Monday, May 05, 2014 - Riggers’ Propaganda

Riggers’ Propaganda

by Sinclair Noe

DOW + 17 = 16,530
SPX + 3 = 1884
NAS + 14 = 4138
10 YR YLD + .02 = 2.61%
OIL - .38 = 99.38
GOLD + 9.10 = 1310.70
SILV + .13 = 19.69

Last week we told you about prosecutors and regulators preparing to criminally prosecute Credit Suisse and maybe BNP Paribas, and the slap on the wrist enforcement efforts of the past decade, and especially under the mis-guidance of Attorney General Eric Holder’s “Too Big to Jail” policy. The Swiss finance minister met Holder on Friday to discuss a US probe into Swiss banks that allegedly helped Americans evade US taxes, which includes Credit Suisse. Today, Holder posted a video on the Justice Department website saying that the DOJ is pursuing criminal investigations of financial institutions that could result in action in the coming weeks and months, and adding that no company was “too big to jail.”

A criminal conviction of an entity regulated in the United States could lead authorities to potentially revoke a charter, essentially a death sentence for a bank. In his video, Holder said prosecutors are working closely with regulators to address the issues before taking action, "Rather than wall off banks from prosecution, the potential for such severe consequences simply means that federal prosecutors conducting these investigations must go the extra mile to coordinate closely with the regulators that oversee these institutions' day-to-day operations."

It’s starting to sound like Holder is going after criminal charges without the consequences of criminal charges; maybe he can collect a slightly bigger fine, but still leave the bank charter in place. Otherwise, this is a big pile of baloney. And the proof will be in the putting. Until we see a banker jailed and a charter revoked, AG Holder is just spouting propaganda.

The propaganda mill is spinning fast in Washington DC these days. Securities and Exchange Commission Chair Mary Jo White flatly rejected claims that retail investors are being fleeced by high-frequency traders who can use their speed to jump ahead with buy and sell orders that fetch better prices.

White told a US House of Representatives panel last week, "The markets are not rigged." White reiterated that her agency's investigators are actively pursuing probes into high-speed traders and dark pools, or anonymous trading venues, but she also sought to dispel the notion that using high-speed technologies to trade ahead of others using stock quotes disseminated on public data feeds could meet the legal definition of "unlawful insider trading." She acknowledged at one point that the market is not "perfect" and told lawmakers that the agency's "data-driven" review of market structure issues surrounding areas such as order types, dark pool trading and data feeds was still ongoing. Even though the SEC has not concluded or barely even launched the investigation, White already knows the facts, saying: "I want to be very clear that the market metrics suggest that the retail investor is very well-served by the current market structure."

The rather unusual reason why SEC Chair White and Congress are suddenly concerned about rigged markets is because of Michael Lewis' latest book Flash Boys and HFT (high-frequency trading) and whether the markets are manipulated. What they're not talking about is how the markets have been set up for institutionalized rigging. And they are rigged; have been for a long time.

It goes back to the time when the NYSE was the only game in town, and prices were quoted in fractions: a half, a quarter, an eighth. Buyers and sellers of listed shares used brokers to send orders to the NYSE Floor for execution. On the Floor, "specialists" are in charge of every stock. Their job was, and still is, to match up buyers and sellers and "keep a fair and orderly market" as they facilitate "price discovery."

The specialist used to see all orders for the stocks they were in charge of because all orders had to come to them. Besides matching up buyers and sellers, specialists can also trade for their own account. That means they can try and make money trading the stocks where they are specialists. Here's how the specialist makes real money, besides getting paid a small fee for matching up orders.

The key to being the specialist is seeing all the order flow. Because specialists have knowledge of who is buying, who wants to buy and how much and at what prices, and the same is true for knowing the sell side, the specialist essentially gets to trade on inside information. The specialist could raise the bid if he wanted to buy stock because he knew there were more buy orders coming into his book, and if he was right and the stock moved higher, he could sell his position for a nice profit.

And that is pretty much how the system works today. Eventually, investors grew weary of having the specialists slice off profits on insider information. Even though we got rid of the fractional system, we still have the insiders slicing off small profits on each trade. Now the Nasdaq doesn’t have a specialist system because there is no central trading floor where dealers meet and call out prices, but in the automated, cyberspace world, each dealer is his own specialist.

Eventually, electronic communications networks (ECNs) sprang up. ECNs were and still are networks where dealers who weren't part of Nasdaq could place their quotes and buy and sell with each other. From there it wasn't long before Nasdaq dealers wanted to get onto all the ECNs and demands were made to trade NYSE and AMEX stocks on the computer networks. That's how technology changed the old specialist system into a mass of different trading venues that now includes entirely new exchanges like BATS, and dark pools where banks and crossing services trade for clients demanding anonymity.

The problem now is that there is no longer any one central place where all orders go to be executed. Orders are spread around based on cost, and services, and, most importantly, "payment for order flow." So, now the online brokerage firms like Schwabb, and Etrade, and whoever, don’t have their own traders to execute trades and they don’t have their own trading desks, so they have to route those orders to an exchange or a couple of exchanges to match up buyers and sellers. In order for exchanges and networks that offer execution of orders to be successful, they have to have orders coming in so they can match up buyers and sellers. Otherwise, if there aren't enough orders to allow matching of buyers and sellers at prices where customers want to transact, that exchange would have no "liquidity" and it would lose business.

So how do all these competing exchanges get orders? They pay for them. They pay Schwab, and Ameritrade and Scottrade for their "order flow." That's right; your order at your discount brokerage is sold to someone so it can be traded on their exchange. Who gets paid for your order? Not you. Your brokerage gets paid.

So, after the switch to decimalization in 2001, we had the rise of the market makers. Market makers are the same as specialists, except they are mini-specialists in the stocks they trade electronically for their broker-dealer or bank trading desk who trade on Nasdaq or on the ECNs or anywhere where an intermediary can interpose himself into a trade, and they will impose their trade ahead of your trade. That’s why they buy order flow, so they can create an internal “book” so they can have their own inside information on the order flow, so they can trade against it, or sell it to other traders.

HFT operators are looking at all the order flow going into all the different exchanges and trading venues they can peer into. They look into the total flow of orders, which no single exchange can see, and with their empirically modeled time sequencing of orders, spreads, and depth that they run through reinforcement learning algorithms, they come up with a trade that steps in to buy or sell shares before someone who intended to transact there gets a chance to.

Speed is critical to high-frequency trading. Exchanges rent HFT shops space next to their servers (co-location) so they get their data faster than everyone else. That's legal. They couldn't do it if there weren't so many exchanges and trading venues competing for orders. You can thank the SEC for making that a reality without sensible limits. They couldn't do it if there was no such thing as payment for order flow; yes, they get paid for their order flow too. You can thank the SEC for allowing that neat little scheme.  HFT shops can buy and sell at the same price (that's a zero profit or loss), but because they provided some venue "liquidity" by sending their super-fast order there to be executed, they get paid. That's not arbitrage in the traditional sense; that's just playing the game. They couldn't do it if they didn't have all the information at the speed they get it at from the exchanges the SEC regulates.

And so you pay whenever you make a trade; you lose about a penny per share, sometimes more, and you’re expected to accept this little slice in the name of liquidity, but it isn’t really liquidity, it’s really just volume. High-frequency trading has nothing to do with what liquidity is, what liquidity means to the market. Volume is not liquidity.

Everything is usually fine when markets are moving up or are relatively stable. We won't really notice HFT. But, in a wicked downdraft, when HFT players turn off their computers, we will see that there are no bids on any specialists' books or parked with market makers. There will be no stopping stocks from falling for that reason. We saw it in the May 2010 flash crash. That's what HFT has done to the market. It has made it a dark pool, and a dark pool is not required to yell out a price like the old-school specialists; instead prices come in at a more leisurely pace, when it suits the ECNs, after they scalped their share. What this means is that we don’t really know what the price is, and you can’t have a market without prices, which means one day we could have a catastrophic market failure; despite the propaganda otherwise. 

Wednesday, April 09, 2014 - Feeding Time at the ZIRP Trough

Feeding Time at the ZIRP Trough
by Sinclair Noe

DOW + 181 = 16,437
SPX + 20 = 1872
NAS + 70 = 4183
10 YR YLD un = 2.68%
OIL + 1.04 = 103.60
GOLD + 4.30 = 1313.30
SILV  - .22 = 19.95

In an otherwise light week for economic news, the big report is today’s release of the FOMC minutes from last month’s meeting. No surprises. You may recall that after the last meeting, Chairwoman Janet Yellen talked about the possibility of raising the fed funds target rate after a “considerable time”; when pressed she indicated a “considerable time” was about six months after the Fed ends it asset purchases under Quantitative Easing. That would mean late spring or summer of 2015.

Fed policymakers were unanimous in wanting to ditch the thresholds they had been using to telegraph a policy tightening; no hard and fast target of 6.5% unemployment or 2% inflation. The minutes indicate the Fed would like to see more improvement in the economy; the emphasis on quality rather than quantity. In other words, the Fed remains dovish, and they will taper but they will also keep rates low for a long time. And also, those “dots” are over-rated.

The dots are actually charts suggesting the fed funds rate would top 2% by the end of 2016. In the minutes published today, several policy-makers claim the charts overstated the shift in projections, which would suggest the Fed is not ready to tighten policy. A couple of the voting members wanted to commit to keeping rates low if inflation remains persistently below the Fed's 2-percent goal.

Wall Street loves feeding at the Zero Interest Rate Policy trough. Stocks were up. Despite the three-day selloff, the S&P 500 index managed to hold above its 50-day moving average around 1,840, a key support level. The Nasdaq Composite is in positive territory year to date.

In other economic news, Commerce Department data showed that wholesale inventories rose at a slower pace of 0.5% in February, in line with expectations, after a revised gain of 0.8% in January, which could support views that restocking did not help the economy in the first quarter. You recall that companies were overstocked on inventory in the fourth quarter; we haven’t worked our way through those full shelves, and that likely means that the economy is slogging along in the first quarter.

The IMF, the International Monetary Fund says the global economy is strengthening but emerging markets still face challenges from outflows of capital and the big threat for the global economy is super-low inflation, or low-flation.

The IMF expects the global economy to grow 3.6% this year and 3.9% in 2015, up from 3% last year. Those figures are just one-tenth of a percentage point below the IMF's previous forecasts in January. And the forecasts will likely be revised lower as more months pass; that seems to be the tendency. The IMF made no changes to its forecasts for US growth, which it estimates at 2.8% this year and 3% in 2015. Overall, the recovery seems to be broad, fairly strong and more stable.

The IMF and the World Bank will hold their spring meetings in Washington this weekend. Finance ministers and central bankers from the Group of 20 leading economies will meet Thursday. The IMF is expected to reiterate the message that central banks should be more aggressive.

Inflation in the 18 countries that use the euro currency fell to an annual rate of 0.5% last month. Though consumers can enjoy flat prices, ultra-low inflation can stifle growth. People and companies postpone purchases knowing that prices will be little changed months later. Debts become harder to pay off. That's a particularly severe problem in Europe, where many governments remain squeezed by debts. Super-low inflation also raises the risk of deflation; a decline in wages and prices that slams the brakes on economic growth.

Another topic at the meetings is expected to be inequality. The IMF’s new interest in income distribution coincides with other, seemingly unorthodox positions coming from the fund and some of its experts since the financial crisis of 2008. It has come to support some controls on cross-border capital flows. Its research has argued in favor of fiscal stimulus, pointing out its positive impacts on economic growth.

In the latest edition of the World Economic Outlook, the fund makes the case that inflation in the United States and other developed nations should be higher to help pull the world economy out of its morass. IMF Director Christine Lagarde now argues economic policy cannot be only about promoting low inflation and robust growth. Healthy, stable economies also depend on a reasonably equitable distribution of the rewards. The study concludes a flatter distribution of income contributes more to sustainable economic growth than the quality of a country’s political institutions, its foreign debt and openness to trade, its foreign investment and whether its exchange rate is competitive.

Deep inequality breeds resentment and political instability, discouraging investment. It can lead to political polarization and gridlock, as it cleaves the political system between the interests of the haves and the have-nots. And it can make it more difficult for governments to deal with brewing crises and economic imbalances. An analysis published last year by economists in the IMF’s fiscal affairs department concluded that efforts to curb budget deficits increase inequality, especially if they take the form of spending cuts. It suggested that targeted government spending and progressive taxes could offset some of these effects.

Fears that High Frequency Traders have been rigging the stock market went mainstream last week when 60 minutes ran a story on Michael Lewis’s new book “Flash Boys”. Then the FBI announced it would investigate; my guess is that this will slowly fade away in the light of the Holder Doctrine, which basically says that the Department of Justice and other supposed law enforcement types only arrest petty criminals, and if you have enough money and provide jobs, you are entitled to a “get out of jail” card.

Anyway, the High Frequency Traders are nothing new, they've been around for a long time. The major exchanges lease high speed access. Perhaps less well known are the dark pools. So much trading is now happening away from exchanges that publicly quoted prices for stocks on exchanges may no longer properly reflect where the market is. And this problem could cost investors far more money than any shenanigans related to high frequency trading.

When the average investor, or even a big portfolio manager, tries to buy or sell shares now, the trade is often matched up with another order by a dealer in a so-called "dark pool," or another alternative to exchanges. Those whose trade never makes it to an exchange can benefit as the broker avoids paying an exchange trading fee, taking cost out of the process. Investors with large orders can also more easily disguise what they are doing, reducing the danger that others will hear what they are doing and take advantage of them. 

The rise of "off-exchange trading" is terrible for the broader market because it reduces price transparency. The problem is these venues price their transactions off of the published prices on the exchanges; and if those prices lack integrity then "dark pool" pricing will itself be skewed. Around 40% of all US stock trades, including almost all orders from "mom and pop" investors, now happen "off exchange," up from around 16% six years ago.

A brokerage has several ways to fill customers' orders. It can match buy and sell orders from its own customers, known as "internalizing," or sell its orders to another broker that can do the same. Brokers also send trades to "dark pools," which are similar to exchanges, except the fees are lower and they are anonymous, with orders going unreported until after they have been executed. And finally, they can send trades to exchanges, where they will have to pay higher fees. A major concern with off-exchange trading is that brokers who internalize trades and offer dark pools do not provide any data to the market before the trade is executed.

On a stock exchange, when an order is sent in, the price of the stock is adjusted and everyone with a data feed sees it. Dark pools only report data after a trade has occurred. At that stage, information about the trade has little influence on the price. In other words, dark pool trading is priceless, and you actually need prices to have a marketplace; price discovery is an essential element; cut that out of the equation, and you can see some serious manipulation and distortion.

And finally, in today’s edition of “Banks Behaving Badly”, Bank of America has agreed to pay nearly $800 million in fines and restitution to settle allegations of deceptive marketing and unfair billing involving credit card products. The Consumer Financial Protection Bureau and Office of the Comptroller of the Currency said the bank had misled roughly 1.4 million people about the cost of two credit card payment protection products, which allow consumers to suspend minimum card payments if they lose their job or suffer a severe illness, and the amount of time they would receive benefits from them.

The bank also billed customers for identity protection products before they received them and did not provide some fraud-monitoring services consumers thought they were buying. About 1.9 million people were unfairly billed. The fines work out to about $5 million the rest in restitution. The bank says it has already issued refund payments to most customers who were affected. Bank of America neither admitted nor denied wrongdoing.

Wednesday, April 02, 2014 - Speak Your Mind by Blowing Your Wad

Speak Your Mind by Blowing Your Wad
by Sinclair Noe

DOW + 40 = 16,573
SPX + 5 = 1890
NAS + 8 = 4276
10 YR YLD + .04 = 2.80%
OIL – 33 = 99.29
GOLD + 10.10 = 1290.90
SILV + .22 = 20.08

The S&P 500 closed at another record high.

The Commerce Department reported that orders to US factories rose 1.6% in February, the most in five months. January's durable goods orders were revised to show a larger drop of 1.0% instead of the previously reported decline of 0.7%. Yesterday, the Institute for Supply Management said its manufacturing index rose in March.

A private survey showed that US companies stepped up their hiring in March. Payroll processer ADP said private employers added 191,000 jobs. ADP also revised February's job creation up to 153,000 from the 139,000 figure reported earlier. The report comes ahead of the government's monthly jobs report, scheduled to be released on Friday; the over-under number for Friday is 200,000 net new jobs.

We know the Federal Reserve will be watching the jobs report. St. Louis Fed President James Bullard speaking to reporters at his branch of the central bank, said a formal rate rise is "still a considerable distance away." Federal Reserve Bank of Atlanta President Dennis Lockhart said today: “Based on my working medium-term outlook, I see the latter half of 2015 as the likely time frame for the first move to higher rates,” but if the economy doesn’t grow as he current expects, Lockhart thinks, “a later liftoff date… will likely be appropriate.”

Lately bad weather was cited as the reason that Walmart and FedEx and Delta’s earnings were disappointing.  If it isn't one-time charges that happen every quarter being removed from reported results, it's the weather being blamed. Of course, even if the weather truly was awful enough to prevent people from shopping, or buying a house, that demand should simply show up in a later month. A certain amount of productive capacity is lost, but pent up demand should rev things right back up again. The March jobs report won’t be the final word on the weather and the economy, but if we don’t see some sort of significant improvement, then we are running out of bad weather excuses.

Russian, American, and European diplomats continue to talk about settlement talks that might halt further Russian military action in Ukraine; Crimea is a done deal, but Ukraine is another matter. NATO will suspend "all practical civilian and military cooperation" with Russia because of its annexation of Crimea, saying it has seen no sign that Moscow was withdrawing troops from the Ukrainian border.

Meanwhile, Gazprom, the Russian energy company has fired a shot across the bow, raising the price it charges Ukraine for natural gas. The price jumped from $268 per 1,000 cubic meters of gas to $385, or about a 44% increase. Gazprom execs attributed the price increase to an unpaid debt for gas. This is not the first time energy has been used as an economic weapon, nor will it be the last.

The US has been undergoing an oil and gas renaissance; the White House has promoted exploration and drilling, and output has jumped. When it comes to natural gas, the US is being compared to Saudi Arabia, or Saudi America. Of course, that provided no advantage to thwart Putin’s aggression in Crimea. One reason Saudi America has failed to instill fear in Russia is that we lack the capacity to export LNG to Europe, and probably won’t be able to export in any significant quantities for a few more years; and then it would probably be a few more years before Ukraine could build facilities to receive such exports.

Meanwhile, we ran into a rash of reports in the past week or so, all telling us that our reliance on fossil fuels is killing us. The American Association for the Advancement of Society, the Intergovernmental Panel on Climate Change, and the World Meteorological Organization all confirmed that the planet is getting hotter; 13 of the past 14 years have been the hottest ever recorded. The Antarctic ice shelf is melting, Greenland too; the rain forests are dying and the Gulf Stream is collapsing. It’s not just the melting ice and the poor polar bears; the reports warn of very human problems of hunger, disease, drought, flooding, refugees, violence, and war.

Necessity is the Mother of Invention, and the time is now for innovation; and the good news is that there are inventors who have been working on these problems and have created solutions; the bad news is that the status quo and the powers that be are entrenched. This is a defining moment, and energy is being used as an economic weapon, and that weapon is pointed directly at our own foot.

And the entrenched powers just became more entrenched. The Supreme Court has struck down the aggregate campaign contribution limits, opening the gates for even more money to flood into the political system. The good news is we have the best politicians money can buy. The bad news is we have the best politicians money can buy. The 5-4 ruling in McCutcheon v. Federal Election Commission was penned by Chief Justice John Roberts and joined by justices Anthony Kennedy, Samuel Alito and Antonin Scalia; Justice Thomas went a step further and called for a complete end to campaign finance reform.

The decision relies heavily on the assertion in the 2010 Citizens United ruling that influence and access are not a corruption concern. This means that a single donor will soon be able to contribute millions of hard dollars in limited contributions, to political parties, candidates and political action committees.

Federal law sets certain limits, so you can't just go write a candidate a check for a million dollars and call it a day. That means you can't give more than $2,600 to any one candidate per election. Even if you were to donate once in the primary election and again in the general, the absolute most you could give to an individual candidate's campaign is $5,200. And you can’t, or couldn’t just spread money across the board. For the 2013-2014 election cycle, Federal Election Commission rules state that a donor can give no more than $123,200 to all political committees, with two sub-limits of $48,600 to candidates and $74,600 to political parties and political action committees. In other words, there was a limit, a cap on aggregate spending. Those limits are no more.

 Now, a single donor can now give more than $5 million in individually limited contributions to every House candidate, every Senate candidate, every state party committee, every national party committee and every leadership PAC connected to one political party. The McCutcheon ruling also did away with the aggregate limit on donations to political action committees, or PACs, which can give money directly to candidates. While there's a limit on how much PACs can give to each candidate, there's no limit on the number of PACs that can exist. Without the aggregate limit, one donor can now give $5,000 each to 1,000 different PACs. And those 1,000 PACs can turn around and funnel that money straight to one candidate. Which means that one candidate could haul in $5 million in direct contributions from one donor, funneled through a network of PACs.

So, if you have a big wad of money that you would like to waste on buying politicians, the Supreme Court has just ruled that you can blow your wad just a freely as you can speak your mind.

The new Michael Lewis book, “Flash Boys” looks at High Frequency Traders front running trades, using technology to jump in front of a trade and skim some profits. The uproar from Wall Street has been hilarious. There are claims that front running isn’t really bad; it doesn’t hurt ordinary investors; it may actually add to liquidity, blah, blah, blah. This is kind of like saying a mafia hit man is good for the neighborhood because he spends his money at the local grocery store and he hasn’t killed anybody on my street.

As we said the other day, High Frequency traders front running the market is not new; it has been going on for years, but the book and the 60 Minutes interview and the publicity finally caught the attention of otherwise somnambulant sleuths at the FBI who are investigating front running, which is a criminal offense. Where this could get interesting is that the High Frequency Trading firms set up shop in close proximity to the stock markets in New York, and they pay for high speed access to the exchanges’ computer systems and data.

The New York Stock Exchange calls it “fully managed co-location space next to the NYSE Euronext’s US trading engines in a new state of the art data center”. The NYSE is the landlord. And they can set up the “super high density” fiber optic connections for an initial fee of $7,000, or a onetime upgrade fee of $9,200. In other words, the New York Stock Exchange and the Nasdaq are complicit in the skimming operation. I didn’t hear Lewis or 60 Minutes talk about that, but that is the ugly truth.

The other funny thing about the Michael Lewis book and interview is the notion that some clever fellows, backed by hedge fund guru David Einhorn and a few other Wall Street big dogs, had come up with a clever technical fix in a new and better exchange called IEX.  Protected by a spool of fiber to ward off the high frequency traders like garlic against vampires. Free market triumphs, mission accomplished. Don't even think about a minimum transaction tax, a speed bump rule such as a minimum order duration, or anything more comprehensive than that.