Arbitrage Is No Fun Anymore
(Bloomberg Opinion) -- Arbitrage.
Here is a delightful New York Fed staff report on “Bank-Intermediated Arbitrage” by Nina Boyarchenko, Thomas Eisenbach, Pooja Gupta, Or Shachar and Peter Van Tassel. We’ll get to their conclusions in a minute, but I want to particularly recommend the paper as a nice layperson’s introduction to what banks do all day. It is stuff like this:
Consider the on-the-run/off-the-run (OTR-OFR) basis trade .... In the textbook OTR-OFR basis trade, a market participant would short the more expensive on-the-run Treasury and buy long the cheaper first off-the-run Treasury of similar maturity, earning the liquidity premium enjoyed by on-the-run securities. In practice, the short position in the on-the-run security would be taken through a reverse repurchase agreement, with the market participant lending cash and receiving the OTR Treasury as collateral, and the long position in the off-the-run security would be financed through a repurchase agreement, with the market participant borrowing cash and posting the OFR Treasury as collateral. Thus, the overall profit (“carry”) that the participant makes by participating in the trade is the OTR-OFR basis, net of the difference between the interest rate paid on the OFR repo and the interest rate earned on the OTR repo, and net of the cost of financing repo haircuts (if any).
In the covered interest rate parity (CIP) trade, an institution trades off the cost of borrowing in U.S. funding markets against the costs of borrowing in foreign markets and swapping the foreign funding into U.S. funding via a forward exchange rate swap. When the basis is positive, U.S. dollar funding is relatively cheap and institutions take advantage by entering into a long position in U.S. Treasuries, a pay-fixed forward exchange rate swap, and shorting a foreign sovereign security with the same maturity. When the basis is negative, U.S. dollar funding is relatively expensive, and institutions take advantage by shorting a U.S. Treasury security, entering into a pay-floating forward exchange rate swap, and buying a foreign sovereign security with the same maturity.
In the CDS-bond basis trade, institutions trade off the cost of taking on credit risk exposure to individual entities through either the cash bond market or through the single-name CDS market. When the CDS-bond basis is positive, corporate bonds are relatively more expensive than single-name CDS, and institutions take advantage by selling protection in the single-name CDS market and shorting the corresponding corporate bond. When the CDS-bond basis is negative, corporate bonds are cheap relative to singlename CDS, and institutions enter into a long position in the corporate bond market and buy protection on the same reference entity in the single-name CDS market.
Obviously banks do lots of other things too, and institutions other than banks do lots of these things. But there is something rather bank-y about the characteristic that these things share, which is that they involve buying a whole lot of one thing and selling a whole lot of an almost-but-not-quite identical thing to profit from small differences between the prices of the two things.
For one thing, that activity—it is normally called “arbitrage”—can shade into the classic bank activity of “market making.” One thing that you do in market making is buy some Stock X from one customer, then sell some Stock X to another customer, keeping your overall inventory of Stock X close to zero. But in more complicated products—options or swaps or exchange-traded funds or even bonds really—your goal is not necessarily to keep your absolute levels of inventory low, but to keep your risk low. If you buy a bunch of Bond X from one customer, and sell the same amount of Bond Y to another customer, and Bonds X and Y are essentially identical—if, say, they are U.S. Treasuries that mature a month apart—then that is almost as good as having no inventory at all. (Or if you buy an ETF and sell the underlying stock, or buy an interest-rate swap and sell a related future, etc. etc.) Market makers in many products think in terms of risk sensitivities—How much net credit or rates or volatility or whatever exposure do I have? How much will I make or lose if interest rates move by a basis poin?—rather than in terms of absolute dollar amounts of particular instruments, which means that they look a bit like arbitrageurs.
For another thing, if you are going to make money off of tiny differences in prices between two almost-identical things, then you need to buy and sell a lot of those things, which means you will need a lot of money. Banks, being where the money is, have a lot of money, which makes them better suited to do these trades than, you know, I am.
Again banks are not the only institutions who do these trades. But in many case the sorts of arbitrage hedge funds that do the trades get the money to do them by borrowing it from their banks: The bank, as prime broker to the hedge fund, lends it money to buy the thing it wants to buy, and lends it the thing it wants to sell so that it can short it. The bank does this because, one, it has the money (and the securities to lend), and, two, because the risk is manageable: The two positions should move together, so if the hedge fund loses money on one side it will make money on the other, so it should be able to pay the bank back.
Another reason this stuff is a natural fit at banks is that it is, essentially, plumbing. Buying the off-the-run Treasury and selling the on-the-run is not the sort of bold call on future economic activity that fundamental investors are supposed to make. It doesn’t directly allocate capital to productive uses, or take big risks in the search of big returns. It just makes the system work a bit more smoothly. If index ETFs track their underlying stocks, then it’s easier for fundamental investors to hedge out market risk, so it’s easier for them to make bold bets allocating capital to the best uses. The work of arbitraging that index ETF is boring and invisible, a work of endlessly making sure that the system is tuned correctly so that other people can use it effectively. It makes sense that banks, as operators of the system, would be involved in a lot of that tuning.
Anyway the paper! The basic gist of it is that the banks can’t do as much of this anymore, so the system is not as finely tuned as it used to be:
We argue that post-crisis bank regulation can explain large, persistent deviations from parity on basis trades requiring leverage. Documenting the financing cost and balance sheet impact on a broad array of basis trades for regulated institutions, we show that the implied return on equity on such trades is considerably lower under post-crisis regulation. In addition, although hedge funds would serve as natural alternative arbitrageurs, we document that funds reliant on leverage from a global systemically important bank suffer significant declines in assets and returns relative to unlevered funds. Thus, post-crisis regulation not only affects the targeted banks directly but also spills over to unregulated firms that rely on bank intermediation for their arbitrage strategies.
The Volcker Rule—which prohibits “proprietary trading” by banks, though some forms of proprietary-ish trading (market making, trading in Treasuries) are still allowed—has had an effect, making it harder for banks to make big bets that one thing will converge with another thing.
But the much bigger impact comes from the supplementary leverage ratio. The main bank capital regulation before the crisis involved risk-based capital; banks had to fund a certain percentage of their “risk-weighted assets” with equity. Risk-weighting allows banks to do (or fund hedge funds that do) a whole lot of these trades, because these trades are not—on the conventional measures used to compute capital, and also probably in reality—particularly risky. If you buy a whole ton of Treasuries, and then sell a whole ton of near-identical Treasuries, it will not use a lot of risk-based capital, because (1) Treasuries are very safe and (2) your positions offset and the net position is small.
But since the crisis the more binding regulatory constraint is often the supplementary leverage ratio, which requires banks to fund a certain percentage of their total unweighted assets (plus some asset-like things like derivative exposures) with equity. Buying a whole ton of Treasuries and selling a whole ton of other Treasuries leaves you, in an SLR world, with two whole tons of Treasuries exposure, which means that you need a lot of equity, which makes the trades less attractive than they used to be if you are optimizing return on equity:
For all the trades we consider, the implied ROE under the supplementary leverage ratio is significantly smaller than the implied ROE under the risk-weighted capital requirement and often does not meet the 12 percent ROE targets that most large financial institutions target. Thus, in the post-SLR regulatory regime, institutions must either accept lower ROE when participating in basis trades or not participate until the absolute level of the trade reaches unusually high levels.
And so the trades just happen less—because banks do less of them, and because hedge funds that rely on big-bank funding also do less of them—and the expected relationships break down more than they used to.
Am I supposed to Have an Opinion About Whether This Is Good? I don’t know. The tradeoffs, broadly speaking, seem straightforward and obvious. The system is less finely tuned, but it is also less tightly wound; the banks are safer but also less useful; the markets are less perfect but also less fragile. There are occasionally efforts to measure those tradeoffs—more in lending than in, like, covered-interest-parity arbitrage—but they are hard to commensurate. If the system is less efficient, then a lot of hedge funds will grumble about the breakdown in covered-interest parity every day, but no one outside of the financial world will care, or even understand what it is they are complaining about. If the system is more finely balanced and fragile, then all of its power users will be a bit less grumbly every day, until one day it all goes wrong and everyone notices.
Yesterday the Securities and Exchange Commission and the Justice Department brought insider-trading charges against a Standard & Poor’s analyst and two of his friends, a hairstylist and a jeweler, who allegedly traded on inside information about a merger that he got from his work. Don’t do that. The jeweler friend opened his first brokerage account just after allegedly being tipped about the merger, and while I am not going to give that a formal Law of Insider trading, it does seem like a bad idea. Maybe mix your insider trading in with some regular trading, you know?
The other friend is a “hair stylist to the stars,” which led me briefly to hope that (1) the S&P analyst had told him about the merger during a haircut and that (2) the analyst’s lawyers would argue that he told him subject to the hairstylist’s duty of confidentiality, and that if the hairstylist then traded then the analyst was not to blame. (We have talked before about other duties of trust and confidence in insider trading law, like the one owed by prostitutes to their clients, or the one owed by golf buddies to each other, so, you know, why not hairstylist confidentiality?) But no, it was outside of the sanctity of the hairstylist/hairstylee relationship; he allegedly just texted him about the merger.
As always in insider trading cases, the obvious question is whether the analyst got a “personal benefit” from tipping his friends. The SEC is vague about this, saying only that “Pinto-Thomaz received a personal benefit from his tips of material nonpublic information to his friends Oujaddou and Millul, including but not limited to the benefit of providing gifts of the information to two close personal friends,” which I guess is probably a sufficient personal benefit under current law. (If they were close enough friends. If they were just his hairstylist and his jeweler, I dunno.) The criminal prosecutors have more to say, insinuating that the jeweler handed the analyst $3,500 in cash for his troubles.
Elsewhere in personal benefits, remember Mathew Martoma? He was the analyst at SAC Capital who paid a doctor $1,000 per hour to tell him secret information about a company’s drug trials, and he was convicted of insider trading, and then last year the U.S. Court of Appeals for the Second Circuit upheld his conviction in a long strange opinion saying essentially that it is no longer really the law that a tipper needs to receive a personal benefit for his tips in order for him (and his tippee) to be guilty of insider trading. This was a strange opinion because it was so unnecessary: Martoma’s doctor had very very very obviously received a personal benefit in the form of getting paid a thousand dollars per hour for talking to Martoma, so there was no particular need for the court to say that actually personal benefits don’t matter, and that tipping someone in the expectation that they’ll trade is enough for insider-trading liability.
This week the Second Circuit issued an amended opinion saying, never mind. (Here is an insider trading blog with more on the new Martoma decision.) The first opinion had said that the Supreme Court’s Salman decision “abrogated Newman’s ‘meaningfully close personal relationship’ requirement”—the Second Circuit rule saying that just giving a gift of inside information only counts as a crime if the gift is to a family member or close friend—and made everything insider trading. The new one says:
The government now takes the position that Salman fully abrogated Newman’s interpretation of the personal benefit element, whereas Martoma argues that Newman’s “meaningfully close personal relationship” standard survived Salman. However, because there are many ways to establish a personal benefit, we conclude that we need not decide whether Newman’s gloss on the gift theory is inconsistent with Salman. At trial, the government presented compelling evidence that Dr. Gilman received a different type of personal benefit: $70,000 in consulting fees, which can be seen either as evidence of a quid pro quo‐like relationship, or simply advance payments for the tips of inside information that Dr. Gilman went on to supply.
That is obviously correct and it’s strange that they’re only getting to it now. One possible explanation is that the Second Circuit’s decision was 2-1, and that there was some likelihood of it being reversed by the full Second Circuit, some of which remains attached to the personal benefit test; narrowing the opinion to just say “come on he paid the guy” avoids that problem. When the first Martoma decision came out last year, I wrote about it under the headline “ Everything Is Insider Trading Again.” Now that it’s been narrowed, maybe some things aren’t.
People are worried about Velocity Per Customer.
These do not sound like standard metrics under U.S. generally accepted accounting principles:
“National Beverage employs methods that no other company does in this area – VPO (velocity per outlet) and VPC (velocity per capita)… Unique to National Beverage is creating velocity per capita through proven velocity predictors. Retailers are amazed by these methods.”
The following day, a release described a VPO calculator “flashing solid green numbers as we bring FY2017 to close.”
That is from a Wall Street Journal story about two press releases issued by National Beverage Corp., which makes LaCroix seltzer, and about the Securities and Exchange’s inquiry into those metrics. “We note your press release filed with the Form 8-K on May 5, 2017 and the references to velocity per outlet VPO and velocity per capita VPC,” said the SEC. “To the extent that VPO and VPC are key performance indicators used in managing your business, please include a discussion of these measures along with comparative period amounts or explain why you do not believe this disclosure is necessary.” National Beverage replied that “this statement characterizes the entrepreneurial spirit of National Beverage and its Chairman,” and that “This information is as secretive as the formulas of our beverages and should not be disclosed to our competition.”
The SEC insisted: “Please provide an expanded response that explains VPO and VPC metrics and reconciles the statement that VPO and VPC are not utilized to manage your business and are not key performance indicators.” And so National Beverage explained, a little, what it was talking about:
VPO (Velocity per Outlet) is calculated by dividing the number of units sold by a given customer during a specified time period by the number of outlets stocking the product. VPC (Velocity per Capita) is calculated by dividing the number of units sold in a given geographic area by the population of the area.
That doesn’t sound all that proprietary, or secretive, or amazing? Doesn’t “velocity” here just mean, um, “sales”? Also I cannot tell you how tired it has made me just to cut and paste that text. The SEC was apparently similarly exhausted after reading it, because it let it go at that, without insisting that National Beverage disclose comparable-period Velocity Per Whatever. The lessons might be that, if you want to impress investors with non-GAAP operating results, you should give them funny names, and if the SEC inquires about them, you should wave your arms and shout a lot until they get tired and go away.
I don’t know much about art, but I steal what I like.
The headline of this Bloomberg article is “The Pros and Cons of Stealing Fine Art,” and the main pro is that if you steal fine art then you will have stolen fine art, which, being fine, is nice to look at. Also being an art thief is cool. Those are literally the pros:
“We’re very bad at catching art thieves,” says Charney. “We have a very low recovery and prosecution rate: Something like 1.5 percent of cases of art theft see the art recovered and the criminal prosecuted.”
So, should a thief have a buyer waiting in the wings, or simply want a painting or art object for himself, there’s a very good chance he’ll get away with it. Add to that the cachet of being an art thief (“Art’s always been associated with the social elite, so it’s an aspirational thing” to take, Charney explains), and stealing art seems like a pretty good deal.
The cons are that it’s hard to find a buyer, and that if you do find a buyer he’s probably a cop. But if you just want to look at your stolen art and purr contentedly about how cool it is to be an art thief, these are not actual problems for you, and I am off to steal some Morandis.
Elsewhere at Bloomberg: “If You Steal It, the Art Vigilante Will Find You,” so that’s confusing.
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