Streetwise Professor

December 15, 2014

Is This Prosecution a Spoof of a Real Manipulation Case?

Filed under: Derivatives,Economics,Regulation — The Professor @ 10:05 pm

Michael Coscia, the defendant in the maiden criminal manipulation “spoofing” prosecution, is calling for dismissal of the case on the grounds that the relevant Frankendodd language is “hopelessly vague.”  This is the obvious argument for him to make. The defendants in the BP propane criminal case walked because Judge Miller decided that the anti-manipulation language of the Commodity Exchange Act was “unconstitutionally vague” as applied to the facts of the case. In some respects, the blame for this goes back to the horrible CFTC decision in the case in re Indiana Farm Bureau. In any event, spoofing does indeed sound like a pretty damn vague allegation. Given that, it will be quite interesting to see whether the DOJ fares better in a Chicago courtroom than it did here in Houston in 2009.

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December 11, 2014

The Height of Absurdity: The Operation of the Government Hinges on Blanche Lincoln’s Brainchild

Filed under: Commodities,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 9:20 pm

There’s a whole lotta stupid in Frankendodd. A whole lot. The SEF Mandate is at the top of the list, but the “Swaps Pushout” isn’t far behind.

The Pushout was the brainchild of ex-Arkansas Senator Blanche Lincoln. (NB: I understand the risks of using “brain” in the same sentence as “Blanche Lincoln”.) Blanche, she of the historic 21 point annihilation in the 2010 midterms.

In brief, the Pushout required federally insured banks to move-“push out”-some swaps dealing activities to separate subsidiaries that do not have access to federal deposit insurance. This does not apply to all swaps, mind you. Not even to the bulk of them (interest rate swaps, many CDS). But just to commodity derivatives (other than gold), equity derivatives, and un-cleared CDS.

I took particular interest in this because-again-it slammed commodity derivatives. It was one of several provisions (position limits being another prominent example) that explicitly targeted commodities. Apparently the belief is that commodity derivatives are uniquely risky and subject to abuse, which is just untrue.

Consider a dealer making a market in a commodity index swap. That swap is easily hedged in the futures markets. Ditto with a NYMEX lookalike gas or oil swap. Yes, maybe an unhedged commodity swap is riskier than your typical unhedged IRS, but so what? That’s not the way dealers typically trade (they typically run matched books, or nearly matched books), and capital requirements and other regulations mean that riskier positions incur additional costs that mitigate the incentive to take on excessive risks.

So commodity derivatives (or equity derivatives) don’t create exceptional risks that justify exceptional treatment. What’s more, creating stand-alone affiliates to handle this business entails additional costs. More people. Duplication of infrastructure. Additional capital. There are also scope economies (deriving in particular from capital efficiencies that arise from greater netting opportunities that arise from holding multiple, relatively uncorrelated, positions in a single book). Sacrificing those scope economies will lead to fewer commodity swaps dealers, which in turn makes hedging costlier and the market for these swaps less competitive.

In other words, like many parts of Frankendodd, the Pushout was all pain, no gain. And the pain, mind you, will be suffered not so much by the dealer banks, but by the firms in the real economy that use commodity derivatives to hedge their price risks.

That said, it never seemed to be that big a deal, given the relatively small scale of commodity derivatives and equity derivatives in comparison to IRS and other trades that banks were allowed to keep on the books of insured entities. Small beer compared to the rest of the havoc wreaked by the rampaging Frankendodd Monster.

But this obscure provision could be the one that brings on yet another government shutdown. The most hardcore lefties in the Senate (e.g., Elizabeth Warren) and the House (e.g., Maxine Waters) have drawn a line in the sand over the part of the “Cromnibus Bill” that would repeal the Pushout. If passed, “Cromnibus” would fund the government (except DHS) for the next year, thereby avoiding another shutdown.

But claiming that eliminating the Pushout would be an unconscionable capitulation to Wall Street, the lefties are going to the barricades, and threatening to bring DC to a grinding halt rather than let the Pushout bite the dust. This is not about substance, but symbolism. It is also about a defeated party carrying out a rearguard action on ground where its most rabid partisans can rally.

You cannot make up this stuff. Blanche Lincoln’s populist hobby horse, a desperate effort by a doomed politician, could be the pretext for yet another unproductive partisan confrontation that has virtually nothing to do with the more serious issues associated with funding the government for the next year. (If the Pushout hadn’t passed, would Lincoln have lost by 25 points or 15, rather than 21?) (I note that Gary Gensler worked very closely with Lincoln on Frankendodd: “During drafting sessions, Gensler sometimes sat at the table reserved for staff, advising its Democratic chairwoman, Blanche Lincoln of Arkansas.”)

Cromnibus raises very serious issues. The Swaps Pushout isn’t one of them. But rather than joining the debate on the real issues, or conceding their thumping at the polls, demagogic progs are screaming Swaps Pushout or Fight.

What a travesty.

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December 6, 2014

Hit the Road, State Street

Filed under: Clearing,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 11:51 pm

Following the lead of Bank of New York, State Street announced that it is exiting the swaps clearing business:

State Street (STT) Corp. is closing down its swaps business after clients said new regulations steered them away for using the products.

The bank will shutter its U.S. business for clearing swaps early next year and will shelve plans to start a similar operation in Europe, Anne McNally, a spokeswoman for the Boston-based company, said in an e-mail statement today.

State Street will instead focus on trading other types of derivatives, particularly more traditional exchange-traded futures, that have not been subject to broad new regulations imposed since the 2008 financial crisis.

“Due to market and regulatory factors, our clients have largely evolved their investment strategies towards the use of futures and away from” over-the-counter derivatives, McNally said in the statement.

From even before Frankendodd was passed, I predicted that the swap clearing firm business would be highly concentrated and dominated by the major dealers who had dominated the OTC market. Indeed, I argued that the regulatory overhead created by Frankendodd would actually tend to increase scale economies and make the clearing services business more concentrated and connected.

But Gensler, with the vocal support of BNY, State Street, and Ken Griffen of Citadel-and also MF Global-argued that there was a clearing cabal of dealer firms that was was creating unnecessary barriers to entry into clearing. BNY and State Street claimed that the dealers were forcing ICE Clear to require members to have excessively large amounts of capital, an this prevented them from becoming clearing members. Tear down those walls, and doughty entrants like BNY and State Street and Newedge and others would make the clearing business far more competitive.

This view was channeled in a NY Times story written by Louise Story almost exactly four years ago: I criticized Story’s story pretty harshly. Reflecting this view, the CFTC rules substantially eased the capital requirements and other requirements to become clearing members. Gensler, BNY, STT, etc., thought that this would lead to a much less concentrated, much more competitive clearing business.

But this was to misunderstand the economics of clearing, clearing firm scale and scope economies, and how the complicated regulatory structure CFTC put in place exacerbated these scale economies. Even futures clearing (which is substantially simpler than swaps clearing) has become much more concentrated over the years. Only the truly huge can survive.

BNY and State Street tried, and failed. They couldn’t overcome their inadequate scale even though they could offer complementary collateral management and custodial services. They were just too small.

State Street announced that it was going to focus on futures clearing, but even here it faces problems. It just lost its biggest customer (Pimco). Moreover, there are scope economies between futures clearing and swap clearing. State Street will be at a disadvantage relative to say Goldman, which can offer customers who trade both swaps and futures one stop shopping for clearing services at lower cost because of these scope economies.

So much for clearing mandates making the financial markets less concentrated and less interconnected: instead we (predictably and predicted) have a derivatives marketplace dominated by a small number of CCPs each dominated by a small number of large bank clearing members who are members of all major CCPs, which makes entire world clearing space concentrated and highly interconnected. That anybody thought the post-crisis regulations would reduce concentration and interconnections in swaps markets is illuminating. It demonstrates that those primarily responsible for implementing Frankendodd didn’t really understand the economics of what they were attempting to regulate, and as a result, they didn’t really know what they were doing.  They thought they were striking a blow against too big to fail and a collusive dealer oligopoly. They were wrong, and State Street’s abandonment of its swaps clearing effort is just further proof of how wrong they were.

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November 5, 2014

Will Commodity Traders Replace Banks as Swap Dealers? I Think Not

Filed under: Commodities,Derivatives,Economics,Energy,Regulation — The Professor @ 9:09 pm

As many (but not all) banks reduce their paper and physical commodity market activities, it is often suggested that commodity trading firms like Glencore, Vitol, Trafigura and Mercuria will step into the breach, and become swap dealers offering customized risk management structures to clients (and loans to customers to boot). Mercuria CEO Marco Dunand says his company is exploring that:

Last month Swiss trading house Mercuria completed the purchase of U.S. bank JPMorgan’s physical commodities unit. It now wants to expand its provision of hedging services to external customers.

“There’s the desire for the company to enter a bit more into the space of customer service – trying to see whether we can offer some solutions to clients, primarily in Europe,” Dunand told the annual Reuters Commodities Summit.

Others, including Trafigura’s Pierre Lorinet, expressed skepticism.

When asked about this over the past several months, I have been firmly in the skeptic camp. It all comes down to balance sheet.

Yes, commodity traders utilize paper markets extensively, but as hedgers to reduce risks. This allows them to deploy their capital, and leverage it, so that they can carry out their core transformation activities: logistics, storage, processing, and blending. They are really buy-side firms, with relatively thin capital bases.

Derivatives market making, particularly in long tenor deals, or structured ones, is a very capital intensive activity. Indeed, one of the reasons that some banks are cutting back  is that particularly in the existing regulatory environment, the capital commitments for this business make it difficult to operate profitably. If Barclays can’t make money, how can Mercuria?

I can see joint efforts between banks and commodity traders in offering such products, in the same way that banks and traders collaborate to provide commodity prepays. But in those deals, the risk participation of the traders is usually 10 percent or less. Maybe something similar will evolve with commodity derivatives, where the trader faces the customer but most of the risk-and the capital to bear it-resides on bank balance sheets. Perhaps clever bankers will be able to find ways to engage in capital arbitrage in these kinds of deals, but I doubt it.

There is another big impediment: Frankendodd and its European equivalents. Under Dodd-Frank, becoming a swaps market maker brings with it a variety of burdens, including reporting requirements, and most notably capital and collateral requirements. Capital requirements are an anathema to trading firms, precisely because they are typically very capital light. They are also not keen in tying up working capital in margins. One of the factors that drove “futurization” in energy derivatives is that due to the swapaphobia of Congress, swaps were subject to more onerous treatment than swaps: to avoid becoming swap dealers energy market participants eagerly stopped using swaps and switched to economically equivalent futures instead.

The trading arms of two oil majors-BP and Shell-have become swap dealers and will offer risk management products to customers: they were so big, that it was likely infeasible to escape the swap dealer designation. Cargill has become a swap dealer as well, and will make markets. But these are large, asset-heavy firms with the balance sheets to carry these sorts of activities. Although I could see Glencore making a similar choice, I can’t see the rest of the big traders doing the same.

Banks and commodity trading firms are fundamentally different. They are both intermediaries that engage in various transformations, but the transformations that banks and traders perform are quite different. Banks are in the business of bearing credit risk and intermediating market price risks (e.g., by hedging in listed markets exposures they assume through OTC transactions). Traders are in the business of transforming physical commodities. Traders are natural customers of banks, not competitors in credit and risk intermediation. These different functions mean that banks and traders have different capital structures. This further means that it commodity traders cannot readily step into functions that banks exit or cut back.

So methinks banks will remain banks, and traders will remain traders.


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November 4, 2014

This Cuts No ICE With Me

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 9:24 pm

I admire  Jeffrey Sprecher. ICE has been an amazing success story, and a lot of that has to do with his rather unique combination of vision and ability to execute.

But he is not above talking his book, and he delivered some self-serving, and in fact anti-competition, remarks in ICE’s earnings call held earlier today:

The head of Intercontinental Exchange, the world’s second-largest exchange group by market value, launched an unusually explicit criticism of its bigger competitor’s business strategy as he touted growth in his flagship oil contract.

Commercial customers such as refineries and airlines propelled this growth “as we see our competitors adopting incentives that attract the type of algorithm . . . trading that typically drives commercial users away,” Mr Sprecher said.

Mr Sprecher said “payment for order flow schemes” such as CME’s expanded the market by “attracting traders that really don’t want to hold the risk of your products but just want . . . to get paid to be there.”

If Mr. Sprecher actually believes that, he should be glad that CME (to speak of competitors plural is rather amusing) is implementing a program that per his telling drives away the paying customers, the commercial users.  That’s doubly true since those commercial users would presumably go to ICE. How is CME supposed to make money giving away trading incentives to traders whose presence those who repel those who pay full fare? If that’s what CME is doing, Mr. Sprecher should remember the old adage about not intervening when your enemy is intent on committing a blunder.

Sprecher was touting the fact that ICE’s Brent contract had now surpassed the older CME WTI contract in open interest. Well, this is good for ICE, certainly, but Sprecher and his exchange really have had very little to do with it: this is further proof that it’s usually better to be lucky, than good. Brent’s relative rise is the result of structural factors, most notably the prolonged logistical bottleneck that isolated WTI from waterborne crudes: that bottleneck is largely gone, replaced instead by a regulatory bottleneck, the US export ban.

ICE should not gloat for too long, though, because it is quite likely that the export ban will go, one way or another. What’s more, the resource base supporting the Brent contract is dwindling, and rapidly, whereas the Midcontinent of the US is experiencing a crisis of abundance, if it is experiencing a crisis at all. Logistical bottlenecks created by such crises tend to be transitory, and even regulatory bottlenecks can be overcome. In a few years, WTI will be deeply connected with the waterborne market, albeit in a non-traditional direction. And Brent will be at the mercy of inexorably declining production, and the ability of Platts and an often fractious community of producers and traders to figure out a contractual fix. (Adding Urals to the Brent basket? Really?) So Brent is riding high now, but over the medium to long term, CME will be one breaking out the shades, because WTI will have the brighter future.

As for incentives offered by upstart markets to unseat incumbents, as CME is attempting to do to ICE in Brent, this is a classic competitive tactic, and almost necessary in futures markets. The network effect of order flow means that (as I say in Gregory Meyer’s FT piece) bigger incumbent contracts have a big competitive advantage. The only way that  a competing contract can possibly build order flow and liquidity is to offer incentives, both to market makers (including HFT and algo traders!) who supply liquidity and to the hedgers and speculators that consume liquidity. (I wrote about this last year. Amusingly, I had forgotten about that post until Greg reminded me of it:-P)

Even that is a dicey proposition. Many have tried, and most have failed. But sometimes the upstart the succeeds, and at other times has forced the incumbent to meet the incentives to keep market share, and that can be expensive for the incumbent. That’s probably what Sprecher really doesn’t like. It’s not that incentives don’t work (as the criticism quoted above suggests): it’s that they just might. And if CME’s incentives work it could be an costly proposition for ICE to respond in kind.

In other words, Sprecher is really criticizing a reasonable competitive tactic, because like any dominant incumbent, he doesn’t like competition. That’s his job, but that kind of criticism cuts no ice with me. Or ICE, either, as much as I admire its achievement.



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October 28, 2014

Convergence to Agreement With Matt Levine

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

Matt Levine graciously led his daily linkwrap with a response to my post on his copper column:

It’s not that hard to manipulate copper.

Craig Pirrong, who knows a lot more about commodities markets than I do [aw, shucks], objects to my take on copper. My view is sort of efficient-markets-y: If one person buys up all the copper in the LME warehouses and then tries to raise the price, the much much greater supply of copper that’s not in those warehouses will flow into the warehouses and limit his ability to do that. And I still think that’s broadly true, but broadly true may not be the point. Pirrong quite rightly points out that there’s lots of friction along the way, and the frictions may matter more than the limits in actual fact.

. . . .

So there are limits to cornering, but they may not be binding on an actual economic actor: You can’t push prices up very much, or forvery long, but you may be able to push them up high enough and for long enough to make yourself a lot of money.

I agree fully there are limits to cornering. The supply curve isn’t completely inelastic. People can divert supplies (at some cost) into deliverable position. The cornerer presents the shorts with the choice: pay me to get out of your positions, or incur the cost of making delivery. Since those delivery costs are finite, the amount the cornerer can extract is limited too.

I agree as well that corners typically elevate prices temporarily: after all, the manipulator needs to liquidate his positions in order to cash out, and as soon as that happens price relationships snap back. But that temporary period can last for some time. Weeks, sometimes more.

What’s more, when the temporary price distortions happen matters a lot. Some squeezes occur at the very end of a contract. This is what happened in Indiana Farm Bureau in 1973. A more recent example is the expiry of the October, 2008 crude oil contract, in which prices spiked hugely in the last few minutes of trading.

The economic harm of these last minute squeezes isn’t that large. There are few players in the market, most hedgers have rolled or offset, and the time frame of the price distortion is too short to cause inefficient movements of the commodity.

But other corners are more protracted, and occur at precisely the wrong time.

Specifically, some corners start to distort prices well before expiration, and precisely when hedgers are looking to roll or offset. Short, out-of-position hedgers looking to roll or offset try to buy either spreads or outrights. The large long planning to corner the market doesn’t liquidate. So the hedgers bid up the expiring contract. Long still doesn’t budge. So the shorts bid it up some more. Eventually, the large long relents and sells when prices and spreads get substantially out of line, and the hedgers exit their positions but at a painfully artificial price. I have documented price distortions in some episodes of 10 percent or more. That’s a big deal, especially when one considers the very thin margins on which commodity trading is done. Combine that price distortion with the fact that a large number of shorts pay that distorted price to get out of their positions, and the dollar damages can be large. Depending on the size of the contract, and the magnitude of the distortion, nine or ten figures large.  (I analyze the liquidation/roll process theoretically in a paper titled “Squeeze Play” that appeared in the Journal of Alternative Investments a few years ago.)

But this is all paper trading, right, so real reapers of wheat and miners of copper aren’t damaged, right? Well, for the bigger, more protracted squeezes that’s not right.

Most hedgers are “out-of-position” they are using a futures contract to hedge something that isn’t deliverable. For example, shippers of Brazilian beans or holders of soybean inventories in Iowa use CBT soybean futures as a hedge. They are therefore long the basis. Corners distort the basis: the futures price rises to reflect the frictions and bottlenecks and technical features of the delivery mechanism, but the prices of the vastly larger quantities of the physical traded and held elsewhere may rise little, if at all. So the out-of-position hedgers don’t gain on their inventories, but they pay an inflated price to exit their futures.

This is why corners are a bad thing. They undermine  the most vital function of futures markets: hedging/risk transfer. Hedgers pay the biggest price for corners precisely because the delivery market is only a small sliver of the world market for a commodity, and because the network effects of liquidity cause all hedging activity to tip to a single market (with a very few exceptions). Thus, the very inside baseball details of the delivery process in a specific, localized market have global consequences. That’s why temporary and not very big and localized are not much comfort when it comes to the price distortions associated with market power manipulations.


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October 27, 2014

Matt Levine Passes Off a Bad Penny

Filed under: Commodities,Derivatives,Economics,Exchanges,Regulation — The Professor @ 5:36 pm

Bloomberg’s Matt Levine is usually very insightful about markets, and about financial skullduggery. Alas, in his article on developments in the copper market, Matt is passing off a bad penny.

The basic facts are these. A single firm, reportedly well-known (and arguably infamous) metals trading fund Red Kite, has accumulated upwards of 50 percent (and at times as much as 90 percent) of copper in LME warehouses that is deliverable against LME futures contracts. Such an accumulation can facilitate a corner of the market, or could be a symptom of a corner: a large long takes delivery of virtually the entire deliverable stock (and perhaps all of it) to execute a corner. So the developments in LME copper bear the hallmarks of a squeeze, or an impending one.

What’s more, the price relationships in the market are consistent with a squeeze: the market is in backwardation. I have not had time to determine whether the backwardation is large, controlling for stocks (as would occur during a corner), but the sharp spike in backwardation in recent days is symptomatic of a corner, or fears of a corner.

Put simply, there is smoke here. But Matt Levine seems intent on denying that. Weirdly, he focuses on the allegations involving Goldman’s actions in aluminum:

Loosely speaking, the problem of aluminum was that it was in deep contango: Prices for immediate delivery were low, prices for future delivery were high, and so buying aluminum and chucking it in a warehouse to deliver later was profitable. So people did, and the warehouses got pretty jammed up, and other people who wanted aluminum for immediate use found it all a bit unsporting.

. . . .

The LME warehouse system is an interesting abstract representation of a commodity market, but you can get into trouble if you confuse it with the actual commodity market. One example of the trouble: Goldman and its cronies were accused of manipulating aluminum prices up by putting too much aluminum in LME warehouses.

Well, yes. But the point is that there are many different kinds of manipulation. Many, many different kinds. An Appeals Court in the US opined in the Cargill case that they number of ways of manipulating was limited only by the imagination of man. Too true. The facts in aluminum and the facts in copper are totally different, and the alleged forms of manipulation are totally different, so the events in aluminum are a red herring (although it is copper that is the red metal)

Levine also makes a big, big deal out of the fact that the amount of copper in LME warehouses is trivial compared to the amount of copper produced in the world, let alone the amount of copper that remains in the earth’s crust. This matters hardly at all.

What matters is the steepness of the supply curve into warehouses. If that supply curve is upward sloping, a firm with a big enough futures position can corner the market, and distort prices, even if the amount of copper actually in the warehouses, or attracted to the warehouses by a cornerer’s artificial demand, is small relative to the size of the world copper market.

Case in point. In December 1995 Hamanaka/Sumitomo cornered the LME copper contract holding a position in LME warrants that was substantially smaller than what one firm now owns. Hamanaka’s/Sumitomo’s physical and futures positions were small relative to the size of the world copper market, measured by production and consumption. But they still had market power in the relevant market because it was uneconomic to attract additional copper into LME warehouses.

Another example. Ferruzzi cornered the CBT soybean contract in July, 1989, owning a mere 8 million bushels of beans in Chicago and Toledo. But since it was uneconomic to move additional supplies into those delivery points, it was profitable for, and possible for, Ferruzzi to corner the expiring contract.

World supply may have an effect on the slope of the supply curve into warehouses, but that slope can be positive (thereby creating the conditions necessary to corner) even if the share of metal in warehouses is small. The slope of the supply curve depends on the bottlenecks associated with getting metal into warehouses, and the costs of diverting metal that should go to consumers into warehouses. These bottlenecks and costs can be acute, even if the amount of warehoused metal is small. Diverting copper that should go to a fabricator or wire mill to an LME warehouse is inefficient, i.e., costly. It only happens, therefore, if the price is distorted sufficiently to offset this higher cost.

Levine ends his post thus:

One example of the trouble: Goldman and its cronies were accused of manipulating aluminum prices up by putting too much aluminum in LME warehouses.The worries about copper — that it could be cornered, pushing prices up — stem from there being too little copper in those warehouses. Both of those things can’t be true.

Yes they can, actually. Different commodities at different times with different fundamental conditions are vulnerable to different kinds of manipulation. It is perfectly possible for it to be true that aluminum was vulnerable to a manipulative scheme that exploited the bottlenecks of taking the white metal out of warehouses starting some years ago, and that copper is vulnerable to a manipulative scheme that exploits the bottlenecks of getting the red metal into warehouses now. No logical or factual contradiction whatsoever.

I know you are better than this, Matt. Don’t let your justifiable skepticism of allegations of manipulation make you a poster child for the Gresham’s Law of Internet Commentary.


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October 24, 2014

Someone Didn’t Get the Memo, and I Wouldn’t Want to be That Guy*

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 9:23 am

Due to the five year gap in 30 year bond issuance, in mid-September the CME revised the deliverable basket for the June 2015 T-bond contract. It deleted the 6.25 of May, 2015 because its delivery value would have been so far below the values of the other bonds in the deliverable set. This would have made the contract more susceptible to a squeeze because only that bond would effectively be available for delivery due to the way the contract works.

The CME issued a memo on the subject.

Somebody obviously didn’t get it:

It looks like a Treasury futures trader failed to do his or her homework.

The price of 30-year Treasury futures expiring in June traded for less than 145 for about two hours yesterday before shooting up to more than 150. The 7.3 percent surge in their price yesterday, on the first day these particular contracts were traded, was unprecedented for 30-year Treasury futures, according to data compiled by Bloomberg. Volume amounted to 1,639 contracts with a notional value of $164 million.

What sets these futures apart from others is they’re the first ones where the U.S. government’s decision to stop issuing 30-year bonds from 2001 to 2006 must be accounted for when valuing the derivatives. The size and speed of yesterday’s jump indicates the initial traders of the contracts hadn’t factored in the unusual rules governing these particular products, said Craig Pirrong, a finance professor at the University of Houston.

“That is humongous,” said Pirrong, referring to the 7.3 percent jump. “We’re talking about a move you might see over weeks or a month occur in a day.” Pirrong said he suspected it was an algorithmic trader using an outdated model. “I would not want to be that guy,” the professor said.

Here’s a quick and dirty explanation. Multiple bonds are eligible for delivery. Since they have different coupons and maturities, their prices can differ substantially. For instance, the 3.5 percent of Feb 39 sells for about $110, and the 6.25 of 2030 sells for about $146. If both bonds were deliverable at par, no one would ever deliver the 6.25 of 2030, and it would not contribute in any real way to deliverable supply. Therefore, the CME effectively handicaps the delivery race by assigning conversion factors to each bond. The conversion factor is essentially the bond’s price on the delivery date assuming it yields 6 percent to maturity. If all bonds yield 6 percent, their delivery values would be equal, and the deliverable supply would be the total amount of deliverable bonds outstanding. This would make it almost impossible to squeeze the market.

Since bonds differ in duration, and actual yields differ from 6 percent, the conversion factors narrow but do not eliminate disparities in the delivery values of bonds. One bond will be cheapest-to-deliver. Roughly speaking, the CTD bond will be the one with the lowest ratio of price to conversion factor.

That’s where the problem comes in. For the June contract, if the 6.25 of 2030 was eligible to deliver, its converted price would be around $142. Due to the issuance/maturity gap, the converted prices of all the other bonds is substantially higher, ranging between $154 and $159.

This is due a duration effect. When yields are below 6 percent, and they are now way below, at less than 3 percent, low duration bonds become CTD: the prices of low duration bonds rise less (in percentage terms) for a given decline in yields than the prices of high duration bonds, so they become relatively cheaper. The 6.25 of 2030 has a substantially lower duration than the other bonds in the deliverable basket because of its lower maturity (more than 5 years) and higher coupon. So it would have been cheapest to deliver by a huge margin had CME allowed it to remain in the basket. This would have shrunk the deliverable supply to the amount outstanding of that bond, making a squeeze more likely, and more profitable. (And squeezes in Treasuries do occur. They were rife in the mid-to-late-80s, and there was a squeeze of the Ten Year in June of 2005. The 2005 squeeze, which was pretty gross, occurred when there was less than a $1 difference in delivery values between the CTD and the next-cheapest. The squeezer distorted prices by about 15/32s.)

The futures contract prices the CTD bond. So if someone-or someone’s algo-believed that the 6.25 of 2030 was in the deliverable basket, they would have calculated the no-arb price as being around $142. But that bond isn’t in the basket, so the no-arb value of the contract is above $150. Apparently the guy* who didn’t get the memo merrily offered the June future at $142 in the mistaken belief that was near fair value.


After selling quite a few contracts, the memo non-reader wised up, and the price jumped up to over $150, which reflected the real deliverable basket, not the imaginary one.

This price move was “humongous” given that implied vol is around 6 percent. That’s an annualized number, meaning that the move on a single day was more than a one-sigma annual move. I was being very cautious by saying this magnitude move would be expected to occur over weeks or months. But that’s what happens when the reporter catches me in the gym rather than at my computer.

This wasn’t a fat-finger error. This was a fat-head error. It cost somebody a good deal of money, and made some others very happy.

So word up, traders (and programmers): always read the memos from your friendly local exchange.

*Or gal, as Mary Childs pointed out on Twitter.

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October 19, 2014

It *Was* Too Quiet Out There

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis — The Professor @ 5:28 pm

Four weeks ago I gave the keynote talk at Energy Risk Asia in Singapore. My talk was a look back at commodity market developments in the past year, followed by a look forward.

The theme of the look back was “A Perfect Calm.” I noted that volatility levels across all markets, not just commodities, were at very low levels. Equity vols, as measured by the VIX, had been in the 10 percent range in August and had only ticked up to around 12 percent by late-September. Commodity volatilities were even more remarkable. Historically, the low level of commodity volatilities (the 5th percentile) have been around the median of equity vols and well above currency and bond vols. During the first half of the year, however, commodity vols were below the 5th percentile of equity vols, and below the 95th percentile of currency and bond vols. Pretty amazing.

I argued that this reflected a happy combination of supply and demand factors. In energy and ags in particular, abundant supplies put a drag on volatility. But volatility from the demand side was low too. The low VIX levels are a good proxy for macro uncertainty, or the lack thereof. Put both of those together, and you get a perfect calm.

But perfect calms are the exception, rather than the rule. The last slide in my talk looked forward, and cribbed a movie cliche: It was titled “It’s Quiet Out There. Too Quiet.” I noted that periods of very low volatility frequently bear the seeds of their destruction. When risk measures are low, firms and traders lever up and increase position sizes. A bit of economic turbulence increases volatilities, which leads to breaches in risk limits, which forces deleveraging and reductions in positions. This tends to lead to reduced liquidity, exaggerated price moves, yet higher volatility, leading to more deleveraging and repositioning, and on it goes. That is, there can be a positive feedback loop. Transitions from low to high volatility can be very abrupt.

It looks like that’s what has happened in the weeks since my return. Equity markets are down substantially. Commodities, notably energy, have slumped: Brent is down to around $88. Volatilities have spiked. The VIX reached over 31 percent last week, and the crude oil VIX went from about 15 percent at the end of August to over 37 percent last week.

The spark appears to have been mounting evidence of a slowdown in Europe and China. Ebola might have been a contributing factor in the last week or two, but in my view the economic weakness is the main driver.

I admit to being like the title character in My Cousin Vinnie. He had difficulty sleeping in the Alabama country quiet, but slept like a lamb in a raucous county jail. Times like these are more interesting, anyways.

So it turns out it was too quiet out there.

And remember. Today is the 27th anniversary of the ’87 Crash (one of the formative experiences of my professional life). Octobers are often . . . interesting (the most dangerous word in the English language). So the markets bear watching closely. If you aren’t interested in them, they may well be interested in you.

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October 13, 2014

You Might Have Read This Somewhere Before. Like Here.

The FT has a long article by John Dizard raising alarms about the systemic risks posed by CCPs. The solution, in other words, might be the problem.

Where have I read that before?

The article focuses on a couple of regulatory reports that have also raised the alarm:

No, I am referring to reports filed by the wiring and plumbing inspectors of the CCPs. For example, the International Organization for Securities Commissions (a name that could only be made duller by inserting the word “Canada”) issued a report this month on the “Securities Markets Risk Outlook 2014-2015”. I am not going to attempt to achieve the poetic effect of the volume read as a whole, so I will skip ahead to page 85 to the section on margin calls.

Talking (again) about the last crisis, the authors recount: “When the crisis materialised in 2008, deleveraging occurred, leading to a pro-cyclical margin spiral (see figure 99). Margin requirements also have the potential to cause pro-cyclical effects in the cleared markets.” The next page shows figure 99, an intriguing cartoon of a margin spiral, with haircuts leading to more haircuts leading to “liquidate position”, “further downward pressure” and “loss on open positions”. In short, do not read it to the children before bedtime.

This margin issue is exactly what I’ve been on about for six years now. Good that regulators are finally waking up to it, though it’s a little late in the day, isn’t it?

I chuckle at the children before bedtime line. I often say that I should give my presentations on the systemic risk of CCPs while sitting by a campfire holding a flashlight under my chin.

I don’t chuckle at the fact that other regulators seem rather oblivious to the dangers inherent in what they’ve created:

While supervisory institutions such as the Financial Stability Oversight Council are trying to fit boring old life insurers into their “systemic” regulatory frameworks, they seem to be ignoring the degree to which the much-expanded clearing houses are a threat, not a solution. Much attention has been paid, publicly, to how banks that become insolvent in the future will have their shareholders and creditors bailed in to the losses, their managements dismissed and their corporate forms put into liquidation. But what about the clearing houses? What happens to them when one or more of their participants fail?

I call myself the Clearing Cassandra precisely because I have been prophesying so for years, but the FSOC and others have largely ignored such concerns.

Dizard starts out his piece quoting Dallas Fed President Richard Fisher comparing macroprudential regulation to the Maginot Line. Dizard notes that others have made similar Maginot Line comparisons post-crisis, and says that this is unfair to the Maginot Line because it was never breached: the Germans went around it.

I am one person who has made this comparison specifically in the context of CCPs, most recently at Camp Alphaville in July. But my point was exactly that the creation of impregnable CCPs would result in the diversion of stresses to other parts of the financial system, just like the Maginot line diverted the Germans into the Ardennes, where French defenses were far more brittle. In particular, CCPs are intended to eliminate credit risk, but they do so by creating tremendous demands for liquidity, especially during crisis times. Since liquidity risk is, in my view, far more dangerous than credit risk, this is not obviously a good trade off. The main question becomes: During the next crisis, where will be the financial Sedan?

I take some grim satisfaction that arguments that I have made for years are becoming conventional wisdom, or at least widespread among those who haven’t imbibed the Clearing Kool Aid. Would that have happened before legislators and regulators around the world embarked on the vastest re-engineering of world financial markets ever attempted, and did so with their eyes wide shut.

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