Streetwise Professor

December 18, 2010

The Kazcynski Crash Report Crashes

Filed under: Politics,Russia — The Professor @ 9:38 am

The Polish government has rejected Russia’s report on the air crash that killed Polish President Kaczynski and 96 others (h/t R):

“In the form it was sent, the report is indisputably unacceptable,” Prime Minister Donald Tusk told reporters Friday on the sidelines of the European Union summit in Brussels. “In the view of negligence, errors and a lack of positive reaction to Polish suggestions, we’re able to say that some conclusions in the report are baseless.”

The findings haven’t been made public, and Mr. Tusk didn’t offer any specifics about what conclusions he found objectionable. The government said earlier that the report would be made public but didn’t say when.

It is interesting to note that Tusk is not hardline, or reflexively anti-Russian, as Kazcynski was.  Indeed, he has been engaged in something of a rapprochement with Russia, much to the chagrin of many Poles.

UPI reports that the Russians failed to take measures that are routine in any air crash investigation in the US or Europe–even those not involving heads of state of visiting countries:

Meanwhile, Warsaw prosecutors are investigating suspicions vital evidence was destroyed by the Russians, Poland Radio said.

Rafal Rogalski, a lawyer representing some the 96 victims’ families, told prosecutors the wreckage is being destroyed, citing a television report showing Russians cutting it into smaller pieces.

Poland has repeatedly asked Russia to protect the evidence, but it was only in October that the plane was fenced off and covered with tarpaulin.

Tusk noted that the Russians did not follow the Chicago Convention on air crash investigations.  (Aside: whenever I see “Chicago” and “convention” in the same sentence, I have visions of riots.  Vivid childhood memory.)

Let’s consider some possible explanations for Russian behavior: (a) coverup, (b) incompetence, (c) they just don’t give a damn.  Hardly an appealing menu.  Any other suggestions?

Poland and Russia have made some tentative steps towards improved relations.  The sloppy handling–under the most charitable interpretation–of a matter of great sensitivity to Poland is hardly evidence for any genuine respect for that country in Russia.  It will be interesting to see whether this disabuses Tusk and others of any illusions they might have about the possibility that Russia seriously contemplates anything remotely resembling a relationship between equals.

In any event, the way this was handled from the first reveals yet again, as if further evidence was needed, of Russia’s consummate skill at undermining its own interests.

December 16, 2010

One Moves Forward, One Doesn’t

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics — The Professor @ 10:24 pm

A busy day at the CFTC today.  One big rule moved forward, another not.

The rule that moved forward implements the Frank-n-Dodd requirement that swaps be traded on “Swap Execution Facilities” or SEFs.  The proposed rule was released on a 4-1 vote, with Commissioner Jill Sommers the lone nay.

Specifically, the rule specifies:

* platforms that provide for a centralized limit order book available to all participants and/or;

* platforms based on transparent request for quote systems that provide requests for quotes that are visible to all participants on platform, allow liquidity providers to post bids and offers and provide time priority for market participants who originated a request for quote.

* Trading platforms are allowed to offer three tiers of transactions:

* Tier 1 transactions are not block trades and exhibit material transaction volume.

* Tier 2 transactions are not block trades and do not exhibit material transaction volume.

* Tier 3 transactions are not subject to clearing and execution requirements, are block trades or are illiquid or bespoke. These swaps could be executed through various methods including voice and limited request for quote systems.

I’m with Sommers on this one. The underlying presumption of the CLOB-or-Public RFQ is that the more pre-trade transparency and anonymous trading, the better for customers, and that lack of transparency is a means of enhancing dealer/market maker market power and profit.

This is not true as a general matter.  As has been seen from time immemorial in securities markets, many customers prefer to trade away from centralized markets as this reduces their trading costs.  It is possible that this “fragmentation” harms other market users more than it helps those that choose not to patronize the centralized, transparent, anonymous market.  That is a common argument, but it is not generally true.  That argument is premised on the (usually) implicit assumption that the CLOB market is perfectly competitive with free entry–which may well not be true, and in fact has been untrue in many markets.

Moreover, for many products, derivatives end-users have had the choice between trading on centralized markets (with clearing and the associated credit arrangements) and trading in decentralized dealing markets (without clearing).  Indeed, the latter combination has grown absolutely and relative to the former.  Although it is difficult to determine the contribution of each element of the transaction and post-trade bundle to traders’ decisions on where to trade, this fact raises serious doubts about the assertion that forcing trades onto centralized platforms will be overwhelmingly beneficial to derivatives end-users.

The rule that didn’t move forward, somewhat surprisingly, was that on position limits.  CFTC Chairman Gensler had already delayed voting on the proposed rule once, and did it again today.  He said that “I think it’s just appropriate to let this one ripen a bit more.”

Uhm, Gary.  It’s pretty ripe already.  As in rotten.

The new position limit proposal is less bad than the one from January.  It no longer has the silly crowd out provision, or the equally silly limited risk management exemption.  The crowd out provision essentially forced market participants to choose between being hedgers, market makers, or speculators.  That micromanagement of firm business models in contravention of the potential for synergies across these functions was an unnecessary constraint on market participants.

On the other hand, the new rule has a very restrictive definition of bona fide hedger.

Although some of the worst elements have been stripped away, the underlying problem with spec limits generally remains.  No one has yet to provide credible evidence showing that speculation has distorted prices in recent years, or even provided a credible theory to demonstrate how this can happen (other than in corners or squeezes, which are better deterred in other ways).

Although it is not quite clear as to why the rule has not garnered majority support in the Commission, anti-speculation crusader Bart Chilton indicated that he did not support the rule as written.  This is likely due in part that he was a big fan of the crowding out provision.  In his remarks after the meeting he also indicated that the two-step approach in the proposal, which would have delayed full-blown implementation of limits until the Commission had the ability to collect data from the swaps market so it would be able to base its choice of  limits on, you know, actual data.  In other words, Chilton is playing Jacobin on this issue.  Republican commissioners have expressed reservations about proceeding without such information.

Apparently, however, Gensler threw a sop to Chilton, by instructing staff to identify position levels that would trigger a Commission review that could result in an order for large traders to reduce their positions.

Position limits have proved to be an extremely contentious issue.  SEFs are very controversial as well.  Both represent attempts by the CFTC–acting at Congressional direction–to transform the ways of executing transactions, and the quantities of transactions, that consenting adults have freely chosen.  That inevitably generates opposition.  There can be justifications for doing this.  Unfortunately, neither Congress nor the CFTC have provided even remotely plausible ones.

Throw Momma From the Flat

Filed under: Politics,Russia — The Professor @ 8:53 pm

In Tsarist times, serfs were often rounded up and sent out to work virgin lands.  In the Soviet era, Soviet citizens were moved forcibly en masse to construct entire factory complexes and cities like Magnitogorsk.  In these eras, workers of the Russian Empire of the Soviet one were treated like cattle to achieve the power fantasies of the rulers.

Apparently this mindset hasn’t changed, although the focus now will not be on shoving workers around, but on shoving non-workers.  Specifically, both Moscow Mayor Sergei Sobyanin and Belgorodskaya governor Yevgeny Savchenko have proposed forcing old people out of their homes in urban centers like Moscow into pensioner villages, thereby freeing space for employable people:

Make it so that there would be five million people living here [in Moscow], and all the issues would be resolved without capital investment,” said Savchenko. He additionally promised to help other regional governors develop the infrastructure necessary for such a project. Under the plan, villages for pensioners would be built all across Russia’s Central Federal District, which spans more than 250,000 square miles around Moscow – and possibly elsewhere. “This is a big country – there’s the Far East, and Siberia,” Savchenko said.

Siberia.  Great.  The very word evokes such wonderful memories for Russian oldsters, I’d bet.

The fact of the matter is that Moscow pensioners live practically in all of your regions – in dachas, in small cottages,” said Sobyanin. “Some live through the winter, cast aside, cold. Some in far away villages.”

The mayor said that such a resettlement strategy could help pensioners currently suffering from their apparently uninhabitable Moscow housing. “It’ll be so they feel normal,” he explained. “This past summer they choked on smoke in those boxes, and it’s better to live in good, well-built villages in nature.”

Sounds wonderful.  Little Friendshipski Villages strewn across Russia’s verdant vales (well, verdant maybe 3 months a year, anyways).  Happy babushkas, whiling away their Golden Years in some Siberian idyll.

Sounds wonderful, that is, until you recognize that the “good, well-built villages in nature” will never, ever, materialize–except for a few Potemkin demonstration projects.  Too expensive.  Instead, if this happens you know that people will be bundled away into godforsaken places in appalling conditions.  I can hear it now: “there are all of these villages that are almost depopulated.  Let’s save on capital investment by moving the old farts into them.  Out of sight, out of mind.”

It is unlikely, of course, that even in modern Russia such a harebrained scheme will come to fruition.  One of the few political challenges Putin faced was from pensioners furious that some of their in-kind benefits had been converted to cash.  That would pale in comparison to the uproar that would accompany a senior “settlement policy” (Savchenko’s exact, creepy phrase).

But the very fact that the recently appointed mayor of Russia’s most important city would discuss such a thing, and indeed say that there is “a seed of rationality in this proposal” is quite revealing.  It betrays the persistence of a mindset in which people are deemed to be little more than chattel to be moved about to achieve state goals.  And state and society in which officials at the highest echelons of power view people as cattle will never achieve even the simulacrum of modernity.

December 13, 2010

Yeah, It Sounds Like He’s Perfect for the Job

Filed under: Economics,Politics,Russia — The Professor @ 12:11 pm

Igor Shuvalov garnered a lot of press for his role in getting Russia the 2018 World Cup. A commentor on SWP (Jennifer, if memory serves) asked if I had heard of him before, and opined that he looks like a very attractive candidate for the Russian presidency in 2018. Depending on your point of view, based on this piece by Kremlin gadfly John Helmer, you would conclude that (a) yes, he’s perfect for the job, or (b) that would be another step in Russia’s descent into force, fraud, and corruption:

The High Court ruling also implies that Frank shares culpability with Igor Shuvalov (2nd right image), currently a deputy prime minister of the Russian government. In the judgement, Justice Smith does not probe the financial or other motives for the collaboration between Frank and Shuvalov, but he concludes that they combined together to force Skarga and Izmaylov out of their shipping companies; Shuvalov became chairman of the Sovcomflot board just weeks after Frank took operational control from Skarga. He remained in charge during the period when, according to Justice Smith, the company used criminal methods – extortion, property break-ins, data theft, perjury, threats of violence – to pursue its campaign of intimidation.

According to Justice Smith, “at about the end of July or the beginning of August 2004, Mr. Frank recommended to the Ministry of Economy and Trade a merger between Sovcomflot and NSC [Novoship]. In about the middle of September, Mr. Igor Shuvalov, who was then Chief Economic Advisor to the Russian President and was designated to be the new Chairman of Sovcomflot, supported the merger proposal, and decided that Mr. Frank should replace Mr. Skarga as Director-General of Sovcomflot in order to pursue the policy.” [Emphasis added.]


Note that this is from a “421-page ruling of UK High Court Justice Andrew Smith” in litigation involving control of the Russian shipping company Sovcomflot.  (Lovely name, too.)  Per Helmer:

The consequences are dramatic for the Russian government. The judgement [sic] makes impossible the public listing of Sovcomflot shares in any international market because of the evidence disclosed that the company lies to its auditors, falsifies financial records, encourages perjury, and knowingly engages corrupt officials for the purpose of fabricating schemes of personal vengeance and wrongful enrichment.

The UK Bribery Act, which comes into force in April as well as the listing rules for both the London Stock Exchange and the Hong Kong Stock Exchange, will expose Sovcomflot’s chief executive, Sergei Frank (2nd left image) , to a level of scrutiny he is unlikely to withstand, following Justice Smith’s ruling that Frank had repeatedly lied in his testimony; had fabricated the case against Skarga and Izmaylov after squads of private detectives he despatched had failed to uncover incriminating evidence; procured false witnesses; filed his claims in London because Russian law precluded his company from pursuing them in the Russian courts; made a practice of concealing his decisions from other responsible Sovcomflot officials; and pursued Skarga and Izmaylov vindictively to prevent them from opposing his scheme for merging Sovcomflot with Novoship, and selling shares in a much bigger IPO than his predecessors, acting on the advice of JP Morgan, had recommended to the government.

Again, remember that political comer Shuvalov is tied at the hip to aforementioned Mr. Frank, thug and perjurer.  The mere fact of a close tie between a high level government official (deputy PM no less) and a business reveals a great deal about the patrimonial, natural, Russian state.  The fact that the business involved and its head are loathsome reveals even more.

Some Further Thoughts Re the NYT and Derivatives

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 11:25 am

One of the sob stories in yesterday’s NYT piece is that the incumbent dealers froze out Bank of New York Mellon from membership in ICE Trust, a CCP for CDS.  The CEO of BNY Mellon Clearing is quoted as saying “We are not a nobody.”

Which raises the question: given BNY Mellon’s non-nobodiness status, if OTC derivatives trading is so obscenely profitable, why didn’t that bank–and others–endeavor to get a bigger piece of those profits and increase the scope of its business in competition with the major dealers?  What was the entry barrier that prevented that?  I’m not saying there wasn’t one, just that nobody has come up with a credible answer as to what it is.

To put things in perspective, BNYM is 7th among US banks (that’s just US banks) in overall derivatives positions.  It is dwarfed by the big 5.  In terms of overall notional, in billions, per OCC data, the rankings are JPM ($75253); BAC  ($48520); Citi ($45991); Goldman ($42087); HSBC ($3683); Wells Fargo ($3612); BNY Mellon ($1457).  In terms of CDS, which is really what is relevant in any discussion of ICE Trust, the numbers are (in the same order): $5355; $4694; $2397; $499; $759; $126; $.7.  Yes, $.7 for BNY.  And even this comparison is misleading, because it covers only (a) US banks, (b) not all of the US derivatives dealers do all their business through a bank; and (c) there are other firms in CDS that rank above BNY Mellon, including: PNC, Suntrust, US Bank NA, Keybank, Fifth Third, RBS Citizens, Morgan Stanley Bank, Deutsche Bank Americas, and Huntington Bank.

That disparity speaks volumes.  As I’ve said before on SWP and elsewhere, and as has been noted in other contexts in the economic literature, cooperative organizations work better and can be governed more efficiently when the members are homogeneous.  BNY Mellon is a very different animal than the members of ICE Trust.  Moreover, is it really credible that the major dealers were so afraid of competition from the bank with the 17th largest CDS book among US banks, with an outstanding position that was rounding error as compared to the other ICE Trust members, that anti-competitive exclusion was the true motive for keeping out Bank of New York Mellon?

Note to Louise Story:  Data is our friend.  Further note to Louise Story (forwarded from George Stigler’s ghost): the plural of “anecdote” is not “data.”

Next thought.  As I suggested in yesterday’s post, there is a tension between the dominant narratives involving OTC derivatives.  The one narrative is that there is an evil cabal of bankers that exercise market power and keep prices (spreads) at supercompetitive levels: this would suppress output.  In this narrative, regulators should take measures that increase competition–and thereby increase output.  The other narrative is that OTC derivatives markets are too big, thereby posing a systemic risk, and that output should shrink.

This sounds like Alice in Wonderland.  One pill makes you too big.  The other pill makes you too small.  Which is it?  Are the markets too big or too small?  Which pill did they take?

If you really think that the OTC derivatives markets are too big because of systemic risks, on second best grounds you should favor reducing competition, and enhancing market power.   You should rejoice that a dealer cabal restricts output.  (You should rejoice on other grounds too: high profits lead to higher capital–to the extent it isn’t paid out in bonuses and dividends–and hence less systemic risk.)

So: pick your poison (or your pill, as you like).

(Further apologies to George Stigler, who said that “Well, there are always second best considerations” is an economics conversation stopper.  Not that I think the above will stop this particular conversation.)

Next item: thanks to Felix Salmon, my sometimes foil/sparring partner, for his extended coverage of SWP in his story on the Story story.  To satisfy your curiosity, Felix: no, she didn’t.

Yeah, and OJ Is Still Looking for the Real Killers

Filed under: Politics,Russia — The Professor @ 10:49 am

While most of the attention the last couple of days has focused on Vladimir Putin doing his turn as Fats Domino, there have also been reports that the FSB much earlier covered Chuck Berry’s “It Wasn’t Me”* (h/t R):

Russia was tracking the assassins of dissident spy Alexander Litvinenko before he was poisoned but was warned off by Britain, which said the situation was “under control”, according to claims made in a leaked US diplomatic cable.The secret memo, recording a 2006 meeting between an ex-CIA bureau chief and a former KGB officer, is set to reignite the diplomatic row surrounding Litvinenko’s unsolved murder that year, which many espionage experts have linked directly to the Kremlin.

The latest WikiLeaks release comes after relations between Moscow and London soured as a result of Britain’s decision to expel a Russian parliamentary researcher suspected of being a spy.

The memo, written by staff at the US embassy in Paris, records “an amicable 7 December dinner meeting with ambassador-at-large Henry Crumpton [and] Russian special presidential representative Anatoliy Safonov”, two weeks after Litvinenko’s death from polonium poisoning had triggered an international hunt for his killers.

During the dinner, Crumpton, who ran the CIA’s Afghanistan operations before becoming the US ambassador for counter-terrorism, and Safonov, an ex-KGB colonel-general, discussed ways the two countries could work together to tackle terrorism. The memo records that “Safonov opened the meeting by expressing his appreciation for US/Russian co-operative efforts thus far. He cited the recent events in London – specifically the murder of a former Russian spy by exposure to radioactive agents – as evidence of how great the threat remained and how much more there was to do on the co-operative front.”

The memo contains an observation from US embassy officials that Safonov’s comments suggested Russia “was not involved in the killing, although Safonov did not offer any further explanation”.

Later the memo records that Safonov claimed that “Russian authorities in London had known about and followed individuals moving radioactive substances into the city but were told by the British that they were under control before the poisoning took place”.

Since we have the word of an ex-KGB colonel general I guess that’s that.  Move along, nothing to see.

*And to close the circle, Chuck Berry regularly performs at Blueberry Hill on Delmar in University City (a St. Louis suburb).

December 12, 2010

Yogi Berra and the OTC Derivatives Markets

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 5:43 pm

Today’s NYT carries a breathless–and endless–expose on OTC derivatives clearing.  All of the issues it discusses have been discussed, at length, here on SWP.  I almost hesitate to say anything more, because it’s tedious to repeat myself because it’s tedious to repeat myself.  But the fact that stale arguments continue to dominate the conventional wisdom–as now officially endorsed by the New York Times–means that I must venture once more into the breach.

In a nutshell, the article repeats a familiar narrative about the OTC derivatives market.  You might call it the What’s the Frequency Kenneth Griffin Narrative.  (Indeed, Citadel and Griffin are cited throughout the article.)  An oligopoly, not to say cabal (though the NYT comes close to doing so, by referring to “a secretive elite”), of large banks operating in an opaque market earns outrageous profits.  It is now attempting to perpetuate its oligopoly through control of clearinghouses, ironically mandated by the Dodd-Frank Act.

Let’s focus on the clearing aspect for a moment.  First of all, as I’ve said repeatedly, there is definitely a double edged sword involved in clearing.  On the one hand, limiting access to clearing is a great way to exercise market power.  On the other hand, too liberal access to clearing can create systemic risks, and make the governance and management of clearinghouses far more complex and far less efficient (by increasing the heterogeneity of the membership).

Indeed, I gave a talk on clearing before the Columbia Program in the Law and Economics of Capital Markets Regulation on Thursday where I made this very point.   The audience (which consisted of a very distinguished group of law and finance scholars) was generally sympathetic to clearing, I think, and as a result there were a lot of skeptical questions.  One was right along the lines of the NYT article, suggesting that dealers were an oligopoly and that clearing would increase competition.  I responded that in fact, clearing could be a great way of cartelizing an oligopoly.  However, trying to mitigate this problem through regulating CCP admissions criteria could undermine the goal of reducing systemic risk.  As I put it in the slides for my talk, this was one of many Morton’s Forks in Dodd-Frank. (I’ll post a link to the slides and the video from my talk when they are available–probably just in time for Christmas!)

The NYT article describes the efforts of the dealer banks to exert control over CCP risk committees.  Well, duh.  It’s their capital at risk.  Which presents another problem here.  To reduce systemic risk, CCPs have to have a lot of capital backing trades.  That capital doesn’t fall from the sky.  Where is it going to come from?  Since clearing has begun, major market intermediaries have provided the capital.  And since it is their capital at risk, they have demanded and exercised control over the risks that they are taking on.  It’s not that complicated.

Attempts to regulate governance in ways that reduce the control that group X exerts means that you will simultaneously reduce the amount of capital that group X is going to supply.  So you need to get capital from someone else.  And if you don’t the CCP will be undercapitalized and then there are problems; indeed, in the event, CCPs will be the source of the very systemic risk legislators and regulators hoped that they would banish.

In other words, there are trade-offs here that are quite thorny, but the NYT–and too many other people who should know better–ignore altogether because they get in the way of a good morality play.  It is particularly ironic, and annoying, that many of those who were baying for clearing mandates are now just waking up to those trade-offs.

There are other issues in this article regarding clearing that need to be addressed.  One is ICE Trust.  The author of the piece, Louise Story, talks about the formation of the ICE Trust, which involved the combination of a dealer-run initiative Formerly Known as the Board of Trade Clearing Corporation and ICE.  As originally envisioned, and as currently operating, ICE Trust was an inter-dealer clearing system.  So who other than the dealers would you expect to dominate it?

In her attempts to make ICE Trust appear as sinister as possible, Story descends into self-parody:

The banks also refused to allow the deal with ICE to close until the clearinghouse’s rulebook was established, with provisions in the banks’ favor. Key among those were the membership rules, which required members to hold large amounts of capital in derivatives units, a condition that was prohibitive even for some large banks like the Bank of New York.

I read that to Mrs. SWP, who laughed out loud.  Mrs. SWP is an art major, but she is endowed with common sense.  Her response (post-laugh): “Like they were going to join an organization before they knew what the rules were?  And they were going to join an organization with rules that hurt them?”

More substantively, the quote makes the capital requirements seem like–and only like–a means for exclusion.  Yes, they can play that role, as I’ve written ad nauseum for years.  But high requirements can also be a crucial way of ensuring the safety of the institution, and reduced heterogeneity in the financial condition of members can make the difference between an effective organization and a dysfunctional one.

In other words, the NYT is printed in black and white, but the issues involve are anything but black and white.  Until people get real in grappling with the trade-offs, we are doomed to pointless arguments and counterproductive policies.

The other big issue in the article relates to transparency and trading, and its effect on profits.

The story begins with this tale:

This fall, many of Mr. Singer’s customers purchased fixed-rate plans to lock in winter heating oil at around $3 a gallon. While that price was above the prevailing $2.80 a gallon then, the contracts will protect homeowners if bitterly cold weather pushes the price higher.

But Mr. Singer wonders if his company, Robison Oil, should be getting a better deal. He uses derivatives like swaps and options to create his fixed plans. But he has no idea how much lower his prices — and his customers’ prices — could be, he says, because banks don’t disclose fees associated with the derivatives.

“At the end of the day, I don’t know if I got a fair price, or what they’re charging me,” Mr. Singer said.

It proceeds:

And the profits on most derivatives are masked. In most cases, buyers are told only what they have to pay for the derivative contract, say $25 million. That amount is more than the seller gets, but how much more — $5,000, $25,000 or $50,000 more — is unknown. That’s because the seller also is told only the amount he will receive. The difference between the two is the bank’s fee and profit. So, the bigger the difference, the better for the bank — and the worse for the customers.

It would be like a real estate agent selling a house, but the buyer knowing only what he paid and the seller knowing only what he received. The agent would pocket the difference as his fee, rather than disclose it. Moreover, only the real estate agent — and neither buyer nor seller — would have easy access to the prices paid recently for other homes on the same block.

Ask yourself: for what product that you buy do you know the markup or the seller’s profit?  Answer: probably none.  You rely on competition, comparison shopping, etc., to discipline sellers and ensure that you get a good price.  Presumably that, and soliciting multiple offers, are exactly what Mr. Singer does when buying the physical oil he sells (the markups on which and profits made by the seller he almost certainly does not know either).  (By the way, do Mr. Singer’s customers know his costs and markups?  Just asking.)

The usual retort is that the OTC derivatives market is an oligopoly and that a lack of price transparency limits competition.  By structural measures, OTC dealing is less concentrated than most industries.  With respect to transparency, many large market participants (end users) repeatedly stress that they have access to multiple bids and offers, and are perfectly capable of shopping for good deals.

Moreover, and this cannot be stressed enough, for many products–including Mr. Singer’s heating oil–there are exchange traded markets with great transparency pre- and post-trade.  Mr. Singer and others can utilize that information to evaluate the price offers being made by the dealers on OTC trades.  Moreover, they can trade on those markets if they are so convinced that the OTC dealers are hosing them. So why don’t they?

I am also annoyed that people, including Ms. Story, accept uncritically the proposition that OTC dealing is obscenely profitable.  Maybe it is–I would definitely like to see a more definitive study on this that goes beyond the mere quoting of revenue numbers from OTC trading and how it compares to overall bank revenues.

Indeed, there’s a fundamental tension between various criticisms of OTC derivatives markets.  On the one hand, they are supposedly extremely profitable.  On the other, they supposedly pose huge risks for the banks that are the major dealers.

Think that there could be a connection?  The counterparty risks that dealers face are a contingent liability.  If OTC derivatives dealing is indeed highly risky, as is often asserted, this contingent liability could be quite large.  Which means that in a competitive market prices–notably spreads between dealer bids and offers–must be wide enough to compensate for that risk.

This further means that looking at profits in “normal” times can be misleading.  These “profits” are in part, and arguably in large part, compensation for risk.  And given the nature of risk in these markets, where things can go along swimmingly for a long time and then go non-linear, the losses for which these “profits” are compensation can be extremely concentrated in time; the contingent liability becomes a real one, and particularly a real big one, relatively infrequently. So you can look at profits over years that look fat and say that they are supercompetitive.  But they can disappear in a trice.

This is arguably analogous to the equity premium puzzle.  That puzzle states that the returns to investing in stock appear to be very high given the risks.  That conclusion is dependent on how you measure the risk, and the compensation required (based on preferences) for these risks.  Legions of finance academics and practitioners have wrestled with those issues for decades now, and there has been no definitive resolution of the puzzle.  Very little–and arguably no–comparable research has been undertaken to study the risk-return trade-off in derivatives dealing.  That problem is, moreover, arguably far more complex than the equity premium puzzle.  It is a tail risk problem, and evaluating tail risks and the appropriate compensation for them is hard.  (Tail risk could be the source of some of the equity premium too.)  With free entry and exit, to a first approximation you would estimate that the prices charged compensate for risk.  You should certainly be very reluctant to draw strong conclusions to the contrary without a much deeper analysis than has been done until now.

(This is also analogous to a peso problem.)

Until the risks of OTC derivatives dealing, and the costs of those risks, are measured far more accurately than has been the case heretofore (and the analysis usually doesn’t go much beyond the kind of stuff that’s in the NYT article), I would be chary indeed about arguing that OTC dealers make supercompetitive profits.

And I would be especially careful about arguing about the huge risks of OTC dealing out of one side of my mouth, and the huge profits of OTC dealing out of the other.

This gets at the main problem with all of these jeremiads against OTC derivatives markets.  OTC dealing is supposedly hugely profitable.  Customers are supposedly exploited.  But OTC derivatives markets expanded dramatically absolutely and relative to the transparent, anonymous exchange markets that offer products that are close substitutes on many dimensions.

Huge profitability and supercompetitive prices should have encouraged entry by other potential OTC counterparties; the entry of new trading mechanisms (including, potentially, exchange-like mechanisms with clearing as well); and the movement of trading to existing futures and options exchanges.  But the reverse happened.

In other words, criticisms like Mr. Singer’s, and Kenneth Griffen’s, and Louise Story’s remind me of what Yogi Berra said about Ruggeri’s (a restaurant on The Hill in St. Louis): “Nobody goes there anymore. It’s too crowded.”   The OTC markets are big and crowded with customers.  If they’re such a bad deal for these customers, why is that true?  Why hasn’t entry, or the movement of customers to available substitutes, constrained market power and prevented exploitation of customers?  Not to say that such an outcome is inconceivable, just that Louise Story, Kenneth Griffin, and the cast of thousands who criticize OTC derivatives markets haven’t come close to answering these questions.

I long for the day when there will be serious consideration of these issues, rather than superficial black hat-white hat narratives.  There are so many thorny, thorny issues involved in derivatives market structure.  The trade-offs are not easy.  Let’s stop pretending that they are.  And most importantly, let’s stop legislating and regulating like they are.

December 10, 2010

Buy Pessimism

Filed under: Economics,Politics,Russia — The Professor @ 10:27 am

Russia appears on the verge of acceptance into the World Trade Organization (WTO).  This guest post by Fredrik Erixon on the FT’s Beyond Brics blog pretty well summarizes my views on the subject:

If the Kremlin also decides to follow the WTO rule book, membership will help to constrain Russia’s erratic trade policy, especially its regular descents into protectionism. Naturally, that would be of value for exporters to Russia (and for importers of Russian goods, too, as Russia regularly uses export taxes), but the biggest beneficiary would be Russia itself. The biggest casualty of protectionism is always the country that imposes such measures.

. . . .

But there are also risks and downsides to having Russia as member of the WTO. The biggest risk is that the Kremlin will simply disregard rulings against Russia in the dispute-settlement system, the backbone of the WTO. As the WTO itself cannot enforce rulings that require policy change in a country, the system requires that countries respect the authority of the dispute-settlement body and that bigger and more powerful countries avoid playing power games with smaller nations over rulings.

. . . .

This risk is underlined by Russia’s recent history of flaunting international agreements (and, as in the case of the Energy Charter Treaty, withdrawing from agreements) in the belief that no one would have the courage to fight the Kremlin to the bitter end.

Russian membership will also add a new layer of difficulties for WTO negotiations, like the current Doha Round. Russia will be part of the protectionist wing of the membership and will resist in areas that are central to world trade today and in future, like freeing up services trade, cutting red tape that prevents trade, and limiting the freedom to subsidize domestic firms at the expense of foreign competitors.

It will also enforce the opposition to addressing “old” issues, like reducing or eliminating tariffs on consumer and industrial goods. Russia’s manufacturing sector is weak – it only represents 6-7 percent of Russia’s export – and suffers from the Dutch disease: the heavy reliance on hydrocarbon exports have pushed the real exchange rate to such a degree that the manufacturing sector has suffered. Many industries are saddled with old Soviet technologies, and they survive on subsidies and border protectionism.

There are positive signs that Russia is keen to change its economic model. The new Kremlin rhetoric on modernization and the privatization plans suggest that energy and state-based economic authoritarianism is on a downward trend. The new dawn in its membership bid for the WTO is also a good sign. But the signs are far too few to be upbeat about Russian economic policy. Like before, optimism over the WTO accession can soon shift to pessimism. The old model is entrenched in the Kremlin economic psyche and there are many powerful figures that dislike the idea of being constrained by international agreements or increased foreign competition. President Medvedev has now secured the support from the US and the European Union for its WTO bid. Now he needs to take the fight with Kremlin colleagues and oligarchs. That may become a far bigger problem.

Russia, even more than most countries, tends to look at these sorts of deals as one-way streets; they’ll exploit every right and benefit, and fight every obligation.

Erixon’s point about the decrepitude of the Russian manufacturing sector, plus the fact that imports into Russia are surging, putting pressure on its balance of payments, will test Russia’s willingness to adhere to the obligations of WTO membership.

But the biggest pressure is internal, as Erixon again alludes to in his remarks regarding the “old model entrenched in the Kremlin psyche.”  My only quibble is that this isn’t a psychological phenomenon.  It is a material and political one.  Rule-based, open access orders like WTO are antithetical to Russia’s natural state system.  As I’ve written over the years, Putin uses protectionism as just one of the levers to pull to retain the political equilibrium in Russia.  Natural states like Russia need to keep the distribution of rents in balance in order to maintain political peace.   That requires that the balancer-in-chief–Putin, in Russia–have the flexibility and discretion to respond to economic shocks that upset that balance in order to restore it.  Protectionism has been one of Putin’s most frequently used, and effective tools.  Moreover, protectionism has been a weapon in international disputes (e.g., agricultural trade disputes with Poland and Belarus, not to mention the US).  That’s not something he’s likely to give up any time soon.

Erixon mentions Medvedev.  Like that really matters.  He talks the talk on WTO, but he’s not the one that, in the end, will have to walk the walk.  And that’s true regardless of whether he remains president or not.  The idea of Medvedev “taking the fight” to anybody who really matters is pretty much a joke.  If that’s what those who are optimistic about the effects of Russian WTO membership are counting on, then go long pessimism.

What Next? The Comfy Chair?

Filed under: Politics — The Professor @ 10:07 am

Nobel Peace Prize Winner Barack Obama really lays into the Chinese over their refusal to let new Nobel Peace Prize winner Liu Xiaobo to travel to Oslo to collect his prize:

“I regret that Mr. Liu and his wife were denied the opportunity to attend the ceremony that Michelle and I attended last year,” he said. “The values he espouses are universal, his struggle is peaceful, and he should be released as soon as possible.”

That’s telling ’em.

This hard hitting condemnation was wrapped inside some saccharine, sick-making multi-culti blather:

“America respects the unique culture and traditions of different countries,” Obama said in a statement. “We respect China’s extraordinary accomplishment in lifting millions out of poverty, and believe that human rights include the dignity that comes with freedom from want. But Mr. Liu reminds us that human dignity also depends upon the advance of democracy, open society, and the rule of law.”

Obama’s soft-peddling of and indifference to any human rights or freedom issue is quite embarrassing, and not limited to countries who have lifted people out of poverty (e.g., Iran, Venezuela).  (He’s also shown complete indifference to human rights issues in Russia, e.g., Magnitsky).   Perhaps it’s a diplomatic tactic, but perhaps too it’s a reflection of a worldview in which non-Western countries are viewed as different, and not subject to the same principles and standards as Western ones.  That’s implicit in the “unique culture and traditions” blather, which sits uncomfortably when juxtaposed against the explicitly universalist rhetoric (“the values he espouses are universal”).   So, like so much that Obama says, this dissolves into complete incoherence.  (The mental gymnastics over the tax deal are yet further evidence of the administration’s incoherence.)

Obama’s oh-so-softly condemnation hasn’t stopped the Chinese from throwing a tantrum.  Ironically, the hysterical reaction hardly conveys an image of strength.  It suggests fear instead.

Obama’s pusillanimity is particularly embarrassing coming from a winner (albeit undeserving) of the Nobel Prize.  It diminishes the stature of an award he received.  But then again, there’s a lot of that going around these days.

December 8, 2010

Interesting, But I’m Reserving Judgment

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics — The Professor @ 2:34 pm

The EU is proceeding with plans to take a much more aggressive regulatory approach in commodity markets.  The scheme will empower the to-be-established European Securities and Market Authority (ESMA) broad powers to intervene in commodity markets.  These powers would include the ability to impose “ex ante” position limits.  These proposals are included in a massive, sweeping proposal to regulate financial markets.  The new powers include:

— supervisors should have powers to intervene at any stage during the life of a derivative contract

— supervisors could require any holder of a contract to provide a full explanation for the position, provide all relevant documentation, reduce the size of the position in the interest of an orderly market and investor protection

— EU regulators to propose standards for setting position limits for derivative contracts traded on and off exchanges and define when such limits should be triggered

. . . .

— a separate “chapter” should be introduced into MiFID to “help ensure that sufficient clarity and regulatory focus are devoted to how commodity derivative markets function in the future”

— there is a need for a position-reporting obligation by categories for traders for contracts trade on all EU venues

— to avoid problems with convergence between futures and spot prices in commodity derivatives, a requirement could be added to the way commodity derivatives contracts are designed to ensure price convergence

— currently commodity trading for own account is exempt from MiFID rules but this waiver should be narrowed

— if an off-exchange, physically settled contract is like an exchange traded contract and standardised then it should also be centrally cleared

John Kemp of Reuters has more detail (sorry, no link: the story was emailed to me and I can’t find it on Reuters):

Under enhanced position management, position holders could be required to provide a full explanation for the position, including relevant documentation, to show whether the purpose is hedging or speculation. They could be required to reduce the position in the interest of an orderly market, investor protection or market integrity. The authorities could intervene at any time in the life of a derivative contract.

. . . .

But the consultation envisages that the future European Securities and Markets Authority (ESMA) would be given a powerful coordinating role and empowered “to propose technical standards to set ex-ante position limits both for derivative contracts traded on exchange and OTC [over-the-counter]” when necessary to address “risks to the overall stability or delivery and settlement arrangements of physical commodity markets”. That looks like a direct reference to preventing squeezes in the delivery mechanism.”New implementing measures could further define the details of when the powers to propose position limits may be triggered. For example, these could be triggered when conditions in a given market in terms of liquidity or market concentration jeopardise market efficiency or integrity,” according to the consultation document.

Decisions about when to invoke enhanced position management powers would be taken by the ESMA rather than left to exchanges. ESMA would set overall principles to be applied at national level. But it could also intervene directly when there is a threat to the orderly functioning and integrity of financial markets and national authorities have not taken sufficient measures to address the issue.

This implies a much bigger, more direct role for the regulator in handling the issue of dominant positions and market squeezes.

The Kemp piece, and some of the elements of the proposal (e.g., the focus on convergence) suggest that the focus of the new position control regime will be to prevent manipulation.  That focus is laudable, in contrast to the vague, obscure, untestable, theoretically and empirically unsupported goal of eliminating “excessive speculation” that underpins the CFTC’s authority to impose position limits (now vastly expanded).  (Give me a few minutes, and I’m sure I could come up with many more pejoratives.)  Manipulation (in its most important forms) is something, in theory and in practice, that can be defined, understood, and empirically identified.  In contrast, determining when speculation is “excessive” is a nebulous task, with no grounding in proper economics and impossible to implement in practice.  As a result, what happens in markets tends to be a Rohrschach Test, with some people (e.g., Bart Chilton, Michael Masters) seeing excessive speculation everywhere, and others not.

Kemp notes that the EC initiative is an implicit rebuke of Britain’s Financial Services Authority, which has argued that position limits are unnecessary. Kemp further notes that the FSA already has many of the powers outlined in the EC proposal, but delegates their implementation to exchanges.  As was seen in cocoa over the summer, and has been seen chronically in the metals markets for decades, that basically means in practice that “light touch” is a massive understatement, and that market participants can undertake some blatantly egregious–manipulative conduct–with little fear of hearing even a whispered “boo” from the exchange or the regulators.

Nor is it evidently much better on the Continent.  Although not related to commodities, the Porsche corner of VW shares, which I’ve written about extensively, was about as brazen and extreme as it gets, but the German regulators played Sergeant Schultz, and saw nothink.

So, in principle a manipulation-focused bolstering of regulatory powers is a good thing.  (See, I’m not an anarchist, despite what some think.)  That said, a highly discretionary system that relies on ex ante intervention is inefficient, compared to a realistic alternative.  I’ve written for what seems forever (although it’s only about 16 years or so) that an ex post regime that imposes sanctions on those that manipulate the market is highly preferable.  It economizes on resources committed to supervision.  Moreover, true corners and squeezes can be identified reliably ex post, and the perps are not judgment proof, and hence can be deterred by the prospect of severe sanctions imposed in the event of a determination that they have manipulated; a determination that can be made with considerable precision, and little likelihood of falsely convicting the innocent.

The EU/EC is in an excellent position here to do something constructive, because it starts with a blank slate.  Unlike the US, which is hamstrung by poorly crafted laws that provide little guidance to judges and regulators, thereby permitting the proliferation of economically deficient (and precedential) decisions, the EU has the ability to create an anti-manipulation statute that is grounded in economics, which provides specific guidance and tests to triers of fact.  My suggestions along these lines are here, amongst other places.  (Hint, hint, nudge, nudge.)

Permitting a private right of action would also be quite beneficial, because those harmed by squeezes are highly motivated to take action if they can be compensated for the damages that they suffered.  As the US experience shows, relying on regulators alone to punish manipulative conduct after the fact, even when they have the power, is all too often woefully inadequate.

Moreover, even if there is a focus on ex ante regulation, that regulation would be more effective, with lower probabilities of inappropriate intervention and inappropriate failures to intervene (cf. cocoa, July, 2010) if it were predicated on a firm economic understanding of manipulation, and if it were to set out in detail the indicia of manipulation and manipulative conduct that would attract regulatory scrutiny.  There is always a fear that a broad, vague grant of discretionary power to regulators can lead to a proliferation of both Type I and Type II errors.

Along these lines, although the descriptions of the EC consultation document suggests a focus on manipulation properly understood, the statements of the politicians in charge of the effort raise serious concerns that the regulation might be used to attack any form of conduct that doesn’t suit the person speaking at the moment.  For instance, EU commissioner Michel Barnier, who is driving the reform effort, has said:

If someone is doing something which affects the market then he or she must be held to account.  Hyper-speculation is scandalous.

“Affects the market” is pretty broad.  The broadside against “Hyper-speculation”–as opposed to manipulation–smells suspiciously like the pernicious “excessive speculation” language in the Commodity Exchange Act.  It doesn’t take too much of an imagination to picture that during some future energy or ag price spike, a regulator subject to political influence would intervene in a destructive way, chasing some chimera of hyper-speculation.  Politically influenced regulators (and there is no other kind) are great at killing the messenger.

Which all means that it is difficult to be too enthusiastic about the proposal.  Yes, a rule focused on manipulation, properly understood, would be an improvement.  But ex ante measures are inferior to ex post, and I strongly suspect that whatever emerges will give regulators a lot of discretion that can be abused–and will be abused, in the event, the next time developments in the commodity market leads to a popular and political hue and cry to “do something.”

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