Direct listing

So it seems like Swedish music streaming company Spotify is going to do a “direct listing” on the markets. Here is Felix Salmon on why that’s a good move for the company. And in this newsletter, Matt Levine (a former Equity Capital Markets banker) talks about why it’s not.

In a traditional IPO, a company raises money from the “public” in exchange for fresh shares. A few existing shareholders usually cash out at the time of the IPO (offering their shares in addition to the new ones that the company is issuing), but IPOs are primarily a capital raising exercise for the company.

Now, pricing an IPO is tricky business since the company hasn’t been traded yet, and so a company has to enlist investment bankers who, using their experience and investor relations, will “price” the IPO and take care of distributing the fresh stock to new investors. Bankers also typically “underwrite” the IPO, by guaranteeing to buy at the IPO price in case investor demand is low (this almost never happens – pricing is done keeping in mind what investors are willing to pay). I’ve written several posts on this blog on IPO pricing, and here’s the latest (with links to all previous posts on the topic).

In a “direct listing”, no new shares of the company are issued, the stock gets listed on an exchange. It is up to existing shareholders (including employees) to sell stock in order to create action on the exchange. In that sense, it is not a capital raising exercise, but more of an opportunity for shareholders to cash out.

The problem with direct listing is that it can take a while for the market to price the company. When there is an IPO, and shares are allotted to investors, a large number of these allottees want to trade the stock on the day it is listed, and that creates activity in the stock, and an opportunity for the market to express its opinion on the value of the company.

In case of a direct listing, since it’s only a bunch of insiders who have stock to sell, trading volumes in the first few days might be low, and it takes time for the real value to get discovered. There is also a chance that the stock might be highly volatile until this price is discovered (all an IPO does is to compress this time rather significantly).

One reason why Spotify is doing a direct listing is because it doesn’t need new capital – only an avenue to let existing shareholders cash out. The other reason is that the company recently raised capital, and there appears to be a consensus that the valuation at which it was raised – $13 billion – is fair.

Since the company raised capital only recently, the price at which this round of capital was raised will be anchored in the minds of investors, both existing and prospective. Existing shareholders will expect to cash out their shares at a price that leads to this valuation, and new investors will use this valuation as an anchor to place their initial bids. As a result, it is unlikely that the volatility in the stock in initial days of trading will be as high as analysts expect.

In one sense, by announcing it will go public soon after raising its last round of private investment, what Spotify has done is to decouple its capital raising process from the going public process, but keeping them close enough that the price anchor effects are not lost. If things go well (stock volatility is low in initial days), the company might just be setting a trend!

People are worried about investment banker liquidity 

This was told to me by an investment banker I met a few days back, who obviously doesn’t want to be named. But like Matt Levine writes about people being worried about bond market liquidity, there is also a similar worry about the liquidity of the market for investment bankers as well. 

And once again it has to do with regulations introduced in the aftermath of the 2008 global financial crisis. It has to do with the European requirement that bankers’ bonuses are not all paid immediately, and that they be deferred and amortised over a few years. 

While good in spirit what the regulation has led to is that bankers don’t look to move banks any more. This is because each successful (and thus well paid) banker has a stock of deferred compensation that will be lost in case of a job change. 

This means that any bank looking to hire one such banker will have to compensate for all the deferred compensation in terms of a really fat joining bonus. And banks are seldom willing to pay such a high price. 

And so the rather vibrant and liquid market for investment bankers in Europe has suddenly gone quiet. Interbank moves are few and far in between – with the deferred compensation meaning that banks look to hire internally instead. 

And lesser bankers moving out has had an effect on the number of openings for banker jobs. Which has led to even fewer bankers looking to move. Basically it’s a vicious cycle of falling liquidity! 

Which is not good news for someone like me who’s just moved into London and looking for a banking job!

PS: speaking of liquidity I have a book on market design and liquidity coming out next month or next next month. It’s in the publication process right now. More on that soon! 

May a thousand market structures bloom

In my commentary on SEBI’s proposal to change the regulations of Indian securities markets in order to allow new kinds of market structures, I had mentioned that SEBI should simply enable exchanges to apply whatever market structures they wanted to apply, and let market participants sort out, through competition and pricing, what makes most sense for them.

This way, different stock exchanges in India can pick and choose their favoured form of regulation, and the market (and market participants) can decide which form of regulation they prefer. So you might have the Bombay Stock Exchange (BSE) going with order randomisation, while the National Stock Exchange (NSE) might use batch auctions. And individual participants might migrate to the platform of their choice.

Now, Matt Levine, who has been commenting on market structures for a long time now, makes a similar case in his essay on the Chicago Stock Exchange’s newly introduced “speed bump”:

A thousand — or at least a dozen — market structures can bloom, each subtly optimized for a different type of trader. It’s an innovative and competitive market, in which each exchange can figure out what sorts of traders it wants to favor, and then optimize its speed bumps to cater to those traders.

Maybe I should now accuse Levine of “borrowing” my ideas without credit! 😛

 

Regulating HFT in India

The Securities and Exchange Board of India (SEBI) has set a cat among the HFT (High Frequency Trading) pigeons by proposing seven measures to curb the impact of HFT and improve “real liquidity” in the stock markets.

The big problem with HFT is that algorithms tend to cancel lots of orders – there might be a signal to place an order, and even before the market has digested that order, the order might get cancelled. This results in an illusion of liquidity, while the constant placing and removal of liquidity fucks with the minds of the other algorithms and market participants.

There has been a fair amount of research worldwide, and SEBI seems to have drawn from all of them to propose as many as seven measures – a minimum resting time between HFT orders, matching orders through frequent batch auctions rather than through the order book, introducing random delays (IEX style) for orders, randomising the order queue periodically, capping order-to-trade ratio, creating separate queues for orders from co-located servers (used by HFT algorithms) and review provision of the tick-by-tick data feed.

While the proposal seems sound and well researched (in fact, too well researched, picking up just about any proposal to regulate stock markets), the problem is that there are so many proposals, which are all pairwise mutually incompatible.

As the inimitable Matt Levine commented,

If you run batch auctions and introduce random delays and reshuffle the queue constantly, you are basically replacing your matching engine with a randomizer. You might as well just hold a lottery for who gets which stocks, instead of a market.

My opinion this is that SEBI shouldn’t mandate how each exchange should match its orders. Instead, SEBI should simply enable individual exchanges to regulate the markets in a way they see fit. So in my opinion, it is possible that all the above proposals go through (though I’m personally uncomfortable with some of them such as queue randomisation), but rather than mandating exchanges pick all of them, SEBI simply allows them to use zero or more of them.

This way, different stock exchanges in India can pick and choose their favoured form of regulation, and the market (and market participants) can decide which form of regulation they prefer. So you might have the Bombay Stock Exchange (BSE) going with order randomisation, while the National Stock Exchange (NSE) might use batch auctions. And individual participants might migrate to the platform of their choice.

The problem with this, of course, is that there are only two stock exchanges of note in India, and it is unclear if the depth in the Indian equities market will permit too many more. This might lead to limited competition between bad methods (the worst case scenario), leading to horrible market inefficiencies and the scaremongers’ pet threat of trading shifting to exchanges in Singapore or Dubai actually coming true!

The other problem with different exchanges having different mechanisms is that large institutions and banks might find it difficult to build systems that can trade accurately on all exchanges, and arbitrage opportunities across exchanges might exist for longer than they do now, leading to market inefficiency.

Then again, it’s interesting to see how a “let exchanges do what they want” approach might work. In the United States, there is a new exchange called the Intercontinental Exchange (IEX) that places “speed bumps” over incoming orders, thus reducing the advantage of HFTs. IEX started only recently, after major objections from incumbents who alleged they were making markets less fair.

With IEX having started, however, other exchanges are responding in their own ways to make the markets “fairer” to investors. NASDAQ, which had vehemently opposed IEX’s application, has now filed a proposal to reward orders by investors who wait for at least once second before cancelling them.

Surely, large institutions won’t like it if this proposal goes through, but this gives you a flavour of what competition can do! We’ll have to wait and see what SEBI does now.

Liquidity and the Trump Trade

The United States Treasury department has floated a new idea to improve liquidity in the market for treasury bonds, which has been a concern ever since the Volcker Rule came into place.

The basic problem with liquidity in the bond market is that there are a large number of similar instruments trading, which leads to a fragmented market. This is a consequence of the issuer (the US Treasury in this case) issuing a new bond every time they wish to borrow more money, and with durations being long, many bonds are in the market at the same time.

The proposed solution, which commentators have dubbed the “Trump Trade” (thanks to the Republican Presidential candidate’s penchant for restructuring debt of his companies), involves the treasury buying back bonds before they have run their full course. These bonds bought back will be paid for by newly issued 10-year bonds.

The idea here is that periodic retirement of old illiquid bonds and their replacement by a new “consolidated” bond can help aggregate the market and boost liquidity. This is not all. As the FT ($) reports,

The US Treasury would then buy older, less liquid and therefore cheaper debt across the market, which could in theory then be reissued at a lower yield. In recent months, yields on older issues have risen more than those for recently sold debt, suggesting a deterioration in liquidity.

This implies that because these “off the run” treasuries are less liquid, they are necessarily cheaper, and this “Trump Trade” is thus a win. This, however, is not necessarily the case. Illiquidity need not always imply lower price – it is more likely that it leads to wider spreads.

Trading an illiquid instrument implies that you need to pay a higher transaction cost. The “illiquidity discount” that many bonds see is because people are loathe to holding them (given the transaction cost), and thus less people are willing to buy them.

When the treasury wants to buy back such instruments, however, it is suddenly a seller’s market – since a large number of bonds need to be bought back to take it off the market, sellers can command a higher spread over the “mid price”.

Matt Levine of Bloomberg View has a nice take on the “IPO pop” which I’ve written about on this blog several times (here, here, here and here). He sees it as the “market impact cost” of trying to sell a large number of securities on the market at a particular instant.

Instead the typical trade of selling, say, $1 million of a bond with $1 billion outstanding, and paying around 0.3 percent ($3,000) for liquidity, you want to sell, say, $1 billion worth of a bond with zero bonds outstanding. That is: You want to issue a brand-new bond, and sell all of it in one day. What sort of bid-ask spread should you pay? First principles would tell you that if selling a few bonds from a large bond issue costs 0.3 percent, then selling 100 or 1,000 times as many bonds — especially brand-new bonds — should cost … I mean, not 100 or maybe even 10 times as much, but more, anyway. No?

Taking an off-the-run bond off the market is reverse of this trade – instead of selling, you are buying a large number of bonds at the same time. And that results in a market impact cost, and you need to pay a significant bid-ask spread. So rather than buying the illiquid bond for cheap, the US Treasury will actually have to pay a premium to retire such bonds.

In other words, the Trump Trade is unlikely to really work out too well – the transaction costs of the scheme are going to defeat it. Instead, I second John Cochrane’s idea of issuing perpetual bonds and then buying them back periodically.

These securities pay $1 coupon forever. Buy these back, not on a regular schedule, but when (!) the day of surpluses comes that the government wants to pay down the debt. Then there is one issue, with market depth in the trillions, and the whole on the run vs. off the run phenomenon disappears.

People don’t worry enough about liquidity when they are trying to solve other liquidity worries, it seems!

 

Investment banks, scientific research and cows

I’ve commented earlier on this blog about how investment banks indirectly fund scientific research – by offering careers to people with PhDs in pure sciences such as maths and physics.

The problem with a large number of disciplines is that the only career opportunity available to someone with a PhD is a career in academia. Given that faculty positions are hard to come by, this can result in a drop in number of people who want to do a PhD in that subject, which has the further effect of diminishing research in that subject.

Investment banks, by hiring people with pure science PhDs, have offered a safety net for people who haven’t been able to get a job in academia, as a consequence of which more people are willing to do PhDs in these subjects. This increases competition and overall improves the quality of research in these topics.

Beef is like investment banks to the dairy industry. I recall an article (can’t recall the source and link to it, though) which talked about V Kurien of Amul going to a meeting called by the Union government on banning cow slaughter. Kurien talked about his mandate from his cooperative being that everything was okay as long as cow slaughter wasn’t banned – for that would kill the dairy industry.

Prima facie (use of latin phrase on this block – check)  this might sound like a far-fetched analogy (research to cows). However, cow slaughter has an important (positive) role to play in encouraging the dairy industry.

When you buy a cow, you aren’t sure how good it is in providing milk, until you’ve put it through a few cycles of childbirth and milking. If after purchase it turns out that the cow is incapable of producing as much milk as you were promised, it turns out to be a dud investment – like getting a PhD in a field with few non-academic opportunities and not being able to get a faculty position.

When cow slaughter is permitted, however, you can at least sell the cow for its meat (when it is still healthy and fat) and hope to recover at least a part of the (rather hefty) investment on it. This provides some kind of a “safety net” for dairy farmers and encourages them to invest in more cows, and that results in increasing milk production and a healthier dairy industry.

This is not all. Legal slaughter means that there is a positive “terminal value” that can be extracted from cows at the end of their milking lives. Money can also be made off the male calves (cruel humans have made the dairy industry one-to-many. Semen from stud bulls is used to impregnate lots of cows, and most bulls never get to fuck) which would otherwise have negative value.

A ban on killing cows implies a removal of these safety nets. Investing in cows becomes a much more risky business. And lesser farmers will invest in that. To the detriment of the dairy industry.

There are already reports that following the ban on cow slaughter in Maharashtra last year, demand for cows is going down as farmers are turning to the more politically pliable buffaloes.

Similarly, with the investment banking industry seeing a downturn and the demand for “quants” going down, it is likely that the quality of input to graduate programs in pure science might go down – though it may be reasonable to expect Silicon Valley to offer a bailout in this case. Cows have no such luck, though.

Matt Levine describes my business idea

When I was leaving the big bank I was working for (I keep forgetting whether this blog is anonymous or not, but considering that I’ve now mentioned it on my LinkedIn profile (and had people congratulate me “on the new job”), I suppose it’s not anonymous any more) in 2011, I didn’t bother looking for a new job.

I was going into business, I declared. The philosophy (that’s a word I’ve learnt to use in this context by talking to Venture Capitalists) was that while Quant in investment banking was already fairly saturated, there was virgin territory in other industries, and I’d use my bank-honed quant skills to improve the level of reasoning in these other industries.

Since then things have more or less gone well. I’ve worked in several sectors, and done a lot of interesting work. While a lot of it has been fairly challenging, very little of it has technically been of a level that would be considered challenging by an investment banking quant. And all this is by design.

I’ve long admired Matt Levine for the way in which he clearly explains fairly complicated finance stuff in his daily newsletter (that you can get delivered to your inbox for free),  and more or less talking about finance in an entertaining model. I’ve sometimes mentioned that I’ve wanted to grow up to be like him, to write like him, to analyse like him and all that.

And I find that in yesterday’s newsletter he clearly encapsulates the idea with which I started off when I quit banking in 2011. He writes:

A good trick is, find an industry where the words “Monte Carlo model” make you sound brilliant and mysterious, then go to town.

This is exactly what I set out to do in 2011, and have continued to do since then. And you’d be amazed to find the number of industries where “Monte Carlo model” makes you sound brilliant and mysterious.

Considering the difficulties I’ve occasionally had in communicating to people what exactly I do, I think I should adopt Levine’s line to describe my work. I clearly can’t go wrong that way.