Streetwise Professor

July 25, 2014

Benchmark Blues

Pricing benchmarks have been one of the casualties of the financial crisis. Not because the benchmarks-like Libor, Platts’ Brent window, ISDA Fix, the Reuters FX window or the gold fix-contributed in an material way to the crisis. Instead, the post-crisis scrutiny of the financial sector turned over a lot of rocks, and among the vermin crawling underneath were abuses of benchmarks.

Every major benchmark has fallen under deep suspicion, and has been the subject of regulatory action or class action lawsuits. Generalizations are difficult because every benchmark has its own problems. It is sort of like what Tolstoy said about unhappy families: every flawed benchmark is flawed in its own way. Some, like Libor, are vulnerable to abuse because they are constructed from the estimates/reports of interested parties. Others, like the precious metals fixes, are problematic due to a lack of transparency and limited participation. Declining production and large parcel sizes bedevil Brent.

But some basic conclusions can be drawn.

First-and this should have been apparent in the immediate aftermath of the natural gas price reporting scandals of the early-2000s-benchmarks based on the reports of self-interested parties, rather than actual transactions, are fundamentally flawed. In my energy derivatives class I tell the story of AEP, which the government discovered kept a file called “Bogus IFERC.xls” (IFERC being an abbreviation for Inside Ferc, the main price reporting publication for gas and electricity) that included thousands of fake transactions that the utility reported to Platts.

Second, and somewhat depressingly, although benchmarks based on actual transactions are preferable to those based on reports, in many markets the number of transactions is small. Even if transactors do not attempt to manipulate, the limited number of transactions tends to inject some noise into the benchmark value. What’s more, benchmarks based on a small number of transactions can be influenced by a single trade or a small number of trades, thereby creating the potential for manipulation.

I refer to this as the bricks without straw problem. Just like the Jews in Egypt were confounded by Pharoh’s command to make bricks without straw, modern market participants are stymied in their attempts to create benchmarks without trades. This is a major problem in some big markets, notably Libor (where there are few interbank unsecured loans) and Brent (where large parcel sizes and declining Brent production mean that there are relatively few trades: Platts has attempted to address this problem by expanding the eligible cargoes to include Ekofisk, Oseberg, and Forties, and some baroque adjustments based on CFD and spread trades and monthly forward trades). This problem is not amenable to an easy fix.

Third, and perhaps even more depressingly, even transaction-based benchmarks derived from markets with a decent amount of trading activity are vulnerable to manipulation, and the incentive to manipulate is strong. Some changes can be made to mitigate these problems, but they can’t be eliminated through benchmark design alone. Some deterrence mechanism is necessary.

The precious metals fixes provide a good example of this. The silver and gold fixes have historically been based on transactions prices from an auction that Walras would recognize. But participation was limited, and some participants had the market power and the incentive to use it, and have evidently pushed prices to benefit related positions. For instance, in the recent allegation against Barclays, the bank could trade in sufficient volume to move the fix price sufficiently to benefit related positions in digital options. When there is a large enough amount of derivatives positions with payoffs tied to a benchmark, someone has the incentive to manipulate that benchmark, and many have the market power to carry out those manipulations.

The problems with the precious metals fixes have led to their redesign: a new silver fix method has been established and will go into effect next month, and the gold fix will be modified, probably along similar lines. The silver fix will replace the old telephone auction that operated via a few members trading on their own account and representing customer orders with a more transparent electronic auction operated by CME and Reuters. This will address some of the problems with the old fix. In particular, it will reduce the information advantage that the fixing dealers had that allowed them to trade profitably on other markets (e.g.,. gold futures and OTC forwards and options) based on the order flow information they could observe during the auction. Now everyone will be able to observe the auction via a screen, and will be less vulnerable to being picked off in other markets. It is unlikely, however, that the new mechanism will mitigate the market power problem. Big trades will move markets in the new auction, and firms with positions that have payoffs that depend on the auction price may have an incentive to make those big trades to advantage those positions.

Along these lines, it is important to note that many liquid and deep futures markets have been plagued by “bang the close” problems. For instance, Amaranth traded large volumes in the settlement period of expiring natural gas futures during three months of 2006 in order to move prices in ways that benefited its OTC swaps positions. The CFTC recently settled with the trading firm Optiver that allegedly banged the close in crude, gasoline, and heating oil in March, 2007. These are all liquid and deep markets, but are still vulnerable to “bullying” (as one Optiver trader characterized it) by large traders.

The incentives to cause an artificial price for any major benchmark will always exist, because one of the main purposes of benchmarks is to provide a mechanisms for determining cash flows for derivatives. The benchmark-derivatives market situation resembles an inverted pyramid, with large amounts cash flows from derivatives trades resting on a relatively small number of spot transactions used to set the benchmark value.

One way to try to ameliorate this problem is to expand the number of transactions at the point of the pyramid by expanding the window of time over which transactions are collected for the purpose of calculating the benchmark value: this has been suggested for the Platts Brent market, and for the FX fix. A couple of remarks. First, although this would tend to mitigate market power, it may not be sufficient to eliminate the problem: Amaranth manipulated a price that was based on a VWAP over a relatively long 30 minute interval. In contrast, in the Moore case (a manipulation case involving platinum and palladium brought by the CFTC) and Optiver, the windows were only two minutes long. Second, there are some disadvantages of widening the window. Some market participants prefer a benchmark that reflects a snapshot of the market at a point in time, rather than an average over a period of time. This is why Platts vociferously resists calls to extend the duration of its pricing window. There is a tradeoff in sources of noise. A short window is more affected by the larger sampling error inherent in the smaller number of transactions that occurs in a shorter interval, and the noise resulting from greater susceptibility to manipulation when a benchmark is based on smaller number of trades. However, an average taken over a time interval is a noisy estimate of the price at any point of time during that interval due to the random fluctuations in the “true” price driven by information flow. I’ve done some numerical experiments, and either the sampling error/manipulation noise has to be pretty large, or the volatility of the “true” price must be pretty low for it to be desirable to move to a longer interval.

Other suggestions include encouraging diversity in benchmarks. The other FSB-the Financial Stability Board-recommends this. Darrel Duffie and Jeremy Stein lay out the case here (which is a lot easier read than the 750+ pages of the longer FSB report).

Color me skeptical. Duffie and Stein recognize that the market has a tendency to concentrate on a single benchmark. It is easier to get into and out of positions in a contract which is similar to what everyone else is trading. This leads to what Duffie and Stein call “the agglomeration effect,” which I would refer to as a “tipping” effect: the market tends to tip to a single benchmark. This is what happened in Libor. Diversity is therefore unlikely in equilibrium, and the benchmark that survives is likely to be susceptible to either manipulation, or the bricks without straw problem.

Of course not all potential benchmarks are equally susceptible. So it would be good if market participants coordinated on the best of the possible alternatives. As Duffie and Stein note, there is no guarantee that this will be the case. This brings to mind the as yet unresolved debate over standard setting generally, in which some argue that the market’s choice of VHS over the allegedly superior Betamax technology, or the dominance of QWERTY over the purportedly better Dvorak keyboard (or Word vs. Word Perfect) demonstrate that the selection of a standard by a market process routinely results in a suboptimal outcome, but where others (notably Stan Lebowitz and Stephen Margolis) argue that  these stories of market failure are fairy tales that do not comport with the actual histories. So the relevance of the “bad standard (benchmark) market failure” is very much an open question.

Darrel and Jeremy suggest that a wise government can make things better:

This is where national policy makers come in. By speaking publicly about the advantages of reform — or, if necessary, by using their power to regulate — they can guide markets in the desired direction. In financial benchmarks as in tap water, markets might not reach the best solution on their own.

Putting aside whether government regulators are indeed so wise in their judgments, there is  the issue of how “better” is measured. Put differently: governments may desire a different direction than market participants.

Take one of the suggestions that Duffie and Stein raise as an alternative to Libor: short term Treasuries. It is almost certainly true that there is more straw in the Treasury markets than in any other rates market. Thus, a Treasury bill-based benchmark is likely to be less susceptible to manipulation than any other market. (Though not immune altogether, as the Pimco episode in June ’05 10 Year T-notes, the squeezes in the long bond in the mid-to-late-80s, the Salomon 2 year squeeze in 92, and the chronic specialness in some Treasury issues prove.)

But that’s not of much help if the non-manipulated benchmark is not representative of the rates that market participants want to hedge. Indeed, when swap markets started in the mid-80s, many contracts used Treasury rates to set the floating leg. But the basis between Treasury rates, and the rates at which banks borrowed and lent, was fairly variable. So a Treasury-based swap contract had more basis risk than Libor-based contracts. This is precisely why the market moved to Libor, and when the tipping process was done, Libor was the dominant benchmark not just for derivatives but floating rate loans, mortgages, etc.

Thus, there may be a trade-off between basis risk and susceptibility to manipulation (or to noise arising from sampling error due to a small number of transactions or averaging over a wide time window). Manipulation can lead to basis risk, but it can be smaller than the basis risk arising from a quality mismatch (e.g., a credit risk mismatch between default risk-free Treasury rates and a defaultable rate that private borrowers pay). I would wager that regulators would prefer a standard that is less subject to manipulation, even if it has more basis risk, because they don’t internalize the costs associated with basis risk. Market participants may have a very different opinion. Therefore, the “desired direction” may depend very much on whom you ask.

Putting all this together, I conclude we live in a fallen world. There is no benchmark Eden. Benchmark problems are likely to be chronic for the foreseeable future. And beyond. Some improvements are definitely possible, but benchmarks will always be subject to abuse. Their very source of utility-that they are a visible price that can be used to determine payoffs on vast sums of other contracts-always provides a temptation to manipulate.

Moving to transactions-based mechanisms eliminates outright lying as a manipulation strategy, but it does not eliminate the the potential for market power abuses. The benchmarks that would be least vulnerable to market power abuses are not necessarily the ones that best reflect the exposures that market participants face.

Thus, we cannot depend on benchmark design alone to address manipulation problems. The means, motive, and opportunity to manipulate even transactions-based benchmarks will endure. This means that reducing the frequency of manipulation requires some sort of deterrence mechanism, either through government action (as in the Libor, Optiver, Moore, and Amaranth cases) or private litigation (examples of which include all the aforementioned cases, plus some more, like Brent).  It will not be possible to “solve” the benchmark problems by designing better mechanisms, then riding off into the sunset like the Lone Ranger. Our work here will never be done, Kimo Sabe.*

* Stream of consciousness/biographical detail of the day. The phrase “Kimo Sabe” was immortalized by Jay Silverheels-Tonto in the original Lone Ranger TV series. My GGGGF, Abel Sherman, was slain and scalped by an Indian warrior named Silverheels during the Indian War in Ohio in 1794. Silverheels made the mistake of bragging about his feat to a group of lumbermen, who just happened to include Abel’s son. Silverheels was found dead on a trail in the woods the next day, shot through the heart. Abel (a Revolutionary War vet) was reputedly the last white man slain by Indians in Washington County, OH. His tombstone is on display in the Campus Martius museum in Marietta. The carving on the headstone is very un-PC. It reads:

Here lyes the body of Abel Sherman who fell by the hand of the Savage on the 15th of August 1794, and in the 50th year of  his age.

Here’s a picture of it:

OLYMPUS DIGITAL CAMERA

The stream by which Abel was killed is still known as Dead Run, or Dead Man’s Run.

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July 24, 2014

The Stamp of Authority: Definitive Proof that the “Separatists” Are Truly Russian

Filed under: Military,Politics,Russia — The Professor @ 7:24 pm

Stamps. That’s the proof.

Russians are obsessed with stamps. Nothing is official unless it is stamped. The most trivial document must be stamped. Preferably several times.

Stamps have magical power. They transform a simple piece of paper with dry, nondescript prose into something talismanic.

Consider this from a long (and horribly written and edited) WSJ piece on the process of brokering a deal between Malaysia and the mouth breathers of the Donetsk People’s Republic to obtain the black boxes from MH17:

Just after 1 a.m., Col. Sakri signed an agreement with a top separatist official confirming the handover of the black boxes.

The stamp of the National Security Council of Malaysia is misspelled, “Sekurity,” suggesting a hasty effort to fulfill bureaucratic protocol by having the stamp made locally.

I know exactly what happened. The deal was painstakingly negotiated over hours. Then the time for signing came. And the mouth breathers said: “It’s not official unless it is stamped.” The Malaysians looked at one another, then replied: “Stamped? WTF?” “It must have your stamp.” So the Malaysians scrambled around, desperately seeking someone who would make them a stamp. They found Ivan the Stampmaker, who of course would pronounce “c” as “s” and spell a hard “c” with a “k”.  But the mouth breathers didn’t know any better-indeed, they might have been suspiciously of a “c”-and were satisfied. They had their stamp. The deal was well and truly official.

It is absurd. It is Kafkaesque.

It is Russian.

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The EU’s Non-Paper and Its Non-Sanctions Show Europe is Non-Serious About Russia

Filed under: Military,Politics,Russia — The Professor @ 7:01 pm

There was a brief frisson of excitement late last night and this morning, because of a rather startling headline in the FT: “Ukraine Crisis: EU to Weigh Far-Reaching Sanctions on Russia.” Oh joy! Maybe they are actually growing a pair:

The sanctions measure, contained in a 10-page options memo prepared by the European Commission and distributed to national capitals, also proposes barring the Russian banks from listing new issues on European exchanges, preventing them from using London or other EU stock markets to raise funds from non-Europeans.

But the Euros didn’t want to go too far:

The proposal would not initially include a similar prohibition for Russian sovereign bond auctions out of fear the Kremlin could retaliate by ordering an end to Russian purchases of EU government debt, the document states.

These conclusions were based on a leaked document that had been circulated among the member states before a highly guarded meeting held today to consider future measures against Russia.

Then further details came out about the document, and when that happened, frisson was replaced by resignation, and an understanding that the Euros are still short more than a pair: their testicular deficit makes the Greek budget deficit pale in comparison.

As it turns out, the document was what in Eurospeak is referred to as a “non-paper.” (Doc embedded here.) Yes, they have things called “non-papers.” How Orwellian is that?

So just what would a non-paper be? This is what it be:

These surreal-sounding documents crop up quite often in Brussels. Non-papers are discussion documents drawn up either by one of the EU’s institutions or by a Union government. They are designed to stimulate discussion on a particular issue and do not represent the official position of the institution or country which drafted them. Non-papers have no official status, but can be very useful in starting debates on particularly sensitive issues, allowing EU decision-makers to talk about issues they would find it politically difficult to take a firm line on. They can also be used to test the water on subjects without obliging countries to take a stand, thus avoiding potential diplomatic rows.

So, at best, non-papers are the start to a conversation. A straw man proposal to shoot at. The country circulating one does not even really take ownership of what is proposed in it. It’s a “so what do you think of this?” sort of thing.

In other words, hardly an action item on the immediate agenda. And definitely not anything being “weighed” seriously, even in the aftermath of the murder of 298 people, and the ongoing maskirovka invasion of Ukraine. It represents the outer limit of maybe, someday: it doesn’t represent anything likely, today.

So rather than moving on the quite robust sanctions proposed in the non-paper, the Euros moved forward with a flaccid enhancement of its sanctions. While the caskets were being carried off of a transport plane in the Netherlands, the stalwart Euros took a strong stand: they added some individuals and a few non-Russian companies to their list of the sanctioned. In other words, rather than taking the advice of the non-paper and doing something robust, the Euros voted in favor of non-sanctions, thereby proving that they are non-serious.

This is apparently the sort of sanctions that Merkel and others consider “prudent.” Not prudent in the sense of accomplishing anything. Quite the contrary, prudent in the sense of not accomplishing anything, because accomplishing something might make Vlad cross, and we can’t have that, can we?

If this is the most the Euros can muster when the corpses of those murdered are still above ground, just imagine how little they can do when the bodies are finally buried. Actually, I think that the prospect of any serious action against Putin will be interred long before the last poor victim reaches her final resting place.

This ineffectual action (but I give it too much credit by calling it ineffectual; or an action) followed a week of rather sordid bickering between the grandees of Europe. No country was willing to agree to measures which imposed more costs on it than on another EU nation. So when the UK urged France to forego the billion plus dollar sale of the Mistrals, the French refused, and heatedly pointed out that the British were hypocrites because they were not volunteering to do anything that would cut off the flow of oligarch cash into London. This was the diplomatic version of: “Don’t call me a crack whore: You’re the real crack whore.”

But I do a grave insult to crack whores by comparing them to European governments.

(With respect to the Mistrals, note well that the French give the same reason for delivering them as Russia gave for delivering arms to Assad: “we are obligated to perform on existing contracts.”)

This matters not just because the pressure on Putin is reduced if the Europeans go AWOL. It also matters because Obama has made it abundantly clear that he will not get too far out front of the Europeans. Numerous anonymous administration officials were busy peddling that message. Meaning that since the Europeans are doing a little more than nothing, Obama will not say to hell with them, and shame them (if they are capable of shame) by implementing measures that will grievously harm Russia. He will do a little more than a little more than nothing, so they won’t look bad.

Meaning that if Putin’s Botox-frozen face was capable of cracking a smile, he’d be grinning from ear to ear. Because he knows he is living the psychopath’s dream: getting away with murder. 298 and counting, to be precise.

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July 22, 2014

The Sesquicentennial of the Most Compelling-and Perhaps Most Important-Battle of the Civil War

Filed under: Civil War,History,Military,Politics — The Professor @ 8:14 pm

Today is the 150th anniversary of what I consider to be the most compelling battle of the Civil War: the Battle of Atlanta.

I find it compelling because it was a true soldier’s battle that demonstrated the unmatched martial virtues of the combatants, especially those in the Union Army of the Tennessee.

It was a soldiers battle because it was not fought according to any plan. There was a plan, and a rather impressive one on paper, but one that did not even make it to the point of first contact with the enemy. Instead, Confederate General John Bell Hood’s plan dissolved before a shot was fired due to the confusion of a night march, the fatigue of soldiers who had been engaged in combat for virtually every day of the previous two-and-a-half months, and wooded terrain crossed by watercourses and millponds.

Hood desired to reprise Jackson’s flank attack at Chancellorsville, a mere 14.5 months prior. But whereas Jackson attacked in depth, with three divisions one behind the other, Hood’s four attacking divisions were were strung out in a long, scraggly line scattered across several miles of Georgia scrub pine forest. Due to the trials of the march, the forbidding terrain, and the need to make haste, Hood’s divisions (commanded by Bate, Walker, Cleburne, and Maney) attacked mainly as brigades operating on their own hook, only tenuously connected with each other, if connected at all.

That said, they caught McPherson’s Army of the Tennessee in a very vulnerable spot. They were assailed from the direct flank (like Jackson had done to O.O. Howard’s hapless XIth Corps at Chancellorsville) and from the rear and front. Most Civil War armies would have fled when hit in force from flank and rear. But in one of the most sublime displays of soldiership in any war, Grant’s old army did not panic. Indeed, with little direction from any officer above brigade or division level, its soldiers reacted to the situation with aplomb. When attacked from the rear, they faced to the rear and beat off the attack. When attacked from the flank, they refused their lines and repelled it.

Some units, particularly those in the XVIIth Corps, were attacked sequentially from the flank, rear, and front. Resolutely, they responded to each threat. When attacked from the rear, they jumped to the front of their earthworks and beat off the assault, sometimes hand-to-hand. In one of the fights, Colonel Belknap of the 15th Iowa reached over the ramparts to grab Colonel Lampley of the 45th Alabama, wrestled him over the earthworks, and made him prisoner. Lampley had been screaming at his men for not following him. Belknap berated him: “Look at your men! They are all dead! What are you cursing them for?” (To demonstrate that martial prowess does not imply moral virtue, Belknap went on to become a corrupt Secretary of War under Grant. He resigned before being impeached for peculation in the matter of Indian trading posts.)

After being attacked in the rear, when attacked from their (previous) front (i.e., from the direction of Atlanta), the XVII Corps men cooly jumped to the proper side of their works, and easily drove off the attack.

When the Confederates assaulted from the flank, they withdrew stubbornly, fighting first from one side of the trenches, then the other, until they eventually formed on Bald Hill.

There the climax of the battle occurred. In ferocious assaults that continued into the dusk and then into the dark, the Rebels tried time and again to drive the Federals from their redoubt and trenches on the hill. But every time, the Illinoisans, Ohioans, Iowans, and Wisconsin men drove them back.

I am not aware of better fighting on any battlefield of the Civil War, or indeed of any other conflict.

Although the conflict around Bald Hill (sadly leveled by the construction of I-20 in the ’50s) is the most stirring part of the battle, the conflict is better known for the action around the Troup Hurt House. The Union counterattack that drove the Confederates from their lodgment in the Federal lines near that mansion is memorialized in the Cyclorama which is still on display in Walker Park in Atlanta. This was indeed an inspiring action that again demonstrated the sterling qualities of the soldiers in each army, but in my view pales in comparison with what occurred to the south on Bald Hill.

Throughout the battle, Confederates attacked ferociously, and the Union troops responded bravely and cooly, even when caught in the most exposed and dangerous positions. I defy anyone to identify a battle in which such a large number of troops (on the order of 30,000) responded as marvelously as did the troops of the XVth, XVIth, and XVIIth Corps of the Army of the Tennessee.

For the most part, they did this on their own initiative, and the initiative of company, regimental, brigade, and sometimes division officers. Their army commander, John B. McPherson, was shot dead early in the engagement. His replacement, John “Black Jack” Logan, provided inspirational leadership, but his tactical role was modest at best. The XVIIth Corps commander, Frank Blair, was far to the rear (which led many to question his courage).

Soldiers fought. Soldiers extemporized. Soldiers won.

Such individual initiative has been the hallmark of American soldiers since 1775. The Army of the Tennessee boys were recalcitrant soldiers in the traditional sense, resentful of discipline, and disdainful of spit and polish. But could they fight! They never lost a battle.

The Army of Northern Virginia is usually considered the exemplar of American armies in the Civil War, and it was indeed a marvel. But man for man, officer for officer, it could not compare to the Army of the Tennessee, especially at its July, 1864 apogee.

I have a personal connection to that Army. My great-grandmother’s brother, John Hatfield, fought in the 46th Ohio Veteran Volunteer Infantry. This unit was in Walcutt’s brigade of the 4th Division (Harrow’s) of the XVth Corps (formerly commanded by Sherman, then by Logan). It performed the signal service of defending the Union flank and rear against the attack of Smith’s Texas Brigade of Cleburne’s division. (John’s brother, Eli, had his arm shattered at the shoulder by a Minie ball at the Battle of Dallas on 28 May, 1864. My great-grandmother, who died when I was 4, talked of “Uncle Eli with the dead arm.” Medical records in the archives reveal that Eli was shot too close to the shoulder to permit amputation, so the surgeon removed all the shattered bone in his arm from the shoulder to the elbow. Ever after, the arm hung limp at his side.)

It is particularly inspiring to me at times like to consider the heroism of men like John and Eli Hatfield; their fellows in Sherman’s army; and even their foes in Hood’s Army of Tennessee. Some redeeming things came out of the carnage of the red clay hills of Georgia 150 summers ago, and these things were not sullied by craven politicians: indeed, it redeemed many of the errors and sins of the political class of 1860s America. That battle sealed the fate of Atlanta (though 6 weeks of grueling combat were to come before the city fell), which in turn sealed the fate of the Confederacy, for the fall of Atlanta secured Lincoln’s re-election, and thus the ultimate victory of the Union. And of course, that victory extinguished slavery in the United States. To have participated in such a thing is a credit to any man.

Would that today, we living Americans could be worthy of those who bled and died on a scorching day in the red clay of central Georgia, 150 years ago.

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Obama Laying Groundwork Through Leaks of Charging Putin With the Geopolitical Equivalent of 3d Degree Manslaughter

Filed under: History,Military,Politics,Russia — The Professor @ 6:49 pm

There were disturbing, but not surprising, signs today that the Obama administration is backing away from holding Putin & Russia to account in any serious way for the MH17 Massacre.

First, Obama had a call with Dutch PM Rutte while on AF1 on his way to (wait for it!) a West Coast fundraising junket. (You are shocked, I’m sure.) He said that he was “concerned” about continued Russian infiltration of weapons into Ukraine. Not gravely concerned. Not deeply concerned. That is soooo last week. Just, “Concerned”. Prediction: Next week it will be “meh.”

Second, the AP ran this very disturbing article, which describes a briefing by anonymous “Senior U.S. intelligence officials.” They bend over backwards to minimize Russia’s-and Putin’s-culpability:

But the officials said they did not know who fired the missile or whether any Russian operatives were present at the missile launch. They were not certain that the missile crew was trained in Russia, although they described a stepped-up campaign in recent weeks by Russia to arm and train the rebels, which they say has continued even after the downing of the commercial jetliner.

In terms of who fired the missile, “we don’t know a name, we don’t know a rank and we’re not even 100 percent sure of a nationality,” one official said, adding at another point, “There is not going to be a Perry Mason moment here.”

White House deputy national security adviser Ben Rhodes said the U.S. was still working to determine whether the missile launch had a “direct link” to Russia, including whether there were Russians on the ground during the attack and the degree to which Russians may have trained the separatists to launch such a strike.

“We do think President Putin and the Russian government bears responsibility for the support they provided to these separatists, the arms they provided to these separatists, the training they provided as well and the general unstable environment in eastern Ukraine,” Rhodes said in an interview with CNN.

Note the emphasis on stating what we (allegedly) don’t know, not on what we do. Note the use of the word “direct” in discussing the linkage to Russia. Classical defense attorney tactics in creating reasonable doubt about the truth of a top charge, like capital murder.

High level intelligence officials brief the press anonymously for two reasons: (1) to kneecap the administration in opposition to policies they dislike, or (2) to prepare the ground for future administration announcements or actions. The fact that the statements of the anonymous officials dovetail with what Rhodes says, (1) is highly unlikely. The fact that multiple officials are saying this further undermines possibility (1). So (2) it is.

Briefings like this do not occur by accident. They are planned. They have a purpose. And here the purpose is to shape expectations, and to lay the groundwork for Obama (and the Euros) to  move on from the horrid, ugly scenes in Donetsk and back away from any confrontation with Putin.

I therefore predict that within a very short interval, we shall see Obama sally forth, and deliver an indictment of Putin for the geopolitical equivalent of Third Degree Manslaughter: “causing the death of another person either through criminal negligence or through the commission of an unlawful act not amounting to a felony.”

Obama-with the Euros nodding furiously in agreement-will accuse Putin of negligently creating the conditions that led to the deaths of 298 innocent people, but no more. Since this is a mere misdemeanor, no harsh penalty will be demanded. Putin will be sentenced to a period of isolation from the international community, not to exceed six months. Which Vlad will probably consider this a vacation, given how much he loathes pretty much every European “leader,” not to mention Obama.

Note: this is not even a plea bargain. Putin will have to make no allocution. It is a preemptive surrender by the prosecutor.

I predict this result primarily because I believe Obama and the Euros have zero appetite to confront Putin. They can live with the low-level warfare in eastern Ukraine. (Not so low-level for the Ukrainians, of course, who have a much harder time living with it: indeed, they often die with it. But they should look out for themselves, because Obama, Merkel, Hollande, et al are casting them in the role of Czechoslovakia in a gala production of Munich!) Conversely, they blanch at the prospect of going eyeball to eyeball with Putin, even with economic weapons alone.

Of course the Panic! in the Kremlin Disco gang interpret the AP interview as “an unforced error.” A mistake that mis-states administration policy. They are invested in the belief that a steely Obama will force Putin to capitulate in panic.

Deluded fools. Denial ain’t a river in Egypt. I understand Obama and the Euros. More importantly, Putin understands Obama and the Euros. They will run to form. Meaning that they will run.

I do not write this with joy, to the contrary.

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July 21, 2014

Doing Due Diligence in the Dark

Filed under: Exchanges,HFT,Regulation — The Professor @ 8:39 pm

Scott Patterson, WSJ reporter and the author of Dark Pools, has a piece in today’s journal about the Barclays LX story. He finds, lo and behold, that several users of the pool had determined that they were getting poor executions:

Trading firms and employees raised concerns about high-speed traders at Barclays PLC’s dark pool months before the New York attorney general alleged in June that the firm lied to clients about the extent of predatory trading activity on the electronic trading venue, according to people familiar with the firms.

Some big trading outfits noticed their orders weren’t getting the best treatment on the dark pool, said people familiar with the trading. The firms began to grow concerned that the poor results resulted from high-frequency trading, the people said.

In response, at least two firms—RBC Capital Markets and T. Rowe Price Group Inc —boosted the minimum number of shares they would trade on the dark pool, letting them dodge high-speed traders, who often trade in small chunks of 100 or 200 shares, the people said.

This relates directly to a point that I made in my post on the Barclays story. Trading is an experience good. Dark pool customers can evaluate the quality of their executions. If a pool is not screening out opportunistic traders, execution costs will be high relative to other venues who do a better job of screening, and users who monitor their execution costs will detect this. Regardless of what a dark pool operator says about what it is doing, the proof of the pudding is in the trading, as it were.

The Patterson article shows that at least some buy side firms do the necessary analysis, and can detect a pool that does not exclude toxic flows.

This long FT piece relies extensively on quotes from Hisander Misra, one of the founders of Chi-X, to argue that many fund managers have been ignorant of the quality of executions they get on dark pools. The article talked to two anonymous fund managers who say they don’t know how dark pools work.

The stated implication here is that regulation is needed to protect the buy side from unscrupulous pool operators.

A couple of comments. First, not knowing how a pool works doesn’t really matter. Measures of execution quality are what matter, and these can be measured. I don’t know all of the technical details of the operation of my car or the computer I am using, but I can evaluate their performances, and that’s what matters.

Second, this is really a cost-benefit issue. Monitoring of performance is costly. But so is regulation and litigation. Given that market participants have the biggest stake in measuring pool performance properly, and can develop more sophisticated metrics, there are strong arguments in favor of relying on monitoring.  Regulators can, perhaps, see whether a dark pool does what it advertises it will do, but this is often irrelevant because it does not necessarily correspond closely to pool execution costs, which is what really matters.

Interestingly, one of the things that got a major dark pool (Liquidnet) in trouble was that it shared information about the identities of existing clients with prospective clients. This presents interesting issues. Sharing such information could economize on monitoring costs. If a a big firm (like a T. Rowe) trades in a pool, this can signal to other potential users that the pool does a good job of screening out the opportunistic. This allows them to free ride off the monitoring efforts of the big firm, which economizes on monitoring costs.

Another illustration of how things are never simple and straightforward when analyzing market structure.

One last point. Some of the commentary I’ve read recently uses the prevalence of HFT volume in a dark pool as a proxy for how much opportunistic trading goes on in the pool. This is a very dangerous shortcut, because as I (and others) have written repeatedly, there is all different kinds of HFT. Some adds to liquidity, some consumes it, and some may be outright toxic/predatory. Market-making HFT can enhance dark pool liquidity, which is probably why dark pools encourage HFT participation. Indeed, it is hard to understand how a pool could benefit from encouraging the participation of predatory HFT, especially if it lets such firms trade for free. This drives away the paying customers, particularly when the paying customers evaluate the quality of their executions.

Evaluating execution quality and cost could be considered a form of institutional trader due diligence. Firms that do so can protect themselves-and their investor-clients-from opportunistic counterparties. Even though the executions are done in the dark, it is possible to shine a light on the results. The WSJ piece shows that many firms do just that. The question of whether additional regulation is needed boils down to the question of whether the cost and efficacy of these self-help efforts is superior to that of regulation.

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The Dogs of Accounting Have to Hound Putin, Not the Average Oligarch With Dirty Money

Filed under: Economics,Politics,Russia — The Professor @ 6:48 pm

An idea to combat Putin and Russia that is gaining traction is to go after dirty Russian money in places like Londongrad and New York and Switzerland. Superficially it is an attractive idea, but upon further analysis it will be ineffectual, and perhaps counterproductive.

I say this as an early recommender of asymmetric financial warfare against Russia. In the immediate aftermath of the invasion of Georgia almost 6 years ago, I wrote that the US should “cry havoc and let slip the accountants of war.” But I recommended pointing the forensic accountants directly at Putin and his chief henchmen. Now, that would include Sechin, Ivanov, Yakunin, and the like.

Going after oligarchs and minigarchs in Belgravia or other similarly fashionable enclaves would certainly discomfit them, but would hardly cause VVP to lose a minute’s sleep, let alone to tame his aggressive ways. Only to the extent that these individuals are straw buyers for Putin would threatening their assets with confiscation for having been acquired illicitly bother the Russian president in the slightest.

Indeed, going after Russians with large investments overseas could actually redound to Putin’s benefit. The ability to spirit their wealth out of the country is the main protection that rich Russian have against Vlad’s predations. He has been campaigning for “on shoring” of Russian wealth squirreled away abroad: he has a variety of reasons to do so. A vigorous investigation of foreign investments and holdings of Russians would help spur the very on shoring that Putin wants (for others, I mean). I can just see him saying: “Come to Vova!” This would be a self-inflicted wound.

Pressuring Putin requires going after his money, and that of his closest cronies, not the wealth of the Abramoviches or Deripaskas. That said, this is a daunting task, given the labyrinth of shell companies and straw buyers that no doubt connects Putin et al to property, investments, and accounts. Indeed, it is likely the case that there is no document with Putin’s name on it: a verbal agreement, backed by the very credible threat of a serious health or legal problem in the event of breach, may suffice. Or if such a document exists, it is in Putin’s safe. (With all the appropriate stamps, of course: it’s not official without stamps!) These documents would say something like “I, Gennady Timchencko, hold in trust for Vladimir Vladimirovich Putin 40 percent of the shares in Gunvor.” Or, “I, Arkady Rotenberg, do pledge to pay to Vladimir V. Putin 20 percent of the gross revenues from state contracts or contracts with OAO Gazprom paid to my companies.” (Putin would probably prefer dividends to ownership per se.)

Thus, attacking Putin’s wealth will be a challenge, and one that no doubt requires the active involvement of US and other intelligence agencies. Moreover, given that definitive ownership would no doubt be difficult to establish, no doubt the US would have to lean on financial institutions which it has strong, but not definitive proof, are the repositories of Putin’s billions, in order to put those monies at risk.

But that’s where investigative efforts should be directed. Harassing even the most obscene, obnoxious oligarch with the dirtiest money in London or the south of France won’t affect Putin’s  policy in Ukraine or anywhere else in the slightest. It might be psychologically satisfying to do this, but it will be ineffectual at best, and counterproductive at worst.

 

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I’m Battling Confirmation Bias, But Obama and the Euros Make It Damned Hard

Filed under: Economics,History,Military,Politics,Russia — The Professor @ 10:45 am

Last night I said to bet on form, and that Putin would be doing so. And indeed, it seems that everyone is reverting to form.

The Euros are talking tough and angry, but when it comes to actually doing something, pretty much nothing. As is their wont, they are squabbling over how to divide the costs. No major country will agree to sanctions that require it to bear a greater burden than other EU members. So the response is, as usual, driven to the least common denominator. Cameron proposes that future arms sales to Russia be stopped: but that conveniently lets the French proceed with the Mistral sale. Other proposals involve adding a few more names to the lists of sanctioned individuals, but no companies, and certainly no level 3 sanctions.

Perhaps taking a cue from the Europeans, to whom he has largely deferred, Obama spoke this morning and just hit the replay button. Russia risks becoming more isolated. Unless Russia acts to de-escalate, “the costs for Russia’s behavior will only continue to increase.” Yadda, yadda, yadda. A remake ofGroundhog Day, with Obama threatening costs and isolation replacing “I Got You Babe” in the soundtrack.

Check out that last phrase. Note the passive voice. Very telling. Just who, pray tell, is going to impose these costs, and how? God? Santa Claus? More seriously: The “international community”? The “community of nations”? What is the US going to do? What are you going to do, Barry?

There is no way this pablum is going to induce panic in the Kremlin. Quite the reverse. Doesn’t Obama realize that repetitions of vacuous statements unaccompanied by serious action only embolden Putin, and are exactly why we are where we are?

That question was completely rhetorical.

The only people who would panic when hearing such empty statements directed at them are those more timorous and craven than those uttering them. If such people exist.

Another disturbing fact that strongly suggests that Obama is shying away from any robust action. His statement focused disproportionately on access to the crime scene, rather than who carried out the crime itself. Although Obama has hinted at Russian culpability in the past, this statement made no connection between Russia and the shootdown. He just made a brief remark about getting the facts out there and holding people accountable.

Look. The public record makes the guilty party obvious for all to see. Obama, with access to US intelligence sources, certainly knows far more. The fact that he continues to be reticent is damning. Five days after KAL007, Reagan had given a national address from the Oval Office (not a quickie on the WH lawn), laid out in detail the case for Soviet guilt, and played tapes of intercepted Soviet communications. We are five days out, and if anything, Obama is being less forthcoming about US information on Russian responsibility.

The crime scene issue is pretty much done with now, anyways. Moreover, it is relatively easy for Putin to make pleasant noises on this issue, now that his thugs have be in control of the place for 5 days.

Further on the panic meme, this article from Bloomberg has gotten huge play. It claims that the Russian economic elite is horrified by Putin’s course in Ukraine. Maybe they are, but the article just quotes some think tank guy who claims that’s what the business class is thinking.

And it’s not as if it matters. Even if they are horrified, will they challenge Putin? Their silence-not a single one was quoted-speaks volumes. If these individuals united in opposition, perhaps they could threaten Putin. But they show no signs of doing so, and some basic game theory says they almost certainly will not. They face a coordination problem. Who will go first in opposition, and lose everything with virtual certainty?: better to stick with Putin, and take a big hit to one’s wealth but be left with something. Including one’s freedom (and maybe one’s life). Everyone  will play Alfonse and Gaston, letting the other guy go first. Trying to conspire secretly is extremely dangerous, given the inability to trust anyone and the omnipresent surveillance and informants.

So even if the business elite is horrified, and indeed panicked, this means exactly squat politically.

One last thing about playing to form. The Russian Ministry of Defense gave its X-Files versions of the causes of the destruction of MH17. The only thing that surprised me is that they did not blame HAARP, for which they have blamed crop failures, earthquakes, and the loss of a space probe. Maybe they’re holding that one in reserve, just in case the other stuff doesn’t pan out.

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July 20, 2014

There’s No Panic! in the Kremlin Disco Because Putin Has Weighed His Foes and Found Them Wanting

Filed under: Economics,History,Military,Politics,Russia — The Professor @ 9:17 pm

As the evidence of Russian guilt for the MH17 massacre mounts and becomes irrefutable, there is widespread conjecture that Putin has been backed into a corner, and that he and the siloviki may be in a state of panic. Color me skeptical. I don’t sense any panic! in the Kremlin disco.

Of course the massacre creates huge complications for Putin. But he will not even begin to panic until he is confronted with something far more threatening than has come out of western capitals in days since the atrocity.

Yes, there have been expressions of outrage. This outrage has been intensified by the desecration carried out by Putin’s thugs on the ground. But outrage is easy. Action is hard.

Here, the signs are much more encouraging to Putin. Merkel made it plain that she still thought it was essential to maintain good relations with Russia, and did not say anything serious about an increase in sanctions. France and Italy have been almost completely silent. Even the nation that suffered worst-the Netherlands-was still willing to give Putin “one last chance.”

Obama and Cameron may actually be playing the role of B’rer Fox to Putin’s B’rer Rabbit. Obama said the US will not provide arms to Ukraine, and again stated-as if this was necessary-US troops would not be deployed. Moreover, he called for an immediate cease fire in eastern Ukraine.

Well guess what. Putin is adamantly opposed to western arms flowing to Ukraine, and is also calling for a cease fire. Precisely because this would buy time and breathing space for his increasingly beleaguered creatures in Donetsk and Luhansk, and precisely because he knows that the obligations under any cease fire would be enforced asymmetrically, with Ukraine being under much more pressure from the west to conform than  the Russian proxy forces would be.

Meaning that Putin might throw Obama just like he did in Syria with regards to chemical weapons. By agreeing to what Obama has demanded, and which Germany and other Euros have demanded-a cease fire-Putin can defuse the pressure for now, and use the respite to bolster the battered rebels, and to give them time to continue to fortify the territories they hold. So by demanding a cease fire, Obama (and other western leaders) are throwing B’rer Rabbit Putin right into the briar patch.

Cameron demanded that Russia guarantee access to the site where MH17 landed. Putin could well grab at this too, and say that the only way he can do that is if Russian “peacekeepers” move in. This is another thing he’s wanted to do. (There are many pictures of armor in Russia with peacekeeping insignia painted on them.) Again into the briar patch.

But the main thing that Putin needs to do is to stall for time. He is no doubt calculating that previous spasms of outrage have dissipated rapidly, especially when corporate champions in Europe ramp up the pressure on their governments, and that this one will too. He has heard the “last chance” mantra before, and his experience is that each last chance is followed by another one. He knows that the Euros have no stomach for a confrontation, even one conducted purely with economic weapons, and that Obama has only little more appetite.

Even while the bodies remain unburied, Europe is divided over intensifying sanctions. Those divisions will only increase as time passes. And you may rest assured that Putin’s connections and agents of influence in the west are working overtime to exploit those divisions, and stoke the well-established tendencies in western governments to procrastinate and avoid confrontation. He saw it after Georgia. He saw it after Crimea. He has seen it repeatedly in the past 3 months over Ukraine.

Certainly Putin could have done without this. The massacre served no military purpose, and has interfered with his schemes in Ukraine. But it has not created an existential, panic-inducing threat to him or his regime. He views it as a setback, but one that he can manage with his usual mixture of double-talk, pacific gestures, and behind the scenes pressure exerted by his corporate allies in Europe and to a lesser extent the US.

The only thing that has the possibility of inducing anything approaching panic in Putin is for Obama and Merkel and the lesser lights in Europe to upset his calculations by playing against type. Impose crippling sanctions with the promise of removing them if Putin essentially capitulates on Ukraine, rather than threatening to impose more costs if he keeps it up.

That is, all the talk about a cornered, panic Putin is so much wishful thinking. It presumes that the shock of the event has caused western governments finally to see Putin as a monster who must be confronted robustly. There’s no evidence that this is the case even while emotions are running their hottest. And past experience suggests that the image of Putin as a monster can actually work to his advantage, because it makes timorous governments all the more intimidated from confronting him.

I would like to believe that the deaths of 298 innocents has not been in vain, and that their murders will resolve western leaders to do what it takes to confront Putin’s aggression. But I’m betting on form. And I am sure Putin is too.  He has weighed his foes, and found them wanting.

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July 18, 2014

Sanctions: Pinprick or Sledgehammer Blow, With Little In Between

Filed under: Commodities,Derivatives,Economics,Energy,Military,Politics,Russia — The Professor @ 11:27 pm

Before the massacre over Donetsk, the big Russia-related story was the new sanctions imposed on Wednesday. Although those sanctions were overshadowed by yesterday’s atrocity, the wanton destruction of MH17 raises the possibility that more intense sanctions will be forthcoming. Therefore, it is worthwhile to examine what the US did Wednesday to see what would be necessary to impose truly crippling costs on Russian companies and the Russian economy generally. (Forget what the Euros did. That is so embarrassing that it should be passed over in silence.)

The sanctions imposed Wednesday are very weak beer. (Here is an FAQ from the Treasury outlining them.) They were different than previous sanctions in that these were directed at companies, rather than individuals. Moreover, some of the targeted companies are on the commanding heights of the Russian economy: Rosneft, VTB, Gazprombank, and Novatek. (Notable absences: Gazprom and Sberbank.)

Under the sanctions, “US Persons” (which can include US subsidiaries in foreign countries) are prohibited from buying new debt from or new making loans to these companies with maturities of 90 days. (Existing loans/bonds are not affected.)  US persons are also precluded from buying “new” equity from the financial firms: they can buy new equity from Rosneft and Novatek.

Since US banks are major lenders to foreign companies, this might seem to be a major impediment to the affected companies, and indeed  Rosneft’s and Novatek’s stock prices were both down more than 5 percent on the news. But in my opinion, this reaction is more related to how the announcement raised the likelihood of more severe sanctions in the future, rather than the direct effects of these new sanctions.

That’s because although the sanctions will constrain the capital pool that Rosneft and the others can borrow from, other lenders in Europe and Asia can step into the breach. The sanctions do make it more difficult for the sanctioned companies to borrow dollars even from foreign banks, because although the sanctions do not bar foreign banks and investors from accessing the US dollar clearing system for most transactions, they could be interpreted to make it illegal to process the banned debt and equity deals:

U.S. financial institutions may continue to maintain correspondent accounts and process U.S. dollar-clearing transactions for the persons identified in the directives, so long as those activities do not involve transacting in, providing financing for, or otherwise dealing in prohibited transaction types identified by these directives.

Some have argued that this is a serious constraint that will effectively preclude the sanctioned companies from borrowing dollars other than on a very short-term basis. This is allegedly a big problem for Rosneft, because its export revenues are in dollars, and borrowing in other currencies would expose the company to substantial exchange rate risk.

I disagree, because there are ways around this. A company could borrow in Euros, for instance, and  sell the Euros for dollars. It could then deposit, invest, or spend the dollars just like the proceeds from dollar loans because it would have access to the dollar clearing system. Alternatively, the companies could borrow in Euros and immediately swap the Euros into dollars. This is because derivatives transactions are not included in the sanctions, and the payments on those could also be cleared. This would add some expense and complexity, but not too much.

The sanctions even permit  financial engineering that would allow US banks  effectively to provide credit for the sanctioned firms because derivatives on debt and equity of the sanctioned firms are explicitly exempted from the sanctions. For instance, a US bank could sell credit protection on Rosneft to a European bank that would increase the capacity of the European bank to extend credit to Rosneft. Syndication is one way that US banks can get credit exposure to Rosneft and reduce the amount of credit exposure that foreign banks have to incur, and even though the sanctions preclude US banks from participating in syndicates, the same allocation of credit risk could be implemented through the CDS market. This would permit foreign banks to increase their lending to the sanctioned firms to offset the decline of US direct lending. (This would still involve the need to convert foreign currency into dollars if the sanctioned borrower wanted dollars.)

Unlike real super majors (who can borrow unsecured, or secured by physical assets), Rosneft is unusually dependent on prepaid oil sales for funding, and these agreements are almost exclusively in dollars. This has led to some debate over whether the sanctions will seriously cramp Rosneft’s ability to use prepays.

There are a couple of reasons to doubt this. First, after the initial round of sanctions raised the specter of the imposition of sanctions on Rosneft, many prepay deals were re-worked to include sanctions clauses. For instance, they permit the payment currency to be switched to Euros, or to another currency in the off chance that the Europeans grow a pair and shut Rosneft out of the Euro payment system. Again, as long as access to the dollar system is not blocked altogether, those non-dollar currencies could be converted into dollars.

Second, there is some ambiguity as to whether prepays would even be covered. The sanctions specify the kinds of transactions that are covered:

The term debt includes bonds, loans, extensions of credit, loan guarantees, letters of credit, drafts, bankers acceptances, discount notes or bills, or commercial paper.

It is not obvious that prepays as usually structured would fall into any of these categories, and prepays are not specifically mentioned. A standard prepay structure is for a syndicate of banks to extend a non-recourse loan to a commodity trading firm like Glencore, Vitol, Trafigura, or BP. The trading firm uses the loan proceeds to make a prepayment for oil to Rosneft. In return, the trading firm gets an off take agreement that obligates Rosneft to deliver oil at a discounted price: the discount is effectively an interest payment.

The banks lend to the trading companies, not Rosneft. But (except for a small participation of 5-10 percent by the traders) the banks have the credit exposure. So this does not fall under any of the listed categories, except for perhaps “extension of credit.” Insofar as the trading firm is the borrower who faces the banks, it’s not clear the banks fall afoul of the sanctions even though that banks bear Rosneft’s credit risk. What about the trading firm? It’s not a US person, and a prepayment is not explicitly listed as a type of debt under the sanctions: again, this would turn on the “extensions of credit” provision. Under prepays, payment is usually with an irrevocable letter of credit, but these generally have maturities of less than 90 days, so that’s free of any sanctions problem.

So, there’s a colorable argument that prepays aren’t subject to the sanctions. But there is a colorable argument that they are. Economically they are clearly loans to Rosneft, though done via a trading firm acting as a conduit. But whether they are “debt” legally under the sanctions definition is not clear.

But especially in this regulatory environment, bank (and trading firm) tolerance for ambiguity is  pretty low. So the FUD factor kicks in: even though they could make a plausible legal argument that prepays fall outside the definition of debt under the Treasury rules, the risk of having that argument fail may be sufficient to dissuade them from doing dollar prepays. This is especially true in the post BNP Paribas world. So it is likely that future prepays may be in currencies other than the dollar, and as long as dollar clearing is open to it, Rosneft will just have to convert or swap the Euros or Sterling or Swiss Francs or whatever  into dollars if it really wants to borrow dollars. Again, an inconvenience and an added expense, but not a major hurdle.

All this means that the most recent round of sanctions are  sound and fury, signifying not very much. Indeed, by deliberately avoiding the truly devastating sanction, this round signifies a continued reluctance to hit Putin and Russia where it really hurts. Someone like Putin likely interprets this as a sign of weakness.

What would the devastating sanction that was deliberately avoided be? Cutting off altogether access to the dollar clearing system. Recall that the just-imposed sanctions say “U.S. financial institutions may continue to maintain correspondent accounts and process U.S. dollar-clearing transactions for the persons identified in the directives.” Change that to “U.S. financial institutions are prohibited from maintaining correspondent accounts and processing U.S. dollar-clearing transactions for the persons identified in the directives” and it would be a whole new ballgame. This would mean that the sanctioned companies could not receive, spend, deposit, or invest a dollar. (Well, they could if they could find a bank insane enough to be the next BNP Paribas. Good luck with that.)

I discussed how this would work in a post in March, and the Banker’s Umbrella provided a very readable and definitive discussion about that time. Basically, every dollar transaction, even one handled by a foreign bank, involves a correspondent account at a US bank. Cut off access to those accounts, and the sanctioned company can’t touch a dollar.

This would close off the various workarounds I discussed above. The sanctioned companies would have to restructure their operations and financing pretty dramatically. This would be particularly challenging for Rosneft, given that the currency of choice in oil transactions is the USD. This would be like the sanctions that have been imposed on Iran and on Sudan.

This would represent the only truly powerful sanction. And that’s one of the issues. Anything short of cutting off all access to the dollar market is at most an irritant to the sanctioned companies. Cutting off all access imposes a major cost. There’s not much in between. It’s a choice between a pinprick and a sledgehammer blow, with little in-between.

But if a Rubicon hasn’t been crossed now, with the murder of 298 people and continued battles in places like Luhansk waged by Russian-armed rebels, it’s hard to imagine it will ever be. If Putin and Russia are going to pay a real price for their wanton conduct, the sledgehammer is the only choice.

 

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