Streetwise Professor

January 4, 2017

The Rosneft Deal: One Step Closer to Reality

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

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

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

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

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

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

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

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

 

 

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December 30, 2016

For Whom the (Trading) Bell Tolls

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

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

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

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

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

It will always be so, regardless of the technology.

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

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

 

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December 16, 2016

Clearinghouse Resilience and Liquidity Black Holes

Filed under: Clearing,Commodities,Derivatives,Economics,Politics,Regulation — The Professor @ 5:11 pm

About six weeks ago I wrote a post on the strains put on clearing by Brexit. This informative post by Clarus’ Tod Skarecky provides some very interesting detail about the mechanics of the LCH’s margining mechanism.

One way to summarize it is to say that the LCH was a liquidity black hole. Not only did it collect intra-day and end-of-day variation margin from losers that was paid out to winners only with a delay, it also collected Market Data Runs, which were effectively intra-day initial margin top-ups. A couple of perverse features. First, a position that initially had a loss that triggered an MDR outflow had to pay out, but if the market turned in its favor intra-day, it didn’t get that money back until the following day. Second, a firm that had a loss that triggered an MDR outflow had to pay out, and if the position incurred a loss on the day, it still had to pay variation margin, and didn’t receive the MDR back until the next day: that is, there was”double dipping.”

Tod puts his figure on the logic (crucially, the logic from LCH’s perspective): “Heck if I managed credit risk at a firm, I’d always choose to be paid now rather than later.” Definitely. That minimizes credit risk. But look at how much liquidity was sucked up in order to do this.

Variation margin is bad enough: despite the (laughable) claim of the BIS some years back, the fact that variation margin is recycled does not mean that it does not create liquidity strains. After all, (a) liquidity demand arises due in large part to differences in timing between the receipt of cash and the payment thereof, and the clearing mechanism (in which the CCP pays out VM some hours after it receives VM) creates such timing differences, and (b) even absent payment timing differences, the VM receivers would have to lend to the VM payers, which is problematic especially during stressed market conditions. But the LCH IM top up exacerbates the problem because the cash is stuck in the clearinghouse overnight, and therefore cannot possibly be recirculated. More liquidity becomes less accessible.

Again, this is understandable from LCH’s microprudential perspective: it reduces the likelihood that it will become insolvent or illiquid. But just because this is sensible from a microprudential perspective does not mean it is macroprudentially sensible. In fact, it is anything but sensible: it greatly adds to liquidity demand, particularly during periods of time when liquidity is likely to be scarce, and when liquidity freezes are a serious risk.

This is a perfect example of the “levee effect” I’ve written about for years: raising the levee around the LCH increases the chances of its survival, but just redirects the stresses to elsewhere in the system.

Note the irony here. Clearing mandates were sold on the idea that there were pervasive externalities in uncleared derivatives markets, due primarily to the potential for default cascades in these markets. But clearing (supersized by mandates, in particular) creates externalities too. Here LCH does things that are in its interest, but which impose costs on others. It has a contractual relationship with some of these (FCMs), so there is some potential that externalities involving these parties can be mitigated through negotiation and changing contracts. But there are myriad parties not in privity of contract with LCH, and which LCH may not even know of, who are impacted, perhaps severely, by a liquidity shock exacerbated by LCH’s self-preserving actions.

In other words, clearing mandates don’t internalize all externalities. They create them too. And given the severe dangers of liquidity crises, the liquidity externality that clearing creates is particularly troubling.

Outgoing CFTC Chairman Timothy Massad says, don’t worry, be happy!:

Brexit’s Impact on Clearing Activity

Let’s first look at the impact on clearing activity. It’s important to remember first that clearinghouses mark all products to market every day, and require that participants with market losses post margin every day, sometimes more than once a day. Margin payments must be paid promptly because for every payment made to the clearinghouse, the clearinghouse must make a payment to another participant who has gains. The clearinghouse always has a balanced or “matched” book.

Even though margins were increased in advance of the vote, the volatility resulted in very large margin calls on June 24.

Clearing members paid $27 billion dollars in variation margin across the five largest clearinghouses registered with the CFTC. This was $22 billion dollars greater than the previous 12-month average—over five times larger. The good news is no one missed a payment, no one defaulted.

Supervisory Stress Tests

The results after Brexit confirmed what we recently found in our own internal testing: resilience in the face of stressful conditions. Last month, CFTC staff released a report detailing the results of a series of stress tests we performed on the five largest clearinghouses under our jurisdiction, which are located in the U.S. and the UK. Our tests assessed the impact of stressful market scenarios across these clearinghouses as well as their clearing members, many of whom are affiliates of the world’s largest banks.

We developed a set of 11 extreme but plausible scenarios based on a number of factors, including historical price changes on dates when there was extreme volatility. By comparison, our assumed price shocks were several times larger than what happened after Brexit. We applied these scenarios to actual positions as of a specific date. And we looked at whether the pre-funded resources held by the clearinghouse—in particular, the initial margin and guaranty fund amounts paid by clearing members as well as the clearinghouse’s capital—were sufficient to cover any losses.

Still not getting it. The discussion of stress tests essentially repeats the same mantra as LCH: it is a decidedly microprudential treatment that focuses on credit risk, not liquidity risk. The discussion of margins is perfunctory, despite the fact that this is what gave market participants serious worries on Brexit Day. No discussion of what extraordinary efforts were required to ensure that all payments were made. No discussion of whether this would have been possible during a bigger–and unanticipated–price shock. No discussion of the liquidity externalities. No discussion of what would happen if operational difficulties (e.g., a technology problem in the payments system like the failure of FedWire on 10/19/87) interfered with the completion of payments. (More payments increases the likelihood that such an operational failure will jeopardize the ability of FCMs to complete them. And a failure to meet a call triggers a default.)

This “what? Me worry?” approach sounds so . . . 2006. And it is exactly this kind of complacency that makes me worry. The nature of the liquidity issue still has not penetrated many regulatory skulls.

This is most likely due to a severe case of target fixation. Clearing mandates were motivated by a desire to reduce credit risk, and all efforts have been focused on that. That is the target that regulators are fixated on, and in the pursuit of that target their field of vision has narrowed, with liquidity risk being largely outside it. It is obviously the target that CCPs are focused on. This is why I take little comfort in the belated efforts to make CCPs more resilient. The recipe for resilience is to demand MOAR LIQUIDITY. Which is also the recipe for a broader market crisis.

Analogous to the dangers of high powered incentives with multi-tasking when some activities can be measured more accurately than others, the mandate to reduce derivatives credit risk has led regulators and market participants–particularly market utilities like CCPs–to devote excessive effort to mitigating credit risk, even though it exacerbates liquidity risk.

I doubt the clearing portions of Title VII of Frankendodd will be eliminated altogether, but the incoming administration should seriously consider a major re-evaluation to determine how to address the serious liquidity issues that clearing mandates create.

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December 10, 2016

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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December 7, 2016

Ivan Glasenberg’s Shock and Awe: But There Has to Be More Than Meets the Eye

Filed under: Commodities,Derivatives,Economics,Energy,Russia — The Professor @ 8:25 pm

Today saw a major surprise. I mean a major surprise. The Russian government announced that a consortium consisting of Glencore and the Qatar Investment Authority had purchased a 19.5 percent stake in Rosneft for €10.5 billion. (Glencore said the price was €10.2 billion.)

The major surprise was that outside investors were involved at all at this time. For weeks the story had been that Rosneft itself would buy back the shares from the Rosneftgaz holding company, and then sell them to a private investor at a later date. This looked like a sham privatization, which fit in with the idea that Igor Sechin was less than enamored with the idea of selling equity to outsiders.

Also a surprise was Glencore’s participation. Qatar’s name had been floated as a possible buyer, but not Glencore’s. And no wonder. The firm is just recovering from a near death experience, has been feverishly de-leveraging, and only a few days ago announced it would pay $1 billion in dividends next year. So it hardly looked like a firm that would have the cash to pay out of pocket, and was not a candidate to borrow a lot.

But it appears there is some financial engineering going on here. A Glencore-QIA joint venture will buy the Rosneft shares, and the two investors will put up a mere €300 million each in equity. The remainder will be financed (according to Putin) by one of “the largest European banks.” Furthermore, the debt is supposedly non-recourse to Glencore or QIA. This means that the loan is essentially secured by the Rosneft shares.

This would allow Glencore to keep the debt off its balance sheet, and skirt sanctions by not having an equity stake in Rosneft.

If those numbers are right, the deal will be leveraged 17.5-to-1. That reminds me of a real estate boom SPV–except that the underlying asset here is even riskier than subprime. Given the riskiness of the underlying asset (Rosneft shares) that gearing seems unsustainable to me. What bank would take that risk?: the bank owns all the downside, and the JV partners get all the upside.

You can bet that any bank wouldn’t let you buy Rosneft shares on that geared a margin loan–and a non-recourse one no less. So I am guessing that there is some other part of the deal that passes the equity price risk back to Glencore and QIA. For instance, a total return swap between the JV and its owners. Or a put (which would make it unnecessary for the JV to make payments to the investors in the event Rosneft stock rises in value, as would be the case in a TRS.) If that, or something like it, is going on here, this is a cute way to keep investment off Glencore’s balance sheet, and also may be a way to work around sanctions, because derivatives on Rosneft debt (e.g., CDS) and equity are not subject to the sanctions. I cannot believe that any bank would lend so heavily based only on the security of Rosneft stock. So there must be a part of the deal that hasn’t been disclosed yet. (This may also involve an arrangement between Qatar and Glencore that limits the latter’s exposure.) There is more here than meets the eye, at least from the initial reporting.

Speaking of sanctions, the fact that a European bank (who?–reportedly Intesa Sanpaolo) is stepping up suggests that they believe the structure is sanctions-proof. This may also be a Trump effect: banks may have less concern about aggressive sanctions interpretation and enforcement in a Trump administration.

If it is Intesa Sanpaolo–that’s also rather interesting. Italian banks aren’t exactly in great shape these days, and are particularly shaky in the aftermath of the rejection of the referendum on Sunday. It is one of Italy’s healthier banks, but like saying someone is one of the healthier patients in the oncology ward. (Its equity is about 7 percent of assets.) Normally a loan of this size would be syndicated to spread the risk. If it isn’t, the loan represents more than 20 percent of Intesa’s equity and almost a quarter of its market cap. That’s insane.

All the more reasons to think that the bank has to find a way to lay off the price risk in the deal. (All the ways I can think of would expose it to the credit risk of Glencore and QIA. The latter isn’t an issue . . . the former could be. All the more reason to consider the possibility of QIA providing some credit support in the deal even if it is formally non-recourse.)

Another interesting aspect to the deal. Trafigura has been an important bulwark for Rosneft in the last two plus years. It dramatically stepped up its pre-pay deals with Rosneft, thereby providing vital (though very short-term sanctions compliant) funding when the Russian company was cut off from the capital markets. Moreover, Trafigura’s participation was a linchpin in Rosneft’s acquisition of Indian refiner Essar. As a result of these deals, Trafigura had nudged out Glencore as Rosneft’s biggest Russian partner. Now Glencore owns a major equity stake, and as part of the deal gets a 220,000 barrel-per-day off-take agreement with Rosneft. This gives Glencore 11.5 million tons/year of oil. Trafigura has been doing about 20 million tons of crude and 20 million tons of product from Rosneft. (Glencore also has off-take volume stemming from a 2013 pre-pay deal.)

Perhaps Trafigura did not have an appetite or capacity for doing much more volume with Rosneft, but it must be disconcerting to see Glencore take such a large equity stake. That undoubtedly has implications for Rosneft’s future dealings.

This transaction says a lot about Ivan Glasenberg. Given the experience of the last two years, one could have understood if he had been risk averse. This shows that his legendary appetite for risk remains. (And the more of the equity risk that is passed back to Glencore through financial engineering, the bigger that appetite will be shown to be.) This was shock and awe.

This deal is a boon for Russia and Putin, who can really use the money, and outside money especially. I wonder if Sechin is all that pleased, though. As noted earlier, he has been dragging his feet on privatization. Earlier this year a Rosneft analysis said the company would only be able to raise $1-$2 billion: obviously this was intended to convince Putin that a privatization would be a giveaway that he should take a pass on. But I’m sticking with my earlier guess that going through with the privatization was the quid pro quo for Putin allowing Rosneft to buy Bashneft. And again, Vlad really needs the money.

One last thing to put this all in perspective. Yes, €10 billion seems like a lot, but that values Rosneft at around $55 billion. The company’s reserves are about 34.5 billion barrels of oil equivalent (BOE). Its output is around 1.75 billion BOE per annum. For comparison, ExxonMobil is worth ~$350 billion. Its reserves are a third smaller than Rosneft’s: 24.8b BOE. Its output of 1.43 billion BOEPA is about 80 percent of Rosneft’s. So on a dollars per unit of reserves or output basis, XOM is about 8-9 times as valuable as Rosneft. That speaks volumes about Rosneft’s inefficiency, and the political risks that go along with the normal commercial risks inherent in an oil company. Keep that in mind when evaluating Putinism.

 

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November 8, 2016

WTI Gains on Brent: You Read It Here First!

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 8:22 pm

Streetwiseprofessor, August 2011:

WTI’s problems arise from the consequences of too much supply at the delivery point, which is a good problem for a contract to have.  The price signals are leading to the kind of response that will eliminate the supply overhang, leaving the WTI contract with prices that are highly interconnected with those of seaborne crude, and with enough deliverable supply to mitigate the potential for squeezes and other technical disruptions.

. . . .

Which means that those who are crowing about Brent today, and heaping scorn on WTI, will be begging for WTI’s problems in a few years.  For by then, WTI’s issues will be fixed, and it will be sitting astride a robust flow of oil tightly interconnected with the nexus of world oil trading.

Bloomberg, November 2016:

In the battle for supremacy between the world’s two largest oil exchanges, one of them is enjoying a turbo charge from the U.S. government.

Traders bought and sold an average of almost 1.1 billion barrels of West Texas Intermediate crude futures each day in 2016, a surge of 35 percent from a year earlier. The scale of the gain was partly because of the U.S. government lifting decades-old export limits last year, pushing barrels all over the world, according to CME Group Inc., whose Nymex exchange handles the contracts. By comparison, ICE Futures Europe’s Brent contract climbed by 13 percent.

WTI and Brent have been the oil industry’s two main futures contracts for decades. In the past, the American grade’s global popularity was restrained by the fact that exports were heavily restricted. Now, record U.S. shipments are heading overseas, meaning WTI’s appeal as a hedging instrument is rising, particularly in Asia, where CME has expanded its footprint.

“You have turbo-charged WTI as a truly waterborne global benchmark,” Derek Sammann global head of commodities and options products at CME Group, said in a phone interview regarding the lifting of the ban. “You’re seeing the global market reach out and use WTI — whether that’s traders in Europe, Asia and the U.S.”

This should surprise no one–but the conventional wisdom had largely written off WTI in 2011. Given that economic price signals were providing a strong incentive to invest in infrastructure to ease the bottleneck between the Midcon and the sea, it was inevitable that WTI would become reconnected with the waterborne market.

Once the physical bottleneck was eased, the only remaining bottleneck was the export ban. But whereas the export ban was costless prior to the shale boom (because it banned something that wasn’t happening anyways), it became very costly when US supply (especially of light, sweet crude) ballooned. As Peltzman, Becker and others pointed out long ago, politicians do take deadweight costs into account. In a situation like the US oil market, which pitted two large and concentrated interests (upstream producers and refiners) against one another, reducing deadweight costs probably made the difference (as the distributive politics were basically a push).  Thus, the export ban went the way of the dodo, and the tie between WTI and the seaborne market became all that much tighter.

This all means that it’s not quite right to say that CME’s WTI contract has been “turbocharged by the federal government.” Shale it what has turbocharged everything. The US government just accommodated policy to a new economic reality. It was along for the ride, as are CME and ICE.

ICE’s response was kind of amusing:

“ICE Brent Crude remains the leading global benchmark for oil,” the exchange said in an e-mailed response to questions. “With up to two-thirds of the world’s oil priced off the Brent complex, the Brent crude futures contract is a key hedging mechanism for oil market participants.”

Whatever it takes to get them through the day, I guess. Reading that brought to mind statements that LIFFE made about the loss of market share to Eurex in early-1998.

The fact is that there is hysteresis in the choice of the pricing benchmark. As exiting contracts mature and new contracts are entered, market participants will have an opportunity to revisit their choice of pricing benchmark. With the high volume and liquidity of WTI, and the increasingly tight connection between WTI and world oil flows, more participants will shift to WTI pricing.

Further, as I noted in the 2011 post (and several that preceded it) Brent’s structural problems are far more severe. Brent production is declining, and this decline will likely accelerate in a persistent low oil price environment: not only has shale boosted North American supply, it has contributed to the decline in North Sea supply. Brent’s pricing mechanism is already extremely baroque, and will only become more so as Platts scrambles to find more imaginative ways to tie the contract to new supply sources. It is not hard to imagine that in the medium term Brent will be Brent in name only.

Since WTI will likely rest on a strong and perhaps increasing supply base, Brent’s physical underpinning will become progressively shakier, and more Rube Goldberg-like. These different physical market trajectories will benefit WTI derivatives relative to Brent, and will also induce a shift towards using WTI as a benchmark in physical trades. Meaning that ICE is whistling past the graveyard. Or maybe they are just taking Satchel Paige’s advice: “Don’t look back. Something might be gaining on you.” And in ICE Brent’s case, that’s definitely true, and the gap is closing quickly.

 

 

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October 31, 2016

A Brexit Horror Story That Demonstrates the Dangers of Clearing Mandates

Filed under: Clearing,Derivatives,Economics,Regulation — The Professor @ 12:43 pm

When I give my class on the systemic risks of clearing, I usually joke that I should give the lecture by a campfire, with a flashlight held under my chin. It is therefore appropriate that on this Halloween Risk published Peter Madigan’s take on the effects of Brexiton derivatives clearing: it is a horror story.

Since the clearing mandate was a gleam in Barney Frank’s eye (yes, a scary mental image–so it fits in the theme of the post!) I have warned that the most frightening thing about clearing and clearing mandates is that they transform credit risk into liquidity risk, and that liquidity risk is more systemically threatening than credit risk. This view was born of experience, slightly before Halloween in 1987, when I witnessed the near death experience that the CME clearinghouse, BOTCC, and OCC faced on Black Monday and the following Tuesday. The huge variation margin calls put a tremendous strain on liquidity, and operational issues (notably the shutdown of the FedWire) and the reluctance of banks to extend credit to FCMs and customers needing to meet margin calls came perilously close to causing the CCPs to fail.

The exchange CCPs were pipsqueaks by comparison to what we have today. The clearing mandates have supersized the clearing system, and commensurately increased the amount of liquidity needed to meet margin calls. The experience in the aftermath of the surprise Brexit vote illustrates just how dangerous this is.

As a result of Brexit, US Treasuries rallied by 32bp. The accompanying move in swap yields resulted in huge intra-day margin calls by multiple CCPs (LCH, CME, and Eurex). Madigan estimates that these calls totaled $25-$40 billion, and that some individual banks were asked to pony up multiple billions to meet margin calls from multiple CCPs. And to illustrate another thing I’ve been on about for years, they had to come up with the money in 60 minutes: failure to do so would have resulted in default. This provides a harrowing example of how tightly coupled the system is.

Some other crucial details. Much of the additional margin was to top up initial margin, meaning that the cash was sucked into the CCPs and kept there, rather than paid out to the net gainers, where it could have been recirculated. (Not that recirculating it would have been a panacea. Timing differences between flows of VM into and out of CCPs creates a need for liquidity. Moreover, recirculation by extension of credit is often problematic during periods of market stress, as that’s exactly when those who have liquidity are most likely to hoard it.)

Second, each CCP acted independently and called margin to protect its own interests. With multiple CCPs, there is a non-cooperative game between them. Each has an incentive to demand margin to protect itself, and to demand it before other CCPs do. The equilibrium in this game is inefficient because there is an externality between CCPs, and between CCPs and those who must meet the calls. This is ironic, because one of the alleged justifications for clearing mandates was the externalities present in the OTC derivatives markets. This is another example of how problems have been transformed, rather than truly banished.

This also illustrates another danger that I’ve pointed out for some time: building the levies high around CCPs just forces the floodwaters somewhere else.

Although there were some fraught moments for the banks who needed to stump up the cash on June 24, there were no defaults. But consider this. As I point out in the Risk article, Brexit was a known event and a known risk, and the banks had planned for it. Events like the October ’87 Crash or the September ’98 LTCM crisis are bolts from the blue. How will the system endure a surprise shock–especially one that could well be far larger than the Brexit move?

Horror stories are sometimes harmless ways to communicate real risks. Perhaps the Brexit event will be educational. Churchill once said that “Nothing in life is so exhilarating as to be shot at without result.” The market dodged a bullet on June 24. Will market participants, and crucially regulators, take heed of the lessons of Brexit and take measures to ensure that the next time it isn’t a head shot?

I have my doubts. The clearing mandate is a reality, and is almost certain to remain one. The fundamental transformation of clearing (from credit risk to liquidity risk) is an inherent part of the mechanism. It’s effects can be at most ameliorated, and perhaps the Brexit tremor will provide some guidance on how to do that. But I doubt that whatever is done will make the system able to survive The Big One.

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October 26, 2016

China Has Been Glencore’s Best Friend, But What China Giveth, China Can Taketh Away

Filed under: China,Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 3:55 pm

Back when Glencore was in extremis last year, I noted that although the company could do some things on its own (e.g., sell assets, cut dividends, reduce debt) to address its problems, its fate was largely out of its hands. Further, its fate was contingent on what happened to commodity prices–coal and copper in particular–and those prices would depend first and foremost on China, and hence on Chinese policy and politics.

Those prognostications have proven largely correct. The company executed a good turnaround plan, but it has received a huge assist from China. China’s heavy-handed intervention to cut thermal and coking coal output has led to a dramatic spike in coal prices. Whereas the steady decline in those prices had weighed heavily on Glencore’s fortunes in 2014 and 2015, the rapid rise in those prices in 2016 has largely retrieved those fortunes. Thermal coal prices are up almost 100 percent since mid-year, and coking coal has risen 240 percent from its lows.

As a result, Glencore was just able to secure almost $100/ton for a thermal coal contract with a major Japanese buyer–up 50 percent from last year’s contract. It is anticipated that this is a harbinger for other major sales contracts.

The company will not capture the entire rally in prices, because it had hedged about 50 percent of its output for 2016. But that means 50 percent wasn’t hedged, and the price rise on those unhedged tons will provide a substantial profit for the company. (This dependence of the company on flat prices indicates that it is not so much a trader anymore, as an upstream producer married to a big trading operation.) (Given that hedges are presumably marked-to-market and collateralized, and hence require Glencore to make cash payments on its derivatives at the time prices rise, I wonder if the rally has created any cash flow issues due to mismatches in cash flows between physical coal sales and derivatives held as hedges.)

So Chinese policy has been Glencore’s best friend so far in 2016. But don’t get too excited. Now the Chinese are concerned that they might have overdone things. The government has just called an emergency meeting with 20 major coal producers to figure out how to raise output in order to lower prices:

China’s state planner has called another last-minute meeting to discuss with more than 20 coal mines more steps to boost supplies to electric utilities and tame a rally in thermal coal prices, according to two sources and local press.

The National Development and Reform Commission (NDRC) has convened a meeting with 22 coal miners for Tuesday to discuss ways to guarantee supply during the winter while sticking to the government’s long-term goal of removing excess inefficient capacity, according to a document inviting companies to the meeting seen by Reuters.

What China giveth, China might taketh away.

All this policy to-and-fro has, of course is leading to speculation about Chinese government policy. This contributes to considerable price volatility, a classic example of policy-induced volatility, which is far more common that policies that reduce volatility.

Presumably this uncertainty will induce Glencore to try to lock in more customers (which is a form of hedging). It might also increase its paper hedging, because a policy U-turn in China (about which your guess and Glencore’s guess are as good as mine) is always a possibility, and could send prices plunging again.

So when I said last year that Glencore was hostage to coal prices, and hence to Chinese government policy–well, here’s the proof. It’s worked in the company’s favor so far, but given the competing interests (electricity generators, steel firms, banks, etc.) affected by commodity prices, a major policy adjustment is a real possibility. Glencore–and other major commodity producers, especially in coal and ferrous metals–remain hostages to Chinese policy and hence Chinese politics.

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October 12, 2016

A Pitch Perfect Illustration of Blockchain Hype

Filed under: Clearing,Commodities,Derivatives,Economics,Regulation — The Professor @ 7:31 pm

If you’ve been paying the slightest attention to financial markets lately, you’ll know that blockchain is The New Big Thing. Entrepreneurs and incumbent financial behemoths alike are claiming it will transform every aspect of financial markets.

The techno-utopianism makes me extremely skeptical. I will lay out the broader case for my skepticism in a forthcoming post. For now, I will discuss a specific example that illustrates odd combination of cluelessness and hype that characterizes many blockchain initiatives.

Titled “Blockchain startup aims to replace clearinghouses,” the article breathlessly states:

Founded by two former traders at Societe Generale, SynSwap is a post-trade start-up based on hyperledger technology designed to disintermediate central counterparties (CCPs) from the clearing process, effectively removing their role in key areas.

“For now we are focusing on interest rate swaps and credit default swaps, and will further develop the platform for other asset classes,” says Sophia Grami, co-founder of SynSwap.

Grami explains that once a trade is captured, SynSwap automatically processes the whole post-trade workflow on its blockchain platform. Through smart contracts, it can perform key post-trade functions such as matching and affirmation, generation of the confirmation, netting, collateral management, compression, default management and settlement.

“CCPs have been created to reduce systemic risk and remove counterparty risk through central clearing. While clearing is key to mitigate risks, the blockchain technology allows us to disintermediate CCPs while providing the same risk mitigation techniques,” Grami adds.

“Central clearing is turned into distributed clearing. There is no central counterparty anymore and no entity is in the middle of a trade anymore.”

The potential disruptive force blockchain technology could have for derivatives clearing could bring back banks that have pulled away from the business due to heightened regulatory costs.

I have often noted that CCPs offer a bundle of many services, and it is possible to considering unbundling some of them. But there are certain core functions of CCP clearing that this blockchain proposal does not offer. Most importantly, CCPs mutualize default risk: this is truly one of the core features of a CCP. This proposal does not, meaning that it provides a fundamentally different service than a CCP. Further, CCPs hedge and manage defaulted positions and port customer positions from a defaulted intermediary to a solvent one: this proposal does not. CCPs also manage liquidity risk. For instance, a defaulter’s collateral may not be immediately convertible into cash to pay winning counterparties, but the CCP maintains liquidity reserves and lines that it can use to intermediate liquidity in these circumstances. The proposal does not. The proposal mentions netting, but I seriously doubt that the blockchain–hyperledger, excuse me–can perform multilateral netting like a CCP.

There are other issues. Who sets the margin levels? Who sets the daily (or intraday) marks which determine variation margin flows and margin calls to top up IM? CCPs do that. Who does it for the hyper ledger?

So the proposal does some of the same things as a CCP, but not all of them, and in fact omits the most important bits that make central clearing central clearing. To the extent that these other CCP services add value–or regulation compels market participants to utilize a CCP that offers these services–market participants will choose to use a CCP, rather than this service. It is not a perfect substitute for central clearing, and will not disintermediate central clearing in cases where the services it does not offer and the functions it does not perform are demanded by market participants, or by regulators.

The co-founder says “[c]entral clearing is turned into distributed clearing.” Er, “distributed clearing”–AKA “bilateral OTC market.” What is being proposed here is not something really new: it is an application of a new technology to a very old, and very common, way of transacting. And by its nature, such a distributed, bilateral system cannot perform some functions that inherently require multilateral cooperation and centralization.

This illustrates one of my general gripes about blockchain hype: blockchain evangelists often claim to offer something new and revolutionary but what they actually describe often involves re-inventing the wheel. Maybe this wheel has advantages over existing wheels, but it’s still a wheel.

Furthermore, I would point out that this wheel may have some serious disadvantages as compared to existing wheels, namely, the bilateral OTC market as we know it. In some respects, it introduces one of the most dangerous features of central clearing into the bilateral market. (H/T Izabella Kaminska for pointing this out.) Specifically, as I’ve been going on about for about 8 years now, the rigid variation margining mechanism inherent in central clearing creates a tight coupling that can lead to catastrophic failure. Operational or financial delays that prevent timely payment of variation margin can force the CCP into default, or force it or its members to take extraordinary measures to access liquidity during times when liquidity is tight. Everything in a cleared system has to perform like clockwork, or an entire CCP can fail. Even slight delays in receiving payments during periods of market stress (when large variation margin flows occur) can bring down a CCP.

In contrast, there is more play in traditional bilateral contracting. It is not nearly so tightly coupled. One party not making a margin call at the precise time does not threaten to bring down the entire system. Furthermore, in the bilateral world, the “FU Option” is often quite systemically stabilizing. During the lead up to the crisis, arguments over marks could stretch on for days and sometimes weeks, giving some breathing room to stump up the cash to meet margin calls, and to negotiate down the size of the calls.

The “smart contracts” aspect of the blockchain proposal jettisons that. Everything is written in the code, the code is the last word, and will be self-executing. This will almost certainly create tight coupling: The Market has moved by X; contract says that means party A has to pay Party B Y by 0800 tomorrow or A is in default. (One could imagine writing really, really smart contracts that embed various conditions that mimic the flexibility and play in face-to-face bilateral markets, but color me skeptical–and this conditionality will create other issues, as I’ll discuss in the future post.)

When I think of these “smart contracts” one image that comes to mind is the magic broomsticks in The Sorcerer’s Apprentice. They do EXACTLY what they are commanded to do by the apprentice (coder?): they tote water, and end up toting so much water that a flood ensues. There is no feedback mechanism to get them to stop when the water gets too high. Again, perhaps it is possible to create really, really smart contracts that embed such feedback mechanisms.

But then one has to consider the potential interactions among a dense network of such really, really smart contracts. How do the feedbacks feed back on one another? Simple agent models show that agents operating subject to pre-programmed rules can generate complex, emergent orders when they interact. Sometimes these orders can be quite efficient. Sometimes they can crash and collapse.

In sum, the proposal for “distributed clearing to disintermediate CCPs” illustrates some of the defects of the blockchain movement. It overhypes what it does. It claims to be something new, when really it is a somewhat new way of doing something quite common. It does not necessarily perform these familiar functions better. It does not consider the systemic implications of what it does.

So why is there so much hype? Well, why was Pets.com a thing? More seriously, I think that there is an interesting sociological dynamic here. All the cool kids are talking about blockchain, and nobody wants to admit to not being cool. Further, when a critical mass of supposed thought leaders are doing something, others imitate for fear of being left behind: if you join and it turns out to be flop, well, you don’t stand out–everybody, including the smartest people, screwed up. You’re in good company! But if you don’t join and it becomes a hit, you look like a Luddite idiot and get left behind. So there is a bias towards joining the fad/jumping on the bandwagon.

I think there will be a role for blockchain. But I also believe that it will not be nearly as revolutionary as its most ardent proponents claim. And I am damn certain that it is not going to disintermediate central clearing, both because central clearing does some things “decentralized clearing” doesn’t (duh!), and because regulators like those things and are forcing their use.

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October 6, 2016

War Communism Meets Central Clearing

Filed under: Clearing,Derivatives,Economics,Politics,Regulation — The Professor @ 1:58 pm

I believe that I am on firm ground saying that I was one of the first to warn of the systemic risks created by the mandating of central clearing on a vast scale, and that CCPs could become the next Too Big to Fail entities. At ISDA events in 2011, moreover, I stated publicly that it was disturbing that the move to mandates was occurring before plans to recover or resolve insolvent clearinghouses were in place. At one of these events, in London, then-CEO of LCH Michael Davie said that it was important to ensure to have plans in place to deal with CCPs in wartime (meaning during crises) as well as in peace.

Well, we are five years on, and well after mandates have been in effect, those resolution and recovery authorities are moving glacially towards implementation. Several outlets report that the European Commission is finalizing legislation on CCP recovery. As Phil Stafford at the FT writes:

The burden of losses could fall on the clearing house or its parent company, its member banks; the banks’ customers, such as pension funds, or the taxpayer.

Brussels is proposing that clearing house members, such as banks, be required to participate in a cash call if the clearing house has exhausted its so-called “waterfall” of default procedures.

The participants would take a share in the clearing house in return, according to drafts seen by the Financial Times.

Authorities would also have the power to reduce the value of payments to the clearing house members, the draft says. In the event of a systemic crisis, regulators could use government money as long as doing so complies with EU rules on state aid.

Powers available to regulators would include tearing up derivatives contracts and applying a “haircut” to the margin or collateral that has been pledged by the clearing house’s end users.

Asset managers have long feared that haircutting margin would be tantamount to expropriating assets that belong to customers.

The draft is circulating in samizdat form, and I have seen a copy. It is rather breathtaking in its assertions of authority. Apropos Michael Davie’s remarks on operating CCPs during wartime, my first thought upon reading Chapters IV and V was “War Communism Comes to Derivatives.” One statement buried in the Executive Summary Sheet, phrased in bland bureaucratic language, is rather stunning in its import: “A recovery and resolution framework for CCPs is likely to involve a public authority taking extraordinary measures in the public interest, possibly overriding normal property rights and allocating losses to specific stakeholders.”

In a nutshell, the proposal says that the resolution authority can do pretty much it damn well pleases, including nullifying normal protections of bankruptcy/insolvency law, transferring assets to whomever it chooses, terminating contracts (not just of those who default, but any contract cleared by a CCP in resolution), bailing in any CCP creditor up to 100 percent, suspending the right to terminate contracts, and haircutting variation margin. The authority also has the power to force CCP members to make additional default fund contributions up to the amount of their original contribution, over and above any additional contribution specified in the CCP member agreement. In brief, the resolution authority has pretty much unlimited discretion to rob Peter to pay Paul, subject to only a few procedural safeguards.

About the only thing that the law doesn’t authorize is initial margin haircutting. Given the audacity of other powers that it confers, this is sort of surprising. It’s also not evident to me that variation margin haircutting is a better alternative. One often overlooked aspect of VM haircuts is that they hit hedgers hardest. Those who are using derivatives to manage risk look to variation margin payments to offset losses on other exposures that they are hedging. VM haircutting deprives them of some of these gains precisely when they are likely to need them most. Put differently, VM haircutting imposes losses on those that are least likely to be able to bear them when it is most costly to bear them. Hedgers are risk averse. One reason they are risk aversion is that losses on their underlying exposures could force them into financial distress. Blowing up their hedges could do just that.

Perhaps one could argue that CCPs are so systemically important and the implications of their insolvency are so ominous that extraordinary measures are necessary–in its Executive Summary, and in the proposal itself, the EC does just that. But this just calls into question the prudence of creating and supersizing entities with such latent destructive potential.

There is also a fundamental tension here. The potential that the resolution authority will impose large costs on members of CCPs, and even their customers, raises the burden of being a member, or trading cleared products. This is a disincentive to membership, and with the economics of supply clearing services already looking rather grim, may lead to further exits from the business. Similarly, bail-ins of creditors and the potential seizure of ownership interests without due process will make it more difficult for CCPs to obtain funding. Thus, mandating expansion of clearing makes necessary exceptional resolution measures that lead to reduced supply of clearing services, and reduced supply of the credit, liquidity, and capital that they need to function.

It must also be recognized that with discretionary power come inefficient selective intervention and influence costs. The resolution body will have extraordinary power to transfer vast sums from some agents to others. This makes it inevitable that the body will be subjected to intense rent seeking activity that will mean that its decisions will be driven as much by political factors as efficiency considerations, and perhaps more so: this is particularly true in Europe, where multiple states will push the interests of their firms and citizens. Rent seeking is costly. Furthermore, it will inevitably inject a degree of arbitrariness into the outcome of resolution. This arbitrariness creates additional uncertainty and risk, precisely at a time when these are already at heightened, and likely extreme, levels. Furthermore, it is likely to create dangerous feedback loops. The prospect of dealing with an arbitrary resolution mechanism will affect the behavior of participants in the clearing process even before a CCP fails, and one result could be to accelerate a crisis, as market participants look to cut their exposure to a teetering CCP, and do so in ways that pushes it over the edge.

To put it simply, if the option to resort to War Communism is necessary to deal with the fallout from a CCP failure in a post-mandate world, maybe you shouldn’t start the war in the first place.

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