Streetwise Professor

March 24, 2014

The Vertical (Silo) Bop: A Reprise

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 7:26 pm

With all the Ukraine stuff, and Gunvor, and travel, some things got lost in my spindle.  Time to catch up.

One story is this article about a debate between NASDAQ OMX’s Robert Greifeld and CME Group’s Phupinder Gill.  The “vertical silo” in which an exchange owns both an execution venue and a clearinghouse was a matter of contention:

Nasdaq OMX Group Inc. CEO Robert Greifeld was asked yesterday about the vertical silo and whether it hurts investors.

“Monopolies are great if you own one,” he said during a panel discussion at the annual Futures Industry Association conference in Boca Raton, Florida, paraphrasing a quote he recalled hearing from an investor. His exchanges don’t use this system. “We have yet to find a customer who is in favor of the vertical model,” he said.

A very retro topic here on SWP.  I blogged about it quite a bit in 2006-2007.  Despite that, it’s still a misunderstood subject :-P

Presumably Greifeld believes that eliminating the vertical silo would open up competition in execution.  Yes, there would be competition, but the outcome would likely still be a monopoly in execution given the rules in futures markets.  Under current futures market regulations, there is nothing analogous to RegNMS which effectively socializes order flow by requiring each execution venue to direct orders to any other venue displaying a better price.  Under current futures market regulations, there is no linkage between different execution venues, and no obligation to direct orders to a better priced market.  This leads traders to submit orders to the venue that they expect will be offering the best price.   In this environment, liquidity attracts liquidity, and order flow tips exclusively to a single market.

So opening up clearing would still result in a monopoly execution venue.  There would be competition to be the monopoly, but at the end of the day only one market would remain standing.  Most likely the incumbent (CME in most cases, ICE in some others.)

It is precisely the fact that competition in clearing and execution would lead to bilateral monopolies that drives the formation of a vertical silo.  This eliminates double marginalization problems and reduces the transactions costs arising from opportunism and bargaining that are inherent to bilateral monopoly situations.

Breaking up the vertical silo primarily affects who earns the monopoly rent, and in what form. These outcomes depend on how the silo is broken up.

One alternative is to require the integrated exchange to offer access to its clearinghouse on non-discriminatory terms.  In this case, the one monopoly rent theorem implies that the clearing natural monopoly could extract the entire monopoly rent via its clearing fee.  Indeed, it would have an incentive to encourage competition in execution because this would maximize the derived demand for clearing, and hence maximize the monopoly price.  (This would also allow the integrated exchange to be compensated for its investment in the creation of new contracts, a point Gill emphasizes.  In my opinion, this is a minor consideration.)

Another alternative (which seems to be what Greifeld is advocating) would be to create a utility CCP (a la DTCC) that provides clearing services at cost.  In this case, the winning execution venue will capture the monopoly rent.

To a first approximation, market users would pay the same cost to trade under either alternative. And most likely, the dominant incumbent (CME) would capture the monopoly rent, either in execution fees, or clearing fees, or a combination of the two.  Crucially, however, total costs would arguably be higher with the utility clearer-monopoly execution venue setup, due to the transactions costs associated with coordination, bargaining, and opportunism between separate clearing and execution venues.  (Unfortunately, the phrase “transactions costs” does double duty in this context.  There are the costs that traders incur to transact, and the costs of operating and governing the trading and clearing venues.)

A third alternative would be to move to a structure like that in the US equity market, with a utility clearer and a RegNMS-type socialization of order flow.  Which would result in all the integration and fragmentation nightmares that are currently the subject of so much angst in the equity world.  Do we really want to inflict that on the futures markets?

As I’ve written ad nauseum over the years, there is no Nirvana in trading market structure.  You have a choice between inefficiencies arising from monopoly, or inefficiencies arising from fragmentation.   Not an easy choice, and I don’t know the right answer.

What I do know is that the vertical silo per se is not the problem.  The silo is an economizing response to the natural monopoly tendencies in clearing and execution (when there is no obligation to direct order flow to venues displaying better prices).  The sooner we get away from assuming differently (and the Boca debate is yet another example of our failure to do so) the sooner we will have realistic discussions of the real trade-offs in trading market structure.

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A Cunning Peasant With a Battleaxe, Fighting Frankendodd

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation,Russia — The Professor @ 10:59 am

That would be me.  At least according to the Google translate version of this profile of me in Neue Zürcher ZeitungIt’s a nice piece, and a fair one (in contrast to some other articles I won’t mention).  Except I am really a mild mannered guy.  Really!

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March 22, 2014

Further Thoughts on Whether Gunvor is Done For

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 4:19 pm

A couple of stray thoughts regarding the Gunvor story.

First, virtually all of the oil trade (and the global commodities trade generally) is done in dollars.  Gunvor needs dollar financing to carry out its trading.  Anything done in dollars puts the provider of the dollar finance in the crosshairs of a panoply of US regulators.

Case in point is RBS, which paid $100 million in settlements to the Fed and the New York Department of Financial Services for violating sanctions on Iran, Burma, Sudan, and Cuba.  One law firm concluded:

A lesson that foreign financial institutions and other multinational companies should draw from these cases is that they continue to face significant risk if they engage in any business related to parties or countries (particularly Iran, Cuba and Sudan) that are restricted under US economic sanctions provisions, even if their activities may have appeared to be lawful at the time.  Such activities create risk when they have even a minimal nexus with the United States, including clearing financial transactions in US dollars, furnishing financial services through institutions in the United States, processing payments through foreign branches of US financial institutions, or knowingly relying on services provided by US persons anywhere in the world to facilitate, participate in, approve, or support restricted transactions.

Foreign persons providing a variety of financial services, including banking, money remittance, insurance, reinsurance, investment, foreign exchange, mortgages and secured transaction/letter of credit services, should recognize the inherent US enforcement risk in concealing or intentionally omitting identifying information from payment messages involving a sanctioned country, entity or person, when the transaction has some nexus to the United States or US persons (including US dollar exchange).  Deceptive activity also formed the basis for part of the recent settlement against Weatherford International Ltd. (see our advisory on Weatherford). [Emphasis added.]

To reiterate.  A “minimal nexus” with the US puts a foreign financial institution at risk when it deals with a sanctioned entity.

Here is an Economist piece on how the US uses merely touching a dollar as a basis for aggressive prosecution.  Here is the Telegraph screeching about how the US has extracted billions of dollars in settlements from British banks for engaging in transactions in dollars.

The basic issue is that any transactions done in US dollars, even between foreign entities, have a US bank involved at some point to process the dollar transactions.  You do a deal in dollars with a US-sanctioned entity, you are at huge risk of prosecution.

The implication is that even if Gunvor deals only with non-US banks, as long as it deals in dollars, if the firm becomes a sanctioned entity anyone who is on the other side of the dollar transaction is at risk.  FUD is most acute with any transaction that touches the dollar.  And you can’t engage in the international oil trade (or commodities trade generally) without dealing in dollars.

Second, a somewhat related issue. Let’s say that Törnqvist really did buy out Timchenko’s shares.  Let’s say he didn’t pay with a note.  Where can Timchenko stash the cash? Paying in Euros or CHF could perhaps avoid the problems discussed above, but even so, what western financial institution wants to take Timchenko’s money?  Even Sberbank might have some reservations.

 

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March 21, 2014

UST: Putin the Mark of Cain on Gunvor

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 1:20 pm

Just landed at O’Hare on my way back from Brussels and Geneva.  Right before taking off I saw that Gunvor’s bond price tanked at the open.  It closed yesterday yielding 10.9 percent, and spiked at the open to 13 percent.  I understand it is still tanked.

In other words, the market either totally disbelieves the story that Timchenko sold out, or thinks that the sale is irrelevant in determining the company’s vulnerability to sanctions or investigation.

My suspicion is the latter, because of the Treasury’s deviously, devilishly clever strategy.  Recall that UST said that Putin is a part owner of Gunvor.  No hedging about that claim, no “may be a part owner”:  a flat statement that Putin is an investor.  It said that Putin might have access to Gunvor funds.

So regardless of whether Timchenko sold, or commits ritual public suicide tomorrow, Treasury has put the Mark of Cain on the company.  Every counterparty, every lender has to have serious, serious concerns that the company may be sanctioned due to the Putin connection.

The tanking bond price makes it clear that the credit markets have serious doubts about the company’s survival prospects.  No doubt this reflects bankers’ serious reluctance to continue to finance a company that the US government has publicly tied to Putin.

Yes, most of Gunvor’s lenders are European banks, but ask Swiss banks about the joy of taking on the US government when it has an important policy objective in mind.  And think of all the leverage the US has over European banks given the myriad ongoing investigations of Libor, FX, ISDA Fix, and on and on.   Even if the Euros don’t sanction Timchenko (or Gunvor) (and they abstained from doing so today, waiting to announce that until I’d left Brussels, the cowards), the US has plenty of leverage over European banks.

The company has the weekend to try to turn things around.  But that Treasury statement casts a huge shadow.   In the current environment, bankers are afraid of their own shadows, let alone the shadow of a US government with blood in its eyes.

Press coverage of this story has been credulous, especially in the FT.  The stories have uncritically repeated Gunvor’s statements that Timchenko sold at fair value, and that there is no option for Timchenko to repurchase.  But they would say that, wouldn’t they?  And the stories don’t point out that the bond market is basically calling BS on Gunvor.

Speaking of fair value, I know Torbjörn Törnqvist is not an idiot.  He can go through the game tree, and realize that there is large probability that his shares, and the ones he purchased from Timchenko, will be worthless.  Meaning that he won’t have paid Timchenko book value, or anything even close.

Which raises the interesting question: if Timchenko is really just a front man for Putin, as the US government asserts, any big discount comes right out of Putin’s pocket.

Which is pretty much the point, isn’t it?  That’s exactly why UST’s statement is a big flashing neon light arrow pointing right at Putin.

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March 20, 2014

Obama Sanctions Timchenko: Will FUD Kill Gunvor?

Filed under: Commodities,Politics,Russia — The Professor @ 2:44 pm

Obama finally did something halfway serious about Putin.  The Treasury Department added several prominent names in Putin’s inner circle to the sanctions list.  Prominently featured were several judo buddies, the Rotenberg brothers and Gennady Timchenko of Gunvor and Novatek.  Also sanctioned were Ivanov and Yakunin.

Timchenko is of particular interest.  The Treasury Department specifically alleged that Putin is a part owner of Gunvor, and might have access to Gunvor funds.  I don’t know, but would love to know, whether this is based on information that UST has developed, or is just a repeat of the allegations from Milov and others that have been made in the past.  If the former . . . that would be a bombshell.

This puts Gunvor in a very delicate position.  Some of its contracts likely have illegality clauses which could conceivably permit counterparties to void the contracts.  Gunvor would no doubt fight this.  But the main threat is that no company is likely to want to deal with Gunvor going forward, and more importantly, that banks are very like to cut or pull altogether credit lines.  These lines are the lifeblood of any commodity trader.  It cannot finance inventories and trades without access to credit.

The fading away of counterparties and banks can set off a death spiral that causes the rapid demise of a trading firm.

The market is already hammering the firm.  Yield on its bond rose 340 basis points to 10.91 percent.

Meaning that we may soon get a live test of an argument that I’ve been making for over a year now, and which I made today at a conference in Brussels (and made to various European regulators yesterday): namely, that commodity trading firms are not systemically important like banks are.  Commodity trading firms can die, without fear of contagion that affects the broader economy.

Gunvor announced that Timchenko has sold his shares to co-founder Törnqvist (a Swede).  I doubt this will clear the serious doubts now swirling around Gunvor.  Banks and potential counterparties will wonder whether there is an explicit or tacit option for Timchenko to repurchase his shares.

Trading firms depend very heavily on reputation, and the trust of counterparties and lenders.  Gunvor is so closely associated with Timchenko-and Putin-that it is hard to see how counterparties and banks would be willing to take the risk of dealing with the firm.   How can they be sure that the firm is out of any threat from action by the US (or the EU, if it follows suit)?  Will they really trust this claim of a miraculous sale that severs all ties between Timchenko and Gunvor?  (If the bond price doesn’t rebound tomorrow, we’ll have our answer.)

There is no doubt that Fear, Uncertainty, and Doubt are swirling around Gunvor right now, and there is little that Timchenko or the company can do to dispel it.  And FUD is often more than enough to kill a trading firm.

The US government can feed the FUD by opening an investigation, not just of the alleged sale, but of other Gunvor activities.  I am sure there is more than enough grounds: the hint,hint; nudge, nudge about the connection between Gunvor and Putin is alone sufficient to give those thinking of dealing with Gunvor the yips.  And the announcement of an investigation, particularly in this environment, is likely to be as fatal as a conviction would be.

I will note that in the aftermath of the Georgia War I specifically called out Gunvor as a firm that deserved special scrutiny as a way of pressuring Putin.  It’s about damn time.

The storm that is brewing around Gunvor will be a gentle spring breeze by comparison to the tempest that would occur if the administration moves to add a name conspicuously absent from today’s list: Igor Sechin.  Again, illegality clauses are likely to come into play, which could permit the banks to pull the prefinancing that was provided in conjunction with prepay contracts between Rosneft and Glencore, Vitol, and Trafigura.  Invocation of these clauses would require Rosneft to repay the loans immediately.  The sums involved are immense, totaling around $12 billion.  Rosneft had announced it was looking to go to the capital markets to raise funds.  Those plans would likely have to be scuppered if Sechin gets named to the Treasury list.

But that’s for another day.  For the immediate future, all eyes on Gunvor.  Let’s see if it can find some legal maneuver to convince lenders and counterparties that it has severed all ties with Timchenko, and therefore has no exposure to punitive actions by the Treasury.  I suspect that many will argue that the downside exposure is so great, that they are unwilling to run that risk.  If that happens, Gunvor will soon implode.  The question is: will much of Putin’s wealth implode with it?

Finally, a personal note. I have had several excellent students in the Masters Program in Commodity Trading and Finance at the University of Geneva who work for Gunvor.  I feel very badly for them.  I know that being young, and bright, and having general human capital  they will wind up on their feet.  But I do sincerely regret what they must be going through now.

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March 17, 2014

What’s Next for Putin? The Comfy Chair?

Filed under: History,Military,Politics,Russia — The Professor @ 11:33 am

The US’s “sanctions” against 7 Russian officials are a pathetic travesty.  The only thing more pathetic is that the Euros omitted the two most important names (Surkov and Rogozin) from their list.

These completely ineffectual measures, which impose no real costs on the real decision makers, or on Russia, will only embolden Putin, rather than deter him.

The administration says that these are the most comprehensive measures imposed on Russia since the end of the Cold War (which is duh-obvious since none have been imposed since the end of the Cold War), and intimates that this is part of a strategy of gradual escalation.

First: yeah, gradual escalation worked out so well for LBJ and McNamara.  Hard men, like Ho Chi Minh and Putin, see “gradual escalation” as a confession of weakness.

Second: what’s the next step in l’escalier? The Comfy Chair?

This is beyond feckless.  Victoria Nuland said “F*ck the EU” because of its pusillanimity in Ukraine.  By her logic, “F*ck the US” is completely appropriate.

To give you an indication of how devastating these “sanctions” were, Russian stocks rallied around 5 percent on the news.

Several of the “targets” took to Twitter to express their disdain.  For instance, Rogozin the Ridiculous said something I agreed with for the first time ever.

Relatedly, Russia has laid down its conditions for Ukraine.  These essentially involve Russia dictating Ukraine’s constitutional order.  Specifically, Russia demands a return to the February 21 agreement, and an imposition of a federal structure on Ukraine, in which regions would have substantial autonomy.  Autonomy which would, no doubt, allow these regions to follow Crimea’s example and vote to join Russia.

If I were Ukraine, I would say: You first.  You call yourself the Russian Federation.  If a true federal structure is so great, Russia should give its various republics and autonomous regions true autonomy, including the right to vote themselves out of the RF.  Sauce for the goose and all that.

Unfortunately, based on the administration’s utter fecklessness and pusillanimity so far, I would imagine that Obama and Kerry will give (or already have given) Ukraine the same advice that Bobby Knight related to Connie Chung years ago.

Surkov certain sees things in a similar light.

Obama is notoriously the most thin-skinned president in recent memory.  Yet Russians mock him repeatedly, without eliciting any reaction, except for maybe “thank you sir, may I have another?”

Usually appeasers eventually wake up when it becomes apparent that their appeasement has only encouraged the object of the policy to take more, more, more.  Carter woke up.  Even Chamberlain eventually woke up.

Obama and the Euros?  Still lost in their dreams, while Putin inflicts a nightmare on the borders of NATO and the EU.

 

 

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March 16, 2014

Was Alfred E. Newman the Duty Officer When MH370 Waltzed Across Malaysia?

Filed under: Military,Politics — The Professor @ 9:23 am

Reuters has a story that sort of addresses the issues in my post from yesterday.  But it raises more questions than answers, really:

While Malaysian military radar does appear to have detected the aircraft, there appear to have been no attempts to challenge it – or, indeed, any realization anything was amiss.

That apparent oversight, current and former officials and analysts say, is surprising. But the incident, they say, points to the relatively large gaps in global air surveillance and the limits of some military radar systems.

“It’s hard to tell exactly why they did not notice it,” says Elizabeth Quintana, senior research fellow for air power at the Royal United Services Institute in London. “It may have been that the aircraft was flying at low level or that the military operators were looking for other threats such as fast jets and felt that airliners were someone else’s problem.”

Current and former officials say that – hopefully, at least – such an incident would be detected much faster in North American or European airspace. There, military and civilian controllers monitor radar continuously on alert for possible hijacks or intruders.

The sudden failure of a transponder, they say, would itself prove a likely and dramatic cause for concern.

“I can’t think of many situations in which one would actually need to switch them off,” said one former Western official on condition of anonymity.

The last bit is particularly important.  An unidentified aircraft with no transponder should have raised serious concerns.  But instead, the Malaysian duty officer was apparently Alfred E. Newman.  No worries: No challenge issued.

Appalling.

But maybe this was precisely why the Malaysians dissembled for so long.  They realized that they had committed an unbelievable blunder, and were loath to admit it.  I conjecture they were forced into an admission by pressure from other nations (most likely China or the US) that had information from other sources about the flight across Malaysia.

What is air defense radar good for if you are going to ignore the information it provides?

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March 15, 2014

Why Didn’t the Malaysian Military Intercept MAH370?

Filed under: Military,Politics — The Professor @ 11:01 am

The disappearance of Malaysia Air Flight 370 is one of the most disturbing episodes of recent years.

Initially, I concluded that the plane had exploded at high altitude, a la TWA 800 (though at a much higher altitude): the sudden disappearance from radar and the deactivation of the transponders supported this conclusion.  I thought terrorism would have been the most likely cause, but did not rule out some other catastrophic but accidental failure (e.g., ignition of fumes in a fuel tank).

I was skeptical about the initial reports that Malaysia had tracked the plane across its airspace on military radar because the utter inability of the Malaysian authorities to tell a coherent story made me doubt anything they said.  And recall the story was denied soon after it ran, and there appeared to be a conflict between civilian and military authorities, which cast doubt on everything.

But it is now confirmed that the plane was indeed tracked by Malaysian military radar traversing the country before turning into the Straits of Malacca. Now the official story, as yet uncontradicted, is that the plane flew on for 7 hours in an unknown direction (northwest? southwest?).  Meaning that it could be anywhere in about 10 percent of the earth’s surface, most of that trackless ocean.

This is so disturbing precisely because it is totally unprecedented as a hijacking or act of terrorism.  It is almost certainly deliberate, but the purpose is unfathomable.

Many aboard were Chinese, suggesting that if it was terrorism, it would be directed at the PRC.  But China’s only serious terrorist threat, the Uighers, have never mounted anything nearly so sophisticated and bold: mass knife attacks in railway stations is more their MO.  And what would be the purpose of creating a mystery with no known perpetrator, rather than making a dramatic statement?  (Unless, of course, the hijackers/terrorists communicated with the Chinese government, which has declined to say anything.)

Thus, this is a puzzle that will unlikely to be solved anytime soon.  If ever.

I just want to raise questions that to my knowledge have not been asked, let alone answered.  Why did the Malaysian military permit an unidentified aircraft traverse its airspace without challenging it?  Did the military challenge the UIA by radio?  Did it get a response? If not, or if the aircraft did not respond to the challenge or follow instructions, did Malaysia attempt to intercept?

The 777 apparently flew quite close to one of Malaysia’s largest cities, Penang.  Is the Malaysian military in the habit of allowing unidentified aircraft fly unhindered over its major cities? Is 9-11 that long ago?

I am a firm believer in the adage “never attribute to malice which can be explained by incompetence.”  And Lord knows, the Malaysians have displayed plenty of incompetence.  But more sinister possibilities cannot be excluded.

In any event, Malaysia must be confronted on its response-or more accurately, its lack of response-to a mystery plane waltzing across its airspace in the direction of a city of 1.5 million people.  If the Malaysian Air Force had acted properly, and intercepted the errant plane, perhaps lives would have been saved.  And even if they had not, and even had a hijacker bent on killing all the plane’s passengers for some unknown purpose crashed the plane or flown on in defiance of orders to land, at least we would not be where we are now: which is not having any idea of where the plane is, let alone how and why it got there.

The embarrassing nature of this question may explain Malaysia’s repeated obfuscation.  The confused signals given by various parts of the Malaysian government suggested that something was being covered up.  If the Malaysian military did not respond in any serious way to the invasion of its air space, the urge to cover up would be intense, especially in a shame-based culture.

We may never have definitive answers about what happened to MAH370 and why.  But Malaysia definitely owes the world some answers for its shockingly inept response to the intrusion of a jumbo jet into its airspace.

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March 13, 2014

Putin Channels Zero Hedge

Filed under: Economics,Politics,Russia — The Professor @ 3:37 pm

@libertylynx reminded me of one of the whoppers that went unnoticed because of all the even bigger whoppers in Putin’s presser 10 days back:

Now, the stock market. As you may know, the stock market was jumpy even before the situation in Ukraine deteriorated. This is primarily linked to the policy of the US Federal Reserve, whose recent decisions enhanced the attractiveness of investing in the US economy and investors began moving their funds from the developing markets to the American market. This is a general trend and it has nothing to do with Ukraine. I believe it was India that suffered most, as well as the other BRICS states. Russia was hit as well, not as hard as India, but it was. This is the fundamental reason.

Some simple facts.  Since the beginning of March, the Russian market is down 13.74 percent.  The largest decline, of over 10 percent, occurred on the Monday after the upper chamber of the Duma authorized an invasion of Ukraine.  In the same time, the MSCI Emerging Market Index was down 2.55 percent: since Russia is included, non-Russian EM stocks were down less than 2.55 percent.  The MSCI EM Index also includes Turkey, which is lurching into chaos. As for India, it is up about 6 percent, and was down less than 1 percent on the day the Russian market crashed 10 percent.

So who you gonna believe?  VVP or those lying charts? Obviously what has hit the Russian markets is not a Fed-driven phenomenon common to BRICs or emerging markets.  This was a Russia-specific phenomenon.  Which means it’s all about Putin and Ukraine.

But the most revealing thing is that Putin can say such readily falsified things with such confidence and panache.  Has he convinced himself it’s true?  Or does he know that his real target audiences, Russians dependent on TV for news, and useful idiots in the West, will just swallow his swill as Gospel and won’t bother to check?

I’m guessing the latter, but I can’t rule out the former.

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March 12, 2014

Go Ahead, Make My Day: Here’s a Russian Bluff That’s Easily Called

Filed under: Commodities,Economics,Energy,Politics — The Professor @ 10:32 am

Russian government officials and Duma members  have threatened that if the US and/or EU impose financial sanctions in response to Crimea/Ukraine, Russian corporates will just default on their debt:

A Kremlin aide warned last week that Moscow might refuse to pay off loans to U.S. banks as a retaliation measure against sanctions.

Mikhail Yemelianov from pro-Kremlin party A Just Russia went even further: “If they (the West) freeze our assets, then our companies could stop paying foreign debts. The Russian corporate debt exceeds $700 billion”.

Please.

Banks don’t lend to Russia in large sums on an unsecured basis.  One of the things that caused Putin to freak out in 2008-2009 was that Russian companies (notably Deripaska’s Rusal) had pledged stock as collateral against loans.  Putin got Russian government banks (Sberbank, VTB) to extend credit to these companies so they could pay off the loans to western banks, thereby preventing them from defaulting and having large blocks of shares pass out of Russian hands.

I don’t know about all $700 billion of Russian debt, but I do know a bit about loans to one company mentioned in the linked article: Rosneft.

Rosneft borrowed upwards of $10 billion to finance the TNK-BP acquisition.  The structure of the borrowing shows just how dodgy even the biggest, most politically connected, state enterprises are viewed by western banks.

The loans were structured as prepays, and included trading firms Glencore, Vitol, and Trafigura as part of the structures.  Rosneft entered into off-take agreements with the trading firms that obligate the Russian company to deliver oil to them over the next several years.  The trading firms will then sell the oil, and send the receipts from the sales to the lending banks, thereby paying off the loans.  That is, the banks do not trust Rosneft to pay.  Rosneft never touches the money from the oil sales.   It goes from the trading companies directly to the banks.

In other words, Rosneft’s oil is security for the loans.  And as I noted when the deals were done, real supermajors (as opposed to pretend ones) don’t have to pledge such security in order to borrow.

So what would happen if Rosneft carries through on Yemelianov’s threat?

The only way to do that would be to default on the off-take agreements, i.e.,  to fail to deliver the contracted volumes to  Vitol et al.

Good luck with that.  The second Rosneft fails to deliver on the off-takes, and tries to sell  cargoes pledged to the trading companies on the open market, the trading companies will take legal measures to seize those cargoes to enforce their legal rights.  Knowing that, no buyer in his right mind will contract with Rosneft once it has stiffed Vitol, Glencore, and Traf.  Meaning that Rosneft cannot just walk away from its debt, if it ever wants to export a barrel of oil ever again.

In Rosneft’s case, therefore, the threat to walk away is an empty one.  The banks and trading companies have seen to that in the way the deals are structured.  Precisely because they don’t trust Russian companies enough to lend on an unsecured basis.

I don’t know the structure of every loan provided by western banks to Russian corporates.  But the structure of the Rosneft loans tells you that the banks have zero trust with Russian companies, and demand some form of security against the credit extended: the form of security will vary by the borrower and type of loan.  Meaning that Russian corporates that attempt to retaliate against sanctions by defaulting on obligations to western creditors will suffer major, major pain.

So I say: call the Russians’ bluff.  Impose sanctions.  If Putin forces Russian companies to default in response, they-and he-will pay a far higher cost than anything inflicted on the nations sanctioning Russia.

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