Are data centers utilities?

Another good post from Mechanical Markets. This time the question is raised if data centers are utilities or not. Given the latency driven compitition, being in the same DC as the exchange can be very profitable. However, it comes at a cost. And one can question to what extend exchanges and data centers are willing and able to provide space to all participants.

And this is exactly what happened in the Nordics between Verizon, Burgundy and Nasdaq OMX. The exchange abused its position in the market and forced Verizon to deny Burgundy acces to the DC in which Nasdaq OMX was providing co-lo services and hosting its matching engines. 

All in all, there are very good and compelling arguments to start seeing DC as utilities! 

You can read the blog here.

LME looking to improve liquidity

Interested in trading metals? The LME launched a month-long consultation on proposals designed to broaden access to its electronic trading platform. 

According to LME the proposals are crucial to  maximize liquidity and participation. CEO Garry Jones believes that opening up access to trading on LMEselect is beneficial to everyone  active on all LME's venues. 

More flexible application criteria for LME membership may lead to some prospective members benefiting from exemptions from the UK Financial Conduct Authority (FCA).

The effort is an important step in  LME’s liquidity roadmap.

Collateral damage?

Transaction cost shocks in financial markets are known to affect asset prices that banks use to collateralize borrowings in monetary policy operations. 

The ECB published an interesting paper presenting a micro-simulation of the impact by transaction cost shocks on asset prices. The conclusion is that banks will on average suffer small collateral losses while selected institutions may face considerably larger collateral decreases. 

The simulation shows that, when disregarding effects on turnover, a 0.1 percentage point increase in transactions cost causes a decrease of -0.30% in collateral value. When taking the effects on the turnover of debt instruments into account in the order of 25% or 75% the collateral value is shown to decrease by -0.22% and -0.07% respectively. 

The study also shows that different assets are impacted differently. Uncovered bank bonds, central government assets and corporate bonds are affected the most with decreases by -0.96%, -0.91% and -0.34% respectively. 

The fight over FTT continues

Yesterday the EU stated that the EU commission is close on reaching a compromise on the discussed Financial Transaction Tax (FTT). The full Bloomberg article can be found here

It is interesting to note that the EU members remain divided over introducing an FTT, the possible compromise would still be without the UK and the Netherlands participating. The European Banking Union rightfully noted that an introduction of FTT in only some countries of the EU would be inconsistent with the EU efforts to build a capital markets union.

In the States meanwhile, Presidential hopefull Bernie Sanders made FTT a part of his campaign, stating that he would tax 50 cents on every 100 USD traded in equity value to provide better education and shrink trading (effectively killing HFT). According to him, both moves would improve and stabilize the economy. Realistically, it will be a cold day in hell when he gets elected but it does show that FTT is still far from dead and still a great tool for politicians to rally the masses.

Meanwhile it would be good to step away from the rhetoric and look at some studies conducted on the effects of FTT. In our studies collection there is a very interesting study from the University of Duisburg. They looked at Italy where FTT was already introduced and measured its effect. They saw an increase in volatilty and a widening of spreads. Read the article here.

Another interesting document is a study done by the City of London Corporation (perhaps not completely unbiassed). They used another angle and researched how an FTT would affect household savings. That is one of the things that usually gets lost in all the rhetoric of the FTT proponents, at the bottom line it will be the end-client that pays the bill.

 

Top US Federal researcher discovers the obvious

Not so long ago, when the industry was in full auto destruct mode, governments and regulators stepped for the big bail-out. Naturally that came at a price. The internet might just be too small to list all the measurements, fees and regulations that followed but one thing stood out; risk associated with the financial industry had to become more visible and had to be contained.

Centralized clearing for those pesky OTC transactions became an essential part of this. It would enhance transparency, deal with counterparty risk and it seemed like the best solution to prevent a domino effect. Instead of lining the domino blocks next to each other, you'd stack them on top of each other.

With that imagery in mind, a top US federal researcher identified the next problem. The stack at the CCP might get too high at a certain point (concentration risk). No, who could have foreseen that?

Read the full article here

HFT don't spoof markets, people spoof markets

A debate on HFT was held at the CFA Institute conference in Frankfurt in April. Panelist included Haim Bodek, in the Netherlands best known for his contributions to VPRO's Tegenlicht documentary on HFT and James Freiss, former white collar crime fighter at the US Treasury.

While the opinions on the matter differed, there were a number of things the panelist could agree on.  

First, it is important to understand that HFT in itself is not a strategy, it is a technology. It is nothing more than a tool. HFT as a tool can add liquidity to the markets but it can also be used to for illegal or unethical activities. So, just like with any other tool, it is a question of how to regulate and monitor the people operating the tool and not just condemn the tool itself.

Read the full article here

An objective look at HFT and dark pools

Sometimes it takes a knowledgeable outsider to bring some perspective and simplicity to a complex environment. That is especially handy when you only need to learn the essentials without becoming an expert.


Enter, PWC. They wrote a clear and concise position paper on dark pools and HFT. A clear explanation of what these phenomenons are and a list of their advantages and disadvantages. 

Read the position paper here

 

Exchanges crack down on market manipulation

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Regardless of the true effect that Sarao had on the 2010 flash crash, one thing seems to be certain. He was manipulating the market and the CME was widely critizized for letting him get away with it for so long.

So, not hard to imagine that in different board rooms at exchanges and regulators, market supervision was a hot topic. The outcome is predictable as well. Read the full article here

"MIFID II, more draconian than regulators realize"

In the continuous rally against MIFID II, there was another opinion voiced yesterday in an article in Pensions & Investments Online,

Tom Conigliario, the MD of Markit, a large US based financial services data provider states that ESMA is taking things too far and that the measurements are more draconian ans troublesome than they realize.

According to Conigliario, trading costs will rise, fund performance may be hindered and further consolidation between funds might take place as the smaller funds will be incorporated with the larger funds. He can also imagine that some asset owners like pension funds may choose to do more internal management.

An associate of Conigliario goes as far as predicting the death of OTC markets. Other experts consulted in the article disagree but do share the opinion that there is a lot of trouble ahead.

Read the ful article here

Pension funds caught between a rock and a hard place

Today Jean Frijns and Rene Maatman penned an opinion piece in the Dutch financial paper "Financieel Dagblad". Jean Frijns was the former CIO of pension giant APG and currently a professor at the Vrije Universiteit of Amsterdam. Rene Maatman is a lawyer at de Brauw Blackstone Westbroek and professor at the Radboud University. As the article is in Dutch, we took the liberty of proving a translation of the piece.

In the piece, Frijns en Maatman call upon policy makers to change the directive that pension funds need to invest in 'risk-free' assets such as government bonds as these have now have a negative yield:

Liberate the pension fund from the 'risk free' straight jacket

A pension fund must invest in accordance with the prudent person principle. This principle leans on the efficient market hypothesis: investors are rational people. An essential element of the prudent person principle is diversification of investments. With regards to government bonds however, this diversification is not necessary according to law makers. They are declared 'risk free' by decree.

Pension funds and Insures now face the question whether they should invest in debt securities with a negative interest rate. The English call this "burning cash": destruction of money. It takes effort to explain that this befits a rational investor. Can we still say that a government bond is 'risk free'? The government should not determine whether an investment is safe.
The flight forward is tempting: Get out of bonds with negative interest rates and fully go for shares and listed property. They show very desirable positive cash returns and value increases. But to a large extent this is due to the actions of the European Central Bank (ECB). Those returns are unlikely to be sustainable, though the downside risk less than 'safe' government bonds.

Pension funds are becoming underfunded as they have to value their liabilities at artificially low interest rates. And because they are in a state of underfunding, they may not increase their allocation to equities and real estate, "as that would increase their risk". Therefore even more assets flow to the  so-called 'risk-free' assets, bonds with a negative interest rate. Could it then be prudent to keep money stashed in an old sock?

The financial assessment framework in force since January 1, 2015, opted for a long-term investment horizon. The hypothesis is that a rolling recovery time frame of 10 years would result in an acceptable result. However, is this still the case when the investment portfolio has been concentrated in 'risk-free' government bonds from the start? When interest rates return to normal levels in the medium term, large capital losses are incurred. The effect on the funding ratio of pension funds possibly remains limited by the simultaneous reduction of the pension liability, but the result is a poverty trap: assets vaporize. Moreover, there are systemic risks. We live in a highly uncertain world. Negative interest rates increase this uncertainty.

Reasoned from the prudent person principle, one should look at investment strategies that generate a reasonable result, regardless of market scenarios. Those are certainly not strategies where the investments are concentrated in negative-yielding bonds. What does that mean for the supervisory framework? A first step would be to repeal the decree that certain assets are risk free. Immediately followed by releasing differentiated solvency buffers in asset classes. Such customization is based on faux science. The reality is that yesterday's risk-free investment can be a systemic risk tomorrow. Instead, a fixed risk buffer can be introduced. This sets pension funds and insurers free from the straitjacket of the existing solvency framework. This liberation undoubtedly has implications for investments in government bonds of "safe" countries, as investing at a negative interest rate can not reasonably comply with the prudent person principle.

This would be beneficial  to the effectiveness of ECB policy as it contributes to directing assets towards other sections of the capital markets. Adhering to the current solvency framework seems like reckless behavior from our point of view. This matter is urgent.