Nonstandardized Derivatives and Complexity

I.   Simplicity and complexityJaffrey Woodriff-Quantitative Investment Management

The problem:  Regulatory complexity has become the goal of banks.

Banks and their lobbyists are slowing down and halting the regulation of equities markets through measures aimed to increase the complexity of the Dodd-Frank regime.  While Dodd-Frank was 848 pages long, its rule-makings alone will likely amount to 30,000 pages.  This has demonstrable impacts on economic growth.  A recent PriceWaterhouseCoopers study including interviews with dozens of CEOs of the world’s largest financial institutions found that “it is clear . . . that it is not simply regulatory change, but regulatory complexity and uncertainty that are really dampening confidence in growth.”

Big banks are largely responsible for this regulatory sclerosis.  Banks have succeeded in lobbying to exempt foreign interest rate swaps from clearing requirements.  Banks have exempted certain activities from Volcker Act prohibitions and have lifted Volcker restrictions during periods of severe market stress.  In 2012, banks convinced a federal judge to strike down Dodd-Frank’s position limits rule, which placed new restrictions on speculative trading in commodities.

Policy proposal:  Mandate simplicity.

Congress should adopt broad concepts and let prosecutors, courts, and the agencies work out the implications.  As Chester Spatt, former Chief Economist at the SEC, has stated in the Harvard Business Law Review: “[R]egulators often would do far better in accomplishing their regulatory goals by adapting relatively simple standards and principles that force market participants to internalize the consequences of their actions.”  A recent presentation by senior Bank of England officials before the Kansas City Federal Reserve also called for the “explicit regulation” of complexity.

One approach would be to adopt a pay-go approach in financial regulation—cutting one regulation or rule-making for every new one that’s added.  The futures market is far simpler than our equities markets.  A study commission could also be authorized to study how equities markets could be modeled after our futures markets.

 II.  Opacity and financial statements

The problem:  Financial statements do not include accurate measurements of risk.

A recent article in the Atlantic by Frank Partnoy and Jesse Eisinger exposed troubling problems in the statements of big banks that mask large levels of systemic risk from shareholders, the public at large, regulators, and policymakers.  The authors subjected to rigorous analysis recent disclosures and statements by WellsFargo, in part concentrating on the “fair value” of assets and liabilities recorded by WellsFargo.

Like other banks, Wells Fargo uses a three-level hierarchy to report the fair value of its securities.  Level 1 includes the reported price of securities, which are transparent and standard.  Level 2 includes derivatives and mortgage-backed securities, which have no active, public markets—so Wells Fargo uses “model-based valuation techniques, such as matrix pricing” to determine fair value, including “observable” inputs such as the prices of similar assets.  This provides only an estimate of fair value.

Level 3 contains the most esoteric financial instruments, such as the credit-default swaps and synthetic collateralized debt obligations that helped cause the 2007 financial crisis. WellsFargo’s Level 3 estimates are “generated primarily from model-based techniques that use significant assumptions not observable in the market.”  “Fair value” at Level 3 is based on no objective data at all.  

Only a small fraction of Wells Fargo’s assets are on Level 1.  Most are on Level 2. And over a third of the capital reserves—$53 billion—are on Level 3.  Scholarly research suggests Level 3 asset valuations can be off by as much as 15%.  This would equate to billions of dollars in misstatements for WellsFargo.  For example, WellsFargo’s statement reports that $8.1 billion fair value of its Level 3 assets are worth exactly the price it paid for them—their “cost basis”).   This seems suspect at best.   The bank is simply using its own internally generated estimates to determine fair value.

Policy proposal:  Standardized “fair value” measurements and full disclosure.

Congress should mandate that the SEC require banks to define “fair value” according to transparent, standardized methodologies that afford investors, regulators, and the public maximum information about levels of risk.  Straightforward standards of disclosure should be enforced.  Different asset classes should be subjected to the same accounting standards.

 III.  “Special-purpose entities”

 The Problem:  Variable Interest Entities are transferring obligations off-balance-sheet.

The Special Purpose Entities Enron used to hide its debts  have now been renamed variable-interest entities (VIEs).  According to Don Young, a former board member of the Financial Accounting Standards Board, these are “Accounting gimmicks to avoid consolidation and disclosure.”  The purported benefit of VIEs is to help a company to transfer the risk associated with financing assets away from shareholders and onto other investors. VIEs are set up to buy a bank’s assets, which improves banks’ balance sheet, because banks use the sale proceeds to pay down liabilities.

Often the VIEs are off-balance-sheet, yet the bank’s obligations remain.  This in effect renders the VIE a hidden loan (therefore hiding risk) from shareholders, the public, and regulators.  Leading up to the financial crisis, Citigroup, for instance, held $292 billion in variable interest entities that did not appear as liabilities on its balance sheet.  In 2007, Citi was forced to buy back $25 billion worth of commercial paper through VIEs at face value, even though the paper was trading at about 33 cents on the dollar, which cost Citi (and its shareholders) $14 billion.

 Policy proposal:  Require greater transparency and honest accounting.

Companies should be required to provide a detailed written disclosure as part of their annual reports of all off-balance sheet activities as well as justify any failure to put these activities on balance sheet.  They should have to disclose in their quarterly and annual reports the daily average leverage ratios and daily average liabilities, which would resolve opacity created by the present requirement that firms only show liabilities and assets as of quarter end and year-end.  Finally, as Frank Partnoy and Lynn Turner argued in the Roosevelt Institute’s Make Markets Be Markets report, firms should be required to disclose information on transactions that were accounted for as sales by the issuer, but have implications for future liquidity.

IV.  Capital requirements for banks

The Problem:  Banks are still over-leveraged.

Banks engage in proprietary trading with too much leverage.  To address this problem, in June 2012, the Fed adopted the Basel III standards by a 7-0 vote, requiring banks to maintain a 7 percent capital cushion relative to the value of their total assets — up from standards that ran as low as 2 percent.   Ben Bernanke explained: “With these proposed revisions to our capital rules, banking organizations’ capital requirements should better reflect their risk profiles, improving the resilience of the U.S. banking system in times of stress, thus contributing to the overall health of the U.S. economy.”

But the rule was delayed in November.  A joint statement from the Fed, the FDIC, and the Office of the Comptroller of the Currency cited “concern” from industry participants about “sufficient time to understand the rule or make necessary systems changes.”

 Policy proposal:  Require more capital.

Stricter requirements would “properly align incentives for megabanks by lessening government support for the financial sector, and reassure financial markets that the U.S. financial system is healthy.”  In October 2012, for instance, Senators David Vitter and Sherrod Brown urged the Fed, the FDIC, and the Comptroller of the Currency to “simplify and enhance the capital rules that will apply to U.S. banks.”   Congress should require these agencies to act and not accept stonewalling and delays from the financial community. 

V.  Glass-Steagall/Volcker Rule

The Problem:  Complexity is undermining the prospects of the Volcker Rule coming into effect.

The banks’ lobbyists have succeeded in slowing down the restoration of the ban on proprietary trading through complex conditions.  One of many examples of such complexity is the distinction between market making and proprietary trading, which the rule untenably tries to discover through the intent of a trade, based on certain quantitative metrics and historical comparisons.

As the International Centre for Financial Regulation explained in a comment letter to the SEC, “The lack of clarity in the aims of the rule is made worse by the level of complexity which is the inevitable result of trying to craft a rule which contains a large number of exemptions.”

Policy proposal:  Pass a simple, clear Volcker Rule.

Congress should pass a far simpler Volcker Rule, e.g.: “Banks are not permitted to engage in proprietary trading.”  The courts and regulators should then interpret the Rule for Congressional intent.  Among others, Senator Elizabeth Warren has supported this approach, calling for “another look at Glass-Steagall, separating the commercial banking activities from the investment activities.”

 VII.  Enforcement

The Problem:  Enforcement has been lackluster and haphazard.

Under the outgoing enforcement chief, Robert Khuzami, the SEC has had only small successes in prosecuting malfeasance, such as Raj Rajaratnam and Rajat Gupta.  The SEC appears to have taken a policy of suing on only one collateralized debt obligation (CDO) per major firm, and then settling.  At DOJ, Lanny Breuer defended the decision not to prosecute HSBC: “Our goal is not to bring HSBC down.  It’s not to cause a systemic effect on the economy.”

The New York Times has harshly criticized the SEC and DOJ for a lack of “creative thinking on the part of federal prosecutors about the web of federal statutes that could be brought to bear on potential cases” and has noted the “institutional determination that it could not win against big banks and top bankers. “  Worse, the statute of limitations—five years for securities fraud and most other federal offenses—is running out, as the financial crisis occurred in 2007.

Policy proposal:  An aggressive, creative approach to prosecutions.

A new approach to prosecutions is needed within the SEC and the DOJ.  More aggressive prosecutors who do not have a prior relationship with the big banks should be hired.  A resourceful, creative approach using every statutory tool available for prosecution of past illegal acts and the prevention of future moral hazard should be employed.  Finally, additional resources should be provided to FBI, Department of Justice, and SEC to investigate and prosecute wrongdoing, as in Rep. Marcy Kaptur’s HB 131, Financial Crisis Criminal Investigation Act, which has been referred to committee.

 VIII.  Breaking Up the Banks

The Problem:  Too Big to Fail.

Banks have become “Too Big to Fail” and are only growing more so.  The current regime of “universal banks” creates high levels of systemic risk because of banks’ dependence on subsidies, their leverage, and their simultaneous creation of, and exposure to, macro risk.  According to Arnold Kling of the Cato Institute, our “big banks are the product, not of economics, but of politics.”  And we are evolving toward “outright corporatism.”

Sanford Weill, the former CEO of Citibank, has called for breaking up the banks:   “What we should probably do is go and split up investment banking from banking, have banks be deposit takers, have banks make commercial loans and real estate loans, have banks do something that’s not going to risk the taxpayer dollars.”  This is a striking reversal given that Weil built Citigroup after the repeal of Glass-Steagall.  Other prominent policymakers have also called for breaking up the banks, such as Paul Volcker, Thomas Hoenig, former President of the Kansas City Fed; Sheila Bair, former FDIC Chair, and Richard Fisher, President and CEO of the Federal Reserve Bank of Dallas.

Policy proposal:  Reduce Banks’ Size

A common-sense but politically challenging proposal is to force any bank over a certain percentage of GDP to break into smaller unaffiliated entities, as required by Senator Sherrod Brown’s SAFE Bill.

Setting aside an express Congressional mandate, there are more creative ways to reduce the size of the banks.  Sheila Bair, former FDIC Chair, has also argued that regulators have the authority under Dodd-Frank’s “living wills” provision to require systemically important financial institutions to restructure “if they cannot show that their nonbank operations can be resolved in bankruptcy without systemic disruptions.” According to Bair, megabank operations should be “simplified and subsidiarized” into “discrete, separately managed legal entities” based on business lines.

Former SEC Commissioner Roberta Karmel also has suggested that each of the major banking groups be split into a “narrow bank,” consisting of an institution that could accept deposits and make loans.  Under SEC supervision, each narrow bank would then spin off its risky businesses that potentially threaten its deposit insurance.   The spinoff could be tax-free, with new shares of the spinoff going to the stockholders, thus separating the narrow bank from its former non-commercial banking activities.

The Complexity of High Frequency Trading

The problems detailed below of order types, rebates, and failed regulations are symptomatic of the deeper, more systemic problem with the regulation of equity markets:undue and dangerous complexity. Ever increasing regulatory and market microstructure complexity endangers market participants and society at large. It is absolutely essential for the long-term health of our financial system that policymakers reduce complexity.

Regulators seem to think that the rules need to be complex because the financial system is complex, but that couldn’t be further from the truth. Rules governing the stock exchanges need to be as simple as possible so that robustness is built into the system. High-frequency traders (HFTs), regulators, and exchanges are all responsible for this complexity, which is manifested most significantly in the following unfortunate properties of our stock market:

1. Order type proliferation and confusion

2. Destination proliferation (numerous of each: lit exchanges, dark pools, internalization)

3. Rebate distortions and complexity

The equity markets’ complexity has led to a burgeoning fragility. In contrast to the opaque and complex equities market, the futures market is several orders of magnitude simpler and more robust. There are fewer futures market venues and there are no rebates which over-complicate the markets while distorting price discovery. Futures market microstructure should be the model and standard for reforming our equities markets.

Recent SEC penalty

The SEC has recently been paying more attention to the advantages HFTs have over all other market participants. In October 2012, the SEC imposed a bold $5 million penalty against the New York Stock Exchange for providing delayed quotes to different traders. One SEC staff member described the penalty in this way: “The NYSE chose ground-shipping for sending market data to the consolidated feed but used next-day air for its paying customers.”

The SEC Is Lagging on Regulation

However, the SEC in general has lagged in their understanding of regulations and their consequences in the new world of super-low latency trading. The SEC’s Division of Risk, Strategy, and Financial Innovation was created to oversee HFT regulation and is currently headed by a physicist and former hedge fund manager named Gregg Berman. Despite his academic qualifications, Berman has been extremely deferential to HFT. For instance, no formal application for a new order type has been denied to the various stock exchanges. Berman’s division in general has been overly cozy with HFTs. In an October Reuters article, Berman explained his reluctance to regulate HFT more aggressively:

 ”I’ve heard many suggestions for how we might slow down the markets. But I think some ideas have ignored the fact that we have markets in which investors demand the ability to trade on an immediate and continuous basis, not at discrete intervals. . . . It’s like saying ‘let’s use the rules of train travel, in which every train is on a specific track, to try to dictate how cars should behave, even though cars can drive between the lanes and on the shoulder.’”

Berman has been strongly criticized for this approach to HFTs. In October 2010, Reuters reported that HFT firms see Berman as very favorable to them. Also see this Firedoglake post titled “Official Report on Flash Crash: Nothing to See Here.”

In August 2012, the SEC announced that Berman is directing a new Data Analysis Group that is looking for staff. Trader Magazine reported that part of the reason for the group was that the “SEC learned it was unprepared to sift through the mountains of market data in the current high-speed, rapid-trading marketplace of today. That was evident when it had difficulty understanding what happened in the market on May 6, 2010-the day of the ‘flash crash.’”

Finally, the SEC recently announced its decision to pay a New Jersey trading firm named Tradeworx $2.5 million for real-time data for the Data Analysis Group. Tradeworx’s founder Manoj Narang has been an extremely staunch defender of HFT and a harsh critic of efforts to limit quote traffic. TradeWorx has designed a proprietary software system called Market Information Data Analytics System (MIDAS) for the SEC, to be released by the end of 2012. SEC’s retention of Tradeworx is another example of the SEC’s too-close relationship with HFTs. As the New York Times reported, a recent Senate hearing featured testimony from a former HFT that the arrangement was “reminiscent of the fox guarding the hen house.”

Reg NMS, Rules 610 and 611

Another example of problematic regulation is the extensive regulatory arbitrage around Regulation National Market System (Reg NMS), which the SEC adopted in 2005 to link together the multiple markets where securities are traded. In 2007, Rule 610 was implemented to require fair and non-discriminatory access to quotations; establish a limit on access fees; and require each exchange to establish rules to prohibit members from locking markets through quotes. Please see Locked Markets, Priority and Why HFTs Have an Advantage: Part I by former HFT trader and SEC whistleblower Haim Bodek.

In plain English, Rule 610 was supposed to stop HFTs from locking up markets through “scalping.” Scalping occurs when an HFT buys a large quantity of a stock at the bid price and then sells as the ask price within a tight time period, without the bid or ask prices moving. This had the effect of locking a market to an outside participant.

Rule 610 was well-intentioned, but created an environment where HFTs send and cancel large numbers of unexecuted transactions to make their orders “stick” at the best price at the top of a queue. After Rule 610, HFTs launched new “spam and cancel” strategies that repeatedly attempted to get to the front of order queues in new ways, often enabled by the exchanges themselves.

For example, one new order feature is to “price slide” the order. After an order, exchanges slightly “slide back” or modify the price to offer a purportedly “convenient” and “sensible” price. When these orders are “slid back,” they lose their placement in the queue. HFTs therefore learn that there are other orders ahead in better queue positions and cancel their “slid orders” and re-place with new orders. However, the orders placed by traditional investors, such as pension funds, typically slide without being canceled, therefore losing ultimate placement in the queue to the HFTs. Many institutional traders have no idea that their orders are being “slid away” from the top of the book.

Some exchanges also give HFTs specialized order confirmation information that enables them to detect when their orders are being “slid,” so they can quickly cancel the price-slid order. These “opt out” options reject orders that might have otherwise been placed in a disadvantaged queue position, giving another hidden advantage to HFTs over institutional traders.

Rule 610 also enabled a new wave of “Hide and Light” strategies offered by the exchanges and exploited by HFTs. “Hide and light” order types gave a superior queue position by automatically “lighting” a hidden order when the order would no longer lock the market, transforming an HFT’s previously hidden order into a “protected quotation” when it is most advantageous. See Bodek’s Locked Markets, Priority and Why HFTs Have an Advantage: Part II. The “Hide and Light” strategies further disadvantage institutional investors, who cannot take advantage of the “special relationship between Rule 610, the processing of the Security Information Processor (SIP) feed, exchange order matching engine practices, and the special order types themselves.”

Finally, Rule 611 of Reg NMS, also known as the Order Protection Rule, has also enabled HFTs to gain an unfair advantage over institutional investors. Rule 611 was intended to create a single, unified national bid and offer by prohibiting exchanges from executing trades that can be filled at better prices at away markets. The SEC created Intermarket Sweep Orders (ISOs) as an exemption to Rule 611. Using ISO types such as the “Immediate-or-Cancel” (IOC) version, which instructs an exchange either to immediately execute an order at a specific price or to cancel it, HFTs defeat institutional investors using slow SIP data feeds. For more information on this very complex issue, see Haim Bodek’s Why HFTs Have an Advantage, Part 3: Intermarket Sweep Orders.

Problems such as these should be fixed with an overhaul of Rule 610 and Rule 611 by the SEC.

Odd Lots

Another example is the SEC’s refusal to require odd lots to be reported to the consolidated tape. Odd lots are trades under 100 shares. As Trader Magazine has reported, a 2011 Cornell University report contained disturbing findings of additional unregulated opacity in our markets.

The report finds that odd lots increased from 2.25% of total volume at the beginning of 2008, to as high as 20% today—a change attributable to HFTs’ algorithms. In the words of one co-author of the study: “Part of what’s happening is algos have now changed how you trade, and so it’s not that uncommon to have an order chopped up into lots of little pieces.”

Some of the increased traffic is caused by HFTs using single share trades—which are considered odd lots—to ping a stock’s price and potential hidden orders. But even though odd lots are under 100 shares, they can still be large trades. Google trades at over $600 a share, so a trade of $60,000 of Google stock is still an odd lot. 34% of all trades in Google are odd lots, and all of these trades go unreported.

Rebates and Order Types

A final example is the enormous and unnecessary complexity surrounding rebate and fee schedules. It should be noted that QIM receives a significant amount in rebates which partially offsets various equity execution costs. Despite this, rebates have a highly distortive effect on the equity markets, and we believe they should be banned. The discriminatory order type and queue system is further enabled by the complex rebate and fee landscape on our stock exchanges. All US stock exchanges currently employ complicated systems of fees and rebates that provide further incentive and opportunity for HFTs to disadvantage all other traders with respect to queue priority.

These systems are not public or transparent, meaning that some exchanges are affording unfair advantages to certain traders, either because they pay for them, because they are confidentially informed about how to get their orders higher in the queue, or because they have collusive relationships with the exchanges themselves. In addition, the sheer enormity of the complexity itself enables a large asymmetry of information that HFTs exploit every second of the trading day. Please see this Wall Street Journal article titled For Superfast Stock Traders, a Way to Jump Ahead in Line for more information.

The vast number of order types also contributes to extreme complexity. See this SEC listing of “common order types,” which is modest and minimal, and coincidentally or not, very similar to the list of available order types on a typical futures exchange. Then compare it with this exhaustive, complex, and extremely opaque list of order types provided by the exchange Direct Edge. There is clearly a gap between industry and government.

As Themis Trading argues, the new order types are “perks sold to them by the exchanges – including colocation, data feeds, and dubious order types – to make sure that they maximize the number of free shots at a risk free rebate. This means they want to bid and be first in line, and only when they are assured that there are other buyers deep behind them, and collect rebates. If they are successful and buy stock and collect a rebate, they can turn around and instantly sell that stock at the same price to the person behind them, still making a profit. This is not liquidity provision. They game ways to be at the top of the book in stocks that already have the liquidity that serves as a backstop.”

Policy Recommendations

1) The SEC and CFTC, led by Congress, should undertake a holistic effort to reduce undue complexity in our regulatory system. This effort would fit well within your regulatory “pay go” proposals and would be akin to the Paperwork Reduction Act of 1995. The government should aspire to make the equities market meet the simplicity and transparency of the futures market.

2) Rules 610 and 611 should be overhauled to address the perverse incentives they have created and the ways in which exchanges are working to give HFTs unfair advantages over all other market participants.

3) As Themis Trading recently suggested, the SEC should institute a moratorium on the approval of new order types; disclose its “yardstick and methodology” for approving complex order types; and overhaul the self-regulatory organization (SRO) rulemaking process. We actually take this much further and urge that most order types be de-authorized.

4) The SEC should hire only top-flight personnel who will subject HFTs and the exchanges to the highest level of scrutiny. This would counter the perception that the SEC itself is seriously behind industry when it comes to crucial issues like discriminatory order types.

5) Monitoring and data systems like the MIDAS system should cover off-exchange trading, including dark pools and, to every extent possible, internalization. This will enable the transparency and complete information that all market participants need and that fair regulation requires.

6) We should seriously consider outlawing rebates altogether. The current rebates for stocks especially with share prices between $1 and $20 are extremely distorting to the price-finding mechanism of a properly functioning market.

7) The SEC should require odd lots to be reported to the consolidated tape.