Streetwise Professor

February 13, 2016

The Great White Hope With A Glass Jaw and Disastrous Policies

Filed under: History,Military,Politics — The Professor @ 12:50 pm

I haven’t written much about the ongoing presidential race because, well, it’s just too damn depressing. The race is nearing a critical period, so I’ll make a few observations and then go back to looking for an island to escape to.

Trump is still ascendant in the Republican race. His closest rival, Cruz, is almost as frightening to the Republican establishment as Trump. So said establishment has seized upon Marco Rubio as its savior. After Iowa, Rubio was anointed as the voice of reason with the best chance of defeating Hillary (assuming that she is the nominee, and given the way the Democratic nominating process is rigged, that could happen even if she loses every primary to the dotty socialist, and has to appear at her inauguration in an orange jumpsuit instead of a canary yellow Mao suit).

That lasted for about a week, when Chris Christie showed that the establishment’s Great White Hope had a glass jaw in the New Hampshire debate. This sent the establishment into paroxysms of defensive rage, directed mainly at Christie for having the temerity to challenge The One and undermining the Republican’s best chance at victory in November.

This logic is delusional. If Rubio can’t handle  a telegraphed punch from a fellow Republican, how could anyone possibly expect him to do anything but wither under the assault of the Clinton machine and the national media (but I repeat myself)?

Even if Rubio is toast, the establishment’s enthusiasm for him and his positions is disturbing, and reveals precisely why Trump and Cruz are dominating the process. Rubio has made foreign policy the centerpiece of his campaign. This despite the fact that the signs are all around that economic troubles are mounting, and that the election is likely to turn on economic issues than foreign policy ones. The seething discontent that feeds Trump (and Cruz, and Sanders on the Dem side) is at root a populist revolt driven by economic anxieties and a belief that the political system is favors elites that have done quite well in the aftermath of the crisis while many Americans are floundering.

Further, the specifics of Rubio’s foreign policy positions are troubling and disconnected. Yes, terrorism is a major concern of many Americans. But Rubio’s nostrums involve a new round of interventions in Syria and Iraq that are unlikely to reduce materially the threat of terrorism. Indeed, mouthing the words of his neoconservative adviser Max Boot and his ilk, Rubio advocates getting involved in intra-Muslim sectarian civil war on the side of the primary source and funders of anti-American terror in a place where only minor American interests are involved, and where intervention would greatly increase the risk of a confrontation with Russia. And large swathes of the Republican establishment cheer him on.

Rubio talks constantly on the stump and in debates about taking the side of the Sunnis in the Sunni-Shia Muslim civil war. Let’s be clear about what he really means: he means taking the side of the Saudis and Qataris and Turks, none of whom are reliable allies, or have US interests at heart. Indeed, (a) the Saudis in particular are the wellspring of terror, and (b) their main interest is in manipulating the US to intervene in their battles to advance their interests, which are in no way aligned with ours. We have no stake in the Muslim civil war.

Ostensibly, Rubio’s (and Boot’s and the neoconservatives’ generally) support for Sunnis is aimed at fighting ISIS, and is anti-sectarian:

Because they currently occupy Sunni cities and villages. Sunni cities and villages can only truly be liberated and held by Sunnis themselves. If they are held by Shias it will trigger sectarian violence. The Kurds are incredible fighters, and they will liberate the Kurdish areas, but Kurds cannot and do not want to liberate and hold Sunni villages and towns. It will take Sunni fighters themselves in that region to take those villages and cities, and then to hold them and avoid the sort of sectarian violence that follows in the past. And why that is important is because if Sunnis are not able to govern themselves in these areas, you are going to have a successor group to ISIS. ISIS is a successor group of al Qaeda. In fact, they broke away from al Qaeda, because as horrible as al Qaeda is, ISIS thought al Qaeda was not radical enough. This is who we’re dealing with, and they have more money than al Qaeda ever had.

This is delusional for several reasons. First, it presumes that “Sunni fighters” are all that interested in fighting ISIS, which is an avowedly Sunni movement that wants to extirpate Shia. In Syria, the Sunnis are focused on toppling Assad. In Iraq, the Sunni powers in the region have little interest in defeating an insurgency because that would empower Iran and the Shia government of Iraq. Second, the governments of Syria and Iraq have no interest in empowering Sunnis who would, if they succeeded in defeating ISIS, become a threat to those governments. The aftermath of a putative defeat of ISIS by the magical Sunni fighters would almost certainly involve conflict between the victorious Sunni forces and the governments of Syria and Iraq, thereby involving the US as a partisan in civil conflicts in both countries. In the case of Syria, this would set up a direct confrontation between Russia and the US. Third, the idea that there are Sunni moderates, or that Sunnis with guns are likely to be moderate, is nuts. In Syria, the armed Sunni groups are overwhelmingly Al Qaeda or Muslim Brotherhood. Both are virulently anti-American. Even if they somehow vanquished ISIS, we would just be empowering other anti-American groups with a history of carrying out terrorism.

The Rubio model (or more accurately, the model of his advisors, because he seems incapable of independent thought) appears to be the Surge in Iraq. Yes, the Surge was very successful, much to the surprise of many. But its success depended on many conditions, none of which can be repeated now.

Remember what was “surged”: American combat units. 150,000 US personnel were involved. Although the Anbar Surge has received most attention, American troops also fought fiercely to subdue Shia militias as part of the effort. Indeed,  that was vital in giving the US credibility in forming alliances with the Sunni tribes in Anbar. Moreover, the Sunni tribes would not have stood up against Al Qaeda in Iraq (the predecessor of ISIS) if there were not tens of thousands of Americans in the fight. This is not happening, nor should it happen, because the gain is not worth the cost.

Nor can one ignore the fact that the US’s ignominious withdrawal from Iraq is what made it possible for ISIS to metastasize and wreak vengeance on those Sunnis who had cooperated. It also allowed the hardcore Shia sectarians in Iraq to run amok, and take their vengeance on Sunnis. The trust that Petraeus and other Americans so painstakingly built to coax the Sunni tribes into the conflict against AQI has been destroyed, and it will not be possible to restore it.

In brief, the success in Anbar was dependent on conditions that cannot be repeated. Those using the Surge as their model for the battle against ISIS are fighting the last war, which inevitably turns out badly.

I should also note that Rubio’s relentless criticism of Assad puts him clearly on the Sunni/Saudi/Turkish/Qatari side of the civil war in Syria. Further, his advisors, and those supporting him, are relentlessly anti-Shia and pro-Sunni. They demonize Assad-who is indisputably a malign man who has committed atrocities-but gloss over the equally malign nature of most of those fighting him. This black-and-white characterization of what is really a black-and-black situation is exactly what led to the disastrous intervention in Libya. Even if ISIS is subdued, the Rubio mindset makes it inevitable that he would get the US involved in a civil war in a minor country that is only tangential at best to American interests.

Here too Trump and Cruz have a better sense of the American people than Rubio. There is widespread opposition to another adventure in the Middle East, even one dressed up as a war against ISIS.

To some extent, this issue would be neutralized in a general election campaign between Clinton and Rubio, because Hillary is also an interventionist, and one who wears Libya like an albatross around her neck. But being an interventionist would be a disadvantage if Hillary was matched up against a non-interventionist.

Rubio’s advisors are strong advocates of the idea of the US as the world’s policeman, and have blasted Cruz, Christie, Paul and Fiorina as “isolationists” because of their skepticism over engaging in new adventures in Syria and elsewhere. Yes, Obama’s anti-interventionism has contributed to the current chaos in the world. But just as Obama over-learned the lessons of the Bush presidency, Rubio, his neoconservative advisors, and the Republican establishment, seem hell-bent on over-learning the lessons of the Obama presidency. The average between too much and too little isn’t “just right.” Rather than see-sawing between extremes, we need a foreign policy that is discriminating in where and how it intervenes, focusing on areas of vital US interests, ignoring sideshows (as tragic as they are), not picking unnecessary battles even with egregious actors (e.g., Putin) and not being played by regional actors with their own agendas.

A callow Rubio, who is clearly very reliant upon the advice of others who are anything but discriminating, would combine the worst characteristics of Bush and Obama. This is definitely not what the US needs right now. Unfortunately, what the US needs is not on offer. Not even close.

 

Print Friendly

February 10, 2016

I[gor], Robot (Hater)

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Russia — The Professor @ 9:40 pm

Igor Sechin comes in a close second to Rogozin the Ridiculous in providing Russian comic relief. Perhaps there are others in Russia that excel them, and I am only aware of these two because they have a bigger presence in the West, but both can be relied upon for some levity–unintentional, to be sure.

Sechin no longer has the outrageous mullet to amuse, but his public utterances suffice. Today at International Petroleum Week in London are a case in point. The mood at the event was gloomy, with pretty much everyone predicting that we are in a prolonged era of low prices, and everyone had their favorite culprit. But Sechin’s scapegoat was unique: Robots! Well, “robot traders”, anyways:

He blamed ‘financial players’ and automated ‘robot’ traders for driving down the price, saying the collapse to near $30 had little to do with supply and demand.

I presume he means algo traders and HFT. Just how these “robots” trading at subsecond frequencies have mesmerized producers and consumers to behave so as to lead to relentless buildups of inventory–including a looming topping out of capacity at Cushing–is beyond my mere economist’s skills to fathom.

Maybe Igor can commiserate with US cattle producers, who blame HFT for causing excessive volatility in beef prices.

Igor also seems to misunderstand that the “US” is not analogous to Saudi Arabia as a producer (although the phrasing is ambiguous, but I interpret this to include the US in “they”):

“At the end of 2014 some Middle East producers followed the US in their desire to increase production,” Mr Sechin told London’s International Petroleum Week. “They have deliberately created this situation and they are committed to low prices.”

The US oil sector is not a unitary decision maker in the way the Saudis are. The US industry is extremely fragmented and diffuse, with dozens of producers acting independently. They are price takers, not price makers. Very different from KSA or other producers with NOCs. (Relatedly, this is why calling the US the “new swing producer” analogous to the Saudis is dumb.)

It’s also more than a little hypocritical of him to criticize others for increasing output: Russian production has been increasing steadily over this same period.

Sechin also engaged in a little wishful thinking:

He forecast prices would recover later this year as US shale output slows. “We believe that in the coming years US shale will lose its grip on the market,” he said.

Good luck with that, Igor. US shale output has proved to be far more resilient than anyone had expected. Productivity gains and lower input costs have mitigated the impact of low prices. More importantly, the shale sector has the ability to ramp up output rapidly if prices do rise, either due to a rise in demand, or an attempt by other major producers to cut output. Indeed, this is likely the real reason the Saudis resist cutting output: they know it is futile because the supply of non-OPEC output is much more elastic than it used to be. This makes the demand for the output of the major producers, notably the Saudis (and the Russians!) more elastic than it used to be. This implies that it is not in the individual interest of any major producer to cut output unilaterally.

Which brings us to the most informative and refreshingly different part of Sechin’s remarks: his discussion of the prospects of a coordinated output cut involving OPEC and Russia.

This idea has captivated traders, who chase the idea like Randy Chasing the Dragon, shooting (the price!) up every time the rumor is floated, only to watch it fly away from their grasp. Once upon a time, Igor was notorious for encouraging such notions. Not this time around:

The most powerful figure in Russia’s oil industry on Wednesday signalled his steadfast opposition to combining with Opec to reverse the crude price rout through co-ordinated cuts in production.

. . . .
“Who are we supposed to be talking to about cuts?” Mr Sechin said when asked by the Financial Times if he was considering working with Opec, the producers’ cartel, to try to shore up the oil price. “Will Saudi Arabia or Iran cut production?”

Methinks that the real story is that the Saudis have made it clear that they trust neither the Russians nor (especially) other members of OPEC to adhere to any agree upon cuts, even assuming a deal can be cut, which is highly doubtful. So Sechin is acting as if he is the one rejecting the idea, primarily because he knows that it is DOA.

Not that this will stop all those Randys from chasing the next rumor of a coordinated cut.

Which raises the questions: Is Randy a robot? Are robots programmed to buy whenever a rumor of a Russo-Saudi oil deal is announced?

Maybe Igor will enlighten us in his next public appearance. Maybe he can do it to some musical accompaniment. Might I suggest this?:

Print Friendly

February 6, 2016

Putin Plays Pyrrhus

Filed under: Music,Politics,Russia — The Professor @ 7:46 pm

The Assad regime and the Russians are on the verge of victory in northern Syria. In particular, the rebel stronghold of Aleppo is on the verge of falling.

This is not all that surprising. It demonstrates the decisive effect of airpower if–and this is crucial–it is operated in support of an even minimally competent ground force, especially one with armor. This is particularly true if the airpower is utilized ruthlessly, with little squeamishness about civilian casualties.

The few victories against ISIS–Kobane, Sinjar, and Ramadi–demonstrate the same point, as does the ineffectualness of the “allied” air attacks against ISIS in Syria and Iraq generally, because these attacks are not mounted in support of a coherent ground attack undertaken by an even moderately effective infantry and armor force.

The Syrian-Russian success also provides an interesting contrast to the Saudi fiasco in Yemen. The Saudis have bombed ruthlessly, with little military effect, because the bombing is not coupled with a credible ground campaign against the Houthis. This no doubt reflects the Saudi’s knowledge of the severe limitations of their ground forces.

These limitations made me laugh at the Saudi offer to deploy troops to fight ISIS in Iraq and Syria. Even overlooking the logistical impracticality of this, the Saudis would be setting themselves up for an embarrassing failure.

The Russians and Syrians actually intensified their offensive in the lead-up to the farcical “peace” talks in Geneva. No surprises here. They are in this to win decisively, not to negotiate a compromise. And there is no better way to send that message than by victory on the battlefield on the cusp of talks.

This has left the US and Europeans and Gulf Arabs sputtering in ineffectual rage. John Kerry was particularly embarrassing (nothing new here!):

“Hospitals have been hit, civilian quarters have been hit, and in some cases, after the bombing has taken place, when the workers have gone in to try to pull out the wounded, the bombers come back and they kill the people who are pulling out the wounded,” Kerry told reporters in Washington. “This has to stop. Nobody has any question about that. But it’s not going to stop just by whining about it.”

But what else is he (or anyone else) doing about it other than whine? Nothing. It would have been better for Kerry to remain silent, rather than advertise his (and The US’s) impotence.

It is also interesting to note that Kerry is damning the Russians and Syrians for bombing civilians, yet is utterly silent on the equally bad (if not worse) Saudi air campaign in Yemen.

In response to the Aleppo debacle, Turkey has closed its border with Syria. Erdogan is no doubt attempting to create (exacerbate, really) a humanitarian crisis in order to goad the US and Europe into intervening. It will never happen. The Europeans lack both the will and the means. The US has the military capability, but not the will: whatever will existed at one time (which was minimal) disappeared when intervention meant a confrontation with the Russians.

So Putin will likely get a battlefield victory. But so what? He and his Syrian creature will conquer a depopulated and devastated country. This will have little impact on the strategic balance in the region, and virtually no impact on US interests. Yes, Erdogan’s imperial and sectarian ambitions will be thwarted. Saudi and Qatari sectarian supremism will be defeated. To the extent that the US is impacted, these are actually favorable developments.

Those in the West who fulminate over Putin’s success in Syria are ironically engaged in the vacuous zero-sum thinking that drives Putin. A Putin victory is not necessarily an American defeat.

But the zero-sum thinker Putin is probably gleeful at the shrieks of distress from Kerry, the head of the UN, the Europeans, and various anti-Russian elements in the Western media. It’s all music to his ears, and also quite useful to him domestically. Another irony, that: the more that Putin’s enemies in the West screech about what is happening in Syria, the more it helps him.

Putin’s victory may be hollow, though, and his glee short-lived. He initially attempted to utilize his intervention in Syria as a way of presenting Russia as an ally of the West in the war against ISIS in order to undermine the sanctions regime, and to bring Russia in from the diplomatic cold. However, his unabashedly pro-Assad campaign, his intensifying the offensive in the run-up to the Geneva talks, the resultant humanitarian and refugee crisis, and the minimal Russian targeting of ISIS will make it impossible for the Europeans to do anything that will appear to be rewarding him. Putin’s intervention, with its demonstration of the cynicism and pointlessness of American policy, and thereby make Obama look bad, will cause our petulant president to retaliate in his passive-aggressive way, but maintaining sanctions, and pressuring the Europeans to do the same.

Putin is overplaying his hand elsewhere in Europe as well. The Russian media and government histrionics over the “Lisa” fake rape case in Germany has deeply angered Merkel who is already under siege over the migrant crisis (and especially the sexual assault crisis that has followed in its wake). Further, Putin met with Bavarian governor Horst Seehofer, Merkel’s most strident critic on immigration.  This will also anger Angela.

Putin, of all people, should realize that if you strike at the king (or queen) you better strike to kill. If Merkel survives-which is likely-she will be ill-disposed to ease sanctions, especially since Putin is ratcheting up the conflict in Donbas as well. Long surviving politicians tend to have long memories as well.

In sum. Air power can be dominant when teamed with infantry and armor. Putin will likely win a tactical victory in Syria. But the victory will be strategically barren, and possibly counterproductive, because (a) the “winner” will inherit a blasted and dysfunctional battleground, and (b) this “victory” will set back Putin’s efforts to roll back sanctions.

If anyone “wins” out of this, it is Iran. The Iranians will maintain their pipeline to Hezbollah, and deal the Saudis a stinging defeat. So Putin will succeed as the mullahs’ muscle, and in the process he will gain the satisfaction of humiliating the US (which stupidly set itself up to be humiliated), but at the cost of perpetuating Russia’s economic isolation, which is exacting a terrible toll on a country already reeling from the collapse in oil prices. That is about as Pyrrhic a victory as one could imagine.

Print Friendly

February 2, 2016

Russian “Privatization”? Only If Putin Is Desperate Indeed

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 10:11 pm

Putin held a meeting with the CEOs of seven state-owned enterprises to discuss the sale of minority stakes in their companies (a move sometimes mischaracterized as “privatization”). Putin frankly admitted that the impetus for this discussion is Russia’s dire budgetary situation. Putin caused some confusion by saying the “new owners of privatized assets must have Russian jurisdiction,” leading some to conclude that he was ruling out foreign investment. Peskov clarified the next day, saying that Russia welcomed foreign investors, but “If the question is about a foreign investor, that’s one thing. If it’s about a Russian investor, it must not be another offshore scheme.”

I consider it likely that this initiative will be stillborn, at least insofar as sales of stakes to foreigners are concerned. Putin said that the sales must not take place at “knockdown prices.” Well, in the current environment, the prices (especially for Rosneft and VTB) are likely to be very low indeed.

This is especially so since foreign investors will demand a substantial discount to compensate for expropriation risk. Savvy investors with long memories will recall that Putin justified expropriating Shell’s Sakhalin II project by saying that the terms of the Sakhalin PSA were unfair to Russia, and that Shell had exploited Russia’s economic desperation when it signed the deal at a previous time of low energy prices. Putin (or whoever succeeds him) could easily resurrect such rhetoric in the future when oil prices rebound. Further, minority shareholders in Russian enterprises–especially state enterprises–have few protections against schemes that divert assets, or which dilute their holdings.

Given that prices are likely to be very low, if there are sales to foreigners, it will indicate (1) that Russia is desperate indeed, and (2) Putin et al consider it unlikely that sanctions will be relaxed anytime soon.

If there are sales, it is likely to be to Russian oligarchs, and in particular those with extensive holdings outside Russia. Just as Putin dragooned them into paying for Sochi and other prestige projects, he could well pressure them into overpaying for stakes in the state enterprises. This would allow him to kill two birds with one stone. It would help stanch the budgetary bleeding. It would also advance Putin’s longstanding goal of onshoring Russian capital. That would fit with the “owners must have Russian jurisdiction” remark.  And Putin has substantial leverage to get oligarchs to do his bidding–literally.

Even if partial sales take place, it will be merely a stopgap budgetary measure: it will not indicate a fundamental reconsideration of Russian economic policy.  Putin is still obviously a firm believer in the state control/state champion model, despite its manifest inefficiency. Putin prefers the control over resources that state control provides to having an efficient economy. Which is why he finds himself in his current straits.

Print Friendly

February 1, 2016

The Buck Stops With Hillary? Unless It’s From Goldman, You Must Be Kidding

Filed under: Politics — The Professor @ 12:13 pm

Hillary’s email excuses get more lame by the day. For months her story–and she has stuck to it–is that none of the emails were marked as classified. Yesterday, when (miracle of miracles!) George Stephenopolous called her on this, her excuse became even lamer. And if I were Cheryl  Mills, Huma Abedin, or Jake Sullivan, I would be afraid, very afraid, after hearing it.

Specifically Stephenopolous asked about a non-disclosure agreement Clinton signed before becoming Secretary of State, which states: “classified information is marked or unmarked … including oral communications.” That is, marking is a sufficient, but not necessary, condition for establishing whether something is classified. The mention of “oral communications” points out the obvious issue: if marking was necessary, verbal information could never be an official secret, which is obviously absurd.

Hillary’s response? Here’s to you, Cheryl, Huma, and Jake!:

Clinton pointed to her aides, saying: “When you receive information, of course, there has to be some markings, some indication that someone down the chain had thought that this was classified and that was not the case.”

Someone down the chain is apparently responsible for establishing whether something sent up the chain should be classified.

There’s only one little problem with this. Per an Obama Executive Order on classified information (which parallels EOs of previous presidents), Hillary was an”original classify[ing] authority.”

Sec. 1.3.  Classification Authority.  (a)  The authority to classify information originally may be exercised only by:

(1)  the President and the Vice President;

(2)  agency heads and officials designated by the President; and

(3)  United States Government officials delegated this authority pursuant to paragraph (c) of this section.

(b)  Officials authorized to classify information at a specified level are also authorized to classify information at a lower level.

(c)  Delegation of original classification authority.

(1)  Delegations of original classification authority shall be limited to the minimum required to administer this order.  Agency heads are responsible for ensuring that designated subordinate officials have a demonstrable and continuing need to exercise this authority.

The “classification authority”, as the title suggests, has the authority and responsibility to classify:

Section 1.1.  Classification Standards.  (a)  Information may be originally classified under the terms of this order only if all of the following conditions are met:

(1)  an original classification authority is classifying the information;

(2)  the information is owned by, produced by or for, or is under the control of the United States Government;

(3)  the information falls within one or more of the categories of information listed in section 1.4 of this order; and

(4)  the original classification authority determines that the unauthorized disclosure of the information reasonably could be expected to result in damage to the national security, which includes defense against transnational terrorism, and the original classification authority is able to identify or describe the damage.

In brief, Hillary was the ultimate classification authority in the State Department, and everyone else in the Department was exercising that authority because it had been delegated by her to them. Further, Hillary had the authority to determine whether “disclosure of the information reasonably could be expected to result in damage to the national security.” The power to make these determinations was explicitly vested in her.

In other words: the classification buck should have stopped with Hillary. She cannot escape the authority and duties assigned her by statute and implementing executive orders.

But of course, the only bucks that stop with Hillary are those donated to the Clinton Foundation for “speaking fees” from Goldman, etc., or extracted from tuition paying college students by political sycophant university administrators.

Hillary is clearly preparing  to throw her closest aides to the wolves. “I was failed by my subordinates who failed to mark properly this information that should have been classified.”  It’s the Clinton way.

It’s also a legal travesty. The woman who believes that it is her right to be a successor of Harry Truman definitely does not live by his motto: “The Buck Stops Here.” It stops with the patsies who have to take the fall in order to protect Her Highness’s political viability.

 

Print Friendly

January 31, 2016

CCPs & RTGS: Devil Take the Hindmost?

Filed under: Clearing,Derivatives,Economics,Politics,Regulation — The Professor @ 6:37 pm

The frantic sewing of parachutes in a plane that is 30,000 feet in the air continues apace. Last week the Office of Financial Research (a Son of Frankendodd) released its 2015 Annual Report. This tome received attention mainly because it raised alarm about potential systemic risks arising from central clearing mandates. An improvement, I guess, but like most official evaluations of the systemic risks of CCPs, it misses the real problems.

It gets off on the wrong foot by misstating the real benefits of CCPs. According to OFR, the top two benefits of clearing are related to the ability of CCPs, and via them regulators, to get more complete, accurate, and timely information on derivatives positions and trading prices. But these can be achieved by transaction reporting alone, without going the full monty to clearing, which also entails collateralization (including both initial and variation margining) and mutualization of default risk. (Trade reporting has turned into a nightmare, which I will write about further soon. But the point is that you don’t need clearing to get the benefits OFR touts.)

But the main problem, yet again, is that OFR focuses on the “single point of failure”/interconnectedness/default loss contagion channel for CCP systemic risk. This is not immaterial, but it is not the main thing. The main thing is that CCPs create potentially massive contingent demands for liquidity, where the liquidity contingency is likely to occur precisely at the worst time–when the system is undergoing a financial crisis.

Further, OFR gets it wrong when it states that CCPs “reduce the risk of counterparty default.” CCPs redistribute the risk of the insolvency or illiquidity of a large financial institution away from its derivatives counterparties towards its other creditors. It protects one group of creditors at the expense of others.

It is very much open to question whether this reallocation is systemically stabilizing, or is instead a means whereby one relatively concentrated group of market participants can advantage themselves at the expense of others.

Reading Izabella Kaminska’s excellent FT Alphaville post on Real Time Gross Settlement (RTGS) mechanisms makes plain that this phenomenon of substituting liquidity risk for credit risk, and redistributing credit risk away from core banks, is not limited to derivatives clearing. RTGS replaced deferred net settlement (DNS) because of banks’ and central banks’ concern that in the latter, interbank credit balances could accumulate, resulting in a default loss to settlement banks in the event that an net payer bank failed before the next netting cycle. RTGS eliminates interbank credit exposure.

But, of course, this doesn’t make credit exposure go away. It redistributes it to settlement banks’ other creditors. To a first approximation, the total losses from the inability of a bank to meet its obligations are the same under RTGS and DNS. The difference is who gets a chair when the music stops. Settlement banks–and crucially, the central banks–like RTGS because they almost always are going to get a chair.

Furthermore, as even its proponents acknowledge, RTGS is much more liquidity intensive. To be able to make every payment in real time, a settlement bank either has to have the cash on hand, or the ability to borrow it on demand intraday from the central bank. Liquidity needs scale with gross payments, which are substantially larger than net payments. Thus, like CCPs, RTGS substitutes liquidity risk for default risk.

This risk is exacerbated by the fact that a prisoner’s dilemma problem exists in RTGS. Participants concerned about the creditworthiness of other banks have an incentive to delay payments and hoard liquidity, since once a payment goes into the system, it is final and the payer is at risk to loss of the entire gross amount if a bank that owes it fails before it pays. This can lead to a seizing up of the liquidity supply mechanism, as the prisoner’s dilemma logic kicks in and everyone starts to hoard.

Since holding cash in sufficient amounts to meet all payment obligations is extremely expensive, RTGS has evolved to permit central banks to lend intraday on a collateralized basis. But as was seen in the 2008 crisis, collateralization poses its own risks, including ballooning haircuts that can set off price spirals due to collateral fire sales. Further, due to the potential for the breakdown of long and large collateral chains, this creates an interconnection risk, and represents a further coupling of the system. And it is coupling, remember, that is at the root of most catastrophic accidents. Secured lending can create a false sense of security.

Izabella’s post also points out another problem with RTGS, which is common to central clearing. It creates a much more tightly coupled system that is very vulnerable to operational risk. This risk crystalized in October, 2014, when a seemingly innocuous change to the system (deleting a member bank) caused the failure of the UK’s CHAPS  settlement system for a day. Ironically, this was the result of an interaction between one part of the system, and another part (the Liquidity Savings Mechanism) that was intended to economize on the liquidity demands of RTGS, and essentially created an RTGS-DNS hybrid. As in most “normal accidents”, unexpected interactions between seemingly unrelated parts of a complex system led to its failure.

There is another way to see all of this. Both central clearing and RTGS are intended to create “no credit” systems. That is true only in a very limited sense–a profoundly unsystemic sense. Yes, CCPs and RTGS are designed so that participants in those arrangements don’t have credit exposure to one another. But those participants aren’t the entire system, just a part of it: the exposure is pushed away from them to others. Further, the method for reducing credit exposure among the participants is to require extensive reliance on liquidity mechanisms that are prone to breakdown in stressed market conditions. Further, these liquidity mechanisms are based on credit: banks (or the CCP) borrow from other banks, or from central banks in order to obtain liquidity. Further, the credit moves into shadowier places.

Not to sound like a broken record, but things like CCPs and RTGS redistribute and transform risks, rather than eliminate them altogether. Unfortunately, these transformations do not necessarily reduce the risk of a systemic crisis, and arguably increase it in some cases. The failure of officialdom, and large swathes of the banking sector, to recognize or address this reflects in large part a failure to take a systemic perspective. Perhaps cynically, this can be explained by the fact that the central banks and banks that drive these reform efforts mistake their own interests for the interest of the system as a whole: le système, c’est nous. As a result, “Devil take the hindmost” could well be applied as the motto of RTGS and central clearing.

This illustrates a broader problem in public policy. Government is too often invoked as a deus ex machina that internalizes externalities. But the fact that most regulatory change efforts are driven by, or ultimately controlled by, a small subset of interested parties who have the most concentrated stake in an issue. Given the diffuseness of other impacted parties this is inevitable. But it means that in practical terms internalizing externalities via regulation of something as complex as the financial system is a chimerical goal. The externality hot potato gets tossed from one segment of the financial sector to another. Government regulation, as opposed to self-regulatory initiatives, mainly affect the makeup of the subset of participants who are involved in influencing the process, and the distribution of the bargaining power. This works through the entire process, from the crafting of legislation, to the writing of regulations, to their implementation. This is why we get things like RTGS or CCP mandates, which make a certain set of participants better off, but which it is heroic indeed to believe are truly welfare increasing.

 

 

 

Print Friendly

January 26, 2016

Liquidity Is King, or Why CME’s Failure in Cocoa Doesn’t Amount to a Hill of Beans

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 9:55 pm

The WSJ reports that the CME Group’s new Euro-Denominated cocoa futures contract is floundering, due to a pronounced lack of liquidity. (h/t @libertylynx) The incumbent ICE Futures Europe Sterling-denominated and ICE Futures US USD-denominated contracts dwarf the CME contract’s volume, even though European hedgers face some currency risks in using these contracts.

This is not a surprise, not by a long shot. It is always very difficult for upstart contract to make inroads, let alone dominate, in competition with an established incumbent. Liquidity is king, and the established contracts have a liquidity advantage that new entrants almost never overcome, even if the new contract is superior on some dimensions.

The only real example of the displacement of an incumbent is Eurex’s wresting of the Bund contract from LIFFE in 1997-1998. That story, which I analyze in a forthcoming paper in the Journal of Applied Corporate Finance, is the exception that proves the rule.

First, because it was supported by German banks who direct a lot of order flow to it, Eurex (and its predecessor, Deutsche Terminborse) had a base of liquidity on which to build.

Second, because it was electronic, it was possible for Eurex to offer faster and easier access to US users once the CFTC approved Eurex’s application to install terminals in the US.

Third, and most important, Eurex exploited LIFFE’s smug complacency. Eurex aggressively cut fees, and LIFFE did not match: it was convinced that its superior liquidity, and the inherent superiority of floor trading, would prevent its customers from defecting to Eurex to save a few DM per contract in fees.

Wrong! As I document in the JACF paper, the liquidity cost difference between the markets wasn’t that great by 1997 (due to the German bank support and the influx of US customers), and taking into account the lower trading fees it was actually cheaper to trade on Eurex. Volume started to leak to Eurex, and the leak turned into a flood. LIFFE belatedly cut fees, but by then it was too late. The market had tipped completely to Eurex, and LIFFE had a near-death experience.

I can speak first hand of LIFFE’s overconfidence. In 1992, I produced a study for DTB that showed that its electronic market’s liquidity was comparable to that of the floor-based LIFFE. The study was not intended for release: it was commissioned to determine whether it was advisable for DTB to add a new membership type analogous to locals in order to improve liquidity. But the results were so surprisingly favorable for DTB that they released the study, much to the derision of LIFFE and the futures trading community generally, which was truly in the grip of the Cult of the Floor.

The CEO of LIFFE was quoted in the FT and Risk Magazine to the effect that I was an ivory tower academic who had no idea the way the real world works, because everybody knows the floor is more liquid and always will be. Real bulletin board material. Literally, in my case.

He who laughs last. When Eurex launched its assault on LIFFE in 1997, it distributed my 1992 study broadly. I doubt that had much of an impact on the final outcome, but it couldn’t have hurt.

The LIFFE CEO ended up resigning after LIFFE capitulated, and voted to close the floor and go electronic. I was a good boy. I resisted the very strong temptation to send him clippings of the FT and Risk articles.

Every other exchange learned a lesson at LIFFE’s expense, and responded to a fee cutting entrant by cutting fees immediately. For instance, the CBT saw off Eurex’s attempt to compete in the Treasury market in short order by cutting fees to zero, raising them after Eurex capitulated.

So CME shouldn’t feel bad. It has plenty of company in launching a contract that fails to make headway against an established incumbent. Indeed, the experience should be comforting, because it is the dominant incumbent in USD STIRs, govvies, equity indexes, FX, grain, precious metal, livestock, and energy futures. It benefits massively from the liquidity entry barrier. Compared to that, the failure to penetrate ICE’s cocoa monopoly doesn’t amount to a hill of beans.

 

Print Friendly

Swaps Execution: The Dogs Still Don’t Eat the Dog Food When They Have the Choice

Filed under: Commodities,Derivatives,Economics,Politics,Regulation — The Professor @ 9:03 pm

The Bank of England has received a lot of attention for its just-released study on the liquidity impact of swap execution facilities (SEFs). It finds that:

as a result of SEF trading, activity increases and liquidity improves across the swap market, with the improvement being largest for USD mandated contracts which are most affected by the mandate. The associated reduction in execution costs is economically significant. For example, execution costs in USD mandated contracts, where SEF penetration is highest, drop, for market end-users alone, by $3 million–$4 million daily relative to EUR mandated contracts and in total by about $7 million–$13 million daily.

The basic methodology is to use a difference-in-difference approach to compare measures of liquidity pre-and-post SEF mandate, and which exploits the fact that non-US banks can avoid the mandate by avoiding trading with US banks: this avoidance issue will is important, and I will discuss it later.

The study is carefully done, but I am not persuaded. For one thing, the measures of liquidity employed are driven by data availability (transactions prices), and are not the ideal measures of liquidity. The primary liquidity measures employed are really measures of price dispersion, rather than preferred measures of liquidity such as bid-ask spreads, depth, or price impact (although greater (lower) price dispersion could be associated with lower (greater) price impact).

There is also the issue that transaction characteristics are endogenous. For instance, it may be the case that it is cheaper to do large deals off-SEF than on-SEF. These deals will tend to be done at prices that are further away from the mean price (or the end-of-day midpoint price), and in the volume-weighted measures employed in the paper, these deals get a bigger weight in the liquidity measures. Thus, price dispersion may be greater pre-mandate, and in Europe, where the mandate can be avoided not because SEFs improve liquidity, but because it is prohibitively costly to transact large deals on SEFs. That is, the results could be symptomatic of a loss of liquidity on some dimensions, rather than proof that the mandate improves liquidity.

The paper documents that there is less dealer intermediation where the mandate is binding. This could also reflect changes in transactions characteristics. Dealers are more likely to be needed to intermediate big deals, or deals that are exceptional on some other dimension.

The paper doesn’t break down transaction characteristics by mandate-impacted and non-mandate-impacted subsamples, and in particular doesn’t include a measure of the dispersion of transactions sizes. As a result, it’s not possible to determine whether the mandate has altered the mix of transaction characteristics.

This relates to another finding of the study: namely, that the mandate has led to the fragmentation of the interest rate swap markets along geographic/currency lines, with SEFs gaining far lower penetration in Euro-denominated swaps that are dominated by European banks who can avoid the mandate by trading with one another, and by trading with European end-users. There is confirmation of this result from Tabb Group, which finds that “European derivatives market continues to resist electronic trading.”

Well, this raises the dog food question: If the dog food is as great as the ads say, why don’t the dogs eat it? if SEFs are so much more liquid, why don’t traders flock to them?

When given a choice between a statistical finding, and revealed preference, I go with the latter. Those who actually internalize the cost of trading largely avoid SEFs. This suggests that they are actually costlier to use, at least for some users, such as those who want to trade in large size, or have other idiosyncratic needs. The choices of those who have the choice strongly suggests that the statistical evidence purportedly showing lower execution costs on SEFs is flawed and misleading.

With this in mind, it was gratifying indeed to see CFTC Chairman Massad stating that he favors allowing market participants to decide whether they transact swaps electronically or using traditional voice execution. There was never a compelling case-or even a weak one-for forcing diverse market users with diverse transactional needs to use a one-size-fits-all execution method. Massad’s free-to-choose approach is therefore a vast and welcome improvement over his predecessor Gary Gensler’s monomaniacal determination to bash everybody over the head with a CLOB.

Update. Here’s a more detailed description of the Tabb Group study I linked to above. One important takeaway: European end users really hate electronic execution, and really love voice execution:

Despite the cost benefits of e-trading, institutional investors still prefer to interact with their dealers via phone. Nearly 80 [!] per cent of the more than 200 European investors interviewed as part of the Greenwich Associates 2015 European Fixed-Income Study confirmed their trading protocol of choice was the phone.

“These trades often require white-glove treatment, and clients work with dealers that are best at limiting market impact and providing the support needed to get the trade done,” says Greenwich Associates Managing Director Andrew Awad (pictured). “As a result, clients still place a high value on the support provided by swaps salespeople in executing complex and large trades.”

This strongly suggests that there are likely to be considerable differences between deals done on SEFs and those done the old fashioned way. Not particularly the point about “limiting market impact.” Those who want to do trades that are “complex and large” go to dealers to trade bilaterally to avoid price impact. If they are not able to do that, because of an electronic execution mandate, they will almost certainly trade differently. Fewer big, complex trades. If that is correct, then the Bank of England study is comparing grapes to grapefruit. If so, the difference in price dispersion documented in the study does not demonstrate greater liquidity on SEFs: it demonstrates worse liquidity, at least for some kinds of trades.

Mind you: end users were the supposed beneficiaries of the SEF mandate. According to GiGi et al, they were being shamelessly exploited by dealers, and SEFs would set them free. Apparently they like their chains just fine, thank you very much.

Again: revealed preference rules. Believe it over a stat every time.

 

Print Friendly

January 25, 2016

The Wages of Incoherence: The Policy Feedback Loop From Hell

Filed under: History,Military,Politics — The Professor @ 11:12 pm

Policies can be misguided, but coherent: that characterizes the Bush II Middle East policy for the most part. Then there are policies that are so bizarre and contradictory so as to be utterly incoherent. That’s the Obama Middle East policy.

On the one hand, for the past several years the administration has bent over backwards to make deals with Iran. In the months since the deal was sealed, it has made concession after concession to the mullahs, including obsequiously thanking the Iranians for releasing sailors whom they illegally seized and mistreated, and arguably paying $1.7 billion in ransom to secure the release of Americans held by Iran. The obsequious attitude to Iran is driving the Saudis into paroxysms of paranoia, which stokes proxy wars throughout the region, most notably in Yemen, Iraq . . . and Syria.

But in Syria, the US is on the side of the Saudis fighting Iran’s allies. Indeed, in Syria the Saudis pay for US covert support of anti-Assad forces fighting Iran’s puppet, the Assad regime. Just today John Kerry–who always has one more cheek to turn to the next Iranian insult–said: “The position of the United States is and hasn’t changed; that we are still supporting the [Syrian] opposition politically, financially and militarily.” You know, the opposition that is fighting Iranian forces on the ground in Syria.

But the US being on the side of the opposition may be old news. Now the rumors are rife that the US has backed away from its previous stance that Assad must step aside during the transition to a new government. This is setting off yet even more paroxysms of paranoia among the Gulf Sunni oil tick states. He said this, by the way, in the context of trying to arrange peace talks between the warring sides. How can you be a peace broker when you are “supporting the opposition politically, financially, and militarily”? That’s incoherence!

So maybe in its dying days the administration is groping for coherence, by going the full Monty on Iran. But I’m betting on continued incoherence.

More incoherence. Obama has been adamant about “no boots on the ground” (a phrases that triggers severe teeth-gnashing by yours truly) in the anti-ISIS campaign. Yet in the past few weeks Defense Secretary Ashton Carter has been going around saying yes, there will be American boots on the ground in Syria and Iraq to fight ISIS. Which is it? (Annoyingly, as of yet I have not heard anyone demand an explanation from Obama for this glaring contradiction. Is Carter off the reservation? Or is Obama merely dodging responsibility, and the press is eagerly enabling? Don’t bother answering. Rhetorical question.)

Then there’s US policy towards the Kurds, where Biden simultaneously supports the Turks in their war against the PKK and supports the PKK’s Syrian offshoot, the YPG, which the Turks hate as much as the PKK.

Yet more incoherence. We frantically support peace efforts in the region (most of them futile) but attempt to appease Saudi and Qatari anger at our concessions to Iran by showering them with weapons . . . which the Saudis turn around and use to bomb the crap out of Iranian proxies in Yemen, which angers the Iranians. And around and around it goes.

In the region, this playing both sides is viewed with deep suspicion. Paranoia is part of the Middle Eastern DNA, and the slightest inconsistency is perceived as double dealing and backstabbing. As a result, we undo our attempts to mollify one element (e.g., the Iranians) by doing something to mollify their enemies (e.g., the Saudis) who are angry at our attempts to mollify the first element.

It’s a policy feedback loop from hell.

Print Friendly

January 23, 2016

Russian Oil Hedging: A Little Late for Herpicide

Filed under: Commodities,Derivatives,Economics,Energy,Russia — The Professor @ 5:29 pm

My grandfather had a wealth of colorful expressions, most of which were the product of his Appalachian upbringing. One, however, was a little different. Whenever it was too late to do something about a particular problem, he’d say: “Well, it’s a little late for herpicide.” In context, I understood what he meant, but the exact meaning escaped me. I asked him one time, and it turns out that Herpicide was a (quack) hair loss cure in the ’30s or ’40s. The company’s add campaign pictured a cue ball-bald man with the caption: “A Little Late for Herpicide.” I guess now it would be “A Little Late for Rogaine.”

This expression came to mind when I read in the FT that “Russia considers hedging part of its oil revenues.” It would have been a good idea when the price was $100, or $90, or even $50. At $30 (or below, as happened on Wednesday and Thursday), well, it’s a little late for hedgicide. Yes, oil could indeed go lower, but hedging today would lock in prices that are low by historical levels.

Hedging would make sense for Russia, just as it does for a highly-leveraged corporate. It clearly incurs financial distress costs when prices are very low. Hedging would reduce the expected costs of financial distress.

Presumably Russia would implement a program like Mexico’s, buying large quantities of out-of-the-money puts. This would allow it to capture the upside but obtain protection on the downside. It would also avoid a problem that it might face if it sold swaps/forwards: finding a counterparty. Selling a put to Russia doesn’t involve counterparty risk. Buying swaps from them would. Although this would be a right-way risk, one could readily see Russia balking on performance if oil prices were to spike, putting a short swap position well out of the money. It would have the cash to pay: the willingness to pay, not so much. Further, although Russia’s ability to pay is closely related to oil prices, it is exposed to other risks that could impair that ability, and these risks would create credit risks for anyone buying swaps from Russia.

Buying puts does create an issue, though: this would require Russia paying a rather hefty premium upfront, at a time when it is cash-strapped. As an illustration of its financial straits, note that it is attempting to avoid having to come up with cash to stabilize troubled megabank VEB. Borrowing to pay the premium is also problematic, given its dicey creditworthiness. Russia’s CDS spread is around 370bp (which, although it has turned up as oil prices took their latest plunge, is still below post-Crimea levels, and even below the levels seen in August). Current sanctions and the prospect of the crystallization of future political risks may also make lenders reluctant to front Russia the premium money.

One interesting thing to consider is how hedging would affect Russia’s output decisions going forward. Hedging, whether by buying puts or selling swaps, would reduce its incentive to cut output in low price environments. As I’ve written before, Russia doesn’t have a strong incentive to cut output anyways because  market share, market demand elasticity, and the cost of shutting down production in Siberia make it a losing prospect (as its refusal to cut output in 2009 and in the past 18 months clearly indicate). However, whatever weak incentives Russia has to cut (in cooperation with the Saudis for instance) would be even weaker if it was hedged. If cooperation on output between OPEC and Russia has proved hard up to now, it would be harder still if Russia was hedged.

A Russian hedging program, if big enough, could affect market pricing, but not the price of oil (at least not directly*): hedging is a transfer of risk, and a big Russian hedge would affect the price of oil risks. Its hedging pressure would tend to increase market risk premia (i.e., reduce forward prices relative to expected spot prices). If done using puts, it would also tend to steepen the put-wing volatility skew and increase volatility risk premium. Adding its hedging pressure to the market would also necessitate the entry of additional speculative capital into the market in order to mitigate these effects. Sechin has criticized speculators in the past: hedging Russian oil price risk would be prohibitively expensive without them.

Although Russia has mooted the possibility, I doubt it will follow through. I would imagine that the combination of the cash cost of options and criticism within the ruling clique of locking in low prices will cause them to pass. If and when oil prices rise substantially, I predict they will forego hedging because they will convince themselves that prices won’t fall again, just as they did post-2009.

In sum, this sounds like an idea that the technocrats have advanced that will die at the hands of the siloviki, like various privatization initiatives.

* The spot price of oil depends on output and demand. Hedging affects spot prices to the extent that it affects output. One way that could happen is that if it reduced Russia’s incentive to cut output. Another way it could happen is that hedging increases Russia’s capacity to finance investments in oil production by reducing capital costs. In this case, investment would be higher and output would be higher.

In each of these scenarios hedging reduces spot oil prices in some states of the world, not because of the direct effects of forward selling, but because the hedging provides incentives to increase output. This is a good thing.

Print Friendly

Next Page »

Powered by WordPress