Tag Archives: MIT Sloan

Unfunded State and Local Healthcare Benefits, the Elephant in the Room?

Last week Bob Pozen, a Visiting Senior Lecturer here at MIT Sloan with a distinguished background in government, business and education gave an eye-opening lunch talk. The topic was “Other Post-Employment Benefits” or OPEBs—which is accounting jargon for the liabilities governments incur for retiree healthcare.

Here’s what he found:

“The 30 largest American cities had over $100 BILLION in retiree healthcare deficits in 2013, as estimated by the Pew Charitable Trust. In that year, New York City showed the most serious retiree healthcare deficits at $22,857 per household. The retiree healthcare deficits of the States were even larger in 2013 — a total of $528 BILLION according to the credit rating agency Standard & Poor’s.”

How have such enormous liabilities gone largely under the radar? One reason appears to be lack of transparency in how they are reported. Governments are not required to fund those liabilities, and in most places they don’t appear on balance sheets. (That omission will be corrected if GASB, the government accounting standards setter, prevails.) OPEBs also lack the constitutional protections of pension promises. That means cities like Detroit that run into financial trouble may find a way out of those obligations. In most places though, taxpayers will foot the bill unless benefits are renegotiated.

You can read more about OPEBs and Bob’s suggestions for how to address them at:

Real Clear Markets – “Unfunded Retired Healthcare Benefits are the Elephant in the Room

Boston Globe – “Boston Must Rein Retiree Health Plans

Tackling the challenges of governments as financial institutions

From the MIT Sloan Newsroom:

Governments not only regulate the private financial marketplace, they also own and operate some of the world’s largest financial institutions. Government agencies make trillions of dollars of loans, insure large and complex risks, and design new financial products. Yet their leaders often lack the analytical support and rigorous financial training of their peers in the private sector, and transparency is often lacking.

 

The MIT Center for Finance and Policy officially launched this month to address those gaps, along with other challenges facing financial policy makers.

“This is a big unmet need,” said Professor Deborah Lucas, director of the center. “To have an academic center devoted to the broad swath of government financial policies that have such an enormous effect on the allocation of capital and risk in the world economy.”

“What we want to do is to promote research that policymakers, practitioners, and informed citizens can turn to as an objective source of information when they’re thinking about these policy issues. That information often isn’t available now,” she said.

Research endeavors so far include, among others: the production of a world atlas of government financial institutions, an effort helmed by Lucas to catalog, compare, and evaluate governments’ financial involvement worldwide; a project led by Professor Andrew Lo to develop a dashboard that measures systemic financial risk; a study of the effects of algorithmic and high frequency trading, led by Professor Andrei Kirilenko; and a study of policies on retirement finance led by MIT Sloan professor and Nobel laureate Robert Merton.

Lo, Kirilenko, and Merton are all co-directors of the center.

Along with the research work, Lucas said there is also an educational mission for the center. In many cases, the center’s leaders say, financial problems could have been avoided, mitigated, or at least predicted had public sector workers had an education on par with that received by many private sector finance professionals.

“The idea is to provide the people who are working on finance within a government context with the same skillset as their peers in private industry,” Lucas said. “One reason you see a lack of finance education is because it’s tended to be a rather expensive education. And people going into the public sector may not even realize that finance is what they will need to know.”

At MIT Sloan, work at the center has already led to the creation of Kirilenko’s new course—Core Values, Regulation, and Compliance—as well as a student club on financial markets and policy.

The center began sponsoring events in October 2013, but officially launched Sept. 12-13 with the inaugural MIT Center for Finance and Policy Conference in Cambridge, Mass. More than 120 people attended the invite-only event, which featured discussions on the cost of government credit support, the costs of single-family mortgage insurance, and contagion in financial markets. Peter Fisher, senior director at BlackRock Investment Institute and a former undersecretary at the U.S. Department of the Treasury, gave a keynote talk.

The conference also included a panel discussion on improving government financial institutions, which addressed the need for government agencies to improve how they manage credit portfolios and monitor program risk levels over time. Panel members also discussed ways to raise red flags when there are problems in government credit programs.

The outlook was not entirely dire. “The move toward embracing risk management concepts across the federal government has been impressive in recent years,” said Doug Criscitello, a managing director at Chicago-based audit, tax, and advisory firm Grant Thornton and the former CFO of the U.S. Department of Housing and Urban Development. “We’ve seen the rise of independent risk management offices … that are housed outside the credit extension department.”

Lucas said she believes MIT’s depth in finance, economics, policy, and systems thinking make it the ideal place to study governments as the world’s largest and most complex financial institutions.

“I think an important reason that more academics haven’t taken on these issues—despite their importance—is that they are extremely complex,” she said. “Making progress takes a big investment in understanding institutions and laws and motivations. The problems are inherently interdisciplinary. And MIT is this great institution in terms of having the horsepower and energy to go after it and say ‘We can hit this question from a lot of different dimensions.’”

What is the optimal trading frequency in financial markets?

Trading speeds in financial markets have increased dramatically over the last decade. In markets for equities, futures and foreign exchange, transactions take place in milliseconds to microseconds (or even nanoseconds). Markets for fixed-income securities like corporate bonds and over-the-counter derivatives like interest rate swaps and CDS are also catching up quickly by adopting electronic trading.

The dramatic speed-up of financial transactions can perhaps only be matched by the intensity of the events and debates surrounding it, especially in the context of high-frequency trading. To many, the Flash Crash of May 2010 was a wakeup call for reevaluating market structure. A series of technology glitches proved to be highly costly for some brokers, proprietary firms and marketplaces in terms of profits and reputation. The SEC launched investigations into HFT firms and their strategies. The French regulators introduced financial transaction tax. Michael Lewis wrote “Flash Boys.” The list goes on.

With these events and controversy come important economic questions: What are the costs and benefits to investors for speeding up trading? Is there an “optimal” trading frequency at which the financial market should operate? And does a faster market affect one group of investors more than another?

In a recent research paper, Welfare and Optimal Trading Frequency in Dynamic Double Auctions, my coauthor Prof. Songzi Du (Simon Fraser University) and I attempt to answer these questions.

Our starting point is very simple. Trading frequency can be measured by how often investors transact through market. A higher-frequency market allows investors to access the market more often per unit of clock time. When investors meet each other in the market, they trade. Trading can be motivated by new information about future asset value and idiosyncratic trading incentives such as tax or inventory considerations.

A fundamental function of financial market is to reallocate assets from investors who value them less to investors who value the assets more, at the right price. The better this function is fulfilled, the more efficient the market is in reallocating the asset. We say that the market “improve welfare”—that is, make all investors better off—if it makes the reallocation of assets more efficient.

The bright side and dark side of a higher-frequency market

A higher trading frequency is double-edged sword. The optimal trading frequency depends on how the benefit and cost balance each other.

On the bright side, a higher-frequency market is more responsive to new information. Investors benefit from being able to react immediately to news. For example, following earnings announcements or merger-acquisition news, an investor may find his previous allocation on a stock no longer desirable. The sooner investors react to this information by trading, the better off they are. This effect favors a high-frequency market.

On the dark side, a higher-frequency market reduces the aggressiveness of investors’ trades. Investors are said to be more aggressive if they are willing to tolerate a greater market impact to achieve their target asset position. For example, aggressive execution means trading larger quantities more quickly. By contrast, unaggressive execution means splitting a large order into many small pieces and trading them gradually over time. The more frequently the market allows investors to transact, the stronger is their incentive to split orders over time to avoid price impact; hence, it takes longer to reach desired asset positions, and this is inefficient. If, however, a market opens infrequently, it encourages investors to trade aggressively now—failing to trade now means waiting for longer for the next opportunity to trade; this in turn leads to a faster convergence to efficient allocations. In this sense, somewhat counter intuitively, a lower-frequency market enhances allocation efficiency.

Scheduled versus stochastic news

We show that the optimal trading frequency depends on the nature of information arrivals, which determines the tradeoff between the benefit and cost of a higher trading frequency.

For scheduled arrivals of information, such as earnings announcements and macroeconomic data releases, we find that the optimal trading frequency should be equal to or lower than the frequency of information arrivals. For example, if news only arrives once per day, it is never optimal for investors to trade more than once a day. Moreover, if the market is competitive enough, the optimal trading frequency is equal to the information frequency.

For stochastic arrivals of information, such as surprise news of mergers and acquisitions, we show that the optimal trading frequency can be much higher. Moreover, if the market is competitive enough, continuous trading (the highest-frequency market) turns out to be optimal.

What does this tell us about optimal trading frequency in reality? Assets such as large-cap stocks or Treasuries that have frequent, unpredictable news shocks should be traded close to continuously. Small, illiquid stocks or bonds that have scarce news may best trade in a low-frequency market that only opens a few times a day; concentrating trading interests at specific time creates a deeper market. Therefore, there is no “one size fits all” optimal trading frequency for all securities.

For more details of this research, see “Welfare and Optimal Trading Frequency in Dynamic Double Auctions”, by Songzi Du and Haoxiang Zhu, http://ssrn.com/abstract=2040609.

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

Professor Zhu’s research on this topic has also been featured on MarketWatch, click to view the article.