Streetwise Professor

October 24, 2015

Creeping Recognition that Regulation Has Created a Liquidity Death Star

Reason number one (by far) that I believe that clearing and collateral mandates increase systemic risk is that they transform credit risk into liquidity risk. Large price moves during stressed market situations require those with losing positions to make large variation margin payments in a very tight frame. These payments need to be funded, and funded immediately. Thus, variation margining causes spikes in the demand for liquidity. Furthermore, clearing in particular creates tight coupling because failures-or even delays-in making VM payments can put the clearinghouse into default, or force it to liquidate collateral in an illiquid market. The consequences of that, you should shudder to contemplate.

To be somewhat hyperbolic, clearing mandates create a sort of liquidity death star.

Recognition of how dangerous spikes in liquidity demand precisely when liquidity supply evaporates creates a major systemic risk is sadly insufficiently widespread, particularly among many regulators who still sing paeans to the glories of clearing. But perhaps awareness is spreading, albeit slowly. At least I hope that this Economist article indicates a greater appreciation of the collateral issue, although it fails to draw the connection to central clearing, and how clearing mandates can dramatically exacerbate collateral shortages:

WHEN the financial system teetered on the brink of collapse in 2008, the biggest problem was a lack of liquidity. Banks were unable to refinance themselves in the short-term debt markets. Central banks had to step in on a massive scale to offer support. Calm was eventually restored, but not without enormous economic damage.

But has the underlying problem of liquidity gone away? A research note from Michael Howell of Crossborder Capital argues that, in the modern financial system, central banks are no longer the only, or even the main, providers of liquidity. Instead, the system looks a lot like that of the Victorian era, with banks dependent on the wholesale markets for funding. Back then, the trade bill was the key asset for bank financing; now it is the mysteriously named “repo” market.

. . . .

Bigger haircuts mean that borrowers need more collateral than before in order to fund themselves. “When market volatility jumps, funding capacity drops in tandem and often substantially,” writes Mr Howell. The result, a liquidity squeeze at the worst possible moment, is a template of how the next crisis may occur (although regulators are trying to reduce banks’ reliance on short-term funding).

And again, it is at these times when the need to fund VM payments will kick in, exacerbating the liquidity squeeze. Moreover, clearing also ties up a lot of the assets (e.g., Treasuries, or cash) that firms could normally borrow against to raise cash. Perversely, that collateral can be accessed only if a clearing member defaults on a variation margin payment.

Just what the liquidity supply mechanism will be in the next crisis in the new cleared world is not quite, well, clear. As the Economist article (and the Crossborder Capital note upon which it is based) demonstrate, central banks lend against collateral, and the collateral constraint will already be binding in stress situation. Presumably central banks will have to be much more expansive in their definition of what constitutes “good” collateral (a la Bagehot).

It still astounds me that even though every major financial crisis in history has been at root a liquidity crisis, in their infinite wisdom the betters who presume to govern us thought they were solving systemic risk problems by imposing a mechanism that will sharply increase liquidity demand and restrict liquidity supply during periods of market stress. That should work out really, really swell.

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October 23, 2015

Massad’s Recent Speech: Flashy, But Misleading, and Beside the Point

Filed under: Derivatives,Economics,HFT,Regulation — The Professor @ 8:53 pm

The other day CFTC Chairman Timothy Massad gave a speech about “flash events” in futures markets that has attracted a lot of attention. Most of the attention was given to Massad’s claim that there had been 35 flash events in WTI futures this year, and between 9 and 25 events per year combined in corn, crude, e-minis, 30 year Treasuries, gold, and the Euro from 2010-2014. Flashy results indeed. But the method for identifying them is misleading, and makes big flash moves seem more likely than they really are.

These results, and specifically the WTI finding for 2015, is an artifact of the definition of a flash event (which Massad acknowledged is somewhat arbitrary):

[E]pisodes in which the price of a contract moved at least 200 basis points within a trading hour— but returned to within 75 basis points of the original or starting price within that same hour.

The problem is that the number of flash events will depend on volatility.  Two percent moves are more likely in high volatility environments, or for high volatility contracts.

This is clearly what’s going on in oil. As this chart of the oil volatility index (OVX) shows, oil volatility was extremely low through most of 2014, but increased sharply in late-2014 through mid-2015, and then has picked up again in recent months:

Screen Shot 2015-10-23 at 7.45.39 PM

With volatility in the 60-70 percent annualized range, you will have a much greater likelihood of a 200 basis point move (and a subsequent 125 bp or so reversal) than with 15 percent vols. The flashy 2015 crude oil results are a reflection of this year’s high underlying volatility, which has been fundamentals driven, rather than the microstructure of modern electronic markets.

The 200/75 basis point standard was chosen because that’s what happened in the Treasury market on 15 October, 2014. But a 200 basis point move in something like Treasuries, which have a volatility of around 10 percent, is a bigger number of standard deviation move than a 200 basis point move in crude, especially with a volatility of 70. So the more appropriate cutoff would have been standard deviations (sigmas) rather than percent. But if Massad had done that, he would have identified a lot fewer events, and his speech would have been met with yawns, rather than the attention it has received.

Let’s also put things in perspective. The contracts considered trade 17-23 hours per day. 252 days a year times (say) 20 hour per day times 6 contracts and 20 events/year gives the odds of a .06 percent of an event in any hour. Using a more realistic sigma standard would reduce the odds of an event comparable to the Treasury flash event to a much smaller number than that.

Put differently, the Treasury event was truly anomalous, and Massad’s way of analyzing the data makes it seem more common than it really is. To get a flashy, eye-catching result, Massad had to use a misleading standard to identify flash events. Objects in his mirror are smaller than they appear.

The taking off point for Massad’s speech was the report on the 2014 Treasury flash crash. Like the infamous May, 2010 equity flash crash, there was a sharp decline in liquidity leading up to the price break. Massad attributes this to the way algorithms are programmed:

We also know that as with humans, the modern algorithms have risk management capabilities embedded within them. So when there is a moment of sudden, unexpected volatility, it may not be surprising that some in the market pull back – potentially faster than a human can.

The report describes how on October 15, some algos pulled back by widening their spreads and others reduced the size of their trading interest. Whether such dynamics can further increase volatility in an already volatile period is a question worth asking, but a difficult one to answer. It is also very difficult for individual institutions of any type to remain in the book, opposing price headwinds, or worse, to try and catch the proverbial falling knife. For many, this decision can be the difference between risk mitigation and significant losses. Contrary to what some have suggested,

This makes perfect sense. Some algorithms-especially HFT algorithms-attempt to determine when order flow is becoming toxic (and hence adverse selection risks are elevated) and reduce exposures when they do. Holding depth constant, greater information flow makes prices more volatile, and the reduction in liquidity that the greater information flow causes makes prices even more volatile.

This means that looking at the depth reductions and associated increases in volatility focuses on a symptom, not the underlying cause. What deserves more attention is what causes the increase in the informativeness of order flow that makes the liquidity suppliers cut back. This hasn’t been done in any study, to my knowledge, nor is it likely to be possible to do so.

And as Massad notes, this phenomenon is not unique to electronic markets. Meat puppet market makers also take a powder when adverse selection risks rise:

Contrary to what some have suggested, I suspect it was difficult for market makers in the pre-electronic era to routinely maintain tight and deep spreads during volatile conditions. They likely took long coffee breaks.*

It’s beyond suspicion, actually. It happens. Look at the Crash of ’87 when locals fled the pits and OTC market makers stopped answering their phones.

These reductions in liquidity are inherent in any trading environment where private information is important, and the rate of information flow varies.  Regardless of trading technology or market microstructure, liquidity suppliers will cut the sizes of their quotes, or stop quoting altogether, when order flow turns very toxic.

Given all this, Massad’s policy prescriptions are oddly disconnected from the flash phenomenon that prompted his talk:

The focus of our forthcoming proposals will be on the automation of order origination, transmission and execution – and the risks that may arise from such activity. These risks can come about due to malfunctioning algorithms, inadequate testing of algos, errors and similar problems. We are concerned about the potential for disruptive events and whether there are adequate measures to ensure effective compliance with risk controls and other requirements.

Now of course, you could have errors before, in the days of pit traders and specialists. You could have failures of systems in less sophisticated times. But generally the consequences were of lesser magnitude than what we may face today. And that’s in large part because the errors were easier to identify, arrest or cure before they caused widespread damage.

I expect that our proposals will include requirements for pre-trade risk controls and other measures with respect to automated trading. These will apply regardless of whether the automated trading is high or low frequency. We will not attempt to define high-frequency trading specifically. I expect that we will propose controls at the exchange level, and also at the clearing member and trading firm level.


That’s all great, but really beside the point. If rogue or fat-fingered algos were the problems in any of the alleged flash events Massad identified (including the Treasury event of a year ago), he would have been able to say so. But he admits that the causes of the various events are all unknown. So it’s a bait-and-switch to pose the problem of flash crashes, and then advance remedies that have nothing to do with them. It’s the regulatory equivalent of applying leeches.

In sum, Massad overstates the flash event problem, and offers policies that have nothing to do with them. The fact remains that these things are probably beyond a policy fix anyways. They inhere in nature of the trading of financial instruments when order flow can become toxic.

*Gillian Tett of the FT gets Massad’s point exactly backwards:

The crucial point is that these automated trading programs — like Hal — lack human judgment. When a crisis erupts and prices churn, computers do not simply “take a long coffee break”, as Mr Massad says, and wait for common sense to return; instead they tend to accelerate trading, fuelling those flash crash swings.

Sheesh. Please read, Gillian. Massad’s point is that the algos do take a metaphorical coffee break. They don’t speed up, they pull back.



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October 17, 2015

An Innocent Abroad: Fred Hof and the Intellectual Failure of American Foreign Policy

Filed under: History,Military,Politics — The Professor @ 10:05 am

Fred Hof, former “special advisor for transition in Syria at the U.S. Department of State,” has written a self-flaggelating flagellating piece about his-and the United States’-failure in Syria. It is part damning indictment of himself and the State Department, and part damning indictment of Obama.

A recurrent theme-implicit, not explicit-is Hof’s incredible naiveté. He was repeatedly fooled by the man he was supposedly working with-Bashir al-Assad-and the man he was working for-Barack Obama. He was fooled because he romantically projected his own beliefs on them, and because he engaged in wishful thinking, when he would have been better served to live by Lily Tomlin’s credo: “We try to be cynical, but it’s hard to keep up.”

Hof was-and remains-genuinely shocked that Assad reacted brutally to the first outbreak of opposition to his regime:

I did not think it inevitable that Assad—a computer-savvy individual who knew mass murder could not remain hidden from view in the 21st century—would react to peaceful protest as violently as he did, with no accompanying political outreach.

. . . .

By firing on peaceful demonstrators protesting police brutality in the southern Syrian city of Deraa, gunmen of the Syrian security services shredded any claim Assad had to governing legitimately. Indeed, Assad himself—as president of the Syrian Arab Republic and commander in chief of the armed forces—was fully responsible for the shoot-to-kill atrocities.

Hof actually believed that computer savviness was some marker for civilized values? He believed that Assad would actually care if his crimes were witnessed by the world? Cringemaking.

Look. Dictum 1 of the Dictator’s Handbook says, in bold, italicized type: “Every dictator who has attempted ‘political outreach’ to opponents has ended up at the end of a rope or bleeding in the dirt. Crush all dissent mercilessly.”

Furthermore, Hof’s optimistic view was completely oblivious to Syria’s history. In the 1970s and early-1980s, Assad’s father faced an extreme threat from the Muslim Brotherhood. The Brotherhood came close to assassinating him, and he responded by extirpating the organization in Syria, most infamously by attacking Hama with armor, artillery, and air power, resulting in the deaths of thousands (which Brotherhood propaganda has succeeded in inflating to 40-50,000). Assad no doubt had intelligence about the resurgence of the MB within Syria, and throughout the Middle East generally. He no doubt understood that the “Arab Spring” was largely the Muslim Brotherhood Spring-something that those in the West generally and the US in particular still fail to grasp. Even if he didn’t know these things, he certainly feared them, and was not going to take any chances that the protests in Deraa were fronting for, or would be exploited by, the Brotherhood.

In other words, the chances he would not have responded to any protest with extreme force were somewhere between zero and none.

But the US, and this administration in particular, not only seems oblivious to the Muslim Brotherhood’s malignity, it actually thinks that it is a progressive force in the Middle East.

Hof also took at face value Assad’s representation that he would sever all ties with Hezbollah in exchange for a return of the Golan heights. This was wishful thinking in the extreme. Just how far did Hof think that the Iranians would let Assad proceed down this path? Iran’s interest in Syria is primarily because it is their vital bridge to Hezbollah. Iran is dedicated to Israel’s destruction. If he had tried to sell out Hezbollah to achieve a deal with Israel, the Iranians would have been in a race with the Brotherhood to kill him.

Indeed, Hof understood this at some level, but chose to ignore it:

Fully complicit in the Assad regime’s impressive portfolio of war crimes and crimes against humanity, Iran relies on its client to secure its overland reach into Lebanon.

As for the man he worked for, Hof reminds me of Flounder in Animal House: “You fucked up! You trusted us!“:

My failure to predict the extent of Syria’s fall was, in large measure, a failure to understand the home team. In August 2011, Barack Obama said Assad should step aside. Believing the president’s words guaranteed decisive follow-up, I told a congressional committee in December 2011 that the regime was a dead man walking. When the president issued his red-line warning, I fearlessly predicted (as a newly private citizen) that crossing the line would bring the Assad regime a debilitating body blow. I still do not understand how such a gap between word and deed could have been permitted. It is an error that transcends Syria.

“Such a gap between word and deed” is the essence of the Obama way. And please. Obama ran in 2008 on disengaging militarily from the Middle East. He ran on the view that US military intervention was inevitably counterproductive. He ran in 2012 bragging about ending the war in Iraq, and took the opportunity to remind the world yet again of his belief of the futility of American military engagement in the Middle East.

You see, there are some words that Obama utters that conform to his deeds almost exactly. The key is understanding which words he means, and which ones he doesn’t. Hof again let his magical thinking delude him into believing that Obama meant the things he said that Hof agreed with, instead of realizing that these words contradicted Obama’s core beliefs, and were uttered for the sole purpose of meeting “a communications challenge: getting Obama on “the right side of history” in terms of his public pronouncements.”

Hof deserves credit for admitting his failures so openly, and I can sympathize on a human level. What is disturbing is that his failure is symptomatic of deeper institutional failures in the United States foreign policy establishment. The examples are many, but Syria alone provides some particularly damning ones. How long has the US been chasing the Assad chimera? Remember Warren Christopher panting after Assad père during the Clinton administration? Nancy Pelosi meeting with and gushing over the Chinless Ophthalmologist in 2007? John Kerry chasing after Assad for years, finally dining with him and his wife in Damascus, then saying this?:

“I have been a believer for some period of time that we could make progress in that relationship,” he said. “And I’m going to continue to work for it and push it.”

In the same year, when he once again wanted to go to Syria, his visit was blocked by the Obama administration.

“President Assad has been very generous with me in terms of the discussions we have had,” he said after his March speech. “And when I last went to – the last several trips to Syria – I asked President Assad to do certain things to build the relationship with the United States and sort of show the good faith that would help us to move the process forward.”

He mentioned some of the requests, including the purchase of land for the US Embassy in Damascus, the opening of an American cultural centre, non-interference in Lebanon’s election and the improvement of ties with Iraq and Bahrain, and said Mr Assad had met each one.

“So my judgment is that Syria will move; Syria will change, as it embraces a legitimate relationship with the United States and the West and economic opportunity that comes with it and the participation that comes with it.”

A few years later, of course, Kerry was comparing Assad to Hitler and pressing for air strikes- a call that Obama spurned. A perfect demonstration of Kerry’s lack of judgment, discernment, and just plain seriousness.

No. Fred Hof is not the problem. Fred Hof is a symptom of a bigger problem: the intellectual failings of American foreign policy.

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October 12, 2015

From the Ridiculous to the Absurd Is But A Single Step: A New Rebel Group Magically Appears in Syria

Filed under: History,Military,Politics,Russia — The Professor @ 6:23 pm

If there’s been a bigger debacle for the US military since St. Clair’s Defeat in 1791 than the fiasco of arming the “moderate” Syrian resistance, I would be hard pressed to name it.

First, there was the fact that the pitifully small number of recruits that we managed to scrape together were either killed or captures no sooner than they had set foot into Syrian territory. Then, other groups turned over arms and equipment to al Nusra to secure safe passage. Then the Russians bombed the snot out of our (CIA-trained) forces while Kerry mewled in protest.

So it was announced that the Pentagon-run train and equip program was being terminated. But check that! The mission has not been ended. Train no: equip yes. We will just give arms to “leaders” we’ve vetted and let them hand them out to . . . whomever.

Meanwhile, in a 60 Minutes interview Obama said that he had been skeptical of arming the opposition from the get-go. (This is no doubt true: remember his dismissive remarks from last year about the futility of arming pharmacists and farmers and expecting them to beat an organized army?)

This immediately raises the questions: (a) then why did you, as commander of chief, permit the program to proceed? (b) if you were going to let it proceed, why didn’t you demand changes to give it a reasonable chance of achieving some success?

What’s more, despite Obama’s alleged skepticism, he is permitting yet another effort. This one would make Rube Goldberg proud. This is so bizarre that you might think I’m playing some sort of joke on you, but I swear, I’m just passing along what’s been reported.

Lo and behold, last night, almost at the exact same time Obama was heaping scorn on the idea of supporting armed opposition groups, a new Syrian resistance group magically appeared: The Democratic Forces of Syria.

It’s sort of the Rainbow Coalition of Syria. Kurds. Arabs. Assyrian Christians. So you should feel all warm and fuzzy about the inclusiveness of the new group.

If you believe the formation this group, and its allegedly ecumenical nature, was spontaneous and indigenous, I have some oceanfront property in Wyoming to sell you.

Bolstered by American arms, the mission of the new group is to advance on Raqqa, and drive ISIS from its Syrian capital. The Kurdish YPG has gained some success against ISIS, and would obviously be the core of any new force.

But we aren’t arming the Kurds! Because that would infuriate Erdogan and Turkey, and he could very well back out of his agreement to allow the US access to Incirlik, and do other nefarious things to kneecap the American efforts (such as they are) against ISIS. So we’re doing this instead:

Officials emphasized that U.S. military aid will go directly to the Arabs, not the Kurds, but the Kurdish fighters stand to benefit from the decision. To date, Washington has hesitated to hand equipment directly to the Kurds. Instead, they send materiel through the central government of Iraq. The new aid will be transported directly to Syria, where Arab groups are expected to launch a new offensive in and around Raqqa, the de facto Islamic State capital, while the Kurds continue to hold border areas where together they have succeeded in routing the militants.

The Kurds are the most effective military force in the region, and the Arabs have been completely unheard from in this sector, so we arm the latter and let the former cool their heels.

From the ridiculous to the absurd is but a single step.

To quote Casey Stengel: Can’t anybody here play this game?

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October 10, 2015

Igor Gensler Helps the Wicked Witch of the West Wing Create Son of Frankendodd

Hillary Clinton has announced her program to reform Wall Street. Again.

The actual author of the plan is said to be my old buddy, GiGi: Gary Gensler.

Gensler, if you will recall, was the Igor to Dr. Frankendodd, the loyal assistant who did the hard work to bring the monster to life. Now he is teaming with the Wicked Witch of the West Wing to create Son of Frankendodd.

There are a few reasonable things in the proposal. A risk charge on bigger, more complex institutions makes sense, although the details are devilish.

But for the most part, it is ill-conceived, as one would expect from Gensler.

For instance, it proposes regulating haircuts on repo loans. As I said frequently in the 2009-2010 period, attempting to impose these sorts of requirements on heterogeneous transactions is a form of price control that will lead some risks to be underpriced and some risks to be overpriced. This will create distorted incentives that are likely to increase risks and misallocations, rather than reduce them.

A tax on HFT has received the most attention:

The growth of high-frequency trading (HFT) has unnecessarily burdened our markets and enabled unfair and abusive trading strategies that often capitalize on a “two-tiered” market structure with obsolete rules. That’s why Clinton would impose a tax targeted specifically at harmful HFT. In particular, the tax would hit HFT strategies involving excessive levels of order cancellations, which make our markets less stable and less fair.

This is completely wrongheaded. HFT has not “burdened” our markets. It has been a form of creative destruction that has made traditional intermediaries obsolete, and in so doing has dramatically reduced trading costs. Yes, a baroque market structure in equities has created opportunities for rent seeking by HFT firms, but that was created by regulations, RegNMS in particular. So why not fix the rules (which in Hillary and Gensler acknowledge are problematic) rather than kneecap those who are responding to the incentives the rules create?

Furthermore, the particular remedy proposed here is completely idiotic. “Excessive levels of order cancellations.” Just who is capable of determining what is “excessive”? Furthermore, the ability to cancel orders rapidly is exactly what allows HFT to supply liquidity cheaply, because it limits their vulnerability to adverse selection. High rates of order cancellation are a feature, not a bug, in market making.

It is particularly ironic that Hillary pitches this as a matter of protecting “everyday investors.” FFS, “everyday investors” trading in small quantities are the ones who have gained most from the HFT-caused narrowing of bid-ask spreads.

Hillary also targets dark pools, another target of popular ignorance. Dark pools reduce trading costs for institutional investors, many of whom are investing the money of “everyday” people.

The proposal also gives Gensler an opportunity to ride one of his hobby horses, the Swaps Pushout Rule. This is another inane idea that is completely at odds with its purported purpose. It breaks netting sets and if anything makes the financial system more complex, and certainly makes financial institutions more complex. It also discriminates against commodities and increases the costs of managing commodity price risk.

The most bizarre part of the proposal would require financial institutions to demonstrate to regulators that they can be managed effectively.

Require firms that are too large and too risky to be managed effectively to reorganize, downsize, or break apart. The complexity and scope of many of the largest financial institutions can create risks for our economy by increasing both the likelihood that firms will fail and the economic damage that such failures can cause.[xiv] That’s why, as President, Clinton would pursue legislation that enhances regulators’ authorities under Dodd-Frank to ensure that no financial institution is too large and too risky to manage. Large financial firms would need to demonstrate to regulators that they can be managed effectively, with appropriate accountability across all of their activities. If firms can’t be managed effectively, regulators would have the explicit statutory authorization to require that they reorganize, downsize, or break apart. And Clinton would appoint regulators who would use both these new authorities and the substantial authorities they already have to hold firms accountable.

Just how would you demonstrate this? What would be the criteria? Why should we believe that regulators have the knowledge or expertise to make these judgments?

I have a Modest Proposal of my own. How about a rule that requires legislators and regulators to demonstrate that they have the competence to manage entire sectors of the economy, and in particular, have the competence to understand, let alone manage, an extraordinarily complex emergent order like the financial system? If some firms are too complex to manage, isn’t an ecosystem consisting of many such firms interacting in highly non-linear ways exponentially more complex to control, especially through the cumbersome process of legislation and regulation? Shouldn’t regulators demonstrate they are up to the task?

But of course Gensler and his ilk believe that they are somehow superior to those who manage financial firms. They are oblivious to the Knowledge Problem, and can see the speck in every banker’s eye, but don’t notice the log in their own.

People like Gensler and Hillary, who are so hubristic to presume that they can design and regulate the complex financial system, are by far the biggest systemic risk. Frankendodd was bad enough, but Son of Frankendodd looks to be an even worse horror show, and is almost guaranteed to be so if Gensler is the one in charge, as he clearly aims to be.

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October 8, 2015

Why Don’t Journalists Scrutinize the Oracle of Syria?

Filed under: Military,Politics — The Professor @ 5:04 pm

One of the most irritating things about coverage of the war in Syria is that virtually every story relies on a single source, the Syrian Observatory for Human Rights, for the bulk of its (alleged) in-country information. This story from Reuters is an example.

The problem is that the Observatory isn’t in country at all. It’s a one man operation run by Rami Abdulrahman from his flat in London,where he’s lived for 15 years.

Despite the distance, and the fog of war, Rami provides exceptionally detailed reports on military operations by all sides in real time. Not a sparrow falls in Syria without Rami’s knowledge. Particularly suspicious are his precise casualty counts. It’s never “around 20 were reported killed.” It’s always “22 were killed” or “27 were killed.” There is seldom that precision in mass casualty reports even in the US, sometimes for days after the event occurs.

Rami’s distance, the extremely fragmented nature of the contestants (the opposition groups number in the dozens), the inherent uncertainties of first person accounts, the incentive of those on the ground to lie, his inability to verify information, and on and on and on should raise serious doubts about his accuracy, even if you don’t wonder about his potential interest. His background strongly suggests a Muslim Brotherhood connection. (The MB was the heart of the anti-Assad opposition for years before the war broke out. That’s who Assad père was trying to wipe out in Hama in 1982.)

Yet I have yet to see one serious journalist inquire about him or his operation, or question his/its reliability. Instead, he is universally treated like some sort of oracle, all knowing and all seeing. Is it just because it’s too hard to report from Syria, and just too easy to pretend that the guy in London knows everything there is to know?

Since the vast bulk of stories rely on this single, doubtful source, it all must be questioned. And he must be questioned, not least by those who rely on him as their primary source. And you must question any article that relies heavily on him. Which means, you must question pretty much every article about Syria.

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October 7, 2015

We Need to Choose Our Battles, and Syria Isn’t It

Filed under: History,Military,Politics,Russia — The Professor @ 11:04 pm

The hysteria over Russian actions in Syria continues. The Russians are making token strikes-at most-against ISIS, and are focusing their firepower on other anti-regime forces in the west of the country.

Well, of course they are. Putin’s objective is to save Assad’s regime. Its core area in the west. The greatest threat is in the west. So that’s where the bulk of the blows will fall.

Today’s cruise missile attack, launched from the Caspian is partly showing off (especially showing off the fact that Iran and Iraq had to concur), but it also makes military sense as part of a preparatory bombardment supporting a counterattack by regime forces, which is apparently in progress. This demonstrates that the Russian air campaign is part of a coherent military operation which integrates air and ground elements. This presents a stark contrast to the air-only US campaign against ISIS, which cannot achieve any decisive result whatsoever. (It remains to be seen whether Russian air support is sufficient to overcome the extreme shakiness of the Syrian army, which wasn’t much to start with and which has been relentlessly ground down by four years of brutal war.) (In contrast to the coherent Russian effort, the US attacks in Syria yesterday involved destroying two “crude oil collection facilities.” Really. No excavators were available?)

There is also hysteria about Russian lying about what they are doing.  This is like attacking a cobra for striking. It’s what they do.

Most of the frenzy focuses on the Russians’ targeting of “our” rebels in the Free Syrian Army. Yes, this is quite deliberate, and a strike at the US for having the temerity of supporting the anti-Assad effort. Putin views this as a part of a broader struggle against the US.

So should the US respond to the challenge frontally, in Syria?  No. And it’s not even a close call.

First, what is the strategic objective to be gained? I find it hard to see an important security interest in Syria. And overthrowing Assad because he’s a monster could be justified, except that monsters-and arguably worse monsters than Assad-will take over. An Assad rout would likely result in a bacchanal of sectarian violence which would result in the extirpation of non-Sunni communities in Syria. There has not been one Middle East war that has ended in anything closely resembling peace, and the circumstances in Syria are even less favorable to such an outcome than in Iraq and Libya.

Second, the idea that the there is a serious “moderate” opposition in Syria is not true today, and arguably never was true. The FSA’s day passed years ago, and our track record of identifying moderate, secular forces in this region is appallingly bad.

Those that are pushing this fantasy include John McCain, who is detached from reality on this issue. Others include journalists Michael Weiss and Hassan Hassan, who have been flogging this narrative for four years, and are frantically doing so now: the more implausible the narrative becomes, the more frenzied they become. One should note that Hassan is tightly connected with UAE, which has been the main supporter of the anti-Assad opposition from the beginning, and Weiss’s connections are murky, and his pom-pomming for a Syrian opposition that is lousy with Islamists raises questions.

(And by the way: I thought the CIA program to arm the opposition was supposed to be covert. Why are we blabbing about it?)

Third, what can be done? The idée du jour supported by left (Hillary Clinton) and right (several GOP candidates, including Rubio, Fiorina, and Christie), is a no fly zone. This is superficially appealing because it relies purely on American airpower, and thus does not require a ground commitment. This virtue is in fact a measure of the non-seriousness of the idea.  It would not have been militarily decisive before the Russians arrived because Assad’s air force played only a marginal role in the conflict. Now it would require a confrontation with the Russians, because it is the Russians that are flying. Why engage in a confrontation that could lead to unpredictable developments elsewhere, and which (per the above) would not result in any material strategic gainer the US?

Rubio goes further, plumping for a “safe zone” that somehow will magically be radical Islamist-free. How this would work outside of some Harry Potter-esque fantasy is beyond me. Further, note the “safe zone” idea is a favorite of Erdogan. Who has been a major supporter of the Islamist groups in Syria. It appears for all the world that Rubio has bought a bill of goods from the GCC and the Turks about the Syrian opposition.

If you look at the correlation of forces (as the Soviets put it), and the strategic stakes, deeper US involvement in Syria makes no sense. The odds of prevailing are low, and the gains from winning are trivial, and likely non-existent.

Russia’s aggressiveness is indeed a concern, and someone with Putin’s mindset will be emboldened if he believes that he will meet no resistance. But an asymmetric response, an indirect approach, is more advisable. Russia’s vulnerabilities are economic and financial, and its greatest sensitivities are on in the Baltics, Poland, and Ukraine.

One last thing. The sputtering denunciations of Putin, notably again by McCain and others, are profoundly counterproductive. They only contribute to Putin’s image as some sort of colossus, which only encourages more aggressiveness and more admiration for him. At the other extreme, the administration’s mewling protests that the Syrian intervention is a testament to Putin’s weakness is just plain pathetic, especially since it is not accompanied by any countermoves anywhere.

Unfortunately, this administration is has neither the intestinal fortitude nor the strategic dexterity to respond effectively, or even coherently. We will have to wait another 15 months at least for a reach change. Unfortunately, there’s not much to look forward to on that front, as none of the Republican candidates have impressed in the least. Rubio particularly disappointed not just because of the safe zone inanity, but because of his clueless remark that Syria is a battle for the future of Sunni Islam: (a) this is not our battle, and (b) it it mimics Saudi and Qatar Sunni chauvinism, and their interests are not ours, in the slightest. (How often has our anger at Iran blinded us to the fact that the Saudis are a deeply malign force too? I actually have a grudging respect for the Iranians. At least they are quite open about their hatred for us.)

We need to pick our battles, and Syria isn’t it. The obsession with it is distracting from the true objective, which should be to construct a coherent strategic response to Putin that exploits our comparative advantages, rather than confronting him where he can exploit his.


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October 3, 2015

People. Get. A. Grip: Glencore Is Not the Next Lehman

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,History,Regulation — The Professor @ 6:53 pm

There is a lot of hysterical chatter out there about Glencore being the next Lehman, and its failure being the next Lehman Moment that plunges the financial system into chaos. Please. Get. A. Grip.

Comparing the firms shows there’s no comparison.

Let’s first talk size, since this is often framed as an issue of “too big to fail.” In November, 2007, Lehman’s total assets were $691 billion. As of August, Glencore’s were $148 billion. Lehman was about 4.5 times bigger. Moreover, Glencore’s assets include a lot of short term assets (inventories and the like) that are relatively liquid. Looking at Glencore as a $100 billion firm is more realistic. Lehman was much bigger.

Then let’s talk leverage. Lehman had 3 percent equity, 97 percent debt. Glencore about one third-two thirds. Stripping out the short term debt and short term assets, it’s about 50-50.

Then let’s talk off-balance sheet. Lehman was a derivatives dealer with huge OTC derivatives exposures both long and short. Glencore’s derivatives book is much smaller, more directional, and much in listed derivatives.

Lehman had derivatives liabilities of about $30 billion after netting and collateral were taken into account, and $66 billion if not (which matters if netting is not honored in bankruptcy). Glencore has $2 billion and $20 billion, respectively.

Lets talk about funding. Lehman was funding long term assets with short term debt (e.g., overnight repos, corporate paper). It had a fragile capital structure. Glencore’s short term debt is funding short term assets, and its longer term assets are funded by longer term debt. A much less fragile capital structure.  Lower leverage and less fragile capital means that Glencore is much less susceptible to a run that can ruin a company that is actually solvent. That also means less likelihood that creditors are going to take a big loss due to a run (as was the case with Lehman).

As a major dealer, Lehman was also more interconnected with every major systemically important financial institution. That made contagion more likely.

But I don’t think these firm-specific characteristics are the most important factors. Market conditions today are significantly different, and that makes a huge difference.

It wasn’t the case that Lehman failed out of a clear blue sky and this brought down the entire financial system through a counterparty or informational channel. Lehman was one of a series of casualties of a financial crisis that had been underway for more than a year. The crisis began in earnest in August, 2007. Every market indicator was flashing red for the next 12 months. The OIS-Libor spread blew out. The TED spread blew out. Financial institution CDS spreads widened dramatically. Asset backed security prices were plummeting. Auction rate securities were failing. SPVs holding structured products were having difficulty issuing corporate paper to fund them. Bear Sterns failed. Fannie and Freddie were put into receivership. Everyone knew AIG was coughing up blood.

Lehman’s failure was the culmination of this process: it was more a symptom of the failure of the financial system, than a major cause. It is still an open question why its failure catalyzed an intensified panic and near collapse of the world system. One explanation is that people inferred that the failure of the Fed to bail it out meant that it wouldn’t be bailing out anyone else, and this set off the panic as people ran on firms that they had thought were working with a net, the existence of which they now doubted. Another explanation is that there was information contagion: people inferred that other institutions with similar portfolios to Lehman’s might be in worse shape than previously believed and hence ran on them (e.g., Goldman, Morgan Stanley, Citi) when Lehman went down. The counterparty contagion channel has not received widespread support.

In contrast, Glencore’s problems are occurring at a time of relative quiescence in the financial markets. Yes commodity markets are down hard, and equities have had spasms of volatility lately, but the warning signs of liquidity problems or massive credit problems in the banking sector are notably absent. TED and OIS-Libor spreads have ticked up mildly in recent months, but are still at low levels. A lot of energy debt is distressed, but that does not appear to have impaired financial institutions’ balance sheets the same way that the distress in the mortgage market did in 2007-2008.

Furthermore, there is not even a remote possibility of an implicit bailout put for Glencore, whereas it was plausible for Lehman (and hence the failure of the put to materialize plausibly caused such havoc). There are few signs of information contagion. Other mining firms stocks have fallen, but that reflects fundamentals: Glencore has fallen more because it is more leveraged.

Put differently, the financial system was more fragile then, and Lehman was clearly more systemically important, because of its interconnections and the information it conveyed about the health of other financial institutions and government/central bank policy towards them. The system is more able to handle a big failure now, and a smaller Glencore is not nearly as salient as Lehman was.

In sum, Glencore vs. Lehman: Smaller. Less leveraged. Less fragile balance sheet. Less interconnected. And crucially, running into difficulties largely by itself, due to its own idiosyncratic issues, in a time of relative health in the financial system, as opposed to being representative of an entire financial system that was acutely distressed.

With so many profound differences, it’s hard to imagine Glencore’s failure would lead to the same consequences as Lehman. It wouldn’t be fun for its creditors, but they would survive, and the damage would largely be contained to them.

So if you need something to keep you up at night, unless you are a Glencore creditor or shareholder, you’ll need to find something else. It ain’t gonna be Lehman, Part Deux. But I guess financial journos need something to write about.

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September 30, 2015

Let Putin Find Out the Hard Way

Filed under: Military,Politics,Russia — The Professor @ 1:13 pm

I have no need to demonstrate my anti-Putin bona fides, but I just roll my eyes at the hysterical response to his intervention in Syria, and today’s launch of Russian bombing operations.  There is much shrieking about the fact that the Russians say they are bombing Isis, but in fact launched a raid on Homs where Isis was not present.

The Russian response is, basically: “Hey, they all look alike to us.” There is much truth to that.

This is not that complicated:

  1. Russia is intervening to save Assad from imminent defeat, and to protect its ports in Syria.
  2. Isis is not the most immediate threat to either Assad or the Russian facilities.
  3. Therefore, Russia will focus on non-Isis targets, while claiming to be fighting Isis.

This is really not that much different than the Turks using Isis as a pretext to attack their real enemy, the PKK.

Yes, this campaign will help Assad, and Assad is an evil bastard. But the Islamists that are dominating the anti-Assad forces are evil bastards too. Many are Al Qaeda offshoots, and others are indistinguishable from Al Qaeda in their ideology and agenda. Or from Isis, for that matter. They are Sunni supremacist Islamists. And wouldn’t you know, we are fighting Sunni supremacist Islamists around the world, and have been for going on 15 years.

There are no good guys in Syria. Stop pretending there are: there is considerable reason to doubt there ever were. And any differences between Isis and the non-Isis Islamists the Russians are bombing are trivial. They do all pretty much look (and act) alike. And what’s more, pretty much everyone in the West looks the same to them: they all think your head would look just splendid mounted on a spike in the front yard.

And yes, Assad’s forces will slaughter his foes if they win. But Assad’s foes will slaughter Assad’s supporters if they win. Syria is a charnel house being fought over by demons.  There is a symmetry of evil.

It is particularly rich that those who are shrieking about Russian involvement say that it will radicalize Sunnis.

Um, where are these people been? Since like 700AD, let alone since 2001 or 2011? Radicalization is a done deal, and the most that the Russians can do is gild that lily.

Moreover, I actually find myself agreeing with some in the administration here. If you truly believe that Syria is a pointless slaughter that we should avoid at all costs (and I believe that is the case today), why would you oppose Putin jumping in? The administration believes (rightly) that we have no current military options that would generate results that even remotely justify the costs: the military realities are exactly the same for Putin. Yes, he will likely secure a rump Syria with its shambolic Russian port facilities (which is more than we could gain). But his airpower is going to be no more decisive than ours, and he is putting himself at risk of getting sucked in more deeply in ways that will cost him blood and treasure that he can’t afford.

As I said before: don’t interrupt an enemy while he is making a mistake.

As for the US, Russian involvement is leading some to advocate getting more heavily involved ourselves. Another military adage is: don’t reinforce failure. Failure is the charitable way of describing US policy in Syria. Don’t reinforce it. Let it go. It’s past our ability to save, or even palliate. It’s done. Both sides.

Let Putin find out the hard way.

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September 28, 2015

Regulation Confronts Reality In the Commodity Markets. Reality Is Losing.

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Financial crisis,Regulation — The Professor @ 6:36 pm

Following the commodities markets today was like drinking from a fire hose. Many big stories, with “up” and “down” being the operative words. Alcoa split up. Shell announcing that it was giving up on its Arctic plans after its controversial test well failed to find commercially viable reserves. Oil price down around 3 percent, etc.

But the biggest news items were Glencore’s continuing downward spiral, and ESMA’s release of its technical recommendations for application of MiFID to non-financial firms, including commodity firms.

Glencore’s stock was down hard at the open, and at one point was down 31 percent. It’s CDS are now trading up-front (always a bad sign), and the spread widened from an already big 550 bp to 757 bp. At conventional recovery rates, this gives a (risk neutralized) probability of default of better than 50 percent. The Biggest Loser was Glencore’s CEO, Ivan Glasenberg, AKA, Ex-Glencore Billionaire.

The CDS are now trading wider than when Glencore had it s last near-death experience at the height of the financial crisis. Arguably the firm’s situation is worse now. It cannot attribute its woes to stressed financial market conditions generally, in which pretty much everyone saw spreads blow out to one degree or another. This is unique to it and the mining sector. It is a verdict on the firm/sector.

Moreover, in 2008 the firm was private, and Glasenberg and the other owners were able to stanch the bleeding by injecting additional capital into the firm. The ominous thing for Ivan et al now is that they tried that again a couple of weeks ago (along with announcing other measures to reduce debt and conserve cash) and it only bought a temporary respite before the blood started gushing again.

Moreover-and this is crucial-Glencore 2015 is a very different creature than Glencore 2008. It was more of a pure trader then: it is a mining firm with a big trading arm now. This means that its exposure to flat prices (of coal and copper in particular) is much bigger now. In fact, most commodity firms saw little drop off in profits in 2008-2009, and several saw profits increase. The fundamentals facing trading firms in 2008-2009 were not nearly as bad as the fundamentals facing mining firms today. That’s because their flat price exposures weren’t large, and margins and volumes (which drive trading profits) are not as sensitive to macro conditions as flat prices. Given the lack of any prospects for a rebound in flat prices, Glencore’s prospects for a recovery are muted.

Some tout Glasenberg et al’s trading acumen. But it is one thing to be able to sniff out arbs/relative mispricings and structure clever trades to exploit them. (Or to hold one’s nose while doing deals with dodgy regimes around the world.) It is something altogether different to predict where prices are going to go. Glencore made a bet on China, and now that bet is not looking good. At all.

In a nutshell, this is pretty much out of Glencore’s hands. It is along for the ride.

The irony here is that Glasenberg sold the Xstrata merger and the new business model as a way of using the less cyclical profitability of the trading venture as a way of dampening the cyclicality of the mining operation. As it is developing, an extremely adverse cyclical downturn in the mining operation is impairing the viability of the trading operation. How the trading operation can flourish within a financially distressed corporation is an open question. Maybe the company will have to pull an Alcoa, and separate the trading from the mining operations, to keep the latter from dragging down the former.

A key takeaway here relates to the other story I mentioned: ESMA’s release of its recommendations regarding the application of MiFID to non-financials. The objective is to mitigate systemic risk. I was always skeptical that commodity traders posed any such risk (and have been making that argument for 3+ years), and so far the Glencore meltdown is supporting that skepticism. There has been no evidence of spillovers/contagion from Glencore to financial institutions, or to the broader market, a la Lehman.

But ESMA has proposed Technical Standards that would impose the full panoply of CRD-IV capital requirements on commodity traders (and other non-financial firms) that cannot avail themselves of an exemption (on which I will say more momentarily).

  1. If firms cannot make use of an exemption under MiFID II, capital requirements under the new banking regulatory framework will apply to them. This new framework consists of Regulation EU No 575/2013 (CRR) and Directive 2013/36/EU (CRD IV), repealing Directives 2006/48/EC and 2006/49/EC. While CRD IV is addressed to CAs and includes, inter alia, qualitative provisions on the Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP), the new CRR imposes quantitative requirements and disclosure obligations pursuant to Basel III recommendations on credit institutions and investment firms, including own funds definition, minimum own funds requirements and liquidity requirements. However, under Article 498(1) of CRR, some commodity dealers falling within the scope of MiFID are transitionally exempt from the CRR’s provisions on own funds requirements until 31 December 2017 at the latest, if their main business consists exclusively of providing investment services or activities relating to commodity derivatives.
  2. Moreover, firms falling within the scope of MiFID II will be considered to be financial counterparties rather than non-financial counterparties under Article 2(8) of EMIR. Therefore, they will not be able to benefit from the clearing thresholds or the hedging exemption available to the latter under Article 10 of EMIR. An additional consequence of being classified as a financial counterparty will be that the trading obligation (i.e. the obligation to trade derivatives which are subject to the clearing obligation and sufficiently liquid on trading venues only, cf. Article 28 of MiFIR) would apply in full without being subject to a threshold.

So, even if you aren’t a bank, you will be treated like a bank, unless you can get the exemption. Apropos what I said the other day about impoverished carpenters, hammers, nails, etc.

To get an exemption, a firm’s non-hedging derivatives business must fall below a particular threshold amount, e.g., 3 percent of the oil market, 4 percent of the metals market. ESMA recommends that hedges be determined using EMIR criteria. The big problem with this is that only months ago ESMA itself recognized that the EMIR framework is unworkable:

  1. It appears that the complex mechanism introduced by EMIR for the NFC+ [Non-Financial Company Plus] classification has so far led to significant difficulties in the identification, monitoring and, as a consequence, possible supervision of these entities by their competent authorities.
  2. As a result, in the context of the revision of EMIR, ESMA would see some merit in the simplification of the current framework for the determination of NFC+.
  3. One route that the Commission may wish to explore is to move from the current two-step process (Hedging/Non Hedging and clearing threshold) to a one-step process, where counterparties would qualify as NFC+ when their outstanding positions exceeds certain thresholds per asset class, irrespective of the qualification of the trades as hedging or non-hedging. This idea is further developed in Section 4.2 which addresses the way in which NFCs qualify their transactions as hedging and non-hedging.

In other words, ESMA judged that it is impossible for regulators to distinguish firms’ hedging derivatives from its speculative ones. Given these difficulties, just a few months ago ESMA recommended jettisoning the entire mechanism that it now proposes to use to determine whether commodity firms are exempt from MiFID, and the associated capital and clearing requirements.

Makes perfect sense. In some universe.*

At the very least the ESMA plan will impose a huge compliance burden on firms who will have to justify their categorizations of derivatives positions as hedges or no. Given the complexities of risk management (e.g., managing risk on a portfolio basis means that saying what trade is a hedge is difficult, if not impossible, the rapid and frequent adjustments of positions inherent in most trading operations, etc.) this will be a nightmare.

So the good news is: You can get an exemption from capital and clearing requirments! Yay!

The bad news is: The entity proposing the exemption says that the process for getting the exemption is unworkable, and you’ll have not just a compliance headache, but a compliance migraine.

So at the very same time that the financial travails of a big commodity firm cast serious doubt on the systemic riskiness of these firms, European regulators advance regulations intended to fix this (non-existent) problem, and are doing so in a way that they themselves have cast serious doubt on.

Put differently: regulation is confronting reality in the commodity markets at this very moment, and reality is coming off second best.

* It also hardly inspires confidence that ESMA fails basic arithmetic. Note that the threshold in oil is 3 percent, then consider this from its Briefing on Non-Financial Topics: “If a firm’s speculative trading activity is less than 50% of its total trading, it may be MiFID II exempt providing its market share is less than 20% of each threshold in the market share test e.g. 0.8% for metals, 0.3% for oil etc.” Um, last time I checked .2 x 3%=0.6%, not 0.3%.


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