Greed is Good?

 “Greed, for lack of a better word, is good. Greed is right. Greed works. Greed clarifies, cuts through, and captures, the essence of the evolutionary spirit.”

– Michael Douglas as Gordon Gekko in Wallstreet

Hedge fund assets increased by a net $149 billion in the fourth quarter of 2010, bringing total industry under management to $1.917 trillion, just shy of the all-time industry high of $1.93 trillion at the end of the second quarter 2008, according to data released Wednesday by Hedge Fund Research. 

Reuters reports, “Macro and relative value funds were the most popular with investors, as clients hoped those types of funds could best navigate volatile currency and interest rate markets.

Event-driven funds which focus on mergers and acquisitions were also popular, pulling in $14 billion during 2010.

But the industry’s biggest category, equity hedge funds that can take long and short bets, failed to excite investors and added only $2.6 billion in new money during the year.”

Money is not flowing into stocks but instead into (“go anywhere”) macro funds.  From personal observation, I can share that there has been a noticeable absence of the Dollar carry trade into the S&P 500 index. This new capital has to find home….

Jan. 18 (Bloomberg) — Hedge funds are the most bullish on feeder-cattle futures since at least 2006, a sign that speculators may expect tight supplies of the animals to boost prices that already have surged to a record in Chicago.

The funds increased their net-long positions by 5.2 percent in the week ended Jan. 11 to 18,622 futures and options contracts on the Chicago Mercantile Exchange, U.S. Commodity Futures Trading Commission data showed on Jan. 14. The holdings are the largest since at least June 2006, when the CFTC began tracking the data.

The price of feeder cattle, the young animals purchased by feedlots and fattened for slaughter, jumped to a CME record on Jan. 14.

Below is a peek at the net long positions by large specs in 2 important agriculture commodities.  Financial speculation in food commodities is at or near all time highs along with the underlying commodities. 

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Hedge funds are not the sole cause of sudden spikes in food prices.  Genuine supply/demand issues along with retail (investors’) money via ETFs have also crowded this space.  CFTC (Commodity Futures Trading Commission) is attempting to curb speculative activity by monitoring position limits. Thus, it warrants some caution as most investors who want to participate are likely already long these markets.  However, the long-term trend of ag commodities remains favorable.

As an aside, it’s worth mentioning that Large Speculators are currently holding record net long positions.  These anti-dollar bets have become more apparent after the Fed announced Quantitative Easing II late last year and certainly added fuel to the fire.

More importantly, financial demand for staple commodities have global consequences.  Food riots are more visible around the globe and likely to get worse.  Countries with high poverty rate and younger demographic base are most vulnerable.  According to the FAO, the global price of food hit a new record high in December.  For most Americans and Europeans, food constitutes a small portion of their disposable income.  But in many areas of the world, even a relatively small rise in the price of food can mean that the survival of millions is suddenly threatened.

Consider the following (courtesy: http://theeconomiccollapseblog.com/) :

#1 Approximately 1 billion people throughout the world go to bed hungry every single night.

#2 Approximately 28 percent of all children in developing countries are considered to be underweight or have had their growth stunted as a result of malnutrition.

#3 Every 3.6 seconds someone starves to death and three-quarters of them are children under the age of 5.

#4 “Least developed countries” spent 9 billion dollars on food imports in 2002.  By 2008, that number had risen to 23 billion dollars.

#5 A study by the World Institute for Development Economics Research discovered that the bottom half of the world population owns approximately 1 percent of all global wealth.

60 Minutes tackles HFT

On May 6th 2010, the ”flash crash”made apparent that the (stock) market had been hijacked by high frequency trading.  Since May, I have dedicated all my posts (Helter Skelter, All Along the Watchtower, SEC wants HFT data, HFT and Systemic Risk) to provide insight and updates on HFT.  Although it was not an unfamiliar phenomenon on Wall street, most of Main street remained uninformed.  Until now…

Last night (October 10, 2010), CBS’ 60 Minutes brought HFT to Prime Time TV. (Embedding was disalbed – just click on video again to see it in Youtube). 

Helter Skelter!

“When I get to the bottom
I go back to the top of the slide
Where I stop and turn
and I go for a ride
Till I get to the bottom and I see you again”                

                                                                                      – The Beatles                

US equity markets remain mired in a trading range, equity mutual funds continue to face outflows and correlations remain very high – both across asset classes and within stocks.  In a market void of alpha, where neither fundamental nor technical analysis provide an advantage, institutional and retail investors are leaving the stock market in droves.  Volume has been abysmal and extreme internal readings are quite frequent.  For all intents and purposes, the current market structure is, at best, fragile.                

While I’ve been on hiatus from the blogosphere for a while, it has been a busy and worthwhile summer on the trading front. Thanks to everyone who follow me on Twitter and with whom I share/exchange my observations and trading ideas daily.  I cover macro issues on this blog and limit the intraday trading missives to 140 characters or less at a time.  My past few posts have addressed High Frequency Trading (HFT) and the current market structure.  Over the past few months, SEC has made little progress in solving these issues.  After failing to pinpoint any specific reason for the flash-crash, in their infinite wisdom, the SEC has established new circuit breaker rules in June.  Another band-aid on a gushing wound!  Meanwhile, following JP Morgan’s footsteps, Gold Sachs recently announced that they are shutting down their (very profitable) proprietary trading desk.  Whatever the reason, this actually may be the first step towards progress, IMHO.                

Today the SEC Chairman Mary Schapiro addressed the issue of “quote stuffing” at the Economic Club of New York. This may impose new rules on HFT after lawmakers and investors questioned whether market participants who execute thousands of transactions in seconds sparked the May 6 market crash.  Such a change would stop high-frequency traders from repeatedly placing and canceling orders in milliseconds.  However, in my view, more pressing issues like trading rebates remain unresolved and need to be addressed.               

“Some could argue that May 6 was an aberration — another perfect storm — and now that it has passed markets have naturally adapted leaving no need for a comprehensive review of our market structure,” Schapiro said. “I disagree.”  The follow-up report on what might have caused the May “flash crash” is expected by the end of September.             

While a longer term chart provides evidence of some well-defined Fibonacci retracements.  It’s not by coincidence that the top-end of the range (1040 – 1130) for S&P 500 has been defined by the “flash-crash” closing price of 1128.                

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Many investors have been frustrated by this range bound market over the last few months, having been accustomed to trending markets in months prior.  By now, the “trading range” phenomenon is well-known in the investor community, thus the likelihood of a breakout/breakdown is getting increasingly plausible.  For now, the currency markets  remain the main source of funding (via carry trades) for Risky assets including stocks.  I provide intraday updates on the Aussie/Yen cross or the USD on Twitter.  Look for dislocations between currency markets and risky assets as early clues of impending changes in equities.

All Along The Watchtower

Today, the SEC’s “Market Structure Roundtable” was held in Washington, D.C.  The panel and agenda were announced on May 28th.  The roundtable featured in-depth discussions of key market structure issues, including high-frequency trading, undisplayed liquidity and the appropriate metrics for evaluating market structure performance.  This comes on the heels of a speech made by the SEC Commissioner Luis Aguilar on May 24th, in which he deplored “the perils of fragmented regulation” and “the dangers of weak oversight of our tightly interconnected financial markets.”  

Moreover, Aguilar conceded the events of May 6 showed regulators were woefully out of their depth:

“The simple truth is that we do not have the tools, resources, and information we need to promptly examine and fully understand the correlations between the equities, futures, options, and OTC derivatives markets and how they may have affected market movements on that day.”

And so was everyone else:

“It’s self-evident in the wake of May 6th that even the people who wrote many of these programs failed to understand how the algorithms would respond to trading initiated by the many other algorithms in the market. Whatever initiated the chain of causality that brought us the May 6th market break, it seems evident that we experienced a significant failure in a system so complex that, even after close to three weeks of intensive analysis of only one hour’s trading, no one — neither the market participants, nor the regulators — fully understands it.”

What steps(if any) are taken and how it affects market liquidity remains to be seen.  Meanwhile, debate raged on from both sides (for and against HFT).

Veteran Traders Blast U.S. Market Structure at SEC

By Jonathan Spicer and Rachelle Younglai

June 2, 2010

WASHINGTON (Reuters) – Traders clashed over the fragmentation and ultra high speed of today’s U.S. equities marketplace on Wednesday, as one charged that more traditional orders are being “gamed” but another said that high-frequency traders are unfairly vilified.

The trading experts — summoned by the Securities and Exchange Commission to peel back layers of today’s complicated, mostly electronic marketplace — argued over what needs to be done to restore confidence after the Dow Jones industrial average mysteriously plunged some 700 points in minutes before sharply rebounding on the afternoon of May 6.

“It shook confidence in our markets and it was avoidable,” said Richard Rosenblatt, who has executed trades for institutional investors since the 1970s. “The clear culprit was a commitment to high speeds whether it made sense or not.”

He added, “The flash crash was embarrassing.”

The May 6 event confirmed some long-held concerns over the marketplace’s stability.

The SEC and some policymakers are questioning the rise of high-frequency traders, which use lightning-quick algorithms to make markets and earn thin profits from tiny imbalances. Some critics have said they put long-term and retail investors at a permanent disadvantage.

The SEC is also probing the fairness and stability of a marketplace where some 50 electronic trading venues compete for ever faster and heavier order flow.

“Today it is very difficult to say that there are not subsegments of this market that are taking advantage of us. They use strategies that are trying to game what we’re doing,” said Kevin Cronin, director of equity trading at Invesco, an asset management firm.

Market makers and high-frequency traders took exception to accusations that they trade with no regard to companies’ fundamentals.

Lime Brokerage President Jeffrey Wecker said high-frequency traders are subject to “misplaced vilification.”

The chief executive of Getco LLC said his firm — a global leader in algorithmic trading — had little to no effect on the long-term price of a publicly traded company. Getco is in the “practice of trying to find the best price equilibrium,” Stephen Schuler said.

Regulators and major exchange operators have yet to pinpoint the cause of the May 6 flash crash and are working on implementing single-stock circuit-breakers, or pauses in trading, if a stock is in free-fall. Nasdaq unveiled a single-stock circuit breaker on Wednesday.

MARKET FRAGMENTATION

The SEC roundtable, conceived earlier this year before the flash crash gave it added urgency, comes as the regulator digests more than 200 letters in response to its wide-ranging paper on trading and market structure.

The “concept release,” which asked several questions about high-frequency trading, was published in January in response to concerns building through 2009 over the fairness and stability of U.S. equity markets.

Diamond Hill Investments Director Stephen Sachs said competition is good, but “we have clearly reached a point where this fragmentation is creating significant issues.”

“We have created an environment that is far more difficult to navigate,” he said.

Others defended the high-speed marketplace that has made trading easier for many.

Gus Sauter, chief investment officer of fund giant Vanguard Group, told the SEC that high-frequency traders reduced trading costs for investors over the past few years and now help to “knit the very fragmented marketplace together.”

Other changes could come, such as saddling high-frequency traders with commitments to trade and cracking down on anonymous trading venues known as dark pools.

“We need to work on incentivizing firms to really step up and commit capital over a duration, and the only way to do that is really through credits and incentives,” Christopher Nagy, head of order routing at online broker TD Ameritrade Holding Corp, told the panel.

SEC Commissioner Luis Aguilar raised concerns that the bulk of roundtable participants were from the financial services industry.

A series of regulatory changes over the last decade contributed to the proliferation of alternative, non-exchange trading venues in the United States, as well as the reliance on computerized high-frequency trading to ensure that there is enough liquidity to keep markets flowing.

(Reporting by Jonathan Spicer and Rachelle Younglai; Editing by Tim Dobbyn, Robert MacMillan, Gary Hill)

SEC wants HFT data

In my last post, I addressed the probable causes of the May 6th “Flash Crash” in US equities.  The SEC’s independent investigation has failed to identify any specific reason for the market meltdown (not a shocker considering the SEC’s history of incompetence).  Given the nature of the crash, my suspicion turned to High Frequency Trading (HFT).  Moreover, I also mentioned that HFT is an unintented consequence of SEC’s own reugaltions (Regulation NMS).  I shared an article with the readers that takes a peek into the highly competitive world of HFT.

Weeks after the crash, the SEC is finally trying to address the HFT dilemma.  The following article discusses the latest steps taken by the SEC to oversee HFT:

 May 26, 2010 

SEC proposes high-frequency trade oversight rules

Exchanges would have to ‘tag’ trades, provide data to repository for review 

By Ronald D. Orol, MarketWatch  

WASHINGTON (MarketWatch) — Nearly three weeks to the day after a massive plunge in stocks that left investors shocked, the Securities and Exchange Commission voted to propose rules that would give the agency and securities exchanges more timely information about high-frequency trades so they can better oversee the markets.  

  

The proposal adopted unanimously by the five commissioners Wednesday requires exchanges and broker-dealer firms that trade on the exchanges to provide detailed information about quotes, orders and trades to what would be a newly created central repository. 

The measure comes partly in response to a stomach-churning intraday swing that saw the Dow Jones Industrial Average drop nearly 1,000 points on May 6 before swiftly recovering to a 348-point loss. A total of 19 billion shares were traded that day on multiple exchanges, each with its own — sometimes incomplete — approach for collecting data. 

SEC Chairwoman Mary Schapiro said that May 6 underscored deficiencies in the commission’s ability to have the pertinent data at hand to exercise its mandate for oversight. 

“The SEC’s efforts to reconstruct the trading on that day are substantially more challenging and time consuming than we would have liked because no standardized, automated system exists to collect data across the various trading venues, products and market participants,” Schapiro said. 

Schapiro acknowledged the rules the SEC’s proposing are a way to come to grip with rapid technological advances in investing — where trades are transacted in milliseconds — that have made it far more difficult for the agency and exchanges to supervise trading activity. 

“This information is designed to allow regulators to more easily and quickly identify potentially manipulative activity occurring across markets and through multiple accounts at multiple broker-dealers,” said Schapiro. 

More information, please  

Exchanges and broker-dealers would be required to provide trade information to the central repository in real time or close to real time, according to the SEC’s proposal. The proposal would require exchanges to be “hooked up” to the system within a year of its approval. 

Broker-dealers would need to be set up within two years. However, the SEC’s also considering an expedited approach that is smaller in scale. 

Broker-dealers would be required to “tag” each order they are making to buy a security that the exchange would need to report to the central repository. Exchanges would also have to tag each order received by a member of the exchange, and that information would also need to be reported to the repository. 

In essence, the agency would seek to follow the trade from its inception to completion. 

Commissioner Kathleen Casey said that she’s supportive but that the benefits wouldn’t come without incurring costs. 

“These costs will be substantial. The benefits will be substantial,” she said. 

Echoing Schapiro, commissioner Elisse Walter said that SEC’s efforts to collect data in the aftermath of May 6 have demonstrated that regulators are not prepared. 

“Valuable resources are wasted and time is lost when our staff is sent to track down disparate information from disparate sources,” she said. “A consolidated audit trail would have enhanced our ability to understand what happened on May 6.” 

Commissioner Luis Aguilar questioned, however, whether the SEC would have the human and technological resources to evaluate the projected 100 gigabytes of data expected to come in daily to the repository. He made a plea to Congress to approve a measure approved by the Senate that would allow the SEC to be self-funded, a provision that would significantly increase the agency’s annual budget. 

“The SEC’s staff must be equipped with the best resources to do the job,” Aguilar said. “Most Americans assumed the SEC has these tools. It is shocking that the SEC does not have its own access to this data. 

“The SEC must have this data and the tools to identify egregious conduct, identify trends and reconstruct market movements.” 

He also argued the SEC should require that over-the-counter derivative transactions to be tagged and added to the repository. The proposal doesn’t cover this category of transactions. 

“It is imperative for financial derivatives and over-the-counter securities,” he said. 

Also in response to the plunge, the agency and securities exchanges are proposing to create a market-wide circuit breaker for all exchanges — including electronic exchanges — to halt or slow down the pace of trades during a major market downturn.

HFT and Systemic Risk

Many theories are floating around about what caused the stock maket crash on May 6th, 2010.  The SEC’s investigation failed to come up with a silver bullet – no surprise there!  I suspect, the SEC will never come up with the culprit. It’s very difficult for them to come to terms with the unintended consequences of Regulation NMS (2007) which eliminated the “human element” from the exchanges and sowed the seeds of HFT (High Frequency Trading).  Meanwhile, in response to SEC’s Concept Release, Ann Vleck, the Managing Director and Associate General Counsel of SIFMA (Securities Industy and Financial Markets Association) outlined the following risks regarding High Frequency Trading and the threat of systemic risk:              

“However, as HFT has increased, issues have arisen regarding the fairness of HFT and whether such trading imposes an unreasonable amount of systemic risk on the equity markets. As discussed below, SIFMA believes there is a need for more disclosure about HFT and related issues. Such disclosure not only would provide market participants with more information related to an important market practice, but also would facilitate the Commission’s efforts to appropriately regulate the markets. Similarly, we support the Commission’s goal of enhancing risk controls related to market access, including HFT, although, as discussed below, significant issues need to be addressed with respect to proposed Rule 15c3-5.”         

“SIFMA recognizes that the volume and rate of message traffic associated with HFT may pose enhanced financial, regulatory, and other risks to broker-dealers and trading markets. Therefore, as a general matter, we support the use of pre- and post-trade controls on market access, and the general principle underlying the SEC’s proposed Rule 15c3-5 that such controls and procedures are appropriate in market access arrangements. However, if proposed Rule 15c3-5 is to be effective, certain significant, complex issues regarding market access must be addressed before the SEC adopts the rule.”         

The following article gives you a glimpse into the competitive world of HFT,  courtesy Traders Magazine Online News

 High-Frequency Trading Is a Tough Game

 

Traders Magazine Online News, November 24, 2009 

Nina Mehta 

Interest in high-frequency trading is at an all-time high, but profit-taking from high-frequency trading strategies focused on low latency is getting tougher. 

“The window of opportunity to get into high-frequency trading is almost closed,” said Mark Casey, president of CFN Services, a network provider. He defined high-frequency trading as strategies whose underpinning is low-latency order placement and execution. 

“If you’re competing primarily on latency, it’s very, very, very, very difficult,” added Nigel Faulkner, chief technology officer for the equities technology group at Goldman Sachs. 

The cost of the technology and infrastucture needed to support high-frequency trading is “tens of millions of dollars” per year, according to Kevin McPartland, a senior analyst at financial services research firm TABB Group. He moderated a panel sponsored by TABB Group and Switch and Data, a data center operator, last Thursday. This article is based on the panel discussion. 

Low latency is necessary, McPartland said, to process market data faster than competitors. And high-frequency trading, which encompasses a range of strategies, depends on that data. “It’s like you’re seeing the Wall Street Journal five microseconds into the future,” he said. 

High-frequency trading firms must be concerned about latency, but that level of concern should depend on “how much profit they intend to make from every millisecond or microsecond,” Goldman’s Faulkner said. He noted that firms must understand the “value of a micro or milli” for the particular strategy they’re running. 

“The infrastucture isn’t the barrier” for firms interested in high-frequency trading, CFN’s Casey told the audience. The barrier is competition. In his view, competing with the most latency-focused firms is a tough, elite game because, at that level, microseconds count. A microsecond is one-millionth of a second, while a millisecond is one-thousandth of a second. 

According to a recent TABB report on financial services data centers, the financial services industry spends $1.8 billion for co-location and private facilities to support fast direct access to market centers. Broker-dealers account for half of that sum, or $900 million. Exchanges represent 23 percent, proprietary trading firms 13 percent, asset managers 10 percent and hedge funds 4 percent. That report was published in March, but the figures remain accurate, McPartland said, based on TABB’s ongoing research on data centers and trading, including for an upcoming report on sellside technology focused on U.S. equity infrastructure. 

McPartland noted that bulge-bracket firms will often have four or five primary data centers to support their own equities trading and the trading of their clients, and 10 or more co-lo sites in the U.S. All brokers, he said, use co-lo at some level, with many operating in at least two or three co-lo sites. 

McPartland added that housing servers within an exchange’s data site is costlier than placing the servers near the facility, such as across the street. The chief features behind a firm’s choice of a data center are cost (which is important to 57 percent of firms), exchange proximity (48 percent), space in the data center to expand (33 percent) and power reliability (29 percent), according to TABB. Additional concerns are service, security, control and network neutrality. 

CFN’s Casey said that “proximity trading” has exploded over the last couple of years. Proximity trading refers to strategies that depend on low latency by installing computer servers near a market center’s matching engine. 

One of the changes in the marketplace in recent years that has fueled high-frequency trading was regulation. In 2007, the Securities and Exchange Commission’s Regulation NMS went into effect. Reg NMS lay down a set of rules to modernize the markets, but it also made the landscape more fertile for high-frequency trading firms. Casey noted that execution strategies that used to be implemented just on Nasdaq, for instance, have given way to more inter-market trading strategies. 

But regulation wasn’t the only significant change. The TABB study found that the “game-changing technology” that spurred the growth of high-frequency trading was bandwidth availability and the relative low cost of buying bandwidth. “That’s what is letting equities volume be eight-to-nine billion shares per day,” McPartland said. 

Several panelists pointed out that while speed is vital, not all high-frequency trading depends on extreme low-latency. Nor is all low-latency trading high-frequency, CFN’s Casey said. Still, Goldman’s Faulkner observed that “if it’s high-enough frequency, it must be low latency.” He added that “we increasingly see that the benchmark [for high-frequency trading firms] is low latency.” 

As more firms now get into high-frequency trading, their infrastructure development has taken different paths. George Hessler, executive vice president at Lime Brokerage, said he thinks the balance for many firms is tipping toward renting components of the technology and infrastructure, rather than building them from scratch. He added that as consolidation takes place in this part of the trading-services industry, the hardware and software services are improving dramatically. Lime services many high-frequency trading clients. 

Goldman’s Faulkner, however, said that it would be hard for a truly latency-sensitive firm to be satisfied with vendor products. For big banks, he added, servicing these firms has also become more complex because their needs are different from the traditional needs of high-volume clients. “We’re having to change the mix of our application developers,” he said. 

Firms that are really latency-sensitive must pull out all the stops to account for every microsecond, since that affects their profitability. They must “account for the last 100 microseconds they can’t find,” and be able to figure out if the latency is in the code, switches, applications or elsewhere, Faulkner said. 

UBS has a “strong bias” to build rather than rent the various components necessary to support high-frequency-trading firms, according to Josh Schubkegel, executive director for client-facing technology at the big bank. He noted that some clients want to get “close to the metal” and do everything themselves, while others do not. 

Schubkegel noted that the focus on serving high-frequency firms has also benefited other clients at some of the big banks. UBS, he said, has leveraged some of the technology platforms developed for high-frequency traders for its direct market access and algorithmic trading business.

Chronology of a Crash

The definition of a crash is when markets don’t function properly.  At one stage today, $1 Trillion of market cap evaporated from the US stock market.  Moreover, the Dow Jones experienced the largest one day drop in history.  Thus, by any measure, today’s action in US stocks qualifies as a bona fide crash!

Business media is turning its attention to some “fat finger” trader at Citi, other observers blame the high frequency traders and/or dark pools of liquidity (or the lack thereof).  Yet others are pointing their fingers at the carry traders who are unwinding their positions after a more than meaningful rise in the US dollar recently.  There may be some truth to that…. intraday charts show that currency markets, more specifically, the Yen/US and Aussie/Yen, were imploding a few minutes prior to the plunge in stocks.  But, I digress…

With the benefit of hindsight, we may someday figure out what caused the meltdown.  Chances are, it was an amalgam of events – a perfect storm, if you will.  However, there were plenty of warning signs around for the acute observer. Here is how I called it on Twitter play by play from the intraday peak of April 26th to today’s plunge:

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 And finally, this morning, I shared the following chart, we all know what happened soon after:

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 You can follow me on Twitter at : http://twitter.com/AlphaEdge or read my tweets on this blog.