Streetwise Professor

June 18, 2014

SWP Itoldyasopalooza

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

While I’m doing the SWP Itoldyasopalooza, three more items.

First, the CFTC has reopened comments on the position limits proposed rule. The CFTC has taken intense incoming fire on the issue of hedge exemptions in particular, and with good reason. There are many problems, but the most egregious is the restriction on “cross hedges” (e.g., using gas futures as a hedge against electricity price risk).

I discussed this issue in my comment letter to the CFTC. Here’s the gist of the problem. The CFTC calculates the hedging effectiveness (measured by the R2 in a regression) of nearby NG futures for spot electricity prices. It finds the effectiveness is low (i.e., the R2 in the relevant regression is small). Looking past the issue of how some risk reduction is better than nothing, this analysis betrays a complete misunderstanding of electricity pricing and how NG futures are used as hedges.

Spot electricity prices are driven by fuel prices, but the main drivers are short term factors such as load shocks (which are driven by weather) and outages. However, these spot-price drivers mean revert rapidly. A weather or outage shock damps out very quickly.

This means that forward power prices are primarily driven by forward fuel prices, because fuel price shocks are persistent while weather and outage shocks are not. So it makes perfect sense to hedge forward power price exposure with gas futures/forwards. The CFTC analysis totally misses the point. Firms don’t use gas forwards/futures to hedge spot power prices. They are using the more liquid gas futures to hedge forward power prices. This is a classic example of hedgers choosing their hedging instrument to balance liquidity and hedging effectiveness. Gas forwards provide a pretty good hedge of power forward prices, and are are more liquid than power forwards. Yes, power forwards may provide a more effective hedge, but that’s little comfort if they turn out to be roach motels that a hedger can check into, but can’t leave if/when it doesn’t need the hedge any more.

The CFTC  ignores liquidity, by the way. How is that possible?

Market participants have strong incentives to make the liquidity-hedging effectiveness trade off efficiently. They do it all the time. Hedgers live with basis risk (e.g., hedging heavy crude with WTI futures) because of the liquidity benefits of more heavily traded contracts. The CFTC position limit rule substitutes the agency’s judgment for that of market participants who actually bear/internalize the costs and benefits of the trade-off. This is a recipe for inefficiency, made all the more severe by the CFTC’s utter failure to understand the economics of the hedge it uses to justify its rule.

As proposed, the rule suggests that the CFTC is so paranoid about market participants using the hedge exemption to circumvent the limit that it has chosen to sharply limit permissible hedges. This is beyond perverse, because it strikes at the most important function of the derivatives markets: risk transfer.

(This issue is discussed in detail in chapter 8 of my 2011 book. I show that the “load delta” for short term power prices is high, but it is low for forward prices. Conversely, the “fuel price delta” is high for power forward prices, precisely because load/weather/outage shocks damp out quickly. The immediate implication of this is that fuel forwards can provide an effective hedge of forward power prices.)

Second, Simon Johnson opines that “Clearing houses could be the next source of chaos.” Who knew? It would have been nice had Simon stepped out on this 5 years ago.

Third, the one arguably beneficial aspect of Frankendodd and Emir-the creation of swaps data repositories-has been totally-and I mean totally-f*cked up in its implementation. Not content with the creation of a single Tower of Babel, American and European regulators have presided over the creation of several! Well played!

Reportedly, less than 30 percent of OTC deals can be matched by the repositories.

This too was predictable-and predicted (modesty prevents me from mentioning by whom). Repositories are natural monopolies and should be set up as utilities. A single repository minimizes fixed costs, and facilitates coordination and the creation of a standard. I went through this in detail in 2003 when I advocated the creation of an Energy Data Hub. But our betters decided to encourage the creation of multiple repositories (suppositories?) with a hodge-podge of reporting obligations and inconsistent reporting formats.

This brings to mind three quotes. One by Ronald Reagan: “‘I’m from the government and here to help you’ are the 8 scariest words in the English language.” The other two by Casey  Stengel. “Can’t anybody play this game?” and “He has third base so screwed up, nobody can play it right.”

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3 Comments »

  1. I use Reagan’s phrase often, so allow me to point out that you should drop the redundant ‘you’, or alternatively undergo a remedial counting course.

    Comment by Noir — June 18, 2014 @ 11:32 pm

  2. I commented on your earlier post about the Klearing Kool Aid that someone needs to develop and market (or just market if already developed) a Conservation of Risk principle that would get the same kind of general take-up as the laws of thermodynamics. Your commentary about the CFTC focusing on one kind of risk while ignoring another underlines my conclusion. Until people internalize in their bones the impossibility of regulating away risks rather than transforming them into another form this type of target-fascination error is going to persist. It seems like liquidity risk is the red-headed stepchild of risk categories lately, but tomorrow it might be credit risk or basis risk.

    Comment by srp — June 19, 2014 @ 7:57 pm

  3. @srp-Modigliani-Miller is essentially a conversation of risk principle. It does puzzle me that people who should know better don’t understand how the first order effect of regulations is to redistribute risk among claimants of firms, rather than reduce it. One group that does tend to get it is bankruptcy attorneys, probably because a good deal of bankruptcy law is related distribution/redistribution of resources among different claimants.

    The simple risk redistribution story implicitly holds fixed all claims outstanding against a firm. Of course, when regulations change, firms will adjust capital structures and investment decisions and operational decisions and that makes things more complicated. But it should a flashing red light whenever anyone asserts that a given regulation will make risk disappear, especially if in their analysis they hold investment and operational choices fixed. Under those conditions, M-M says that risk has been redistributed, not reduced.

    The ProfessorComment by The Professor — June 19, 2014 @ 10:27 pm

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