Streetwise Professor

Reuters reports that Putin’s meeting in Norilsk in August put the end to any talk of the Rusal plan to pay an extraordinary dividend.

Imagine that.  The head of government dictating a company’s dividend policy.  That would never happen here.

Except it did–with BP.  And we also have a government that controls executive pay in some companies, and invalidates the contractual rights of some parties in bankruptcy in order to benefit a politically favored group.

This kind of thing works so well in making Russia a haven for investment.  I’m sure it will do wonders here as well.

News reports out of Russia state that the most recent test launch of the Bulava SLBM was a success.

Let’s see if they can make it two in a row.

This is a big deal, though, because more failures would put the program in jeopardy of cancellation, or at least a complete makeover.  This, in turn, would make the most modern Russian boomer fleet units useless, because their tubes are designed specially for the Bulava, and Russia’s other SLBM (the liquid fueled Sineva) will not fit in the new subs’ missile tubes.

I read Information Dissemination, a Navy blog, with some regularity.  It provides some very detailed analysis of important issues that don’t make the papers.  It is particularly good in discussing some of the shocking issues relating to procurement, and especially shipbuilding.  When it veers into politics and policy, it is pretty pro-Obama, but not to a KoolAid drinking extent.

A couple of days, ago, though, I was pretty dismayed at ID.  In discussing how the major players came off in Woodward’s book, this is what it had to say about Obama:

Barack Obama–The portrayal of the President is a generally positive one–I can’t recall having read a single devastatingly negative comment about the President in this book (other than Vice President Cheney’s “dithering” about the Afghanistan decision comment, which was made publicly)–which could be a sign that he did not warrant any, or it could be a sign of author bias.  The President seemed to demand a logical and thorough decision making process, and he appeared to be engaged, educated, and in charge.  He was however, operating moreso as a political figure in the NSC meetings than he was as Commander-in-Chief.  Careful not to reveal his political cards, it was clear that his frustrations with the options given were driven by electoral time-lines and their impact on other domestic legislation.  I don’t fault him for this–he’s a political figure with a number of policies and programs to balance.  I do however, strain to find any evidence in this book of a Presidential will to “win” this conflict, or even to see it in terms that can be described as “success oriented”.

If this is a positive portrayal, I’d hate to see a negative one.  The blogger, Bryan McGrath, basically concedes the entire bill of particulars that the president’s critics (neocons in particular) have advanced: he was driven by politics in his meetings with his National *Security* Team; his actions in Afghanistan are “driven by electoral time lines” and their domestic political implications; he has no will to win; and indeed has no real desire to achieve success.  Translation: Afghanistan is a distraction from his transformative domestic agenda and an annoyance that he wants to put behind him at any cost.

McGrath defends Obama by saying that the president is just a politician, and that’s what politicians do.

Sorry, Bryan, but that doesn’t come close to cutting it.  A President needs to recognize the grave responsibilities of being Commander-in-Chief.  Lives–American lives, Allied lives, Afghan lives–hang on his decisions.  He needs to recognize that the responsibility for the lives of American servicemen and women, and for the security of the nation, transcend partisan political goals.  (And the “policies and programs” and “domestic legislation” were clearly partisan endeavors, for which Obama is now reaping what he sowed.)  This is the most important part of the job, period, and if you don’t like it and don’t want those responsibilities, you should not take the job: Commander-in-Chief is Job 1 in Article II of the Constitution; you know, the part that says what the President is supposed to do.  We shouldn’t have a Commander-in-Chief that views national security and the lives of those under his command as a political inconvenience.

We’ve seen this movie before.  It starred Lyndon Baines Johnson.  If you don’t remember, it didn’t turn out well.

Russia has announced plans to curb foreign borrowing, and to oversee the foreign financing of big Russian companies (h/t LR):

Russia is limiting access to the Eurobond market to prevent a repeat of the surge in foreign- currency indebtedness that triggered company bailouts in 2008 as borrowing costs tumble.

The government created a group last week to monitor overseas debt by state companies and “systemically” important financial institutions. OAO Gazprom, Russia’s largest company, and diamond monopoly ZAO Alrosa are among state-controlled borrowers planning their first Eurobond sales in at least a year as the economic rebound sends yields to a record low.

“Issuance by major borrowers at the same time could destabilize and worsen market conditions,” Deputy Finance Minister Alexei Savatyugin said in an interview on Sept. 30 after his appointment to head the Inter-Agency Working Group for Monitoring the Conditions on the Financial Market.

This reflects a couple of related factors.  First, it is an admission by the Russian government that it cannot pre-commit not to bail out big Russian companies, like Rusal or Severstal in the event of another financial crisis.  In particular, it cannot precommit not to bail out, when the failure to do so would result in these companies falling into the hands of foreigners.  To limit the potential demand of these companies on the public purse ex post, the government believes it necessary to control their foreign borrowing ex ante.

Second, this may be part of an effort to bolster Russian banking and capital markets.  Historically, due to the underdeveloped nature of Russian financial markets, foreign currency earnings (primarily from commodity exports) have flowed to foreign banks, where they are then directed back to Russia in the form of loans or direct investments.  Medvedev in particular has made plain his desire to foster the development of Russian financial markets, and limiting access to foreign finance is one way of doing that.  I am skeptical that this force feeding will work.  The underdevelopment of Russia’s financial markets is fundamentally a structural problem, driven by the lack of the institutions (property rights, contractual rights, investor protection, rule of law) that are necessary for financial markets to work properly.

The announcement provides a glimpse of the reasons why investors are always jumpy whenever the Russian government sticks its nose into the markets:

The advisory group may cause concern because of the potential for the government to meddle in company plans, said Neil Shearing, a senior emerging-market analyst at Capital Economics in London.

“Everything will depend on the implementation,” Shearing said. “Greater state involvement always starts red warning lights flashing in this regard.”

Ya think, Neil?

These institutional weaknesses, and their effects on the Russian economic environment are reflected in this story from the FT’s Beyond BRICs blog:

Emerging markets are starting to resemble pole-vaulters who, no matter how high the bar is raised, jump over it effortlessly. Back in April, the Institute of International Finance – a global club of banks – had predicted private capital inflows to emerging markets would total $709bn this year; it now recognises emerging markets will pass that level with ease. So the IIF has raised the bar: its new estimate is $825bn – that’s $116bn higher.

However, while the greatest pole-vaulters were Russian, the most favoured emerging markets are certainly not. Russia will actually receive less capital inflows than initially thought – with Russian stocks attracting barely half of what was predicted in April.

The IIF estimates that inflows into Russia will be $67.5bn this year, down from $72.4bn estimated in April. Russian equities, which were expected to bring in $12.5bn, will now account for just $6.7bn of the total.

The explanation?  I’m glad you asked:

The explanation, says Philip Suttle, chief economist at the IIF, is two-fold. On the one hand, Russia’s economy continues to suffer from state intervention and dubious governance. On the other, the extent of the country’s own boom and bust – with banks suffering from having granted excessive consumer credit – has been overlooked.

As a result, optimism that a firming oil price would bring foreign investors into Russia appears to have been misplaced. It appears that, however often analysts say Russian equities are attractively priced, few foreign investors want to move first.

Yes: institutional weakness and the residual effects of a financial crisis that hit Russia harder than just about any G-20 nation.  To which I would add the realization, based on recent experience, that the country is still uniquely vulnerable to another such shock.  Given the shakiness of the developed world economies, the probability of such a shock is bounded well away from zero.  (For instance,  look out for the effects of the ongoing foreclosure firestorm–it could crater banks worse than the original crisis, or force the government into an extraordinary HAMP/TARP-on-PCP bailout.)

Foreign direct investment was an important contributor to Russia’s 2000-2008 growth, especially in 2005-2008.  It has gone, and not come back.  The above report indicates that it is unlikely to come back anytime soon, even though other BRIC countries are worrying about too much money flowing from overseas.

And about that “Russian equities are attractively priced” bit.  Yes, Russian equities are cheap.  They are cheap for a reason: the risks of investing there are huge. Thunderbird is cheaper than Romanée Conti.  Quality matters.  You get what you pay for.

Investor angst over Russian government interference was plainly evident at the Russia Calling! forum sponsored by VTB. [Russia calling?  Sorry.  Wrong number.  Nobody home.  We don’t want any.  Whatever I have to say to make you go away.]  Julia Ioffe describes the Q&A that Putin endured–barely:

Someone asked about a corrupt court decision — said to have been worth some $300 million — and Putin, who tends to say nothing about the extremely independent Russian judiciary — promised to look into it. Someone asked about the privatization of a chunk of VTB. Someone asked about Gazprom’s market capitalization.

Then a lady got up, and asked Putin to address the fact that, “all the investors I meet with have big concerns, and they see that when the [Russian] government enters [into a deal/holding/etc.], the share price falls to nothing.” The conference, after all, was partly to convince foreign investment to come back to Russia, which it hasn’t really done since many billions fled in the fall of 2008.

Putin tried to convince her that that was not the case, that they sold out of enterprises like that for money. That the arrival of companies like Transneft (state oil transport concern) was good for them.

Lady: “Are they scared of you?”

Putin: “There’s no need to be scared of us.”

Then the lady brought up Yukos and the whole room froze. “There’s no meeting that goes by,” she said, “where investors haven’t asked about it.”

“Yukos is a special case,” Putin thundered, suddenly losing his jokey, back-slapping demeanor. He was pissed. Seriously, seriously pissed.

Ah, yes, the Pavlovian Putin, who begins salivating like a rabid dog at the very mention of Yukos and Khodorkovsky.  [That woman questioner has brass–kudos to her!]

Putin may not like it, but those kinds of things live on in memory.  Putin actually doesn’t make things any better by putting Khodorkovsky on trial again (his lame assertions that he didn’t even know there was a second trial being completely risible).  Putin mentioned that “it had been proven by a court” that Yukos’s security head had been involved in murder.  Even if this is true, has Khodorkovsky ever been charged, let alone convicted of this of this specific offense?  Even in a Russian kangaroo court?  No.  So shut up about it.

Look, if Putin gets “pissed” because Khodorkovsky is a martyr, he has no one to blame but himself now, for Putin has consciously extended his martyrdom indefinitely.  It is a testament to how much Putin hates–and likely fears–Khodorkovsky that he continues the relentless prosecution even though it undermines his goal of attracting more investment to Russia.  Ditto Browder and the egregious official response to the Magnitsky affair.

You know, Vladimir, you reap what you sow.  The years of expropriation, theft, and corruption have left their mark in the minds of foreign investors.  I don’t see any way for Russia to erase that mark any time soon.  It will definitely not happen as long as Putin and the siloviki are in the saddle.

This article (now gated, unfortunately) makes some spot-on points about the regulatory train wreck to come.  In particular, it makes pretty clearly a point that I’ve written about a few times here on SWP: namely, that all of the mom-and-apple-pie paeans to transparency are simpleminded, and fail to take into account substantial variability across instruments and the people who trade them.

He article quotes Mary Schapiro, and then goes off on her with some tart sarcasm, and justifiably so:

The challenge for the SEC, as Schapiro sees it, is to “cultivate” a market structure for security-based swaps “that reflects the virtues of the current equities market: competition, access, liquidity and transparency.”

We should be grateful to Schapiro for this insight [I can sense the snark coming!], but it is alarming rather than reassuring exactly what way the equities market is similar to and should serve as the blueprint for a new derivatives industry is, at this stage, somewhat mystifying to all except the SEC [yup, right on cue–very British snark, too.]

She went on to say that incorporating the same degree of transparency that exists in the equity market will produce greater liquidity and lower transactions costs.  To enhance this transparency, all security-based swap trades will be reported immediately in real time.

The regulators are very keen on transparency at the moment, but whether this will result in lower costs and greater liquidity through all aspects of the derivatives market is not proven [by a long shot, surely].

Author Simon Boughey then discusses the single name CDS market particularly, providing an interesting case study of a Gaz de France bond hedge.  He concludes by saying:

If the regulators make a god of transparency, then this sort of trade would result in great transaction costs rather than lower ones, transaction costs that will be passed on to the customer and ultimately to the shareholder

Hear, hear.

The CFTC’s Gensler, of course, is as bad–or worse–an offender as Schapiro when it comes to overselling the virtues of transparency and trading on centralized markets.  Who can forget his apple metaphor?  (Believe me–I’ve tried.)  (Though it is interesting to note that Gensler has deigned to consider the possibility that voice brokering “may be OK” on block trades, although he’s still all hot for real time reporting and transparency.)

Both Mar’ and Gar’ are regulatory versions of Procrustes, trying to jam all trading of all types of instruments for all types of counterparties into a single model: centralized markets with extensive pre- and post-trade transparency.

It is sort of amazing–scary, but amazing–to try to reverse engineer their mental models of the financial markets.  The markets as we know them have evolved a variety of trading mechanisms.  These mechanisms vary pretty systematically by instrument, and the kind of firms that trade them.  Equity markets are different from FX are different from corporate bonds.  There are even differences within categories: there is a diversity of order execution mechanisms in equity, for instance.

How do Mr. and Mrs. Procrustes explain these variations?  Is it all just random to them?  How can that be?  Have they ever tried to test their randomness hypothesis?  Have they considered alternatives, like, oh, I don’t know, maybe that under the pressures of competition and the drive to reduce costs and improve the utility of market users, relatively efficient structures adapted to the nature of transactions and transactors have evolved?  Even if they take the view that cabals of interested parties design markets for their own selfish ends, how do they explain why different markets have different trading mechanisms and protocols?  If centralized exchange trading with lots of price transparency is so great, why has that prevailed only in some segments of the equity and derivative markets?

The arrogance, and the narrowness, of their view of the world is truly quite staggering.  In their minds, quite clearly, the financial markets are one big market failure, with a few exceptions–exchange traded equities and derivatives.  And they know better.  They know how things should trade.

This mindset, at root, denies the roles of competition, innovation, creative destruction, and survival of the efficient in determining/selecting market institutions and structures.  It is a command-and-control, we-know-better mindset.  It is a truly pessimistic mindset, too, for it effectively denies the ability of dispersed individual decision makers to make economically efficient choices.

I believe in contrast that one should try to explain and understand how market structures are what they are, and change the way that they have, before dictating sweeping changes to them.  A useful starting point for any theory is to assume that market institutions economize on costs, and that market participants operate in reasonably competitive environments, to derive the implications of these assumptions for instruments/goods with different characteristics, and then test these implications against the observed structures.  Then identify the anomalies–the things the theory can’t explain–and try to understand them better.

Believe it or not, this exercise is not Panglossian.  You won’t always conclude that we are in the best of all worlds.  In my own work, I’ve shown how various frictions can lead to less than first best outcomes.  But I’ve also shown that many seemingly curious institutions and organizational choices–such as not-for-profit, mutual organization of exchanges, or vertical integration between execution and clearing–make economic sense.

But this approach leads to a much more nuanced understanding of complex institutions and practices, and a much more practical way of identifying possible ways to improve the way the markets work.

In contrast, the you’ll-fit-in-this-bed-and-like-it approach epitomized by Schapiro and Gensler is simpleminded, ignorant, and arrogant.

Stretching or crushing markets to fit a standard template will dramatically reduce the efficiency, effectiveness, and adaptiveness of our financial markets.  But that’s what Mary and Gary Procrustes have in mind.

CFTC Commissioner Jill Sommers gave a speech at a conference titled “Clearinghouses as Mitigators of Systemic Risk” that makes interesting reading.

As the title of the conference might suggest, Sommers was quite conversant in the clearing catechism:

Generally, a comprehensively regulated clearinghouse should help reduce systemic risks by facilitating the netting of transactions and by mutualizing credit risks. When a contract between a buyer and seller is submitted to a clearinghouse for clearing, the contract is “novated” to the clearinghouse. As such, the clearinghouse is substituted as the counterparty to the contract and then stands between the buyer and the seller. Clearinghouses then guarantee the performance of each trade that is submitted for clearing. Clearinghouses use a variety of risk management practices to assure the fulfillment of this guarantee function and to avoid losses at the clearinghouse. Moreover, the CFTC has closely monitored these risk management practices at the clearinghouse level and at the futures commission merchant level to ensure risk is properly being managed. The Commission has always recognized that the clearinghouse must protect itself from unnecessary risk, and if it failed to do so, large segments of the markets and market participants could be put at unnecessary risk as well.

Clearinghouses mitigate risk through the daily discipline of marking to the market price, at least once each business day, each position cleared through the use of prices that are independently determined by the clearinghouse. All gains and losses that arise as a result of the mark-to-market process are settled (i.e., paid and received) each day. Clearinghouses also require the daily posting of margin to cover the daily changes in the value of all positions as extra protection against potential market changes that are not covered by the daily mark-to-market. The methodology used by clearinghouses to calculate such margin requirements are subject to regulatory review and approval.

. . . .

With the mandated use of a regulated clearinghouse coupled with effective risk management practices, the failure of a single large trader, like AIG, would be much less likely to jeopardize all of the counterparties to its trades. I must stress, however, all risk is not eliminated, but it is substantially reduced. One of the lessons that emerged from the recent financial crisis was that institutions were not just “too big to fail,” but also too interconnected through non-transparent swaps that the institutions did not effectively manage. By mandating the use of central clearinghouses, institutions would become much less interconnected, mitigating risk and increasing transparency. Throughout this entire financial crisis, trades that were carried out through regulated exchanges and clearinghouses continued to be cleared and settled.

Needless to say, I’m a heretic.  Mandated clearing doesn’t necessarily increase netting opportunities, and even if it does, since it effectively reorders creditor priority it does not necessarily reduce systemic risk.  And if netting reduces costs so much, why didn’t firms adopt clearing voluntarily?  The “daily discipline of marking to the market price” is problematic if “the market price” is difficult to determine, due to illiquidity/lack of trading.  What’s more, regular posting of variation margin is not unique to CCPs, and is quite common in OTC deals.  Furthermore, the variation margin mechanism can be exactly what touches off or exacerbate market panics.  AIG is a terribly misleading example.  CCPs do not reduce interconnectivity; they just change the topology of the interconnections.  Furthermore, CCPs are tightly embedded in the financial marketplace, most notably in the credit system.  To pretend otherwise is foolish.

Sommers’s other remarks are more intriguing.  She recounts of the CFTC’s previous policies towards OTC derivatives and clearing in particular:

In July 1989, the Commission published its 1989 Swaps Policy Statement. This statement reflected the Commission’s view that most swap transactions, although possessing elements of futures or option contracts, were not appropriately regulated as such under the Act and Commission regulations. This was important because the Commodity Exchange Act required all futures contracts to be traded on exchange. The policy statement allowed these transactions to continue trading off-exchange by creating a “non-exclusive safe harbor” for transactions satisfying certain requirements. The safe harbor requirements included five elements: (1) individually-tailored terms; (2) absence of exchange-style offset; (3) absence of clearing organization or margin system; (4) the transaction is undertaken in conjunction with a line of business; and (5) a prohibition against marketing to the public.

In other words, prior to the CFMA of 2000, any attempt to introduce netting (item (2)) or clearing and margining (item (3)) into the OTC market would have run afoul of the Commodity Exchange Act’s requirement that all futures contracts must be traded on exchanges (designated contract markets); netted and/or cleared swaps would have been considered futures.

This should be remembered, but is typically not.  I’ve often wondered whether CFTC policy, and the CEA more generally, discouraged the evolution of OTC clearing, and channeled the industry along the path that Dodd-Frank has now declared an anathema.  We’ll never know for sure, but it must be recognized that during the formative years of the OTC market, the law and regulation effectively foreclosed–precluded–the development of institutions that Congress and the CFTC now deem essential for financial stability.  The irony.

Sommers adds some refreshing honesty about the monster that is Frank-n-Dodd.  Most notably, she discusses the swaps execution facility mandate:

An area that I am very interested in, as are many other market participants, is what the requirements of trading swaps on a SEF will be. The CFTC and SEC heard a great deal of concern about this issue from market participants at a joint roundtable on September 15th. CFTC staff has recently estimated that 30-40 entities will register as SEFs or designated contract markets. The designated contract market model is easy for the Commission and market participants to deal with. We know how they work, and market participants know how they work. SEFs are new, and the relevant statutory language is not very clear. When you read the new statutory language in conjunction with existing statutory language, it raises some questions.

Section 1(a)(34) of the CEA defines “trading facility.” It is a definition that the CFTC and market participants have been working with for years. In essence, a trading facility is a physical or electronic facility or system wherein multiple participants can execute or trade agreements by interacting and accepting bids or offers of multiple other participants. A many-to-many type model.

In defining what a SEF is in Section 721 of Dodd-Frank, Congress did not require that a SEF be a trading facility. Instead, Congress defined a SEF as a “a trading system or platform” in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility, that (A) facilitates the execution of swaps between persons; and (B) is not a designated contract market.” (emphasis added).

So clearly, by this definition Congress intended that a trading facility could be a SEF, but that a SEF did not have to be a trading facility because Congress used the words “trading system or platform” to define SEFs. In my view, by introducing the term “trading system or platform” when we already have “trading facility” as a defined term means that Congress must have intended a SEF to be different from a trading facility.

Her confusion is palpable.  And understandable.  If the status quo ways of executing swaps were OK, Dodd-Frank would not have added  an SEF requirement.  If Dodd-Frank intended an SEF to be the same as a trading facility, it would have said so.  Thus, Frank-n-Dodd says what SEFs aren’t–the status quo or trading facilities–but doesn’t say what they are.  It is particularly confusing because some of the requirements that SEFs must meet–interaction between bids and offers submitted by multiple participants–characterize trading facilities.  So Congress essentially handed the CFTC an enigma and walked away.  One can feel for Sommers, her fellow Commissioners, the staff–and the industry.

She also mentions the confusion over the definition of swap dealer:

One of the areas that has caused a great deal of concern among many market participants is whether they will be classified as a swap dealer or major swap participant. Such a classification brings with it the imposition of capital, margin, recordkeeping and retention and business conduct rules, and rules for segregating customer funds. Currently six rule writing teams are working on this area. One is working on a series of definitions, including swap dealer and major swap participant, one is working on registration requirements, and others are working on business conduct standards, capital, margin, and segregation issues.

The CFTC’s Chairman has stated that initial estimates are that there could be in excess of 200 entities that will be swept up into the definition of swap dealer based upon current ISDA primary member status. Registering and regulating that many swap dealers will be a huge task for the CFTC and will have very important implications for those entities and their businesses. Comparatively, we now have about 127 FCMs that are registered with the Commission. In my view it is critical that we ensure that this new regulatory regime intersects seamlessly with our existing regime to ensure that registrants and their customers suffer no disruption in their business and hedging strategies. I have asked staff to estimate the number of entities that may be swept into the definition of major swap participant. Unfortunately, they have not yet been able to do so. This uncertainty raises concerns about ensuring a disruption-free transition, an issue that the Commission and staff will be closely monitoring.

Note, and beware.  If Gensler’s 200 number is even ballpark, CFTC will have responsibility over more than twice as many entities as is currently the case.  Moreover, these new entities are often larger, more complex, and certainly more diverse than the population of FCMs currently under its ambit.  Big hedge funds, supermajor oil companies, big money managers, and universal banks are all likely to be considered swap dealers, or major swap market participants.  These are very different animals, and far more complicated ones, than the FCMs.  Moreover, they are all different from one another in crucial ways, but they have to be shoehorned into one of two standardized categories.  This is unlikely to end well.

Sommers also notes that CFTC is tasked with establishing position limits, but doesn’t have the data necessary to do the job properly:

Complicating all of that are the provisions of Dodd-Frank. The CFTC and SEC have 360 days to issue regulations establishing swap data repositories to which swap data will be reported. The Commission has 180 days for energy and 270 days for agriculture to propose aggregate position limits across futures markets and equivalent OTC markets. The problem is, Dodd-Frank requires us to propose position limits months before a mechanism is in place for obtaining the necessary data from the OTC swap markets. In order to propose appropriate limits, we must know the size of these markets. Without the necessary data for OTC markets, we will not really have all the information we need to propose appropriate limits. But, the law is the law so we will propose limits and hope they are at such a level that they do not cause damage to these markets.

Sommers also indulges in hope over experience:

CFTC and the SEC. Historically, the SEC and CFTC have not been very successful proposing joint rules, even when directed by Congress to do so. This time, however, may actually be different.

Seeing will be believing.  And even if everybody has been playing well together so far, the tough decisions have yet to be confronted, and the affected interests have yet to play one agency against another, as will occur inevitably.  Add to that normal inter-agency rivalry, compounded by a profound change in relative authority, and it is pretty plain that serious disputes are inevitable.

Sommers’s speech is a good overview of the issues and challenges facing the CFTC.  Reading her speech and Frank-n-Dodd gives me the same feeling that I had on some Christmas mornings when tasked with assembling some rather complicated toy, and having to rely on directions originally written in Chinese, then translated into Korean, before being translated into English.  The main difference being that if I threw up my hands in frustration, there would be just one disappointed little girl.

I wish Sommers and the CFTC luck.  They’re going to need it.  And so will we.

The CFTC-SEC joint report on the May 6 Flash Crash.  I am underwhelmed.  It provides some new details, but (a) leaves the most important questions unanswered, and (b) fails to perform some rather straightforward analyses that would go a long way to providing a much stronger basis for its conclusions–or disprove them.

The report supports most of the conjectures I (and others) made in the immediate aftermath of the crash.  In the chaos of the time, with the profound uncertainty surrounding the Greek crisis, liquidity on the major markets went down.  In particular, the depth on the buy side of the S&P Emini contract on the CME declined dramatically.  Into that declining liquidity came a sequence of large sell orders entered as part of a hedge implemented by a firm not named in the report, but widely reported to be Waddell and Reed.  Given the diminished liquidity, the sell orders pushed down the market, which triggered arbitrage trades that dragged down other markets as well.

Whenever you see a big price move in a short period, you look for positive feedbacks.  The positive feedback I conjectured in this case at the time was a dynamic put replication strategy, in which the hedger sells more as price declines in order to match the delta of a put position.  Although the report indicates that the W&R strategy was a hedge, it does not discuss in detail what triggered the initiation of the strategy: why did the hedge kick in just then?  Key question, but an unanswered one.  It is plausible that the earlier selloff had triggered the initiation of the W&R program.

But the report does suggest that once the original order was submitted, there was a positive feedback mechanism, but a truly novel one, and something different than dynamic put replication.  In particular, the algorithm that W&R employed based its sell orders on market volume.  It had a given number of contracts to sell (75K), and the timing of those sales at any time was conditioned on trading volume in the immediately prior minutes.  According to the report, the initial big price drop triggered a substantial amount of HFT trading activity.  This was mainly offsetting: HFT buys and sells were almost exactly equal in magnitude.  But this generated volume; this volume caused the W&R program to submit more sell orders; and this reinforced the price decline.

This is a plausible story, but the Commissions could have done more to support it.  In particular, the Report asserts a causal connection: W&R sell orders; price decline; big uptick in HFT trades; more W&R orders; more price declines.  These causal hypotheses are readily tested in a standard vector autoregression framework.  The elements of the vector could include price changes (on a second or five second time frequency, for example); (signed) W&R orders; HFT buys; HFT sells; and the buys and sells of other trader types.  It would also be worthwhile to include buy side and sell side depth changes in the vector to see whether liquidity was responding dynamically to any of these other variables, and vice versa.

This framework would permit a more definitive attribution of the price move to the various factors identified in the report, and permit a better understanding of the actual dynamics and feedbacks.  If, indeed, the mechanism posited in the Report is correct, the VAR analysis would demonstrate this.

A better understanding of the various feedback mechanisms would also facilitate the development of better market surveillance tools.  Most importantly, it would provide information that would permit more discriminating regulation of HFT–or demonstrate that no such regulation is necessary.

But the most disappointing part of the report is that although it documents the decline in EMini liquidity, and discusses in general terms the potential causes of this (uncertainty surrounding Greece, rising volatility as indicated by the VIX), it does not undertake a thorough empirical investigation.  With normal liquidity, the W&R orders likely would not have had any appreciable price impact.  With the emaciated liquidity of the afternoon of 6 May, the sell program plausibly had the price impact the Commissions attributed to it.  So understanding why liquidity declined is essential to an understanding of why the Flash Crash occurred.

In other words, if the sell program was the match, the lack of liquidity was the dry tinder.  That’s what needs a more thorough investigation.

Again, the VAR framework would be very useful in this regard.  One could investigate the dynamic relations between buy and sell side depth changes, volatility changes, price changes, customer order flows, and other factors that could affect liquidity.  This would permit a more discriminating analysis of what triggered the decline in liquidity that made the Flash Crash possible.

The analysis could be extended to include a larger sample period, in order to get a more complete understanding of what drives liquidity in these markets.  Without understanding this, it is impossible to understand the role of HFT.  A more thorough understanding of the dynamics of liquidity supply would also help exchanges monitor markets for potentially destabilizing developments.  This could permit the development of smarter circuit breakers.

The report makes clear, as should have been evident soon after the Crash happened, that the CME’s stop order logic played a crucial role in stopping the cascading prices.  This was a pretty smart circuit breaker, but a better understanding of the dynamics of liquidity supply would permit the development of even smarter ones.

And this shouldn’t be a one time, fire-and-forget exercise.  The dynamics of liquidity supply will almost certainly evolve over time.  Frequent updating of the analysis would help identify these changes, and permit a similar updating of market monitoring and circuit breaker mechanisms.

In brief, we know a little more about the causes of the Crash, but not much more than we did on the day and the days immediately following. The Commissions’ staffs obviously trolled through massive amounts of data, for which they should be congratulated.  But it was possible to do so much more with that data.  Maybe the staffs did, but it didn’t make it into the Report.  Standard analytical tools applied to that data could provide a far more detailed understanding of the complex feedback mechanisms that contributed to that Crash, and which could recur in future ones.  Let’s hope that analysis gets done, either by the Commissions, the exchanges, or independent scholars.  Armed with such an analysis, it will be possible to craft better policy responses.  Without it, policy mistakes are more likely.

Gretchen Morgensen wrote a long piece in today’s NYT about the potential systemic risk–and too big to fail problem–associated with CCPs, for which I am appreciative.  She included a rather long quote from me, saying things you’ve read here (no surprise there).  It’s an interesting article with some supporting quotes from a variety of other folks.

It would have been nice had this debate taken place, oh, six months ago, or a year ago.

The Hunt brothers are the poster children for the old joke: “Want to make a small fortune trading commodities?  Start with a large one!”  [Ba Dum Ching!]

Their not-so-excellent silver adventure is also an interesting object lesson in other ways.  In particular, it shows that clearing, initial margin, rigorous daily mark-to-market variation margin, and exchange trading are do not immunize the broader financial markets from contagion originating in the derivatives markets.

It is no doubt true that initial and variation margin reduce the credit exposure in a specific derivatives trade.  But that doesn’t mean that requiring collateralization of derivatives trades in a way that dramatically reduces credit exposure in a particular trade reduces the amount of leverage in the system; or reduces the likelihood of default against that borrowed money as the result of an adverse price move in the derivatives market.

This is because the creditworthy will get credit, until they aren’t.  If you deny them one channel to obtain credit (e.g., by charging hefty margins on futures trades) they can get credit through other channels.  They can use that credit to support their speculations in derivatives markets.  And if those speculations go the wrong way, it can cause the formerly creditworthy to default.  If they’ve borrowed enough, the whole system can have trouble.

That’s exactly what happened in the Hunt case.  The Hunts borrowed, from various sources, approximately $1.3 billion to support their silver market activities. That’s the equivalent of about $3.5 billion today.  They used the borrowings to pay margins and to buy physical silver.  When the price of silver fell, they couldn’t pay back their loans.  This almost led to the failure of several major brokers and banks, and could have sparked a full-scale banking crisis.  In a process not too different from that involved with the rescue of LTCM in 1998, banks restructured the Hunts debt in order to avoid a crisis: the Fed’s (and Paul Volcker’s) role in this was and is very murky, but (a) it was decidedly contrary to stated Fed policy at the time, (b) Volcker could have killed it if he had wanted, but (c) it happened.  So draw your own conclusions.

Here are the details.  After skyrocketing in late-1979, the price of silver started to drift down in 1980.  The Hunts needed cash to meet margin calls, and they borrowed money–about $233 million–from their main broker, Bache.  The loan was collateralized by silver.  Bache, in turn, rehypothecated the capital and used it to back borrowing of the money from First National Bank of Chicago.  In addition, the Hunts borrowed large sums from Swiss Bank, as did their pilot fish in this endeavor, a group of Saudi investors who were trading through the firm IMIC.  In addition, IMIC borrowed money from Merrill Lynch and commodity broker ACLI.

Most of these borrowings were used to meet margin calls.  Most of these borrowings were collateralized with physical silver.

Prices continued their downward drift, and on 17 March, 1980 the Hunts missed a margin call.  Bache covered it.  IMIC also missed margin calls on 3/25.  Broker Conti covered it.

The price decline the accelerated, and threatened to turn into a rout, when the Hunts announced an ad hoc, not to say harebrained, scheme to sell silver bonds.  This signaled to anybody paying attention that the heretofore supremely confident silver bulls were having serious cash flow issues.  The prospect of their silver hoard (and that of their IMIC shadow) being dumped on the market put prices under serious pressure.

On the 26th, the Hunts told Bache they could not meet any additional margin calls.  Bache panicked, and tried to get the CFTC and COMEX to close the silver market, and force settlement of all outstanding contracts at a price that would allow the Hunts to pay them back.  COMEX and CFTC refused.

The market therefore opened on the 27th–“Silver Thursday.”  Bache liquidated Hunt positions, and sold silver held as collateral.  It made the sales in London through a UK subsidiary, incurring losses–but Bache NY promised to cover the losses.

There were serious concerns that day that Bache would go under.  The CFTC deemed other brokers to be vulnerable, notably ACLI, Conti, Merrill, and Paine Webber .  A default by any one of these would have put the COMEX clearinghouse in jeopardy: a default by more than one, almost certainly would have.  The Fed’s (now) venerable Gerald Corrigan, openly worried about the viability of the COMEX clearinghouse.  Given the realized and potential losses, a COMEX clearing failure was a real possibility.  Again: clearing is not a panacea.

To raise cash to meet its obligations to the clearinghouse, Bache dumped stocks as well as silver.  They were not alone.  Stocks declined rapidly, the Dow losing about 5 percent, before recovering to close almost unchanged.  (Another interesting sidelight of this episode: a “Flash Crash” years before anybody even dreamed of HFT.*)

But Bache was able to scrape together enough money to meet its obligations to the clearinghouse and pay off its loans.  The owners of ACLI and Conti injected capital. Things seemed to be under control.  Disaster seemed to have been averted.

Not so fast.  When prices were sky high, silver giant Engelhard was having a difficult time meeting margin calls on its short COMEX silver futures positions.  So it had entered into exchange-for-physical (EFP) deals with the Hunts, whereby the Hunts agreed to take the Engelhard short positions (which were offset against some Hunt longs), and agreed to buy physical silver from Engelhard for delivery at the end of March, 1980.  Again–more credit, this time, extended by Engelhard to the Hunts.

When the delivery date came, based on the sales price in the EFP contracts and the prevailing price of silver, the Hunts were underwater by $335 million.  Engelhard insisted on cash.  The Hunts said sorry, ain’t got no cash.

Engelhard could have forced the Hunts into default and bankruptcy.  If that had happened, the entire Hunt debt pyramid, all $1 billion plus, would have been in default.  Several banks would have been at risk of failure–First Chicago, the nation’s 9th largest bank, most notable among them.

But Engelhard blinked–or did the country a favor, depending on how you look at it.  It accepted some Hunt oil properties in the Beaufort Sea instead of cash.

Another bullet dodged.  But the banks still realized that the Hunts were in hock to them for huge sums, and a good chunk of the brother’s wealth was still in silver that was worth a fraction of what they had paid for it.  There was still a serious risk of default, and the Hunts had a lot of bargaining leverage.  The prospect of a protracted war in bankruptcy court was hardly appetizing to the banks.

So they bit the bullet (sorry–free association at work), and renegotiated the loans with the Hunts.  The loans to the brothers were paid off by a new loan to the Hunt family oil firm, Placid Oil.  Finally, the problem was taken care of.

The role of the Fed and Chairman Volcker in this loan is shrouded in mystery. Congress pressed Volcker for answers, and he, in classical central banker fashion, obfuscated and stiffed them.  But it should be noted that the loan was starkly at odds with the Fed’s new policy of restricting credit, most especially credit for commodity speculation.  Volcker had insisted that the loan include the condition that the Hunts cease speculating in all commodities, not just silver.  Moreover, given the Fed policy and its power, if Volcker had wanted to stop the loan, there is no doubt he could have.  Thus, there is evidence of both active and tacit Fed approval of the ultimate solution.

This arrangement foreshadows the solution, 18 years later, to the LTCM problem.  Then, as in 1980, the Fed shepherded a group of private banks to finance the resolution of the victim of a derivatives blowup.

To sum up.  Here we have a market that was (a) exchange traded, (b) cleared, (c) subject to initial margins, and (d) subject to rigorous daily variation margins.  All of the things that our latter day financial reformers assert will purge derivatives-related financial contagion from the system.  Yet a derivatives-related financial contagion occurred nonetheless.

Why is that?  The reasons are pretty clear.  The real source of potential derivatives related contagion exists when (a) a large entity takes on a substantial price risk through the derivatives market (or the underlying market, e.g., silver, or both), and (b) that entity is highly leveraged.  The clearing, margining, etc., is intended to reduce the leverage extended to the entity via the derivatives transactions.  But even if it doesn’t get credit via the derivatives trade, a creditworthy entity can use its debt capacity to get credit elsewhere.  If it does so, and its speculative bet goes wrong, it may default.  If it borrow enough, the default may lead to a financial crisis.

The default may impact the clearinghouse.  Clearing members may be among the defaulter’s creditors.   The default may lead to missed margin payments.

But even if the clearinghouse survives, a crisis may occur nonetheless.  It’s the total amount leverage that matters most, far more than the form of that leverage.  If a given position is collateralized, thereby reducing the credit exposure inherent to it, but that collateral is effectively borrowed, the risk to the system isn’t any different than if the position isn’t collateralized but the entity doesn’t do any other borrowing.  All that really changes is who ends up carrying the can in the event of a default.

This is a Modigliani-Miller-like result.  It means that regulating the credit in one part of a position doesn’t really matter if the entity can obtain credit elsewhere.  If that entity has a given debt capacity, or target debt level, they’ll get the credit somewhere.  This means that you can’t really affect the systemic risk posed by big speculators by limiting their access to one channel of credit.

Which further means that requiring the clearing and collateralization of speculative positions will not substantially reduce the systemic risk posed by speculative trading.  Nor will exchange trading.  You can take risk on an exchange or off.  You can get credit through a derivatives trade, or elsewhere.  Either way, a big speculator can put together the same price risk + leverage position.  It is that risk+leverage exposure that matters, not how you get there.  Clearing and exchange trading mandates just affect the route, not the final destination.

The Hunt episode should thus serve as a cautionary tale.  Like the story of the Gold Panic of 1869, it shows that cleared, exchange traded markets pose systemic risks too.  Married with some rather straightforward economic logic, these episodes show that you should not expect that mandating how things are traded and how they are collateralized will materially affect systemic risks.  Those who assert the contrary are missing the forest for the trees, and instilling a false sense of security.

PS.  That shouldn’t cause you too much extra work, Allan:)

* Speaking of the Flash Crash, I’ve read the CFTC-SEC joint report. I will post on it tomorrow.  Teaser: the report leaves the most interesting and important questions unanswered.

Weather in Ghana has been good to the cocoa crop this year, which is putting downward pressure on prices:

After four years of shortages that sent the price of cocoa to its highest level in three decades, traders almost unanimously believe that the cocoa market is set to move into a surplus in the 2010-11 marketing year, which starts on Friday.

The looming oversupply has sent cocoa prices down by a third in the past two-and-a-half months.

The surge in production in west Africa, which accounts for nearly 70 per cent of the world’s supplies of the commodity used in chocolate, is a setback for investors such as hedge funds Armajaro and Clive Capital, which bet on rising prices earlier this year.

The cost of cocoa in London – the benchmark – has fallen to about £1,900 a tonne, down from a 33-year high of £2,732 a tonne set in July.

So Tony Ward must be hurting, right?  After all, he told the world–the world–that due to his super-sophisticated weather forecasting system, a proprietary network of weather stations, and the best weather data in the world, he knew a crop shortage was coming. So he must have been way long, and the price fall must have crushed him.

Well no, actually:

Investors say that Anthony Ward, the founder of Armajaro’s flagship CC+ fund, has suffered less than expected, however, as bearish hedges cushioned the fund from the price drop.

Oh, really?  Hedges, huh?

This means that the story he was flogging in July and August was complete bilge.  He wasn’t bullish on the new crop. It would be more accurate to say that he was bullsh*t on the new crop.

Which also means that his cover story for taking delivery in July was also complete bilge/bullsh*t.

Not that I am the least bit surprised.  The story made no sense anyways: it’s nuts to take delivery of the old crop at a big backwardation just because you think the new crop price is going to shoot up.  If you think that, buy the new crop, not the old crop. Duh.

Here’s a far more credible explanation of what happened.  Armajaro cornered the cocoa market.  Being clever, Ward knew the most difficult part of cornering is burying the corpse, so he did that by obtaining a burial plot in advance: the “bearish hedges” mentioned in the article.  All of the new crop shortage stories were just so much eyewash to fool the gullible.

Of whom, as this article and others indicate, FT reporters–most notably Javier Blas–are the foremost.  If they won’t get a room, could they at least get a clue?