by Jonathan Macey and David Swensen
December 24, 2015

AMERICA’S equity markets are broken. Individuals and institutions make transactions in rigged markets favoring short-term players. The root cause of the problem is that stocks trade on numerous venues, including 11 traditional exchanges and dozens of so-called dark pools that allow buyers and sellers to work out of the public eye. This market fragmentation allows high-frequency traders and exchanges to profit at the expense of long-term investors.

Individual investors, trading through brokers like Charles Schwab, E-Trade and TD Ameritrade, suffer first as the brokers profit by hundreds of millions of dollars from selling their retail orders to high-frequency traders and again as those traders take advantage of the orders they bought.

Market depth, critically important to investors who trade large blocks of securities, also suffers in the world of high-frequency traders. Startling evidence for the lack of robustness in today’s market comes from a 2013 Securities and Exchange Commission report that found order cancellation rates as high as 95 to 97 percent, a result of high-frequency traders’ playing their cat and mouse game. Market depth is an illusion that fades in the face of real buying and selling.

Securities markets work best as a central clearinghouse where all buyers and sellers of stocks come together. Not so long ago, when the New York Stock Exchange and the Nasdaq operated as virtual monopolies, American equity markets were the envy of the world. Until 2000, Nasdaq was wholly owned by a nonprofit corporation; the New York Stock Exchange was nonprofit until 2006. To ensure that they would operate in the public interest, they were treated much like public utilities.

The unfairness of trading markets became a subject of intense focus with the publication in 2014 of Michael Lewis’s book “Flash Boys: A Wall Street Revolt,” which describes the way these markets are rigged in favor of high-frequency traders. Fortunately, Mr. Lewis provides a hopeful ending, predicting that the book’s hero, a trader named Brad Katsuyama, would save the day by forming his own exchange to serve real investors.

Mr. Lewis was right. Mr. Katsuyama’s company, IEX (in which Yale has a small indirect investment), has filed an application to become a national securities exchange. Exchanges are the key to price discovery — the determination of the true price of an asset — because the National Market System requires brokers to route trades to the exchange displaying the best price. Right now, brokers and their larger exchange competitors can ignore IEX and other regulated alternative trading platforms, even if they display the best prices.

Its exchange competitors, which include the New York Stock Exchange, Nasdaq and BATS, cater to the interests of high-frequency traders, which typically provide more than 50 percent of all trading volume. In addition to trading fees, exchanges charge fees for high-speed proprietary data feeds that provide privileged access to market data.

Exchanges advance the interests of traders by sponsoring esoteric order types, which for hard-to-understand reasons receive the approval of the S.E.C. An example is the New York Stock Exchange Day Intermarket Sweep Add Liquidity Only Order. Regular investors have no idea such an order type exists or what it means. Yet order types like these are essential to the dirty work of the high-frequency trader.

High-frequency traders pay to locate their computer servers inside of exchanges’ order execution centers, where they get early access to trade information that they use to jump in front of — front run — other clients. These co-located computers detect orders to buy and sell on one exchange and then rapidly send cancellations and orders to other venues where their servers are also co-located. Does this sound like a fair system?

IEX’s plan is to forgo the high profits earned by the major exchanges from selling speed advantages on the theory that they can make money more ethically by attracting long-term investors.

Its strategy is simple. IEX will not allow traders to reap the benefits of speed, instead slowing down all participants by 350 microseconds. This prevents the front-running facilitated by exchanges, which has led to vigorous and vitriolic opposition from groups that profit from the current arrangement.

An unholy alliance of exchanges (including the New York Stock Exchange, Nasdaq and BATS) and high-frequency traders like Citadel have petitioned the S.E.C. to reject IEX’s current application. In essence, the petitioners argue that it is consistent with commission rules for an exchange to sell certain customers an advantage over others, but IEX should not be allowed to remove these advantages.

The New York Stock Exchange, Nasdaq and BATS seek to block IEX from competing, when they collectively own 10 of the 11 national stock exchanges. By creating (and receiving S.E.C. approval for) so many exchanges, the current infrastructure fragments the market without providing the benefits of real competition.

Maybe IEX’s business model will work and maybe it won’t, but the S.E.C. should act in the public interest. Approval of IEX’s application will not fix America’s equity markets; it will make them less broken. The commission should not succumb to the special interests of competitors and their fellow travelers. It should approve IEX’s application and provide a real alternative for long-term investors.

Jonathan Macey is a professor of law and David Swensen is the chief investment officer at Yale.

by Stephen S. ROach
December 23, 2015

NEW HAVEN – By now, it’s an all-too-familiar drill. After an extended period of extraordinary monetary accommodation, the US Federal Reserve has begun the long march back to normalization. It has now taken the first step toward returning its benchmark policy interest rate – the federal funds rate – to a level that imparts neither stimulus nor restraint to the US economy.

A majority of financial market participants applaud this strategy. In fact, it is a dangerous mistake. The Fed is borrowing a page from the script of its last normalization campaign – the incremental rate hikes of 2004-2006 that followed the extraordinary accommodation of 2001-2003. Just as that earlier gradualism set the stage for a devastating financial crisis and a horrific recession in 2008-2009, there is mounting risk of yet another accident on what promises to be an even longer road to normalization.

The problem arises because the Fed, like other major central banks, has now become a creature of financial markets rather than a steward of the real economy. This transformation has been under way since the late 1980s, when monetary discipline broke the back of inflation and the Fed was faced with new challenges.

The challenges of the post-inflation era came to a head during Alan Greenspan’s 18-and-a-half-year tenure as Fed Chair. The stock-market crash of October 19, 1987 – occurring only 69 days after Greenspan had been sworn in – provided a hint of what was to come. In response to a one-day 23% plunge in US equity prices, the Fed moved aggressively to support the brokerage system and purchase government securities.

In retrospect, this was the template for what became known as the “Greenspan put” – massive Fed liquidity injections aimed at stemming financial-market disruptions in the aftermath of a crisis. As the markets were battered repeatedly in the years to follow – from the savings-and-loan crisis (late 1980s) and the Gulf War (1990-1991) to the Asian Financial Crisis (1997-1998) and terrorist attacks (September 11, 2001) – the Greenspan put became an essential element of the Fed’s market-driven tactics.

This approach took on added significance in the late 1990s, when Greenspan became enamored of the so-called wealth effects that could be extracted from surging equity markets. In an era of weak income generation and seemingly chronic current-account deficits, there was pressure to uncover new sources of economic growth. But when the sharp run-up in equity prices turned into a bubble that subsequently burst with a vengeance in 2000, the Fed moved aggressively to avoid a Japan-like outcome – a prolonged period of asset deflation that might trigger a lasting balance-sheet recession.

At that point, the die was cast. No longer was the Fed responding just to idiosyncratic crises and the market disruptions they spawned. It had also given asset markets a role as an important source of economic growth. The asset-dependent economy quickly assumed a position of commensurate prominence in framing the monetary-policy debate.

The Fed had, in effect, become beholden to the monster it had created. The corollary was that it had also become steadfast in protecting the financial-market-based underpinnings of the US economy.

Largely for that reason, and fearful of “Japan Syndrome” in the aftermath of the collapse of the US equity bubble, the Fed remained overly accommodative during the 2003-2006 period. The federal funds rate was held at a 46-year low of 1% through June 2004, before being raised 17 times in small increments of 25 basis points per move over the two-year period from mid-2004 to mid-2006. Yet it was precisely during this period of gradual normalization and prolonged accommodation that unbridled risk-taking sowed the seeds of the Great Crisis that was soon to come.

Over time, the Fed’s dilemma has become increasingly intractable. The crisis and recession of 2008-2009 was far worse than its predecessors, and the aftershocks were far more wrenching. Yet, because the US central bank had repeatedly upped the ante in providing support to the Asset Economy, taking its policy rate to zero, it had run out of traditional ammunition.

And so the Fed, under Ben Bernanke’s leadership, turned to the liquidity injections of quantitative easing, making it even more of a creature of financial markets. With the interest-rate transmission mechanism of monetary policy no longer operative at the zero bound, asset markets became more essential than ever in supporting the economy. Exceptionally low inflation was the icing on the cake – providing the inflation-targeting Fed with plenty of leeway to experiment with unconventional policies while avoiding adverse interest-rate consequences in the inflation-sensitive bond market.

Today’s Fed inherits the deeply entrenched moral hazard of the Asset Economy. In carefully crafted, highly conditional language, it is signaling much greater gradualism relative to its normalization strategy of a decade ago. The debate in the markets is whether there will be two or three rate hikes of 25 basis points per year – suggesting that it could take as long as four years to return the federal funds rate to a 3% norm.

But, as the experience of 2004-2007 revealed, the excess liquidity spawned by gradual normalization leaves financial markets predisposed to excesses and accidents. With prospects for a much longer normalization, those risks are all the more worrisome. Early warning signs of troubles in high-yield markets, emerging-market debt, and eurozone interest-rate derivatives markets are particularly worrisome in this regard.

The longer the Fed remains trapped in this mindset, the tougher its dilemma becomes – and the greater the systemic risks in financial markets and the asset-dependent US economy. It will take a fiercely independent central bank to wean the real economy from the markets. A Fed caught up in the political economy of the growth debate is incapable of performing that function.

Only by shortening the normalization timeline can the Fed hope to reduce the build-up of systemic risks. The sooner the Fed takes on the markets, the less likely the markets will be to take on the economy. Yes, a steeper normalization path would produce an outcry. But that would be far preferable to another devastating crisis.
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Stephen S. Roach, former Chairman of Morgan Stanley Asia and the firm's chief economist, is a senior fellow at Yale University's Jackson Institute of Global Affairs and a senior lecturer at Yale's School of Management. He is the author of Unbalanced: The Codependency of America and China.

The Apex Of Market Stupidity
By Charles Gave
December 8, 2015

In some 40 years of watching financial markets, my dominant emotion has been a mixture of curiosity, amusement and despair. It seems the stock market must have been invented to make the maximum number of people miserable for the greatest possible amount of time. The bond market, meanwhile, has just one goal in life: to make economists’ forecasts for interest rates look even more silly than their other predictions.

Over the years I have often observed how most market participants are able to concentrate on only one set of information at a time. For example, in the 1970s, the only data release that mattered was the consumer price index. In the days leading up to the CPI’s publication, everybody dropped all other considerations to speculate feverishly about what the number might be. And then following the release, they would spend the next week or two commenting sagely on what the number actually had been. Eventually Milton Friedman convinced the Federal Reserve (and from there the markets) that there was some kind of relationship between the money supply and the CPI. So everyone stopped looking at the CPI, and instead started to focus on the publication every Thursday evening of M1 (or was it M2?). Inevitably each week would see an immediate rash of commentary on these arcane matters from the leading specialists at the time, Dr. Doom and Dr. Gloom.

This gave way to a period in which the US dollar went through the roof on the covering of short positions established during the era of the minister of silly walks in the 1970s. For a few years, the only thing that mattered was the spread between the three-month T-bill yield and the three-month rate on dollar deposits in London (an indication of the shortage of dollars outside the US). The beauty of this one was that the scribblers on Wall Street could comment on it twice a day or more, which of course had no discernible impact on reality, except for the destruction of the forests needed to print so much waffle.

That era came to an end in 1985 with the Plaza Accord. At that point the Fed, under the wise guidance of Paul Volcker—my favorite central banker of all time, probably because he was the only one without a PhD in economics, which may well explain his success—decided it was going to follow a type of Wicksellian rule-based policy under which short rates were kept closely in line with the rate of GDP growth. Of course, this meant the Fed paid little attention to the vagaries of the financial markets, so there was very little to comment on. The result of policymakers’ lack of interest in financial markets was that from 1985 to 2000 the US enjoyed a long period of rising economic growth, low inflation, low unemployment and high productivity; a period dubbed “the great moderation”. The trouble was that no one was able to make any money trading on inside information provided by the politicians and central bankers. As an advertisement for Sm ith Barney put it at the time: “We are making money the old way. We earn it.”

Naturally, that wouldn’t do at all. After nearly 20 years of economic success, the US budget was in surplus, the pension funds were over-funded, and the “consultants” in Washington were on the verge of bankruptcy, having nothing to say. Clearly something had to be done, and it was: policy shifted to accommodate Wall Street, with forward guidance, negative real rates, the privatization of money, and a lack of regulation. This allowed Wall Street to make money, but it created nightmares elsewhere through the ever-successful euthanasia of the dreadful rentier.

Still, the shift to an economy driven by the decisions of central bankers meant the market commentators were back in business in a big way. For the last 12 years, the only thing that has mattered has been to know whether or not the chairman of the Federal Reserve has had a good night’s sleep. Similarly in Europe, the dysfunctional euro, created by a bunch of incompetent politicians and Eurocrats, bred drama after drama. Since nobody wanted to admit it was a failure, the most important man in Europe became the president of the European Central Bank. 

In the last week, we have reached what is surely the apex of this stupidity. A bunch of algo traders programmed their computers expecting “Derivative Draghi” to be extremely dovish, as any proper Italian central banker should be. I am not sure I understand why, but some traders obviously decided that he had not been dovish enough. European stock markets plunged by -4%, while the euro went up by roughly the same amount in the space of a few minutes. What that means is simple: value in the financial markets is no longer a function of the discounted cash flow of future income, but instead is determined by the amount of money the central bank is printing, and especially by how much it intends to print in the coming months. So we are in a world where I can postulate the following economic and financial law: variations in the value of assets are a function of the expected changes in the quantity of money printed by the central bank. To put it in a format that today’s economists understand:

Δ (VA) = x * Δ (M),

where VA is the value of assets and M is the monetary increase.

What we are seeing is in fact in one of the stupidest possible applications of the Cantillon effect, whereby those who are closest to the money-printing, i.e. the financial markets, are the biggest beneficiaries of that printing. This is exactly what happened in 1720 in France during the Mississippi Bubble inflated by John Law. The end results were not pretty (see “Of Central Bankers, Monkeys And John Law” [above]).
What I find most hilarious is that some serious commentators have been pontificating at considerable length about what the market’s participants think. These days, some 70% of market orders are generated by computers, and many of the rest by indexers. And computers do not think. They simply calculate at light speed, which allows them to react to short term movements in market prices as they were programmed to do. And since they are all programmed the same way, the result is some big short term market moves. In essence, these computers act as machines that allow market participants to stop thinking. As a result, I cannot remember a time when less thinking has ever been done in the financial markets, which is why I find today’s financial markets infinitely boring.
We are swimming in an ocean of ignorance, just like France in 1720. It seems all the painful economics lessons learned over the last 300 years have been forgotten. I suppose that means we will just have to wait for another Adam Smith to appear. La vie est un éternel recommencement..

Of Central Bankers, Monkeys, and John Law
By Charles Gave via Mauldin Economics
April 17, 2015

A revealing experiment involved monkeys being placed in a cage with a pile of nuts stashed on an upper level. Their efforts to snaffle the food caused them to be doused in water, blasted with a siren and startled by an electric shock. After a number of attempts the monkeys gave up. Later, a second group of monkeys were introduced—the new entrants made a beeline for the goodies, but were quickly beaten back by the chastened first group of monkeys. Finally, this first group were removed from the cage and replaced by a fresh contingent. The new monkeys immediately made a dash for the nuts, but were beaten back by the second group; i.e., those who had never experienced the cold water, siren or shocks.
It does not take a wild imagination to see a parallel between our monkeys and central bankers. For generations central bankers were cowed by their inflation-scarred colleagues and accepted that the top of the cage was off limits. But then a rebel monkey, erh central banker, emerged in the shape of Alan Greenspan. As the gorilla in the pack he persuaded the rest that the fruits at the top of the cage may not be forbidden. The result of this “bravery” in economic policymaking has been two huge financial crises.

The funny thing is that the general public remains grateful to the central bankers since their “new-fangled” actions to “save” the world economy appear to be working. For the most part our monetary guardians have escaped responsibility for the crashes, with popular ire focusing instead on “nasty” commercial bankers. The concern must be that few experiments (certainly in economics) are “new”, except for those which ignore history. And, of course, to quote philosopher George Santayana “Those who cannot remember the past are condemned to repeat it”.

History has thrown up multiple attempts to create wealth by printing money from the Song Dynasty in China to renaissance era Italian bankers, through revolutionaries in France and their Assignat notes, to the more recent case of Zimbabwe. However, one of the most revealing cases took place in the early 18th century when France was ruled by the boy king Louis XV and power was exercised by his uncle, the Regent.

Heroes and villains

This story has two protagonists: the first being a classic villain in the shape of John Law, a Scottish professional gambler, who can been thought of as a proto Mario Draghi. Our hero was Richard Cantillon, an Irishman, whose actions shared similarities with Georges Soros, the investment manager who in 1992 forced the pound to leave the European exchange rate mechanism. Back in the early 18th century France was almost bankrupt because of the wars that accompanied the end of Louis XIV’s reign. As a result, the French “rente”, the equivalent of today’s OAT, was selling at a huge discount to its face value.

Enter John Law who presented the Regent with a simple solution to the kingdom’s straitened financial situation: the government would grant a client company “La Compagnie des Indes Orientales” (CIO) a monopoly to conduct international trade between France and French colonies in the new world. Later CIO would become Banque Royale as its notes were to be guaranteed by the crown. Law would arrange for shares in CIO to be sold to the public, allowing payment to be made using the discounted French rente at full value, rather than its discounted market price. The price of the shares, and also that of the rente, went through the roof, which we have come to recognize as the usual response to a quantitative easing program. Since the run lasted quite a while, it led to a remarkable boom, centered on the Palais Royal in Paris and the luxury industries.

At this point, Cantillon joins the story. He was an astute financial operator who, sensing an opportunity, decided to move to Paris. He quickly had three key insights:

•    No new wealth was being created in France; rather there was just a massive increase in the monetary value ascribed to older assets. In fact France was getting less, rather than more competitive. He went short the French currency and long the British pound, a trade which eventually made him a ton of money.
 
•    The main beneficiaries of the artificial wealth being created were those cronies closest to the Banque Royale which had been granted the trade monopoly. This phenomenon was later called the “Cantillon effect”.
 
•    The system could work only as long as nobody asked to be repaid in real money, at that time gold.
When Cantillon started to see great French aristocrats (those close to the Banque Royal such as Prince de Conti) selling their shares against gold he opened up a large short position, and made out like an (Irish) bandit. When the system imploded, he was sued for both shorting the French currency and also being short the shares of the colonial monopolist. He won, as at that time the courts in France were genuinely independent.

Fortunately, he committed his analysis to paper in the book “Traite sur la nature du commerce” which is a must-read for anyone interested in financial speculation. Schumpeter spoke highly of Cantillon, who was probably the first economist to clearly distinguish wealth from money. He recognized the distinction between asset prices rising due to an economy becoming more productive rather than as a result of a massive expansion of the supply of credit. In the second case, the value of money is going down versus the price of assets, which is a form of inflation.

This audacious attempt to monetize asset prices by printing money resulted in ruin for the French middle class, which had sold its weak but solvent French rente against worthless shares. What followed was a collapse in the credit sphere followed by a great deflation. The lesson is that a huge inflation in asset prices is seldom followed by inflation in retail prices; rather once asset prices start deflating what usually follows is a deflation in retail prices (see “The Debt Deflation Theory Of Great Depressions” by Irving Fisher).

The stability of the system was predicated on the guarantee that French government bonds could, if asked, be repaid in gold, and the same for the shares in CIO. At the peak of the “Mississippi Bubble” the Banque Royale had 4mn francs in its vault and outstanding notes totaling more than 100mn francs. So when the consummate insider, Prince de Conti, started to convert his positions for gold, the system began to collapse. Within a year the CIO share price had fallen by more than 80%. From start to finish, the episode lasted a little more than three years.

Why I am recounting this old story? Because we are at it again. Simply replace the French rente with current Italian or Spanish Bonds; the Regent with Francois Hollande; John Law with Mario Draghi and it is clear that very little has changed. My hope is that most of our clients will end up following Cantillon rather than face the predicament of France’s ruined middle class at such time that latter day Prince de Contis cash out.

In the current system, gold is being replaced by the willingness of Germans to keep accumulating financial assets issued by the rest of Europe, which will never be repaid. The ratio that exorcised Cantillon was the value of the gold stock / the value of engagements; the modern equivalent may be the net external balance of Germany vs the rest of Europe with Angela Merkel or the Bundestag playing the Prince de Conti.

And what has Mario Draghi, in the role of John Law, done to prolong the agony? He has manipulated the cost of money by increasing the quantity of money, or, at least, promised to do so in the hope that speculators front run the ECB. They have, of course, duly obliged. And what happened during the Mississipi Bubble is now unfolding in our time. The increase in the quantity of money in itself cannot lead to an increase in wealth. For confirmation, consider the case of Italy as shown in the chart below.

The blue line is the ratio between the Italian and the German industrial production indices. From 1960 to 2000, Italian industrial output grew faster than its German equivalent by 48%. However, since 2002, the Italian measure has declined 40% versus that in Germany. As a result, the Italian stock market, which outperformed the German market between 1970 and 2002 by a robust 250% (in common currency terms) has, since 2002, underperformed by 60% (red line, right scale). I have few doubts that a modern day Cantillon would have been short the Italian stock market versus the German one at least since 2002.

Indeed, it is clear that wealth creation in Italy has effectively stopped, as shown by the fact that since 2000 the economy has spent three quarters of its time in recession. Indeed, measured in absolute terms, industrial production today is 25% below where it was in 2000.

Of course, the only sensible approach for a heavily indebted country which has seen growth disappear would be to devalue its currency. Since that option was off the table due to the strictures of the euro system, the bond markets, from 2008 onwards started to play the default game. By 2012, spreads had opened to such an extent that it should have been obvious that the euro was doomed (see bottom pane of the chart above).

At this point “Derivative Draghi” did his worst and promised to do “whatever it takes”. The bond markets understood this as a promise that the ECB would buy Italian, Spanish and Portuguese government bonds. As a result, yields promptly collapsed. But, and this is a big but, the Italian economy kept shrinking and the German economy kept expanding. If the policy had succeeded, one would have expected the expression of the relative return-on-investment in the two economies (namely the ratio between the two stock markets indices) to change direction.

Nothing of the sort has happened. In fact, the Italian government can now borrow at 1.5% or so, while the average growth rate of the Italian economy has been -1% for the last two years. Italy was and remains solidly in a debt trap; debt as a share of GDP will keep rising as long as the 10-year yield is above -1%. The problem is that negative rates destroy a country’s savings industry and thus its long term growth rate. The same is true for France or Spain, not so much because interest rates are too high but because both countries have massive primary deficits.

Conclusion

So what should the savvy investor do? Remember Richard Cantillon and do not trust John Law. Stay short the Italian stock market versus the German one (equivalent to CIO stock in 1717). Remain short the German bond market versus the US (equivalent to being short the French currency vs. the British one in 1717).