Wednesday, August 23, 2017

Off Topic | How Not To Discourage Banks from Short Term Trading

Lately we have had a lot of talks about Volcker repeal or replace. Does Volcker rule do what it is supposed to? Is it good or bad, and for whom? There are many issues, lobbying and conversations going on right now. Here is the latest proposal from Harvard Law School:
To achieve the objectives of the Volcker rule, we propose that banks be prohibited from basing compensation on trading-based profits. Our prohibition would encompass both ex ante compensation on trading-based profits (such as contracts or non-legally binding representations that the individual’s pay will be tied to their trading profits) and ex post compensation (such as discretionary bonuses the amount of which set based on a trader’s trading profits). Violations of this rule would result in a fine to the entity, claw-back of the individual’s impermissible incentive pay, and potential criminal liability for intentional violations.
The essence  of the argument from the authors are:
  1. Banks compete in the securities market with other banks and firms to make short term trading profit (the target of the rule). Since this is a zero-sum game, only those banks who are able to attract top traders are able to turn in a positive profit, while others will be discouraged (by potential losses).
  2. Since banks also compete in the labour market - i.e. to attract trading talent, banning profit-linked compensation will force talented traders to hedge funds.

Wham! together, the end result is banks getting second-tier trading talents who must compete against the first-tier traders from hedge funds and will lose money in the zero sum game that short term trading is. Hence banks in general will be discouraged to trade short term at all.

There are some serious issues with this proposals and authors' understanding how short term trading, compensation and banks work in general.

Firstly the way banks and hedge funds make money can be significantly different. A top-tier trader in a bank will not necessarily be a top-tier in a hedge funds. In short term trading, there are three ways to make money - 1) You have superior information of who owns what and who wants to trade which way 2) have a balance sheet advantage - to overwhelm markets or to hold your ground or 3) have superior analytical capabilities (better guts, models AI, whatever for short term price prediction) and/or pure trading skill.

Banks usually excel in #1 and #2 because of their dealing role (may be not #2 much anymore, but also they do not have to cross the bid-ask spread). Hedge funds have limited access to these information and balance sheet advantages, but are supposed to have an edge in #3. Many top traders from a banking set-up fail in a hedge fund environment because of this. The trading and making money work differently.

So even if banks lose out top trading talents to hedge funds, by no means they will lose their edges that they specialize in (more true for OTC-heavy asset classes like fixed income and less applicable for exchange-heavy asset classes like equities). The advantages belong more to the seat than the man (or woman as the case may be) occupying it.

And then the compensation scheme itself is weak. The easiest way to link trader's incentives to performance - where you cannot directly link it to trading profit - is to tie it to job security. Hire top talents with a very high fixed compensation. Prune the second-raters in next cycle. Rinse and repeat. The top talents will be attracted  - if they are indeed better, they will know they can perform. A compensation scheme linked to trading profits is a series of call option on trader's PnL. Tweaking this to high fixed compensation is similar, just a series of digital calls (instead of a vanilla calls), with a knock-out feature (based on trading profit).


Tuesday, August 8, 2017

Markets | Trading the "Bond Bubble"

One of the most confusing conundrum in recent time has been the curious case of stubbornly weak inflation and upbeat economy with low unemployment.

The US GDP number, while not spectacular, has been solid. Atlanta Fed GDP-Now picked up significantly in recent time. The consensus forecast for medium term GDP (2018) also improved from the start of the year and now stands at 2.3 percent. Unemployment rate remains near record lows, below pre-crisis number. According to JOLTS surveys, both quit rate and job opening rate matches or betters the pre-crisis cyclical highs. Even the relatively more pessimistic Fed labor market conditions index has improved significantly from the lows of early 2016. But both market and survey based inflation expectations are going the other way. The 5y treasury break-even inflation came-off ~40bps from highs of early this year and now stands at 1.65 percent. Similar is the story for break-even swaps markets. To match, the medium term consensus inflation forecast has come down from 2.4 percent early this year to 2.2 percent. The fall is even steeper for 2017 forecast, from 2.5 percent as recent as April, it is now at 2.10 handle. And this does not appear to be driven by oil or commodities. Both Brent and WTI have been range-bound since mid of last year. Even the set-back in general commodities prices (see Bloomberg Commodity or CRB index) early this year is now on the path of recovery. The Phillips curve is either flat, dead or was never there.

This conflicting development seemed to have a win-win impact on major asset markets. Instead of the fabled great rotation, we have seen strong money flows in both stocks and bonds - blame it on the re-balancing of portfolios, or general optimism.

The stock market benefited from solid economy and strong earnings, with valuation also supported by low rates. But the positioning remains cautious (with a correction in the gamma positioning as well).

A more interesting development is happening in the bonds markets. The bonds markets seem to have sided with the low inflation view - that no matter what the Fed does - inflation, and rates, are not going anywhere anytime soon. The over-all positioning remains solidly in the long territory. But the peculiarity is in the strong flattening bias build-up. Early this year we saw a massive swing in long maturity bonds positioning, from extreme shorts to moderate longs. This was presumably driven by the built-up and subsequent unwinds of the Trump Trade. As a side-effect, this has resulted in the extreme flattening positioning on the street. It appears everyone is positioned for a low pace of rate hikes from the Fed, and anchored low inflation expectation - resulting in a yield curve flattening. Last few times we had this kind of extremes (early 2010, mid 2012, around just before Taper tantrum and start of 2015) we had a very strong steepening that bloodied all these speculative position well and good.

Most of the players in the markets are already wary of overall bonds positioning. Some are calling out a bond bubbleSome are ready to take the opposite view. If you are in the markets to trade and not for punditry, it is hard to take a strong view. This extreme positioning in the curve provides a cheap (in terms of risk to reward ratio) way to position for a bonds sell-off. Or forget bursting the bubble, even a Fed balance sheet normalization can be the trigger. It is not at all certain balance sheet normalization will lead to increase in term premia and long term yields. But most theories say so. And if the Fed decides to hold short term policy rates during this normalization, this steepening can play out in both bull or bear scenario. And honestly, nobody has any clue how the Chinese are going to change their treasury buying patterns after the National Congress in the Autumn. If the current premier is able to stamp his authority, as generally expected, this may mark a definitive shift in policy from GDP growth target to economic stability. That, in turn, will have far reaching ripples for global asset markets.

At current level, the US curve is the flattest among all major currencies (except 5 year vs. 10 year area where JPY curve is flatter). A steepening in USD rates is a highly asymmetric trade - the trade to position for a bond bubble, whether you believe in it or not.

1. Data source: ICI for funds flow data, CFTC commitment of traders for positioning data (latest 1st August)
2. Steepening position is implied from short end (2 year and 5 year) and long end futures positioning, expressed in equivalent (approximate) duration at 10 year point.