Streetwise Professor

October 12, 2016

A Pitch Perfect Illustration of Blockchain Hype

Filed under: Clearing,Commodities,Derivatives,Economics,Regulation — The Professor @ 7:31 pm

If you’ve been paying the slightest attention to financial markets lately, you’ll know that blockchain is The New Big Thing. Entrepreneurs and incumbent financial behemoths alike are claiming it will transform every aspect of financial markets.

The techno-utopianism makes me extremely skeptical. I will lay out the broader case for my skepticism in a forthcoming post. For now, I will discuss a specific example that illustrates odd combination of cluelessness and hype that characterizes many blockchain initiatives.

Titled “Blockchain startup aims to replace clearinghouses,” the article breathlessly states:

Founded by two former traders at Societe Generale, SynSwap is a post-trade start-up based on hyperledger technology designed to disintermediate central counterparties (CCPs) from the clearing process, effectively removing their role in key areas.

“For now we are focusing on interest rate swaps and credit default swaps, and will further develop the platform for other asset classes,” says Sophia Grami, co-founder of SynSwap.

Grami explains that once a trade is captured, SynSwap automatically processes the whole post-trade workflow on its blockchain platform. Through smart contracts, it can perform key post-trade functions such as matching and affirmation, generation of the confirmation, netting, collateral management, compression, default management and settlement.

“CCPs have been created to reduce systemic risk and remove counterparty risk through central clearing. While clearing is key to mitigate risks, the blockchain technology allows us to disintermediate CCPs while providing the same risk mitigation techniques,” Grami adds.

“Central clearing is turned into distributed clearing. There is no central counterparty anymore and no entity is in the middle of a trade anymore.”

The potential disruptive force blockchain technology could have for derivatives clearing could bring back banks that have pulled away from the business due to heightened regulatory costs.

I have often noted that CCPs offer a bundle of many services, and it is possible to considering unbundling some of them. But there are certain core functions of CCP clearing that this blockchain proposal does not offer. Most importantly, CCPs mutualize default risk: this is truly one of the core features of a CCP. This proposal does not, meaning that it provides a fundamentally different service than a CCP. Further, CCPs hedge and manage defaulted positions and port customer positions from a defaulted intermediary to a solvent one: this proposal does not. CCPs also manage liquidity risk. For instance, a defaulter’s collateral may not be immediately convertible into cash to pay winning counterparties, but the CCP maintains liquidity reserves and lines that it can use to intermediate liquidity in these circumstances. The proposal does not. The proposal mentions netting, but I seriously doubt that the blockchain–hyperledger, excuse me–can perform multilateral netting like a CCP.

There are other issues. Who sets the margin levels? Who sets the daily (or intraday) marks which determine variation margin flows and margin calls to top up IM? CCPs do that. Who does it for the hyper ledger?

So the proposal does some of the same things as a CCP, but not all of them, and in fact omits the most important bits that make central clearing central clearing. To the extent that these other CCP services add value–or regulation compels market participants to utilize a CCP that offers these services–market participants will choose to use a CCP, rather than this service. It is not a perfect substitute for central clearing, and will not disintermediate central clearing in cases where the services it does not offer and the functions it does not perform are demanded by market participants, or by regulators.

The co-founder says “[c]entral clearing is turned into distributed clearing.” Er, “distributed clearing”–AKA “bilateral OTC market.” What is being proposed here is not something really new: it is an application of a new technology to a very old, and very common, way of transacting. And by its nature, such a distributed, bilateral system cannot perform some functions that inherently require multilateral cooperation and centralization.

This illustrates one of my general gripes about blockchain hype: blockchain evangelists often claim to offer something new and revolutionary but what they actually describe often involves re-inventing the wheel. Maybe this wheel has advantages over existing wheels, but it’s still a wheel.

Furthermore, I would point out that this wheel may have some serious disadvantages as compared to existing wheels, namely, the bilateral OTC market as we know it. In some respects, it introduces one of the most dangerous features of central clearing into the bilateral market. (H/T Izabella Kaminska for pointing this out.) Specifically, as I’ve been going on about for about 8 years now, the rigid variation margining mechanism inherent in central clearing creates a tight coupling that can lead to catastrophic failure. Operational or financial delays that prevent timely payment of variation margin can force the CCP into default, or force it or its members to take extraordinary measures to access liquidity during times when liquidity is tight. Everything in a cleared system has to perform like clockwork, or an entire CCP can fail. Even slight delays in receiving payments during periods of market stress (when large variation margin flows occur) can bring down a CCP.

In contrast, there is more play in traditional bilateral contracting. It is not nearly so tightly coupled. One party not making a margin call at the precise time does not threaten to bring down the entire system. Furthermore, in the bilateral world, the “FU Option” is often quite systemically stabilizing. During the lead up to the crisis, arguments over marks could stretch on for days and sometimes weeks, giving some breathing room to stump up the cash to meet margin calls, and to negotiate down the size of the calls.

The “smart contracts” aspect of the blockchain proposal jettisons that. Everything is written in the code, the code is the last word, and will be self-executing. This will almost certainly create tight coupling: The Market has moved by X; contract says that means party A has to pay Party B Y by 0800 tomorrow or A is in default. (One could imagine writing really, really smart contracts that embed various conditions that mimic the flexibility and play in face-to-face bilateral markets, but color me skeptical–and this conditionality will create other issues, as I’ll discuss in the future post.)

When I think of these “smart contracts” one image that comes to mind is the magic broomsticks in The Sorcerer’s Apprentice. They do EXACTLY what they are commanded to do by the apprentice (coder?): they tote water, and end up toting so much water that a flood ensues. There is no feedback mechanism to get them to stop when the water gets too high. Again, perhaps it is possible to create really, really smart contracts that embed such feedback mechanisms.

But then one has to consider the potential interactions among a dense network of such really, really smart contracts. How do the feedbacks feed back on one another? Simple agent models show that agents operating subject to pre-programmed rules can generate complex, emergent orders when they interact. Sometimes these orders can be quite efficient. Sometimes they can crash and collapse.

In sum, the proposal for “distributed clearing to disintermediate CCPs” illustrates some of the defects of the blockchain movement. It overhypes what it does. It claims to be something new, when really it is a somewhat new way of doing something quite common. It does not necessarily perform these familiar functions better. It does not consider the systemic implications of what it does.

So why is there so much hype? Well, why was a thing? More seriously, I think that there is an interesting sociological dynamic here. All the cool kids are talking about blockchain, and nobody wants to admit to not being cool. Further, when a critical mass of supposed thought leaders are doing something, others imitate for fear of being left behind: if you join and it turns out to be flop, well, you don’t stand out–everybody, including the smartest people, screwed up. You’re in good company! But if you don’t join and it becomes a hit, you look like a Luddite idiot and get left behind. So there is a bias towards joining the fad/jumping on the bandwagon.

I think there will be a role for blockchain. But I also believe that it will not be nearly as revolutionary as its most ardent proponents claim. And I am damn certain that it is not going to disintermediate central clearing, both because central clearing does some things “decentralized clearing” doesn’t (duh!), and because regulators like those things and are forcing their use.

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October 11, 2016

Why Waste US Special Operators in Battles That Make Game of Thrones Look Simple and Civilized?

Filed under: Military,Politics — The Professor @ 9:43 pm

A week ago, a US Special Forces soldier was killed by an IED in Afghanistan. In its disgusting fashion, the administration denied that this truly fine soldier had perished in combat, but said he was in a “combat situation.” This post-modern word weaseling for political purposes is an insult to those who are putting their lives on the line.

I have long been deeply disturbed by the overuse of special operations troops, for no apparent strategic purpose. To Obama, they are the human equivalent of drones, a way of employing military power in the shadows.

Things are likely to get worse. Special operators are on the ground in northern Syria. (Do they wear boots? Or do they levitate? Obama promised no boots on the ground, after all.) For their troubles, they are routinely insulted by Turkish-backed Salafist rebels, who call them Christian pigs and Crusaders.

But it will likely get even worse. After months of glacial preparation, an attack on Mosul appears if not imminent, on the verge of being imminent. Why do I say worse? Not just because the battle for Mosul is likely to be something akin to Fallujah I and Fallujah II, but because even if ISIS is defeated the aftermath is likely to be extremely messy, and the conditions will likely create fertile conditions for the emergence of another radical Sunni group.

Things were already complicated, with the Kurds and the Shia-dominated Iraqi government sharing the goal of ejecting ISIS, but having incompatible purposes once that happens. But things are getting even more convoluted and conflicted, with Turkey’s Erdogan asserting that his nation will participate in the campaign. Erdogan doesn’t want to see the Kurds in control. He also wants to gain power in northern Iraq, which is oil rich. He also has sectarian motives.

So glad that Obama thought that Erdo was one of his five best friends among world leaders. With friends such as these . . . . Another example of Obama’s incredibly flawed judgment.

Erdogan’s agenda is an anathema to the government of Iraq, so there is now a war of words going on between Erdogan and the Iraqi prime minister Haider al-Adabi.

All this means that post-“victory” Mosul will be a seething cockpit of competing forces, each one worse than the other (with the Kurds being the best of the lot, but thoroughly hated by all the rest). Kurds fighting Turks fighting Iraqi government forces and Shia militias. The Iranians will get involved, likely through their intelligence forces working hand-in-glove with the militias. Local Sunnis will be abused by the Iraqis and will fight back. The situation will make Game of Thrones look simple, ordered, and civilized.

The US will be everyone’s enemy, but every one of these factions will attempt to manipulate the US to do its bidding. And who will be at the center of this mess? US special operations forces. Who will have to keep their heads on a swivel. They will inevitably be targeted by everyone, and will not be able to do anything more than furiously spin the hamster wheel from hell. It will be Afghanistan, only worse. They will exhibit exceptional heroism and unmatched operational skill, and kill a lot of horrible people, but the ultimate result will be indecisive.

What could be our objective? What outcomes are even possible, and what would it cost in lives and treasure to achieve them? I find it hard to conceive of any outcome that would be worth the cost.

And US special operations troops would bear the brunt of those costs. They are too special, in many senses of the word, to fritter away in incipient fiascos like Mosul promises to be.

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October 6, 2016

We Are Not Saudi Arabia’s Mercenaries

Filed under: Military,Politics — The Professor @ 6:57 pm

The Middle East has become the Mother of All FUBARs. Yet there are many in the United States, on both sides of the partisan divide, advocating deeper American involvement.

The focus is on Syria. Yes, the war there is horrific. Yes, the Syrians and Russians have dramatically ratcheted up the intensity of their brutal air campaign in Aleppo, even during an alleged cease fire. But what could the US accomplish by getting more deeply involved? Perpetuating a stalemate?

Or let’s say that somehow magically the US is able to support the toppling of Assad without sparking a war with Russia. What would be the outcome? It would be the victory of Sunni jihadis who would inevitably wreak a vengeance on Alawis, Shias, and Christians that would rival if not exceed anything Assad has done. Further, Sunni jihadis are America’s enemies, and have killed far more Americans than the Assads ever did, even when they were neck deep in supporting terrorism. Indeed, the worst that Assad has done to the US in the past decades is support the rat line that supplied Al Qaeda in Iraq (ISIS’ predecessor). After an Assad defeat, Syria would become a base for anti-American jihadis.

Which helps us how, exactly?

Many of those advocating deeper American involvement in Syria point to the fact that Putin is winning there. So what? To think that a Putin victory axiomatically spells an American defeat are engaged in precisely the type of zero sum thinking that leads Putin to exaggerate Syria’s importance. The more we fret about his “winning” in Syria, the more we feed his ambitions there and elsewhere in the region, and convince him that he’s on the right track.

Speaking of Russia, John Kerry has expressed outrage that Russia deceived him, and ramped up its military operations in Aleppo immediately after he thought they had agreed to a cease fire. Have we ever had such a credulous oaf in such a high position? Kerry needs to acquaint himself with The Farmer and the Viper (or the Frog and the Scorpion). The entire idea of a deal between Russia and the US is farcical, as long as the US insists that Assad must go. Russia is all in for Assad, and will not go for any deal that threatens him. The US claims it will not go for any deal that strengthens him. These positions are utterly incompatible.

Truth be told, it is the Saudis and the Qataris and others in the GCC who have a strong interest in Syria. They view it as a front in their Muslim Civil War with Shia Iran and express grave fear of a Shia Crescent running from Iran through Iraq to the Mediterranean. They exert tremendous influence in DC. Those who fall for their line, and parrot their line, are not acting in American interests.

The Saudis’ attempts to influence US policy are not limited to Syria. They are bogged down in a war in Yemen that is also a front in their conflict with Iran, and are importuning the United States to support them in that conflict as well.

The US has even less of an interest in Yemen than it does in Syria.

In fact, the US has very little interest in the Muslim Civil War, other than that neither side win. Militarily, neither the Iranians or the GCC have the ability to conquer the other, so we have zero reason to get in the middle. If they want to fritter away treasure and lives in peripheral conflicts, so be it.

We are not Saudi Arabia’s mercenaries. Let them fight their own battles.

It is highly unlikely we could achieve a good military outcome in either Syria or Yemen.  The latter has a lot in common with Afghanistan, the former with Iraq and Libya, and look how swimmingly THOSE are going. And even if we could create some simulacrum of peace, at what would be a heavy price in lives and money, how would the US gain? I am not seeing it.

These are sideshows. We should be more focused on peer competitors like China and Russia. After 15 years of grinding conflict and budgetary stringency, the US urgently needs to recapitalize its military. In these circumstances, risking a confrontation with Russia to fight Saudi Arabia’s battles is beyond insane. To hell with them and the camel they rode in on.

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Igor for the Win!, or Privatization With Russian Characteristics

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 5:19 pm

Today Russia announced that Rosneft has been approved to purchase Bashneft. This despite the Economics Ministry’s earlier attempts to prevent state-owned Rosneft from participating in a “privatization” of a company that had been de-privatized (through expropriation), and Putin’s statement that this was not the best option.

But there’s more! The company was handed to Rosneft on a platter. Rosneft didn’t have to win an auction. There was no competitive tender process. It was just Christmas in October for Igor.

This speaks volumes about how Russia is run. (I won’t say “governed” or “managed.”) In a natural state way, a favored insider was rewarded despite the fact that all economic considerations push the other way. For one thing, privatization has been touted as a way of alleviating Russia’s severe budgetary problems. This will not do that. The decision occurred at a time when all indications are that the economic stringency will endure. There is no prospect for a serious rebound in oil prices, and there is also little prospect of an easing in sanctions. Indeed, Putin’s obduracy in Ukraine and his escalation in Syria may result in the imposition of additional sanctions. Putin’s spending priorities are increasing the economic strain. He plans to increase defense spending by $10 billion, and reduce social spending by less than that. Furthermore, Rosneft is a wretchedly run company that will generate far less value from Bashneft than would another owner, including a private Russian firm like Lukoil.

In brief, a cash-strapped Putin passed up an opportunity to generate some revenue and handed over Bashneft to a company that destroys value rather than enhances it. Such are the ways of a natural state that functions by allocating rents to courtiers. Privatization, with Russian characteristics.

In sum, in the Bashneft deal, Igor wins. And Russia loses.

The only thing that could potentially redeem this is if there was a quid pro quo, namely, that Sechin would relent to the sale of big stake in Rosneft to outside investors. Nothing of the sort was announced today, and perhaps they are waiting for some time to pass so as not to suggest that there was a deal. But I doubt it. I am guessing that Igor will win that argument too.

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War Communism Meets Central Clearing

Filed under: Clearing,Derivatives,Economics,Politics,Regulation — The Professor @ 1:58 pm

I believe that I am on firm ground saying that I was one of the first to warn of the systemic risks created by the mandating of central clearing on a vast scale, and that CCPs could become the next Too Big to Fail entities. At ISDA events in 2011, moreover, I stated publicly that it was disturbing that the move to mandates was occurring before plans to recover or resolve insolvent clearinghouses were in place. At one of these events, in London, then-CEO of LCH Michael Davie said that it was important to ensure to have plans in place to deal with CCPs in wartime (meaning during crises) as well as in peace.

Well, we are five years on, and well after mandates have been in effect, those resolution and recovery authorities are moving glacially towards implementation. Several outlets report that the European Commission is finalizing legislation on CCP recovery. As Phil Stafford at the FT writes:

The burden of losses could fall on the clearing house or its parent company, its member banks; the banks’ customers, such as pension funds, or the taxpayer.

Brussels is proposing that clearing house members, such as banks, be required to participate in a cash call if the clearing house has exhausted its so-called “waterfall” of default procedures.

The participants would take a share in the clearing house in return, according to drafts seen by the Financial Times.

Authorities would also have the power to reduce the value of payments to the clearing house members, the draft says. In the event of a systemic crisis, regulators could use government money as long as doing so complies with EU rules on state aid.

Powers available to regulators would include tearing up derivatives contracts and applying a “haircut” to the margin or collateral that has been pledged by the clearing house’s end users.

Asset managers have long feared that haircutting margin would be tantamount to expropriating assets that belong to customers.

The draft is circulating in samizdat form, and I have seen a copy. It is rather breathtaking in its assertions of authority. Apropos Michael Davie’s remarks on operating CCPs during wartime, my first thought upon reading Chapters IV and V was “War Communism Comes to Derivatives.” One statement buried in the Executive Summary Sheet, phrased in bland bureaucratic language, is rather stunning in its import: “A recovery and resolution framework for CCPs is likely to involve a public authority taking extraordinary measures in the public interest, possibly overriding normal property rights and allocating losses to specific stakeholders.”

In a nutshell, the proposal says that the resolution authority can do pretty much it damn well pleases, including nullifying normal protections of bankruptcy/insolvency law, transferring assets to whomever it chooses, terminating contracts (not just of those who default, but any contract cleared by a CCP in resolution), bailing in any CCP creditor up to 100 percent, suspending the right to terminate contracts, and haircutting variation margin. The authority also has the power to force CCP members to make additional default fund contributions up to the amount of their original contribution, over and above any additional contribution specified in the CCP member agreement. In brief, the resolution authority has pretty much unlimited discretion to rob Peter to pay Paul, subject to only a few procedural safeguards.

About the only thing that the law doesn’t authorize is initial margin haircutting. Given the audacity of other powers that it confers, this is sort of surprising. It’s also not evident to me that variation margin haircutting is a better alternative. One often overlooked aspect of VM haircuts is that they hit hedgers hardest. Those who are using derivatives to manage risk look to variation margin payments to offset losses on other exposures that they are hedging. VM haircutting deprives them of some of these gains precisely when they are likely to need them most. Put differently, VM haircutting imposes losses on those that are least likely to be able to bear them when it is most costly to bear them. Hedgers are risk averse. One reason they are risk aversion is that losses on their underlying exposures could force them into financial distress. Blowing up their hedges could do just that.

Perhaps one could argue that CCPs are so systemically important and the implications of their insolvency are so ominous that extraordinary measures are necessary–in its Executive Summary, and in the proposal itself, the EC does just that. But this just calls into question the prudence of creating and supersizing entities with such latent destructive potential.

There is also a fundamental tension here. The potential that the resolution authority will impose large costs on members of CCPs, and even their customers, raises the burden of being a member, or trading cleared products. This is a disincentive to membership, and with the economics of supply clearing services already looking rather grim, may lead to further exits from the business. Similarly, bail-ins of creditors and the potential seizure of ownership interests without due process will make it more difficult for CCPs to obtain funding. Thus, mandating expansion of clearing makes necessary exceptional resolution measures that lead to reduced supply of clearing services, and reduced supply of the credit, liquidity, and capital that they need to function.

It must also be recognized that with discretionary power come inefficient selective intervention and influence costs. The resolution body will have extraordinary power to transfer vast sums from some agents to others. This makes it inevitable that the body will be subjected to intense rent seeking activity that will mean that its decisions will be driven as much by political factors as efficiency considerations, and perhaps more so: this is particularly true in Europe, where multiple states will push the interests of their firms and citizens. Rent seeking is costly. Furthermore, it will inevitably inject a degree of arbitrariness into the outcome of resolution. This arbitrariness creates additional uncertainty and risk, precisely at a time when these are already at heightened, and likely extreme, levels. Furthermore, it is likely to create dangerous feedback loops. The prospect of dealing with an arbitrary resolution mechanism will affect the behavior of participants in the clearing process even before a CCP fails, and one result could be to accelerate a crisis, as market participants look to cut their exposure to a teetering CCP, and do so in ways that pushes it over the edge.

To put it simply, if the option to resort to War Communism is necessary to deal with the fallout from a CCP failure in a post-mandate world, maybe you shouldn’t start the war in the first place.

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October 4, 2016

Going Deutsche: Beware Politicians Adjudicating Political Bargains Gone Bad

A few years ago, when doing research on the systemic risk (or not) of commodity trading firms, I thought it would be illuminating to compare these firms to major banks, to demonstrate that (a) commodity traders were really not that big, when compared to systemically important financial institutions, and (b) their balance sheets, though leveraged, were not as geared as banks and unlike banks did not involve the maturity and liquidity transformations that make banks subject to destabilizing runs. One thing that jumped out at me was just what a monstrosity Deutsche Bank was, in terms of size and leverage and Byzantine complexity. Its

My review (conducted in 2012 and again in 2013) looked back several years.  For instance, in 2013, the bank’s leverage ratio was around 37 to 1, and its total assets were over $2 trillion.

Since then, Deutsche has reduced its leverage somewhat, but it is still huge, highly leveraged (especially in comparison to its American peers), and deeply interconnected with all other major financial institutions, and a plethora of industrial and service firms.

This makes its current travails a source of concern. The stock price has fallen to record low levels, and its CDS spreads have spiked to post-crisis highs. The CDS curve is also flattening, which is particularly ominous. Last week, Bloomberg reported signs of a mini-run, not by depositors, but by hedge funds and others who were moving collateral and cleared derivatives positions to other FCMs. (I’ve seen no indication that people are looking to novate OTC deals in order to replace Deutsche as a counterparty, which would be a real harbinger of problems.)

Ironically, the current crisis was sparked by chronic indigestion from the last crisis, namely the legal and regulatory issues related to US subprime. The US Department of Justice presented a settlement demand of $14 billion dollars, which if paid, would put the bank at risk of breaching its regulatory capital requirements: the bank has only reserved $5 billion. Deutsche’s stock price and CDS have lurched up and down over the past few days, driven mainly by news regarding how these legal issues would be resolved.

The $14 billion US demand is only one of Deutsche’s sources of legal agita, most of which are also the result of pre-crisis and crisis issues, such as the IBOR cases and charges that it facilitated accounting chicanery at Italian banks.

Deutsche’s problems are political poison in Germany, for Merkel in particular. She is in a difficult situation. Bailouts are no more popular in Europe than in the US, but if anyone is too big to fail, it is Deutsche. Serious problems there could portend another financial crisis, and one in which the epicenter would be Germany. Merkel and virtually all other politicians in Germany have adamantly stated there would be no bailouts: politically, they have to. But such unconditional statements are not credible–that’s the essence of the TBTF problem. If Deutsche teeters, Germany–no doubt aided by the ECB and the Fed–will be forced to act. This would have seismic political effects, particularly in Europe, and especially particularly in southern Europe, which believes that it has been condemned to economic penury to protect German economic interests, not least of which is Deutsche Bank.

No doubt the German government, the Bundesbank, and the ECB are crafting bailouts that don’t look like bailouts–at least if you don’t look too closely. One idea I saw floated was to sell off Deutsche assets to other entities, with the asset values guaranteed. Since direct government guarantees would be too transparent (and perhaps contrary to EU law), no doubt the guarantees will be costumed in some way as well.

The whole mess points out the inherently political nature of banking, and how the political bargain (in the phrase of Calomaris and Haber in Fragile by Design) has changed. As they show quite persuasively (as have others, such as Ragu Rajan), the pre-crisis political bargain was that banks would facilitate income redistribution policy by provide credit to low income individuals. This seeded the crisis (though like any complex event, there were myriad other contributing causal factors), the political aftershocks of which are being felt to this day. Banking became a pariah industry, as the very large legal settlements extracted by governments indicate.

The difficulty, of course, is that banks are still big and systemically important, and as the Deutsche Bank situation demonstrates, punishing for past misdeeds that contributed to the last crisis could, if taken too far, create a new one. This is particularly true in the Brave New World of post-crisis monetary policy, with its zero or negative interest rates, which makes it very difficult for banks to earn a profit by doing business the old fashioned way (borrow at 3, lend at 6, hit the links by 3) as politicians claim that they desire.

It is definitely desirable to have mechanisms to hold financial malfeasors accountable, but the Deutsche episode illustrates several difficulties. The first is that even the biggest entities can be judgment proof, and imposing judgments on them can have disastrous economic externalities. Another is that there is a considerable degree of arbitrariness in the process, and the results of the process. There is little due process here, and the risks and costs of litigation mean that the outcome of attempts to hold bankers accountable is the result of a negotiation between the state and large financial institutions that is carried out in a highly politicized environment in which emotions and narratives are likely to trump facts. There is room for serious doubt about the quality of justice that results from this process. Waving multi-billion dollar scalps may be emotionally and politically satisfying, but arbitrariness in the process and the result means that the law and regulation will not have an appropriate deterrence effect. If it is understood that fines are the result of a political lottery, the link between conduct and penalty is tenuous, at best, meaning that the penalties will be a very poor way of deterring bad conduct.

Further, it must always be remembered that what happened in the 2000s (and what happened prior to every prior banking crisis) was the result of a political bargain. Holding bankers to account for abusing the terms of the bargain is fine, but unless politicians and regulators are held to account, there will be future political bargains that will result in future crises. To have a co-conspirator in the deals that culminated in the financial crisis–the US government–hold itself out as the judge and jury in these matters will not make things better. It is likely to make things worse, because it only increases the politicization of finance. Since that politicization is is at the root of financial crises, that is a disturbing development indeed.

So yes, bankers should be at the bar. But they should not be alone. And they should be joined there by the very institutions who presume to bring them to justice.

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September 26, 2016

Laissez les bons temps rouler!

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

One of the great myths of commodity futures trading is the “roll return,” which Bloomberg writes about here (bonus SWP quote–but he left out the good stuff!, so I’ll have to fill that in here). Consider the oil market, which is currently in a contango, with the November WTI future ($45.99/bbl) trading below the December ($46.52/bbl). This is supposedly bad for those with a long ETF position, or an index position that includes many commodities in contango, because when the position is “rolled” forward in a couple weeks as the November contracts moves towards expiration, the investor will sell the November contract at a lower price than he buys the December, thereby allegedly causing a loss. The investor could avoid this, supposedly, by holding inventory of the spot commodity.

The flip side of this allegedly occurs when the market is in backwardation: the expiring contract is sold at a higher price than the next deferred contract is bought, thereby supposedly allowing the investor to capture the backwardation, whereas since spot prices tend to be trending down in these conditions, holders of the spot lose.

This is wrong, for two reasons. First, it gets the accounting wrong, by starting in the middle of the investment. The profit or loss on the November crude futures position depends on the difference between the price at which the November was sold in early October and bought in early September, not the difference between the price at which the November is sold and the December is bought in early October. Similarly, in November, the P/L on the December position will be the difference between sell and buy prices for the December futures, not the difference between the prices of the December and January futures in early December.  You need to compare apples to apples: the “roll return” compares apples and oranges.

On average and over time, the investor engaged in this rolling strategy earns the risk premium on oil (or the portfolio of commodities in the index). This is because the futures price is the expected spot price at expiration plus a risk premium. The rolling position receives the spot price at expiration and pays the expected spot price at the time the position is initiated, plus a risk adjustment. On average the spot price parts cancel out, leaving the risk premium.

Second, the expected change in the price of the spot commodity compensates the holder for the costs of carrying inventory, which include financing costs (very small, at present), and warehousing costs, insurance, etc. Net of these costs, the P/L on the position includes a risk premium for exposure to spot price risk, and in a well-functioning market, this will be the same as the risk premium in the corresponding future.

Moving away from commodities illustrates how the alleged difference between a rolled futures position and a spot position is largely chimerical. Consider a position in S&P 500 index futures when the interest rate is above the dividend yield. (Yes, children, that was true once upon a time!) Under this condition, the S&P futures would be in contango, and there would be an apparent roll loss when one sells the expiring contract and buying the first deferred. Similarly, comparing the futures price to the spot index at the time the future is bought, the future will be above the spot, and since at expiration the future and the spot index converge to the same value, the future will apparently underperform the investment in the underlying. But this underperformance is illusory, because it neglects to take into account the cost of carrying the cash index position (which is driven by the difference between the funding rate and the dividend yield). When buys and sells are matched appropriately, and all costs and benefits are accounted for properly, the performance of the two positions is the same.

Conversely, in the current situation using the roll return illogic, the rolled position in S&P futures will apparently outperform an investment in the cash index, because the futures market is in backwardation. But this backwardation exists because the dividend yield exceeds the rate of financing an investment in the cash index. The apparent difference in performance is explained by the fact that the futures position doesn’t capture the dividend yield. Once the cost of carrying the cash index position (which is negative, in this case) is taken into consideration, the performance of the positions is identical.

Back in 1992, Metallgesellschaft blew up precisely because the trader in charge of their oil trading convinced management that a stack-and-roll “hedging” strategy would make money in a backwardated market, because he would be consistently selling the future near expiration for a price that exceeded the next-deferred that he was buying. This “logic” was again comparing apples to oranges. By implementing that “logic” to the tune of millions of barrels, Metallgesellschaft became the charter member of the billion dollar club–it was the first firm to have lost $1 billion trading derivatives.

So don’t obsess about roll returns or try to figure out ways to invest in cash commodities when the market is in a contango/carry. Futures are far more liquid and cheaper to trade, so if you want exposure to commodity prices do it through futures directly or indirectly (e.g., through ETFs or index funds). Decide on the allocation to commodities based on the risk it adds to your portfolio and the risk premium you can earn. Don’t worry about the roll. If you decide that commodities fit in your portfolio, laissez les bon temps roullez!

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September 23, 2016

With Friends Like the Saudis, America Needs No Enemies

Filed under: Military,Politics — The Professor @ 8:34 pm

Today Obama vetoed a bill that would permit families of those who perished on 911 to sue the Saudi Arabian government for supporting the hijacker/murderers. Earlier this week, the Senate defeated an effort led by Rand Paul to halt arms sales to the kingdom because of its ongoing war in Yemen.

The Saudis are feeling the pressure and are trying desperately to change the subject–to Iran. The gravamen of the Saudi case is that Iran is a major state sponsor of terrorism. There is, of course, something to this. Iran has indeed been a state sponsor of terrorism, and has directed its campaign against the United States and Israel for decades.

But it is more than a little disgusting to hear the Saudis cast aspersions about terrorism. The modalities of Iranian efforts differ from those of Saudi Arabia. But it is indisputable that Saudi Arabia is responsible for more terrorism that has killed more Americans than the Iranians have been.

Indeed, Iran’s methods are in many ways more conventional and less insidious than those emanating in Saudi Arabia. Iranian terrorism (and unconventional warfare) efforts are indeed carried out at the direction of state organs, and often work through quasi-state organizations (such as Hezbollah). In contrast, the archaic nature of the Saudi state, with its immense royal family with numerous wealthy members, means that the concept of “state support” is much more amorphous. Saudi Arabia is not a state in the western sense, or even in the Iranian sense. This makes Iran in some respects a much more conventional adversary than Saudi Arabia.

Furthermore, Saudi Arabia’s contribution to terrorism around the world has been demonstrably far greater than Iran’s. The funding of Wahhabi mosques and madrassas throughout the Middle East, Southwest Asia, the Balkans, Africa, and the Caucasus–and Europe and the United States–has inculcated the poisonous Islamist ideology that has created terror. Most of this money has not been spent to support explicitly terrorist groups or terrorist acts. But it has created the ideological and religious infrastructure that has been the catalyst for these groups and acts. However bad as Iran has been, objectively speaking Saudi Arabia and other oil tick states of the Gulf have been far worse. With allies like these, we need no enemies.

Furthermore, the diffuse and ideological nature of the Saudi support for terrorism makes it much more difficult to combat than Iran. Not to say that Iran is an easy adversary, but the very fact that it is a fairly conventional (if revolutionary) state makes it a more addressable foe than Saudi Arabia. The Saudi state may not support terrorism in the same way that the Iranian state does (though it might), but that actually greatly complicates the task of the terrorism that emanates from Saudi territory, Saudi citizens, and Saudi money.

One can sense that the Saudis feel that they are facing an existential crisis, fed in large part by Obama administration policy towards Iran. The Iranian nuclear deal and the lifting of sanctions has stoked these anxieties. The Saudis are deeply insecure, in part because there is a large and alienated Shia population in the major oil producing provinces. Iran is a larger and more educated country that has dominated its Arab neighbors for centuries. Low oil prices have gutted the Saudi economy and are placing tremendous budgetary strains on the country.

Fear of Iran drives the bloody–and (typically for an Arab army)–inept and indecisive war in Yemen, in which Saudi Arabia has succeeded in using American technology to kill large numbers of Yemenis (including numerous civilians) with no discernible strategic effect. It also drives the strong Saudi support for the opposition in Syria, because the Saudis view Assad as an Iranian vassal who is an important part of an “Shia crescent” that threatens the Sunni countries of the Middle East, of which Saudi Arabia considers itself the leader: it is clearly their paymaster. The Saudis being Saudis, they have no qualms in supporting extreme jihadist elements: indeed, that is their preference.

This demonstrates the drooling incoherence of Obama policy in the Middle East. Empowering Iran through the nuclear deal has fed Saudi fears that lead them to intensify their various proxy wars against Iran, and the administration has responded by supporting the Saudis in these wars, quite robustly in Yemen, more equivocally in Syria. If the Saudis succeed in Syria this will empower Salafist elements that are viciously anti-American. In essence, the Obama administration has succeeded in stoking both sides in the conflict, which helps explain its clear escalation in the past two years.

The Saudis have oil–the largest reserves in the world. That is the American–and world–interest in Saudi Arabia. But (a) the Saudis want to sell their oil, and (b) protecting the Saudi oil fields does not necessitate supporting or even acquiescing to Saudi Arabia’s support for Wahhabist radicalism that is spreading death and destruction from Southeast Asia to Central Africa and pretty much everywhere in between–and even to the shores of the United States.

Indeed, US policy should be aimed at finding how to contain Saudi influence, rather than enable it. But old mindsets and Saudi money have prevented that. In the 1970s and 1980s, the Saudis insinuated themselves as allies of the US, united with us against common enemies: Iran and the Soviet Union. I remember distinctly that in the aftermath of the Iranian Revolution, and during the Hostage Crisis, the Saudis portrayed themselves as the moderate Muslims, and the Iranians as the radicals. With Americans held in Tehran, and mobs in the streets shouting “Death to America,” that sounded plausible. Nigh on to 40 years of painful experience have shown, however, that Saudi Arabia is anything but the voice of moderate Islam: it is the wellspring of violent radicalism.

Furthermore, the Soviet Union is no more. Whatever geopolitical rationale there was for supporting Saudi funding of Muslim fighters in the 1980s, it has long past, and in retrospect, looks like the benefits that we gained were not worth the decades of terror that came in the bargain.

In sum, indulgence of Saudi radicalism was based on ignorance of their true character which we should now be well past, and on a strategic situation that no longer exists. The time for indulgence is therefore long over.

But Saudi money has bought influence. It has bought politicians, of both parties: it was nauseating, for example, to see Lindsey Graham’s impassioned defense of Saudi Arabia in his speech against the Paul bill, and of course the Saudis have lavished money on ex-presidents from both parties and potential future ones (namely Hillary). It has bought think tanks. It has deeply corrupted American politics. It is therefore highly doubtful that its influence can be easily purged.

That’s why it has been encouraging to see the the Paul bill go as far as it did, and to see the 911 victims bill pass. Yes, I understand that the concerns that the logic of the the bill could be turned against the US. But it should be a wake up call to DC that many Americans understand the nature of the Saudi regime and the threat that it poses far better than the foreign policy establishment. A wise administration would attempt to find an alternative that would address the sovereign immunity concerns but at the same time make Saudi Arabia pay a price for its multifaceted support for Islamic radicalism and Islamic terrorism around the world. Instead, Obama caves to the Saudis and vetoes the bill, and fights against the Paul bill, and enables Saudi efforts in Yemen and Syria.

Iran is a problem, but it is a nation that can be confronted and contained (if not easily tamed) using conventional American power. Saudi Arabia poses problems that we have yet to find a solution to. And our biggest problem is that we (or at least our “elite”) haven’t even fully acknowledged that it is a problem, in large part because Saudi money has suborned our politics.

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September 16, 2016

Trump’s Political Jujitsu Creates Outrage and Schadenfreude

Filed under: Politics — The Professor @ 6:54 pm

If there is a more conceited, self-important group of twits than the national news media I am not aware of it. Its members view themselves as the arbiters of American politics. They make the rules, and enforce them. And woe betide anyone who dares defy them. Especially after they broke Nixon, they believe they can even get presidents to bend to their will. Presidents come and go, after all. The media is there forever.

Today they thought they were going to break Trump. After Trump announced an event at his hotel in DC, and intimated that he would make a statement on the Obama birther issue, the press let its imagination run wild. They believed–get this–that Trump would hold an event at his own hotel where his name and image are everywhere (including on the bottles of water in the fridges!) and abase himself before them, confessing his sins about insinuating that Obama had not been born in the US and subjecting himself to a barrage of their gotcha questions.

This tells you just how far up their own colons they live. It also tells you how clueless they are. Trump has shown time and again that he does not play by the conventional rules of DC, the rules that the national media presumes to enforce, and that he has zero deference for the media: he uses them, rather than the other way around. He has shown time and again that he makes his own rules. And so he did today. He did not just puncture the media’s presumptions. He stomped, crushed, mangled, spindled and mutilated them. Then emptied his bladder on them for good measure.

As it played out in reality, as opposed to the imaginations of the national media, his event was mainly rah-rah about his new real estate project. Further he trotted out dozens of retired flag officers and war heroes to provide backdrop. Then, after promoting his project, at the very end of his appearance, he said:

Hillary Clinton and her campaign in 2008 started the birther controversy. I finished it. You know what I mean. President Barack Obama was born in the United States, period. Now we all want to get back to making America strong and great again.

So not only did he not don (no pun intended!) sackcloth and ashes and beg forgiveness for being a birther he said he ended birtherism and that Hillary started it. Political jujitsu of the first order.

The noise you heard this afternoon was thousands of media heads exploding. Just Google something like “Trump birther press conference” and you’ll see outraged article after outraged article. “We were played. We were Rick Rolled.” And on and on and on.

The press pool stamped their little feet and held their breath, and not only vowed not to show the pool footage of the event, but to erase it. That’ll learn him!

Er, another indication of the media’s failure to recognize that the world has changed. They are no longer the gatekeepers. They cannot decide who sees what. There are other recordings of the event. There are numerous other channels–YouTube, Twitter, etc.–through which those recordings can spread. Their outraged articles and on-air rants will only intensify the Banned in Boston/Streisand Effect and will ensure that the attempt to censor will only make more people want to see it. It will go viral.

Yet another indication of the media’s obliviousness: they actually believe that people will care that Trump has affronted their amour propre. As if. Rather than sympathizing with the media for being tricked by Trump, far more people will indulge in schadenfreude. The media are heartily disliked by vast swathes of Americans, who will enjoy nothing more than witnessing them getting their comeuppance precisely at the moment that they thought they would demonstrate their dominance.

This episode is another illustration of (a) elite failure, and (b) the dramatic change in political norms. The elite establishment is offended that Trump does not obey their rules. But to a very large number of Americans–whom Hillary slurred as “deplorables,” an epithet that many have now embraced with pride–this is precisely Trump’s appeal. They think the rules are rigged against them. They don’t want no water: they want somebody to burn the motherf*cker down.  These people believe the elite has failed them, and what’s more, the elite has failed to recognize it: a double failure, and perhaps a fatal one.  They revel in the humiliation of the elite.

The pre-Brexit dynamic was very similar, and we saw what happened there. The old verities are cracking. The old rules are being flouted. The old rulers are despised. And they just don’t get it, and don’t know how to handle it.

This is an ominous moment for the media. Not only were they frustrated by Trumps failure to bend to their rules, his in-your-face demonstration that you can break the rules and survive will encourage others to do the same. In large part, the media’s power is predicated on the deference of politicians. Lose that deference, and the power is lost. So this is not just about the 2016 election. It is about elections after that. Perhaps Trump is a one-off. But success breeds imitators. Trump has successfully broken the rules, and that could lead to their demise.

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De Minimis Logic

CFTC Chair Timothy Massad has come out in support of a one year delay of the lowering of the de minimis swap dealer exemption notional amount from $8 billion to $3 billion. I recall Coase  (or maybe it was Stigler) writing somewhere that an economist could pay for his lifetime compensation by delaying implementation of an inefficient law by even a day. By that reckoning, by delaying the step down of the threshold for a year Mr. Massad has paid for the lifetime compensation of his progeny for generations to come, for the de minimis threshold is a classic analysis of an inefficient law. Mr. Massad (and his successors) could create huge amounts of wealth by delaying its implementation until the day after forever.

There are at least two major flaws with the threshold. The first is that there is a large fixed cost to become a swap dealer. Small to medium-sized swap traders who avoid the obligation of becoming swap dealers under the $8 billion threshold will not avoid it under the lower threshold. Rather than incur the fixed cost, many of those who would be caught with the lower threshold will decide to exit the business. This will reduce competition and increase concentration in the swap market. This is perversely ironic, given that one ostensible purpose of Frankendodd (which was trumpeted repeatedly by its backers) was to increase competition and reduce concentration.

The second major flaw is that the rationale for the swap dealer designation, and the associated obligations, is to reduce risk. Big swap dealers mean big risk, and to reduce that risk, they are obligated to clear, to margin non-cleared swaps, and hold more capital. But notional amount is a truly awful measure of risk. $X billion of vanilla interest rate swaps differ in risk from $X billion of CDS index swaps which differ in risk from $X billion of single name CDS which differ in risk from $X billion of oil swaps. Hell, $X billion of 10 year interest rate swaps differ in risk from $X billion of 2 year interest rate swaps. And let’s not even talk about the variation across diversified portfolios of swaps with the same notional values. So notional does not match up with risk in a discriminating way.  Further, turnover doesn’t measure risk very well either.

But hey! We can measure notional! So notional it is! Yet another example of the regulatory drunk looking for his keys under the lamppost because that’s where the light is.

So bully for Chairman Massad. He has delayed implementation of a regulation that will do the opposite of some of the things it is intended to do, and merely fails to do other things it is supposed to do. Other than that, it’s great!

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