Streetwise Professor

May 23, 2011

The Moment You’ve All Been Waiting For*

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 8:58 am

The International Swaps and Derivatives Association, ISDA, has now officially released my Discussion Paper on central clearing of derivatives.  (This is what I’ve been referring to as my white paper.)  It is the inaugural paper in the ISDA Discussion Paper series.

The link to the press release is here, and the press release contains a link to the PDF.

Any comments would be appreciated.  The paper focuses on most of the hot button issues relating to clearing, and to many of the pending regulatory issues.  Hopefully it will contribute constructively to policy, and more broadly to understanding of the issue.

I’m grateful to ISDA, and in particular ISDA CEO Conrad Voldstad, for providing this opportunity and this platform.  I also appreciate the insights and input of David Murphy, ISDA’s Global Head of Risk and Research.

*Said tongue in cheek, of course.

May 20, 2011

Medvedev Makes a Fool of Himself–and Obama

Filed under: History,Politics,Russia — The Professor @ 7:15 pm

I won’t comment much about Obama’s speech on the Middle East, except to say that it was a stitched together mess that will likely have the opposite of the intended effect.  Even those typically fairly well-disposed towards Obama are having a difficult time saying anything positive about it: this is one example.

But the foreign policy focus of the last few days combined with recent events in Russia made me think about the “Reset” with Russia.  This was one of Obama’s early, signature foreign policy initiatives, and at the time but especially in retrospect it was a harbinger of the unrealism at the heart of his putatively Realist foreign policy.

Those clever folks in the Obama foreign policy team thought that they could manipulate the duumvirate, and in particular work with Medvedev the Modernizer.  Medvedev and Obama have had a veritable bromance, for instance being burger buddies at Five Guys. Administration people made clunky attempts to portray Medvedev as the future, and Putin as a relic of the past.  They put their chips on building a relationship with the president in the hope that he would prevail over Putin.

This was a sucker bet from the outset, given the clear dominance of Putin in the Russian political landscape.  It is now an utter embarrassment given that Medvedev has gone from being perceived as someone with only a slight chance of supplanting Putin, to an object of disdain and mockery.

Medvedev’s much hyped press conference at Skolkovo was a disaster that has unleashed a torrent of criticism and outright ridicule, and is widely reckoned to be the death knell of his political ambitions.  The Economist asks what the point was.  Time is scathing:

It was impossible to pinpoint the exact moment of the transformation, but by the time Russian President Dmitri Medvedev left the podium after his first big press conference on Wednesday, he had morphed into a lame duck. The problem was not so much that he failed to state his plans for re-election next year, but, as some members of his own circle now admit, the President seemed to be courting a constituency of just one man — Prime Minister Vladimir Putin, who will alone decide whether Medvedev stays or goes.

Some Russian commentors were equally dismissive:

His unprofessional performance added to the overall commotion and silliness of the event. Medvedev was clearly agitated by the challenge, constantly losing his breath during the first half of the conference, apparently caused by public speech stress. Time and again Medvedev had fits of seemingly uncontrollable giggling when answering questions, also apparently caused by public speech stress. The Kremlin press service announced “the president was pleased by his performance at the conference” (RIA Novosti, May 18). Officially approved observers were bewildered by the uninspiring performance. Known critics of the regime posted angry comments about Medvedev on the Internet demonstrating his utter inability to reform or lead Russia (RIA Novosti,, May 18).

It seems Putin in 2007 wisely chose Medvedev as his “successor” or a de facto figurehead president. Medvedev, who this week demonstrated the absence of his leadership capabilities and charisma—a lack of intelligence and integrity—will hardly ever be able to effectively lead Russia in a time of change. Many Russians and foreigners who believed that Medvedev—the young and progressive president—will actually modernize, Westernize and liberalize Russia may forget their dreams. Medvedev’s constant chatter about “modernization,” with little or nothing being done, may only cause the Russian populace to begin to hate the term, as the word “democracy” became a popular curse after the unfair and lawless reforms of the 1990’s. Former Kremlin insider Gleb Pavlovsky believes Medvedev’s dismal press conference performance was intended to appeal to Putin to gain endorsement for a second presidential term (Vedomosti, May 19). This is a popular version in Moscow—Medvedev was doing his best to be seen as an incompetent and harmless political nobody for Putin to allow him six more years as a figurehead in the Kremlin.


And Foggy Bottom and the White House–the one on the Potomac, not the Moskva–should be feeling the pain.  The alternative scenarios: (a) Medvedev is shoved aside by Putin, or (b) Putin keeps Medvedev like an organ grinder keeps his monkey or a ventriloquist keeps his dummy.  Either way, the entire basis of the Reset collapses.

It would probably be best for the US if (a) occurs.  For if Putin chooses door (b), it is quite possible that the fantasists in the State Department and the White House will continue to delude themselves that they can build a mutually beneficial relationship with Russia through Medvedev, and make deals and concessions in the hope of building the Reset, whereas even they would have to concede to the reality of Putin’s domination and the futility of the Reset under option (a).  Thus, (b) would let Putin to continue to manipulate the United States by exploiting its delusions.

The manipulative potential is one factor that may lead Putin to choose (b).  But domestic political considerations will almost certainly prove decisive.

In the US, the Reset has largely faded from view.  Obama has moved on to other things.  But it should not be forgotten because it provides a very dispiriting example of his foreign policy judgment–or more properly, the lack thereof–and that of his entire foreign policy cadre.

May 19, 2011

What’s the Frequency, Luigi?

Chicago finance prof Luigi Zingales has written a short oped on OTC derivatives markets.  Considering the source, it is very disappointing, not to say embarrassing.

Indeed, it seems that Luigi is on the same frequency as Kenneth Griffin of Citadel: their arguments, such as they are, are virtually indistinguishable.

Zingales’s basic argument is that the OTC derivatives market is oligopolistic, and that all sorts of bad things flow from that structure:

Indeed, today the market for derivatives is oligopolistic, with a few banks running huge profit margins. And, regardless of whatever political motivations might lie behind the latest investigations, this market concentration is a real problem. According to a 2009 study by the European Central Bank, the five largest CDS dealers were party to almost half of the total outstanding notional amounts, while the 10 largest CDS dealers accounted for 72% of the trades. The markets for other derivatives are not much better.

As is usual in assertions of dealer oligopoly, there is seldom any comparison to other markets.  The concentration figures Zingales cites are hardly exceptional when compared to other industries, and I daresay to the markets for groceries or gasoline in Chicago.

But worse, Luigi’s argument is very anti-Chicago.  Long, long ago, dating back to the 1960s and 1970s, Chicago eviscerated the structure-conduct-performance paradigm associated with Harvard (and Joe Bain in particular).  Folks like Harold Demsetz and Sam Peltzman pointed out that market structure is endogenous, that concentration can result from the exploitation of cost advantages, that prices can be close to marginal cost even in concentrated markets, and that large profits in such markets are not prima facie evidence of weak or absent competition.

This means that rather than taking the concentration data (as benign as they are by comparison with other industries) and making the leap that this concentration indicates a lack of competition, Zingales should ask why the structure is what it is, what forces generated it, and whether concentration is actually symptomatic of an inefficient, non-competitive market structure.  Put differently, concentration is neither sufficient nor necessary condition for a non-competitive outcome. Regurgitating concentration statistics and proclaiming “QED” is bad economics.

That’s all bad enough, but then he really goes off the rails:

A high degree of concentration distorts the market in several ways. First, when they transact among themselves, large players do not insist on an adequate amount of collateral, relying on the counterparty’s generic creditworthiness (and on the implicit guarantees that governments provided to large firms). Not only does this severely undermine the ability of small firms to compete, but it also contributes to systemic instability of the type that we experienced in 2008, thus increasing the likelihood that taxpayers will have to step in. Market concentration renders mostly illusory the beneficent risk-spreading role that is claimed for derivatives, because the bulk of the risk is borne by very few players.

The point about implicit guarantees is fine–but that’s a policy error that can’t be fixed by jiggering with the market structure.  But the criticism that banks don’t collateralize trades but rely on generalized creditworthiness is wide of the mark for many reasons.  For one, under standard credit support annexes, dealers don’t post independent amounts with one another, but do collateralize via variation margins on a daily basis.  Hence, inter-dealer credit is limited to one-day moves.

For another, Zingales is overlooking the fungibility of credit: initial margins/independent amounts could be funded by borrowing–and banks kind of have access to a lot of borrowing channels.  And since dealers typically rehypothecate collateral, what’s the point of interdealer independent amounts anyways?: with hypothecation A can give collateral to B who can effectively turn around and give it back to A; the actual money flows are a little more complicated, but rehypothecation effectively allows banks to lend each other the collateral that they post with one another.  What’s the point of that?

For yet another, regarding the “undermining the ability of small firms to compete”–can he be serious?  Because of the borrowing point I just made, no doubt if independent amounts on all inter-dealer trades were somehow mandated, who do you think would have the lower cost of funding these margins, the big incumbent banks, or small firms?  I would wager that mandated collateralization would actually favor bigger, more creditworthy firms.

Moreover, Zingales also overlooks other potential scale and scope advantages in derivatives dealing: yes, some of these may be artificial because they arise from TBTF subsidies, but again, that is a problem that needs to be tackled directly.

Zingales then trots out the conventional arguments regarding opacity:

Over-the-counter trading also contributes to the opacity of derivatives markets, further reducing competition and increasing the margin enjoyed by the traders – and the prices that final users (mostly industrial firms) must pay. The combined profits of the key players in this market total $80 billion, which represents a massive tax on the real economy.

To fix this problem, we need to move the bulk of derivative trading onto organized exchanges, where daily collateral requirements would guarantee systemic stability, and price transparency would force competition, reduce margins, and increase the market’s depth. In the United States, the Dodd-Frank Act moves some of the way in this direction, and similar efforts are underway in Europe.

I’ve been over this ground so many times, so I’ll try to keep it brief (for me, anyways).  Zingales presents no evidence that margins are excessive.  End users have choices, including very close exchange-traded substitutes for many OTC derivatives, but they choose to trade OTC instead: like others who have made similar criticisms, Zingales apparently believes that end users are suffering from Stockholm Syndrome or Battered Spouse Syndrome.  When touting exchanges as an alternative, he also overlooks the very real possibility that face-to-face OTC dealings reduce adverse selection costs that end users incur, but would incur on anonymous exchanges.

Moreover, apropos the earlier point about anti-Chicago, if margins are so wide and profits are so fat, why doesn’t entry occur?  Why doesn’t competition work to erode margins and profits here, like in other markets?  Perhaps there’s a story, but Luigi sure doesn’t tell one–and he is far from alone in this.  The statement about profits being a tax is so embarrassing I will pass over it in silence.  The profit number itself is completely contextless; his statements about profits based on absolute magnitude (“boy, that’s big”) remind me of the periodic attacks on oil industry profits that are similarly without any context, or attempt to control for capital deployed, risk, etc.  Given that he alludes to the concentrated riskiness of derivatives positions, perhaps he should at least entertain the possibility that the profits are in fact compensation for risk:  indeed, large profits in “normal” times interspersed with periods of big losses is characteristic of the risk-reward profile associated with tail risk.

As for his proposed “solution,” I can only stand and wonder.  The hook for the entire piece is the EC’s antitrust investigation of the OTC market:

the existence of political motivations does not undermine the legitimacy of the new EU investigations, which will be conducted alongside an ongoing inquiry by the United States Justice Department into anti-competitive practices in the trading, clearing, and pricing of CDS in the US

He starts out his critique of the OTC market by focusing on concentration in the OTC market, and concludes that high concentration is symptomatic of a lack of competition.

Uhm, has he looked at concentration in the exchange space? Is he aware that virtually every major exchange-traded derivatives contract is a monopoly?  Has he looked at concentration trends in exchanges?  Has he noticed the major consolidation wave that has been going on in exchanges since about 2005, and which as picked up again after tailing off during the crisis?

To go on: Is he aware that OTC markets also engage in “daily collateralization”, particularly among dealers?  Is he aware that such daily collateralization is not necessarily stability enhancing, as he asserts? Is he aware that “price transparency” already exists, though in a different form, on OTC markets?  Is he aware that the price transparency on exchanges is accompanied by counterparty opacity that can actually increase trading costs for the uninformed end user due to adverse selection?  And again: if the advantages of exchange trading are so great for end users, why haven’t exchanges made greater inroads in attracting their business, and why have end users in fact gravitated more towards OTC markets where he claims they are getting shafted?

Luigi is a very accomplished economist.  He can do much better than uncritically recycling stale and unpersuasive conventional wisdom.

Please, Luigi: adjust the frequency on your receiver.

May 17, 2011

Who Knew?

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 3:23 pm

Derivatives Reform Proving Difficult.

Regulatory arbitrage raises its ugly head.

‘ET’ [Extraterritoriality] stokes fears about sweeping swap rules.

Clearinghouses Would Not Have Prevented the Financial Crisis.

I’m Shocked! Shocked! to hear that reforming complex markets based on complex contracts among numerous complex financial firms that span myriad jurisdictions around the globe is actually like complicated or something.  I thought Chrissy and Barney and Timmy!  and various Euro-types could rearrange these markets at a whim and make everything all better.

Not really.  I’ve seen a train-wreck from the get go.

Take clearing in particular.  If you’ve spent any time on this at all, you know that the details are incredibly complex.  The economics are challenging, the legal aspects daunting.  My white paper* goes into this in some detail.  This paper does a nice job at explaining some of the legal issues–but still only scratches the surface. If you think you can rearrange something so intricate and have it all work out just swell, you’re in for a rude surprise.  The problem is that you don’t learn what the problems are until they appear, completely unanticipated.

Mark my words.  Re-engineering these markets will lay the foundation for a future crisis.  If only people had heeded Hayek’s aphorism: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

* The white paper is done, and approved.  It should be released formally this week–maybe tomorrow.  Apparently the PR folks at the organization that commissioned the study wanted a few days with it to figure out how to distribute and market it optimally.

They Don’t Even Trust Each Other

Filed under: Economics,Energy,Politics,Russia — The Professor @ 2:28 pm

In a stroke of good fortune for BP shareholders, the deal with Rosneft is apparently dead because BP, its TNK-BP AAR “partners”, and Rosneft were unable to come to terms on buying out AAR.   And although reports are somewhat murky (go figure!) apparently price wasn’t the issue.  Trust was.  Between the Russians.

In particular, the AAR Russians wanted the Rosneft Russians to provide legal guarantees that the buyout of AAR from TNK-BP would proceed after TNK-BP agreed to let the BP-Rosneft share swap and Arctic JV proceed.  There is an issue of asynchronous performance here, and AAR evidently doesn’t trust Rosneft to follow through on its part of the deal once AAR gave its approval to the BP-Rosneft tie-up that is contrary to the current TNK-BP shareholder agreement:

“We made some progress but not enough,” a person close to the Russian shareholders said. A key sticking point was AAR’s insistence on guarantees that the buyout would be completed if AAR let BP and Rosneft proceed with their planned swap and arctic partnership first, the people close to the talks said. They said Rosneft was uncomfortable with that demand.

This is especially amusing in light of the way that Putin’s and the government’s (which amounts to the same thing) failure to force AAR to concede its rights is being spun:

One person close to the process says the Russian shareholders’ ability to defend their position is not to do with Mr Sechin’s waning power, but is connected to a concerted new drive by the Russian president and the government to improve the investment climate.

“The president and the government demonstrated that Russia is a place where rule of law and the sanctity of contracts is respected by not interfering, no matter how high or powerful a politician is steering the deal, and by saying that the parties should resolve their differences in London’s High Court.”

I had to clean off my computer screen and keyboard after reading that bit. (Note to self: never take a gulp of coffee when reading something where the subject of Russia’s adherence to “rule of law and sanctity of contracts” might be mentioned.)

First, “the president” doesn’t really have much to do with it, really.  If you’ve been paying the least bit of attention in recent weeks, you will have noted a dramatic ramping up of efforts to make Medvedev look like a total chump.  Not that those efforts were ever absent, or that it’s all that difficult to do: Just that the efforts have been put into overdrive recently: the “Popular Front” effort is just the most obvious manifestation of that, and the release of the Medvedev dance video the most entertaining and embarrassing.  Really, his theme song should be Otis Redding’s Mr. Pitiful.

Meaning that if Putin really felt that this was an issue on which Medvedev was trying to put is stamp, and was using to appear presidential and to establish his credentials as an independent leader, it would have been exactly the issue on which Putin would have intervened as obnoxiously as possible.  No, if things are happening this way, it is because Putin wants it to happen this way, and that if anything Medvedev’s preferences would cut the other way.

That’s why I think this is a more reasonable interpretation:

But other observers say the collapse of the talks are more an indication of the power of the AAR group of shareholders, led by Mikhail Fridman, in Russia’s political hierarchy, while once again casting foreign investors into uncertainty as to whether investment security lies with partnering with the state.

Which mainly leaves the question of the source of the power of Fridman et al, or what deal they’ve made with Putin.

Second, evidently even AAR doesn’t believe that this is a harbinger of the rule of law.  If it did, why wouldn’t it trust Rosneft to adhere to an agreement?

Third, that whole improving the investment climate thing isn’t working out so well, is it?  Witness the continued capital flight.  Note especially that Russians are at the head of the pack when it comes to getting their money out of the country: there’s that Russians-not-trusting-Russians thing again.  Witness too the spate of canceled Russian IPOs due to lack of demand: there are six including the five mentioned in this article plus ChelPipe.  All this in the face of a sharply higher oil price, which in 2006-2008 led to boom times in Russia.  Not now: economic growth has actually slowed to an anemic 4.1 percent.  (Anemic by comparison to what would be expected in the aftermath of a major decline in the economy in 2008-2009, and in comparison to the growth rates observed the last time oil prices spiked.)

Fourth, even if the hands-off approach to AAR’s assertion of its contractual rights is indeed an attempt to convince the world that Russia is endeavoring to adhere to the rule of law, in fact it just adds to the unpredictability of the place.  BP thought it knew how the game is played.  It didn’t.  It thought a roof was necessary and sufficient, and that Sechin could be its roof.  Wrong.  So anybody watching has to ask: Is this a one off?  Is it just the result of some unknown deal between Fridman et al and Putin?  How is this game played?

As long as the system remains institutionally undeveloped and intensely personalized, foreign investors will tread with trepidation.  There has to be some certainty that commitments made by the state are credible: AAR’s reluctance to trust Rosneft makes it clear that not even powerful Russians believe that they are so.

Fifth, if you follow the news, you’ll see many more discordant notes that completely contradict the meme of Russia’s newfound commitment to the rule of law.  For instance, the prosecution of Alexei Navalny or the continued efforts to prosecute William Browder–efforts spearheaded by the very tax cheats who robbed his company and effectively murdered his employee who attempted to fight the robbery, and who the Russian government is incapable of or more likely is completely uninterested in prosecuting.

Rosneft is now considering approaching another international oil company, such as Shell or ExxonMobil, to partner with in Arctic exploration.  The whole BP fiasco is hardly calculated to make them jump at the chance.  Again, who even knows what the rules are?  What’s more, post-Mocando, BP was desperate–Shell and XOM aren’t.  BP was a fool that rushed in where angels fear to tread, and it would take an even greater fool to follow in its footsteps.  Rex Tillerson is not a fool.  The Chinese have also been mooted as potential partners, but (a) they don’t have the Arctic expertise needed, and (b) if you haven’t noticed, Rosneft (with Transneft acting as the stalking horse) and China are already at loggerheads over a relatively simple pipeline/oil sale deal.

No, it is is becoming increasingly clear that Putin intends to dominate Russian politics and government for the foreseeable future (even if he can’t start a new Lada!), and people are drawing the appropriate implications from that.  The hamster wheel from hell will keep spinning.  Putin’s Purgatory will continue, and indeed will become even more stifling and static.  It is conventional wisdom that Russians pine for stability.  Be careful what you pine for.

May 13, 2011

Almost as Pitiful, Only in a Different Way

Filed under: Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 5:55 pm

It’s hard to know whether to laugh or cry when reading day after day the expression of newly recognized concerns about the possible consequences of clearing mandates and other efforts to re-engineer the very complex derivatives markets.  All around the world, it is dawning on this Sorcerer’s Apprentice or that one that gee, a wave of the legislative or regulatory wand may just unleash forces that they did not intend with results they may not like.  Newly recognized by some, that is.

For instance, for quite a while now I’ve pointed out that the economies of scale and scope in clearing mean that it will be highly unlikely that this sector is going to be highly competitive.  There are strong natural monopoly elements.  This is an inherent part of the economics of risk and clearing.

One Apprentice awakes to this realization:

Over-the-counter (OTC) derivatives into clearing houses must not reinforce monopolies in the clearing business, otherwise the wider economy will suffer, a British government minister has warned.

. . . .

Mr Hoban said: “But we must not allow new standards for CCPs, combined with a legal obligation to clear derivative products, to embed monopolies in clearing that will result in costs passing back to the wider economy.”

But then he proceeds to bugger up the economics completely (sorry about the language, but he is a Brit):

The comments, by Mark Hoban, financial secretary to the Treasury, are a sign of growing unease in London over a trend gathering pace globally for exchanges to have their own clearing houses in a so-called vertical silo.

. . . .

“To prevent this, our view is that, while linked structures – so called vertical silos – can be effective, they must be subject to fair and open access requirements,” he told a conference organised by Markit, a derivatives data company.

Proponents of vertical silos, which include Deutsche Börse and CME Group, the US exchange operator, say that vertical silos are efficient and that derivatives traders like the fact that they offer a single pool of liquidity in key derivatives contracts, offering more opportunities to get deals done at keener prices.

In the latest draft of Emir, circulating among EU member states, a clearing house that has been authorised to clear [OTC] derivative contracts “shall accept clearing such contracts on a non-discriminatory, and transparent, basis, regardless of the venue of execution”.

Mr Hoban said: “Market participants should be offered a meaningful choice of using all or part of a vertical structure.”

This is getting tiresome.  Again: the very fact that there are strong natural monopoly elements in both execution and clearing is exactly why vertical integration–the dreaded silo–is so common, and in fact is becoming more so (e.g., LME’s recent mooting of setting up its own clearinghouse, following similar efforts by ICE and EuroNextLIFFE).  Straightforward transactions costs economics and even some straightforward neoclassical economics (double marginalization) provide a strong rationale for integration of execution and clearing venues.

Scope economies are the only thing that really push against this.  To the extent that there are greater scope economies in clearing than in execution, vertical integration can be more costly as it means that scope economies are not fully exploited.

But the fact remains that scale and scope economies and transactions costs and double marginalization effects are going to lead to industry structures that are likely to involve a lot of concentration and a lot of integration (in part because there’s a lot of concentration).  Forcing greater use of clearing and exchange-like execution venues is only going to intensify these effects.

Bloviating about mandating “meaningful choice” doesn’t change the fundamental economic drivers.  People who regulate and legislate in blissful disregard of these drivers, and then express Shock!, Shock! that the results they engender are not what they desired are annoying beyond belief. Annoying and pathetic.

The Most Pitiful Thing I’ve Read in Months

Filed under: Politics,Russia — The Professor @ 5:28 pm

Putin and Medvedev, the latter of whom has taken to wearing a bomber-jacket emblazoned ‘Commander-in-Chief.'”

May 10, 2011

How Valuable is Bob Dudley’s Face?

Filed under: Economics,Energy,Politics,Russia — The Professor @ 1:40 pm

Or Igor Sechin’s for that matter?   Based on photos–not much!–but given the Frankenstein deal that Rosneft, AAR, TNK-BP and BP are stitching together, they must be really valuable.  That’s because the only reason to proceed with this monstrosity is to save Dudley’s and Sechin’s faces.

How wacky is the structure proposed by BP and apparently accepted by AAR? This wacky:

Three details of the January deal have been changed, Vedomosti reported.

Firstly TNK-BP replaces BP in the share swap. Second, the shares which were to be traded are to be placed in a ring-fenced fund exclusively for investment spending.

Finally, BP and Rosneft cannot elect their own representatives on to each other’s boards. Voting rights on behalf of the swapped shares will be held by an independent fund manager.

So, no board representation, the shares cannot be voted, BP’s ownership in the Arctic venture is diluted by half, BP is stitched even tighter with the AAR crowd that it hates (with said hate returned with interest–one swap that keeps on paying), the Arctic prospects must be explored through TNK-BP which doesn’t have the technical expertise to do so, thereby requiring BP people to be assigned to TNK-BP, which is hugely inefficient and is one of the things that led to the blowup culminating in Dudley’s ouster a couple of years back.  I’m sure I left something out, but that’s more than enough to convince any sane person to say tomato-tomahto let’s call the whole thing off.

This wasn’t obviously a great deal for BP under the originally proposed terms.  I thought it was a bad risk putting so many eggs in the Russian basket, and wrote it off as a testament to BP’s desperation, post-Macondo.  But that deal was a jewel, compared to this . . . thing . . . being stitched together now.

But Sechin (and apparently Putin) and Dudley are so invested in a deal–any deal, apparently–that they feel compelled to proceed.  Again, only face saving can explain this.   BP’s shareholders should revolt, because they’re paying for Dudley’s mug with their money.  So should the Russian people, because they’re paying for Sechin’s, but pigs have yet to learn to fly.

The only party that will come out of this deal happy will be the AAR guys.  They will, no doubt, make the lives  everybody at Rosneft and BP’s so miserable in the coming months that they will get bought out at a handsome price.  One would hope that they use some of the money to sculpt a bust of Dudley, because the value of his visage will make them even filthier rich than they already are.

May 9, 2011

No Margin For Error

The commodity markets have been volatile of late.  The tumult started in silver, which sold off dramatically after reaching post-Hunt highs.  Last week the sell-off broadened to a good chunk of the commodities markets, with oil especially hard hit.  In response to the roiling markets, the CME raised margins sharply on silver, and today on oil and the rest of the energy complex.

This raises the question of the effect of margin changes on prices.  The CME’s head of clearing, Kim Taylor, vigorously defended the CME’s margin increases in silver (and would presumably make the same defense of today’s moves).  Kim’s justification characterizes the clearinghouse’s move as a response to changed market conditions:

Changes to margin requirements are a routine part of market surveillance at CME Clearing, the risk management and compliance unit at CME Group Inc. (CME), which owns Nymex. So far this year, CME has issued over 57 margin change notices.

“I don’t agree that the margin change was a trigger for changes in the market,” said Kim Taylor, president of CME Clearing. Taylor leads a team of sever hundred risk management and compliance professionals who monitor CME’s markets around the clock.

“The market is well tuned so that if there’s a market move that approaches or exceeds our volatility limits” participants know to expect an increase in margin requirements, she said.

The decision to alter trading margins on a contract typically involves risk management professionals involved in day-to-day monitoring of the specific market as well as senior management of the clearing house. The team looks at a variety of quantitative factors like rising volatility and qualitative factors like seasonality and relevant news events in making margin decisions.

“We try to make changes in a way that we can telegraph to the market, so that participants have notice. We try to be routine and predictable and provide no surprises,” Taylor said.

The trading margins are designed to cover around 95% of expected losses, and act as a pre-payment on the coming day’s market move.

“When market conditions become more volatile we would increase margins in anticipation of that, and when volatility decreases we don’t want to create unnecessary capital costs,” Taylor said.

In past instances, CME Clearing has often raised trading margins ahead of certain events in an attempt to damp their impact on trading. For example, the exchange-operator increased trading margins on several products, including crude oil, ahead of Hurricane Katrina to ensure traders were prepared for higher volatility .

“We try to be proactive with either something we can measure or something we can judge to likely effect our markets,”

This is sensible, in a way that I’ll explain in a moment, and the way that CCPs usually act.  Taylor tries to emphasize that the changes are predictable, and in some respects they are, but this is not sufficient to relieve CME of the charge that margin changes can cause market movements.

The changes that CME made, and which Kim explains, are sensible in a microprudential sense.  They help ensure that the CME has a sufficient buffer to absorb defaults by traders.  CCPs try to work on the “loser pays” model, and with more volatility, there are bigger losers–so margins have to be higher to ensure they can pay.

But the implicit assumption here is there isn’t feedback between margins and prices.*  Indeed, that’s the gravamen of Taylor’s argument (“I don’t agree that the margin change was a trigger for changes in the market”).  That is the essence of a microprudential approach.  That assumption, however, is quite tenuous, and almost certainly untrue.  This is particularly the case for big margin changes during unsettled market conditions.

That is, when setting margins, CCPs (and participants in bilateral markets too) typically act as if they are price (and volatility) takers, when in fact they are big enough and their decisions are material enough to be price and volatility makers.  Acting microprudentially, they typically fail to take into account the feedback between their decisions and market prices, or at least do not do so completely.

The feedback mechanism works because frequently market participants will respond to margin changes by liquidating positions.  Those who have already lost money as a result of big price moves are the most likely to liquidate, which tends to exacerbate the original moves.  That’s one reason why you can see bigger than expected moves (as occurred in oil last week) to fundamental shocks.

This is why CCP policies that are prudent in some sense can be macroprudentially dangerous.  Silver, and perhaps oil and other commodities, may be providing an object lesson of what is in store when clearing is extended to vast new markets.  When OTC clearing mandates kick in, the scope for these destabilizing feedbacks will expand dramatically.

Kim suggests that predictability mitigates these impacts, but CCPs are not that predictable, and margin methods are not necessarily that transparent.  So market participants cannot foresee the changes perfectly.  And even if they could, all this means is that they will likely react in anticipation of margin changes. The timing of the response may depend on predictability, but not the existence of the response.

This can create some really strange dynamics and non-linearities.  There’s a big selloff.  Longs anticipate that in response, CCPs will raise margins.  Those that have lost a lot of money know they can’t afford the higher margins, so they preemptively liquidate, exacerbating the selloff.  The bigger price move induces the CCPs to raise margins more than they would have without the preemptive liquidations.

This is exactly the kind of feedback mechanism that can induce chaos (in the technical and conversational senses of the word) in a tightly coupled system like a financial market. This mechanism is particularly prone to chaos if the CCP setting margin doesn’t take into account, or cannot predict accurately, the feedback between its margin changes and the trading of market participants.  And how could it know this effect with any accuracy?

This is a classic example of the tension between microprudential and macroprudential policies that I discussed in some earlier blog posts, and which is a major theme in my forthcoming white paper/discussion paper on clearing.  (This should be available within a week to ten days, if all goes well: final edits and approvals are in the works.)  The information and incentive structures tend to induce microprudentially sensible actions based on the price/volatility taking assumption.  But those actions can be destabilizing. CCPs acting in their own self-interest, and those of their clearing members, may not choose the systemically optimal actions.

It’s worth noting that the CFTC’s Proposed Risk Management Standards for Designated Clearing Organizations effectively codifies this sort of behavior.  Its proposed rule (a) requires that CCPs set margins “actual coverage of the initial margin requirements produced by such models, along with projected measures of the models’ performance, shall meet an established confidence level of at least 99%”, (b) determine the adequacy of margins on a daily basis, (c) backtest the adequacy of margins on a daily basis for products experiencing “significant market volatility,” and (d) backtest the adequacy of margins for all products at least monthly.  Similarly, both the Federal Reserve’s and the SEC’s proposed regulations require the use of risk-based models and at least monthly review of margin levels.

All of these requirements are microprudentially sensible, but will result in margin increases during periods of heightened market volatility.  As just noted, this can create destabilizing feedback effects, particularly during periods of extreme market volatility.

In contrast, the Committee on the Global Financial System recommended the use of a “through-the-cycle approach employing data from a long time series of market movements” when setting initial margins, precisely to reduce the procyclicality in margin that results from adjusting it frequently based on changes in market risks.

Which means don’t look at last week’s commodity mini-crash, or the earlier bigger crash in silver, as historical events.  Look at them as harbingers, as warnings.  Just the normal operation of a tight, mechanical variation margin process can be destabilizing.  Changes in initial and maintenance margins adopted in response to big price moves can destabilize things more.  The financial system can shake off such an occurrence in a market as small as silver, or even one the size of oil.  When it’s a bigger market–and especially when it’s a much bigger market, like some of the huge OTC markets–these changes will shake the markets, perhaps by more than they can withstand.

*Failures to account for feedback between one’s behavior and market prices is a common element in many market crises.  For instance, LTCM’s risk models–like most models in finance–presumed that the hedge fund was a price taker.  But once it became huge, it was no longer a price taker; its trades moved prices and affected liquidity.  Similarly, portfolio insurance strategies took price processes as exogenous, when in fact the strategies themselves affected prices.

Is it True? and Do We Want it to Be?

Filed under: History,Military,Politics — The Professor @ 4:15 pm

There is a concerted effort underway to portray Bin Laden as exerting operational control over Al Qaeda, based on material collected during the raid on his compound. Color me skeptical.

First, it’s hard to imagine how he could exercise any control at anything but the broadest strategic and conceptual level while he was relying on couriers to communicate with subordinates. Second, this hierarchical model is contrary to virtually all that has been written about Al Qaeda going back to its early days: the organization has been consistently portrayed as networked and distributed rather than hierarchical. Indeed, the conventional characterization of Al Qaeda represents it as more of a franchise operation in which the franchisees have considerable autonomy.

But let’s assume for a moment that the organization was hierarchical, and that operational elements required direction and approval from Bin Laden to implement any attack.  If that’s true, we may have actually done ourselves a disservice by killing Osama.  For it would be almost trivially simple to get inside AQ’s OODA (“observe, orient, decide, and act”) loop and disrupt and destroy its operations.  Even if we didn’t know what AQ was up to, we could disrupt their plans just by mixing (randomizing) our strategies, by unexpectedly changing up the way we do things.  If response to such changes required  the locals carrying out missions to report back to OBL via a painfully slow communications system, await a decision, and wait for the decision to be couriered back, they would be unable to do anything serious.  In this case, killing OBL would free the locals to be more flexible and responsive–and hence more dangerous.  It would permit AQ to become more of a network, less predictable, and more able to adapt to our moves.

Given these difficulties, I find it hard to believe–exceedingly hard–that AQ actually operated this way.  Even if OBL wanted to play terrorist mastermind, how could he enforce decisions?  Put different, if he was the principal, how could he overcome the agency problems that would bedevil his ability to impose his will on his subordinates?

Which is why I’ll go with my original analysis: that OBL was primarily a symbolic figure, and operationally irrelevant.  No doubt the various minions tried to humor the old man, and to feed his belief that he was in control of the war against the Great Satan.  But there’s an intent to deceive behind the “OBL was in operational control” narrative too.  It is an attempt to make the achievement bigger than it truly is, and perhaps, to justify an Obama pivot on a variety of issues–Afghanistan and the military-law enforcement mix of anti-terror policy come to mind.  It was indeed important, but we would be harming ourselves by exaggerating that importance.

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