Streetwise Professor

April 8, 2014

Tales From the Crypt of Corruption

Filed under: Economics,Military,Politics,Russia — The Professor @ 7:58 pm

The vicissitudes of life have prevented me from writing-or even reading much-for the last few days. But a few Russia-related things caught my eye.

Most notably: Putin calls for swift action to improve Russia’s business climate.

Talk about low hanging fruit! Give me a hard problem, Vladimir Vladimirovich! If you resign, and take your judo clique and Sechin and the rest of the St. Petersburg gang with you, Russia’s business climate would improve dramatically and swiftly!

No charge for this sure-fire advice. It’s on the house.

The Russian economy is sputtering, but it would be quite easy to crater it. As I’ve discussed before, the US could squash the Russian economy like an overripe grape, but the markets have decided that the US and the west are all bark, no bite. The initial post-Crimea selloff has been largely reversed:

President Vladimir Putin’s pledge not to expand beyond the Crimea peninsula in Ukraine is driving short sellers out of the Russian stock market.

Traders have scaled back bets on declines in theMarket Vectors Russia (RSX) exchange-traded fund to 5 percent of outstanding shares from a record-high 21 percent on March 3. That’s the largest drop for a comparable period since June, according to data compiled by Bloomberg and Markit.

As short sellers retreat, the market is rebounding, with the Bloomberg Index of Russia’s most-traded stocks in New York posting the longest stretch of weekly gains since October. Foreign Minister Sergei Lavrov said at the end of last month that there’s no intention to go beyond Crimea, fueling speculation that tensions with the U.S. and the EU are abating. Putin told lawmakers in Moscow on March 18 that Russia isn’t about to occupy Eastern Ukraine.

Let me put it this way. The article is wrong. The market isn’t taking Putin at his word that Russia won’t invade Ukraine. The market just believes that even if he does, nothing will happen. The west will wuss out. Again.

Yeah. I’m looking at you, Germany. And you, Obama.

Believe me. Putin is drawing the exact same conclusion.

Make sure you are sitting down for this last one. Sophisticated Russian hackers were responsible for mounting a massive attack on Nieman Marcus. But that’s not the shocking part. The US approached the Russian government for help and . . . nothing. Crickets:

Attempts to shut down the criminal network have failed despite international sting operations and secret meetings with Russian intelligence officials, according to two former U.S. officials who asked not to be named because they weren’t authorized to discuss the activities. Federal Bureau of Investigation officials visited their Russian counterparts in 2008 and 2009 to share information that could help locate and stop hackers, one of the former officials said.

“The FBI has tried to get cooperation, the State Department has asked for help and nothing happens, so law enforcement options under the current circumstances are pretty negligible,” said Richard Clarke, special adviser for cybersecurity under George W. Bush.

Law enforcement officials describe Russian stonewalling as just one obstacle as they try to curb the burgeoning theft of credit-card data that has sparked a Congressional inquiry and left banks and retail chains blaming each other for the failures of outdated credit-card technology.

This, no doubt, is because the FSB received a cut of the hackers’ take.  I am sure you are standing there, mouth agape, in shock at this stunning news.

But this corrupt, criminal colossus is twisting the far wealthier, far more powerful west around its little finger. There is a pronounced asymmetry in power, but an even greater asymmetry in the will to use it.

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April 5, 2014

Pinging: Who is the Predator, and Who Is the Prey?

Filed under: Economics,Exchanges,HFT,Politics,Regulation — The Professor @ 11:59 am

The debate over Lewis’s Flash Boys is generating more informed commentary than the book itself. One thing that is emerging in the debate is the identity of the main contending parties: HFT vs. the Buy Side, mainly big institutional traders.

One of the criticisms of HFT is that it engages in various strategies to attempt to ferret out institutional order flows, which upsets the buy side. But the issue is not nearly so clearcut as the buy side would have you believe.

The main issue is that not all institutional orders are alike. In particular, there is considerable variation in the informativeness of institutional order flow. Some (e.g., index fund order flow) is unlikely to be informed. Other order flow is more informed: some may even be informed by inside information.

Informed order flow is toxic for market makers. They lose on average when trading against it. So they try to determine what order flow is informed, and what order flow isn’t.

Informed order flow must hide in order to profit on its information. Informed order flow uses various strategies based on order types, order submission strategies, choice of trading venues, etc., to attempt to become indistinguishable from uninformed order flow. Uninformed order flow tries to devise in strategies to signal that it is indeed uninformed, but that encourages the informed traders to alter their strategies to mimic the uninformed.

To the extent that market makers-be they humans or machines-can get signals about the informativeness of order flow, and  in particular about undisclosed flow that may be hitting the market soon, they can adjust their quotes accordingly and mitigate adverse selection problems. The ability to adjust quotes quickly in response to information about pending informed orders allows them to quote narrower markets. By pinging dark pools or engage in other strategies that allow them to make inferences about latent informed order flow, HFT can enhance liquidity.

Informed traders of course are furious at this. They hate being sniffed out and seeing prices change before their latent orders are executed. They excoriate “junk liquidity”-quotes that disappear before they can execute. Because the mitigation of adverse selection reduces the profits they generate from their information.

It can be frustrating for uninformed institutional investors too, because to the extent that HFT can’t distinguish perfectly between uninformed and informed order flow,  the uninformed will often see prices move against them before they trade too.  This creates a commercial opportunity for new trading venues, dark pools, mainly, to devise ways to do a better way of screening out informed order flow.

But even if uninformed order flow often finds quotes running away from them, their trading costs will be lower on average the better that market makers, including HFT, are able to detect more accurately impending informed orders. Pooling equilibria hurt the uninformed: separating equilibria help them. The opposite is true of informed traders. Market makers that can evaluate more accurately the informativeness of order flow induce more separation and less pooling.

Ultimately, then, the driver of this dynamic is the informed traders. They may well be the true predators, and the uninformed (or lesser informed) and the market makers are their prey. The prey attempt to take measures to protect themselves, and ironically are often condemned for it: informed traders’ anger at market makers that anticipate their orders is no different that the anger of a cat that sees the mouse flee before it can pounce. The criticisms of both dark pools and HFT (and particularly HFT strategies that attempt to uncover information about trading interest and impending order flow) are prominent examples.

The welfare impacts of all this are unknown, and likely unknowable. To the extent that HFT or dark pools reduce the returns to informed trading, there will be less investment in the collection of private information. Prices will be less informative, but trading will be less costly and risk allocation improved. The latter effects are beneficial, but hard to quantify. The benefits of more informative prices are impossible to quantify, and the social benefits of more informed prices may be larger, perhaps substantially so, than the private benefits, meaning that excessive resources are devoted to gathering private information.

More informative prices can improve the allocation of capital. But not all improvements in price efficiency improve the allocation of capital by anything near the cost of acquiring the information that results in these improvements, or the costs imposed on uninformed traders due to adverse selection. For instance, developing information that permits a better forecast of a company’s next earnings report may have very little effect on the investment decisions of that company, or any other company. The company has the information already, and other companies for which this information may be valuable (e.g., firms in the same industry, competitors) are going to get it well within their normal decision making cycle.  In this case, incurring costs to acquire the information is a pure waste. No decision is improved, risk allocation is impaired (because those trading for risk allocation reasons bear higher costs), and resources are consumed.

In other words, it is impossible to know how the social benefits of private information about securities values relate to the private benefits. It is quite possible (and in my view, likely) that the private benefits exceed the social benefits. If so, traders who are able to uncover and anticipate informed trading and take measures that reduce the private returns to informed trading are enhancing welfare, even if prices are less informative as a result.

I cannot see any way of evaluating the welfare effects of financial trading, and in particular informed trading. The social benefits (how do more informative prices improve the allocation of real resources) are impossible to quantify: they are often difficult even to identify, except in the most general way (“capital allocation is improved”). Unlike the trade for most goods and services, there is no reason to believe that social and private benefits align. My intuition-and it is no more than that-is that the bulk of informed trading is rent seeking, and a tax on the risk allocation functions of financial markets.

It is therefore at least strongly arguable that the development of trading technologies that reduce the returns to informed trading are a good thing. To the extent that one of the charges against HFT-that it is better able to detect and anticipate (I will not say front-run) informed order flow-is true, that is a feature, not a bug.

I don’t know and I am pretty sure nobody knows or even can know the answers to these questions. Which means that strongly moralistic treatments of HFT or any other financial market technology or structure that affects the returns to informed trading is theology, not economics/finance. Agnosticism is a defensible position. Certitude is not.

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April 4, 2014

Not Willing to Sacrifice the Bonus of a Single Frankfurt Banker

Filed under: History,Military,Politics,Russia — The Professor @ 7:52 pm

Few things I’ve read recently are more depressing than this WSJ article about European, and specifically German, enabling of Putin’s and Russia’s aggression:

Opposition to economic sanctions as a way to penalize Russia runs from 36% in Germany to 23% in Great Britain, to 15% in Denmark, Sweden, and Norway, according to a YouGov poll taken across Europe from March 21 to 27.

In an interview with the weekly newspaper Die Zeit, former German Chancellor Helmut Schmidt said he found Mr. Putin’s actions “absolutely understandable” and urged Germans to reflect on history before condemning the Kremlin.

“More important than appealing to international law is the historical development of Crimea,” Mr. Schmidt said. “Historians are divided over whether there is even such a thing as a Ukrainian nation.”

Gerhard Schröder, who as chancellor until 2005 developed a close friendship with Mr. Putin, has expressed his understanding for Russia’s “fear of encirclement” by the West.

Mr. Schröder’s pro-Russian leanings are well known in Germany. The ex-chancellor, now chairman of a gas-pipeline venture majority-owned by Russian state energy giant Gazprom, once deemed Mr. Putin a “flawless democrat.”

While not condoning the Crimea annexation, Mr. Schröder has made light of Russia’s violation of international law, saying that Germany and NATO also broke international law when they bombed Serbia without U.N. authorization—a precedent that Mr. Putin also cites.

Ms. Merkel has used tough rhetoric against Mr. Putin and warned the crisis could inflict “massive damage” on Russia. Much of the German press panned Mr. Schröder, Mr. Schmidt, and other “Putin-understanders” and “Russia-understanders” for excusing 19th-century-style military aggression.

But the sympathetic tone strikes a chord with the German public and some elites. Siemens  AG   chief executive Joe Kaeser cited the two former chancellors’ remarks in justifying his controversial visit to Mr. Putin last week.

Among Germans polled on March 31 and April 1, 49% said the country’s foreign policy should represent a “middle position between the West and Russia,” whereas 46% said Germany should stick to a firm alliance with the West, according to polling company infratest dimap. In another poll taken in mid-March, half of Germans said the EU should simply accept Russia’s annexation of Crimea.

“People who say ‘Russia-understander’ never understand what they are talking about—it’s either black or white for them,” said former German Ambassador to Russia Ernst-Jörg von Studnitz. “Many people call me that, and I don’t mind at all.”

Germany appears dead set on making the French look grateful.

This whinging about Russia being “surrounded by enemies” and having “defenseless borders”  and being threatened by Nato expansion is so much bologna. Nato has neither offensive capability or intent. Russia has more strategic depth than any nation in the world. Just ask Charles XII, Napoleon or Hitler. As they all found out to their bitter chagrin, you can cross Russia’s borders, only to get lost in the trackless wastes that lie beyond.

And if Putin is so worried about Nato moving closer to Russia’s borders, why is he making moves in Ukraine that would move Russia’s borders closer to Nato?

Russian “fears” about a Nato invasion threat are not based in reality: they are either paranoid delusions, or contrived, or both.

Germans whine about not wanting another Cold War. Sorry, Fritz: this isn’t your choice. Putin has a vote too. Or to paraphrase Trotsky: you might not be interested in another Cold War, but another Cold War is interested in you. Courtesy of Vladimir Vladimirovich.

In large part due to the heavy burden of its horrific past, Germany wants a vacation from history and civilizational conflict. But Putin is on a civilizational mission, and if he is not stopped now, he will continue to push until some confrontation occurs in the future.

But to achieve this, Germany is not willing to sacrifice the bonus of one Frankfurt banker, let alone the bones of a single Pomeranian grenadier. And indeed, it appears that mercenary considerations are paramount. German business leaders, notably from Siemens (one of the world’s technology leaders-as well as a leader in bribery and corruption), are bleating about the economic costs of even mild economic measures against Russia.

Looking over the past several years, it becomes clear that such commercial considerations are paramount in Berlin. Germany abjures any leadership role when it comes to Russia, rationalizing this choice by harking to its bad experience with Führers. But when it comes to German money in Greece or Spain, Germany was quite willing to throw its weight around and push policies that advance German economic interests. That is, it’s not about historical burdens making Germans shirk from leadership. It’s about German commercial interests causing it to conduct a passive foreign policy sometimes, and a very heavy-handed one at others.

In other words: le perfide Allemagne. The common denominator in German policy towards Europe and Russia is what benefits German industry and German banks. Germany’s foreign policy is ultimately corporatist, and the country is quite willing to sell the rope that hangs some poor Eastern Europeans.

Germany has never hesitated to preen about its moral superiority, and to attack the US in particular for doing the dirty work that has kept Germany free and prosperous for going on 70 years. The pretense is beyond annoying.

Germany is enabling Putin, and for the most crass commercial reasons. Its policy is due neither deference nor respect.

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April 2, 2014

Michael Lewis’s HFT Book: More of a Dark Market Than a Lit One

Filed under: Derivatives,Economics,Exchanges,HFT,Politics,Regulation,Uncategorized — The Professor @ 2:35 pm

Michael Lewis’s new book on HFT, Flash Boys, has been released, and has unleashed a huge controversy. Or put more accurately, it has added fuel to a controversy that has been burning for some time.

I have bought the book, but haven’t had time to read it. But I read a variety of accounts of what is in the book, so I can make a few comments based on that.

First, as many have pointed out, although this has been framed as evil computer geniuses taking money from small investors, this isn’t at all the case. If anyone benefits from the tightening of spreads, especially for small trade sizes, it is small investors. Many of them (most, in fact) trade at the bid-ask midpoint via internalization programs with their brokers or through payment-for-order-flow arrangements. (Those raise other issues for another day, but have been around for years and don’t relate directly to HFT.)

Instead, the battle is mainly part of the struggle between large institutional investors and HFT. Large traders want to conceal their trading intentions to avoid price impact. Other traders from time immemorial have attempted to determine those trading intentions, and profit by trading before and against the institutional traders.  Nowadays, some HFT traders attempt to sniff out institutional orders, and profit from that information.  Information about order flow is the lifeblood of those who make markets.

This relates to the second issue. This has been characterized as “front running.” This terminology is problematic in this context. Front running is usually used to describe a broker in an agency relationship with a customer trading in advance of the customer’s order, or disclosing the order to another trader who then trades on that information. This is a violation of the agency relationship between the client and the broker.

In contrast, HFT firms use a variety of means-pinging dark pools, accessing trading and quoting information that is more extensive and obtained more quickly than via the public data feeds-to detect the presence of institutional orders. They are not in an agency relationship with the institution, and have no legal obligation to it.

And this is nothing new. Traders on the floor were always trying to figure out when big orders were coming, and who was submitting them. Sometimes they obtained this information when they shouldn’t have, because a broker violated his obligation. But usually it was from watching what brokers were trading, knowing what brokers served what customers, looking at how anxious the broker appeared, etc.  To throw the floor of the track, big traders would use many brokers. Indeed, one argument for dual trading was that it made it harder for the floor to know the origin of an order if the executing broker dual traded, and might be active because he was trading on his own account rather than for a customer.

This relates too to the third issue: reports that the FBI is investigating for possible criminal violations. Seriously? I remember how the FBI covered itself in glory during the sting on the floors in Chicago in ’89. Not really. The press reports say that the the FBI is investigating whether HFT trades on “non-public information.”  Well, “non-public information” is not necessarily “inside information” which is illegal to trade on:  inside information typically relates to that obtained from someone with a fiduciary duty to shareholders. Indeed, ferreting out non-public information contributes to price discovery: raising the risk of prosecution for trading on information obtained through research or other means, but which is not obtained from someone with a fiduciary relationship to a company, is a dangerous slippery slope that could severely interfere with the operation of the market.

Moreover, it’s not so clear that order flow information is “non-public”.  No, not everyone has it: HFT has to expend resources to get it, but anybody could in theory do that. Anybody can make the investment necessary to ping a dark pool. Anybody can pay to get a faster data feed that allows them to get information that everyone has access to more quickly. Anybody can pay to get quicker access to the data, either through co-location, or the purchase of a private data feed. There is no theft or misappropriation involved. If firms trade on the basis of such information that can be obtained for a price that not everyone is willing to pay, and that is deemed illegal, how would trading on the basis of what’s on a Bloomberg terminal be any different?

Fourth, one reason for the development of dark pools, and the rules that dark pools establish, are to protect order flow information, or to make it less profitable to trade on that information. The heroes of Lewis’s book, the IEX team, specifically designed their system (which is now a dark pool, but which will transition to an ECN and then an exchange in the future) to protect institutional traders against opportunistic HFT. (Note: not all HFT is opportunistic, even if some is.)

That’s great. An example of how technological and institutional innovation can address an economic problem. I would emphasize again that this is not a new issue: just a new institutional response. Once upon a time institutional investors relied on block trading in the upstairs market to prevent information leakage and mitigate price impact. Now they use dark pools. And dark pools are competing to find technologies and rules and protocols that help institutional investors do the same thing.

I also find it very, very ironic that a dark pool is now the big hero in a trading morality tale. Just weeks ago, dark pools were criticized heavily in a Congressional hearing.  They are routinely demonized, especially by the exchanges. The Europeans have slapped very restrictive rules on them in an attempt to constrain the share of trading done in the dark. Which almost certainly will increase institutional trading costs: if institutions could trade more cheaply in the light, they would do so. It will also almost certainly make them more vulnerable to predatory HFT because they will be deprived of the (imperfect) protections that dark pools provide.

Fifth, and perhaps most importantly from a policy perspective, as I’ve written often, much of the problem with HFT in equities is directly the result of the fragmented market structure, which in turn is directly the result of RegNMS. For instance, latency arbitrage based on the slowness of the SIP results from the fact that there is a SIP, and there is a SIP because it is necessary to connect the multiple execution venues. The ability to use trades or quotes on one market to make inferences about institutional trades that might be directed to other markets is also a consequence of fragmentation. As I’ve discussed before, much of the proliferation of order types that Lewis (and others) argue advantage HFT is directly attributable to fragmentation, and rules relating to locked and crossed markets that are also a consequence of RegNMS-driven fragmentation.

Though HFT has spurred some controversy in futures markets, these controversies are quite different, and much less intense. This is due to the fact that many of the problematic features of HFT in equities are the direct consequence of RegNMS and the SEC’s decision (and Congress’s before that) to encourage competition between multiple execution venues.

And as I’ve also said repeatedly, these problems inhere in the nature of financial trading. You have to pick your poison. The old way of doing business, in which order flow was not socialized as in the aftermath of RegNMS, resulted in the domination of a single major execution venue (e.g., the NYSE). And for those with a limited historical memory, please know that these execution venues were owned by their members who adopted rules-rigged the game if you will-that benefited them. They profited accordingly.

Other news from today brings this point home. Goldman is about to sell its NYSE specialist unit, the former Spear, Leeds, which it bought for $6.5 billion (with a B) only 14 years ago.  It is selling it for $30 million (with an M).  That’s a 99.5 decline in market value, folks. Why was the price so high back in 2000? Because under the rules of the time, a monopoly specialist franchise on a near monopoly exchange generated substantial economic rents. Rents that came out of the pockets of investors, including small investors.  Electronic trading, and the socialization of order flow and the resultant competition between execution venues, ruthlessly destroyed those rents.

So it’s not like the markets have moved from a pre-electronic golden age into a technological dystopia where investors are the prey of computerized super-raptors. And although sorting out cause and effect is complicated, the decline in trading costs strongly suggests that the new system, for all its flaws, has been a boon for investors. Until regulators or legislators find the Goldilocks “just right” set of regulations that facilitates competition without the pernicious effects of fragmentation (and in many ways, “fragmentation” is just a synonym for “competition”), we have to choose one or the other. My view is that messy competition is usually preferable to tidy monopoly.

The catch phrase from Lewis’s book is that the markets are rigged. As I tweeted after the 60 Minutes segment on the book, by his definition of rigging, all markets have always been rigged. A group of specialized intermediaries has always exercised substantial influence over the rules and practices of the markets, and has earned rents at the expense of investors. And I daresay it would be foolish to believe this will ever change. My view is that the competition that prevails in current markets has dissipated a lot of those rents (although some of that dissipation has been inefficient, due to arms race effects).

In sum, there doesn’t appear to be a lot new in Lewis’s book. Moreover, the morality tale doesn’t capture the true complexity of the markets generally, or HFT specifically. It has certainly resulted in the release of a lot of heat, but I don’t see a lot of light. Which is kind of fitting for a book in which a dark pool is the hero.

 

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March 30, 2014

Kerry & Lavrov Negotiate Ukraine’s Surrender in Paris: Were All the Rooms in Munich Booked?

Filed under: History,Military,Politics,Russia — The Professor @ 11:06 am

Following up on Putin’s phone call to Obama, Kerry is making a detour to Paris to negotiate with Lavrov over the fate of Ukraine.

Lavrov has laid out Russia’s terms, and intimates that Obama and Kerry have accepted the principles underlying these terms.

First, Russia demands that Ukraine adopt a new constitution that establishes a federal structure that gives each region considerable autonomy.  Translate this to mean that these regions would be able to pull a Crimea.  Or, more accurately, that Russia would be able to pull a Crimea, slicing off pieces of Ukraine and splicing them onto Russia.

Crucially, Lavrov said: “I can say that ‘federation’ is no longer a taboo word in our negotiations.”  Meaning that if he is telling the truth (always a big if) Obama has conceded that Ukraine’s constitutional order is up for negotiation, on Moscow’s terms.

Second, Russia demands that Ukraine’s new constitution incorporate guarantees that Ukraine will not join Nato or any other alliance.

In brief: the Secretary of State of the United States is traveling to Paris to negotiate the constitution of a sovereign country, without the presence of that country.  The end state of this negotiation would be to turn Ukraine into a Russian satrapy, to be gobbled up piecemeal, and with no ability to conduct an independent foreign policy.

Lavrov’s teaser is that Russia has no intention of invading Ukraine.  But if you read his words closely, you will understand that he means Russia has no intention of invading if its terms are accepted. Otherwise, Ukraine is a fascist, Nazi threat to Russia and to Russian “compatriots.”  And we know what Putin believes such a threat justifies.

The 1930s analogies keep coming, fast and furious. Here the analogy is Munich, where France and Germany negotiated Czechoslovakia’s fate with Hitler, without the Czechs being present.  The Czechs called the agreement the Munich Diktat. Will the Ukrainians call this the Paris Diktat?

There are other similarities.  The pretext of the Germans in 1938 was and Russia in 2014 is the necessity of protecting co-ethnics allegedly threatened by independent nations not invited to the negotiations.  Munich resulted in the handover of the major industrial region of Czechoslovakia to Germany: the likely outcome of an agreement on Putin’s terms would be to handover Ukraine’s main industrial region to Russia. The Munich negotiations took place under the threat of a German invasion of Czechoslovakia if Hitler’s terms were not accepted, and German troops were massed on the border to carry out that threat.  The Paris negotiations are taking place under the threat of a Russian invasion of Ukraine if Putin’s terms are not accepted, and Russian troops are massed on the border with the capability to carry out that threat.

Once upon a time “No More Munichs!” was a catchphrase in US foreign policy. No longer, apparently. Obama and Kerry seem to be saying “Why Not Munich?”

Even if no agreement comes of these talks, or talks that follows, it is deeply shameful that the United States would even engage in such a negotiation on such terms with such a nation.  Deeply shameful.

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March 29, 2014

Putin is From Mars, Obama is From Venus, and Germany is From Denial

Filed under: History,Military,Politics,Russia — The Professor @ 1:25 pm

Yes, I know the meme is cliché. But clichés become cliché because they capture some basic truths.

Have any doubts? Just compare Putin’s speech on Crimea to Obama’s speech in Brussels.  Compare what Lavrov says to what Kerry says.  Compare the different versions of the various phone conversations between Obama and Putin released by the Kremlin and the White House, most especially the readouts of yesterday’s conversation: the immediate question is “are these people talking about the same phone call?”

Obama is all about diplomacy, community, talk, de-escalation, agreement on mutually beneficial terms.  Putin is all about grievance, righting historical wrongs, battling dark forces (i.e., Ukrainian fascists and Nazis and Western interlopers), winner take all.

The reason their conversations seem disjointed is that they are.  They start from totally different premises, totally different world views.  They are talking past one another.

Oh.  And Putin is doing more than talking.  He is acting.

And this means that  Obama’s Vensuian lets-talk-about-it-and-get-to-win-win approach is utterly without foundation.  For it presumes that your would-be interlocutor and partner-to-be is operating from the same assumptions, premises, and world view as you are.

When that’s not true, the jaw-jaw Venusian approach will be about as constructive as any conversation between two parties speaking mutually incomprehensible languages.

And what’s more, the advantage in this type of contest between Mars and Venus is decidedly on the Martian side in the realm of international relations, where third party enforcement is absent. Especially when the Martian side can deploy little green men on its doorstep against a far weaker neighbor.

Before writing this, I Googled “Putin is from Mars Obama is from Venus,” to see if anyone had used this meme recently. I didn’t find that on the first several pages of search results, but I did find several pieces saying that the US (and hence Obama) is Mars, and Europe is Venus.

Yes, the US-and even Obama-are positively Martian compared to the Euros. And that’s precisely a major problem. Because it means that the Euros are absolutely dead-set against doing anything to confront Russia. And Obama is completely willing to defer to them.

And the worst offender is the nation that was once the most militantly Martian on earth: Germany.  Rather than recognize the similarities of Putin’s Russia to the bad  Germany of old, and understand the need to oppose and deter such conduct, Germany is hell bent on imitating its appeasing opponents of decades past.

Two depressing articles tell you all you need to know.

German businesses whine about sanctions, and complain about the West (!) escalating tensions with Russia. Germany swears it’s not soft on Russia.

My knowledge of Greek and Roman mythology is inadequate to figure out what Europe (and especially Germany) are if Obama is Venus to Putin’s Mars.  I guess I have to back further.  To Egypt.  Because Germany is from Denial.

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Margin Sharing: Dealer Legerdermain, or, That’s Capital, Not Collateral.

Concerns about the burdens of posting margins on OTC derivatives, especially posting by clients who tend to have directional positions, have led banks to propose “margin sharing.”  This is actually something of a scam.  I can understand the belief that margin requirements resulting from Frankendodd and Emir are burdensome, and need to be palliated, but margin sharing is being touted in an intellectually dishonest way.

The basic idea is that under DFA and Emir, both parties have to post margin.  Let’s say A and B trade, and both have to post $50mm in initial margins.  The level of margins is chosen so that the “defaulter (or loser) pays”: that is, under almost all circumstances, the losses on a defaulted position will be less than $50mm, and the defaulter’s collateral is sufficient to cover the loss.  Since either party may default, each needs to post the $50mm margin to cover losses in the event it turns out to be the loser.

But the advocates of margin sharing say this is wasteful, because only one party will default.  So the $50mm posted by the firm that doesn’t end up defaulting is superfluous.  Instead, just have the parties post $25mm each, leaving $50mm in total, which according to the advocates of margin sharing, is what is needed to cover the cost of default.  Problem solved!

But notice the sleight of hand here.  Under the loser pays model, all the $50mm comes out of the defaulter’s margin: the defaulter pays,  the non-defaulter receives all that it is owed, and makes no contribution from its own funds.  Under the margin sharing model, the defaulter may pay only a fraction of the loss, and the non-defaulter may use some of its $25mm contribution to make up the difference.   Both defaulter and non-defaulter pay.

This is fundamentally different from the loser pays model.  In essence, the shared margin is a combination of collateral and capital.  Collateral is meant to cover a defaulter’s market losses.  Capital permits the non-defaulter to absorb a counterparty credit loss.  Margin sharing essentially results in the holding of segregated capital dedicated to a particular counterparty.

I am not a fan of defaulter pays.  Or to put it more exactly, I am not a fan of mandated defaulter pays.  But it is better to confront the problems with the defaulter pays model head on, rather than try to circumvent it with financial doubletalk.

Counterparty credit issues are all about the mix between defaulter pays and non-defaulter pays.  Between collateral and capital.  DFA and Emir mandate a corner solution: defaulter pays.  It is highly debatable (but lamentably under-debated) whether this corner solution is best.  But it is better to have an open discussion of this issue, with a detailed comparison of the costs and benefits of the alternatives.  The margin sharing proposal blurs the distinctions, and therefore obfuscates rather than clarifies.

Call a spade a spade. Argue that there is a better mix of collateral and capital.  Argue that segregated counterparty-specific capital is appropriate.  Or not: the counterparty-specific, segregated nature of the capital in margin sharing seems for all the world to be a backhanded, sneaky way to undermine defaulter pays and move away from the corner solution.  Maybe counterparty-specific, segregated capital isn’t best: but maybe just a requirement based on a  firm’s aggregate counterparty exposures, and which doesn’t silo capital for each counterparty, is better.

Even if the end mix of capital and collateral that would result from collateral sharing  is better than the mandated solution, such ends achieved by sneaky means lead to trouble down the road.  It opens the door for further sneaky, ad hoc, and hence poorly understood, adjustments to the system down the line.  This increases the potential for rent seeking, and for the abuse of regulator discretion, because there is less accountability when policies are changed by stealth.  (Obamacare, anyone?)  Moreover, a series of ad hoc fixes to individual problems tends to lead to an incoherent system that needs reform down the road-and which creates its own systemic risks.  (Again: Obamacare, anyone?)  Furthermore, the information produced in an honest debate is a public good that can improve future policy.

In other words, a rethink on capital vs. collateral is a capital idea.  Let’s have that rethink openly and honestly, rather than pretending that things like margin sharing are consistent with the laws and regulations that mandate margins, when in fact they are fundamentally different.

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March 28, 2014

A Victory for Neanderthal Rights: Rusal Defeats the LME in Court. But the Neanderthal Is Still Endangered.

Filed under: Commodities,Derivatives,Economics,Politics,Russia — The Professor @ 8:01 pm

Late last year, the company of My Favorite Neanderthal, Oleg Deripaska’s Rusal, sued the London Metal exchange, claiming that the LME’s new rules on load out of aluminum violated Rusal’s human rights.  Yesterday, a judge in Manchester, UK gave Oleg a victory.

Although the judge found the human rights issue “an interesting and difficult question,” he did not rule on it.  Too bad!  That could have been entertaining.

But he did hand Rusal a victory, ruling that the LME’s process in adopting the new rule was flawed (bonus SWP quote).  As a result, the LME will not implement the rule, and has to go back to the drawing board.

Until a new rule is adopted, the bottleneck in the LME aluminum warehouses (notably Metro in Detroit) will remain stoppered.  Premiums will remain high and volatile.

And that’s the point.  By keeping the huge stocks of aluminum that accumulated in LME warehouses during the financial crisis off the market, the bottleneck keeps the prices of aluminum ex-warehouse artificially high.  This harms consumers, but enhances producers’ profits.  Which is precisely why Rusal sued.

But the victory may well by a Pyrrhic one.  For despite the fact that the warehouse bottleneck props up aluminum prices, and despite the fact that Rusal and other producers have reduced capacity, there is still a substantial supply imbalance that has weighed on prices: due to the bottleneck, prices are higher than they would be otherwise, but they are still quite low.  As a result, Rusal just posted a whopping $3.2 billion loss.

The company is heavily indebted, and the chronic losses imperil its ability to pay this debt.  The company has been frantically negotiating with its lenders, and says that if it does not get relief it will default.  Given that Deripaska has pledged shares as collateral for some borrowings, his status as a billionaire is in jeopardy.

Deripaska has been in such straits before.  He is in some ways the Donald Trump of Russia.  Putin bailed him out in 2008/2009.  Will he do it again?

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March 27, 2014

Obama Speaks. Putin Smiles.

Filed under: History,Military,Politics,Russia — The Professor @ 8:21 pm

Obama has given two major sets of remarks about Ukraine, one set on teleprompter, the other off.  Like Tolstoy’s unhappy families, each was appalling in its own way.  It is hard to say which is worse.

The off-teleprompter remarks were delivered at a press conference.  The statement that garnered the most attention, and rightly so, was Obama’s assertion that Russia was a mere regional power that is not a threat to the US, and invaded Crimea out of weakness.

Where to begin?

Part of the problem is the man’s preternatural pettiness.  He denigrated Russia in  part because he will not, cannot, concede that Romney might have been closer to the truth than he was when the Republican candidate named Russia as our number one national security threat, and Obama responded with a snarky “the 80s called and want their foreign policy back.”  A bigger man would have given Romney his due.  But that would be a different man than Obama.

But the bigger problem is the substance.  First, I would be the first to acknowledge that Russia’s military is decrepit and its ability to project power beyond the Eurasian landmass is limited.  But the Eurasian landmass is pretty damned big, and Russia’s region includes many areas of vital interest to the United States.

Second, Russia has many other sources of power that transcend those of a mere regional power (like Brazil, say).  Most obviously: It has nukes.  It has a UNSC veto.  It has extremely effective asymmetric capabilities, notably cyberwarfare (conducted in large part through private and criminal elements that work for Russian intelligence out of a combination of patriotic and mercenary motives) and intelligence.  (Snowden, anyone?)

Moreover, Putin’s anschluss, and the threatened moves beyond Crimea (not just Ukraine, but reasonably feared in any country with substantial Russian speaking minorities, which includes countries formally allied with the US) upset the entire international order.  Not just the post-World War II and post-Cold War settlements, but the principles of international order stretching back to the Peace of Westphalia in 1648.   Turning a blind eye to revanchism and irredentism threatens to unleash similar forces on every continent.  The chaos and disorder that would result would present a profound challenge to stability, and the interests of the United States.

Obama appears to believe that it is beneath a stronger power to confront weaker ones.  But what is the point of strength and power, if they cannot be deployed against peer adversaries because that would be too costly, and they cannot be deployed against weaker ones because that’s unsporting?

Indeed, if Obama’s diagnosis is correct, and Russia is a weak power (put aside whether the weakness is the motivation for Putin’s aggressiveness, as Obama claims), given the stakes there is a compelling case to deploy American power (mainly economic, financial, and political, rather than military) to squash the weak upstart.  Because that would contribute to tranquility throughout Eurasia, and pour encourager les autres.

The formal speech in Belgium was a disaster in different ways.  Obama gave a treacly tribute to the bravery of Maidan, and then basically said: “sorry, people, you’re on your own!  Good luck!  We wish you the best!”  He laid out a rather compelling case that Putin’s challenge to the international system threatened dire consequences far beyond Ukraine, but despite this he threatened no measures beyond the oft-repeated gradualism of escalating financial consequences: how many historical examples are required to demonstrate that such gradualism, so appealing in the faculty lounge and think tank, is actually an encouragement to hard men like Putin?

Disgustingly, Obama conceded many of Putin’s arguments, most notably that Russia has special rights in Ukraine due to the longstanding historical relationship between the countries.  This is to make modern Ukrainians subordinate to Russia because their forebears provided a patina of civilization to Muscovite thugs, and then suffered centuries of subjugation at the hands of these thugs which at times lapsed into genocide.  Yes, the Holodomor was truly the epitome of a special relationship, no?

If anything, the historical relations between Ukraine and Russia provide a compelling case to defend Ukraine against further Muscovite predations, rather than an excuse to consign the country to Putin’s tender mercies.

The speech put more emphasis on what the US won’t do, than what it will.  Obama repeated three times that the US will not engage in any military response to Russian aggression in Ukraine.  I’m sure Putin got that message, and smiled.

Obama emphasized a desire for continued diplomacy, and de-escalation.  Both of which Russia has already rejected, repeatedly.  (Look at the picture of Lavrov meeting with the Ukrainian FM.  I am sure The Tarantula would have preferred an appendectomy without anesthesia to that meeting.) This is political onanism of the most embarrassing sort.

But there’s more! Not only did Obama conspicuously put Ukraine outside the American security perimeter, he also slammed the door on Georgia, saying that it was not on a path to membership in Nato.  Given that Georgia is one of Putin’s biggest bêtes noire, you may rest assured that Putin is going to take this as an invitation.

In sum, the speech signaled a supine attitude that will embolden Putin.  Obama appears robust only in comparison to the Europeans, who would have to stiffen considerably in order to become mere boneless wonders (to quote Churchill’s devastating critique of Stanley Baldwin).

Some have claimed that Obama’s speech was tough, both on the Russians and the Europeans.  The markets deemed otherwise.  Gazprom was up.  Sberbank was up.  Rosneft was up.  Micex was up.  The Ruble was up.

And no wonder. Last week’s encouraging expansion of sanctions have been followed by . . . nothing.  Except empty threats to do more: that’s all Obama’s speech contained.  It is clear that there is no appetite in western capitals for aggressive action against Russia, even though it would be possible to crush the Russian economy.

Need convincing? German firms are making pilgrimages to Moscow.  German politicians are loud in their criticism of sanctions, and bend over backwards to rationalize Putin’s conduct.

Just why did we defend these people for 60 plus years, anyways?  They are obsessed with Snowden and the thought that the NSA might be perusing their Amazon purchases.  Never mind that a thugocracy is on the march.  It’s so much easier for the Germans to criticize the US than Russia.  The US doesn’t fight back.

Speaking of NSA, one of the companies that paid homage to Putin in his court was Siemens, a notoriously corrupt firm. Former CIA director James Woolsey said we spy on European companies precisely because of their corruption.  Perhaps some kompromat or prosecutions are in order.

Obama appears to be deferring to German wishes.  Specifically, I smell Merkel’s influence over the Georgia remarks.  Why did Obama have to mention Georgia at all, let alone to throw it very publicly under the bus?  Then recall that Merkel has been adamant over excluding Georgia from integration into Nato on any time frame.

Russian troops are massing on Ukraine’s borders.  Russia’s most capable formations, its paratroops (VDV) and Guards armored/mechanized units are assembled there.  But don’t worry! Russian defense minister Shoygu assures that these troops are only there for maneuvers.  And the drunk who is our SecDef believes him:

At the Pentagon, there remains confidence in the assurances provided to Defense Secretary Chuck Hagel from Russian Defense Minister Sergey Shoygu that the Russian troops amassing on the border with Ukraine were there only for exercises.

“[Shoygu] told me that they had no intention of crossing the border into Ukraine,” Hagel said at the Pentagon this week.

Can we really be this stupid?  (Don’t answer that.  The question was totally, totally rhetorical.)

Just why, pray tell, need the Russians conduct maneuvers with 50K of their best troops on a sensitive border? And given that Putin repeatedly lied about his intentions in Crimea, why should we believe Shoygu-especially since there are serious doubts that Shoygu is in Putin’s decision making clique?

In sum, in his various remarks, Obama has revealed that he has many, many cheeks, and is willing to turn them all.  To Putin, anyways: not to Romney or other Republicans. Putin will take this as an invitation, and take all that he can.  If he isn’t stopped now-and rolled back, actually-he will continue to press.  The necessity of confrontation will not be eliminated, just deferred.

 

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March 25, 2014

The Wages of Being a Petrostate: Using the Energy Weapon is Economic Suicide

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 12:07 pm

Although the Euros wring their hands at the costs they would bear if serious economic sanctions were imposed on Russia, as I’ve said, there is a huge asymmetry in vulnerability: Russia is substantially more vulnerable to a cutoff in trade, especially the energy trade.  Take gas.  Germany imports about 12b Euros of gas annually.  Its GDP is about 2.5t Euros.  So natural gas expenditures are about .5 percent of GDP, and even a substantial price increase would represent a relatively small burden on German expenditures.  In contrast, Russian energy exports (63 percent of which are to Europe) account for 50 percent of the country’s budget.  So trade restrictions would be an inconvenience for Europe, and pose an existential challenge for Russia.

Such are the wages of being a petrostate.  Using the energy weapon is national economic suicide.

FT Alphaville has a nice overview of this and other asymmetries.

One quibble, related to this:

In response to Iran-style sanctions, Russia could muster one unprecedented measure. It and its allies could stop buying euros, dollars, and Western government debt. However, Western governments should be able to brush this manoeuvre aside.

If it comes to a trade and finance showdown, it won’t have the money to be buying anything.  So a cutoff of purchases of dollars, euros, etc., is not something that Russia could threaten: it would be an inevitable consequence of a trade and finance war.  And Russia is not such a big buyer that it would make all that much of a difference anyways.

The FTA piece also dispatches the fantasy Russians and their fellow travelers are peddling: that China will assist Russia by waging economic combat against the West.  China is a huge dollar and UST long, so it would be an incredible act of economic masochism to dump dollars or Treasuries.  And Russian fantasies aside, China is not that into them.

The asymmetry of power, especially economic power, couldn’t be more obvious.  But that is counterbalanced by an asymmetry in will, and heretofore that has proved the decisive difference.  Putin has wagered that Europe is unwilling to suffer any discomfort to counterattack against Putin’s anschluss.  So far, he has been right.

 

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