Streetwise Professor

April 22, 2016

Schrödinger’s Clearinghouse?

Filed under: Clearing,Derivatives,Exchanges,Regulation — The Professor @ 6:31 pm

Three weeks ago I wrote about, and criticized, LSE CEO Xavier Rolet’s statement that “We can cross margin our over-the-counter clearing with their listed derivatives without merging the clearinghouses, and without comingling the risk-management framework. [Emphasis added.]”  Then three days ago I read Philip Stafford’s article in the FT stating “Deutsche Börse and LSE plan to link clearing houses“:

The two sides are working on common risk management and default frameworks for their market utilities, which risk manage billions of dollars of derivatives trades on the market every day. [Emphasis added.]

The exchanges’ long-term aim is for each customer to become a member of both the LSE-controlled LCH and Deutsche Börse’s Eurex clearing houses. The customers, which are typically banks, would agree to hand over their trading data in return for better risk management of their derivatives, according to two people familiar with the talks.

The planned London-based holding company would instruct the two clearing houses on how to proceed with a default after consultations with central banks, one of the people said. The two sides are discussing their plans with their regulators and customers, one person said.

So how do you have a “common risk management framework” without “commingling the risk-management framework”? Is there some fine verbal distinction I am missing? Or perhaps this is like Schrödinger’s CCP, in a state of quantum superposition, both commingled and uncommingled until someone opens the box.

In my post, I mentioned default management as one reason to integrate the CCPs:

Another part of the “risk management framework” is the management of defaulted positions. Separate management of the risk of components of a defaulted portfolio is highly inefficient. Indeed, part of the justification of portfolio margining is that the combined position is less risky, and that some components effectively hedge other components. Managing the risks of the components separately in the event of a default sacrifices these self-hedging features, and increases the amount of trading necessary to manage the risk of the defaulted position. Since this trading may be necessary during periods of low liquidity, economizing on the amount of trading is very beneficial.

Apparently the recent experience with the default of Maple Bank brought home the benefits of such integration:

One person familiar with the talks highlighted problems created by February’s default of Frankfurt-based bank Maple, which was a member of both exchanges’ clearing houses.

“Right now what you have is a blind process — the liquidation of positions is conducted without co-ordination,” the person said. “Therefore it has a negative price impact in the market as you have two guys running out liquidating positions in the name.”

Huh. Go figure.

“Commingling” makes sense. Coordination is vital, both in daily operations (e.g., setting margins and monitoring to reduce the risk of default) and in extremis (during a default).

Perhaps Rolet was trying to deceive regulators who are so obsessed with too big to fail (sorry, both Eurex and LCH are TBTF already!) and who are blind to the benefits of coordination. If the regulators need to be deceived thus, we are doomed, because then it would be clear they have no clue about the real issues.

One wonders if they will recognize coordination and commingling even after they look in the box. Apparently Rolet thinks not. If they do, Xavier will have a lot of ‘splainin’ to do.

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April 18, 2016

Corn is Chicken Feed, But the Losses from Chinese Malinvestment Aren’t

Filed under: China,Commodities,Economics,Politics — The Professor @ 6:34 pm

The WSJ reports that China could face a $10 billion write-down on the huge corn stocks that it accumulated as part of its efforts over the past years to prop up prices for farmers. Corn is chicken feed, but $10 billion ain’t.

But I think that the moral of this story goes far beyond corn. Chinese agricultural price supports are just one example of the myriad policies that the country has adopted over recent years that distort prices and lead to misallocations of resources. Indeed, the deadweight losses from ag price supports are probably chicken feed in comparison with the waste resulting from distortions in the capital and credit markets that have led to massive malinvestment in industrial capacity (note the huge overcapacity in industries like steel), infrastructure, and housing.

Perhaps the main difference is that the corn inventories are being written down. The corn counted towards national income when it was produced, and writing down the inventories will reduce national income. Alas, the vast bulk of the malinvestments elsewhere will not be marked to market, and reported Chinese national income will be too high as a result.

What’s particularly important is that although the Chinese are apparently recognizing that their agricultural policies were inefficient, they cannot wean themselves from the credit stimulus habit. About 2 years ago I gave talks where I said China faced three alternatives, two of which were bearish for commodities: hard landing, transition to a more market-based, consumer-oriented system, or continued reliance on credit stimulus to keep measured growth high. I further opined that the latter alternative would just defer the choice between the first two for some time.

I did not venture a strong opinion on which alternative would happen, because I believed (and believe) that the choice is ultimately political, and I am in no position to predict with confidence Chinese politics. My sense was (and is), however, that sustaining the status quo was (and is) the most likely outcome. This would involve cranking up the stimulus in the face of any slowdown.

Recent experience suggests that’s the case:

China’s economy slowed further in the beginning of the year, though Beijing’s policies to revive growth with old-style tools such as lending and construction appeared to gain traction in March.

China’s gross domestic product expanded by 6.7% year-over-year in the first quarter, down from a 6.8% gain in the previous quarter, the National Bureau of Statistics said Friday. The figure, the slowest quarterly growth for China since the height of the financial crisis in 2009, was in line with forecasts.

In the past month, some confidence has returned to the world’s second-largest economy, fueled in part by sharp property-price rises in China’s major cities as well as some lessening of currency volatility and capital outflows that spilled over onto global markets last year and early in 2016. In March, China’s foreign-exchange reserves grew for the first time in five months.

Friday’s data release provided signs that a host of stimulus measures put in place over the past 15 months are having some impact—or are at least delivering some short-term gains. Industrial output, retail sales and property investment rose more than expected in March after a weak performance in January and February. Fixed-asset investment also improved.

And lending soared. Chinese financial institutions issued 1.37 trillion yuan ($211.3 billion) in new yuan loans in March, rocketing well past economists’ expectations of around 1.1 trillion yuan, and almost twice February’s volume.

This means more new malinvestment, and more papering over (with credit) the write down (and hence recognition) of past malinvestments.

This credit splurge helps explain the commodities rebound in recent months. But it also shows how tenuous the foundations of that rebound are. It is an artifact of artificially stimulated investment. Eventually, inevitably, the accumulated waste and distortions will bring the entire Chinese economy to a shuddering halt, and perhaps a crash. Eventually the accumulation of distortions becomes so great that a shakeout and rationalization is necessary, and inevitable. China is at best delaying the reckoning.

Corn is a small part of a much bigger picture. But it is a revealing part. It shows how perverse pricing policies lead to inefficient accumulations of capital that eventually become worth far less than the amount invested. Corn is relatively easy to value, and the cost of the malinvestment in corn stocks looks to be about $10 billion. When one considers how many other wasteful investments have been made in China as a result  of its interventionist policies, and the imagination staggers at what the losses would be.

Put differently, China’s performance would look far less stellar if national income accounting was accurate, and realistically marked its past investments to market. Of course, it is this very fact that induces the Chinese authorities to use every trick in the book to prevent that from happening. But there will come a day, because losses this large cannot be concealed forever.

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April 13, 2016

You Can’t Handle the Truth! Censoring Politically Inconvenient Research at the CFTC

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 2:29 pm

I had missed that the CFTC’s Office of the Inspector General had found that the Office of the Chief Economist had “prohibited relevant but potentially controversial research” on position limits. According to the OIG, during a routine interview with a CFTC staff economist, without being asked, the economist told the OIG that s/he had been prevented from doing research on position limits. According to the OIG, “several OCE economists identified position limits as an example of a topic on which economic research is no longer permitted.” One said: ”you can’t write a report on something that destroys three years of (CFTC) work.”

The basic conclusion is damning:

Several other economists confirmed their impression that OCE is now censoring research topics that might conflict with the official positions ofthe CFTC. Some ofthis censorship occurs on the part ofindividual staffeconomists themselves-when selecting potential topics, they now choose non-controversial ones. However, multiple OCE economists also reported that the Chief Economist has declined to permit research on certain topics relevant to the CFTC mission, including position limits.

Some OCE economists expressed uncertainty as to the purpose of OCE’s research program if the Office is prevented from studying topics relevant to current CFTC rulemaking. Yet OCE economists reported that the Chief Economist has rejected or delayed research paper topic ideas if tey were related to pending rulemaking or could challenge the validity of agency regulations. One OCE economist described the policymaking process as one in which a decision is made and then analysis is done in a fashion designed to support the decision. There is a perception within OCE that the ChiefEconomist is “more Commission-friendly,” and that he discourages research that might offend Commissioners.

During “multiple” discussions with the OIG, the Chief Economist at first admitted that this was so, then backtracked:

He agreed that he had initially rejected a research proposal on position limits on the basis that it was politically controversial. The Chief Economist later stated his belief that the CFTC did not have the data or the in-house expertise to do this project in any event. The Chief Economist explained that this was a matter of discretion, and that he did in fact permit research into politically controversial topics. He provided an example ofresearch into high-frequency trading and instances ofself-trading. When asked, the Chief Economist agreed that the Chairman actively supported this line ofresearch. The Chief Economist also stated that he wanted to be able to take to the Chairman and Commissioners anything he or OCE did.

Appalling.

Chairman Massad has recently rejected the OIG’s conclusion, the statements of multiple staff economists, and the initial gaffe (i.e., truth telling) by the Chief Economist. It wasn’t politics, you see. It was priorities:

“Our Office of the Chief Economist has many excellent economists, the morale there is very good and the work they produce is very good. They often produce things that might conflict with the views I have and the views other commissioners have, but we don’t have any kind of political screen on what we do,” said Massad, testifying before the Senate Committee on Appropriations on April 12.

“We do have, however, priority setting. It’s a small division and we must set priorities. We can’t always have a staff person just do the research they would like to do, as opposed to research we really need to focus on. That’s the only way in which we focus their work,” he added.

To state the obvious: priorities are inherently political. The statement about priorities therefore does not refute the belief of the staff economists that the decision to forbid research on position limits was ultimately political.

Chairman Massad’s assertion also is flatly inconsistent with the opinions expressed by multiple individuals, including his own Chief Economist (before he got his mind right, anyways). Thus, there is certainly a widespread perception in the OCE that permissible research means politically correct research. Either this perception is correct, or Chairman Massad has done a poor job of communicating to the economists the criteria by which research resources are allocated.

In a Washington where everything is politicized, and in particular where Senator Elizabeth Warren clearly attempts to censor those expressing dissenting opinions, and attempts to intimidate and slander those who dare to express such opinions, it is utterly plausible that the economists’ perceptions are very well grounded in reality. I view the economists’ complaint as facially valid, but potentially rebuttable. Mr. Massad’s testimony does not even come close to rebutting their assertions. Indeed, knowing how to decode words like “priorities” from GovSpeak, if anything his testimony buttresses the complaint, rather than rebuts it.

But let me suspend disbelief for a moment, and take Chairman Massad at his word. Just what does that imply?

First, it implies that a position limits initiative that would impose substantial burdens on the industry is of insufficient importance to justify a researcher or two to spend a portion of their time to study. Not to denigrate the value of the economists’ time, but in the scheme of things this does not represent a huge expenditure of resources. If position limits are of that little importance, what is the potential benefit of the regulation? Why does the Commission persist in pushing it if it is not even worth the time of a few staff economists?

Second, what does this say about the Commission’s commitment to carrying out its statutory obligation to conduct a cost-benefit analysis of the regulation?

Third, and relatedly, if the Chief Economist is correct and his staff does not possess “the data or the in-house expertise to do this project” how would it even be possible for the OCE, and the Commission, to perform a valid cost-benefit analysis? In particular, since the proposed research appears to speak to the issue of the benefits and necessity of limits, how can the Commission generally, and Chairman Massad in particular, credibly claim that they have determined that limits offer sufficient benefit to make them necessary, or to exceed their cost, if its own Chief Economist claims that his office has neither the data nor the expertise to perform valid research on the effects of limits?

Position limits have been a political project from Day 1. They remain a political project, as Senator Warren’s recent jeremiad (directed substantially at yours truly) demonstrates. The economic case for them remains dubious at best. Given this history and this context, the assertion that prohibiting CFTC staff economists from researching the issue was politically motivated is all too plausible.

The Risk article that I linked to quotes Gerry Gay, who was Chief Economist under Wendy Gramm in the Bush I administration. Gerry notes that prior to 1993, economics and economists had pride of place within the CFTC. It was viewed as “an economist’s shop.”

That is a fair statement. What happened in 1993? The Clinton administration took over, and (as Gerry notes) de-emphasized economics. I remember distinctly an article in Futures Magazine that solicited the opinion of many industry figures as to the changes the new administration would bring. Ex-CFTC Commissioner Philip McBride Johnson’s statement sticks in my mind. This is almost an exact quote, though it is from memory: “We can now get rid of the economists and put the lawyers back in charge.”

That’s exactly what happened then, and with a few exceptions during the Bush II years, has remained true ever since. Just as Clemenceau said that war is too important to be left to the generals, the DC set established that regulating the markets is too important to be left to the economists. What’s more, particularly in the Obama administration, starting with Gensler’s tenure as head of the Commission, it was determined that certain kinds of lawyers had to be in charge, and they had to follow marching orders from politicians. Do not forget that Gensler was only able to overcome skepticism about his Goldman background by pledging fealty to the Democratic senators on the relevant committees, and to their agenda. Truly independent regulators get crushed. (Remember the fate of FCC head Tom Wheeler when he strayed just a little bit off the party line on net neutrality?)

Keep that in mind when attempting to determine the true story of the disapproved research on position limits. It has been determined that you can’t handle the truth.

Update: Note well that the CFTC economists’ concerns about acceptable research extend beyond position limits. It is clear that several believe that policy-relevant research is discouraged, at least if it could contradict existing or pending regulations. If that’s in fact true, it would be fair to ask why the hell the CFTC has economists anyways. Economics has a vital role in informing policy on markets. The economists could pay their lifetime salaries many times over by stopping or correcting one misguided regulation, or even one misguided piece of a broader regulation. (I recall a quote from Coase that an economist could pay for his lifetime salary by just delaying a bad regulation a day.) The only real reason to have economists at the CFTC or any agency is to provide critical evaluation of pending or existing rules and regulations. It is beyond absurd to preclude economists from working on exactly those things, when they could upset some politically-driven regulation.

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April 10, 2016

What Happens in Panama Doesn’t Stay in Panama, Apparently

Filed under: Politics,Russia — The Professor @ 9:01 am

The media has been aflutter during the last week over the Panama Papers. Much of the excitement has focused on Putin’s presence-or lack thereof, actually-in the Biggest Leak Ever.

My reaction: BFD.

Insofar as what about Russia is actually in the leak: can you honestly say that it provided you with any new information? Hardly. Offshoring of dirty Russian money has been a thing since the USSR collapsed. Before, actually. Putin has actually made an issue of it. To the extent that the leak reveals anything, it shows the hypocrisy and political nature of Putin’s anti-offshoring drive. The politically favored can still do this, although with the knowledge that the Sword of Damocles hangs over their heads. If favor turns into disfavor, the offshoring can be used to destroy them.

At most, the leaks regarding Russia provide some interesting information as to how the offshoring works in practice. But this mere detail which provides no new insight on the nature of the Russian system.

The hypocrisy is also evident in China, where family members of anti-corruption crusader CCP General Secretary Xi Jinxing have been disclosed to have offshore shell corporations. But again, the hypocrisy should not be a surprise. As has been the case with autocrats since time immemorial, Xi’s anti-corruption drive has been more of a means of extending his power and control, than an idealistic effort to clean up China’s government and economy.

Insofar as Putin is concerned personally, why would anyone expect his name to be on any document detailing ownership of anything? Do you think he’s that stupid?

For all the hyperventilating by Bill Browder and others of Putin’s alleged massive fortune (which Browder puts at $200 billion), a little common sense is sufficient to discount these stories. Actually formally/legally owning things provides little benefit to Putin, but poses risks. It is all downside, with no upside.

If evidence of such a massive fortune was uncovered, it would be an embarrassment, or worse, for Putin: his very pretense of being a servant of the people who earns a very modest salary demonstrates that he believes that being revealed definitively as a plutocrat (rather than merely an autocrat) would be dangerous for him politically.

And what does he gain by having his name on some legal papers documenting ownership of vast amounts of wealth? Absolutely nothing. In this current role, he has practical ownership of pretty much everything in Russia. That is, if you view ownership as a bundle of rights to use assets, Putin has ownership, regardless of whether his name is on pieces of paper or not. If he wants use of this asset or that, who is going to deny his request? Further, there are myriad ways that he can use the power of the Russian state to direct wealth to those he favors (e.g., through massively corrupt contracting practices for projects like Sochi, or through Gazprom), who in turn direct some of that to people or purposes that Putin requests. And all of this can be done with Putin not having formal legal ownership of anything.

Furthermore, Putin realizes that formal ownership would not secure him a quiet retirement of opulent luxury. His informal ownership rights exist only so long as he is in power, and as soon as he is out of power any formal ownership rights over vast assets would be too tempting a target for his successor to resist. He could never enjoy the benefits of such wealth when out of power, and doesn’t need it when in it. So what’s the point?

So I would put a different spin on it: the very absence of Putin’s name in the Panama Papers is exactly what is informative. It reveals that he is not leaving power in a vertical posture, of his own volition, because when he does, his practical ownership rights evaporate with his power. This also makes it plain why he is doing things to secure domestic control in advance of the 2017 Duma election and the 2018 presidential “contest”. The creation of a National Guard under his personal control, for instance.

As to speculation regarding who leaked and why: meh. These parlor games bore me, and are essentially forms of ad hominem argument that have no bearing on the truth or falsity of the information.

The claims by Russian authorities (including Putin personally) and Julian Assange (who first praised the leak then turned on it) that it is a CIA/State Department/Soros plot to undermine Putin and Russia are implausible. If anything, the leak was very helpful to Putin. By far the biggest casualty of the leak has been Ukrainian president Poroshenko, who was revealed to have been negotiating moving his assets overseas at the same time his army was being slaughtered in the Donbas. The already divided and shaky Ukrainian polity has become even more so as a result of the revelations, and this redounds to Putin’s benefit. Most of the other casualties have been western democratic politicians, notably David Cameron. In other words, if this was a CIA/State Department plot, it was an epic miscalculation.

Following this cui bono logic, others have swung to the opposite extreme. Most notably, Brooking’s Clifford Gaddy mooted that since Putin has benefited, this may be a Russian operation. I agree that despite the initial frenzy Putin has been a beneficiary, but believe that it is far more likely that it is just another episode in his recent streak of good luck.

As for the ethics of the leak, and how the material has been handled, the entire episode points out the ambiguities and dilemmas of this means of holding public officials and private individuals accountable. Unlike Wikileaks, the entire set of material is under control of a set of journalists and publications, and is not open for search by the public. This creates the potential for manipulative select disclosure. This is problematic, and this very possibility also creates a narrative that can be used to discredit the entire project. But since innocent private individuals’ information is also in the database, open access would impose huge collateral damage. The choice is binary (selective disclosure controlled by a group of self-selected gatekeepers who may have an agenda, or open access), and the severe downsides to either alternative call into question the utility of leaking as a means of revealing (and perhaps punishing) misconduct by government officials, or private individuals.

It also shows the costs of privacy and transparency, which highlights a fault line in the current debate. In that debate, Privacy and Transparency are both praised as ideals even though they are obviously in substantial tension. What information should be private and what should be transparent, and whose information should be private, whose information should be transparent, and who should make these choices are extremely difficult questions. Even if one can identify the ideal boundaries in the abstract, respecting them in practice is devilish hard. The Panama Papers case reveals that in spades.

 

 

 

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April 4, 2016

Barbarian at the Gate, Exchange Edition

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 11:04 am

ICE’s Jeffrey Sprecher has a way of getting inside the heads of his competitors. He is obviously in the head of LSE CEO Xavier Rolet, before he’s even formally announced a rival offer for the LSE:

The boss of the London Stock Exchange has dismissed the owner of the New York Stock Exchange as a “slash and burn” organisation which would throw parts of the British bourse “in the bin”.

. . . .

He branded ICE’s ownership of Euronext, the pan-European exchange, as a “disaster,” claiming it had “eviscerated” the four-country exchange platform for cost-cutting.

Mr Rolet, who acknowledged that the LSE’s board would consider any “serious proposal,” made clear that he is not interested in a bid from an “interloper”.

“I don’t want just anyone, particularly not some ‘slash and burn’ type  organisation, to come in and kill all of the stuff we’ve done over the last few years,” he said.

“It is not a company based in Atlanta… that is going to worry about the financing of European industry… It’s just not going to be part of their strategy.

“Which is why they chucked out Euronext. They kept the clearing business that they had, and they kept the derivatives engine. And that is not a strategy for British industry. I doubt that this [Aim] would be part of the strategy of any frankly global exchange…Our 1000 Companies programme, that costs money. Our Elite programme, that costs money. All that stuff would be chucked in the bin.”

Rolet sounds like the typical 1980s CEO quaking in fear of a hostile takeover, fussing over every little piece of the empire he built. Which is exactly why everything about Sprecher that Rolet condemns as a bug is a feature.

ICE has an excellent record at making acquisitions work. A crucial reason for that is that Sprecher focuses ruthlessly on value and value creation, and doesn’t have sentimental attachments to particular businesses, especially those that are inefficient and bloated, and which don’t fit strategically within the organization he has built.

He recognized that Euronext was an excessively costly firm in a low margin commoditized business that didn’t offer any synergies to his core derivatives business. So he acquired EuronextLiffe, put Euronext on a diet, and spun it off for a decent price. He kept LIFFE and Euronext’s clearing business and integrated them into the ICE structure in a way that should make other acquirers (I’m looking at you, UAL!) green with envy.

As for sentimental musings about “financing European industry”, if it is so valuable, it would pay. If it doesn’t pay, it’s not valuable. No evident externalities here, and if there are, it’s fantasy to believe that any individual company will be able to internalize it.

As for programs that “cost money”: the question is if they generate an adequate return on that investment. If Aim, or the 1000 Companies program, or the Elite program don’t generate a compensatory return, they deserve to be binned or restructured. If they can earn a compensatory return, believe me, Sprecher won’t bin them. Rolet’s lament bears all the signs of a man who is personally invested in pet projects that he knows don’t pass the value creation test.

Rolet, in other words, sees Sprecher as a latter day Barbarian at the Gates. But if you give it even a superficial look, it is evident that by every measure ICE has been singularly successful at creating value in a very dynamic and competitive exchange and clearing space. If Jeff Sprecher is a barbarian, then civilized CEOs are vastly overrated. Give me the barbarians any day.

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April 2, 2016

The Rube Goldberg Approach to Integrating CCPs: A Recipe for Disaster

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Regulation — The Professor @ 12:38 pm

As noted in earlier posts (and by others commenting on the proposed Eurex-LSE merger) the main potential benefit to exchange customers* is the capital and margin savings from netting efficiencies between Eurex futures and LCH swaps. However, regulators and others have expressed concerns that the downside is the creation of an bigger too big to fail clearing entity. A couple of weeks back Silla Brush and John Detrixhe reported that the merger partners are trying to square that circle by cross-margining, but not merging the CCPs:

LCH.Clearnet and Eurex held 150 billion euros ($169.5 billion) of collateral on behalf of their members as of Dec. 31, according to the merger statement. The London-based clearer is developing a system that allows traders to offset their swap positions at LCH.Clearnet with their futures holdings at Eurex. The project, which works even though the two clearinghouses are separate, should enable customers to reduce the total amount of collateral they must set aside.

“We can cross margin our over-the-counter clearing with their listed derivatives without merging the clearinghouses, and without comingling the risk-management framework,” LSE Group CEO Xavier Rolet said in a Bloomberg Television interview on Wednesday. Rolet will step aside if the companies complete their merger.

The devil will clearly be in the details, and I am skeptical, not to say suspicious. In order for the separate but comingled system to work, Eurex’s CCP must have a claim on collateral held by LCH (and vice versa) so that deficiencies in a defaulter’s margin account on Eurex can be covered by excess at LCH (and vice versa). (As an illustration of the basic concept, Lehman had five different collateral pools at CME Clearing–interest rate, equity, FX, commodities, energy. There were deficiencies in two of these, but CME used collateral from the other three to cover them. As a result there was no hit to the default fund.)

How this will work legally is by no means evident, especially inasmuch as this will be a deal across jurisdictions (which could become even more fraught if Brexit occurs). Further, what happens in the event that one of the separate CCPs itself becomes insolvent? I can imagine a situation (unlikely, but possible)  in which CCP A is insolvent due to multiple defaults, but the margin account at A for one of the defaulters has excess funds while its margin account at CCP is deficient. Would it really be possible for B to access the defaulter’s collateral at bankrupt CCP A? Maybe, but I am certain that this question would be answered only after a nasty, and likely protracted, legal battle.

The fact that the CCPs are going to be legally separate entities suggests their default funds will be as well, and that they will be separately capitalized, meaning that the equity of one CCP will not be part of the default waterfall of the other. This increases the odds that one of the CCPs will exhaust its resources and become insolvent. That is, the probability that one of the separate CCPs will become insolvent exceeds the probability that a truly merged one would become so. Since even the separate CCPs would be huge and systemically important, it is not obvious that this is a superior outcome.

I am also mystified by what Rolet meant by “without comingling the risk management framework.” “Risk management framework” involves several pieces. One is the evaluation of market and credit risk, and the determination of the margin on the portfolio. Does Rolet mean that each CCP will make an independent determination of the margin it will charge for the positions held on it, but do so in a way that takes into account the offsetting risks at the position held at the other CCP? Wouldn’t that at least require sharing position information across CCPs? And couldn’t it result in arbitrary and perhaps incoherent determinations of margins if the CCPs use different models? (As a simple example, will the CCPs use different correlation assumptions?) Wouldn’t this have an effect on where firms place their trades? Couldn’t that lead to a perverse competition between the two CCPs?+ It seems much more sensible to have a unified risk model across the CCPs since they are assigning a single margin to a portfolio that includes positions on both CCPs.

Another part of the “risk management framework” is the management of defaulted positions. Separate management of the risk of components of a defaulted portfolio is highly inefficient. Indeed, part of the justification of portfolio margining is that the combined position is less risky, and that some components effectively hedge other components. Managing the risks of the components separately in the event of a default sacrifices these self-hedging features, and increases the amount of trading necessary to manage the risk of the defaulted position. Since this trading may be necessary during periods of low liquidity, economizing on the amount of trading is very beneficial.

In other words, co-mingling risk management is a very good idea if you are going to cross margin.

It seems that Eurex and LSE are attempting to come up with a clever way to work around regulators’ TBTF neuroses. But it is not clear how this workaround will perform in practice. Moreover, it seems to sacrifice many of the benefits of a merged CCP, while creating ambiguities and legal risks. It also will inevitably be more complex than simply merging the two CCPs. Such complexity creates systemic risks.

One way to put this is that if the two CCPs are legally separate entities, under separate managements, relations between them (including the arrangements necessary for cross margining and default management) will be governed by contract. Contracts are inevitably incomplete. There will be unanticipated contingencies, and/or contingencies that are anticipated but not addressed in the contract. When these contingencies occur in practice, there is a potential for conflict, disagreement, and rent seeking.

In the case of CCPs, the relevant contingencies not specified in the contract will most likely occur during a default, and likely during stressed market conditions. This is exactly the wrong time to have a dispute, and failure to come to a speedy resolution of how to deal with the contingency could be systemically catastrophic.

One advantage of ownership/integration is that it mitigates contractual incompleteness problems. Managers/owners have the authority to respond unilaterally to contingencies. As Williamson pointed out long ago, efficient “selective intervention” is problematic, but in the CCP context, the benefits of managerial fiat and selective intervention seem to far outweigh the costs.

I have argued that the need to coordinate during crises was one justification for the integration of trade execution and clearing. The argument applies with even greater force for the integration of CCPs that cooperate in some ways (e.g., through portfolio margining).

In sum, coordination of LCH and Eurex clearing through contract, rather than through merger into a single entity is a highly dubious way of addressing regulators’ concerns about CCPs being TBTF. The separate entities are already TBTF. The probability that one defaults if they are separate is bigger than the probability that the merged entity defaults, and the chaos conditional on default, or the measures necessary to prevent default, probably wouldn’t be that much greater for the merged entity: this means that reducing the probability of default is desirable, rather than reducing the size of the entity conditional on default. Furthermore, the contract between the two entities will inevitably be incomplete, and the gaps will be discovered, and extremely difficult to fill in-, during a crisis. This is exactly when a coordination failure would be most damaging, and when it would be most likely to occur.

Thus, in my view full integration dominates some Rube Goldberg-esque attempt to bolt LCH and Eurex clearing together by contract. The TBTF bridge was crossed long ago, for both CCPs. The complexity and potential for coordination failure between separate but not really organizations joined by contract would create more systemic risks than increasing size would. A coordination failure between two TBTF entities is not a happy thought.

Therefore, if regulators believe that the incremental systemic risk resulting from a full merger of LCH and Eurex clearing outweighs the benefits of the combination, they should torpedo the merger rather than allowing LSE and Eurex to construct some baroque contractual workaround.

*I say customers specifically, because it is not clear that the total benefits (including all affect parties) from cross margining, netting, etc., are positive. This is due to the distributive effects of these measures. They tend to ensure that derivatives counterparties get paid a higher fraction of their claims in the event of a default, but this is because they shift some of the losses to others with claims on the defaulter.

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March 29, 2016

Vertical Integration in LNG? Strike That: Reverse It

Filed under: Commodities,Economics,Energy — The Professor @ 8:24 pm

The LNG market has taken an even harder fall than the oil market, with prices down from a peak of over $20/mmBTU a couple of years ago to around $4 now. Slower demand growth plus the entry of megaprojects in Australia and the US have done a double whammy. Indeed, some big projects have been canceled of late due to the grim price environment.

Anticipating a growth in supply that was likely outstrip demand growth (but not by as much as has actually happened), in 2014 I predicted that an overhang of cargoes would catalyze the development of the spot market. This is in fact occurring. A larger fraction of the trade is being consummated on a short term basis, and longer term contracts are relying less on oil indexing (which I called a barbarous relic, and analogized to the drunk looking for his car keys under the streetlight) and destination clauses (which limit the ability of buyers to resell gas they don’t need), and more on gas-on-gas pricing and destination flexibility.

This is the beginning of a virtuous cycle by which liquidity begets liquidity, making spot trading even cheaper relative to long term supply contracts. As I referred to it in 2014, whereas in the first 50 years of LNG* it was necessary to rely on long term contracts to achieve security of supply and demand, in the next 50 years liquid markets would provide this security, as has been in the case in oil markets for the last nearly 40 years.

The oil market demonstrates that long term contracts are not necessary to support the financing of very capital intensive upstream energy projects. Further, there will be less of a need for megaprojects for some time (given the supply overhang). What’s more, smaller scale liquefaction facilities are becoming commercially viable. For example, the ex-CEO of Cheniere, Charif Souki, has a well-financed startup that is focusing on developing such projects.

Which means that the next decade of LNG will be an evolution towards a market that looks more like the oil market, or other traded commodity markets.

Some don’t see it that way, and seeing the financial struggles of megaprojects are suggesting a move in the opposite direction. For instance, today in Reuters, Clyde Russell pulls the panic alarm and recommends that LNG firms move to vertical integration:

The industry needs to consider going downstream in order to ensure its long-term viability.

Much like oil companies’ move from producing oil into refining it and then retailing fuels, so too will LNG companies have to find ways to establish a sustainable market that will create and maintain demand for their product.

This means investing in re-gasification terminals in developing nations, along with associated pipeline infrastructure and storages.

It may also mean building gas-fired power plants, transmission grids and or even partnering with companies at the retail level to install gas-powered heating systems in buildings and residences.

In the words of Willy Wonka: “Strike that. Reverse it.” (H/T Number One Daughter.)

There are a lot of reasons for vertical integration, none of which apply in the current LNG market. Neoclassical reasons include double marginalization (monopolies at successive levels of the value chain) or circumventing price controls.

Transactions cost reasons include asset specificity that create a bilateral monopoly problem. A classic example is site specificity, as when a power plant is located at the mouth of a coal mine. This reduces transportation costs, but would subject the mine owner to the opportunism of the power plant owner (and vice versa) if they were separate entities. Integration prevents wasteful haggling over quasi-rents.

These conditions don’t hold in LNG. In fact, the reverse is true. Since LNG can be shipped anywhere in the world, since it is an extremely homogenous commodity, and since there are an increasing number of producers, every producer can deal with many buyers, and every buyer can deal with many sellers. This eliminates double marginalization and asset specificity problems.

Moreover, integration can limit the optionality by tying a seller to a small number of consumers. There is  also a multiple equilibrium issue. If a large fraction of buyers and sellers are tied together via integration (or long term contracts), the spot market is less liquid, making it more costly for the remaining firms to rely on spot sales and purchases: this leads them to integrate (or enter into long term contracts), which reduces of the spot market further.

The LNG market is on the cusp of moving in the opposite direction, which would allow it to exploit optionality more effectively. And optionality is becoming more important as gas generation is becoming more common around the world, not just in Asia and Europe, but in Africa as well. This creates more destination options, and these options are valuable due to uncertainties in supply and demand. To take a recent example, drought in Amazonia has led to an increase in demand for gas generation in Brazil: traders like Trafigura have met the demand by sending cargoes there. When the rains return, the cargoes can find another market. As another example, the Fukushima nuclear disaster led to an increase in the demand for gas in Japan. A Russian supply disruption would lead to a spike in demand in Europe.

Given the inherent variability in gas supply and demand, which vary due to the vagaries of the weather, supply shocks, and myriad other factors, and which are crucially imperfectly correlated geographically, destination options are valuable. Flexibility allows gas to move to places experiencing increases in demand or reductions in supply via pipelines. Vertical integration impedes the ability to exploit these options, and hence destroys value.

Thus, vertical integration is the exact wrong way to go in LNG. The biggest virtue of LNG is that it can be shipped anywhere: why undermine that virtue by constraining shipping options? The deepening of market liquidity, which is proceeding apace, will reduce the transactions costs of exploiting optionality. The silver lining in the current glut of LNG is that is speeding the development of liquidity. Meaning that Clyde Russell’s prescription of vertical integration is the exact wrong response to that glut. The glut increases liquidity. Liquidity enhances optionality. Optionality creates value. Don’t stymie this salutary development. Go with it. It will pay off in both the short term and the long term.

* The first cargo of Algerian LNG was shipped in 1964. The birth of the LNG industry is often dated to that shipment, although LNG had been shipped from the US in the 1950s.

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March 27, 2016

A Practical President, Who Believes Himself Exempt From Intellectual Influence

Filed under: Economics,Politics — The Professor @ 7:26 pm

Obama caused a kerfuffle with his remarks in Argentina on Thursday. The most common interpretation of his remarks was that he was drawing an equivalence between communism/socialism and capitalism. Yes, one can interpret his speech that way, but I don’t think that’s the most accurate way to parse it.

Obama was denigrating all ideological frames as interesting subject matter for academic debate, but of little interest or relevance to practical politics:

I guess to make a broader point, so often in the past there’s been a sharp division between left and right, between capitalist and communist or socialist. And especially in the Americas, that’s been a big debate, right? Oh, you know, you’re a capitalist Yankee dog, and oh, you know, you’re some crazy communist that’s going to take away everybody’s property. And I mean, those are interesting intellectual arguments, but I think for your generation, you should be practical and just choose from what works. You don’t have to worry about whether it neatly fits into socialist theory or capitalist theory — you should just decide what works.

In short, he advocated a rigorously pragmatic approach. Or put differently, a Chinese menu theory of government: take one item from menu A, another from menu B, depending on your taste and what “works” for you.

The criticism here should be directed at his vapidity and superficiality and question begging. By what criteria are the things that “work” to be determined? How do liberty, individual autonomy, and reliance on coercion and repression come into play when evaluating what works?

Further, real world decisions always involve trade-offs. Works-Doesn’t Work is binary: trade offs aren’t.

Obama also apparently believes that it is possible to design policies without a theoretical framework. Hayek was closer to the truth when he said without theory the facts are silent. Theories are about causal mechanisms, and policies are all about manipulating cause to achieve particular effects. You can’t make a reasonable evaluation ex ante of what policies will “work” (based on your objective function) without some theoretical framework. Further, those who don’t think deeply about cause and effect when designing policies inevitably unleash unintended consequences that are usually more baleful than beneficial.

All that said, the fact that Obama apparently believes that some socialist or communist policies “work” by any criteria held by non-socialists/communists is revealing. All empirical experience is that explicitly communist and socialist systems have delivered lower standards of living (often dramatically so), less freedom, and more coercion. Further, their alleged virtue–equality–is largely chimerical. There is always a privileged elite in socialist/communist systems, and what equality there is tends to be an equality of misery. What’s more, inequality can be palliated (and is considerably even in the US) by transfer programs that fall well short of communism or socialism. The Bernie worshipping millennial idiots who point to Denmark or Sweden as socialist paradises have no clue: they are welfare states, which is a very different kettle of fish.

The examples from Cuba that Obama cited as things that “work” in a communist system are something of a joke. Non-communist/socialist systems deliver better education and health care than Castro’s Cuba.

Obama was not revealing that he is a closet commie, although he clearly does not think communism is inherently a bad thing. In fact, he was being an old school progressive, making arguments old school progressives have made since Wilson and through FDR. The New Dealers were of a similarly pragmatic bent, and like Obama, openly advocated using policies adopted by fascist or communist countries if they “worked.” Stalin, Hitler, and Mussolini all had admirers among the New Dealers, who believed that they had found better policies than voluntary contract and exchange, and open competition.

When I read Obama’s remarks, I immediately thought of FDR’s speech at Oglethorpe University in May, 1932 (while he was running for president):

Do not confuse objectives with methods. When the Nation becomes substantially united in favor of planning the broad objectives of civilization, then true leadership must unite thought behind definite methods.

The country needs and, unless I mistake its temper, the country demands bold, persistent experimentation. It is common sense to take a method and try it: If it fails, admit it frankly and try another. But above all, try something. The millions who are in want will not stand by silently forever while the things to satisfy their needs are within easy reach.

“Bold experimentation” is basically a prescription to try anything and see if it “works.” If one thing doesn’t “work,” (i.e., “if it fails”) try something else. Once the “broad objectives” are defined, any method that achieves those objectives is fair game. Roosevelt in Georgia, like Obama in Argentina, was saying that all methods should be open for consideration and evaluated on purely pragmatic grounds.

Roosevelt was also making a favorable reference to planning, which at the time was associated with the USSR. Like Obama, he was saying don’t rule out a particular policy just because it originates in communism.

Of course, the implementation of this theory of government in the New Deal led to a confused hodge-podge of policies that largely failed to achieve their stated objectives, and indeed, in many cases worsened the nation’s economic crisis: that is, these policies were rife with unintended consequences.

This provides an excellent example of Hayek’s dictum. Those operating based on standard microeconomic (e.g., capitalist) principles/theories rightly predicted that cartelizing product and labor markets would not lead to higher output, and they were right. Contrary to Obama, “capitalist theory” was more than an intellectually interesting subject for classroom debate: it was a very useful guide to evaluating the practical effects of policies, which the New Dealers ignored, to the nation’s detriment.

And those progressives like Wilson, FDR, and now Obama who touted the superiority of pragmatism, and claimed their practicality and independence from theoretical abstractions and systems, were largely fooling themselves. The Pragmatism (note the capitalization) that has infused progressive thought for well over a century isn’t a-theoretical or a-ideological. It is an ideological and philosophical system developed in Germany in the 19th century. Not that Obama gets that.

No, Obama seems to be exactly the kind of man that Keynes so trenchantly described in the General Theory 80 years ago:

Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

What Keynes describes is a form of intellectual conceit common among politicians, and especially progressive ones. That conceit, rather than some soft spot for socialism, is the problem with Obama’s “do what works” nostrum.

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March 25, 2016

Killing the Marine Corps With a Theory

Filed under: History,Military,Politics — The Professor @ 7:03 pm

The United States Marine Corps is one of the most, if not the most, exceptional and effective military force of its size in history. I dare you to identify an organization with as long and storied a record of bravery, sacrifice, and victory under the most trying conditions. From the decks of the USS Constitution to Tripoli, Mexico City, Belleau Wood, the jungles of Central America, Tarawa, Guadalcanal, Cape Gloucester, Saipan, Peleliu, Iwo Jima, Okinawa, Inchon, Chosin, I Corps, the berms of Kuwait and Kuwait City, Fallujah and many other battlefields the USMC has compiled an unrivaled combat record.

This record is the product, first and foremost, of a unique military culture. Often marginalized and frequently forced to fight for its existence, not on the battlefield, but in the halls of Congress, the Marine Corps over more than two centuries has developed a unique esprit de corps  that would be impossible to recreate from scratch today.

Read Eugene Sledge’s With the Old Breed, and you will understand.

When I was at the Naval Academy, I knew I could never be a Marine in a million years, largely because I knew I could not subsume my identity into that of the Corps.  And that is what the Corps demands. But I was, and am, damn glad that there have been millions of Americans who have been willing to do so. The Marines have performed the amazing feats that they have precisely because they demand the surrender of individuality. It’s not for everybody, but that is fine, because the Marines don’t need and can’t take everybody. Over the centuries, there have been enough.

This is a unique institution which should be defended and preserved. It makes an irreplaceable contribution to the defense of this nation.

But precisely because the Marines’ military culture is a glorious anachronism, a thing from another time, it is hated and despised by the politically correct, and the gender warriors in particular. The Marine Corps has fought the Obama administration’s ideologically-driven campaign to gender-integrate all combat units and specialties. It fought with data. It has insisted that only one metric matters, success on the battlefield, and has concluded that by that metric complete gender integration fails miserably.

This resistance has drawn the ire of arguably the most execrable high ranking member of the Obama administration (quite an accomplishment that), Navy Secretary Ray Mabus. Mabus responded to the Corps’ resistance by ordering the gender integration of Marine basic training–which will be an unmitigated disaster–and further demanded that the Corps rename all job titles to remove the word “man”. Now, there is an official plan to impose “cultural change” on the Corps.

Again, I commend you to read With the Old Breed. Time and again Sledge states bluntly that the only reason that he and his fellow Marines were able to fight and win appalling and grinding battles was the Spartan ethos and unrelenting training that the Marines underwent before hitting the beaches. He hated doing it, but he knew it was the only thing that made it possible for him to come out alive. It is inevitable that gender integration will undermine that ethos, and the rigor of the training.

The Marine Corps–and other branches of the military–should have one overriding objective and one only: to fight and win wars. The unique culture of the Marine Corps has ensured that it has been able to achieve that objective under the most trying conditions imaginable. Why in God’s name would anyone who takes the national defense seriously contemplate changing such an exceptional culture?

The answer, of course, is that people like Mabus and many others in the Obama administration and Congress are more interested in fighting and winning culture and gender wars than shooting wars. This is despicable.

I have often quoted Jefferson Davis’s epitaph for the Confederacy: Died of a Theory. Ray Mabus, Obama, and the other cultural/gender warriors who dominate Washington are hell bent on killing with a theory, an ideology. In this instance, they are hell bent on killing a military culture that has served this country gloriously, and which has produced millions of ordinary leathernecks and jarheads who have fought and bled and died while winning this nation’s wars.

“Died of (or killed by) a theory” is more than a metaphor in the case of the USMC and the Obama administration. People will literally die because of the imposition of a politically correct ideology that will inevitably compromise military effectiveness. And for what?

But those who will die cannot be identified now. They do not have names or faces. For most, they are not even abstractions. And when they die Obama and Mabus and the others will not be held to account. Indeed, they will receive accolades from many for making another successful march through American institutions, in this case, the most successful military institution in the nation’s history.

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March 23, 2016

Our Peevish President Dismisses Terrorism, and Bolsters a Repressive Regime

Filed under: History,Military,Politics — The Professor @ 6:30 pm

The latest terrorist atrocity, this time in Brussels, proves yet again that Europe is infested with dens of vipers, which it is largely powerless to control. Perhaps this should be expected in a country like Belgium, which cannot execute raids between the hours of 10 PM and 5 AM, and must ring the doorbell when they do.

Obama’s reaction to these appalling events was appalling in its own way. The most peevish president was obviously immensely annoyed that ugly reality intruded on his Cuban victory lap/holiday. He grudgingly spared a grand total of 51 seconds to address the subject during a scheduled speech in Havana. He then proceeded to take in a baseball game, during which he did the wave with his new besty Raul Castro.

Obama’s remarks, such as they were, displayed his impatience with and indifference to the issue of terrorism. It consisted of the standard bromides, including the old standby of a promise to help bring the perpetrators to justice.

Um. The perpetrators were suicide bombers. They blew themselves up. They are quite clearly well beyond the reach of human justice.

When pressed on the issue today in Argentina, Obama responded with his by now familiar petulance and irritation at the topic.  He has a lot on his plate, he said, by way of rationalizing not giving the matter more attention. Further, in a reprise of another well-worn theme, Obama stated that terrorism is not an existential threat to the US.

This is Obama’s typical false choice/straw man rhetoric in action. There are very few existential threats: if presidents were bound to respond only to existential threats, their plates would be quite empty. Plenty of time for golf and ESPN. Come to think of it . . . . Seriously, though, although Obama thinks Americans are irrationally obsessed with a terrorism threat which in his mind ranks somewhere below the risk of drowning in the bathtub (no, really), although not existential, it is a sufficiently great danger that a more aggressive posture is fully warranted.

It should be said that Obama is doing more than he lets on. But that in itself is a problem. For the second time in recent months, only the death of an American serviceman has forced the administration (though not Obama personally, for he floats above it all, unquestioned by the press) to admit a more extensive involvement in combat in Iraq and Syria. This time, the death of a Marine in an ISIS rocket attack on  firebase in Iraq compelled the Pentagon to concede its existence, which it had previously not acknowledged: if the Marine hadn’t died (with eight more wounded) the firebase would remain a secret. From Americans, anyways. In response to questions arising from the Marine’s death, SecDef Carter was forced to concede that US personnel numbers in Iraq exceeded, by about 50 percent, the authorized number.

So this means that the war against ISIS is more robust than Obama admits. That’s good in a way, but the secrecy is disturbing. It is not for operational reasons: after all, ISIS clearly figured out the base was there, and took it under fire. It is purely to protect Obama personally. Acknowledging more robust campaign would be an admission that his past inaction on ISIS was a mistake. And Obama is constitutionally incapable of admitting error. Sadly, a press that would be baying like hounds on the trail of a fox if a Republican president had done this is silent, and thereby complicit in concealing military action from the American people.

Obama’s terrorism remarks were only one of many low points on his two day visit to Cuba. He spewed one leftist shibboleth about the Communist country after another. It was an extended exercise in moral equivalence between the US and Cuba.

For instance, he said the Cuban Revolution and the American Revolution were quite similar, in that they were both fighting oppression. Even overlooking the fact that the philosophical and political foundations of the two revolutions could not be more different, the obvious difference is that the Cuban Revolution replaced one tyranny with a far worse one, whereas the American revolution gave (in Lincoln’s words) a new birth of liberty. It is deeply insulting to compare the American founding generation to the murderous thugs who led the Cuban uprising, and who continue to grind the country under their geriatric heels almost 60 years later.

Further, Obama said that Cuba had things to teach the US about human rights (!), specifically citing universal health care. Where to begin? Identifying health care as a human right is typically progressive, but leave that aside for the moment. Cuba’s “universal health care” is a sick joke. The elite gets far better treatment than the vast majority of Cubans, who universally get crappy medical treatment: they are equal in the primitiveness of the treatment they get.

The low point in the visit was a photo op in front of the Cuban Interior Ministry, complete with a huge portrait of mass murdering, racist Che looming in the background. Given the meticulous planning that goes into presidential visits, this had to be deliberate: leftist trolling at its worst.

The boycott of Cuba is an anachronism. It is justifiable to jettison it, and to restore relations with Cuba. But that does not require doing what Obama did: validating, and arguably celebrating, a vicious, oppressive regime, while insulting and apologizing for the country that did him the honor of electing him president twice.

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