Category: General Finance

Early Peek Advantage?

From 2007 to June 2013, a small group of fee-paying, high-speed traders received the bi-monthly results of the Michigan Index of Consumer Sentiment (ICS) from Thomson Reuters at 9:54:58, two seconds before the broader release at 9:55:00. This arrangement was initially reported on April 5, 2013 by Financial Times regarding a complaint by a former Thomson Reuters employee for his dismissal after telling US federal agent about this arrangement of tiered distribution of information. Wider media coverage followed in June and July as well as a review by the office of New York Attorney General (see, for example, “Thomson Reuters Gives Elite Traders Early Advantage” by CNBC and “Traders Pay for an Early Peek at Key Data” by Wall Street Journal on June 12, “Seconds Out” by Economists on July 13, 2013). In July 2013, Thomson Reuters decided to suspend the program.

Despite the negative “optics” projected by this practice of tiered information release, a series of questions were raised: To what extent does it give an advantage to those with early information? Does it hurt general investors and hence damage the integrity of the financial market? How does it affect the efficiency of the price discovery process in the market? More careful analysis is needed in order to answer these questions.

In a recent research paper with Professor Xing Hu at University of Hong Kong and Professor Jun Pan at MIT, we have examined in detail the price dynamics and trading activity in E-mini S&P 500 futures around ICS releases during this episode. We focus on S&P 500 futures because ICS, reflecting consumer opinions of the overall economy, is likely to move the entire market instead of individual stocks. Being highly liquid and unaffected by short-sale constraints, E-mini S&P 500 futures is an ideal instrument to trade on both positive and negative market-wide information.

During the period when Thomson Reuters offers early peek advantage, we find abnormally high trading activity in E-mini S&P 500 futures at 9:54:58 on ICS announcement days. On average, the trading volume jumps to 1,473 contracts per second at 9:54:58, well above the sample average of 124 contracts per second, which reflects the trading volume of general investors. One second later at 9:54:59, the abnormal volume drops to 261 contracts, still well above the sample average but sharply down from the trading volume at 9:54:58. The volume pattern makes two points: First, early peek by high-frequency traders does generate high volume of trading, but mostly among themselves. (There is no reason be believe that general investors will choose to trade more at the time when they have an information disadvantage.) Second, the first second at 9:54:58 is disproportionally more meaningful to them.

More detailed study of price dynamics after the early peek reveals a clearer picture: We find that the prices are fully adjusted to the ICS news after the first 10% of the trades during 9:54:58, which lasts about 14 to 16 milliseconds. There is no evidence of further price drift after the initial price discovery. This implies that most of the transactions during 9:54:58 and all the transactions afterwards, including the public announcement at 9:55:00, are traded at the fully adjusted market prices. The scope of the early peek advantage is therefore narrowly contained and limited to high-speed traders trading amongst themselves. Outside of this narrow time window, general investors, as well as high-speed traders, trade at fully adjusted prices and are not disadvantaged by the early peek of a few.

The initiation and later suspension of the early peek program by Thomson Reuters also provides a natural experiment for us to examine how different mechanisms of information release might impact the speed of price discovery. Associated with the early peek program is highly concentrated trading amongst those fee-paying, high-speed traders over a span of two seconds. As a result of this intense and coordinated trading, we see a superfast price discovery in the order of 14 to 16 milliseconds. After the suspension of the early peek program, however, we do not see the same level of trading intensity and we find that the price discovery takes much longer. From this perspective, one might argue that, as a mechanism of information release, the tiered program provides a venue to facilitate concentrated and coordinated trading among informed high-speed traders and therefore makes price discovery more efficient.

How information actually transmits and impounds into market prices remain a central question in our understanding of how the financial market functions. Empirical investigations aimed at tackling this question are always hindered by the fact that most information is private in nature and hence unobservable to researchers, even ex post. The multi-tiered process adapted by data vendors in feeding market-moving information to their different clients, as in the case of Thomson Reuters when releasing CSI data, offers a rare instance where we know precisely what information is transmitted, when and to what subset of market participants. This situation allows us to examine with more clarity how information, private to some traders, drives their trading behavior and influences the market. It may also help us to better design and regulate the information dissemination process in the market.

For details of this research, see Grace Xing Hu, Jun Pan and Jiang Wang, “Early Peek Advantage?”

Is Bitcoin a viable currency?

The media and blogosphere have been full of Bitcoin discussions recently and almost everyone has an opinion, but most of these opinions are tied to the technology of Bitcoin, that is, whether this new currency represents a major technological revolution in money.  So, most commentary has focused on questions about Bitcoin’s technological advantages: Is it really secure?  Is it truly anonymous?  Can it be counterfeited?  Are transaction costs actually lower?   Here, here and here are a few of examples and they contain comments like “Bitcoin is the first practical solution to a longstanding problem in computer science called the Byzantine Generals Problem.”  That is, they focus on the technology of Bitcoin.

But what of the finance and economics of Bitcoin?  Does it have the economic properties to be a viable currency?  I don’t think so.

Good money had three economic properties and uses.  It is a unit of account, used to measure and write contracts for things like income, wealth, and prices of goods.  It is a means of payment, used to avoid barter.  And it is a store of value, held to be able to make transactions in the future.  Of these three properties the third is the most important.  Unless money has a stable value, it does not serve the purposes that it should.  People will be wary of accepting something that might lose lots of value, and something with a volatile price makes a bad unit of account.

And my argument is not just that Bitcoin has had wild fluctuations in value that undermine its role as a viable currency, but deeper, that Bitcoin is destined to have wild fluctuations – it is poorly designed and conceived and so is likely to fail as a currency.  Why?

First, and primarily, Bitcoin lacks a mechanism for setting the supply of Bitcoin equal to the demand for Bitcoin to maintain its value.  History is replete with examples of governments that tied their hands in the supply of their currencies, much like Bitcoin has done.  What happens?  The value of the currency fluctuates.  Often a lot.  Before the founding of the Fed in the US, the dollar was backed by gold, and gold discoveries lead to inflations, and collapses in the price of gold to recessions and even financial crises.  Since the end of the Great Depression in the US, the Fed has actively managed the money supply to achieve price stability (at some times better than others).

Consider the example of the Y2K scare.  Before January 1, 2000, people were concerned that the change from the year 1999 to the year 2000 could lead to serious errors in computer systems, and in particular that it might become hard to use credit cards or get money out of a bank (or worse, bank deposits might even get lost).  As a result, people withdrew cash before New Year’s, lots of it. (These types of cautionary actions were widespread: governments grounded all airline flights overnight.).  These withdrawals were increased demand for cash that might have driven up the price of dollars – ie. led to deflation and changed interest rates.  But the large increase in the demand for cash did not cause any such real economic effects.  Why?  Because when demand increased the Fed simply expanded the amount of currency in circulation.  When New Year’s came and went without serious incident, people re-deposited their cash and the Fed reduced the money supply. The US price level remained stable.

Similar examples abound.  Prior to the founding of the Fed, the seasonal agricultural cycle lead to big seasonal swings in the demand for credit and currency which lead to seasonal swings in nominal interest rates (that is, the usual interest rate we think of which is the real interest rates plus changes in the value of money, that is, plus inflation).  If Bitcoin gains traction, will it have a seasonal fluctuations in its value that track the seasonal spending patterns of the world.  Will Bitcoins be more valuable in early December and comparably cheap in January?

Every day, central banks supply their currencies in proportion to the needs of the users of their currencies, so as to maintain a stable value for their currencies.  Bitcoin does not have a central bank.  It has a relatively inflexible supply mechanism (known as Bitcoin mining).  As a result, Bitcoin is destined not to have a stable value.  And a volatile price is bad for Bitcoin’s usefulness as a currency.  Central banks are an enormous competitive advantage for traditional currencies that the Bitcoin supply process completely lacks.

A second problem with maintaining a stable value is that digital currency is not really in limited supply. Its proponents will argue that it is.  The Bitcoin technology is carefully, maybe even brilliantly, designed to ensure that the supply grows slowly and it ultimately limited. But what happens when Bitcoin 2.0 comes out?  What if it has slightly better properties than the old technology?  Do people stop using Bitcoin 1.0 entirely leading it to become worthless?  Probably.  Is such a scenario likely?  Well,  think about the potential profits that one could make introducing Bitcoin 2.0, just by keeping a share of the initial number of coins.  These potential profits provide an incentive for the hi-tech business that comes up with a better Bitcoin to take over the digital currency market through advertising, lobbying, payments to businesses and so forth.  Or consider this alternative scenario.  Global banks start to provide currency transfers within their institutions but across borders that are as safe rapid, and low cost as Bitcoin payments.  There is no technological advantage to Bitcoin relative to a global bank with branches in many countries.  The point: while Bitcoin is in limited supply, digital currencies are not and neither are inexpensive ways to transfer money and make payments.

There are several other important cards stacked against Bitcoin.  But I will conclude with only one more., The “money supply” in the every country in the world is actually hard currency times the money multiplier – the ramping up of the hard currency into deposits in banks and lines of credit and gift cards and so forth.  In the US, the money supply – counting all of these money-like assets – is about twenty times the supply of hard currency.  And Bitcoin banking is developing and could go one of two ways.  First, it could be significantly private and unregulated.  The history of unregulated banking is that it is a disaster full of bank runs, volatile price levels currency collapses and so on.  The banking sector’s volatility becomes the volatility of the supply of Bitcoins which becomes price volatility.  Look just recently how the collapse of a single Bitcoin exchange affected the price of Bitcoins.  The second way Bitcoin banking could go would be as a regulated banking sector, becoming part of the tradition banking sector.  But then several claimed benefits of Bitcoin go out the window.  The true, large supply of Bitcoin is governed by banking regulation (but in every country in the world – what a mess!).  And while a Bitcoin is anonymous, a Bitcoin deposit is not anonymous. Once a bank gives you a credit for a Bitcoin and knows who you are, can it see in the Bitcoin chain how it was spent?  Not sure, but I would worry about it.

In sum, I am not worried about the technology – I have complete confidence that people at the other end of the MIT campus can solve almost all of the technological problems.  But the finance is suspect.  I am guessing that Bitcoin either remains small and volatile, with only transactions of suspect legality willing to accept the volatility as the price of true anonymity, or that Bitcoin goes down in history as a bubble, ultimately as worthless as the sequence of zeroes and ones that make up each coin.

Designing More Efficient CDS Auctions

Professor Haoxiang Zhu

Credit default swaps (CDS) are an important derivative class. According to the Bank for International Settlements, as of June 2013, CDS contracts have $24 trillion notional amount outstanding and $725 billion market value globally.

A CDS contract is a default insurance contract written on a firm, loan or sovereign country. Buyers of protection (CDS buyers) pay periodic premiums on a notional amount of debt to sellers of protection (CDS sellers), until the contract expires or default occurs, whichever is earlier. For example, if a bond investor wishes to insure against the default of $100 million corporate bonds, and a five-year CDS contract on that bond is quoted at 500 basis points (5%) per year, then the CDS buyer pays $5 million per year to the CDS seller for five years. If the bond defaults within five years, the CDS seller pays the CDS buyer the loss given default. The question is: What are the recovery value and default compensation?

The market uses CDS auctions to determine the recovery value of a defaulted bond. For example, the auction-determined recovery rate of Greece debt is 21.5 cents per euro. So, CDS sellers pay CDS buyers 78.5 (=100-21.5) cents per euro of debt insured. In addition to settling CDS contracts, CDS auctions also give investors an opportunity to trade defaulted bonds at zero bid-ask spread. Given the sheer size of CDS markets and high-profile defaults in the recent recession, it is important that CDS auctions deliver unbiased prices and efficient allocations. But do they?

In a recent research paper with Professor Songzi Du of Simon Fraser University, we find that the current design of CDS auctions leads to systematically biased prices and inefficient allocations.

To understand why the auction design is biased and inefficient, we need to understand the auction procedure itself. A CDS auction consists of two stages. In the first stage, investors who have CDS positions submit market orders (called “physical requests”) to buy or sell the defaulted bonds. An investor’s market order on the bond must be in the opposite direction of his CDS position, and no larger in magnitude. The sum of these market orders, called “open interest,” is sold in the second stage, which is a uniform-price auction. Importantly, only one-sided limit orders are allowed in the second stage. If the open interest is to buy, only limit sell orders are allowed; if the open interest is to sell, only limit buy orders are allowed. The market-clearing price in the second stage is the “official” recovery rate of the defaulted bond for settling CDS.

From 2006 to November 2013, this auction procedure has settled more than 140 defaults, including those of Lehman Brothers, Fannie Mae, General Motors, and Greece, among others.

Through a formal auction model, we show that the biased design comes from the restrictions imposed on the two stages of CDS auctions. To get the intuition, consider a CDS buyer. A CDS buyer naturally wishes to sell the defaulted bonds to minimize the uncertainty in the auction final price; he can eliminate this price risk by selling an amount equal to his CDS position. If this CDS buyer also has a low value for owning the bonds (for information or hedging motives), he would want to sell more. But the auction procedure forbids him from selling these additional quantities. A supply to sell is therefore suppressed in the first stage. In the second stage, this supply is suppressed again if the open interest is to sell (as only buy limit orders are allowed). Information from a suppressed demand cannot come into the price. Therefore, price is systematically biased, and allocations of bonds are inefficient.

This is not the end of the story. In an earlier version of the same research paper, we show that, if CDS traders are large, they also have a strong incentive to manipulate the final price auction price—to get favorable settlement payments on their CDS positions. Manipulation also leads to price biases.

The administrators of CDS auctions are aware of the biased prices; as a remedy, they impose a price cap or a price floor, depending on dealers’ quotes and the direction of the open interests. But this measure is imperfect and can backfire. We find that although a price cap or floor can correct price biases, it can also make bond allocations even less efficient.

What is a better solution then? We show that a simple, unconstrained double auction delivers better price discovery and allocative efficiency. A double auction for settling CDS is similar to the open and close auctions on stock exchanges. Since double auctions have done well in equity markets, why not consider it for CDS auctions?

For details of this research, see Songzi Du and Haoxiang Zhu, “Are CDS Auctions Biased and Inefficient?”. An earlier version of this paper is summarized by FT Alphaville (part 1, part 2).

Haoxiang  Zhu is Assistant Professor of Finance at the MIT Sloan School of Management