Streetwise Professor

October 13, 2014

You Might Have Read This Somewhere Before. Like Here.

The FT has a long article by John Dizard raising alarms about the systemic risks posed by CCPs. The solution, in other words, might be the problem.

Where have I read that before?

The article focuses on a couple of regulatory reports that have also raised the alarm:

No, I am referring to reports filed by the wiring and plumbing inspectors of the CCPs. For example, the International Organization for Securities Commissions (a name that could only be made duller by inserting the word “Canada”) issued a report this month on the “Securities Markets Risk Outlook 2014-2015”. I am not going to attempt to achieve the poetic effect of the volume read as a whole, so I will skip ahead to page 85 to the section on margin calls.

Talking (again) about the last crisis, the authors recount: “When the crisis materialised in 2008, deleveraging occurred, leading to a pro-cyclical margin spiral (see figure 99). Margin requirements also have the potential to cause pro-cyclical effects in the cleared markets.” The next page shows figure 99, an intriguing cartoon of a margin spiral, with haircuts leading to more haircuts leading to “liquidate position”, “further downward pressure” and “loss on open positions”. In short, do not read it to the children before bedtime.

This margin issue is exactly what I’ve been on about for six years now. Good that regulators are finally waking up to it, though it’s a little late in the day, isn’t it?

I chuckle at the children before bedtime line. I often say that I should give my presentations on the systemic risk of CCPs while sitting by a campfire holding a flashlight under my chin.

I don’t chuckle at the fact that other regulators seem rather oblivious to the dangers inherent in what they’ve created:

While supervisory institutions such as the Financial Stability Oversight Council are trying to fit boring old life insurers into their “systemic” regulatory frameworks, they seem to be ignoring the degree to which the much-expanded clearing houses are a threat, not a solution. Much attention has been paid, publicly, to how banks that become insolvent in the future will have their shareholders and creditors bailed in to the losses, their managements dismissed and their corporate forms put into liquidation. But what about the clearing houses? What happens to them when one or more of their participants fail?

I call myself the Clearing Cassandra precisely because I have been prophesying so for years, but the FSOC and others have largely ignored such concerns.

Dizard starts out his piece quoting Dallas Fed President Richard Fisher comparing macroprudential regulation to the Maginot Line. Dizard notes that others have made similar Maginot Line comparisons post-crisis, and says that this is unfair to the Maginot Line because it was never breached: the Germans went around it.

I am one person who has made this comparison specifically in the context of CCPs, most recently at Camp Alphaville in July. But my point was exactly that the creation of impregnable CCPs would result in the diversion of stresses to other parts of the financial system, just like the Maginot line diverted the Germans into the Ardennes, where French defenses were far more brittle. In particular, CCPs are intended to eliminate credit risk, but they do so by creating tremendous demands for liquidity, especially during crisis times. Since liquidity risk is, in my view, far more dangerous than credit risk, this is not obviously a good trade off. The main question becomes: During the next crisis, where will be the financial Sedan?

I take some grim satisfaction that arguments that I have made for years are becoming conventional wisdom, or at least widespread among those who haven’t imbibed the Clearing Kool Aid. Would that have happened before legislators and regulators around the world embarked on the vastest re-engineering of world financial markets ever attempted, and did so with their eyes wide shut.

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October 12, 2014

Achtung! Jabos

Filed under: History,Military,Politics — The Professor @ 9:11 pm

Here is a fascinating document from WWII. It’s a semi-official history of the IX Tactical Air Command, written to promote the unit’s achievements and build morale. It’s not independent and objective, but it does provide valuable information. I note especially the description of the vital importance of personnel on the ground to spot targets and coordinate the actions of the fighter bombers and the armor and infantry on the ground p. 7:

Some things don’t change: the need for air-ground cooperation has been proven again and again, in Europe, in Viet Nam, in the two Gulf Wars, and in Afghanistan. But apparently a community organizer knows better.

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He Doth Protest Too Much, Methinks

Filed under: Military,Politics,Russia — The Professor @ 1:56 pm

In recent weeks there have been a spate of stories about how JP Morgan and perhaps 13 other financial institutions were the target of a massive cyber probing attack. The early reporting fingered Russians. Now there is pushback:

There is no indication that Vladimir Putin, the Russian government or any foreign nation state was involved in the JPMorgan cyberattack this summer, a source familiar with the incident tells CNBC.

There have been media reports speculating that the Russians may have carried out the attack in retaliation for U.S. sanctions on Russia, but that appears not to be the case, the source said. “Anyone who says this is the Russians, that’s ridiculous,” the source said. “There’s no indication of any foreign nation state. Any reporting on that is not coming from someone who knows what’s going on.”

Um, except that wasn’t the reporting, at all. Here’s an example:

JPMorgan Chase & Co.’s own investigators have found clues that a global network of computers available for hire by sophisticated criminals was used to reroute data stolen from the bank to a major Russian city, according to people familiar with the probe.

. . . .

The use of a Russian-based data center is another piece of a puzzle being constructed by investigators as they chase answers to urgent questions such as the attack’s motive, the hackers’ identity, and the possibility other banks may have been attacked or probed by the same group.

The link to Russia cybercriminals is pretty concrete here. Yes, some people pointed out the obvious: that there are links between Russian cybercriminals and the Russian state, specifically its intelligence agencies. Especially given the ongoing confrontation between the US and Russia, involving sanctions, aggressive Russian actions in the air and at sea, etc., and Russia’s history of using private hackers in attacks on states it is at odds with, it is reasonable to suspect that the probes of US financial firms has some connection to the Russian security services.

Given these facts, and this history, the very aggressive denial, and the invocation of Putin by name, is very odd. He doth protest too much, methinks.

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October 11, 2014

If You Set Out to Bomb ISIS, Bomb ISIS

Filed under: History,Military,Politics — The Professor @ 9:15 pm

As a follow up on my post about the devastating use of airpower to turn back the Eastertide Offensive in Viet Nam in 1972, consider this judgment delivered by LTG David Deptula (USAF ret):

The issue is not the limits of airpower, the issue is the ineffective use of airpower. According to [The Department of Defense's] own website, two B-1 sorties can deliver more ordnance than did all the strikes from the aircraft carrier Bush over the last six weeks. Two F-15E sorties alone are enough to handle the current average daily task load of airstrikes in both Iraq and Syria.

Wise analysts understand that those blaming airpower for not ‘saving Kobani’ are confusing the limits of ‘airpower’ with the sub-optimization of its application. One can see [ISIS] tanks and artillery . . . in the open on TV, yet the coalition forces for ‘Operation Un-named Effort’ are not hitting them. Airpower can hit those targets and many others, but those in charge of its application are not—that’s the issue—not the limits of airpower.

The airstrikes to date have been very closely controlled, tactical in nature, and reflect the way they have been ‘metered’ in Afghanistan. The process that is being used to apply airpower is excessively long and overly controlled at too high a command level.

Exactly. Air power has limits, but we haven’t even come close to those limits in Iraq and Syria. The limits on the current campaign don’t inhere in the nature of air power, but are being imposed by those in command.

Note the last line: “overly controlled at too high a command level.” The highest command level, in fact. We know that Obama is exercising tight control over this operation, and it shows.

I know all about zoomies exaggerating the capabilities of air power. They claim that it can win wars unaided. That’s never happened. But most of the over-promising relates to strategic bombing. Tactical air can be devastating (think the Luftwaffe during the blitzkrieg, or the ferocious Jabos of the IX Tactical Air Command in Europe in 1944-45), but the USAF has always bridled at being beholden to the ground pounders. (This is why the A-10s have always had more to fear from the Air Force brass than enemy fire.)

Well, here and now there are no ground pounders involved. For better or worse, this is an Air Force and Naval Air show.  They can be decisive, if allowed to do what they are capable of doing.

The current desultory campaign is worse than no campaign at all. Apropos what Napoleon said about taking taking Vienna, if you set out to bomb ISIS, bomb ISIS. Here is definitely a case where moderation in war is imbecility. It achieves nothing except embolden the enemy and raise their stature, and make the US look like a timorous, cringing giant, thereby encouraging further challenges. The current effort is bolstering Assad, and infuriating the anti-Assad forces we are looking to support the fight against ISIS. It is reinforcing America’s image as a betrayer of the Kurds. This is exactly why I despaired at the thought of Obama waging a war.

I am sure that most in the military are beside themselves. But what to do about it? Perhaps those in the Pentagon, and especially the Joint Chiefs, should read H. R. McMaster’s Dereliction of Duty, or maybe give LTG McMaster a call.

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October 9, 2014

To See How We’re Doing It Wrong, Consider When We Did It Right: Eastertide, 1972

Filed under: History,Military,Politics — The Professor @ 10:17 pm

Watching the desultory air campaign in Syria and Iraq, and in particular the minimal strikes in defense of Kobani, brought to mind an example of what air power can do to rescue a beleaguered, poorly-led, and demoralized ground force: the crushing US air strikes against the North Vietnamese Eastertide Offensive in 1972.

This paper provides a very thorough history and analysis.

Particularly devastating were massive B-52 strikes, delivered in 3 ship “Arc Light” packages. Flying too high to be heard or seen, the first indication that the NVA soldiers on the ground had that they were Arc Light targets was the world exploding around them. Many of the dead were found without a mark, killed by the concussive force of the explosions. Gunships, initially AC-47s and eventually AC-130s, were also very effective in night-time raids. (The USAF also used B-52s with devastating effectiveness against Iraqi Republican Guard and regular infantry units during Desert Storm.)

For a Kobani comparison, look at the Battle of An Loc, where outnumbered and shaky PAVN units were saved by wave after wave of US air strikes.

Two things stand out. The first, to be decisive, the attacks were massed and unrelenting. Second, and this is particularly relevant in the Iraq-Syria context, was the vital role played by Tactical Air Controllers. You know, boots on the ground (gag) calling in the strikes.* Without them the NVA would have prevailed. They were the difference between success and failure.

The effort in 1972 was massive. But that’s because the NVA attack was massive, well over 200,000 strong, heavily supported by armor and artillery. The losses inflicted by the air campaign were also massive: the NVA lost over 100,000 casualties, perhaps half of those KIA.

The ISIS forces are much smaller, so such a massive effort would not be needed. Moreover, the advent of precision guided weapons allows the delivery of decisive fires with fewer sorties and fewer bombs dropped. The terrain is also more favorable, desert in which concealment is difficult vs. dense jungle.

Unlike the NVA, ISIS is unlikely to stand still and be pounded into dust. But that’s fine. They can’t advance, and they can’t win, if they are hunkered down.

Air power works best if it works hand-in-glove with ground forces. But the events of 1972 show that  air power can be decisive if employed in overwhelming force and is guided by expert soldiers and airmen on the ground.

At present the US is doing neither. Hence we will fail, and we will have chosen failure.

*I hate, hate, hate the expression “boots on the ground” by the way. It was annoying when first used years ago, by Colin Powell I think. It has only become more annoying through overuse by people who know less about the military than you could learn by watching Gomer Pyle reruns. I use it sarcastically here  because it has been used ad nauseum in this context.

 

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Not an Intellectual, and Not a Leader

Filed under: History,Military,Politics — The Professor @ 7:24 pm

This Reuters article about Obama’s Syria policy, such as it is, is brutal, but at the same time overly charitable.

The charitable part is about him being “analyst in chief.” Yes, the article makes it clear that this is not intended to be a compliment, and that the administration is a classic case of paralysis by analysis. But I think it’s unduly charitable to credit Obama with any real analytical prowess. I’ve yet to see evidence of it. He is the master of logical fallacies and rhetorical tricks (the straw man, the false choice). He can regurgitate progressive tropes in a stentorian voice. But original thought? Incisive intellect? Those are certainly not on public display. His intellectual gifts are vastly overhyped.

A related criticism is that Obama is too professorial to be president. As Richard Epstein (who truly is an analytical genius with a penetrating intellect) has noted, Obama wasn’t a professor (he was a senior lecturer) who never produced one piece of independent research, and what’s more, he assiduously avoided the intellectual give and take at Chicago. He did not participate in the amazing and unique lunch and seminar culture.

This is offensive to me, actually. As a Chicago alum (three times over) I realize how special that culture is. It borders on the criminal to have the opportunity to be a part of it, and spurn it. No real intellectual would do that. So spare me the he’s-too-cerebral bunk. He’s not a professor. He’s a poser.

Other parts of the piece suggest a man who is rigidly wedded to his preconceptions, and cannot adjust when reality does not conform to them:

The president’s supporters say his approach is based on principle, not bias. He ran on a platform of winding down the Iraq War and made his views crystal-clear on military action in the Middle East. Obama believed that the human and financial costs of large-scale interventions weren’t worth the limited outcomes they produced. He held that U.S. force could not change the internal dynamics of countries in the region.

The problem is that those beliefs  and principles appear to have been immune to contradictory evidence, as revealed by how tightly he clung to them as things spun out of control.

The most damning part of the Reuters piece is not the analyst-in-chief stuff. It relates to his control freakery, inability to delegate,  reliance on a small group of staff, and failure to engage seriously people who might actually know something and who have independent heft:

In some ways, Obama’s closer control and the frequent marginalization of the State and Defense departments continues a trend begun under Bill Clinton and George W. Bush.

But under Obama, the centralization has gone further. It was the White House, not the Pentagon, that decided to send two additional Special Operations troops to Yemen. The White House, not the State Department, now oversees many details of U.S. embassy security – a reaction to Republican attacks over the lethal 2012 assault on the U.S. consulate in Benghazi, Libya. A decision to extend $10 million in nonlethal aid to Ukraine also required White House vetting and approval.

On weightier issues, major decisions sometimes catch senior Cabinet officers unawares. One former senior U.S. official said Obama’s 2011 decision to abandon difficult troop negotiations with Baghdad and remove the last U.S. soldiers from Iraq surprised the Pentagon and was known only by the president and a small circle of aides.

. . . .

Some aides complained that alternative views on some subjects, such as Syria, had little impact on the thinking of the president and his inner circle. Despite the open debate, meetings involving even Cabinet secretaries were little more than “formal formalities,” with decisions made by Obama and a handful of White House aides [can you say Valerie Jarrett? I knew you could!], one former senior U.S. official said.

Obsession with control, inability and unwillingness to confront conflicting views, and a refusal to delegate are classic management/leadership fails, especially in a vast organization like the USG. A former NSC staffer hits the nail on the head:

“The instinct is to centralize decision-making with the hope of exerting more control,” she said. “But that often limits the U.S. government’s agility and effectiveness at a time when those two traits are most needed.”

The conventional explanation of these tendencies is that Obama is excessively arrogant, as epitomized by this quote:

“I think that I’m a better speechwriter than my speechwriters. I know more about policies on any particular issue than my policy directors. And I’ll tell you right now that I’m gonna think I’m a better political director than my political director.”

But I wonder whether the condescension and arrogance are a narcissistic mask for deep insecurity. A truly confident man would wade into the rough-and-tumble Chicago workshop culture with a relish, rather than avoid it. A truly confident man would have no problems surrounding himself with women and men of independent stature, rather than toadies and non-entities totally reliant on him for their position: his Lilliputian second term cabinet speaks volumes (and it’s not as if his first term cabinet was a collection of giants). A confident man would be able to delegate in the belief that subordinates would be willing and able to act on his instructions in accordance to the circumstances that they encounter. Fearful men are obsessed with control.

There are other indications of narcissism, notably the injured and self-pitying response to criticism:

Six years of grinding partisan warfare over foreign policy (and much else) have left Obama increasingly fatalistic about his critics. [Note the attribution of partisanship to others exclusively, and no recognition of his own contribution to partisan rancor.]

While on vacation in Martha’s Vineyard in late August, he was widely criticized for golfing after making a condolence call to the family of murdered American journalist James Foley. Minutes after declaring Foley’s murderer – Islamic State – a “cancer” that had “no place in the 21st century,” Obama teed off with a campaign contributor, an old friend and a former NBA star.

Obama later told aides the criticism was inevitable. No matter what I do, he said, my enemies will attack me.

That is, rather than acknowledging that some criticism might be accurate, and trying to learn from it, he uses the fact that some criticism is partisan (from “enemies”-Nixon much?) to dismiss all of it, so he can rationalize doing just what he wants to do (e.g., playing golf at a time of tragedy).

I guess the intellectual and psychological roots of Obama’s failure as a leader don’t really matter (and if Jimmy Carter slags you for foreign policy fecklessness, you are a failure). What does matter is that the world is in flames, America’s standing is at its lowest ebb in living memory, dictators and authoritarians are on the march, and we have two more years to endure this before there is a possibility of an improvement. For Obama isn’t going to change. Regardless of why he is who he is, he is who he is. And who he is is not constitutionally equipped to lead during times of strife, especially strife that is largely the result of his own failures to lead.

 

 

 

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October 8, 2014

Pugachev’s Rebellion

Filed under: History,Politics,Russia — The Professor @ 8:41 pm

Spare a thought for ex-oligarch Sergei Pugachev, who was expropriated by the Russian state in 2012. Sergei has had a blinding insight about the nature of Putinistan:

A former close associate of Vladimir Putin has said Russian businessmen were all now “serfs” who belonged to the president, with none of the country’s companies beyond his reach.

. . . .

Speaking to the Financial Times, Mr Pugachev warned that there were no longer any “untouchables” in a Russian business landscape increasingly dominated by Mr Putin. The Russian economy, he argued, had been transformed into a feudal system where businessmen were only nominal owners of their assets.

“Today in Russia there is no private property. There are only serfs who belong to Putin,” he said.

. . . .

“Now there is Putin and there are his lieutenants who carry out his orders – and all cash generated is put on the balance of Putin,” he said. “The country is in a state of war. And therefore big business cannot live as before. It has to live under military rules.”

Excuse me while I wipe away a tear for a fallen oligarch.

But seriously, this is a revelation? This has been obvious since very early on in the Putin years.

Indeed, it is just a recognition that Putin’s Russia is the continuation of a historical tradition stretching back to the dawn of Muscovy. As Richard Pipes wrote years ago, Russia/Muscovy was a patrimonial state in which all property was the tsar’s. Possession was temporary,  contingent on service, and conditional on the will of the tsar. Muscovy was the land of kormenlie-”the feeding”-in which the tsar granted a lucrative territory to an official, who was expected to support himself off of what he could take from it, and provide the tsar with service. Lands and serfs were granted to individuals in exchange for service, but were not property as such. Everything was occupied at the sufferance of the tsar. The system was later softened, and the service obligation weakened, but since forever the patrimonial aspects of the Russian state have survived. Putin is just the latest in a long tradition.

As I’ve written since the very beginning of the blog, Putin’s Russia is a “natural state” in which the ruler adopts policies that create rents, and then divvies up those rents in order to secure support,  to reward those who do his bidding and punish those who don’t: patrimonialism is one of the most primitive forms of the natural state. So the Timchenkos and Rotenbergs and Sechins live large, and the Yevtushenkovs and Khordokovskys and Pugachevs get crushed. Sometimes people are broken for a reason: sometimes the fall is arbitrary, just to demonstrate who is boss and to reinforce the understanding that wealth and power are contingent on the Putin’s will.

As I also wrote for a long time, especially around the time of the crisis in 2008-2009, the survival of this system depends on the existence of a stream of rents. When that stream dries up, it is more difficult to buy the subservience (I would not characterize it as loyalty) of the placemen. At such times, the system becomes vulnerable to collapse.

And there are some indications that this is the case now. One must always be cautious about trying to figure out what is going on behind the scenes in Russia, but there are some visible indications of a system under stress. One is the resort to sticks, with Yevtushenkov’s arrest being one example, and myriad repressive measures being others: sticks are needed all the more when the carrots run low. Another is the pervasiveness of propaganda. Yet another is the need for foreign adventures, confrontations with the outside world, and the assiduous cultivation of an us-versus-them mentality.

But perhaps the most telling indicator is the increasingly bizarre cult of personality being constructed around Putin. Putin’s apotheosis is occurring on his 62nd birthday. Almost literally. Recently an Orthodox activist suggested that Putin will become God, or the human embodiment of God on earth, through divine grace. There was an exhibition in Moscow portraying him as a Russian Hercules.  Russians from all walks of life-including hockey playing ape Alex Ovechkin-thronged to wish VVP a happy birthday. Other evidence of cultism abound.

A society that does this is not healthy. A society that does this is deeply insecure. A society that does this is desperate to believe that it is the hands of a savior because the alternative is too frightening to contemplate.

A society like this, a polity like this, is extremely brittle. It is at risk to shattering into a thousand shards.

Centuries ago, a rebel named Pugachev shook Catherine the Great’s Russia to its foundations. The 21st century Sergei Pugachev does not pose such a threat, but in a state as brittle as Putin’s Russia, a latter day Pugachev may arise from the steppe. Or from the center of Moscow.

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October 7, 2014

The Crude Export Ban: Moot For Now, But That’s Not Necessarily a Good Thing

Filed under: Commodities,Economics,Energy,Politics,Regulation — The Professor @ 7:55 pm

Markets are wondrous things.

Consider the crude oil market. Remember the debate about the US crude export ban? Well, in a few months, that has turned out to be a moot issue. Due to the collapse of demand in Europe, and the freeing up of Nigerian supplies formerly exported to the US, price relationships have changed dramatically. Whereas Louisiana Light Sweet had recently traded at a big discount to Brent, it is now at a sufficiently high premium that it is economical to import Brent to the US, especially to the East Coast. Jones Act tankers expected to take crude from the Gulf to the East Coast are swinging at anchor because it is now economical to feed the EC refineries with Brent.

What’s more, the US crude glut fattened domestic refining margins. So how did US refiners respond? By increasing capacity, and reducing maintenance schedules by 30 percent. This has increased the demand for domestic crude, which has in turn helped close, and at times reverse, the US price discount. This investment in capacity and adjustment of maintenance schedules is arguably inefficient: it’s better to direct some of the crude to underutilized European refineries than to expand refining capacity in the US. But the point is that this inefficiency is attributable to inefficient laws: the laws on oil export have stood still, but the markets have moved on to mitigate the damage.

Meaning at present, price differentials are such that it would not be profitable to export crude even if it were permitted.

This may be true now, but of course it is not destined to be true forever. Therefore, it is still desirable to eliminate the ban, if only to eliminate the incentives to use scarce resources to take advantage of the price distortions that the ban can sometimes cause.  The ban might be a moot issue for now, but that’s not necessarily a good thing.

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Manipulation Prosecutions: Going for the Capillaries, Ignoring the Jugular

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 7:32 pm

The USDOJ has filed criminal charges against a trader named Michael Coscia for “spoofing” CME and ICE futures markets. Frankendodd made spoofing a crime.

What is spoofing? It’s the futures market equivalent of Lucy and the football. A trader submits buy (sell) orders above (below) the inside market in the hope that this convinces other market participants that there is strong demand (supply) for (of) the futures contract. If others are so fooled, they will raise their bids (lower their offers). Right before they do this, the spoofer pulls his orders just like Lucy pulls the football away from Charlie Brown, and then hits (lifts) the higher (lower) bids (offers). If the pre-spoof prices are “right”, the post-spoof bids (offers) are too high (too low), which means the spoofer sells high and buys low.

Is this inefficient? Yeah, I guess. Is it a big deal? Color me skeptical, especially since the activity is self-correcting. The strategy works if those at the inside market, who these days are likely to be HFT firms, consider the away from the market spoofing orders to be informative. But they aren’t. The HFT firms at the inside market who respond to the spoof will lose money. They will soon figure this out, and won’t respond to the spoofs any more: they will deem away-from-the-market orders as uninformative. Problem solved.

But the CFTC (and now DOJ, apparently) are obsessed with this, and other games for ticks. They pursue these activities with Javert-like mania.

What makes this maddening to me is that while obsessing over ticks gained by spoofs or other HFT strategies, regulators have totally overlooked corners that have distorted prices by many, many ticks.

I know of two market operations in the last ten years plausibly involving major corners that have arguably imposed mid-nine figure losses on futures market participants, and in one of the case, possibly ten-figure losses. Yes, we are talking hundreds of millions and perhaps more than a billion. To put things in context, Coscia is alleged to have made a whopping $1.6 million. That is, two or three orders of magnitude less than the losses involved in these corners.

And what have CFTC and DOJ done in these cases? Exactly bupkus. Zip. Nada. Squat.

Why is that? Part of the explanation is that previous CFTC decisions in the 1980s were economically incoherent, and have posed substantial obstacles to winning a verdict: I wrote about this almost 20 years ago, in a Washington & Lee Law Review article. But I doubt that is the entire story, especially since one of the cases is post-Frankendodd, and hence the one of the legal obstacles that the CFTC complains about (relating to proving intent) has been eliminated.

The other part of the story is too big to jail. Both of the entities involved are very major players in their respective markets. Very major. One has been very much in the news lately.

In other words, the CFTC is likely intimidated by-and arguably captured by-those it is intended to police because they are very major players.

The only recent exception I can think of-and by recent, I mean within the last 10 years-is the DOJ’s prosecution of BP for manipulating the propane market. But BP was already in the DOJ’s sights because of the Texas City explosion. Somebody dropped the dime on BP for propane, and DOJ used that to turn up the heat on BP. BP eventually agreed to a deferred prosecution agreement, in which it paid a $100 million fine to the government, and paid $53 million into a restitution fund to compensate any private litigants.

The Commodity Exchange Act specifically proscribes corners. Corners occur. But the CFTC never goes after corners, even if they cost market participants hundreds of millions of dollars. Probably because corners that cost market participants nine or ten figures can only be carried out by firms that can hire very expensive lawyers and who have multiple congressmen and senators on speed dial.

Instead, the regulators go after much smaller fry so they can crow about how tough they are on wrongdoers. They go after shoplifters, and let axe murderers walk free. Going for the capillaries, ignoring the jugular.

All this said, I am not a fan of criminalizing manipulation. Monetary fines-or damages in private litigation-commensurate to the harm imposed will have the appropriate deterrent effect.

The timidity of regulators in going after manipulators is precisely why a private right of action in manipulation cases is extremely important. (Full disclosure: I have served as an expert in such cases.)

One last comment about criminal charges in manipulation cases. The DOJ prosecuted the individual traders in the propane corner. Judge Miller in the Houston Division of the  Southern District of Texas threw out the cases, on the grounds that the Commodity Exchange Act’s anti-manipulation provisions are unconstitutionally vague. Now this is only a district court decision, and the anti-spoofing case will be brought under new provisions of the CEA adopted as the result of Dodd-Frank. Nonetheless, I think it is highly likely that Coscia will raise the same defense (as well as some others). It will be interesting to see how this plays out.

But regardless of how it plays out, regulators’ obsession with HFT games stands in stark contrast with their conspicuous silence on major corner cases. Given that corners can cause major dislocations in markets, and completely undermine the purposes of futures markets-risk transfer and price discovery-this imbalance speaks very ill of the priorities-and the gumption (I cleaned that up)-of those charged with policing US futures markets.

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October 6, 2014

Laughing Gaz(prom)

Filed under: Commodities,Derivatives,Economics,Energy,Russia — The Professor @ 6:21 pm

Silly me, I thought the “gaz” in Gazprom was methane. But reading this article in Platts, I’m thinking it’s nitrous oxide.  I had to read it several times before I could catch a glimpse of what Sergei Komlev, head of Gazprom Export’s contract structuring and price formation department, was getting at. I now see the basic problem is that he thinks the price of gas in Europe is too low. And the culprit? Speculators! Paper traders! “Virtual gas”!

Come on Sergei, you can’t get originality points for that one. Round up the usual suspects and all that.

Anyways, FWIW, here are Sergei’s deep, N20 inspired thoughts on the subject:

“Paradoxically, gas price erosion is taking place at a time when physical supplies are tight,” Komlev said, adding that some European market analysts had acknowledged that hubs were overflowing with largely “paper” gas.

This became possible with the development of the spot gas market as hubs developed a new class of customer such as banks and commodity traders, Komlev said.

But “as no one is in a position to predict the weather, traded volumes of ‘paper’ gas significantly surpassed real world demand for gas because of the abnormally warm winter in 2014,” he said.

This artificial oversupply had put significant pressure on the market, resulting in a collapse in spot prices, he said.

“As a result, our European customers are facing negative margins as they have to supply gas to end-consumers at lower prices than they pay for physical deliveries under long-term contracts,” he said.

“When some time ago our clients sold our contract volumes on a forward curve for many months ahead they targeted this new class of customers first,” he said.

I’m doubled over in convulsions here, and I haven’t even taken a hit. Is there such a thing as second hand N20?

Let me translate what really happened. Speculators went long. Weather was unusually warm. Prices fell, and speculators took a bath. Simple story. As for “tight physical supplies”, later on Sergei lets on that gas demand in Europe fell 20 percent in the 1st half of 2014.

Sorry, but “paper gas” doesn’t heat a single home or turn a single turbine. It doesn’t oversupply. It doesn’t overdemand. It just transfers price risk. As contracts go prompt, the price of paper gas converges to the price of physical gas, which is driven by supply and demand fundamentals-most notably the weather. What frosts (or is it burns?) Sergei is that the price converged to a low price which is out of line with the oil-linked prices in Gazprom contracts. This has imposed pain on Gazprom’s customers, who are clamoring to renegotiate their contracts, which Sergei and Gazprom no likey.

Like the proverbial blind hog and the acorn, Sergei did root up a bit of the truth:

Long-term contracts were shaped at a time when spot gas markets in Europe were not developed, and the gas price — linked to oil prices — “was practically independent of supply/demand dynamics,” Komlev said.

I repeat: The oil linked price was/is “practically independent of supply/demand dynamics.”

Exactly! That’s the problem! That’s why a move to hub-based pricing, where gas prices can reflect gas values, is so necessary: it ensures that contract prices reflect supply/demand dynamics. Prices that don’t reflect values lead to distortions in output and consumption and investment, and to conflicts between buyers and sellers that inflate transactions costs.

Komlev went on to say that since price in the contracts was not flexible, and was out of line with gas values, it was necessary to permit quantity flexibility in Gazprom contracts. If the company is dragged kicking and screaming into the 21st century, and must index its contractual gas prices to-wait for it-gas prices, it will eliminate the quantity optionality.

Throw the customers into that b’rer patch, Sergei. Truth be told, fixed quantity forward supply contracts are quite the thing in the US, and have been since the dysfunctional price controls on gas were discarded in the 1980s. Companies can buy and sell base load volumes using fixed quantity long term contracts (perhaps at indexed prices); respond to near term fundamental conditions with short-term (e.g., month ahead) forward contracts entered into during something analogous to “bid week” and respond to intra-month/daily supply and demand swings with spot transactions. They can also get various customized contracts that are seasonally shaped, or have some optionality that permits efficient responses to supply and demand shocks (though the CFTC’s proposed Seven Prong-Prong, not Pirrong-test for determining whether supply contracts with quantity optionality are swaps subject to Frankendodd could wreak havoc with that).

A liberated gas market offers a variety of contract terms, including contracts that embed various sorts of quantity optionality. But the point is that heterogeneous suppliers and demanders can utilize a variety of contracts tailored to meet their idiosyncratic needs, as opposed to Gazprom contracts, which remind me of nothing so much as an ill-fitting Soviet suit.

I do have to thank Sergei. I haven’t had such a good laugh in a long time, with or without chemical assistance. But I doubt he-and Gazprom-will be laughing for long. The disconnect between oil and gas prices has become too large and too persistent for their beloved oil linkage to survive much longer.

Speaking of oil-linked prices, this is an issue in LNG markets too. I recently authored a white paper on the subject. I’ll provide a link and write a post on that subject in the next few days.

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