Results for “private equity”
114 found

The case for real estate as investment

That is the topic of my latest Bloomberg column, here is one bit:

The authors of the aforementioned study — Òscar Jordà, Moritz Schularick and Alan M. Taylor — have constructed a new database for the U.S. and 15 other advanced economies, ranging from 1870 through the present. Their striking finding is that housing returns are about equal to equity returns, and furthermore housing as an investment is significantly less risky than equities.

In their full sample, equities average a 6.7 percent return per annum, and housing 6.9 percent. For the U.S. alone, equities return 8.5 percent and housing 6.1 percent, the latter figure being lower but still quite respectable. The standard deviation of housing returns, one measure of risk, is less than half of that for equities, whether for the cross-country data or for the U.S. alone. Another measure of risk, the covariance of housing returns with private consumption levels, also shows real estate to be a safer investment than equities, again on average.

One obvious implication is that many people should consider investing more in housing. The authors show that the transaction costs of dealing in real estate probably do not erase the gains to be made from investing in real estate, at least for the typical homebuyer.

Furthermore, due to globalization, returns on equities are increasingly correlated across countries, which makes diversification harder to achieve. That is less true with real estate markets, which depend more on local conditions.

Do read the whole piece.

The Peltzman Model of Regulation and the Facebook Hearings

If you want understand the Facebook hearings it’s useful to think not about privacy or  technology but about what politicians want. In the Peltzman model of regulation, politicians use regulation to tradeoff profits (wanted by firms) and lower prices (wanted by constituents) to maximize what politicians want, reelection. The key is that there are diminishing returns to politicians in both profits and lower prices. Consider a competitive industry. A competitive industry doesn’t do much for politicians so they might want to regulate the industry to raise prices and increase firm profits. The now-profitable firms will reward the hand that feeds them with campaign funds and by diverting some of the industry’s profits to subsidize a politician’s most important constituents. Consumers will be upset by the higher price but if the price isn’t raised too much above competitive levels the net gain to the politician will be positive.

Now consider an unregulated monopoly. A profit-maximized monopolist doesn’t do much for politicians. Politicians will regulate the monopolist to lower prices and to encourage the monopolist to divert some of its profits to subsidize a politician’s most important constituents. Monopolists will be upset by the lower price but if the price isn’t lowered too much below monopoly levels the net gain to the politician will be positive. (Moreover, a monopolist won’t object too much to reducing prices a little since they can do that without a big loss–the top of the profit hill is flat).

With that as background, the Facebook hearings are easily understood. Facebook is a very profitable monopoly that doesn’t benefit politicians very much. Although consumers aren’t upset by high prices (since Facebook is free), they can be made to be upset about loss of privacy or other such scandal. That’s enough to threaten regulation. The regulatory outcome will be that Facebook diverts some of its profits to campaign funds and to subsidize important political constituents.

Who will be subsidized? Be sure to watch the key players as there is plenty to go around and the money has only begun to flow but aside from campaign funds look for rules, especially in the political sphere, that will raise the costs of advertising to challengers relative to incumbents. Incumbents love incumbency advantage. Also watch out for a deal where the government limits profit regulation in return for greater government access to Facebook data including by the NSA, ICE, local and even foreign police. Keep in mind that politicians don’t really want privacy–remember that in 2016 Congress also held hearings on privacy and technology. Only those hearings were about how technology companies kept their user data too private.

Email exchange on bank leverage, regulation, and economic growth

Emailed to me:

What do you think would happen if we returned to a world where commercial bank leverage was much reduced? (E.g. 2X max.) Or, maybe equivalently, if central banks didn’t act as a lender of last resort? Is that “necessary” for a modern economy?

Asset prices would fall a lot (presumably). What else? How much worse off would current people become? (Future people are presumably somewhat better off, growth implications notwithstanding—they are less burdened with the other side of all these out-of-the-money puts that central banks have effectively issued.) > > How should we think about the optimization space spanning growth rates, banking capital requirements, and intergenerational fairness?

My response:

First, these questions are in those relatively rare areas where even at the conceptual level top people do not agree. So maybe you won’t agree with my responses, but don’t take any answers on trust from anyone else either.

I think of the liquidity transformation of banks in terms of two core activities:

a. Transforming otherwise somewhat illiquid activities into liquid deposits. That boosts risk-taking capacities, boosts aggregate investment, and makes depositors more liquid in real terms. Those are ex ante gains, though note that more risk-taking, even when a good thing, can make economies more volatile.

b. Giving private depositors more nominal liquidity, but in a way that raises prices and thus doesn’t really increase real, inflation-adjusted liquidity for depositors as a whole. There is thus a rent-seeking component to bank activity and liquidity production.

Less bank leverage, you get less of both. In my view a) is usually much more important than b). For those who defend narrow banking, 100% fractional reserves, or just extreme capital requirements, a) is usually minimized. Nonetheless b) is real, and it means that some partial, reasonable regulation won’t wreck the sector as much as it might seem at first.

There is however another factor: if bank leverage gets too high, bank equity takes on too much risk, to take advantage of bank creditors and possibly taxpayers too. Or too much leverage can make a given level of bank manager complacency too socially costly to bear. This latter factor seems to have been very important for the 2007-2008 crisis.

So bank leverage does need to be regulated in some manner, and the better it is regulated the more the system can dispense with other forms of regulation.

That said, the delta really matters. Requiring significantly less bank leverage, at any status quo margin, probably will bring a recession. The recession itself may make banks riskier than the lower leverage will make them safer. In this sense many economies are stuck with the levels of leverage they have, for better or worse. It is not easy to pop a “leverage bubble.”

I don’t find the idea of 40% capital requirements, combined with an absolute minimum of regulation, absurd on the face of it. But I don’t see how we can get there, even for the future generations. We’ll end up doing too many stupid things in the meantime; Dodd-Frank for all its excesses could have been much worse.

I also worry that 40% capital requirements would just push leverage elsewhere in the economy. Possibly into safer sectors, but I wouldn’t be too confident there. And reading any random few books on “bank off-balance sheet risk” will scare the beejesus out of anyone, even in good times.

Now, you worded your question carefully: “commercial bank leverage was much reduced.”

A lot of commercial bank leverage can be replaced by leverage from other sources, many less regulated or less “establishment.” Overall, on current and recent margins I prefer to keep leverage in the commercial banking sector, compared to the relevant alternatives. It may be less efficient but it is socially safer and held within the Fed’s and FDIC regulatory safety net, probably the best of the available politicized alternatives. That said, there is a natural and indeed mostly desirable trend for the commercial banking sector to become less important over time, in part because it is regulated and also somewhat static in basic mentality. (Note that the financial crisis interrupted this process, for instance Goldman taking up a bank charter. I would still bet on it for the longer run.)

Obviously, VC markets are a possible counterfactual. This all gets back to Ed Conard’s neglected and profound point that “equity” is what is scarce in economies, and how many troubles stem from that fact. Ideally, we’d like to organize much more like VC markets, partly as a substitute for bank leverage and the accompanying distorting regulation, and maybe we will over time, but there is a long, long way to go.

One big problem with attempts to radically restrict bank leverage is that they simply shift leverage into other parts of the economy, possibly in more dangerous forms. Should I feel better about commercial credit firms taking up more of this risk? Hard to say, but the Fed would not feel better about that, it makes their job harder. This gets back to being somewhat stuck with the levels of leverage one already has, until they blow up at least. There are pretty much always ways to create leverage that regulators cannot so easily control or perhaps not even understand. Again this bring us back to “off-balance risk,” among other topics including of course fintech.

I view central banks as “lenders of second resort.” The first resort is the private sector, the last resort is Congress. I favor empowering central banks to keep Congress out of it. Central banks are actually a fairly early line of defense, in military terms. And I almost always prefer them to the legislature in virtually all developed countries.

I fear however that we will have to rely on the LOLR function more and more often. Consider how it interacts with deposit insurance. If everything were like a simple form of FDIC-insured demand deposits, FDIC guarantees would suffice.

But what if a demand deposit is no longer so well-defined? What about money market funds? Repurchase agreements? Derivatives and other synthetic positions? Guaranteeing demand deposits is a weaker and weaker protection for the aggregate, as indeed we learned in 2008. The Ricardo Hausmann position is to extend the governmental guarantees to as many areas as possible, but that makes me deeply nervous. Not only is this fiscally dangerous, I also think it would lead to stifling regulation being applied too broadly.

But relying more and more on LOLR also makes me nervous. So I view this as a major way in which the modern world is headed for recurring trouble on a significant scale, no matter what regulators do.

I am never sure how much of the benefits of banking/finance are “level effects” as opposed to “growth effects.” It is easy for me to believe that good banking/finance enables more consumption at a sustainably higher level, in part because precautionary savings motives can be satisfied more effectively and with less sacrifice. I am less sure that the long-term growth rate of the economy will rise; if so, that does not seem to show up in the data once economies cross over the middle income trap. That said, if there were an effect, since growth rates slow down with high levels in any case, I don’t think it would be easy to find and verify.

Revisiting why realized and expected volatility are so low

An email from Alebron:

Might it be worth revisiting this, since it’s been 3 years?

https://marginalrevolution.com/marginalrevolution/2014/06/is-there-a-paradox-of-low-market-volatility.html

Vol is low right now, lots of hand-wringing about it. Some possible factors:

– Shiller used to say the puzzle was that equity vol was so high (at least in the context of plausible DCF models). More money is now in the hands of “smart” market participants (certainly as a fraction of total trading volume this is true), and they overreact less to news.

– Stagnation/complacency. Or alternatively, all the action is in private firms (unicorns and the like). Firms only go/stay public if they are boring/stable.

– Consider a model where an industry has n firms, and some of them are mismanaged but investors don’t know which ones. Then any news about one of them reveals something about which are the good/bad ones. Suppose that the spread of (a) management consulting, (b) corporate regulation, and (c) efficiency due to information technology brings everyone towards the mean. Bad companies aren’t as bad as they used to be (they have access to competitors’ good ideas, Dodd-Frank/SOX/etc prevent egregious mis-management/mis-reporting, etc), and good ones aren’t as good (their good ideas leak out, they get saddled with unavoidable costs due to Dodd-Frank/SOX/etc). Thus, the value of news decreases, vol decreases.

– Trump of course. Pro-business, but more accurately pro-big-business, or pro-rent-seeking? I’m inclined to mostly dismiss this, since it’s not like vol cratered when he got elected. Vol has been pretty low for most of the last 5 years.”

– Does 1990s low-vol Japan have lessons?
Curious if you have other thoughts…

The excellent Samir Varma sends me this new article on VIX and volatility.  We all know there are models where volatility begets further volatility, if only because the initial big price moves make investors more wary, less willing to hold some positions, and more willing to bail out of others.  Perhaps we need a more in-depth study of how non-volatility begets further non-volatility.  When prices just aren’t moving by very much, maybe certain kinds of information get drained away, and it becomes harder to conclude that some position other than your status quo default position makes sense.

The market for truck drivers

Getting a signing bonus is often associated with top young athletes. Now, taking a job driving a chemical truck in the U.S. can earn you a signing bonus of as much as $5,000 — and then there are also recruiting bonuses, retention bonuses and safety bonuses.

Those are the tactics that Randy Strutz, president of Quality Carriers in Tampa, Florida, is using to fill positions as unemployment lingers near the lowest level since before the last recession. The situation is cropping up across more industries in the U.S., as businesses feel increasing pressure to offer better wages and incentives to attract workers.

“It’s been a challenge to get good, qualified drivers,” said Strutz, who supervises about 2,500 truckers at the company owned by private-equity firm Apax Partners. “I expect we’ll probably have to spend more money to find applicants.”

That is from Patricia Laya.  What does it say about the job prospects for the remaining able-bodied, male unemployed?  There has been some recent coverage of video games, and incarceration, now it is time for more consideration of “can’t pass a drug test.”

What is the opportunity cost of additional government borrowing?

No, it is not zero, not even if government borrowing rates were literally at zero.  Yet I’ve seen that claim a few dozen times in the last year or two, so let’s walk through some arguments that were fully standard by the 1970s.

Opportunity cost is ultimately defined in real resource terms, converted into value.  So if the government borrows more money and mobilizes robots to do some work, that means fewer robots to do work elsewhere.

So what is the marginal private rate of return on capital?  That’s a bottomless pit sort of question, but it’s not unusual to find sources which suggest a number for the average return in the range of 15% or so, see p..53 from this Stern School study here (pdf), with the median estimate running at about 12% (p.54).  The papers from the 1980s found about the same, sometimes higher.

That’s way too high, says this stagnationist!  Let’s instead cut it down to historic U.S. equity returns and say seven percent for the return at the margin.

Now, even today there are some unemployed resources.  But most government fiscal policy works through well-known, fairly large contractors that at the margin have already well-established networks of capital and labor.  So circa 2016, I don’t think that is a significant factor.  Even in more down times, fiscal policy doesn’t always target unemployed resources so well.

That means a government project faces a seven percent hurdle rate.  You may wish to up that for risk (the value of government output covaries positively with national income), and more yet for irreversibility.  Let’s say that brings us up to a ten percent hurdle rate, and that’s being quite conservative.  Sometimes irreversibility premia can multiply hurdle rates by 2x or 3x.

So that’s a (hypothetical) hurdle rate of ten percent, not zero percent.  Of course it’s not unusual for private companies to use hurdle rates of twenty or more for their investment decisions.

There are further complications if the borrowing is financed by foreign finance capital.  But there is still likely a real resource displacement in the home market as robots are shifted from one line of work to another.  In addition, foreign ownership of the debt is about one-third of the total, noting the average and marginal here may diverge.  Still, the domestic capital case seems to be the dominant effect.

You really can bicker about the right number here, and I’ve elided the question of whether some of the crowding out might come from consumption through a positive elasticity of robot supply; check the early papers of Martin Feldstein on related questions.  But if someone tells you zero percent is the correct hurdle rate for government infrastructure investment, they are wrong.

Opportunity cost remains an underrated idea in economics.

The verdict on the Fed’s interest rate hike

Good job, people.  Just to recap what has been my perspective, here is from my September post, The Paradox of No Market Response:

…the good news scenario is if the Fed’s decision doesn’t matter much for the markets.  Woe unto you if your economy is so fragile that a quarter point or so in the short rate, mixed in with some cheap talk, were to matter so much.

So if at first prices were to stay steady, following any Fed decision, then equities should jump in price.  That is the “no news is good news” theory, so to speak.  It’s a better state of the world if it is common knowledge that the Fed’s actions don’t matter so much in a particular setting.

Equity markets did in fact rise across most of the world, after a slight period of no reaction.  And I wrote:

If I were at the Fed, I would consider a “dare” quarter point increase just to show the world that zero short rates are not considered necessary for prosperity and stability.  Arguably that could lower the risk premium and boost confidence by signaling some private information from the Fed.

Someone at Bloomberg — I can no longer remember who — wrote at the time that this was the worst possible argument they ever had heard in favor of what the Fed was thinking of doing and subsequently did.  Was itOther commentators today have called this a “risk rally,” namely that fear of a prior risk seems to have diminished.

And to recap some broader points:

1. In most periods of crisis, central bankers are too reluctant to use expansionary monetary policy soon enough or strong enough.

2. However true that may be, it doesn’t describe our current situation.

3. Beware of models which rely too heavily on the Phillips curve, and two-factor “inflation rate vs. unemployment” considerations, especially in “long run” situations.  I don’t see that any of the commentators working in this tradition had good predictions this time around.

4. The successful “lift off” still probably won’t matter very much, but better a success than not.  Don’t think that America’s major economic problems somehow have gone away.

Swiss Referendum on 100% Reserves

A Swiss group has collected the 100,000 signatures necessary to require a national referendum on requiring banks to hold 100% reserves.

In a nut shell, the proposal extends the Swiss Federation’s existing exclusive right to create coins and notes, to also include deposits.  With the full power of new money creation exclusively in the hands of the Swiss National Bank, the commercial banks would no longer have the power to create money through lending. The Swiss National Bank’s primary role becomes the management of the money supply relative to the productive economy, while the decision concerning how new money is introduced debt free into the economy would reside with the government.

After interest in the 1930s Chicago plan of Fisher and Simons died off, Murray Rothbard and other libertarians were virtually the only people calling for 100% reserves. More recently, however, the idea has almost become mainstream. Consider Martin Wolf’s FT column:

Printing counterfeit banknotes is illegal, but creating private money is not. The interdependence between the state and the businesses that can do this is the source of much of the instability of our economies. It could – and should – be terminated.

…Banks create deposits as a byproduct of their lending. In the UK, such deposits make up about 97 per cent of the money supply. Some people object that deposits are not money but only transferable private debts. Yet the public views the banks’ imitation money as electronic cash: a safe source of purchasing power.

Banking is therefore not a normal market activity, because it provides two linked public goods: money and the payments network. On one side of banks’ balance sheets lie risky assets; on the other lie liabilities the public thinks safe. This is why central banks act as lenders of last resort and governments provide deposit insurance and equity injections. It is also why banking is heavily regulated. Yet credit cycles are still hugely destabilising.

What is to be done? A minimum response would leave this industry largely as it is but both tighten regulation and insist that a bigger proportion of the balance sheet be financed with equity or credibly loss-absorbing debt.

…A maximum response would be to give the state a monopoly on money creation. One of the most important such proposals was in the Chicago Plan, advanced in the 1930s by, among others, a great economist, Irving Fisher. Its core was the requirement for 100 per cent reserves against deposits. Fisher argued that this would greatly reduce business cycles, end bank runs and drastically reduce public debt. A 2012 study by International Monetary Fund staff suggests this plan could work well.

Similar ideas have come from Laurence Kotlikoff of Boston University in Jimmy Stewart is Dead, and Andrew Jackson and Ben Dyson in Modernising Money.

Hat tip on the Swiss proposal to Dirk Niepelt who offers further comment.

Refugee markets in everything

The annual report in 2013 from a multibillion-dollar London private-equity firm that counts a French pastry baker and a Dutch shoemaker among its holdings touted a new opportunity with “promising organic and acquisitive growth potential.”

That investment was the management of refugee camps.

“The margins are very low,” said Willy Koch, the retired founder of the Swiss company, ORS Service AG, which runs a camp in Austria that overflowed this summer with migrants who crossed from the Balkans and Hungary. “One of the keys is, certainly, volume.”

The WSJ story is here, or maybe here.  And here is a related business:

In Sweden, the government paid a language-analysis firm $900,000 last year to verify asylum-seekers’ claims of where they were from.

Look for more stories along these lines.  Hat tip goes to Hugo Lindgren.

My Tanner lecture comment on Elizabeth Anderson

I was pleased to have been invited to deliver one of the comments at Elizabeth Anderson’s Tanner lectures at Princeton a few weeks ago.  I have put the comment on my home page here.  I introduce the topic in this manner:

I won’t summarize her views, but I will pull out one sentence to indicate her stance: “Here most of us are, toiling under the authority of communist dictators, and we don’t see the reality for what it is.” These communist dictators are, in her account, private business firms. That description may be deliberately hyperbolic, but nonetheless it reflects her attitude that capitalist companies exercise a kind of unaccountable, non-democratic power over the lives of their workers, in a manner which she thinks is deserving of moral outrage.

Here is one bit from my response:

This may sound counterintuitive or even horrible to many people, but the economist will ask whether workers might not enjoy “too much” tolerance and freedom in the workplace, at least relative to feasible alternatives. For every benefit there is a trade-off, and the broader employment offer as a whole might involve too little cash and too much freedom and tolerance. To oversimplify a bit, at the margin an employer can pay workers more either with money or with freedom and tolerance, which we more generally can label as perks. Money is taxed, often at fairly high rates, whereas the workplace perks are not; that’s one reason why a lot of Swedish offices are pretty nice. It’s simple economics to see that, as a result, the job ends up with too many perks and not enough pay, relative to a social optimum. I doubt if our response to this distorting tax wedge, which can be significant, should be to increase the perks of the workers rather than focusing on their pay.

And:

In fact there are some reasons why labor-managed firms may give their workers less personal freedom. The old-style investment banking and legal partnerships expected their owner-members to adhere to some fairly strict social and professional codes, even outside the workplace. More generally, when workers are motivated to monitor each other, through the holding of equity shares, monitoring becomes easier and so corporations engage in more of it. Again, the main issue is not controlling bosses vs. freedom-seeking workers.

Do read the whole thing.

What will European QE look like? And will it work?

Claire Jones at the FT reports:

The European Central Bank is set to unveil a programme of mass bond buying next week to save the eurozone from deflation, but has bowed to German pressure to ensure that its taxpayers are not liable for any losses incurred on other countries’ debt.

This is not a surprise.  Alen Mattich had a good Twitter comment:

How could you trust ECB promise to “do whatever it takes” if it doesn’t accept the risk of holding national sov debt on its books?

Guntram B. Wolff has an excellent, detailed analysis, worth reading in full, here is one bit:

So the purely national purchase of national sovereign debt would either leave the private creditors as junior creditors, or the national central bank has to accept negative equity. What would negative equity mean for a central bank? De facto it would mean that the national central bank, that has created euros to buy government debt, would have lost the claim on the government. It would still owe the euros it has created to the rest of the Eurosystem.(4) The Eurosystem could now either ask the national central bank to return that liability, which it is unable to do without a recapitalisation of its government. Or, the Eurosystem could decide to leave the claim standing relative to the national central bank. In that case, the loss made on the sovereign debt would de facto have been transferred to the Eurosystem. In other words, the attempt to leave default risk with the national central bank will have failed.

…Overall, this discussion shows that monetary policy in the monetary union reaches the limits of feasibility if the principle of joint and several liability at the level of the Eurosystem is given up.

An important open issue is whether the ECB could buy Greek bonds, given that they are up for restructuring and (presumably) the Bank cannot voluntarily relieve Greece of any debt (see Wolff’s discussion).  There are plenty of rumors that Greece will indeed be excluded from any QE program, unless you imagine they settle things with the Troika rather more quickly than they are likely to.  Yet a bond-buying program without Hellenic participation doesn’t seem so far from hurling an “eurozone heraus!” painted brick through their front window in the middle of the night.

Overall, shuffling assets and risk profiles between national monetary authorities and national fiscal authorities would seem to accomplish…nothing.  Not buying up the debt of your biggest problem country also seems to accomplish nothing, in fact it is worth than doing nothing.

Here is my 2012 column on how the eurozone needs to agree on who is picking up the check.  They still haven’t agreed!  In the meantime, Grexit is a very real possibility, through deposit flight, no matter how badly Greek citizens may wish their country to stay in.

So, so far I am not so optimistic about this whole eurozone QE business, even though in principle I very much favor the idea.  It is again a case of politics getting in the way of a problem which does indeed have a (partial) economic solution.  The only way it (partially) works is if it (implicitly) bundles debt relief with higher rates of price inflation.  Have a nice day.

Does the Shake Shack IPO mean you should stop eating there?

A simple theory of IPOs suggests that they arrive when a product or company is experiencing “peak buzz,” or at least when the insiders in the privately held company think they are at or near peak buzz.  This will maximize the expected returns on the IPO when it comes to market.

When it comes to food, peak buzz usually arrives a wee bit after peak quality, given reputational lags.  So if you are seeing peak buzz, it is probably time to bail on the restaurant, at least on a restaurant which is going to be sold.  Bailing on the restaurant may in fact be slightly overdue.

After an IPO, the equity share of the original creators — in this case Danny Meyer — is diluted.  Meyer’s incentive to maintain quality standards and his personal brand name is weakened.  The subsequent public shareholders are more likely to insist on a less risky and more mass market approach, which is not in tune with what you, highly intelligent reader of this blog, are likely to prefer.

In other words, both the signaling and the moral hazard arguments suggest that soon you should stop eating at Shake Shack.  Alternatively, perhaps you should now go lots of times, in quick succession, given that quality will decline even more and you must stock up on your fix as a kind of intertemporal substitution.

Is there a paradox of low market volatility?

The FT reports:

Wall Street’s “fear gauge” has fallen to a seven-year low, helping propel US stocks to a record peak but suggesting investor complacency reigns over financial markets.

The CBOE Vix equity volatility index, a barometer of investor sentiment, slipped below 11 on Friday, nearly half the long-term average and its lowest level since February 2007. The Vix has fallen in recent years in conjunction with a robust recovery in equity prices from crisis levels as central banks pumped money into the financial system.

Now, it seems the Fed would be less afraid if it saw investors being more afraid, or at least that is the new conventional wisdom.  That is a coherent view if the Fed knows that it doesn’t know what it is doing with the unwind of the taper and the like.  The Fed has private information that things may be screwy, but private investors don’t have that same information.  The Fed then thinks that investors might thus be overextending themselves and then the Fed gets worried all the more.

But is that, taken alone, a coherent equilibrium of beliefs?  Not yet, because it seems someone’s beliefs should have to budge.

So how does all this hang together?  The Fed doesn’t want to crush the market, it just wants to test whether investors might in fact have some private information of their own.  By “leaking” that it is worried about low volatility in the market, the Fed can see whether investors suddenly panic or whether they have a relatively firm basis for not feeling so worried.

And so far investors have not panicked, quite the contrary.  The relatively sanguine beliefs of private investors thus seem to have a fair amount of depth.  The Fed has nudged investors, to learn something about the shape of the response curve, and those investors have held their place or warmed to the data all the more.

So if you believe in rational actor models (a big if, admittedly), you should be bullish about asset prices looking forward.  Maybe about the real economy too.  We’re seeing lots of good numbers about credit for the United States and that is a significant leading indicator.

A loyal MR reader on high-frequency trading

He/she writes to me:

Since there is a lot of confusion in the media regarding HFT, I wanted to clear some of it up.  Disclaimer:  this is my personal view, I am not representing any firm or group and I wish to remain anonymous.

Colocation is a practice, whereby any market participant can pay the exchange a fee which allows them to locate their trading computers in the same building as the exchange itself ( the matching engine ).

Colocation is actually good for investors.  Why?  Suppose a mutual fund from Kansas City wants to execute orders to buy stocks on an exchange which physically located in New Jersey.  If this mutual fund is looking at the market data feed directly from Kansas City, then it is at a disadvantage relative to investors who just happen to accidentally be in New Jersey.  So, what are the options?  Well, the fund can either rent space in a New Jersey data center or execute through a bank/broker which is doing exactly that.  However, all New Jersey data centers would still have to somehow connect to the exchange.  And their location within New Jersey would matter – some data centers would be better to locate at relative to some other ones.

With co-location, all investors are given the opportunity to trade from the right data center – the same one that houses the exchange.

If exchanges operated on some sort of discrete auctions rather than continuous matching, some of the issues above would be mitigated. But other issues would arise, for example, lack of synchronization of auctions between different exchanges, as well as increased incentives to trade more prices within a given amount of time, thus generating increased volatility

Furthermore, exchanges, as private for-profit businesses, are able to grow their profit and bottom line by selling co-location services to speed sensitive traders, thus mitigating the need to grow the revenues in other ways, such as raising commissions and trading fees on all investors

Direct Data Feeds and Accusations of Insider Trading

Exchanges sell access to direct data feeds to all investors.  When high frequency traders subscribe to a real time direct feed in the colocated facility and they observe the order book as well as trades, they have no idea who is trading – a customer, a big bank or another HFT firm.  They see the same exact trades in this feed as all other market participants.   Many, if not most,  HFT firms do not deal in any way with customers whatsoever.  The ones that do are supposed to have a clear separation (a Chinese Wall) between customers and proprietary trading, so no customer information can flow through to the prop desk – the same thing is true of big banks and other broker/dealers.

Consider, for example, the trade that is described in Flash Boys. HFT places 100 shares on the offer at 100.01 on BATS and when it trades, it goes and buys the same offer price of 100.01 at Nasdaq, thereby running up the price to 100.02 and selling back the liquidity at 100.02 to the non-HFT customer

This doesn’t actually work.  Why?  because in order to sell successfully at 100.02, HFT algorithm had to have priority in the order book queue and the only way to do that is to continuously quote that price, not knowing at all whether or not anyone is going to buy at 100.01 on BATS, and facing market risk of market running though 100.02

Secondly, just because the offer price on BATS traded, that doesn’t mean that the market cannot go down right after that and the HFT has no way of knowing who bought the price they bought and why they bought it.  It could have easily been a fund or a retail trader who have no alpha (no predictive power ).

Contrast this with the main protagonist of Flash Boys Brad Katsuyama, who was getting paid multiple millions at RBC for executing customer order flow.

Suppose a customer called Brad and asked to buy 3 million shares of IBM right now and 2 million potentially later in the day

The current market on public ( “lit” ) exchanges is 188.00 bid 188.01 offered

Brad says, ok, I will do the deal for 188.15 ( 14 ticks above the current market ) and then proceeds to work the 3 million shares in the market in order to buy back what he sold at a price lower than 188.15

Now, Brad is trading in the market, having material non-public information about his customer’s order flow.  This trading has to be immensely profitable for the bank to pay Brad millions a year.  So to the extent that there is any insider trading going on, and not market making, it is being done by Brad and not by the HFT algorithm because Brad really is using truly non public information and HFT is reading the direct data feed available to anyone who cares to sign up for it

Bank Equity Trading Revenues

http://www.economist.com/news/special-report/21577187-trading-equities-barely-profitable-these-days-many-banks-are-carrying

Indeed, as a result of HFT which quotes much tighter spreads than the banks, bank equity trading revenues have gone down dramatically, by much more than the profits generated by HFTs in equities.  Where did the difference go?  it accrued to investors in the form of lower trading fees

Ok. Is There Anything Wrong With US Equity Markets?

Yes.  Dark pools are destructive to all investors, including HFTs.  An HFT firm that derives its edge from mining statistical patterns in the data cannot do this very well for dark pool data because it is simply not available in a clean format.  But neither can any other investors

In order to promote transparency and reduce conflicts of interest between broker/dealers and their customers, our regulatory agencies should force all equity trading to happen on lit exchanges

By the way, this is a problem not just with equity dark pools.  Consider trading in off-the-run treasuries ( off the run meaning not the latest issue ) or interest rate swaps, or many other securities that Wall Street banks trade for their customers

Since none of these are on the exchanges, and there is no transparent data, effective spreads paid by customers are wide, lining the bank pockets.  If regulators were able to force trading in these instruments to happen on exchanges, it would reduce fragility of the financial system and create pricing transparency

What about Reg NMS

Reg NMS was designed to make sure that if a better price is available on any exchange, that price has to be filled before taking out worse prices on other exchanges

In practice, it has created a lot of complexity in the market and forced market participants to all implement their own software solutions to comply and monitor with it

All this compliance should be fully shifted to exchanges and other trading venues themselves, where it’s much easier for regulatory bodies to verify compliance