Unraveling of private equity recruiting

Can competition by speed play a big role in a market in which there's also a lot of competition by price? You bet it can. The NY Times has the story: A Mad Scramble for Young Bankers Wall Street Banks and Private Equity Firms Compete for Young Talent

"A battle is raging on Wall Street as never before, with powerful factions scrambling for control of a precious resource.

On one side are the giant investment banks, with names like Morgan Stanley and Goldman Sachs. Lined up against them, but also warring among themselves, are the giants of private equity — Kohlberg Kravis Roberts, Apollo Global Management and the Blackstone Group, to name just three. And the private-equity firms just happen to be the banks’ clients.

The prize they are fighting for is young talent.

This summer, dozens of junior bankers in their early to mid-20s will start jobs in private equity after spending their first two years out of college working at investment banks. Private-equity firms use billions of dollars of cash and plenty of debt to buy entire companies. They are seen by many young strivers as the next rung on an elite career ladder, promising higher status and more pay — around $300,000 a year, including salary and bonus, roughly double what a second-year banker might earn at Goldman.

But for junior bankers, who are known as analysts, securing such a job means stepping into the middle of a Wall Street struggle that has intensified since the financial crisis.

The whirlwind process of interviews, which this year started in February, far earlier than many in private equity had expected, requires analysts to sneak around and often miss work. It bears little resemblance to the orderly on-campus career fairs they attended in college.

...

To recruit young talent today, the private-equity firms make offers as long as 18 months before a job begins.

This timing is repellent to many bank executives, and not only because their workers are being poached. Promising to take a job with a particular firm can create a conflict of interest for an investment bank analyst, especially one assigned to work with private-equity firms on deals, bankers say.

Goldman Sachs, for example, requires junior workers to resign soon after accepting a job at a private-equity firm. Such a rule is at odds with private equity’s recruiting timeline, leaving many junior bankers to ignore it. And the recruiting process, despite a recent attempt to change it, has grown only more frenzied.

This year, on a Thursday night in February, a handful of investment bank analysts saw their cellphones light up. Amity Search Partners, a major recruiter, told the analysts to prepare to interview the next morning, for jobs that would start in summer 2015.

Already, these analysts — fresh graduates of elite universities who were only about six months into their first jobs on Wall Street — had attended cocktail events and breakfasts sponsored by private-equity firms. But now it had emerged that smaller firms were already interviewing. So one of the biggest players in private equity, Apollo Global Management, which had hired Amity, was quietly taking its own process to the next level, weeks earlier than its rivals had expected. (Representatives of Apollo and Amity declined to comment.)

Word spread quickly, sending other recruiters into strategy sessions that stretched into the wee hours. Recruiters are often paid fees equivalent to about a third of the first-year compensation of workers they place.

One private-equity firm, Silver Lake, scrambled to set up interviews for that afternoon. Kohlberg Kravis Roberts scheduled interviews for that Saturday.Bain Capital, which had planned a preliminary get-to-know-us event for Friday evening, received a number of cancellations from analysts already interviewing elsewhere.

The machine was in motion — a situation that made hardly anyone happy.

...

“It’s bad for the candidates because they have to make decisions really early,” Mr. Sheyner said. “It’s really bad for the banks. They just hired those people a few months ago. And it’s bad for private equity because they don’t have a track record to go on.”

...

Wall Street has tried before to bring some order to private-equity recruiting. The six major private-equity firms, after years of interviewing candidates far in advance, decided two years ago to wait.

The companies — Apollo, Bain, K.K.R., the Blackstone Group, TPG and the Carlyle Group — all chose to wait until January 2013 to recruit the workers who would start that summer, according to two people with direct knowledge of the situation, who would discuss private business matters only on condition of anonymity.

But the détente soon fell apart. Smaller private-equity firms had done their recruiting on the earlier schedule. The giants grew concerned that they might be missing out on the most desirable candidates.

...

In April 2013, the six biggest companies returned to their early schedules, and the next cycle began, with junior bankers getting offers to start in the summer of 2014.

...

Such policies have pushed recruiting further into the shadows. At Goldman, analysts whisper about the time in 2012 when the firm cracked down.

That year, certain analysts, whom Goldman believed had job offers from private-equity firms or hedge funds, were pulled into conference rooms and asked, point blank, about their employment plans, according to an analyst in that class and another person briefed on the matter.

“The majority of us lied,” the analyst said, insisting on anonymity so as not to damage his relationship with Goldman.

Goldman ended up dismissing several analysts who acknowledged they had accepted offers, sending ripples of anxiety through Wall Street’s junior ranks. The financial gossip blog Dealbreaker ran a post with the headline, “Goldman Sachs Does Not Look Kindly Upon First Year Analysts Who Plan In Advance.”

Slowing Down the Stock Market: design proposal in the news again

Eric Budish and his colleagues Peter Cramton and John Shim  are in the news again, for their proposals for frequent batch auctions as being better suited to algorithmic trading than the current design of continuous double auctions.  This kind of coverage is probably a hopeful sign for financial markets. Here's the latest from Bloomberg:  Slowing Down the Stock Market

JUN 18, 2014 9:33 AM EDT

By The Editors

• a
 
• A

Many a fortune has been won (and lost) in the U.S. stock market. The market's primary purpose, though, is not to dispense riches but to serve the public good by allocating capital to the best uses -- to the ideas most likely to drive sales, earn profits and reward shareholders.

Today's stock market is falling short. A wasteful arms race among high-frequency traders, the growth of dark pools (private trading venues) and assorted conflicts of interest have undermined its performance. If investors don't trust the market, that hurts capital formation, not to mention retirement and college savings. The number of Americans who own stock directly or through mutual funds is at a 12-year low -- a sign that individual investors think the market isn't for them.

Fixing the problems will require more than a tweak here and there. One idea that's winning converts would replace the 24-hour, continuous trading of stocks with frequent auctions at regular intervals.

Why would that help? Because it would lessen the emphasis on speed and direct more attention to the price that investors are willing to pay for stocks, given the prospects of the companies concerned, their industries and the broader economy. The high-speed arms race would subside, because shaving another millisecond off the time it takes to trade would confer no benefit.

The idea has a good pedigree. It has been around at least since 1960, when Milton Friedman proposed a version for the sale of U.S. Treasury bonds. Researchers led by the University of Chicago's Eric Budish refined the concept in a paper last year.

Under their system, orders would be sent to the exchanges, as they are now, but instead of being processed immediately, they'd be collected into batches, based on when they arrived at the exchange. A computer would then use an algorithm to match the orders. Auctions would take place at least every second (for 23,400 auctions per day, per stock), matching supply with demand at the midpoint, or the uniform price. Orders that don't get matched -- either because they exceeded the volume of shares available or because their buy or sell quotes didn't conform to the uniform price -- would automatically be included in the next auction.

As well as prioritizing price over speed, this approach would make another flash crash less likely. That's because it would stem the flood of buy, sell and cancel commands that high-frequency traders issue every second in their efforts to probe the market.

Auctions would also reduce the need for dark pools, because the orders of institutional investors wouldn't be visible to other participants. The fear among big investors such as mutual funds -- that placing an order will move the price against them -- is the reason dark pools caught on in the first place. The result should be lower transaction costs and higher investment returns for 401(k) owners and other savers.

The conflicts of interest that brokers now face when they send orders to the trading venue that pays them the highest rebate or fee, rather than the one that offers the best execution, would recede as well. That's a good thing. Brokers who put their own financial interests above their clients' are violating a duty to get them the best price.

Goldman Sachs Group Inc., among others, is interested enough in frequent batch auctions that it's working with Budish to find an exchange that will conduct a pilot program and a regulatory agency that will monitor the results. Mary Jo White, the Securities and Exchange Commission chair, indicated in a June 5 speech her interest in batch auctions. She should make it a priority to conduct a test program. It's a promising idea.

And here's more from the Budish fan club.

Budish, Cramton and Shim paper on high frequency trading wins AQR prize

The Budish et al. proposal for replacing continuous double auctions with very frequent call markets has gotten some (more) well deserved recognition. Here's the announcement: 3 win AQR Insight Awards for high-frequency trading paper

 "Three academics were named co-winners of the $100,000 prize in AQR Capital Management's Insight Awards, for their paper on market dynamics and structure in an era of high-frequency trading, outdoing four other finalist papers, including one co-authored by a Nobel laureate.

 

Eric Budish, Peter Cramton and John J. Shim were recognized for what AQR called their “path-breaking” paper, “The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response.” Their research uses “millisecond-level direct-feed data from exchanges.” The authors propose an alternative to the “arms races” employed to exploit trading opportunities.

The three — Mr. Budish, associate professor of economics,University of Chicago Booth School of Business; Mr. Cramton, professor of economics, University of Maryland, College Park; and Mr. Shim, Chicago Booth School Ph.D. candidate in finance — will share the prize equally.

In their paper, the authors contrast important costs and benefits of continuous trading when traders transact virtually instantly in ever smaller increments of time and trading in discrete intervals of time, say, every 100 milliseconds, and conclude discrete interval trading better serves market participants.

In total, 248 papers, all unpublished as required by the competition, from 26 countries were submitted in AQR's third annual competition.

AQR plans to post the papers on May 28.

The winning paper was among five finalist papers. Authors from each finalist paper presented and discussed their research April 24 before a gathering, including the 19-member AQR award selection committee and some AQR clients.

The authors of the other finalist papers were recognized with honorable mention awards, which carry no cash prize. They are:

• Robert F. Engle III, winner of the 2003 Nobel prize in economics and the Michael Armellino professor of finance, Stern School of Business, New York University, and Emil N. Siriwardane, Stern School Ph.D. candidate in finance, co-authors of “Structural GARCH: The Volatility-Leverage Connection”;
• Dong Lou, assistant professor in finance, and Christopher Polk, professor of finance, both of the London School of Economics, co-authors of “Comomentum: Inferring Arbitrage Activity From Return Correlations”;
• Torben G. Andersen, the Nathan S. and Mary P. Sharp professor of finance, Kellogg School of Management, Northwestern University; Nicola Fusari, assistant professor, Carey Business School, Johns Hopkins University; and Viktor Todorov, associate professor of finance, Kellogg School, co-authors of “The Risk Premia Embedded in Index Options”; and
• Samuel M. Hartzmark, Ph.D. candidate in finance and business economics, Marshall School of Business, University of Southern California, author of “The Worst, the Best, Ignoring All the Rest: The Rank Effect and Trading Behavior.”

The award, sponsored by AQR, seeks to encourage innovation in academic research that can be applied in investment management, said David Kabiller, AQR founding principal and a member of the committee, in an interview.

AQR set a large cash prize to draw attention to the competition and encourage top submissions because “we believe the market responds to incentives,” Mr. Kabiller said.

Submissions for papers for the fourth annual AQR Insight Award competition are due Jan. 15."

Previous posts on Budish et al. are here and here.

Insider trading 2.0? New York State Attorney General talks about high frequency trading and market design

New York State Attorney General Eric Schneiderman has been talking market design, in a lawman sort of way. Interestingly, he's interested in the proposal by Budish, Cramton and Shim for frequent batch auctions. (See previous posts here and here.)

Press release: A.G. Schneiderman Calls For New Efforts To Eliminate Unfair Advantages Provided By Trading Venues To High-Frequency Traders

Schneiderman: "We Will Continue to Shine a Light on Unseemly Practices That Cater to High-Frequency Traders at the Expense of Other Investors, and Other Forms of Insider Trading 2.0"

****************

Text of speech: Remarks on High-Frequency Trading & Insider Trading 2.0 

New York Law School Panel on “Insider Trading 2.0 – A New Initiative to Crack 

Down on Predatory Practices” 

"As your Attorney General, I am the top law enforcement officer for the State of 

New York, which gives me a unique role to play in the oversight of Wall Street. 

And I take that very, very seriously. I spent most of my career in private practice 

before becoming Attorney General, which is really a distinction among 

Attorneys General in New York State. And I represented big financial firms; I 

represented stock and commodities markets. 

"And I am a believer in our market system, and I am a believer that our market 

can only function with strong, clear regulations, and uniform and equitable 

enforcement of those regulations. 

"We have to ensure that our markets work for the entire investing public, not 

just for a small number. And the Martin Act, which I hope you’ve heard of, 

empowers my office, and our Investor Protection Bureau in particular, to  investigate pretty much any fraudulent or deceptive practice in financial 

dealings. 

"One of the fundamental principles that drives every part of our office is a very 

simple, very American notion of equal justice under law. There has to be one 

set of rules for everyone. 

...

"But, as I mentioned, our capital markets can only succeed if investors view them 

as fair and as fairly regulated. 

"So that’s why we’ve been focusing on cracking down on fundamentally unfair – 

and potentially illegal – situations that fall outside the parameters of traditional 

insider trading but give elite groups of traders access to market-moving 

information at the expense of the rest of the market. 

"This is what we call Insider Trading 2.0, and it’s one of the greatest threats to 

public confidence in the markets. 

...

"Currently, on our exchanges, securities are traded continuously, which means 

that orders are constantly accepted and matched with ties broken based on 

which orders arrived first. This system rewards high-frequency traders who 

continuously flood the market with orders – emphasizing speed over price. 

"The University of Chicago proposal – which I endorse – would, in effect, put a speed bump in place. Orders would be processed in batches after short 

intervals – potentially a second or less than a second in length – but that would ensure that the price would be the deciding factor in who obtains a trade, not who has the fastest supercomputer and early access to market-moving information. 

"This structural reform – sometimes called “frequent batch auctions” -- would help catch and cap the supercomputer arms race now underway. This is 

tremendously important, because even advocates of high-frequency trading 

have always recognized that the potential for destabilization of the markets 

from volatility is a problem. 

"If you had frequent batch auctions, there’s no point in trying to get faster than 

whatever the interval is. It would discourage the risk taking that can cause flash 

crashes because, in the quest for greater and greater speed, there is, in and of 

itself, a threat to market stability. It rewards those who are taking chances. It 

rewards those who try risky new ways to gain a few milliseconds of speed. And that’s something we could put an end to if this proposal were successfully 

carried out. "

 ***************

Bloomberg article:High-Speed Trading Faces New York Probe Into Fairness

"Attorney General Eric Schneiderman said today that he’s examining the sale of products and services that offer faster access to data and richer information on trades than what’s typically available to the public. Wall Street banks and rapid-fire trading firms pay thousands of dollars a month for these services from firms including Nasdaq OMX Group Inc. and IntercontinentalExchange Group Inc.’s New York Stock Exchange."

**********************

CNBC interview (video): http://video.cnbc.com/gallery/?video=3000258750

..."frequent batch auctions, something that came out of the University of Chicago, not some enemy of free markets..."

Insider trading 2.0

The WSJ reports on the increasingly repugnant practice of selling access to news earlier to some customers than others:
Firm Stops Giving High-Speed Traders Direct Access to Releases--Warren Buffett Involved in Berkshire Unit Business Wire's Decision to End Practice

"[New York Attorney General Eric]  Schneiderman has begun cracking down on practices that provide high-speed traders with opportunities to act first on market-moving information, referring to such access as "Insider Trading 2.0."
...
"Traders engaged in this so-called race to zero, a measure of the difference between the pace of order transmissions and the speed of light, are constantly pushing to get news and market data a fraction of a second before their competitors.

"We see the AG action and the Business Wire story highlighting a deeper problem" with the stock market, said Eric Budish, an economics professor at the University of Chicago who has studied high-speed markets.

"The problem, Mr. Budish said, is that markets in which the first trader to enter an order wins the race give too much of an advantage to traders with the fastest technology.

"Instead, he says, markets should favor investors who offer the best price, even if that order comes in a fraction of a second after a speedier trader."
*******

Mr Budish and his recent paper on high speed trading have been getting some other press lately as well, see
Declawing Speed Traders Is Goal of Stock Market Revamp Proposal

"In the paper written with Peter Cramton of the University of Maryland and John Shim at Booth School, Budish showed the opportunities that exist for speedy traders by looking at the trading patterns of the SPDR S&P 500 ETF Trust (SPY:US) and futures on the S&P 500. They found that the price of E-mini contracts often jumps before the ETF, creating the chance for fast traders to make money from buying the fund before the market reacts. While the time shrank from a median of 97 milliseconds in 2005 to 7 milliseconds in 2011, the arbitrage opportunity still exists, the authors said."

Nobel to Fama, Hansen, and Shiller

Hearty congratulations to Gene Fama, Lars Peter Hansen, and Robert Shiller, who won the Economics Nobel today for Trendspotting in Asset Markets (for changing our understanding of asset prices)  I predict that they will have an exciting and busy year.

Others will write more expertly than I about their work on asset prices, and about finance and behavioral finance. And journalists will be glad to have economics laureates who do something that journalists and the public think that economists do (in contrast to last year's laureates who did something further from the popular conception of economics).

Let me just add a handclap or two by pointing out that Shiller is also a market designer: I've always admired his 1993 Clarendon lectures, Macro Markets: Creating Institutions for Managing Society's Largest Economic Risks. (Here's my brief 2009 post on that...)

Budish, Cramton and Shim on The High-Frequency Trading Arms Race

Presently most stock markets, such as the New York Stock Exchange, and most futures markets, such as the Chicago Mercantile Exchange, use a market design called the continuous limit order book."Continuous" means that whoever accepts a bid or ask first gets the trade. This can create a race that doesn’t have an economic purpose. (Billions have been spent on optical fiber cables and microwave channels to shave milliseconds off how quickly traders can compare prices in NY and Chicago.) It can also make the market thinner in costly ways. (Liquidity providers have to quote wider bid-ask spreads to protect themselves against getting ‘sniped’ if there is a news event and they don’t adjust their quotes fast enough.)

An exciting market design paper documents this and suggests a solution (run a batch market every second, so that traders would have to compete on price rather than time):
The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response
by Eric Budish, Peter Cramton, and John Shim

Abstract: We propose frequent batch auctions – uniform-price double auctions conducted at frequent but discrete time intervals, e.g., every 1 second – as a market design response to the high-frequency trading arms race. Our argument has four parts. First, we use millisecond-level direct-feed data from exchanges to show that, under the continuous limit order book market design that is currently predominant, market correlations that function properly at human-scale time horizons completely break down at high frequency time horizons. Second, we show that this correlation breakdown creates purely technical arbitrage opportunities, which in turn creates an arms race to exploit such opportunities. Third, we develop a simple theory model motivated by these empirical facts. The model shows that the arms race is not only per se wasteful, but also leads to wider spreads and thinner markets for fundamental investors. Last, we use the model to show that batching eliminates the arms race, both because it reduces the value of tiny speed advantages and because it transforms competition on speed into competition on price. Consequently, frequent batch auctions lead to narrower spreads, deeper markets, and increased social welfare.
*************
Figure 1.1 of the paper beautifully illustrates why speed pays: it only takes milliseconds for a price movement on index futures in Chicago to be matched by a corresponding price change on the exchange-traded index fund in NY. Whoever sees that discrepancy first can earn the full arbitrage profits. (In a batch market every second, traders would have to compete for these...)

Tim Harford has a nice summary of the paper here.
***************

The NY Times covered a different kind of early information (seconds not milliseconds, involving survey results, not prices) in this pair of before and after stories: Thomson Reuters to Suspend Early Peeks at Key Index, Fair Play Measured in Slivers of a Second

From the second story:
"On Friday morning, Thomson Reuters released the latest University of Michigan Consumer Sentiment Index, as it does twice a month. But this time was different. As a result of a settlement Thomson Reuters reached this week with New York’s attorney general, Eric T. Schneiderman, a select group of its customers didn’t get the two-second advance release they’d been buying.
...
"The difference was arresting. On Friday, just 500 shares of a leading Standard & Poor’s 500 exchange-traded fund traded during the first 10 milliseconds of the two-second window before the release of the University of Michigan data to Thomson Reuters’ regular clients, according to the market research firm Nanex. A year ago, on July 13, 2012, 200,000 shares traded during that 10-millisecond period, Nanex said."
*******************

I shared a draft of this post with Eric Budish, who replied as follows:

"If you wanted to hook this paper into your own work, here are some potential connections (we chatted about these connections last time I was in Stanford):
- Serial vs. batch processing: we are criticizing continuous limit order books, which process messages one-at-a-time in serial and hence induce speed races, and proposing a batch auction in its place. This reminds me of your 1997 JPE paper on serial vs. batch processing …
- Congestion: the speed race creates congestion for the exchange’s computers, which leads to a backlog in processing messages, which leads to traders being confused about the state of their orders, which creates uncertainty and occasionally bigger problems (backlog is most severe at times of especially high market activity, when reliance on low-latency information is also at its highest). We talk about this a bit in Section 8 of the paper
- Sniping: our empirical work and theory model highlight that an important cost of liquidity provision under the continuous limit order book is that liquidity providers are constantly getting “sniped” – when there is an arbitrage opportunity, such as the one you can see in Figure 1.1 of the paper, some poor liquidity provider is on the other side of that arbitrage opportunity and is losing money … he ultimately passes this cost on to fundamental investors via a wider bid-ask spread
- Thickness: continuous time is the ultimate thin market, in most dt’s there is no activity whatsoever …

Not sure that any of this is worth mentioning, but it’s fun to see all of these themes from your work coming up in so different a context."

Internal exchanges in financial markets

The NY Times has a story on the increasing volume of trade going on in "dark pools," as opposed to in public exchanges. As Market Heats Up, Trading Slips Into Shadows. One point it makes is that some funds feel the exchanges aren't as safe as they used to be, e.g. because of high frequency traders.

The passage I found most interesting however, was about intercepting the trades of small investors before they get to exchanges:

"Other places besides the 30-plus dark pools are stealing the business of stock exchanges. A handful of firms including Citigroup and Knight Capital pay retail brokers like TD Ameritrade and Scottrade for the opportunity to trade with ordinary retail investors before the orders can reach an exchange, a phenomenon known as internalization. This type of off-exchange trading has also been growing, in part because of the recent revival of interest in the stock market among ordinary investors."

This is a little bit like what we are seeing in kidney exchange, in which big transplant centers withhold their easy to match pairs and transplant them internally.  See e.g.
Ashlagi, Itai and Alvin E. Roth, "New challenges in multi-hospital kidney exchange," American Economic Review papers and proceedings, May 2012, 102,3, 354-59

Design of electronic stock exchanges (after the Facebook IPO)

The technical (as opposed to financial and disclosure) difficulties in the recent Facebook IPO have led to renewed discussion in the press about market design in a world of high velocity trading. Here's one of the more thoughtful stories: Could Computers Protect the Market From Computers?

"The Securities and Exchange Commission, which oversees the capital markets, has proposed a "consolidated audit trail" requiring exchanges to report every trade to a central repository, where they could later be analyzed.

"The project is a "very high priority" for the SEC, says an official, but the agency doesn't know when the rules for it will be completed. The main obstacle: agreeing on how to standardize the various formats that brokers and exchanges use to gather trading data.

"It will cost money to improve and modernize market structure," says Bryan Harkins, chief operating officer at Direct Edge, the fourth-largest stock exchange. "But the short-term money pales in comparison to boosting investor confidence in the long term."

"The SEC has estimated that a centralized order-tracking system would cost approximately $4 billion to set up and $2.1 billion a year to maintain.

"Mr. Leinweber of Berkeley has a simpler, and probably cheaper, solution in mind. He proposes that supercomputers—like those at national laboratories such as Berkeley's—should track every trade in real time. If volume began surging dangerously, the system would flash a "yellow light." Regulators or stock exchanges could then slow trading down, giving the market time to clear and potentially averting a crisis."

John Campbell on Mortgage Market Design

John Campbell writes about Mortgage Market Design

"Although the US has roughly average levels of homeownership (67%) and mortgage debt
(72% of GDP), it is unusual in two other respects. Figure 3 plots the average number of
years that a mortgage carries a fixed rate. The lowest values (around 1 year) are in southern European countries such as Portugal, Spain, and Italy, where adjustable-rate mortgages predominate. The UK and Ireland similarly rely heavily on adjustable-rate mortgages.The average fixed-rate period is 5 years in Canada, 7-10 years in Belgium, France, and Germany, almost 20 years in Denmark, and 27 years in the US reflecting a roughly 90% market share for 30-year nominal fixed-rate mortgages. These instruments, which are taken for granted in the US, are anomalous within the global mortgage system.

"Figure 4 plots an index of government participation in housing finance, constructed by
the IMF (2011), against the homeownership rate. The IMF index combines information on subsidies to home purchases, government funding or guarantees for mortgage loans, preferential tax treatment for mortgage interest or capital gains on housing, and the existence of a dominant state-owned mortgage lender. The figure shows that US housing policy is highly interventionist, more so than any other country illustrated except Singapore. The high value of the government participation index for the US results from subsidies to low and middle income homebuyers, subsidized mortgage guarantees by the government sponsored entities (GSEs), and favorable tax treatment of mortgage borrowing and housing capital gains. The main stated goal of much US housing policy is to increase the homeownership rate, but as previously noted the US has only average homeownership, and more generally there is only a very weak positive cross-country correlation between housing market intervention and
homeownership."
...
"I argue that there is a legitimate public interest in a stable, efficient mortgage system and call for deliberate experimentation with mortgage market design. Although our theoretical understanding of mortgage markets is still quite weak relative to the theory that underpins classic applications of market design (to auctions and matching problems, for example), financial theory and theoretically grounded empirical research will be important for this enterprise. Thus mortgage research offers financial economists an exciting opportunity to contribute to the well-being of society.

Could the Church of England declare finance to be repugnant?

It looks like they might try: Church leaders accuse bankers of losing their 'moral moorings'

"..."It is hard to imagine a more powerful way of telling someone that they are of little value than to pay them one-third of 1% of your salary," he said.

"Among the ill effects of very large income differences between rich and poor are that they weaken community life and make societies less cohesive."

"He said that "Queen's honours" – meaning peerages, knighthoods and other official honours – should not be given "to those who have already rewarded themselves handsomely".

Buying and selling pensions

Does buying future payoffs on someone else's pension become more or less repugnant if that person is in financial distress? (This is an aspect of repugnant transactions and markets that is one of the toughest to focus on, having to do on the one hand with the motivation for the transaction and on the other with ideas about coercion and exploitation...)

The WSJ reports on the mainstreaming of investment opportunities to buy the income stream from pensions:  Investing in a Stranger's Retirement

"The burgeoning business of investing in someone else's pension has never been easier—or more controversial and risky.

"For pensioners who are eager to sell, websites beckon with names such as BuyYourPension.com and pension4cash.com. Financial middlemen then bundle the information from pensioners into spreadsheets that are supplied to financial advisers for their clients.
...
"No one keeps track of how many pensions are turned into instant cash, and the number for now is believed to be small. But in recent months, websites have proliferated, and obscure middlemen far from Wall Street have ramped up efforts to win over financial advisers to the concept. They are finding some acceptance among those who favor alternative investments as part of an overall diversified portfolio.

"It's becoming more of a staple part of our business," said Daniel Cordoba, founder of Asset Exchange Strategies LLC, a Leander, Texas, financial-advisory firm that has sold a handful of pension-payment deals to clients in recent weeks. "There's a starvation for yield" with most bonds paying little interest, and clients are scared of the volatile stock markets, he added.
...
"In general, pension deals thread the needle of federal law that discourages the assignment of pensions for public policy reasons, according to court rulings. In a preliminary ruling in August, a California state-court judge said that military-pension transactions by Structured Investments Co., which has been in business since the 1990s, are "prohibited and unenforceable."

Brett Rubin, a lawyer for Structured, said the firm believes its transactions are proper. Over the years, its agreements have been enforced by other courts, including a U.S. bankruptcy court, according to court filings.
...
"Several buyers of pension payments who were interviewed by The Wall Street Journal declined to be identified because they didn't want to be seen as profiting from anyone's financial desperation.

"I had misgivings at first," said an investor in Philadelphia who this summer bought seven years of pension payments from a retired sailor. She forwarded $50,000, to be repaid in monthly installments that includes 6% annual interest.

"As part of the deal, the woman got some information about the seller, including that he needed the money to escape foreclosure. The retired sailor's "distress" bothered her, she said, but she "concluded this would help him save the house."

Speed of transactions in algorithmic finance

Markets suffer from congestion when there isn't enough time to make or evaluate all the offers that participants want to make. Even markets in which offers can be made very quickly can suffer from congestion, as I discovered years ago when I studied a labor market with about a six minute turnaround time between getting an offer rejected and making a new one.

In financial markets, the time required to make an offer is sometimes called the latency time, and it apparently can never be short enough: The New Speed of Money, Reshaping Markets

"In this high-tech stock market, Direct Edge and the other exchanges are sprinting for advantage. All the exchanges have pushed down their latencies — the fancy word for the less-than-a-blink-of-an-eye that it takes them to complete a trade. Almost each week, it seems, one exchange or another claims a new record: Nasdaq, for example, says its time for an average order “round trip” is 98 microseconds — a mind-numbing speed equal to 98 millionths of a second.

The exchanges have gone warp speed because traders have demanded it. Even mainstream banks and old-fashioned mutual funds have embraced the change.

“Broker-dealers, hedge funds, traditional asset managers have been forced to play keep-up to stay in the game,” Adam Honoré, research director of the Aite Group, wrote in a recent report.

"Even the savings of many long-term mutual fund investors are swept up in this maelstrom, when fund managers make changes in their holdings. But the exchanges are catering mostly to a different market breed — to high-frequency traders who have turned speed into a new art form. They use algorithms to zip in and out of markets, often changing orders and strategies within seconds. They make a living by being the first to react to events, dashing past slower investors — a category that includes most investors — to take advantage of mispricing between stocks, for example, or differences in prices quoted across exchanges.

"One new strategy is to use powerful computers to speed-read news reports — even Twittermessages — automatically, then to let their machines interpret and trade on them.

"By using such techniques, traders may make only the tiniest fraction of a cent on each trade. But multiplied many times a second over an entire day, those fractions add up to real money. According to Kevin McPartland of the TABB Group, high-frequency traders now account for 56 percent of total stock market trading. A measure of their importance is that rather than charging them commissions, some exchanges now even pay high-frequency traders to bring orders to their machines.

"High-frequency traders are “the reason for the massive infrastructure,” Mr. McPartland says. “Everyone realizes you have to attract the high-speed traders.”

Unraveling in the war for new private equity talent

Kevin Roose at Dealbook writes of A Grab for Wall Street’s Rising Stars Before They’ve Risen

"Some of the world’s largest private equity firms are in a tug of war over top talent. But the competition isn’t over brand-name executives commanding eight-figure salaries. Instead, firms are fighting for the affections of bankers barely old enough to rent cars.

"This month starts the private equity recruiting season, an annual Wall Street ritual in which young analysts from leading investment banks like Goldman Sachs and Morgan Stanley are wined and dined by Kohlberg Kravis Roberts, the Blackstone Group, TPG Capital and a handful of other top-flight firms. The industry is gearing up earlier than ever this year, with some firms already making offers for jobs that won’t start until the fall of 2012, a full 18 months from now.

“Five years ago, it happened in September, then July, then May, then April. This year, it’s March,” said a senior partner at a large private equity firm, who spoke on the condition of anonymity because he was not authorized to comment on the hiring process.

Young analysts typically fulfill two-year contracts at their banks before making the switch to the more prestigious, higher-paid world of private equity. It’s a common move often referred to as “two and out.” Many of these analysts, referred to as “pre-M.B.A. hires,” are contacted by private equity firms only months into their first post-collegiate jobs, and some are as young as 22.

“There is a shortage of stars, and that gives a strong incentive for a given firm to be the first,” said Adam Zoia, chief executive of Glocap Search, whose clients include leading private equity firms. “But everyone sensible — the clients, the banks, the candidates — believes it’s in no one’s interest to start this early.”

"Top firms have traditionally made informal agreements to synchronize their recruiting drives. It is a delicate monthlong dance that can include cocktail hours, meet-and-greets with executives and interview marathons sometimes referred to as “Super Saturdays.” This year, many of the largest firms scheduled events in April, approximately the same time as last year.

"But in early March, word spread that Bain Capital, the $65 billion private equity firm, was holding interviews and making offers to top candidates, according to several people familiar with the matter. Bain’s competitors — some of which moved early in previous years — were forced to scramble. They quickly rearranged schedules and, in some cases, canceled planned recruiting events in order to make their offers as soon as this week.

“Every year, we talk to the other private equity firms and actually pretend we have a vested interest in being reasonable about this,” said a private equity executive who oversees his firm’s hiring efforts. “And every year, some jerk kicks off the process a month early.” The executive, who also spoke on the condition of anonymity to avoid angering rival firms, called the analyst recruiting process “one of the last vestiges of completely rogue behavior” in the well-heeled world of private equity.

"Bain declined to comment.

"The early recruiting process has serious limitations. Private equity firms are essentially wooing young analysts with less than a year’s experience, giving them little time to learn crucial skills like building complex financial models to value companies. Few have also received the annual performance reviews necessary for identifying top talent.

“The kids we’re talking to got out of college last summer, spent six months in training, entered the job in January, and have done exactly nothing since then,” the executive said. “So we’re asking them about their transaction experience, and they’re talking about what fraternity they were in.”
...
"Competition is fierce. According to industry insiders, more than a thousand analysts are expected to apply for perhaps 50 spots at the largest buyout firms this year. Coming from a so-called target group can help an analyst’s chances — Goldman Sachs’s technology, media and telecom group and Morgan Stanley’s mergers and acquisitions group are thought to be the cream of the crop — but there are no guarantees.
...
"In perhaps the clearest sign that the recruiting frenzy has hit a boiling point, several smaller private equity firms have hired star students or well-connected ones straight out of college. Industry experts say they don’t expect that trend to spread to mega-firms like K.K.R. and Blackstone. But even longtime private equity players, like the executive managing his firm’s hiring process, admit that the competition has made anything possible.

“It’s a land grab,” the executive said. “And it’s a land grab for completely undeveloped property.”

HT: Eric Budish, the market design guy at Chicago, who writes "Back in my former life as a wall street guy this recruiting process was in spring of the second year (of a two year gig... )

Microfinancial crisis

The NY Times reports India Microcredit Faces Collapse From Defaults

"India’s rapidly growing private microcredit industry faces imminent collapse as almost all borrowers in one of India’s largest states have stopped repaying their loans, egged on by politicians who accuse the industry of earning outsize profits on the backs of the poor.
...
"Initially the work of nonprofit groups, the tiny loans to the poor known as microcredit once seemed a promising path out of poverty for millions. In recent years, foundations, venture capitalists and the World Bank have used India as a petri dish for similar for-profit “social enterprises” that seek to make money while filling a social need. Like-minded industries have sprung up in Africa, Latin America and other parts of Asia.


"But microfinance in pursuit of profits has led some microcredit companies around the world to extend loans to poor villagers at exorbitant interest rates and without enough regard for their ability to repay. Some companies have more than doubled their revenues annually.

"Now some Indian officials fear that microfinance could become India’s version of the United States’ subprime mortgage debacle, in which the seemingly noble idea of extending home ownership to low-income households threatened to collapse the global banking system because of a reckless, grow-at-any-cost strategy. "

Paul Klemperer's "product mix auction"

Paul Klemperer writes from Oxford:

"the Bank of England has now been running my "product mix auction" for the last two months almost exactly as set out in Section 2 of "The Product-Mix Auction: a New Auction Design for Differentiated Goods" (including "paired bids" etc.)

"Although I designed it for the financial crisis when I was consulted in 2007 after Northern Rock bank run, full implementation was slow. But it is now fully implemented and running regularly (in part, so using it is not seen as a signal of crisis).

"It's perhaps best understood as a "proxy" version of a simultaneous multiple round auction. That is, bidders input their preferences, and the auction chooses the outcome that an SMRA would select assuming straightforward bidding. Because the auction is "sealed bid", it runs instantaneously (important in the Bank's financial-market context), and it therefore also less vulnerable to collusion. Another novel feature is that the auctioneer also bids its preferences about how the proportions of different varieties that it will sell will depend upon the auction prices. (By contrast, SMRA implementations I am aware of specify the number of each type of good to be sold in advance.) It's also related to Paul Milgrom's independently-invented assignment auction, but the way bidders represent their preferences is different (easier and more general in some ways).

"The Bank's specific problem is to auction loans linked to varying qualities of collateral [to inject liquidity into the banking system rapidly], but

        --charge different borrowers different interest rates reflecting the different collateral-qualities [to reduce moral hazard];

        --allow market conditions, as revealed by the bids, to determine BOTH the interest-rate-premium for inferior collateral AND the proportion of inferior collateral accepted [because the Bank may neither be sufficiently informed about conditions, nor wish to send a 'signal' to the market];

        --permit borrowers to specify how the collateral they supply will depend upon the auction outcome [because the interest-rate-premium is not - see above - pre-specified]

"I've advised other Central Banks. Other future applications might include other purchasing "toxic assets", selling electricity, and trading biodiversity."

Design of financial clearinghouses: Over the counter derivatives markets

The Bank for International Settlements' Committee on Payment and Settlement Systems has, in a followup to the recent financial crisis, issued two reports.


The first concerns clearinghouses-- Central Counterparties (CCPs). Here is the summary, and the report. From the summary:

"Over the past several years, public and private sector entities have undertaken a coordinated effort to improve the post-trade infrastructure for OTC derivatives transactions. The recent financial crisis demonstrated the need to further enhance the safety and transparency in the OTC derivatives markets. As a result, authorities in many jurisdictions have set out several important policy initiatives encouraging greater use of CCPs for OTC derivatives markets. The CPSS and the Technical Committee of IOSCO support these positive developments.
A well designed CCP can reduce the risks and uncertainties faced by market participants and contribute to the goal of financial stability. Nevertheless, because of the complex risk characteristics and market design of OTC derivatives products, clearing them safely and efficiently through a CCP presents unique challenges that clearing listed or cash-market products may not. "


Some of the challenges seem to be in making the products well defined...


These apply also to Trade Repositories, which are meant to be simple registers of what positions are held. Again, here's the summary and the report.

Market orders, programmed trading and loss of thickness

I haven't yet read a convincing account of the one-day stock market crash and rebound on May 6, but here's an early (May 9, NY Times) story that makes a case that a lot of conventional market tools could have interacted to produce a bad outcome: Thursday’s Stock Free Fall May Prompt New Rules.

"The S.E.C., which oversees the nation’s equity markets, requires a suspension in trading only in the event of a broad market collapse, defined as a drop of at least 10 percent in the Dow Jones industrial average, which is based on the share prices of 30 large American companies.
Other countries, like Germany, impose similar circuit breakers on trading in shares of any individual company that has a similar drop, but the S.E.C. has never done so. A former S.E.C. official said the possibility had been discussed in recent years, but “I don’t think there was quite the urgency to deal with it.”
The S.E.C. and the Commodity Futures Trading Commission said in a joint statement on Friday that the issue now had their attention.
“We are scrutinizing the extent to which disparate trading conventions and rules across various markets may have contributed to the spike in volatility,” the statement said. “This is inconsistent with the effective functioning of our capital markets and we will make whatever structural or other changes are needed.”
Early this year, the S.E.C. also began a broad review of equity markets, including whether computerized trading is properly regulated.
The heads of several of the largest electronic exchanges said Friday that they would support industrywide rules for breaking free falls.
But there are other ideas to keeping computerized markets in check. Lawrence E. Harris, a finance professor at the University of Southern California, said regulators should simply require all sellers to specify a minimum price below which they do not want to complete the sale of their shares. Market orders, placed at the best available price, can be too risky in the fast-moving age of electronic trading.
On Thursday, some sellers placed orders that were not fulfilled until prices had plunged as low as a penny a share. If sellers had placed “limit orders” instead, those transactions would not have happened, Professor Harris said.
“Electronic exchanges in most other countries only accept limit orders,” said Professor Harris, a former S.E.C. chief economist. “Without any mechanisms to stop the market, we just had stocks falling through the ice.”
But Rafi Reguer, a spokesman for the electronic exchange Direct Edge, said retail investors liked market orders because limit orders could be rejected, forcing the seller to try again, in some cases at a lower price.
“Sometimes what people value is the certainty of execution,” Mr. Reguer said.
Experts also note that the value of limit orders can be subverted if investors routinely set unrealistically low limits, to avoid the inconvenience of having their orders rejected.
The BATS Exchange, a large electronic exchange based near Kansas City, rejects orders if the price would be more than 5 percent or 50 cents away from the last completed transaction.
During the market panic on Thursday, between 2:40 and 3 p.m., BATS prevented more than 47.6 million orders from executing — more than 95 percent of all orders during that period, according to Randy Williams, a spokesman for the company. "

And here's a May 19 NY Times story on the SEC's new rules: New Rules Would Limit Trades in Volatile Market
"The Securities and Exchange Commission said Tuesday that it would temporarily institute circuit breakers on all the stocks in the Standard & Poor’s 500-stock index after the huge market gyrations on May 6.
The circuit breakers will pause trading in those stocks for five minutes if the price moves by 10 percent or more in a five-minute period. The trial run will begin after a 10-day comment period and will last through Dec. 10, the commission said. The circuit breakers will apply both to rising and falling stock prices.
But in a separate report, the S.E.C. and the Commodity Futures Trading Commission said that they had not been able to pinpoint the cause of the sharp market decline that shook investors and markets two weeks ago.
Generally, the agencies said, the drop was caused by traders stepping back from the market and refusing to buy or sell, in both the stock and futures markets. The government found that there was also a heavy reliance by investors on automated orders to sell at the market price once stock prices had declined by a certain amount. Further, there were different rules on different exchanges about when trading is automatically slowed or stopped. "

Usury and anti-semitism

From Ira Stoll's review of Capitalism and the Jews, by Jerry Z. Muller, Princeton University Press:

"The book by Mr. Muller, a professor of history at Catholic University, consists of a short introduction and four chapters. It's the first chapter, "The Long Shadow of Usury," that's the most enlightening.
"Usury was an important concept with a long shadow. It was significant because the condemnation of lending money at interest was based on the presumptive illegitimacy of all economic gain not derived from physical labor. That way of conceiving of economic activity led to a failure to recognize the role of knowledge and the evaluation of risk in economic life," he writes. "So closely was the reviled practice of usury identified with the Jews that St. Bernard of Clairvaux, the leader of the Cistercian Order, in the middle of the twelfth century referred to the taking of usury as 'Jewing'" says Mr. Muller."

Finance as portrayed in Victorian novels

I think of my work on repugnance, and on protected transactions, as part of a broader project of understanding how the workings of the economy are viewed by non-economists, in ways that may have economic consequences. Some popular views are very longlasting, while some, as politicians know, are subject to change, particularly when the economy goes from boom to bust.

One way to gain some intuition about this might be to study how various kinds of markets and transactions are portrayed in literature. The 2009 book Guilty Money: The City of London in Victorian and Edwardian Culture, 1815-1914 by the financial historian Ranald Michie takes a timely look back at how financial markets were imagined in an earlier century.

He looks at how finance is portrayed in novels, writing "Given the steady production of novels over this period, they also provide a means of continually monitoring changing cultural values. In contrast, other evidence of contemporary culture lacks either the continuity or depth necessary to observe trends over time. Cartoons do provide useful snapshots, such as during the Railway Mania, while there was a brief flurry of paintings with a City theme in the late 1870s, but finance only rarely lends itself to visual display..."

In the Winter 2009 issue of the Business History Review, Andrew Popp writes of the book
"The portrayals are rarely flattering: the City is a place of speculation, gambling, fraud, and deceit; financiers are not to be trusted and are often Jewish, foreign, or both; morals are currupted; true religion is impossible; old England is another, better world; the aristocracy are degraded fools; and all widowers, spinsters, and retired clergymen are innocent dupes."
...
"At the end, the mystery remains of how global financial success could coexist so happily with a fiercely antifinancial culture."

All this seems very timely. Yesterday the Times of London reported from Davos on French President Sarkozy's speech about bankers under the headline Davos: Fear and loathing in the Alps
"Sarkozy railed against the evils of unbridled capitalism and reserved special opprobrium for bankers. “To earn such enormous sums and not to bear responsibility is immoral,” he said. There was a stony silence, broken by a clutch of people who had the courage to clap.
“I thank those two members of the audience for their support,” Sarkozy said with a grin, getting a big laugh. "