Streetwise Professor

July 13, 2014

If Angela Merkel is the Bad Cop, Putin Has It Made

Filed under: History,Military,Politics,Russia,Snowden — The Professor @ 8:42 pm

Germany has won the World Cup, which is somewhat annoying because they will become even more insufferable. And that is saying something given their recent behavior, especially with regards to Russia, and the spying imbroglio with the US.

Regarding Russia, it was particularly nauseating to see Merkel being quite chummy with Putin at the Cup final game. The Euros had pressured Ukrainian president Poroshenko to go as well, so that he could have a chat with Vlad. Poroshenko wisely begged off, staying home to direct the counterattack against the Russia-supported, inspired, and supplied rebellion in two eastern provinces. He no doubt realized that he would be sandbagged if he went to Rio, and for that he could have blamed it on Angela.

For despite her reputation as the bad cop in dealing with Putin (earned only by comparison with outright enablers, understanders, and collaborators like Steinmeier and Schroeder), Merkel has been putting much more pressure on the beleaguered Poroshenko than on Putin. The Euros, led by Germany, have been pushing Ukraine to negotiate directly with the freakazoid “leaders” of the “republics” of Donetsk and Luhansk. Moreover, Merkel tutted that Ukraine’s counterattack should be “proportionate.”

Well, “proportionality” is usually trotted out by the friends of those who are losing to stymie the advance of the stronger side that is winning by preventing it from exploiting its advantages. In this instance, moreover, “proportionate” would involve Ukraine sending armor across the border into Belgorod and Voronezh, and supporting separatists in Dagestan and Chechnya. BUt somehow I don’t think that’s what Angela means. I think she means that Ukraine should not fight to win, and that suits Putin just fine.

The Ukrainians are fighting a rebel force that has inflicted large casualties on it; has embedded itself in civilian areas; committed (per the UN) widespread “stomach churning” atrocities; destroyed bridges and rail lines; and deployed landmines and booby traps. Under the circumstances, Poroshenko has been restrained.

But Angela is running interference for her soccer buddy. In other ways as well. For instance, she is resisting the permanent deployment of NATO troops in new eastern European member states, like Poland and the Baltics. She brought up the NATO-Russia Founding Act in order to rationalize her position, but this has absolutely nothing to do with the deployment of conventional troops: it only discusses the deployment of nuclear weapons in former Warsaw Pact states.

Then there’s the spying issue, which contrary to usual practice, the Germans are making into a major public spectacle, culminating in its request that the head CIA official in Germany depart the country.

The Germans really need to get over themselves on this one. As I’ve written before, they have earned the scrutiny they get. Indeed, their heel-dragging on Russia warrants skepticism about them. They have often worked against the US within NATO. The rejection of Georgia and Ukraine in 2008 is one example. Libya is anotherIt has contributed to the rejuvenation of the Russian military (a tradition going back to the 1920s). It is an important country that bears watching. Not just for those reasons, but because (as I have noted before) the country is well-known to have been heavily penetrated by Soviet then Russian intelligence, and its businesses are rather notorious for their use of bribery to get international sales and contracts: this summary of Siemens’ sins over the years makes for enlightening reading. Since the US can have little confidence that Germany will advance US interests, and since the US has strong reasons to believe Germany might actually work against US interests, it is definitely in our interest to know what Germany is thinking and planning.

In other words, Germany wants it both ways, in a very adolescent way. It wants to pursue an independent policy that is often at odds with US policy and interests, but it also expects the US to treat it like a country whose interests are strongly aligned with ours. Sorry. If you want to act routinely contrary to US interests, the US is more than justified in not trusting, and verifying. And that involves espionage.

One of the things that has exercised the Germans most about the current spy scandal is that the man in question, “Marcus R,” passed documents relating to a German parliamentary investigation of the Snowden allegations. Well, that brings up another thing, doesn’t it? Snowden inflicted major damage on the US, and his collaborators (notably Appelbaum and Poitras) are living large in Berlin. A good part of the German establishment has been very supportive of Snowden. All of these things are rather hostile to the US, so what, we’re supposed to shrug and say “whatever”? Given Snowden’s current location, this also plays into the earlier-mentioned problem of German enabling of Putin and Russia. German dealings with Snowden are very much a matter of American national security.

It’s also rather annoying that the Germans are getting so exercised about American espionage, but direct no outrage whatsoever at Russian activities in the country.

The linked article says that public pressure has forced Merkel to act. With respect to the most recent spying issue, that’s not much of an excuse: the public pressure is the result of Germany’s publicizing the episode.

What’s more, Germany made claims that it had uncovered a second US spy, but that story pretty much evaporated on exposure to the sunlight. It now appears that the military officer in question was in touch with the State Department, not the CIA or any other US intelligence agency. Moreover, a search of the man’s home revealed nothing. So the Germans went off half-cocked and inflamed an already difficult situation, rather than acting in a more responsible way in an attempt to tamp down the passions. Another adolescent and self-absorbed political move.

Perhaps the only good thing to come of this is that it has united Congress and the administration on at least one thing. Both are heartily annoyed at the German teenage temper tantrum.

The bottom line for the US is that its interests and those of Germany are not closely aligned, especially on issues relating to Russia. So be it. But this is precisely why Obama’s policy of largely deferring to Europe (which de facto means largely deferring to Germany) on policy towards Russia and Ukraine is so problematic. Yes, the Germans (and Italians and Austrians etc.) will squeal. But doing things their way will embolden Putin, and that will just lay the groundwork for even bigger problems in the future. If Angela Merkel is the bad cop, Putin has it made.

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July 11, 2014

25 Years Ago Today Ferruzzi Created the Streetwise Professor

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,HFT,History,Regulation — The Professor @ 9:03 am

Today is the 25th anniversary of the most important event in my professional life. On 11 July, 1989, the Chicago Board of Trade issued an Emergency Order requiring all firms with positions in July 1989 soybean futures in excess of the speculative limit to reduce those positions to the limit over five business days in a pro rata fashion (i.e., 20 percent per day, or faster). Only one firm was impacted by the order, Italian conglomerate Ferruzzi, SA.

Ferruzzi was in the midst of an attempt to corner the market, as it had done in May, 1989. The EO resulted in a sharp drop in soybean futures prices and a jump in the basis: for instance, by the time the contract went off the board on 20 July, the basis at NOLA had gone from zero to about 50 cents, by far the largest jump in that relationship in the historical record.

The EO set off a flurry of legal action. Ferruzzi tried to obtain an injunction against the CBT. Subsequently, farmers (some of whom had dumped truckloads of beans at the door of the CBT) sued the exchange. Moreover, a class action against Ferruzzi was also filed. These cases took years to wend their ways through the legal system. The farmer litigation (in the form of Sanner v. CBT) wasn’t decided (in favor of the CBT) until the fall of 2002. The case against Ferruzzi lasted somewhat less time, but still didn’t settle until 2006.

I was involved as an expert in both cases. Why?

Well, pretty much everything in my professional career post-1990 is connected to the Ferruzzi corner and CBT EO, in a knee-bone-connected-to-the-thigh-bone kind of way.

The CBT took a lot of heat for the EO. My senior colleague, the late Roger Kormendi, convinced the exchange to fund an independent analysis of its grain and oilseed markets to attempt to identify changes that could prevent a recurrence of the episode. Roger came into my office at Michigan, and told me about the funding. Knowing that I had worked in the futures markets before, asked me to participate in the study. I said that I had only worked in financial futures, but I could learn about commodities, so I signed on: it sounded interesting, my current research was at something of a standstill, and I am always up for learning something new. I ended up doing about 90 percent of the work and getting 20 percent of the money :-P but it was well worth it, because of the dividends it paid in the subsequent quarter century. (Putting it that way makes me feel old. But this all happened when I was a small child. Really!)

The report I (mainly) wrote for the CBT turned into a book, Grain Futures Contracts: An Economic Appraisal. (Available on Amazon! Cheap! Buy two! I see exactly $0.00 of your generous purchases.) Moreover, I saw the connection between manipulation and industrial organization economics (which was my specialization in grad school): market power is a key concept in both. So I wrote several papers on market power manipulation, which turned into a book . (Also available on Amazon! And on Kindle: for some strange reason, it was one of the first books published on Kindle.)

The issue of manipulation led me to try to understand how it could best be prevented or deterred. This led me to research self-regulation, because self-regulation was often advanced as the best way to tackle manipulation. This research (and the anthropological field work I did working on the CBT study) made me aware that exchange governance played a crucial role, and that exchange  governance was intimately related to the fact that exchanges are non-profit firms. So of course I had to understand why exchanges were non-profits (which seemed weird given that those who trade on them are about as profit-driven as you can get), and why they were governed in the byzantine, committee-dominated way they were. Moreover, many advocates of self-regulation argued that competition forced exchanges to adopt efficient rules. Observing that exchanges in fact tended to be monopolies, I decided I needed to understand the economics of competition between execution venues in exchange markets. This caused me to write my papers on market macrostructure, which is still an active area of investigation: I am writing a book on that subject. This in turn produced many of the conclusions that I have drawn about HFT, RegNMS, etc.

Moreover, given that I concluded that self-regulation was in fact a poor way to address manipulation (because I found exchanges had poor incentives to do so), I examined whether government regulation or private legal action could do better. This resulted in my work on the efficiency of ex post deterrence of manipulation. My conclusions about the efficiency of ex post deterrence rested on my findings that manipulated prices could be distinguished reliably from competitive prices. This required me to understand the determinants of competitive prices, which led to my research on the dynamics of storable commodity prices that culminated in my 2011 book. (Now available in paperback on Amazon! Kindle too.)

In other words, pretty much everything in my CV traces back to Ferruzzi. Even the clearing-related research, which also has roots in the 1987 Crash, is due to Ferruzzi: I wouldn’t have been researching any derivatives-related topics otherwise.

My consulting work, and in particular my expert witness work, stems from Ferruzzi. The lead counsel in the class action against Ferruzzi came across Grain Futures Contracts in the CBT bookstore (yes, they had such a thing back in the day), and thought that I could help him as an expert. After some hesitation (attorneys being very risk averse, and hence reluctant to hire someone without testimonial experience) he hired me. The testimony went well, and that was the launching pad for my expert work.

I also did work helping to redesign the corn and soybean contracts at the CBT, and the canola contract in Winnipeg: these redesigned contracts (based on shipping receipts) are the ones traded today. Again, this work traces its lineage to Ferruzzi.

Hell, this was even my introduction to the conspiratorial craziness that often swirls around commodity markets. Check out this wild piece, which links Ferruzzi (“the Pope’s soybean company”) to Marc Rich, the Bushes, Hillary Clinton, Vince Foster, and several federal judges. You cannot make up this stuff. Well, you can, I guess, as a quick read will soon convince you.

I have other, even stranger connections to Hillary and Vince Foster which in a more indirect way also traces its way back to Ferruzzi. But that’s a story for another day.

There’s even a Russian connection. One of Ferruzzi’s BS cover stories for amassing a huge position was that it needed the beans to supply big export sales to the USSR. These sales were in fact fictitious.

Ferruzzi was a rather outlandish company that eventually collapsed in 1994. Like many Italian companies, it was leveraged out the wazoo. Moreover, it had become enmeshed in the Italian corruption/mob investigations of the early 1990s, and its chairman Raul Gardini, committed suicide in the midst of the scandal.

The traders who carried out the corners were located in stylish Paris, but they were real commodity cowboys of the old school. Learning about that was educational too.

To put things in a nutshell. Some crazy Italians, and English and American traders who worked for them, get the credit-or the blame-for creating the Streetwise Professor. Without them, God only knows what the hell I would have done for the last 25 years. But because of them, I raced down the rabbit hole of commodity markets. And man, have I seen some strange and interesting things on that trip. Hopefully I will see some more, and if I do, I’ll share them with you right here.

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July 8, 2014

The Securities Market Structure Regulation Book Club

Filed under: Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 4:30 pm

There was another hearing on HFT on Capitol Hill today, in the Senate. The best way to summarize it was that it reminded me of an evening at the local bookstore, with authors reading selections from their books.

Two examples suffice. Citadel’s Ken Griffin (whom I called out for talking his book on Frankendodd years ago) heavily criticized dark pools, and called for much heavier regulation of them. But he sang the praises of purchased order flow, and warned against any regulation of it.

So, go out on a limb and bet that (a) Citadel does not operate a dark pool, and (b) Citadel is one of the biggest purchasers of order flow, and you’ll be a winner!

The intellectually respectable case against dark pools and payment for order flow is the same. Both “cream skim” uninformed orders from the exchanges, leaving the exchange order flow more informed (i.e., more toxic), thereby reducing exchange liquidity by increasing adverse selection costs. I’m not saying that I agree with this case, but I do recognize that it is at least grounded in economics, and that an intellectually consistent critic of dark pools would also criticize purchased order flow.

But some people have books to sell.

The other example is Jeffrey Sprecher of ICE, which owns and operates the NYSE. Sprecher lamented the fragmentation of the equity markets, and praised the lack of fragmentation of futures markets. But he went further. He said that futures markets were competitive and not fragmented.

Tell me another one.

Yes, there is limited head-to-head competition in some futures contracts, such as WTI and Brent. But these are the exceptions, not the rule. Futures exchanges do not compete head to head in any other major contract. Execution in the equity market is far more competitive than in the futures market. Multiple equities exchanges compete vigorously, and the socialization of order flow due to RegNMS makes that competition possible. This is why the equities exchange business is low margin, and not very profitable. Futures exchanges own their order flow, and since liquidity attracts liquidity, one exchange tends to dominate trading in a particular instrument. So yes, futures markets are not fragmented, but no, they are not competitive. These things go together, regardless of what Sprecher says.  He wants to go back to the day when the NYSE was the dominant exchange and its members earned huge rents. That requires undoing a lot of what is in RegNMS.

Those were some of the gems from the witness side of the table. From the questioner side, we were treated to another display of Elizabeth Warren’s arrogant ignorance and idiocy. The scary thought is that the left views her as the next Obama who will deny Hillary and vault to the presidency. God save us.

Overall the hearing demonstrated what I’ve been saying for years. Market structure, and the regulations that drive market structure, have huge distributive effects. Everybody says that they are in favor of efficient markets, but I’m sure you’ll be shocked to learn that their definition of what is efficient happens to correspond with what benefits their firms. The nature of securities/derivatives trading creates rents. The battle over market structure is a classic rent seeking struggle. In rent seeking struggles, everybody reads out of their books. Everybody.

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July 6, 2014

Putin: Waging Not War, Not Peace in Ukraine.

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

The military and diplomatic situations in Ukraine are fluid and highly uncertain.

Under pressure from the Ukrainian army’s “Anti-Terrorist Operation” (“ATO”),  ”separatists” in Slavyansk decamped suddenly for the city of Donetsk. Their shadowy commander, Girkin, offered another plea for Russian assistance, which has not been forthcoming-in the form of an outright invasion, anyways. The Ukrainian army is advancing elsewhere in the Donbas.

One would have thought that the fleeing rebels would have been extremely vulnerable to air attack, but most reports indicate that they made it to Donetsk largely unhindered. (I did see one Tweet that purports to show rebel vehicles that had been destroyed on the road, but one must be cautious about the veracity of Tweets, and even the Ukrainian government reports that the separatists are regrouping in Donetsk and does not claim to have mauled the rebels in their retreat.) This suggests (a) that the separatists left in a hurry,  (b) poor intelligence and reconnaissance by the Ukrainians, or (c) Ukrainian fear of MANPADS that have brought down several of their aircraft: the retreating column would have been vulnerable to air attack while on the run.

The priority for Ukraine should be to secure the border and to cut off the rebels from Russian logistical support. Deprived of supplies, arms, and reinforcements, the separatist force will surrender, disintegrate, or just fade away.

This puts Putin on the horns of a dilemma. He is already being blasted for abandoning the Russophone/Russophile forces. But overt intervention risks a more robust Western response, and the prospect of a military quagmire.

Of these, the military problem is more acute. Russia’s military still has (conscripted) feet of clay, and the invasion and occupation of a large territory is almost certainly beyond its capability.

What’s more, every signal emanating from the West is equivocal at best.

Multi-party talks last week saw Germany and France putting pressure on Ukraine to make concessions. The talks were held in Berlin, but Munich would have been a more appropriate setting for the appeasement and pressuring the victim of aggression that was on display:

Germany’s Foreign Affairs Minister, Frank-Walter Steinmeier, convened this meeting as an emergency response to Ukraine’s June 30 resumption of military operations against Russia’s proxy forces on Ukraine’s territory. Those forces had inflicted serious losses on Ukraine during the ten days’ ceasefire that Ukraine had unilaterally adhered to. Berlin had nudged Kyiv into that unilateral ceasefire (see EDM, June 21 through June 30).

Recognizing that the pro-Russia forces breached the ceasefire massively, Germany now seeks to establish a bilateral ceasefire and follow-up negotiations between the Ukrainian government and the pro-Russia secessionists, in a framework that includes Russia while excluding the West. These elements form the basis of a Russo-German consensus regarding Ukraine.

The “Joint Declaration by the Foreign Ministers of Germany, France, Russia, and Ukraine” (www.auswaertiges-amt.de, July 2) “stress[es] the necessity of a sustainable ceasefire to be agreed upon swiftly and observed by all concerned…Ministers agree to take all necessary measures and use their influence on the concerned parties with a view to achieving this goal.”

That implies: a) an unconditional ceasefire, thereby throwing out Ukrainian President Petro Poroshenko’s June 20 peace plan, in which ceasefire is conditional upon disarmament of pro-Russia forces (in return for amnesty) and/or the evacuation of those forces from Ukraine to Russia; b) treating the “parties” (Ukrainian government and Russia’s armed proxies) on an equal footing by the Berlin document; c) Russia is asked to control its protégés in the field more tightly, in return for Germany and other West-European governments pressing Ukraine into giving up its right to self-defense.

Insofar as the British are concerned, Cameron gave a deadline of June 30 for Russia to bring the separatists into line. That deadline has passed, with not a peep from the UK. And the US is no better. On June 26, Kerry told Russia to disarm the separatists “within hours.” That is now more than 240 hours ago. And the US has done nothing. Not even the usual Kerry bluster followed by Obama inaction. Just. Nothing.

Yes, there are stories that Merkel is losing patience, and taking a “harder stance.” Maybe in the sense that pasta cooked for 15 minutes is harder than pasta cooked for 20. But it’s still limp. And you know that in the face of  intense whinging by big German businesses like that quoted in the linked FT story, and the even more intense opposition of the Putin understanders (especially in the SDP) she’ll find a pressing reason to do nothing, to find some hint of a “de-escalation” (ugh) by Putin. The fact that Nato just announced that it will not admit new members out of fear of offending Russia will only strengthen Putin’s conviction that the West not confront him in Ukraine even if he continues, or even increases, his support for the rebellion.

This all makes the current situation highly unpredictable. The military momentum has shifted decisively in favor of the Ukrainian government. Even though its military is a shambolic Sovok relic, it still overawes the rebels. Unless the rebels are reinforced, or the Russian military invades, the rebellion will eventually be crushed (or suffocated). This would be a stinging defeat for Putin.

Putin’s military instrument is superior to Ukraine’s, but only in the sense of being somewhat less shambolic. Moreover, its mission in Ukraine would be more challenging than what the Ukrainians are attempting. Moreover, the West might stir to do something that seriously hurts Russia if Putin escalates, and particularly if he invades. But there is substantial uncertainty about what the Western response would be, and it has been sufficiently pusillanimous heretofore that Putin could reasonably conclude that he could intervene more robustly without triggering a serious response.

My best guess is that due to the frailties of his military, and the risk of serious sanctions, Putin will not go all in and invade. He can achieve his basic objectives by maintaining a frozen conflict in eastern Ukraine. As long as the Ukrainian government does not achieve a decisive victory, and as long as the rebels remain a force-in-being that occupy some major cities, Ukraine will be deprived a victory and will be hamstrung in its ability to reform and integrate more closely with Europe.

This means that it is imperative that Putin prevent the Ukrainians from sealing the border, and that he maintain a corridor to Donetsk and wherever else the separatists dig in. Maybe he will achieve this through the oxymoronic “peacekeeper” gambit employed previously in Abkhazia, South Ossetia, and Transnistria. Maybe he will employ artillery and air power, and justify this by claiming it is a response to a Ukrainian incursion into Russia. I don’t know, exactly. But in my view, Putin will try to modulate the violence. Just enough to keep a frozen conflict alive, but not so much as to compel the Euros and US to take actions that would hurt Russia seriously. Unfortunately, the obvious reluctance of Merkel, Obama, and Cameron, not to mention Hollande, to do anything serious gives Putin  considerable latitude.

If Ukraine does move robustly to seal the border things will come to a head quickly. No doubt the Euros will put pressure on Ukraine not to do that (and Obama will vote “present”-or maybe even “not present”). If this pressure prevails, the conflict will continue to simmer. If the Ukrainians buck the pressure, it will be Putin’s move. I doubt he will back down. I doubt that he will double down. He will instead strive for some middling way that will keep the rebellion alive but not provoke a serious confrontation with the West.

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July 1, 2014

Energetic Bear. Conspicuous Silence.

Filed under: Military,Politics,Russia — The Professor @ 3:47 pm

In news that should shock no one, Russian hackers have unleashed a Stuxnet-like virus against American and European energy companies. One of the security firms that discovered the intrusion has labeled it “Energetic Bear”. Energetic because it involves energy. Bear because it involves Russia. The Russian link is based on time stamps and the presence of Cyrillic in the code. Moreover, the sophistication of the software strongly suggests (Russian) state involvement.

Though most of the attacks appear to be designed to collect information about the industrial control systems used by these energy companies, that is cold comfort: careful attackers collect intelligence to identify vulnerabilities before mounting an attack. This is also a way of sending a message: You are vulnerable. You mess with us, we can mess with you.

The news of the Russian hack was announced by Kaspersky, the famous cybersecurity firm.

Just kidding. I’m such a card. This revelation came from 2 US firms. Kaspersky has been as quiet as a mouse. A dead mouse.

Which is always the way when there is a Russian hack. When there is an American operation, e.g., Stuxnet, Kaspersky trumpets it for all the world to hear.

One other thing. The names of the SCANA producers targeted have not been revealed. But note that Siemens, the most vocal corporate supporter of Russia in Germany and the most vehement opponent to sanctions, is one of the world leaders in SCANA systems. So it is almost certain that Siemens has been a target of Energetic Bear. But Siemens has been as silent as Kaspersky.

The silences are far more revealing than the story itself.

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Putin’s Tell on What He Really Fears: Let’s Take the Hint and Make His Nightmares Reality

Filed under: Economics,Military,Politics,Regulation — The Professor @ 2:58 pm

Vladimir Putin played his favorite game today: divide and conquer. He weighed in on the $9 billion US fine of French bank BNP Paribas for its flagrant and repeated violations of US sanctions on Sudan and Iran. He took a typically narcissistic view: according to Vova, the US offered to relent on its prosecution of BNPP if France terminated its sales of Mistral attack ships to Russia:

“We know about the pressure which our U.S. partners are applying on France not to supply the Mistrals to Russia,” Putin told Russian diplomats in Moscow today. “And we even know they hinted that if the French don’t deliver the Mistrals, they would quietly get rid of the sanctions against the bank, or at least minimize them,” he said without naming BNP Paribas.

He knows this how, exactly? Electronic surveillance? (Don’t tell Angela!) A leak from the French?

Certainly Putin is trying to stir trouble between the US and France, and exploiting the French anger at the US penalties. (To which I say: the anger should be directed at the mangers of BNP Paribas, especially the offenders in its Geneva commodity finance operation who violated sanctions against malign regimes with malice aforethought.)

But the chronology is way off. The US prosecution of BNP began long before Ukraine exploded. Years before. The USDOJ was particularly furious at the French bank’s flagrant attempts to conceal its sanctions busting: the bank eliminated identifying information from the transactions in order to evade detection, a sure sign of a specific intent to commit a violation. This fury was well-stoked long before Putin’s adventurism in Ukraine/Crimea. What’s more, US prosecutors operate very independently, and those involved in the BNP case would be outraged at attempts to interfere in their case against the French by a White House playing geopolitical games, especially given the years and blood, sweat, and tears involved in the prosecution. Prosecutors do not take orders from on high, especially in big cases like this.

This is likely another example of Putin projection. This is how Putin would have instructed his prosecutors to act, and they would have implemented his instructions without question: he just presumes that the same would happen in the US. But the US is very different in that regard. Indeed, I would wager that if the White House did attempt to interfere in this way, the prosecutors would have leaked.

Of course Putin has another agenda here. He realizes that the biggest threat he faces is US sanctions that would be enforced (via the financial provisions of the Patriot Act) by prosecuting any sanctions violator who deals in dollars just as the US has prosecuted BNP. By emphasizing the existential legal threat that European banks would face under a sanctions regime, Putin is attempting to fuel opposition to sanctions: since Obama has made it plain that he will not proceed with sanctions without European support, by fomenting European opposition he can counter the US. To the Europeans (and probably American banks too), the easiest way to avoid severe punishments for sanctions violations is to have no sanctions at all. Which is what Putin wants.

In other words, Putin’s mischievous comment on the BNP Paribas case is a tell. He is revealing what he really fears.  So let’s take the hint, and make his nightmares reality.

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What Gary Gensler, the Igor of Frankendodd, Hath Wrought

I’ve spent quite a bit of time in Europe lately, and this gives a rather interesting perspective on US derivatives regulatory policy. (I’m in London now for Camp Alphaville.)

Specifically, on the efforts of Frankdodd’s Igor, Gary Gensler, to make US regulation extraterritorial (read: imperialist).

Things came to a head when the head of the CFTC’s Clearing and Risk  division, Ananda K. Radhakrishnan, said that ICE and LCH, both of which clear US-traded futures contracts out of the UK, could avoid cross-border issues arising from inconsistencies between EU and US regulation (relating mainly to collateral segregation rules) by moving to the US:

Striking a marked contrast with European regulators calling for a collaborative cross-border approach to regulation, a senior CFTC official said he was “tired” of providing exemptions, referring in particular to discrepancies between the US Dodd-Frank framework and the European Market Infrastructure Regulation on clearing futures and the protection of related client collateral.

“To me, the first response cannot be: ‘CFTC, you’ve got to provide an exemption’,” said Ananda Radhakrishnan, the director of the clearing and risk division at the CFTC.

Radhakrishnan singled out LCH.Clearnet and the InterContinental Exchange as two firms affected by the inconsistent regulatory frameworks on listed derivatives as a result of clearing US business through European-based derivatives clearing organisations (DCOs).

“ICE and LCH have a choice. They both have clearing organisations in the United States. If they move the clearing of these futures contracts… back to a US only DCO I believe this conflict doesn’t exist,” said Radhakrishnan.

“These two entities can engage in some self-help. If they do that, neither [regulator] will have to provide an exemption.”

It was not just what he said, but how he said it. The “I’m tired” rhetoric, and his general mien, was quite grating to Europeans.

The issue is whether the US will accept EU clearing rules as equivalent, and whether the EU will reciprocate. Things are pressing, because there is a December deadline for the EU to recognize US CCPs as equivalent. If this doesn’t happen, European banks that use a US CCP (e.g., Barclays holding a Eurodollar futures position cleared through the CME) will face a substantially increased capital charge on the cleared positions.

Right now there is a huge game of chicken going on between the EU and the US. In response to what Europe views as US obduracy, the Europeans approved five Asian/Australasian CCPs as operating under rules equivalent to Europe’s, allowing European banks to clear though them without incurring the punitive capital charges. To emphasize the point, the EU’s head of financial services, Michael Barnier, said the US could get the same treatment if it deferred to EU rules (something which Radhakrishnan basically said he was tired of talking about):

“If the CFTC also gives effective equivalence to third country CCPs, deferring to strong and rigorous rules in jurisdictions such as the EU, we will be able to adopt equivalence decisions very soon,” Barnier said.

Read this as a giant one finger salute from the EU to the CFTC.

So we have a Mexican standoff, and the clock is ticking. If the EU and the US don’t resolve matters, the world derivatives markets will become even more fragmented. This will make them less competitive, which is cruelly ironic given that one of Gensler’s claims was that his regulatory agenda would make the markets more competitive. This was predictably wrong-and some predicted this unintended perverse outcome.

Another part of Gensler’s agenda was to extend US regulatory reach to entities operating overseas whose failure could threaten US financial institutions. One of his major criteria for identifying such entities was whether they are guaranteed by a US institution. Those who are so guaranteed are considered “US persons,” and hence subject to the entire panoply of Frankendodd requirements, including notably the SEF mandate. The SEF mandate is loathed by European corporates, so this would further fragment the swaps market. (And as I have said often before, since end users are the alleged beneficiaries of the SEF mandate-Gary oft’ told us so!-it is passing strange that they are hell-bent on escaping it.)

European US bank affiliates with guarantees from US parents have responded by terminating the guarantees. Problem solved, right? The dreaded guarantees that could spread contagion from Europe to the US are gone, after all.

But US regulators and legislators view this as a means of evading Frankendodd. Which illustrates the insanity of it all. The SEF mandate has nothing to do with systemic risk or contagion. Since the ostensible purpose of the DFA was to reduce systemic risk, it was totally unnecessary to include the SEF mandate. But in its wisdom, the US Congress did, and Igor pursued this mandate with relish.

The attempts to dictate the mode of trade execution even by entities that cannot directly spread contagion to the US via guarantees epitomizes the overreach of the US. Any coherent systemic risk rationale is totally absent. The mode of execution is of no systemic importance. The elimination of guarantees eliminates the ability of failing foreign affiliates to impact directly US financial institutions. If anything, the US should be happy, because some of the dread interconnections that Igor Gensler inveighed against have been severed.

But the only logic that matters her is that of control. And the US and the Europeans are fighting over control. The ultimate outcome will be a more fragmented, less competitive, and likely less robust financial system.

This is just one of the things that Gensler hath wrought. I could go on. And in the future I will.

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June 27, 2014

Have Some Fun At Vlad’s Expense

Filed under: History,Military,Politics,Russia — The Professor @ 9:09 pm

Given the dreary news emanating from about everywhere, a little levity is needed. And what better way to enjoy a Friday than to exult in Putin’s embarrassment.

Putin went to a rather flamboyantly decorated room to watch the launch of Russia’s new rocket, the Angara. And he sat and watched. And sat and watched. And sat and watched. And nothing happened.

Due to a technical problem, the launch had to be scrubbed.

Some obviously scared military officials reported the bad news to him. (One hopes they planned ahead and wore their Depends!) Then Putin went off on them, saying something like “Yeah-it didn’t work.” (Echoes of his response to a question about the Kursk: “It sank.” I think the “it didn’t work” line was sarcastic. Sort of “no shit Sherlock. Tell me something I can’t see with my own effing eyes.”) He is obviously furious.

But I’d like to help out Vlad. I think I have found the culprit. Look at the gophers that appear at about the 25 second mark in this video:

Obviously Amerikan agents and saboteurs! After all, if the evil Zionists can train sharks and vultures to carry out their fiendish plots, the Americans could train gophers to carry out theirs. Because remember, according to some Russian officials, American plots were responsible for the crashes of the Sukhoi Superjet and the Phobos-Grunt space probe. The theories advanced in those cases were about as plausible as the Gopher Saboteur theory.

And I have video proof of the destructive power of American gophers!

Just ask Bill Murray about them. I’m sure the FSB is trying to get ahold of him now for advice on how to deal with them.

Even if the theory advanced does not involve rodents, I think it’s only a matter of time before there are dark mutterings about the role of the US in this.

Which will only add to the levity.

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June 26, 2014

There’s Gold in Them Thar Vaults, Boys! Um, Maybe Not

Filed under: China,Commodities,Economics,Politics,Regulation — The Professor @ 7:48 pm

If the vaults are in China, that is. Over the weekend I posted on the fraudulent commodity-based lending (collateralized by aluminum) in Qingdao. Now a Chinese government auditor claims that the gold used as collateral in $15 billion of loans does not exist.

To put this into context, Goldman (ha!) estimates that there are about $80 billion in loans in China collateralized by gold. Thus, the auditor’s report means that at least 20 percent of those loans are fraudulent. Given that it is likely easier to verify the existence of gold pledged as collateral than is the case for copper or soybeans, this suggests that even higher percentages of these other commodity-based loans (totaling another $80 billion) are backed by warehouse receipts that aren’t worth the paper they are printed on.

This situation creates the conditions for a horrific information contagion, which is the worst sort of systemic risk. Many analyses of systemic risk focus on counterparty credit risk, where the failure of one institution topples a set of interconnected dominoes. But historically, the domino problem has been less of a source of financial crises than information contagion. For instance, information contagion was arguably a far more important cause of the 2008 crisis than counterparty contagion.

Information contagion is a panic that results when the quality of assets in one part of the financial system leads people to question the value of other assets, usually similar but not always. For instance, in 2008,  the problems at Bear and Lehman were the result of bad mortgage investments by these firms. This raised questions about the solvency of other financial institutions that held, or were believed to hold, similar assets. Suddenly all banks became suspect, and had problems funding their assets. They started dumping assets to raise cash, which cratered prices and thereby created problems in institutions that had to mark their assets to a (now depressed) market. Banks that had extended liquidity support to SIVs had to bring them back on their balance sheets, threatening to make them undercapitalized.

Information contagion is most likely to occur, and is most severe when it does, when (a) asset values and balance sheets are opaque, and (b) financial institutions engage in a lot of maturity transformation (i.e., borrowing short to lend long). When asset values and balance sheets are opaque, market participants are more likely to draw inferences from revelations about the values of other firms/assets, because they can’t evaluate the firms/assets directly. In these circumstances, bad news about one firm or one type of asset can lead to a massive loss in confidence in other firms and assets. When these assets are funded with short term borrowings, firms can’t roll over their loans under these conditions, and are more likely to go bankrupt. Moreover, they are more likely to dump assets in fire sales that impose externalities on other firms holding similar assets.

China’s financial system is nothing if opaque. This is particularly true of the shadow banking system, but the banking system is also incredibly murky. For instance, the actual quality of loans on bank books is very difficult to assess. A lot of loans reported as performing are actually quite dodgy.

Information contagion is especially likely because the nature of the revelations about commodity loans raises serious questions about the monitoring of loans and the evaluation of the creditworthiness of borrowers and the quality (and existence!) of their collateral by financial institutions. If banks do a bad job at evaluating commodity loans and borrowers, and commodity collateral, it is reasonable to infer that they do a bad job at monitoring other loans and evaluating other borrowers. It is these sorts of inferences that lead to information contagion.

Moreover, maturity transformation is ubiquitous in China. This is especially true in the shadow banking system.

What this means is that although a few tens of billions of loans backed by non-existent collateral may not seem like a big deal in a financial system with about $17 trillion in credit outstanding (about 35 percent of which is in the shadow sector), the ramifications are far more serious than the value of these commodity loans suggest. There is a serious risk that doubts about the quality of the commodity loans will lead to growing doubts about the quality of other assets, especially in the shadow banking sector.  This creates the potential for panics and runs in that sector, and given the connections between shadow financial institutions and mainstream banks (connections which are themselves opaque) this could spillover into the conventional sector.

In other words, the potential for information contagion in a highly leveraged (with credit at about 250 percent of GDP), highly maturity transformed, and exceedingly opaque financial system is what makes the fraudulent commodity loans a big deal. Potentially a very big deal.

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Understand This: Germany Won’t Sanction Russian Companies, But Will Sanction American Ones

Filed under: History,Military,Politics,Russia,Uncategorized — The Professor @ 3:13 pm

Both the US and Germany are making noise about ratcheting up sanctions on Russia. Kerry told the Russians to disarm separatists “within hours” or else. That was hours ago, and nothing has happened.

Germany’s Merkel has also toughened “sanctions talk.”

Angela Merkel, German chancellor, has raised the prospect of broader economic sanctions against Russia, just two days before an EU summit at which her hardening stance against Moscow is expected to steer the diplomatic agenda.

One theory is that Merkel and Steinmeier are playing good cop, bad cop, with Angela in the role of the heavy. If Merkel is the bad cop, Putin and his clique have absolutely nothing to worry about.

Merkel has talked (relatively) tough before, but has always found some reason to back off. This time, no doubt Putin’s transparently phony call for his senate (and it is his, in the same sense that his dog is his) to repeal the authorization to invade Ukraine will give Merkel the excuse she needs to keep her finger off the sanctions trigger. That plus Putin’s typically convoluted (and contradictory) support for a ceasefire. Meanwhile, the war of subversion in Donbas goes on, transparently supported by Russia. Only those who will not see don’t understand this.

But Angela has found someone to sanction: the US, or more specifically, US telecom Verizon. German outrage over the Snowden revelations was a major reason for the decision.

Yes, there is reason for outrage here–outrage directed at Germany. Here is a nation that bends over backwards to find reasons not to sanction any Russian company. Even the pathetic sanctions  it has meted out (as part of the EU) are directed primarily at individuals, most of whom are nobodies. Talk of sanctioning Russian companies elicits howls of anger and pain from the German business community. There is constant talk of the need to “understand” the Russians, with the result being described by the French proverb “to understand all is to forgive all.” All including the anschluss in Crimea and the ongoing subversion in Ukraine. There is even a German phrase to describe this lot: Putin Verstehers. Putin understanders. Germans-and Merkel in particular-look for the slightest sign of compromise by Putin, and when they see it, they back off doing anything to penalize him, Russia, or any Russian company. Russia/Putin get the benefit of every German doubt.

But evidently the US does not get the benefit of any German doubt. So they sanction Verizon (not my favorite company, by the way) in their very narcissistic pique and outrage over US surveillance of Germany. No attempt to understand the US whatsoever, let alone an attempt to be as understanding as the Germans are with the corrupt autocrat and oligarchic thugs and espionage-crazy security service in the nation to their east.

But oh, there is a lot that the Germans need to understand about why they are a surveillance target, and not given the same deference as the Five Eyes nations. (I will let pass in silence the fact that Germany’s intelligence service the BND has long cooperated with the US.) One thing to understand: the fact that 911 hijackers made themselves at home in Germany. Another thing to understand: German politics and government has long been penetrated by Soviet, and then Russian, agents and collaborators. And yet another thing to understand: the fact that the German business community and government have clearly been suborned by Russian money. German companies (notably Siemens) have been deeply involved in corrupt dealings in Russia. And yet another thing: although it has cleaned up its act some lately, for a long time German businesses assisted Iran in its efforts to develop nuclear weapons.

In brief: Germany has earned the scrutiny that it has received from the NSA. Indeed, its continued enabling of Putin’s behavior just provides further evidence that it is an unreliable partner and uncertain ally that needs watching.

Germany only has the luxury to engage in its moral preening and biting American ankles and corrupt canoodling with the Russians because the US kept out the Russians for 45 years. And I thought the French were ingrates.

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