Thursday, 25 July 2013

Welby and Wonga; Why APR is a meaningless number for small short term loans.

APR; Annual Percentage Rate. In theory, a useful measure to compare the cost of a loan. In practice almost meaningless.

What is a reasonable cost for a short term loan? 
Ignoring the term (length) of the borrowing, for a company to lend money it incurs administrative costs, such as transferring money, keeping records, performing a credit check, chasing up payments, running the website, etc.

This is before considering the cost of capital (ie how much money costs Wonga to borrow) or the likelihood of borrower default (ie the chance that a borrower will not repay the loan).

If one goes to Wonga's website, and looks at the cost of  borrowing just £1 for 1 day, the fees and interest are £5.57.

Now if you were a moron you would conclude that this was an outrage because the APR is;


OR you would wake up and realize that it is an utterly stupid measure.

There is an absolute cost of lending money and performing transactions that has no relation to the size of the loan, is £5 for a loan really outrageous?

Welby would perhaps say that a credit card APR is more "fair", that would mean that the cost of borrowing £1 overnight would be 0.05p ie less than one twentyth of a penny. Nobody in their right mind could think that you could make a loan and record a transaction, check a credit score and transfer money for that price.

I could go into more detail, obviously Wonga lend to people with poor credit quality, that means they are exposed to high number of people that will default on their loan, and as such they need to charge more to just breakeven. Even if 5% of customers failed to repay a one week loan, that would necessitate an APR of over 1000%, before you consider any administration costs, or heaven forbid the cost of capital or the firm's profit.

I hope that people will stop being "outraged" by numbers that are meaningless and inappropriate.

Wednesday, 24 July 2013

"Layering", Spoofing, Spiving & "false" market orders

The FCA recently fined a trader for "layering" ; fca pdf link

Details are incredibly important when discussing the mechanisms of trading.

A brief synopsis of Mr Coscia's strategy; to buy a contract, he'd place a small bid at the best bid, and simultaneous a larger sell order above the best offer, then he'd place further sell orders in the order book above the best offer, when he got filled on the bid he'd pull his sell orders.

In essence the charge is that he is manipulating the order book and giving a false impression of the "real" demand and supply.

As Mr Coscia’s large orders were so unlikely to be executed (due to their short 
resting time on the order book and inevitable cancellation once the small order 
was executed or they were partially executed) they created false impressions of 
liquidity rather than genuine market supply and demand.

The market participants who were most likely to trade with Mr Coscia and be 
impacted by his trading strategy were HFT market participants or traders using 
algorithmic and/ or automated systems rather than manual traders.

At least one significant market participant withdrew from ICE during the Relevant 
Period directly as a result of Mr Coscia’s trading pattern which reduced liquidity 
for other market participants as well as resulting in the loss of trading 

 I have a serious problem with this sort of charge. An order is an order, you have no obligation to leave it in the market for a certain length of time. The reason that other market participants like resting orders is because they provide the opportunity for profit for other traders.

For example a large and stationary bid is a great opportunity for "pennying", resting or leaning on. say a trader put in an order to pay 51.50 for 3000, and the order book is 3000 x 51.50 / 51.60 x 100. This allows other traders to bid 51.51, when they get filled they have almost a guaranteed stop loss of 0.01 and can offer out the stock they've picked up at 51.60, ie to make 9c profit only risking 1c.

The other way to see the cost of this latency, is to imagine that you had to leave your order for a long period of time, you'd suffer from a serious amount of adverse selection.

Anyone placing an order whether they "want" it to be filled or not, is taking risk. It makes no difference whether you trade with a "spoof" order or a "real" order the transaction is the same.

Market participants that are trading on the information in the order book are not liquidity providing. If when you see a large sell order you are "spoofed" into selling on the bid, then you are taking liquidity out of the market, I don't think Warren Buffett is there smashing the bid in KO every time he sees a thousand lot offered up two ticks above the best offer. If anything spoof orders can only help long term investors and retail traders as they provide cover for their resting orders and provide additional bid and offers that they may agress against.