Lawbitrage

Cutting Through the Noise About High-Frequency Trading

One might expect that the impact of high-speed, computerized securities trading would not be a controversial subject because the relevant information can be quantified, measured, and assessed.

But one would be wrong.

When it comes to the impact of high-frequency trading (HFT) on securities markets, limited data and inconsistent measures of its impact only fuel a controversy in which there seems to be little ground between those who seem to know that HFT has ruined markets and those believing that investors have never had it better.

Adding to the controversy about the impact of HFT is today's publication of Flash Boys: A Wall Street Revolt by famed author Michael Lewis. While the book no doubt does a great job of explaining the complexities of modern financial markets to non-experts, based on excerpts, reviews, and interviews describing the stock market as being "rigged," those wanting a more nuanced view should look elsewhere. 

To cut through the noise surrounding HFT, it's helpful to look at empirical studies on the subject. 

And indeed, there's lots of empirical studies finding that HFT in various forms undermines the quality of markets and increases costs to investors. Perhaps the best review of evidence-based studies in this regard is a December 2013 publication by R. T. Leuchtkafer. It reviews numerous academic, industry, and government studies with conclusions such as "HFT can be highly destabilizing as it propagates shocks across markets at very high speed," "high frequency traders do not as a rule engage in the provision of liquidity like traditional market makers," and there is "strong evidence that HFT increases the trading costs of institutional investors."

But the usefulness of Leuchtkafer's review is limited: it only includes negative findings (and opinions, for that matter).

In March 2014, staff of the U.S Securities and Exchange Commission (SEC) conducted its own review of empirical studies on the impact of HFT. While certainly not comprehensive, the SEC's review includes several studies not included in Leuchtkafer's review. And many of these additional studies find that HFT has a positive impact on markets and investors.

Among other things, these studies found that HFT "was associated with a 15% decline in effective spreads and a 23% reduction in the adverse selection costs of posted prices," that "price efficiency as measured by [order imbalance and price delay] is significantly higher on days of high HFT aggressiveness," and that for investors "trading costs did not change significantly" following a fee change that reduced HFT. 

The SEC's review is hardly an endorsement of HFT. Overall, it finds the impact mixed. In any case, the SEC's review recognizes its own limitations, noting that the HFT "picture remains unfinished" due to the limited availability of data. 

So while empirical studies of HFT"s impact hardly paint a conclusive picture, they do help to cut through the noise of HFT's most vocal critics and proponents. Hopefully, a balanced view of the empirical record will have the most influence over any reforms undertaken by regulators or market participants.

Research by Nobel Prize-Winning Economists Raises Doubts About Derivatives Regulation

The 2012 Nobel prize in economics was awarded today to Alvin Roth and Lloyd Shapley for their research on how markets are best designed.

Although neither has applied their research to derivatives markets, their winning ideas seem to undermine the case for designing derivatives markets around a central clearinghouse, which is precisely what the Dodd-Frank Act of 2010 and other reforms around the world seek to do.

In a 2008 article, Roth noted that well-functioning centralized markets should:

provide thickness, i.e. they need to attract a large enough proportion of the potential participants in the market...and they need to make it safe and sufficiently simple to participate in the market, as opposed to transacting outside of the market, or having to engage in costly and risky strategic behavior.

But when it comes to derivatives markets, there's a major problem: many types of derivatives markets will never be thick enough to function well if centralized clearing is required.

Take credit default swaps (CDSs), the notorious type of derivatives contract that motivated Dodd-Frank's central clearing requirement. Even with the contract standardization and other operational improvements that have taken place in recent years, the market for CDSs that use clearinghouses is very thin.

For example, of the 1000 most active single-name CDSs, there are over 900 that reference corporations. However, the largest CDS clearinghouse (the Intercontinental Exchange) only clears 253 single-name corporate CDSs, or about 28 percent of the most active CDSs. In fact, the value of the currently outstanding CDSs on the Intercontinental Exchange's clearinghouses ($1.5 trillion in open interest) constitutes only 5 percent of the total value of CDSs ($28 trillion in notional value as of year end 2011).

These statistics show that using clearinghouses is a market design that doesn't appeal to a lot of CDS market participants--that it lacks Roth's "thickness" standard.

Roth also notes that well-functioning markets must be safe, which in finance means systemically stable. Although many aspects of derivatives regulation and practice are still evolving, designing the market around clearinghouses reduces safety in a way that may ultimately impede the market from functioning.

In a 2012 article, I noted the risks that the clearinghouse model will introduce, including clearinghouses becoming undercapitalized due to technical risk-management failures or because a clearinghouse reduces its standards to attract business. In addition, clearinghouses may create moral hazard by removing the direct incentive for CDS counterparties to consider counterparty risk upon entering a trade since that risk is shifted to the clearinghouse.

The beauty of Roth and Shapely's research is its practical orientation. Unfortunately, when applied to how derivatives markets are effectively being redesigned by global regulation, it's hard to conclude that the result will be the most functional.

Director Stock Sales May Cause Companies to Become Less Innovative

Facebook director Peter Thiel drew enormous attention last month when he sold the majority of his Facebook stock for nearly $400 million. Most commentators focused on whether Thiel's sale as an insider indicated that Facebook may not be a good investment. 

But there is another issue raised by Thiel's stock sale, and any significant future sale of stock by other Facebook directors as well.

Put simply, academic studies suggest that directors are less effective the fewer shares they own in the company. This is because directors with stock ownership in a company may be especially focused on its long-term, strategic growth.

A 2010 review of corporate governance studies noted that greater stock ownership by directors is one of the few governance characteristics associated with better company performance.

A particular problem for an innovative company like Facebook is the potentially negative relationship between long-term, innovation activities and director stock ownership. The few studies that look at the issue find evidence that companies with lower director stock ownership engage in less research and development. These studies are briefy summarized on pages 869-870 of this 2007 article. 

None of the foregoing strongly suggests that Thiel will actually be less effective at advising Facebook now that he has dumped most of his stock in the company. The studies referred to above are very limited in providing solid predictions of individual behavior or company performance. And Facebook's culture and Mark Zuckerberg's own repeated committment to the long-term may also mitigate any negative impact of Thiel's reduced stock holdings.

Nonetheless, it is still worth contemplating whether a Facebook board with less skin-in-the-game may also be less committed to long-term activities that produce innovation.

CDOs: Designed for Fees, Not to Fail

An important new study on collateralized debt obligations (CDOs) finds that the assets used to make CDOs just prior to the financial crisis consistently performed much worse than comparable non-CDO assets. The authors suggest that banks used CDOs to transfer low quality assets to CDO investors as part of a plan to unload financial "lemons."

A Bloomberg story on the paper notes that it supports the narrative that prior to the financial crisis bank issued CDOs that were "designed to fail" and stuffed with toxic mortgage-related risk. Dealbreaker's Matt Levine also argues that, in any case, such activities may reflect well on banks' risk management to the extent CDOs were intended to transfer mispriced assets to investors.

However, while the paper does indeed bolster the case that CDOs were used to transfer risk, it is actually more likely that structuring and issuing CDOs was motivated primarily to generate fees for underwriters (and ratings firms). This is because underwriters continued to create CDOs even when outside investors stopped buying them.

As noted by the Financial Crisis Inquiry Commission report (p. 188), despite a lack of outside investor interest in buying CDOs, by 2006

The CDO machine had become self-fueling. Senior executives—particularly at three of the leading promoters of CDOs, Citigroup, Merrill Lynch, and UBS— apparently did not accept or perhaps even understand the risks inherent in the products they were creating. More and more, the senior tranches were retained by the arranging securities firms, the mezzanine tranches were bought by other CDOs...

Importantly, the "other CDOs" were also created by CDO issuers to purchase mortgage-related securities that outside investors did not want to buy. As the IMF explained in a 2008 report (p. 59):

These CDOs-squared and structured-finance CDOs were created almost solely to resecuritize MBS and CDO mezzanine tranches, for which there was not sufficient demand from investors. Therefore their value added in transferring risk is questionable.

While the "designed to fail" motivation may explain some CDOs, the fee-generation explanation seems superior and indeed underlies perhaps most important result of pre-crisis CDOs: they did not transfer risk but rather caused billions of dollars in write-downs at the financial institutions that created them.

The Structure of Venture Capital Contracts

A recent 136-page review of academic papers on venture capital by Da Rin, Hellmann, and Puri provides a high-level empirical description of how venture capital contracts are structured (extra paragraph breaks added):

In two seminal papers, Kaplan and Strömberg (2003; 2004) empirically examine the structure of VC contracts....Contracts routinely separate cash flow and control rights, make extensive use of state contingent clauses, control tends to shift to the VC (entrepreneur) in bad (good) states of natures...They also find that investor-friendly cash flow and control rights tend to be complements, not substitutes.

Kaplan and Strömberg (2004) ask why VCs use certain clauses in certain deals....They find that higher internal and external risks are associated with more VC control and more contingent compensation, whereas execution risk is related to the vesting of founder shares.... Kaplan and Strömberg find that anticipation of control actions (such as founder replacement) is associated with greater VC control rights, whereas anticipation of value-adding activities is associated with larger VC equity stakes.

...Bengtsson and Sensoy (2011a) find that higher ability investors make less use of contractual clauses to protect their returns on the downside, where ability is proxied by experience. Bengtsson and Ravid (2011) find that companies and VCs in California also use considerably less downside protection; this is also the case when the VC is physically closer to the company....

Bengtsson and Sensoy (2011b) study how contracts evolve as companies secure new rounds of financing. They find that following poor company performance, the contracts for the new investors include more downside protection and the contracts of the previous round investors are more likely to be renegotiated.

Finally, Bengtsson (2011b) shows that covenants are more likely in contracts that also include higher fixed claims on the downside. Garcia-Appendini et al. (2011) find a positive relationship between the use of covenants and investment returns.

Complementing this research is Wilson Sonsini's latest quarterly analysis of trends in venture capital financing terms.