Financial Blog Watch: Don't Believe Everything You Read

One of the mantras my supervisors taught me on the trading desk was not to make other people smarter - if you hear someone say something that you know to be incorrect, assuming they don't work for your firm, you let them go on with their misconceptions. Knowledge is money.

I always had a slight problem with this, since I hate rampant stupidity, and now, since I'm no longer trying to profit off the ignorance of others, I am eager to shed some light on some misconceptions that are spreading amongst some blogs that I read daily, enjoy immensely, and find tremendously valuable.

Tyler Durden at ZeroHedge has quickly made a name for himself as an intelligent and detailed blogger in the financial realm. TD's deep investigative insights and tireless work ethic have earned him a rabid following for his blog, where he posts detailed, insightful posts several times a day. However, it's clear to me that TD is a fixed income guy at heart, and that his equity observations are frequently based on conspiracy theories or erroneous conclusions.

What's dangerous is that in this day and age people seem to believe everything they read on the internet. Financial bloggers have done a MASSIVE service in educating the public (or those who want to be educated at least) but that doesn't mean that everything that is written is the truth. Even more dangerous is when one blogger writes something erroneous, and others pick up on it - spreading the errors amongst their own rabid blog readership.

So, Tyler Durden at Zero Hedge has been on Goldman Sachs's (GS) case for a while about their massive increase in principal program trading volume. The numbers are published publicly by the NYSE, based on a report the broker dealers file nightly called the DPTR (daily program trading report). Principal trading volume is volume that the firm trades for its own account. TD's thesis is that Goldman Sachs is manipulating the market via fancy computer trading models, and ripping off the public. Now, interestingly, Tyler's posts gained so much traction that Goldman Sachs actually replied to them, explaining that the increase in volume was the result of GS participating in a new NYSE program called the SLP - supplemental liquidity program - where Goldman provides liquidity by posting bids and offers on the NYSE, and is compensated by the NYSE by receiving a tiny "rebate" whenever a counterparty accesses their quote.

To simplify, Goldman Sachs narrows the bid-ask spread by posting inside quotes, and they get paid a fraction of a penny if someone trades against their market. There is a temptation by the uninformed to conclude that sophisticated computers are controlling the market and ruining the world, but the truth is almost certainly that most investors are benefited by this added liquidity, as it lowers their cost of execution (in the form of a narrower bid-ask spread).

But that's not even what I wanted to write about!

Friday, Tyler Durden included the following quote in his post about this week's NYSE Program Trading numbers:

Zero Hedge is compiling materials to demonstrate the phenomenal gamble CS is taking by being the largest holder of the ETF-underlying pair trade. The ensuing implosion, once the market loses the invisible futures bid, will likely destroy Switzerland's second biggest bank and likely take down the country with it.

Probably most notable is the screaming increase in overall program trading, from 30.7% of all NYSE volume to 40.4%! Virtually every broker saw their Principal PT operations double week over week: seems like everyone is brokering those ETF trades now. Poor SPY and IWM are being mangled 10 ways from Sunday nowadays.

Never mind the massive increase in the weekly principal transaction numbers - it's due to June's quarterly expiration, where brokers trade massive baskets of stock against expiring futures and options. I can tell you already that next week's program trading statistics will show a large increase in the "customer facilitation" numbers, because that's how the trades for Friday's annual rebalancing of the Russell indices will be coded. What I want to talk about is the misunderstanding about the "ETF-underlying pair trade." First, let me take a quick tangent.

Another blogger who I enjoy for his relentless attempt to try to expose the wrongdoings of the authorities is Karl Denninger. Denninger had some additional insights related to my recent post on AIG dumping its assets on the Fed, pointing out that the Fed's actions here are outright illegal. However, Denninger also jumped all over the ZeroHedge quote about the ETF-underlying trade and its relationship to increased program trading volume:

"For those who aren't savvy in this stuff what's going on here is a pair trade between the underlying instrument(s) and the ETFs on the exchanges. This is an arb play and it works until it doesn't - for an example of "doesn't" in the single-name world witness what happened to VW/Porsche earlier this year when the arb speculators on their merger got rammed, or those hedgies who were playing the Citibank preferred-conversion arb earlier this year.

These are allegedly "hedged" transactions in that there is an alleged unbreakable correlation that protects the person doing it from loss.

In truth there is no such thing as an unbreakable correlation and the alleged "protection" against getting reamed is illusory. This is the same sort of "genius trade" that was run with AIG's CDS positions - remember the claim that "we're unlikely to ever see a loss"?

So, now it's time for a lesson about arbitrage. There are many types of arbitrage. The simplest, which I still remember reading about in the famous "Gold Book" that UBS Warburg provided all of its new employees back in the 1990's as an introduction to options and markets theory, was "if you can buy gold for $400/oz in New York, and sell it for $450/oz in London, that's called an "arbitrage." This is a pure arbitrage. You buy gold for $400 and sell it for $450. You profit $50, minus the cost of transporting the gold.

Another type of arbitrage is merger arbitrage: Let's say company ABC is buying company XYZ, and that ABC is offering shareholders of XYZ 1 share of ABC stock for each share of XYZ they currently own. The prices of the two stocks should converge as the deal nears completion. There will be a spread between the two stock prices, depending on the risk of the deal (and some other factors like the dividends that will be paid out until the deal closes, and some financing costs). Merger arbitrage has risk - the deal might fall apart - if you buy XYZ shares and short ABC shares at a higher price, you are very much NOT guaranteed to capture that spread. The Citi vs Citi Preferred trade that Denninger mentioned falls into this category - the traders got hurt because the spread widened, but if the conversion actually goes through, they will recapture the spread they have lost (although there are still issues with this trade due to the high costs associated with borrowing C stock to short it for a longer period of time than initially expected.)

Then there are convergence trades like the ones Long Term Capital Management made famous, based upon traditional trading relationships between two assets. LTCM would buy the "cheap" asset and sell the "expensive" asset and expect the two to converge. Clearly, there is no assurance that the prices will converge here - and when you add massive leverage to the mix like LTCM did, small adverse price movements can have disastrous consequences. The Porsche-VW (POAHF.PK)-(VLKAY.PK) stub trade which Denninger mentioned is most related to this class of convergence trades.

We also have share class trades - for stocks like Berkshire Hathaway, which have two classes of shares: BRK/A (BRK.A) and BRK/B (BRK.B). In Berkshire, the B shares are supposed to trade, I think, at 1/30th the price of the A shares - but there is no mechanism for which you are entitled to exchange shares between the two share classes. Thus, if you put on a trade seeking to profit from the disparity in value between the A and B shares, you have to wait and hope the prices converge so you can reap your profit.

This brings us to the ETF-Underlying pairs trade. Now, forgive me if I'm putting words in Tyler Durden's or Karl Denninger's mouths, but it seems that they are referring to the trade where a broker, say Credit Suisse (CS), buys an ETF (like the iShares Russell 2000 Index ETF (IWM)) and shorts the underlying basket of stocks against it. The IWM is composed of the 2000 stocks in the Russell 2000 index, and the trust that issues the IWM owns these underlying stocks against the IWM shares it has issued. Lately, CS has shown up as a large holder of IWM and SPY, as well as some other ETFs.

Friday, both ZeroHedge, and, jumping on the bandwagon, Karl Denninger, decried this as a portent of doom - a potentially lethal arbitrage that could blow up in CS's face. There's only one problem - if CS is buying the ETFs and shorting the underlying baskets of stocks, as expected, there is no risk. This trade is not like the trades I mentioned above for one specific reason - ETFs can be created and redeemed daily: If you own a chunk of IWM (the minimum unit is 50k shares) you can take your IWM shares and deliver them in to the trust (aka: redeem) in exchange for the corresponding number of shares in each of the 2000 underlying stocks (which you then use to cover your short positions). Similarly, if you are long the underlying components, you can deliver them in to the trust (aka create) and they will give you IWMs. It's precisely this fungibility that completely nullifies TD's and Denninger's fears. It's a very simple concept, and it's not at all like the convergence trades above, where you cannot control the collapsing of the two legs of the trade.

Denninger isolates all of the comments on his posts in his forums, and regarding this topic, he elaborated:

Let's say that there's a "divergence" of a nickel between the two instruments. You short one and buy the other, allegedly pocketing the nickel. The theory is that the correlation will remove the spread, at which point you close both positions.

Again - with ETFs you can create and redeem at will - so you don't have to rely on any "theory" or "correlation." You can make it happen yourself.

I'm somewhat surprised that two bloggers as intelligent as Tyler Durden and Karl Denninger erred in their assault on this concept, but I was even more troubled by the comments in each of their respective posts, which show that the misinformation spreads rapidly, as their readership takes what they write as truth. In the ZeroHedge post, I offered a possible explanation of why CS has these trades on:

CS probably has some sort of funding efficiency where they lend out the long ETF and charge a borrow rate that exceeds their cost of capital (courtesy of near zero short term rates from the Fed)... if this funding efficiency goes away they just redeem the ETF to cover their short stock position.

Financial blogging has been a great breakthrough in the last several years, with a plethora of blogs offering an educated, insightful look at issues that the mainstream media could never understand. Many bloggers are actually former professionals in the topics that they blog about, which gives them unique insight into topics that journalists could not attain. Still, the flaw of the internet is that it spreads all information equally, and as a reader it's up to you to verify the thought processes and make sure you understand them before you take them as fact.

Note: I have never worked at GS or CS. I have no incentive to defend GS - I don't particularly like the "walk on water" status they have attained. Also, I do not intend for this post to be an assault on TD or Denninger - I think they both write excellent blogs, they are just wrong on this topic.

Comments

[Clive Corcoran:]

Your excursion through the various kinds of arbitrage is interesting but fails to emphasize how vital underlying market liquidity is to any form of trading with two legs to it. LTCM had theoretically miniscule risk from holding matched and offsetting legs of different trades but when push came to shove in August 1998 and markets were freaked out over Russian debt repudiation and it came time for LTCM to exit one or either of the legs there were no bids. . To paraphrase a remark which I believe is in Lowenstein' excellent book on the subject - they sold what they could and not what they wanted to.

Similar problems brought down Lehman and AIG

This is why I think you underestimate the gravity of the situation that people like Tyler Durden are describing. The likelihood of incurring losses in high frequency arbitrage are very small until they're massive i.e. in a systemic collapse of market liquidity.
Of course as we now know the various government liquidity programs will probably come to the rescue of a GS or UBS if they're left holding the baby the next time the music stops.

And those rescue plans will work until they don't.

Jun 28 05:29 AM

[Kid Dynamite:]

No Clive - the entire point of this post is that your argument does not apply to the ETF-Underlying arbitrage. There is zero liquidity risk because you don't have to hold the position - you can create the conversion event yourself by redeeming your SPY or IWM into the trust and receiving the underlying shares. You can close out your position at will. It's NOT the same as LTCM - that's the point.

don't confuse high frequency stat arb (which is again still different from GS's participation in the NYSE's SLP) with ETF-Underlying trades. They are not at all the same.


On Jun 28 05:29 AM Clive Corcoran wrote:

> Your excursion through the various kinds of arbitrage is interesting
> but fails to emphasize how vital underlying market liquidity is to
> any form of trading with two legs to it. LTCM had theoretically
> miniscule risk from holding matched and offsetting legs of different
> trades but when push came to shove in August 1998 and markets were
> freaked out over Russian debt repudiation and it came time for LTCM
> to exit one or either of the legs there were no bids. . To paraphrase
> a remark which I believe is in Lowenstein' excellent book on the
> subject - they sold what they could and not what they wanted to.
>
>
> Similar problems brought down Lehman and AIG
>
> This is why I think you underestimate the gravity of the situation
> that people like Tyler Durden are describing. The likelihood of
> incurring losses in high frequency arbitrage are very small until
> they're massive i.e. in a systemic collapse of market liquidity.
>
> Of course as we now know the various government liquidity programs
> will probably come to the rescue of a GS or UBS if they're left holding
> the baby the next time the music stops.
>
> And those rescue plans will work until they don't.

Jun 28 09:59 AM

[TexasBill:]

Fascinating article. I follow Tyler, among others, with the goal of trying to figure out why things happen in the markets the way they do.

I seek divergent views because for every buyer there is a seller. They both see the same set of data yet they both think they are doing the right thing at that time. I think it's useful to understand both sides of a trade because I believe that in many cases the "truth" lies somewhere in the middle.

Therefore, I appreciate the opportunity to read Kid's critique of Tyler's post (and the cogent discussion of arb strategies and their risks). And I applaud the fact that Kid was able to disagree with Tyler's post without malice. It sure would be nice to see more of this kind of rational discussion at Seeking Alpha.

Jun 28 10:54 AM

[mahoney:]

Excellent discussion of arbitrage, and a welcome critique of the critiques. Surely TD and Denninger will be the first to admit if/when they are wrong, or else logically demonstrate why they are not.

As for the ETF-underlying arbitrage, it seems you are right: as long as the two assets are fungible by virtue of the instruments themselves, then the arbitrage risk is independent of their market valuations.

I don't find the ETF "funding efficiency" theory particularly clear, however. But I'm just learning here. :-)

Jun 28 11:50 AM

[Snitzer:]

Wow! Unlike a few months ago, I can almost follow the exotic twists and turns of this debate. Maybe I am learning. In the words of Will Smith: "Definitely some next level stuff going on here".

Jun 28 11:54 AM

[max12345:]

I have a simple question further below. (for whomever might like to take a crack at it)

Basically, I have zero interest in arbitrage, or derivatives, or derivatives of derivatives or in the plethora of "fancy instruments" or fancy gimmicks of either the past, present...and undoubtedly also the future (since innumerable new clever folks will emerge and will be busy creating more and more by the day) and in how they work, or who is doing it, how they are doing it, or even whether it is right or wrong to engage in such practices.

I am happy to just leave that to the government to regulate them or not, promote them or not, or put them behind bars or not. (that's why they have 200 PhDs in Finance at the Federal Reserve) (so that I don't have to bother getting one)

But just as I wouldn't like to play cards when I know the other guy has got a stacked deck I would like to simply be able to invest in a company because I think it's going to be profitable or because I like it...or other such banal and mundane reasons without having to be "outfoxed" by some cleverer-than-thou turkeys out there who are skimming money off the top (or the bottom or the middle) or finding some other devious ways of syphoning off a cut before the rest of us dummies get their share.

So my question to one of those clever folks out there who is much much more familiar with all of the assorted clever wizardry (and the assorted clever sophistry that accompanies it) than I ever can hope to be (or hope not to be) could you please just put an estimate on how much the rest of us common folks are being ripped off by all of the heavy duty gimmickry....(remembering that a rose by any other name would smell as sweet)....or are we as usual "just being helped" by actors who "ultimately help the markets to function better"?

If anyone is in a particularly honest mood and could answer the above meaningfully and truthfully I would appreciate it. (since I can always go and gamble in Las Vegas instead where I already more or less know what cut the house is taking) And if I am dead wrong about all the above suppositions and I am just approaching catatonic paranoia....I don't mind if you tell me that as well.



I am also quite happy to remain mostly blissfully ignorant about such subjects. (since I am also still far too blissfully ignorant about lots of other subjects that are far more important) (and my time on the planet is fast running out)

Jun 28 12:14 PM

[Taxi:]

awesome

Jun 28 02:37 PM

[TradingHelp...:]

"Don't Believe Everything You Read".

You know you are a true conspiracy theorist when you fall upon one of your own old articles by accident and immediately get suspicious that the writer is lying to you for his own dark motives - before you realise it's your own work.

That's when you know you need to lighten up a little.

Jun 28 04:36 PM

[Wisdom vs. ...:]

why are ZH and John Carney each getting attacked from several sides simultaneously? some of the attacks are rabid and absurd like Rorty's attack on Carney and some, like this one, are reasoned, but I see... a conspiracy! just kidding, sort of

Jun 28 07:03 PM

[Prudent Inv...:]

To your well balanced post on financial blogging I want to add just one thing.
Most commercial media do not permit comments on their sites whereas only a few bloggers like CNBC's Larry Kudlow adhere to the same system in order to avoid justified criticism of factual errors or their sometimes very out-of-date views that have not adapted to such facts like the USA having turned from biggest creditor into biggest debtor since Nixon closed the gold window.
Bloggers are well advised to check for factual errors or potentially 6 billion eye pairs will correct them in their comment sections at an instant. I too learn a lot from comments which I keenly read as they assist in steepening my lifelong learning curve.

Jun 28 07:45 PM

[montyman:]

Fungibility? Didn't Alan Greenspan apply that term to the housing market?

Jun 28 07:58 PM

[Kid Dynamite:]

this post is certainly not an attack - it's an attempt to educate. i just can't stand when the readers of a blog with a sizable and dedicated readership jump on the rabid bandwagon of misinformation - as is evidenced by the comments section on TD's post and on Denninger's too.


On Jun 28 07:03 PM Wisdom vs. Information wrote:

> why are ZH and John Carney each getting attacked from several sides
> simultaneously? some of the attacks are rabid and absurd like Rorty's
> attack on Carney and some, like this one, are reasoned, but I see...
> a conspiracy! just kidding, sort of

Jun 28 08:01 PM

[Dave Dorgan:]

Thanks for the good article. When there is this kind of open discussion we all learn.

Jun 28 10:28 PM

[sethmcs:]

Good article. Hummm...buy EFT and short the stocks in the EFT. The EFT must trade at a premium for this trade to work. As with most if not all arb opportunities risk is involved. Risk is defined as the probability of events not being what is expected. Tyler has every right to publicly expose this risk seeing how the Taxpayers will foot the bill if this GS arb activity blows up. Long-Term Capital failure did cause a financial crisis.

Jun 29 12:22 AM

[Kid Dynamite:]

sethmcs: if you're buying the ETF, it would be trading at a discount, not a premium.

there is nothing to blow up. there is absolutely execution risk - during the time the ETF is trading at a discount - when the broker buys the ETF and shorts the underlying it's certainly possible for them to lose money. some times this will happen, but will not " likely destroy Switzerland's second biggest bank and likely take down the country with it" as Tyler wrote in his article.


On Jun 29 12:22 AM sethmcs wrote:

> Good article. Hummm...buy EFT and short the stocks in the EFT.
> The EFT must trade at a premium for this trade to work. As with
> most if not all arb opportunities risk is involved. Risk is defined
> as the probability of events not being what is expected. Tyler has
> every right to publicly expose this risk seeing how the Taxpayers
> will foot the bill if this GS arb activity blows up. Long-Term Capital
> failure did cause a financial crisis.

Jun 29 09:13 AM