Streetwise Professor

The most important recommendation in the report of the Flash Crash Advisory Board that I wrote about several days ago is that the SEC consider implementing a “Trade-at” rule in place of the current no trade-through rule.  Trade-at would require a firm receiving an order to direct that order to the market offering the best quote for execution, whereas under no-trade-through, the firm could internalize the order and execute it by matching the best price currently displayed at any execution venue.  Trade-at would largely cripple “dark pools” and internalization (although the Board disclaims any desire to hamper the operation of pools that facilitate block transactions)–what in the old days were referred to as “third markets.”

As I wrote in my original post, trade-at is a red herring when it comes to preventing Flash Crashes.  It’s primary effect will be to alter the way securities markets work in normal times, rather than exceptional ones.

The objection to internalization is that it is a form of “cream skimming” that free rides on price discovery in public markets.  This reduces liquidity in the public markets, widening spreads, reducing depth, and reducing the informativeness of prices.

Free riding is an externality that would lead to a less efficient outcome if you believe that the public market is competitive.  Many of the criticisms of internalization* and recommendations that it be eliminated, or at least constrained via regulation, implicitly assume that the public markets are perfectly competitive.

This is crucial, because if these markets are not perfectly competitive, free riding can actually improve efficiency.  When you have a departure from the first best (due to market power, for instance), what would be a market failure in a first best world can actually improve things.  For example, usually market power is bad.  Pollution is bad.  But if there are no taxes or other restrictions on pollution, it can actually be better for a polluting industry to be monopolized rather than competitive.  A competitive industry pollutes too much, but a monopolized industry restricts output, and therefore reduces pollution.  Market power markups serve the same function as a tax on pollution.  In this instance, two bads are better than one.

So when evaluating the desirability of internalization and dark markets generally, it is imperative to examine the nature of competition in public markets.  If public markets exercise market power, the existence of an externality (cream skimming) is insufficient to justify eliminating it.

Sadly, this is a point virtually absent from academic analysis of the issue, and seldom raised in public policy debates either.  But some people get it:

Kevin Foley, chief executive of Aqua, a block crossing platform, said: “A ‘trade at’ rule is hugely anti-competitive. We haven’t seen the SEC do something [like that] in ages.”

And the prize goes to a Russian guy (and who says I’m always slagging on Russia?):

Dmitri Galinov, head of liquidity strategy in Credit Suisse’s Advanced Execution Services unit, said that a “trade at” rule would have to be paired with reform in the SEC’s regulation of exchange fees, which are higher than fees charged by dark pools and other non-exchange venues.

Exactly right, Dmitri.   As I showed in my 2002 JLEO piece, and an earlier working paper titled “Third Markets and the Second Best,” cream skimming, internalization, block markets, payment for order flow, etc., can improve welfare when exchanges exercise market power.  And as I’ve also shown in my research, (a) network effects and coordination costs give exchanges market power, and (b) there is empirical evidence that exchanges do in fact exercise market power.  Off-exchange trading venues–dark markets in the current parlance, third markets in the old–are a source of competition.  The ability to free ride off prices in the public markets reduces the costs that these competitors incur–that is, it makes them more effective competitors and reduces exchange market power.

Indeed, there is a report in the FT that provides an excellent illustration of how exchanges exercise market power by charging supercompetitive fees: “Anger as Exchanges Raise Closing Auction Fees.”  Once upon a time exchanges exercised market power and generated rents for their members by limiting the number of members: now they do it by charging supercompetitive fees.

The wars over securities market structure drag on.  The criticism of dark pools and internalization is nothing new.  If you believe that public exchanges don’t exercise market power, then you won’t like dark pools and internalization.  If you believe that exchanges do exercise market power, the case isn’t obvious, and you have a strong basis to conclude that free riding is the lesser of two evils.  I’m of the belief that exchanges do exercise market power, and as a result I am highly skeptical of regulations intended to clamp down on internalization and dark pools.

Too often, however, this crucial issue of competition has been overlooked.  Discussing the pros and cons of internalization without coming to grips with exchange market power is to ignore the crucial issue.  It’s good to see that at least some are making the point.

* Kind of ironic that internalization creates an externality!

Gary has a magic box, called a “clearinghouse.”  You put counterparty risk in the box, and it disappears!:

One of the central goals of Dodd-Frank is to redirect much of the OTC derivatives market through exchanges, electronic trading platforms and central clearinghouses that stand behind dealings in derivative contracts.

“What that means to the American public is it’s less likely that the taxpayers stand behind that transaction,” [Gary Gensler] said.

“Instead the clearinghouse stands behind it, and I think that’s what Congress recognized. Moving as much of this into clearinghouses lowers interconnectedness, but also says a clearinghouse stands there, not the taxpayer.”

Uhm, but what stands behind the clearinghouse?  Where does that risk go?  Well, financial institutions—including many major banks—actually stand behind clearinghouses.   Meaning that if counterparty losses are big enough, the banks bear a big chunk of the loss (so things are still interconnected).  Or, if the banks limit the amount of loss they are willing to bear, the clearinghouse can fail.  Who wears the loss in that event?

Gensler might argue that collateralization in clearinghouses makes it highly unlikely the banks will bear any loss, and even less likely that the clearinghouse will fail.  Let’s say that collateralization is indeed extremely robust, so that the risk of clearinghouse failure is vanishingly small.  Does that mean that everything is great?

Well no, really. The risk still hasn’t disappeared.  Given the positions that firms take*, collateralization (and netting, another commonly touted benefit of clearing) affects the distribution of losses arising from the bankruptcy of a derivatives trading firm, not the total amount of the losses.  If collateralization is so robust that derivatives counterparties always get paid, that means that the entire loss arising from a bankruptcy falls on the firm’s other creditors.  So the magician may point to the magic derivatives clearinghouse box and say: “See!  No losses!  They disappeared!”  But they are somewhere, behind the curtain, borne by somebody else; collateralization changes the priority of claims, not their magnitude.**  Most likely, the loss is shifted to unsecured creditors—who may include banks backed by taxpayers, or owners of money market mutual funds who may run if it looks like their funds will break the buck, which can also lead to a Federal bailout (like what happened in September, 2008).

There’s also the issue of where the collateral comes from.  Some of it may come in the form of loans extended by banks that used to extend credit via derivatives trades; like in a real-world magic trick, the credit didn’t disappear, it was just shifted somewhere else.  Some collateral may come from firms foregoing higher yielding, but less liquid investments: this is a real cost as too many resources are tied up in liquid assets and too little invested in more productive projects.

There are other things going on behind the curtain.  Rather than enter into expensive collateral derivatives trades, firms may decide to hedge less, forcing their claimants (including lenders, employees, suppliers, and shareholders) to bear more risk.  Again, the risk doesn’t disappear–it leaves through a trapdoor and winds up someplace else.

And collateral can have perverse effects in a crisis.  The pressure of collateral calls can force firms to liquidate positions, exacerbating price moves.  Or firms may engage in fire sales of other assets to meet the calls, causing price shocks to spill over from the derivatives market to other markets.  How’s that for an interconnection?

Gary also has a magic transparency trick, a visibility cloak if you will.  Exactly the opposite of Harry Potter’s invisibility cloak, it makes the invisible visible:

“I also think transparency helps,” he said, looking back to the widespread uncertainty during the crisis of the value of assets on the books of giants such as American International Group.

“The law now says they have to be valued daily and valuations have to be shared between the counter-parties and if they run a clearinghouse, the clearinghouse has to share it with the public.”

Indeed, this cloak is so magical it can make visible things that don’t even exist.   For, in situations like AIG, the problem was that the values of the assets were uncertain because there were no trades: these things weren’t marked to market, they were marked to a guess—or to a self-serving price that was hard to challenge because there were no real prices to compare it to.   Many of the contracts that Gensler would like to see cleared trade little, if at all—and no trades, no prices.  It is a magical cloak indeed that can make prices and valuations visible when there are no trades to produce actual prices.

Magical thinking about clearing, counterparty risk, and transparency is extremely dangerous.  It creates very real risks.  Those who believe that things like clearing and transparency are magical solutions, and who do not grapple with the complex realities and difficult trade-offs are all too likely to impose rules and regulations that make things worse, not better.  Sad to say, I think that’s happening in spades, both here in the US and in Europe–and that’s not a card trick.  The consequences are pretty sobering to contemplate.

* The amount of margin will affect the sizes of positions and the structure of positions that firms take.  Netting will also affect positions, because (a) netting can actually economize on collateral, and (b) the amount of collateral savings can depend on how extensive cross-margining and portfolio margining are.  It is difficult to know what the net effect of clearing mandates will be on the trades that firms make, and the composition of the firms that make them.  I mention one possible effect below–some hedgers may exit the market, or hedge less.  Indeed, the potential effects are so extensive it is difficult even to list them.  Making it costlier to shift risks via derivatives transactions affects not just risk management decisions, but capital structure decisions (hedging really being just a capital structure choice), investment decisions (the amount and composition of investment), management compensation decisions, and on and on.  All I want to emphasize in the main discussion is that one major effect of collateralization is to affect claim priority, given the total aggregate size of claims against a bankrupt firm.  It secures some claims–which reduces the priority of other claims.

**Same caveat.

Paul Krugman is obsessed with Texas. He repeatedly attacks the state, primarily because it has chosen to cut spending to address its budget shortfalls, rather than raising taxes.  This is an anathema to Krugman, so he lambastes the state repeatedly.

As an I-got-here-as-soon-as-I-could Texan, Krugman’s antipathy is actually a badge of honor.  And he adds to the pride with his most recent column.  Perhaps in anticipation of Texas Independence Day (yesterday, 2 March), on Monday Krugman launched an all-out assault.  His main target was Texas schools:

But here’s the thing: While low spending may sound good in the abstract, what it amounts to in practice is low spending on children, who account directly or indirectly for a large part of government outlays at the state and local level.

And in low-tax, low-spending Texas, the kids are not all right. The high school graduation rate, at just 61.3 percent, puts Texas 43rd out of 50 in state rankings. Nationally, the state ranks fifth in child poverty; it leads in the percentage of children without health insurance. And only 78 percent of Texas children are in excellent or very good health, significantly below the national average.

But wait — how can graduation rates be so low when Texas had that education miracle back when former President Bush was governor? Well, a couple of years into his presidency the truth about that miracle came out: Texas school administrators achieved low reported dropout rates the old-fashioned way — they, ahem, got the numbers wrong.

It’s not a pretty picture; compassion aside, you have to wonder — and many business people in Texas do — how the state can prosper in the long run with a future work force blighted by childhood poverty, poor health and lack of education.

Well, there are a lot of factors in addition to spending that go into determining educational outcomes (and health outcomes for that matter).  But Krugman fails to mention those altogether.  It is well known by first year econometrics students, let alone Nobel Prize winning economists, that omitting variables from an analysis usually leads to biased estimates.  So by not controlling for these other factors, Krugman’s denigration of Texas performance is quite likely subject to bias.  (Krugman? Bias? In the same sentence? Heaven forfend!)

Provoked by Krugman’s attack, non-Texan and hilarious satirist Iowahawk decided to play it straight and see how Krugman’s criticism holds up when you include a key omitted variable.  Specifically, Iowahawk compared Texas’s educational performance to that of Wisconsin, that bastion of progressivism and empowered teacher unions. More specifically, he compared scores on the standardized NEAP math, science, and reading tests for 4th and 8th graders within three ethnic categories.  That is, Iowahawk controlled for a major source of variability across states–the racial/ethnic makeup of the student body.  With all due disclaimers, which I second:

[T]his has nothing to do with innate ability or aptitude. Quite to the contrary, I believe the test gap between minority students and white students can be attributed to differences in socioeconomic status. And poverty. And yes, racism. And yes, family structure. Whatever combination of reasons, the gap exists, and it’s mathematical sophistry to compare the combined average test scores in a state like Wisconsin (4% black, 4% Hispanic) with a state like Texas (12% black, 30% Hispanic).

The results were not pretty–for Wisconsin.  Texas, that Dickensian hellhole of cruelty to children in Krugman’s telling, outperformed enlightened Wisconsin in 17 out of 18 categories (3 subjects x 2 grades x 3 ethnic categories).  If Texas and Wisconsin were equal performers, the odds of that happening are microscopic: .00007, to be exact

Now, Iowahawk doesn’t control for everything, but he certainly controls for something important that Krugman does not. And terrible Texas comes out on top.  If Krugman or his numerous acolytes believe that other controls would reverse the results then: (a) he/they should admit that the original column is fatally flawed because it controls for nothing, and (b) support his/their claim with a rigorous analysis based on a defensible set of controls.

Iowahawk begins his post by making plain that it is not one of his usual–and invariably funny–satirical efforts:

Please pardon this brief departure from my normal folderol, but every so often a member of the chattering class issues a nugget of stupidity so egregious that no amount of mockery will suffice. Particularly when the issuer of said stupidity holds a Nobel Prize.

Iowahawk doesn’t have to satirize, because Krugman has become self-satirizing, especially when it comes to his Ahab-like obsession with Texas.  (New motto: “Don’t Obsess With Texas.”)  Indeed, Krugman’s  opinion writing generally has gone completely pear shaped.  But as this photo suggests, that may be part of a pattern.

To quote a reader: “Poor cat.”

When two historically antagonistic nations are jointly threatened by the rise of a third, aggressive one, the conventional response is for the two to find a way to resolve their disputes and join together against the new rival.

The example that immediately comes to mind is France and Britain in the face of a rising, obstreperous Germany in the early-20th century.  France and Britain/England had been adversaries for centuries.  Starting with the Hundred Years War (or 1066, if you prefer), the two nations were at war for a good part of the succeeding years, culminating in 1815.  During this time, these countries fought some of the first truly world wars, the Seven Years War, the Wars of Revolution, and the Napoleonic Wars.  Although the 19th century was relatively quiescent, the countries still viewed each other as their most likely enemies.  As late as the Fashoda Incident of 1898, war between the two countries was a real possibility.

But the rise of Wilhelmine Germany threatened both countries.  So, in 1904 the countries put aside their centuries of hostility and began to cooperate in defense planning.  Soon the countries entered into a formal alliance.

For a second example, Communist China and the US were enemies from 1948 on.  The two countries fought to a bloody stalemate in Korea, 1950-1953.  But they put aside their differences to cooperate against the USSR, starting with Nixon’s trip to China in 1972.

This article argues that Russia and Japan fear a rising China.  That makes sense.  What would also make sense is for Japan and Russia to find ways to reach an accommodation over issues that divide them.  The most notable of these divisive issues is the Kuriles.  But instead of toning down the confrontation, Russia in particular is ramping things up with the Japanese.  It has greatly elevated the rhetoric over the islands, and heightened the profile of the dispute with high level visits to the islands by Medvedev and Defense Minister Serdyukov.  It has just announced plans to greatly increase the armaments on the islands, including S-400 anti-aircraft missile systems adn Bastion mobile coastal missile system with Yakhont supersonic anti-ship missiles. The Japanese have responded with some animosity, and there have been outbreaks of popular anti-Russian protest in Japan (including a tragicomic flag burning incident).

If Russia is truly concerned about China, this course is insane.  The wiser course would be to explore a rapprochement with Japan involving some sort of deal on the Kuriles and cooperation on other economic and defense matters (e.g., North Korea). If Russia truly fears China, picking a fight with Japan is not just pointless, it is counterproductive.  Putting aside long term distrust and disagreements would not be easy, but worth the effort: instead, the distrust and disagreements are being aggravated.

Another explanation that has been advanced to explain Russia’s sudden interest in the Kuriles is that it is really motivated by a fear of the US, particularly the fear that Russian ballistic missile submarines in the Sea of Okhotsk are vulnerable to US attack.  The Kuriles are a barrier to the Sea, and placing a strong defense there would protect the Russian boomers lurking behind them.

This is also insane.  In terms of prioritizing threats, especially to the Russian east, Russia should rank China higher.  Again, a more reasonable geopolitical strategy would be to find common ground with the US in dealing with a more powerful and assertive China.  But that would require the Russian political and military leadership to banish the American bugbear from their minds.  Given the complex that afflicts virtually the entirety of said leadership, that’s not going to happen.

What explains this insanity?  I’m open to suggestions.  Some possibilities include:  This is just a consequence of political rivalry inside Russia in the lead up to the election, with Medvedev trying to establish a reputation as a guardian of Russian interests.  Or, it is just a reflection of deep insecurity combined with a sense that Russia does not have the means to address the main problem–rising Chinese power.  Or that Russia is trying to send a signal to China by getting into a spat with the Japanese.

The explanation is unlikely to be straightforward, because Russia is not taking the more conventional, straightforward course in this matter.  If China is indeed its main anxiety, especially in Asia, it would be hard to come up with a worse way of addressing it.

The estimable and experienced (not to say jaded!) Tim Newman at White Sun of the Desert feigns surprise at some revelations in a Transparency Watch-Revenue Watch Institute study of transparency among energy companies.  The Nigerian National Petroleum Company (motto: “We’re here to make Russia look good!”) earned a Bluto Blutarski GPA, which is to say in the immortal words of Dean Wormer, “ZERO POINT ZERO.”

Gazprom is in the Flounder range: “0.2… Fat, drunk and stupid is no way to go through life, son.”  Gazprom scored a zero on anti-corruption reporting.  To echo Tim:  I’m shocked!  Shocked!

Speaking of Gazprom and unsurprising developments, it picked up the Kovykta gas field for a song:

“They have got it virtually for free,” concluded one analyst after state-owned Gazprom triumphed with a $773m (£474m) bid for the giant field that is thought to contain enough gas to supply the world demand for eight months.

It certainly looks likes a good deal, at first glance, with Gazprom paying the equivalent of 6 cents per barrel of oil equivalent for the rights to extract the field’s estimated two trillion cubic metres of reserves.

BP’s shareholders should know the Kovykta gas field well: until recently, BP owned a 50pc stake in it through its TNK-BP joint venture. It was once one of the joint venture’s most promising prospects. One of the largest undeveloped sites in the world, positioned close to the growing Chinese market, City analysts put a $2bn price tag on the field.

Technically, Rosneft was in the running.   The results suggest that this was mere window dressing intended to give the charade a simulacrum of competitiveness.  There wasn’t arms-length bargaining in this deal.  Strong arming is more like it.

I especially like this part:

Gazprom initially claimed it wasn’t interested in bidding. “From the point of view of long-term balance we don’t see how gas from Kovykta can be used,” claimed executive Viktor Timoshilov just a few months ago. You can only assume that the Russian giant has since figured it out.

BP presumably believes that it has immunized itself against a repeat of this fiasco by dealing with state-owned Rosneft and Igor Sechin, rather than a group of mere oligarchs.  Maybe so, but worms have a way of turning in Russia.  Or, to mix metaphors, one’s roof can protect you today, and collapse on you tomorrow.

This is especially true in a country where with respect to corruption and investor protection you can look down on Nigeria.  Maybe.

The apoplexy on the left over the Koch brothers, the Koch foundation, and anything Koch is quite a spectacle.  They have joined Rush Limbaugh and Fox News as the betes noir of the progressive set.  This apoplexy is informative, but not quite in the way they think.

Part of the attack on the Kochs is Alinskyite picking, freezing, personalizing and polarizing.  But part of it reflects the fact that certain kinds of people are really incapable of comprehending spontaneous, emergent, unplanned social and political movements.  They are prone to what Thomas Sowell called (in Knowledge and Decisions) the “animist fallacy”: the belief that there is a conscious human or human-like agency behind every action who intends that action to occur.  In politics, this fallacy tends to lead people to think along conspiratorial lines: and especially today, the paranoid style of American politics is not the monopoly of the Bircher right.

Indeed, the current political environment is a serious challenge to progressives, even those who are not necessarily prone to political animism.  In particular, the Tea Party movement generates severe cognitive dissonance within the progressive left.  The thought that a spontaneous, broad-based, grass roots political movement could be predominately bourgeois (an alliance of the entrepreneurial and middle-middle and lower-middle classes), libertarian and anti-statist rather than proletarian, minority-dominated and avowedly statist (if not truly socialist) is outside their mental universe.  The idea is utterly alien–hence the need to find an alternative explanation.

Thus, personalizing the broad anti-establishment movement (and yes, the Tea Party movement is clearly anti-establishment, if you understand what the current establishment is, and don’t cling to 1960s tropes) that has completely upset the political equilibrium in the US (thereby discomfiting both parties) meets the needs of the Alinskyite left, the animist left, and the cognitively dissonant left.  As the most prominent long term funders of libertarian activities and entities, the Kochs are the natural boys to put on the posters. The early and rather generous support that the Kochs have provided to Tea Party-inspired candidates and groups feeds the villain narrative perfectly.

It’s pretty clear, however, that the Kochs are riding a wave that they did not create.  A glance at the timeline–one which many on the left have documented–completely undercuts the case that they are the fathers of the Tea Party movement, rather than (likely surprised) beneficiaries of its unexpected rise.  For this timeline shows that the Kochs have been giving to libertarian causes for decades.  They founded the Cato Institute in 1977.  They gave millions to it in the 1980s and 1990s.  Even their more recent endeavors, like the Americans for Prosperity Foundation are hardly new: APF dates from 2004.

So the Kochs spent on their causes for years, with virtually nothing tangible politically to show for it.  Indeed, until 2010, the conventional wisdom was that the political momentum was all in the other direction: witness 2008 and the resulting narrative that the country had moved left and that Obama was creating a new political dynamic–one definitely not to the Kochs’ taste.

Well, Obama (with a major boost from the economic fallout from the crisis) created a new political dynamic, all right.  It was just diametrically opposed to the one everyone thought he was creating.  The backlash against his progressive onslaught served to catalyze and coordinate the spontaneous emergence of a movement that was broadly in sympathy with many of the things the Kochs had been advocating and funding for years.  You can argue over whether these libertarian, anti-government tendencies were latent in a large part of the body politic but required something to turn an inchoate set of individuals into a more cohesive collective movement, or whether the events of the past couple of years have significantly altered the views of large numbers of people.  But you can’t really argue with the proposition that Obama (and the Congressional Democrats) have transformed American politics in entirely unintended ways.

Surely the Kochs consider this a beneficial development.  Surely the Kochs are quite pleased that they have new groups and candidates and issues that they can fund with realistic hopes that this money will translate into concrete political, legal, legislative, and regulatory changes.

But the Kochs’ many years in the political wilderness–the political fringes–demonstrates that their money and support was most decidedly not a sufficient condition to achieve their political and ideological goals.  They spent much to no effect before.  They are spending now, but even then the main political dynamic is not of their creation, and they can only affect it in the most marginal way.  That dynamic is now driven by the nation’s fiscal position, its economic difficulties, and the polarizing influence of Obama.  The Kochs are merely along for the ride.  Indeed, it is likely that the success of the Tea Party movement is not necessarily tied in any serious way to what the Kochs do.

In other words, the Kochs didn’t make the Tea Party.  The Tea Party made the Kochs.  In attacking this personification of a movement that they do not really comprehend but deeply fear, the progressive left is wasting its time and energy on something of peripheral importance.  If they want to find their real foe, well, it is them: for the anti-government dynamic that they loath is not the creation of the Brothers Koch, but is instead a reaction to them and what they believe.