Streetwise Professor

February 15, 2017

Never Argue From a Price Change, Oil Market Edition

Filed under: Commodities,Derivatives,Economics,Energy — The Professor @ 9:19 pm

In the FT, Greg Meyer ponders a puzzle: “A mystery is confounding the US oil market: when inventories rise, prices rise, too.”

Yes, it is normally the case that inventories and prices, and inventories and the spot-deferred spread, move in opposite directions. But this does not have to be the case.

The typical case is based on the following economic logic. Inventories respond mainly to current, and temporary, supply and demand shocks. If current demand falls, and this demand shock is anticipated to be temporary, then current availability rises relative to expected future availability. The efficient way to respond to this is to store more today because the commodity is abundant today relative to what is expected in the future, and efficient allocations move resources from where they are relatively abundant to where they are relatively scarce. Storage increases expected future availability, which depresses expected future prices. The nearby price must fall relative to the expected future price in order to encourage storage, and together the fall in the expected future price and the fall in the nearby price relative to the expected future price causes the nearby price to fall.

A similar story holds with respect to a temporary increase in current supply.

Parenthetically, the temporary nature of the shock is important in driving the change in storage because this causes a change in relative availability that is necessary to make it optimal to store more. A shock that is anticipated to persist does not change current availability relative to expected future availability, so there is no benefit to shifting resources through time via storage. A persistent shock causes a parallel shift (roughly) in the forward curve, and no change in storage. In my academic research, I show that in a dynamic storage model supply/demand shocks with a very short half-life (on the order of 30 days) drive storage behavior, and that very persistent shocks drive the overall level of prices.

But there are other kinds of shocks. One kind of shock is to anticipated future demand or supply. Let’s say supply is expected to decline in the future. This increase in expected future scarcity can be mitigated by storing more today (i.e., reducing current consumption). This spreads the effect of the anticipated future supply loss over time, and thereby smooths consumption in an efficient way. The only way to reduce current consumption in order to increase inventories is to increase the spot price. So in this scenario, (a) inventories and prices move in the same direction, and (b) inventories and calendar spread (deferred minus nearby) move in opposite directions in order to reward the higher amount of storage.

Here’s a real world example. The Energy Policy Act of 2005 mandated increased use of renewable fuels–notably ethanol–in future years. This caused an increase in anticipated future demand for corn used to produce ethanol. When the act was passed, the supply of corn was basically fixed. One way of responding to the expected increase in future corn demand was to store more immediately (thereby carrying current supplies into the future when demand was going to be higher). Given the fixed supply, the only way to achieve this higher storage (and hence reduced current consumption) was for prices to rise.

Therefore, one explanation for the positive co-movement between prices and inventories is a shock to the expected future supply/demand balance. For example, an increased likelihood that OPEC will extend its supply cuts beyond April could produce this result.

Another kind of shock that can lead to a positive co-movement between spot prices and inventories is a shock to supply/demand volatility: I discussed this in an early blog post, and later analyzed this formally in my 2011 book. (A good example of the synergy between blogging and rigorous research, BTW.)

The intuition is this. Inventories are a way of insuring against uncertainty: putting something aside for a rainy day, as it were. If fundamental economic uncertainty goes up, it is efficient to hold more inventory. Since supply is fixed in the short run, the only way to increase inventory is to reduce current consumption. The only way to increase current consumption is for spot prices to rise. Moreover, to compensate increased inventory holding, futures prices must rise relative to spot prices. Therefore, for this kind of shock (like a shock to future demand) the forward curve rises and becomes steeper (i.e., increased contango).

So although the positive co-movement between spot prices and inventory may be unusual, it can occur in a rational, efficient market. It depends on the underlying driving shock. The typical case occurs when shocks to current supply/demand dominate. The more unusual case occurs when the shocks are to expected future supply and demand, or to fundamental volatility.

This relates directly to something I mentioned in the “kill the economists” post yesterday. Specifically: never argue from a price change. It is necessary to understand what is causing the price change. When there are multiple shocks that can affect prices (e.g., supply and demand shocks; current or future shocks; shocks to supply/demand volatility as well as to the level of supply/demand), just looking at the pice movement is not sufficient to draw conclusions about either its effect, or its cause. Indeed, it is even misleading to talk about the “effect” of the price change, because the price change is itself the endogenous effect of underlying causes/shocks.

The usual way to sort out what is going on is to look at quantities as well as prices. For instance, in a simple supply-demand model if you see prices go down, that could be because supply rose or demand fell. You can figure out which only by observing quantity: if you see quantity fall, for instance, you know that a demand decline caused the movements.

This means that the recent co-movements in oil inventories and prices reflects market participants’ assessment that the supply/demand balance is expected to tighten in the future, or that fundamental uncertainty is going up, or both.

 

 

 

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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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January 25, 2017

Live From Moscow! Rosneft Kabuki!

Filed under: Commodities,Derivatives,Economics,Energy,Russia — The Professor @ 3:31 pm

Today it was announced that Putin will indeed meet with Glencore’s Ivan Glasenberg,  QIA’s Sheikh Abdullah Bin Hamad Al Thani, and  Intesa Sanpaolo SpA Managing Director Carlo Messina. According to Bloomberg,

Putin will talk about “the investment climate, the reliability of Russia for foreign investors and prospects for expanding cooperation,” Peskov said on a conference call. The Kremlin said Jan. 23 that Sechin was keen to underline the significance of the deal with Glencore and Qatar and to outline new projects.

Yes, this is all about portraying the Rosneft stake sale as a normal deal, and as an indication that Russia presents a normal investment climate.

In fact, the deal does nothing of the sort. The bizarreness of what is known, that the curtain of secrecy that prevents so much from being known, show that the deal is highly abnormal by the standards of the US, Europe, Japan, and other major investment regions.

A Russian analyst puts his finger on it: this is PR, not reality:

The deal meant Rosneft avoided buying back the 19.5 percent stake itself. That would have been seen as “Russia’s demise” in the search for investors, according to Ivan Mazalov, a director at Prosperity Capital Management Ltd., which has $3.5 billion under management.

“It was important for Russia to win a PR battle that Russia is open to do business and that investors consider Russia as a good destination for their capital,” Mazalov said by e-mail.

But that’s the thing. We don’t know for sure that Rosneft avoided buying back the 19.5 percent stake. It apparently did not buy all 19.5 percent, but there is the matter of that missing 2.2 billion Euros. Further, who knows how the complex structure of shell companies involved the deal parses out actual economic ownership? And even if Rosneft isn’t putting up money or taking economic exposure to the stake, it’s pretty clear that some Russian entity or entities are.

But the show must go on! This Frankenstein’s monster of a deal must be made to look like the epitome of commercial normalcy: Since henchman Igor (Sechin, that is) is obviously not up to the task, Herr Doktor Putin himself must make an appearance to calm the agitated villagers.  Ivan Glasenberg is no doubt quite happy to play his part, because Glencore apparently made out very well in the deal, due in large part to the offtake agreement that went along with it. And il Signor Messina has stumped up Euros 4.5b, so he is certainly going to chew the scenery.

So who you gonna believe, Putin and his troupe, or your lyin’ eyes?

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January 24, 2017

Rosneft & Glencore & QIA & ???: More Kabuki

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 7:58 pm

Today Reuters ran a long article summarizing all of the holes in the official Russian story about the sale of the Rosneft stake. Nice of them to catch up: there is nothing in the article that wasn’t discussed here, or in RBC reports, from six weeks to two weeks ago.

The main question is who is covering the €2.2 billion hole. My leading candidates: (1) a Russian state bank (likely VTB) providing debt financing, or (2) Rosneft buying its own equity from Rosneftgaz (perhaps using funding from a Russian state bank directly, or indirectly via proceeds from its recent bond sale). One factor in favor of (2) is the web of shell companies involved in the deal: these could be used to conceal the faux nature of the “privatization” and the supposed transfer of foreign money to the budget in an amount equal to the announced purchase price. The money could be used to launder Russian money, making it look like it was coming from a foreign source.

Recall that when it was doubted Rosneft would find a foreign buyer, the fallback plan was to have the firm purchase its shares from Rosneftgaz, and then sell them to a foreign buyer later. Option (2) would be a variant on that.

Regardless, even if the details are not known, it is abundantly clear that the privatization was not the clean, blockbuster deal originally announced. It is a stitched up job intended to obscure the failure to make a straight, uncomplicated sale to foreign buyers.

Interestingly, Rosneft has allegedly paid $40 million in legal fees. (H/T @leenur.) In 2017. That’s about $2 million/day, and if the deal was done in 2016, that’s when the legal expenses would be expected to be incurred. This is consistent with this being very much a work in progress. Or maybe, a work in regress.

But the Kabuki play must go on! Sechin is inviting Putin to meet with Glencore, QIA, and Intesa:

The chief executive of Russia’s biggest oil firm Rosneft on Monday asked President Vladimir Putin to receive the company’s partners Glencore, Intesa and the Qatar Investment Authority (QIA), the Kremlin said.

Trading house Glencore and the QIA recently became Rosneft shareholders in a multi-billion-dollar deal partly funded by Italian bank Intesa.

Rosneft boss Igor Sechin said at a meeting with Putin on Monday that Rosneft was planning new projects with the three partners and they wanted to tell Putin about the prospects for those projects, the Kremlin said in a statement on its website.

This is clearly intended to lend Putin’s authority to the deal (as he already did in his end of year Q&A). Bringing in Putin and the alleged principals for a Sovok PR gimmick is pathetic, and amusing–and amusing because it’s so pathetic!

Any such act will not end the questions. It will just bring attention to the deal, and any attention will only bring the questions to the fore.

Not that we can expect to get any answers from the Russians, or from QIA. But why the UK authorities and the LSE seem so complacent about the participation of a UK/LSE-listed company in such a dodgy deal, with such little disclosure, is beyond me. Glencore may argue that it has disclosed the basics of its involvement, but without knowing about the structure of the entire deal it is evaluate the accuracy of those disclosures, in particular relating to what Glencore’s real economic exposure is. The relevant parties in the UK should be pressing hard for much greater disclosure from Glencore.

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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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January 5, 2017

Rosneft/Glencore/QIA: More Answers Mean More Questions

Filed under: Commodities,Economics,Energy,Russia — The Professor @ 8:01 am

Soon after I posted yesterday, news stories reported that the Rosneft-Glencore-QIA deal had closed. But questions still remain.

Here’s the Rosneft statement:

“As part of the previously agreed privatization deal all sides in the project, including Rosneftegaz and the consortium of foreign investors – one of the world’s largest sovereign funds, Qatar Investment Authority, and a leading Swiss commodity producer and trader Glencore – as well as financial and legal consultants, financial institutions and creditors, have finalized all corporate and technical closure and payment procedures,” the statement read.

I had to take that from Sputnik, because, curiously, there is no statement on Rosneft’s website. Yes, I know it’s the holidays in Russia, but still.

Also, look at this part: “have finalized all corporate and technical closure and payment procedures.” But on December 16, it was reported that Sechin had told Putin that the funds had been transferred to the Russian budget. Putin said so during his end-of-year gabfest. But the release says that only payment procedures have been finalized. So, whence the money that appeared in the Russian budget?

There is still the open question of the arithmetic. The moneys supposedly pledged by Glencore, QIA, and Intesa don’t add up to the purchase price. Close to 20 pct is pretty big for rounding error. So where’s that coming from?

I found this interesting:

“The technical procedures for closing (the deal) required the preparation and signing of more than 50 documents and agreements,” Rosneft said in a statement. “All this reflects the unprecedented complexity of the deal.”

Why so complex? Indeed, unprecedentedly so? What are the complexities? Many players who have not been named publicly? A complicated set of indemnities, collateralization agreements, guarantees and cross guarantees?

Another intriguing fact. Glencore announced the closing on Tuesday, 3 January. This is the sum and substance of the statement:

The Company announces that final settlement has been completed and closing achieved for the transaction described in its release of 10 December 2016.

I know Glencore is still a Swiss trading company at heart, but it is a public company now and such firms are usually somewhat more forthcoming about large transactions. Some even brag a little. Or a lot. Glencore’s statement is like a legal notice in a newspaper.

So the deal is done. Apparently, beyond that, we know little. And the principals are quite obviously very happy to keep it that way. Which is revealing in its own way.

Update. A Russian reporter kindly tells me that the Rosneft press release is available on its website. On the Russian language site, go to: “Shareholders and Investors” section > Disclosure of information > Main shareholder Rosneftegaz and open the first from the top pdf-release. It’s a PDF in Russian, moreover, meaning that you just can’t translate it in Chrome. How could I possibly have missed that?

Meanwhile, English language version of the home page of the Rosneft website tells you that “Rosneft launches Italian Cafe Chain A-Cafe in Moscow.” So we know what’s really important.

 

 

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January 4, 2017

The Rosneft Deal: One Step Closer to Reality

Filed under: Commodities,Derivatives,Economics,Energy,Russia — The Professor @ 4:51 pm

After-a thinking-a about it-a for almost a month-a, Italian bank Intesa Sanpaolo has apparently decided to stump up €5.2 billion to fund the Rosneft-QIA-Glenocre transaction.

A few interesting aspects to this, beyond that it took so long to commit after Rosneft said it was a done deal in the first week of December.

First, by my arithmetic, the deal is still short about €1.9 billion short. Intesa is putting up €5.2 billion, QIA €2.8 billion, Glencore €.3 billion. That’s €8.3 billion. The deal is for €10.2 billion. So where’s the other money coming from?

Second, Intesa is saying they will lend now, and syndicate the loan later. That’s not unheard of, but it’s not typical. Not least because Intesa’s bargaining position is weak now: potential syndicate members will know that Intesa has to unload the risk, and be patient in the hope of getting better terms.

Third is this gem at the end: “The underwriting, to be syndicated, has strong protection in terms of collateral and guarantees.” So who is providing the guarantees? What is the substance of the guarantees?

We have Glencore’s statement about indemnity, and some basis to believe that Gazprombank is the provider. But does QIA have a guarantee as well?

In any event, the deal looks more real than it did last month. But there are still open questions.

 

 

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December 30, 2016

For Whom the (Trading) Bell Tolls

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Exchanges,History — The Professor @ 7:40 pm

It tolls for the NYMEX floor, which went dark for the final time with the close of trading today. It follows all the other New York futures exchange floors which ICE closed in 2012. This leaves the CME and CBOE floors in Chicago, and the NYSE floor, all of which are shadows of shadows of their former selves.

Next week I will participate in a conference in Chicago. I’ll be talking about clearing, but one of the other speakers will discuss regulating latency arbitrage in the electronic markets that displaced the floors. In some ways, all the hyperventilating over latency arbitrages due to speed advantages measured in microseconds and milliseconds in computerized markets is amusing, because the floors were all about latency arbitrage. Latency arbitrage basically means that some traders have a time and space advantage, and that’s what the floors provided to those who traded there. Why else would traders pay hundreds of thousands of dollars to buy a membership? Because that price capitalized the rent that the marginal trader obtained by being on the floor, and seeing prices and order flow before anybody off the floor did. That was the price of the time and space advantage of being on the floor.  It’s no different than co-location. Not in the least. It’s just meatware co-lo, rather than hardware co-lo.

In a paper written around 2001 or 2002, “Upstairs, Downstairs”, I presented a model predicting that electronic trading would largely annihilate time and space advantages, and that liquidity would improve as a result because it would reduce the cost of off-floor traders to offer liquidity. The latter implication has certainly been borne out. And although time and space differences still exist, I would argue that they pale in comparison to those that existed in the floor era. Ironically, however, complaints about fairness seem more heated and pronounced now than they did during the heyday of the floors.  Perhaps that’s because machines and quant geeks are less sympathetic figures than colorful floor traders. Perhaps it’s because being beaten by a sliver of a second is more infuriating than being pipped by many seconds by some guy screaming and waving on the CBT or NYMEX. Dunno for sure, but I do find the obsessing over HFT time and space advantages today to be somewhat amusing, given the differences that existed in the “good old days” of floor trading.

This is not to say that no one complained about the advantages of floor traders, and how they exploited them. I vividly recall a very famous trader (one of the most famous, actually) telling me that he welcomed electronic trading because he was “tired of being fucked by the floor.” (He had made his reputation, and his first many millions on the floor, by the way.) A few years later he bemoaned how unfair the electronic markets were, because HFT firms could react faster than he could.

It will always be so, regardless of the technology.

All that said, the passing of the floors does deserve a moment of silence–another irony, given their cacophony.

I first saw the NYMEX floor in 1992, when it was still at the World Trade Center, along with the floors of the other NY exchanges (COMEX; Coffee, Sugar & Cocoa; Cotton). That space was the location for the climax of the plot of the iconic futures market movie, Trading Places. Serendipitously, that was the movie that Izabella Kaminska of FT Alphaville featured in the most recent Alphachat movie review episode. I was a guest on the show, and discussed the economic, sociological, and anthropological aspects of the floor, as well as some of the broader social issues lurking behind the film’s comedy. You can listen here.

 

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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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December 10, 2016

The Glencore/QIA/Rosneft Deal: A Little Clearer Than Mud

Filed under: Commodities,Derivatives,Economics,Energy,Russia — The Professor @ 8:28 pm

Rosneft and Glencore have released some additional information on the three way involving these two firms and the Qatar Investment Authority. These releases answer some of the questions about the deal–and evidently there is now a deal–but not all of them.

The new information indicates that I got some things wrong and some things right in my snap take. What I got wrong was the amount of equity, and hence the amount of leverage in the deal. My original conclusion that the equity investment was €600 million was based on (a) the announcement that Glencore would invest €300 million, and (b) Sechin’s statement that Glencore and QIA would be “equal partners.” (Silly me for believing Igor!) As it turns out, the QIA will invest €2.5 billion, making the deal leveraged a mere 3.6 to 1.

Where I got it right was my surmise that there was a lot of financial engineering going on. We still don’t know the full extent of such machinations, but the Glencore statement gives a glimpse. The key tipoff is the fact that although the Glencore-QIA consortium is 50:50, Glencore is at great pains to emphasize that its “economic exposure” to Rosneft represents a mere .54 percent share of the Russian company, and that “Glencore will not have any economic exposure to its interests in the Shares.”

Well, if the consortium is buying 19.5 percent of Roseneft, and Glencore is 50 percent of the consortium, that’s a wee bit bigger than .54 percent, isn’t it? So there must be some structure or structures that effectively shift the risk to other parties.

The Glencore statement provides a hint of at least one of these structures. It describes this feature:

  • Limited liability structure fully ring-fenced and non-recourse to Glencore apart from its €300 million equity contribution and the provision of margin guarantees of up to €1.4 billion, for which Glencore has obtained full indemnification from appropriate Russian banks.

My interpretation of this is term is that the loan funding the bulk of the purchase includes a margining feature, as in a stock margin loan. That is, the borrower is obligated to put up additional cash if the collateral value of the shares declines. In this case, Glencore has apparently promised to pay up to €1.4 billion. But apparently Glencore has passed this risk to “appropriate Russian banks.” (What’s an “appropriate bank”, anyways?) That is, the Russian banks will stump up the cash in the event of a stock price decline. Sounds to me like the banks have written a put on Rosneft shares (which is one of the structures that I had originally guessed at).

Well, puts aren’t free. Neither of the documents indicates the price of the put, or who is paying the premium.

If Glencore’s downside is limited to €300 million, certainly it doesn’t have a claim to 50 percent of the upside. One possibility is that it is paying for the put by writing a call. If so, the deal basically embeds a swap between Glencore and “appropriate banks” via which the risk of Rosneft shares are essentially transferred to the banks (with Glencore being short the swap and the banks long). If so, this would be a backdoor way for the Russian banks to buy Rosneft shares. To a first approximation their exposure is on the order of 9 percent (19.5 x .5 minus a little to reflect Glencore’s exposure).

This interpretation would square with Glencore’s assertion that “Glencore will not have any economic exposure to its interests in the Shares.” That means neither upside nor downside exposure. Where did the upside exposure go? Most likely to the Russian banks.

The QIA has been totally silent on the deal. It has not issued a press release. (Its web page looks like it was designed by a 15 year old in 1999, and is remarkably uninformative. Go figure.) Therefore, it is unknown if Qatar also has posted “margin guarantees.” If so, it would make calling the debt “non-recourse” highly misleading. It’s not as if QIA could put the keys in the mail and walk away with no additional liability in the event of a large decline in the value of Rosneft stock. Such a margin guarantee feature would effectively make a good portion of the debt recourse, rather than non-recourse, and convert its position into a conventional leveraged equity purchase. (This is because the lenders would have a claim on QIA assets beyond the initial investment.)

Another way to look at this is to ask: where does the risk go? The candidates are: QIA, Glencore, Intesa Sanpaolo and other funding banks, Russian banks “providing financing and credit support,” and even Rosneft (there would be Enronesque ways of passing the risk of an SPV back to Rosneft). Even with the additional disclosure, we only have a limited understanding of where the risk is going. Glencore is insisting its downside risk is very limited: €300 million. Its upside potential is unclear, but it is highly likely that has been transferred elsewhere, mainly to pay for Glencore’s limiting its downside exposure. We know some of the downside exposure has gone to Russian banks. The exact division is unclear.

If I had to guess, I would surmise that the exposure of Intesa and other banks providing funding is limited: margin guarantees limit their risk to a stock price decline. Due to the indemnification, Intesa et al have a rather complex exposure to the credit of Russian banks and Glencore, where this credit exposure also depends on the price of Rosneft stock. Good luck modeling that correlation risk and (implicit) tranching!

As I noted earlier, my guess is that Qatar has a fairly standard leveraged long position in Rosneft.

The Russian banks have a long position too, through the indemnification feature, and likely through the way that is paid for (e.g., a call). If this is the case, and if the “appropriate banks” are state banks like VTB, that makes the privatization something of a sham, or at least only half of what Sechin and Putin are trumpeting, because Russian state entities would have an long equity exposure to Rosneft.

A couple of asides on how this story evolved–or should I say is evolving. First, Rosneft evidently made its initial announcement without clearing it with Glencore. I have been told that the first Glencore’s corporate affairs people heard of the news was when reporters contacted them. Glencore then made a rather bizarre statement, the first sentence of which was: “Glencore notes the announcement released by the Russian government regarding the privatization of shares in Rosneft.” (Emphasis added.) Notes the announcement. Doesn’t confirm the truth of it, just notes it. Glencore then proceeded to say that negotiations were still ongoing and that no deal was finalized, though it anticipated such a result. Methinks that Rosneft made the announcement to pressure Glencore into finalizing the transaction.

Second, just how the official announcement would read was a  matter of contention up to the last minute. Rosneft told several wire services that they would receive a briefing at 11PM Moscow time on Friday (!). But that was delayed hours, apparently because Glencore and Rosneft (and their lawyers) were fighting over how Glencore’s participation would be described. My conjecture is that Rosneft wanted it to appear that Glencore was a full equity participant, thereby putting its imprimatur on Rosneft as a great investment: this would also conceal the risk being passed onto Russian banks. Glencore, as we’ve already seen, is intent on conveying that its exposure to Rosneft is minimal. This would no doubt allay its creditors concerns–but it would also undermine Sechin’s narrative. Hence the battle. Reading the releases, it looks like Glencore won. The sense I get is that Glencore is signaling that it gained significant trading benefits (a big offtake agreement, and potential for future commercial ventures with Rosneft) without having to expose itself all that much to Rosneft’s embedded price, operational, and political risks.

Perhaps some additional details will come out. But I doubt much more will. If I’m right, Rosneft and the Russian banks have little interest in disclosing how much risk Glencore is passing along to them. Glencore will be happy as long as it is convinced its creditors and investors believe that it has little exposure to Rosneft but has gained significant commercial advantages. And QIA don’t need to tell nobody nothing.

So as it stands, things are clearer than mud, but not much. Like the Brazos River or somesuch.

 

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