Streetwise Professor

November 12, 2015

Big Sister on the Warpath Against Commodity Derivatives

Filed under: Commodities,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 3:27 pm

Elizabeth Warren’s panties were in a bunch the other night because of an ad that portrayed her as a “Commie dictator” (her description). (Liz’s panties always seem to be in a bunch, but they were bunchier than usual on Tuesday.) The ad, which blasts Warren’s anti-Constitutional monstrosity, the Consumer Financial Protection Bureau is actually somewhat amusing. Warren’s image appears in the background on a Big Brother-ish–or would that be Big Sister-ish?–banner.

I agree with Warren. She is not a  Commie dictator. She is a wannabe Commie dictator.

Her anti-market efforts are not limited to birthing and defending the CFPB. She is also a virulent critic of derivatives, especially when banks trade them. Pre-commercial, her ire this week was focused on the repeal of the swaps pushout rule, the brainchild (and I use that term very loosely) of fortunately ex-Senator Blanch Lincoln (D-for-dim, Arkansas). Warren fulminated that as a result of the repeal, banks were able to keep $10 trillion notional in particularly risky swaps in their deposit-taking units, rather than spinning them off into separately capitalized subsidiaries that cannot benefit from deposit insurance.

This rule was targeted at swaps that were deemed especially risky, including most notably, commodity swaps. But commodity swaps, and many equity derivatives, are not especially risky. Risk depends on whether the positions are hedged or hedgeable, the creditworthiness of the counterparty, and the credit support (e.g., collateral) in the transactions. And notional principle is certainly not a measure of how much risk is in a derivatives book. Therefore, putting commodity swaps, equity swaps, etc., in a ghetto does not make economic sense. There is no reliable mapping between the underlying of a derivative and the risk it creates.

Furthermore, risk has to be evaluated on a portfolio basis. Segmenting derivatives books can reduce diversification benefits, and crucially, breaks netting sets. Breaking netting sets tends to increase counterparty risk, or require more costly collateral to keep counterparty risk the same. (As I’ve written many times, the systemic effects of netting and collateral are ambiguous because of their main effect is redistributive. But if you are concerned about the counterparty risks that banks face, you should prefer more netting to less.)

Frankendodd is chock-full o’ stupid and dangerous, but the swaps push out was in the running for the title of dumbest and most dangerous. It makes no economic sense as a way of achieving the purported purpose of reducing the risks that banks pose to taxpayers. But Warren and other progressives have made it a litmus test for determining which side you are on, that of the angels, or the banksters? This is a false choice.

But expect Big Sister Liz to remain on the warpath against derivatives. Which is exactly why the 1984-esque portrayal of her in that commercial is spot on.


Print Friendly

November 4, 2015

I’m Not Spoofing You About Judicial Overkill

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 11:02 pm

Yesterday in a federal court in Chicago, Michael Coscia of Panther Energy Trading was convicted of six counts each of commodity manipulation and fraud for “spoofing.” Coscia faces decades in prison.

I haven’t seen the evidence, so I cannot judge whether Coscia did manipulate. For the purposes of this post I will stipulate that he did. But even given that stipulation, this entire exercise was judicial overkill and a travesty that can do serious damage to the markets.

What is spoofing? A trader puts in a large order (an offer, say) several ticks away from the best price in the market. He also places a small limit order on the other side of the market (a bid, in this example). If the market moves towards the large order, the spoofer cancels and replaces the order several ticks away from the new inside market. It is this cancellation that attracts all the attention. Much of the coverage says that the spoofer submits orders with the intent of canceling them.

That’s not the whole story though. The point of spoofing is to increase the odds that the small order is executed. After all, what would be the point of submitting orders that are never executed?

In the example, the large sell order is intended to convince others that the current price is too high. This may induce some bidders to cancel their bids, and others to cross the market and hit the bid. Both of these actions increase the odds that the spoofer’s small order will be executed.

So how does he make money? It can’t be by driving down the price persistently. The spoofer has bought: to profit, prices must rise subsequently. So, often the spoofer will reverse direction, putting in a big bid away from the market, and a small offer.

If spoofing works, the spoofer will repeatedly buy at the bid and sell at the offer, making the dealer’s turn. This will not cause the price to diverge persistently from where it would be, absent this conduct.

That’s apparently what happened with Coscia. He made a whopping $1K on the six episodes for which he was charged and convicted. He was just making a tick here and a tick there. And crucially, unlike the kinds of manipulation that cause real damage-corners, in particularly-he is not causing the price to be persistently inflated or depressed.

So who is hurt? Some people may be induced to trade when they wouldn’t have absent the spoofing. Their losses are approximately equal to the spoofers gains, on the order of a tick. And since some might have hit the spoofer’s bid even absent the spoofing, only a fraction of those with whom the spoofer trades are damaged.

Others who might be damaged are those who are fooled into canceling orders, and see the spoofer execute a trade they would have liked to if they hadn’t been fooled. The spoofer takes some of the profit they would have earned.

I find it hard to believe that these damages are are all that large. (They would also be hard to estimate because it is virtually impossible to identify who traded because of the spoofing, and who pulled a quote because of the spoofing, and gave up the opportunity to trade.) And regardless, this is exactly the kind of conduct that can be deterred using monetary fines.

This brings me to another bizarre aspect of these spoofing cases. Many of those who scream loudest about spoofing, like Eric Hunsader of Nanex, say: “SPOOFING IS SO OBVIOUS!!!! JUST LOOK AT THE DATA!”

As another case in point, I saw a Tweet embedding a .gif of someone’s TT trading screen, in which the quoted depth a couple of ticks above the inside market would rise and fall by 800 contracts or so. The Tweeter (I can’t find the Tweet) said something to the effect “look at this obvious spoofing.”

Well, I agree with the obviousness of it, but the implication of that is exactly the opposite of what Hunsader, the Tweeter, and presumably the DOJ and CFTC believe: If it so obvious, nobody is fooled. If nobody is fooled, it can’t affect trading behavior or prices. If it doesn’t affect trading behavior or prices, there is no economic harm. If there is no economic harm, it shouldn’t be prosecuted.

There is a law and economics take on this too. Classic Gary Becker analysis shows that draconian penalties-like 25 years per fraud charge and 10 years per manipulation charge-are justifiable if the probability of detection of a harm/crime is small. This is necessary to make the expected cost paid by the offender equal to the cost of the harm. But if the conduct is obvious, even only ex post, the probability of detection should be high, so penalties far greater than any harm are excessive. In this case, grotesquely excessive. (Furthermore, again pace Gary Becker, incarceration of a defendant who can pay the monetary value of the harm caused is a social waste, in the form of the cost of imprisonment, and the lost output of the convict.)

But it gets worse. The Coscia prosecution-and the popular condemnation of spoofing-focuses obsessively on the large rate of order cancellation. But perfectly legitimate market making strategies involve large rates of order cancellation, especially in volatile markets. They also involve buying frequently at the bid and selling at the offer. Given the Javert-like zeal of prosecutors, their dim understanding of trading, and the difficulty of explaining market making to a jury create the very real risk that a market maker could be charged, and convicted, and be punished severely, because he cancelled a lot of orders, and made the dealer’s turn all day long. This huge and very real risk will no doubt lead to less aggressive quoting (a market maker is less willing to quote aggressively if he is reluctant to cancel too often for fear of being accused of spoofing).

And who pays for that? Market users, including both institutional and retail traders, who take the liquidity market makers supply. Thus, you and me are harmed by overzealous prosecution of spoofing that threatens to demoralize legitimate, efficiency-enhancing trading.

This raises the very real possibility that the prosecution of actions that produce little economic harm will inflict a far larger harm. That is perverse.

What is particularly infuriating is that enforcement authorities are apparently incapable of prosecuting much truly damaging market conduct. Federal prosecutors are crowing over getting Coscia’s scalp, and the Chairman of the CFTC is using the verdict to intimidate would-be spoofers, but 6 years ago Federal prosecutors in Houston utterly botched the BP propane corner case (US v. Radley). That was a real manipulation that caused real damage. But the prosecutors totally flubbed the case, and the perps walked. Then there are those obvious manipulations that the Feds haven’t even bothered to prosecute (perhaps to spare themselves the embarrassment of flubbing another one.)

It reminds me of the old joke about the lawyer who said: “I lost the cases I should have won, and won the cases I should have lost. Therefore, on average, justice was done.”

No, actually, Mr. Lawyer: justice is never done if the guilty walk free and the innocent are punished. And sad to say, US manipulation law is perilously close to embodying that cynical joke.



Print Friendly

October 31, 2015

On the Spot: How a Surfeit of Supply is Transforming LNG Trading

Filed under: Commodities,Derivatives,Russia — The Professor @ 6:22 pm

In September of last year, I gave the dinner speech at the CWC LNG Asia Pacific Summit conference in Singapore. The dinner was held at the Singapore Aquarium, and I spoke in front of the Aquarium’s giant shark tank. I couldn’t help but think of the scene with Kim Jung Il and Hans “Brix” Blix from Team America. Especially after the way my remarks were received, which ranged between cool and rather hostile.

I predicted the demise of oil-based pricing, and increased reliance on the spot market or long-term contracts indexed to spot prices. There were three basic parts to my argument. The first was that the large increase in supplies coming online in 2015-2017 combined with the even-then apparent slowdown in demand in China, and the likely decline from Japan due to the restarting of its nuclear plants, would lead to a large overhang of cargoes that would need to find a home. The trading of these cargoes would lead to increased spot market activity.

The second part of my argument was that the dynamics of liquidity would then take over. Liquidity creates liquidity. More spot market activity reduces the transactions costs of trading spot, which leads to more spot trading. There is a virtuous cycle in liquidity, and the increase in spot trading to dispose of contracted of but now unneeded cargoes would start the cycle.

The third part of my argument was that a robust spot market would support gas indexing, as opposed to oil indexing, in term contracts. Oil indexing is akin to the drunk looking for his wallet under the lamppost, because the light is best there, not because he lost it there. LNG buyers and sellers looking for a price benchmark looked to oil in the early days because in the 70s oil was a substitute for gas in power generation, so there was some connection between the markets, but mainly because oil was the only lamppost around. But especially now, with gas and oil having little fundamental connection in either consumption or production, oil prices are not closely correlated with the marginal value of a ton of LNG. The development of a liquid LNG spot market would-will, in my view-allow contracts to be indexed to a price that reflects gas values. This would also permit the development of a paper hedging market.

My unpopular prediction is now looking much better, though not all are persuaded. There is a huge LNG overhang, with Australian and US supplies about to come on stream. This supply increase is occurring simultaneously with a protracted decline in demand growth. Much of this overhang will find its way to the spot market. That, in turn, will start the virtuous cycle.

The supply overhang will have other consequences. It will force down prices world-wide, and lead to a redirection of supplies from Asia to Europe. One of the biggest losers from this will be Russia, which will face more intense price competition in its biggest export market in Europe, and a reduced Chinese appetite for the gas it had hoped to send east. Another will be Qatar, at present the world’s largest supplier.

Making things even more interesting is that Russia and Qatar are adversaries in Syria. (And by the way, those conspiracy theorists who think that the Syrian civil war was started by Qatar because Assad would not allow the construction of a pipeline to bring Qatari gas to Europe-spare me. Qatar’s big LNG investment dramatically reduced its need for a pipeline, and it anticipated being able to sell all it could to a growing Asian market.)

The next few years will be interesting in LNG. I am even more convinced that in 3 to 5 years the market will look nothing like it does today. It will look more like the oil, iron ore, and coal markets. Furthermore, in the near-to-medium term it will be more of a buyer’s market, and indeed, these things are connected. The surfeit of supply that makes it a buyer’s market will catalyze the development of a spot market.

Print Friendly

October 24, 2015

Creeping Recognition that Regulation Has Created a Liquidity Death Star

Reason number one (by far) that I believe that clearing and collateral mandates increase systemic risk is that they transform credit risk into liquidity risk. Large price moves during stressed market situations require those with losing positions to make large variation margin payments in a very tight frame. These payments need to be funded, and funded immediately. Thus, variation margining causes spikes in the demand for liquidity. Furthermore, clearing in particular creates tight coupling because failures-or even delays-in making VM payments can put the clearinghouse into default, or force it to liquidate collateral in an illiquid market. The consequences of that, you should shudder to contemplate.

To be somewhat hyperbolic, clearing mandates create a sort of liquidity death star.

Recognition of how dangerous spikes in liquidity demand precisely when liquidity supply evaporates creates a major systemic risk is sadly insufficiently widespread, particularly among many regulators who still sing paeans to the glories of clearing. But perhaps awareness is spreading, albeit slowly. At least I hope that this Economist article indicates a greater appreciation of the collateral issue, although it fails to draw the connection to central clearing, and how clearing mandates can dramatically exacerbate collateral shortages:

WHEN the financial system teetered on the brink of collapse in 2008, the biggest problem was a lack of liquidity. Banks were unable to refinance themselves in the short-term debt markets. Central banks had to step in on a massive scale to offer support. Calm was eventually restored, but not without enormous economic damage.

But has the underlying problem of liquidity gone away? A research note from Michael Howell of Crossborder Capital argues that, in the modern financial system, central banks are no longer the only, or even the main, providers of liquidity. Instead, the system looks a lot like that of the Victorian era, with banks dependent on the wholesale markets for funding. Back then, the trade bill was the key asset for bank financing; now it is the mysteriously named “repo” market.

. . . .

Bigger haircuts mean that borrowers need more collateral than before in order to fund themselves. “When market volatility jumps, funding capacity drops in tandem and often substantially,” writes Mr Howell. The result, a liquidity squeeze at the worst possible moment, is a template of how the next crisis may occur (although regulators are trying to reduce banks’ reliance on short-term funding).

And again, it is at these times when the need to fund VM payments will kick in, exacerbating the liquidity squeeze. Moreover, clearing also ties up a lot of the assets (e.g., Treasuries, or cash) that firms could normally borrow against to raise cash. Perversely, that collateral can be accessed only if a clearing member defaults on a variation margin payment.

Just what the liquidity supply mechanism will be in the next crisis in the new cleared world is not quite, well, clear. As the Economist article (and the Crossborder Capital note upon which it is based) demonstrate, central banks lend against collateral, and the collateral constraint will already be binding in stress situation. Presumably central banks will have to be much more expansive in their definition of what constitutes “good” collateral (a la Bagehot).

It still astounds me that even though every major financial crisis in history has been at root a liquidity crisis, in their infinite wisdom the betters who presume to govern us thought they were solving systemic risk problems by imposing a mechanism that will sharply increase liquidity demand and restrict liquidity supply during periods of market stress. That should work out really, really swell.

Print Friendly

October 23, 2015

Massad’s Recent Speech: Flashy, But Misleading, and Beside the Point

Filed under: Derivatives,Economics,HFT,Regulation — The Professor @ 8:53 pm

The other day CFTC Chairman Timothy Massad gave a speech about “flash events” in futures markets that has attracted a lot of attention. Most of the attention was given to Massad’s claim that there had been 35 flash events in WTI futures this year, and between 9 and 25 events per year combined in corn, crude, e-minis, 30 year Treasuries, gold, and the Euro from 2010-2014. Flashy results indeed. But the method for identifying them is misleading, and makes big flash moves seem more likely than they really are.

These results, and specifically the WTI finding for 2015, is an artifact of the definition of a flash event (which Massad acknowledged is somewhat arbitrary):

[E]pisodes in which the price of a contract moved at least 200 basis points within a trading hour— but returned to within 75 basis points of the original or starting price within that same hour.

The problem is that the number of flash events will depend on volatility.  Two percent moves are more likely in high volatility environments, or for high volatility contracts.

This is clearly what’s going on in oil. As this chart of the oil volatility index (OVX) shows, oil volatility was extremely low through most of 2014, but increased sharply in late-2014 through mid-2015, and then has picked up again in recent months:

Screen Shot 2015-10-23 at 7.45.39 PM

With volatility in the 60-70 percent annualized range, you will have a much greater likelihood of a 200 basis point move (and a subsequent 125 bp or so reversal) than with 15 percent vols. The flashy 2015 crude oil results are a reflection of this year’s high underlying volatility, which has been fundamentals driven, rather than the microstructure of modern electronic markets.

The 200/75 basis point standard was chosen because that’s what happened in the Treasury market on 15 October, 2014. But a 200 basis point move in something like Treasuries, which have a volatility of around 10 percent, is a bigger number of standard deviation move than a 200 basis point move in crude, especially with a volatility of 70. So the more appropriate cutoff would have been standard deviations (sigmas) rather than percent. But if Massad had done that, he would have identified a lot fewer events, and his speech would have been met with yawns, rather than the attention it has received.

Let’s also put things in perspective. The contracts considered trade 17-23 hours per day. 252 days a year times (say) 20 hour per day times 6 contracts and 20 events/year gives the odds of a .06 percent of an event in any hour. Using a more realistic sigma standard would reduce the odds of an event comparable to the Treasury flash event to a much smaller number than that.

Put differently, the Treasury event was truly anomalous, and Massad’s way of analyzing the data makes it seem more common than it really is. To get a flashy, eye-catching result, Massad had to use a misleading standard to identify flash events. Objects in his mirror are smaller than they appear.

The taking off point for Massad’s speech was the report on the 2014 Treasury flash crash. Like the infamous May, 2010 equity flash crash, there was a sharp decline in liquidity leading up to the price break. Massad attributes this to the way algorithms are programmed:

We also know that as with humans, the modern algorithms have risk management capabilities embedded within them. So when there is a moment of sudden, unexpected volatility, it may not be surprising that some in the market pull back – potentially faster than a human can.

The report describes how on October 15, some algos pulled back by widening their spreads and others reduced the size of their trading interest. Whether such dynamics can further increase volatility in an already volatile period is a question worth asking, but a difficult one to answer. It is also very difficult for individual institutions of any type to remain in the book, opposing price headwinds, or worse, to try and catch the proverbial falling knife. For many, this decision can be the difference between risk mitigation and significant losses. Contrary to what some have suggested,

This makes perfect sense. Some algorithms-especially HFT algorithms-attempt to determine when order flow is becoming toxic (and hence adverse selection risks are elevated) and reduce exposures when they do. Holding depth constant, greater information flow makes prices more volatile, and the reduction in liquidity that the greater information flow causes makes prices even more volatile.

This means that looking at the depth reductions and associated increases in volatility focuses on a symptom, not the underlying cause. What deserves more attention is what causes the increase in the informativeness of order flow that makes the liquidity suppliers cut back. This hasn’t been done in any study, to my knowledge, nor is it likely to be possible to do so.

And as Massad notes, this phenomenon is not unique to electronic markets. Meat puppet market makers also take a powder when adverse selection risks rise:

Contrary to what some have suggested, I suspect it was difficult for market makers in the pre-electronic era to routinely maintain tight and deep spreads during volatile conditions. They likely took long coffee breaks.*

It’s beyond suspicion, actually. It happens. Look at the Crash of ’87 when locals fled the pits and OTC market makers stopped answering their phones.

These reductions in liquidity are inherent in any trading environment where private information is important, and the rate of information flow varies.  Regardless of trading technology or market microstructure, liquidity suppliers will cut the sizes of their quotes, or stop quoting altogether, when order flow turns very toxic.

Given all this, Massad’s policy prescriptions are oddly disconnected from the flash phenomenon that prompted his talk:

The focus of our forthcoming proposals will be on the automation of order origination, transmission and execution – and the risks that may arise from such activity. These risks can come about due to malfunctioning algorithms, inadequate testing of algos, errors and similar problems. We are concerned about the potential for disruptive events and whether there are adequate measures to ensure effective compliance with risk controls and other requirements.

Now of course, you could have errors before, in the days of pit traders and specialists. You could have failures of systems in less sophisticated times. But generally the consequences were of lesser magnitude than what we may face today. And that’s in large part because the errors were easier to identify, arrest or cure before they caused widespread damage.

I expect that our proposals will include requirements for pre-trade risk controls and other measures with respect to automated trading. These will apply regardless of whether the automated trading is high or low frequency. We will not attempt to define high-frequency trading specifically. I expect that we will propose controls at the exchange level, and also at the clearing member and trading firm level.


That’s all great, but really beside the point. If rogue or fat-fingered algos were the problems in any of the alleged flash events Massad identified (including the Treasury event of a year ago), he would have been able to say so. But he admits that the causes of the various events are all unknown. So it’s a bait-and-switch to pose the problem of flash crashes, and then advance remedies that have nothing to do with them. It’s the regulatory equivalent of applying leeches.

In sum, Massad overstates the flash event problem, and offers policies that have nothing to do with them. The fact remains that these things are probably beyond a policy fix anyways. They inhere in nature of the trading of financial instruments when order flow can become toxic.

*Gillian Tett of the FT gets Massad’s point exactly backwards:

The crucial point is that these automated trading programs — like Hal — lack human judgment. When a crisis erupts and prices churn, computers do not simply “take a long coffee break”, as Mr Massad says, and wait for common sense to return; instead they tend to accelerate trading, fuelling those flash crash swings.

Sheesh. Please read, Gillian. Massad’s point is that the algos do take a metaphorical coffee break. They don’t speed up, they pull back.



Print Friendly

October 10, 2015

Igor Gensler Helps the Wicked Witch of the West Wing Create Son of Frankendodd

Hillary Clinton has announced her program to reform Wall Street. Again.

The actual author of the plan is said to be my old buddy, GiGi: Gary Gensler.

Gensler, if you will recall, was the Igor to Dr. Frankendodd, the loyal assistant who did the hard work to bring the monster to life. Now he is teaming with the Wicked Witch of the West Wing to create Son of Frankendodd.

There are a few reasonable things in the proposal. A risk charge on bigger, more complex institutions makes sense, although the details are devilish.

But for the most part, it is ill-conceived, as one would expect from Gensler.

For instance, it proposes regulating haircuts on repo loans. As I said frequently in the 2009-2010 period, attempting to impose these sorts of requirements on heterogeneous transactions is a form of price control that will lead some risks to be underpriced and some risks to be overpriced. This will create distorted incentives that are likely to increase risks and misallocations, rather than reduce them.

A tax on HFT has received the most attention:

The growth of high-frequency trading (HFT) has unnecessarily burdened our markets and enabled unfair and abusive trading strategies that often capitalize on a “two-tiered” market structure with obsolete rules. That’s why Clinton would impose a tax targeted specifically at harmful HFT. In particular, the tax would hit HFT strategies involving excessive levels of order cancellations, which make our markets less stable and less fair.

This is completely wrongheaded. HFT has not “burdened” our markets. It has been a form of creative destruction that has made traditional intermediaries obsolete, and in so doing has dramatically reduced trading costs. Yes, a baroque market structure in equities has created opportunities for rent seeking by HFT firms, but that was created by regulations, RegNMS in particular. So why not fix the rules (which in Hillary and Gensler acknowledge are problematic) rather than kneecap those who are responding to the incentives the rules create?

Furthermore, the particular remedy proposed here is completely idiotic. “Excessive levels of order cancellations.” Just who is capable of determining what is “excessive”? Furthermore, the ability to cancel orders rapidly is exactly what allows HFT to supply liquidity cheaply, because it limits their vulnerability to adverse selection. High rates of order cancellation are a feature, not a bug, in market making.

It is particularly ironic that Hillary pitches this as a matter of protecting “everyday investors.” FFS, “everyday investors” trading in small quantities are the ones who have gained most from the HFT-caused narrowing of bid-ask spreads.

Hillary also targets dark pools, another target of popular ignorance. Dark pools reduce trading costs for institutional investors, many of whom are investing the money of “everyday” people.

The proposal also gives Gensler an opportunity to ride one of his hobby horses, the Swaps Pushout Rule. This is another inane idea that is completely at odds with its purported purpose. It breaks netting sets and if anything makes the financial system more complex, and certainly makes financial institutions more complex. It also discriminates against commodities and increases the costs of managing commodity price risk.

The most bizarre part of the proposal would require financial institutions to demonstrate to regulators that they can be managed effectively.

Require firms that are too large and too risky to be managed effectively to reorganize, downsize, or break apart. The complexity and scope of many of the largest financial institutions can create risks for our economy by increasing both the likelihood that firms will fail and the economic damage that such failures can cause.[xiv] That’s why, as President, Clinton would pursue legislation that enhances regulators’ authorities under Dodd-Frank to ensure that no financial institution is too large and too risky to manage. Large financial firms would need to demonstrate to regulators that they can be managed effectively, with appropriate accountability across all of their activities. If firms can’t be managed effectively, regulators would have the explicit statutory authorization to require that they reorganize, downsize, or break apart. And Clinton would appoint regulators who would use both these new authorities and the substantial authorities they already have to hold firms accountable.

Just how would you demonstrate this? What would be the criteria? Why should we believe that regulators have the knowledge or expertise to make these judgments?

I have a Modest Proposal of my own. How about a rule that requires legislators and regulators to demonstrate that they have the competence to manage entire sectors of the economy, and in particular, have the competence to understand, let alone manage, an extraordinarily complex emergent order like the financial system? If some firms are too complex to manage, isn’t an ecosystem consisting of many such firms interacting in highly non-linear ways exponentially more complex to control, especially through the cumbersome process of legislation and regulation? Shouldn’t regulators demonstrate they are up to the task?

But of course Gensler and his ilk believe that they are somehow superior to those who manage financial firms. They are oblivious to the Knowledge Problem, and can see the speck in every banker’s eye, but don’t notice the log in their own.

People like Gensler and Hillary, who are so hubristic to presume that they can design and regulate the complex financial system, are by far the biggest systemic risk. Frankendodd was bad enough, but Son of Frankendodd looks to be an even worse horror show, and is almost guaranteed to be so if Gensler is the one in charge, as he clearly aims to be.

Print Friendly

October 3, 2015

People. Get. A. Grip: Glencore Is Not the Next Lehman

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,History,Regulation — The Professor @ 6:53 pm

There is a lot of hysterical chatter out there about Glencore being the next Lehman, and its failure being the next Lehman Moment that plunges the financial system into chaos. Please. Get. A. Grip.

Comparing the firms shows there’s no comparison.

Let’s first talk size, since this is often framed as an issue of “too big to fail.” In November, 2007, Lehman’s total assets were $691 billion. As of August, Glencore’s were $148 billion. Lehman was about 4.5 times bigger. Moreover, Glencore’s assets include a lot of short term assets (inventories and the like) that are relatively liquid. Looking at Glencore as a $100 billion firm is more realistic. Lehman was much bigger.

Then let’s talk leverage. Lehman had 3 percent equity, 97 percent debt. Glencore about one third-two thirds. Stripping out the short term debt and short term assets, it’s about 50-50.

Then let’s talk off-balance sheet. Lehman was a derivatives dealer with huge OTC derivatives exposures both long and short. Glencore’s derivatives book is much smaller, more directional, and much in listed derivatives.

Lehman had derivatives liabilities of about $30 billion after netting and collateral were taken into account, and $66 billion if not (which matters if netting is not honored in bankruptcy). Glencore has $2 billion and $20 billion, respectively.

Lets talk about funding. Lehman was funding long term assets with short term debt (e.g., overnight repos, corporate paper). It had a fragile capital structure. Glencore’s short term debt is funding short term assets, and its longer term assets are funded by longer term debt. A much less fragile capital structure.  Lower leverage and less fragile capital means that Glencore is much less susceptible to a run that can ruin a company that is actually solvent. That also means less likelihood that creditors are going to take a big loss due to a run (as was the case with Lehman).

As a major dealer, Lehman was also more interconnected with every major systemically important financial institution. That made contagion more likely.

But I don’t think these firm-specific characteristics are the most important factors. Market conditions today are significantly different, and that makes a huge difference.

It wasn’t the case that Lehman failed out of a clear blue sky and this brought down the entire financial system through a counterparty or informational channel. Lehman was one of a series of casualties of a financial crisis that had been underway for more than a year. The crisis began in earnest in August, 2007. Every market indicator was flashing red for the next 12 months. The OIS-Libor spread blew out. The TED spread blew out. Financial institution CDS spreads widened dramatically. Asset backed security prices were plummeting. Auction rate securities were failing. SPVs holding structured products were having difficulty issuing corporate paper to fund them. Bear Sterns failed. Fannie and Freddie were put into receivership. Everyone knew AIG was coughing up blood.

Lehman’s failure was the culmination of this process: it was more a symptom of the failure of the financial system, than a major cause. It is still an open question why its failure catalyzed an intensified panic and near collapse of the world system. One explanation is that people inferred that the failure of the Fed to bail it out meant that it wouldn’t be bailing out anyone else, and this set off the panic as people ran on firms that they had thought were working with a net, the existence of which they now doubted. Another explanation is that there was information contagion: people inferred that other institutions with similar portfolios to Lehman’s might be in worse shape than previously believed and hence ran on them (e.g., Goldman, Morgan Stanley, Citi) when Lehman went down. The counterparty contagion channel has not received widespread support.

In contrast, Glencore’s problems are occurring at a time of relative quiescence in the financial markets. Yes commodity markets are down hard, and equities have had spasms of volatility lately, but the warning signs of liquidity problems or massive credit problems in the banking sector are notably absent. TED and OIS-Libor spreads have ticked up mildly in recent months, but are still at low levels. A lot of energy debt is distressed, but that does not appear to have impaired financial institutions’ balance sheets the same way that the distress in the mortgage market did in 2007-2008.

Furthermore, there is not even a remote possibility of an implicit bailout put for Glencore, whereas it was plausible for Lehman (and hence the failure of the put to materialize plausibly caused such havoc). There are few signs of information contagion. Other mining firms stocks have fallen, but that reflects fundamentals: Glencore has fallen more because it is more leveraged.

Put differently, the financial system was more fragile then, and Lehman was clearly more systemically important, because of its interconnections and the information it conveyed about the health of other financial institutions and government/central bank policy towards them. The system is more able to handle a big failure now, and a smaller Glencore is not nearly as salient as Lehman was.

In sum, Glencore vs. Lehman: Smaller. Less leveraged. Less fragile balance sheet. Less interconnected. And crucially, running into difficulties largely by itself, due to its own idiosyncratic issues, in a time of relative health in the financial system, as opposed to being representative of an entire financial system that was acutely distressed.

With so many profound differences, it’s hard to imagine Glencore’s failure would lead to the same consequences as Lehman. It wouldn’t be fun for its creditors, but they would survive, and the damage would largely be contained to them.

So if you need something to keep you up at night, unless you are a Glencore creditor or shareholder, you’ll need to find something else. It ain’t gonna be Lehman, Part Deux. But I guess financial journos need something to write about.

Print Friendly

September 28, 2015

Regulation Confronts Reality In the Commodity Markets. Reality Is Losing.

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Financial crisis,Regulation — The Professor @ 6:36 pm

Following the commodities markets today was like drinking from a fire hose. Many big stories, with “up” and “down” being the operative words. Alcoa split up. Shell announcing that it was giving up on its Arctic plans after its controversial test well failed to find commercially viable reserves. Oil price down around 3 percent, etc.

But the biggest news items were Glencore’s continuing downward spiral, and ESMA’s release of its technical recommendations for application of MiFID to non-financial firms, including commodity firms.

Glencore’s stock was down hard at the open, and at one point was down 31 percent. It’s CDS are now trading up-front (always a bad sign), and the spread widened from an already big 550 bp to 757 bp. At conventional recovery rates, this gives a (risk neutralized) probability of default of better than 50 percent. The Biggest Loser was Glencore’s CEO, Ivan Glasenberg, AKA, Ex-Glencore Billionaire.

The CDS are now trading wider than when Glencore had it s last near-death experience at the height of the financial crisis. Arguably the firm’s situation is worse now. It cannot attribute its woes to stressed financial market conditions generally, in which pretty much everyone saw spreads blow out to one degree or another. This is unique to it and the mining sector. It is a verdict on the firm/sector.

Moreover, in 2008 the firm was private, and Glasenberg and the other owners were able to stanch the bleeding by injecting additional capital into the firm. The ominous thing for Ivan et al now is that they tried that again a couple of weeks ago (along with announcing other measures to reduce debt and conserve cash) and it only bought a temporary respite before the blood started gushing again.

Moreover-and this is crucial-Glencore 2015 is a very different creature than Glencore 2008. It was more of a pure trader then: it is a mining firm with a big trading arm now. This means that its exposure to flat prices (of coal and copper in particular) is much bigger now. In fact, most commodity firms saw little drop off in profits in 2008-2009, and several saw profits increase. The fundamentals facing trading firms in 2008-2009 were not nearly as bad as the fundamentals facing mining firms today. That’s because their flat price exposures weren’t large, and margins and volumes (which drive trading profits) are not as sensitive to macro conditions as flat prices. Given the lack of any prospects for a rebound in flat prices, Glencore’s prospects for a recovery are muted.

Some tout Glasenberg et al’s trading acumen. But it is one thing to be able to sniff out arbs/relative mispricings and structure clever trades to exploit them. (Or to hold one’s nose while doing deals with dodgy regimes around the world.) It is something altogether different to predict where prices are going to go. Glencore made a bet on China, and now that bet is not looking good. At all.

In a nutshell, this is pretty much out of Glencore’s hands. It is along for the ride.

The irony here is that Glasenberg sold the Xstrata merger and the new business model as a way of using the less cyclical profitability of the trading venture as a way of dampening the cyclicality of the mining operation. As it is developing, an extremely adverse cyclical downturn in the mining operation is impairing the viability of the trading operation. How the trading operation can flourish within a financially distressed corporation is an open question. Maybe the company will have to pull an Alcoa, and separate the trading from the mining operations, to keep the latter from dragging down the former.

A key takeaway here relates to the other story I mentioned: ESMA’s release of its recommendations regarding the application of MiFID to non-financials. The objective is to mitigate systemic risk. I was always skeptical that commodity traders posed any such risk (and have been making that argument for 3+ years), and so far the Glencore meltdown is supporting that skepticism. There has been no evidence of spillovers/contagion from Glencore to financial institutions, or to the broader market, a la Lehman.

But ESMA has proposed Technical Standards that would impose the full panoply of CRD-IV capital requirements on commodity traders (and other non-financial firms) that cannot avail themselves of an exemption (on which I will say more momentarily).

  1. If firms cannot make use of an exemption under MiFID II, capital requirements under the new banking regulatory framework will apply to them. This new framework consists of Regulation EU No 575/2013 (CRR) and Directive 2013/36/EU (CRD IV), repealing Directives 2006/48/EC and 2006/49/EC. While CRD IV is addressed to CAs and includes, inter alia, qualitative provisions on the Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP), the new CRR imposes quantitative requirements and disclosure obligations pursuant to Basel III recommendations on credit institutions and investment firms, including own funds definition, minimum own funds requirements and liquidity requirements. However, under Article 498(1) of CRR, some commodity dealers falling within the scope of MiFID are transitionally exempt from the CRR’s provisions on own funds requirements until 31 December 2017 at the latest, if their main business consists exclusively of providing investment services or activities relating to commodity derivatives.
  2. Moreover, firms falling within the scope of MiFID II will be considered to be financial counterparties rather than non-financial counterparties under Article 2(8) of EMIR. Therefore, they will not be able to benefit from the clearing thresholds or the hedging exemption available to the latter under Article 10 of EMIR. An additional consequence of being classified as a financial counterparty will be that the trading obligation (i.e. the obligation to trade derivatives which are subject to the clearing obligation and sufficiently liquid on trading venues only, cf. Article 28 of MiFIR) would apply in full without being subject to a threshold.

So, even if you aren’t a bank, you will be treated like a bank, unless you can get the exemption. Apropos what I said the other day about impoverished carpenters, hammers, nails, etc.

To get an exemption, a firm’s non-hedging derivatives business must fall below a particular threshold amount, e.g., 3 percent of the oil market, 4 percent of the metals market. ESMA recommends that hedges be determined using EMIR criteria. The big problem with this is that only months ago ESMA itself recognized that the EMIR framework is unworkable:

  1. It appears that the complex mechanism introduced by EMIR for the NFC+ [Non-Financial Company Plus] classification has so far led to significant difficulties in the identification, monitoring and, as a consequence, possible supervision of these entities by their competent authorities.
  2. As a result, in the context of the revision of EMIR, ESMA would see some merit in the simplification of the current framework for the determination of NFC+.
  3. One route that the Commission may wish to explore is to move from the current two-step process (Hedging/Non Hedging and clearing threshold) to a one-step process, where counterparties would qualify as NFC+ when their outstanding positions exceeds certain thresholds per asset class, irrespective of the qualification of the trades as hedging or non-hedging. This idea is further developed in Section 4.2 which addresses the way in which NFCs qualify their transactions as hedging and non-hedging.

In other words, ESMA judged that it is impossible for regulators to distinguish firms’ hedging derivatives from its speculative ones. Given these difficulties, just a few months ago ESMA recommended jettisoning the entire mechanism that it now proposes to use to determine whether commodity firms are exempt from MiFID, and the associated capital and clearing requirements.

Makes perfect sense. In some universe.*

At the very least the ESMA plan will impose a huge compliance burden on firms who will have to justify their categorizations of derivatives positions as hedges or no. Given the complexities of risk management (e.g., managing risk on a portfolio basis means that saying what trade is a hedge is difficult, if not impossible, the rapid and frequent adjustments of positions inherent in most trading operations, etc.) this will be a nightmare.

So the good news is: You can get an exemption from capital and clearing requirments! Yay!

The bad news is: The entity proposing the exemption says that the process for getting the exemption is unworkable, and you’ll have not just a compliance headache, but a compliance migraine.

So at the very same time that the financial travails of a big commodity firm cast serious doubt on the systemic riskiness of these firms, European regulators advance regulations intended to fix this (non-existent) problem, and are doing so in a way that they themselves have cast serious doubt on.

Put differently: regulation is confronting reality in the commodity markets at this very moment, and reality is coming off second best.

* It also hardly inspires confidence that ESMA fails basic arithmetic. Note that the threshold in oil is 3 percent, then consider this from its Briefing on Non-Financial Topics: “If a firm’s speculative trading activity is less than 50% of its total trading, it may be MiFID II exempt providing its market share is less than 20% of each threshold in the market share test e.g. 0.8% for metals, 0.3% for oil etc.” Um, last time I checked .2 x 3%=0.6%, not 0.3%.


Print Friendly

September 26, 2015

Capital My Boy, Capital: Or, the Day of the MiFIDs

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,Politics,Regulation — The Professor @ 6:42 pm

As the EU’s Markets in Financial Instruments Directive II (“MiFID II”) slouches towards its destiny in Brussels, one of the last items on the agenda is capital requirements for commodity traders. It appears that the entity responsible for providing technical advice to the European Commission, European Securities and Markets Authority (“ESMA”–my God when it comes to acronyms the US military has nothing on the EU) is like the proverbial poor carpenter who owns only a hammer, so that everything looks like a nail. Or in ESMA’s case, that every firm that intermediates looks like a bank, and must be regulated accordingly, including through capital requirements. Thus, firms that serve as intermediaries in physical commodities are likely to be subject to the same type of capital requirements as firms that engage in financial intermediation, like banks, and be forced to hold a higher proportion of equity in their capital structures than they currently do.

This raises the question: what “market failure” (to use a shorthand that I dislike but which gets at the basic idea) justifies the regulation of the capital structures of firms?

One can make the case for banks and some other financial intermediaries. Banks have fragile capital structures because they engage in liquidity and maturity transformations that make them vulnerable to runs. Runs on a particular institution can impose costs on other institutions, and the resulting financial crises can have devastating effects on the broader economy. The effects on the broader economy occur because financially impaired banks cannot produce their most valuable output, credit, and contractions of credit can cause a broad downturn. Banks don’t internalize these effects, and thus may choose capital structures that are too fragile. Capital requirements can ameliorate this externality.

Commodity trading firms intermediate, but they are totally different than banks. I set out the reasons in detail in this white paper (sponsored by Trafigura*-with bonus video!). A few of the key points. Commodity trading firms (“CTFs”-hey, I can play the acronym game too!) aren’t too big to fail because they aren’t that big, by comparison to banks in particular. More importantly, they don’t have fragile capital structures because although CTFs transform commodities in space, time, and form, they don’t engage in financial transformations in maturity or liquidity like banks do. They aren’t even that highly leveraged, in comparison to European banks in particular. Further, whereas a bank can’t produce its main product (credit) if it is financially distressed, the human and physical assets of a commodity trading firm can continue to transform commodities even if the firm is financially distressed: it can operate under insolvency protection or its assets can be spun off to another firm.

This is not to say commodity trading firms can’t go bust. They can: we might see that in a big way if Glencore’s travails worsen. It is to say the fallout will be limited to their creditors and shareholders, and will not be the catalyst for a financial crisis.

Consequently, there is no justification for regulating the capital structures of these entities. But Europe, in its wisdom, apparently thinks otherwise.

The numbers are big. Based on public data from 2010-2012 for five big European energy companies with trading arms alone, I estimate that the additional equity required is in the vicinity of $120 billion with a “b”. Smaller entities will take smaller hits, but it will add up and probably put the final number in the $150 billion-$200 billion range. Some Swiss entities won’t be hit directly on their main trading businesses, but they have derivatives affiliates in the UK that will be. They might decide that the weather is better elsewhere.

The big driver in the number is the Operational Risk category, which is based off 15 percent of revenues averaged over the last three years. This number is big for commodity traders because they buy and sell a lot, which generates revenues that typically dwarf their incomes (because margins are on the order of 1-2 percent).

Operational risk is a catch-all category that encompasses things other than price and credit risks, such as rogue trader risk (of which there was an example just this week), a systems failure that results in a loss, etc. Yes bigger firms with bigger revenues are likely to have bigger operational losses, but these risks don’t scale with commodity firm revenues.

I have been told that there is whispering in Brussels against these numbers, because they are based on revenues derived when oil was north of $100/bbl. At lower prices, the operational risk charge will be smaller.

Thanks for proving my point, you whisperers! Please speak up, so everyone can hear!

Operational risks are more related to the scale of the physical business (e.g., the number of barrels traded)  which is much more stable than the price of oil. So a revenue-based operational risk charge expands and contracts like an accordion with the price of commodities, but the operational risk that the charge is supposed to absorb doesn’t fluctuate nearly so much. Given the costs of increasing equity, it is likely that firms will hold equity based on high commodity price-based revenues, leading to equity capitalization that is excessive in most environments. (Well, since the regulation generates no meaningful benefits, any requirement is excessive, but it will be extremely excessive given the way it is set up.)

You might say: “Who cares?” After all, in a Modigliani-Miller world, capital structure is irrelevant. Requiring firms to issue more equity and less debt doesn’t impose costs.

Yes. In a Modigliani-Miller world, which, like the Coase world, points out the things that must be true for the irrelevance result to hold. A theoretical world, in other words, not the real world we live in.

Firms care about capital structure because in a world with economic frictions capital structure can generate or destroy value. Imposing a capital structure that firms would not freely choose therefore imposes costs.

Firms affected by the new regs will adjust on many margins. Some will decamp from Europe, for other locales like Singapore. Others who cannot be so footloose will restructure their businesses to mitigate the impact. For instance, they might try to restructure to ring fence the trading activities that are subject to MiFID. Their ability to do so will depend on whether the Commission makes physical forwards subject to the regulation. Again, since these firms did not choose these locations or structures in the absence of the regulation, these changes will involve an increase in cost and a destruction in value, with no corresponding benefit that offsets this cost even  in part.

Privately held firms may face the biggest conundrum. There is a good reason for private ownership: it aligns the incentives of owners and managers because the managers are the owners. This is a more feasible option for commodity firms than large entities in other industries because commodity price risks can be laid off to the broader financial market using derivatives hedges. The downside of private ownership is that it limits access to public capital markets for equity funding. Clever financing policies (e.g., the issuance of very long term debt that provides long term funding without a loss of control) can finesse this problem, but requiring a big boost in equity would likely force firms either to contract their balance sheets and reduce their size (again, creating an economic cost because these firms will be artificially small), or go public, and incur increased agency costs (because of a poorer alignment of incentives).

In brief, application of bank-like capital requirements on commodity traders would be all pain, no gain. The efficiency of commodity intermediation would decline. This will harm producers (who get lower prices) and consumers (who pay higher prices) because middlemen’s margins must rise to cover the higher costs caused by the burdensome regulation of their capital structures. This will not be offset by any reduction in systemic risk.

There’s an early post-WWII SciFi novel titled Day of the Triffids, in which a plague of blindness leads to the rise of an aggressive species of plant. Well, MiFID rhymes with triffid, and Day of the MiFID would be a candidate for a sequel. Why? Because blindness about the realities of commodity trading is allowing an aggressive variety of plant (Brussels bureaucrats-believe me, the metaphor fits!) to wreak havoc on the poor folk who trade, produce, and consume commodities.

Well played, Europe! Well played!

* For those whose intellect cannot conceive of any other reason than personal gain to explain an individual’s opinion, do remember that I arrived at most of the conclusions contained in the white paper when I was retained to analyze the systemic risk of commodity traders by a bank trade association that very much wanted me to conclude the opposite, and who therefore spiked the study. But the truth gets out eventually.

Print Friendly

September 9, 2015

The Future of Chinese Futures

Filed under: China,Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 8:19 pm

China has created some amazingly successful futures markets in recent years. By contract volume, the top 5 ag futures are traded in Zhengzhou, Dalian, or Shanghai, as are 4 out of the top 5 metals contracts. Once upon a time, China also had the most heavily traded equity futures contracts. Once upon a time, like two months ago.

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.

The stock market (led, as is usually the case, by index futures) was bearing bad news, so the Chinese decided to shoot the messenger. Then back over it a few times with a tank and bury it in cement. Just to make sure.

There is a wider lesson here. Namely, China may talk the reform talk, but doesn’t walk the reform walk. It likes one way bets:  markets when they are rising, not when they are falling. And not just the futures markets have been told to get their minds right. Chinese authorities-and by authorities, I mean security services-have told fund managers not to sell, only buy. A market with Chinese characteristics, apparently: all buyers and no sellers. Kind of zen actually, in the spirit of “what is the sound of one hand clapping?”

This urge to exercise ham-fisted control is exactly the kind of thing that will impede China’s development going forward. It will undermine the ability of capital markets to do their jobs of incentivizing the accumulation of capital and directing it to the highest value uses.

China’s predilection for control has manifested itself in futures markets in other ways. You might recall some months ago that I wrote about China’s threats against Singapore and ICE if the American exchange offered lookalike contracts on ZCE cotton and sugar at its new Singapore affiliate. Yesterday ICE announced the contracts it will launch in Singapore, and cotton and sugar lookalikes were conspicuous by their absence.

No competition for us, thank you. We’re Chinese.

This protectionism may help ensure the success of China’s new futures market initiative: an oil futures contract. Protectionism and pricing in yuan and constraints on the ability of mainland firms to trade overseas make it likely that the contract will succeed. The Chinese are overoptimistic, however, if they believe this contract will supplant WTI and/or Brent. LME and COMEX copper, and ICE cotton and sugar, to give some examples, have thrived even as Chinese markets in these commodities grew. Moreover, myriad restrictions on the ability of foreigners to trade in China and the currency issue will make the Shanghai contract impractical as a hedging and speculative vehicle for non-Chinese firms and funds: the main non-Chinese trading will likely be arbitrage plays between Shanghai, CME/NYMEX and ICE, which will ironically serve to boost to the US exchanges’ volumes.

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. I 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.


Print Friendly

Next Page »

Powered by WordPress