Topic: Finance, Banking & Monetary Policy

Reflections on High Frequency Trading

Here are a few thoughts on high frequency trading [HFT] – not a thorough analysis of the problems and solutions, but rather a brief outline to encourage further discussion.

What is HFT?

The modern version of HFT, as described by Malkiel and Leavitt in an April 11 Wall Street Journal op-ed, “involves the placement of high-speed computers in close proximity to stock-market servers to give some participants the ability to buy and sell stocks faster than the blink of an eye.”  The favored participant purchases early access to information from either a public exchange or a so-called dark pool, which is essentially a private exchange established by investment banks.  With privileged access, the HF trader can learn of a pending order before it is executed, and then earn a small profit by buying or selling ahead of the order.  For example, a sell order exists at $100.00; an HF trader learns of a pending buy order at $100.02, which allows the HF trader to earn $.02 by first buying at $100.00 then selling at $100.02.

What are the pluses and minuses of HFT?

Benefits of HFT can include market efficiency, increased liquidity, and lower transactions costs.  To illustrate: Assume orders have been placed to sell 5,000 shares of XYZ at $15.02 and 5,000 shares at $14.94.  Assume further, a pending buy order for a minimum of 10,000 shares at $15.00.  The HF trader, acting as market-maker, might buy 10,000 shares from the two sellers at an average price of $14.98 and re-sell the shares to the buyer for $15.00.  The result would be a narrowed bid-asked spread, reduced trading costs, increased volume, and enhanced liquidity.

On the other hand, as Malkiel and Leavitt point out, HFT is a form of insider trading known as front-running whereby “optimally positioned traders can see trade orders from other investors before they are executed.  They can execute a purchase just ahead of those orders and run the price up just a bit, pocketing the difference.”  In addition, HFT has been blamed for increased market volatility.

Revisiting Central Clearing for Derivatives

The Dodd-Frank requirement that over-the-counter derivatives be centrally cleared is one of the (slightly) less controversial provisions of the Act, at least in spirit if perhaps not always in substance. But for a time, a few observers have worried - myself included - that concentrating derivatives clearing activities in one or two single-purpose entities may increase, rather than reduce, the risk to the broader economy posed by the default of a counterparty.

As it turns out, we skeptics are not alone. In yesterday’s Wall Street Journal, the good folks at BlackRock are cited as having raised concerns in a recent study about the lack of clarity regarding where the risk ultimately falls in the event of default by a large counterparty. Banks and investors want the clearinghouses themselves to backstop some of this risk. The BlackRock study notes that “post-crisis rules have forced a large swath of risky trades… and this risk needs to be addressed.”

It is perhaps, therefore, a good time to hark back to Craig Pirrong’s Cato Policy Analysis from 2010, released on the day the Act was signed into law. In it, Mr. Pirrong argues that central clearing leads to better and more efficient risk pricing ONLY if the clearinghouse has perfect information. He notes the risk sharing that occurs through the clearinghouse mechanism encourages excessive risk taking, which creates moral hazard. Pirrong also highlights that “if the clearinghouse has imprecise information, the margin levels it chooses will sometimes overly constrain the trading of its members and sometimes constrain them too little…all of these factors mean that it is costly for the clearinghouse to control moral hazard.” As Pirrong notes, a clearing mandate reduces market efficiency and poses “its own systemic risks in a world where information is costly.”

One of the major criticisms of the previous or “bilateral” approach to derivatives clearing was that banks and investors could not adequately monitor their own risk exposure to counterparties (with some side complaints about banks mispricing risk etc.). However, as the BlackRock study notes, it is not clear that the central clearing approach addresses this concern, especially since the rules governing outcomes in the event of a major default have yet to be finalized. In particular, if a major counterparty defaults and the clearinghouse is not holding sufficient collateral to cover that counterparty’s trades, who loses out? Is it the members? The Federal Reserve? (Remember, one of the Board’s first actions under Dodd-Frank was to allow clearinghouses to borrow at the discount window in the same way that commercial banks do). Will the clearinghouse perhaps declare bankruptcy (and, if so, what impact will the failure of a major utility have on operational stability)?

More importantly, just when counterparties have realized these products must be treated with caution, the system is incentivizing the market participants with the best information (the members) to pool and therefore increase the riskiness of their activities. Derivatives are an important economic tool and vital to most companies’ (financial or otherwise) risk management. But we should not assume that the framework created by Dodd-Frank will eliminate risk in the derivatives trade, real or perceived.

FSOC’s Failing Grade?

All the recent hype over the legitimacy of high frequency trading has overshadowed another significant event in financial regulation: In a speech in Washington, D.C., yesterday Securities and Exchange Commissioner Luis Aguilar offered some fairly strong criticisms of recent actions by the Financial Stability Oversight Council (FSOC). The speech was significant because it is the first time that a Democratic commissioner has criticized the actions of one of the Dodd-Frank Act’s most controversial creations. (To date, only the Republican commissioners have criticized the FSOC, and we all know that Republicans don’t much like Dodd-Frank.) Indeed, Aguilar’s statements indicate just how fractured and fragmented the post-Dodd-Frank “systemic risk monitoring” system is.

At issue is the FSOC’s recent foray into the regulation of the mutual fund industry. Aguilar described the FSOC’s actions as “undercut(ting)” the SEC’s traditional authority and described a major report on asset management by the FSOC’s research arm, the Office of Financial Research, as “receiv(ing) near universal criticism.”

He went on to note that “the concerns voiced by commenters and lawmakers raise serious questions about whether the OFR’s report provides (an) adequate basis for the FSOC to designate asset managers as systemically important … and whether OFR is up to the tasks called for by its statutory mandate.”

For those of us who have been following this area for a while, the answer to the latter question is a resounding “no”. The FSOC claims legitimacy because the heads of all the major financial regulatory agencies are represented on its board. Yet it has been clear for a while that the FSOC staff has been mostly off on a frolic of its own.

Aguilar notes that the SEC staff has “no input or influence into” the FSOC or OFR processes and that the FSOC paid scant regard to the expertise or industry knowledge of the traditional regulators. Indeed, the preliminary actions of the FSOC in determining whether to “designate” mutual funds as “systemic” echoes the Council’s actions in the lead-up to its designation of several insurance firms as “Systematically Important Financial Institutions” that are subject to special regulation and government protection. It should be remembered that the only member of the FSOC board to vote against the designation of insurance powerhouse Prudential as a “systemic nonbank financial company” was Roy Woodall, who is also the only board member with any insurance industry experience. And in the case of mutual funds and asset managers, the quality of the information informing the FSOC’s decisions—in the form of the widely ridiculed OFR study—is even weaker. The process Aguilar describes, where regulatory agencies merely rubber stamp decisions made by the FSOC staff, is untenable (in part because the FSOC staff itself has no depth of experience, financial or otherwise).

Aguilar’s comments could be viewed as the beginning of the regulatory turf war that was an inevitable outcome of Dodd-Frank’s overbroad and contradictory mandates to competing regulators. But the numerous and well documented problems with the very concept of the FSOC means that it is time for Congress to pay some attention to Aguilar’s comments and rein in the FSOC’s excessive powers. 

IRS Shouldn’t Force Taxpayers Into Tax-Maximizing Transactions

While tax evasion is a crime, the Supreme Court has long recognized that taxpayers have a legal right to reduce how much they owe, or avoid taxes all together, through careful tax planning. Whether that planning takes the form of an employee’s deferring income into a pension plan, a couple’s filing a joint return, a homeowner’s spreading improvement projects over several years, or a business’s spinning-off subsidiaries, so long as the actions are otherwise lawful, the fact they were motivated by a desire to lessen one’s tax burden doesn’t render them illegitimate.

The major limitation that the Court (and, since 2010, Congress) has placed on tax planning is the “sham transaction” rule (also known as the “economic substance” doctrine), which, in its simplest form, provides that transaction solely intended to lessen a commercial entity’s tax burden, with no other valid business purpose, will be held to have no effect on that entity’s income-tax assessment. The classic sham transaction is a deal where a corporation structures a series of deals between its subsidiaries, producing an income-loss on paper that is then used to lower the parent company’s profits (and thus its tax bill) without reducing the value of the assets held by the commercial entity as a whole.

We might quibble with a rule that effectively nullifies perfectly legal transactions, but a recent decision by the U.S. Court of Appeals for the Eighth Circuit greatly expanded even the existing definition of “economic substance,” muddying the line between lawful tax planning and illicit tax evasion. At issue was Wells Fargo’s creation of a new non-banking subsidiary to take over certain unprofitable commercial leases. Because the new venture wasn’t a bank, it wasn’t subject to the same stringent regulations as its parent company. As a result, the holding company (WFC Holdings Corp.) was able to generate tens of millions of dollars in profits.

Will Republicans Make a Principled Stand Against Ex-Im Reauthorization in 2014?

Jobs are good. Exports create jobs. We create exports. Renew our charter.

Such is the essence of the marketing pitch of the U.S. Export-Import Bank, whose officials have begun ramping up their lobbying efforts ahead of a 2014 vote concerning reauthorization of the Bank’s charter, which expires in September.  Last go around, in 2012, Ex-Im ran into some unexpected turbulence when free-market think tanks, government watchdog groups, and limited government Republicans in Congress raised some compelling – but ultimately ignored – objections to reauthorization.

The ostensible purpose of the Ex-Im Bank is to assist in financing the export of U.S. goods and services to international markets. Even if that were a legitimate role of government, the public must keep a watchful eye on how much and to whom loans are made – especially given the current administration’s tendency to bet big on particular industries and specific firms, and in light of its commitment to seeing U.S. exports reach $3.14 trillion in 2014.

From the U.S. Export-Import Bank’s 2013 Annual Report:

The Ex-Im Bank’s mission is to support American jobs by facilitating the export of U.S. goods and services. The Bank provides competitive export financing and ensures a level playing field for U.S. exporters competing for sales in the global marketplace. Ex-Im Bank does not compete with private-sector lenders but provides export financing that fill gaps in trade financing. The Bank assumes credit and country risks that the private sector is unable or unwilling to accept. It also helps to level the playing field for U.S. exporters by matching the financing that other governments provide to their exporters. The Bank’s charter requires that the transactions it authorizes demonstrate reasonable assurance of repayment.

The defensive tone of this mission statement anticipates Ex-Im critics’ objections, but it certainly doesn’t answer them. The objectives of filling gaps in trade financing passed over by the private sector and expecting a reasonable assurance of repayment are mutually exclusive – unless the threshold for “reasonable assurance” is more risk-permissive than the private-sector’s most risk-permissive financing entities.  Therefore, Ex-Im is either putting taxpayer resources at risk or it is competing directly with private-sector lenders for customers in need of finance. And if the latter, then as it seeks to create the proverbial “level playing field” for the U.S. companies whose customers it finances, Ex-Im is un-leveling the playing field for the finance industry, as well as for the U.S. firms in industries that compete globally with these U.S-taxpayer financed foreign companies.

Tax Reform Error #1: Confusing Tax Expenditures with Revenues

House Ways and Means Chairman Dave Camp has released a complex 182-page “discussion draft” called The Tax Reform Act of 2014. Rather get bogged down in details, I will take this opportunity to review several fundamental errors that repeatedly plagued most past and present efforts to reform the federal income tax, including the Camp proposal.

One of the most pernicious errors among would-be tax reformers is to assume that, as the Tax Policy Center asserts, “tax expenditures are revenue losses” attributable to various “loopholes.” On the contrary, the Joint Committee on Taxation (JCT) clearly states that the estimated dollar value of any “tax expenditure … is not the same as a revenue estimate for the repeal of the tax expenditure provision.” As the JCT explains, “unlike revenue estimates, tax expenditure calculations do not incorporate the effects of the behavioral changes that are anticipated to occur in response to the repeal of a tax expenditure provision…. Taxpayer behavior is assumed to remain unchanged for tax expenditure estimate purposes … to simplify the calculation.”

One glaring difference between revenue estimates and tax expenditure estimates involves taxation of capital gains if those gains are realized by selling assets from a taxable account (unlike IRAs or most home sales). Estimated tax expenditures from not taxing realized capital gains at the top income tax rate of 43.4 percent is listed as a big revenue-losing tax expenditure, even though Treasury, the JCT and the Congressional Budget Office (CBO) revenue estimates would rightly predict that the behavioral response to such a high tax would crush asset sales and thus lose revenue. 

Mainly because the artificially estimated “tax expenditure” from a lower capital gains tax is wrongly equated with estimated revenues, the Simpson-Bowles plan hopes to raise an extra $585 billion over ten years. In reality, investors realize fewer gains when the tax rate goes up, so the higher tax on fewer transactions means revenues fall rather than rise.

Will Venezuela Be Next?

Last year, Nicholas Krus and I published a chapter, “World Hyperinflations”, in the Routledge Handbook of Major Events in Economic History. We documented 56 hyperinflations – cases in which monthly inflation rates exceeded 50% per month. Only seven of those hyperinflations have savaged Latin America (see the accompanying table).

At present, the world’s highest inflation resides in Latin America, namely in Venezuela. The Johns Hopkins – Cato Institute Troubled Currencies Project, which I direct, estimates that Venezuela’s implied annual inflation rate is 302%. Will Venezuela be the eighth country to join the Latin American Hall of Shame? Maybe. But, it has a long way to go.

The Hanke-Krus Hyperinflation Table
Latin American edition

Country Month With Highest Inflation Rate Highest Monthly Inflation Rate Equivalent Daily Inflation Rate Time Required for Prices to Double
1. Peru Aug. 1990 397% 5.49% 13.1 days
2. Nicaragua Mar. 1991 261% 4.37% 16.4 days
3. Argentina Jul. 1989 197% 3.69% 19.4 days
4. Bolivia Feb. 1985 183% 3.53% 20.3 days
5. Peru Sep. 1988 114% 2.57% 27.7 days
6. Chile Oct. 1973 87.6% 2.12% 33.5 days
7. Brazil Mar. 1990 82.4% 2.02% 35.1 days

Source: Steve H. Hanke and Nicholas Krus (2013), “World Hyperinflations”, in Randall Parker and Robert Whaples (eds.) Routledge Handbook of Major Events in Economic History, London: Routledge Publishing.