Category: Financial Markets

Can slower financial traders find a haven in a world of high-speed algorithms?

From The Conversation.

It sounds like a scene from “Jurassic World”: fast, agile predators pursue their slower, less nimble prey, as the latter flee for safer pastures. Yet this ecology framework turns out to be an apt analogy for today’s financial markets, in which ultra-fast traders vie for profits against less speedy counterparts.

In fact, the algorithmic traders (known variously as algos, bots and AIs) proliferating in financial markets may well be viewed as an invasive species that has upended the prevailing order in their shared habitat. A 2013 article asserts that the financial world has become a “techno-social” system in which human traders are shunted aside, unable to keep up with the bots interacting in a “new machine ecology beyond human response time.”

And in a rapidly evolving world of autonomous traders, past experience may not provide reliable assurance of safety and predictability. The hallmark of a flash crash is lack of an apparent triggering event, generating uncertainty that can further destabilize markets.

Is the regime of algorithmic traders making the financial world more dangerous? How can market innovation and regulations shape this habitat for better or worse? For policy makers, the pressing question is: how can we operate our markets so that they remain stable and efficient amid fundamental technological changes?

In my research on artificial intelligence and strategic reasoning, I’ve been exploring answers to these questions by modeling how the world of trading works.

‘Latency’ arms race

What makes this world especially different and unpredictable is the unprecedented speed at which trading bots can respond to information.

A slight edge translates into profit because of the way exchanges match orders. When new information arrives, the first trader to react is able to make money off of slower rivals, while any relative delay or latency of even a fraction of a millisecond can mean no trade and no profit.

This leads inevitably to a latency arms race in which the designers of trading algorithms adopt any available method to shave milliseconds or even microseconds – one millionth of a second – from response time.

Most exchanges and trading forums have catered to the high-frequency traders, providing premium access options and interface features that preserve or enhance the advantage of speed.

An exception is the alternative trading system IEX, featured in Michael Lewis’s Flash Boys and backed by institutional investors, which introduced a 350 microsecond delay on order submission to shield against high-speed bots. On June 17, the Securities and Exchange Commission (SEC) approved IEX’s application to operate as a public exchange – rather than only as a private trading platform – against strong opposition by high-frequency traders and competing exchanges.

Ending the latency race

But there is another way to neutralize small speed advantages: change the way markets time the matching of buy and sell orders.

Today’s typical market works by matching orders to buy and sell a stock or other asset on a continuous basis. For example, when a trader submits a request to buy a share of Apple at a specific price, the exchange matches it immediately if there is an offer from someone else to sell at the same price or less. This immediacy is what allows a trader able to react more swiftly to new information (say news about the latest iPhone) to profit off of slower rivals.

In a frequent call market, on the other hand, orders to buy and sell are matched at fixed intervals (such as once every second). So our Apple buyer with knowledge of the release of a big improvement in the iPhone wouldn’t be able to get a jump on rivals because her order wouldn’t transact immediately, giving time for others to “catch up.”

By ensuring that speed no longer categorically prevails, the incentive for shaving milliseconds and microseconds is virtually eliminated. Orders within the interval compete instead based on price, leading to a more efficient overall set of trades.

Regulators have taken notice. New York Attorney General Eric Schneiderman has publicly endorsed the frequent call market – also known as a frequent batch auction – to even the playing field. And SEC Chair Mary Jo White said it could help counter problems with algorithmic trading.

At present, however, no stock exchange operates as a full-fledged frequent call market. One major hurdle to adoption is perception: the view that faster is always better.

Another problem that some have raised is that it would only be viable if all exchanges adopted the method simultaneously because otherwise traders would always pick the venue offering the most immediacy.

But is this true? Given the option of trading on either a continuous market or a frequent call market, which one would investors prefer? Or, in the terms of our ecology metaphor, would they flock to the new habitat operating in discrete time intervals or stay in the traditional continuous domains?

Predator and prey

To answer this question, in research conducted at the University of Michigan, Elaine Wah and I developed a model with two markets, one continuous and the other a frequent call market.

In this model, traders are either fast (think high-frequency) or slow (such as institutional and retail investors). Each trader can choose to buy and sell in one of the two markets and so will prefer to pick the one that offers the highest expected trading gains, taking all others’ behavior as given.

If all the agents are in one market, no individual can benefit by going to the other, as there is nobody to trade with. We therefore focused on market attraction, measured in terms of the prevalence of conditions that would make one trader want to switch.

Our results show that fast traders prefer the continuous market, where they can make the most money, but only when the slow traders are also there. In other words, the predators need their prey in order to be profitable, which means they have a pronounced tendency to follow the slow traders to whichever market they go.

Slow traders, on the other hand, can evade their pursuers by fleeing to the market with fewer fast traders. If the fast traders are prevalent in both markets, then slower ones tend to seek refuge in the frequent call market, which offers some protection from faster traders with better information, as well as generally higher trading gains.

A recent paper by Zhuoshu Li and Sanmay Das from Washington University also found, under quite different assumptions, a tendency for the frequent call market to attract traders away from continuous markets.

Lessons for exchanges

What both of these studies suggest is that we may not need a top-down mandate to transform financial markets from continuous to discrete-time trading. Simply making the option available in one or two exchanges may capture the population, as the haven for slow traders can attract both the prey and the predators in pursuit.

High-frequency traders have been relentless in their pursuit of lower latencies and faster access to market-moving information, but ultimately it’s the continuous markets that deserve blame for allowing this predator-prey dynamic to take shape.

Neutralizing the advantage of tiny speed improvements with something like a frequent call market offers a clear-cut solution. The introduction of such a market will provide an attractive haven for investors, and widespread adoption could eventually send the latency arms race the way of the dinosaurs.

Author: Michael Wellman, Professor of Computer Science & Engineering, University of Michigan

Companies may be misleading investors by not openly assessing the true value of assets

From The Conversation.

Some companies are taking years to recognise asset impairments, and may be misleading investors who are not privy to the valuation decisions. Research shows this is because managers of many firms think or hope that assets are not overvalued.

This occurs when companies either don’t recognise, or delay the recognition of asset impairments. These asset impairments represent a downward adjustment in the value of assets, to what is called “recoverable amount”. This is determined by either the value the asset could be sold for, or its value to the business right now.

One example of this process of recognising asset impairments can be easily seen in Nine Entertainment Corporation Ltd in 2015. Through the first half of 2015 the share market value declined significantly, and by year end its book value (the value of net assets on the balance sheet) would have exceeded the firm’s market value.

This was probably occurring as investors revised their estimates of future returns in response to changes in the television industry and increasing competition from pay television, internet-based television and other online media. These factors are indicators of declining asset values, which are explicitly identified in the regulation, and this requires a test for asset impairment by the firm.

Next, Nine would have determined the recoverable amount of the assets. The company would have had to estimate future returns and, while there are extensive guidelines on how this should be done, considerable judgement is still required. The end result in this case was an asset impairment of A$792 million that resulted in Nine reporting a loss for the year.

The Australian Securities and Investment Commission (ASIC) regularly reviews the financial reports of listed firms. Where necessary, it seeks their explanations for particular accounting treatments. Risk-based criteria are used to select which firms are reviewed and in some instances this leads to material changes in their reports.

The most recent review by the corporate regulator into end-of-year financial reports for 2015 found the biggest number of the queries (11 out of 24) into accounting related to the valuation of assets.

It is unlikely this is a consequence of poor regulation. The regulation sets out clear criteria, identifying the circumstances when asset impairment should be formally considered (i.e., where indicators of impairment exist) and the basis for calculating the amount of asset impairment.

In some cases determination of asset impairments should be straight forward. For example, where firms are unprofitable and the book value exceeds the market value of equity, the indicators of impairment are readily observable to all because it can be identified using “firm level” information.

However, in other cases it is not so straightforward and determining whether impairments are necessary and calculating the recoverable amount is then much more difficult.

Asset impairments are required to be evaluated at the level of business units, or what the regulation refers to as “cash-generating units”, rather than at the firm level. Accordingly, while asset impairments may be necessary in some business units, the need for or amount of asset impairments may be obscured in firm-level information.

For example, Arrium is clearly experiencing financial problems and has made a number of asset impairments. But it is not all bad; some of its business units are profitable. When the firm level information is considered it may start to mask the very poor performance in other business units. Hence, whether the need for asset impairment is obviously necessary will depend on relative size and number of poorly performing business units.

Significant judgement will be required in these cases. This includes defining business units and attributing assets to them. Only then can future returns be estimated, and this can never be done with certainty. If there are problems with the exercising of this judgement, then maybe the assumptions on which asset impairment decisions are based should be made clear and disclosed.

Unfortunately, the people who use these financial statements, such as investors, are often kept in the dark because firms are only required to disclose the assumptions behind their judgements if an impairment is actually made. However if these disclosures were always made, it would either support the asset values reported, or alternatively confirm that asset impairments are really necessary.

In the absence of these disclosures, investors and other users of financial statements do not get important up-to-date information about future returns that would underpin share prices.

It’s time to amend the regulation and reveal the explanations for not recognising asset impairments. Whenever there are indicators that impairment is necessary, companies should be required to disclose their assumptions even if the decision is not to impair.

Doing this will highlight how asset impairments are being (or, more critically, not being) determined and assets valuation will always be more transparent.

Authors: Peter Well, Professor, Accounting Discipline Group, University of Technology Sydney; Brett Govendir, Lecturer, University of Technology Sydney;  Roman Lani, Associate Professor, Accounting, University of Technology Sydney.

 

An uncertain election result may lead to stagnant financial markets

From The Conversation.

For the second time in the space of ten days, it appears that betting markets and pollsters have got it wrong. First, despite odds showing a 90% likelihood of “Remain” winning, the UK voted to “Leave” the European Union in its June 23 referendum.

Now, a mammoth federal election campaign has resulted in political stalemate in Australia, and the result will not be known until Tuesday at the earliest.

Clearly, the repercussions of a hung parliament are not as wide-ranging as “Brexit” and we are unlikely to see Canberra’s streets flooded with protesters. However, when Australian markets open on Monday they will still be faced with a high degree of political uncertainty. Investors do not tend to react favourably to such ambiguity.

Investors reduce risk under political uncertainty

Investors tend to respond in one of two ways. The most-common situation is for the political uncertainty to manifest in higher levels of market volatility and a flight to quality as investors try to reduce their exposure to risk.

This was what we witnessed post-Brexit: Australian stockmarkets and the dollar fell by more than 3%, while “safe” government bond yields hit an all-time low.

An alternative is for markets to become locked in stasis – where investors sit on their hands, unsure as to whether they should buy or sell. Market liquidity falls and asset prices become resistant to change.

This is effectively what happened following the hung parliament of August 2010. In the aftermath of that election, stock prices remained within a tight trading range and the dollar hardly budged over the course of the following week.

When the result of the 2016 election is finally known, it appears that the outcome will be either a minority Coalition government or a hung parliament. The Senate is likely to be more fractious than prior to the election.

Talk has already started about potential unrest among the conservative faction of the Liberal Party who supported former prime minister Tony Abbott. There is even discussion of an election re-run if the parliament proves ungovernable. Clearly, this uncertainty could linger for months.

Concerns for jobs and growth

The likelihood of a lengthy period of uncertainty is important. It means it will be difficult to pass any economic or budgetary reforms. Without such reforms, it is unlikely the budget will return to surplus in the near future (if ever) and it becomes more likely that the AAA credit rating will be lost.

This creates multiple concerns for Australian financial markets, and the broader economy. A credit rating downgrade will likely increase the cost of funding for Australia’s banks.

The Big Four banks will be particularly impacted given the significant role that offshore funding plays in their balance sheet management. This will mean higher interest rates for borrowers – which would not be beneficial for the housing market.

A prolonged period of uncertainty will make it difficult for firms to finalise investment decisions. At a time when the economy is still attempting to transition away from the boom in mining investment this will dent economic growth and employment. So much for “jobs and growth”.

Essentially, this is a recipe for a “risk-off” environment of declining stockmarkets and a depreciating Australian dollar. It is also likely that the market will price a higher likelihood of a reduction in the RBA target rate at the July or August meeting. This will further aid a continued rally in relatively safe government bonds (bond prices rise as yields fall).

If you consider the ongoing political uncertainty resulting from Brexit and the forthcoming US presidential elections in addition to the federal election, then months of nervous markets may lay ahead.

Author: Lee Smales, Senior Lecturer, Finance, Curtin University

UK Loses AAA Rating – S&P

Rating agency Standard & Poor’s (S&P), the only agency which had previously given the UK a AAA rating, just revised it down. S&P said the the referendum result could lead to “a deterioration of the UK’s economic performance, including its large financial services sector”. They say Brexit will “weaken the predictability, stability, and effectiveness of policy making in the UK”. This follows downgrades from Fitch – from AA+ to AA – forecasting an “abrupt slowdown” in growth in the short-term and Moody’s last Friday cut the UK’s credit rating outlook to negative.

A ratings drop is likely to raise the cost of Government debt on the international markets. Here is the pound US$ chart, which fell further on Monday to a 31 year low.

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Brexit rocks Australian sharemarket, worse to come

From The Conversation.

The UK has voted to leave the European Union but even before all the votes were counted volatility made its way across Asian markets and to Australia.

The S&P ASX200 has finished 3.3% down at the close, wiping off approximately $50 billion in value, while the Australian dollar has dropped 3.4% to 73.4 US cents.

Richard Holden, Professor of Economics at UNSW says the volatility is likely to continue at least for another 24 hours.

“We could see volatility, perhaps not as extreme as the current levels, for a really extended period of time,” Professor Holden says.

One of the major factors in this will be how affected UK banks and therefore Australian banks will be by this decision, as they rely on short term funding for their operations.

“If those markets start to dry up and there’s uncertainty about their funding getting rolled over, one day to the next, then that’s when things can go pear shaped within an incredibly short period of time,” he adds.

The position of hedge funds, banks and other financial institutions in betting on currencies in over-the-counter markets (not regular currency markets) in times like this, also adds to the uncertainty.

“Basically we don’t know, what we don’t know and suddenly there’s a liquidity crunch and someone gets into trouble and that has flow-on effects like we saw in 2008,” Professor Holden says.

The S&P ASX200 index closed -3.3% following the Brexit vote. S&P ASX 200

He also warns that a drop in the Australian dollar shows that money could flow out of Australia and back to the UK as financial institutions there change their positions.

In the longer term, Brexit could affect the way Australian companies trade with the European Union through the UK.

“All of a sudden that’s going to be more complicated, it’s going to have to go through under some new trade agreement and we know that a series of bilateral trade agreements are always more complicated and have more nuance than large multilateral trade agreements,” Professor Holden says.

All this comes as Australia goes into the last week of an election campaign and this volatility will keep economic management top of mind for Australian voters.

“I don’t think either side of politics in Australia has an exclusive right to say they are going to be the best economic managers, I guess we’ll have to wait and see about that as well.”

Jenni Henderson, Assistant Editor, Business and Economy, The Conversation Interviewed Richard Holden,Professor of Economics, UNSW Australia

Ex-Deutsche Bank trader pleaded guilty in U.S. to Libor scheme

According to Reuters, U.S. and European authorities investigations relating to LIBOR rate rigging have resulted in roughly US$9 billion in sanctions worldwide against financial institutions, and 16 people being charged by the Justice Department. We discussed the problem of these financial benchmarks yesterday. Now, U.S. prosecutors have secured a guilty plea from a second former Deutsche Bank AG trader for conspiring to manipulate Libor, the benchmark interest rate at the center of global investigations of various banks, court records show.

Timothy Parietti, a 50-year-old former managing director of Deutsche Bank’s New York money market derivatives trading desk, pleaded guilty on May 26 in Manhattan federal court to conspiring to commit wire fraud and bank fraud, records unsealed on Wednesday showed. According to a transcript, Parietti admitted that from 2006 to 2008, he participated in a scheme with other bank employees to manipulate Libor so that trades he made on financial instruments linked to the benchmark might be more profitable.

“At the time, I knew that this practice was dishonest. I participated in this dishonest practice and I accept responsibility for my role,” Parietti said. “I’m sorry for my conduct.”

The plea, pursuant to a cooperation agreement, was followed on June 2 by the U.S. Justice Department unveiling an indictment against two other former Deutsche Bank traders, Matthew Connolly of New Jersey and Gavin Campbell Black of London.

Both cases followed the earlier guilty plea in October of a former senior trader at Deutsche Bank, Michael Curtler of London. The bank agreed in April 2015 to pay $2.5 billion to resolve related U.S. and U.K. probes. According to charging papers, from 2005 to 2011 Parietti and others engaged in a scheme to manipulate Libor, which was tied to the profitability of derivative trades in which they had a financial interest. In charging Connolly and Black, prosecutors said that at least eight other people, including Curtler, were involved in the scheme to submit false estimates for some Libor rates in order to manipulate it. Connolly has pleaded not guilty. Black’s attorney has previously declined comment.

 

ASIC commences proceedings against Macquarie Investment Management

ASIC has announced it has commenced proceedings in the Supreme Court of New South Wales against Macquarie Investment Management Ltd (MIML) as the responsible entity of the van Eyk Blueprint International Shares Fund (VBI Fund). The proceedings involve investments of $30 million made by the VBI Fund in 2012 into a Cayman Islands based fund, known as Artefact Partners Global Opportunities Fund (Artefact). The VBI Fund was one of the Blueprint series of funds of which van Eyk Research Pty Limited (now in liquidation) was investment manager, and MIML was responsible entity.

MIML has admitted to five contraventions of the Corporations Act and the parties have filed an Agreed Statement of Facts.

ASIC and MIML have agreed that MIML failed to comply with its duties as a responsible entity by:

  • failing to adequately address risks associated with the decision for the VBI Fund to make 3 investments into Artefact between 6 July to 30 October 2012;
  • allowing members to redeem or withdraw units from the VBI Fund when it was illiquid in contravention of the Corporations Act and the scheme’s constitution between 15 June 2013 to 9 September 2013; and
  • failing to make adequate and timely enquiries in relation to van Eyk’s monitoring of the VBI Fund’s investment in Artefact between 18 February 2013 and 21 July 2014 (including not making adequate and timely enquiries as to why a full redemption from Artefact had not been paid between 1 January 2014 to 21 July 2014).

The Court will hear joint submissions from ASIC and MIML as to the appropriate penalty amounts. The final penalty amount is a matter that will be determined by the Court.

On 1 August 2014, MIML suspended redemptions from the VBI Fund and three other funds due to their exposure to the VBI Fund.  Between them these funds managed over $450 million.

On 15 August 2014, MIML terminated the VBI Fund, with unitholders owed around $30.9m relating to the Artefact investments. Since then, Artefact has repaid $20m to the VBI Fund. MIML recently paid the remaining approximately $10.9 million plus interest to unit holders (less fees and winding up costs) and expects to recover the majority of that amount from Artefact’s liquidator. ASIC acknowledges the efforts made by MIML to have the investors’ funds repaid.

ASIC has an ongoing investigation into van Eyk Research Pty Ltd, the entity MIML appointed as the investment manager of the VBI Fund. Van Eyk Research Pty Ltd went into liquidation in 2014.

Commissioner Greg Tanzer said, ‘The Corporations Act places important obligations on responsible entities which protect the interests of investors.  Those obligations require responsible entities to have a supervisory and monitoring role in relation to funds, even where external investment managers have been appointed. ASIC will take action against responsible entities when they fail to meet their obligations.’

The proceedings will be listed for directions on Monday 27 June 2016 and the parties will request an early hearing date from the Court.

ASIC highlights significant failures in the retail OTC derivatives industry

ASIC has released a report detailing the findings of a recent surveillance program and identifying some serious and widespread compliance failures in the retail over-the-counter (OTC) derivatives industry. Over 70% of AFS licensees reviewed demonstrated issues with three or more of the seven compliance risks.

OTC-ASICIn recent years, ASIC has made a number of public statements about the concerning degree of non-compliance in the retail OTC derivatives sector. ASIC considers retail OTC derivatives to be complex, high-risk products which are often difficult to understand, even for experienced investors.

ASIC has observed a material increase in the number of Australian financial services (AFS) licence applications from entities seeking to operate retail OTC derivatives financial services businesses in Australia. In conjunction with this trend, we also identified increasing non-compliance by existing AFS licensees with a number of their Australian regulatory requirements.

We recently undertook a review to assess a large proportion of the AFS-licensed retail OTC derivatives industry against the following seven compliance risks:

  • failure to comply with the net tangible assets (NTA) requirement
  • failure to comply with notification requirements for change of control events and issues around new ownership compliance
  • failure to comply with client money provisions
  • poor, misleading or deceptive Product Disclosure Statements (PDS) and website disclosure
  • failure to comply with financial reporting obligations
  • failure to supervise authorised representatives and non-compliance by authorised representatives, and
  • claims that no financial services are being provided under the AFS licence.

This report summarises the key findings of that review and identifies areas where compliance standards can be raised in the retail OTC derivatives sector.

Our findings

Our review identified a high degree of non-compliance. Over 70% of AFS licensees reviewed demonstrated issues with three or more of the seven compliance risks. In particular, our compliance review identified that:

  • over 80% demonstrated issues with the disclosure in their PDS or website
  • over 60% had undergone a change of control (with some issuers exhibiting multiple changes of control in a 12-month period) and 85% of those entities had failed to notify ASIC as required
  • over 50% had not adequately complied with their financial reporting obligations
  • around 50% required additional detailed assessment to determine whether they adequately complied with their NTA requirements, and
  • nearly 30% did not appear to be providing any financial service under their AFS licence, despite some being licensed for a number of years.

Many of the compliance concerns we detected were contraventions of well-established regulatory requirements or non-compliance with fundamental AFS licensing obligations. We also observed a significantly high number of smaller, foreign-owned or foreign-controlled AFS licensees demonstrating either a lack of awareness or understanding of their Australian regulatory obligations, or reluctance to invest resources in meeting compliance obligations for their Australian businesses.

In total, we obtained more than 150 regulatory outcomes as a result of our review, including:

  • recapitalisation to comply with financial requirements
  • improvements to defective disclosure
  • submission of overdue financial reports
  • corrections to registry and AFS licence information
  • improved supervision of authorised representatives
  • rectification of compliance failings
  • cessation of unlicensed conduct, and
  • AFS licence suspensions and cancellations.

Commissioner Cathie Armour said, ‘This report highlights some serious compliance failures in this industry. We expect industry to take note of our findings and proactively remediate any areas requiring improvement to ensure they have adequate and enduring compliance measures to fulfil their regulatory obligations.

‘The report also provides a prudent warning to investors. We hope the report will encourage them to be more aware of the risks of these types of products as well as improve their understanding of the standards of practice they should expect from retail OTC derivative providers.

‘As can be seen from our surveillance findings and announcements, many of these investment products may not be appropriate for average investors, who are often caught out by the complexity and may not understand the heightened risk profile,’ she said.