Streetwise Professor

March 24, 2017

Creative Destruction and Industry Life Cycles, HFT Edition

Filed under: Derivatives,Economics,Exchanges,Regulation — The Professor @ 11:56 am

No worries, folks: I’m not dead! Just a little hiatus while in Geneva for my annual teaching gig at Université de Genève, followed by a side trip for a seminar (to be released as a webinar) at ESSEC. The world didn’t collapse without my close attention, but at times it looked like a close run thing. But then again, I was restricted to watching CNN so my perception may be a little bit warped. Well, not a little bit: I have to say that I knew CNN was bad, but I didn’t know how bad until I watched a bit while on the road. Appalling doesn’t even come close to describing it. Strident, tendentious, unrelentingly biased, snide. I switched over to RT to get more reasonable coverage. Yes. It was that bad.

There are so many allegations regarding surveillance swirling about that only fools would rush in to comment on that now. I’ll be an angel for once in the hope that some actual verifiable facts come out.

So for my return, I’ll just comment on a set of HFT-related stories that came out during my trip. One is Alex Osipovich’s story on HFT traders falling on hard times. Another is that Virtu is bidding for KCG. A third one is that Quantlabs (a Houston outfit) is buying one-time HFT high flyer Teza. And finally, one that pre-dates my trip, but fits the theme: Thomas Peterffy’s Interactive Brokers Group is exiting options market making.

Alex’s story repeats Tabb Group data documenting a roughly 85 percent drop in HFT revenues in US equity trading. The Virtu-KCG proposed tie-up and the Quantlabs-Teza consummated one are indications of consolidation that is typical of maturing industries, and a shift it the business model of these firms. The Quantlabs-Teza story is particularly interesting. It suggests that it is no longer possible (or at least remunerative) to get a competitive edge via speed alone. Instead, the focus is shifting to extracting information from the vast flow of data generated in modern markets. Speed will matter here–he who analyzes faster, all else equal, will have an edge. But the margin for innovation will shift from hardware to data analytics software (presumably paired with specialized hardware optimized to use it).

None of these developments is surprising. They are part of the natural life cycle of a new industry. Indeed, I discussed this over two years ago:

In fact, HFT has followed the trajectory of any technological innovation in a highly competitive environment. At its inception, it was a dramatically innovative way of performing longstanding functions undertaken by intermediaries in financial markets: market making and arbitrage. It did so much more efficiently than incumbents did, and so rapidly it displaced the old-style intermediaries. During this transitional period, the first-movers earned supernormal profits because of cost and speed advantages over the old school intermediaries. HFT market share expanded dramatically, and the profits attracted expansion in the capital and capacity of the first-movers, and the entry of new firms. And as day follows night, this entry of new HFT capacity and the intensification of competition dissipated these profits. This is basic economics in action.

. . . .

Whether it is by the entry of a new destructively creative technology, or the inexorable forces of entry and expansion in a technologically static setting, one expects profits earned by firms in one wave of creative destruction to decline.  That’s what we’re seeing in HFT.  It was definitely a disruptive technology that reaped substantial profits at the time of its introduction, but those profits are eroding.

That shouldn’t be a surprise.  But it no doubt is to many of those who have made apocalyptic predictions about the machines taking over the earth.  Or the markets, anyways.

Or, as Herb Stein famously said as a caution against extrapolating from current trends, “If something cannot go on forever, it will stop.” Those making dire predictions about HFT were largely extrapolating from the events of 2008-2010, and ignored the natural economic forces that constrain growth and dissipate profits. HFT is now a normal, competitive business earning normal, competitive profits.  And hopefully this reality will eventually sink in, and the hysteria surrounding HFT will fade away just as its profits did.

The rise and fall of Peterffy/Interactive illustrates Schumpeterian creative destruction in action. Interactive was part of a wave of innovation that displaced the floor. Now it can’t compete against HFT. And as the other articles show, HFT is in the maturation stage during which profits are competed away (ironically, a phenomenon that was central to Marx’s analysis, and which Schumpeter’s theory was specifically intended to address).

This reminds me of a set of conversations I had with a very prominent trader. In the 1990s he said he was glad to see that the markets were becoming computerized because he was “tired of being fucked by the floor.” About 10 years later, he lamented to me how he was being “fucked by HFT.” Now HFT is an industry earning “normal” profits (in the economics lexicon) due to intensifying competition and technological maturation: the fuckers are fucking each other now, I guess.

One interesting public policy issue in the Peterffy story is the role played by internalization of order flow in undermining the economics of Interactive: there is also an internalization angle to the Virtu-KCG story, because one reason for Virtu to buy KCG is to obtain the latter’s juicy retail order flow. I’ve been writing about this (and related) subjects for going on 20 years, and it’s complicated.

Internalization (and other trading in non-lit/exchange venues) reduces liquidity on exchanges, which raises trading costs there and reduces the informativeness of prices. Those factors are usually cited as criticism of off-exchange execution, but there are other considerations. Retail order flow (likely uninformed) gets executed more cheaply, as it should because it it less costly (due to the fact that it poses less of an adverse selection risk). (Who benefits from this cheaper execution is a matter of controversy.) Furthermore, as I pointed out in a 2002 Journal of Law, Economics and Organization paper, off-exchange venues provide competition for exchanges that often have market power (though this is less likely to be the case in post-RegNMS which made inter-exchange competition much more intense). Finally, some (and arguably a lot of) informed trading is rent seeking: by reducing the ability of informed traders to extract rents from uninformed traders, internalization (and dark markets) reduce the incentives to invest excessively in information collection (an incentive Hirshleifer the Elder noted in the 1970s).

Securities and derivatives market structure is fascinating, and it presents many interesting analytical challenges. But these markets, and the firms that operate in them, are not immune to the basic forces of innovation, imitation, and entry that economists have understood for a long time (but which too many have forgotten, alas). We are seeing those forces at work in real time, and the fates of firms like Interactive and Teza, and the HFT sector overall, are living illustrations.

 

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February 25, 2017

Should Social Media Be Regulated as Common Carriers?

Filed under: Economics,Politics,Regulation — The Professor @ 6:43 pm

Major social media, notably Twitter and Facebook, are gradually moving to censor what is communicated on them. In Twitter’s case, the primary stated rationale is to “protect its users from abuse and harassment.” It has also taken upon itself to  “[identify] and [collapse] potentially abusive and low-quality replies so the most relevant conversations are brought forward.” There are widespread reports that Twitter engages in “shadowbanning”, i.e., hiding the Tweets of those users it identifies as objectionable, and making these Tweets inaccessible in searches.

Further, there are suspicions that there is a political and ideological component to the filters that Twitter applies, with conservative (and especially alt-right) content and users being more likely to fall afoul of these restrictions: the relentlessly leftist tilt of CEO Jack Dorsey (and most of its employees) gives considerable credence to these suspicions.

For its part, Facebook is pursuing ways to constrain users from posting what it deems as “misinformation” (aka “fake news”). This includes various measures such as cooperating with “third party fact-checking organizations“. Given the clear leftist tilt of Mark Zuckerberg and Facebook’s workforce, and the almost laughably leftist slant of the “fact-checkers”, there is also considerable reason for concern that the restrictions will not be imposed in a politically neutral way.

The off-the-top classical liberal/libertarian response to this is likely to be “well, this is unfortunate, but these are private corporations, and they can do what they want with their property.” But however superficially plausible this position appears to be, in fact there is a principled classical liberal/libertarian response that arrives at a very different conclusion. In particular, as arch-libertarian Richard Epstein (who styles himself as The Libertarian in his Hoover Institute podcast) has consistently pointed out, even during the heyday of small government, classical liberal government and law, the common law recognized that restrictions on the autonomy of certain entities was not only justifiable, but desirable. In particular, natural monopolies and near-monopolies were deemed to be “common carriers” upon whom the law imposed a duty of providing access on a non-discriminatory basis. The (classically liberal) common law of that era recognized that such entities could exercise market power, or engage in discriminatory conduct without fear of competitive check. Thus, the obligation to serve all on a non-discriminatory basis in order to constrain the exercise of market power, or invidious discrimination based on the preferences of the owner of the common carrier.

Major social media (and Google as well–perhaps most of all) clearly have market power, and the ability to discriminate without fear of losing business to competitors. The network nature of social media (and search engines) leads to the dominance of a small number of platforms, or even one platform. Yes, there are competitors to Facebook, Twitter, and Google, but these companies are clearly dominant in their spaces, and network effects make them largely immune to competitive entry. Imposition of a common carrier-inspired obligation to provide non-discriminatory access is therefore quite reasonable, and has a substantial economic and legal foundation. Thus, libertarians and classical liberals and conservatives and even fringe voices should not resign themselves to being second or third class citizens on social media, merely because these are private entities, rather than government ones. (Indeed, the analogy should go the other direction. A major reason for limiting the ability of the government to control speech is because of its monopoly of legal violence. It is monopoly power, regardless of whether in a market or political setting, that needs to be constrained through things like rights to free speech, or non-discriminatory access to common carriers.)

Further, insofar as leftists (including the managements of the major social media companies) are concerned, it is utterly incoherent for them to assert that as private entities they are perfectly free to restrict access according to their whims, given that leftists also adamantly (indeed, obnoxiously) insist that anti-discrimination laws should be imposed on small entities operating in highly competitive environments. Specifically, leftists believe that bakers or caterers or pizzarias with zero market power should be required to serve all, even if they have religious (or other) objections to doing so. But a baker refusing to sell a wedding cake to a gay couple does not meaningfully deprive said couple of the opportunity to get a cake: there are many other bakeries, and given the trivial costs of entry even if most incumbent bakers don’t want to serve gays, this only provides a commercial opportunity for entrant bakers to cater to the excluded clientele. Thus, discrimination by Baker A does not impose large costs on those s/he would prefer not to serve (even though forcing A to serve them might impose high costs on A, due to his/her sincere religious beliefs).

The same cannot be said of Twitter or Facebook. Given the nature of networks, social and otherwise, entrants or existing competitors are very poor substitutes for the dominant firms, which gives them the power to exclude, and which makes their exercise of this power extremely costly to the excluded.  In other words, if one believes that firms in highly competitive markets should be obligated to provide service/access to all on a non-discriminatory basis, one must concede that the Twitters, Facebooks, and Googles of the world should be similarly obligated, and that given their market power their conduct should be subject to a substantially higher degree of scrutiny than a small firm in a competitive market.

Of course, it is one thing to impose de jure an obligation on Twitter et al to provide equal access and equal treatment to all, regardless of political beliefs, and quite another to enforce it de facto. Of course Jack and Mark or Sergey don’t say “we discriminate against those holding contrary political opinions.” No, they couch their actions in terms of “protecting against abusive behavior and hate speech” or “stamping out disinformation.” But they retain the discretion to interpret what is abusive, hateful, and false–and it is clear that they consider much mainstream non-leftist belief as beyond the pale. Hence, enforcement of an open non-discriminatory access obligation would be difficult, and would inevitably involve estimation of discriminatory outcomes using statistical measures, a fraught exercise (as employment discrimination law demonstrates). Given the very deep pockets that these firms have, moreover, prevailing in a legal battle would be very difficult.

But this is a practical obstacle to treating social media like common carriers with a duty to provide non-discriminatory access. It is not a reason for classical liberals and libertarians to concede to dominant social network operators that they have an unrestricted right to restrict access as a matter of principle. In fact, the classical liberal/libertarian principle cuts quite the other way. And at the very least, imposing a common carrier-like obligation would substantially raise the cost that social network operators would pay to indulge in discrimination based on politics, beliefs, or ideology, and this could go a long way to make these places safe for the expression of political opinions that drive Jack, Mark, et al, nuts.

 

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February 20, 2017

Trolling Brent

Filed under: Commodities,Derivatives,Economics,Energy,Regulation — The Professor @ 10:14 am

Platts has announced the first major change in the Brent crude assessment process in a decade, adding Troll crude to the “Brent” stream:

A decline in supply from North Sea fields has led to concerns that physical volumes could become too thin and hence at times could be accumulated in the hands of just a few players, making the benchmark vulnerable to manipulation.

Platts said on Monday it would add Norway’s Troll crude to the four British and Norwegian crudes it already uses to assess dated Brent from Jan 1. 2018. This will join Brent, Forties, Oseberg and Ekofisk, or BFOE as they are known.

This is likely a stopgap measure, and Platts is considering more radical moves in the future:

It is also investigating a more radical plan to account for a possible larger drop-off in North Sea output over the next decade that would allow oil delivered from as far afield as west Africa and Central Asia to contribute to setting North Sea prices.

But the move is controversial, as this from the FT article shows:

If this is not addressed first, one source at a big North Sea trader said, the introduction of another grade to BFOE could make “an assessment that is unhedgeable, hence not fit for purpose”. “We don’t see any urgency to add grades today,” he added. Changes to Brent shifts the balance of power in North Sea trading. The addition of Troll makes Statoil the biggest contributor of supplies to the grades supporting Brent, overtaking Shell. Some big North Sea traders had expressed concern Statoil would have an advantage in understanding the balance of supply and demand in the region as it sends a large amount of Troll crude to its Mongstad refinery, Norway’s largest.

The statement about “an assessment that is unhedgeable, hence not fit for purpose” is BS, and exactly the kind of thing one always hears when contracts are redesigned. The fact is that contract redesigns have distributive effects, even if they improve a contract’s functioning, and the losers always whinge. Part of the distributive effect relates to issues like giving a company like Statoil an edge . . . that previously Shell and the other big North Sea producers had. But part of the distributive effect is that a contract with inadequate deliverable supply is a playground for big traders, who can more easily corner, squeeze, and hug such a contract.

Insofar as hedging is concerned, the main issue is how well the Brent contract performs as a hedge (and a pricing benchmark) for out-of-position (i.e., non-North Sea) crude, which represents the main use of Brent paper trades. Reducing deliverable supply constraints which contribute to pricing anomalies (and notably, anomalous moves in the basis) unambiguously improves the functioning of the contract for out-of-position players. Yeah, those hedging BFOE get slightly worse hedging performance, but that is a trivial consideration given that the very reason for changing the benchmark is the decline in BFOE production–which now represents less than 1 percent of world output. Why should the hair on the end of the tail wag the dog?

Insofar as the competition with WTI is concerned, the combination of larger US supplies, the construction of pipelines to move supplies from the Midcon (PADDII) to the Gulf (PADDIII)  and the lifting of the export ban have restored and in fact strengthened the connection of WTI prices to seaborne crude prices. US barrels are now going to both Europe and Asia, and US crude has effectively become the marginal barrel in most major markets, meaning that it is determining price and that WTI is an effective hedge (especially for the lighter grades). And by the way, the WTI delivery mechanism is much more robust and transparent than the baroque (and at times broken) Brent pricing mechanism.

As if to add an exclamation point to the story, Bloomberg reports that in recent months Shell has been bigfooting–or would that be trolling?–the market with big trades that have arguably distorted spreads. It got to the point that even firms like Vitol (which are notoriously loath to call foul, lest someone point fingers at them) raised the issue with Shell:

While none of those interviewed said Shell did anything illegal, they said the company violated the unspoken rules governing the market, which is lightly regulated. Executives of several trading rivals, including Vitol Group BV, the world’s top independent oil merchant, raised objections with counterparts at Shell last year, according to market participants.

What are the odds that Mr. Fit for Purpose is a Shell trader?

All of this is as I predicted, almost six years ago, when everyone was shoveling dirt on WTI and declaring Brent the Benchmark of the Forever Future:

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.

So Brent boosters, enjoy your laugh while it lasts.  It won’t last long, and remember, he who laughs last laughs best.

That’s exactly how things have worked out, even down to the point about the difficulties of getting the big boys to play together (a lesson gained through extensive personal experience, some of which is detailed in the post). Just call me Craignac the Magnificent. At least when it comes to commodity contract design 😉

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February 14, 2017

“First, Kill All the Economists!” Sounds Great to Some, But It Won’t Fix Monetary Policy

Filed under: Economics,Financial crisis,Financial Crisis II,History,Regulation — The Professor @ 9:00 pm

A former advisor to the Dallas Fed has penned a book blasting the Fed for being ruled by a “tribe” of insular egghead economics PhDs:

In her book, Ms. Booth describes a tribe of slow-moving Fed economists who dismiss those without high-level academic credentials. She counts Fed Chairwoman Janet Yellen and former Fed leader Ben Bernanke among them. The Fed, Mr. Bernanke and the Dallas Fed declined to comment.

The Fed’s “modus operandi” is defined by “hubris and myopia,” Ms. Booth writes in an advance copy of the book. “Central bankers have invited politicians to abdicate leadership authority to an inbred society of PhD academics who are infected to their core with groupthink, or as I prefer to think of it: ‘groupstink.’”

“Global systemic risk has been exponentially amplified by the Fed’s actions,” Ms. Booth writes, referring to the central bank’s policies holding interest rates very low since late 2008. “Who will pay when this credit bubble bursts? The poor and middle class, not the elites.”

Ms. Booth is an acolyte of her former boss, Dallas Fed chair Richard Fisher, who said “If you rely entirely on theory, you are not going to conduct the right policy, because policies have consequences.”

I have very mixed feelings about this. There is no doubt that under the guidance of academics, including (but not limited to) Ben Bernanke, that the Fed has made some grievous errors. But it is a false choice to claim that Practical People can do better without a coherent theoretical framework. For what is the alternative to theory? Heuristics? Rules of thumb? Experience?

Two thinkers usually in conflict–Keynes and Hayek– were of of one mind on this issue. Keynes famously wrote:

Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

For his part, Hayek said “without a theory the facts are silent.”

Everybody–academic economist or no–is beholden to some theory or another. It is a conceit of non-academics to believe that they are “exempt from any intellectual influence.” Indeed, the advantage of following an explicit theoretical framework is that its assumptions and implications are transparent and (usually) testable, and therefore can be analyzed, challenged, and improved. An inchoate and largely informal “practical” mindset (which often is a hodgepodge of condensed academic theories) is far more amorphous and difficult to understand or challenge. (Talk to a trader about monetary policy sometime if you doubt me.)

Indeed, Ms. Booth gives evidence of this. Many have been prophesying doom as a result of the Fed’s (and the ECB’s) post-2008 policies: Ms. Booth is among them. I will confess to have harbored such concerns, and indeed, challenged Ben Bernanke on this at a Fed conference on Jekyll Island in May, 2009. It may happen sometime, and I believe that ZIRP has indeed distorted the economy, but my fears (and Ms. Booth’s) have not been realized in eight plus years.

Ms. Booth’s critique of pre-crisis Fed policy is also predicated on a particular theoretical viewpoint, namely, that the Fed fueled a credit bubble prior to the Crash. But as scholars as diverse as Scott Sumner and John Taylor have argued, Fed policy was actually too tight prior to the crisis.

Along these lines, one could argue that the Fed’s most egregious errors are not the consequence of deep DSGE theorizing, but instead result from the use of rules of thumb and a failure to apply basic economics. As Scott Sumner never tires of saying (and sadly, must keep repeating because those who are slaves to the rule of thumb are hard of hearing and learning) the near universal practice of using interest rates as a measure of the state of monetary policy is a category error: befitting a Chicago trained economist, Scott cautions never argue from a price change, but look for the fundamental supply and demand forces that cause a price (e.g., an interest rate to be high or low). (As a Chicago guy, I have been beating the same drum for more than 30 years.)

And some historical perspective is in order. The Fed’s history is a litany of fumbles, some relatively minor, others egregious. Blame for the Great Depression and the Great Inflation can be laid directly at the Fed’s feet. Its most notorious failings were not driven by the prevailing academic fashion, but occurred under the leadership of practical people, mainly people with a banking background,  who did quite good impressions of madmen in authority. Ms. Booth bewails the “hubris of Ph.D. economists who’ve never worked on the Street or in the City,” but people who have worked there have screwed up monetary policy when they’ve been in charge.

As tempting as it may sound, “First, kill all the economists!” is not a prescription for better monetary policy. Economists may succumb to hubris (present company excepted, of course!) but the real hubris is rooted in the belief that central banks can overcome the knowledge problem, and can somehow manage entire economies (and the stability of the financial system). Hayek pointedly noted the “fatal conceit” of central planning. That conceit is inherent in central banking, too, and is not limited to professionally trained economists. Indeed, I would venture that academics are less vulnerable to it.

The problem, therefore, is not who captains the monetary ship. The question is whether anyone is capable of keeping such a huge and unwieldy vessel off the shoals. Experience–and theory!–suggests no.

 

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February 11, 2017

Risk Gosplan Works Its Magic in Swaps Clearing

Filed under: Clearing,Commodities,Derivatives,Economics,Politics,Regulation — The Professor @ 4:18 pm

Deutsche Bank quite considerately provided a real time example of an unintended consequence of Frankendodd, specifically, capital requirements causing firms to exit from clearing. The bank announced it is continuing to provide futures clearing, but is exiting US swaps clearing, due to capital cost concerns.

Deutsch was not specific in citing the treatment of margins under the leverage ratio as the reason for its exit, this is the most likely culprit. Recall that even segregated margins (which a bank has no access to) are treated as bank assets under the leverage rule, so a swaps clearer must hold capital against assets over which it has no control (because all swap margins are segregated), cannot utilize to fund its own activities, and which are not funded by a liability issued by the clearer.

It’s perverse, and is emblematic of the mixed signals in Frankendodd: CLEAR SWAPS! CLEARING SWAPS  IS EXTREMELY CAPITAL INTENSIVE SO YOU WON’T MAKE ANY MONEY DOING IT! Yeah. That will work out swell.

Of course Deutsch Bank has its own issues, and because of those issues it faces more acute capital concerns than other institutions (especially American ones). But here is a case where the capital cost does not at all match up with risk (and remember that capital is intended to be a risk absorber). So looking for ways to economize on capital, Deutsch exited a business where the capital charge did not generate any commensurate return, and furthermore was unrelated to the actual risk of the business. If the pricing of risk had been more sensible, Deutsch might have scaled back other businesses where capital charges reflected risk more accurately. Here, the effect of the leverage ratio is all pain, no gain.

When interviewed by Risk Magazine about the Fundamental Review of the Trading Book, I said: “The FRTB’s standardised approach is basically central planning of risk pricing, and it will produce Gosplan-like results.” The leverage ratio, especially as applied to swaps margins, is another example of central planning of risk pricing, and here indeed it has produced Gosplan-like results.

And in the case of clearing, these results are exactly contrary to a crucial ostensible purpose of DFA: reducing size and concentration in banking generally, and in derivatives markets in particular. For as the FT notes:

The bank’s exit will reignite concerns that the swaps clearing business is too concentrated among a handful of large players. The top three swaps clearers account for more than half the market by client collateral required, while the top five account for over 75 per cent.

So swaps clearing is now hyper-concentrated, and dominated by a handful of systemically important banks (e.g., Citi, Goldman). It is more concentrated that the bilateral swaps dealer market was. Trouble at one of these dominant swaps clearers would create serious risks for CCPs that they clear for (which, by the way, are all interconnected because the same clearing members dominate all the major CCPs). Moreover, concentration dramatically reduces the benefits of mutualizing risk: because of the small number of clearers, the risk of a big CM failure will be borne by a small number of firms. This isn’t insurance in any meaningful way, and does not achieve the benefits of risk pooling even if only in the first instance only a single big clearing member runs into trouble due to a shock idiosyncratic to it.

At present, there is much gnashing of teeth and rending of garments at the prospect of even tweaks in Dodd-Frank. Evidently, the clearing mandate is not even on the table. But this one vignette demonstrates that Frankendodd and banking regulation generally is shot through with provisions intended to reduce systemic risk which do not have that effect, and indeed, likely have the perverse effect of creating some systemic risks. Viewing Dodd-Frank as a sacred cow and any proposed change to it as a threat to the financial system is utterly wrongheaded, and will lead to bad outcomes.

Barney and Chris did not come down Mount Sinai with tablets containing commandments written by the finger of God. They sat on Capitol Hill and churned out hundreds of pages of laws based on a cartoonish understanding of the financial system, information provided by highly interested parties, and a frequently false narrative of the financial crisis. These laws, in turn, have spawned thousands of pages of regulation, good, bad, and very ugly. What is happening in swaps clearing is very ugly indeed, and provides a great example of how major portions of Dodd-Frank and the regulations emanating from it need a thorough review and in some cases a major overhaul.

And if Elizabeth Warren loses her water over this: (a) so what else is new? and (b) good! Her Manichean view of financial regulation is a major impediment to getting the regulation right. What is happening in swaps clearing is a perfect illustration of why a major midcourse correction in the trajectory of financial regulation is imperative.

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February 4, 2017

The Regulatory Road to Hell

One of the most encouraging aspects of the new administration is its apparent commitment to rollback a good deal of regulation. Pretty much the entire gamut of regulation is under examination, and even Trump’s nominee for the Supreme Court, Neil Gorsuch, represents a threat to the administrative state due to his criticism of Chevron Deference (under which federal courts are loath to question the substance of regulations issued by US agencies).

The coverage of the impending regulatory rollback is less that informative, however. Virtually every story about a regulation under threat frames the issue around the regulation’s intent. The Fiduciary Rule “requires financial advisers to act in the best interests of their clients.” The Stream Protection Rule prevents companies from “dumping mining waste into streams and waterways.” The SEC rule on reporting of payments to foreign governments by energy and minerals firms “aim[s] to address the ‘resource curse,’ in which oil and mineral wealth in resource-rich countries flows to government officials and the upper classes, rather than to low-income people.” Dodd-Frank is intended prevent another financial crisis. And on and on.

Who could be against any of these things, right? This sort of framing therefore makes those questioning the regulations out to be ogres, or worse, favoring financial skullduggery, rampant pollution, bribery and corruption, and reckless behavior that threatens the entire economy.

But as the old saying goes, the road to hell is paved with good intentions, and that is definitely true of regulation. Regulations often have unintended consequences–many of which are directly contrary to the stated intent. Furthermore, regulations entail costs as well as benefits, and just focusing on the benefits gives a completely warped understanding of the desirability of a regulation.

Take Frankendodd. It is bursting with unintended consequences. Most notably, quite predictably (and predicted here, early and often) the huge increase in regulatory overhead actually favors consolidation in the financial sector, and reinforces the TBTF problem. It also has been devastating to smaller community banks.

DFA also works at cross purposes. Consider the interaction between the leverage ratio, which is intended to insure that banks are sufficiently capitalized, and the clearing mandate, which is intended to reduce systemic risk arising from the derivatives markets. The interpretation of the leverage ratio (notably, treating customer margins held by FCMs as an FCM asset which increases the amount of capital it must hold due to the leverage ratio) makes offering clearing services more expensive. This is exacerbating the marked consolidation among FCMs, which is contrary to the stated purpose of Dodd-Frank. Moreover, it means that some customers will not be able to find clearing firms, or will find using derivatives to manage risk prohibitively expensive. This undermines the ability of the derivatives markets to allocate risk efficiently.

Therefore, to describe regulations by their intentions, rather than their effects, is highly misleading. Many of the effects are unintended, and directly contrary to the explicit intent.

One of the effects of regulation is that they impose costs, both direct and indirect.  A realistic appraisal of regulation requires a thorough evaluation of both benefits and costs. Such evaluations are almost completely lacking in the media coverage, except to cite some industry source complaining about the cost burden. But in the context of most articles, this comes off as special pleading, and therefore suspect.

Unfortunately, much cost benefit analysis–especially that carried out by the regulatory agencies themselves–is a bad joke. Indeed, since the agencies in question often have an institutional or ideological interest in their regulations, their “analyses” should be treated as a form of special pleading of little more reliability than the complaints of the regulated. The proposed position limits regulation provides one good example of this. Costs are defined extremely narrowly, benefits very broadly. Indirect impacts are almost completely ignored.

As another example, Tyler Cowen takes a look into the risible cost benefit analysis behind the Stream Protection Rule, and finds it seriously wanting. Even though he is sympathetic to the goals of the regulation, and even to the largely tacit but very real meta-intent (reducing the use of coal in order to advance  the climate change agenda), he is repelled by the shoddiness of the analysis.

Most agency cost benefit analysis is analogous to asking pupils to grade their own work, and gosh darn it, wouldn’t you know, everybody’s an A student!

This is particularly problematic under Chevron Deference, because courts seldom evaluate the substance of the regulations or the regulators’ analyses. There is no real judicial check and balance on regulators.

The metastasizing regulatory and administrative state is a very real threat to economic prosperity and growth, and to individual freedom. The lazy habit of describing regulations and regulators by their intent, rather than their effects, shields them from the skeptical scrutiny that they deserve, and facilitates this dangerous growth. If the Trump administration and Congress proceed with their stated plans to pare back the Obama administration’s myriad and massive regulatory expansion, this intent-focused coverage will be one of the biggest obstacles that they will face.  The media is the regulators’ most reliable paving contractor  for the highway to hell.

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January 24, 2017

Two Contracts With No Future

Filed under: China,Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 7:14 pm

Over the past couple of days two major futures exchanges have pulled the plug on contracts. I predicted these outcomes when the contracts were first announced, and the reasons I gave turned out to be the reasons given for the decisions.

First, the CME announced that it is suspending trading in its new cocoa contract, due to lack of volume/liquidity. I analyzed that contract here. This is just another example of failed entry by a futures contract. Not really news.

Second, the Shanghai Futures Exchange has quietly shelved plans to launch a China-based oil contract. When it was first mooted, I expressed extreme skepticism, due mainly to China’s overwhelming tendency to intervene in markets sending the wrong signal–wrong from the government’s perspective that is:

Then the crash happened, and China thrashed around looking for scapegoats, and rounded up the usual suspects: Speculators! And it suspected that the CSI 300 Index and CSI 500 Index futures contracts were the speculators’ weapons of mass destruction of choice. So it labeled trades of bigger than 10 (!) contracts “abnormal”–and we know what happens to people in China who engage in unnatural financial practices! It also increased fees four-fold, and bumped up margin requirements.

The end result? Success! Trading volumes declined 99 percent. You read that right. 99 percent. Speculation problem solved! I’m guessing that the fear of prosecution for financial crimes was by far the biggest contributor to that drop.

. . . .

And the crushing of the CSI300 and CSI500 contracts will impede development of a robust oil futures market. The brutal killing of these contracts will make market participants think twice about entering positions in a new oil futures contract, especially long dated ones (which are an important part of the CME/NYMEX and ICE markets). Who wants to get into a position in a market that may be all but shut down when the market sends the wrong message? This could be the ultimate roach motel: traders can check in, but they can’t check out. Or the Chinese equivalent of Hotel California: traders can check in, but they can never leave. So traders will be reluctant to check in in the first place. Ironically, moreover, this will encourage the in-and-out day trading that the Chinese authorities say that they condemn: you can’t get stuck in a position if you don’t hold a position.

In other words, China has a choice. It can choose to allow markets to operate in fair economic weather or foul, and thereby encourage the growth of robust contracts in oil or equities. Or it can choose to squash markets during economic storms, and impede their development even in good times.

I do not see how, given the absence of the rule of law and the just-demonstrated willingness to intervene ruthlessly, that China can credibly commit to a policy of non-intervention going forward. And because of this, it will stunt the development of its financial markets, and its economic growth. Unfettered power and control have a price. [Emphasis added.]

And that’s exactly what has happened. Per Reuters’ Clyde Russell:

The quiet demise of China’s plans to launch a new crude oil futures contract shows the innate conflict of wanting the financial clout that comes with being the world’s biggest commodity buyer, but also seeking to control the market.

. . . .

The main issues were concerns by international players about trading in yuan, given issues surrounding convertibility back to dollars, and also the risks associated with regulation in China.

The authorities in Beijing have established a track record of clamping down on commodity trading when they feel the market pricing is driven by speculation and has become divorced from supply and demand fundamentals.

On several occasions last year, the authorities took steps to crack down on trading in then hot commodities such as iron ore, steel and coal.

While these measures did have some success in cooling markets, they are generally anathema to international traders, who prefer to accept the risk of rapid reversals in order to enjoy the benefits of strong rallies.

It’s likely that while the INE could design a crude futures contract that would on paper tick all the right boxes, it would battle to overcome the trust deficit that exists between the global financial community and China.

What international banks and trading houses will want to see before they throw their weight behind a new futures contract is evidence that Beijing won’t interfere in the market to achieve outcomes in line with its policy goals.

It will be hard, but not impossible, to guarantee this, with the most plausible solution being the establishment of some sort of free trade zone in which the futures contract could be legally housed.

Don’t hold your breath.

It is also quite interesting to contemplate this after all the slobbering over Xi’s Davos speech. China is protectionist and has an overwhelming predilection to intervene in markets when they don’t give the outcomes desired by the government/Party. It is not going to be a leader in openness and markets. Anybody whose obsession with Trump leads them to ignore this fundamental fact is truly a moron.

 

 

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December 16, 2016

Clearinghouse Resilience and Liquidity Black Holes

Filed under: Clearing,Commodities,Derivatives,Economics,Politics,Regulation — The Professor @ 5:11 pm

About six weeks ago I wrote a post on the strains put on clearing by Brexit. This informative post by Clarus’ Tod Skarecky provides some very interesting detail about the mechanics of the LCH’s margining mechanism.

One way to summarize it is to say that the LCH was a liquidity black hole. Not only did it collect intra-day and end-of-day variation margin from losers that was paid out to winners only with a delay, it also collected Market Data Runs, which were effectively intra-day initial margin top-ups. A couple of perverse features. First, a position that initially had a loss that triggered an MDR outflow had to pay out, but if the market turned in its favor intra-day, it didn’t get that money back until the following day. Second, a firm that had a loss that triggered an MDR outflow had to pay out, and if the position incurred a loss on the day, it still had to pay variation margin, and didn’t receive the MDR back until the next day: that is, there was”double dipping.”

Tod puts his figure on the logic (crucially, the logic from LCH’s perspective): “Heck if I managed credit risk at a firm, I’d always choose to be paid now rather than later.” Definitely. That minimizes credit risk. But look at how much liquidity was sucked up in order to do this.

Variation margin is bad enough: despite the (laughable) claim of the BIS some years back, the fact that variation margin is recycled does not mean that it does not create liquidity strains. After all, (a) liquidity demand arises due in large part to differences in timing between the receipt of cash and the payment thereof, and the clearing mechanism (in which the CCP pays out VM some hours after it receives VM) creates such timing differences, and (b) even absent payment timing differences, the VM receivers would have to lend to the VM payers, which is problematic especially during stressed market conditions. But the LCH IM top up exacerbates the problem because the cash is stuck in the clearinghouse overnight, and therefore cannot possibly be recirculated. More liquidity becomes less accessible.

Again, this is understandable from LCH’s microprudential perspective: it reduces the likelihood that it will become insolvent or illiquid. But just because this is sensible from a microprudential perspective does not mean it is macroprudentially sensible. In fact, it is anything but sensible: it greatly adds to liquidity demand, particularly during periods of time when liquidity is likely to be scarce, and when liquidity freezes are a serious risk.

This is a perfect example of the “levee effect” I’ve written about for years: raising the levee around the LCH increases the chances of its survival, but just redirects the stresses to elsewhere in the system.

Note the irony here. Clearing mandates were sold on the idea that there were pervasive externalities in uncleared derivatives markets, due primarily to the potential for default cascades in these markets. But clearing (supersized by mandates, in particular) creates externalities too. Here LCH does things that are in its interest, but which impose costs on others. It has a contractual relationship with some of these (FCMs), so there is some potential that externalities involving these parties can be mitigated through negotiation and changing contracts. But there are myriad parties not in privity of contract with LCH, and which LCH may not even know of, who are impacted, perhaps severely, by a liquidity shock exacerbated by LCH’s self-preserving actions.

In other words, clearing mandates don’t internalize all externalities. They create them too. And given the severe dangers of liquidity crises, the liquidity externality that clearing creates is particularly troubling.

Outgoing CFTC Chairman Timothy Massad says, don’t worry, be happy!:

Brexit’s Impact on Clearing Activity

Let’s first look at the impact on clearing activity. It’s important to remember first that clearinghouses mark all products to market every day, and require that participants with market losses post margin every day, sometimes more than once a day. Margin payments must be paid promptly because for every payment made to the clearinghouse, the clearinghouse must make a payment to another participant who has gains. The clearinghouse always has a balanced or “matched” book.

Even though margins were increased in advance of the vote, the volatility resulted in very large margin calls on June 24.

Clearing members paid $27 billion dollars in variation margin across the five largest clearinghouses registered with the CFTC. This was $22 billion dollars greater than the previous 12-month average—over five times larger. The good news is no one missed a payment, no one defaulted.

Supervisory Stress Tests

The results after Brexit confirmed what we recently found in our own internal testing: resilience in the face of stressful conditions. Last month, CFTC staff released a report detailing the results of a series of stress tests we performed on the five largest clearinghouses under our jurisdiction, which are located in the U.S. and the UK. Our tests assessed the impact of stressful market scenarios across these clearinghouses as well as their clearing members, many of whom are affiliates of the world’s largest banks.

We developed a set of 11 extreme but plausible scenarios based on a number of factors, including historical price changes on dates when there was extreme volatility. By comparison, our assumed price shocks were several times larger than what happened after Brexit. We applied these scenarios to actual positions as of a specific date. And we looked at whether the pre-funded resources held by the clearinghouse—in particular, the initial margin and guaranty fund amounts paid by clearing members as well as the clearinghouse’s capital—were sufficient to cover any losses.

Still not getting it. The discussion of stress tests essentially repeats the same mantra as LCH: it is a decidedly microprudential treatment that focuses on credit risk, not liquidity risk. The discussion of margins is perfunctory, despite the fact that this is what gave market participants serious worries on Brexit Day. No discussion of what extraordinary efforts were required to ensure that all payments were made. No discussion of whether this would have been possible during a bigger–and unanticipated–price shock. No discussion of the liquidity externalities. No discussion of what would happen if operational difficulties (e.g., a technology problem in the payments system like the failure of FedWire on 10/19/87) interfered with the completion of payments. (More payments increases the likelihood that such an operational failure will jeopardize the ability of FCMs to complete them. And a failure to meet a call triggers a default.)

This “what? Me worry?” approach sounds so . . . 2006. And it is exactly this kind of complacency that makes me worry. The nature of the liquidity issue still has not penetrated many regulatory skulls.

This is most likely due to a severe case of target fixation. Clearing mandates were motivated by a desire to reduce credit risk, and all efforts have been focused on that. That is the target that regulators are fixated on, and in the pursuit of that target their field of vision has narrowed, with liquidity risk being largely outside it. It is obviously the target that CCPs are focused on. This is why I take little comfort in the belated efforts to make CCPs more resilient. The recipe for resilience is to demand MOAR LIQUIDITY. Which is also the recipe for a broader market crisis.

Analogous to the dangers of high powered incentives with multi-tasking when some activities can be measured more accurately than others, the mandate to reduce derivatives credit risk has led regulators and market participants–particularly market utilities like CCPs–to devote excessive effort to mitigating credit risk, even though it exacerbates liquidity risk.

I doubt the clearing portions of Title VII of Frankendodd will be eliminated altogether, but the incoming administration should seriously consider a major re-evaluation to determine how to address the serious liquidity issues that clearing mandates create.

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November 29, 2016

A Policy Inspired More by the Marx Brothers Than Marx

Filed under: China,Climate Change,Commodities,Economics,Politics,Regulation — The Professor @ 9:51 pm

As goes China, so go the commodity markets. The problem is that where China goes is largely driven by a bastardized form of central planning which in turn is driven by China’s baroque political economy. In past years, China’s rapid growth conferred on the government a reputation for wisdom and foresight that was largely undeserved, but now more people are waking up to the reality that Chinese policy engenders tremendous waste, and that the country would actually be richer–and have better prospects for the future–if its government tempered its dirigiste tendencies.

Case in point: Morgan Stanley’s Chief China Economist uses the ham-fisted intervention into the coal industry to illustrate the broader waste in the Chinese system:

These reforms entail the necessary reduction of excess capacity, particularly in state-owned enterprises (SOEs) and industries where overproduction issues are often the most acute.

While economists agree that a reduction of excess capacity, particularly in heavy industry, is key to the nation’s efforts to get on a more sustainable growth trajectory, China’s supply side reforms bare little resemblance to the “trickle down” Reaganomics of the 1980s, which seized upon tax cuts and deregulation as a way to foster stronger growth.

In Morgan Stanley’s year-ahead economic outlook for the world’s second-largest economy, Chief China Economist Robin Xing uses the coal industry to detail two key ways in which supply-side reforms with Chinese characteristics have been ill-designed.

“The state-planned capacity cuts and the slow progress in market-oriented SOEs reform have come at the cost of economic efficiency,” laments the economist.

In a bid to shutter overproduction and address environmental concerns, Beijing moved to restrict the number of working days in the sector to 276 from 330 in February.

But in enacting these cuts, policymakers employed a one-size-fits-all approach.

“The production limit was implemented to all companies in the sector, which means good companies that are more profitable and less vulnerable to excess capacity are affected just as much as the bad ones with obsolete capacity and weak profitability,” writes Xing.

This is largely true, but begs the question of why China adopted this approach. The most likely explanation is that the real motive behind the cuts has little to do with “environmental concerns”, though those are a convenient excuse. Instead, forcing the most inefficient producers out of business–or allowing them to go out of business–would cause problems in the banking and (crucially) the shadow banking sectors because these firms are heavily leveraged. Allowing them to continue to produce, and propping up prices by forcing even relatively efficient firms to cut output, allows them to service their debts, thereby sparing the banks that have lent to them, and the various shadow banking products that hold their debt (often as a way of taking it off bank balance sheets).

If the goal was to reduce pollution, it would have been far more efficient to impose a tax on coal-related pollutants. But this tax would have fallen most heavily on the least efficient producers, and would caused many of them to fail and shut down. The fact that China has not pursued that policy is compelling evidence that pollution–as atrocious as it is–was not the primary driver behind the policy. Instead, it was a backdoor bailout of inefficient producers, and crucially, those who have lent to them.

Morgan Stanley further notes the inefficiency of the capital markets which favor state owned enterprises:

As such, this misallocation of production serves to amplify the already prevalent misallocation of credit stemming from state-owned firms’ favorable access to capital. That arguably undermines market forces that would otherwise help facilitate China’s economic rebalancing.

But this too is driven by politics: SOEs have favorable access to capital because they have favorable access to politicians.

The price shock resulting from the output cuts hit consuming firms in China hard, which has led to a lurching effort to mitigate the policy:

This month, Beijing was forced to reverse course to allow firms to meet the pick-up in demand — another case of state dictate, rather than price signals, driving economic activities.

“In this context, we think the more state-planned production control and capacity cuts cause distortions to the market and are unlikely to be sustainable,” concludes Xing.

“Beijing was forced to reverse course” because utilities consuming thermal coal and steel producers consuming coking coal pressured the government to relent.

The end result is a policy process that owes more to the Marx Brothers than to Marx. A cockamamie scheme to address one pressing problem causes problems elsewhere.

Methinks that Mr. Xing is rather too sanguine about the ability or willingness of the Chinese government to sustain such highly distorting policies. They have done so for years, and are showing no inclination to change their ways. Efficiency is sacrificed to achieve distributive and political objectives, and the bigger and more complex the Chinese economy the more difficult it is for the authorities to predict and control the effects of their policy objectives. But this just induces the government to resort to more authoritarian means, and attempt to exercise even more centralized power. This is costly, but these are costs the authorities are willing and able to bear. Inefficiency is the price of power, but it is a price that the authorities are willing to pay.

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November 9, 2016

Blessed Are Ye Who Are Long Gamma

Filed under: Economics,Energy,Politics,Regulation — The Professor @ 9:03 am

Hillary Clinton made history last night. Just not quite the way she had expected. Rather than “shatter the glass ceiling” (gag), she was crushed as the roof caved in on a complacent, corrupt, and clueless establishment of which she was the exemplar. Donald Trump was the personification of the forces that defeated her and the “elite”, but pretty much only that: either by canny calculation or dumb luck he rode a deep current of popular discontent to achieve a stunning victory that saw at least five, and likely six, strongly Democratic states flip from D to R. The Democrats prevailed only in the leftist strongholds of the P-Coast, the Northeast, The Illinois Salient, and Governmentlandia (Virginia and Maryland). The rest of the country went red. Trump was the effect, not the cause. The vessel that floated on the tide, not the tide itself.

Blessed are ye who are long gamma. Those who have the flexibility and optionality to respond to uncertain developments are the winners here, for there will be uncertainty aplenty. The future with Hillary would have been drearily predictable: the future with Trump will be a wild ride.

Consider few representative areas.

The Supreme Court: Hillary would have chosen rigid leftist ideologues intent on remaking the country–not just its government and economy, but its social fabric. Trump? I have no clue, and either does anyone else. My guess that his court picks generally will be highly idiosyncratic with no unifying philosophical orientation–because Trump lacks one as well.

Government appointments: Hillary would tap from the Empire’s vast array of apparatchiks, most of whom would be statist to the core. The middle and lower level appointments would have teemed with the kinds of political cockroaches revealed in the light of the Podesta emails. As an outsider, Trump has no similar pool of bureaucrats-in-waiting. The transition process will likely be chaotic, and he will have to rely on a Republican establishment that he distrusts (and which distrusts him) to advance candidates. Again, the outcome is wildly unpredictable, and will probably result in a hodgepodge of appointments with no unifying ideology or philosophy, who will often work at cross purposes.

There will be new blood, which is a good thing: people from outside the ranks of the courtiers in DC and the coastal metropolises are desperately needed. These people will inevitably be high variance. But that is an inevitable part of the process of change.

Economic policy: Hillary would have continued the onslaught of regulations that has been producing an Amerisclerosis that rivals Eurosclerosis. Agencies like the EPA would have continued to propose and implement burdensome, growth-sapping regulations. She would have pushed the kinds of taxes on capital that are also inimical to growth (although her ability to get those through Congress would have been a very open question). Trump? He is an economic ignoramus, but it is likely that Congress will temper some of his wackier ideas. Further, he is open to reducing many of the regulatory monstrosities like those that the EPA has imposed, and to removing barriers to energy production and transportation. His tax ideas are unpredictable, but again they are not relentlessly hostile to investment and capital. And a big thing: there is an opportunity to fix Obamacare. Hillary would have fixed it by moving to single payer. There is an opportunity to move away from government control, not doubling down on it.

Regulatory policy and taxes will require cooperation with Congress. The relations between Trump and the Republican leadership are fraught, at best. Idiots like Max Boot are delusional if they think that a Republican House and Senate will give Trump carte blanche. But Trump views himself as a negotiator, and will no doubt engage in negotiations with Congress with zest. The outcome of those negotiations? Impossible to predict. Likely something best described by the old joke: “What is a giraffe? A horse designed by committee [or negotiation].” Again, tremendous uncertainty.

With respect to economic policy, personnel will matter here. Again, Hillary’s appointments to agencies like EPA, SEC, FERC, FTC, FCC, and CFTC would have been tediously predictable statists intent on extending government control over the economy. Trump’s appointments are much more likely to be a very mixed bag, leading to less predictable outcomes. I do think it is likely, however, that there will be many fewer regulatory control freaks. Thus, I expect that at the CFTC, for instance, a Trump commission will jettison economic inanities like Reg AT and position limits.

Foreign policy: Hillary has a strong interventionist, not to say warmongering, streak, and would have almost certainly been more aggressive in Syria than Obama has been, with very sobering consequences (including a substantially increased risk of confrontation with Russia). Trump’s predilections seem much less interventionist, but events, dear boy, events, can lead presidents to do things that they would prefer not to. And given Trump’s mercurial nature, how he will respond to events is wildly unpredictable.

He will have to deal with other major issues, notably China. He will approach these like a negotiator–including, I expect, large doses of bluff and bluster–and the outcomes of these negotiations will be even harder to predict than those of his negotiations with Congress. (One issue that could have both domestic and foreign policy effects is that I conjecture it is likely that the Sequester will die under Trump, whereas it would have continued with a divided government.)

It is clear, therefore, that Trump will disrupt the system, both domestically and internationally, whereas Hillary would have perpetuated it. And I am not unduly concerned about extreme disruptions, because the inherent complexity of the American system of government, the tension between Trump and Congress, and quite frankly, Trump’s limited attention span will temper his more extreme impulses.

Further, shaking up the system is a good thing, for the system is dysfunctional and corrupt. Hillary would have continued our relentless slouch to cryptosocialism and would have cemented the rule of a contemptible and remote establishment: the possibility of an upside is greater with Trump, even if by accident. Hillary would have delivered us sclerosis on purpose.

I would also suggest that a Hillary victory would have increased the likelihood of a bigger cataclysm in the future. She and her acolytes would have disdained and dismissed the forces that in the event propelled Trump to victory. She would have doubled down on the policies that have contributed to our present discontent. As a result, that discontent would have only increased, thereby increasing in turn the likelihood of an even bigger political spasm in the future.

To put things differently: with Trump, we will be on a roller coaster. With Hillary, we would have been on the luge.

I think Trump will be a transitional figure. Transitioning to what, I have no idea. But given the deeply dysfunctional nature of the status quo, transition holds out hope. Shaking up a decrepit and corrupt system creates the possibility for change. Creative Destruction is a possibility with Trump. With Hillary, no.

All this said, the Empire will strike back. It will wage a relentless war from its redoubts in the media, and to a lesser degree, the courts. Look at what the Remain crowd is doing in the UK in its attempt to undo its loss at the polls. That will happen here too: there will be a Thermidor, or at least an attempted one. And that battle will produce uncertainty.

And not all of the Empire’s minions are Democrats: the Republican establishment will fight Trump from within the citadel. This political warfare adds the prospect of even more uncertainty. Again, a reason to be long gamma.

I cannot say I predicted this, because I didn’t. I do think it is fair to say that I limned the outlines of what has transpired. This came in two parts. First, I noted that as with Brexit, this possibility was far more likely than elite opinion believed. A complacent elite sat smugly atop the volcano, blithely ignorant of the pressure of deep popular disdain pushing up the earth under their feet, disdain powered by the financial crisis, bloody and inconclusive wars, and an anemic economy. Talking only to one another, the elite received no feedback about what voters were thinking and feeling.  Existing in an echo chamber made them vulnerable to shock and surprise. Moreover, their contempt for those not in their class also led them to think that such feedback was irrelevant, because these little people didn’t matter. They knew better.

But the little people, largely without voice in the forums in which the elite communicate and interact, nursed their injuries, bided their time, and took their revenge.

Second, Hillary is a horrible person, and a horrible candidate–or should I say deplorable? Look at the vote totals vs. Obama in 2012. To say she underperformed is an extreme understatement. She underperformed because she had nothing new to offer, and indeed, the old conventional liberal stuff she was offering was long past its sell-by date. Add to that her horrible personal packaging (the corruption, the endless scandal, the inveterate lying) and she was crushed by an inarticulate political novice carrying more baggage than the cargo hold of an Airbus A380.

I did not have the courage of my convictions to predict that these two factors would result in a Trump victory. I thought Jacksonian America was too small to prevail. I too was in the thrall of conventional wisdom to some degree.

If you asked me to describe my mood, I would echo the title of a Semisonic song: Feeling strangely fine. Part of that feeling, I must admit somewhat guiltily, is due to schadenfreude: the hysteria of those whom I despise is quite enjoyable to witness. But part of it is that I think I am long gamma, and that the US is long gamma too. The old system and the old establishment have crushed American dynamism. Shaking up that system has more upside than downside, and whatever you think about Trump, you have to know he will shake things up.

I’ll close by quoting about the most un-Trump-like president I can think of: Eisenhower. “If you can’t solve a problem, enlarge it.” In other words, disrupt. Get out of the box. Don’t continue down the same endless path: try something new. The United States has been facing many insoluble problems, political, economic, strategic. The establishment had no clue at how to solve these problems, and their attempts to try the same things expecting different results put us on a slow road to ruin. Or maybe not so slow. A disruption was needed. An overthrow of the elite was imperative. Those things will in some respects enlarge our problems, by creating turmoil. But out of that enlargement there is the prospect of solutions–and yes, the prospect of catastrophe.

I don’t think that Trump himself will be the architect of those solutions. His role will be to tear down–he’s already done that to a considerable degree. Others will have to build up. Who that is, I don’t know. What construction will emerge, I don’t know. But there is far more upside now than there would have been with President Hillary Clinton. And that is reason to feel fine, strangely so or not

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