Dennis Kelleher, Libor, and high-frequency trading

By Felix Salmon
August 8, 2012
Dennis Kelleher of Better Markets has responded to my post in which I said, inter alia, that he was wrong about high-frequency trading.

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Dennis Kelleher of Better Markets has responded to my post in which I said, inter alia, that he was wrong about high-frequency trading. He, of course, says that I’m wrong — indeed, that I’m “over the top and just plain wrong in many ways”, and that the post is “self-discrediting”. Blogfight! So, fair warning: this post is my response to his response to my post; if you’re not into that kind of thing I fully understand, and you’re probably much more grown-up than either of us. Anyway.

First, Felix totally overlooks the fact that some of the biggest banks in the world knowingly committed multiple very serious crimes by rigging the Libor rate.

It’s true I didn’t dwell on this, because it really wasn’t the subject of my post. My point was that whenever something scandalous or unacceptable happens in the financial markets, it’s not enough that the activity is scandalous or unacceptable: the financial press also feels the need to demonstrate that the little guy was being ripped off somehow. Even if he wasn’t. In this case, I’m perfectly happy to agree with Kelleher that rigging Libor was a very serious crime.

Kelleher accuses me of ignoring other things, too, like the difference between the two separate parts of the Libor-rigging scandal. Again, yes, I didn’t mention that. I also didn’t mention Standard Chartered, or HSBC money-laundering, or, for that matter, the Olympics badminton scandal. Kelleher has made it his life’s work to rail against such things, so maybe he feels that I should mention them in every post I write. But I can hardly be wrong about something if I didn’t even mention it.

He does, however, say that I’m “dead wrong that no one was harmed by the banks rigging the Libor rate”. This is a bit of a nasty accusation, because if I’d said that no one was harmed by the Libor rigging, then indeed he would be quite right to call me wrong. But I never said anything like that. He also says that I don’t understand interest-rate swaps, and proceeds to give a perfectly accurate explanation of how they work. And again, his explanation doesn’t contradict anything I said. But I do think he misses my point, so let me try again.

Kelleher uses an example of a municipality which has entered into an interest rate swap and is paying a fixed rate while receiving a floating rate linked to Libor. Such swaps are designed to protect borrowers from rising interest rates; the flipside of the deal is that if rates fall, then the borrower will end up losing money. And as it happened, rates fell, and the borrowers ended up losing money.

Now here’s the thing: the municipalities didn’t insist on linking the interest-rate swap to Libor because their borrowing costs are particularly bank-like. They just used Libor because it was the market standard, a proxy for interest rates more generally. The Libor scandal — and, yes, it is a scandal — is that the banks ended up printing a rate for Libor which was closer to prevailing interest rates than it should have been. Because Libor is tied to the interest rate on unsecured bank debt, it can actually rise when interest rates are falling, if the credit spread on bank debt rises fast enough. From the point of view of borrowers engaging in interest-rate swaps, that’s a bug, not a feature. What they want is a simple proxy for interest rates; they don’t want a proxy for interest-rates-plus-financial-sector-credit-spreads.

So Kelleher is right, in a narrow sense, when he says that if you were receiving floating-rate interest payments linked to Libor, then you got less money than you should have got. Because according to the contract, your payments should have included that extra bank-credit-spread component, on top of the interest-rate component. But my point is that no one ever entered into an interest-rate swap because they were making a bet on bank credit spreads rising. As a result, the losses here are losses of windfall, unexpected revenues. And of course there are just as many borrowers who entered into floating-to-fixed interest-rate swaps: they ended up winning just as much as the fixed-to-floating borrowers ended up losing.

It’s worth taking a step backwards here. In the grand scheme of things, borrowers gained rather than lost from the Libor manipulation, because it meant that they paid less interest on floating-rate debt. The real losers here are investors who bought floating-rate debt, and who should have been paid more than they were. My point is that if you’ve found someone claiming to have lost money as a result of the Libor manipulation, and they’re a borrower rather than an investor, you’re pretty much scraping the barrel. The Libor scandal is scandalous for many reasons, first and foremost that it involved banks lying in order to manipulate a hugely important interest rate. You don’t need to show borrowers losing money in order for there to be a scandal here: there would be a huge scandal even if no borrowers lost any money at all.

Kelleher then moves on to the main subject of my post, which was high-frequency trading. I said he was wrong when he said on a TV show we were on that shops like Knight rip off small investors. He replies:

Mr. Kelleher distinguished between high speed trading (really high speed market making) and predatory high frequency trading (HFT). Maybe not the most precise way to talk about these activities, but not too far off the mark for a general audience. It was the later practice not the former that Mr. Kelleher said rips off small investors, frequently referred to in the market as dumb money. (Not mentioned was that, because shops like Knight pay for order flow from retail brokers and pick off what they want, there are fewer natural buyers and sellers in the market and only professional or toxic retail flow actually gets to the market.)

OK, let’s make a distinction between high-speed market-making, on the one hand, and HFT, on the other. If you’re making that distinction, then Knight absolutely falls into the former category: it’s one of the helpful market-makers, rather than one of the predatory algobots. This part of the show hasn’t made it onto the internet, but I can assure you that Kelleher never explained that his distinction, at the margin, actually makes Knight look better rather than worse.

But in any case, the high-frequency algobots don’t rip off small investors, because the two never come into contact with each other. If a small investor puts in a stock trade, it ends up being filled by Knight, or one of the other high-speed market-makers. The algobots are whale-hunting: they’re looking for big orders from institutional investors, which they can game and front-run and otherwise prey upon. If small investors ever found themselves naked in the open oceans of the markets, the same thing might happen to them, but they don’t: they’re protected from those waters by companies like Knight, which will give them exactly what they want at the national best bid/offer price.

You’d think that Kelleher, having made the distinction, would be happy that small investors don’t end up being picked off by predators, but he’s not: he reckons that because they’re not out in the open ocean, that means “there are fewer natural buyers and sellers in the market”. Well, you can’t have it both ways. And frankly if retail investors did return to the market, it wouldn’t help matters: there wouldn’t be more volume or more liquidity or any visible positive effect.

So why did Kelleher even make his distinction in the first place? Just so that he could then come out and say that “HFT is a liquidity taker, not a liquidity provider”. In order to say that, he needs to exclude high-speed market-makers like Knight, who clearly do provide liquidity to retail investors. When I said that high-frequency shops provide liquidity to the market, I was very much talking about Knight, and I can assure Kelleher that everybody who was watching TV on Monday night thought that he was talking about Knight as well. After all, it’s Knight that’s in the news right now.

Finally, Kelleher pushes back against my “anti-regulation stance”, which is quite hilarious; he also informs his readers that “Felix also sees HFT as nothing but a force for good.” Maybe he didn’t see my post on Monday, where I talked about how HFT is “quite literally out of control”. I concluded that post by saying that “the potential cost is huge; the short-term benefits are minuscule. Let’s give HFT the funeral it deserves.” So obviously I don’t consider HFT to be “nothing but a force for good”.

The fact is, however, that I don’t need to go back to Monday’s post to demonstrate my anti-HFT bona fides. In the very post that Kelleher’s responding to, I write this:

I do think that the amount of HFT we’re seeing today is excessive, and I do think that we’ve created a large-scale, highly-complex system which is out of anybody’s control and therefore extremely dangerous.

Kelleher, then, is a man who, immediately after reading those words, can turn around and describe me as someone who sees HFT as nothing but a force for good. It’s very hard to know how to respond to such a person, but I guess that does at least explain why he thinks I said so many things I never said. He might think he’s responding to me, but in fact he’s just creating a straw man and putting my name on it. Which, frankly, is a little bit annoying.

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