Saturday, November 19, 2016

Who gets cycles on the graph?

VoxEU: Recent financial market misconduct in the interbank lending (Libor) and foreign exchange markets – involving misuse of information about clients' orders – has prompted legal action, incurred record fines, compromised reputations, and prompted international initiatives to curb information sharing. In US Treasury auctions, where trillions of dollars are sold each year largely to, or through, a small set of primary dealers, the use of information has similarly come under increased scrutiny (Bloomberg 2015).  While it may all sound straightforward, it is in fact not obvious who is harmed when information is shared.
Regulatory initiatives to curb information sharing in Treasury and other markets attempt to protect clients from harm, but we find that information sharing among dealers creates value for investors and improves risk-sharing. Investors are harmed from information sharing not when dealers exchange information with other dealers, as one may suspect, but when dealers share information with other investors. For the Treasury, information sharing can boost auction revenues, an effect that we estimate in the order of about $4.8 billion per year. This increased revenues come at a cost of increased revenue volatility and risk of a failed auction, which is when revenues fall well below expectations. 
This is the continuing theme started by Matt Levine, and goes back decades.  The regulators have been outdone by technology, the trading pits are starting to show up, and they sell cycles on the graph to anyone.

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