Streetwise Professor

October 10, 2015

Igor Gensler Helps the Wicked Witch of the West Wing Create Son of Frankendodd

Hillary Clinton has announced her program to reform Wall Street. Again.

The actual author of the plan is said to be my old buddy, GiGi: Gary Gensler.

Gensler, if you will recall, was the Igor to Dr. Frankendodd, the loyal assistant who did the hard work to bring the monster to life. Now he is teaming with the Wicked Witch of the West Wing to create Son of Frankendodd.

There are a few reasonable things in the proposal. A risk charge on bigger, more complex institutions makes sense, although the details are devilish.

But for the most part, it is ill-conceived, as one would expect from Gensler.

For instance, it proposes regulating haircuts on repo loans. As I said frequently in the 2009-2010 period, attempting to impose these sorts of requirements on heterogeneous transactions is a form of price control that will lead some risks to be underpriced and some risks to be overpriced. This will create distorted incentives that are likely to increase risks and misallocations, rather than reduce them.

A tax on HFT has received the most attention:

The growth of high-frequency trading (HFT) has unnecessarily burdened our markets and enabled unfair and abusive trading strategies that often capitalize on a “two-tiered” market structure with obsolete rules. That’s why Clinton would impose a tax targeted specifically at harmful HFT. In particular, the tax would hit HFT strategies involving excessive levels of order cancellations, which make our markets less stable and less fair.

This is completely wrongheaded. HFT has not “burdened” our markets. It has been a form of creative destruction that has made traditional intermediaries obsolete, and in so doing has dramatically reduced trading costs. Yes, a baroque market structure in equities has created opportunities for rent seeking by HFT firms, but that was created by regulations, RegNMS in particular. So why not fix the rules (which in Hillary and Gensler acknowledge are problematic) rather than kneecap those who are responding to the incentives the rules create?

Furthermore, the particular remedy proposed here is completely idiotic. “Excessive levels of order cancellations.” Just who is capable of determining what is “excessive”? Furthermore, the ability to cancel orders rapidly is exactly what allows HFT to supply liquidity cheaply, because it limits their vulnerability to adverse selection. High rates of order cancellation are a feature, not a bug, in market making.

It is particularly ironic that Hillary pitches this as a matter of protecting “everyday investors.” FFS, “everyday investors” trading in small quantities are the ones who have gained most from the HFT-caused narrowing of bid-ask spreads.

Hillary also targets dark pools, another target of popular ignorance. Dark pools reduce trading costs for institutional investors, many of whom are investing the money of “everyday” people.

The proposal also gives Gensler an opportunity to ride one of his hobby horses, the Swaps Pushout Rule. This is another inane idea that is completely at odds with its purported purpose. It breaks netting sets and if anything makes the financial system more complex, and certainly makes financial institutions more complex. It also discriminates against commodities and increases the costs of managing commodity price risk.

The most bizarre part of the proposal would require financial institutions to demonstrate to regulators that they can be managed effectively.

Require firms that are too large and too risky to be managed effectively to reorganize, downsize, or break apart. The complexity and scope of many of the largest financial institutions can create risks for our economy by increasing both the likelihood that firms will fail and the economic damage that such failures can cause.[xiv] That’s why, as President, Clinton would pursue legislation that enhances regulators’ authorities under Dodd-Frank to ensure that no financial institution is too large and too risky to manage. Large financial firms would need to demonstrate to regulators that they can be managed effectively, with appropriate accountability across all of their activities. If firms can’t be managed effectively, regulators would have the explicit statutory authorization to require that they reorganize, downsize, or break apart. And Clinton would appoint regulators who would use both these new authorities and the substantial authorities they already have to hold firms accountable.

Just how would you demonstrate this? What would be the criteria? Why should we believe that regulators have the knowledge or expertise to make these judgments?

I have a Modest Proposal of my own. How about a rule that requires legislators and regulators to demonstrate that they have the competence to manage entire sectors of the economy, and in particular, have the competence to understand, let alone manage, an extraordinarily complex emergent order like the financial system? If some firms are too complex to manage, isn’t an ecosystem consisting of many such firms interacting in highly non-linear ways exponentially more complex to control, especially through the cumbersome process of legislation and regulation? Shouldn’t regulators demonstrate they are up to the task?

But of course Gensler and his ilk believe that they are somehow superior to those who manage financial firms. They are oblivious to the Knowledge Problem, and can see the speck in every banker’s eye, but don’t notice the log in their own.

People like Gensler and Hillary, who are so hubristic to presume that they can design and regulate the complex financial system, are by far the biggest systemic risk. Frankendodd was bad enough, but Son of Frankendodd looks to be an even worse horror show, and is almost guaranteed to be so if Gensler is the one in charge, as he clearly aims to be.

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October 3, 2015

People. Get. A. Grip: Glencore Is Not the Next Lehman

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,History,Regulation — The Professor @ 6:53 pm

There is a lot of hysterical chatter out there about Glencore being the next Lehman, and its failure being the next Lehman Moment that plunges the financial system into chaos. Please. Get. A. Grip.

Comparing the firms shows there’s no comparison.

Let’s first talk size, since this is often framed as an issue of “too big to fail.” In November, 2007, Lehman’s total assets were $691 billion. As of August, Glencore’s were $148 billion. Lehman was about 4.5 times bigger. Moreover, Glencore’s assets include a lot of short term assets (inventories and the like) that are relatively liquid. Looking at Glencore as a $100 billion firm is more realistic. Lehman was much bigger.

Then let’s talk leverage. Lehman had 3 percent equity, 97 percent debt. Glencore about one third-two thirds. Stripping out the short term debt and short term assets, it’s about 50-50.

Then let’s talk off-balance sheet. Lehman was a derivatives dealer with huge OTC derivatives exposures both long and short. Glencore’s derivatives book is much smaller, more directional, and much in listed derivatives.

Lehman had derivatives liabilities of about $30 billion after netting and collateral were taken into account, and $66 billion if not (which matters if netting is not honored in bankruptcy). Glencore has $2 billion and $20 billion, respectively.

Lets talk about funding. Lehman was funding long term assets with short term debt (e.g., overnight repos, corporate paper). It had a fragile capital structure. Glencore’s short term debt is funding short term assets, and its longer term assets are funded by longer term debt. A much less fragile capital structure.  Lower leverage and less fragile capital means that Glencore is much less susceptible to a run that can ruin a company that is actually solvent. That also means less likelihood that creditors are going to take a big loss due to a run (as was the case with Lehman).

As a major dealer, Lehman was also more interconnected with every major systemically important financial institution. That made contagion more likely.

But I don’t think these firm-specific characteristics are the most important factors. Market conditions today are significantly different, and that makes a huge difference.

It wasn’t the case that Lehman failed out of a clear blue sky and this brought down the entire financial system through a counterparty or informational channel. Lehman was one of a series of casualties of a financial crisis that had been underway for more than a year. The crisis began in earnest in August, 2007. Every market indicator was flashing red for the next 12 months. The OIS-Libor spread blew out. The TED spread blew out. Financial institution CDS spreads widened dramatically. Asset backed security prices were plummeting. Auction rate securities were failing. SPVs holding structured products were having difficulty issuing corporate paper to fund them. Bear Sterns failed. Fannie and Freddie were put into receivership. Everyone knew AIG was coughing up blood.

Lehman’s failure was the culmination of this process: it was more a symptom of the failure of the financial system, than a major cause. It is still an open question why its failure catalyzed an intensified panic and near collapse of the world system. One explanation is that people inferred that the failure of the Fed to bail it out meant that it wouldn’t be bailing out anyone else, and this set off the panic as people ran on firms that they had thought were working with a net, the existence of which they now doubted. Another explanation is that there was information contagion: people inferred that other institutions with similar portfolios to Lehman’s might be in worse shape than previously believed and hence ran on them (e.g., Goldman, Morgan Stanley, Citi) when Lehman went down. The counterparty contagion channel has not received widespread support.

In contrast, Glencore’s problems are occurring at a time of relative quiescence in the financial markets. Yes commodity markets are down hard, and equities have had spasms of volatility lately, but the warning signs of liquidity problems or massive credit problems in the banking sector are notably absent. TED and OIS-Libor spreads have ticked up mildly in recent months, but are still at low levels. A lot of energy debt is distressed, but that does not appear to have impaired financial institutions’ balance sheets the same way that the distress in the mortgage market did in 2007-2008.

Furthermore, there is not even a remote possibility of an implicit bailout put for Glencore, whereas it was plausible for Lehman (and hence the failure of the put to materialize plausibly caused such havoc). There are few signs of information contagion. Other mining firms stocks have fallen, but that reflects fundamentals: Glencore has fallen more because it is more leveraged.

Put differently, the financial system was more fragile then, and Lehman was clearly more systemically important, because of its interconnections and the information it conveyed about the health of other financial institutions and government/central bank policy towards them. The system is more able to handle a big failure now, and a smaller Glencore is not nearly as salient as Lehman was.

In sum, Glencore vs. Lehman: Smaller. Less leveraged. Less fragile balance sheet. Less interconnected. And crucially, running into difficulties largely by itself, due to its own idiosyncratic issues, in a time of relative health in the financial system, as opposed to being representative of an entire financial system that was acutely distressed.

With so many profound differences, it’s hard to imagine Glencore’s failure would lead to the same consequences as Lehman. It wouldn’t be fun for its creditors, but they would survive, and the damage would largely be contained to them.

So if you need something to keep you up at night, unless you are a Glencore creditor or shareholder, you’ll need to find something else. It ain’t gonna be Lehman, Part Deux. But I guess financial journos need something to write about.

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September 28, 2015

Regulation Confronts Reality In the Commodity Markets. Reality Is Losing.

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Financial crisis,Regulation — The Professor @ 6:36 pm

Following the commodities markets today was like drinking from a fire hose. Many big stories, with “up” and “down” being the operative words. Alcoa split up. Shell announcing that it was giving up on its Arctic plans after its controversial test well failed to find commercially viable reserves. Oil price down around 3 percent, etc.

But the biggest news items were Glencore’s continuing downward spiral, and ESMA’s release of its technical recommendations for application of MiFID to non-financial firms, including commodity firms.

Glencore’s stock was down hard at the open, and at one point was down 31 percent. It’s CDS are now trading up-front (always a bad sign), and the spread widened from an already big 550 bp to 757 bp. At conventional recovery rates, this gives a (risk neutralized) probability of default of better than 50 percent. The Biggest Loser was Glencore’s CEO, Ivan Glasenberg, AKA, Ex-Glencore Billionaire.

The CDS are now trading wider than when Glencore had it s last near-death experience at the height of the financial crisis. Arguably the firm’s situation is worse now. It cannot attribute its woes to stressed financial market conditions generally, in which pretty much everyone saw spreads blow out to one degree or another. This is unique to it and the mining sector. It is a verdict on the firm/sector.

Moreover, in 2008 the firm was private, and Glasenberg and the other owners were able to stanch the bleeding by injecting additional capital into the firm. The ominous thing for Ivan et al now is that they tried that again a couple of weeks ago (along with announcing other measures to reduce debt and conserve cash) and it only bought a temporary respite before the blood started gushing again.

Moreover-and this is crucial-Glencore 2015 is a very different creature than Glencore 2008. It was more of a pure trader then: it is a mining firm with a big trading arm now. This means that its exposure to flat prices (of coal and copper in particular) is much bigger now. In fact, most commodity firms saw little drop off in profits in 2008-2009, and several saw profits increase. The fundamentals facing trading firms in 2008-2009 were not nearly as bad as the fundamentals facing mining firms today. That’s because their flat price exposures weren’t large, and margins and volumes (which drive trading profits) are not as sensitive to macro conditions as flat prices. Given the lack of any prospects for a rebound in flat prices, Glencore’s prospects for a recovery are muted.

Some tout Glasenberg et al’s trading acumen. But it is one thing to be able to sniff out arbs/relative mispricings and structure clever trades to exploit them. (Or to hold one’s nose while doing deals with dodgy regimes around the world.) It is something altogether different to predict where prices are going to go. Glencore made a bet on China, and now that bet is not looking good. At all.

In a nutshell, this is pretty much out of Glencore’s hands. It is along for the ride.

The irony here is that Glasenberg sold the Xstrata merger and the new business model as a way of using the less cyclical profitability of the trading venture as a way of dampening the cyclicality of the mining operation. As it is developing, an extremely adverse cyclical downturn in the mining operation is impairing the viability of the trading operation. How the trading operation can flourish within a financially distressed corporation is an open question. Maybe the company will have to pull an Alcoa, and separate the trading from the mining operations, to keep the latter from dragging down the former.

A key takeaway here relates to the other story I mentioned: ESMA’s release of its recommendations regarding the application of MiFID to non-financials. The objective is to mitigate systemic risk. I was always skeptical that commodity traders posed any such risk (and have been making that argument for 3+ years), and so far the Glencore meltdown is supporting that skepticism. There has been no evidence of spillovers/contagion from Glencore to financial institutions, or to the broader market, a la Lehman.

But ESMA has proposed Technical Standards that would impose the full panoply of CRD-IV capital requirements on commodity traders (and other non-financial firms) that cannot avail themselves of an exemption (on which I will say more momentarily).

  1. If firms cannot make use of an exemption under MiFID II, capital requirements under the new banking regulatory framework will apply to them. This new framework consists of Regulation EU No 575/2013 (CRR) and Directive 2013/36/EU (CRD IV), repealing Directives 2006/48/EC and 2006/49/EC. While CRD IV is addressed to CAs and includes, inter alia, qualitative provisions on the Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP), the new CRR imposes quantitative requirements and disclosure obligations pursuant to Basel III recommendations on credit institutions and investment firms, including own funds definition, minimum own funds requirements and liquidity requirements. However, under Article 498(1) of CRR, some commodity dealers falling within the scope of MiFID are transitionally exempt from the CRR’s provisions on own funds requirements until 31 December 2017 at the latest, if their main business consists exclusively of providing investment services or activities relating to commodity derivatives.
  2. Moreover, firms falling within the scope of MiFID II will be considered to be financial counterparties rather than non-financial counterparties under Article 2(8) of EMIR. Therefore, they will not be able to benefit from the clearing thresholds or the hedging exemption available to the latter under Article 10 of EMIR. An additional consequence of being classified as a financial counterparty will be that the trading obligation (i.e. the obligation to trade derivatives which are subject to the clearing obligation and sufficiently liquid on trading venues only, cf. Article 28 of MiFIR) would apply in full without being subject to a threshold.

So, even if you aren’t a bank, you will be treated like a bank, unless you can get the exemption. Apropos what I said the other day about impoverished carpenters, hammers, nails, etc.

To get an exemption, a firm’s non-hedging derivatives business must fall below a particular threshold amount, e.g., 3 percent of the oil market, 4 percent of the metals market. ESMA recommends that hedges be determined using EMIR criteria. The big problem with this is that only months ago ESMA itself recognized that the EMIR framework is unworkable:

  1. It appears that the complex mechanism introduced by EMIR for the NFC+ [Non-Financial Company Plus] classification has so far led to significant difficulties in the identification, monitoring and, as a consequence, possible supervision of these entities by their competent authorities.
  2. As a result, in the context of the revision of EMIR, ESMA would see some merit in the simplification of the current framework for the determination of NFC+.
  3. One route that the Commission may wish to explore is to move from the current two-step process (Hedging/Non Hedging and clearing threshold) to a one-step process, where counterparties would qualify as NFC+ when their outstanding positions exceeds certain thresholds per asset class, irrespective of the qualification of the trades as hedging or non-hedging. This idea is further developed in Section 4.2 which addresses the way in which NFCs qualify their transactions as hedging and non-hedging.

In other words, ESMA judged that it is impossible for regulators to distinguish firms’ hedging derivatives from its speculative ones. Given these difficulties, just a few months ago ESMA recommended jettisoning the entire mechanism that it now proposes to use to determine whether commodity firms are exempt from MiFID, and the associated capital and clearing requirements.

Makes perfect sense. In some universe.*

At the very least the ESMA plan will impose a huge compliance burden on firms who will have to justify their categorizations of derivatives positions as hedges or no. Given the complexities of risk management (e.g., managing risk on a portfolio basis means that saying what trade is a hedge is difficult, if not impossible, the rapid and frequent adjustments of positions inherent in most trading operations, etc.) this will be a nightmare.

So the good news is: You can get an exemption from capital and clearing requirments! Yay!

The bad news is: The entity proposing the exemption says that the process for getting the exemption is unworkable, and you’ll have not just a compliance headache, but a compliance migraine.

So at the very same time that the financial travails of a big commodity firm cast serious doubt on the systemic riskiness of these firms, European regulators advance regulations intended to fix this (non-existent) problem, and are doing so in a way that they themselves have cast serious doubt on.

Put differently: regulation is confronting reality in the commodity markets at this very moment, and reality is coming off second best.

* It also hardly inspires confidence that ESMA fails basic arithmetic. Note that the threshold in oil is 3 percent, then consider this from its Briefing on Non-Financial Topics: “If a firm’s speculative trading activity is less than 50% of its total trading, it may be MiFID II exempt providing its market share is less than 20% of each threshold in the market share test e.g. 0.8% for metals, 0.3% for oil etc.” Um, last time I checked .2 x 3%=0.6%, not 0.3%.


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September 26, 2015

Capital My Boy, Capital: Or, the Day of the MiFIDs

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,Politics,Regulation — The Professor @ 6:42 pm

As the EU’s Markets in Financial Instruments Directive II (“MiFID II”) slouches towards its destiny in Brussels, one of the last items on the agenda is capital requirements for commodity traders. It appears that the entity responsible for providing technical advice to the European Commission, European Securities and Markets Authority (“ESMA”–my God when it comes to acronyms the US military has nothing on the EU) is like the proverbial poor carpenter who owns only a hammer, so that everything looks like a nail. Or in ESMA’s case, that every firm that intermediates looks like a bank, and must be regulated accordingly, including through capital requirements. Thus, firms that serve as intermediaries in physical commodities are likely to be subject to the same type of capital requirements as firms that engage in financial intermediation, like banks, and be forced to hold a higher proportion of equity in their capital structures than they currently do.

This raises the question: what “market failure” (to use a shorthand that I dislike but which gets at the basic idea) justifies the regulation of the capital structures of firms?

One can make the case for banks and some other financial intermediaries. Banks have fragile capital structures because they engage in liquidity and maturity transformations that make them vulnerable to runs. Runs on a particular institution can impose costs on other institutions, and the resulting financial crises can have devastating effects on the broader economy. The effects on the broader economy occur because financially impaired banks cannot produce their most valuable output, credit, and contractions of credit can cause a broad downturn. Banks don’t internalize these effects, and thus may choose capital structures that are too fragile. Capital requirements can ameliorate this externality.

Commodity trading firms intermediate, but they are totally different than banks. I set out the reasons in detail in this white paper (sponsored by Trafigura*-with bonus video!). A few of the key points. Commodity trading firms (“CTFs”-hey, I can play the acronym game too!) aren’t too big to fail because they aren’t that big, by comparison to banks in particular. More importantly, they don’t have fragile capital structures because although CTFs transform commodities in space, time, and form, they don’t engage in financial transformations in maturity or liquidity like banks do. They aren’t even that highly leveraged, in comparison to European banks in particular. Further, whereas a bank can’t produce its main product (credit) if it is financially distressed, the human and physical assets of a commodity trading firm can continue to transform commodities even if the firm is financially distressed: it can operate under insolvency protection or its assets can be spun off to another firm.

This is not to say commodity trading firms can’t go bust. They can: we might see that in a big way if Glencore’s travails worsen. It is to say the fallout will be limited to their creditors and shareholders, and will not be the catalyst for a financial crisis.

Consequently, there is no justification for regulating the capital structures of these entities. But Europe, in its wisdom, apparently thinks otherwise.

The numbers are big. Based on public data from 2010-2012 for five big European energy companies with trading arms alone, I estimate that the additional equity required is in the vicinity of $120 billion with a “b”. Smaller entities will take smaller hits, but it will add up and probably put the final number in the $150 billion-$200 billion range. Some Swiss entities won’t be hit directly on their main trading businesses, but they have derivatives affiliates in the UK that will be. They might decide that the weather is better elsewhere.

The big driver in the number is the Operational Risk category, which is based off 15 percent of revenues averaged over the last three years. This number is big for commodity traders because they buy and sell a lot, which generates revenues that typically dwarf their incomes (because margins are on the order of 1-2 percent).

Operational risk is a catch-all category that encompasses things other than price and credit risks, such as rogue trader risk (of which there was an example just this week), a systems failure that results in a loss, etc. Yes bigger firms with bigger revenues are likely to have bigger operational losses, but these risks don’t scale with commodity firm revenues.

I have been told that there is whispering in Brussels against these numbers, because they are based on revenues derived when oil was north of $100/bbl. At lower prices, the operational risk charge will be smaller.

Thanks for proving my point, you whisperers! Please speak up, so everyone can hear!

Operational risks are more related to the scale of the physical business (e.g., the number of barrels traded)  which is much more stable than the price of oil. So a revenue-based operational risk charge expands and contracts like an accordion with the price of commodities, but the operational risk that the charge is supposed to absorb doesn’t fluctuate nearly so much. Given the costs of increasing equity, it is likely that firms will hold equity based on high commodity price-based revenues, leading to equity capitalization that is excessive in most environments. (Well, since the regulation generates no meaningful benefits, any requirement is excessive, but it will be extremely excessive given the way it is set up.)

You might say: “Who cares?” After all, in a Modigliani-Miller world, capital structure is irrelevant. Requiring firms to issue more equity and less debt doesn’t impose costs.

Yes. In a Modigliani-Miller world, which, like the Coase world, points out the things that must be true for the irrelevance result to hold. A theoretical world, in other words, not the real world we live in.

Firms care about capital structure because in a world with economic frictions capital structure can generate or destroy value. Imposing a capital structure that firms would not freely choose therefore imposes costs.

Firms affected by the new regs will adjust on many margins. Some will decamp from Europe, for other locales like Singapore. Others who cannot be so footloose will restructure their businesses to mitigate the impact. For instance, they might try to restructure to ring fence the trading activities that are subject to MiFID. Their ability to do so will depend on whether the Commission makes physical forwards subject to the regulation. Again, since these firms did not choose these locations or structures in the absence of the regulation, these changes will involve an increase in cost and a destruction in value, with no corresponding benefit that offsets this cost even  in part.

Privately held firms may face the biggest conundrum. There is a good reason for private ownership: it aligns the incentives of owners and managers because the managers are the owners. This is a more feasible option for commodity firms than large entities in other industries because commodity price risks can be laid off to the broader financial market using derivatives hedges. The downside of private ownership is that it limits access to public capital markets for equity funding. Clever financing policies (e.g., the issuance of very long term debt that provides long term funding without a loss of control) can finesse this problem, but requiring a big boost in equity would likely force firms either to contract their balance sheets and reduce their size (again, creating an economic cost because these firms will be artificially small), or go public, and incur increased agency costs (because of a poorer alignment of incentives).

In brief, application of bank-like capital requirements on commodity traders would be all pain, no gain. The efficiency of commodity intermediation would decline. This will harm producers (who get lower prices) and consumers (who pay higher prices) because middlemen’s margins must rise to cover the higher costs caused by the burdensome regulation of their capital structures. This will not be offset by any reduction in systemic risk.

There’s an early post-WWII SciFi novel titled Day of the Triffids, in which a plague of blindness leads to the rise of an aggressive species of plant. Well, MiFID rhymes with triffid, and Day of the MiFID would be a candidate for a sequel. Why? Because blindness about the realities of commodity trading is allowing an aggressive variety of plant (Brussels bureaucrats-believe me, the metaphor fits!) to wreak havoc on the poor folk who trade, produce, and consume commodities.

Well played, Europe! Well played!

* For those whose intellect cannot conceive of any other reason than personal gain to explain an individual’s opinion, do remember that I arrived at most of the conclusions contained in the white paper when I was retained to analyze the systemic risk of commodity traders by a bank trade association that very much wanted me to conclude the opposite, and who therefore spiked the study. But the truth gets out eventually.

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September 7, 2015

Regardless of What Happens to Glencore or Noble, The Commodities River Will Keep on Rolling

Filed under: Commodities,Economics,Energy,Financial crisis — The Professor @ 4:16 pm

It is not outside the realm of possibility that my analysis of whether commodity trading firms are systemically risky-“too big to fail”-will be put to the test not once, but twice, in the coming weeks and months.

One firm that has shipped a lot of water lately is the biggest, by far: Glencore. This spawn of Marc Rich has been hit very hard by the sharp decline in copper and coal prices in particular. It’s CDS spreads have widened dramatically, tripling to 450 bp before tightening some in the last few days. Its stock price is down dramatically. S&P has changed its rating to BBB/Negative, meaning that a downgrade to junk is possible.

In response, the company has announced rather radical measures to slash debt in order to maintain its vital investment grade credit rating. It has announced a cut in its dividend and an issuance of new equity via  a rights issue (about a quarter of which  will be purchased by management). It is also shopping assets, notably the recently acquired grain trading assets acquired with the Swiss firm bought Canada’s Viterra. It has responded to the copper price decline by shutting a mine in Africa.

The market’s initial reaction to these moves has been positive: Glencore’s stock rose when it announced these measures.

Glencore’s distress is a direct result of the sharp declines in copper and coal prices, which in turn are the direct result of the slowdown in China.

Although Glencore’s origins were as a trading firm, and it is still considered a trading firm, it is in many respects the exception that proves the rule, and hence is not a harbinger of doom for other traders. As I documented in my first white paper, The Economics of Commodity Trading Firms, Glencore is the most asset heavy of the firms commonly considered traders. Moreover, its assets are concentrated in the upstream, especially in the aftermath of its acquisition of Xsrata. In its current incarnation, it is more of a mining firm with a trading firm attached, than a trading firm.

Glencore always touted that its trading operation could be an internal hedge for its upstream activities: trading profitability is driven by volumes and margins, and these are less sensitive to commodity supply and demand conditions than prices, because the inelasticities of supply and demand mean that price, rather than volume, bears the brunt of demand and supply shocks. The Glencore argument makes sense, but there is only so much that the trading arm can do to offset an upstream bloodbath. Glencore’s exposure to flat price is so large now that in the grim pricing environment of the present it swamps the ability of the trading arm to bail it out.

Will it escape insolvency? I don’t know, precisely because its fate is out of its control, and dependent on flat prices, which neither I nor its management can predict with any certainty. Events, my boy. Events. Because of its upstream exposure, Glencore is on a ride on the China train. (By the way, those who thought that Glencore was a lower risk than other miners because of some superior ability to predict flat price because it is a trader: what were you thinking?)

If it goes insolvent, will it matter? Well, it’s creditors will mind. But beyond that, the arguments I made in my other white paper, Not Too Big to Fail, imply that the knock-on effects will be minimal. Industrial and mining firms can fail, and go through insolvency/bankruptcy without larger systemic effects.

The possible Viterra sale illustrates another point I made in the paper. Namely, that the financial distress of a commodity trader does not mean that the supply of commodity transformation services will decline. The distressed firm’s assets can continue to operate. One way to ensure that they continue to operate efficiently is to sell them to others. The wheat, canola, and barley that go through Viterra’s elevators don’t really care whose name is on the door. Nor, for the most part, do the farmers upstream or the consumers downstream.

What about other commodity traders? The purer traders they are (i.e., the less upstream asset exposure), the better off they are. Indeed, the lower price environment in oil in particular facilitates the contango trade because contangoes tend to widen when prices decline. BP’s trading arm announced lower profits in Q2 precisely because the contango play was not as profitable: I would expect that to turn around in Q3 and Q4 if prices remain low and the contango remains fat. As another example, Vitol made a well-timed purchase of the remainder of a Dutch oil storage company, presumably to allow it to exploit such plays.

The other firm that could test my arguments is the Hong Kong firm Noble. Nobles issues are somewhat different than Glencore’s. Noble’s accounting has come under sharp questioning, by a rather mysterious outfit called Iceberg (which Noble claims is basically the blog of a disgruntled ex-employee).

The issue is Noble’s aggressive booking of profits on long term deals. Something like 90 percent of the book value of its equity is attributable to these accounting items, whereas for other firms the figure is more on the order of 5-10 percent. Iceberg has also questioned Noble’s reported leverage, alleging that it has engaged in various off-balance sheet repo transactions (a la Lehman repo 105) to conceal debt.

The market has taken these charges seriously.  Noble’s stock has taken a pounding. It rebounded some recently, when Mitsubishi announced the acquisition of a 20 percent share of Olam, another Asian commodity firm whose accounting had been challenged, attracting some aggressive short sellers. But even with the rebound, Noble is flirting with dangerous territory and is at serious risk of insolvency or illiquidity if its bankers get sufficiently concerned (which amounts to insolvency for a commodity trader, which is very dependent on access to credit). Noble’s CDS spread reached 700+ bp in mid-August.

In the event of the worst happening, I again would expect that the pain would be limited to the creditors. Other firms, likely Japanese or Chinese trading firms, would pick up the pieces, and perhaps the whole caboodle. The commodities Noble moves would be moved by somebody else. Banks would eat a loss, but that’s part of their business. Other commodity traders’ accounting would get more scrutiny, from their creditors in particular. And that’s not a bad thing.

Commodity firms have come and gone over the years. (Everybody remembers Enron. Anybody remember Cook Industries? Andre Cie?) But the big commodities river keeps on rolling along.

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August 24, 2015

I Knew Black Monday. Black Monday Was a Friend of Mine. This Was No Black Monday

Filed under: Economics,Financial crisis — The Professor @ 6:26 pm

Today the S&P500 dropped about 4 percent. A pretty big move, yes, but hardly a catastrophe. But to follow the financial media and Twitter, you’d think it was market Armageddon. It’s Monday, so of course everybody was screeching “Black Monday,” and (of course)^2, #blackmonday trended on Twitter.

Not even close.

I worked at an FCM in Chicago on Black Monday. Well I guess I still worked there. After a falling out with my boss, I submitted my resignation at 7AM on the October 19, 1987: so now you know the real cause of the Crash. But I was in the office, and had a ringside seat to an honest-to-God crash. People, please. Today wasn’t even close.

Today’s move was about a 3 sigma move. Black Monday, 1987, was a 20 sigma move. If the world was normal-which it ain’t, of course-a 20 sigma move should occur every several billion lives of the universe. Three sigma moves occur about once every five years. So in fact, we’re a little bit overdue.

In brief, there is no comparison.

Despite the decline in stock prices, there is still one raging bull market. In stupidity. Today’s market move triggered Pavlovian responses from both idiots and people who should know better.

Leading the idiot parade were Bernie Sanders and Donald Trump. (You’re shocked, I’m sure.) Both took to the express lane of stupidity, Twitter, to share with us their deep thoughts. Sanders reflexively blamed trade:

The results are in. Unfettered free trade has been a disaster for working Americans. It is high time we ended our disastrous trade policies.

Trump blamed China, and (apparently) US policy makers dancing to China’s tune:

Markets are crashing – all caused by poor planning and allowing China and Asia to dictate the agenda. This could get very messy! Vote Trump.

Yes, China has something to do with it, but (a) as noted above, today’s “crash” is small beer indeed, and (b) the sort of autarky that Trump fantasizes about would have made us far less wealthy than we are, resulting in stock prices (and other asset prices) far below than the level to which they “crashed” today.

And then there’s Zero Hedge, which wet itself repeatedly in excitement, all the while declaring that the era of DOOM! is upon us. Too bad for ZH that if there’s anybody who’s effed by recent developments, it’s ZH’s BFF Putin and Russia. (Ruble above 71, and Brent at a 42 handle today. Good times, Vlad!)

As for people who should know better, consider Mark Cuban:

Later, in an interview on CNBC’s “Fast Money,” Cuban said the historic moves in the market on Monday were not caused by normal trading.

“No one else that trades can move the market [by] hundreds of points in hundreds of seconds in either way,” Cuban said.

“What we saw today was like a three stooges market… that doesn’t happen from normal traders, that doesn’t happen from large funds taking positions or selling positions, that happens because algorithms watch everything that’s happening and everything that’s correlated to what’s happening in equities and they take action.

Cuban has an obsession with HFT, and today gave him an opportunity to spout off on it again, revealing his ignorance, and unreasoning hatred, of it. Days like today, and market movements like today (with big gaps) have occurred before anyone even thought of algos, before markets were computerized, and before Mark Cuban was born. Days like today occurred when prices were recorded on blackboards in chalk. Days like today occurred when the closest thing to HFT was the telegraph and the stock ticker. Regardless of the technology, markets do things like they did today.

Everybody should just give it a rest. Days like today happen with some regularity. No reason to panic. Indeed, it should be a source of some comfort that the impetus for the selloff was events in China, rather than (as in 2008) the impending implosion of the US banking sector.

And do yourself a favor. Turn off the TV, and just look at Twitter so that you can mock the likes of Trump and Sanders. The signal-to-noise ratio is asymptotically approaching zero. When you really need to panic, you’ll know.


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July 21, 2015

The Fifth Year of the Frankendodd Life Sentence

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 7:52 pm

Today is Frankendodd’s fifth birthday. Hardly time for celebration. It is probably more appropriate to say that this is the fifth year in the Frankendodd life sentence.

So where do we stand?

The clearing mandate is in force, and a large fraction of derivatives, especially interest rate and credit index derivatives are cleared. This was intended to reduce systemic risk, and as I’ve written since before the law was passed and signed, this was a chimerical goal. Indeed, in my view the systemic risk effects of the mandate are at best a push (merely shifting around the source of systemic risk), and at worse the net effects of the mandate are negative.

Belatedly regulators are coming around to the recognition of the risks posed by CCPs. They understand that CCPs have concentrated risk, and hence the failure of one of these entities would be catastrophic. So there is a frenzy of activity to try to make CCPs less likely to fail, and to ensure their rapid recovery in the event of problems. Janet Yellen has spoken on the subject, as has the head of the Office of Financial Research, Robert Dudley of the NY Fed, and numerous European regulators. Efforts are underway in the US, Europe, and Asia to increase CCP resources, and craft recovery and resolution procedures.

This is an improvement, I guess, over the KoolAid quaffing enthusiasm for the curative effects of CCPs that virtually all regulators indulged in post-crisis. But it distinctly reminds me of people madly sewing parachutes after the rather dodgy plane has taken off.

Further, these efforts miss a very major point. The main source of systemic risk from the clearing mandate derives from the huge liquidity strains that clearing (notably variation margin on a rigid time schedule) will create when the market is stressed. There has been some attention to ensuring CCPs have access to liquidity in the event of a default, but that’s not the real issue either. The real issue is funding large margin calls during a crisis.

Moreover, as I’ve also discussed, efforts to make CCPs more resilient can increase pressures elsewhere in the financial system (the “levee effect.”) Relatedly, regulators have not fully come to grips with the redistributive aspects of clearing–including in particular how netting, which they adore, can just relocate systemic risks.

I therefore stand by my prediction that a regulation-inflated clearing system will the source of the next systemic crisis.

Moving on, I called the SEF mandate the worst of Dodd-Frank. In the US, the majority of swap trades are done on SEFs, though mainly through RFQs rather than the central limit order books that Barney and Co. dreamed about in 2010.

There was never a remotely plausible systemic risk reducing rationale for the SEF mandate. Hence, if SEFs are inefficient ways to execute transactions, the mandate is all pain, no gain. As an indication of that this is indeed the case, note that virtually all European banks and end users stopped trading Euro-denominated swaps with US counterparties exactly when the mandate kicked in. The swaps mandate was too onerous, and anyone who could escape it did.

In a piece in Risk, I referred to the Made Available to Trade part of the SEF mandate the worst of the worst of Dodd-Frank. It made no sense to force all market participants to trade a particular kind of swap on SEFs just because one SEF decided to list it. Apparently that realization is slowly sinking in. The CFTC recently held a meeting on the MAT issue, and it seems as if there is a good chance that the CFTC will eventually determine what has to be traded on SEFs.

It is an indication of my loathing for MAT as it currently exists that I consider that an improvement.

Still moving on, Frankendodd was intended to reduce concentration and interconnectedness in the financial system. The actual result cannot really be called a mere unintended consequence: it was the exact opposite of the intended effect. Completely predictably (and predicted) the huge regulatory overhead increased concentration rather than reduced it. This is particularly true with respect to clearing. Gary Gensler’s dream of letting a thousand clearing firms bloom has turned into a nightmare, in which the clearing business is concentrated in a handful of big financial institutions, exacerbating too big to fail problems. And clearing has turned out to be the Mother of All Interconnections, because every big financial institution is connected to all big CCPs, and because pretty much everyone has to funnel the bulk of their derivatives trades through clearinghouses.

I could go on. Let me just re-iterate another risk of Frankendodd: standardization–the regulators’ fetish–is  a major source of systemic risk. Monocultures are particularly vulnerable to catastrophic failure, and the international regulatory standardization that was birthed in Pittsburg in 2009, and enacted in Frankendodd and MiFID and Emir, has created a regulatory monoculture. Some are grasping the implications of this. But too few, and not the right people.

I’ve focused here on the sins of commission. But there are also the sins of omission. Frankendodd did nothing about the Fannie and Freddie monster, which is coming back from the dead. F&F was a real systemic risk, but the same political dynamic that fed it in the 1990s and pre-2008 is at work again. Get ready for a repeat.

Frankendodd should have just focused on raising capital requirements for banks and other financial institutions with liquidity and maturity mismatches, and driven a stake through Fannie and Freddie. Instead, it sought to impose a detailed engineered solution on an emergent order. This inevitably ends badly.

So maybe it would be more accurate to say that we’re in our fifth year on death row. Someday the warden will come knocking.

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April 3, 2015

BATS in the OCC’s Belfry?, or The Perils of Natural Monopoly Regulation, CCP Edition

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Regulation — The Professor @ 11:13 am

The Options Clearing Corporation (“OCC”) and the exchanges that own it (Chicago Board Options Exchange, Incorporated, International Securities Exchange, LLC, NASDAQ OMX PHLX LLC, NYSE MKT LLC, and NYSE Arca) are embroiled in a dispute with virtually everyone else in the options business regarding its new capital plan. Pursuant to its designation as a “Systemically Important Financial Market Utility” (“SIFMU”) under Frankendodd, OCC was required to boost capital from $25 million to nearly $250 million. Part of this will be obtained through retained earnings, with an additional $150 million via a capital injection from the four owner-exchanges. In addition, CBOE et al promise to inject up to $117 million in the event of “unexpected losses”, which would be most likely to occur during a financial crisis.

In return, the owner-exchanges receive in essence preferred stock, which pays a dividend in perpetuity. The exact amount of the dividend is not known publicly, but those objecting to the plan (including BATS and KCG) claim that it could be as much as 16-19 pct, at least in the first few years of the plan’s operation.

Non-owner exchanges like BATS and market users like KCG are furious, claiming that the the capital plan allows OCC’s owners to “monetize” the rents accruing to its status as the monopoly clearer for options transactions in the US. They believe that OCC will pay for the dividend by charging super competitive fees that will impair competition among exchanges (advantaging the owner exchanges over the non-owners) and will burden market users.

This is a difficult issue, the nature of OCC. Here are some thoughts:

1. OCC is a regulated monopoly, and arguably a natural monopoly.This creates the traditional conflict between the owners of the utility and its customers, which include other exchanges that aren’t owners (like BATS) and clearing firms and market users (like KCG). This is in many ways very similar to a dispute between a traditional electric utility and its ratepayers heard before a state utility commission, with the exception that this is before the SEC.

2. Like a traditional are case involving a regulated utility, the dispute here is over what is a fair rate of return on capital. BATS and KCG are objecting to the rate of return the 4 exchange owners of OCC are being promised for their capital contribution, and the process by which the SEC approved this rate of return.

3. It is particularly challenging to determine a “fair” rate of return on this capital because of the unique risks that the OCC exchanges are assuming. This capital is at risk of taking a big hit, and the owner-exchanges are potentially obligated to make additional capital contributions, during periods of financial crisis (the “dire circumstances”) referred to in BATS’s letter to the SEC. This tends to make this capital very expensive, and it should therefore earn a relatively high rate of return (high dividend). Capital that has bad returns when the market is doing poorly overall-“high beta”, if you will-is expensive capital. The type of capital being provided is fraught with wrong-way risk: it is likely to take a hit precisely when the capital suppliers are least able to afford it. Determining how much of a risk premium is warranted is a challenge, because of the exceptional nature of the risk. In essence, the exchanges are assuming tail risk, i.e., the risk of exceptional events, and it is inherently difficult to evaluate and price these risks.

4. The other exchanges and firms like KCG benefit from the risk bearing capital supplied by the owner exchanges. Otherwise, they would have to bear the risk. But of course they would like to underpay for this benefit, just as the owner exchanges might want to overcharge for it.

5. In other words, this situation is tailor made for disputes. Monopoly rate setting to determine fair rates and a fair rate of return on capital with very unusual and hard to evaluate risks.

6. The fears about the effects of pricing on inter-exchange competition in execution service are misdirected. Yes, it is possible that the owner exchanges will capture monopoly rents accruing to the OCC’s dominant position, but traditional “one monopoly rent” analysis implies that they don’t have an incentive to use OCC pricing power to advantage their competitive position in execution services. Indeed, the opposite is true.

This also highlights some organization, ownership and governance issues that I addressed in my research on exchanges that culminated in my 2000 JLE piece. Exchanges (and clearinghouses) have market power, and serve disparate and heterogeneous interests. They can use pricing to redistribute rents (which accrue in part due to market power) from one group of intermediaries to another. Not-for-profit status and mutual ownership (having the exchange or CCP operate as a non-profit “utility” serving disparate intermediary-owners is a way of reducing rent seeking and mitigating the use of pricing to redistribute rents.

But non-profit, mutual organization comes at a cost. It requires highly participative, committee-heavy governance that slows decision making and often creates gridlock that makes it difficult for the exchanges/CCPs to respond to technology, regulatory, or market shocks. (Look at the CBT in the 1990s and early-2000s if you want an example.) If everybody has a voice and a vote, it is very difficult to get things done.

In sum, “financial market utility” pricing and governance is inherently messy and controversial.  It has all of the problems associated with public utility regulation, and then some. The problems are particularly daunting when it comes to capitalizing, allocating and pricing the systemic and wrong way risks that CCPs bear. Given these complexities, I won’t venture an opinion here, except to say that (a) I can see both sides of the argument here, and (b) this ain’t going away anytime soon.

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March 30, 2015

An Elegant Answer to the Wrong Question (or an Incomplete One)

Filed under: Clearing,Derivatives,Economics,Financial crisis,Regulation — The Professor @ 1:14 pm

Rodney Garrett and Peter Zimmerman of the NY Fed have produced a paper studying the effect of clearing on derivatives counterparty risk exposures. It is basically an extension of the Duffle-Zhu paper from a few years ago. It studies more realistic networks and a more diverse set of scenarios than D-Z. It demonstrates that with a variety of network structures, clearing actually reduces netting efficiency and increases counterpart risk exposures. This is especially true with “scale free” or “core-periphery” networks, which are more realistic representations of actual derivatives markets than the all-to-all structure in D-Z. They show that when the system relies on relatively few crucial nodes, as is the case in most dealer structures, clearing reduces netting efficiency. This, as Garrett and Zimmerman note, could explain why clearing has not been adopted voluntarily. It also raises doubts about the advisability of clearing mandates, inasmuch as the alleged benefit of clearing is a reduction in counterparty credit exposures.

A few comments. The results, taken on their own terms, make sense. In particular, networks connecting dealers and customers via derivatives transactions, are endogenous. And although network structures are not necessarily efficient due to network externalities and path dependence, there are forces that lead to minimizing credit exposures. thus, although it would be Panglossian to assert that existing structures minimize these exposures, it should not be surprising that interventions that lead to dramatic alterations to networks increase counterparty risk exposures as existing networks are configured at least in part to reduce these exposures.

More importantly, though, there is the issue of whether counterparty risk exposure in derivatives transactions is the proper metric to evaluate the effect of clearing mandates. As I have noted for  years (as has Mark Roe), when participants in derivatives transactions have other liabilities, changes in netting efficiency in derivatives primarily redistribute wealth to or from one group of creditors (derivatives counteparties) from or to other creditors (e.g., unsecured lenders, commercial paper purchasers, deposit insurers). Netting and offset essentially privilege the creditors that can use them, at the expense of others who cannot. So telling me policy A reduces counterparty risk exposures by netting provides me very little information about the systemic effects of the policy. To understand the systemic effects, you need to understand the distributive effects across the full set of creditors impacted by the change in derivatives netting efficiency induced by the policy–and that would be every creditor of derivatives market participants. This paper, like all others in the area, does not do that.

Put another way. Papers in this literature say little about systemic risk because they only analyze a piece of the system. The derivatives-centric approach is of little value in assessing systemic risk. To analyze systemic risk, you need to analyze the system, not a piece of it.

What’s more, shuffling around credit risk is probably not the most important effect of clearing mandates, even though it receives the vast bulk of the attention. As I’ve written repeatedly in the past, including here, clearing reduces credit risk by increasing liquidity risk, most notably, through variation margining which results in the need to obtain cash in a hurry to meet margin calls, which can be large when there are large market shocks. The expansion of clearing to OTC markets which dwarf listed derivatives potentially leads to orders-of-magnitude increases in liquidity needs.

It is these liquidity demands which create huge potential systemic risks. Financial crises are usually liquidity crises: mechanisms such as clearing increase demands for liquidity in stressed market conditions, and do so in a way that increases the rigidity and tightness of the coupling in the financial system. This is extremely dangerous. Tight coupling in particular is associated with system failure in a variety of real world systems including both financial and non-financial systems.

Indeed, all of the attempts to make CCPs invulnerable all tend to exacerbate these problems. This raises the possibility that CCPs could be bastions surviving in the midst of a completely rubbled financial system.

In sum, papers like the Garrett-Zimmerman work are very elegant and technically sophisticated, and help answer a question: Does clearing reduce derivatives counterparty risk exposures? But all the elegance and technical sophistication is likely for naught given that the question is the wrong question, or a very incomplete one.

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March 23, 2015

The Systemic Risk, or Not, of Commodity Trading Firms

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,Politics,Russia — The Professor @ 2:03 pm

My latest white paper, “Not too big to fail: Systemic Risk, Regulation, and the Economics of Commodity Trading Firms” was released today. A video of me discussing it can be found here (as can my earlier white papers on commodity traders and LNG trading).

The conclusion in a nutshell: commodity trading firms do not pose systemic risks, and therefore it is inappropriate to subject them to bank-like prudential regulations, including capital requirements. Commodity trading firms are not systemically risky because (a) they aren’t really that big, (b) they are not that highly leveraged, (c) their leverage is not fragile, (d) the financial distress of a big trader is unlikely to result in contagious runs on others, or fire sale problems, and (e) their financial performance is not highly pro cyclical. Another way to see it is that banks are fragile because they engage in maturity and liquidity transformations, whereas commodity trading firms don’t: they engage in different transformations altogether.

Commodity traders are in line to be subject to Capital Requirement Directive IV starting in 2017. If the rules turn out to be binding, they will cause firms to de-lever by shrinking, or issue more equity (which may force them to forego private ownership, which aligns the interests of owners and managers). These will be costs, not offset by any systemic benefit. All pain, no gain.

It is my understanding that banks obviously think differently, and are calling for “consistent” regulations across banks, commodity traders, and other intermediaries. Since these firms differ on many dimensions, imposing the same regulations on all makes little sense. Put differently, apropos Emerson, a foolish consistency is the hobgoblin of little minds. Or bankers who want to handicap competitors.

The white paper has received some good coverage, including the Financial Times, Reuters, and Bloomberg. I will be writing more about it when I return to the states later in the week.

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