Friday, September 29, 2006

Groundhog Day

Each morning I rise and shine thinking, hoping, and wishing that the world be better place than the one I left behind the night before. Gosh knows I try to be a better in what ways I can. But why oh why do nation states in general (and to get to the point for this is an economics-related blog of sorts) and the various finance ministries & central banks in particular have such difficulty making it "a better place" and doing the right things for world as a whole?

I am not here to bash "free trade", the benefits of trade, or the imperative of each minister or chief banker to regard the interests of the polity from whence he came above the interests of the world in general. But each day, we seem to diverge further from, rather than converge towards, any medium-term sustainable global equilibrium. And each morning as I scan the headlines and review the figures in detail, I am both both saddened and worried anew. Yes cliched as it is, like Bill Murray in "Groundhog Day".

Just once might I get up and hear: "The head of the BoJ admitted that Japanese interest rates are too low (and have been for too long) and thus effective immediately will be normalizing rates. "He said further that such normalisation will occur "at once", and there will be quote "No pussy-footing around". When questioned about the impact of the move upon the stability of financial markets, he said: "Speculators who have borrowed YEN at near zero to finance investment activities in other parts of the world when economic activity and inflation are so obviously very buoyant must be smoking crack or be severely mentally challenged if they didn't factor in the risk of eventual normalisation of YEN rates into their speculative equations. From Japan's point of view, they deserve whatever financial fate befalls them, not to mention that the Darwinian shakeout will make the world financial markets more efficient in the future.

Or how about: "PBoC Chief Zhou today announced the full scale float of the RMB, effective immediately. In teh same breath, he warned speculators that Chinese Banks have lots of bad debt, Chinese rates while low, are not expected to rise anytime soon, and that inflation is actually much higher than officially admitted, but that the float of the RMB will help the market enforce some much needed discipline..."

And then of course, we would all like to hear: "US lawmakers, feeling the deficit is really rather too large, said today they believe the USA needs to raise Federal revenues, and thus taxes, at least until revenue and expenditure correlate more closely. Speaking for the unanimous bi-partisan coalition, Sen Chaffee said they'll be effecting it by raising marginal inome tax rates by 10% on the dollar in the highest brackets as well as implementing a windfall resource tax, and a hefty nationwide Carbon Tax to both raise revenue and promote efficiency).

One day of course, I would be profoundly gladdened to hear "The entire Bush administration has resigned effective immediately". "New elections will be called for next week..."

Or, in keeping with the main topic of this board, Japanese equities, I would see a better world if: "Masayoshi Son, alledged charismatic and enigmatic founder of the Softbank internet empire was led away by officials from the Tokyo Prosecutors office Financial Crimes Squad as they investigate wrong-doings within the Softbank group of companies. Reporters were told Mr Son admitted to the various counts of fraud and was deeply deeply apologetic to those who as a result of his notoriety and schemes came to believe that wealth could be created in ways other than through the alignment of great prescience and good hard honest work, and of course time...".

I can dream, can't I?

Wednesday, September 27, 2006

Abe & Omi

I know this is irrelevant in comparison to the weighty subjects often tackled here but has anyone noticed how cute the names of new Japanese Primo and MoFo Chief (Abe & Omi) sound when ennunciated together?

In both German & Dutch the sweet nicknames for Grandama & Grandpa are "Oma" & "Opa". Along the south Indian coast, the same is Ajja & Ajji. Father & Mother in Hebrew are of "Abba" & "Ema". "Abe" and "Omi" just has such a cute and ring to it, that one might mistake them for a an absent-minded elderly couple puttering about their business meaning no one any harm. And heavens knows that that such an image might be important in the battle to defend what are indefensible interest rate and weak yen policies. one could imagine that every little bit will help...

Tuesday, September 26, 2006

Amaranth: Was It The Market?

That Amaranth had a losing position is [now] a USD $6billion undeniable fact. But the nagging question that I have about this trade-gone-bad is: (a) did the position itself sink Amaranth", (b) did the market sink Amaranth or (c) did some more nefarious interplay of causes sink Amaranth?

The common perception is that it was (a) "the position", which means the size of its bet, and the severe wrongness of the bet was responsible. This ascribes the disaster essentially to bad luck and poor risk-management and oversight. An elephant skating on thin ice, so to speak, that broke. To the young (after all, he IS rather green) Mr Hunter's defense, he didn't expect such a large move in such a compressed period. And he had been blessed with remarkable luck and prescience before so he (and his boss) might be foregiven for a lapse whereby they extrapolated Mr Hunter's (and by extension Amaranth's) luck into skill.

But I have been around the block a few times, and things are rarely what they seem. I am not ruling it out, but "the market" is rarely as big an anonymous as lore and certainly financial hacks purport. "The market" is, after all, the sum of participants, and though the mythology of capitalism would be furthered by widepsread belief that prices are set in pure competition by thousands of small anonymous ineffectual hedgers and speculators, reality very often differs. For the inconvenient truth (to borrow Mr Gore's pleasant turn of phrase) IS that some players are huge and alone can set or at least [temporarily] have great impact upon the marginal price. And all-too-often, large investors DO collude thus acting in concert. Yes it's prohibited, but when has that ever stopped anyone from trying to squeeze a profit? And it is none-too-easy for authorities to prove it in fact. And there are other feedback mechanisms such CTA trend-following strategies that have the same de facto collusive effect, even if the particpants never speak.

Where I am going with this? Metalgesellschaft's oil plunge, Sumitomo-Hamanaka's "little" copper problem, as well as Codelco's Juan-Pablo Davila's copper cock-up were all examples where feedback mechanisms whether overtly revealed, parsed from price-action, or driven by plausible rumour, innuendo, or margin calls, are rather different from the over-sized wrong-footed bet where the market random goes against. In all these, and potentially Amaranth's case, the market is hunting. They smell blood, and may not know why or what is precisely causing the move but as it moves, "they" (the market-as-hunter-killer) increase positions and press, thereby shaking the proverbial tree to see what falls. In Amaranth's case, there was information available to the market as it was common knowledge to the Energy cognoscenti that they'd bought MotherRock's book. And LTCM's [rightly} resident paranoic Lawrence Hillenbrand will tell you that unles you're Exxon that is the beginning of the end...

To my suspicious mind, this is getting warmer to the truth. And it somewhat shifts the "blame" from "stupidly unlucky" to "unluckily stupid", since getting caught out as such reveals hubris, overconfidence, and a feeling that one is smarter than "the market". All cardinal market sins and Bad! Bad! Bad!

But there is third possibility that is understandably NOT discussed in the mainstream media, but surprisingly is not discussed in the trade press either. And this is the possibility that their clumsy and quasi-public long Natty position was the subject of predatory trading by those with material non-public information about the Fund and it's positions. You see, Securities firms and Mega-Banks are required to have what are called Chinese walls, ostensibly to reflect the scale and impermeability of the Great Wall of China. But this is a rather poor analogy. "Shoji Partition" might be better. Or perhaps, "A Blood-brain barrier", or even "Placenta-like Separations". These are more accurate because information can and does flow to "those who require it" in the firm, i.e. risk-management personnel, Executive Committee members, CEO, CEO staff. Irrespective of what these firms might advertise, whe information flows, nothing is secure - certainly not as secure as one with an oversized-Natty position and already high-leverage would require to feel safe and secure (at least where I sit).

Roger Lowenstein's account, When Genius Failed reconstructed the scenario pretty well. Essentially, if you're very leveraged, once someone sees your positions, you're a target. Hillenbrand was seemingly the only one who really understood this risk. He made sure they used multiple Prime Brokers, swapped positions between leverage providers to insure no one saw the full extent of their leverage or their positions. If one cannot be certain as to whether one has an offsetting position at another shop, the risk-reward equation for "gunning" is greatly reduced. After LTCM started to take a hit, and needed either new capital or bigger lines, anyone who might supply the credit that was needed also needed to see "the position". All the Positions. He fought it, but there was recourse, and that was the precise point at which Hillenbrand knew they were dead.

LTCM accused many of the people of trading against them once they saw their positions, Goldman Sachs being singled out, in particular. But AIG, Citigroup, Berkshire, all had seen the enitre book. But everyone had lines with LTCM, so even for those who didn't see the whole book, and even they didn't know whether there was a hedge on the other side, they knew what THEIR risk was, or rather what as a lender to LTCM, they would soon be owning as principal in the event LTCM missed their call, or violated the fine print. As a creditor, a firm knew precisely what to sell and its childish to think they didn't take measures to protect themselves directly by "hedging" their risk (i.e. selling some or all of the position out directly in anticipation) or that opportunists managing the various trading desks didn't understand "the wink & the nod" that this client was now "shark bait", or that the sales manager on the bond desk couldn't resist helping another large client who would still be a client AFTER the mess was mopped up, make a little money.

But there was another incident a couple of years ago called "Eifuku" (amusingly pronounced "I F*ck You"), in which a Japanese hedge fund priming with Goldman Sachs took on entirely too-much leverage, and ploughed it into rather stupid concentrated positions. And in the span of a few short days, "the market" moved against them, and lo and behold, Goldman "owned" the position. The proprietor screamed "foul play", and sent a letter to his investors that all his positions mysteriously moved against him at the same time, causing margin call after consecutive margin call until POP!! Rumours circulated later that they had been "gunned" by Goldman. And Admittedly, this is suspect since it would make very bad business sense to risk a franchise for a little trading profit. But the world is small. And there ARE other plausible, though unproven, possibilities. For example, the head of a large London hedge fund might have worked at Goldman, and still had private friends there, and might have even been a big client of theirs. Perhaps Mr "Eifuku" had an oversized ego and inflated opinion of himself, was a Cowboy, and a potential liability to the white-shoes. Coveted position information thus passed could have seen such a client and fund trade against the position. Given the leverage, it would only take a couple days to torpedo it. Goldman would then "own the inventory" and would presumably sell the offsetting position to the client hedge fund locking in a lovely profit, and solving the problem of a loose cannon. Not to mention that the now-enriched client, with boosted returns, would gather more assets, thus completing a virtuous circle. "Boat drinks!!" Of course all the foregoing is pure and unsubstantiated conjecture, and by way of disclosure, is meant to entertain a plausible alternative explanation for very real events.

Which brings us to what really happened to Amaranth. We know they had a big energy position that was compromised from the get-go because others bid for it, so they knew marfin calls were being made. We know that they had reasonably high leverage across the fund (and I don't care what anyone says or what comparisons they make to LTCM, it WAS high). We know Citadel is very active in the energy markets and has boatloads of capital, and probably "saw" the MotherRock position. Having missed it, and seen the market tail south, did THEY "gun" it? Did their Prime Brokers "see" the position and decide it was scarily big and thus sell some Natty to hedge their credit risk, thus creating larger margin calls? Did the IB prop desks (through their Prime's) "get wind" of the position, see the margin calls, and give it a friendly "push"? Did the CTA Trend followers acclerate the trend through their "informationless" feedback loop? Maybe all? Maybe none. But be assured that there is an objective reality out there and the NYMEX Natty "time and sales" audit trail that flows back to the ultimate traders will reveal a story. How nefarious that story ultimately is will have to wait for a determined investigative pit-bull. I wonder to what extent "plausible deniability" is being manufactured as you read this?

Monday, September 25, 2006

Never Feel Sorry For A Man With His Own Plane

One of the top headlines in Bloomberg news this morning was the revelation in an Austrian Magazine that an Austrian speculator had been forced to sell amongst other things a van Gogh in order to repay the Austrian Bank whose money he was reputed to have lost in the markets. The article closed by saying that the centerpiece was, (of all places), now adorning the walls of Steve Wynn's Las Vegas palace, and that it's former owner was too distraught to cast eyes upon it ever again.

In addition to the irony that the famous canvas finds itself yet again, in a gambling establishment, it must be pointed out that that it is but another in a long list of speculators and famous works sold under duress. Alan Bond, Ryoei Saito who's story is detailed by Cassandra here, along with many others whose involuntary art dispositions and subsequent legal humiliation were far worse than what's at stake here.

Perhaps the point of the Bloomberg article was to mock the feelings the van Gogh's former owner, though with Mr Bloomberg himself being a collector, such an accusation might be out of line. Or perhaps the implied sympathies were genuine. After all, the wealthy do have feelings too. But the implicit plea for sorrow made me think of that film with Anthony Hopkins, Alec Baldwin, (and Bart The Bear, for whihc he won a special Academy Award) called "The Edge", in which Hopkins plays a fabulously wealthy older man with a stunning young wife who as it happens is having an affair with his confidante, the young Mr Baldwin. They are all away in somewhere in Alaska for Hopkins character's birthday celebration where they (sans wife) take a little sea plane voyage to do some fly fishing or such.

Baldwin's character, emboldened 'cause he's sleeping with his rich old Friend's beautiful young wife starts taunting Hopkins asking how difficult and challenging it must be "to be rich". "You never who your friends are", "You never know if someone is sincere or just wants something for from you....". "Yeah it must be rough...". Hopkins is silent. Expressionless. He hears what Baldwin is saying, clearly contemplating it carefully as they cross beautiful virgin Alaska wilderness. Then, in with the utmost of non-chalance, Hopkins responds: "Yes, well you should NEVER feel sorry for a man who owns his own Jet Plane...". Which seems rather fitting in the circumstances in case one was in danger of shedding too many sympathetic tears.

Thursday, September 21, 2006

Get Rich Funds vs. Stay Rich Funds

Are you a "Get Rich Fund" or a "Stay Rich Fund"?!??, I recall him asking. "You're a "Stay Rich Fund", which is all very nice and I am sure you're a nice girl, but, I only invest in "Get Rich Funds. Perhaps, you should talk to Izzy...since he's sweet on "Stay Rich Funds...." . Yup, that was a "potential investor meeting" following the LTCM debacle in late 1998. It followed a meeting in which the short, cigar-chomping Jewish allocator screamed "Dammit, Leverage is POISON!!". That of course followed the guy who said: "...only 20% pa and Sharpe of 2x?!?? You'll be lucky to raise a two dimes...I saw three guys this morning doing 35% with Sharpe's of 12..."

Such were the dark days in 1998 following LTCM's mere hiccup in comparison to the heaving technicolour yawn of the Amaranth Fund's demise. What will be the fallout for the street, hedge funds and hedgefund investors?

At $9bn, everyone who could, seemingly did have a piece of Nick Mouanis' Amaranth. Every Fund of Fund, family office, and large pension fund will have got stung. Many, will make public pronouncements, because they have to, though others -particularly in Switzerland - will be either more discreet or too embarassed to admit association. And surely the Japanese were there. Maybe that's why Mouanis let it happen: in response to the pathetically selfish neo-mercantilism of Japanese monetary policy? OK, probably not. And surely some of the Petro-dollars got "recycled" from Russian & Middle-Eastern owners to CTA's and the investment banks shorting Natty (who must have been the big winners), in their pursuit of putting the wounded holder of "The Ill-Fated Long Position", out of their margin-call misery.

LTCM was a capital dislocation event. It widened spreads of all variety across all credit-sensitive markets. And they stayed divergent or distended for a reasonably long period because LTCM was pari-passu with every prop-desk and Wall Street firm inventory position (and they had eaten their fill and weren't taking any more). The heightened perceived risk caused capital to pull in its horns, making it difficult for anyone to raise equity let alone think about dramatically increasing leveraged exposure to risk. Eventually it dissipated as the Fed ill-fatedly open the spigots in fear for the Y2K bug-a-boo. And the pain of investor losses faded.

But make no mistakes: the demise of Amaranth IS a capital dislocation event. Fortunately for the markets, their leveraged exposure was concentrated in Energy, and zero-sum. And though its zero sum, this is a dramatic destruction of equity, is not entirely offset since the short-Natty "winners" are not necessarily levered Spec Funds, per se. But more imtportantly, like in 1998 there will be ripples, and these ripples will cause risk-reduction, meaning position reduction in anticipation of year-end redemptions. Risk-spreads will widen, even though this was not a credit event. Christmas in Greenwich will not be as gluttonous as it might otherwise have been.

For the real economy, global imbalances (and the median US stock), Amaranth and its fallout is probably good news (for the moment). That there was excess speculation by all manner of Macro, Strategi, and Trend-Following investor in energy (and other commodities) as well as their stocks is obvious. Kicking the shit out of Natty validates the reality that there is plenty of supply (for the moment). Copper & Nickel are probably next. Maybe the whole real-asset complex. The net result will improve sentiment across the board by taking the heat off rising goods & service prices, the Fed, and especially the US's massive trade and current a/c deficits. PCE will take that much longer to roll over, and Nouriel Roubini's bold recession call, may prove to a quarter or two too-premature.

In the meantime, for hedge fund principals, and marketers alike, it is worth rehearsing your investor explanation for why you are no longer (and never really have been) a go-go "Get Rich Fund", but in fact are (and always have been) a conservative "Stay Rich Fund", irrespective of your momentum-humping pursuits, and envelope-pushing leverage. Just hope and pray that they do not demand to "look under the hood"...

[Bad] Hedge Fund Poetry Corner

So, Farewell
Then Amaranth
Fund L.P.

The Myth
of Your Floral
Permanence -
Now Shattered.

Seekers of
"the Secrets
Between Price
& Value", You
Might've Been.

But, Torpedoed
by "Natty"
Shooting The Moon!"
Will Be
Your Epithet

Some Will Call
You "Vermin",
"Fraud" May Roll
From The Lips
of Others.

But Markets
Will Remember You
Simply As:
"Cannon Fodder".

(with apologies to EJ Thribb)

Monday, September 18, 2006

That Joint IMF Statement (in full).

All work and no play makes Hank, Sadakazu & Zhou dull boys. All work and no play makes Hank, Sadakazu & Zhou dull boys. All work and no play makes Hank, Sadakazu & Zhou dull boys. All work and no play makes Hank, Sadakazu & Zhou dull boys. All work and no play makes Hank, Sadakazu & Zhou dull boys. All work and no play makes Hank, Sadakazu & Zhou dull boys. All work and no play makes Hank, Sadakazu & Zhou dull boys. All work and no play makes Hank, Sadakazu & Zhou dull boys. All work and no play makes Hank, Sadakazu & Zhou dull boys. All work and no play makes Hank, Sadakazu & Zhou dull boys. All work and no play makes Hank, Sadakazu & Zhou dull boys.

& Zhou

.syob llud uohz & uzakadaS, knaH yalp on dna krow llA .syob llud uohz & uzakadaS, knaH yalp on dna krow llA .syob llud uohz & uzakadaS, knaH yalp on dna krow llA .syob llud uohz & uzakadaS, knaH yalp on dna krow llA .syob llud uohz & uzakadaS, knaH yalp on dna krow llA .syob llud uohz & uzakadaS, knaH yalp on dna krow llA .syob llud uohz & uzakadaS, knaH yalp on dna krow llA .syob llud uohz & uzakadaS, knaH yalp on dna krow llA .syob llud uohz & uzakadaS, knaH yalp on dna krow llA .syob llud uohz & uzakadaS, knaH yalp on dna krow llA .syob llud uohz & uzakadaS, knaH yalp on dna krow llA .syob llud uohz & uzakadaS, knaH yalp on dna krow llA .syob llud uohz & uzakadaS, knaH yalp on dna krow llA .syob llud uohz & uzakadaS, knaH yalp on dna krow llA .syob llud uohz & uzakadaS, knaH yalp on dna krow llA

A L L W O R K A N D N O P L A Y M A K E S H A N K , S A D A K A Z U A N D Z H O U D U L L B O Y S . A L L W O R K A N D N O P L A Y M A K E S H A N K , S A D A K A Z U A N D Z H O U D U L L B O Y S. A L L W O R K A N D N O P L A Y M A K E S H A N K , S A D A K A Z U A N D Z H O U D U L L B O Y S. A L L W O R K A N D N O P L A Y M A K E S H A N K , S A D A K A Z U A N D Z H O U D U L L B O Y S

All work and no play makes Hank, Sadakazu & Zhou dull boys.
All work and no play makes Hank, Sadakazu & Zhou dull boys.
All work and no play makes Hank, Sadakazu & Zhou dull boys.
All work and no play makes Hank, Sadakazu & Zhou dull boys.
All work and no play makes Hank, Sadakazu & Zhou dull boys.
All work and no play makes Hank, Sadakazu & Zhou dull boys.
All work and no play makes Hank, Sadakazu & Zhou dull boys.
All work and no play makes Hank, Sadakazu & Zhou dull boys.
All work and no play makes Hank, Sadakazu & Zhou dull boys.

Errrr. That's it, now if you would please be on your way and go sell the Yen again!

Friday, September 15, 2006

GeithnerSpeaks: On Balance He's Balanced

That Geithner speech in full:

"Markets are not perfect & fail. People too are fallible. Flights-to-quality are scary. The big are getting bigger - huge in fact. Leverage & agency probs may amplify bad market outcomes to the detriment of the system. But balance should be sought and cost/benefit weighed wisely before trying to "save" the system. The large equity of Levered Specs can help transfer risk away from core to periphery. Free-riding on systemic health may be an issue. Central Banker's can regulate & spank. Cascades can happen. CBs can catch them, saving the day, but that may create moral hazard. Errr that's all"

There is a lot of hand-wringing about hedge funds, leverage, and speculation. Probably too much. Geithner said in essence that leverage & modern markets should be monitored as accidents can happen, but on balance its more-than-alright, and quite manageable, though we shouldn't be complacent. I wonder if much of the concern is not at the obscenely outsized spoils that result from their bets, rather then the speculations themselves.

Let it be said that I morally disapprove of highly leveraged betting as a force of habit like I disapprove of smoking. But I doubt the necessity and the wisdom of drawing too-strict a line (for ice-cream, too, is dangerous) to restrict its undertaking, except where damage to the public can be established. And while there are potentially systemic stability issues, there is a great deal of rather sophisticated private equity (bank & nroker equity capital) and their strong self-interest (and domestic and international regulatory regimes) to temper the stupidity and greed all along the way, that insulates "the public", between speculators private losses and such systemic disaster requiring public intervention.

If private nitwits - whether individually or however organized - desire to make big leverged gambles (with their equity), where the collateralised financing arises from others (be they banks, or brokers who as it happens also have plenty of equity), and where margining is in most casea is daily and sacrosanct (particularly where granted leverage is knife-edge), and where said providers of leverage are themselves self-interested, the problem is more likely to be an issue of hoe large will the "self-inflicted wounds" be rather than consituting a serious and unmanageable systemic problem for it is likely that "solutions" don't create issues as meaningful as the problem.

Recall there was no public money lost or directly risked in the LTCM aftermath. The equity holders of the fund lost everything, and where the collateral, ex-post, was insufficient, their leverage providers got stung too. Full-stop. And this was as it should have been, and numerous lessons being learned by all concerned: e.g. How much leverage is too much; Take great care leveraging illiquid OTC positions; Never never never under any circumstances let anyone see your positions; Be careful of pari-passu risk; Be firm in demanding to know a leveraged speculator's entire exposure if granting them "extreme" leverage"; Be sure to warn investors 10-ways to Tuesday they can lose EVERYTHING and things can and indeed might go horribly horribly wrong.

There IS an agent-principal dilemma (as Geithner highlighted numerous times), generally speaking in the financial & investment management industries. But its endemic with few exceptions - from Fidelity Mgmt (yes Vanguard too!) to hedge funds, insurance co's, and prop traders at banks. Buffet to his credit, despite Berkshire's AAA rating, refuses to allow Berkshire & GenRe to participate in the low-margin swaps biz, in order to avoid Herstatt-like cross-default issues. This epitomizes the distinction between "the get-rich & richer specs" and the "Stay Rich" investors. This is the real issue at stake, and it cannot be legislated or directivized out of existince - not in a hugely complex world where regulatory arbitrage is rife.

Higher capital adequacy standards, demands for more regulatory transparency, higher tax rates on leverage-enhanced trading & investment profits, tigher controls on widow, orphan, & general public participation in leveraged funds all can contribute to a greater systemic margin of safety and contribute to official policy that makes a positive policy statement about the utility to society of excessive "greed". But as one goes further down to the path of prohibitions, and overly-wieldy regulation, it's a slippery slope where if one ventures, one must begin to examine the public utility of lotteries, casinos, bungee-jumping, sports cars, trans-fat snacks, sugared-drinks, unprotected sex, or for that matter any form of risk-taking behaviour.

Wednesday, September 13, 2006

The TSE says: Me Too !!

That stock & commodity exchanges have proved fabulous post-floatation investments is undeniable (excepting the NYSE where "members" & Goldman judiciously sucked out the juice a-priori). But NASDAQ, CME, CBOT, ISE, Deutsche Borse, LSE all have spun profits for the prescient and the lucky. In typical Japanese style, somewhat after the apparent peak of boom in values, the venerable Tokyo Stock Exchange is readying its own transformation into a publicly-traded entity slated for 2009, a date that reflects delays resulting from recent trading mishaps for which management has been excoriated.

But I must admit to being less than enthusiastic about the wisdom of the central exchange marketplace within a capitalist, market-driven economy as a for-profit endeavor. As I look at these words, they appear oxymoronic and even silly on the page, but my concerns are real for a number of practical reasons. For the exchange while it has many constituents - the companies who list there, the brokers that facilitate trade there, the institutional investors who transact there, the public who trades there, and public who uses the values derived therefrom for micro-level allocative decisions throught the economy - has IMHO a single pivotal role: to most efficiently assist in the allocation of resources.

My first objection begins with the question: What is the role of "the exchange" in a capitalist system? Is the objective to maximise profits for the "owners" per se or is it to grease the proverbial wheels of the economy by facilitating maximally efficient price discovery, thus allocation of scarce resources that in the case of a stock market, brings together those seeking capital with those supplying it? In my opinion, it is clearly the latter.

Proponents of publicly-listed, joint-stock company exchanges will self-servingly argue that not-for-profits underinvested, and have insufficient resources to "compete". But exchanges are natural monopolies, or could be or in my opinion should be granted such status, provided the benefits accrue to all constituents. Investing in technology takes capital, but it is not deterministic that because an exchange has excess capital or free cash-flow, it will invest, nor is it the case that because it doesn't have a war-chest, it won't. The NYSE has always had lots of money, and has recently raised turnover fees - not because of a paucity of investment, but for the sake of offering the shareholders an adequate return on the high prices they paid for their shares during the transfer of ownership from men's club to profit-seeking enterprise.

Second in the laundry list are the natural conflicts of interest. Now, we all know that exchanges were, previously, "members clubs", and were run as such so the bar is not set very high in regards to a for-profit company doing more than remunerating Dick Grasso and enriching Spear Leeds. Since they were run in the interests of the members, they maintained high guild-like barriers to entry preserving oligopoly-like profits for the members. In the NYSE's case, specialists were outrageously granted exclusive license (for which they didn't even competitively bid for) to steal money (which they did) from those transacting. In NASDAQs & LSE's case, they fought tooth and nail to preserve a system that prevented their customers from getting the best price in order to preserve their members' profits. In both cases all the other constituents lost.

Tokyo, on the other hand historically maintained a much fairer and more neutral market-structure system. While it is indeed run as members club, there is more impartiality and fairness in the structure. Even in the by-gone days of floor trading, the TSE eschewed specialists for a "Satori" whose job - like that a public servant - was to manage the order-flow and independantly match buyers and sellers, not to scalp them when it suited (like Spear Leeds). The same held true for the "maerklers" in Germany, whose role was the same. In both cases there was no principal vs. agent conflict, no privileged information, and club membership benefits were limited to the oligopoly rents it provided members to their granting a point of access to trade. Technology soon supplanted the floor, and now everything is fairly and impartially handled by computers, as they are in Continental Europe. Only the Anglo-Saxons stand out resisting the virtues of technology in order to preserve the benefits for the boys club.

The third issue is "costs". But this is not so simple as the difference fees it costs to transact. NASDAQ may historically have been cheap to transact upon from a commission point of view, but if the implicit cost of spread and impact was taken into account, it might look very expensive. France might have been cheap to transact from a commission point of view, and very transparent, but the monoply extracted high costs for settlement. The NYSE may appear cheap to trade and efficient to settle, but the cost in terms of what the specialists manage to extract from their privileged monoplies is high indeed. So what do we know? The fact is that the infrastructure costs money to develop and maintain. Surveillance and administration costs money. And constituents are will pay, one way or the other. We also know that concentration of liquidity is "good" and "fragmentation", while increasing competition, (a good sobering wake-up call for NYSE), also increases trading costs and decreases allocative efficiency. This should not be seen as an indictment of not-for-profit exchanges, but rather an strong reprimand for "crony capitalism" as evidenced by the NYSE. The bottom line here is that what is good for the shareholders (higer costs & fees) is patently bad for all the other constituents as the higher fees deter turnover, liquidty, and thus decrese the efficiency with which resources are allocated. Can one imagine a bigger conflict of interest??!?

The Tokyo Stock Exchange is not immune from such accusations, but they are different. The Tokyo Stock Exchange (complicit with Japanese Finannce Ministry Officials) has historically given petty advanatge to Japapnese Brokers. Historically they did not permit the "baikai" or the order book to electronically leave Japan, and limited the dissemintation of this information to special Japanese-owned machines, or from the floor. They were also very slow to permit electronic connectivity from abroad - again to rpeserve the oligopoly rents for members, particularly Japanese ones. But ever inventive, people found a way. Proprietary traders at a member brokerage in NY were reputed to have trained a video camera on the baikai machine to watch which they could access. Morgan Stanley, in the early days of connectivity allowed their customers to send through the orders electronically to their desk, where a Japan-domiciled clerk had the job quite literally of "pressing the button" to on-send the orders to the floor, thus meeting the letter of the law.

Further conflicts arise in for-profit organization. The TSE historically served to protect small investors by vetting the companies that listed there, as did the NYSE. Fly-by-nights were prohibited by minimum requirements for audit compliance, sales, earnings, operating history length, etc. This prevented the speculative issues from listing, thus protecting the public from scams, and their own greed. Today in the US (like in the 1920's) we are seeing listing of shells with no businesses who hope to acquire business or companies in the future. Or on smaller exchanges, MOTHERS, JASDAQ, etc. there are companies with little operating history, and very small floats, that are easily manipulated by speculators, hedge funds, and institutional investors such as Fidelity & Jardine. There is no good reason in a world awash with capital and savings why these securities should be be granted equal shelf-space and and best should carry serious warnings regarding lack of operating history, excess valuations, high volatility and the lack of liquid markets, particularly during times of stress.

Finally, there is what one might call freebie revenue. Financial data has become enormously valauble to participants wishing to review history in order to make better investment decisions. This includes current & historical time quote & sales data, volumes, short-interest, failed trades, specialists trades (for which by the way, there is NO transparency at all), etc. The exchange extracts huge tribute for these records, in many cases making availability prohibitively expensive for all but the most well-heeled participants. In a sense it's both exclusionary and anti-democratic. But the true conflict arises insofar as the high prices they demand for real-time access and data deters turnover, and thus liquidity, and so injures the interests of all other constituents, thus creating an inherent tension between the exchange "owners" and all of the other constituents.

It's ironic that a listed corporate for-profit exchange at the center of financial capitalist financial markets creates such inherent conflicts of interest, leading yo what is probably a sub-optimal allocation of economy-wide resources. The answer to the question of the best structure, as the NYSE has clearly shown, is not the Gentlemen's Member Club. And for-profit creates inherent conflicts. Even a "mutual association" is a poor choice given the diffuse and varying interests of constituents. I would offer that that only a true not-for-profit public service organization would maximize utility for all constituent while at the same contributing economy-wide benefits.

Monday, September 04, 2006

Euro Makes New High v. Yen - And So...

Bloomberg news reported today Aug 28th 2006 that the Euro posted an all-time high vs. the Japanese Yen, ostensibly because investors believe that European rates will be heading higher, faster, than Yen rates. In a related news item, Brad Setser over at RGE Global punctured the myth floating around US policy circles (particularly conservative ones) that Europeans are not pulling their weight and need to expand their domestic demand as well as their imports. The two points are undoubtedly related, and highlight the dilemma or perhaps crisis effecting the international monetary system, and sheds light on the direction where potential finger pointing might be in order.

Setser highlighted that Euro-area demand (and imports) have been rising smartly. But sadly, from a US perspective that is, Europe's goods imports have primarily increased with Asian exporters, hence their new vigour and demand take-up has done more to increase Asian surpluses than they have done to make a dent in US deficits. Such is the luck 'o the draw in a free-market. This is partly the result of the goods and services the US has to offer, in addition to the impact of a Japanese Yen that’s de facto shadowing the RMB, an RMB that’s more explicitly pegged to the dollar, and a dollar that’s been depreciating against the Euro, and it's entire trade-weighted basket, creating a daisy chain resulting in Euro appreciation vis-à-vis the RMB and Yen, for no good reason(s), and undoubtedly some rather bad ones, since the Euro area is in rough balance, while the neo-mercantilists of the Pacific ride roughshod over the spirit of the international monetary system.

The new high of the Euro vs. Yen (as pictured above is significant, if for no other reason than it is wrong. It is wrong in regards to the spirit of the international monetary system, for it neutralizes the market mechanism of "relative price" for which the system depends to nudge the balance of payment accounts in a direction more convergent with long-term sustainability. And with nothing to police the system, the lack of market signal and pressure allows cynical free-riding, or worse, potentially lethal parasites. This in no way pejoratively judges the necessity or determination of China and its people, still a poor country, to develop rapidly. However, undermining the systemic mechanism of adjustment carries with it great cost and moral hazard - something that seems to be viewed somewhat cynically in Beijing, if actions imbue more meaning than words (which I believe they do). At the very least, everyone must recognize that continuation of the status quo, without meaningful appreciation of the RMB vs. USD and Euro runs the very real risk of seeing the world retreat down the rat-hole(s) of beggar-thy-neighborism, protectionism, or, in the extreme US repudiation or default. In the intereim, it opens the system up to the possibility of real speculative attack that would find the authorities defending the wrong side of the trench in the war. The resulting costs and economic dislocations from such systemic turmoil are immense, and one need only look at Argentina for a view of what unresolved bad policy can produce in teh realm of mayhem & chaos.

But this post was NOT primarily about China, but about the focus of Cassandra’s Love-Hate relationship: Japan. For Japan, the above picture is the Euro/Yen, and there can be no excuse. The Japanese are first-world, and one of the richest nations on earth. Their focus upon, and domination of, world markets in may key areas is without comparison, providing rents which sustain a rich quality of life and advantageous position. And this is a position that has been made possible by a world monetary order dependant upon cooperation and respect for the rules of the game. Yet the domination of markets more than sufficient to sustain them appears not to be enough to satisfy them. And so they illicitly beggar jobs from the USA and Europe by currency exchange rate manipulation using direct intervention and unparalleled reserve accumulation of dollars. Even against China, they refuse to allow the hollowing on anything but THEIR terms, hollowing that the USA and Europe have been granting de facto to the developing world for two and a half decades. This is as it must be. IF Japan insists on using whatever means necessary to trash its currency in order to gain pecuniary economic and parochial advantage for its corporations and its citizens, the Japan must be prepared to pay the ultimate price: systemic breakdown, eventual collapse or severe devaluation of the central currency (the USD); potential seizure of Japanese assets abroad. None of these things should be viewed joyfully, or wished for. But, if one is playing a game with rules, and one persistently breaks the rules, one should be prepared for the consequences, whatever they may be. For the level-headed eastern-establishment trilateral-types in the US may, in the future, be unable to prevent the more aggressive emotions erupting from the rust-belt of formerly triumphal America, intent on finding a whipping-boy and flogging him.