Sunday, October 28, 2012

Germany Restricts High-Frequency Trading, Chicago Fed Recommends Same

WSJ Article: Germany to Tap Brakes on High Frequency Trading
NYT Article: Germany Act to Increase Limits on High Speed Trades

Late last month, New York Times and WSJ reported on Germany's intention to restrict High Frequency Trading.  High Frequency Trading is the use of proprietary algorithms to trade securities rapidly and at high speed. The idea is to capture fractions of a penny per trade. 

Chicago Fed's Concern About HFT
Earlier this month, the Chicago Fed published an essay on the risks of HFT for financial markets. Every exchange it investigated has had problems attributable to errant algorithms and software malfunctions. The worst was the 2010 Flash Crash which caused a 700 point drop in the Dow within seconds. 

At fault is insufficient risk controls, a phenomenon due to the competitive time pressures involved. The Chicago Fed found that exchanges that impose pre-trade risk checks increase latency. Furthermore, investor confidence in the markets has also been adversely affected and the markets have seen a rise in volatility. 

In order to control risks associated with HFT, the Chicago Fed has recommended:
               Limits on the number of orders that can be sent to an exchange within a specified period of time;
               A “kill switch” that could stop trading at one or more levels;
               Intraday position limits that set the maximum position a firm can take during one day; 
               Profit-and-loss limits that restrict the dollar value that can be lost.

Germany Acts to Restrict HFT
Draft legislation on the matter was approved by the German parliament. Proposed measures include requiring that all high-frequency traders be licensed, clear labeling of all financial products traded by HF algorithms without human intervention, and a limit to the number of orders that may be placed without a corresponding trade.

According to a press conference by the German Finance Ministry, as much as 40 percent of all trading sales can be attributed to HFT. Germany's goal in acting are essentially to limit the identified risks associated with HFT. If the bill becomes law, "excessive use" of trading systems would come with added fees. Traders also would have to maintain a balance between orders and executed transactions.

While France has already imposed a tax on high-frequency trades, legislation is also under consideration at the European Parliament and may become the basis for governmental legislation on HFT across the EU.
Max Berre is an economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.

Thursday, October 11, 2012

Zero Lower Bound: When Interest Rates Can't Drop Any Further

Recently, a new issue has emerged in the unfolding drama of the global financial crisis. After four years of reducing interest rates and increasing money supply at central banks of virtually all of the world's major economies, both academia and the media have started to mention a new obstacle, the Zero Lower Bound.

The underlying challenge of the Zero Lower Bound is that because interest rates are at zero, they cannot usually be lowered any further. Moreover, the context is typically one in which the economy is sluggish and stimulus is needed. In such circumstances, monetary policy has to proceed by unconventional means. Otherwise, a liquidity trap might develop along the lines of the situation Japan has been stuck in for nearly two decades. The question is of particular relevance today, since both the ECB and Fed have had their policy rates hovering around zero since 2008-2009. 

The Policy Alternatives
In 2010, the ECB published a working paper outlining the two ways that ZLB can be confronted are via a change in the way monetary policy is conducted, or via stimulatory changes in fiscal policy. 

In any case, whenever ZLB has been confronted in the recent past, some unorthodox monetary measures have been tried, with varying degrees of success:

  • Quantitative Easing: This can always be done, no matter how low interest rates are. This has been recommended for the case of Japan.

  • Switching the way monetary policy is conducted. Switching to inflation targeting is the rhetoric of choice now. In the 1990s, it was exchange-rate targeting. The downfall of this approach is credibility. If markets don't buy the idea that the central bank will commit to either exchange rate targeting or inflation targeting, the plan will run into difficult terrain. Since it has taken central banks decades to build the credibility of their current low-inflation path, a change in course might be difficult to establish credibly. At least overnight. 

  • Changing the distribution mechanism. Last year, the Fed engaged in "Operation Twist", an effort to engage in quantitative easing by injecting liquidity along various points on the yield curve. 

  • Negative Interest Rates: During the Swedish crisis in 1991, the Swedish central bank forced policy rates into negative territory temporarily by charging banks a premium for storage of funds within the central bank, as well as for access to LOLR services. This encouraged banks to actually lend funds which they were being issued. 

  • Reliance on Fiscal Policy: Market confidence can also be affected by changes in revenue and expenditure. Unfortunately, during hard times, the capability of the state to credibly increase its expenditure is limited. This is especially the case where central banks have the commitment not to monetize deficits. 

During the WWI and WWII eras the British tried a somewhat different take on this approach. In 1914, for example,  Keynes recommended direct monetary intervention to compensate losses in the international trade finance sector caused by the sudden German embargo. In concept, the idea is similar to the US' Troubled Asset Relief Program, a fiscal measure to directly intervene in the failed derivative market in 2008-2009. 

Regardless of the approach (or combination of approaches) used, the issue of maintaining an expansionary stance in the face of ZLB is one of the more challenging issues in monetary economics and central banking. It may be quite some time before a policy consensus develops in this area. One thing is certain however: central banks will all need to develop adequate ZLB tactics at one point or another. 

Max Berre is an economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.

Thursday, October 4, 2012

Middle-Class Squeeze: Wages are Down, but we Aren't More Competitive
American wages and labor conditions have been continuously deteriorated since the 1980s. Since the start of the 21st century however, this trend has become especially pronounced. Known as the Middle Class Squeeze, this phenomenon has been particularly pronounced in the US, while real wages expanded strongly in European OECD countries such as the UK, France, Italy and Germany, as well as in the BRIC countries since 2000. It has become a major issue in both the 2008 and 2012 presidential elections. In 2008, the House Committee on Government Reforms published a brief study which concluded that median real household income dropped by almost $1,300 while real household expenses increased by nearly $5,000 over the 2000-2008 period.

How it Happens
Essentially, the deterioration of incomes on the US labor market has emerged in two ways:

1: The large-scale loss of high-skilled, high value added mid-wage employment, to be replaced by low skilled, low value-added, and low-wage employment. According to the National Employment Law Project, 
sixty percent of of US job losses experienced during the recession, while comprising only around twenty  percent of the jobs gained during the current recovery period. Low-skilled jobs meanwhile made up only around twenty percent of the jobs lost during the recession  but nearly sixty percent of the jobs recovered thus-far in the recovery.

2: Declining real incomes: The maintenance of median wage and salary levels in the face of increased price levels and cost of living. Healthcare and energy costs have especially increased, as has education. To compound this trap, the new millennium has seen the rise of household debt to try to cover the difference. The debt-to-income ratio reached its highest level in 24 years for middle class households, while Bush-era bankruptcy reform has made the debt trap considerable more difficult to climb out of. In 2010, the Levy Institute published a study showing that both household debt and the US GINI coefficient spiked upwards since 2000.

Why This is Problematic
According to the standard ruling paradigm in labor market economics, low wages are helpful to a country's economic competitiveness. But, this only begs questions such as:

  • How much wage deterioration is enough and when will the US's wage levels become "competitive"? Do wages and labor standards have to sink to those of China? 
  • What will happen to consumer demand as a result of this trend?
  • If wages are supposed to equal the marginal productivity of labor, how can the replacement of mid-wage, high-skilled jobs with low-skilled Mcjobs possibly be a positive development for our labor market?

Setting aside the ominous ethical significance to what is perceived as the US' core traditional values posed by the progressively increasing American wealth gap, there are long term economic side-effects which we have also seen emerge. 

Among these are a weaker, more debt-dependent consumer market, lower growth in productivity levels within the American workforce. All of this will hurt the progress of the American economic recovery, and will undermine long-term economic health. 

What Can Be Done
Unfortunately, the Middle Class Squeeze has no magic overnight solutions. Addressing this issue would take a package of policy solutions. We can start by asking what the rest of the OECD countries have done in order to promote real income growth. We also take measures to counteract the primary immediate causes of the short-term squeeze.

  • More attention needs to be focused on increasing our labor force's productivity level. This means not only improving the educational level, but securing access to mid-career and between job training as well. In policy terms, it means that our school systems must perform better, university education must be cheaper, and employer training has to be incentivized. 
  • Healthcare costs have to be tamed. 
  • Consumer debt markets have to be reformed and Bush-era bankruptcy reforms need to be scrapped. The growing debt-trap is a large component of the middle class squeeze. It also undermines both short and long term consumer confidence and household savings, two key ingredients to healthy, sustainable economic growth. Climbing out of the debt trap has got to be made easier if the American economy will continue to succeed in the long-run. 
  • High-skilled employment clusters have to be constructed and defended. Essentially this means that the long-term survival of clusters such as Detroit and Silicon Valley have got to be treated as issues of national interest.
Max Berre is an economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.