Streetwise Professor

September 10, 2014

Family Feud: Lifting the Oil Export Ban

Filed under: Commodities,Energy,Politics,Regulation — The Professor @ 7:42 pm

Larry Summers has called for an end to the crude oil export ban in the US. This is pretty much a no-brainer for even a pedestrian economist, let alone one of Summers’s intelligence, not to say one as intelligent as Summers thinks he is.

No-brainer or not, eliminating the ban (which isn’t a total ban, in any event) will have only modest effects. This is because although crude cannot be exported freely, refined products can be. Lifting the ban will mainly entail a substitution of crude exports for product exports, which will result in modest impacts on final product prices.

Here’s a crude outline of how opening up exports will play out (pun intended).

  1. The price of crude in the US will rise, and the price in Europe (notably Brent) will fall, until the price differential is approximately equal to transport costs of a buck or two, in contrast to the current differential of approximately $6.50. This isn’t immaterial, but it’s not a huge change either, given current prices in the $90s.
  2. The amount of crude refined in the US will decline, and the amount of crude refined overseas will rise. Refining margins in Europe will rise and those in the US will fall. The differentials in product prices will remain about the same, because products will be exported after the ban is lifted just as they are now, though export volumes will decline. Prices will differ by transportation costs post-lifting, just as they do now.
  3. The effect on product prices in the US (e.g., the price of gasoline) is a priori impossible to sign, because there are offsetting effects. US refiner input prices will rise, but margins will fall. The net price effect of higher costs and lower margins can’t be determined a priori.
  4. One factor will definitely lead to lower product prices. Post-free trade in crude, there will be a better match between crude slates and refineries. US refineries are more complex, and optimized to process heavier crudes from Mexico and Venezuela. Most are not optimized to process the large quantities of very light crudes that are flowing from Eagle Ford and the Bakken. In contrast, European refineries are better able to process lighter crudes. This better match of refineries to crude will reduce costs and increase productivity, which tends to reduce product prices.
  5. The main factor that will determine whether product prices rise or fall will be the effect of the lifting of the ban on the total output of crude: if more crude is produced, more products will be produced, and prices will decline. The lifting of the ban will reduce Brent prices, which will reduce North Sea output (and Nigerian output too). The lifting of the ban will increase US prices, which will cause US output to rise. The net effect on total crude output depends on the relative elasticities of supply. If, for instance, Brent supply is very elastic and US supply is very inelastic, total crude output could well fall, which would tend to increase gasoline and distillate prices in the US. If the elasticities are reversed, total supply would likely rise leading to lower product prices.
  6. If I had to guess, I would say that given that the product price changes will be negative but small, and hard to detect in the normal fluctuations of prices. The combined price effect shared between the US and non-US markets for light crudes is relatively small (on the order of 5 percent of price) and the offsetting effect on foreign and domestic output leaves a net effect on output (and hence prices) that will be relatively small.
  7. Tom Friedman supports lifting the ban, which makes me think twice. Friedman also says that lifting the ban will cause crude prices to drop by $25/bbl and thereby crush Putin and Iran and ISIS, thereby saving Ukraine and the MIddle East. Tom Friedman is an idiot. Pay no attention.

There will be one major effect, which Summers alludes to, and which I have emphasized when I teach about the export restriction in my Energy Policy course for EMBAs: the main effect of the change in policy will be to redistribute rents within the domestic oil industry. It will reduce the profitability of US refiners, especially some independents who are feasting on the abundant supply of light crude. It will increase the profitability of domestic crude producers.

In other words, contrary to a lot of the rhetoric, this isn’t about “big oil” vs. main street. It’s about Downstream Medium Oil vs. Upstream  Medium Oil. The big integrated majors basically see money shifted from one pocket to the other: since the lifting of the ban will increase total surplus in the energy market, the integrated majors will benefit, but the benefit will be smallish. The independent refiners will be losers, and pure upstream companies will be winners.

This is, in other words, a sort of family feud. A battle between different branches of the US energy sector family. But as any cop called to the scene of a domestic dispute will tell you, these can be pretty intense.

In sum, ending the ban would make the pizza slightly bigger, but you won’t notice it much at the pump, if you notice it at all. The main effect would be to change the size of the slices. But since conflicts over how the pizza is divided drive politics, the export ban will generate  political battles of an intensity out of proportion to its modest effects  on overall wealth and welfare.

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September 9, 2014

The Euros Get Tough on Google, But Run and Hide From Gazprom

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 8:09 pm

The European Commission’s competition commissioner has scuppered a proposed settlement with Google. The Commission has already taken many pounds of flesh from Microsoft and Intel over the past year, so now it is looking to add some Google cuts to the meat locker.

What about the EU’s case against Gazprom, you ask? <Crickets.>

I’m not a big Google or Microsoft fan, but the accusations leveled against them (and Intel) are highly speculative. Gazprom’s exercise of market power, and its protection of that market power, is almost textbook. The egregious price discrimination, and its use of contractual terms (no re-sale) to support that discrimination, is a blatant example. So on the merits, the Gazprom case should proceed and the Google case should be settled, and on anything but onerous terms.

But the craven Euros quake before Gazprom. Indeed, they seem to be even less willing to confront the company now that Putin is on the war path.

They have a better case against Gazprom, and that case could be a political lever in what is an existential battle over European security: Putin and the Russians have ranted and raved about the case when the Euros did press it some, which indicates that it hits the company, and hence Russia, where it hurts.  But rather than hitting this pressure point, the Euros bury the case and go kick Google instead.

Don’t think that Putin doesn’t notice. And know that it is exactly this kind of cowardice that emboldens him.

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Igor Might Cash In, But Only Because the Future Is Bleak

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 7:44 pm

It looks like Igor may get his money:

Allocation of over $40 billion from Russia’s National Welfare Foundation for Rosneft oil giantcould be reasonable, as the investment will be repaid, Russian Prime Minister Dmitry Medvedev said in an interview to the Vedomosti newspaper, released Monday.

“This number only seems so impressive, but this is not [supposed to be repaid] within a year,” Medvedev said, answering a reporter’s question on whether Rosneft’s request for $40 billion is feasible.

“The company needs to keep up production, since Rosneft is a major contributor to the budget. In this regard, we have to help them by maintaining the investment level,” Medvedev explained, adding that the government is considering specific ways of aiding Rosneft.

Now, this is Medvedev speaking, so take it for what it’s worth. But it’s my impression that lately Dmitri’s designated role is ventriloquist’s dummy, and if you looked closely you can probably see Putin’s lips moving. This is at least a trial balloon, and perhaps it is laying the groundwork for an official announcement. It is sufficiently controversial within the Russian government that Putin probably does not want to act precipitously and is putting Medvedev out there to see if the proposal attracts too much fire.

This statement likely reflects a couple of realities. First, Sechin’s influence with Putin. The second is the effect of sanctions. Although the EU and US sanctions have not been as draconian as they might be, the FUD factor has worked. Western capital markets and banks are largely shut to Russian companies, especially those subject to sanctions (like Rosneft). Rosneft has maturing debt to refinance, and as Medvedev says, it needs to invest to maintain production.

Output dropped 1.3 percent in August, as the productivity of western Siberian fields continues to drop as they age.

In another indication of the stress that it is facing, Rosneft (and thus Putin/Russia) actually agreed to let China invest in Russian oil fields on terms never extended to a western firm. The Chinese can bring capital, but not the expertise and technology that Rosneft needs to develop the challenging resources on which has staked its future. And the Chinese usually drive a hard bargain. So even with state money, Rosneft will struggle to achieve anything like the lofty ambitions that Sechin has laid out.

The state money will buy some time for Rosneft. Presumably Putin and Sechin are hoping that the state money will get them through the sanctions, which they likely anticipate will fade away in the near-to-medium term. But the FUD factor will continue to limit Rosneft’s access to western capital and western technology. Yes, energy firms and banks will come back if and when sanctions go away, but on terms that will be far less favorable than had been available pre-Ukraine. Putin’s unpredictability has dramatically raised the political risks of investing in Russia, especially in the energy sector.  Future capital will come with strings, and will be reluctant to invest in long term projects that could fall victim to Putin’s next adventure.

In other words, if Putin indeed permits Rosneft to dip deeply into the National Welfare Fund, it will be an acknowledgement that Russia has burned its bridges with western finance and technology.

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September 8, 2014

Cleaning Up After the Dodd, Frank & Gensler Circus

A lot of CFTC news lately. Much of it involves the agency, under new chairman Timothy Massad, dealing with the consequences of Frankendodd and the overzealous efforts of his predecessor Gary Gensler to implement it.

One of Massad’s priorities relates to clearinghouses (CCPs):

CFTC Chairman Timothy Massad said in a Sept. 5 interview that his agency will bolster examinations of clearinghouses, which process trillions of dollars in transactions and are potentially vulnerable to market shocks or cyber attacks. The agency is working with the Federal Reserve on the effort, he said.

New rules requiring banks and other firms to use clearinghouses owned by LCH.Clearnet Group Ltd., CME Group Inc. (CME) and Intercontinental Exchange Inc. (ICE) have been “a great thing” and have helped regulators “monitor and mitigate risks, but it doesn’t eliminate risk,” according to Massad.

“We’ve got to be very focused on the health of clearinghouses,” he said.

It’s nice to see that the CFTC, as well as prudential regulators, recognize that CCPs are of vital systemic importance. But as I’ve said many times, on four continents: In a complex, interconnected financial system, making CCPs less likely to default  does not necessarily increase the safety of the financial system. Making one part of the system safer does not make the system safer. It can prevent one Armageddon scenario, but increase the likelihood of others.

Gensler babbled repeatedly about the clearing mandate reducing the interconnectedness of the financial system. In fact, it just reconfigures the interconnections. The very measures that are intended to ensure CCPs get paid what they are owed even in periods of crisis can redirect crushing stresses to other vulnerable parts of the financial system. CCPs may end up standing, surrounded by the rubble of the rest of the financial system.

CCPs are deeply enmeshed in a complex web of credit and payment relationships. Mechanisms intended to reduce CCP credit exposure-multilateral netting, high initial margins, rigorous variation margining-feed back into other parts of that web.

There are so many interconnected parts. Today Risk ran an article about how LCH relies heavily on two settlement banks, JPM and Citi. Although LCH will not confirm it, it appears that these two banks process  about 85 percent of the payments between clearing members and LCH. This process involves the extension of intraday credit. This creates exposures for these two big SIFIs, and makes the LCH’s viability dependent on the health of these two banks: if one of them went down, this could cause extreme difficulties for LCH and for the clearing members. That is, OTC derivatives clearing adds a new way in which the financial system’s health and stability depend on the health of big banks, and creates new risks that can jeopardize the health of the big banks.

So much for eliminating interconnectedness, Gary. It’s just been moved around, and not necessarily in a good way.

Again, mitigating systemic risk requires taking a systemic perspective. The fallacy of composition is a major danger, and a very alluring one. The idea that the system gets safer when you make a major part of it safer is just plain wrong. The system is more than just the sum of its parts. Moreover, it can actually be the case that making one part of the system stronger, but more rigid, as clearing arguably does, makes the system more vulnerable to catastrophic failure. Or at least creates new ways that it can fail.

Another issue on Massad’s plate is addressing the conflict between his agency and Europe on giving regulatory approval to each other’s CCPs. It looks like this issue will not get resolved by the drop dead date in December. This will result in substantially higher costs (primarily in the form of higher capital requirements and higher margins), the fragmentation of OTC derivatives markets, and greater counterparty concentration (as US firms avoid European CCPs and vice versa).

The CFTC is also trying to fix its fundamentally flawed position limit proposal, and particularly the defective, overly restrictive, and at times clueless hedging exemptions. Mencken defined Puritanism as “The haunting fear that someone, somewhere, may be happy.” The CFTC’s hedging exemption, as currently constituted, reflects a sort of financial Puritanism: “The haunting fear that someone, somewhere, may be speculating.” To avoid this dread possibility, the exemptions are so narrow that they eliminate some very reasonable risk management strategies, such as using gas forwards to hedge electricity price exposures.

This has caused an uproar among end users, including firms like Cargill that have been hedging since the end of the freaking Civil War. Perhaps their survival suggests they might know something about the subject.

In the “be careful what you ask for” category, the CFTC is wrestling with a very predictable consequence of one of its decisions. In an attempt to wall off the US from major shocks originating overseas, the Gensler CFTC adopted rules that would have subjected foreign firms dealing with foreign affiliates of US banks to US regulations if the parents provided guarantees for those affiliates. Foreign firms definitely didn’t want to be subjected to the tender mercies of the CFTC and Frankendodd regs. So to maintain this business, the parents stripped away the guarantees.

Problem solved, right? The elimination of the guarantee would eliminate a major potential channel of contagion between the dodgy furriners and the US financial system, right? That was the point, right?

Apparently not. The CFTC has major agida over this:

Timothy Massad, the new CFTC chairman, said in an interview he is concerned aboutrecent moves by several large Wall Street firms to sidestep CFTC oversight by changing the terms of some swap agreements made by foreign affiliates.

“The concern has always been that activity that takes place abroad can result in the importation of risk into the U.S.,” Mr. Massad said. He said there is a concern that a U.S. bank’s foreign losses would ultimately find their way to U.S. shores, infecting the parent company in possibly destabilizing ways.

. . . .

The moves mean any liability for those swaps lies solely with the offshore operation, which the banks have said will protect the U.S. parent from contagion. Yet without that tie to the U.S. parent, the contracts won’t fall under U.S. jurisdiction and so won’t be subject to strict rules set by the 2010 Dodd-Frank financial-overhaul law, including requirements that contracts historically traded over the telephone be traded publicly on U.S. electronic platforms [i.e., the SEF mandate].

By de-guaranteeing, the US banks have eliminated the most direct channel of contagion from over there to over here. But apparently the CFTC is worried that unless its regulations are followed overseas, there will be other, albeit more indirect, backdoors into the US.

In essence, then, the CFTC believes its regulations are by far superior to those in Europe and elsewhere, and that unless its regulations are implemented everywhere, the US is at risk.

Not too arrogant, eh?

A few observations should make you question this arrogance, and in a  big way.

First, note that the most likely effect of the CFTC getting its way of exporting its regulations into any transaction and any entity involving any affiliate of a US financial institution is that foreign entities will just avoid dealing with any such affiliate. This will balkanize the global derivatives market: ‘mericans will deal with ‘mericans, and Euros with Euros, and never the twain shall meet. This will likely result in greater counterparty concentration. Such developments would create systemic vulnerabilities, and even though the direct counterparty credit channel could not bring that risk back to US banks, the myriad other connections between foreign banks and American ones would.

Second, note the last sentence of the quoted paragraph: “including requirements that contracts historically traded over the telephone be traded publicly on U.S. electronic platforms.” So apparently attempts to avoid the SEF mandate infuriate the CFTC. But the SEF mandate has nothing to do with systemic risk. For this reason, and others, I named this mandate “The Worst of Frankendodd.” But so intent is the CFTC on pursuing this systemically irrelevant unicorn that it is questioning moves by US banks that actually reduce their exposure to problems in foreign markets.

Timothy Massad has the unwelcome task of cleaning up after the elephant parade at the Dodd, Frank & Gensler Circus. Clearing mandates, coordinating with overseas regulators, position limits, and the elimination of affiliate guarantees are only some of the things that he has to clean up. I hope he’s got a big shovel and a lot of patience.

 

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August 18, 2014

Wage Asymmetric Warfare: Unleash the SPR!

Filed under: Commodities,Economics,Energy,Military,Politics,Russia — The Professor @ 3:25 pm

The decline in the price of oil-Brent is down almost to $100/bbl, and Urals-Med is below that level-puts pressure on an already stressed Russian economy. And it especially puts pressure on a stressed Russian government budget, which balances at about $110+. What’s more, Russia is looking to replace private western funding with state support for its banks, and some corporations: recall my post yesterday which described how Sechin is panting after tens of billions of government money to replace western creditors. Further, Putin has made all sorts of promises, including lavish spending on the military and on infrastructure (e.g., a hugely expensive bridge over the Kerch Strait to Crimea). All of these add to the strains on the Russian budget.

Some of this is due to a weakening of the Russian economy for independent factors. Some of it is due to the sanctions.

The effectiveness of the sanctions could be enhanced by putting even further pressures on the Russian government. The most direct means of doing so would be through the price of oil, and short of persuading the Saudis to do a reprise of their 1986 act of flooding the market with oil, the best way to do that would be to release oil from the Strategic Petroleum Reserve.

Especially given the burst in US domestic oil production, the already weak case for maintaining a large reserve is even weaker. Moreover, since much of the oil in the SPR is Brent, and thus could presumably be exported, this would be a way of mitigating the distortions associated with the existing crude export ban.

The number of barrels that would actually flow to the market would presumably be somewhat lower than the amount released from the SPR, because some of the public storage would be replaced by private storage. (As I argued in 2011, this effect depends on market expectations regarding how the SPR would be used.) But the direction of the price effect is clear, and the price impact would not be trivial.

Putin is waging asymmetric war in Ukraine. (Though it is becoming less asymmetric, and more conventional, by the day.) Sanctions are an asymmetric form of warfare. A release of the SPR would be another asymmetric move that would impact Russia directly, and indirectly by enhancing the financial strains produced by the sanctions. There’s no substantive economic case for retaining the SPR at its current levels. Seems like an obvious move. Will Obama make it?

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August 17, 2014

Nationalize the Clearinghouses?

Filed under: Clearing,Commodities,Derivatives,Economics,Politics,Regulation — The Professor @ 3:48 pm

Stephen Lubben has garnered a lot of attention with his recent paper “Nationalize the Clearinghouses.” Don’t get nervous, CME, ICE, LCH: he doesn’t mean now, but in the event of your failure.

A few brief comments.

First, I agree-obviously, since I’ve been saying this going back to the 90s-that the failure of a big CCP would be a catastrophic systemic event, and that a failure is a set of positive measure. Thus, planning for this contingency is essential. Second, I further agree that establishing a procedure that lays out in advance what will be done upon the failure of a CCP is vital, and that leaving things to be handled in an ad hoc way at the time of failure is a recipe for disaster (in large part because how market participants would respond to the uncertainty when a CCP teeters on the brink). Third, it is evident that CCPs do not fit into the recovery and resolution schemes established for banks under Frankendodd and EMIR. CCPs are very different from banks, and a recovery or resolution mechanism designed for banks would be a bad, bad fit for clearers.

Given all this, temporary nationalization, with a pre-established procedure for subsequent privatization, is reasonable. This would ensure continuity of operations of a CCP, which is essential.

It’s important not to exaggerate the benefits of this, however. Stephen states: nationalization “should provide stakeholders in the clearinghouses with strong incentives to oversee the clearinghouse’s management, and avoid such a fate.” I don’t think that the ex ante efficiency effects of nationalization will be that large. After all, nationalization would occur only after the equity of the CCP (which is pretty small to begin with) is wiped out, and the default fund plus additional assessments have been blown through. Shooting/nationalizing a corpse doesn’t have much of an incentive effect on the living ex ante.

Stephen recommends that upon nationalization that CCP memberships be canceled. This is superfluous, given the setup of CCPs. Many CCPs require members to meet an assessment call up to the amount of the original contribution to the default fund. Once they have met that call, they can resign from the CCP: that’s when the CCP gives up the ghost. Thus, a CCP fails when members exercise their option to check out. There are no memberships to cancel in a failed CCP.

Lubben recommends that there be an “expectation of member participation in the recapitalization of the clearinghouse, once that becomes systemically viable.” In effect, this involves the creation of a near unlimited liability regime for CCP members. The existing regime (which involves assessment rights, typically capped at the original default fund contribution amount) goes beyond traditional limited liability, but not all the way to a Lloyds of London-like unlimited liability regime. Telling members that they will be “expected” to recapitalize a CCP (which has very Don Corleone-esque overtones) essentially means that membership in a CCP requires a bank/FCM to undertake an unlimited exposure, and to provide capital at times they are likely to be very stressed.

This is problematic in the event, and ex ante.

Stephen qualifies the recapitalization obligation (excuse me, “expectation”) with “once that becomes systemically viable.” Well, that could be a helluva long time, given that the failure of a CCP will be triggered by the failure of 2 or more systemically important financial institutions. (And let’s not forget that given the fact that FCMs are members of multiple clearinghouses, multiple simultaneous failures of CCPs is a very real possibility: indeed, there is a huge correlation risk here, meaning that surviving members are likely to be expected to re-capitalize multiple CCPs.) Thus, even if the government keeps a CCP from failing via nationalization, the entities that it expects to recapitalize the seized clearinghouse will will almost certainly be in dire straits themselves at this juncture. A realistic nationalization plan must therefore recognize that the government will be bearing counterparty risk for the CCP’s derivatives trades for some considerable period of time. Nationalization is not free.

Ex ante, two problems arise. First, the prospect of unlimited liability will make banks very reluctant to become members of CCPs. Nationalization plus a recapitalization obligation is the wrong-way risk from hell: banks will be expected to pony up capital precisely when they are in desperate straits. My friend Blivy jokingly asked whether there will soon be more CCPs than clearing firms. An “expectation” of recapitalizing a nationalized CCP is likely to make that a reality, rather than a joke.

Second, the nationalization scheme creates a moral hazard. Users of CCPs (i.e., those trading cleared derivatives) will figure that they will be made whole in the event of a failure: the government and eventually the (coerced) banks will make the creditors of the CCP whole. They thus have less incentive to monitor a CCP or the clearing members.

Thus, other issues have to be grappled with. Specifically, should there be “bail-ins” of the creditors of a failed CCP, most notably through variation margin haircutting? Or should there be initial margin haircutting, which would intensify the incentives to monitor (as well as spread the default risk more broadly, and not force it disproportionately on those receiving VM payments, who are  likely to be hedgers) ? Hard questions, but ones that need to be addressed.

It is good to see that serious people like Stephen are now giving serious consideration to this issue. It is unfortunate that the people responsible for mandating clearing didn’t give these issues serious consideration when rushing to pass Frankendodd and EMIR.

Again: legislate in haste, repent at leisure.

 

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August 16, 2014

Sechin: Sanctions Don’t Hurt Rosneft, But I Need $42 Billion Because of Sanctions

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 2:46 pm

Igor Sechin, he of the ape drape, is asking the Russian government for $42 billion for Rosneft, to be paid from the National Wealth Fund. This would represent almost half of the value of that fund’s $86 billion. Sechin “said the company needed the money to help it cope with a ban on U.S. credits and loans with a maturity longer than 90 days, which European banks and investors have joined.”

This newfound fear of sanctions contradicts what Sechin and other Russian officials have said: they have dismissed them as irrelevant trifles.

I really don’t think that Sechin has become convinced that the sanctions do in fact pose a serious threat to Rosneft. This is just his way of trying to let no crisis go to waste, and get his hands on Russian government monies. Sechin has always fought tooth and nail against Medvedev’s repeatedly shelved plans to sell off a big stake in Rosneft: he doesn’t want nosy western investors cramping his style. The sanctions, and their alleged impact on Rosneft’s ability to borrow in the west, gives him an opportunity to show the door to pesky western creditors as well. Sechin no doubt believes that he can exert far more influence and power over the Russian government than he can over foreign bankers and traders. Bad, empire building investments; sweetheart contracts with favored supply firms; and tunneling funds are all easier when the main obstacles are government bureaucrats who can be bought off or threatened with horrible fates. The challenges are greater when outside investors and creditors are involved.

Sane Russian economics officials (there are some!) are aghast:

An anonymous official cited by Vedomosti called Sechin’s plan “horrible”, and another government source told the paper Prime Minister Dmitry Medvedev was unlikely to back it.

As if Medvedev matters.

I doubt Sechin will get his $42 billion, but I imagine he will get a lot more than zero. Maybe the $12 billion that Rosneft has to repay this year. Putin is likely to be sympathetic, given his decided autarkic turn.

In other possibly sanctions-related news, Gazprom is apparently relocating its London trading operations to Zug. To its discredit, Switzerland has refused to join in on EU sanctions, or to adopt serious sanctions of its own. Switzerland’s economy minister cautioned against joining EU sanctions, and advanced his country as a mediator with the Russians.

Which makes this Russian rant over the one timorous move that Switzerland has made truly revealing:

The Russian Foreign Ministry on Friday sharply criticized the Swiss government for restrictivemeasures against Russia related to Moscow’s stance on the Ukrainian crisis, saying such moves could harm bilateral relations.

“We express our disappointment in connection with these decisions taken by Bern,” the ministry said in a statement.

Earlier on Friday, the Swiss government decided to draft additional measures aimed at preventing the use of the territory of the Swiss Confederation to circumvent the existing EU sanctions against Russia. The government also confirmed the ban on transfers of dual-purpose products and technologies to Russia.

Those Russians. Poster children for Dale Carnegie.

But who could resist the appeal of a guy like this?:

sechin_ape_drape

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July 29, 2014

The FUD Factor At Work

Filed under: Commodities,Economics,Energy,Politics,Regulation,Russia — The Professor @ 9:35 am

Going back to the original round of sanctions, I have been arguing that the terms of US sanctions have been left deliberately vague in order to make  banks and investors very cautious about dealing with sanctioned firms. Spreading fear, uncertainty, and doubt-FUD-leverages the effect of sanctions.

When I read the last round of sanctions, I had many questions, and hence many doubts about actually how far the sanctions would reach. I was not alone. Professionals-lawyers at banks and Wall Street law firms-are also uncertain:

But compliance officers at some U.S. banks and broker-dealers say the sanctions, issued by Treasury’s Office of Foreign Assets Control (OFAC), are not clear enough. That has left financial institutions guessing, in certain instances, at how to comply. They worry they are vulnerable to punitive action by U.S. regulators.

Fear, uncertainty, and doubt, all in one paragraph. The fear part is particularly interesting, and quite real, especially in the aftermath of the truly punitive action by U.S. regulators in the BNP-Paribas case.

OFAC-The Office of Foreign Asset Control, which is in charge of overseeing the sanctions-is in no hurry to clarify matters:

Another senior compliance officer at a major U.S. bank said bankers “are frustrated that OFAC is not providing more guidance.”

The day after the sanctions were issued, OFAC held a conference call with hundreds of financial services industry professionals in an effort to answer concerns. Although some issues were cleared up, others were left undecided, said two sources who were on the call.

Dear Mr. Senior Compliance Officer: that’s on purpose. Believe me.

A new round of sanctions may be imminent. I am hoping to be proven wrong in my forecasts, because reports are that the Europeans are going to do something serious. Add serious doubts to serious action, and American and European banks won’t touch most Russian banks or major companies with a 10 foot pole while wearing a hazmat suit. That will cause some major economic problems for Putin and Russia. Not 1998-magnitude problems, but maybe something bordering on 2008 problems, although a $100+ oil price will help contain the damage, despite the added difficulties that sanctions will create for the Russians to cash the checks for that oil.

Then it will be Vlad’s move. What that move will be, I do not know.

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July 25, 2014

Benchmark Blues

Pricing benchmarks have been one of the casualties of the financial crisis. Not because the benchmarks-like Libor, Platts’ Brent window, ISDA Fix, the Reuters FX window or the gold fix-contributed in an material way to the crisis. Instead, the post-crisis scrutiny of the financial sector turned over a lot of rocks, and among the vermin crawling underneath were abuses of benchmarks.

Every major benchmark has fallen under deep suspicion, and has been the subject of regulatory action or class action lawsuits. Generalizations are difficult because every benchmark has its own problems. It is sort of like what Tolstoy said about unhappy families: every flawed benchmark is flawed in its own way. Some, like Libor, are vulnerable to abuse because they are constructed from the estimates/reports of interested parties. Others, like the precious metals fixes, are problematic due to a lack of transparency and limited participation. Declining production and large parcel sizes bedevil Brent.

But some basic conclusions can be drawn.

First-and this should have been apparent in the immediate aftermath of the natural gas price reporting scandals of the early-2000s-benchmarks based on the reports of self-interested parties, rather than actual transactions, are fundamentally flawed. In my energy derivatives class I tell the story of AEP, which the government discovered kept a file called “Bogus IFERC.xls” (IFERC being an abbreviation for Inside Ferc, the main price reporting publication for gas and electricity) that included thousands of fake transactions that the utility reported to Platts.

Second, and somewhat depressingly, although benchmarks based on actual transactions are preferable to those based on reports, in many markets the number of transactions is small. Even if transactors do not attempt to manipulate, the limited number of transactions tends to inject some noise into the benchmark value. What’s more, benchmarks based on a small number of transactions can be influenced by a single trade or a small number of trades, thereby creating the potential for manipulation.

I refer to this as the bricks without straw problem. Just like the Jews in Egypt were confounded by Pharoh’s command to make bricks without straw, modern market participants are stymied in their attempts to create benchmarks without trades. This is a major problem in some big markets, notably Libor (where there are few interbank unsecured loans) and Brent (where large parcel sizes and declining Brent production mean that there are relatively few trades: Platts has attempted to address this problem by expanding the eligible cargoes to include Ekofisk, Oseberg, and Forties, and some baroque adjustments based on CFD and spread trades and monthly forward trades). This problem is not amenable to an easy fix.

Third, and perhaps even more depressingly, even transaction-based benchmarks derived from markets with a decent amount of trading activity are vulnerable to manipulation, and the incentive to manipulate is strong. Some changes can be made to mitigate these problems, but they can’t be eliminated through benchmark design alone. Some deterrence mechanism is necessary.

The precious metals fixes provide a good example of this. The silver and gold fixes have historically been based on transactions prices from an auction that Walras would recognize. But participation was limited, and some participants had the market power and the incentive to use it, and have evidently pushed prices to benefit related positions. For instance, in the recent allegation against Barclays, the bank could trade in sufficient volume to move the fix price sufficiently to benefit related positions in digital options. When there is a large enough amount of derivatives positions with payoffs tied to a benchmark, someone has the incentive to manipulate that benchmark, and many have the market power to carry out those manipulations.

The problems with the precious metals fixes have led to their redesign: a new silver fix method has been established and will go into effect next month, and the gold fix will be modified, probably along similar lines. The silver fix will replace the old telephone auction that operated via a few members trading on their own account and representing customer orders with a more transparent electronic auction operated by CME and Reuters. This will address some of the problems with the old fix. In particular, it will reduce the information advantage that the fixing dealers had that allowed them to trade profitably on other markets (e.g.,. gold futures and OTC forwards and options) based on the order flow information they could observe during the auction. Now everyone will be able to observe the auction via a screen, and will be less vulnerable to being picked off in other markets. It is unlikely, however, that the new mechanism will mitigate the market power problem. Big trades will move markets in the new auction, and firms with positions that have payoffs that depend on the auction price may have an incentive to make those big trades to advantage those positions.

Along these lines, it is important to note that many liquid and deep futures markets have been plagued by “bang the close” problems. For instance, Amaranth traded large volumes in the settlement period of expiring natural gas futures during three months of 2006 in order to move prices in ways that benefited its OTC swaps positions. The CFTC recently settled with the trading firm Optiver that allegedly banged the close in crude, gasoline, and heating oil in March, 2007. These are all liquid and deep markets, but are still vulnerable to “bullying” (as one Optiver trader characterized it) by large traders.

The incentives to cause an artificial price for any major benchmark will always exist, because one of the main purposes of benchmarks is to provide a mechanisms for determining cash flows for derivatives. The benchmark-derivatives market situation resembles an inverted pyramid, with large amounts cash flows from derivatives trades resting on a relatively small number of spot transactions used to set the benchmark value.

One way to try to ameliorate this problem is to expand the number of transactions at the point of the pyramid by expanding the window of time over which transactions are collected for the purpose of calculating the benchmark value: this has been suggested for the Platts Brent market, and for the FX fix. A couple of remarks. First, although this would tend to mitigate market power, it may not be sufficient to eliminate the problem: Amaranth manipulated a price that was based on a VWAP over a relatively long 30 minute interval. In contrast, in the Moore case (a manipulation case involving platinum and palladium brought by the CFTC) and Optiver, the windows were only two minutes long. Second, there are some disadvantages of widening the window. Some market participants prefer a benchmark that reflects a snapshot of the market at a point in time, rather than an average over a period of time. This is why Platts vociferously resists calls to extend the duration of its pricing window. There is a tradeoff in sources of noise. A short window is more affected by the larger sampling error inherent in the smaller number of transactions that occurs in a shorter interval, and the noise resulting from greater susceptibility to manipulation when a benchmark is based on smaller number of trades. However, an average taken over a time interval is a noisy estimate of the price at any point of time during that interval due to the random fluctuations in the “true” price driven by information flow. I’ve done some numerical experiments, and either the sampling error/manipulation noise has to be pretty large, or the volatility of the “true” price must be pretty low for it to be desirable to move to a longer interval.

Other suggestions include encouraging diversity in benchmarks. The other FSB-the Financial Stability Board-recommends this. Darrel Duffie and Jeremy Stein lay out the case here (which is a lot easier read than the 750+ pages of the longer FSB report).

Color me skeptical. Duffie and Stein recognize that the market has a tendency to concentrate on a single benchmark. It is easier to get into and out of positions in a contract which is similar to what everyone else is trading. This leads to what Duffie and Stein call “the agglomeration effect,” which I would refer to as a “tipping” effect: the market tends to tip to a single benchmark. This is what happened in Libor. Diversity is therefore unlikely in equilibrium, and the benchmark that survives is likely to be susceptible to either manipulation, or the bricks without straw problem.

Of course not all potential benchmarks are equally susceptible. So it would be good if market participants coordinated on the best of the possible alternatives. As Duffie and Stein note, there is no guarantee that this will be the case. This brings to mind the as yet unresolved debate over standard setting generally, in which some argue that the market’s choice of VHS over the allegedly superior Betamax technology, or the dominance of QWERTY over the purportedly better Dvorak keyboard (or Word vs. Word Perfect) demonstrate that the selection of a standard by a market process routinely results in a suboptimal outcome, but where others (notably Stan Lebowitz and Stephen Margolis) argue that  these stories of market failure are fairy tales that do not comport with the actual histories. So the relevance of the “bad standard (benchmark) market failure” is very much an open question.

Darrel and Jeremy suggest that a wise government can make things better:

This is where national policy makers come in. By speaking publicly about the advantages of reform — or, if necessary, by using their power to regulate — they can guide markets in the desired direction. In financial benchmarks as in tap water, markets might not reach the best solution on their own.

Putting aside whether government regulators are indeed so wise in their judgments, there is  the issue of how “better” is measured. Put differently: governments may desire a different direction than market participants.

Take one of the suggestions that Duffie and Stein raise as an alternative to Libor: short term Treasuries. It is almost certainly true that there is more straw in the Treasury markets than in any other rates market. Thus, a Treasury bill-based benchmark is likely to be less susceptible to manipulation than any other market. (Though not immune altogether, as the Pimco episode in June ’05 10 Year T-notes, the squeezes in the long bond in the mid-to-late-80s, the Salomon 2 year squeeze in 92, and the chronic specialness in some Treasury issues prove.)

But that’s not of much help if the non-manipulated benchmark is not representative of the rates that market participants want to hedge. Indeed, when swap markets started in the mid-80s, many contracts used Treasury rates to set the floating leg. But the basis between Treasury rates, and the rates at which banks borrowed and lent, was fairly variable. So a Treasury-based swap contract had more basis risk than Libor-based contracts. This is precisely why the market moved to Libor, and when the tipping process was done, Libor was the dominant benchmark not just for derivatives but floating rate loans, mortgages, etc.

Thus, there may be a trade-off between basis risk and susceptibility to manipulation (or to noise arising from sampling error due to a small number of transactions or averaging over a wide time window). Manipulation can lead to basis risk, but it can be smaller than the basis risk arising from a quality mismatch (e.g., a credit risk mismatch between default risk-free Treasury rates and a defaultable rate that private borrowers pay). I would wager that regulators would prefer a standard that is less subject to manipulation, even if it has more basis risk, because they don’t internalize the costs associated with basis risk. Market participants may have a very different opinion. Therefore, the “desired direction” may depend very much on whom you ask.

Putting all this together, I conclude we live in a fallen world. There is no benchmark Eden. Benchmark problems are likely to be chronic for the foreseeable future. And beyond. Some improvements are definitely possible, but benchmarks will always be subject to abuse. Their very source of utility-that they are a visible price that can be used to determine payoffs on vast sums of other contracts-always provides a temptation to manipulate.

Moving to transactions-based mechanisms eliminates outright lying as a manipulation strategy, but it does not eliminate the the potential for market power abuses. The benchmarks that would be least vulnerable to market power abuses are not necessarily the ones that best reflect the exposures that market participants face.

Thus, we cannot depend on benchmark design alone to address manipulation problems. The means, motive, and opportunity to manipulate even transactions-based benchmarks will endure. This means that reducing the frequency of manipulation requires some sort of deterrence mechanism, either through government action (as in the Libor, Optiver, Moore, and Amaranth cases) or private litigation (examples of which include all the aforementioned cases, plus some more, like Brent).  It will not be possible to “solve” the benchmark problems by designing better mechanisms, then riding off into the sunset like the Lone Ranger. Our work here will never be done, Kimo Sabe.*

* Stream of consciousness/biographical detail of the day. The phrase “Kimo Sabe” was immortalized by Jay Silverheels-Tonto in the original Lone Ranger TV series. My GGGGF, Abel Sherman, was slain and scalped by an Indian warrior named Silverheels during the Indian War in Ohio in 1794. Silverheels made the mistake of bragging about his feat to a group of lumbermen, who just happened to include Abel’s son. Silverheels was found dead on a trail in the woods the next day, shot through the heart. Abel (a Revolutionary War vet) was reputedly the last white man slain by Indians in Washington County, OH. His tombstone is on display in the Campus Martius museum in Marietta. The carving on the headstone is very un-PC. It reads:

Here lyes the body of Abel Sherman who fell by the hand of the Savage on the 15th of August 1794, and in the 50th year of  his age.

Here’s a picture of it:

OLYMPUS DIGITAL CAMERA

The stream by which Abel was killed is still known as Dead Run, or Dead Man’s Run.

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July 18, 2014

Sanctions: Pinprick or Sledgehammer Blow, With Little In Between

Filed under: Commodities,Derivatives,Economics,Energy,Military,Politics,Russia — The Professor @ 11:27 pm

Before the massacre over Donetsk, the big Russia-related story was the new sanctions imposed on Wednesday. Although those sanctions were overshadowed by yesterday’s atrocity, the wanton destruction of MH17 raises the possibility that more intense sanctions will be forthcoming. Therefore, it is worthwhile to examine what the US did Wednesday to see what would be necessary to impose truly crippling costs on Russian companies and the Russian economy generally. (Forget what the Euros did. That is so embarrassing that it should be passed over in silence.)

The sanctions imposed Wednesday are very weak beer. (Here is an FAQ from the Treasury outlining them.) They were different than previous sanctions in that these were directed at companies, rather than individuals. Moreover, some of the targeted companies are on the commanding heights of the Russian economy: Rosneft, VTB, Gazprombank, and Novatek. (Notable absences: Gazprom and Sberbank.)

Under the sanctions, “US Persons” (which can include US subsidiaries in foreign countries) are prohibited from buying new debt from or new making loans to these companies with maturities of 90 days. (Existing loans/bonds are not affected.)  US persons are also precluded from buying “new” equity from the financial firms: they can buy new equity from Rosneft and Novatek.

Since US banks are major lenders to foreign companies, this might seem to be a major impediment to the affected companies, and indeed  Rosneft’s and Novatek’s stock prices were both down more than 5 percent on the news. But in my opinion, this reaction is more related to how the announcement raised the likelihood of more severe sanctions in the future, rather than the direct effects of these new sanctions.

That’s because although the sanctions will constrain the capital pool that Rosneft and the others can borrow from, other lenders in Europe and Asia can step into the breach. The sanctions do make it more difficult for the sanctioned companies to borrow dollars even from foreign banks, because although the sanctions do not bar foreign banks and investors from accessing the US dollar clearing system for most transactions, they could be interpreted to make it illegal to process the banned debt and equity deals:

U.S. financial institutions may continue to maintain correspondent accounts and process U.S. dollar-clearing transactions for the persons identified in the directives, so long as those activities do not involve transacting in, providing financing for, or otherwise dealing in prohibited transaction types identified by these directives.

Some have argued that this is a serious constraint that will effectively preclude the sanctioned companies from borrowing dollars other than on a very short-term basis. This is allegedly a big problem for Rosneft, because its export revenues are in dollars, and borrowing in other currencies would expose the company to substantial exchange rate risk.

I disagree, because there are ways around this. A company could borrow in Euros, for instance, and  sell the Euros for dollars. It could then deposit, invest, or spend the dollars just like the proceeds from dollar loans because it would have access to the dollar clearing system. Alternatively, the companies could borrow in Euros and immediately swap the Euros into dollars. This is because derivatives transactions are not included in the sanctions, and the payments on those could also be cleared. This would add some expense and complexity, but not too much.

The sanctions even permit  financial engineering that would allow US banks  effectively to provide credit for the sanctioned firms because derivatives on debt and equity of the sanctioned firms are explicitly exempted from the sanctions. For instance, a US bank could sell credit protection on Rosneft to a European bank that would increase the capacity of the European bank to extend credit to Rosneft. Syndication is one way that US banks can get credit exposure to Rosneft and reduce the amount of credit exposure that foreign banks have to incur, and even though the sanctions preclude US banks from participating in syndicates, the same allocation of credit risk could be implemented through the CDS market. This would permit foreign banks to increase their lending to the sanctioned firms to offset the decline of US direct lending. (This would still involve the need to convert foreign currency into dollars if the sanctioned borrower wanted dollars.)

Unlike real super majors (who can borrow unsecured, or secured by physical assets), Rosneft is unusually dependent on prepaid oil sales for funding, and these agreements are almost exclusively in dollars. This has led to some debate over whether the sanctions will seriously cramp Rosneft’s ability to use prepays.

There are a couple of reasons to doubt this. First, after the initial round of sanctions raised the specter of the imposition of sanctions on Rosneft, many prepay deals were re-worked to include sanctions clauses. For instance, they permit the payment currency to be switched to Euros, or to another currency in the off chance that the Europeans grow a pair and shut Rosneft out of the Euro payment system. Again, as long as access to the dollar system is not blocked altogether, those non-dollar currencies could be converted into dollars.

Second, there is some ambiguity as to whether prepays would even be covered. The sanctions specify the kinds of transactions that are covered:

The term debt includes bonds, loans, extensions of credit, loan guarantees, letters of credit, drafts, bankers acceptances, discount notes or bills, or commercial paper.

It is not obvious that prepays as usually structured would fall into any of these categories, and prepays are not specifically mentioned. A standard prepay structure is for a syndicate of banks to extend a non-recourse loan to a commodity trading firm like Glencore, Vitol, Trafigura, or BP. The trading firm uses the loan proceeds to make a prepayment for oil to Rosneft. In return, the trading firm gets an off take agreement that obligates Rosneft to deliver oil at a discounted price: the discount is effectively an interest payment.

The banks lend to the trading companies, not Rosneft. But (except for a small participation of 5-10 percent by the traders) the banks have the credit exposure. So this does not fall under any of the listed categories, except for perhaps “extension of credit.” Insofar as the trading firm is the borrower who faces the banks, it’s not clear the banks fall afoul of the sanctions even though that banks bear Rosneft’s credit risk. What about the trading firm? It’s not a US person, and a prepayment is not explicitly listed as a type of debt under the sanctions: again, this would turn on the “extensions of credit” provision. Under prepays, payment is usually with an irrevocable letter of credit, but these generally have maturities of less than 90 days, so that’s free of any sanctions problem.

So, there’s a colorable argument that prepays aren’t subject to the sanctions. But there is a colorable argument that they are. Economically they are clearly loans to Rosneft, though done via a trading firm acting as a conduit. But whether they are “debt” legally under the sanctions definition is not clear.

But especially in this regulatory environment, bank (and trading firm) tolerance for ambiguity is  pretty low. So the FUD factor kicks in: even though they could make a plausible legal argument that prepays fall outside the definition of debt under the Treasury rules, the risk of having that argument fail may be sufficient to dissuade them from doing dollar prepays. This is especially true in the post BNP Paribas world. So it is likely that future prepays may be in currencies other than the dollar, and as long as dollar clearing is open to it, Rosneft will just have to convert or swap the Euros or Sterling or Swiss Francs or whatever  into dollars if it really wants to borrow dollars. Again, an inconvenience and an added expense, but not a major hurdle.

All this means that the most recent round of sanctions are  sound and fury, signifying not very much. Indeed, by deliberately avoiding the truly devastating sanction, this round signifies a continued reluctance to hit Putin and Russia where it really hurts. Someone like Putin likely interprets this as a sign of weakness.

What would the devastating sanction that was deliberately avoided be? Cutting off altogether access to the dollar clearing system. Recall that the just-imposed sanctions say “U.S. financial institutions may continue to maintain correspondent accounts and process U.S. dollar-clearing transactions for the persons identified in the directives.” Change that to “U.S. financial institutions are prohibited from maintaining correspondent accounts and processing U.S. dollar-clearing transactions for the persons identified in the directives” and it would be a whole new ballgame. This would mean that the sanctioned companies could not receive, spend, deposit, or invest a dollar. (Well, they could if they could find a bank insane enough to be the next BNP Paribas. Good luck with that.)

I discussed how this would work in a post in March, and the Banker’s Umbrella provided a very readable and definitive discussion about that time. Basically, every dollar transaction, even one handled by a foreign bank, involves a correspondent account at a US bank. Cut off access to those accounts, and the sanctioned company can’t touch a dollar.

This would close off the various workarounds I discussed above. The sanctioned companies would have to restructure their operations and financing pretty dramatically. This would be particularly challenging for Rosneft, given that the currency of choice in oil transactions is the USD. This would be like the sanctions that have been imposed on Iran and on Sudan.

This would represent the only truly powerful sanction. And that’s one of the issues. Anything short of cutting off all access to the dollar market is at most an irritant to the sanctioned companies. Cutting off all access imposes a major cost. There’s not much in between. It’s a choice between a pinprick and a sledgehammer blow, with little in-between.

But if a Rubicon hasn’t been crossed now, with the murder of 298 people and continued battles in places like Luhansk waged by Russian-armed rebels, it’s hard to imagine it will ever be. If Putin and Russia are going to pay a real price for their wanton conduct, the sledgehammer is the only choice.

 

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