Streetwise Professor

March 1, 2015

The Clayton Rule on Speed

Filed under: Commodities,Derivatives,Economics,Exchanges,HFT,Politics,Regulation — The Professor @ 1:12 pm

I have written often of the Clayton Rule of Manipulation, named after a cotton broker who, in testimony before Congress, uttered these wise words:

“The word ‘manipulation’ . . . in its use is so broad as to include any operation of the cotton market that does not suit the gentleman who is speaking at the moment.”

High Frequency Trading has created the possibility of the promiscuous application of the Clayton Rule, because there is a lot of things about HFT that do not suit a lot of gentlemen at this moment, and a lot of ladies for that matter. The CFTC’s Frankendodd-based Disruptive Practices Rule, plus the fraud based manipulation Rule 180.1 (also a product of Dodd-Frank) provide the agency’s enforcement staff with the tools to pursue a pretty much anything that does not suit them at any particular moment.

At present, the thing that least suits government enforcers-including not just CFTC but the Department of Justice as well-is spoofing. As I discussed late last year, the DOJ has filed criminal charges in a spoofing case.

Here’s my description of spoofing:

What is spoofing? It’s the futures market equivalent of Lucy and the football. A trader submits buy (sell) orders above (below) the inside market in the hope that this convinces other market participants that there is strong demand (supply) for (of) the futures contract. If others are so fooled, they will raise their bids (lower their offers). Right before they do this, the spoofer pulls his orders just like Lucy pulls the football away from Charlie Brown, and then hits (lifts) the higher (lower) bids (offers). If the pre-spoof prices are “right”, the post-spoof bids (offers) are too high (too low), which means the spoofer sells high and buys low.

Order cancellation is a crucial component of the spoofing strategy, and this has created widespread suspicion about the legitimacy of order cancellation generally. Whatever you think about spoofing, if such futures market rule enforcers (exchanges, the CFTC, or the dreaded DOJ) begin to believe that traders who cancel orders at a high rate are doing something nefarious, and begin applying the Clayton Rule to such traders, the potential for mischief-and far worse-is great.

Many legitimate strategies involve high rates of order cancellation. In particular, market making strategies, including market making strategies pursued by HFT firms, typically involve high cancellation rates, especially in markets with small ticks, narrow spreads, and high volatility. Market makers can quote tighter spreads if they can adjust their quotes rapidly in response to new information. High volatility essentially means a high rate of information flow, and a need to adjust quotes frequently. Moreover, HFT traders can condition their quotes in a given market based on information (e.g., trades or quote changes) in other markets. Thus, to be able to quote tight markets in these conditions, market makers need to be able to adjust quotes frequently, and this in turn requires frequent order cancellations.

Order cancellation is also a means of protecting market making HFTs from being picked off by traders with better information. HFTs attempt to identify when order flow becomes “toxic” (i.e., is characterized by a large proportion of better-informed traders) and rationally cancel orders when this occurs. This reduces the cost of making markets.

This creates a considerable tension if order cancellation rates are used as a metric to detect potential manipulative conduct. Tweaking strategies to reduce cancellation rates to reduce the probability of getting caught in an enforcement dragnet increases the frequency that a trader is picked off and thereby raises trading costs: the rational response is to quote less aggressively, which reduces market liquidity. But not doing so raises the risk of a torturous investigation, or worse.

What’s more, the complexity of HFT strategies will make ex post forensic analyses of traders’ activities fraught with potential error. There is likely to be a high rate of false positives-the identification of legitimate strategies as manipulative. This is particularly true for firms that trade intensively in multiple markets. With some frequency, such firms will quote one side of the market, cancel, and then take liquidity from the other side of the market (the pattern that is symptomatic of spoofing). They will do that because that can be the rational response to some patterns of information arrival. But try explaining that to a suspicious regulator.

The problem here inheres in large part in the inductive nature of legal reasoning, which generalizes from specific cases and relies heavily on analogy. With such reasoning there is always a danger that a necessary condition (“all spoofing strategies involve high rates of order cancellation”) morphs into a sufficient condition (“high rates of order cancellation indicate manipulation”). This danger is particularly acute in complex environments in which subtle differences in strategies that are difficult for laymen to grasp (and may even be difficult for the strategist or experts to explain) can lead to very different conclusions about their legitimacy.

The potential for a regulatory dragnet directed against spoofing catching legitimate strategies by mistake is probably the greatest near-term concern that traders should have, because such a dragnet is underway. But the widespread misunderstanding and suspicion of HFT more generally means that over the medium to long term, the scope of the Clayton Rule may expand dramatically.

This is particularly worrisome given that suspected offenders are at risk to criminal charges. This dramatic escalation in the stakes raises compliance costs because every inquiry, even from an exchange, demands a fully-lawyered response. Moreover, it will make firms avoid some perfectly rational strategies that reduce the costs of making markets, thereby reducing liquidity and inflating trading costs for everyone.

The vagueness of the statute and the regulations that derive from it pose a huge risk to HFT firms. The only saving grace is that this vagueness may result in the law being declared unconstitutional and preventing it from being used in criminal prosecutions.

Although he wrote in a non-official capacity, an article by CFTC attorney Gregory Scopino illustrates how expansive regulators may become in their criminalization of HFT strategies. In a Connecticut Law Review article, Scopino questions the legality of “high-speed ‘pinging’ and ‘front running’ in futures markets.” It’s frightening to watch him stretch the concepts of fraud and “deceptive contrivance or device” to cover a variety of defensible practices which he seems not to understand.

In particular, he is very exercised by “pinging”, that is, the submission of small orders in an attempt to detect large orders. As remarkable as it might sound, his understanding of this seems to be even more limited than Michael Lewis’s: see Peter Kovac’s demolition of Lewis in his Not so Fast.

When there is hidden liquidity (due to non-displayed orders or iceberg orders), it makes perfect sense for traders to attempt to learn about market depth. This can be valuable information for liquidity providers, who get to know about competitive conditions in the market and can gauge better the potential profitability of supply ing liquidity. It can also be valuable to informed strategic traders, whose optimal trading strategy depends on market depth (as Pete Kyle showed more than 30 years ago): see a nice paper by Clark-Joseph on such “exploratory trading”, which sadly has been misrepresented by many (including Lewis and Scopino) to mean that HFT firms front run, a conclusion that Clark-Joseph explicitly denies. To call either of these strategies front running, or deem them deceptive or fraudulent is disturbing, to say the least.

Scopino and other critics of HFT also criticize the alleged practice of order anticipation, whereby a trader infers the existence of a large order being executed in pieces as soon as the first pieces trade. I say alleged, because as Kovac points out, the noisiness of order flow sharply limits the ability to detect a large latent order on the basis of a few trades.

What’s more, as I wrote in some posts on HFT just about a year ago, and in a piece in the Journal of Applied Corporate Finance, it’s by no means clear that order anticipation is inefficient, due to the equivocal nature of informed trading. Informed trading reduces liquidity, making it particularly perverse that Scopino wants to treat order anticipation as a form of insider trading (i.e., trading on non-public information). Talk about getting things totally backwards: this would criminalize a type of trading that actually impedes liquidity-reducing informed trading. Maybe there’s a planet on which that makes sense, but its sky ain’t blue.

Fortunately, these are now just gleams in an ambitious attorney’s eye. But from such gleams often come regulatory progeny. Indeed, since there is a strong and vocal constituency to impede HFT, the political economy of regulation tends to favor such an outcome. Regulators gonna regulate, especially when importuned by interested parties. Look no further than the net neutrality debacle.

In sum, the Clayton Rule has been around for the good part of a century, but I fear we ain’t seen nothing yet. HFT doesn’t suit a lot of people, often because of ignorance or self-interest, and as Mr. Clayton observed so long ago, it’s a short step from that to an accusation of manipulation. Regulators armed with broad, vague, and elastic authority (and things don’t get much broader, vaguer, or more elastic than “deceptive contrivance or device”) pose a great danger of running amok and impairing market performance in the name of improving it.

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February 27, 2015

Is Nato a Threat to Russia? If Only.

Filed under: Economics,Military,Politics,Russia — The Professor @ 8:53 pm

Putin and Lavrov and the Russian leadership  routinely rant about Nato and the threat it poses to Russia. They demand that Ukraine pledge not to join Nato as a condition for a resolution of the Russian invasion of the country. Sadly, numerous “realists” in the West just as routinely repeat and rationalize the Russian fears, and blame the current parlous state of Russo-Western relations on the post-1991 eastward expansion of Nato. (Yeah. I’m looking at you Stephen Walt and Ian Bremmer.)

This raises the question: Are the Russians and their Western apologists serious? If so, it calls into question their mental state.

The idea that Nato qua Nato poses a threat to invade Russia is risible. Hell, Nato’s ability to defend its eastern marches is quite uncertain.

Even if one ignores the fact that Nato has no intent to engage in a land war against Russia, on the basis of military capability Russia would have nothing to fear from Nato even if it was hard on Russia’s borders. Virtually all of Nato’s ground combat power is embodied in American units, which have almost totally withdrawn from Europe to CONUS. They pose no threat to Russia from Fort Hood or Fort Stewart or Fort Riley or Fort Bliss, and even if they moved into Poland-and hell, into Ukraine-they would not threaten Russia. Their numbers are insufficient, and the logistic obstacles of attacking Russia  are beyond daunting.

As for the rest of Nato, it as become a mockery of a military alliance. Only France spends more than 2 percent of GDP on defense. The Germans have stinted on defense: its military expenditures are closer to 1 percent of GDP than the Nato “standard” (honored more in the breach than the promise) of 2 percent. They have sold off a large portion of their modern armor. Recent reports state that a large fraction of its aircraft are inoperable. A particularly shocking story states that a supposedly elite unit attached to Nato’s rapid reaction force had to train with broomsticks at a recent exercise, due to the lack of machine guns. As for the Dutch, Belgians, and other assorted Lilliputians, they couldn’t threaten anybody.

Out of area operations are unthinkable. Even modest efforts in Libya (carried out almost entirely by airpower) and Africa (e.g., Mali) were dependent on US airlift, refueling, and reconnaissance assets.

European navies are similarly shrunken and incapable of projecting power.

Yes, the US has the capability of inflicting huge damage on Russia, but other Nato countries enhance that capability not by one whit. And virtually all of that capability is based in the United States proper.

So why are the Russians always on about Nato? Do Putin and the military realize that the alliance presents no danger, but just hype the threat because it gulls the domestic hoi polloi and credulous Westerners? Or are they so paranoid that they see threats where none exist?

I think it may well be some of both, but more of the former. By claiming Nato is a military threat, Russia gets to play the victim, an act which many at home and abroad fall for, and which provides a cover for the real reasons for Russia’s hostility. Putin et al fear the West, but more because they know that Russia cannot compete against it economically, politically, and culturally. They want to exploit, in a colonialist way, the ex-Soviet space. Ukraine was a classic example. Corrupt ties between Russia and Ukraine enriched Russian and Ukrainian thugs alike. Maidan threatened all that.

Note that what precipitated the crisis with Russia was not a Ukrainian move towards Nato-that was not on the table, and the very idea did not garner majority support in the country last year. Rather, it was Ukraine’s move towards greater economic integration with Europe that sparked Putin’s ferocious reaction. In addition to threatening the loss of markets for Russia’s non-competitive products, greater integration with Europe would have helped nudge the country down the path towards better governance and less corruption. This threatened the interests of Russia’s kleptocracy (over which Putin reigns) as as much as it did Ukraine’s. To that must be added an indirect threat that the example of an ex-Sovok republic moving towards political and economic modernity would  pose to a retrograde Russia.

At least that’s what I think is the most likely explanation for Russia’s unrelenting drumbeat against Nato. But I cannot rule out rampant paranoia. The Nemtsov murder also betrays considerable paranoia, as the opposition poses no real political threat to Putin.

What I can rule out metaphysically is that Nato is an actual military threat to Russia. To quote Patton, European forces in Nato couldn’t fight their way out of a piss-soaked paper bag even if attacked, let alone pose an offensive threat to a vast continental nation like Russia. And the Americans are very, very far away. Which means that Russian ranting about Nato is either camouflage for their well-grounded insecurity about their ability to compete economically, socially, and politically with the West, or the product of colossal paranoia, or both.

Regardless, it means that the only way that Russia can conceive of co-existing with the West is along the lines of the Yalta model, with the only question being where the lines are drawn. The sooner the West recognizes this, and moves beyond its romantic notion of a “special”, or even non-adversarial, relationship with Russia, the better. But the persistence of these romantic ideas even in the face of Russian aggression in Ukraine and the threat of more in the Baltics and elsewhere suggests that this won’t happen soon enough.

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Anna Chapman’s Bank Says: “I Don’t Want to Go on the Cart!”

Filed under: Economics,Politics,Russia — The Professor @ 10:37 am

The past months have been chock full of episodes of Russian absurdity. Some of them are quite disturbing. Some are rather amusing. This story involving the Central Bank of Russia’s seizure of Russian lender FundServisBank is a particularly good example. The absurdity begins-but only begins-with the fact that it counts Anna Chapman as one of its “top executives.” What better signal of top notch leadership could you ask for?

The linked article includes a photograph of Anna delivering deep thoughts on “entreprenurship” (complete with diagrams!): apparently spelling was not something that Anna quite nailed during her soiree in the US.

But that’s only the beginning. The bank apparently is furious at the CBR for depriving it of its option to gamble for resurrection:

FundServisBank claimed Wednesday that it had no financial problems.

“From a purely economic point of view the bank has no problems … you start to wonder who is behind this,” FundServisBank spokesman Grigory Belkin told The Moscow Times.

“Novikombank is taking the place of FundServisBank,” Belkin said.

“It’s like there is an experienced doctor who appears and says you are ill, fatally ill. You say ‘I am alive,’ but he says ‘no, no, no!'”

This brings to mind the classic bit from Monty Python and the Holy Grail, with FundServisBank doing a turn in the role of Dead Person, Novikombank playing Customer, and the CBR playing Mortician:

MORTICIAN: Bring out your dead!
CUSTOMER: Here’s one — nine pence.
DEAD PERSON: I’m not dead!
MORTICIAN: What?
CUSTOMER: Nothing — here’s your nine pence.
DEAD PERSON: I’m not dead!
MORTICIAN: Here — he says he’s not dead!
CUSTOMER: Yes, he is.
DEAD PERSON: I’m not!
MORTICIAN: He isn’t.
CUSTOMER: Well, he will be soon, he’s very ill.
DEAD PERSON: I’m getting better!
CUSTOMER: No, you’re not — you’ll be stone dead in a moment.
MORTICIAN: Oh, I can’t take him like that — it’s against regulations.
DEAD PERSON: I don’t want to go in the cart!
CUSTOMER: Oh, don’t be such a baby.
MORTICIAN: I can’t take him…
DEAD PERSON: I feel fine!
CUSTOMER: Oh, do us a favor…
MORTICIAN: I can’t.
CUSTOMER: Well, can you hang around a couple of minutes? He won’t
be long.
MORTICIAN: Naaah, I got to go on to Robinson’s — they’ve lost nine
today.
CUSTOMER: Well, when is your next round?
MORTICIAN: Thursday.
DEAD PERSON: I think I’ll go for a walk.
CUSTOMER: You’re not fooling anyone y’know. Look, isn’t there
something you can do?
DEAD PERSON: I feel happy… I feel happy.
[whop]
CUSTOMER: Ah, thanks very much.

First the Bruce Willis Bank. Now the Anna Chapman Bank. Is there nothing sacred that Russia’s creeping financial crisis will spare?

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February 15, 2015

As An Oil Analyst, Mullet Man Igor Sechin Makes a Better KGB Agent

Filed under: Commodities,Derivatives,Economics,Energy,Russia — The Professor @ 11:10 am

Igor Sechin, he of the ape drape, has taken to the pages of the Financial Times to diagnose the causes of the recent collapse in oil prices. I am sure you will be  shocked to learn that it is those damned speculators:

In today’s distorted oil markets, prices do not reflect reality. They are driven instead by financial speculation, which outweighs the real-life factors of supply and demand. Financial markets tend to produce economic bubbles, and those bubbles tend to burst. Remember the dotcom bust and the subprime mortgage crisis? Furthermore, they are prone to manipulation. We have not forgotten the rigging of the Libor interest rate benchmark and the gold price.

. . . .

Financial bubbles, market manipulations, excessive regulation, regional disparities — so grotesque are these distortions that you might question whether there is any such thing as an oil “market” at all. There is the semblance of a market: buyers and sellers and prices. But they are performing a charade.

What is to be done? First, financial players should no longer be allowed to have such a big influence on the price of oil. In the US, Senators Carl Levin and John McCain have called for steps to prevent price manipulation, though whether they will be implemented, and when, remains an open question.

In any case, the authorities should go further, ensuring that at least 10 or 15 per cent of oil trades involve actually delivering some physical oil. At present almost all “oil trades” are conducted by financial traders, who exchange nothing but electronic tokens or pieces of paper.

No, condemnations of speculation are not the last refuge of scoundrels attempting to assign blame for sharp movements in commodity prices: they are the first and only refuge. Prices going up? Speculators! Prices going down? Speculators! Poor, poor little companies like doughty Rosneft and even international cartels like OPEC are mere straws at the tossed before the speculative gales.

Sechin’s broadside is refreshingly untainted by anything resembling actual evidence. The closest he comes is to invoke long run considerations, relating to the costs of drilling new wells. But supply and demand are both very inelastic in the short run, meaning that even modest demand or supply shocks can have large price impacts that cause prices to deviate substantially from long run equilibrium values driven by long run average costs.

It is also hard to discern a credible mechanism whereby diffuse and numerous financial speculators could cause prices to be artificially low for a considerable period of time. (It is straightforward to construct models of how a local market can be manipulated downwards, but these are implausible for a global market. Moreover as I showed years ago, markets that are vulnerable to upward manipulation by longs are relatively invulnerable to downward manipulation by shorts.)

And the empirical implications of any such artificiality are sharply inconsistent with what we observe now. Artificially low prices would induce excessive consumption, which would in turn result in a drawdown in inventories. This is the exact opposite of what we see now. Inventories are growing rapidly in the US in particular (where we have the best data). There are projections that Cushing storage capacity will be filled by May. Internationally, traders are leasing supertankers to store oil. These are classic effects of demand declines or supply increases or both that are expected to be transient.

Insofar as requiring some percentage of oil contracts (by which I presume he means futures and swaps) be satisfied by delivery, the mere threat of delivery ties futures prices to physical market fundamentals at contract expiration. What’s more, the fact that paper traders are largely out of the market when contracts go spot means that they cannot directly affect the supply or demand for the physical commodity.

Sechin’s FT piece is based on a presentation he gave at International Petroleum Week. Rosneft thoughtfully, though rather stupidly given the content, posted Sechin’s remarks and slides on its website. It makes for some rather amusing reading. Apparently shale oil companies are like dotcoms, and shale oil was a bubble. According to Igor, US shale producers are overvalued. His evidence? A comparison of EOG and Hess to Lukoil. The market cap of the EOG is substantially higher than Lukoil’s, despite its lower reserves and production, and lack of refining operations. Therefore: Bubble! Overvaluation!

Gee, I wonder if the fact that Lukoil is a Russian company, and that Russian company valuations are substantially below those of international competitors, regardless of the industry, has anything to do with it? In fact, it has everything to do with it. Sechin’s comparison of a US company with a Russian one points out vividly the baleful consequences of Russia’s lawless business climate. It’s not that EOG and other shale producers are bubbles: it’s that Lukoil (and other Russian companies) are black holes.  (It was the very fact that Russia’s lack of property rights, the rule of law, and other institutional supports of a market economy that got me interested in looking at the country in detail in the first place almost a decade ago.)

I was also amused by Sechin’s ringing call for greater transparency in the energy industry. This coming from the CEO of one of the most opaque companies in the most opaque countries in the world.

Reading anything by Sechin purporting to be an objective analysis of markets or market conditions is always good for a chuckle. His FT oped and IPW remarks are no exception. As a market analyst, he makes a better KGB operative. Enjoy!

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February 8, 2015

When It Comes to Oil, the “I” in BIS is Superfluous

Filed under: Commodities,Derivatives,Economics,Energy,Regulation — The Professor @ 9:56 pm

The Bank for International Settlements  is creating some waves with a teaser about a forthcoming report that claims to show that financialization is largely responsible for the recent fall in oil prices. Even by the standards of argument usually seen criticizing financializaton, this one is particularly lame.

BIS notes that the upstream business is heavily leveraged: “The greater debt burden of the oil sector may have influenced the recent dynamics of the oil market by exposing producers to solvency and liquidity risks.” The BIS summarizes the well-known fact that yields on oil company bonds have skyrocketed, and claims that this has contributed to the price decline. But it is plainly obvious that cause and effect overwhelmingly goes the other way: it is the sharp decline in prices that damaged the financial conditions of E&P firms. The closest that BIS can come to showing the direction of causation going from debt to price is this: “Debt service requirements may induce continued physical production of oil to maintain cash flows, delaying the reduction in supply in the market.”

At most, this means that future output may be higher in the future than it would have been had these firms been less leveraged, thereby weighing on future prices and through inter temporal linkages (e.g., storage) on current prices. It is difficult indeed to attribute the earlier price declines that caused the financial distress to this effect. Moreover, the BIS suggests that oil output from existing wells can be turned off like a water faucet. Given that the costs of capping a well are not trivial, this is not true: except under rather extreme circumstances, producers will continue to operate wells (which flow at an exogenously determined rate) even when prices fall substantially. Thus, this channel is not a plausible contributor to an appreciable fraction of the 50 percent decline in prices since July.

Then BIS turns its attention to hedging:

Since 2010, oil producers have increasingly relied on swap dealers as counterparties for their hedging transactions. In turn, swap dealers have laid off their exposures on the futures market as suggested by the trend increase in the CFTC short futures positions of swap dealers over the 2009-13 period.

However, at times of heightened volatility and balance sheet strain for leveraged entities, swap dealers may become less willing to sell protection to oil producers. The co-movement in the dealers’ positions and bouts of volatility suggests that dealers may have behaved procyclically – cutting back positions whenever financial conditions become more turbulent. In Graph 2, three such episodes can be seen: the onset of the Great Recession in 2008, the euro area crisis combined with the war in Libya in 2011, and the recent price slump. In response to greater reluctance by dealers to take the other side of sales, producers wishing to hedge their falling revenues may have turned to the derivatives markets directly, without going through an intermediary. This shift in the liquidity of hedging markets could have played a role in recent price dynamics.

BIS’s conjecture regarding producers hedging directly can be tested directly. The CFTC Commitment of Traders data, which BIS relies on, also includes a “Producers, Merchants, Processors and Users” category. If BIS is correct and producers have gone to the futures market directly rather than hedged through dealers, PMPU short interest should have ticked up. So why they are guessing rather than looking at the data is beyond me.

What’s more, using declines in swap dealer futures positions to infer pro-cyclicality seems rather odd. Swap dealer futures hedges of swap positions means that they are not taking on a lot of risk to the balance sheet. That is the risk that is being passed on to the futures market, not the risk that is being kept on the balance sheet.

The decline in swap dealer short futures positions more likely reflects a reduced hedging demand by producers. For instance, at present we are seeing a sharp drop in drilling activity in the US, which means that there is less future production to hedge and hence less hedging activity. The fact that the decline in swap dealer short futures is much more pronounced now than in 2008-2009 is consistent with that, as is the big rise in these positions during the shale boom starting in 2009. This is exactly what you’d expect if hedging demand is driven primarily by E&P companies in the US. Regardless, the BIS release does not disclose any rigorous analysis of what drives swap dealer positions or hedging positions overall, so the “reluctance of dealers” argument is at best an untested hypothesis, and more likely a wild-assed guess. Using drilling activity, or capex, or E&P company borrowing as control variables would help quantify what is really driving hedging activity.

And the conclusion is totally inane: “This [unproven] shift in the liquidity of hedging markets could have played a role in recent price dynamics.” Well, maybe. But maybe the fact that the moon will be in the seventh house on Valentine’s Day could have played a role too. Seriously: what is the mechanism by which this (unproven) shift in liquidity in hedging markets affected price dynamics?

Further, if E&P company balance sheet woes are making it harder for them to find hedge counterparties, this would impair their ability to fund new drilling, and tend to support prices. This would offset the alleged we’ve-got-to-keep-pumping-to-pay-the-bills effect.

BIS also offers this pearl of wisdom:

Rather, the steepness of the price decline and very large day-to-day price changes are reminiscent of a financial asset. As with other financial assets, movements in the price of oil are driven by changes in expectations about future market conditions.

What, commodities have not previously been subject to large price moves and high volatility? Who knew? I’ll bet if I dug for a while I could find BIS studies casting doubt on the prudence of bank participation commodity markets because the things are so damned volatile. And what accounts for the extremely low volatility in the first half of 2014, something BIS itself documented? Is financialization that fickle?

Moreover, why shouldn’t oil prices be driven by changes in expectations about future market conditions? It’s a storable commodity (both above and below ground), and storage links the present with the future. Furthermore, investments today affect future production. Current decisions and hence current prices should reflect expected future conditions precisely because of the inter-temporal nature of production and consumption decisions.

In fact, oil is not a financial asset, properly understood. The fact that the oil market goes into backwardation is sufficient to demonstrate that point. But it is hardly a sign of inefficiency, or of a lamentable corruption of the oil markets by the presence of financial players, that expectations of future conditions affect current prices. In fact, it would be inefficient if expectations did not affect current prices.

I understand that what the BIS just put out is only a synopsis of a more complete analysis that will be released next month. Maybe the complete paper will be an improvement on what they’ve released so far. (It would have to be.) But that just raises another problem.

Research by press release is a lamentable practice, but one that is increasingly common. Release the entire paper along with the synopsis, or just shut up until you do. BIS is getting a big splash with its selective disclosure of its purported results, while making it impossible to evaluate the quality of the research. The impression has been created, and by the time March rolls around and the paper is released it will be much harder to challenge that established impression by pointing out flaws in the analysis: that’s much more easily done at the time of the initial announcement when minds are open. This is the wrong way to conduct research, especially on policy-relevant issues.

Update: I had a moment to review the CFTC COT data. It does not support the BIS’s claim of a shift from dealer-intermediated hedging to direct hedging. From its peak on 1 July, 2014 to the end of 2014, Open interest in the NYMEX WTI contract fell from 1.78 million contracts to 1.46 million, or 18 percent. PMPU short positions fell from 352K to 270K contracts, or about 24 percent. Swap dealer shorts fell from 502K to 326K, or about 36 percent. Thus, it appears that the fall in short commercial positions were broad-based. Given that PMPU positions include merchants hedging inventories (which have been rising as prices have been falling) not too much can be made of the smaller proportional decline in PMPU positions vs. swap dealer positions. Similarly, dealer shorts include are hedges of swaps done with hedge funds, index funds, and others, and hence are not a clean measure of the amount of hedging done by producers via swaps.

I am also skeptical whether producers who can no longer find a bank to sell them a swap can readily switch to direct hedging. One of the advantages of entering into a swap is that it often has less stringent margining than futures. How can cash-flow stressed producers fund the margins and potential margin calls?

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February 7, 2015

Obama Bigfoots Net Neutrality: Wasn’t Screwing Up Health Care Enough of a Legacy?

Filed under: Economics,History,Politics,Regulation — The Professor @ 8:38 pm

Last week the Chairman of the Federal Communications System announced that the FCC will pursue net neutrality regulation by subjecting the Internet to Title II of the Federal Cable and Telecommunications Act. This will essentially treat the Internet as a utility, rather than as an information service as has been the case since 1996. Like telecoms, Internet Service Providers would effectively become common carriers subject to a panopoly of restrictions on the prices they can charge and their ability to control access to their infrastructures.

The issue is an extremely complex one, and moreover, one that has been subjected to a barrage of simplistic, propagandistic, rhetoric. To cut through the rhetoric to see the economics, I recommend this article by Gary Becker, Dennis Carlton, and Hal Sider.

Becker, Carlton, and Hal characterize the goals of net neutrality as follows:

In the FCC’s view,

its proposed net neutrality rules would “prohibit a broadband Internet access provider from discriminating against, or in favor of, any content, application or service.” Broadband access providers would be prohibited from: (1) prioritizing traffic and charging differential prices based on the priority status; (2) imposing congestion-related charges; (3) adopting business models that offer exclusive content or that establish exclu- sive relationships with particular content providers; and (4) charging content providers to access the Internet based on factors other than the bandwidth supplied. [References omitted.]

In a nutshell, NN rules and Title II would limit the pricing policies of ISPs, limit their ability to regulate access to their networks, and limit their ability to vertically integrate upstream or downstream (e.g., by purchasing content providers).

The motivation for all of this is a belief that the broadband industry is not competitive, and that price discrimination, access limitations, and vertical integration are means of exercising market power to the detriment of consumers downstream and suppliers of content upstream.

As Becker et al point out, however, evidence that competition is weak is lacking. Most consumers have choices of broadband providers, and the development of wireless services such as 4G is increasing consumer choice.  (Personally, I would estimate that I have gone from relying 100 percent on wired access to 50 percent wired-50 percent wireless. The focus of Facebook and other social media and content suppliers on mobile indicates how important wireless is becoming.) Moreover, there is considerable switching of suppliers, which is further indication of competition.

Further, as a general matter, price discrimination is often-one might say usually-welfare enhancing when there products are differentiated and the costs of these products differ. Different forms of content utilize different amounts of bandwidth. Services vary in their need for speed (e.g., streaming vs. ordinary web-browsing vs. email). It is more costly to deliver bandwidth-intensive services. Limiting the ability to charge prices that reflect differences in cost and value lead to misallocations in the use of existing bandwidth capacity, and tend to reduce incentives to invest in capacity. Moreover, the “two-sided” nature of the Internet tends to make price discrimination welfare-improving. (This paper by Weismen and Kulick makes the very useful distinction between “differential pricing” and “price discrimination.” The former is based on differences in cost, the latter on differences in demand elasticity across customers.) In addition, when there are strong economies of scale, price discrimination (e.g., Ramsey pricing) can be a first-best or second-best way of allowing producers to cover fixed costs.

Put differently, net neutrality/common carrier access treats the internet as a commons which limits the use of prices to allocate scarce resources. Yes there can be cases in which this is beneficial (as in a textbook natural monopoly, but sometimes not even then), but suppressing the price system and price signals is usually a horrible idea. The rebuttable presumption should be that we rely more, not less, on prices to allocate scarce resources and provide incentives to consume, produce, and invest. Net neutrality betrays a strong animus to the price system and the use of prices to allocate resources.

Vertical arrangements are also frequently looked on with deep suspicion. I wrote about this a lot in the context of exchange ownership of clearing some years ago. But usually vertical arrangements, including restrictive contracts and vertical integration, are contractual means to address inefficiencies in price competition. They are typically ways of internalizing externalities or constraining opportunistic behavior. Moreover, they are often particularly important in information-intensive goods, because of the difficulties of enforcing property rights in information and the pervasiveness of free riding on information goods.

Some of the horror stories NN advocates tell involve an ISP denying access to a service or content downstream consumers value high: usually the story involves a small startup proving a bandwidth intensive service that can’t afford to pay premium access charges. But in a world where venture capital and other forms of funding is constantly on the lookout for the next big thing, these concerns seem vastly overblown. Moreover, permitting ISPs to own content providers is one way of addressing this issue. The demand for ISP services is derived from the value customers get from the content and services an ISP delivers. It is self-defeating for them to exclude truly valuable content because it reduces demand, and they have incentives to structure pricing and terms of access and vertical arrangements with content providers to maximize value. If there are gains from trade, in a reasonably competitive market there are strong forces pushing entities at all segments of the value chain to reap those gains.

Suppressing price signals and limiting the ability to craft creative arrangements to capture gains from trade are bad ideas, except under exceptional circumstances. So color me deeply skeptical on NN. Other features inherent in intrusive regulatory systems like Title II due to public choice considerations only deepen that skepticism. Such systems are extremely conducive to rent seeking. Though usually sold as ways to enhance competition, in practice they are typically exploited by incumbents to restrict competition. They tend to be strongly biased against innovation-precisely because much innovation of the creative destruction variety is intensely threatening to incumbents who have an advantage in influencing regulators. Classical Peltzman-Becker models of regulation show that regulators have an incentive to suppress cost-justified price differentials in order to redistribute rents, thereby creating distortions.

Other than that, NN and Title II are great.

If the substance isn’t bad enough, the process is even worse. FCC Chairman Tom Wheeler was originally leaning towards a less intrusive approach to net neutrality that would avoid dropping the Title II bomb. But Obama orchestrated a campaign behind the scenes to pressure an ostensibly independent agency to go all medieval (or at least all New Deal) on the Internet. Obama added to the backstage pressure with a very public call for intrusive regulation that put Wheeler and the other two Democrats on the Commission in an impossible position. (Another illustration of the consequences of Presidential elections: it’s not just the commander that matters, but the anonymous foot soldiers and the camp followers too.)

Yes, part of Obama’s insistence reflected his beliefs: after all, he is a big government control freak. And yes, part reflects the fact that some of his biggest supporters and donors are rabid NN supporters-primarily because they will benefit if they don’t have to pay the full cost that they impose.

But what convinced Obama to make this a priority was his personal vanity and his determination to engage in political warfare by pursuing initiatives that he can implement unilaterally without Congressional involvement. Read this and weep:

While Obama administration officials were warming to the idea of calling for tougher rules, it took the November elections to sway Mr. Obama into action.

After Republicans gained their Senate majority, Mr. Obama took a number of actions to go around Congress, including a unilateral move to ease immigration rules. Senior aides also began looking for issues that would help define the president’s legacy. Net neutrality seemed like a good fit.

Soon, Mr. Zients paid his visit to the FCC to let Mr. Wheeler know the president would make a statement on high-speed Internet regulation. Messrs. Zients and Wheeler didn’t discuss the details, according to Mr. Wheeler.

Mr. Obama made them clear in a 1,062-word statement and two-minute video. He told the FCC to regulate mobile and fixed broadband providers more strictly and enact strong rules to prevent those providers from altering download speeds for specific websites or services.

In the video, Mr. Obama said his stance was confirmation of a long-standing commitment to net neutrality. The statement boxed in Mr. Wheeler by giving the FCC’s two other Democratic commissioners cover to vote against anything falling short of Mr. Obama’s position.

That essentially killed the compromise proposed by Mr. Wheeler, leaving him no choice but to follow the path outlined by the president.

Read this again: “Senior aides also began looking for issues that would help define the president’s legacy. Net neutrality seemed like a good fit.” So to achieve a legacy, the Narcissist in Chief decides to interfere with the most successful, innovative industry of the past half-century, and perhaps ever.

What, screwing up the health care industry isn’t enough of a legacy?

I guess not. No price is to high to pay to stick it to the evil Republicans. And if you get stuck too, well, omelet, eggs, and all that. You are expendable when there’s a legacy at stake.

What comes out of the FCC as a result of Obama’s arm-twisting will be a beginning, not an end. It will no doubt set off a flurry of legal challenges.(Among lawyers and lobbyists, as always in such things, there is much rejoicing.)  Congress may get involved, and although Obama can block anything for the next two years, it  may take longer than that to finalize the rules (look at how long it is taking to get a simple-by-comparison position limit rule through the CFTC), and a new president in 2017 might not be so enamored with burnishing Barry’s legacy. Well, one can hope, can’t one? Looking for silver linings here.

I had thought that old school Progressive and New Deal style regulation had been largely discredited in the 70s and 80s. Indeed, Democrats (including Carter and Ted Kennedy) played vital roles in dismantling regulations in transportation in particular. But Obama is going all back to the future, and attempting to impose a regulatory paradigm that was all the rage when men all wore fedoras to what is arguably the most dynamic and innovative industry ever. Because, legacy.

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February 4, 2015

Turn Out the Lights, The Party’s Over

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,History — The Professor @ 8:12 pm

What party, you ask? The one with the mosh pit at LaSalle and Jackson in Chicago.  The one held in the building that’s in the background image of this page.

That’s right. Today the CME Group announced it was ending floor trading of futures (with the exception of the S&P 500) in Chicago and New York. Floor trading of options will continue.

As a Chicagoan who knew the floor in its glory days, this is a sad day. The floor was an amazing place. (Even though the floors will remain open until July, the past tense is appropriate in that sentence.)  A seemingly chaotic place full of shouting and gesticulating men (and yes, it was an overwhelmingly male place). Despite the chaos, it was an extraordinarily efficient way to buy and sell futures. In the bond pit in the 80s and 90s, $100,000,000 notional could be bought in sold with a shout and a wave. Over and over and over.

The economics of the pits were fascinating, but the sociology was as well. They were truly little societies. There were the exchange rules that were in the book, and there were the rules not written in any book that you adhered to, or else. Face-to-face interactions day after day over periods of years created a unique dynamic and a unique culture with its own norms and hierarchies and rituals. And soon it will be but a memory.

Even though I am wistful at the passing of this remarkable institution, I was ahead of the curve in predicting its eventual demise. I worked at an FCM in 1986, when the CME, CBT, and Reuters announced the initial Globex initiative. This got me interested in electronic trading, and when I became an academic a few years later, I researched the subject. In 1994 I wrote one of the early papers documenting that electronic markets could be as liquid and deep as floor-based markets, and I conjectured that parity in liquidity and superiority in speed and cost of access would result in the ultimate victory of computers over the floor. The collective response in the industry was scorn: everyone knew the floor was more liquid, and always would be. The information environment on the floor could never be duplicated on the screen, they said. This view was epitomized by the CEO of LIFFE, Daniel Hodgson, who ridiculed me in the FT as an ivory tower academic.

The first sign that the floor’s days were numbered occurred in 1998, when computerized Eurex wrested the Bund futures contract from LIFFE. (Eurex used my research as part of its marketing push.) LIFFE suffered a near death experience, barely surviving by shutting the floor and going fully electronic. (Mr. Hodgson was shown the door, and I resisted the temptation of sending him a certain FT clipping.)

Computerized trading was only slowly making inroads in the US at the time, in part because the incumbent exchanges resisted its operation during regular floor trading hours. But the fear of the machines was palpable by the mid-1990s. The CBT built its massive trading floor in 1997 in part because the members believed that if it spent so much on a new building the exchange couldn’t afford to render it useless by going electronic. Ironic that a group of traders who lived and breathed real world economics would fall victim to the sunk cost fallacy, and be blind to the gales of competition and creative destruction.

The floor continued to thrive, but inexorably the machines gained on it. By the early-2000s electronic volumes exceeded floor volumes for most contracts, especially in the financials. By the end of the first decade of the millennium, the floors were almost vacant. I remember going to the crude oil pit in NY in early-2009, and where once well over 100 traders stood, engaged in frenzied buying and selling, now a handful of guys sat on the steps of the pit, reading the Post and the Daily News.

When the CME demutualized, and when it acquired CBT and NYMEX, it made commitments to keep the floors open for some period of time. But the commitments were not in perpetuity, and declining floor volumes made it evident that eventually the day would come that the CME would shut down the floors.

Today was that day.

This was inevitable, but in the 80s and 90s the floor trading community, and the futures business generally, couldn’t possibly imagine that machines could ever do what they did. But the technology of the floor was essentially static. Yes, the technology of getting orders to the pit evolved along with telecommunications, but once the orders got there, they were executed in the same way that they had been since 1864 or so.* That execution technology was highly evolved and efficient, but static. In the meantime, Moore’s Law and innovation in hardware, software, and communications technology made electronic trading faster and smarter. Electronic trading lacked some of the information that could be gleaned looking in the eyes of the guy standing across the pit, or knowing who was bidding or offering, but it made accessible to traders vast sources of disparate information that was impossible to absorb on the floor. By the late-00s, HFT essentially computerized what was in locals’ heads, and did it faster with more information and fewer errors and less emotion. Guys that were all about competition were displaced by the competition of a more efficient technology.

Floor trading will live on for a while, in the options pits. Combination trades in options are complex in ways that there are efficiencies in doing them on the floor. But eventually machines will master that too. ICE closed its options pits a couple of years ago (four years after it closed its futures pits), and one day the CME will do so too.

The news of the CME announcement reminded me of something that happened almost exactly 10 years ago, 21 February 2005. Around that time, the management of  the International Petroleum Exchange was discussing the closure of the floor. (It decided to do so on 7 March.) Floor traders were very anxious about their future. Totally oblivious to this, Greenpeace decided to mount a protest on the IPE floor to commemorate the Kyoto Protocol. Bad decision. Bad timing. The barrow boys of the London floors, already in a sour mood, didn’t take kindly to this invasion, and mayhem ensued. Punches were thrown. Bones were broken. Furniture was thrown. There was much comedy:

“The violence was instant,” reported one aggrieved recipient of a rain of blows to the head. “I’ve never seen anyone less amenable to listening to our point of view.”

You can’t make that up.

From what I understand, the response was much more subdued in Chicago and New York today. But then again, Occupy or GMO protesters didn’t attempt to sally onto the floor to flog their causes. If they had, they just might have caught a flogging like the enviros did in London a decade back.

Being of a historical bent, I will look back on the floors with fascination. I am grateful to have known them personally, and to have known many who trod the boards in the pit in their colorful jackets, shouting themselves hoarse and at constant risk of being stabbed in the neck with a pencil wielded by a hyperactive peer.

Today is a good day to watch Floored or The Pit. Or even play a game of Pit. The films will give you something of a feel, but just a bit.

2015. The year Chicago lost Ernie Banks and the floor. But life moves on. Machines do not have the color of the floor, but they perform the markets’ vital functions more efficiently now. And not everything has changed in Chicago. The Cubs are still horrible.

*The exact beginning of floor trading on the CBT is unknown. The Board of Trade of the City of Chicago was formed in 1848, but futures trading proper probably did not begin until the Civil War. Sometime in the 1862-1864 period floor trading as we know it today-or should I say knew it?-developed. The first formal trading rules were promulgated in 1867. If you look at pictures from the 19th century or early-20th century, other than the clothes things don’t look much different than they did in the 1980s or 1990s. Electronic boards replaced chalk boards, but other than that, things look very similar.

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January 31, 2015

A Devastating Critique of the Worst of Frankendodd: The SEF Mandate

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 9:05 pm

On the day of its passage, I proclaimed the Swaps Execution Facility (SEF) Mandate to be the Worst of Frankendodd. Somewhat later, I called the Made Available for Trade (MAT) process to be the Worst of the Worst. Nothing that has happened since has led me to change my mind. To the contrary.

Many considerations led me to these conclusions. Most notably, the SEF mandate, especially as implemented by the CFTC, substituted government judgment for user choice in how to execute swaps transactions. In particular, the mandate imposed a one-size-fits-all execution model on a very diverse marketplace. In the swaps market, heterogeneous participants with varying objectives want to engage in heterogeneous transactions, and over time a variety of execution methods evolved to accommodate this diversity. The mandate ran roughshod over this evolved ecosystem.

Congress, and especially the CFTC, took the futures market with centralized exchanges as its model. They liked the futures markets’ pre-trade and post-trade price transparency. (Remember Gentler and his damn apples?) They liked counterparty opacity (i.e., anonymity). They liked centralized execution and a central limit order book. They liked continuous markets.

But swaps markets evolved precisely because those features did not serve the needs of market participants. The sizes of most swap transactions, and the desire of participants to transact in such size relatively infrequently, are not handled efficiently in a continuous market. Moreover, the counterparty transparency available to the parties of bilateral trades each to evaluate the trading motives of the other, thereby limiting exposure to opportunistic informed trading: this enhances market liquidity. Limited post-trade transparency makes it cheaper for dealers who took on an exposure in a trade with a customer to hedge that risk. The inter dealer broker model also facilitates the efficient transfer of risk among dealer banks.

But those arguments were unavailing. Congress and the CFTC were deeply suspicious of the bank-dominated swaps markets. They viewed this structure as uncompetitive (despite the fact that there were more firms engaged in that market than in most major sectors of the economy), and the relationship between dealers and end users as one of greatly unequal power, with the former exploiting the latter. The protests of end users over the mandate did not move them in the slightest.

I predicted several consequences of the mandate. Fragmentation along geographical/jurisdictional lines was the most notable: I predicted that non-US entities that could avoid the strictures of Frankendodd would do so.  I also predicted a decline in swaps trading activity, due to the higher costs of an ill-adapted trading system.

These things have come to pass. What’s more, it’s hard to discern any offsetting benefits whatsoever. Indeed, when compliance costs and the costs of investing in and operating SEF infrastructure are considered, the deadweight losses almost certainly run into the many billions annually.

If you want detailed chapter and verse describing just how misguided the mandate is, you now have it. Thursday CFTC Commissioner Christopher Giancarlo released a white paper that exposes the flaws in the mandate as implemented by the CFTC, and recommends reforms. It is essential reading to anyone involved in, or even interested in, the swap markets.

Commissioner Giancarlo may be talking his ex-book as an executive of IDB GFI, but in this case that means he knows what he’s talking about. He carefully demonstrates the economic purposes and advantages of pre-Dodd Frank swaps market structure and trading protocols, and shows how the CFTC’s implementation of the mandate undermined these.

The most important part of the white paper is its demonstration of the fact that the CFTC made the worst even worse than it needed to be. Whereas Congress envisioned that a variety of different execution methods and platform would meet its purposes, CFTC effectively ruled out all but two: a central limit order book (CLOB) and request for quote (RFQ). It even imposed unduly restrictive requirements for RFQ trading. As the commissioner proves, the statute didn’t require this: CFTC chose it. Actually, it would be more accurate to say that Gensler chose it. Giancarlo does not name names, for obvious reasons, but I operate under no such constraints, so there it is.

Commissioner Giancarlo also goes into great deal laying out the perverse consequences of the mandate, including in addition to the fragmentation of liquidity and the inflation of costs the creation of counterproductive tensions in relations between American and foreign regulators. Perhaps the most important part of the paper is the discussion of fragility and systemic risk. By creating a more baroque, complex, rigid, illiquid, and fragmented marketplace, the CFTC’s SEF regulations actually increase the likelihood and severity of a market disruption that could have systemic consequences. This is exactly contrary to the stated purpose of Dodd-Frank.

Seemingly no detail goes unaddressed. Take, for instance, the discussion of the provision that voids swaps that fail to clear ab initio, i.e., a swap that fails to clear for any reason-even a trivial clerical error that is readily fixed-treated as if it never existed. In addition to raising transactions costs, this provision increases risks and fragility. For instance, a dealer that uses one swap to hedge another loses the hedge if one of the swaps is rejected from clearing. If this happens during unsettled market conditions, the dealer may need to re-establish the hedge at a less favorable price. Since there are no free lunches, the costs associated with these risks will inevitably be passed on to end users.

The white paper suggests many reforms, most of which comport with my original critique. Most importantly, it recommends that the CFTC permit a much broader set of execution methods beyond CLOB and RFQ, and that the CFTC let the market evolve naturally rather than dictate market structure or products. Further, it recommends that market participants be allowed to determine by contract and consent acceptable practices relating to, inter alia, confirmations, the treatment of swaps rejected from clearing, and compression. More generally, it advocates a true principles-based approach, rather than the approach adopted by the CFTC, i.e., a highly prescriptive approach masquerading as a principled based one.

One hopes that these very sound ideas get a fair hearing, and actually result in meaningful improvements to the SEF regulations but I am skeptical. The Frankendodd SEF monster has long since escaped the confines of the castle on 21st Street. Moreover, in the poisoned and reductionist political environment in DC, Dodd Frank is treated by many (Elizabeth Warren and the editorial board of the NYT in particular) as something carved on stone tablets that Barney brought down from Mount Sinai, rather than Capitol Hill. The Warren-NYT crowd considers any change tantamount to worshipping the Golden Calf of Wall Street.

But to reform the deformed and inform the uninformed you have to start somewhere, and the Giancarlo white paper is an excellent start. One hopes that it provides the foundation for reasoned reform of the most misbegotten part of Dodd Frank. I challenge the die hard defenders of every jot and tittle of this law to meet Giancarlo’s thorough and thoughtful contribution with one of their own. But I’m not holding my breath.

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Russian Central Bank Roulette: Rubble the Ruble or the Banking System?

Filed under: Economics,Politics,Russia — The Professor @ 2:53 pm

On Friday the Central Bank of Russia surprised pretty much everyone by cutting its policy interest rate from 17 percent to 15 percent. Bloomberg lays responsibility at Putin’s feet, and no doubt he had to approve. But the evidence the article cites is not dispositive by any means. Yes, Central bank Governor Elvira Nabiullina had sworn up and down a little more than a week ago that the bank would not cut rates: if she’d said anything differently, she would have set off a speculative attack on the ruble, so she had to say that even if a policy change was being considered.

The fact is that CBR faces a terrible trade-off. Keeping the interest rate high damages severely the banking system, and is a drag on the real economy. Lowering the interest rate undermines the ruble (which indeed fell sharply on the news) and stokes inflation, which is already high and accelerating, and which has a disproportionate adverse impact on low and middle income individuals. Significantly, the RBC’s pubic statements have shifted from mentioning only inflation as a policy target, to a Russian version of Humphrey-Hawkins balancing of inflation and growth.

No doubt there is substantial political support for this that extends far beyond Putin. In particular, domestic banks are central bankers’ most important constituency and responsibility. Indeed, central banks are at risk of capture by domestic banks, and a banking crisis is frequently a greater fear than a sharp depreciation in the currency (though those things are of course related). Major Russian bankers, notably Sberbank’s German Gref have been lamenting the damage that high interest rates are doing to banks. Further, a mid-tier Russian bank (SB) began to limit deposit withdrawals, and the entire sector is suffering funding difficulties. Given all this, the CBR decided to rubble the ruble rather than the banking system. This is a piece with the government’s plans to recapitalize the banking system.

In sum, given the choice between supporting the ruble and the banking system, it chose to support the banking system. That appears to be the more imminent danger, and one that is of primary concern to the CBR. No doubt Putin agrees, but it’s unlikely he had to force an unwilling Central Bank into that decision. If another sharp selloff in the ruble occurs, the bank may reverse course, but for now, it has chosen the banking system (and Russian corporate borrowers) over the ruble and inflation.

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January 27, 2015

A Good SWIFT Kick

Filed under: Economics,Politics,Russia — The Professor @ 7:39 pm

They say a foolish consistency is the hobgoblin of little minds, so it must be that Russians have truly expansive minds indeed. On the one hand, by May they will have established a payments system that will eliminate dependence on the international payments system called SWIFT. The Russians have also been boasting about how deals with China and Iran to conduct business using their own currencies rather than the dollar will immunize them from American financial measures. Do your worst, stupid Americans!

On the other hand, excluding Russia from SWIFT would be a declaration of war. According to VTB CEO Andrei Kostin, the day after this occurred, ambassadors would be leaving capitals.

Today Medvedev (yes, he’s alive! and awake too!) reiterated the threat:

Western countries’ threats to restrict Russia’s operations through the SWIFT international bank transaction system will prompt Russia’s counter-response without limits, Prime Minister Dmitry Medvedev said on Tuesday.

“We’ll watch developments and if such decisions are made, I want to note that our economic reaction and generally any other reaction will be without limits,” he said.

Without limits! And that goes for non-economic reactions too! So I guess that Putin plans to do a reverse Reagan, and in the event of a SWIFT cutoff take to the airways and intone “My fellow Russians, I’m pleased to tell you today that I’ve signed legislation that will outlaw the US forever. Bombing begins in 5 minutes.”

Of the two inconsistent sets of statements, the ones where the Russians freak out about being shut out of SWIFT are much more likely to be true. It would be a devastating blow to the Russian economy, and even if a parallel system is in place, unless foreign entities agree to use it, it could not supplant SWIFT for international transactions (including getting cash out of the country!) And even if foreign entities were considering ROTS (Russian Overseas Transactions System, as I’ve decided to call it), they could easily be persuaded not to by the US imposing penalties on those who did. Due to the FUD effect, even the potential for such penalties would have a deterrent effect.

Word to the wise: autarky ain’t all it’s cracked up to be.

Realistically, though, I don’t think either the US or the Europeans have the fortitude to take this step. Russian hysterical threats of “unlimited” responses are no doubt intended to feed Western reluctance. Normally I’d say the Russian threats aren’t credible, but Putin is just crazy enough that there’s room for doubt, especially given that a SWIFT kick would be an existential threat to the Russian economy.

The Greek election, which has put a pro-Putin coalition in power, makes European action even less likely. Once the EU’s Greek gangrene was only financial: now it has infected foreign policy as well, as just today the new PM rejected an EU statement blaming Russia for the Mariupol attack, and threatening additional sanctions. The Euros should have amputated long ago, and are likely to rue their failure to do so.

It is unlikely, therefore, that a SWIFT cutoff will be used, precisely because it would be so devastating. But if Putin goes all in in Ukraine, who knows?

One last humorous aside. Zero Hedge highlighted the Medvedev threat and Russia’s move to reduce its exposure to the dollar system. ZH claimed that this is another in a series of blows against the dollar: de-dollarization is one of its favorite hobby horses to ride.

So riddle me this, Tyler: if there is such panicked flight from the dollar, led by such countries as Russia, China, and Iran, why is it up almost 20 percent (as measured by the DXY) since May? That would be the most bizarre flight from a currency in recorded history. (h/t Ty-not Tyler-for pointing me to the ZH post, and the contradiction.)

 

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