Streetwise Professor

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.


December 29, 2016

Thank God for the 20th Amendment

Filed under: History,Politics,Russia — The Professor @ 8:36 pm

The 20th Amendment to the US Constitution, adopted in 1933, moved inauguration day from March 4 to January 20. And thank God for that, for imagine what Obama could do in those extra six weeks.

He’s already done enough, believe me. The most egregious was the failure to veto a UN resolution targeting Israeli settlements. Indeed, it has been plausibly pled that the administration was instrumental in pushing forward the resolution, though it has implausibly denied this.

There is a colorable case against the settlements. Be that as it may, Obama’s actions were low and destructive, rather than constructive. This is in part because Obama failed to make the case when there was political risk of doing so, waiting until he could no longer be held accountable. This is a serious matter that represented a sea change in American policy, and as such it deserved public debate. If Obama is so persuasive, he should have been able to make the case right? (More on his persuasiveness below.) Thus, the process was terribly flawed.

Moreover, it is clear that Obama was driven more by personal peevishness and dislike for Benjamin Netanyahu, rather than higher motives.

Insofar as the substance is concerned, the move will not increase the likelihood of a peaceful resolution between the Israelis and Palestinians. Indeed, it will likely make such an outcome less likely, because it will encourage Palestinian intransigence by encouraging their belief that they can achieve through the UN what they cannot achieve at the bargaining table. Trump will no doubt attempt to disabuse them of these notions, but much of the damage has already been done. This is a mess that Trump will have to clean up, at the cost of diverting attention from other pressing matters. It is, in other words, an unnecessary complication driven mainly by malice.

Another 11th hour Obama move was putting millions of acres of offshore areas off-limits for oil and gas drilling. In the short run, this is unlikely to be a major impediment to US energy production, especially in the expensive-to-drill Arctic, because exploration and development in these regions is currently uneconomic at prevailing prices. But Obama specifically intended to make his action difficult to reverse, so it may bind in the future. Again, the process here was high-handed and autocratic, resembling a ukase more than a considered executive action subject to legislative or legal check.

Which brings us to today’s action, the sanctioning of senior members of Russian intelligence agencies (notably the GRU), the expulsion of 32 diplomats for spying, and the restriction of their use of some consular properties, in retaliation for alleged hacking of the election. To justify the action, the FBI and Homeland Security released a lame report, befitting of a lame duck administration. The report discloses that–I hope you are sitting down–government agencies and employees are routinely subject to hacking attempts, most notably phishing attacks.

This is news? Um, no. FFS, who isn’t routinely subject to phishing attempts? Nobody. The main difference is that most people (unlike Podesta) have the good sense not to be a real big phish.

What is rather shocking is the administration’s going to Code Red on this, after its rather blasé response to far more serious hacks, notably the OPM disaster, and hacks of the White House and State Department and various defense contractors. Back then, they were all Alfred E. Neuman “what, me worry?” Suddenly it’s a grave threat, because there is a desperate need to explain away a stunning defeat of the candidate that Obama expected to protect his legacy, rather than dismantle it. Even if the allegations regarding Russian interference are correct, the damage is far less than these other cyberattacks, but the public response is inversely proportional to the harm inflicted.

Notably missing from the document is any specific mention of the DNC or Podesta emails, or of Wikileaks: it is a generic description of a virtually continuous stream of activity carried out by numerous state and non-state actors. Most bizarrely, as for attributing the attacks to Russia, we are merely given this ipse dixit, with no supporting evidence: “However, public attribution of these activities to RIS [Russian Intelligence Services] is supported by technical indicators from the U.S. Intelligence Community, DHS, FBI, the private sector, and other entities.” Maybe they figure if they told us more, they’d have to kill us all. So they’re doing us a favor by keeping us in the dark.

This “trust me” attribution is undermined by a header on the document:


In other words, this is classified “Don’t Quote Me on This! But it’s totally legit!”


Although ostensibly aimed at Russia, this move is more targeted at Trump. It leaves him with the unpalatable choice of sustaining a decision unsupported by any real publicly disclosed evidence, or reversing it and thereby triggering the “Trump is Putin’s Boy/Manchurian Candidate” shrieks. Russian (and Chinese, and Iranian, and Nork and . . . ) cyberattacks are an issue which the incoming administration will have to consider and address, and a less peevish president would have let it done so without interference.

I told a friend that this was aimed at Trump as soon as I heard of it. Then later I found out that I wasn’t alone in advancing this hypothesis:

“We think that such steps by a U.S. administration that has three weeks left to work are aimed at two things: to further harm Russian-American ties, which are at a low point as it is, as well as, obviously, to deal a blow to the foreign policy plans of the incoming administration of the president-elect,” Peskov said.

Obama puts me on the same side as Dmitry Fricking Peskov. This is what we’ve come to.

Russia reacted with some amusing snark. The best of which was this tweet. Hapless, indeed. Hapless, narcissistic and peevish.

One last amusing note. The administration also announced that it would engage in covert retaliation. (Limited time offer! Only good for three weeks!) What’s next in the oxymoron follies? The administration’s highly classified transparency initiative?

(The juxtaposition of Obama’s high dudgeon at alleged Russian interference with the 2016 elections–which, if it occurred, involved the disclosure of embarrassing facts–with his smack at Israel is particularly choice, given that Obama clearly attempted to influence Israel’s 2015 Knesset elections.)

I could go on, but I’ll leave it at these three Greatest Hits.

In between leaving behind manure piles for Trump to clean up, Obama has been giving interviews. These can best be summarized as: “I am wonderful. My only failing was I did a horrible job of telling everyone how wonderful I am, thereby allowing Fox News and Rush Limbaugh and the NRA to shape public perceptions of me”:

OBAMA: The — the problem is, is that we’re not there on the ground communicating not only the dry policy aspects of this, but that we care about these communities, that we’re bleeding for these communities…
OBAMA: … that we understand why they’re frustrated. There’s a — there’s a…
AXELROD: And the values behind these things.
OBAMA: And the values. And there’s an emotional connection, and part of what we have to do to rebuild is to be there and — and that means organizing, that means caring about state parties, it means caring about local races, state boards or school boards and city councils and state legislative races and not thinking that somehow, just a great set of progressive policies that we present to the New York Times editorial board will win the day. And — and part of…
AXELROD: But some of that would fall on us. I mean, I — take you and me because maybe we didn’t spend as much time on that project while you were here. I mean, we’re trying to save the economy and doing these other things.
OBAMA: Well, yeah. No, you know, I mean…
AXELROD: Our campaigns did it, but…
OBAMA: It’s interesting. You and I both, I think, would acknowledge that when we were campaigning, we could connect. Once you got to the White House and you were busy governing, then…
OBAMA: … partly, you’re just constrained by time, right? You are then more subject to the filter. And this is — you know, I brought up Fox News, but it was Rush Limbaugh and the NRA and there are all these mediators who are interpreting what we do, and if we’re not actually out there like we are during campaigns, then folks in — in a lot of these communities, what they’re hearing is Obama wants to take away my guns…
OBAMA: Obamacare’s about transgender bathrooms and not my job, Obama is disrespecting my culture and is primarily concerned with coastal elites and minorities. And so — so part of what I’ve struggled with during my presidency and part of what I think I’ll be thinking a lot about after my presidency is how do we work around all these filters?
And it becomes more complicated now that you’ve got social media, where people are getting news that reinforces their biases and — and separates people out instead of bringing them together. It is going to be a challenge, but look, you look at what we did in rural communities, for example…

Apparently not realizing that the 2016 election (not just for president, but for the House, the Senate, and state offices) was largely a repudiation of him and his presidency, Obama stated presumptuously that he would have been able to defeat Trump and win a third term.

Obama says he will take some time to “be quiet for a while” to “still myself” and “find my center.” Take your time! As much time as you like!

Looking at the bright side, Obama says he is going to dedicate himself to rebuilding the Democratic Party. Given that he’s the one that singlehandedly led it to the brink of catastrophe, this is great news. Sort of like having someone you don’t really like hire the Three Stooges to fix his plumbing.

The 20th Amendment was adopted because a lame duck Hoover administration was unable to respond decisively to the economic crisis that gripped the country in early-1933. The amendment was intended to prevent the government being hamstrung for months in a future crisis occurring during a transition to a new administration. But in retrospect, the real virtue of the 20th is not that it accelerates the ability of an incoming president to deal with crisis: it is that it limits the time that a departing president has to wreak havoc. This is especially important when the departing president is preternaturally vain and narcissistic (even by comparison with other politicians, who are only naturally vain and narcissistic), when he is unconstrained by accepted norms and traditions, and when there is no political cost to be paid for indulging his peeves and pursuing his vendettas. One shudders to think what Obama would have done with an extra six weeks to act with no means of holding him to account.

Cromwell’s parting words to the Rump Parliament are apposite here: “You have sat too long here for any good you have been doing. Depart, I say, and let us have done with you. In the name of God, go.” Fortunately, the 20th Amendment ensures that Obama will go sooner than he would have without it. And thank God for that.

December 25, 2016

A Christmas Miracle in Moscow?

Filed under: Economics,Energy,Politics,Russia — The Professor @ 12:27 pm

Putin gave his annual marathon address a few days ago. As usual, some of the things he said were quite sensible. Some things were more debatable. And some things were just codswallop:

Speaking at an annual press conference on Friday, Mr Putin said that “foreigners” had “transferred the money into the Russian budget in full.” The [Rosneft-Glencore-QIA] deal is worth Rbs700bn ($11.5bn).

This echoes a Sechin statement from 9 days ago:

Rosneft CEO Igor Sechin reported to Russian President Vladimir Putin that the federal received all proceeds from privatization of a 19.5% stake in Rosneft, according to Presidential spokesman Dmitry Peskov.

“Sechin told Putin that all funds from Rosneftegas were transferred to the budget,” Peskov said.

There is some ambiguity here: Putin could have been referring to “the foreigners'” equity stakes. But that would leave open the question of where the balance of the money came from, and there is no way that Russia has received the entire $11.5b from “foreign” sources. Note that the bank (Intesa Sanpaolo) that had been named–by Rosneft–as leading the funding for the purchase has said that it’s still thinking about it:

Intesa said earlier this week that its “potential involvement” in the deal was “still under evaluation.” Financial regulators in Rome are examining whether Intesa Sanpaolo’s financing of a €10.2bn investment in Russian oil group Rosneft complies with sanctions

No other foreign bank or banks have stepped up to provide funding.

Maybe Glencore and QIA would have made their equity investment without financing for the balance of the purchase price. But I doubt it. There is no way Rosneftgaz would have parted with ownership of the 19.5 percent stake in Rosneft without being paid in full. So where did the money come from? Either it came from Russian sources, or the deal is not done–both which would be contrary to what Putin asserts. And if it’s from Russian sources, that would give to lie to Sechin’s and Putin’s original claims that all the money would come from foreign sources.

So where did it come from (assuming that it came from anywhere at all)? Some possibilities:

  • Rosneftgaz. Note Sechin’s statement that “all funds from Rosneftegas were transferred.” Rosneftgaz owned (owns?) the shares. Perhaps it made a payment to the budget from its own funds, and retained ownership of shares in anticipation of selling them to the Glencore-QIA consortium at a later date. (This was the common belief as to how the “privatization” would occur prior to the announcement of the Glencore-QIA consortium.) But there is no way that Rosneftgaz transferred $11.5b received from foreigners.
  • Rosneft. It is interesting that on December 5 Rosneft announced plans to issue about $9b of bonds. Add that $9b to the amount allegedly being invested by the consortium, and you get pretty close to the purchase price for the 19.5 percent stake. (Coincidence?) The bonds haven’t been issued yet (apparently), but Rosneft could borrow from Russian banks in anticipation of repaying the loan with the proceeds from the bond issue. More speculatively, the Russian banks could have turned around and used a loan extended to Rosneft as collateral to a loan from the Central Bank of Russia, making the CBR the ultimate funding source. (John Helmer asserts that this is the case.)
  • Russian banks. Russian banks could have lent the money to the consortium. Alternatively, Russian banks could have lent to Rosneft, Rosneftgaz, or both.

But it is incontestable that either (a) the deal isn’t really done, or that (b) contrary to the statements trumpeted at the start of the deal, it was primarily funded by Russian banks, rather than western ones.

We now do have some idea of what an “appropriate Russian bank” is. (That was the mysterious phrase used in Glencore’s release to refer to a Russian bank providing an indemnity to Glencore.). RBC reports that Gazprombank is involved in the transaction. The Russian government operates under the fiction that Gazprombank is not a state bank. Putin had said that Russian state banks would not be involved, because that would not be a true privatization. The obvious inference is that an “appropriate” bank is a non-state one.

Even looking beyond whether Gazprombank is reasonably considered a non-state bank, (a) it was supposed to be indemnifying Glencore’s borrowing from western banks to fund the purchase, not providing the funding itself, and (b) on its own, it wouldn’t have the scratch to finance the entire purchase. Putting all this together, it means that either (a) the money is coming from other banks–which have to be Russian state banks (most likely Sberbank and VTB), or (b) the deal ain’t done.

It is interesting to note that neither Glencore nor QIA have made an announcement that the deal has closed. Indeed, they declined comment when asked about Putin’s statement. If the deal has closed, Glencore would have said something. Western banks funding the deal would have said something. The silence speaks volumes.

What accounts for the reticence of Intesa, and other western banks? Perhaps it’s coincidence, but Intesa was just fined $235 million for “anti-money laundering failures and violations of bank privacy laws.” The fine was levied by New York state regulators, not the Feds. Furthermore, lending to fund the transaction would not appear to violate sanctions, because it does not involve the purchase of new equity. However, Intesa and other western banks (and others have to get involved, because Intesa could not afford to finance it itself) know that there are many ways that the US government could express its displeasure at doing a deal that adhered to the letter of sanctions, but violated the spirit (as interpreted by the Treasury Department). The fine may have have gotten Intesa’s (and other banks’) minds right–and that may have been the point.

In sum, there is no way that $11.5b of western money has been transferred to the Russian budget to pay for a 19.5 percent stake in Rosneft. Thus, Putin was telling a stretcher at his presser.

Or perhaps it was a Christmas miracle. Money magically appeared in Rosneftgaz’s kitty, which it then generously transferred to the Russian government budget, out of the goodness of its heart in the spirit of the season. That would make as much sense as the story Putin spun.

And speaking of Christmas miracles, I hope that all my loyal readers are favored with one as well. Have a Merry Christmas, and a Happy New Year.

December 18, 2016

The eReformation: Every Man His Own Editor

Filed under: Politics,Russia — The Professor @ 8:45 pm

The concept of “fake news” is running neck-and-neck with “Putin Did It!” as the leading explanation for the inexplicable (inexplicable to the self-identified elite, anyways). These explanations sometimes overlap, when the Russians are blamed for disseminating fake news, never mind the fact that what the Russians are primarily blamed for (the DNC and Podesta leaks) was anything but fake: it was all too real. Indeed, perhaps the most egregious example of fake news is the mantra that the leaks are fake news. (A new competitor for this dubious honor is the WaPoo’s and NYT’s repetition of the claim that the FBI and the DNI have endorsed the CIA’s claim that the Russians hacked to help Trump, based solely on the (ironically) leaked ipse dixit of the CIA.)

The idea that fake news is somehow, well, new, is farcical. All that has changed is the means of dissemination. I remember vividly poorly printed flyers distributed in Chicago making lurid accusations about Harold Washington. (Ironically, some of the people bewailing fake news now were quite likely involved in some of those old school Chicago antics.) But go back centuries: American political newspapers and pamphlets in the 18th and 19th centuries contained slanderous falsehoods.

But “fake news” has become a thing because Hillary et al are desperate for some excuse for Trump’s triumph. More sinisterly, they are panicking at the realization that they no longer control the flow of information, which once gave them a decided political advantage. They are all about narratives, and when people depended on traditional media channels for news, it was much easier to control the narrative. Now that control is slipping away, they are desperately trying to regain their dominance by enlisting major social media companies in a campaign to crack down on alleged fake stories on their platforms. In the case of Facebook, this involves employing allegedly independent fact checkers, who are in fact made members of the leftist media establishment.

What has obviously happened is that the Internet has disintermediated traditional news media. There are so many channels through which stories (true and false) can flow that the traditional gatekeepers, and the beneficiaries of a more controlled media environment (namely, the political establishment), have lost control. This is inducing hysteria and a panicked effort to regain it.

This reminds me of the Reformation, which disintermediated the incumbent religious hierarchy, and the rulers who relied on the Church to exert social control. Then, the establishment railed at false theology. Today, the establishment rails at false news. Then, the translation of the Bible into the vulgate allowed individuals to make their own theological judgments outside the authority of the institutional church: today, the ability of people to access myriad stories and opinion pieces allows them to make their own political and social judgments without the authority of media or political mandarins. Then, the phrase was “every man his own priest”: today, it could be “every man (or woman) his (or her) own editor.” In the 16th century, the elite–the Church and many secular rulers–reacted to the popularization of religion in by attempting to reassert their religious and social authority over the masses, at times with violence.  In 2016 what passes for an elite is attempting to reassert its ideological and social authority over the masses. As yet, there has been no violence. But it’s early days yet.

The Counter-Reformation ultimately failed because the underlying technological (e.g., printing) and social forces overwhelmed the ability of traditionalists to restore their authority. I expect that the same will be true in the case of the ongoing eReformation. What Facebook and other social media are attempting to do will likely be little more than a futile rearguard action. It is ironic, and somewhat pathetic, that companies which are themselves the product of the technology that disintermediated information are now trying to impose themselves as the new information intermediaries: they certainly like the profits that the technology has showered upon them (well, not Twitter), but are deeply frightened about how the that technology has liberated the reliance of the masses on the elite for their information. They want their cake, and to eat it to.

But this will fail. The contradictions here are so glaring that I am tempted to resort to Marxian language to describe them. I will resist the temptation, and merely conclude by saying that Facebook and Twitter and all of the other would be intermediaries will not be able to surmount these contradictions. And thank God for that.

December 16, 2016

Who is the Biggest Winner From the Blame It on Vlad Frenzy? Vlad.

Filed under: Politics,Russia — The Professor @ 8:47 pm

Hillary Clinton is busy crafting a narrative to explain her crushing defeat. Not surprisingly, it is a narrative in which she bears no personal responsibility. Instead, blame attaches to bad men, namely the FBI’s James Comey and Vladimir Putin:

There were some unprecedented factors that I don’t think we can ignore, because to do so is at our peril. Now, don’t take it from me. Take it from independent analysts. Take it from the Trump campaign. Take it from Nate Silver, who’s pointed out that swing-state voters made their decisions in the final days, breaking against me, because of the FBI letter from Director Comey. And Nate Silver believes — I happen to believe this — that that letter most likely made the difference in the outcome. But we’re also learning something more every day about the unprecedented Russian plot to swing this election. And this is something every American should be worried about. You know, we have to recognize that, as the latest reports made clear, Vladimir Putin himself directed the covert cyber attacks against our electoral system, against our democracy, apparently because he has a personal beef against me.

Poor, poor victim Hillary. She had been such an amazingly successful and strong Secretary of State that Putin was going to stop at nothing to thwart her.

Sure. Whatever gets you through the night, Hillary.

The CIA is doing its best to bolster the narrative, by outrageously leaking the content of letters alleging that it knows that Putin personally directed hacks against the Democrats for the express purpose of electing Trump and defeating Hillary. Just how the CIA knows what went on in the inner sanctum of the Kremlin (and between Putin’s ears) must remain left to the imagination. The FBI and the DNI were not willing to agree with the CIA’s first claim about Putin’s intent. So the CIA leaked another letter, in which CIA Director Brennan allegedly told agency staff that the FBI and DNI now agreed with the CIA. However, neither Comey nor Clapper have stated this publicly. Instead, the WaPo and other mainstream outlets are treating Brennan’s unsubstantiated assertion (which contradicts the FBI’s and DNI’s previous denials) as fact.

This is beyond outrageous. First, the CIA should make its statements on matters of such gravity publicly and provide evidence. Ex cathedra statements released anonymously and devoid of any supporting evidence are clearly inadequate given the gravity of this situation, and the political ramifications of Brennan’s actions. Second, if the FBI and DNI agree, then Brennan, Clapper, and Comey should release a joint statement signed by all. Third, the forum for such disclosures is not leaks to the WaPo (apparently the designated mouthpiece for the agency) but in formal statements, and in testimony before the relevant Congressional committees.

But the CIA pointedly declined to make anyone available to meet with the intelligence committees, despite the fact that they had been asked specifically to do so. This is just appalling.

So why is Brennan doing this? The only plausible explanation is that it is an attack on Trump intended to de-legitimize the election and undermine his presidency before he even raises his right hand to take the oath of office. The CIA has much practice doing this abroad. It is a very siloviki, Chekist thing to do. Ironic, isn’t it?

Trump must act forcefully to submit this agency to presidential control. Given all the gnashing of teeth over the threat posed by Mattis to civilian control over the military, the silence from these quarters over the CIA is stunning–and telling.

There is still no definitive evidence that Wikileaks obtained the offending documents from the Russians: Assange claims that it was not a nation state. One of Assange’s friends, a former UK ambassador to Uzbekistan, claims that he knows who provided the information, and that it was an insider: as I noted from the outset, this is totally plausible. (Assange is apparently irritated at this claim.)

As for the claim (endorsed by Hillary) that the DNC and Podesta documents were released by the Russians specifically to harm her, then why were none of her missing emails leaked? Or are we supposed to believe the fairy tale that hers was the one computer in the entire US that was immune from cyberattack?

Further, this is all a sideshow. What harmed Hillary was the substance of the leaked documents, which showed her and the Democratic Party apparatus to be manipulative and corrupt. Comey’s letters were damaging because they drew attention to Hillary’s palpable dishonesty and high-handedness about her private server. It was the substance was fatal, but Hillary has not-and I warrant will not-addressed the issue of the substance in a serious way.

It is also amazing to watch the schizo behavior of the Democrats and anti-Trump fellow travelers (e.g., Tom Nichols). They are reacting with fury to criticism of the CIA’s behavior. How dare we question these patriots? They are consummate government professionals, working hard to protect us! Yet at the same time they want us to believe that the FBI are partisan hacks, and that the Bureau is a virtual Trumpland that wanted to see Hillary go down in flames.

So let’s see. CIA=non-partisan professionals and patriots. FBI=unprofessional partisan hacks. How does that work, exactly? How do two agencies of the US government develop alpha and omega cultures? The intellectual incoherence here is beyond belief. But those pushing these utterly incompatible stories apparently see no contradiction.

It is also beyond bizarre to see the Democratic Party unabashedly defend the CIA and treat any criticism of it as near treason. Frank Church must be rolling in his grave.

Although there is an element of absurdity to all this, it is a very dangerous set of developments. Hillary and the Democratic Party are crafting something analogous to the Stab in the Back narrative that the German militarists pushed in the aftermath of WWI. Just like Erich von Ludendorff et al, Hillary et al are denying any responsibility for their defeat. Instead they blame it on malign forces that deprived them of the victory that they deserved. Such denial prevents an honest reckoning with the past, and feeds bitterness and resentment. It poisons politics, divides Americans, undermines respect for existing institutions, and will feed extremism. Moreover, Hillary’s narrative basically insults tens of millions of Americans because she insinuates that they were either unwitting dupes of a malign plot hatched abroad, or enthusiastic supporters thereof. This will make any rapprochement in the US impossible, leaving both sides daggers drawn for the foreseeable future. Call it The Deplorables vs. The Better Thans. This will not end well.

That is, Hillary’s indulgence of her amour propre will prevent any political reconciliation in the United States. This is an act of incredible selfishness and destructiveness. But considering who she is, this comes as no surprise.

For his part, Obama spoke on the alleged Russian interference in the election in a press conference today. He said that he told Putin to “cut it [hacking] out.” That’s telling him. Did Obama draw a red line? That’s always a sure winner. Obama also channeled his inner Dean Wormer, and put Putin on Double Secret Probation. That is only a slight exaggeration: Obama said that the US would retaliate, but won’t say how:

President Obama said the U.S. must retaliate against Russia for the election-season hack into Democrats’ emails and that his administration will do so on its own time frame — perhaps in secret.

“Some of it may be explicit and publicized, some of it may not be,” Obama said during an interview that aired on National Public Radio on Friday morning.

“I think there is no doubt that when any foreign government tries to impact the integrity of our elections … we need to take action,” Obama told NPR host Steve Inskeep. “And we will, at a time and place of our own choosing.”

Dude. You are only going to be in office for 35 more days. You don’t have a lot of time to choose from.

Proving that he has learned nothing and forgotten nothing, Obama continued his old habit of belittling Putin and Russia:

After unleashing a string of putdowns about Russia, describing America’s Cold War adversary as “a weaker country” that “doesn’t produce anything anyone wants to buy except oil and gas and arms,” Obama conceded the country could exploit political divisions in the United States.

“They can impact us if we lose track of who we are. They can impact us if we abandon our values,” Obama said.

Yes. Because the putdown strategy has worked so, so great in the past several years. (What, no comments about Putin’s posture?) Talk about the antithesis of speak softly and carry the big stick. This approach will only encourage Putin, and earn his disdain.

In the years after 911, the phrase “if we do X the terrorists will have won” became common and the subject of ridicule–and justly so. Well, in the present case by obsessing over Putin, he does win. Exaggerating his influence in order to absolve oneself of responsibility, and to avoid coming to grips with the repudiation of large numbers of Americans–as Hillary and most Democrats and NeverTrumpers are doing–will sow strife in American politics and bolster Putin’s standing both in Russia and abroad. And as a result, the biggest winner from this 21st century counterpart to waving the bloody shirt will be one Vladimir Vladimirovich Putin.

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.

December 11, 2016

Exxon’s Russian Dealings Are No Reason to Fret About Tillerson. If Anything, the Reverse is True

Filed under: Economics,Energy,Politics,Russia — The Professor @ 12:16 pm

Current reports suggest that Trump will select ExxonMobil CEO Rex Tillerson as his Secretary of State. Like many things Trump, this creates substantial uncertainty. For despite the fact that Tillerson has been a public figure for years, he has not been part of the foreign policy community, and hence his view on specific issues (China, the Middle East, and on and on), and his philosophical/ideological/doctrinal orientation are unknown.

As for the fact he has not been part of the FP community–good! It’s not as if it has covered itself in glory in the past couple of decades. Chin pullers moan that Tillerson’s appointment would represent the biggest discontinuity in US foreign policy in years. Again–good! We’re in a rut. Discontinuity has potential.

Others fret that as the mere CEO of one of the largest (if not the largest) corporations in the world, which invests in highly complex technology, operates in virtually every country on the globe, and which must navigate complex political issues in these myriad countries, is just not up to the job of managing the complexities of international diplomacy:

Some former officials said it was an open question whether Tillerson could make the transition from running Exxon, a vast company that explores for oil and gas on six continents, to the even greater complexity of being secretary of state.

“Negotiating a real estate deal or an oil contract with Saudi Arabia is not the same thing,” said Aaron David Miller, a former State Department Middle East specialist now at the Wilson Center think-tank in Washington.

“It’s not a complicated summit where you are trying to reconcile historical woundings, religious identities, sectarian tensions.”

“I’m not arguing that he can’t make this conversion. I just don’t think we know.”


Because ex-pols and career diplomats like John Kerry, Hillary Clinton, Warren Christopher, Cyrus Vance, James Baker, etc., are such towering geniuses that they are much better able to manage the complexities of foreign affairs.


In today’s hysteria over Russia, of course Exxon’s and Tillerson’s relationship with Russia and Putin has been the focus of much angst and criticism. He received the “Order of Friendship” from Putin! XOM was going to invest zillions in Russia but sanctions prevented that! Sanctions cost Exxon billions! He’ll go easy on Russia to help Exxon!

Tillerson ran an oil company. Oil companies look for oil. Russia has oil. Tillerson’s company looked for oil in Russia. Not that complicated.

Further, XOM was not nearly as dependent on Russia as other majors, such as BP or Shell. Consider the billion or so that Exxon had at risk in joint ventures with Rosneft, but which were scuppered by sanctions. Well, a billion is real money, it’s not nearly as big a deal for Exxon because, well, Exxon is so damn big. Even at the depressed values due to low oil prices, $1 billion is .25 percent of XOM’s market cap. The other numbers bandied about–$400-$500 billion in investments in the Arctic over decades–are highly speculative, and dependent on many contingencies. Indeed, the main source of these numbers is hype by Igor Sechin, and should be discounted accordingly.

But even going beyond that, oil exploration and development is a highly fraught and unpredictable endeavor, especially in harsh natural environments like the Arctic, and harsh political environments like Russia. Seemingly promising finds can turn out to be disappointing. Numerous technological hurdles must be overcome. Political difficulties must be surmounted. Take a look at the Shtokman saga to see how these things can bedevil big Arctic projects.

Most importantly, development economics depend on prices, and prices are highly volatile. The initial XOM-Rosneft deals were negotiated in 2011-2013 when oil prices were north of $100/bbl, and were expected to stay there for, well, pretty much forever. A mere year later, oil prices cratered, and now the conventional wisdom is that $100/bbl oil is not on the horizon, even the distant horizon. Even absent sanctions, there would have been a massive re-evaluation of the scale and scope of the Rosneft-XOM cooperation.

Look at Shell. The technological challenges and costs of the Arctic, plus low prices, have led it to pull the plug on its once vaunting ambitions there.

Here’s something else that should provide this perspective. One of Tillerson’s most important moves as CEO was the acquisition of shale operator XTO Energy, for which Exxon paid $31 billion. This dwarfs the commitment to Russia, and shows that Tillerson was investing bigger dollars  in a technology that actually reduced the need for access to Russian resources.

To some, any involvement in Russia inevitably makes one beholden to Putin. Consider this from one of the lead hysterics, Julia Ioffe:

What does that kind of friendship mean? Past experience suggests it is not a relationship of equals. It means that, at the drop of a hat, the Kremlin might discover serious environmental violations at your Sakhalin plant and drive you out of the country, as it did to Royal Dutch Shell, and then give the lucrative access to a better, domestic ally. It might decide to harass you with lawsuits to force you out, as it did to BP. And it might even throw you in jail, as it did to powerful Russian oligarch Vladimir Yevtushenkov in order to take a small oil company, Bashneft, away from you and give it to Sechin. Putin would even arrest his largely popular economics minister, as he did on November 15, to help Sechin retain it.

The lesson of Putin’s 16-year tenure is a lesson that all businesspeople, foreign and domestic, have learned: to do business in Russia, you have to be on good, personal terms with Putin and Sechin. And you have to understand that those two gatekeepers to Russia’s riches are fickle and sadistic, and, as former KGB operatives, know little of real friendship. To do business in Russia—both for Exxon Mobil and for Tillerson’s own massive retirement fund whose fortunes would rise significantly if a Trump White House lifted sanctions—you have to dance to Putin’s tune, and take whatever favors and humiliations he sends your wayPutin may act a friend and pin state medals on your breast, but he is, ultimately, a cynic. And to play ball with him, you have to be a cynic, too. Forget your honor, your rule of law, your independent judiciary, your human rights, your international law, and focus on the gold coins he throws to your feet. And forget looking dignified as you gather them up.

Note that none–NONE–of Ioffe’s examples involve ExxonMobil. Consider Shell’s travails in Sakhalin. ExxonMobil had a project in Sakhalin as well–Sakhalin I. Gazprom tried for years–years–to muscle its way in on that the way it muscled in on Shell’s Sakhalin II. It failed miserably. XOM swatted them away. And note that Gazprom and the Russian government didn’t pull the crap with Exxon that they pulled with Shell, or with BP in Kovytka or with TNK-BP. That’s a very big dog that didn’t bark. You think the Russians were just being nice to Exxon? Hardly. They respond to strength, and knew better than to confront Exxon.

When Rosneft and Exxon were negotiating their deals in the 2011-2013 time frame, Sechin wanted an arrangement similar to that he extracted/extorted from BP: an XOM investment in Rosneft combined with a big Rosneft equity stake in XOM. This went nowhere. Instead, Exxon negotiated a set of joint ventures that limited its exposure and gave it a lot of optionality and off-ramps, thereby limiting its vulnerability to Russian extortion. As further protection, it also exchanged hostages, namely JVs in the GOM. (These were ironically terminated last week, due to bad economics and unfavorable exploration results, thereby demonstrating the tenuous nature of these kinds of ventures.) Sachin was the supplicant, and was rejected.

All of this reveals that ExxonMobil, and Tillerson personally, were quite aware of the nature of the Putin regime, and the dangers in dealing with it. He hardly needs instruction from Julia Ioffe on these things. Indeed, he has more schooling in these matters that pretty much anyone alive, and has far fewer scars to show for it than pretty much anybody else who has tried to deal in Russia (Bob Dudley, for instance). He has fewer scars because he had more power to fight back than even behemoths like BP. Because Exxon is the behemoth among behemoths.

XOM/Tillerson were clearly aware of the lack of property rights in Russia, and the vulnerability to expropriation. They were the industry leaders at structuring contracts to reduce their risk to this. Further, they had the economic heft to stand up to Russia and Putin: Exxon’s market cap is almost equal to the market cap of the entire Russian market. What’s more, Exxon used this economic heft to get good deals out of Russia. If anything, Russia needed Exxon more than Exxon needed Russia–something that BP or even Shell could not say.

In other words, Tillerson is a man who understands Russia well, is intimately aware of its dysfunctions, understands relative power, and is willing to negotiate from a position of strength in order to obtain positive outcomes that limit the risk of exposure to these dysfunctions.

This is a problem why, exactly? That sounds like the perfect skill set. I know those still in shock after losing an election want to blame Russia for all their misfortunes and are (insanely) seeking open confrontation. That’s idiocy. He will have the resources of the most powerful nation in the world at his disposal, and he will know that American power vastly exceeds Russia’s. Tillerson has taken Putin’s measure, knows the players, and knows how to deploy power to reach mutually beneficial outcomes. Sounds good to me.

Also, incentives matter. As CEO, Tillerson was accountable to shareholders, and his compensation largely aligned his incentives accordingly. He was not (directly) accountable to the US government or the American people, and therefore it is expected that he would sometimes make decisions that benefited Exxon but which were not necessarily aligned with American policy or even American interests. (Though no one has provided a compelling example of that.*)

As Secretary of State, however, his incentives will be far different, and his interests will be far less aligned (if aligned at all) with his former employer. However imperfectly, the incentive structure of democratic politics will lead him to make choices that will differ substantially from those he would have made as CEO of Exxon. I would note that there are many, many instances where what people do in office is very different from what they did or said previously. This is because they face very different incentives. To go out on a limb, I would not be surprised if Tillerson becomes a Strange New Respect winner.

I have no idea how Tillerson will perform as Secretary of State. But I am highly confident that his long experience in Russia does not represent a serious concern: in fact, I would venture that it is his greatest attribute.  He dealt with the Russians for years, and didn’t get run over, and indeed, negotiated some pretty favorable deals with them. That speaks volumes.

Further, I would note that Russia is obviously an important policy challenge, but as a declining power that faces some rather daunting geopolitical and economic handicaps, I do not consider it our primary policy threat. The political class’ recent obsession with Russia, to the exclusion of more important countries–China, most notably–reflects the narcissistic rage of a part of the political class that was thwarted in its ambitions, and which is casting about for a scapegoat. These people didn’t give a damn about Russia before last summer, and indeed, to the extent they mentioned it at all it was to scorn those (e.g., Romney) who raised alarms about it. These are not serious people and their hysterics should not be taken seriously. Fixating on Tillerson’s Russian experience and dealings will distract attention from inquiries about his policy thinking on more important issues.

*In the comments Tim Newman mentions ExxonMobil’s dealings with Kurdistan in defiance of US government policy. That’s a good example, though I do find American policy in this regard problematic. Another example that comes to mind is Tilleson’s decision to terminate drilling in Ukrainian waters around the time of the Crimean crisis.

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.


The CIA Leak About the DNC & Podesta Leaks: The Ad Hominem Fallacy Run Amok

Filed under: Politics,Russia — The Professor @ 10:52 am

Today’s Daily Freak Out relates to a WaPoo story claiming that a “secret” (not any more!) CIA study has concluded that Russians with “links to the Russian government” provided Wikileaks with the hacked DNC and Podesta emails. (I only note in passing the irony of leaking a document to stoke outrage about leaks. Evidently judgments about leaking are instrumental and situational.)

If the CIA has identified individuals who at the very least are accessories, presumably the FBI and DOJ will launch criminal investigation and (if the evidence is a rock solid as the CIA claims) indict them. Unless that happens, I put the credibility of this report somewhere around the level of Curve Ball and aluminum tubes.

Even the “secret” report acknowledges that the CIA has no evidence that these purported individuals were directed by the Russian government. Instead, the CIA infers that the Russian government intended to influence the election based on the (alleged) fact that the RNC was also hacked, but its communications were not leaked.

Can the CIA actually be this stupid? (Rhetorical question alert!)

If the DNC and Podesta emails were damaging, it was because they revealed highly unflattering information about Hillary Clinton and her legions of flying monkeys in Democratic Party circles. The leaked documents revealed that the DNC was actively partisan in its support for Hillary, and took active measures to rig the process against Bernie Sanders. (Which is why I still wouldn’t rule out that a disgruntled Bernie-ite in the DNC played a role here.) Individually and collectively, the emails cemented the narrative of a corrupt Hillary and a corrupt party establishment rigging the system against Sanders: the narrative was already out there, with plenty of evidence to back it up, and these emails just put the cherry on the sundae. They revealed that Hillary and the Democratic National Committee were actively anti-democratic.

It is quite possible that RNC emails would have also revealed a party apparatus intent on undermining an insurgent candidate. Who would have been Trump. That is, whereas the DNC and Podesta emails showed Hillary and her minions to be the perpetrators of an offense, the most likely scenario is that the RNC documents would have shown Trump to be the target and victim of a campaign to disable his candidacy. That would have actually played to Trump’s benefit! It would have fit right in with his narrative of a man fighting the system and the establishment. It would have confirmed all of the criticism he had leveled against the party during the primaries.

Can you see the difference here? If your IQ is above 85 or thereabouts, I presume so. But then apparently you would be disqualified for working as a crack analyst at the CIA.

And let’s always keep one fact in mind. Those who decry the impact of the leaks are effectively taking the position that it would have been better for the American people to have cast their votes in ignorance. That the problem with the leaks wasn’t that they were lies: it was that they revealed unpleasant truths. The provenance of the documents, and how they came to light is secondary or tertiary: the content is primary. If your defense is “it’s an outrage I got caught and those who caught me are dirty bastards”, you deserve no deference or sympathy.

This controversy is the ad hominem fallacy run amok, that it is the speaker (or the source) not the substance that matters.  If revelations about your conduct contributed to the election of a mercurial political neophyte, your conduct, not the party that brought it to light (no matter their motives) is to blame.


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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