Streetwise Professor

No, it’s not that both can make you cry.  It’s that if Sen. Blanche Lincoln (D-AR), chair of the Senate Ag Committee has her way, futures trading on both will be banned.  Onion futures have been banned since 1958, and the passage of Public Law 85-839 (legislation spearheaded by Gerald Ford, by the way).  Since that time, onions have had the dubious distinction of being the only commodity in which futures trading is specifically banned.  Now, the draft of Lincoln’s derivatives regulation bill would give onions company, by proscribing futures trading on “motion picture box office receipts, or any index, measure, value, or data related to such receipts.”

Now you could make a case–a weak one, but a case nonetheless–for the onion ban.  There were periodic manipulations of onion futures in Chicago.  Onions are perishable, and short sellers would sometimes bring in a few extra carloads of onions and deliver them.  Due to the perishability, a modest enhancement in supply would crater the price, generating a profit for the futures short.  There are stories that the price of onions would fall below the cost of the bags they were delivered in.

That said, empirical studies of the effects of the ban have shown that the ban did not reduce the volatility of onion prices.  Thus, the ban didn’t have any measurably beneficial effect.  But the CME (where onions were traded) has moved onto other things, and the market isn’t big enough to make it worth anybody’s while to lobby Congress to get the ban lifted.  So it has remained, a quaint curiosity.

Given that movie futures haven’t even started to trade yet, dire stories of adverse effects are, pardon the pun, mere speculation.  But a visible, connected, and influential interest group, that just happens to give Democrats in particular large sums of money, supports a ban.  So it made it into Lincoln’s bill, and into the news, ironically, on the day that the CFTC gave initial approval for such contracts.

But oh, were this the worst part of the bill.  As it is, it is merely a visible, risible, symbol of just how bad the bill is.  I will blog more on it later, but it has all the bad things in the Dodd and Frank bills, and much more to boot; it is the Dodd bill on steroids–or meth.  It is chock-full of anti-bank populism.  Most notably, it precludes any swaps dealer from having access to the Fed window.  As if banks can’t get themselves in financial trouble the old fashioned way, with no derivatives involved.

(It would be interesting to hear an explanation of how, if derivatives dealing is as obscenely profitable as Timmy! and Gensler and various Congresspeople argue, depriving banks of this revenue is going to make them healthier and less likely to require government help.)

Moreover, although the Lincoln bill mandates clearing, and offers only very limited exemptions from the clearing requirement, it also denies clearinghouses access to the discount window.  Even those broadly supportive of wider use of clearing recognize the potential systemic issues, and recommend that clearinghouses have access to central bank liquidity facilities.  But Stella–I mean, Blanche–thinks differently.  (Maybe somebody should tell her about the near death of the CME and CBT clearinghouses on 20 October, 1987.)

Let’s see, Congress  creates systemically important institutions that concentrate risk by mandating clearing, and then deprives them of access to the lender of last resort whose responsibility is to provide liquidity to systemically important institutions in times of crisis.  Just how is that supposed to work?

It was widely thought that Lincoln’s bill would be more moderate than Dodd’s but the reverse turned out to be true.  Some reporting suggests that she was near a compromise with her committee’s ranking Republican, Saxby Chambliss, but that the White House pressured her to back off.  The administration certainly made derivatives regulation a centerpiece of its rhetoric last week, and has evidently decided that anti-bank, anti-derivatives populism is a winning political issue that will put Republicans in an uncomfortable position.  Lincoln is in trouble in her re-election bid, so she could use the populist cred too.

It has all the appearances of a good cop-bad cop routine.  Don’t like the Dodd bill?  Just look how bad the alternative is.   Sad to say, I think that this means that the Dodd bill, or something close to it, is likely to become law.

Andrew is showing some progress.  During the week, the initial prognosis looked a little optimistic.  But there has been a notable improvement in the last 48 hours.  He is periodically awake, and responds to some verbal instructions.  There’s likely a long road ahead, but he is moving in the right direction now.

Thanks for all your thoughts and prayers.

Hewlett-Packard executives are under investigation for bribing Russian officials in 2003 to win a contract to supply computer equipment.  The recipient of the bribe?  Someone (or someones) in the office of the Russian prosecutor general, which was purchasing the gear.  (The WSJ helpfully tells us: “The office handles criminal prosecutions in Russia, including many corruption cases.”)

There is nothing more that needs to be said.

Today was chock full of derivatives-related news.  One big story was that Senate Ag Committee Chair Blanche Lincoln is apparently going to propose a derivatives regulation bill that can best be described as the Dodd bill on steroids, with very few end user exemptions and a strict exchange trading requirement.  You can guess my appraisal of those ideas, but I’ll defer my analysis until something official is released.  I will say now, though, that it is evident that the administration is going full bore with a derivatives crack down.  Obama spoke out on the issue personally today, and Treasury people have been very vocal.  Ugh.

The other big story was that an un-redacted version of the Valukas report was released, revealing the names of the winning bidders for Lehman’s CME positions, and the payments to them.   According to the report, the winning bidders received consideration worth about $1.2 billion dollars more than the liabilities that they assumed.  Valukas argues that the Lehman estate could have a claim against the CME for forcing the liquidation of the positions, and against the winning bidders.

There are several related points that are relevant here.

The first is that Valukas’s valuation was based on settlement prices on Wednesday, 17 September, 2008.  The auction was held on the morning of the 18th.  The positions were large, and there is no guarantee that they could have been liquidated at those settlement prices.  The report details only the values of the options in the Lehman portfolios, based on the previous day’s settle.  This means that it values the futures at zero, meaning that it implicitly assumes that the settlement price hadn’t changed over night.

The SPAN margin values for the positions were large, indicating that the positions were large and risky.  Particularly given the extraordinary conditions at the time, assuming that the positions could have been liquidated at the previous day’s settle is extremely problematic.  Prices were extraordinarily volatile, and they could be expected to get only more volatile in the aftermath of a Lehman bankruptcy.  Moreover, liquidity was drying up, major financial institutions were suffering serious liquidity strains, and could not count on tapping the capital necessary to carry big risk positions.  Given the conditions in the market, it was possible that it would take some time to unwind positions assumed in the auction, and that the winning bidders would have faced considerable risk of loss during that unwind process.  In these circumstances, it was inevitable that firms would assume these positions only at discounted values.  Just how big a discount was warranted is impossible to say given the sparse disclosure in the Valukas report.

Indeed, even with much better knowledge of the positions, given the turmoil prevailing at the time determining the “fair” price to assume such a large position is a difficult and highly subjective exercise.  (Knowledge of the CME GLOBEX order book would be somewhat helpful in estimating market depth, but still any analysis would involve considerable conjecture.)  The SPAN risk numbers are probably a better benchmark than the position marks  that Valukas used to derive his $1.2 billion figure.  The transfer of margin monies exceeded the SPAN requirements by $100 million, but given the exceptional conditions at the time, SPAN is a problematic benchmark too.  SPAN attempts to adjust to reflect changes in volatilities and correlations, but whether it did so in a realistic way on 17 September, given the virtually unprecedented conditions in the market, is open to serious question.  It is quite possible that the bidders had much different estimates of the risk that they were assuming than that generated by SPAN, and bid accordingly.  I would argue that the sophisticated bidders had at least as good information and risk modeling as that embedded in SPAN, and almost certainly better, for reasons I’ve set out in some academic papers over the years.  SPAN also doesn’t explicitly incorporate liquidity risks (i.e., risks related to the time it would have taken to move positions, and the price impact of doing so), but in the conditions at the time liquidity risks were arguably huge, and bidders would have taken that into account.  I would therefore not place too much weight on second guesses based on SPAN.

Suffice it to say that Valukas may be right that there is a colorable claim, but the case is far from proven, and it will be extremely difficult and contentious to prove it.

The second point is that although the replacement risk associated with defaulted positions has received a good deal of attention in OTC markets, it is not absent in cleared markets.  The idea is that in OTC markets, when somebody defaults, its counterparties have to find new firms to take the place of the defaulter.  In stressed market conditions associated with the failure of a major dealer or trader (e.g., LTCM), it is likely that these replacement trades will occur at prices that deviate substantially from the prices prevailing before the default; those stepping in for the defaulter are only willing to trade at far more favorable prices than the pre-default prices.

Well, that’s exactly what happened here.  Goldman, DRW, etc., replaced Lehman as the counterparty on these trades, and were only willing to do so at prices that differed substantially from the pre-auction prices.  In the event, Lehman’s collateral was sufficient to cover the replacement cost (this can happen in the OTC market too), but it is not outside the realm of possibility that the collateral of a big defaulter would not be sufficient, and that other clearing members would be called on to make up the difference.

This should be a cautionary tale for those hot to force a substantial extension of the use of clearing.  Many of the products that are not cleared now, but which would be cleared under mandates, would be less liquid, more difficult to value, and pose risks more difficult to evaluate than currently cleared products like those that Lehman held at CME (and similarly, at LCH.Clearnet’s SwapClear).  As a result, any replacement cost problem would likely be more severe than that experienced at CME in 2008, and the risk that collateral would be insufficient would be greater.

Put differently, just because clearing worked OK (not great) for the futures and futures options at issue at CME with Lehman, does not mean that things would work just as well with an expanded set of cleared products.  Indeed, things would almost inevitably be worse.  The set of cleared products is not exogenously determined: it is endogenous.  The products that are easier to clear are more likely to be cleared now.  Forcing, exogenously by government fiat, clearing of more products which almost by definition are more difficult to clear (and perhaps substantially so) means that the process of handling the next Lehman will be messier than the process of handling the last one at CME.

And think of the spillover effects.  Consider a realistic scenario in which during the next crisis, difficulties associated with positions that are cleared only because of a mandate imperil a big clearinghouse, like the CME’s or ICE’s.  This could impose losses not just on those products, but on the other products cleared, including those that would have been cleared without the mandate.  (For instance, if replacement cost losses on these newly cleared products were so large that the CME clearinghouse’s financial condition were threatened, those trading ordinary futures contracts could suffer default losses too.)

Again, clearing does not make risk disappear.  The experience of CME with the Lehman situation shows that clearly.  Forcing risks that are harder to manage into a clearinghouse does not necessarily improve the safety of the financial system.  It could do the exact opposite, by threatening the safety of clearinghouses that could handle the risks they currently manage, but not the additional, more problematic risks forced upon them.

The third issue relates to the auction process.  CME originally solicited bids from 6 firms, and then in a second round from only 5 (dropping Morgan Stanley because its earlier bids had been uncompetitive.)  Felix Salmon considers this “scandalous”:

Not only was the whole thing utterly unprecedented, it was also far from transparent: only six firms were invited to bid. If the CME was actively trying to get the lowest possible bids it’s hard to think how they could have done better than this, holding a hurried auction in the midst of utter market chaos, with no minimum bids and seemingly not a care in the world about whether Lehman was getting a fair price for its assets. It looks very much as though the CME wanted to hand Lehman spoils to its largest clients, since Lehman itself was clearly not going to be a client going forwards and was in no position to object.

Regarding “unprecedented”–well, circumstances were pretty unprecedented.  Regarding “hurried . . . in the midst of utter chaos”–is Salmon proposing a langourous process, waiting for the market to return to “normal”?  Like, when, exactly?  And what if CME had waited, and Lehman had gone bankrupt, what then?  Would it have been any easier to deal with these defaulted positions?  As if.

Regarding the number of bidders.  Consider the CME’s position.  It didn’t want to jump from the frying pan into the fire, and transfer the positions to another firm or firms that didn’t have the capital to handle the risk thereby assumed.  It wanted to move the positions into firms that it felt could handle them.  (Not that, in retrospect, Goldman and Morgan Stanley were in much of a condition at the time to handle the risk.)  Under the circumstances, limiting the number of bidders makes some sense.

And consider the irony of Salmon’s concern for whether Lehman was getting a “fair price.”  (Just exactly what were fair prices “in the midst of utter market chaos,” Felix?) The whole reason that many–including Salmon–advocate a move to clearing is to protect other financial entities from the knock-on effects of a default by a particular entity.  That’s exactly what CME was trying to do: to protect the other clearing members from the knock-on effects of a default.  Yes, that has distributive effects: to the extent  that the clearinghouse reduces the losses its members suffer, the defaulter’s other creditors lose, dollar for dollar.  But that’s part of the clearing package, as I’ve written repeatedly.  By advocating clearing, you are providing advantages to one set of creditors, at the expense of others.  That may be advisable, if the advantaged creditors are more systemically important than the disadvantaged ones.  But if you advocate that one group of folks should get first crack at the seats in the lifeboats, in the event you really can’t cry over the people left at the rail while the ship goes down.  That’s a predictable consequence of the choice.

One would hope that this window onto clearing as it is, as opposed to clearing in the fantasy land that is DC, would be a revelation to Timmy!, and Gensler, and Dodd, and Frank, and now Blanche Lincoln.  But, alas, one would almost surely hope in vain.

Kyrgyzstan’s self-anointed new government acknowledges that Russia provided support in its overthrow of the Bakiyev government/regime:

Omurbek Tekebayev, a former Kyrgyz opposition leader who took charge of constitutional matters in the new government, said that “Russia played its role in ousting Bakiyev”. (From the Telegraph.)

. . . .

Kyrgyzstan’s self-proclaimed new leadership said on Thursday that Russia had helped to oust President Kurmanbek Bakiyev, and that they aimed to close a U.S. airbase that has irritated Moscow. (From the Globe and Mail.)

The most public evidence of support was a propaganda offensive by state controlled Russian media against Bakiyev in recent months.  What additional support was provided can only be surmised, but the confirmation from the new government/regime makes it more than likely that Russian complicity didn’t start and end on TV.

All of which means that Putin’s (excuse me, “your humble servant’s”) denial of any Russian involvement was a transparent lie.

And, it was likely intended to be a completely transparent lie.  Putin, domestically, in the near abroad, and the further abroad (e.g., Washington, DC) wants it known that Russia is playing for keeps in the Great Game.  The non-denial denial is just the way that game is played.

The response of the US administration seems even more halting and clueless than usual.  I know the administration has been criticized for it turning a blind eye to Bakiyev and thereby setting itself up for this problem.  But what was the alternative?  I ask that question seriously: before judging I’d like to know what the choices were.  This is a part of the world where “meet the new boss, same as the old boss” is a daily reality, rather than just a line from a rock anthem. Moreover, there is no doubt that Russia definitely has home field advantage in that part of the world, and if the US was less than pristine in its dealings with the Kyrgyz government, Russia is clearly willing to use even dirtier gambits to get its way.

That said, the administration should have been better prepared.  It’s not like this should be a bolt from the blue.  But it seems that there is genuine surprise.  It certainly seems that there is no coherent response or countermove.

It is particularly telling that at the very time that Medvedev and Obama were playing BFFs in Prague, a member of Medvedev’s entourage stated that Russia expected that Manas would be closed.  The response from the administration?  [Crickets chirping.]  I bet they howl in Moscow about what a chump Obama is.

And Russia is playing him perfectly.  Medvedev (who doesn’t matter) slobbers over Obama, playing on his constant need for narcissistic reinforcement.  While Obama is thereby manipulated into believing that he and Medvedev are pioneering new achievements in Russia-US relations, Putin, who does matter, is relentlessly implementing his vision of Russia’s national interest.

Can we get Jimmy Carter back?  I say that only partly in (mordant) jest.  At least Jimmah wised up eventually.  This lot?  Such a revelation is not in immediate prospect.

As derivatives legislation wends its way through the Senate, with the Dodd bill and another being written in the Senate Ag committee, the battlelines are pretty well drawn.  The administration in particular is still on the clearing bandwagon, and is overtly hostile to any proposals to exempt end users from the clearing requirement.  The most strident rhetoric on this issue emanates from Gary Gensler (go figure), but also from Treasury.  Deputy Treasury Secretary Neal Wolin said: “we will oppose all attempts to create loopholes or carve-outs.”

By “carve outs,” he is referring to end user exemptions, primarily.  Which is all so ironic.  If you think through how clearing works in futures markets, it is primarily a mechanism to shift default risks from end user customers (the buy side) to the clearinghouse members.  That is, it is a customer protection institution.  But here many customers are adamantly opposed.  Thus, there must be some costs that offset–and indeed, more than offset–the benefits associated with this customer protection.

But instead of an effort to step back, and ask “why” and consider in an intellectually serious way what are the costs and benefits of clearing, the administration and many on Capitol Hill plunge ahead.  When they attempt to explain end user opposition at all, they stoop to asinine conspiracy theories.  Gensler, for instance, attributes the end user opposition to their being waterboys for the dealer banks.

Yeah, Caterpillar, etc., are just creatures of the banks.  Whatever, Gary.

But this is all so odd.  Gensler argues that the dealer banks routinely rape their customers, by exploiting the purported lack of transparency in the OTC market to extract supercompetitive spreads.

So, why would the rape victims (in one of Gensler’s narratives) be the willing supplicants of the banks (in another)?  Stockholm Syndrome?  Battered Spouse Syndrome?

Can we please have a serious discussion, with some serious analysis of trade-offs, rather than these dueling, and facially inconsistent, morality tales?

Yeah, I know.

But I will say that in Europe they are being far more serious and adult.  (And it kills me to have to say that.)  For instance, Jeremy Grant reports that European regulators recognize the legitimacy of end user concerns:

Industrial companies have won recognition from European regulators that they should be granted exemptions from sweeping regulation of the over-the-counter derivatives markets.

It marks a partial victory amid fears that a crackdown on off-exchange derivatives markets, blamed by some for exacerbating the financial crisis, could unfairly penalise corporate users of such instruments.

. . . .

In a “discussion paper” from the European Commission’s directorate general for internal markets, regulators say that “in principle, non-financial institutions could be exempt from the clearing obligation”.

It says the main mechanism for transferring risk to the real economy during the crisis was through the financial sector. “This suggests that the appropriate boundary for a clearing obligation is between the financial sector and the non-financial sector.”

Richard Raeburn, chairman of the European Association of Corporate Treasurers, said: “This suggests that [the Commission] supports the need for an exemption for non-financial users. It is certainly the first time that we’ve seen such a clear statement.”

Eact in January sent a letter to Brussels, signed by 160 companies, warning that without exemptions there could be “a reduction in the amount of funds allocated to productive investment in the [European] economy”.

Just how to structure the exemption is still under discussion.  But at least there is a recognition that there are serious issues that deserve serious discussion.

Could somebody in Europe pick up the clue phone and give Gensler and Wolin and Dodd a call?

Grant also reports that the Europeans recognize that clearing is not the deus ex machina that will descend from the heavens and solve all the systemic risk problems.  Indeed, they understand that clearinghouses can create systemic risks, and hence it is advisable to proceed carefully in ordering a new market structure by fiat:

Watchdogs are concerned about the possibility that proposed linkages between clearing houses could pose fresh dangers to the financial system.

They fear two-way or three-way linkages between clearers could trigger a domino effect if one clearer was to default.

What?  You mean that clearing doesn’t eliminate interconnections in the financial system?  Who knew?  (I know who doesn’t know, sad to say.)

In fact, contrary to the bologna constantly ground out by Timmy! and Gensler et al, clearing creates a particular interconnection among financial institutions–the same financial institutions (by and large) that are too interconnected today in the OTC market.  Multiple clearinghouses creates another set of linkages.  These can by systemically problematic.

The Europeans haven’t sorted through all these issues yet.  But at least they recognize them.  We, alas, are governed by know nothings masquerading as know it alls.

Which suggests a new administration spokesman on derivatives market regulation.

The overthrow of the government in Kyrgyzstan has opened another chapter in the saga of the Manas airbase used by US forces to resupply operations in Afghanistan.  Certainly the corruption of Kyrgyz President Kurmanbek Bakiyev, and the sharp geographic division in the country, gave plenty of reason for his violent overthrow.  But Bakiyev also gave Putin and Russia plenty of reason to support his violent overthrow too.  Putin had thought that he had bought Bakiyev’s promise to close Manas, but in that part of the world people don’t stay bought for long.  After taking Russia’s coin in exchange for his agreement to close the base, Bakiyev turned around and gave the US a new lease.  I would give better than even odds that by sealing that deal, he sealed his fate.

Of course, we will never know for sure, but Russia is certainly the major beneficiary of his fall.  The new Kyrgyz government immediately high-tailed it to Moscow, and expressed its fealty.  The new government has raised questions about the base’s future.  A Russian official accompanying Medvedev’s delegation to Prague for the signing of the new START deal indicated that Russia expected the base to be closed.  (How’s that reset working out for us, Barry?)  Russia recognized the new government within hours–suggesting that it knew all about the new government before it was even a new government.  (In contrast the US and even the Chinese were caught flatfooted by the change.)  Not dispositive, but all pointing in the direction of Russian involvement.

But what clinches it for me is Putin’s statement: “Neither Russia, nor your humble servant, nor Russian officials have any links whatsoever to these events.”  Humble servant–gag me.  No, this sounds like typical Putinesque wink-wink, nudge-nudge irony, meaning that one should believe the exact opposite.

Removing the US from Manas, or even constraining its use of the base, will crimp our operational capabilities in Afghanistan.  Which makes Russian whinging (yeah, so what else is new?) about the US’s/NATO’s failure to crush the Afghan opium trade all the more outrageous.  Russia has an addiction crisis*and the flow of drugs into the northern Caucasus from Afghanistan is helping finance the insurgency in the region–which, of course, is not limited to the region as the Moscow bombings attest.

So, since opium is such a scourge in Russia, you’d think that Russia would want to do everything possible to help the US and NATO in Afghanistan, right?

Yeah, right.  What happens to Manas, and how Russia is involved in that process, will speak volumes.  I expect that Manas will be closed, and that long-promised Russian logistical assistance will remain just that–a promise.  All the wailing and moaning about the opium problem is just another stick to beat the US and NATO with: the typical Russian refusal to take responsibility for its own failings; the typical Russian compulsion to blame others; and the typical Russian opportunistic tendency to exploit human misery to score some geopolitical points.  Given a choice between reducing the Afghan drug problem and handing the US a defeat (or a bleeding ulcer of a commitment), and a defeat in the Great Game no less, Putin et al will choose more junkies every time; especially since he’ll be able to gull enough of the sheeple in Russia to believe that’s the American’s fault too.

* Why do I have this feeling that a comment or comments will soon appear claiming that the accounts of an addiction problem in Russia are vastly overblown.  That everything there is just great!  After all, the birth rate is up, dontcha know.

The death of Polish President Lech Kaczynski, along with his wife and a large number of Poland’s political and economic elite, is replete with irony.  A Polish patriot, deeply suspicious of Russia and intent on freeing his country (and the wider region) from Russian domination, he died in a Russian aircraft built by the successor to the Soviet Tupolev design bureau while landing in Russia to commemorate the deaths of over 20,000 Poles at Soviet hands in Katyn. Poland and Russia, still inextricably intertwined, and almost never in a happy way.

The Tupolev TU-154 aircraft which crashed has the world’s most appalling accident record, but initial reports suggest pilot error rather than mechanical failure was responsible.  That said, the unseemly haste with which the local Russian officials in Smolensk immediately laid the blame on the pilot does not inspire confidence that the crash inquiry will be thorough and objective.  A joint Polish-Russian team should perform any investigation.  Russia should welcome Polish participation; given Kaczynski’s implacable opposition to Russia, his antagonism with Putin (who had pointedly invited Polish PM Tusk rather than Kaczynski to attend the Katyn commemoration), and the longstanding suspicions of Russia within Poland, conditions are ripe for conspiracy theories.  That’s the last thing anyone needs right now.

Kaczynski’s death does not come at an opportune time.  (No, death never does, but there are some times that are less opportune than others.)  Russian truculence, American and European fecklessness, and economic turmoil, added to the weight of centuries of history, have made a volatile region even more so.  Although Kaczynski’s post was a ceremonial one, his passing, and the deaths of so many top Polish officials, will inject uncertainty into the country’s politics.  And more uncertainty is not what Eastern Europe, and the world, need right now.

This blog is hosted by my brother-in-law, Andrew.  He was recently diagnosed with a massive brain aneurism, and yesterday (and into the early morning today) he underwent 14 hours of surgery.  The initial prognosis is good, but all prayers are welcome.

Andrew is a remarkable man.  He’s intelligent, creative, hard working, and inquisitive.  He’s done many things in his life, from art to sales to web design to food service.  He’s a pretty amazing autodidact, having just written a book on the evolutionary origins of autism, amongst other things.  An online version is here.

It would be the understatement of the century to say that Andrew and I are worlds apart politically, and in worldview.  But we get along quite well because he is truly tolerant, tries to understand, and does not personalize difference.  We debate, we disagree, but we respect.  Would that more were like him.

My prayers are with you Andrew.  Get well soon.

The most recent derivatives/speculation kerfuffle involves something novel—futures contracts on movie box office receipts.  Two entities, Cantor Fitzgerald and Movie Derivatives, Inc.  have announced plans to introduce such contracts.  The film industry is in a tizzy at the prospect, and has enlisted the help of the usual anti-speculation suspects on Capitol Hill.

The virulence of the reaction is interesting, and deserves explanation.  Here’s my initial stab at the problem.

The most likely effect of the introduction of this contract is that it will facilitate “box office discovery.”  That is, information about the likely success (and quality) of a movie prior to its release will improve.  This will occur because those with private information about films, and those who can better utilize public information to predict a film’s performance, will be able to trade on this information.  The resulting price will aggregate this information, leading to more precise predictions about box office receipts.

Moreover, and crucially, potential filmgoers can utilize the information in the prediction to choose which movies to attend.  If the predictions are good signals of quality, they will have a certain self-fulfilling feature: bad (good) movies will have low (high) contract prices, which will result in low (high) attendance.*

At first blush, this sounds great, but it may not be good news for film producers, distributors, or theaters.  To fix ideas, consider this simple model.  Assume that when movies are released, there is no information that allows potential patrons to determine which movies are good, and which are bad.  Making their decision about which films to view from behind this veil of ignorance, consumers will randomize, and all movies will earn (roughly) the same revenue when first released.  Subsequently, word of mouth and other information will lead to revelation of the true quality of movies, and good (bad) movies will earn high (low) revenues in the weeks after release.

Thus, ignorance effectively reduces the variability of film revenues in the first days after release.

With better information, available immediately upon release due to the existence of a market, however, good (bad) movies will earn more (less) right off the bat.  Thus, one would expect that the variability of receipts will increase due to the new derivatives.  This will make risk averse firms and individuals who are long a piece of the revenues worse off.  (Diversification across films is one way of addressing this risk, but due to the nature of the business, diversification possibilities may be limited.  Nonetheless, it would be reasonable to expect an increase in diversification, perhaps through consolidation of producers, distributors, etc., and perhaps through expansion of equity-like sharing relationships.)

Of course, there is already some information about film quality that is available to consumers before release, so the above characterization is extreme.  Nonetheless, to the extent that the new derivatives improve information, the variability of receipts soon after release should increase.

This revenue risk increasing effect could explain the hostility of the industry to the innovation.  Against this, it could be argued that the contracts would permit hedging.  I am skeptical, however, that these contracts will become sufficiently liquid to make hedging practical.  Virtually the entire industry is long; there is nobody who is short receipts.   This natural hedging imbalance would require substantial speculative participation to offset.  Moreover, given that movies are heterogeneous and relatively numerous, no single benchmark can emerge that can serve as a liquid hedging and speculative market the way that CBT corn or NYMEX WTI can.  Put differently, basis risk is huge here, almost by definition.  The fragmentation of the market is antithetical to liquidity, and without liquidity hedging won’t thrive.  That is, the market is likely to remain a fringe, boutique market that generates valuable information that increases the riskiness of producing and distributing films, but does not work as a hedging mechanism.

There are other potential sources of opposition.  In particular, incumbent producers of information do not like competition from a new source.   The incumbent producers of information include studio marketing departments, advertising firms, and the trade media.

In brief, the angry response is quite understandable.  Film derivatives will likely gore many quite wealthy and well-connected oxen who are quite adept at self-promotion.  Indeed, it’s hard to see a natural constituency that would favor them.

It is also consider the effects of better information resulting from a market on the allocation of resources.  One effect will be to lead a better match between moviegoers and movies (i.e., fewer disappointments).  This is beneficial (and would tend to increase the demand to see movies, because there will be lower risk when choosing which movie to see, which would be something of a benefit to the industry.)  Moreover, it could influence the incentive to increase quality, through, for instance, greater selectiveness in choosing projects to produce, and greater effort to ensure quality during casting, filming, etc.   In my veil of ignorance story, movie quality is essentially in the public domain at release, reducing the value of quality internalized by producers (opening revenue is based on expected quality, not the quality of any particular film).  Finally, there is always the possibility that the ability to trade on information leads to rent seeking, as is true of any market; the social value of private information does not necessarily match well at all its private value.   (I won’t go into manipulation possibilities here.  Most of the horror stories told about this seem overblown.   Very Hollywood, in fact.)

My story has some empirical implications.  It implies that the variability of movie receipts (in the cross section) in the days after release should be higher with derivatives than without them.  It also implies that the variability in receipts in the time series should be lower, because the disparities in information about film quality will be smaller over time with derivatives.  These effects should be more pronounced, the more informative the derivatives prices (net of any effect that their introduction has on the amount of information produced from traditional sources, which should decline due to the new source of information.)

All in all, this will be a fascinating experiment on the informational effect of the introduction of a new market.  If, that is, the powers that be don’t strangle it in the cradle.

* One could argue that this self-fulfilling effect could lead to a perverse outcome.  Let’s say that all trading in the new derivatives is noise trading, and the prices are uninformative, but moviegoers think they are informative.  Then they will go to movies with high derivatives prices, and avoid ones with low prices.  Voila—the uninformative prices look informative ex post.  I doubt that this will in fact occur, however.  Post release, word of mouth and other sources of information will exist, which will permit an ex post evaluation of the accuracy of the derivative price predictions of movie quality.  If consumers learn that the prices are in fact poor measures of quality, they will not rely on them to choose what new releases to attend.