Streetwise Professor

October 31, 2016

A Brexit Horror Story That Demonstrates the Dangers of Clearing Mandates

Filed under: Clearing,Derivatives,Economics,Regulation — The Professor @ 12:43 pm

When I give my class on the systemic risks of clearing, I usually joke that I should give the lecture by a campfire, with a flashlight held under my chin. It is therefore appropriate that on this Halloween Risk published Peter Madigan’s take on the effects of Brexiton derivatives clearing: it is a horror story.

Since the clearing mandate was a gleam in Barney Frank’s eye (yes, a scary mental image–so it fits in the theme of the post!) I have warned that the most frightening thing about clearing and clearing mandates is that they transform credit risk into liquidity risk, and that liquidity risk is more systemically threatening than credit risk. This view was born of experience, slightly before Halloween in 1987, when I witnessed the near death experience that the CME clearinghouse, BOTCC, and OCC faced on Black Monday and the following Tuesday. The huge variation margin calls put a tremendous strain on liquidity, and operational issues (notably the shutdown of the FedWire) and the reluctance of banks to extend credit to FCMs and customers needing to meet margin calls came perilously close to causing the CCPs to fail.

The exchange CCPs were pipsqueaks by comparison to what we have today. The clearing mandates have supersized the clearing system, and commensurately increased the amount of liquidity needed to meet margin calls. The experience in the aftermath of the surprise Brexit vote illustrates just how dangerous this is.

As a result of Brexit, US Treasuries rallied by 32bp. The accompanying move in swap yields resulted in huge intra-day margin calls by multiple CCPs (LCH, CME, and Eurex). Madigan estimates that these calls totaled $25-$40 billion, and that some individual banks were asked to pony up multiple billions to meet margin calls from multiple CCPs. And to illustrate another thing I’ve been on about for years, they had to come up with the money in 60 minutes: failure to do so would have resulted in default. This provides a harrowing example of how tightly coupled the system is.

Some other crucial details. Much of the additional margin was to top up initial margin, meaning that the cash was sucked into the CCPs and kept there, rather than paid out to the net gainers, where it could have been recirculated. (Not that recirculating it would have been a panacea. Timing differences between flows of VM into and out of CCPs creates a need for liquidity. Moreover, recirculation by extension of credit is often problematic during periods of market stress, as that’s exactly when those who have liquidity are most likely to hoard it.)

Second, each CCP acted independently and called margin to protect its own interests. With multiple CCPs, there is a non-cooperative game between them. Each has an incentive to demand margin to protect itself, and to demand it before other CCPs do. The equilibrium in this game is inefficient because there is an externality between CCPs, and between CCPs and those who must meet the calls. This is ironic, because one of the alleged justifications for clearing mandates was the externalities present in the OTC derivatives markets. This is another example of how problems have been transformed, rather than truly banished.

This also illustrates another danger that I’ve pointed out for some time: building the levies high around CCPs just forces the floodwaters somewhere else.

Although there were some fraught moments for the banks who needed to stump up the cash on June 24, there were no defaults. But consider this. As I point out in the Risk article, Brexit was a known event and a known risk, and the banks had planned for it. Events like the October ’87 Crash or the September ’98 LTCM crisis are bolts from the blue. How will the system endure a surprise shock–especially one that could well be far larger than the Brexit move?

Horror stories are sometimes harmless ways to communicate real risks. Perhaps the Brexit event will be educational. Churchill once said that “Nothing in life is so exhilarating as to be shot at without result.” The market dodged a bullet on June 24. Will market participants, and crucially regulators, take heed of the lessons of Brexit and take measures to ensure that the next time it isn’t a head shot?

I have my doubts. The clearing mandate is a reality, and is almost certain to remain one. The fundamental transformation of clearing (from credit risk to liquidity risk) is an inherent part of the mechanism. It’s effects can be at most ameliorated, and perhaps the Brexit tremor will provide some guidance on how to do that. But I doubt that whatever is done will make the system able to survive The Big One.

October 30, 2016

Hillary’s the One!

Filed under: Politics — The Professor @ 7:01 pm

No. I have not lost my mind and decided to come out in support of Hillary. The reference in the post title is to Richard Nixon’s 1968 campaign slogan, and Hillary epitomizes all of the worst of Nixon’s traits.

Nixon infamously said “if the president does it, it’s not illegal.” Hillary’s version of this is actually more ambitious: by deed, if not word, her credo is: “If Hillary does it, it’s not illegal.” The email saga is just the latest in a series of events going back almost 40 years (to her work on a Watergate committee, ironically) in which Hillary has acted as if the rules do not apply to her. Any rules. Any laws.

The Podesta emails reveal that even many of those around her were shocked and chagrined at her audacity to flouting the law and democratic and republican mores by operating a private server. But there was no adult who was willing to challenge her. Instead, everyone–and this arguably includes Obama, who corresponded (under an alias!) with her on her private email–enabled and excused her lawlessness.

One of Hillary’s rationalizations for her behavior is that everyone is out to get her–her paranoia is another Nixonesque trait. This most recent episode will only deepen that paranoia.

Which means that if Hillary is actually elected next Tuesday, the nation is in for a continuing series of these scandals. As president, her sense of entitlement and superiority to the law and paranoia will only only increase. In her mind, if Hillary does it, it’s not illegal, especially because she does it because otherwise her enemies (who are everywhere!) will destroy her.

Put differently, the woman is constitutionally unfit for any position of public trust, let alone the most powerful office in the land. Because of her constitutional unfitness, she is a walking (well, sometimes) Constitutional crisis.

The truly dispiriting thing about all this is that it is not news. The standard Clinton excuse for everything is “this is old news.” Well, Hillary’s defective character is very, very old news: the country has been on notice since at least 1993, and those paying attention knew about it well before that. Nonetheless, she was elected to the Senate from New York twice; appointed to the most senior cabinet position; nominated to run for president by the oldest political party in America; and is on the cusp of being elected president.

Hillary’s character failings are her responsibility alone. Tens of millions of people are responsible for the fact that she remains a carbuncle on the body politic. The most culpable are the alleged elite in this country, who plague us from their dens in DC, Manhattan, the Hamptons, Boston, and California. They are the main accessories in the degradation of the rule of law that is the result of the relentless rise of this woman who believes herself above the law.

One last thing. My comparison of Hillary to Nixon is terribly unfair to the latter. Hillary has none of the intelligence and strategic insight of Nixon. Hillary has ridden the coattails of her husband, whereas Nixon was as close to a self-made man as there has been in American politics in the 20th century. Most importantly, for all of his ethical and legal lapses, from time to time Nixon betrayed having a conscience: Hillary has exhibited no such weakness. (I think Obama knows this too. When the email scandal broke anew and Obama advised Hillary to “follow her conscience,” I think he was engaged in trolling on an epic scale.)

But this is the woman who, barring a staggering development in the most recent episode of the email saga, is likely to be the next president. God bless America. We’ll need it.

October 29, 2016

James Comey: From Hero to Demon

Filed under: Politics — The Professor @ 9:02 pm

In July, FBI Director James Comey was a hero on the left. He made a contorted presentation of the law and the facts relating Hillary Clinton’s email in order to justify not recommending charging her with any crime. Yes, he said some very critical things about Hillary, but the end result was that she appeared to be out of legal jeopardy.

For her part, Hillary misrepresented what Comey had said, and claimed that he had found nothing discreditable about her conduct. That wasn’t true, but it didn’t really matter. What mattered was that this particular obstacle to her election appeared to have been cleared.

As a result, Comey was lionized on the left, and the Democrats attacked Republicans who criticized him. Donna Brazile, for instance, tweeted  link to a Washington Post article that claimed that Republican criticism of Comey was an attack on the rule of law.

But that was then! Now the left is in paroxysms of rage because yesterday–on a Friday afternoon, natch–Comey sent a letter to Congress claiming that new information found in the–get this–Anthony Weiner investigation had led him to re-open the Hillary investigation. Comey’s letter was equivocal and hedged, but the fact that 11 days before the election the email issue had risen from the dead (just in time for Halloween!) has unleashed leftist furies.

Hillary was informed of this new development while on her plane. She did not leave it for 25 minutes while it sat on the ground in Iowa. Maybe she was doing her best Keith Moon impersonation. You know she’s capable of it.

Yesterday and today the left has been out in full force, demonizing Comey for being a partisan hack attempting to throw the election to Trump. Yesterday I Tweeted in jest “Does the FBI work for the Russians?” because they have become the explanation for all of Hillary’s travails of late. (Joe McCarthy, call your office!) But some people apparently take this seriously. Like Howard Dean, who tweeted “Ironically, James Comey put himself on the same side as Putin.”

The absurdity just keeps on metastasizing.

And just how does this work, exactly? If Comey is a partisan hack intent on torpedoing Clinton and electing Trump, why would he twist himself into knots to exonerate her (well, at least put an end to any thought of charging her) in July? He could have well and truly put her in political peril then. Further, the accommodations he made to Clinton and her close staff were truly extraordinary, and would not have been extended to you or me or pretty much anybody other than Hillary. That’s hardly the kind of thing some partisan Javert would have done. This late in the day modified limited hangout is certainly not a welcome development to Hillary, but is not nearly as threatening as a recommendation to charge would have been in July.

So it is wildly implausible that Comey is attempting to swing the election. Washington being Washington, the most likely explanation for what Comey is doing is CYA. It’s what they do best on the banks of the Potomac.

There was no doubt tremendous discontent in the ranks at the way he handled the Hillary investigation. The (probably unexpected) discovery of information on Anthony Weiner’s and Huma Abedin’s devices would have come out eventually, and if Comey had sat on it until after the election there would have been a political explosion that would have cost him dearly. He also had to calculate that there was a high likelihood that some agent outraged at how the investigation had been handled would leak the new development, which would be the worst of both worlds for him: the information would be out, and it would look like he had tried to suppress it.

So I am guessing that Comey felt himself to be in the position of the weasel in a snare, and chewed off his leg to escape. Yeah, it’s not something he wanted to do, but given the alternatives, it was probably the best course of action available to him.

Just moments ago I read that the FBI did not have permission from Justice to actually read what they had discovered. Given its harrumphing today about how Comey violated department policy by taking actions that could affect an election, no doubt DoJ will not give such permission. And no doubt, Comey knew that they wouldn’t. He could therefore issue his CYA letter in the knowledge that its practical and legal ramifications would be very limited. Justice would stop the investigation dead in its tracks, meaning that no compromising information would be released before the election.

I therefore sadly conclude that this will mean little in the end. The most likely outcome is that Huma Abedin will be sacrificed to save the queen. But the queen will live. And James Comey will limp off into obscurity.


October 27, 2016

Michael Morrel, One of Hillary’s Camp Followers Slouching Towards Washington

Filed under: History,Military,Politics — The Professor @ 8:19 pm

Back in the 1970s there was an entire genre in popular fiction, film, and television in which the CIA was the arch-villain, engaged in vast conspiracies to subvert free government at home or abroad. The stock personal villain in these works was invariably a tightly wrapped, bloodless, controlling, manipulative and often psychopathic CIA official.

At the time, I was not a big fan of these dramas. They were formulaic and seemed overwrought. But I am reconsidering that after the recent rise to public prominence of one Michael Morrel, the ex-deputy director of the CIA. Morrel is straight out of 1970s central casting–tightly wrapped, bloodless, controlling, manipulative and arguably psychopathic.

Morrel is hell-bent on getting the US involved neck-deep into the wars in Syria and Yemen, including doing things that would run the risk of a war with Russia. In August, he advocated killing Russians and Iranians in Syria, “to make them pay a price”:

“The Iranians were making us pay a price. We need to make the Iranians pay a price in Syria. We need to make the Russians pay a price.”

He went on to explain making them “pay the price” would mean killing Russians and Iranians, and said he wants to make Syrian president Bashar al-Assad uncomfortable.

“I want to go after those things that Assad sees as his personal power base. I want to scare Assad.”

This is all but an open call for the US to engage in assassinations of Russians, Iranians, and Syrians in Syria. Perhaps Mr. Morrel missed the part about this being illegal since the 1970s.

Today he advocated intervening on the Saudi side in the war with the Houthis in Yemen, including boarding Iranian vessels. So apparently Mr. Morrel is totally on board with the US being Saudi mercenaries.

This is what America has come to. From fighting against Hessian hirelings to achieve independence, to advocating serving as hirelings for terror funding oil ticks engaged in a pointless war that does not involve American interests in the slightest–and which also risks bringing the US into a broader regional conflict that could easily escalate.

Morrel has also been out front of the attack on Trump’s national security credentials, including making the allegation (based on his ipse dixit alone, of course) that Putin recruited Trump as an “unwitting agent” of Russia.

Just like the stock 70s CIA villain, Morrel obviously burns with ambition. He clearly wants to be Hillary’s CIA director and is willing to say anything to achieve that ambition. Of course, she already owes him, for Morrel was deeply involved in altering the Benghazi talking points in order to support her false version of events.

The thought of someone like Morrel as head of CIA is deeply disturbing. The thought that he likely reflects Hillary Clinton’s foreign policy instincts is doubly so. For getting involved deeply in Syria to overthrow Assad (and confronting the Russians to do so) and in Yemen to advance the Saudi proxy war against Iran are decidedly not in American interests, and would likely result in the waste of great amounts of American blood and treasure, for no strategic purpose whatsoever.

I have long said that you don’t have to worry just about the candidate that is elected to the presidency: you have to pay close attention to her or his camp followers who upon her/his election would be ensconced throughout the vast government bureaucracy, where they can do untold damage with little prospect of being held to account. Michael Morrel epitomizes these dangers. He is a soulless, power-obsessed little man who cavalierly muses about embroiling America in pointless wars, and risking superpower confrontation to do so. He is one of Hillary’s most prominent camp followers. Think of what other ones are currently slouching their way towards Jerusalem on the Potomac in her train.

October 26, 2016

China Has Been Glencore’s Best Friend, But What China Giveth, China Can Taketh Away

Filed under: China,Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 3:55 pm

Back when Glencore was in extremis last year, I noted that although the company could do some things on its own (e.g., sell assets, cut dividends, reduce debt) to address its problems, its fate was largely out of its hands. Further, its fate was contingent on what happened to commodity prices–coal and copper in particular–and those prices would depend first and foremost on China, and hence on Chinese policy and politics.

Those prognostications have proven largely correct. The company executed a good turnaround plan, but it has received a huge assist from China. China’s heavy-handed intervention to cut thermal and coking coal output has led to a dramatic spike in coal prices. Whereas the steady decline in those prices had weighed heavily on Glencore’s fortunes in 2014 and 2015, the rapid rise in those prices in 2016 has largely retrieved those fortunes. Thermal coal prices are up almost 100 percent since mid-year, and coking coal has risen 240 percent from its lows.

As a result, Glencore was just able to secure almost $100/ton for a thermal coal contract with a major Japanese buyer–up 50 percent from last year’s contract. It is anticipated that this is a harbinger for other major sales contracts.

The company will not capture the entire rally in prices, because it had hedged about 50 percent of its output for 2016. But that means 50 percent wasn’t hedged, and the price rise on those unhedged tons will provide a substantial profit for the company. (This dependence of the company on flat prices indicates that it is not so much a trader anymore, as an upstream producer married to a big trading operation.) (Given that hedges are presumably marked-to-market and collateralized, and hence require Glencore to make cash payments on its derivatives at the time prices rise, I wonder if the rally has created any cash flow issues due to mismatches in cash flows between physical coal sales and derivatives held as hedges.)

So Chinese policy has been Glencore’s best friend so far in 2016. But don’t get too excited. Now the Chinese are concerned that they might have overdone things. The government has just called an emergency meeting with 20 major coal producers to figure out how to raise output in order to lower prices:

China’s state planner has called another last-minute meeting to discuss with more than 20 coal mines more steps to boost supplies to electric utilities and tame a rally in thermal coal prices, according to two sources and local press.

The National Development and Reform Commission (NDRC) has convened a meeting with 22 coal miners for Tuesday to discuss ways to guarantee supply during the winter while sticking to the government’s long-term goal of removing excess inefficient capacity, according to a document inviting companies to the meeting seen by Reuters.

What China giveth, China might taketh away.

All this policy to-and-fro has, of course is leading to speculation about Chinese government policy. This contributes to considerable price volatility, a classic example of policy-induced volatility, which is far more common that policies that reduce volatility.

Presumably this uncertainty will induce Glencore to try to lock in more customers (which is a form of hedging). It might also increase its paper hedging, because a policy U-turn in China (about which your guess and Glencore’s guess are as good as mine) is always a possibility, and could send prices plunging again.

So when I said last year that Glencore was hostage to coal prices, and hence to Chinese government policy–well, here’s the proof. It’s worked in the company’s favor so far, but given the competing interests (electricity generators, steel firms, banks, etc.) affected by commodity prices, a major policy adjustment is a real possibility. Glencore–and other major commodity producers, especially in coal and ferrous metals–remain hostages to Chinese policy and hence Chinese politics.

October 23, 2016

They Did It, Dad

Filed under: History,Sports — The Professor @ 8:59 am

Last night the Chicago Cubs beat the LA Dodgers 5-0, to win the National League Pennant. It is literally true that I have been waiting for this all my life.

Baseball generally, and the Cubs in particular, were one of the most important things to my dad, as indicated by the fact that my first crib toys were a baseball bat rattle and a plush baseball. My dad lived and died by the Cubs, which meant dying, mainly.

There was a glimmer of hope in 1969. I attended opening day at Wrigley Field that year. I was there with my mom, because my dad couldn’t get off work. I waited patiently before the game and got Ernie Banks’ autograph–on a comic book, because my mom was too cheap to buy a program. (I was visible in a picture on the front page of the Tribune the next day, along with Banks and others waiting for his autograph.) Though Don Money hit 2 homers for the Phillies, Ernie Banks answered with 2 for the Cubs. The game went into extra innings when Willie Smith ended it with a pinch-hit homer. That seemed to be an omen, and the Cubs started off great, eventually building an 8.5 game lead. Yes, there were stumbles, like Don Young dropping two fly balls in a game against the Mets, but it looked like this was the year that would end a mere 24 years(!) of futility.

Then it all went wrong. An old team with thin and overworked starting pitching collapsed. My most vivid memory is Randy Hundley (my favorite player) jumping up-and-down protesting a close play at the plate involving Tommy Agee. (Would things have been different with replay?)


Eliot wrote that “April is the cruelest month.” In 1969, April was the most joyous month for Cubs fans. It was September that was cruel beyond words. (Not that April hasn’t been cruel to the Cubs. April 1997 being a particularly acute example.)

The 1970s were miserable–I mean, if Dave Kingman is the most memorable thing about an entire decade of baseball, even “miserable” seems an inadequate description. The aging players of the 1969 team faded rapidly, and the skinflint ownership of the Wrigleys stinted on the farm system, meaning the team’s player development was abysmal.

The 1980s brought a glimmer of hope after a bad beginning. Dallas Green built a very good 1984 team, only to watch it all go for naught when an easy grounder went between Leon Durham’s legs in San Diego. (Ironically, the man Durham replaced, Bill Buckner, was the goat the same year when he infamously let a grounder go between his legs to give the Mets a victory. This was the living proof of the “ex-Cub factor.”)

In the Pirrong households there was much anguish.

The 1990s–another largely lost decade.

Things looked bright again in 2003. But again, the season ended in failure. It is hard to describe the gloom in the motel room in Franklin, Tennessee when my dad and I watched the Cubs lose game 7 to the Marlins the night after the infamous Bartman game. (We were in Franklin on our annual Civil War battlefield trip.)

2003 pretty much snapped it for me. I’d invested a lot emotionally with the Cubs since I could remember, only to experience repeated frustration and disappointment. Family, work, and other things pressed, and I paid only glancing attention to the Cubs until a couple of years ago, when there were glimmers of hope. Even then, I will admit that my commitment was somewhat tentative. Too many Charlie Brown moments had left their mark.

Not my dad, though. He soldiered on, loyally. (Loyalty being one of his many admirable traits, even though that loyalty had often been unrewarded–worse, actually–in his professional life.)

Here, in baseball as in work, his loyalty did not receive its reward. He passed away at the very beginning of the Cubs renaissance. Almost literally at the beginning. We put on the Cubs game in the room of the hospice where he lay dying. He passed away almost exactly at the first pitch of opening day of the 2014 season.

My dad was a second-generation Cubs fan. His father had been an intense fan too, and could claim (reasonably) to have seen the Cubs win a World Series game in a year when they won the World Series–1908. My grandfather grew up in the neighborhood near the old West Side Grounds at Polk and Wood where the Cubs played in the first decade of the 20th century. When my grandfather was an invalid, watching the Cubs on Channel 9 was one of the few joys in his life, even though that was during the nadir of post-War Cub fortunes (he died in September, 1968).

To give an idea of how big baseball was in the Pirrong family, my grandfather would routinely take my dad to see Negro League games in Comiskey Park. In my father’s memory, they were the only white people in sight, and my dad–a North Sider–grew up thinking there were no white people south of Madison Street. My dad was so obsessed with baseball that his ambition was to go into management. After getting his MBA at Northwestern, he left my pregnant mother to attend the Baseball Management Academy in Florida. It was money well spent: he realized that in that era, only family members of ownership had a shot at real responsibility. As he put it, an outsider would be lucky to be put in charge of the peanut concession. So he put his baseball dreams aside and became the picture of a 1960s-1970s middle manager in corporate America.

When my grandfather was failing, my dad would say “I hope the Cubs win a pennant before dad dies.” Then for years he would say about himself “I hope the Cubs win a pennant before I die.” He skipped over me altogether. When my girls were young he told them “I hope the Cubs win a pennant before you die.”

Sadly, his hopes for himself were not realized. He–we–reveled in the Bulls championships of the 1990s, and especially in the Blackhawks wins in 2010 and 2013. But those things would have paled in comparison to a Cubs pennant, if they had been able to achieve it. (He always said “pennant” rather than “World Series.” I’ve been pondering why in recent days.)

But alas, that was not to be. I am trying to share it with him, vicariously, through memory. I remember the first time we went to a game together–Cubs-Reds, 1967 (the Cubs won.) I remember his uncanny ability to turn on the car radio at the very second that the pitcher was winding up for the first pitch. (Even when we watched on TV, we listened to the radio because my father detested Jack Brickhouse. Not that the radio duo of Jack Lloyd and Lou Boudreau were much better: dad called them “fumbles and mumbles.”) I remember his intimate knowledge of the game–pitch selection, pitch location, positioning, calling hit-and-run plays, etc. And yes, I remember him waving his hand and yelling “BULLSHIT” at the TV in response to a bad call or a bad play or a bad managerial move. Because he was into it. (And no, the apple did not fall far from the tree.)

I know there are many Chicagoans who can tell similar stories right now. Because, after all, there have literally been generations of futility. It’s only a game, and it’s only a team, but a particular team playing a particular game have had a profound impact on many people. And the most profound impact has been to forge memories of shared experiences between parents and children–fathers and sons, especially (though they have contributed to shared experiences between me and my girls, too). So last night, being in the moment actually meant scrolling through myriad moments past.

In a few weeks, the 2016 season will fade from most people’s minds, regardless of what happens in the World Series. Life presses. New seasons begin. But it will leave behind the residue of memories, and some future event will bring those memories flooding forth. It would be a blessing to the rememberers if the recollections that do come are as intense and poignant as the memories of my dad that I experienced last night.




October 12, 2016

A Pitch Perfect Illustration of Blockchain Hype

Filed under: Clearing,Commodities,Derivatives,Economics,Regulation — The Professor @ 7:31 pm

If you’ve been paying the slightest attention to financial markets lately, you’ll know that blockchain is The New Big Thing. Entrepreneurs and incumbent financial behemoths alike are claiming it will transform every aspect of financial markets.

The techno-utopianism makes me extremely skeptical. I will lay out the broader case for my skepticism in a forthcoming post. For now, I will discuss a specific example that illustrates odd combination of cluelessness and hype that characterizes many blockchain initiatives.

Titled “Blockchain startup aims to replace clearinghouses,” the article breathlessly states:

Founded by two former traders at Societe Generale, SynSwap is a post-trade start-up based on hyperledger technology designed to disintermediate central counterparties (CCPs) from the clearing process, effectively removing their role in key areas.

“For now we are focusing on interest rate swaps and credit default swaps, and will further develop the platform for other asset classes,” says Sophia Grami, co-founder of SynSwap.

Grami explains that once a trade is captured, SynSwap automatically processes the whole post-trade workflow on its blockchain platform. Through smart contracts, it can perform key post-trade functions such as matching and affirmation, generation of the confirmation, netting, collateral management, compression, default management and settlement.

“CCPs have been created to reduce systemic risk and remove counterparty risk through central clearing. While clearing is key to mitigate risks, the blockchain technology allows us to disintermediate CCPs while providing the same risk mitigation techniques,” Grami adds.

“Central clearing is turned into distributed clearing. There is no central counterparty anymore and no entity is in the middle of a trade anymore.”

The potential disruptive force blockchain technology could have for derivatives clearing could bring back banks that have pulled away from the business due to heightened regulatory costs.

I have often noted that CCPs offer a bundle of many services, and it is possible to considering unbundling some of them. But there are certain core functions of CCP clearing that this blockchain proposal does not offer. Most importantly, CCPs mutualize default risk: this is truly one of the core features of a CCP. This proposal does not, meaning that it provides a fundamentally different service than a CCP. Further, CCPs hedge and manage defaulted positions and port customer positions from a defaulted intermediary to a solvent one: this proposal does not. CCPs also manage liquidity risk. For instance, a defaulter’s collateral may not be immediately convertible into cash to pay winning counterparties, but the CCP maintains liquidity reserves and lines that it can use to intermediate liquidity in these circumstances. The proposal does not. The proposal mentions netting, but I seriously doubt that the blockchain–hyperledger, excuse me–can perform multilateral netting like a CCP.

There are other issues. Who sets the margin levels? Who sets the daily (or intraday) marks which determine variation margin flows and margin calls to top up IM? CCPs do that. Who does it for the hyper ledger?

So the proposal does some of the same things as a CCP, but not all of them, and in fact omits the most important bits that make central clearing central clearing. To the extent that these other CCP services add value–or regulation compels market participants to utilize a CCP that offers these services–market participants will choose to use a CCP, rather than this service. It is not a perfect substitute for central clearing, and will not disintermediate central clearing in cases where the services it does not offer and the functions it does not perform are demanded by market participants, or by regulators.

The co-founder says “[c]entral clearing is turned into distributed clearing.” Er, “distributed clearing”–AKA “bilateral OTC market.” What is being proposed here is not something really new: it is an application of a new technology to a very old, and very common, way of transacting. And by its nature, such a distributed, bilateral system cannot perform some functions that inherently require multilateral cooperation and centralization.

This illustrates one of my general gripes about blockchain hype: blockchain evangelists often claim to offer something new and revolutionary but what they actually describe often involves re-inventing the wheel. Maybe this wheel has advantages over existing wheels, but it’s still a wheel.

Furthermore, I would point out that this wheel may have some serious disadvantages as compared to existing wheels, namely, the bilateral OTC market as we know it. In some respects, it introduces one of the most dangerous features of central clearing into the bilateral market. (H/T Izabella Kaminska for pointing this out.) Specifically, as I’ve been going on about for about 8 years now, the rigid variation margining mechanism inherent in central clearing creates a tight coupling that can lead to catastrophic failure. Operational or financial delays that prevent timely payment of variation margin can force the CCP into default, or force it or its members to take extraordinary measures to access liquidity during times when liquidity is tight. Everything in a cleared system has to perform like clockwork, or an entire CCP can fail. Even slight delays in receiving payments during periods of market stress (when large variation margin flows occur) can bring down a CCP.

In contrast, there is more play in traditional bilateral contracting. It is not nearly so tightly coupled. One party not making a margin call at the precise time does not threaten to bring down the entire system. Furthermore, in the bilateral world, the “FU Option” is often quite systemically stabilizing. During the lead up to the crisis, arguments over marks could stretch on for days and sometimes weeks, giving some breathing room to stump up the cash to meet margin calls, and to negotiate down the size of the calls.

The “smart contracts” aspect of the blockchain proposal jettisons that. Everything is written in the code, the code is the last word, and will be self-executing. This will almost certainly create tight coupling: The Market has moved by X; contract says that means party A has to pay Party B Y by 0800 tomorrow or A is in default. (One could imagine writing really, really smart contracts that embed various conditions that mimic the flexibility and play in face-to-face bilateral markets, but color me skeptical–and this conditionality will create other issues, as I’ll discuss in the future post.)

When I think of these “smart contracts” one image that comes to mind is the magic broomsticks in The Sorcerer’s Apprentice. They do EXACTLY what they are commanded to do by the apprentice (coder?): they tote water, and end up toting so much water that a flood ensues. There is no feedback mechanism to get them to stop when the water gets too high. Again, perhaps it is possible to create really, really smart contracts that embed such feedback mechanisms.

But then one has to consider the potential interactions among a dense network of such really, really smart contracts. How do the feedbacks feed back on one another? Simple agent models show that agents operating subject to pre-programmed rules can generate complex, emergent orders when they interact. Sometimes these orders can be quite efficient. Sometimes they can crash and collapse.

In sum, the proposal for “distributed clearing to disintermediate CCPs” illustrates some of the defects of the blockchain movement. It overhypes what it does. It claims to be something new, when really it is a somewhat new way of doing something quite common. It does not necessarily perform these familiar functions better. It does not consider the systemic implications of what it does.

So why is there so much hype? Well, why was a thing? More seriously, I think that there is an interesting sociological dynamic here. All the cool kids are talking about blockchain, and nobody wants to admit to not being cool. Further, when a critical mass of supposed thought leaders are doing something, others imitate for fear of being left behind: if you join and it turns out to be flop, well, you don’t stand out–everybody, including the smartest people, screwed up. You’re in good company! But if you don’t join and it becomes a hit, you look like a Luddite idiot and get left behind. So there is a bias towards joining the fad/jumping on the bandwagon.

I think there will be a role for blockchain. But I also believe that it will not be nearly as revolutionary as its most ardent proponents claim. And I am damn certain that it is not going to disintermediate central clearing, both because central clearing does some things “decentralized clearing” doesn’t (duh!), and because regulators like those things and are forcing their use.

October 11, 2016

Why Waste US Special Operators in Battles That Make Game of Thrones Look Simple and Civilized?

Filed under: Military,Politics — The Professor @ 9:43 pm

A week ago, a US Special Forces soldier was killed by an IED in Afghanistan. In its disgusting fashion, the administration denied that this truly fine soldier had perished in combat, but said he was in a “combat situation.” This post-modern word weaseling for political purposes is an insult to those who are putting their lives on the line.

I have long been deeply disturbed by the overuse of special operations troops, for no apparent strategic purpose. To Obama, they are the human equivalent of drones, a way of employing military power in the shadows.

Things are likely to get worse. Special operators are on the ground in northern Syria. (Do they wear boots? Or do they levitate? Obama promised no boots on the ground, after all.) For their troubles, they are routinely insulted by Turkish-backed Salafist rebels, who call them Christian pigs and Crusaders.

But it will likely get even worse. After months of glacial preparation, an attack on Mosul appears if not imminent, on the verge of being imminent. Why do I say worse? Not just because the battle for Mosul is likely to be something akin to Fallujah I and Fallujah II, but because even if ISIS is defeated the aftermath is likely to be extremely messy, and the conditions will likely create fertile conditions for the emergence of another radical Sunni group.

Things were already complicated, with the Kurds and the Shia-dominated Iraqi government sharing the goal of ejecting ISIS, but having incompatible purposes once that happens. But things are getting even more convoluted and conflicted, with Turkey’s Erdogan asserting that his nation will participate in the campaign. Erdogan doesn’t want to see the Kurds in control. He also wants to gain power in northern Iraq, which is oil rich. He also has sectarian motives.

So glad that Obama thought that Erdo was one of his five best friends among world leaders. With friends such as these . . . . Another example of Obama’s incredibly flawed judgment.

Erdogan’s agenda is an anathema to the government of Iraq, so there is now a war of words going on between Erdogan and the Iraqi prime minister Haider al-Adabi.

All this means that post-“victory” Mosul will be a seething cockpit of competing forces, each one worse than the other (with the Kurds being the best of the lot, but thoroughly hated by all the rest). Kurds fighting Turks fighting Iraqi government forces and Shia militias. The Iranians will get involved, likely through their intelligence forces working hand-in-glove with the militias. Local Sunnis will be abused by the Iraqis and will fight back. The situation will make Game of Thrones look simple, ordered, and civilized.

The US will be everyone’s enemy, but every one of these factions will attempt to manipulate the US to do its bidding. And who will be at the center of this mess? US special operations forces. Who will have to keep their heads on a swivel. They will inevitably be targeted by everyone, and will not be able to do anything more than furiously spin the hamster wheel from hell. It will be Afghanistan, only worse. They will exhibit exceptional heroism and unmatched operational skill, and kill a lot of horrible people, but the ultimate result will be indecisive.

What could be our objective? What outcomes are even possible, and what would it cost in lives and treasure to achieve them? I find it hard to conceive of any outcome that would be worth the cost.

And US special operations troops would bear the brunt of those costs. They are too special, in many senses of the word, to fritter away in incipient fiascos like Mosul promises to be.

October 6, 2016

We Are Not Saudi Arabia’s Mercenaries

Filed under: Military,Politics — The Professor @ 6:57 pm

The Middle East has become the Mother of All FUBARs. Yet there are many in the United States, on both sides of the partisan divide, advocating deeper American involvement.

The focus is on Syria. Yes, the war there is horrific. Yes, the Syrians and Russians have dramatically ratcheted up the intensity of their brutal air campaign in Aleppo, even during an alleged cease fire. But what could the US accomplish by getting more deeply involved? Perpetuating a stalemate?

Or let’s say that somehow magically the US is able to support the toppling of Assad without sparking a war with Russia. What would be the outcome? It would be the victory of Sunni jihadis who would inevitably wreak a vengeance on Alawis, Shias, and Christians that would rival if not exceed anything Assad has done. Further, Sunni jihadis are America’s enemies, and have killed far more Americans than the Assads ever did, even when they were neck deep in supporting terrorism. Indeed, the worst that Assad has done to the US in the past decades is support the rat line that supplied Al Qaeda in Iraq (ISIS’ predecessor). After an Assad defeat, Syria would become a base for anti-American jihadis.

Which helps us how, exactly?

Many of those advocating deeper American involvement in Syria point to the fact that Putin is winning there. So what? To think that a Putin victory axiomatically spells an American defeat are engaged in precisely the type of zero sum thinking that leads Putin to exaggerate Syria’s importance. The more we fret about his “winning” in Syria, the more we feed his ambitions there and elsewhere in the region, and convince him that he’s on the right track.

Speaking of Russia, John Kerry has expressed outrage that Russia deceived him, and ramped up its military operations in Aleppo immediately after he thought they had agreed to a cease fire. Have we ever had such a credulous oaf in such a high position? Kerry needs to acquaint himself with The Farmer and the Viper (or the Frog and the Scorpion). The entire idea of a deal between Russia and the US is farcical, as long as the US insists that Assad must go. Russia is all in for Assad, and will not go for any deal that threatens him. The US claims it will not go for any deal that strengthens him. These positions are utterly incompatible.

Truth be told, it is the Saudis and the Qataris and others in the GCC who have a strong interest in Syria. They view it as a front in their Muslim Civil War with Shia Iran and express grave fear of a Shia Crescent running from Iran through Iraq to the Mediterranean. They exert tremendous influence in DC. Those who fall for their line, and parrot their line, are not acting in American interests.

The Saudis’ attempts to influence US policy are not limited to Syria. They are bogged down in a war in Yemen that is also a front in their conflict with Iran, and are importuning the United States to support them in that conflict as well.

The US has even less of an interest in Yemen than it does in Syria.

In fact, the US has very little interest in the Muslim Civil War, other than that neither side win. Militarily, neither the Iranians or the GCC have the ability to conquer the other, so we have zero reason to get in the middle. If they want to fritter away treasure and lives in peripheral conflicts, so be it.

We are not Saudi Arabia’s mercenaries. Let them fight their own battles.

It is highly unlikely we could achieve a good military outcome in either Syria or Yemen.  The latter has a lot in common with Afghanistan, the former with Iraq and Libya, and look how swimmingly THOSE are going. And even if we could create some simulacrum of peace, at what would be a heavy price in lives and money, how would the US gain? I am not seeing it.

These are sideshows. We should be more focused on peer competitors like China and Russia. After 15 years of grinding conflict and budgetary stringency, the US urgently needs to recapitalize its military. In these circumstances, risking a confrontation with Russia to fight Saudi Arabia’s battles is beyond insane. To hell with them and the camel they rode in on.

Igor for the Win!, or Privatization With Russian Characteristics

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 5:19 pm

Today Russia announced that Rosneft has been approved to purchase Bashneft. This despite the Economics Ministry’s earlier attempts to prevent state-owned Rosneft from participating in a “privatization” of a company that had been de-privatized (through expropriation), and Putin’s statement that this was not the best option.

But there’s more! The company was handed to Rosneft on a platter. Rosneft didn’t have to win an auction. There was no competitive tender process. It was just Christmas in October for Igor.

This speaks volumes about how Russia is run. (I won’t say “governed” or “managed.”) In a natural state way, a favored insider was rewarded despite the fact that all economic considerations push the other way. For one thing, privatization has been touted as a way of alleviating Russia’s severe budgetary problems. This will not do that. The decision occurred at a time when all indications are that the economic stringency will endure. There is no prospect for a serious rebound in oil prices, and there is also little prospect of an easing in sanctions. Indeed, Putin’s obduracy in Ukraine and his escalation in Syria may result in the imposition of additional sanctions. Putin’s spending priorities are increasing the economic strain. He plans to increase defense spending by $10 billion, and reduce social spending by less than that. Furthermore, Rosneft is a wretchedly run company that will generate far less value from Bashneft than would another owner, including a private Russian firm like Lukoil.

In brief, a cash-strapped Putin passed up an opportunity to generate some revenue and handed over Bashneft to a company that destroys value rather than enhances it. Such are the ways of a natural state that functions by allocating rents to courtiers. Privatization, with Russian characteristics.

In sum, in the Bashneft deal, Igor wins. And Russia loses.

The only thing that could potentially redeem this is if there was a quid pro quo, namely, that Sechin would relent to the sale of big stake in Rosneft to outside investors. Nothing of the sort was announced today, and perhaps they are waiting for some time to pass so as not to suggest that there was a deal. But I doubt it. I am guessing that Igor will win that argument too.

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