Streetwise Professor

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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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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