Flash & High Frequency Trading

Part Two:

When the Securities and Exchange Commission authorized electronic exchanges in 1998, the intent was to open markets to any investor with a desktop computer.  The idea was that the electronic investors would be on the same footing as floor traders.  In the United States today, more than 60% of trades are automated.  The number of automated trades increases by about 6% per year.  The old phone and pit trades have been replaced with point and click trades and they file in from all over the globe.

Earlier in July, a Goldman Sachs programmer, Sergey Aleynikov, was accused of stealing secret computer codes that the prosecutor said had the capacity to “manipulate markets in unfair ways.”  The case has sparked more than a fair amount of interest in the high frequency trading platform, which clearly performs at a level far above the level of desktop traders and even above traders with faster computers but who do not have access to “flash” advance notices.

Former Chairman of the New York Stock Exchange, William Donaldson, described the trading disparity; “This is where the money is getting made.  If an individual investor does not have the means to keep up, they are at a huge disadvantage.”

New York Senator Charles Schumer, a member of the Senate Banking Committee, agrees.  The Senator has notified the SEC that if flash notices to high frequency traders are not halted, he will introduce legislation to level the trading floor and terminate the two-tiered trading platform.  “If the SEC fails to curb this practice, I plan to introduce legislation in the U.S. Senate to prohibit the use of flash orders.”

Government Regulators Involved

Last month the Nasdaq and BATS Exchange joined the rapidly expanding trading venue, Direct Edge, in furnishing flash advances to certain investor clients.  The expansion has intensified the controversy over high frequency trading, flash notices and dark pool activity. 

The SEC has received several letters from New York Stock Exchange parent NYSE Euronext posing opposition to flash applications from Nasdaq and BATS.  Specifically, the complaints state that the practice of flashes; “impedes a free and open market system and harms the investing public.”

NYSE Euronext concerns were also supported by letters of protest from The Securities Industry and Financial Markets Association (FINRA), Morgan Stanley and GETCO, a high frequency trading firm.  In fact, The New York Stock Exchange has notified the SEC that if action is not taken, NYSE will be forced to offer the same service so as not to lose trading volume.

The 1998 SEC decision to start electronic trading was well intended.  As the emergence of algorithms (huge blocks of trades called algos) and super fast computers evolved, the focus changed from electronic processing to super-fast volume processing.  Now more than half of electronic trading is transacted via algos. 

As various exchanges began to compete for traders, the concept of mass processing revealed viable bulk profit centers.  Theoretically, high frequency trading is not the culprit, but when combined with flash advances give an unfair advantage to certain high volume traders.

Flashing provides these traders access to investor’s trade limits, which has always been carefully guarded and undisclosed information.  The practice allows movers and shakers to use this information to control pricing and reap rewards without any risk. 

Today, when traders enter a limit, they can be fairly certain the trade will occur close to the ceiling.  Flashes are costing some investors money while benefiting a select minority who are reaping profits off the unprivileged.  The results are mixed messages about the state of the economy and the value of shares.  Suddenly, the market is not being driven by economic conditions, earnings or trends.  Instead, markets are being driven by HFT’s acting with flash information.

Behind the Scenes

Despite protests by NYSE and others, the spotlight did not concentrate on flashes and high frequency trading until Goldman Sachs’ Sergey Aleynikov, the former Goldman programmer, “stole proprietary, ‘black box’ computer programs that Goldman uses to be lucrative, rapid-fire trades in the financial markets.” 

The case has sparked big media attention and has caused regulators, who have previously looked the other way, to take a longer, harder look at the practices.  Aleynikov’s act apparently poses such a threat to Goldman Sachs that they were forced to go to federal authorities, so something heavy weighs in the balance.

Speculation is that the market does not know how Goldman turned such remarkable numbers in the 2^nd quarter.  The Aleynikov investigation may well reveal the answers and point regulators down a very steep road.

High Frequency Trades Explode Profits

Part One

In the millisecond-to-millisecond shootout at Wall Street’s OK Corral, the fastest guns are firing bullets before the slower guns get out of their holsters.  Those lightning fast trigger fingers are reaping big profits, taking no hostages and cashing in before Johnny Law arrives to set things right.  Since May, an overdue shootout between some of transparency’s biggest guns and technology’s flashiest gunslingers has been brewing.  At stake is the trading integrity, which appears to have left the marketplace’s barn.

As reported by The New York Times and other media sources, Senator Charles Schumer served notice to SEC chairperson Mary Schapiro that the time has come to level the trading floor.  On Friday, Schumer called for a ban on “flash” advances to certain high-tech traders like Goldman Sachs and Credit Suisse who are capitalizing on their high-tech abilities to capture profits at the expense of other, well-intended traders.  

Schumer warned that failure by the SEC to curb the practice would result in legislation to cease the ethically questionable practice.  In a letter to Schapiro, Schumer said, “If the SEC fails to curb the practice, I plan to introduce legislation in the U.S. Senate to prohibit the use of flash orders.”

Flashes are notices that stock exchanges send to a select group of traders before revealing the details to the broader market.  In other words, a select group of investors has advance notice to inside trading intentions.  Many of these traders have employed high technology to enter the trading fray on the low end, sell on the high end and be clear of the transaction in less than half a second at absolutely no risk.  Genius, yes!  Ethical, no! 

As Schumer said in his letter to the SEC, “dark pool activity seriously compromises the integrity of our markets and creates a two-tiered system where a privileged group of insiders receives preferential treatment.”  The Senator expanded his statement, “If allowed to continue, these practices will undermine the confidence of ordinary investors and drive them away from our capital markets.”

Flashes & Dark Pools

Flashes are notices of buy and sell orders sent to certain traders.  These flashes notify the traders of pending transactions.  The transactions are completed in milliseconds.

In those milliseconds, investors, like publicly-traded and taxpayer bailout-recipient Goldman Sachs and private hedge funds like Citadel Investment Group, D.E. Shaw, Global Electronic Trading Company, Renaissance Technologies and Wolverine Trading use the flash notice to buy stocks on the low end and sell on the high end just under the trade’s declared ceiling.  Dark pools are also called the “upstairs market” or “dark liquidity” which descriptions underscore the unavailability of this information to the trading public.

The practice raises many ethical issues but also inspires questions about how firms like Goldman Sachs have managed to post such substantial profits while outperforming market trends.  The second quarter profitability performances by financial companies seem to signal the recession recovery is underway, but if the recovery is based on profits from dark pool trading, how real can it be?

Goldman Sachs Triggers Investigation

In 1998, the Securities and Exchange Commission authorized electronic exchanges.  The authorization was intended to create broader markets and allow anyone with a desktop computer access to trading.  The plan worked and worked well, but the technology race had then commenced.

Big traders made big technology investments and algorithms (algos) were created to execute millions of orders each second while scanning public and private marketplaces for the most favorable pricing.  In the world of high-speed, high-tech trading, a second represents a lifetime of trading opportunity.

As an example, the New York Times points to the events of July 17, 2009, concerning the semiconductor company called Broadcom.  Based on news from giant chipmaker, Intel, and sensing a positive move, Broadcom was targeted as a strong buying opportunity.

Non-flash traders faced a delicate balancing act whereby they did not want to tip their hands but had demand for large numbers of shares.  Rather than place one large order, these traders divided orders into bunches of smaller orders.  One second after the market opened, Broadcom was selling at $26.20.

The technologically slower traders began to process their trades.  The details of these offers were sent to high-frequency traders in advance of the actual trade.  In just 0.03 seconds, these high-frequency traders used this information to ascertain that the ceiling of the slower trader’s position was $26.40.  High-frequency traders purchased 56,000 shares at lower prices and immediately sold the shares to the slower traders at $26.39. 

In those 0.03 seconds, the 56,000 shares of Broadcom were actually traded twice.  With no risk, the high-frequency traders profited $7,800; not a bad return on a risk-free half second.  Now, take that half second and think about how much money is made in a minute, an hour, a day, a month or a quarter and therein lies a whole new insight on the Goldman Sachs, hedge fund performance that is leading The U.S. out of the recovery, or down the road to financial disaster.

Automated trading expands at 6% per year.  If unchecked, high frequency trading will account for 19% of all 2011 trading.  Andy Nybo of the financial consulting and research firm TABB explained; “Having the fastest quote engine, the speediest analytics or the fastest connection to an exchange is no longer sufficient.”  Nybo expanded by reporting that big firms spend $15 million per year to support and improve technology.

Another fear of this dark pool trading is that just as high frequency trading can be used to drive prices up, it can also be employed to drive prices down.  The Tabb Group reports that high-frequency traders profited $21 billion in 2008.  One can only wonder how deeply publicly sponsored bailouts and Wall Street bonus pools would have been affected without that $21 billion and what the SEC will do to protect the taxpayers that bailed out these companies.

 

 

Bernanke on The Hill

The Chairman of The Federal Reserve stared down the Senate Banking Committee and displayed the perseverance that has led the country through its deepest recession.    In two days of testimony on Capitol Hill, the chairman concluded his semi-annual report on the central bank’s monetary policy.  Ben Bernanke took the opportunity to advise the Senate on a wide range of issues. 

Bernanke has come under fire for his handling of Bear Stearns, AIG and the Fed’s role in the JPMorgan takeover of Merrill Lynch.  There has been strong support for changes to the Federal Reserve’s operating authority and mandate. 

Bernanke attacked a bill proposed by The House of Representatives and calling for audits of the Federal Reserve to be performed by the Government Accountability Office (GAO).  The chairman believes that such audits would alarm financial markets causing nervousness that monetary policy will fall subject top political agenda.

Of late, the Fed has been severely criticized for failing to protect consumers.  The new bill would remove consumer protection from the Fed’s mandate and vest the responsibility with another agency.  Bernanke agreed that the central bank has made errors but strongly suggested these powers should remain with the Fed.

“A few suggestions I would make.  One would be to put consumer protection in the Federal Reserve Act along with the full employment and price stability as a major goal of the Fed.  A second step could be to require the chairman to come before another committee at least once a year to present a report the same way we do for monetary policy, on our consumer protection steps,” Bernanke said.

Republican Jim Bunning asserted that “I understand your concern about the Fed’s independence, but you are the one that threw away the independence by acting as an arm of the Treasury and engaging in fiscal policy…  Your job is monetary policy, not fiscal policy.”

Unemployment and Consumer Confidence

Chairman Bernanke indicated that an easing in housing was underway.  He also reported that the Fed is working with banks to bring the Commercial Real Estate market under control. 

Bernanke made it clear that while corporate profits and equity markets were improving, the biggest obstacle to recovery is the declining employment market.  The chairman expects unemployment to remain very high well into 2011.  This trend will only intensify pressure on overall consumer confidence.

The news came in the wake of high corporate earnings generated through the trimming of operating costs and specifically employment.  Many companies that report impressive earnings are still lagging in sales.  Year-over-year sales figures are alarmingly low and attest to the lack of consumer confidence.

Meanwhile, the central bank has lowered interest rates to near zero and has doubled the balance sheet to $2 trillion to combat the effects of the global recession.  This huge expansion will pose a strong test for the control of inflation. 

Bernanke explained that the Fed has an exit strategy and can pull back on its enormous stimulus when the time is right.  The Fed could arrange reverse re-purchase agreements with financial firms and could also offer term deposits. 

The chairman made it clear that he does not see the American consumer leading the country out of the recession.  Bernanke stressed that the Fed is busy advising American trading partners that they must push their national consumers to participate more aggressively in the recovery.  Bernanke’s assessment that countries must encourage their own national infrastructure spending to spur their economic growth sent waves through equity markets.

CIT Gets $3 Billion Band-Aid

Monday’s rise in the U.S. index of leading economic indicators and the announcement that ailing CIT Group was able to procure a temporary $3 billion loan contributed to a warm and fuzzy feeling throughout global equity markets.  Asian stocks reached their highest level since September 2008.  Also contributing to the warm and fuzzy feeling across equity markets were reports of expected improvements in corporate earnings to be released in the next week.

CIT Group’s announcement lends credence to signs that the recovery is underway.  However, many experts believe the CIT temporary funding is merely a band-aid that scratches the surface of a multitude of underlying  issues. 

The recession hit CIT Group hard.  A December 2008 recipient of $2.3 in TARP financing, CIT faces a $1.1 billion long-term loan payment in August and another $2.5 billion payment by the end of 2009. 

After the company’s refinancing plans were rejected by a triumvirate from The Federal Reserve, The Treasury and the FDIC, CIT Group seemed headed for bankruptcy.  A bondholder group headed by Pacific Investment Management Co. of Alliant SE will be providing the $3 billion.  The loan will have a 2.5 year term and be secured by $10 billion in unsecured assets.

With $75.7 billion in assets, a CIT Group bankruptcy would have been the largest U.S. financial failure since Lehman Brothers collapsed in September.  With a broad base of retail clients dependent on the company for day-to-day financing, the ripple effects could have had devastating consequences for many of the country’s small businesses.

Despite pressure from various retail organizations and the Small Business Administration, government regulators balked at a more comprehensive rescue plan for CIT.  Clearly the Obama Administration is sending a signal to other potential rescue candidates that the market must provide future remedies.

FDIC Chair Sheila Bair led the government’s resistance to a CIT rescue.  The company did not meet Bair’s high standards and new prospects now know the bar has been raised.  Many investors supported the government’s position that it cannot be all things to all people.

CIT will now pursue restructuring its debt.  Due to the distressed nature of the retail sector and many of CIT’s assets, that restructuring may be a monumental challenge.  Two years ago, CEO Jeffrey Peek expanded into the treacherous subprime mortgage waters.  That decision has come back to haunt CIT and Peek, who was surprised by the government’s refusal to help.

Government Out of Bailout Business

The temporary rescue of CIT by private capital investors is a welcome sight to market observers, who see a gradual healing of the deepest recession in 25 years.   William Larkin, a portfolio manager with Cabot Money Management, issued the following observation; “At this point in the game, the government has signaled that ‘We are no longer writing the checks.’  That is an important indication that going forward people will have to come up with their own solutions.  It is another sign the administration believes the economy is healthy enough that the market should be able to deal with CIT no matter what happens.”

The days of government bailouts of too big to fail companies like AIG, Chrysler and General Motors appear over.  The government has committed to spending billions in stimulus financing and is seeking alternative remedies to housing and unemployment to further spur the recovery.

Global Recession Easing    

While the government’s change of policy may signal the belief that the economy is progressing, there are other encouraging signs around the globe.  China has committed $585 billion in stimulus spending.  Most of this spending has gone to shoring up financial institutions.  Unlike many other governments, Cjhina has been able to induce banks to lend. 

As a result, China is making strides in GDP growth.  However, Liu Mingkang, the head of the China Banking Regulatory Commission, encouraged banks to continue due diligence and avoid excessive risks.

Germany and Australia are also headed to more stimulus investment.  Germany is seeking to boost its troubled banking sector while Australia is looking to lower unemployment.   

Equity markets accepted more good news from Goldman Sachs who raised its year-end target for the S&P 500 to 1,060, up from 940.  The projected year-end is 13% above the current level.

CIT Down To Wire

Trading of CIT Group, one of the country’s largest lenders specializing in loans to small and mid-sized businesses, was halted late Wednesday afternoon.  The struggling lender received $2.3 billion in TARP funding in December and has applied to The Federal Deposit Insurance Corp for assistance under a program that guarantees newly issued debt for bank holding companies.

The FDIC is reluctant to intervene.  In strained meetings with the FDIC, The Treasury and The Federal Reserve, CIT’s financial instability has come under fire and poses a serious roadblock for a proposed bailout.

At stake is the financial security of CIT’s one million customers.  Aware of CIT’s tenuous position, many of these clients began to draw down on their credit lines to the tune of $750 million on Monday and Tuesday.

With a staggering, unexpected first quarter loss, CIT’s funding options began to disappear as investors migrated to safer platforms.  With $2.5 billion in debt due in 2009 and another $7.4 billion due in the first quarter of 2010, the handwriting may be on the wall for CIT.

Although similarities ring true between the CIT dilemma and Lehman Bros. and AIG, the consensus is that CIT Group does not fall into the too big to fail category that spurred the government bailout of many of the country’s biggest banks.  Second quarter big bank earnings indicate a return to strength for the country’s biggest lenders. 

David Havens, a credit manager at Hexagon Securities, explained; “I think the market is looking at CIT as an isolated situation.  There aren’t many sizable companies that fit into that bucket.”

Fed Policy at Stake  

While CIT appears imperiled, the company’s customer base puts it in a unique position.  As a big lender to small and mid-sized businesses, many of these business may fall be the wayside.  Small business is expected to generate big employment numbers to ease the recovery’s most detrimental component.

Reportedly, the failure of CIT Group would leave approximately one million small business borrowers unable to meet payroll.  CIT Group provides financing to airlines, railways, retailers and manufacturers.  According to the Small Business Administration, CIT was the country’s top lender to small business in 2008 with $524.9 million in loans.  2009 loan volume stands at $65.7 million and places CIT Group as the 16^th largest small business lender.

“They are major players when it comes to financing.  But, I don’t see the same type of impact if CIT goes under as when AIG was being batted around,” said the managing director of fixed income at Wall Street Access.

Although CIT Group now qualifies as a bank holding company and as such meets the criteria for FDIC intervention, FDIC chair Sheila Bair remains unwavering in her opposition to CIT’s application for assistance.  A fierce defender of the FDIC, Bair cites heavy risks related to CIT’s junk-status credit rating, the quality of its assets and its liquidity problems as a formula for disaster.  If CIT Group receives Bair’s endorsement, the FDIC would be responsible for the company’s losses in the event of default.

The Treasury and the Fed have entered the CIT fray.  Round the clock meetings have yielded no results as the Fed and Treasury look for ways to protect the small business clientele by giving CIT Group another temporary lifeline.

Financing Options

Under consideration is temporary bridge financing.  The question is where the bridge will lead.  One government plan proposes that CIT transfer its assets to its bank and then pledge the assets at the Federal Reserve discount window and thus refinance some of the debt.  Raising money through conventional means is not an option for CIT.

The real rescue debate is fueled by the perception that the risk may outweigh the gain.  Opponents of government assistance support community bank involvement in financing the country’s small businesses with assistance of the bigger banks for mid-sized businesses. 

On Wednesday, the SEC halted trading of CIT GROUP shares as the Chairman of the House Financial Services Committee addressed the subject in interviews.

“I have spoken with Secretary Geithner and I understand they’re working hard to try to come up with something responsible to try to prevent the failure.  I think there would be a great deal of harm to the overall economy,” said Frank.  The Chairman went on to suggest that Congress needs to design a system that allows large financial institutions to unwind while minimizing the residual fallout.

The chief executive of the National Retail Foundation is pressing hard for government intervention.  Financing for more than 10,000 small retailers is at stake.  In an industry already struggling with the effects of the recession, this will close many doors, empty much commercial real estate and add significantly to the unemployment dilemma.

The retailers characterize the CIT problem as short-term liquidity, but FDIC Chair Bair remains adamant in her staunch opposition.  Her resistance has pulled Geithner and Bernanke to the table.  

 

 

     

June Deficit Roars

June Deficit Roars at $94.32 Billion

The only surprise with the June budget deficit was the magnitude of the $94.32 billion price tag.  The Treasury report marked the ninth consecutive month that the government has run a deficit.  June 2009 will go down as the highest June deficit on record.

On three previous occasions, government has run deficits 11 consecutive months.  As the Treasury extends efforts to boost the economy, pressure from automakers and banking continues to pressure the government.  

Historically, June is a productive month for the economy.  In fact, the last time the government operated at a deficit in June was 1991.  In June 2008, the budget captured a $33.65 billion gain.  The largest single monthly deficit on record was the $194 billion accrued in February 2008.

June concludes the first nine months of the government’s fiscal 2009.  The deficit for this period now stands at $1.086 trillion.  The budget deficit through June 2008 was $285.85 billion. 

The Federal deficit is expected to surpass the benchmark 11-month streak and continue deep into the third quarter 2009.  Citing the breadth and depth of the unemployment crises, economists now expect a deficit of $1.5 trillion for fiscal 2009. 

John Silva of Wells Fargo Securities explained; “The Federal Deficit is now at a post World War II high and is likely to continue to rise in the near term as deficits rise and the economy remains weak.  These deficits will influence the allocation of global savings for the foreseeable future.  No doubt where this train is going.”

The economy continues to send mixed signals.  Custodio Asset Management remains cautiously optimistic about the recovery.  CAM welcomes all inquires at 410-988-2511 or by e-mail at info@camtrading.com.

 

Retail Sales Slump Continues

10 Straight Monthly Losses for Retailers

A wet June, staggering unemployment and sagging consumer confidence drove retail sales down for the 10^th straight consecutive month.  The loss marks the longest down streak since 2000 and raised serious concerns about a late summer back-to-school rally.

As reported by Reiss, Inc. a commercial real estate reporting service, the retail strip mall real estate market and the regional shopping mall retail markets have hit 20-year highs for vacancy rates and 8 year lows for income per square foot.

As unemployment heads upwards to 10.5% and with the tightening of consumer credit, same-store retail sales fell by 4.9% in June.  More than 50% of stores surveyed by Reuters missed expectations.  Not surprisingly, teen apparel chains and department stores posted the largest declines.

Abercrombie & Fitch declined 32%, Neiman Marcus 20.8% as big retailer Target fell 6.2% and Costco Wholesale Corp fell 6.0%.  Department store giant Macy’s tumbled 8.9%.

Craig Johnson, President of the retail research firm Customer Growth Partners, commented on the report; “We continue to have an exceptionally stressed consumer.  Almost across the board, there’s evidence the green shoots are few, if any, among very brown fields.”

At this time last year, consumers were receiving and spending their tax rebate checks.  This has contributed to the year over year declines.

Newsletter 07-01-09

Is Our Economy Recovering from the Deep Recession?

These days the market looks for anything to cheer about!   On a daily basis, sharp gains immediately are followed by negative declines.  Lately, the pattern is ongoing.  After the Dow loses 180 points one day, it gains 200 points the next.  These shifts have created the false impression of an economy that is in recovery.  

Recent numbers paint a different picture. 

The latest non-farm payroll report shows 467,000 more Americans filed for unemployment.  National unemployment is at 9.6%.  Housing prices continue to decline and more people on all economic levels are facing foreclosure.  In efforts to help ease the glut of unsold real estate flooding the market, the government is now creating incentives to close short sales.

The US auto manufacturers are still burdened by enormous debt while the government is scrambling to bring order to the chaos. 

For the past several weeks, attention-grabbing headlines have had no correlative effect on the market’s direction.  What may seem like good news before the start of the day could cause a sell-off by the close. 

This recent, random volatility has brought a -1.0% return for CAM’s clients for the month of June   bringing the YTD return to -1.22%.   CAM’s strategy simply did not fit the daily volatility of the recent market patterns.  By the end of the month, the market outperformed us.   

As we move to the second half of the year and look forward to the future, we are confident and stand behind our evolving strategy to continue producing year-over-year positive results for our clients.   Every day is challenging, but investing with a long-term perspective will allow our clients to see through the clutter and keep their goals in sight.

As always, we welcome all inquires at 410-988-2511 or by e-mail at info@Camtrading.com.