the exchange.
  • The broker’s dilemma: brokers were matching orders between buyers and sellers, so brokers created dark pools. Broker A gets the buy, Broker B gets the sell, what’s the incentive for Broker A to trade with B?
  • In today’s market there are 11 exchanges, 40+ dark pools (IEX right now is a dark pool, but will try to become an exchange eventually).
  • Exchange dilemma: exchanges facilitate issuers with investors. Exchanges are supposed to be neutral to all participants, but now are for-profit companies who build services for specific customers. This is not the intended purpose of exchanges, and biases these exchanges towards one kind of participant (HFTs) over another.
  • There have been three generations of market algos so far:
    • 1 automatic traders flow, algos execute upon traders’ ideas, helping these traders focus on “their work” as opposed to execution
    • 2 gaming automatic trader-based algos. These algos took advantage of transparent inefficiencies in the first generations functionality.
    • 3 counteract generation 2. A trader who wants to buy size needs to game level two algos in order to hide intent and execute efficiently.
  • Participants send orders, but they don’t arrive at the actual exchange at the same time.
  • At the micro level, markets are deterministic (opposite of physics).
  • Latency arb—in a distributed system, race conditions matter. HFT aims to exploit the race. Exchanges need to know where the market is before pricing a transaction.  Introducing the 350 microsecond delay through a fishing-line like fiber. In doing so, assume the order is not fast. And then figure out where the market is.
  • Resistance to IEX so far has come from 2nd generation algo programmers. 


A Tale of 3 Tech IPOs and the Punditry Narrative

When LinkedIn IPO'd in May 2011, underwriters priced the offering at $45 per share. The stock closed the day up 109%, at $94/share. Henry Blodgett at Business Insider quickly published an article entitled "Congratulations LinkedIn, You Just Got Screwed Out of $130 Million," bashing the underwriters for misreading demand and reaping immense profits for themselves at the company's expense. Blodgett wasn't alone in critiquing LinkedIn's underwriters, as the media and financial commentators worked into a frenzy about just how poorly the IPO was priced. Jim Cramer chimed in with his own fury over how the underwriters "juiced" the IPO.

As Facebook geared up for its IPO, to much enthusiasm, people were asking whether Wall Street would avoid doing what it did to LinkedIn (aka "robbing" them) by pricing the offering fairly. A "fair price" would enable the company itself to maximize its own proceeds. In response, Facebook was priced as aggressively as possible. It was priced so aggressively that Blodgett called the IPO "Muppet Bait" for how dangerous a proposition buying into Facebook was for retail investors. We all know what happened next. There were no buyers of the shares hitting public markets, and the stock instantly entered a tailspin dubbed the "Facebook Faceplant." Here the underwriters were accused of "botching" the IPO at the expense of retail investors.

Leading up to Twitter's IPO, the biggest question was "how could we avoid another Facebook?" (too many such links to pick one worth sharing). Twitter purposely wanted to temper enthusiasm and price its offering low enough to encourage long-term investors to buy shares. Sure enough, Twitter opened over 70% above the $26 offering price and the company similarly left boatloads of money on the table a la LinkedIn. In each subsequent tech IPO, the prior "victim" ended up reaping the rewards.

Across these three big IPOs, we have seen punditry complain about the underwriters, company insiders, and the exchanges, amongst others, without ever looking into the proverbial mirror.  The media whirlwind surrounding these events has created a narrative which permeates society. This narrative then influences the actors in the next scene to attempt to avoid the pitfalls of the prior narrative, only to fall victim to new problems seen one long cycle ago. Punditry continuously drives a vicious cycle of reactionary moves with commensurate media complaints and the same problems sadly repeat themselves over and again. All we have learned in all this is that the underwriters simply can't win a PR windfall with these IPOs (though they do make plenty of money), and punditry will inevitably find a villain and a victim to create a story at its leisure. 


Disclosure: No position in any of the stocks mentioned.

Why Subsidize Speculation in Commodities?

If you follow me on Twitter @ElliotTurn, you know that commodities have been a big point of interest of late.  I’ve been spending some time trying to distill whether the driver of the commodities bull market for the last decade has been US monetary policy or China’s rapid acceleration in growth.  The answer to that question has significant implications for several different types of investments today, and is really just an interesting and important point in understanding today’s macroeconomy.  But today, with commodities a hot-topic and tax day quickly approaching, I want to take a glimpse at commodities through a different lens entirely.  With oil prices rising quickly in the face of our largest build in crude oil inventories since 2008, there are obvious questions being raised about the impact of speculation in commodity markets (see here for a good look at the question).  After all, how can something go up in the face of an overabundance of supply?  Rather than try to answer the question of how much of a premium in commodity prices is driven by speculation, to this too, I want to take a different angle altogether.

Whether one agrees or disagrees with speculation being a factor in commodity markets, I think we can all agree that such activity should not be subsidizes no matter what.  Yet, that is exactly what our tax code does—it incentivizes speculation in commodities over speculation in any other market.  Even more, speculation in commodities is a great way to guarantee a lower tax rate than the general income tax, when compared to any other profession in America.  There is a hot debate over carried interest, yet this loophole is at least as egregious. 

Broadly speaking, we are in a state of heightened global macroeconomic volatility, and that alone does yield way to increased volatility in demand and pricing for resources; however, that does not explain some of the radical swings in commodities ranging from oil to palladium to gold in recent times.  Since the 2003 Bush Tax Cuts, long-term capital gains are taxed at a 15% rate, while short-term capital gains are taxed as general income, at a 35% rate.  These capital gains apply to most forms of investment income; however, they do not apply on gains in futures contracts–the principle way in which commodities are traded.  Futures contracts, as prescribed by Section 1256 of the tax code, are taxed with a blended rate of long and short-term gains: 60% long-term capital gains and 40% short-term.  The blended rate results in an effective tax rate of 23% on income derived from futures/commodity trading (check out this site for more information on trading taxes).

In essence, the tax code promotes short-term speculation in commodities markets, and it does so in several ways.  People who are speculating in commodity future markets are inherently short-run, and care far more about the discount on the short term capital gains tax rate than they do the increased cost of long-term commodity ownership.  Whereas a short-term equity speculator is taxed at the general income rate, a commodities/futures speculator is taxed at 23%.  The consequences of this are two-fold: first, there is an economic incentive for speculators to ply their craft in commodities markets as opposed to equity markets, and second, speculators desire volatility in the short-run in order to maximize their capacity to make money, such that there is a serious misalignment of incentives between speculative market participants and the purpose of commodity markets. 

The goal of commodity futures markets is to provide a venue through which buyers and sellers of raw materials can share some of the risks in price fluctuations and both can secure some sort of certainty for longer-term budgetary purposes.  Fundamental commodity market particpants are not necessarily trying to make money on each transaction, but rather their aim is to gain security in price on both sides of the equation in order to more efficiently plan and manage their business.  Because this is the existential purpose of commodity markets, it should be noted that volatility poses dangerous risks to the players who need smooth functioning in these markets most. 

Meanwhile, short-term transactions that result in realized gains in commodity markets are not done with the intention ever taking or giving delivery of the underlying goods themselves.  Rather, these transactions are done for the purpose of realizing a gain off of changes in price.  These transactions require inefficiencies between supplier and buyer PLUS volatility in order to generate a profit.  In seeking volatility, such transactions promote yet further volatility.  Because of this fact, volatility and market dislocations lead directly to more opportunities for speculative gains.  Pushing such actors into commodity markets creates a situation where volatility becomes a self-fulfilling prophecy for the benefit of a significant portion of market participants, but a detriment to society at large. 

Speculative traders do play an important role in that they provide liquidity for the true suppliers and consumers of commodities; however, there is no reason for the government to provide a direct subsidy in inducing speculators to prefer commodity rather than any other market.  And there’s really no reason that speculators who engage in these markets for a living should pay a lower tax rate than any other hard working American.

Since markets like these are zero-sum, where one actor must inherently make money at the expense of another, there is unquestionably at least some coefficient of a speculative cost in the price of commodities.  No one these days is seriously concerned about a lack of liquidity in commodity markets, if anything we as a society acknowledge the abundance of this liquidity between the proliferation of commodity-based ETFs.  While we can’t necessarily weed out all speculation from these markets, we can realign the incentive structure to be symmetrical with every other profession in our country.  This is a question to which both Democrats and Republicans should be able to find some common ground.

On HFT, Liquidity, and the Flash Crash

“I think the notion that liquidity of tradable common stock is a great contributor to capitalism is mostly twaddle.  The liquidity gives us these crazy booms, so it has as many problems as virtues.” –Charlie Munger
Today it seems like CNBC has designated high frequency trading and liquidity collectively as the topic du jour.  I find this slightly amusing, because the talking heads on TV and in my Twitter feed who I'd label as perma-bears are the ones complaining most loudly and frequently about market structure, liquidity and HFT.  Market structure is unquestionably something I view to be a problem, although the more long-term investors in the marketplace, the less short-term liquidity is actually all that important anyway.  Short-term liquidity creates profitable trading opportunities, but it in no way impacts the quality (or lack thereof) of an individual long-term investment.  

Liquidity in this context takes on a different meaning than what I think it really should mean.  We have used the term to drive spreads to within a penny on the bid and ask, but has moving from quarter to nickel to penny spreads changed the capacaty for individuals or institutions to make long-term investments?  Liquidity does seriously matter in terms of creating systemic opportunities for investment, but only to a point.  An entire marketplace without good liquidity increases the cost of investment substantially and that's not a good thing, yet, at the end of the day, none of these complaints about HFT are dealing with the fundamental question anyway.  We have plenty of systemic liquidity upon which any long-term investor could accumulate or distribute a substantial ownership interest, but we have a marketplace that is harder to make short-term money off of price spreads.  Those are two different questions.
On the day of the Flash Crash, before it was even dubbed the Flash Crash, I wrote a pretty emotional and frustrated rant, lashing out on HFT and supplemental liquidity providers.  I still think my statements from that day sum up the spectrum of my feelings about HFT.  Without getting into it any further, here's my post from May 6th, 2010, the day of the Flash Crash in its entirety:

So there's a report going around that a Citigroup trader hit the "b"illion button instead of the "m"illion and I just want to right off that bat make clear that not only do I not buy that story, but I am absolutely certain that it is not THE cause behind today's collapse.  I believe today's collapse is a confluence of factors that generated the perfect storm of volatility, chaos and panic.  Here are a few of those factors:

  1. Global fear levels are elevated amidst talks of a Greece default and trouble in Spain.
  2. Markets traded aggressively higher off of the February lows without a substantial pullback.  This led to large pent up selling demand.  People were waiting for the first downtick to sell, and when the selling begat selling.
  3. With high frequency trading accounting for an ever-increasing percentage of total market volume, when the volatility storm, hit the computers shut off.  I was staring right at it in the Level IIs...the bids in just about every stock disappeared.  There was no liquidity.
  4. Proctor and Gamble (PG) alone dropped almost $25 points from its intraday highs.  With the Dow being a price-weighted index--with each components $1 move correlating to 7.2 Dow points--PG alone accounted for 180 of the Dows nearly 1,000 point crash.  That's insane for a stable company.   I'm not a huge Cramer fan, but I LOVE what he had to say live on TV: "if that stock is there just go buy it...that's not real...just go buy it!"  Major props to Cramer for speaking some truth and bringing sanity to the panic.

Now just for some personal thoughts during all this and a rant: I got terribly scared today.  The speed with which the market dropped 700 Dow points, I could not help but think the worst.  My head was running wild.  Was there a terrorist attack?  A coup in Greece?  Hedge fund blowup?  Bank failure?  Sure enough there was not a single new story.  Nothing in the world changed!  Well not entirely true.  Trillions of dollars moved around, but absolutely NOTHING really changed.  The state of the economy and I'm sure investor and consumer confidence all took major hits today, but really, NOTHING CHANGED!  Sure it was perfectly explicable that there were sellers and the market went down today, but what happened?

I want to rant about #3 from my list of causes.  A considerable portion of high frequency trading is run by "supplemental liquidity providers."  These SLP's are supposed to be the good HFT programs which step in when bidders leave the market.  They are supposed to provide liquidity when there is none.  SLP programs run each and everyday and are incredibly profitable for their firms.  Sure enough, the largest such service provider and NYSE's primary partner in the SLP initiate is none other than Goldman Sachs.  Where was the liquidity?  What happened!?!?  These SLPs run each and everyday, yet today when liquidity evaporates they're not there?  I saw it.  There were NO BIDS!  Where were you Goldie when we need you?   Not necessarily saying it happened on purpose, but maybe just maybe we'd be better off bringing back a human specialist as opposed to a money-making machine.  HFT is not good liquidity and doesn't seem to play itself out in a market-neutral manner.  It steamrolls on itself.

What an absolutely insane day.  I really cannot explain the emotions that run through while staring at capitalism spontaneously combust and rebound in a matter of minutes.  Yeah we had our 2008 when everything melted down, but that was a process.  There was news.  Things happened.  This was 2008 and 2009 combined into one 5 minutes bar on a candlestick chart.  What a joke.  If this was a computer glitch then bring back the specialists.  It makes everything seem so fake and unreal.  Since when was an economy measured by green and red digitized numbers flashing on a computer screen?  What ever happened to REAL things?  Innovation, production, etc.  Today was/is ridiculous and is a sign of the lack of progress we have made since this "financial crisis" began.

End Rant.