Streetwise Professor

April 30, 2011

F(X) Scott Fitzgerald Goes to Timmy!’s Treasury Department

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 8:19 pm

Timmy!’s Treasury Department has released a decision exempting foreign currency swaps from Dodd-Frank clearing and SEF rules.  I agree with the decision, because I think clearing and SEF mandates are a bad idea (if you haven’t noticed).  But the “reasoning” behind the Treasury’s decision would embarrass South Park Timmy!  Really.

Where to begin?  First of all, the Notice of Proposed Determination (NOPD) completely undercuts all of the justifications for Frank-n-Dodd clearing mandates.  In multiple ways.

The NOPD tries to distinguish between FX swaps and other swaps: For instance [with my numbering for subsequent reference]:

(1) [f]oreign exchange swap and forward participants know their own and their counterparties’ payment obligations and their full extent of the exposure throughout the life of the contract, whereas the counterparties to other derivatives contracts do not.  (2) Moreover, foreign exchange swap and forward contracts have a very short average length and, therefore, relative to other swaps and derivatives, create significantly lower levels of counterparty credit risk.

(3) Settlement of foreign exchange swap and forward contracts requires the exchange of the full principal amount of the contract . . . whereas the payment obligations of most other derivatives are based on the incremental profit or loss on a transaction.  The physical settlement requirement distinguishes foreign exchange swaps and forwards from other derivates and contributes to a risk profile that is largely concentrated on settlement risk.

To which I say:

(1) So what? And, so misleading.  As the Treasury acknowledges on the prior page, the market value of the FX swap can change.  That’s what creates counterparty risk.  If the dollar crashes (despite Timmy!’s–Turbo Tax Timmy!’s, not South Park Timmy!’s–and Banana Ben’s assurances that it won’t which is primarily why I think it will), those long the dollar under swap agreements will suffer a big loss thereby creating a credit exposure for their counterparties.  That’s what matters.

What’s more, there are a lot of derivatives that are cleared that have this feature.  The counterparties to every physically settled commodity contract, and to every standard stock option, know exactly what the delivery and payment obligations are.  A buyer of a corn futures contract knows the seller has to delivery 5000 bushels of corn, and the seller knows exactly how much money the buyer has to deliver in return.  The buyer of a put on IBM knows exactly what he has to pay on exercise (the strike price times the number of shares), and the seller knows exactly how many shares he will have to deliver.  It’s variations in the market values on these contracts that create credit risk, and that’s the risk that the CME clearinghouse or the OCC take on. If the certainty of delivery and payment obligations meant clearing didn’t add value, why would these kind of products be cleared?  Why have they been cleared for decades?  Why?  Precisely because changes in market values may result in one party to a contract not performing on the fixed and known obligation, and thereby imposing a replacement cost loss on the counterparty.  So how is FX different in any way?

(2) This may be relevant on average, but there are many long tenor FX derivatives.   The NOPD states that 68 percent of FX derivatives mature in less than a week, and that 98 percent mature in less than a year.  This, plus the focus on CLS Bank (the FX settlement service), suggests that they are lumping in all FX trades in their analysis.  By doing so, Treasury mixes apples and oranges.  The logic of Frank-n-Dodd may still compel the clearing of the longer-dated products–which still make up a big chunk of change.  Interesting that the Treasury reports percentages without saying exactly what goes into the calculation, and doesn’t report the amount of principal at risk on longer dated contracts.

(3) Here’s the real whopper.  This actually means that an FX forward or swap has greater counterparty risk than other derivatives (e.g., interest rate swaps) of the same tenor and underlying volatility.   That’s because principal is at risk in a default of an FX swap, but it isn’t at risk in a typical interest rate, equity, or commodity swap.  To quote The Man when it comes to counterparty credit risk, Jon Gregory:

Foreign exchange exposures can be considerable due the high FX volatility driving the risk coupled to the long maturities and the final exchanges of notional required in most swap contracts.  The risk of these instruments is driven by a large final payment and thus the profile increases monotonically until the maturity of the trade (p. 85).

Gregory also has some charts that show FX swap credit exposures being larger than the exposures on IR deals.

All of which pretty much calls Bull! on the Treasury’s “argument” as to why differences between FX swaps and other swaps means that it’s not necessary to clear the former.  If anything, to a Frank-n-Dodd fan, the reverse should be true, at least for longer-dated swaps.  Similarly, the NOPD makes it clear that non-delivery settled forwards are not exempted–even though the lack of principal being at risk means that all else (e.g., tenor, currencies) equal NDSFs entail less counterparty risk.

So, if you believe that counterparty risk is best handled through CCPs–which you have to believe if you are a Frank-n-Dodd clearing mandate pom-pom squad member–you should think longer tenor FX swaps are especially important to clear.

But it gets better!  Or worse, depending on your point of view.  Treasury also argues that a clearing mandate would be burdensome because it could lead firms to eschew risk management.

Seriously!  Let me repeat that: Treasury also argues that a clearing mandate would be burdensome because it could lead firms to eschew risk management.

Don’t believe me?  Read it for yourself:

Commenters argue that additional costs associated with collateral, margin, and capital requirements required by the CCP would potentially reduce their incentives to manage foreign exchange risks.  Such additional costs borne by non-financial end-users could lead to lower cash flows or earnings, which would divert financial resources from investment and discourage international trade, thereby limiting the growth of U.S. businesses.

. . . .

In light of these and similar factors raised by the commenters, Treasury believes that mandating centralized clearing and exchange trading under the CEA for foreign exchange swaps and foreign exchange forwards actually would introduce significant operational challenges and potentially disruptive effects in this market which would outweigh any marginal benefits for transparent trading or reducing risk in these instruments.

So don’t these burdens exist in other markets?  If “additional costs associated with collateral, margin, and capital requirements required by the CCP” lead to less FX hedging, won’t they also lead to less interest rate, credit risk, and commodity price hedging?  If the reduction in risk management is such a serious concern in FX, why not in these other markets?

But we’re not done yet!  Get this: another justification for the exemption is that most FX derivatives are traded by banks either directly or on behalf of clients, and–wait for it–

[b]anks are subject to consolidated supervision, and supervisors regularly monitor their foreign exchange related exposures, internal controls, risk management systems, and settlement practices.

In case you didn’t catch that, FX derivatives should be exempted from clearing because:

Banks are subject to consolidated supervision, and supervisors regularly monitor their foreign exchange related exposures, internal controls, risk management systems, and settlement practices.

Here’s more:

The predominant participants in the foreign exchange swaps and forwards market are banks which have long been subject to prudential supervision.  In fact, nearly all trading within the foreign exchange market involves bank counterparties.  Roughly 95 percent of foreign exchange trading occurs between banks acting in the capacity of either principal or agent.  Compared to non-bank entities, banks have distinct advantages to provide the liquidity and funding necessary to conduct foreign exchange swaps and forwards, which involve the exchange of principal, rather than variable cash flows.  In conjunction with providing the liquidity and funding needs to conduct these transactions, banks are uniquely qualified to have access to CLS to settle transactions on a real-time basis, and thereby meet the payment and short-term funding needs of the end users.

Prudential supervisors regularly monitor the activities, exposures, internal controls and risk management systems of these banks.  In order to meet safety-and-soundness requirements, banks have implemented monitoring systems, limits, internal controls, hedging techniques, and similar risk-management measures.  Counterparty credit risk management is a fundamental issue for banking supervisors and is extensively addressed in bank supervisory guidelines as well as under the Basel Accords.

So let me make sure I have this right:  bank dominated markets need not be cleared because banks are subject to rigorous prudential regulation.

But wait a minute.  The whole point of Frank-n-Dodd was that derivatives trading was uniquely dangerous for banks, and clearing mandates were necessary to reduce the risk of the derivatives-induced collapse of a too big to fail bank, all because prudential oversight hadn’t worked and couldn’t be relied on. Moreover, whereas Dodd-Frank contemplated the exemption of non-bank firms from clearing mandates, margining on non-cleared trades, and capital requirements, the Act forces banks to clear standardized products, and to collateralize non-cleared trades.  All in the name of reducing systemic risk and shifting counterparty risk from banks to CCPs (which are capitalized by banks, but let’s ignore that little detail).

In order for this to make any sense whatsoever, it must be the case that prudential regulation is insufficient to reduce derivatives-related systemic risks.  But the NOPD relies heavily on the adequacy of prudential regulation to justify exempting FX swaps from the clearing mandate.

I ask, in all seriousness: if dominance by banks that are prudentially supervised implies that clearing is not necessary, why are CDS subject to a mandate?  After all, they’re bank dominated.  And don’t banks have “distinct advantages to provide the liquidity and funding necessary to conduct” other kinds of swaps?

F. Scott Fitzgerald said “the test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.”  You have to be a genius and hold Frank-n-Dodd and the Treasury NOPD in your mind simultaneously, because they are definitely opposed ideas.  Every substantive justification for the exemption in the NOPD is diametrically at odds with the justifications for the Dodd-Frank clearing mandates.

But the fun isn’t finished!  The NOPD’s rationalization for exempting FX from SEF requirements is also entertaining.  I quote:

Foreign exchange swaps and forwards already trade in a highly transparent market.  Market participants have access to readily available pricing information through multiple sources.  Approximately 41 percent and 72 percent of foreign exchange swaps and forwards, respectively, already trade across a range of electronic platforms and the use of such platforms has been steadily increasing in recent years.14  The use of electronic trading platforms provides a high level of pre- and post-trade transparency within the foreign exchange swaps and forwards market.  Thus, mandatory exchange trading requirements would not significantly improve price transparency or reduce trading costs within this market.

I’m not disputing any of this, but  just think of all the questions that this should raise in the minds of those who argue that it is necessary to force open electronic trading on swap market participants–but which it evidently hasn’t.

Recall that the NOPD makes a big deal out of the fact that FX is bank-dominated–dominated, in fact, by the same banks that dominate IR, credit, and equity derivatives trading.  In IR, credit, and equity, the argument goes that banks have actively fought pre- and post-trade transparency and electronic execution in order to protect their market power.  So . . . why didn’t they try and succeed in doing that in FX?  To create a natural experiment?  I kinda doubt that.

Maybe–just maybe–it’s because trading structure is endogenous and reflects the nature of the instruments traded and the firms that trade them, and there are enough differences across markets to make different trading structures optimal.  Maybe–just maybe–market structures and trading mechanisms have evolved to match in a discriminating way the characteristics of instruments and participants.

I don’t know that’s definitely the case, but it’s certainly a possibility, and it makes economic sense.  It’s certainly a more plausible explanation of cross sectional variation in trading mechanisms than the Treasury or SEF mandate boosters offer–because they don’t offer any.  Another F. Scott Fitzgerald moment here, apparently,  for the very facts in the Treasury NOPD undercut the narrative used to justify SEF mandates that Treasury has advocated strongly in the past.

Of course I seriously doubt that the espousal of completely contrary positions on all these matters is a reflection of first rate intellects at work.  Nor is it an exercise in eristics.  Instead, it is a symptom of complete intellectual muddle and confusion, blended with politics and rent seeking. Timmy!, Dodd, Frank and all the other Sorcerer’s Apprentices have no real understanding of the economic forces they have unleashed, and what will result.  The FX swap exemption is a first order issue, and the completely intellectually discreditable way with it has been handled provides a very sobering preview of how derivatives market regulation generally, and CCP regulation in particular, is likely to be carried out in the future.  If they can’t think carefully and seriously about this, what can they think carefully and seriously about?  Are they incapable of self-reflection?  Of embarrassment?  Do they not see the glaring contradictions between the NOPD and the entire rationale for the Dodd-Frank Act that gave birth to the NOPD in the first place?

I’ve said it often before, but it still bears repeating.  Regulators create systemic risks because they act on the entire system, and there are few of the kind of ameliorative feedback mechanisms that work in markets.  I fear that the NOPD is a harbinger of the kinds of regulation- and regulator-created systemic risks that will haunt derivatives markets for years to come.

April 29, 2011

Do Us a Favor Jimmy: Stay in NoKo

Filed under: History,Politics — The Professor @ 1:21 pm

Apparently panicked that Barrack Obama may supplant him as the Worst Foreign Policy President in History, in an effort to show that he gives way to no man when it comes to foreign policy idiocy, Jimmy Carter dashed off to his home-away-from-home–Pyongyang–to accuse the United States and South Korea of human rights violations for refusing to provide food aid to North Korea.

No, seriously.

Any mention of the fact that North Korea is the most brutal, repressive dictatorship on the planet?  Surely you jest.  Any mention of the fact that the starvation in North Korea is the product of the regime’s destructive, inhumane policies full stop?  No: Carter merely “observe[d] the country’s food rationing system.”  A rationing system that is, by the way, a major element of the regime’s mechanism of political control by which the population is brutalized.

In other words, Jimmy Carter played Enabler-in-Chief to the world’s most reprobate regime, and traveled to that country to attack his own nation.  It used to be unpardonable for any prominent American politician, let alone an ex-president, to slander his own country from abroad.  To do so from Pyongyang is beyond unpardonable.

It is truly sobering to think that a man with such warped judgment–and indeed, arguably a man who is warped, period–was elected president of the United States.

Oh They’re Reliable All Right

Filed under: Economics,Energy,Politics,Russia — The Professor @ 11:08 am

Russia has announced a sharp hike in export taxes on gasoline, and a complete ban of refined petroleum exports for May.  The reason: shortages of gasoline, leading to “panic buying” in numerous regions.

Now, shortages result from price controls–almost always.  But the Russian government has no authority to set prices--officially, anyways.   But unofficially–that’s a different story.  And that’s exactly what’s happening.  Bigfoot–Putin, that is–is interfering in the market:

Government officials, and in particular Prime Minister Vladimir Putin, have strongly warned gasoline producers and retailers to maintain cheap prices for gas. “I don’t want to think that the reason for the jump in prices is as trite as the wish to crudely extract an unreasonable, maximum gain,” said Putin in mid-February.

Such statements from government officials are often recognized as a kind of informal regulation by oil and gas companies, said Elena Anankina, a senior director at the Standard & Poor’s rating agency, and the companies may be willing to make some concessions on gasoline prices in order to maintain favorable terms for negotiation on crude oil and other products. Nonetheless, price caps will produce an expected, negative effect in any market.

“Officially, the government has no authority to regulate gas prices, but in a country like Russia where the government is an important factor in doing business, even if there is no legally binding power to that statement, oil companies need to listen to what the government is saying. At the same time, as anybody who lived in the Soviet Union will tell you, if prices are artificially low by government decree, it creates a shortage,” said Anankina.

I especially like that part about “the wish to crudely extract an unreasonable, maximum gain.”  Translated: That’s my (Putin’s) job; well, me and my judo buddies’.*

Or, as this AFP story put it:

“Putin ordered (oil companies) to control wholesale and retail prices and they complied,” the Vedomosti business daily remarked.

“But world oil prices continued to grow and the companies quietly stepped up their exports, leaving only enough for the domestic market to keep their own (gas station) chains going,” Vedomosti observed.

More evidence of state pressure:

Jonathan Muir, chief financial officer of Russia’s No.3 producer TNK-BP, said on Wednesday that “regulatory pressure” on domestic fuel prices prices had cost the company $54 million in the first quarter.

One of the knouts used to beat suppliers into submission is the antitrust authorities:

In February, Prime Minister Vladimir Putin issued a stern warning over fuel prices and vowed increased oversight of the fuel business.

“This may be one of the kinds of cartel agreement for which the antimonopoly legislation includes criminal responsibility as a measure of last resort,” Federal Antimonopoly Service head Igor Artemyev said in a statement after a Monday meeting with fuel unions.

. . . .

The Altai branch of the FAS launched a suit against Rosneft and Gazprom Neft on Tuesday on suspicion of price collusion.

Uhm, no, actually.  Cartel agreements that jack up prices do not cause shortages.  Shortages occur not because prices are too high, but because they are too low.

In sum, for populist political reasons Putin pressures companies to keep down prices in Russia despite rising prices for crude and refined products abroad.  So, not surprisingly–well, maybe to Putin, who’s no economic swiftie–Russian refiners sell less in Russia and more abroad.  Moreover, the inability to charge a market clearing price in Russia leads to shortages domestically and a shifting of supplies from Russia to other markets.  It’s not that complicated.

Russia–and Putin personally–like to preen about how reliable they are as energy suppliers.  Oh, they’re reliable, all right.  You can rely on them to cut off supplies in a trice for a political or geopolitical reason.  Someone at Gazprom Neft is quoted as saying “export contracts are holy.”  Thanks for that!  I needed a laugh.

More evidence of Russia’s obvious readiness for WTO membership.  As we’ve witnessed over and over again in recent months, on things from cars to grain to energy Putin uses tariffs, export taxes, and trade bans to achieve political objectives.  Not that he’s alone in this, mind you, but he is distinctively aggressive–and unrepentent–in his use of trade restrictions to shift around rents and put out political fires in the natural state.

There’s also a potentially bigger issue looming in the background.  Inflation is picking up in Russia, and to the surprise of some analysts, Russia’s central bank is taking aggressive action (unexpectedly raising interest rates) to combat it.  Putin has made fighting inflation his top priority.  His remarks on US monetary “hooliganism” must be read in that context.  This is a politically sensitive issue, and Putin is pulling out all the stops to deal with it.

The thing is, there are some stops that are good to pull, others not.  Attempting to control inflation through export bans and price controls–official or unofficial–leads to huge real distortions.  The grain export ban is evidently leading to sharp cut backs in planting, and imposing hardships on farmers.  The gas export ban and associated information price controls will also lead to distortions.

But politicians everywhere–especially those likely seeking reelection–have a tendency to overlook those distortions and seek short term palliatives.  But in the end the costs have to be paid.

Russia is just one country coping with inflationary pressures.  What hath Ben wrought?  More on that subject as time permits.

* For a great illustration of how judo makes you really, really smart–and hence rich–check out this story about the shenanigans involving the Novorossiysk port, in which Putin’s judo buddies raked off a cool billion, no risk, no work.

April 27, 2011

One Size Fits Few

Filed under: Clearing,Commodities,Derivatives,Exchanges,Politics,Regulation — The Professor @ 4:34 pm

The CFTC and SEC have released their swap definitions. Among other things, the CFTC rule excludes commodity forward contracts from the swap definition.

The CFTC proposed rule is 300 pages long.  Do you believe that such a massive attempt at definition will not have ambiguities and uncertainties that will require clarification?  Do you believe that market participants will not try to write contracts to take advantage of exclusions and exemptions, and that these attempts will not result in litigation?  Do you believe that a rulemaking that is far broader in its application than pre-CFMA laws and regulations  will not result in the growth of a thicket of decisions, interpretive letters, no action letters, etc., that will be more confusing and more contradictory than that which developed prior to 2000 (before the passage of the CFMA) to clarify the distinction between “futures” that had to be traded on exchanges and commodity forward contracts that didn’t?

If so, have a nice dream.  Reality will be waiting for you when you wake up.

The Commission also voted out a proposal for a hybrid margin segregation mechanism, where customer funds would be segregated operationally (i.e., held in a single account), but would not be at risk to a the default of another customer.

This is a victory for BlackRock and other big money managers who lobbied hard for it.  And yes, they are winners.  But make no mistake, the main effect of this rule is redistributive, meaning that there are losers.  And to the extent that it affects efficiency, the effect is negative because mandatory segregation encourages moral hazard: clearing member customers now have zero incentive to monitor their clearing members.

The distributive effect arises from the fact that removing customers from default risk mutualization means that default losses are just shifted elsewhere, e.g., CCP equity or the CCP’s default fund.  Alternatively, CCPs may choose to up margins to reduce default fund exposure to customer defaults.

The costs of default don’t go away.  They are mainly shifted around.  Low default risk firms (e.g., BlackRock, pension funds) will no longer be at risk and will benefit.  But somebody else will pay.

A much preferable approach would be to establish omnibus segregation as a default standard, but permit clearing members and their clients contract for individually segregated accounts .  This would permit those who value segregation more highly than it costs clearing members to segregate to negotiate mutually beneficial arrangements with clearing firms.  Such contracts would reflect information available only to the contracting parties, but which regulators could not know when setting a one-size-fits-all standard.

This would internalize (i.e., price) many of the costs of segregation which  under the CFTC proposal would be shifted to default fund participants (i.e., other clearing members) and from some customers (the BlackRocks of the world) to others.

For instance, if a large money manager and a clearing member negotiate a segregation arrangement, this would shift risk to the member’s other customers, and to the CCP default fund. The shift in risk to other customers would tend to reduce their demand for the member’s services, leading this firm to internalize some, and perhaps all, of the effects of this risk transfer.

However, the risk transferred to the default fund would not necessarily be priced.  This problem could be addressed by allowing the CCP to set default fund contributions based on segregation, with members with larger sums in segregated accounts being required to make a larger default fund contribution.

I don’t understand the mania for one-size-fits-all rules when private contracting can result in efficient outcomes that take into account individual differences.  Derivatives market participants are by and large quite sophisticated, and capable of trading off the costs and benefits of alternative arrangements, including alternative segregation arrangements.  Permitting individualized negotiation which prices these costs and benefits–which differ among market participants–is the most efficient and effective way of ensuring they optimize that trade off, and do so in ways that reflect differences among them.  Let CCP members who participate in the default fund come up with methods that internalize the potential spillover between segregation and the default fund.

One size fits all rules create a tremendous incentive for affected parties to influence the rulemaking process for their benefit.  BlackRock, Pimco, some big pension funds, etc., seem to have done that in this instance.  They’ve secured a rule that protects them from some risks–by shifting those risks to others, not by reducing them (in fact the overall risk likely has increased due to moral hazard).  The outcome is affected by the costs and benefits of exercising influence, not by the economic costs and benefits of alternative segregation mechanisms.

This is another example–as if we needed more–of a prescriptive regulation dictating an allocation of resources that is perfectly amenable to private contracting.  And one where there are no obvious barriers to private contracting, and where as a result such contracting would lead to an allocation that balances efficiently costs and benefits.

Putting Patraeus Out of the Loop

Filed under: Military,Politics — The Professor @ 2:29 pm

President Obama has named Leon Panetta to replace Robert Gates as SecDef, and General David Patraeus to replace Panetta at CIA.

Glad to hear Panetta’s alive.  I was wondering.

Here’s my quick take.  Patraeus seems completely out of place at CIA.  He’ll be completely isolated with no real relationships within the agency.  He should be head of the Joint Chiefs–or SecDef, although it’s problematic having the Pentagon headed by a man immediately out of uniform.

But Obama is at war with the Pentagon, and that conflict is going to intensify due to the budget issues, the incompetence and incoherence of Obama’s “campaign” in Libya, and the Afghan ulcer.  Having Patraeus as top hat at the Joint Chiefs (or SecDef) would place a well-known, popular, and smart individual opposite Obama in that battle.  So, he’d rather have a political type–a reliable Democrat politician to boot–in the Pentagon to help him in his fight with the rest of the building–and the rest of the military.  At CIA, Patraeus might as well be on the moon–which is just fine with Obama.

A Taxing Situation

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 1:53 pm

I wonder if these stories may have some connection.  First, Rosneft and BP are apparently working to structure a deal to buy out AAR from TNK-BP.  Second, the Russian government has revoked a tax holiday on TNK-BP’s Verknechonskoye field, as well as another field held by Surgutneftgaz.

This will apparently cost TNK-BP $450 million.  Nice way to put some downward pressure on the value of TNK-BP–and hence the price AAR can demand for their piece of it.

Of course there are other reasons to remove the tax breaks, notably the Russian government’s need for money.

But there’s a bigger issue here too.  A constantly changing, unpredictable, and ultimately arbitrary tax regime subject to the short-term political currents in Russia (e.g., Putin promises more bennies as part of his political campaign, and the money has to come from somewhere) as well as the vicissitudes of natural state rent reshuffling, is hardly conducive to robust investment.  Russia is notorious for its low rate of investment, especially compared to its alleged peers.  Foreign direct investment is moribund, and Russians are shifting capital out of the country.  This is another short term measure that undermines the long-term prospects for Russian development.

Not that short-termism is a solely Russian phenomenon.  I hope to post soon on how it is becoming a serious problem in the US too.

No (Environmental) Justice, No Peace?

Filed under: Politics,Regulation — The Professor @ 11:20 am

The  EPA has a made a big deal of “environmental justice”:

Environmental Justice is the fair treatment and meaningful involvement of all people regardless of race, color, national origin, or income with respect to the development, implementation, and enforcement of environmental laws, regulations, and policies. EPA has this goal for all communities and persons across this Nation. It will be achieved when everyone enjoys the same degree of protection from environmental and health hazards and equal access to the decision-making process to have a healthy environment in which to live, learn, and work.

The environmental justice movement is predicated on the belief that there is widespread “environmental racism” whereby minorities and the poor are victimized by the deliberate placement of polluting facilities.  Here are a couple of definitions:

Environmental racism is an internationally recognized sociological term referring to the enactment of any policy or regulation that negatively affects the living conditions of low-income or minority communities at a rate disproportionate from affluent communities.[1]

The phenomenon can be either intentional or unintentional, and the term is often used to describe specific events in which minority communities are targeted for the siting of polluting industries and factories

. . . .

Environmental racism is the disproportionate impact of environmental hazards on people of color.

Environmental justice/environmental racism are staples of the progressive left, of which Obama is an exemplar. Indeed, he has portrayed himself as a battler against environmental racism while he was a community organizer.

Now consider a couple of recent news items.  Obama has praised Brazil for drilling for oil offshore.  The Obama administration is providing $3 billion in loan guarantees for a Columbian oil refinery.  Just yesterday, Obama pleaded with foreign oil producers to increase output:

Amid a surge in the cost of gasoline, President Barack Obama said Tuesday he is calling on major oil producers such as Saudi Arabia to increase their oil supplies and lower prices, warning starkly that lack of relief would harm the global economy.

“We are in a lot of conversations with the major oil producers like Saudi Arabia to let them know that it’s not going to be good for them if our economy is hobbled because of high oil prices,” Obama said in an interview with a Detroit television station.

Now, at the same time that Obama is praising, subsidizing, and pleading for increased energy output abroad, he is doing everything to stop energy production here–on environmental grounds.  EPA rules are forcing a shutdown of Shell’s plans to drill offshore in the Arctic. The administration is still slow-walking drilling approvals in the Gulf of Mexico–and as a result, rigs are moving from the Gulf to Brazil.  The EPA has gone to the mattresses over permitting refineries in Texas.

I’m genuinely curious.  Just how do Obama, and Obama’s EPA, square their environmental justice/environmental racism rhetoric with their simultaneous war on energy production here in the US and support of energy production overseas?  Why is the administration promoting “policies [and] regulations that negatively affect the living conditions of low-income [countries] at a rate disproportionate from affluent [countries, notably the US”?  How are their policies not environmentally racist–by their own definitions?  It is a puzzle.

April 25, 2011

A Glimpse Behind the Commodity Trading Curtain

Filed under: Commodities,Derivatives,Economics — The Professor @ 5:57 pm

Today’s FT carried an interesting article about a Glencore trade in wheat and corn.  FT is a royal PITA to quote from, so I’ll just recapitulate.  In brief, as the Russian drought was beginning, Glencore received early reports from “Russian farm assets” of rapidly deteriorating growing conditions in Russia.  It bought wheat and corn, and profited handsomely from the trade.  It claims that such proprietary trades are exceptional for the firm.

More controversially, on 3 August, 2010 Yury Oganev, Glencore’s Russian grain division chief, publicly advocated a ban on Russian exports (a position not endorsed by Glencore).  Two days later Russia indeed banned exports.  Glencore claims that its export business wasn’t helped by the ban, but note the dog that isn’t barking:  the company does not make any statements about whether profits from the wheat and corn trade more than offset the loss to the export business.

Several things bear noting here.

First, this is a classic example of how information is generated and used in commodity markets.  Market participants with physical assets collect information on supply and demand fundamentals, and use that information in their trading.  It is trading on private information, and it tends to contribute to price discovery–as well as generate profits for those with the information advantage.  Such private information tends to reduce market liquidity and impose costs on the (relatively) uninformed, but that’s part of the inherent trade-off between price informativeness and liquidity.

Second, this shows why trading firms with physical assets can have advantages.  Ownership of these assets helps produce valuable information on fundamentals.

Third, this is “speculation,” but it illustrates how such speculation can actually improve the allocation of resources.  Glencore had an early warning of an impending shortage.  It traded on that information, thereby causing prices to reflect it.  This provided a signal that other market participants could use  to take actions to mitigate the effects of the drought.  In particular, market participants who base their consumption and storage decisions on market prices would tend to adjust those decisions in response to the price changes.  The magnitude, or value, of those adjustments is impossible to quantify, but are conceivably large.  In particular, delayed reaction to the drought information would likely have resulted in greater consumption prior to the information becoming public, which in turn would have led to a bigger price spike when it became widely known.

Fourth, the actions of Oganev are far less admirable, in particular if he made the public call for an export ban after the trade was put on.  I believe that the Russian government had reasons of its own–not “good” reasons from an economic efficiency perspective, but political reasons–to impose an export ban.  Hence, I think that Oganev’s plea probably didn’t affect the Russian government in any way.  But it is unethical for a firm with a position to advocate wasteful policies that would tend to favor that position, and an export ban would have done just that.  Advocating wealth-destroying policies is hardly laudable either, position or no.

Commodity trading and processing firms are notoriously opaque–precisely because they make money on the information they generate in their operations, and have every incentive to hold that information very tightly.  This story provides a very revealing glimpse at what goes on in those firms.  It is a particularly interesting example of the synergy between the operation of physical assets and trading operations.

Who Could Have Possibly Predicted That Clearing Mandates Aren’t A Silver Bullet?

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 9:53 am

Oh, yeah.

The WSJ seized on Ben Bernanke’s “Puddin’head Wilson” speech about the need to be especially vigilant about the risks inherent in huge CCPs, including those engendered or expanded by Frank-n-Dodd mandates (h/t Carl E and Mark B):

One by one, financial regulators who supported the Dodd-Frank law in 2010 are beginning to deny paternity, especially for the bouncing bundle of new derivatives rules. Perhaps they now realize the law created more systemic risk than it eliminated. Witness Federal Reserve Chairman Ben Bernanke speaking in Atlanta recently and warning about the consequences of forcing much of the derivatives market into central clearinghouses.

Mr. Bernanke specifically warned of this “concentration of substantial financial and operational risk in a small number of organizations, a development with potentially important systemic implications.” He went on to say that “strong risk management at these organizations as well as effective prudential oversight is essential.”

It sure is, and the federal regulators who failed to oversee the big banks will now have to oversee both the banks and the new entities housing their derivatives trades. As we’ve noted before, clearinghouses have succeeded in managing risk and enabling efficient markets in many areas of trading over many years. They are especially useful when they develop organically to meet a market need. [Emphasis added.]

Uhm, where have I heard the phrase about CCPs “develop[ing] organically to meet a market need”?  Sounds verrryyy familiar.

Perhaps the WSJ is too aggressive in stating affirmatively that Frank-n-Dood “created more systemic risk than it eliminated.”  But it would not be aggressive at all to state that (a) that is a very real risk, (b) that risk depends in large part on the decisions that regulators make going forward, and (c) that risk received virtually zero attention from legislators and policymakers at Treasury (a very guilty party), the CFTC (similarly guilty), the Fed, or Congress.

The WSJ is on very firm ground in excoriating those who have now found their voices on CCP risks, but who remained conspicuously silent when weighing in on the issue could have slowed down the stampede to clearing:

Add it all up and you have a disturbing number of financial eminences suddenly rushing to get clearinghouse warnings into the public record. Do they know something that the taxpayer doesn’t? It’s hard to tell, because even as the Beltway crowd scrambles to draft clearinghouse warning memos for posterity—and for their posteriors—regulators are also promoting “independent director” rules that will discourage people with knowledge and experience from overseeing these institutions. This is the last thing regulators should be doing if they now understand the risks.

When we started warning against forcing this market into clearinghouses in 2008, the regulators who agreed could have held meetings inside a phone booth, if we still had phone booths. Last May, our story about Senator Chris Dodd’s effort to give clearinghouses access to the Fed’s discount window—and therefore to a taxpayer rescue—attracted scarcely more support. Dodd-Frank was the law of the land by July, with taxpayers officially backing Wall Street derivatives trading for the first time.

Now taxpayers get to watch regulators who did nothing to stop this policy, when their opposition might have made a difference, suddenly offering insightful critiques when it doesn’t.

I share the WSJ’s anger and dismay at the Johnny-come-latelies who now sound alarms.  NOW they tell us.  I wonder if it’s not just CYA, as the Journal would have it, but also another way to assert power and authority, and to expand bureaucratic turf.

The Economics of Contempt is, er, contemptuous of the WSJ stand:

The WSJ says that it’s “not aware of any governments that have ever asked clearinghouses to manage risks as complicated as those mandated by Dodd-Frank.”

That’s funny, because we still don’t know what financial instruments will be subject to Dodd-Frank’s clearing requirement yet! So how does the WSJ know how complicated the risks that clearinghouses will be asked to manage are? They don’t. The CFTC and the SEC don’t even know yet. The WSJ is just making things up.

This is like the people who make the fairly simple and widely-understood point that clearinghouses don’t work well for illiquid or bespoke instruments, and then claim that because of this, Dodd-Frank’s clearing requirement was a bad idea. They apparently don’t have the patience to wait to see which instruments the CFTC and the SEC decide have to be cleared — they want to demagogue the clearing requirement, and they want to demagogue it now, dammit!

FWIW, EOC is a pretty strong Dodd-Frank booster.

IMO, EOC is far too contemptuous of the Journal piece.  Yes, many of the implementation details of Frank-n-Dodd remain to be determined, notable among them just what products will be cleared, and more importantly the process by which that decision will be made.  Yet it is abundantly clear that the intent of the authors of Frank-n-Dodd, the Treasury, and Gensler in particular at the CFTC is to push as many derivatives as possible onto CCPs.  This can be done directly through mandating that particular products be cleared, or indirectly, by imposing punitive margin and capital requirements on non-cleared trades.  We don’t know exactly what they will do, but we know what they want to do–they’ve told us over and over again.  The WSJ editorial is quite fair in speaking to the risks that CCPs could pose if these people get their way.

But even if EOC is right, then we have two alternatives: either clearing mandates and much of Frank-n-Dodd was sound and fury, signifying nothing, or it runs the kinds of risks that the WSJ and, uhm, others identify.  And the sound and fury is not without its costs.  It has created huge uncertainty, and led to the commitment of innumerable resources to trying to understand, shape, plan for, etc., the regulatory changes.

Regardless, the WSJ is spot on in calling out those currently speaking out on their failure to do so when it mattered.

But that’s water over the dam now.  What’s needed is for these newly vocal regulators to put their supposedly new revelations into practice.  Two very practical issues on which they can do so are taking a duly humble approach to the process of determining what gets cleared and what doesn’t (the issue that EOC focuses on), and on CCP membership and governance standards.

Not that I’m holding my breath.

April 23, 2011

Putin’s Purgatory: Meet the New Tsar, Same as the Old Tsar

Filed under: Economics,Military,Politics,Russia — The Professor @ 8:19 am

In another sign of the impending apocalypse, Vladimir Putin said something I can pretty much agree with:

Russian Prime Minister Vladimir Putin slammed expansionary U.S. monetary policy, calling it “hooliganism”, in remarks that followed more veiled criticism from China after Standard & Poor’s Corp. cut the outlook on its U.S. debt rating this week.

“We see that everything is not so good for our friends in the States,” Putin told lawmakers Wednesday.“Look at their trade balance, their debt, and budget. They turn on the printing press and flood the entire dollar zone — in other words, the whole world — with government bonds. There is no way we will act this way anytime soon. We don’t have the luxury of such hooliganism,” he said.

Actually, this is a fascinating display of the usual Putin mix of attitudes about the United States–the envy and resentment, combined with schadenfreude at any American trouble. I don’t buy into all that, of course, but the substance of his critique has some merit.

Speaking of the substance: you can’t read the financial press without seeing articles about growing inflationary pressures throughout the world.  Now, inflation is a monetary phenomenon: indeed, if you follow Milton Friedman, you believe that inflation is always and everywhere a monetary phenomenon.  Clearly, the biggest monetary shock in the world has been QEII.  It is therefore a reasonable hypothesis that there is a direct, causal, connection between QEII and world inflation.  But Bernanke denies this.  And Fed members have been engaged in a concerted campaign to deny that rising commodity prices–which is a major source of inflation in emerging markets particularly–are harbingers of inflation.  Maybe so.  But I’d like to hear a convincing explanation.  I’ve heard nothing even close yet.

But now to the primary subject of this post–Putin, yes, but his recent speech to the Duma.  In some respects, it was a literal purgatory.  It lasted four hours, including the Q&A; apparently Vladimir Zhirinovsky needed a potty break.

More importantly, it was a no apologies assertion that social, political, and economic purgatory–stasis–is right for Russia:

The country needs decades of solid, steady growth without going back and forth with ill-thought-out experiments based on often unfounded liberalism and social demagoguery.

He compared the opposition to “harmful bacteria”:

Of course, there will always be certain elements that seek to destabilise the situation. This is similar to an outwardly healthy human body, which is nevertheless always inhabited by some harmful bacteria; however, if the immune system is strong, they remain in check. Should the immune system weaken, we would immediately catch the flu. If we maintain the country’s high level of social and economic immunity, no quasi-political flu is going to make itself felt. [Quibble: influenza is caused by a virus, not a bacteria.]

Clearly, he contemplates no political or economic modernization.  He touted the virtues of protection of Russian industry:

If we had made concessions like some of our neighbouring countries and, say, slashed to zero our positions in aircraft and aviation equipment imports, it would have been impossible to talk about the revival of our aircraft industry today. Same about the automobile industry – if we had zeroed the lorry manufacturing, for example, there would have been no hope of reviving the automobile industry now. If we had retreated in agriculture, there would have been no farmers to support today.

. . . .

And, of course, the economy should encourage demand for skilled workers and engineers. This brings up the question of the nature of our economic growth. I am confident that we should initiate a new wave of Russian industrial technological development and create an environment for attracting long-term “smart” investment and innovative technology to the country. This is the only option, the only alternative, if we want to ensure the competitiveness of our human resource potential and bolster the demand for it.

You must remember that the effects of the economic downturn were most visible at auto plants, which were halting their conveyors. That was really troubling because Russian automakers employ about 600,000 people, and another 3 million people work for related companies. Along with their families, you can imagine how many people that could affect. We certainly could not leave them without support.

During the recession, when automobile production in Russia slumped by 60%, the government provided unprecedented support to the industry. Throughout 2009 and 2010, the industry received a total of 170 billion roubles of federal funds under various programmes. As a result, the production of cars more than doubled in 2010; the production of trucks surged 74.5% and buses by 23.6%.

In the past twelve months – since April 2010 – Russia’s auto industry grew by a double-digit figure every month. Vehicles assembled in Russia accounted for 70% of all automobile sales on the domestic market.

I remember how I had to fight a host of protests and complaints against supporting Russian automakers. But who else should we support? Foreign producers? The industry is up and running now, introducing new technologies, and all international brands are here.

We have implemented a car-scrapping programme. It was introduced just in time to promote a faster revival of domestic demand, while half a million Russians were able to buy new cars with a discount. This was an anti-crisis policy, which supported the auto industry, as well as an important social programme.

I can tell you that we are allocating another 5 billion roubles for the car-scrapping programme this year. We will support Russian companies which have far-reaching development plans, and also help people buy new cars.

There is something else. Some dealerships inflate the prices of cars offered under this programme.  I mean, the same model can be acquired at a cheaper price for cash. Clever people, these dealers. Yes, you get this one. The “scrapping” discount is eaten up by the price mark-up. This practice has to be eliminated. Law enforcement agencies will be monitoring the process. But I am also asking you, when you travel to the regions, please look out for these things and take some action as soon as possible.

We also need to set up a system to remove old, rusted cars from the streets and courtyards or areas outside the city boundaries.

As I said, nearly all the leading international automakers now have plants in Russia. They have become an integral part of the Russian auto industry. We have issued new requirements for their production and for the percentage of components that need to be produced locally. Although these negotiations aren’t always easy, our partners generally agree with these requirements; they understand our needs and agree to compromise. Locally produced parts now have to account for 60% or more of the total, and annual output should be around 300,000 vehicles, not 25,000 as it was before.

Putin also voiced near-paranoiac suspicion of the WTO:

Now, as for alleged demands of the World Trade Organisation not to fund research, not to fund agriculture and to increase fuel prices. It seems Mr Zyuganov got somewhat carried away by the argument. In fact, there have been no such demands from anyone. But then, I agree with Mr Zyuganov that there is a potential trap somewhere here. We should be on our guard during the process of joining the WTO. Mr Zyuganov is right here. And that is just what we are doing, I assure you. Every point is thoroughly debated. It is not for nothing that the talks have been on for 17 years.

Putin welcomed foreign investment–as long as the foreigners bring technologies to Russia, an echo of Peter I.  He also promised increased social spending.  All in all, the natural state lives.

Speaking of paranoia, check this out (and you’ll be checking it out on the internet, ironically):

So, we are not going to slash anything. The internet is only a tool in addressing topical economic and social issues. It provides the opportunity for people to communicate and express themselves. It is a tool to improve people’s living standards and society’s access to information.

Indeed, many major resources are located abroad rather than in this country, to be more exact, they are overseas. And this fact causes concern of some Russian security services because these web resources can be used for purposes that run counter to the interests of our society and government. But I would like to emphasise that these are only the security services’ concerns.

His main spending initiatives focus on infrastructure and military procurement: I doubt that it is a coincidence that these are the areas in which corruption are most lucrative.  He also promised greater spending on medical equipment:

For example, we place billion-rouble orders for medical equipment with foreign companies. I will talk about it in more detail later. I think it would be only natural for our partners to gradually relocate their production facilities to Russia.

The government will also channel over 120 billion roubles to modernise the national pharmaceutical and medical equipment industries and to build up technology reserves, under a new federal programme until 2020. The plan is to establish 17 research centres to develop new drugs and design medical equipment. In 2010 alone, Russian and foreign companies invested over 40 billion roubles to develop the production of pharmaceuticals and medical equipment.

And this is another area in which corruption is rife:

In [prominent physician Leonid Roshal’s] remarks, he said too much money is being budgeted for equipment, much of it useless, because it is easy for bureaucrats to “saw off” a kickback for themselves. Doctors, he noted, have to make do on official salaries of less than $300 a month. (He didn’t mention that most doctors here insist on under-the-table payments from their patients.) With just 3.9 percent of gross domestic product going to health care, he said, the result is a shortage of doctors, especially in rural areas, and of hospitals. [For these remarks, Roshal was subjected to a scathing, Sovietesque attack from the Ministry of Health.]

In speaking of the Russian military, Putin sang a paean to the USSR:

I would like to emphasise once again that a strong defence industry, nuclear industry, rocket industry – these are our competitive advantages inherited from previous generations, for which we are very grateful to them. And we are determined to strengthen and further develop these sectors.Ladies and gentlemen!

We need to depoliticise these issues. We inherited this from the Soviet Union and we are proud of it. A low bow to those who designed these systems. We will work on their further development.

No mention of all the other wonderful things that Russia inherited from the USSR–economic collapse, social squalor, authoritarianism.  No mention of the negative part of the legacy even as it relates to the military, most notably the dysfunctional nature of the Russian armed forces.  Putin, not surprisingly, talked mainly about the new hardware, not on the lack of human software to operate it properly.

All in all, vintage Putin.  A reactionary speech in the tired, old, and failed Russian tradition of state directed modernization.  Although that is really an oxymoron, for state directed efforts focus on the material trappings of modernity–the machinery, the technology–while missing completely its intellectual, ideological, economic, and social essence.  Just as Peter I was bedazzled by the boats and machines and completely misunderstood what made Holland modern, Putin believes that a static, state-dominated, non-competitive socio-political-uneconomic system can achieve self-sustaining economic and personal growth.  Meet the new tsar, same as the old tsar: why should the results be any different?  Kudrin definitely doesn’t think so.

Putin was also his humorous self this week.  He continued his Sergeant Schultz imitation–“I know nuthink!”–by maintaining his ignorance of BP’s agreement requiring it to engage in all activities within Russia in conjunction with TNK-BP.  This is risible, because (a) the partnership agreement terms were widely known, and (b) Putin made a remark to BP’s Dudley at the announcement of the BP-Rosneft deal warning him of AAR’s litigiousness; why would he say that if he had no inkling of the basis for an AAR action?

But that wasn’t the real howler of the week.  This was:

The Russian government intends to stay out of the shareholder conflict between BP and its partners in TNK-BP local venture, the AlfaAccessRenova consortium, Prime Minister Vladimir Putin said on Wednesday.

The government does not interfere in the operations of companies,” Putin said when asked how the government could help solve the conflict, which followed a $16 billion deal between BP and Russia’s top oil firm Rosneft to swap shares and develop the Arctic shelf.

Ba-da-boom.  The government does little but interfere with and direct the operations of companies.  That’s the way the natural state works.  And if Putin has his way, it’s the way it will work for decades to come.  At least until the time that Putin is a doddering, drooling Brezhnev-like imbecile, continuing to lord over a dying country.

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