Slouching Towards Wall Street… Notes for the Week Ending Friday, 8 July 2011
Can’t anybody here play this game?
The stated purpose of securities regulation is to provide a level playing field for investors by upholding the integrity of the marketplace. This is done through a disclosure regime, overseen by the SEC, that ensures a transparent marketplace, and supported by a behavioral regime, implemented by the SROs, that sets guidelines for market participants. That the exercise of oversight requires meddling is unavoidable. That meddling is, well, meddlesome is also not lost on us. It is the job of the regulator to chafe just enough that the actors in the market are aware of their presence, without rubbing their flesh raw at every opportunity.
Business does not care for meddlers, and though it is their job to insist on controls, Congress and a succession of Presidents — Obama no less than others, despite shrill cries that he is “anti-business” — have fallen over themselves to apologize for the regulators’ meddlesomeness. The Hands Off approach to market wickedness is now fully enshrined in the American psyche. “Enshrined,” as in, “Holy.”
The religion of Free Market Capitalism, as articulated by the Fed — Our Father of the Perpetual Easing — continues to promulgate the doctrine of Sola Fide — By Faith Alone — which we trace in its current form to the presidency of Ronald Reagan. Reagan was not the Force that drove our society to its current state but, like the Silver Surfer, he rode the Power Cosmic of the Zeitgeist and left the world changed forever in his wake.
The defeat of the 1978 labor reform bill represents a major turning point in our history. Designed to broaden the influence of organized labor, the bill passed the House and enjoyed majority support in the Senate. But organized Business proved more powerful than organized labor, and a major campaign brought about a filibuster that ultimately killed the bill. Since that time, labor has succeeded by recasting itself in the image of its nemesis, Big Business. By the time of the automotive industry bailout, the only way you could tell the union official was by the moustache. Fade out, Jimmy Carter — fade in, Ronald Reagan, and in short order all social and political discourse was cast in the language of dollars, as opposed to social outcomes. Economics is to Science as Painting is to Biology: it produces something that looks lifelike, yet it fails the test of reality. Nonetheless, Economics is now enshrined as the Power Cosmic driving political decisions. The fundamental economic trope is that human behavior is driving by decisions that seek to optimize outcomes. This is a useful analytical tool for understanding social phenomena. But these Outcomes are now always and only expressed in terms of dollars. Should we try to save the planet? — How much will it cost in foregone profits? Should we prevent a nation from destroying itself and its neighbors in a genocidal war? — How much will our military engagement cost? Should we insist that our Middle Eastern allies promote human rights and a free press? — How will that affect the price of oil? Anyone who doubts this need look no further than the state of public education and health care in The Greatest Country on Earth. Improve our public schools? Who’s gonna pay for it?
It may be no accident that America, established on Judeo-Christian principles as understood by our Protestant Founders, believes that in order to succeed, it is necessary — and perhaps sufficient — to have faith in the free market. The doctrine of Sola Fide — Only Faith — particularly significant in Protestant doctrine, holds that God’s salvation is attained solely through faith. In its maximalist form, the doctrine dispenses entirely with the notion of Good Works, saying that Faith alone will bring salvation. Similarly, the Reaganomics doctrine of Trickle Down Economics assures us that it is a Good Thing when the rich get richer, because the mysterious workings of the Free Market will cause their wealth to spill over, benefitting all. We leave it to historians and other social scientists to tease apart the skein of Protestantism and Free Market Capitalism, but we suggest this is potentially fecund ground.
As a corollary notion, anyone who acts against the unfettered operation of the market is not merely mistaken, but may actually be violating the proper working of society. A disturbing study of the relationship between free market capitalism and the police state is presented by University of Chicago professor Bernard Harcourt in his new book The Illusion of Free Markets: Punishment and the Myth of Natural Order, which posits a parallel development of a state-manipulated market that is called “free,” together with harsh punishments imposed on those who defy the state’s often arbitrary principles. While Professor Harcourt sometimes stretches to make a point, his fundamental thesis is chilling and cries out for deeper study.
And what happens when acolytes of the inner temple of Capitalism challenge the infallibility of the holy overseers of Opus Foro — the Work of the Marketplace? Thus Sunday’s New York Times Magazine (10 July, “Sheila Bair’s Bank Shot”) features an exclusive “exit interview” with the newly departed head of the FDIC — journalist Joe Nocera points out that the only two senior regulators to have been characterized by Cabinet officials as “not team players” are Bair and Brooksley Born. To this we might add Elizabeth Warren, the latest victim of the Grand Inquisitors of Washington. These officials all committed the cardinal sin of insisting that the purpose of market regulation is to protect participants in the marketplace by preventing large players from taking excessive risks, the consequences of which would be borne by unwitting individuals — ultimately, the taxpayers.
Judging from the news streaming out of Washington, it appears that Dodd-Frankenstein — feeble creature that it is — may be smothered on the very slab upon which it was patched together. Bair expresses her overall approval of the bill, but sees a gaping abyss in the regulatory process that saved Bear Stearns and paid AIG bondholders and counterparties 100 cents on the dollar, while permitting millions of Americans to lose their homes. It is lost neither on Ms. Bair, nor on us, that those homeowners were led to their mortgages through aggressive “chicken in every pot” government programs — nor that the CEO’s of the entities that imploded got paid, while the homeowners got shoved out onto the sidewalks. Bair says the industry “didn’t think borrowers were worth helping.” Clearly, the industry, not We The People, had Washington’s ear.
We find it chilling that senior government officials who try to make regulations work for everyone are made marginal (Bair), called villains (Born), and accused of systematic dishonesty (Warren). More chilling still is the lack of vehement support for these unpopular views. While economics may be, at best, a pseudo-science, Born and Bair’s predictions proved horribly prophetic.
Whither, at this juncture, Ms. Bair? Some of our Broad Street Irregulars think her a logical next choice to head up the SEC. We think this would be a shame. The SEC is a failed agency. Its standout squad is Enforcement, thanks to Robert Khuzami and his team, and his close connections with the Justice Department. The oversight, audit and investigative functions are so rife with deadwood, so encumbered by decades of failure as to not be salvageable. The agency is, to coin a phrase, Too Failed to Get Big. Republican opponents of the SEC are barking up the wrong tree by trying to deny them their budget. Rather than cut funding, they should insist that the Commission cut 80% of its staff and replace them with Wall Street executives. Loyal readers of the Screed will roll their eyes, as we have flogged this deceased dray in the past. Fear not, we shall not perseverate.
We have the highest regard for Ms. Bair. She showed how a true public servant is supposed to behave. Though she irked the Old Boys, even Hank Paulson had to concede that she tenaciously did her job, which was to advocate for protection for individual depositors. She deserves far better than to be stuffed into a regulatory backwater.
Speaking of people who may not have done their job, word is that Secretary Geithner may be looking to move on. Business Insider, for example, believes he may go once the debt ceiling debate is over (1 July, “Dear Tim Geithner, Meet Your Replacement”). Business Insider is the successful website and blog launched by disgraced former Merrill Lynch analyst (and, full disclosure, Yale graduate) Henry Blodgett. The site used to have a feature called the “Geithner to Goldman Countdown Clock,” though we haven’t seen it updated in a while. Perhaps Blodgett has figured out that Goldman wouldn’t touch the soon-to-be-former Secretary with a ten foot T-Bill. After all, what can Geithner do for Goldman Sachs? Get Hank Paulson on the phone?
Business Insider appears to have gotten one other key bit of information wrong. On their Geitner page they list him as “current US Secretary of the Treasury in the Obama Administration, and an economist.” But the whole world has Geithner on record as telling Slate “I’m not an economist.” Clearly someone has the wrong end of this particular stick.
With all the commotion in the Obama administration, it looks as though soon he may have no one left to screw things up. Call us hopeless optimists, but we think a Treasury Secretary Bair would be the right call.
If Obama thinks he still Can, he should take radical steps. Faint heart never won fair lady, nor a second term. Obama could send a very clear message by appointing someone with Bair’s clear cut dedication to what is right, coupled with her obvious record of success. We think he is more likely to retreat to the inner sanctum and bow to the inquisitors of Opus Fora. Too bad for us, we say. And ultimately, too bad for him. Contemplating his team’s handling of the economy, President Obama should have a cushion embroidered with another famous Stengelism: “Don’t cut my throat. I may want to do that later myself.”
Transparency, that guarantor of market integrity, doesn’t always stay ahead of the curve. Observers of the securities markets should not be surprised by a new study that implies that the Bad Guys keep pace with upgrades in market transparency. If anything, they appear to find them quite useful. Readers who are astonished at the possibility may wish to take a liedown, followed by large quantities of strong whisky.
In response to increased market activity, the exchanges this month expanded the transparency of the Consolidated Quote System (CQS), the central facility that displays quotes across all trading markets. The CQS is the basis for the regulatory requirement of providing customers with best executions — defined broadly as the national best bid and offer (NBBO). Executing an order at the NBBO means that customer bought or sold at the most advantageous price currently available in the marketplace. At least in theory.
Under the notion that the purpose of regulation is to ensure a level playing field, the SEC introduced Regulation NMS (National Market System) whose purpose was to ensure that all customer orders were routed to the NBBO, no matter where that was, by creating complete transparency across all national trading venues, as displayed in the CQS.
There is no “stock market” — there are actually multiple markets. Shares of companies listed on the NYSE or Nasdaq also trade secondarily on each other’s exchanges, on regional and global exchanges, and in private venues such as Instinet, and in the dark pools where larger institutional orders are matched. The purpose of Reg NMS was to require exchanges to route customer orders for execution to the trading venue displaying the best price at the moment the order was received. Reg NMS defines compliance as not holding up an order for longer than one second, a definition that cries out for abuse.
In the brave new world of computerized trading, the exchanges displayed customer orders for half a second, called Flash Orders, visible only to members. High-speed traders could execute a flash order and still leave half a second for the exchange to route the unfilled portion of the order to another venue. Proponents of Flash Orders insist that they provide customers better prices than those foreseen by Reg NMS, because the price limit on flash orders had to be better than the price on the secondary exchange. Opponents had two complaints. One is that flash orders are a Members Only facility, so prices are not seen in the broad marketplace, which goes against the regulatory definition of market transparency. The second is that high frequency trading (HFT) firms can game the system by executing a flash order at a better price than currently shown in the market, then flipping it to a customer at a price that enables the HFT firm to pocket a few pennies, even if it is better than the NBBO price.
Last week, in a bid to increase transparency, the exchanges increased the capacity of the Consolidated Quote System by one-third. Market research firm Nanex studied the effect on trading traffic of enhancements to the CQS. Responding to market volume, the CQS through-put capacity was expanded to one million quotes per second — a capacity that was overloaded immediately on the very first trading day. Nanex’ analysis says quote volume of this magnitude should signal “the greatest bull or bear market ever known,” but prices stagnated or showed minor and directionless moves in response to the increased flow of orders. Nanex found the surge in quote volume had no correlation to price moves, and “a significant percentage of those quotes will have already expired before they even leave the exchange network.” This is potentially important because it may signal a group of firms intent on manipulating the CQS quotes so they can trade on quote information that has not yet reached the market.
Market participants believe this is the work of “secretive hedge funds” — their expression, not ours. Using direct data feeds from the exchanges, these firms obtain real-time prices from the exchanges themselves. They then flood the CQS with orders, most of which are either immediately cancelled, or allowed to expire — the whole process takes less than a second. By overloading the CQS capacity, they supposedly slow down the publicly disseminated quote, giving them several milliseconds’ lead time to execute at the price on the primary exchange before trades are done versus the CQS price.
Traders call this “latency arbitrage,” where professionals trade the difference between the actual price shown on the primary exchange where a stock trades, and the price reflected in the millisecond delay on the CQS — the price off of which the customer’s order must be filled under Reg NMS..
Retail investors have been allowed into the rarified world of institutional products and strategies over the years as these strategies became less attractive to the professionals. It is the natural order on Wall Street that a professional comes up with a brilliant idea and makes lots of money until so many people are doing the same thing that there is no longer a meaningful profit opportunity, at which point it gets thrown open to the private investor. This happened with ETFs and hedge funds, which are now available to retail investors, and it has now come to Dark Pools — the once sacrosanct home of reclusive Big Money.
The Financial Times reports (7 July, “Citi Plans ‘Dark Pool’ To Link HTFs And Smaller Investors”) Citigroup is planning to launch a new platform where HFTs can trade directly with retail investors. The story says brokers are looking for ways to replace lost commission business and says “the average order size on most dark pools has become not much larger than those on public exchanges” as HFTs and algorithmic traders increasingly do their business in the dark.
The article cites studies that show “retail investors frequently miss out on the best price,” and says market participants complain that “retail brokers’ best execution policies favour big exchanges.” This statement is disingenuous: the exchange-displayed quotes — seen in the CQS — are the benchmark for Best Execution. Therein may lie an undisclosed rub for the retail investor, as the same high-frequency trader who executes your retail order in the dark pool may be gaming quotes in the public marketplace by stuffing orders into the CQS.
Here’s the good news: no one is suggesting there is widespread fraud. Here’s the bad news: it is impossible to track. It takes one powerful computer, but next to no trading capital to enter and cancel several thousand orders in the course of a millisecond. Seventy percent of today’s stock trading is done by algorithms, and legitimate traders enter multiple orders as they compete for the best prices with thousands of others like themselves. Most legitimate orders are either canceled — because they get executions in other venues — or expire unexecuted. Looking for bogus quote stuffers is worse than the proverbial needle in the haystack — it’s looking for the needle in a stack of needles.
Give ‘em the fist, give ‘em the wrist, give ‘em the finger!
- The Inspector General (starring Danny Kaye)
The SEC inspector general’s office, headed by David Kotz, says the Commission doesn’t keep tabs on firms’ regulatory compliance (Washington Post, 30 June, “SEC Lax In Monitoring Firms’ Compliance, Inspector General Report Says”). In fact, the report finds that the Commission even lacks a formal process for monitoring firms’ adherence to the terms of regulatory settlements and says examiners rarely focus on the issue, even when examining firms operating under a consent decree or other regulatory constraint. Some view this report as the latest in “The Collected Works of David Kotz,” citing earlier criticism of the Commission for failing to catch Madoff, for leasing office space it didn’t have the money to pay for, and for failing to prevent staffers from using the agency’s computers to download pornography.
The report cites the Commission’s practice of granting exemptions, either through suspending imposition of a rule — such as the 2010 relief granted to the rating agencies under Dodd-Frank — or through the issuance of no-action letters, often granted to a specific firm, but then broadly applied by industry practitioners. The IG report finds that the Commission does not track firms to ensure they comply with the terms of a no-action letter, and says “significant violations of the securities laws” may result, as some firms take the exemption, but fail to implement the attendant requirements. The report says many SEC staffers take the view that, once an exemption has been granted, the risk has been reduced. In fact, says the report, such exemptions are risk factors and merit higher scrutiny.
The SEC’s written response to the IG’s report says they “generally agree with the recommendations.” They also say that much of what is proposed would require “significant resources” to implement — as in the budget increase that Congress seems bent on denying them. Defending their position, the SEC staff said that companies that seek relief “do so because they are attuned to compliance issues.” Forgive our cynicism, but this means that firms ask the SEC to give them an exemption from a rule because they don’t want to have to comply with that rule. Since the firm’s lawyers are almost always better paid, more experienced, and smarter than the Commission lawyers, they often get what they want. And what are the chances that, even if you don’t stick to the terms of the exemption, the Commission won’t ever find out? Ask any of the former SEC attorneys now working for Wall Street firms. They’ll be happy to tell you. For a fee.
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