Tag Archives: MIT

Barclays Gets Washed Up in Dark Pools and High Frequency Trading

By Barry Elias | Friday, 30 Oct 2015 07:02 AM

Barclays Bank seems like it is next in line to settle with the authorities regarding its dark pool operations.

In recent years, the Securities and Exchange Commission (SEC) and the New York State Attorney General (NYSAG) have focused on the disruptive nature of dark pools and high frequency trading: especially when used in tandem, as the authorities allege to be the case with Barclays Bank. The SEC and NYSAG claim Barclays misled its clients into believing high frequency traders would be less active in their LX dark pool trading venue.

Dark pools are essentially private, anonymous, off-exchange and opaque venues that permit the trading of exchange-listed securities. This structure helps camouflage the trading strategies of large financial institutions, such as mutual funds, pension funds, hedge funds, and insurance funds to afford them optimal profits or minimal losses. These venues are lightly regulated, require less public disclosure, do not carry the same protective margin requirements as the public exchange marketplaces, and allow banks to forego paying fees to exchanges for trade execution.

Dark pool trading as a percentage of total trading volume more than tripled from 4 percent in early 2008 to nearly 14 percent by the end of 2011, according to Rosenblatt Securities. Haoxiang Zhu, a financial economist at the MIT Sloan School of Management and the author of a new paper in the Review of Financial Studies, cites a study in which 71 percent of financial professionals believe dark pools are “somewhat” or “very” problematic in establishing stock prices.

Despite denying any wrongdoing and fighting this case, Barclays is in serious discussions to pay a fine of $65 million.

Thus far, two firms have agreed to pay fines related to this activity: $14 million by UBS Group and $20.3 million by Investment Technology Group, which has admitted to wrongdoing in its case. A third, Credit Suisse, has a planned agreement to pay an $85 million fine.

To evade recent proposals that would regulate and undermine dark pool trading, some U.S. banks are conducting their derivative trades through non-U.S. subsidiaries that do not have explicit guarantees from the U.S. parent.

The SEC and other regulatory bodies need to keep the playing field level for all, and where possible, prosecute individuals as a more effect deterrent.

© 2015 Newsmax Finance. All rights reserved.

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Nobel Laureate Tirole Says Financial Regulation Is Inadequate

My article below, first published on October 17, 2014, is further validated by Paul Krugman’s op-ed piece in the New York Times on July 24, 2015.

Krugman, an MIT-trained Nobel Laureate in Economics, suggests as I did: the MIT-inspired model is more empirically accurate than the one promoted by scholars at the University of Chicago.

MIT economists recommended pragmatic and tailored financial regulations.  Chicago on the other hand – Nobel Laureate Milton Friedman in particular – subscribed to a more laissez-faire, less regulated construct.

Krugman writes:

“The coming of stagflation was a big win for Milton Friedman, who had predicted exactly that outcome if the government tried to keep unemployment too low for too long; it was widely seen, rightly or (mostly) wrongly, as proof that markets get it right and the government should just stay out of the way.

Or to put it another way, many economists responded to stagflation by turning their backs on Keynesian economics and its call for government action to fight recessions.

At M.I.T., however, Keynes never went away. To be sure, stagflation showed that there were limits to what policy can do. But students continued to learn about the imperfections of markets and the role that monetary and fiscal policy can play in boosting a depressed economy.”

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Nobel Laureate Tirole Says Financial Regulation Is Inadequate
By Barry Elias
Friday, October 17, 2014

Jean Tirole, the 2014 recipient of the Nobel Prize in Economic Sciences, believes the financial industry is not properly regulated.

The selection of Tirole, a professor at the Toulouse School of Economics in France, comes on the heels of the 2008 financial crisis that unveiled the serious shortcomings in the regulation of banks and other financial firms, and the extraordinary market power of technology companies, such as Google and Apple.

Tirole, an MIT-trained economist, was mentored by Eric Maskin, another MIT economist and Nobel Laureate. His area of expertise is industrial organization, regulation and competition. The underlying premise of his work, which has been substantially validated empirically, suggests markets are inefficient, reflect choices based on behavioral psychology and require some level of regulation. This is in strong contrast to the long-held view by theorists from the University of Chicago that markets are efficient and require little, if any, regulation.

George Stigler, the 1982 Nobel Laureate in Economic Sciences from the University of Chicago for his work on regulation, acknowledged in his memoirs that he was very surprised by the confidence he had when he recommended the breakup of the U.S. Steel monopoly in the 1950s, despite having little knowledge of how the industry operated. He said this belief was driven by consensus more than evidence.

Tirole demonstrated that game theory and contract theory can be applied to regulatory paradigm, especially between strong market participants under oligopolistic and monopolistic conditions, where the quality, quantity and prices of goods and services are controlled by very few actors. In essence, he says firms factor into their strategic decision making how rivals will react when they vary prices or product offerings. The University of Chicago school recognized this, but did not follow the implications.

In addition, information asymmetries exist, since the regulated tend to have much more knowledge than the regulators regarding the successful operation of their business, specifically in terms of costs and strategic options. Additionally, there is incentive for firms to be opaque and hide knowledge, thereby “playing games” with other firms and those who regulate them.

A clever regulator can offset these asymmetries by permitting the firm to select from a series of contracts. The firms choice will hint at their cost structure and how much flexibility they have to lower prices.

Tirole believes each industry is unique in how the regulations need to be applied, and it is crucial that they not stymie long-term investment in innovation and productivity. He also suggests that regulation needs to apply to vertical industries that control many aspects of the production process, from simple raw materials to multiple end uses.

His research has been applied successfully in many industries, such as communications, technology and banking. In the 1980s, he helped European governments divest state monopolies. His recommended paradigm encouraged investment and innovation, curbed excess windfall profits and enabled consumers to experience lower prices and better service. In many industries, the United States has not adopted these regulatory measures.

In the late 1990s, Tirole stressed the importance of liquidity in the banking system, where assets can be readily converted to cash to meet financial obligations. He now recognizes the importance of systemic risk where regulated banks interact with unregulated financial entities. This was not addressed prior to the crisis, said Tirole.

Recently, he has been focusing more on banking and finance. He has teamed up with Emmanuel Farhi, another MIT-trained economist and now a Harvard professor of economics, to study the optimal bank bailout policy by the federal government in times of crisis. Tirole is also examining how central banks can enhance liquidity to commercial banks when the demand and supply of their assets are low.

Finally, regulators across the globe are requiring banks to hold more liquid assets.
Tirole also stresses, once you devise and implement an effective regulation strategy, it must be enforced efficiently by the state. To her credit, Federal Reserve Chair Janet Yellen is committed to reigning in the excessive risks taken by the financial community in recent decades.

The financial industry needs strong minds to tackle this issue before another cataclysm rears its ugly head.

© 2015 Newsmax Finance. All rights reserved.

First published on October 17, 2014.

Financial Disruption: Part III

Finance is continuing down the path of technological disruption with marked acceleration.

Helping to lead the charge is the Massachusetts Institute of Technology in Cambridge, Massachusetts, known for an environment that incubates innovative intellectual ideas with pragmatic applications. (Disclosure: my son is currently an undergraduate student at MIT.)

At the forefront of this revolutionary change is the concept of the virtual currency, such as bitcoin.

As the pioneers at MIT describe it, this “currency” is much more than a currency: it represents a platform and protocol for ownership and transfer of virtually any good or service in return for any another – whether it is a carrot, a car, condominium, a contract, or a convertible bond.

The principle reason for this highly perfected barter arrangement is the infinitely divisible property of digital assets. In this model, a portion of your kitchen table can be sold and used to purchase a two-year internet connectivity contract. The title of ownership will be more secure and less susceptible to manipulation by individuals, corporations or governments, since the information is decentralized and available for the world to see. Moreover, this system removes many financial intermediary layers, thereby affording quicker and cheaper transactions.

Michael Casey, the senior advisor to the Digital Currency Initiative at the MIT Media Lab explains the real beauty of this system is that no one needs to trust anyone else in the transaction – neither the counterparty nor a neutral third-party – since the information is available to an extraordinary number of people globally. He believes this methodology will enable irrefutable, self-sovereign identity markers of property ownership, irrespective of their socioeconomic or financial status, and enable asset collateralization for exchanging of goods and services He also makes the case that these digital assets can be used to collateralize currency creation, which would be helpful to a country like Greece, so it could pledge state-owned assets to reorganize and service its debt obligations.

Brian Ford, the Director of Digital Currency at the MIT Media Lab, has spent decades at the nexus of technology, public policy and entrepreneurship. He has been leading efforts to mainstream digital currencies through research and incubation of high-impact applications of this emerging technology. In collaboration with global experts from government, nonprofits and the private sector, he is exploring how cryptography, economics, privacy, and digital systems can be used to support the commercial and social viability of this technology. . He recently served as the Senior Advisor for Mobile and Data Innovation at the White House where he led efforts to leverage emerging technologies to address the President’s most critical national priorities.

One of the goals of this initiative is to seriously engage the MIT community to test digital currency concepts that address issues surrounding security, stability, scalability, individual rights, and the economy – with an eye on high social impact. The world-at-large has been taking important note, including government and regulatory entities, central banks, the financial community, and business organizations.

Yanis Varoufakis, a former Greek finance minister, suggested a digital currency could replace the euro if it were backed by future tax revenue; the Bank of England claims the technology will have extraordinary implications; Deloitte issued a report on the potential for state-sponsored cryptocurrencies as an alternative to conventional money; the chief information officer at UBS believes it would simplify banking substantially; Nasdaq is testing bitcoin technology for use on its stock exchange; and many large corporations accept bitcoin for purchases of their products and services, including DISH TV, Dell, the Sacramento Kings, and Kmart.

In my view, the most important application of digital currencies is its use in partially backing the creation of money and credit.

Monetary creation becomes much more responsible, effective and efficient when it is partially backed by the production of goods and services, such as digital assets. This model permits more consistent monetary growth that is linked to the supply and demand of goods and services. The cost of currency production is then reflected more proportionately in the real economy with greater stability and predictability across geographic boundaries and through time. This minimizes extreme and volatile business cycles, enables a more fluid employment environment, and increases income and purchasing power for the many.

We should warmly welcome this new technological disruption.

© 2015 Newsmax Finance. All rights reserved.

Boston Marathon Will Generate Long Term Economic Growth

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Many people are focusing on the lost economic activity in the Boston area due to the tragic events over the past two weeks.  While the region has suffered in the short term, this incident may trigger extraordinary future economic growth.

The key driver of this growth will be the use of bionic limbs for amputees.  Dr. Hugh Herr, who heads the Biomechatronics research group at the MIT Media Lab, has been instrumental in developing bionic prostheses that provide extraordinary functionality.   As a double-amputee, Dr. Kerr can attest to the great strides in this area and how beneficial it can be to society.  He believes this technology will become extremely popular and useful in the future, especially given the recent incident at the Boston Marathon.

These bionic limbs are functioning more like our natural limbs and may actually surpass them in the future.  Dr. Herr receives periodic upgrades to his hardware and software, which enable him to continue his passion for rock climbing.  He anticipates the development of future limbs that will enable the user to feel their surroundings, such as sand on a beach versus water in a lake.  He is inspirational as someone who has transformed major liabilities into tremendous assets.  Several months ago, 60 Minutes featured a Department of Defense initiative called Revolutionary Prosthetics, in which artificial limbs are controlled by mere thought.

From an economic standpoint, the long term benefits heavily outweigh the short term expenditures, thereby providing a high return on investment for society.  These benefits include the reduction of secondary disabilities – such as joint arthritis and pain – less rehabilitative intervention, and a more productive, income generating population.  Greater income, lower healthcare costs and a better quality of life will enable a more healthful economic environment in the future.