Streetwise Professor

March 30, 2014

Kerry & Lavrov Negotiate Ukraine’s Surrender in Paris: Were All the Rooms in Munich Booked?

Filed under: History,Military,Politics,Russia — The Professor @ 11:06 am

Following up on Putin’s phone call to Obama, Kerry is making a detour to Paris to negotiate with Lavrov over the fate of Ukraine.

Lavrov has laid out Russia’s terms, and intimates that Obama and Kerry have accepted the principles underlying these terms.

First, Russia demands that Ukraine adopt a new constitution that establishes a federal structure that gives each region considerable autonomy.  Translate this to mean that these regions would be able to pull a Crimea.  Or, more accurately, that Russia would be able to pull a Crimea, slicing off pieces of Ukraine and splicing them onto Russia.

Crucially, Lavrov said: “I can say that ‘federation’ is no longer a taboo word in our negotiations.”  Meaning that if he is telling the truth (always a big if) Obama has conceded that Ukraine’s constitutional order is up for negotiation, on Moscow’s terms.

Second, Russia demands that Ukraine’s new constitution incorporate guarantees that Ukraine will not join Nato or any other alliance.

In brief: the Secretary of State of the United States is traveling to Paris to negotiate the constitution of a sovereign country, without the presence of that country.  The end state of this negotiation would be to turn Ukraine into a Russian satrapy, to be gobbled up piecemeal, and with no ability to conduct an independent foreign policy.

Lavrov’s teaser is that Russia has no intention of invading Ukraine.  But if you read his words closely, you will understand that he means Russia has no intention of invading if its terms are accepted. Otherwise, Ukraine is a fascist, Nazi threat to Russia and to Russian “compatriots.”  And we know what Putin believes such a threat justifies.

The 1930s analogies keep coming, fast and furious. Here the analogy is Munich, where France and Germany negotiated Czechoslovakia’s fate with Hitler, without the Czechs being present.  The Czechs called the agreement the Munich Diktat. Will the Ukrainians call this the Paris Diktat?

There are other similarities.  The pretext of the Germans in 1938 was and Russia in 2014 is the necessity of protecting co-ethnics allegedly threatened by independent nations not invited to the negotiations.  Munich resulted in the handover of the major industrial region of Czechoslovakia to Germany: the likely outcome of an agreement on Putin’s terms would be to handover Ukraine’s main industrial region to Russia. The Munich negotiations took place under the threat of a German invasion of Czechoslovakia if Hitler’s terms were not accepted, and German troops were massed on the border to carry out that threat.  The Paris negotiations are taking place under the threat of a Russian invasion of Ukraine if Putin’s terms are not accepted, and Russian troops are massed on the border with the capability to carry out that threat.

Once upon a time “No More Munichs!” was a catchphrase in US foreign policy. No longer, apparently. Obama and Kerry seem to be saying “Why Not Munich?”

Even if no agreement comes of these talks, or talks that follows, it is deeply shameful that the United States would even engage in such a negotiation on such terms with such a nation.  Deeply shameful.

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March 29, 2014

Putin is From Mars, Obama is From Venus, and Germany is From Denial

Filed under: History,Military,Politics,Russia — The Professor @ 1:25 pm

Yes, I know the meme is cliché. But clichés become cliché because they capture some basic truths.

Have any doubts? Just compare Putin’s speech on Crimea to Obama’s speech in Brussels.  Compare what Lavrov says to what Kerry says.  Compare the different versions of the various phone conversations between Obama and Putin released by the Kremlin and the White House, most especially the readouts of yesterday’s conversation: the immediate question is “are these people talking about the same phone call?”

Obama is all about diplomacy, community, talk, de-escalation, agreement on mutually beneficial terms.  Putin is all about grievance, righting historical wrongs, battling dark forces (i.e., Ukrainian fascists and Nazis and Western interlopers), winner take all.

The reason their conversations seem disjointed is that they are.  They start from totally different premises, totally different world views.  They are talking past one another.

Oh.  And Putin is doing more than talking.  He is acting.

And this means that  Obama’s Vensuian lets-talk-about-it-and-get-to-win-win approach is utterly without foundation.  For it presumes that your would-be interlocutor and partner-to-be is operating from the same assumptions, premises, and world view as you are.

When that’s not true, the jaw-jaw Venusian approach will be about as constructive as any conversation between two parties speaking mutually incomprehensible languages.

And what’s more, the advantage in this type of contest between Mars and Venus is decidedly on the Martian side in the realm of international relations, where third party enforcement is absent. Especially when the Martian side can deploy little green men on its doorstep against a far weaker neighbor.

Before writing this, I Googled “Putin is from Mars Obama is from Venus,” to see if anyone had used this meme recently. I didn’t find that on the first several pages of search results, but I did find several pieces saying that the US (and hence Obama) is Mars, and Europe is Venus.

Yes, the US-and even Obama-are positively Martian compared to the Euros. And that’s precisely a major problem. Because it means that the Euros are absolutely dead-set against doing anything to confront Russia. And Obama is completely willing to defer to them.

And the worst offender is the nation that was once the most militantly Martian on earth: Germany.  Rather than recognize the similarities of Putin’s Russia to the bad  Germany of old, and understand the need to oppose and deter such conduct, Germany is hell bent on imitating its appeasing opponents of decades past.

Two depressing articles tell you all you need to know.

German businesses whine about sanctions, and complain about the West (!) escalating tensions with Russia. Germany swears it’s not soft on Russia.

My knowledge of Greek and Roman mythology is inadequate to figure out what Europe (and especially Germany) are if Obama is Venus to Putin’s Mars.  I guess I have to back further.  To Egypt.  Because Germany is from Denial.

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Margin Sharing: Dealer Legerdermain, or, That’s Capital, Not Collateral.

Concerns about the burdens of posting margins on OTC derivatives, especially posting by clients who tend to have directional positions, have led banks to propose “margin sharing.”  This is actually something of a scam.  I can understand the belief that margin requirements resulting from Frankendodd and Emir are burdensome, and need to be palliated, but margin sharing is being touted in an intellectually dishonest way.

The basic idea is that under DFA and Emir, both parties have to post margin.  Let’s say A and B trade, and both have to post $50mm in initial margins.  The level of margins is chosen so that the “defaulter (or loser) pays”: that is, under almost all circumstances, the losses on a defaulted position will be less than $50mm, and the defaulter’s collateral is sufficient to cover the loss.  Since either party may default, each needs to post the $50mm margin to cover losses in the event it turns out to be the loser.

But the advocates of margin sharing say this is wasteful, because only one party will default.  So the $50mm posted by the firm that doesn’t end up defaulting is superfluous.  Instead, just have the parties post $25mm each, leaving $50mm in total, which according to the advocates of margin sharing, is what is needed to cover the cost of default.  Problem solved!

But notice the sleight of hand here.  Under the loser pays model, all the $50mm comes out of the defaulter’s margin: the defaulter pays,  the non-defaulter receives all that it is owed, and makes no contribution from its own funds.  Under the margin sharing model, the defaulter may pay only a fraction of the loss, and the non-defaulter may use some of its $25mm contribution to make up the difference.   Both defaulter and non-defaulter pay.

This is fundamentally different from the loser pays model.  In essence, the shared margin is a combination of collateral and capital.  Collateral is meant to cover a defaulter’s market losses.  Capital permits the non-defaulter to absorb a counterparty credit loss.  Margin sharing essentially results in the holding of segregated capital dedicated to a particular counterparty.

I am not a fan of defaulter pays.  Or to put it more exactly, I am not a fan of mandated defaulter pays.  But it is better to confront the problems with the defaulter pays model head on, rather than try to circumvent it with financial doubletalk.

Counterparty credit issues are all about the mix between defaulter pays and non-defaulter pays.  Between collateral and capital.  DFA and Emir mandate a corner solution: defaulter pays.  It is highly debatable (but lamentably under-debated) whether this corner solution is best.  But it is better to have an open discussion of this issue, with a detailed comparison of the costs and benefits of the alternatives.  The margin sharing proposal blurs the distinctions, and therefore obfuscates rather than clarifies.

Call a spade a spade. Argue that there is a better mix of collateral and capital.  Argue that segregated counterparty-specific capital is appropriate.  Or not: the counterparty-specific, segregated nature of the capital in margin sharing seems for all the world to be a backhanded, sneaky way to undermine defaulter pays and move away from the corner solution.  Maybe counterparty-specific, segregated capital isn’t best: but maybe just a requirement based on a  firm’s aggregate counterparty exposures, and which doesn’t silo capital for each counterparty, is better.

Even if the end mix of capital and collateral that would result from collateral sharing  is better than the mandated solution, such ends achieved by sneaky means lead to trouble down the road.  It opens the door for further sneaky, ad hoc, and hence poorly understood, adjustments to the system down the line.  This increases the potential for rent seeking, and for the abuse of regulator discretion, because there is less accountability when policies are changed by stealth.  (Obamacare, anyone?)  Moreover, a series of ad hoc fixes to individual problems tends to lead to an incoherent system that needs reform down the road-and which creates its own systemic risks.  (Again: Obamacare, anyone?)  Furthermore, the information produced in an honest debate is a public good that can improve future policy.

In other words, a rethink on capital vs. collateral is a capital idea.  Let’s have that rethink openly and honestly, rather than pretending that things like margin sharing are consistent with the laws and regulations that mandate margins, when in fact they are fundamentally different.

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March 28, 2014

A Victory for Neanderthal Rights: Rusal Defeats the LME in Court. But the Neanderthal Is Still Endangered.

Filed under: Commodities,Derivatives,Economics,Politics,Russia — The Professor @ 8:01 pm

Late last year, the company of My Favorite Neanderthal, Oleg Deripaska’s Rusal, sued the London Metal exchange, claiming that the LME’s new rules on load out of aluminum violated Rusal’s human rights.  Yesterday, a judge in Manchester, UK gave Oleg a victory.

Although the judge found the human rights issue “an interesting and difficult question,” he did not rule on it.  Too bad!  That could have been entertaining.

But he did hand Rusal a victory, ruling that the LME’s process in adopting the new rule was flawed (bonus SWP quote).  As a result, the LME will not implement the rule, and has to go back to the drawing board.

Until a new rule is adopted, the bottleneck in the LME aluminum warehouses (notably Metro in Detroit) will remain stoppered.  Premiums will remain high and volatile.

And that’s the point.  By keeping the huge stocks of aluminum that accumulated in LME warehouses during the financial crisis off the market, the bottleneck keeps the prices of aluminum ex-warehouse artificially high.  This harms consumers, but enhances producers’ profits.  Which is precisely why Rusal sued.

But the victory may well by a Pyrrhic one.  For despite the fact that the warehouse bottleneck props up aluminum prices, and despite the fact that Rusal and other producers have reduced capacity, there is still a substantial supply imbalance that has weighed on prices: due to the bottleneck, prices are higher than they would be otherwise, but they are still quite low.  As a result, Rusal just posted a whopping $3.2 billion loss.

The company is heavily indebted, and the chronic losses imperil its ability to pay this debt.  The company has been frantically negotiating with its lenders, and says that if it does not get relief it will default.  Given that Deripaska has pledged shares as collateral for some borrowings, his status as a billionaire is in jeopardy.

Deripaska has been in such straits before.  He is in some ways the Donald Trump of Russia.  Putin bailed him out in 2008/2009.  Will he do it again?

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March 27, 2014

Obama Speaks. Putin Smiles.

Filed under: History,Military,Politics,Russia — The Professor @ 8:21 pm

Obama has given two major sets of remarks about Ukraine, one set on teleprompter, the other off.  Like Tolstoy’s unhappy families, each was appalling in its own way.  It is hard to say which is worse.

The off-teleprompter remarks were delivered at a press conference.  The statement that garnered the most attention, and rightly so, was Obama’s assertion that Russia was a mere regional power that is not a threat to the US, and invaded Crimea out of weakness.

Where to begin?

Part of the problem is the man’s preternatural pettiness.  He denigrated Russia in  part because he will not, cannot, concede that Romney might have been closer to the truth than he was when the Republican candidate named Russia as our number one national security threat, and Obama responded with a snarky “the 80s called and want their foreign policy back.”  A bigger man would have given Romney his due.  But that would be a different man than Obama.

But the bigger problem is the substance.  First, I would be the first to acknowledge that Russia’s military is decrepit and its ability to project power beyond the Eurasian landmass is limited.  But the Eurasian landmass is pretty damned big, and Russia’s region includes many areas of vital interest to the United States.

Second, Russia has many other sources of power that transcend those of a mere regional power (like Brazil, say).  Most obviously: It has nukes.  It has a UNSC veto.  It has extremely effective asymmetric capabilities, notably cyberwarfare (conducted in large part through private and criminal elements that work for Russian intelligence out of a combination of patriotic and mercenary motives) and intelligence.  (Snowden, anyone?)

Moreover, Putin’s anschluss, and the threatened moves beyond Crimea (not just Ukraine, but reasonably feared in any country with substantial Russian speaking minorities, which includes countries formally allied with the US) upset the entire international order.  Not just the post-World War II and post-Cold War settlements, but the principles of international order stretching back to the Peace of Westphalia in 1648.   Turning a blind eye to revanchism and irredentism threatens to unleash similar forces on every continent.  The chaos and disorder that would result would present a profound challenge to stability, and the interests of the United States.

Obama appears to believe that it is beneath a stronger power to confront weaker ones.  But what is the point of strength and power, if they cannot be deployed against peer adversaries because that would be too costly, and they cannot be deployed against weaker ones because that’s unsporting?

Indeed, if Obama’s diagnosis is correct, and Russia is a weak power (put aside whether the weakness is the motivation for Putin’s aggressiveness, as Obama claims), given the stakes there is a compelling case to deploy American power (mainly economic, financial, and political, rather than military) to squash the weak upstart.  Because that would contribute to tranquility throughout Eurasia, and pour encourager les autres.

The formal speech in Belgium was a disaster in different ways.  Obama gave a treacly tribute to the bravery of Maidan, and then basically said: “sorry, people, you’re on your own!  Good luck!  We wish you the best!”  He laid out a rather compelling case that Putin’s challenge to the international system threatened dire consequences far beyond Ukraine, but despite this he threatened no measures beyond the oft-repeated gradualism of escalating financial consequences: how many historical examples are required to demonstrate that such gradualism, so appealing in the faculty lounge and think tank, is actually an encouragement to hard men like Putin?

Disgustingly, Obama conceded many of Putin’s arguments, most notably that Russia has special rights in Ukraine due to the longstanding historical relationship between the countries.  This is to make modern Ukrainians subordinate to Russia because their forebears provided a patina of civilization to Muscovite thugs, and then suffered centuries of subjugation at the hands of these thugs which at times lapsed into genocide.  Yes, the Holodomor was truly the epitome of a special relationship, no?

If anything, the historical relations between Ukraine and Russia provide a compelling case to defend Ukraine against further Muscovite predations, rather than an excuse to consign the country to Putin’s tender mercies.

The speech put more emphasis on what the US won’t do, than what it will.  Obama repeated three times that the US will not engage in any military response to Russian aggression in Ukraine.  I’m sure Putin got that message, and smiled.

Obama emphasized a desire for continued diplomacy, and de-escalation.  Both of which Russia has already rejected, repeatedly.  (Look at the picture of Lavrov meeting with the Ukrainian FM.  I am sure The Tarantula would have preferred an appendectomy without anesthesia to that meeting.) This is political onanism of the most embarrassing sort.

But there’s more! Not only did Obama conspicuously put Ukraine outside the American security perimeter, he also slammed the door on Georgia, saying that it was not on a path to membership in Nato.  Given that Georgia is one of Putin’s biggest bêtes noire, you may rest assured that Putin is going to take this as an invitation.

In sum, the speech signaled a supine attitude that will embolden Putin.  Obama appears robust only in comparison to the Europeans, who would have to stiffen considerably in order to become mere boneless wonders (to quote Churchill’s devastating critique of Stanley Baldwin).

Some have claimed that Obama’s speech was tough, both on the Russians and the Europeans.  The markets deemed otherwise.  Gazprom was up.  Sberbank was up.  Rosneft was up.  Micex was up.  The Ruble was up.

And no wonder. Last week’s encouraging expansion of sanctions have been followed by . . . nothing.  Except empty threats to do more: that’s all Obama’s speech contained.  It is clear that there is no appetite in western capitals for aggressive action against Russia, even though it would be possible to crush the Russian economy.

Need convincing? German firms are making pilgrimages to Moscow.  German politicians are loud in their criticism of sanctions, and bend over backwards to rationalize Putin’s conduct.

Just why did we defend these people for 60 plus years, anyways?  They are obsessed with Snowden and the thought that the NSA might be perusing their Amazon purchases.  Never mind that a thugocracy is on the march.  It’s so much easier for the Germans to criticize the US than Russia.  The US doesn’t fight back.

Speaking of NSA, one of the companies that paid homage to Putin in his court was Siemens, a notoriously corrupt firm. Former CIA director James Woolsey said we spy on European companies precisely because of their corruption.  Perhaps some kompromat or prosecutions are in order.

Obama appears to be deferring to German wishes.  Specifically, I smell Merkel’s influence over the Georgia remarks.  Why did Obama have to mention Georgia at all, let alone to throw it very publicly under the bus?  Then recall that Merkel has been adamant over excluding Georgia from integration into Nato on any time frame.

Russian troops are massing on Ukraine’s borders.  Russia’s most capable formations, its paratroops (VDV) and Guards armored/mechanized units are assembled there.  But don’t worry! Russian defense minister Shoygu assures that these troops are only there for maneuvers.  And the drunk who is our SecDef believes him:

At the Pentagon, there remains confidence in the assurances provided to Defense Secretary Chuck Hagel from Russian Defense Minister Sergey Shoygu that the Russian troops amassing on the border with Ukraine were there only for exercises.

“[Shoygu] told me that they had no intention of crossing the border into Ukraine,” Hagel said at the Pentagon this week.

Can we really be this stupid?  (Don’t answer that.  The question was totally, totally rhetorical.)

Just why, pray tell, need the Russians conduct maneuvers with 50K of their best troops on a sensitive border? And given that Putin repeatedly lied about his intentions in Crimea, why should we believe Shoygu-especially since there are serious doubts that Shoygu is in Putin’s decision making clique?

In sum, in his various remarks, Obama has revealed that he has many, many cheeks, and is willing to turn them all.  To Putin, anyways: not to Romney or other Republicans. Putin will take this as an invitation, and take all that he can.  If he isn’t stopped now-and rolled back, actually-he will continue to press.  The necessity of confrontation will not be eliminated, just deferred.

 

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March 25, 2014

The Wages of Being a Petrostate: Using the Energy Weapon is Economic Suicide

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 12:07 pm

Although the Euros wring their hands at the costs they would bear if serious economic sanctions were imposed on Russia, as I’ve said, there is a huge asymmetry in vulnerability: Russia is substantially more vulnerable to a cutoff in trade, especially the energy trade.  Take gas.  Germany imports about 12b Euros of gas annually.  Its GDP is about 2.5t Euros.  So natural gas expenditures are about .5 percent of GDP, and even a substantial price increase would represent a relatively small burden on German expenditures.  In contrast, Russian energy exports (63 percent of which are to Europe) account for 50 percent of the country’s budget.  So trade restrictions would be an inconvenience for Europe, and pose an existential challenge for Russia.

Such are the wages of being a petrostate.  Using the energy weapon is national economic suicide.

FT Alphaville has a nice overview of this and other asymmetries.

One quibble, related to this:

In response to Iran-style sanctions, Russia could muster one unprecedented measure. It and its allies could stop buying euros, dollars, and Western government debt. However, Western governments should be able to brush this manoeuvre aside.

If it comes to a trade and finance showdown, it won’t have the money to be buying anything.  So a cutoff of purchases of dollars, euros, etc., is not something that Russia could threaten: it would be an inevitable consequence of a trade and finance war.  And Russia is not such a big buyer that it would make all that much of a difference anyways.

The FTA piece also dispatches the fantasy Russians and their fellow travelers are peddling: that China will assist Russia by waging economic combat against the West.  China is a huge dollar and UST long, so it would be an incredible act of economic masochism to dump dollars or Treasuries.  And Russian fantasies aside, China is not that into them.

The asymmetry of power, especially economic power, couldn’t be more obvious.  But that is counterbalanced by an asymmetry in will, and heretofore that has proved the decisive difference.  Putin has wagered that Europe is unwilling to suffer any discomfort to counterattack against Putin’s anschluss.  So far, he has been right.

 

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I Didn’t Know the Half of It: US Leverage Over Foreign Banks

Filed under: Commodities,Economics,Politics,Russia — The Professor @ 11:01 am

In my post from Sunday I mentioned how commodity trading firms require dollar funding and trade in dollars, and that anything that touches a dollar is vulnerable to US sanctions.  This detailed post from The Banker’s Umbrella shows just how much leverage the US has over foreign banks, as a result of the Patriot Act.  The most interesting thing is that you can do a deal in Euros or any other non-dollar currency, but you are vulnerable to asset seizure as long as your bank has a correspondent account at a US bank.  Money quote (pun intended):

So as you can see, from a purely technical perspective, bringing Russia and Putin to his knees is really not that difficult a task. The legislative framework is there and it is brutally effective. The question is does the USA have the political will and the stomach to face the inevitable repercussions of such actions, or is it just easier to say a few words of support in favour of the Ukraine and then let things carry on as before?

Putin surely knows this.  And apropos Obama’s mantra that Russia is acting out of weakness rather than strength, he can only have calculated that the USA (not to mention the Euros) does not “have the political will and stomach” to exploit its strengths and Russia’s weaknesses.

It is remarkable that Gazprom in particular has not been subject to sanctions, given that it will receive stolen property: gas blocks off the Crimean coast, blocks that Ukraine was going to explore.  It is a state company, that helps bankroll the state.  If it isn’t sanctions bait, what company is? And as the Banker’s Umbrella shows, like any other Russian company, it would be extremely vulnerable.

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March 24, 2014

Kill Me Now

Filed under: History,Military,Politics,Russia — The Professor @ 7:58 pm

Quoted without comment, because (a) the stupidity and fecklessness is so obvious that no explication is necessary, and (b) this is so maddening and depressing I can’t bring myself to say anything:

U.S. Secretary of State John Kerry said on Monday he hoped the Crimea crisis would not harm cooperation with Russia on international efforts to destroy Syria’s chemical weapons.

Syrian President Bashar Assad’s government agreed to destroy its chemical weapons arsenal as part of a U.S.-Russian agreement negotiated after a chemical attack last August that killed hundreds of people around Damascus.

“All I can say is I hope the same motivations that drove Russia to be a partner in this effort will still exist,” Kerry told reporters in The Hague, where he was due to attend a summit of the Group of Seven leading industrial nations.

“This is bigger than either of our countries. This is a global challenge,” Kerry said.

Okay.  One comment.

With such credulous idiots in charge, we are so screwed.  So screwed.

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Abbot and Costello Do Manipulation Enforcement

Filed under: Commodities,Economics,Energy,Politics,Regulation — The Professor @ 7:36 pm

I heard a hilarious story the other day about an incident that occurred when European Commission investigators raided a trading shop in connection with the Brent investigation.  While going through trader emails and documents, one of the crack investigative team came across numerous documents about trading on ICE.  The investigator was puzzled, so he asked the a lawyer for the trading company: “You trade ice?”  Lawyer: “Yes, we trade on ICE.”  Investigator: “You mean you really trade ice?  Frozen water?”  Lawyer: This is my please-tell-me-you’re-sh*tting-me face.

No prizes for figuring out which was Abbot, and which was Costello.

We are in the best of hands.  The best of hands.

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The Vertical (Silo) Bop: A Reprise

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 7:26 pm

With all the Ukraine stuff, and Gunvor, and travel, some things got lost in my spindle.  Time to catch up.

One story is this article about a debate between NASDAQ OMX’s Robert Greifeld and CME Group’s Phupinder Gill.  The “vertical silo” in which an exchange owns both an execution venue and a clearinghouse was a matter of contention:

Nasdaq OMX Group Inc. CEO Robert Greifeld was asked yesterday about the vertical silo and whether it hurts investors.

“Monopolies are great if you own one,” he said during a panel discussion at the annual Futures Industry Association conference in Boca Raton, Florida, paraphrasing a quote he recalled hearing from an investor. His exchanges don’t use this system. “We have yet to find a customer who is in favor of the vertical model,” he said.

A very retro topic here on SWP.  I blogged about it quite a bit in 2006-2007.  Despite that, it’s still a misunderstood subject :-P

Presumably Greifeld believes that eliminating the vertical silo would open up competition in execution.  Yes, there would be competition, but the outcome would likely still be a monopoly in execution given the rules in futures markets.  Under current futures market regulations, there is nothing analogous to RegNMS which effectively socializes order flow by requiring each execution venue to direct orders to any other venue displaying a better price.  Under current futures market regulations, there is no linkage between different execution venues, and no obligation to direct orders to a better priced market.  This leads traders to submit orders to the venue that they expect will be offering the best price.   In this environment, liquidity attracts liquidity, and order flow tips exclusively to a single market.

So opening up clearing would still result in a monopoly execution venue.  There would be competition to be the monopoly, but at the end of the day only one market would remain standing.  Most likely the incumbent (CME in most cases, ICE in some others.)

It is precisely the fact that competition in clearing and execution would lead to bilateral monopolies that drives the formation of a vertical silo.  This eliminates double marginalization problems and reduces the transactions costs arising from opportunism and bargaining that are inherent to bilateral monopoly situations.

Breaking up the vertical silo primarily affects who earns the monopoly rent, and in what form. These outcomes depend on how the silo is broken up.

One alternative is to require the integrated exchange to offer access to its clearinghouse on non-discriminatory terms.  In this case, the one monopoly rent theorem implies that the clearing natural monopoly could extract the entire monopoly rent via its clearing fee.  Indeed, it would have an incentive to encourage competition in execution because this would maximize the derived demand for clearing, and hence maximize the monopoly price.  (This would also allow the integrated exchange to be compensated for its investment in the creation of new contracts, a point Gill emphasizes.  In my opinion, this is a minor consideration.)

Another alternative (which seems to be what Greifeld is advocating) would be to create a utility CCP (a la DTCC) that provides clearing services at cost.  In this case, the winning execution venue will capture the monopoly rent.

To a first approximation, market users would pay the same cost to trade under either alternative. And most likely, the dominant incumbent (CME) would capture the monopoly rent, either in execution fees, or clearing fees, or a combination of the two.  Crucially, however, total costs would arguably be higher with the utility clearer-monopoly execution venue setup, due to the transactions costs associated with coordination, bargaining, and opportunism between separate clearing and execution venues.  (Unfortunately, the phrase “transactions costs” does double duty in this context.  There are the costs that traders incur to transact, and the costs of operating and governing the trading and clearing venues.)

A third alternative would be to move to a structure like that in the US equity market, with a utility clearer and a RegNMS-type socialization of order flow.  Which would result in all the integration and fragmentation nightmares that are currently the subject of so much angst in the equity world.  Do we really want to inflict that on the futures markets?

As I’ve written ad nauseum over the years, there is no Nirvana in trading market structure.  You have a choice between inefficiencies arising from monopoly, or inefficiencies arising from fragmentation.   Not an easy choice, and I don’t know the right answer.

What I do know is that the vertical silo per se is not the problem.  The silo is an economizing response to the natural monopoly tendencies in clearing and execution (when there is no obligation to direct order flow to venues displaying better prices).  The sooner we get away from assuming differently (and the Boca debate is yet another example of our failure to do so) the sooner we will have realistic discussions of the real trade-offs in trading market structure.

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