Streetwise Professor

March 24, 2017

Creative Destruction and Industry Life Cycles, HFT Edition

Filed under: Derivatives,Economics,Exchanges,Regulation — The Professor @ 11:56 am

No worries, folks: I’m not dead! Just a little hiatus while in Geneva for my annual teaching gig at Université de Genève, followed by a side trip for a seminar (to be released as a webinar) at ESSEC. The world didn’t collapse without my close attention, but at times it looked like a close run thing. But then again, I was restricted to watching CNN so my perception may be a little bit warped. Well, not a little bit: I have to say that I knew CNN was bad, but I didn’t know how bad until I watched a bit while on the road. Appalling doesn’t even come close to describing it. Strident, tendentious, unrelentingly biased, snide. I switched over to RT to get more reasonable coverage. Yes. It was that bad.

There are so many allegations regarding surveillance swirling about that only fools would rush in to comment on that now. I’ll be an angel for once in the hope that some actual verifiable facts come out.

So for my return, I’ll just comment on a set of HFT-related stories that came out during my trip. One is Alex Osipovich’s story on HFT traders falling on hard times. Another is that Virtu is bidding for KCG. A third one is that Quantlabs (a Houston outfit) is buying one-time HFT high flyer Teza. And finally, one that pre-dates my trip, but fits the theme: Thomas Peterffy’s Interactive Brokers Group is exiting options market making.

Alex’s story repeats Tabb Group data documenting a roughly 85 percent drop in HFT revenues in US equity trading. The Virtu-KCG proposed tie-up and the Quantlabs-Teza consummated one are indications of consolidation that is typical of maturing industries, and a shift it the business model of these firms. The Quantlabs-Teza story is particularly interesting. It suggests that it is no longer possible (or at least remunerative) to get a competitive edge via speed alone. Instead, the focus is shifting to extracting information from the vast flow of data generated in modern markets. Speed will matter here–he who analyzes faster, all else equal, will have an edge. But the margin for innovation will shift from hardware to data analytics software (presumably paired with specialized hardware optimized to use it).

None of these developments is surprising. They are part of the natural life cycle of a new industry. Indeed, I discussed this over two years ago:

In fact, HFT has followed the trajectory of any technological innovation in a highly competitive environment. At its inception, it was a dramatically innovative way of performing longstanding functions undertaken by intermediaries in financial markets: market making and arbitrage. It did so much more efficiently than incumbents did, and so rapidly it displaced the old-style intermediaries. During this transitional period, the first-movers earned supernormal profits because of cost and speed advantages over the old school intermediaries. HFT market share expanded dramatically, and the profits attracted expansion in the capital and capacity of the first-movers, and the entry of new firms. And as day follows night, this entry of new HFT capacity and the intensification of competition dissipated these profits. This is basic economics in action.

. . . .

Whether it is by the entry of a new destructively creative technology, or the inexorable forces of entry and expansion in a technologically static setting, one expects profits earned by firms in one wave of creative destruction to decline.  That’s what we’re seeing in HFT.  It was definitely a disruptive technology that reaped substantial profits at the time of its introduction, but those profits are eroding.

That shouldn’t be a surprise.  But it no doubt is to many of those who have made apocalyptic predictions about the machines taking over the earth.  Or the markets, anyways.

Or, as Herb Stein famously said as a caution against extrapolating from current trends, “If something cannot go on forever, it will stop.” Those making dire predictions about HFT were largely extrapolating from the events of 2008-2010, and ignored the natural economic forces that constrain growth and dissipate profits. HFT is now a normal, competitive business earning normal, competitive profits.  And hopefully this reality will eventually sink in, and the hysteria surrounding HFT will fade away just as its profits did.

The rise and fall of Peterffy/Interactive illustrates Schumpeterian creative destruction in action. Interactive was part of a wave of innovation that displaced the floor. Now it can’t compete against HFT. And as the other articles show, HFT is in the maturation stage during which profits are competed away (ironically, a phenomenon that was central to Marx’s analysis, and which Schumpeter’s theory was specifically intended to address).

This reminds me of a set of conversations I had with a very prominent trader. In the 1990s he said he was glad to see that the markets were becoming computerized because he was “tired of being fucked by the floor.” About 10 years later, he lamented to me how he was being “fucked by HFT.” Now HFT is an industry earning “normal” profits (in the economics lexicon) due to intensifying competition and technological maturation: the fuckers are fucking each other now, I guess.

One interesting public policy issue in the Peterffy story is the role played by internalization of order flow in undermining the economics of Interactive: there is also an internalization angle to the Virtu-KCG story, because one reason for Virtu to buy KCG is to obtain the latter’s juicy retail order flow. I’ve been writing about this (and related) subjects for going on 20 years, and it’s complicated.

Internalization (and other trading in non-lit/exchange venues) reduces liquidity on exchanges, which raises trading costs there and reduces the informativeness of prices. Those factors are usually cited as criticism of off-exchange execution, but there are other considerations. Retail order flow (likely uninformed) gets executed more cheaply, as it should because it it less costly (due to the fact that it poses less of an adverse selection risk). (Who benefits from this cheaper execution is a matter of controversy.) Furthermore, as I pointed out in a 2002 Journal of Law, Economics and Organization paper, off-exchange venues provide competition for exchanges that often have market power (though this is less likely to be the case in post-RegNMS which made inter-exchange competition much more intense). Finally, some (and arguably a lot of) informed trading is rent seeking: by reducing the ability of informed traders to extract rents from uninformed traders, internalization (and dark markets) reduce the incentives to invest excessively in information collection (an incentive Hirshleifer the Elder noted in the 1970s).

Securities and derivatives market structure is fascinating, and it presents many interesting analytical challenges. But these markets, and the firms that operate in them, are not immune to the basic forces of innovation, imitation, and entry that economists have understood for a long time (but which too many have forgotten, alas). We are seeing those forces at work in real time, and the fates of firms like Interactive and Teza, and the HFT sector overall, are living illustrations.

 

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March 10, 2017

US Shale Puts the Saudis and OPEC in Zugzwang

Filed under: Commodities,Derivatives,Economics,Energy,Politics — The Professor @ 2:55 pm

This was CERA Week in Houston, and the Saudis and OPEC provided the comedic entertainment for the assembled oil industry luminaries.

It is quite evident that the speed and intensity of the U-turn in US oil production has unsettled the Saudis, and they don’t know quite what to do about it. So they were left with making empty threats.

My favorite was when Saudi Energy Minister Khalid al-Falih said there would be no “free rides” for US shale producers (and non-OPEC producers generally). Further, he said OPEC “will not bear the burden of free riders,” and “[w]e can’t do what we did in the ’80s and ’90s by swinging millions of barrels in response to market condition.”

Um, what is OPEC going to do about US free riders? Bomb the Permian? If it cuts output, and prices rise as a result, US E&P activity will pick up, and damn quick. The resulting replacement of a good deal of the OPEC output cut will limit the price impact thereof. The best place to be is outside a cartel that cuts output: you can get the benefit of the higher prices, and produce to the max. That’s what is happening in the US right now. OPEC has no credible way of showing off, or threatening to show off, free riders.

As for not doing what they did in the ’80s, well that’s exactly OPEC’s problem. It’s not the ’80s anymore. Now if it tries to “swing millions of barrels” to raise price, there is a fairly elastic and rapidly responding source of supply that can replace a large fraction of those barrels, thereby limiting the price impact of the OPEC swingers, baby.

Falih’s advisers were also trying to scare the US producers. Or something:

“One of the advisors said that OPEC would not take the hit for the rise in U.S. shale production,” a U.S. executive who was at the meeting told Reuters. “He said we and other shale producers should not automatically assume OPEC will extend the cuts.”

Presumably they are threatening a return to their predatory pricing strategy (euphemistically referred to as “defending market share”) that worked out so well for them the last time. Or perhaps it is just a concession that US supply is so elastic that it makes the demand for OPEC oil so elastic that output cuts are a losing proposition and will not endure. Either way, it means that OPEC is coming to the realization that continuing output cuts are unlikely to work. Meaning they won’t happen.

OPEC also floated cooperation with US producers on output. Mr. al-Falih, meet Senator Sherman! And if the antitrust laws didn’t make US participation in an agreement a non-starter, it would be almost impossible to cartelize the US industry given the largely free entry into E&P and the fungibility of technology, human capital, land, services, and labor. Maybe OPEC should hold talks with the Texas Railroad Commission instead.

Finally, in another laugh riot, OPEC canoodled with hedge funds. Apparently under the delusion that financial players play a material role in setting the price of physical barrels, rather than the price of risk. Disabling speculation could materially help OPEC only by raising the cost of hedging, which would tend to raise the costs of E&P firms, especially the more financially stretched ones. (Along these lines, I would argue that the big increase in net long speculative positions in recent months is not due to speculators pushing themselves into the market, but instead they have been pulled into the market by increased hedging activity that has occurred due to the increase in drilling activity in the US.)

Oil prices were down hard this week, from a $53 handle to a (at the time of this writing) $49.50 price. The first down-leg was due to the surprise spike in US inventories, but the continued weakness could well reflect the OPEC and Saudi messaging at CERA Week. The pathetic performance signaled deep strategic weakness, and suggests that the Saudis et al realize they are in zugzwang: regardless of what they do with regards to output, they are going to regret doing it.

My heart bleeds. Bleeds, I tells ya!

 

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February 20, 2017

Trolling Brent

Filed under: Commodities,Derivatives,Economics,Energy,Regulation — The Professor @ 10:14 am

Platts has announced the first major change in the Brent crude assessment process in a decade, adding Troll crude to the “Brent” stream:

A decline in supply from North Sea fields has led to concerns that physical volumes could become too thin and hence at times could be accumulated in the hands of just a few players, making the benchmark vulnerable to manipulation.

Platts said on Monday it would add Norway’s Troll crude to the four British and Norwegian crudes it already uses to assess dated Brent from Jan 1. 2018. This will join Brent, Forties, Oseberg and Ekofisk, or BFOE as they are known.

This is likely a stopgap measure, and Platts is considering more radical moves in the future:

It is also investigating a more radical plan to account for a possible larger drop-off in North Sea output over the next decade that would allow oil delivered from as far afield as west Africa and Central Asia to contribute to setting North Sea prices.

But the move is controversial, as this from the FT article shows:

If this is not addressed first, one source at a big North Sea trader said, the introduction of another grade to BFOE could make “an assessment that is unhedgeable, hence not fit for purpose”. “We don’t see any urgency to add grades today,” he added. Changes to Brent shifts the balance of power in North Sea trading. The addition of Troll makes Statoil the biggest contributor of supplies to the grades supporting Brent, overtaking Shell. Some big North Sea traders had expressed concern Statoil would have an advantage in understanding the balance of supply and demand in the region as it sends a large amount of Troll crude to its Mongstad refinery, Norway’s largest.

The statement about “an assessment that is unhedgeable, hence not fit for purpose” is BS, and exactly the kind of thing one always hears when contracts are redesigned. The fact is that contract redesigns have distributive effects, even if they improve a contract’s functioning, and the losers always whinge. Part of the distributive effect relates to issues like giving a company like Statoil an edge . . . that previously Shell and the other big North Sea producers had. But part of the distributive effect is that a contract with inadequate deliverable supply is a playground for big traders, who can more easily corner, squeeze, and hug such a contract.

Insofar as hedging is concerned, the main issue is how well the Brent contract performs as a hedge (and a pricing benchmark) for out-of-position (i.e., non-North Sea) crude, which represents the main use of Brent paper trades. Reducing deliverable supply constraints which contribute to pricing anomalies (and notably, anomalous moves in the basis) unambiguously improves the functioning of the contract for out-of-position players. Yeah, those hedging BFOE get slightly worse hedging performance, but that is a trivial consideration given that the very reason for changing the benchmark is the decline in BFOE production–which now represents less than 1 percent of world output. Why should the hair on the end of the tail wag the dog?

Insofar as the competition with WTI is concerned, the combination of larger US supplies, the construction of pipelines to move supplies from the Midcon (PADDII) to the Gulf (PADDIII)  and the lifting of the export ban have restored and in fact strengthened the connection of WTI prices to seaborne crude prices. US barrels are now going to both Europe and Asia, and US crude has effectively become the marginal barrel in most major markets, meaning that it is determining price and that WTI is an effective hedge (especially for the lighter grades). And by the way, the WTI delivery mechanism is much more robust and transparent than the baroque (and at times broken) Brent pricing mechanism.

As if to add an exclamation point to the story, Bloomberg reports that in recent months Shell has been bigfooting–or would that be trolling?–the market with big trades that have arguably distorted spreads. It got to the point that even firms like Vitol (which are notoriously loath to call foul, lest someone point fingers at them) raised the issue with Shell:

While none of those interviewed said Shell did anything illegal, they said the company violated the unspoken rules governing the market, which is lightly regulated. Executives of several trading rivals, including Vitol Group BV, the world’s top independent oil merchant, raised objections with counterparts at Shell last year, according to market participants.

What are the odds that Mr. Fit for Purpose is a Shell trader?

All of this is as I predicted, almost six years ago, when everyone was shoveling dirt on WTI and declaring Brent the Benchmark of the Forever Future:

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.  But the Brent contract will be an inverted paper pyramid, resting on a thinner and thinner point of crude production.  There will be gains from trade–large ones–from redesigning the contract, but the difficulties of negotiating an agreement among numerous big players will prove nigh on to impossible to surmount.  Moreover, there will be no single regulator in a single jurisdiction that can bang heads together (for yes, that is needed sometimes) and cajole the parties toward agreement.

So Brent boosters, enjoy your laugh while it lasts.  It won’t last long, and remember, he who laughs last laughs best.

That’s exactly how things have worked out, even down to the point about the difficulties of getting the big boys to play together (a lesson gained through extensive personal experience, some of which is detailed in the post). Just call me Craignac the Magnificent. At least when it comes to commodity contract design 😉

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February 15, 2017

Never Argue From a Price Change, Oil Market Edition

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

 

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February 11, 2017

Risk Gosplan Works Its Magic in Swaps Clearing

Filed under: Clearing,Commodities,Derivatives,Economics,Politics,Regulation — The Professor @ 4:18 pm

Deutsche Bank quite considerately provided a real time example of an unintended consequence of Frankendodd, specifically, capital requirements causing firms to exit from clearing. The bank announced it is continuing to provide futures clearing, but is exiting US swaps clearing, due to capital cost concerns.

Deutsch was not specific in citing the treatment of margins under the leverage ratio as the reason for its exit, this is the most likely culprit. Recall that even segregated margins (which a bank has no access to) are treated as bank assets under the leverage rule, so a swaps clearer must hold capital against assets over which it has no control (because all swap margins are segregated), cannot utilize to fund its own activities, and which are not funded by a liability issued by the clearer.

It’s perverse, and is emblematic of the mixed signals in Frankendodd: CLEAR SWAPS! CLEARING SWAPS  IS EXTREMELY CAPITAL INTENSIVE SO YOU WON’T MAKE ANY MONEY DOING IT! Yeah. That will work out swell.

Of course Deutsch Bank has its own issues, and because of those issues it faces more acute capital concerns than other institutions (especially American ones). But here is a case where the capital cost does not at all match up with risk (and remember that capital is intended to be a risk absorber). So looking for ways to economize on capital, Deutsch exited a business where the capital charge did not generate any commensurate return, and furthermore was unrelated to the actual risk of the business. If the pricing of risk had been more sensible, Deutsch might have scaled back other businesses where capital charges reflected risk more accurately. Here, the effect of the leverage ratio is all pain, no gain.

When interviewed by Risk Magazine about the Fundamental Review of the Trading Book, I said: “The FRTB’s standardised approach is basically central planning of risk pricing, and it will produce Gosplan-like results.” The leverage ratio, especially as applied to swaps margins, is another example of central planning of risk pricing, and here indeed it has produced Gosplan-like results.

And in the case of clearing, these results are exactly contrary to a crucial ostensible purpose of DFA: reducing size and concentration in banking generally, and in derivatives markets in particular. For as the FT notes:

The bank’s exit will reignite concerns that the swaps clearing business is too concentrated among a handful of large players. The top three swaps clearers account for more than half the market by client collateral required, while the top five account for over 75 per cent.

So swaps clearing is now hyper-concentrated, and dominated by a handful of systemically important banks (e.g., Citi, Goldman). It is more concentrated that the bilateral swaps dealer market was. Trouble at one of these dominant swaps clearers would create serious risks for CCPs that they clear for (which, by the way, are all interconnected because the same clearing members dominate all the major CCPs). Moreover, concentration dramatically reduces the benefits of mutualizing risk: because of the small number of clearers, the risk of a big CM failure will be borne by a small number of firms. This isn’t insurance in any meaningful way, and does not achieve the benefits of risk pooling even if only in the first instance only a single big clearing member runs into trouble due to a shock idiosyncratic to it.

At present, there is much gnashing of teeth and rending of garments at the prospect of even tweaks in Dodd-Frank. Evidently, the clearing mandate is not even on the table. But this one vignette demonstrates that Frankendodd and banking regulation generally is shot through with provisions intended to reduce systemic risk which do not have that effect, and indeed, likely have the perverse effect of creating some systemic risks. Viewing Dodd-Frank as a sacred cow and any proposed change to it as a threat to the financial system is utterly wrongheaded, and will lead to bad outcomes.

Barney and Chris did not come down Mount Sinai with tablets containing commandments written by the finger of God. They sat on Capitol Hill and churned out hundreds of pages of laws based on a cartoonish understanding of the financial system, information provided by highly interested parties, and a frequently false narrative of the financial crisis. These laws, in turn, have spawned thousands of pages of regulation, good, bad, and very ugly. What is happening in swaps clearing is very ugly indeed, and provides a great example of how major portions of Dodd-Frank and the regulations emanating from it need a thorough review and in some cases a major overhaul.

And if Elizabeth Warren loses her water over this: (a) so what else is new? and (b) good! Her Manichean view of financial regulation is a major impediment to getting the regulation right. What is happening in swaps clearing is a perfect illustration of why a major midcourse correction in the trajectory of financial regulation is imperative.

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February 4, 2017

The Regulatory Road to Hell

One of the most encouraging aspects of the new administration is its apparent commitment to rollback a good deal of regulation. Pretty much the entire gamut of regulation is under examination, and even Trump’s nominee for the Supreme Court, Neil Gorsuch, represents a threat to the administrative state due to his criticism of Chevron Deference (under which federal courts are loath to question the substance of regulations issued by US agencies).

The coverage of the impending regulatory rollback is less that informative, however. Virtually every story about a regulation under threat frames the issue around the regulation’s intent. The Fiduciary Rule “requires financial advisers to act in the best interests of their clients.” The Stream Protection Rule prevents companies from “dumping mining waste into streams and waterways.” The SEC rule on reporting of payments to foreign governments by energy and minerals firms “aim[s] to address the ‘resource curse,’ in which oil and mineral wealth in resource-rich countries flows to government officials and the upper classes, rather than to low-income people.” Dodd-Frank is intended prevent another financial crisis. And on and on.

Who could be against any of these things, right? This sort of framing therefore makes those questioning the regulations out to be ogres, or worse, favoring financial skullduggery, rampant pollution, bribery and corruption, and reckless behavior that threatens the entire economy.

But as the old saying goes, the road to hell is paved with good intentions, and that is definitely true of regulation. Regulations often have unintended consequences–many of which are directly contrary to the stated intent. Furthermore, regulations entail costs as well as benefits, and just focusing on the benefits gives a completely warped understanding of the desirability of a regulation.

Take Frankendodd. It is bursting with unintended consequences. Most notably, quite predictably (and predicted here, early and often) the huge increase in regulatory overhead actually favors consolidation in the financial sector, and reinforces the TBTF problem. It also has been devastating to smaller community banks.

DFA also works at cross purposes. Consider the interaction between the leverage ratio, which is intended to insure that banks are sufficiently capitalized, and the clearing mandate, which is intended to reduce systemic risk arising from the derivatives markets. The interpretation of the leverage ratio (notably, treating customer margins held by FCMs as an FCM asset which increases the amount of capital it must hold due to the leverage ratio) makes offering clearing services more expensive. This is exacerbating the marked consolidation among FCMs, which is contrary to the stated purpose of Dodd-Frank. Moreover, it means that some customers will not be able to find clearing firms, or will find using derivatives to manage risk prohibitively expensive. This undermines the ability of the derivatives markets to allocate risk efficiently.

Therefore, to describe regulations by their intentions, rather than their effects, is highly misleading. Many of the effects are unintended, and directly contrary to the explicit intent.

One of the effects of regulation is that they impose costs, both direct and indirect.  A realistic appraisal of regulation requires a thorough evaluation of both benefits and costs. Such evaluations are almost completely lacking in the media coverage, except to cite some industry source complaining about the cost burden. But in the context of most articles, this comes off as special pleading, and therefore suspect.

Unfortunately, much cost benefit analysis–especially that carried out by the regulatory agencies themselves–is a bad joke. Indeed, since the agencies in question often have an institutional or ideological interest in their regulations, their “analyses” should be treated as a form of special pleading of little more reliability than the complaints of the regulated. The proposed position limits regulation provides one good example of this. Costs are defined extremely narrowly, benefits very broadly. Indirect impacts are almost completely ignored.

As another example, Tyler Cowen takes a look into the risible cost benefit analysis behind the Stream Protection Rule, and finds it seriously wanting. Even though he is sympathetic to the goals of the regulation, and even to the largely tacit but very real meta-intent (reducing the use of coal in order to advance  the climate change agenda), he is repelled by the shoddiness of the analysis.

Most agency cost benefit analysis is analogous to asking pupils to grade their own work, and gosh darn it, wouldn’t you know, everybody’s an A student!

This is particularly problematic under Chevron Deference, because courts seldom evaluate the substance of the regulations or the regulators’ analyses. There is no real judicial check and balance on regulators.

The metastasizing regulatory and administrative state is a very real threat to economic prosperity and growth, and to individual freedom. The lazy habit of describing regulations and regulators by their intent, rather than their effects, shields them from the skeptical scrutiny that they deserve, and facilitates this dangerous growth. If the Trump administration and Congress proceed with their stated plans to pare back the Obama administration’s myriad and massive regulatory expansion, this intent-focused coverage will be one of the biggest obstacles that they will face.  The media is the regulators’ most reliable paving contractor  for the highway to hell.

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January 25, 2017

Live From Moscow! Rosneft Kabuki!

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

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

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

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

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

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

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

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

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

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

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

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January 24, 2017

Two Contracts With No Future

Filed under: China,Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 7:14 pm

Over the past couple of days two major futures exchanges have pulled the plug on contracts. I predicted these outcomes when the contracts were first announced, and the reasons I gave turned out to be the reasons given for the decisions.

First, the CME announced that it is suspending trading in its new cocoa contract, due to lack of volume/liquidity. I analyzed that contract here. This is just another example of failed entry by a futures contract. Not really news.

Second, the Shanghai Futures Exchange has quietly shelved plans to launch a China-based oil contract. When it was first mooted, I expressed extreme skepticism, due mainly to China’s overwhelming tendency to intervene in markets sending the wrong signal–wrong from the government’s perspective that is:

Then the crash happened, and China thrashed around looking for scapegoats, and rounded up the usual suspects: Speculators! And it suspected that the CSI 300 Index and CSI 500 Index futures contracts were the speculators’ weapons of mass destruction of choice. So it labeled trades of bigger than 10 (!) contracts “abnormal”–and we know what happens to people in China who engage in unnatural financial practices! It also increased fees four-fold, and bumped up margin requirements.

The end result? Success! Trading volumes declined 99 percent. You read that right. 99 percent. Speculation problem solved! I’m guessing that the fear of prosecution for financial crimes was by far the biggest contributor to that drop.

. . . .

And the crushing of the CSI300 and CSI500 contracts will impede development of a robust oil futures market. The brutal killing of these contracts will make market participants think twice about entering positions in a new oil futures contract, especially long dated ones (which are an important part of the CME/NYMEX and ICE markets). Who wants to get into a position in a market that may be all but shut down when the market sends the wrong message? This could be the ultimate roach motel: traders can check in, but they can’t check out. Or the Chinese equivalent of Hotel California: traders can check in, but they can never leave. So traders will be reluctant to check in in the first place. Ironically, moreover, this will encourage the in-and-out day trading that the Chinese authorities say that they condemn: you can’t get stuck in a position if you don’t hold a position.

In other words, China has a choice. It can choose to allow markets to operate in fair economic weather or foul, and thereby encourage the growth of robust contracts in oil or equities. Or it can choose to squash markets during economic storms, and impede their development even in good times.

I do not see how, given the absence of the rule of law and the just-demonstrated willingness to intervene ruthlessly, that China can credibly commit to a policy of non-intervention going forward. And because of this, it will stunt the development of its financial markets, and its economic growth. Unfettered power and control have a price. [Emphasis added.]

And that’s exactly what has happened. Per Reuters’ Clyde Russell:

The quiet demise of China’s plans to launch a new crude oil futures contract shows the innate conflict of wanting the financial clout that comes with being the world’s biggest commodity buyer, but also seeking to control the market.

. . . .

The main issues were concerns by international players about trading in yuan, given issues surrounding convertibility back to dollars, and also the risks associated with regulation in China.

The authorities in Beijing have established a track record of clamping down on commodity trading when they feel the market pricing is driven by speculation and has become divorced from supply and demand fundamentals.

On several occasions last year, the authorities took steps to crack down on trading in then hot commodities such as iron ore, steel and coal.

While these measures did have some success in cooling markets, they are generally anathema to international traders, who prefer to accept the risk of rapid reversals in order to enjoy the benefits of strong rallies.

It’s likely that while the INE could design a crude futures contract that would on paper tick all the right boxes, it would battle to overcome the trust deficit that exists between the global financial community and China.

What international banks and trading houses will want to see before they throw their weight behind a new futures contract is evidence that Beijing won’t interfere in the market to achieve outcomes in line with its policy goals.

It will be hard, but not impossible, to guarantee this, with the most plausible solution being the establishment of some sort of free trade zone in which the futures contract could be legally housed.

Don’t hold your breath.

It is also quite interesting to contemplate this after all the slobbering over Xi’s Davos speech. China is protectionist and has an overwhelming predilection to intervene in markets when they don’t give the outcomes desired by the government/Party. It is not going to be a leader in openness and markets. Anybody whose obsession with Trump leads them to ignore this fundamental fact is truly a moron.

 

 

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January 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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