Streetwise Professor

April 29, 2016

Rounding Up the Usual Suspects, With Chinese Characteristics

Filed under: China,Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 8:32 pm

Commodity prices on Chinese exchanges, especially for ferrous metals, have been skyrocketing in recent weeks. Rebar, iron ore and coking coal have been particularly active, but thermal coal and cotton have been jacked too.

In response, the Chinese authorities are cracking down on speculation.  Exchanges have raised margins in order to attempt to rein in trading. The government is making ominous statements about speculation and manipulation. And we know what can happen to speculators who fall afoul of the government.

Ironically, prices never appear to be just right, by the lights of the Chinese authorities. Last summer, and earlier this year, speculators were allegedly causing stock prices and commodity prices to be too low. Now they are causing commodity prices to be too high.

This is a case of the Chinese authorities playing Claude Rains in Casablanca, and ordering a roundup of the usual suspects. Speculators make convenient targets, and they appear to be the proximate cause: after all, their trades produce the rapidly rising prices.

But the speculators are merely the messengers. If the Chinese authorities want to find the real culprits, they need to look in the mirror, for the speculators are responding to the most recent lurch in Chinese economic policy.

Put simply, after the economic slowdown of the second half of 2015 (a slowdown masked by fraudulent official statistics, but evident nonetheless), the government pushed the panic button and fell back on its standard remedy: injecting a burst of credit.  Some estimates put the Chinese debt to GDP at 237 percent. Since GDP is likely also an overstated measure of national income, due to fraudulent statistics and the fact that the losses on past investments have not been recognized (in part because much of the credit is pumped  into zombie companies that should be bankrupt) this ratio understates the true burden of the debt.

The surge in credit is being extended in large part through extremely fragile and opaque shadow banking channels, but the risk is ending up on bank balance sheets. To engage in regulatory arbitrage of capital rules, banks are disguising loans as “investments” in trust companies and other non-bank intermediaries, who then turn around and lend to corporate borrowers.  Just call a loan a “receivable” and voila, no nasty non performing loan problems.

There is one very reasonable inference to draw from this palpably panicked resort to stimulus, and the fact that many companies in commodity intensive industries are in desperate financial straits and the government is loath to let them go under: today’s stimulus and the implied promise of more in the future whenever the economy stutters will increase the demand for primary commodities. The speculators are drawing this inference, and responding accordingly by bidding up the prices of steel, iron ore, and coal.

Some commentors, including some whom I respect, point out that the increase does not appear to be supported by fundamentals, because steel and coal output, and capacity utilization, appear to be flat. But the markets are forward looking, and the price rises are driven by expectations of a turnaround in these struggling sectors, rather than their current performance. Indeed, the flat performance is one of the factors that has spurred the government to action.

When the Chinese responded to the 2008-2009 crisis by engaging in a massive stimulus program, I said that they were creating a Michael Jackson economy, one that was kept going by artificial means, to the detriment of its long term health. The most recent economic slowdown has engendered a similar response. Its scale is not quite as massive as 2008-2009, but it’s just begun. Furthermore, the earlier stimulus utilized a good portion of the nation’s debt capacity, and even though smaller, the current stimulus risks exhausting that capacity and raising the risk of a banking or financial crisis. It is clear, moreover, each yuan of stimulus today generates a smaller increase in (officially measured) output. Thus, in my view, the current stimulus will only provide a temporary boost to the economy, and indeed, will only aggravate the deep underlying distortions that resulted from past attempts to control the economy. This will make the ultimate reckoning even more painful.

But the speculators realize that the stimulus will raise commodity demand for some time. They further recognize that the stimulus signals that the authorities are backsliding on their pledges to reorient the economy away from heavy industry and investment-driven growth, and this is bullish for primary materials demand going forward: the resort to credit stimulus today makes it more likely that the authorities will continue to resort to it in the future. So they are bidding up prices today based on those predictions.

In other words, as long as the Michael Jackson economy lives and stays hooked, its suppliers will profit.

So yet again, commodity markets and the speculators who trade on them are merely a lurid facade distracting attention from the underlying reality. And the reality in China is that the government cannot kick the stimulus habit. The government may scream about (and worse) the usual suspects, but it is the real cause of the dizzying rise in Chinese commodity prices, and the burst of speculation.

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April 22, 2016

Schrödinger’s Clearinghouse?

Filed under: Clearing,Derivatives,Exchanges,Regulation — The Professor @ 6:31 pm

Three weeks ago I wrote about, and criticized, LSE CEO Xavier Rolet’s statement that “We can cross margin our over-the-counter clearing with their listed derivatives without merging the clearinghouses, and without comingling the risk-management framework. [Emphasis added.]”  Then three days ago I read Philip Stafford’s article in the FT stating “Deutsche Börse and LSE plan to link clearing houses“:

The two sides are working on common risk management and default frameworks for their market utilities, which risk manage billions of dollars of derivatives trades on the market every day. [Emphasis added.]

The exchanges’ long-term aim is for each customer to become a member of both the LSE-controlled LCH and Deutsche Börse’s Eurex clearing houses. The customers, which are typically banks, would agree to hand over their trading data in return for better risk management of their derivatives, according to two people familiar with the talks.

The planned London-based holding company would instruct the two clearing houses on how to proceed with a default after consultations with central banks, one of the people said. The two sides are discussing their plans with their regulators and customers, one person said.

So how do you have a “common risk management framework” without “commingling the risk-management framework”? Is there some fine verbal distinction I am missing? Or perhaps this is like Schrödinger’s CCP, in a state of quantum superposition, both commingled and uncommingled until someone opens the box.

In my post, I mentioned default management as one reason to integrate the CCPs:

Another part of the “risk management framework” is the management of defaulted positions. Separate management of the risk of components of a defaulted portfolio is highly inefficient. Indeed, part of the justification of portfolio margining is that the combined position is less risky, and that some components effectively hedge other components. Managing the risks of the components separately in the event of a default sacrifices these self-hedging features, and increases the amount of trading necessary to manage the risk of the defaulted position. Since this trading may be necessary during periods of low liquidity, economizing on the amount of trading is very beneficial.

Apparently the recent experience with the default of Maple Bank brought home the benefits of such integration:

One person familiar with the talks highlighted problems created by February’s default of Frankfurt-based bank Maple, which was a member of both exchanges’ clearing houses.

“Right now what you have is a blind process — the liquidation of positions is conducted without co-ordination,” the person said. “Therefore it has a negative price impact in the market as you have two guys running out liquidating positions in the name.”

Huh. Go figure.

“Commingling” makes sense. Coordination is vital, both in daily operations (e.g., setting margins and monitoring to reduce the risk of default) and in extremis (during a default).

Perhaps Rolet was trying to deceive regulators who are so obsessed with too big to fail (sorry, both Eurex and LCH are TBTF already!) and who are blind to the benefits of coordination. If the regulators need to be deceived thus, we are doomed, because then it would be clear they have no clue about the real issues.

One wonders if they will recognize coordination and commingling even after they look in the box. Apparently Rolet thinks not. If they do, Xavier will have a lot of ‘splainin’ to do.

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April 13, 2016

You Can’t Handle the Truth! Censoring Politically Inconvenient Research at the CFTC

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 2:29 pm

I had missed that the CFTC’s Office of the Inspector General had found that the Office of the Chief Economist had “prohibited relevant but potentially controversial research” on position limits. According to the OIG, during a routine interview with a CFTC staff economist, without being asked, the economist told the OIG that s/he had been prevented from doing research on position limits. According to the OIG, “several OCE economists identified position limits as an example of a topic on which economic research is no longer permitted.” One said: ”you can’t write a report on something that destroys three years of (CFTC) work.”

The basic conclusion is damning:

Several other economists confirmed their impression that OCE is now censoring research topics that might conflict with the official positions ofthe CFTC. Some ofthis censorship occurs on the part ofindividual staffeconomists themselves-when selecting potential topics, they now choose non-controversial ones. However, multiple OCE economists also reported that the Chief Economist has declined to permit research on certain topics relevant to the CFTC mission, including position limits.

Some OCE economists expressed uncertainty as to the purpose of OCE’s research program if the Office is prevented from studying topics relevant to current CFTC rulemaking. Yet OCE economists reported that the Chief Economist has rejected or delayed research paper topic ideas if tey were related to pending rulemaking or could challenge the validity of agency regulations. One OCE economist described the policymaking process as one in which a decision is made and then analysis is done in a fashion designed to support the decision. There is a perception within OCE that the ChiefEconomist is “more Commission-friendly,” and that he discourages research that might offend Commissioners.

During “multiple” discussions with the OIG, the Chief Economist at first admitted that this was so, then backtracked:

He agreed that he had initially rejected a research proposal on position limits on the basis that it was politically controversial. The Chief Economist later stated his belief that the CFTC did not have the data or the in-house expertise to do this project in any event. The Chief Economist explained that this was a matter of discretion, and that he did in fact permit research into politically controversial topics. He provided an example ofresearch into high-frequency trading and instances ofself-trading. When asked, the Chief Economist agreed that the Chairman actively supported this line ofresearch. The Chief Economist also stated that he wanted to be able to take to the Chairman and Commissioners anything he or OCE did.

Appalling.

Chairman Massad has recently rejected the OIG’s conclusion, the statements of multiple staff economists, and the initial gaffe (i.e., truth telling) by the Chief Economist. It wasn’t politics, you see. It was priorities:

“Our Office of the Chief Economist has many excellent economists, the morale there is very good and the work they produce is very good. They often produce things that might conflict with the views I have and the views other commissioners have, but we don’t have any kind of political screen on what we do,” said Massad, testifying before the Senate Committee on Appropriations on April 12.

“We do have, however, priority setting. It’s a small division and we must set priorities. We can’t always have a staff person just do the research they would like to do, as opposed to research we really need to focus on. That’s the only way in which we focus their work,” he added.

To state the obvious: priorities are inherently political. The statement about priorities therefore does not refute the belief of the staff economists that the decision to forbid research on position limits was ultimately political.

Chairman Massad’s assertion also is flatly inconsistent with the opinions expressed by multiple individuals, including his own Chief Economist (before he got his mind right, anyways). Thus, there is certainly a widespread perception in the OCE that permissible research means politically correct research. Either this perception is correct, or Chairman Massad has done a poor job of communicating to the economists the criteria by which research resources are allocated.

In a Washington where everything is politicized, and in particular where Senator Elizabeth Warren clearly attempts to censor those expressing dissenting opinions, and attempts to intimidate and slander those who dare to express such opinions, it is utterly plausible that the economists’ perceptions are very well grounded in reality. I view the economists’ complaint as facially valid, but potentially rebuttable. Mr. Massad’s testimony does not even come close to rebutting their assertions. Indeed, knowing how to decode words like “priorities” from GovSpeak, if anything his testimony buttresses the complaint, rather than rebuts it.

But let me suspend disbelief for a moment, and take Chairman Massad at his word. Just what does that imply?

First, it implies that a position limits initiative that would impose substantial burdens on the industry is of insufficient importance to justify a researcher or two to spend a portion of their time to study. Not to denigrate the value of the economists’ time, but in the scheme of things this does not represent a huge expenditure of resources. If position limits are of that little importance, what is the potential benefit of the regulation? Why does the Commission persist in pushing it if it is not even worth the time of a few staff economists?

Second, what does this say about the Commission’s commitment to carrying out its statutory obligation to conduct a cost-benefit analysis of the regulation?

Third, and relatedly, if the Chief Economist is correct and his staff does not possess “the data or the in-house expertise to do this project” how would it even be possible for the OCE, and the Commission, to perform a valid cost-benefit analysis? In particular, since the proposed research appears to speak to the issue of the benefits and necessity of limits, how can the Commission generally, and Chairman Massad in particular, credibly claim that they have determined that limits offer sufficient benefit to make them necessary, or to exceed their cost, if its own Chief Economist claims that his office has neither the data nor the expertise to perform valid research on the effects of limits?

Position limits have been a political project from Day 1. They remain a political project, as Senator Warren’s recent jeremiad (directed substantially at yours truly) demonstrates. The economic case for them remains dubious at best. Given this history and this context, the assertion that prohibiting CFTC staff economists from researching the issue was politically motivated is all too plausible.

The Risk article that I linked to quotes Gerry Gay, who was Chief Economist under Wendy Gramm in the Bush I administration. Gerry notes that prior to 1993, economics and economists had pride of place within the CFTC. It was viewed as “an economist’s shop.”

That is a fair statement. What happened in 1993? The Clinton administration took over, and (as Gerry notes) de-emphasized economics. I remember distinctly an article in Futures Magazine that solicited the opinion of many industry figures as to the changes the new administration would bring. Ex-CFTC Commissioner Philip McBride Johnson’s statement sticks in my mind. This is almost an exact quote, though it is from memory: “We can now get rid of the economists and put the lawyers back in charge.”

That’s exactly what happened then, and with a few exceptions during the Bush II years, has remained true ever since. Just as Clemenceau said that war is too important to be left to the generals, the DC set established that regulating the markets is too important to be left to the economists. What’s more, particularly in the Obama administration, starting with Gensler’s tenure as head of the Commission, it was determined that certain kinds of lawyers had to be in charge, and they had to follow marching orders from politicians. Do not forget that Gensler was only able to overcome skepticism about his Goldman background by pledging fealty to the Democratic senators on the relevant committees, and to their agenda. Truly independent regulators get crushed. (Remember the fate of FCC head Tom Wheeler when he strayed just a little bit off the party line on net neutrality?)

Keep that in mind when attempting to determine the true story of the disapproved research on position limits. It has been determined that you can’t handle the truth.

Update: Note well that the CFTC economists’ concerns about acceptable research extend beyond position limits. It is clear that several believe that policy-relevant research is discouraged, at least if it could contradict existing or pending regulations. If that’s in fact true, it would be fair to ask why the hell the CFTC has economists anyways. Economics has a vital role in informing policy on markets. The economists could pay their lifetime salaries many times over by stopping or correcting one misguided regulation, or even one misguided piece of a broader regulation. (I recall a quote from Coase that an economist could pay for his lifetime salary by just delaying a bad regulation a day.) The only real reason to have economists at the CFTC or any agency is to provide critical evaluation of pending or existing rules and regulations. It is beyond absurd to preclude economists from working on exactly those things, when they could upset some politically-driven regulation.

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April 4, 2016

Barbarian at the Gate, Exchange Edition

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 11:04 am

ICE’s Jeffrey Sprecher has a way of getting inside the heads of his competitors. He is obviously in the head of LSE CEO Xavier Rolet, before he’s even formally announced a rival offer for the LSE:

The boss of the London Stock Exchange has dismissed the owner of the New York Stock Exchange as a “slash and burn” organisation which would throw parts of the British bourse “in the bin”.

. . . .

He branded ICE’s ownership of Euronext, the pan-European exchange, as a “disaster,” claiming it had “eviscerated” the four-country exchange platform for cost-cutting.

Mr Rolet, who acknowledged that the LSE’s board would consider any “serious proposal,” made clear that he is not interested in a bid from an “interloper”.

“I don’t want just anyone, particularly not some ‘slash and burn’ type  organisation, to come in and kill all of the stuff we’ve done over the last few years,” he said.

“It is not a company based in Atlanta… that is going to worry about the financing of European industry… It’s just not going to be part of their strategy.

“Which is why they chucked out Euronext. They kept the clearing business that they had, and they kept the derivatives engine. And that is not a strategy for British industry. I doubt that this [Aim] would be part of the strategy of any frankly global exchange…Our 1000 Companies programme, that costs money. Our Elite programme, that costs money. All that stuff would be chucked in the bin.”

Rolet sounds like the typical 1980s CEO quaking in fear of a hostile takeover, fussing over every little piece of the empire he built. Which is exactly why everything about Sprecher that Rolet condemns as a bug is a feature.

ICE has an excellent record at making acquisitions work. A crucial reason for that is that Sprecher focuses ruthlessly on value and value creation, and doesn’t have sentimental attachments to particular businesses, especially those that are inefficient and bloated, and which don’t fit strategically within the organization he has built.

He recognized that Euronext was an excessively costly firm in a low margin commoditized business that didn’t offer any synergies to his core derivatives business. So he acquired EuronextLiffe, put Euronext on a diet, and spun it off for a decent price. He kept LIFFE and Euronext’s clearing business and integrated them into the ICE structure in a way that should make other acquirers (I’m looking at you, UAL!) green with envy.

As for sentimental musings about “financing European industry”, if it is so valuable, it would pay. If it doesn’t pay, it’s not valuable. No evident externalities here, and if there are, it’s fantasy to believe that any individual company will be able to internalize it.

As for programs that “cost money”: the question is if they generate an adequate return on that investment. If Aim, or the 1000 Companies program, or the Elite program don’t generate a compensatory return, they deserve to be binned or restructured. If they can earn a compensatory return, believe me, Sprecher won’t bin them. Rolet’s lament bears all the signs of a man who is personally invested in pet projects that he knows don’t pass the value creation test.

Rolet, in other words, sees Sprecher as a latter day Barbarian at the Gates. But if you give it even a superficial look, it is evident that by every measure ICE has been singularly successful at creating value in a very dynamic and competitive exchange and clearing space. If Jeff Sprecher is a barbarian, then civilized CEOs are vastly overrated. Give me the barbarians any day.

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April 2, 2016

The Rube Goldberg Approach to Integrating CCPs: A Recipe for Disaster

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Regulation — The Professor @ 12:38 pm

As noted in earlier posts (and by others commenting on the proposed Eurex-LSE merger) the main potential benefit to exchange customers* is the capital and margin savings from netting efficiencies between Eurex futures and LCH swaps. However, regulators and others have expressed concerns that the downside is the creation of an bigger too big to fail clearing entity. A couple of weeks back Silla Brush and John Detrixhe reported that the merger partners are trying to square that circle by cross-margining, but not merging the CCPs:

LCH.Clearnet and Eurex held 150 billion euros ($169.5 billion) of collateral on behalf of their members as of Dec. 31, according to the merger statement. The London-based clearer is developing a system that allows traders to offset their swap positions at LCH.Clearnet with their futures holdings at Eurex. The project, which works even though the two clearinghouses are separate, should enable customers to reduce the total amount of collateral they must set aside.

“We can cross margin our over-the-counter clearing with their listed derivatives without merging the clearinghouses, and without comingling the risk-management framework,” LSE Group CEO Xavier Rolet said in a Bloomberg Television interview on Wednesday. Rolet will step aside if the companies complete their merger.

The devil will clearly be in the details, and I am skeptical, not to say suspicious. In order for the separate but comingled system to work, Eurex’s CCP must have a claim on collateral held by LCH (and vice versa) so that deficiencies in a defaulter’s margin account on Eurex can be covered by excess at LCH (and vice versa). (As an illustration of the basic concept, Lehman had five different collateral pools at CME Clearing–interest rate, equity, FX, commodities, energy. There were deficiencies in two of these, but CME used collateral from the other three to cover them. As a result there was no hit to the default fund.)

How this will work legally is by no means evident, especially inasmuch as this will be a deal across jurisdictions (which could become even more fraught if Brexit occurs). Further, what happens in the event that one of the separate CCPs itself becomes insolvent? I can imagine a situation (unlikely, but possible)  in which CCP A is insolvent due to multiple defaults, but the margin account at A for one of the defaulters has excess funds while its margin account at CCP is deficient. Would it really be possible for B to access the defaulter’s collateral at bankrupt CCP A? Maybe, but I am certain that this question would be answered only after a nasty, and likely protracted, legal battle.

The fact that the CCPs are going to be legally separate entities suggests their default funds will be as well, and that they will be separately capitalized, meaning that the equity of one CCP will not be part of the default waterfall of the other. This increases the odds that one of the CCPs will exhaust its resources and become insolvent. That is, the probability that one of the separate CCPs will become insolvent exceeds the probability that a truly merged one would become so. Since even the separate CCPs would be huge and systemically important, it is not obvious that this is a superior outcome.

I am also mystified by what Rolet meant by “without comingling the risk management framework.” “Risk management framework” involves several pieces. One is the evaluation of market and credit risk, and the determination of the margin on the portfolio. Does Rolet mean that each CCP will make an independent determination of the margin it will charge for the positions held on it, but do so in a way that takes into account the offsetting risks at the position held at the other CCP? Wouldn’t that at least require sharing position information across CCPs? And couldn’t it result in arbitrary and perhaps incoherent determinations of margins if the CCPs use different models? (As a simple example, will the CCPs use different correlation assumptions?) Wouldn’t this have an effect on where firms place their trades? Couldn’t that lead to a perverse competition between the two CCPs?+ It seems much more sensible to have a unified risk model across the CCPs since they are assigning a single margin to a portfolio that includes positions on both CCPs.

Another part of the “risk management framework” is the management of defaulted positions. Separate management of the risk of components of a defaulted portfolio is highly inefficient. Indeed, part of the justification of portfolio margining is that the combined position is less risky, and that some components effectively hedge other components. Managing the risks of the components separately in the event of a default sacrifices these self-hedging features, and increases the amount of trading necessary to manage the risk of the defaulted position. Since this trading may be necessary during periods of low liquidity, economizing on the amount of trading is very beneficial.

In other words, co-mingling risk management is a very good idea if you are going to cross margin.

It seems that Eurex and LSE are attempting to come up with a clever way to work around regulators’ TBTF neuroses. But it is not clear how this workaround will perform in practice. Moreover, it seems to sacrifice many of the benefits of a merged CCP, while creating ambiguities and legal risks. It also will inevitably be more complex than simply merging the two CCPs. Such complexity creates systemic risks.

One way to put this is that if the two CCPs are legally separate entities, under separate managements, relations between them (including the arrangements necessary for cross margining and default management) will be governed by contract. Contracts are inevitably incomplete. There will be unanticipated contingencies, and/or contingencies that are anticipated but not addressed in the contract. When these contingencies occur in practice, there is a potential for conflict, disagreement, and rent seeking.

In the case of CCPs, the relevant contingencies not specified in the contract will most likely occur during a default, and likely during stressed market conditions. This is exactly the wrong time to have a dispute, and failure to come to a speedy resolution of how to deal with the contingency could be systemically catastrophic.

One advantage of ownership/integration is that it mitigates contractual incompleteness problems. Managers/owners have the authority to respond unilaterally to contingencies. As Williamson pointed out long ago, efficient “selective intervention” is problematic, but in the CCP context, the benefits of managerial fiat and selective intervention seem to far outweigh the costs.

I have argued that the need to coordinate during crises was one justification for the integration of trade execution and clearing. The argument applies with even greater force for the integration of CCPs that cooperate in some ways (e.g., through portfolio margining).

In sum, coordination of LCH and Eurex clearing through contract, rather than through merger into a single entity is a highly dubious way of addressing regulators’ concerns about CCPs being TBTF. The separate entities are already TBTF. The probability that one defaults if they are separate is bigger than the probability that the merged entity defaults, and the chaos conditional on default, or the measures necessary to prevent default, probably wouldn’t be that much greater for the merged entity: this means that reducing the probability of default is desirable, rather than reducing the size of the entity conditional on default. Furthermore, the contract between the two entities will inevitably be incomplete, and the gaps will be discovered, and extremely difficult to fill in-, during a crisis. This is exactly when a coordination failure would be most damaging, and when it would be most likely to occur.

Thus, in my view full integration dominates some Rube Goldberg-esque attempt to bolt LCH and Eurex clearing together by contract. The TBTF bridge was crossed long ago, for both CCPs. The complexity and potential for coordination failure between separate but not really organizations joined by contract would create more systemic risks than increasing size would. A coordination failure between two TBTF entities is not a happy thought.

Therefore, if regulators believe that the incremental systemic risk resulting from a full merger of LCH and Eurex clearing outweighs the benefits of the combination, they should torpedo the merger rather than allowing LSE and Eurex to construct some baroque contractual workaround.

*I say customers specifically, because it is not clear that the total benefits (including all affect parties) from cross margining, netting, etc., are positive. This is due to the distributive effects of these measures. They tend to ensure that derivatives counterparties get paid a higher fraction of their claims in the event of a default, but this is because they shift some of the losses to others with claims on the defaulter.

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March 9, 2016

Clearing Angst: Here Be Dragons Too

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 3:21 pm

We are now well into the Brave New World of clearing and collateral mandates. The US clearing mandate is in place, and the Europeans are on the verge of implementing it. We are also on the cusp of the mandate to collateralize non-cleared swaps.

After years of congratulating themselves on how the Brave New World was going to be so much better than the Bad Old World, the smart set is now coming to grips-grudgingly, slowly-with the dawning realization that not all the financial demons have been slain: here be dragons too. From time to time I’ve written about regulators recognizing this reality. There have been several more examples recently indicating that this has become the new conventional wisdom. For instance, Bloomberg recently editorialized on CCPs becoming the New Too Big to Fail: meet the new systemic risk, not that different from the old systemic risk. The BoE is commencing a review of CCPs, focusing not just on financial risks but operational ones as well. Researchers as Citi are warning that CCPs need more skin in the game. Regulators are warning that CCPs have become a single point of aim for hackers as they have become more central to the financial system. Researchers at three central banks go Down Under back into the not-too-distant past to show how CCPs can get into trouble–and how they can wreak havoc when they try to save themselves. An economist at the Chicago Fed warns that CCPs create new risks as they address old ones. Even the BIS (which had been an unabashed clearing cheerleader) sounds warnings.

I could go on. Suffice it to say that it is now becoming widely recognized that central clearing mandates (and the mandated collateralization of non-cleared derivatives) is not the silver bullet that will slay systemic risk, as someone pointed out more than seven years ago.

This is a good thing, on the whole, but there is a danger. This danger inheres in the framing of the issue as “CCPs are too big to fail, and therefore need to be made fail-safe.”  Yes, the failure of a major CCP is a frightening prospect: as the article linked above about the crisis at the New Zealand Futures and Options Exchange demonstrates, the collapse of even a non-major CCP is not a cheery prospect either.

But the measures employed to prevent failure pose their own dangers. The “loser pays” model is designed to reduce credit risk in derivatives transactions by requiring the posting of initial margins and the payment of variation margins, so that the CCP’s credit exposure is reduced. But balance sheets can be adjusted, and credit exposure through derivatives can be-and will be, to a large extent-replaced by credit exposure elsewhere, meaning that collateralization primarily redistributes credit risk, rather than reduces it.

Furthermore, the nature of the credit can change, and in bad ways. The need to meet large margin calls in the face of large price movements  causes spikes in the demand for credit that are correlated with market disruptions: this liquidity risk is a wrong way risk of the worst sort, because it tends to occur at times when the supply of liquidity is constrained, and it therefore can contribute to liquidity crises/liquidity hoarding and can cause a vicious spiral. In addition, as the article on the NZFOE demonstrates other measures that are intended to save the clearinghouse (partial tearups, in that instance) redistribute default losses in unpredictable ways, and it is by no means clear that those who bear these losses are less systemically important than, or more able to withstand them than, those who would bear them in an uncleared world.

The article on the NZFOE episode points out another salient fact: dealing with a CCP crisis has huge distributive effects. This makes any CCP action the subject of intense politicking and rent seeking by the affected parties, and this inevitably draws in the regulators and the central bankers. This, in turn, will inevitably draw in the politicians. Thus, political considerations, as much or more than economic ones, will drive the response. With supersized CCPs, the political fallout from any measures adopted to save CCPs (including extending credit to permit losers to make margin calls) will be acute and long lived.

Thus, contrary to the way they were hawked in the aftermath of the crisis, CCPs and collateralization mandates are not fire-and-forget measures that reduce burdens on regulators generally, and central banks in particular. They create new burdens, as regulators and central banks will inevitably be forced to resort to extraordinary measures, and in particular extraordinary measures to supply liquidity, to respond to systemic stresses created by the clearing system.

In his academic post-mortem of the clearing during the 1987 Crash, Ben Bernanke forthrightly declared that it was appropriate for the Fed to socialize clearinghouse risks on Black Monday and the following Tuesday. In Bernanke’s view, socializing the risk prevented a more serious crisis.

When you compare the sizes of the CCPs at issue then (CME Clearing, BOTCC, and OCC) to the behemoths of a post-mandate world, you should be sobered. The amount of risk that must be socialized to protect the handful of huge CCPs that currently exist dwarfs the amount that Greenspan (implicitly) took onto the Fed balance sheet in October, 1987.

Put differently, CCPs have become single points of socialization. Anyone who thinks differently, is fooling themselves.

Addendum: The last sentence of the Bernanke article is rather remarkable: “Since it now appears that the Fed is firmly committed to respond when the financial system is threatened, it may be that changes in the clearing and settlement system can be safely restricted to improvements to the technology of clearing and settlement.” The argument in a nutshell is that the Fed’s performance of its role as “insurer of last resort” (Bernanke’s phrase to describe socializing CCP risk) during the Crash of 1987 showed that central banks could readily handle the systemic financial risks associated with clearing. Therefore, managing the financial risks of clearing can easily be delegated to central banks, and CCPs and market users should focus on addressing operational risks.

There is an Alfred E. Newman-esque feel to these remarks, and they betray remarkable hubris about the powers of central banks. I wonder if he thinks the same today. More importantly, I wonder if his successors at the Fed, and their peers around the world, share these views. Given the experience of the past decade, and the massive expansion of derivatives clearing world, I sure as hell hope not.

 

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March 7, 2016

Clear the Way: LSE (and LCH!) on the Block

The biggest news from the exchange world in a long time is the proposed merger between LSE and Eurex. Both entities operate stock exchanges, but that’s a commoditized business these days, and it’s not the real driver of the merger. Instead, LSE’s LCH.Clearnet, and in particular LCH’s SwapClear, are the prizes. LSE and Eurex also both have valuable index businesses, but its hard to see how their value is enhanced through a combination: synergies, if they exist, are modest.

There are potentially large synergies on the clearing side. In particular, the ability to portfolio margin across interest rate products (notably various German government securities futures traded and cleared on Eurex, and Euro-denominated swaps cleared through LCH) would provide cost savings for customers that the merged entities could capture through higher fees. (Which is one reason why some market users are less than thrilled at the merger.)

A potential competitor to buy LSE, ICE, could also exploit these synergies. Indeed, its Euro- and Sterling-denominated short term interest rate futures contracts are arguably a better offset against Euro- and Sterling-denominated swaps than are Bunds or BOBLs.

The CME’s experience suggests that these synergies are not necessarily decisive competitively. The CME clears USD government security and STIRs, as well as USD interest rate swaps, and therefore has the greatest clearing synergies in the largest segment of the world interest rate complex. But LCH has a substantial lead in USD swap clearing.

It is likely that ICE will make a bid for LSE. If it wins, it will have a very strong clearing offering spanning exchange traded contracts, CDS, and IRS. Even if it loses, it can make Eurex pay up, thereby hobbling it as a competitor going forward: even at the current price, the LSE acquisition will strain Eurex’s balance sheet.

CME might also make a bid. Success would give it a veritable monopoly in USD interest rate clearing.

And that’s CME’s biggest obstacle. I doubt European anti-trust authorities would accept the creation of a clearing monopoly, especially since the monopolist would be American. (Just ask Google, Microsoft, etc., about that.) US antitrust authorities are likely to raise objections as well.

From a traditional antitrust perspective, an ICE acquisition would not present many challenges. But don’t put it past the Europeans to engage in protectionism via antitrust, and gin up objections to an ICE purchase.

Interestingly, the prospect of the merger between two huge clearinghouses is making people nervous about the systemic risk implications. CCPs are the new Too Big to Fail, and all that.

Welcome to the party, people. But it’s a little late to start worrying. As I pointed out going back to the 1990s, there are strong economies of scale and scope in clearing, meaning that consolidation is nearly inevitable. With swaps clearing mandates, the scale of clearing has been increased so much, and new scope economies have been created, that the consolidated entities will inevitably be huge, and systemically important.

If I had to handicap, I would put decent odds on the eventual success of a Eurex-LSE combination, but I think ICE has a decent opportunity of prevailing as well.

The most interesting thing about this is what it says about the new dynamics of exchange combinations. In the 2000s, yes, clearing was part of the story, but synergies in execution were important too. Now it’s all about clearing, and OTC clearing in particular. Which means that systemic risk concerns, which were largely overlooked in the pre-crisis exchange mergers, will move front and center.

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February 20, 2016

Brent: The George Washington’s Axe of Oil Pricing Markers

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 12:53 pm

Platts is preparing for a Brentless future by introducing a new Dated Brent CIF Rotterdam assessment.  The idea is that as North Sea production continues its decline, other streams of light crude that are imported into Rotterdam can be added to the assessment. Adding (or substituting) say Nigerian crude to the FOB Brent assessment would be much more difficult because of locational differences: FOB Nigeria and FOB North Sea can be quite different, even adjusting for quality, due to freight differentials. A CIF contract eliminates that.

The decline in North Sea production has been occurring for some time, so the need to adjust the pricing mechanism has been apparent. Plants has been thrashing around for a while, mooting the possibility of adding other crude (e.g., Urals Med) to the assessment.  It had already widened the delivery window to make more cargoes eligible (remember 15 Day Brent? 21? It’s now 25 Day.) This problem has become more pressing though, as the decline in prices is hastening the decline in North Sea production.

It is ironic that at the same time that Platts (and therefore, ICE) are grappling with the problem of  declining supply, the main rival to Brent has the exact opposite problem. The WTI contract is currently drowning in oil. Storage at Cushing is bumping up against capacity, and there are reports that some storage operators there are refusing requests to store additional crude.

Although the current situation at Cushing (and in the North American market generally) is as much a demand story as a supply story, the facts are that (a) the NYMEX WTI contract is linked to a much more robust and flexible production base than Brent, and (b) the WTI contract’s periodic difficulties are due to infrastructure issues that are more readily, cheaply, and rapidly addressed than production issues. Thus it has been for the past five years or so, as I discussed when I wrote that those foretelling the demise of WTI were fundamentally mistaken:

But these problems are all surmountable.  WTI’s problems arise from the consequences of too much supply at the delivery point, which is a good problem for a contract to have.  The price signals are leading to the kind of response that will eliminate the supply overhang, leaving the WTI contract with prices that are highly interconnected with those of seaborne crude, and with enough deliverable supply to mitigate the potential for squeezes and other technical disruptions.

Brent’s problems are more fundamental, because they arise from declining supply.  Even as paper volumes continue to rise, physical volumes available for delivery are falling inexorably.  The Brent complex had faced this problem before, and confronted it by adding Forties, Oseberg, and Ekofisk to the eligible stream.  But BFOE production has declined from 1.6 mm bbl/d in 2006 to barely more than half that today.  And the decline continues apace.  This makes the contract vulnerable to squeezes of a kind that were chronic in the 1990s and early 2000s, and which spurred Platts to add the three other grades to the benchmark.

. . . .

Which means that those who are crowing about Brent today, and heaping scorn on WTI, will be begging for WTI’s problems in a few years.  For by then, WTI’s issues will be fixed, and it will be sitting astride a robust flow of oil tightly interconnected with the nexus of world oil trading.  But the Brent contract will be an inverted paper pyramid, resting on a thinner and thinner point of crude production.  There will be gains from trade–large ones–from redesigning the contract, but the difficulties of negotiating an agreement among numerous big players will prove nigh on to impossible to surmount.  Moreover, there will be no single regulator in a single jurisdiction that can bang heads together (for yes, that is needed sometimes) and cajole the parties toward agreement.

The CIF alternative makes sense, and is probably superior to the “economic par” contract I suggested in the 2011 post. But once you move to a Rotterdam pricing basis, why remain tied to an assessment mechanism based on transactions in immense full cargoes? The large size of the lots inherently limits the number of transactions, which makes the assessment mechanism more erratic and subject to manipulation. The lumpiness of the market has also led Platts to design a baroque process involving bids and offers, contracts for differences, futures prices, spreads, etc., to increase the number of trades that go into the assessment.

The WTI contract, in contrast, is based on delivery in store of modest-sized (1000 barrel) units of crude. This is much more flexible, and permits a large number of firms to participate in the delivery process. This makes delivery and the threat of delivery a reliable and efficient way of ensuring convergence of futures to cash market values. The mechanism is not immune to all types of manipulation: delivery squeezes are still possible (though relatively unlikely in current market conditions). But small numbers of transactions can’t have a pronounced impact on pricing, and the in store delivery mechanism does not rely on an arcane and mysterious assessment mechanism (which also helps to enrich the party making the assessment).

So rather than shifting to a Rotterdam CIF mechanism, why not shift the futures market to a Rotterdam in store delivery contract? This mechanism is more flexible and resilient in the short run, and is readily adjusted in the long run to respond to changes in the underlying physical production base as NYMEX did by adding foreign crude streams (including Brent) to address the (then) declining domestic production base.

I can see why Platts wouldn’t like this, but it has some decided advantages for ICE, not the least of which is reducing its dependence on Platts. Given the difficulties of changing contract specifications, or generating liquidity for even a better contract introduced in competition with an established liquid one, I doubt this will happen. Which means that ICE, and the market generally, will have to continue to endure periodic changes the “Brent” assessment mechanism as North Sea production continues to decline.

I put “Brent” in quotes because the handwriting is on the wall: any future European-based contract may be called “Brent” even after Brent (and Forties, and Oseberg, and Ekofisk) no longer represent the bulk of the benchmark stream. The contract will come to resemble the old Harry Anderson comedy bit, where he juggled a chainsaw and an axe. He would stop juggling, hold up the axe and say: “This is George Washington’s axe. The handle was replaced years ago, and I just put on a new head, but it’s George Washington’s axe!” So it will be with Brent, and sooner than anyone would have thought even a few short years ago.

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February 10, 2016

I[gor], Robot (Hater)

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Russia — The Professor @ 9:40 pm

Igor Sechin comes in a close second to Rogozin the Ridiculous in providing Russian comic relief. Perhaps there are others in Russia that excel them, and I am only aware of these two because they have a bigger presence in the West, but both can be relied upon for some levity–unintentional, to be sure.

Sechin no longer has the outrageous mullet to amuse, but his public utterances suffice. Today at International Petroleum Week in London are a case in point. The mood at the event was gloomy, with pretty much everyone predicting that we are in a prolonged era of low prices, and everyone had their favorite culprit. But Sechin’s scapegoat was unique: Robots! Well, “robot traders”, anyways:

He blamed ‘financial players’ and automated ‘robot’ traders for driving down the price, saying the collapse to near $30 had little to do with supply and demand.

I presume he means algo traders and HFT. Just how these “robots” trading at subsecond frequencies have mesmerized producers and consumers to behave so as to lead to relentless buildups of inventory–including a looming topping out of capacity at Cushing–is beyond my mere economist’s skills to fathom.

Maybe Igor can commiserate with US cattle producers, who blame HFT for causing excessive volatility in beef prices.

Igor also seems to misunderstand that the “US” is not analogous to Saudi Arabia as a producer (although the phrasing is ambiguous, but I interpret this to include the US in “they”):

“At the end of 2014 some Middle East producers followed the US in their desire to increase production,” Mr Sechin told London’s International Petroleum Week. “They have deliberately created this situation and they are committed to low prices.”

The US oil sector is not a unitary decision maker in the way the Saudis are. The US industry is extremely fragmented and diffuse, with dozens of producers acting independently. They are price takers, not price makers. Very different from KSA or other producers with NOCs. (Relatedly, this is why calling the US the “new swing producer” analogous to the Saudis is dumb.)

It’s also more than a little hypocritical of him to criticize others for increasing output: Russian production has been increasing steadily over this same period.

Sechin also engaged in a little wishful thinking:

He forecast prices would recover later this year as US shale output slows. “We believe that in the coming years US shale will lose its grip on the market,” he said.

Good luck with that, Igor. US shale output has proved to be far more resilient than anyone had expected. Productivity gains and lower input costs have mitigated the impact of low prices. More importantly, the shale sector has the ability to ramp up output rapidly if prices do rise, either due to a rise in demand, or an attempt by other major producers to cut output. Indeed, this is likely the real reason the Saudis resist cutting output: they know it is futile because the supply of non-OPEC output is much more elastic than it used to be. This makes the demand for the output of the major producers, notably the Saudis (and the Russians!) more elastic than it used to be. This implies that it is not in the individual interest of any major producer to cut output unilaterally.

Which brings us to the most informative and refreshingly different part of Sechin’s remarks: his discussion of the prospects of a coordinated output cut involving OPEC and Russia.

This idea has captivated traders, who chase the idea like Randy Chasing the Dragon, shooting (the price!) up every time the rumor is floated, only to watch it fly away from their grasp. Once upon a time, Igor was notorious for encouraging such notions. Not this time around:

The most powerful figure in Russia’s oil industry on Wednesday signalled his steadfast opposition to combining with Opec to reverse the crude price rout through co-ordinated cuts in production.

. . . .
“Who are we supposed to be talking to about cuts?” Mr Sechin said when asked by the Financial Times if he was considering working with Opec, the producers’ cartel, to try to shore up the oil price. “Will Saudi Arabia or Iran cut production?”

Methinks that the real story is that the Saudis have made it clear that they trust neither the Russians nor (especially) other members of OPEC to adhere to any agree upon cuts, even assuming a deal can be cut, which is highly doubtful. So Sechin is acting as if he is the one rejecting the idea, primarily because he knows that it is DOA.

Not that this will stop all those Randys from chasing the next rumor of a coordinated cut.

Which raises the questions: Is Randy a robot? Are robots programmed to buy whenever a rumor of a Russo-Saudi oil deal is announced?

Maybe Igor will enlighten us in his next public appearance. Maybe he can do it to some musical accompaniment. Might I suggest this?:

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January 26, 2016

Liquidity Is King, or Why CME’s Failure in Cocoa Doesn’t Amount to a Hill of Beans

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 9:55 pm

The WSJ reports that the CME Group’s new Euro-Denominated cocoa futures contract is floundering, due to a pronounced lack of liquidity. (h/t @libertylynx) The incumbent ICE Futures Europe Sterling-denominated and ICE Futures US USD-denominated contracts dwarf the CME contract’s volume, even though European hedgers face some currency risks in using these contracts.

This is not a surprise, not by a long shot. It is always very difficult for upstart contract to make inroads, let alone dominate, in competition with an established incumbent. Liquidity is king, and the established contracts have a liquidity advantage that new entrants almost never overcome, even if the new contract is superior on some dimensions.

The only real example of the displacement of an incumbent is Eurex’s wresting of the Bund contract from LIFFE in 1997-1998. That story, which I analyze in a forthcoming paper in the Journal of Applied Corporate Finance, is the exception that proves the rule.

First, because it was supported by German banks who direct a lot of order flow to it, Eurex (and its predecessor, Deutsche Terminborse) had a base of liquidity on which to build.

Second, because it was electronic, it was possible for Eurex to offer faster and easier access to US users once the CFTC approved Eurex’s application to install terminals in the US.

Third, and most important, Eurex exploited LIFFE’s smug complacency. Eurex aggressively cut fees, and LIFFE did not match: it was convinced that its superior liquidity, and the inherent superiority of floor trading, would prevent its customers from defecting to Eurex to save a few DM per contract in fees.

Wrong! As I document in the JACF paper, the liquidity cost difference between the markets wasn’t that great by 1997 (due to the German bank support and the influx of US customers), and taking into account the lower trading fees it was actually cheaper to trade on Eurex. Volume started to leak to Eurex, and the leak turned into a flood. LIFFE belatedly cut fees, but by then it was too late. The market had tipped completely to Eurex, and LIFFE had a near-death experience.

I can speak first hand of LIFFE’s overconfidence. In 1992, I produced a study for DTB that showed that its electronic market’s liquidity was comparable to that of the floor-based LIFFE. The study was not intended for release: it was commissioned to determine whether it was advisable for DTB to add a new membership type analogous to locals in order to improve liquidity. But the results were so surprisingly favorable for DTB that they released the study, much to the derision of LIFFE and the futures trading community generally, which was truly in the grip of the Cult of the Floor.

The CEO of LIFFE was quoted in the FT and Risk Magazine to the effect that I was an ivory tower academic who had no idea the way the real world works, because everybody knows the floor is more liquid and always will be. Real bulletin board material. Literally, in my case.

He who laughs last. When Eurex launched its assault on LIFFE in 1997, it distributed my 1992 study broadly. I doubt that had much of an impact on the final outcome, but it couldn’t have hurt.

The LIFFE CEO ended up resigning after LIFFE capitulated, and voted to close the floor and go electronic. I was a good boy. I resisted the very strong temptation to send him clippings of the FT and Risk articles.

Every other exchange learned a lesson at LIFFE’s expense, and responded to a fee cutting entrant by cutting fees immediately. For instance, the CBT saw off Eurex’s attempt to compete in the Treasury market in short order by cutting fees to zero, raising them after Eurex capitulated.

So CME shouldn’t feel bad. It has plenty of company in launching a contract that fails to make headway against an established incumbent. Indeed, the experience should be comforting, because it is the dominant incumbent in USD STIRs, govvies, equity indexes, FX, grain, precious metal, livestock, and energy futures. It benefits massively from the liquidity entry barrier. Compared to that, the failure to penetrate ICE’s cocoa monopoly doesn’t amount to a hill of beans.

 

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