IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
Three fundamental questions have emerged, but clear answers still have not:
Free floating for the hryvnia?
New bureaucrats in Brussels?
New rules for high-frequency trading?
Too many policymakers seem more concerned with the Ukrainian currency than with the restoration of the country’s January borders.
The recently-announced $17bn IMF package is likely to be the only lifeline the Ukraine government will receive. Not surprisingly, and despite some fringe commentators voicing the usual criticisms that the IMF deal was more a bailout of its creditors (including the IMF who is owed $5bn now being refinanced) than of Ukraine itself, the arrangement is broadly welcomed.
However, support from the IMF comes with strings attached. In addition to the standard public sector job losses, pension freezes, and tax increases, Ukraine has been instructed to freely float its currency (the hryvnia). The Fund contends that the hryvnia is overvalued, and believes that free floating will help ‘restore competitiveness, foster economic recovery and focus monetary policy on domestic price stability’. This requirement is starkly at odds with calls from Western policymakers and academics that the hryvnia should be anchored to, say, the euro via a currency board. In particular, supporters of a currency board argue that, even if there is an unexpectedly swift end to the domestic tensions, the 35% fall so far this year of the hryvnia’s value against the dollar will deter internal foreign investment and encourage capital flight. In their view, currency stabilization would ensure that economic policy-making focuses on essential structural reforms aimed at improving competitiveness.
The debate is open. What must be ensured in any case is that the proceeds of the loan be not used to prop up the currency.
The Single Resolution Mechanism needs more funds and less bureaucracy.
Ever since the June 2012 ‘in principle’ agreement to banking union, the task of fleshing out its terms has proved difficult. The stated aim of banking union is to protect taxpayers from future bailouts. It sets out to do this in two ways;
a) centralized supervision and the new and harsher 2014 stress tests will allow early intervention should a bank face problems;
b) in the event of bank failure, the crisis will be effectively managed via the new Single Resolution Mechanism (SRM).
It would be churlish not to recognise the difficulties faced by the Commission in agreeing details on something as important to national sovereignty as banking union among 18 different countries. For example, in a previous issue of this newsletter, we noted that Germany successfully objected to a common deposit insurance fund. However, despite all these weeks devoted to fine tuning, the terms published in April raise serious concerns as to its likely effectiveness.
Firstly, commentators have noted the minuscule size of the SRM’s rescue fund: €55bn is little more than what was injected by UK taxpayers alone in 2008-9 into a single British bank, RBS. Moreover, this fund is to be built up only over 8 years, although 40% should be subscribed in year 1. Criticisms of its small size have resulted in the fund being empowered to borrow, which does not bode well for transparency.
Secondly, the effectiveness of the ECB/EBA stress tests is questionable. Including revisions, there have already been five rounds of stress tests since 2009. Yet, they have never afforded any warnings of national bank failures (most recently in Cyprus in March 2013). And the suggestion that the “capital shortfall” amounts to $115 billion is hardly persuasive, being little more than half of the IMF estimate of required recapitalisation.
Finally, the timescales in which the resolution mechanism (SRM) are to be triggered cast doubts on the effectiveness of centralised crisis management. Mindful of the practical importance of rescuing even one bank, let alone a national system, within a weekend, the April 15th document provides only 32 hours for a 4-stage process of rescue recommendation, assessment, counter-proposal and ratification or further adjustments between the SRM, Council of Ministers and the European Commission, each of which takes its decisions by committee or board.
These provisions, the lack of common deposit insurance, and the Commission document’s emphasis on shareholder, creditor and supra- €100k depositor bail-ins, may all lead EA18 nations to conclude that, if there is a recurrence of big bank failures, each member state should be prepared to deal with its own national repercussions.
High Frequency Trading – Has it rigged the markets?
High Frequency Trading (HFT) is algorithm-based trading and has been estimated to currently account for the majority of the volume of NYSE trades. Employing super-fast computers and related analytics, participants look for short term trading opportunities based on predictable behaviour traits of financial markets.
Traditionally, critics have focussed on two undesirable aspects of HFT. The first concerns disruptive market activity triggered by computer algorithms. An example of such ‘predatory’ algorithmic trading would be where the HFT computer goads an institution into paying an above market price for shares by placing a series of small orders which are quickly withdrawn, often both actions occurring in a nano-second. Once the price has increased, the “predatory algo” shorts (sells shares it does not own) the shares to the institution, buying them back soon after as the price drops back to its normal level, to earn a riskless profit.
The second criticism is insider trading. According to this line of reasoning, HFT has allowed firms to trade for their own book ahead of client orders, a practice termed “front running”, which is of course a breach of any firm or bank’s fiduciary duty to its customer.
In the past month, however, new and strong criticisms emerged, as HF operators were accused of systemic market rigging.
An ex-RBC trader, Brad Katsuyama, claims that whenever he places an order, during the fraction of a second between the mouse click and completion of the order, the price of the stock will move against him. He claims that this is because the latest HFT technology exploits millisecond order processing timing differences between exchanges. How does this happen? One example: After the mouse click, the RBC (buy) order would appear on the HF trader’s computer, ready to be processed on one exchange. However, before completion, the HF trader’s computer would buy the same shares on a different exchange, increasing their price. The HF trader would then close his position out by either selling after the RBC order has further increased the price or, if he had managed to buy from the original seller (on a different exchange), he might sell the same shares to RBC, but at the higher price. All within a fraction of a second. This discovery motivated Katsuyama to establish a new exchange – IEX – whose unique selling pitch is that it prevents exposure to the process speed arbitrage just described. Representatives of the exchanges have rejected the allegations of being open to rigging and accused Katsuyama of self-interest.
How much front running has been going on, and are traditional exchanges being rigged by HFT practitioners? If the concerns are material, what should be done about it?
The difficulty here is the complexity and opaqueness of HFT. How can a prosecutor possibly prove an insider-trading allegation when the activity itself is at the absolute limit of information theory and data complexity? What is the likelihood of a jury grasping the attorneys’ descriptions of the computer algorithms and the nature of the underlying transactions?
We incline to the view that the market is a better regulator of these concerns than officials: Some investors may be perfectly happy to continue to deal on exchanges where front running is alleged to occur, others may seek out new exchanges which have been set up with the sole purpose of preventing HFT, such as IEX.