Streetwise Professor

I’ve written often in the past about ammunition explosions in Russia.  Well, it happened again, this time in Orenberg, near the border with Kazakhstan.  The Moscow Times refers to it as a “freak explosion”, but it happens with sufficient regularity that freakish isn’t the word for it.

Four kilotons-yes, 4000 tons-of ammunition exploded while being unloaded from a train.  That’s a lot of ammunition.  4000 one ton bombs. About 90,000-yes, ninety-thousand-155mm artillery shells.

The cause is the subject of dispute, with local officials and defense officials offering different explanations.  Shocking, I know:

Local emergency officials told RIA-Novosti that the blasts were triggered by a fire at the Donguz base’s ammunition-unloading station.

Defense officials, however, claimed that the shells spontaneously ignited.

They just blew up, all by themselves.  Honest!  (Scarily similar to one of Homer Simpson’s three rules to live by: “It was like that when I got here.”)  Why would they just “spontaneously ignite”?  Were they unstable from age or improper storage?

I cannot remember a single major ammunition dump explosion in the US or western Europe in years.  There have been four (by my recollection) in Russia in the past three years or so.  Further evidence, if any was needed, of the shambolic nature of the Russian military.

And some bonus social commentary:

Despite emergency workers’ efforts to evacuate more than 10,000 people from towns within a 10-kilometer radius of the base, only 19 residents agreed to leave. Others feared for their would-be unattended homes.

“The residents were more afraid of looters than the explosions,” an emergency worker told Interfax.

Russophobe.

The sunk cost post mentioned filling the vacuum left by the American withdrawal from Iraq.  I specifically mentioned Iran.  But look who else is taking advantage:

Russian President Vladimir Putin will on Wednesday meet with Iraqi Prime Minister Nuri al-Maliki to discuss joint energy projects and ways to expand investment cooperation between the two countries.

Al-Maliki is in Russia on a working visit on Putin’s invitation. He has already met with Russian Prime Minister Dmitry Medvedev and State Duma speaker Sergei Naryshkin.

Cooperation in the oil and gas sector and the power industry remains a key direction in bilateral relations. Large Russian companies Lukoil, Gazprom Neft, Bashneft and others work on the Iraqi market.

And there’s this too:

Russia announced on Tuesday it has signed $4.2 billion in arms deals with Iraq, making it the largest weapons supplier to the Middle East country after the United States.

The deals, disclosed in a Russian government document issued at a meeting between Prime Minister Dmitry Medvedev and Iraqi Prime Minister Nuri al-Maliki, give Russia a big boost at a time when the future of its arms sales to Libya and Syria is uncertain.

And, of course, the Alfred E. Newmans at the State Department have no worries:

In Washington, the U.S. State Department signaled it was not overly concerned by the Russian deal.
“Iraq overall has initiated some 467 foreign military sales cases with the United States. If all of these go forward, it will be worth over $12.3 billion, so obviously our own military support relationship with Iraq is very broad and very deep,” State Department spokeswoman Victoria Nuland told a news briefing.

Look.  Russia has every interest in making trouble in this region.  Their deepening involvement in Iraq only increases their ability to do so. Is that so hard to understand?  In Foggy Bottom, apparently so.

And the State Department projects this “what me worry” attitude in the face of a clear alignment of Iraq and Russia on Syria:

Nouri al-Maliki, Iraq’s prime minister and the country’s most powerful politician, came out with some ground breaking statements in Moscow – not only on military-technical cooperation with Russia, but also on the worsening Turkish-Syrian conflict. Previously seen as a neutral party to the internal conflict between the government and the rebels in Syria, the Iraqi prime minister cracked up to be a staunch opponent of NATO’s interference in Syria – especially if the intervention takes place under the pretext of fending off a Syrian “aggression” against Turkey.

In an interview to the Russian news agency Interfax, al-Maliki dismissed the “tales about Syrian planes dropping bombs on the Turkish territories.” “Even if something like that happened, these stories are blown out of proportion,” the Iraqi prime minister is quoted as saying. “There is no need to use it as a pretext for a war and to get a whole organization, such as NATO, involved in Turkey’s defense. There is no threat to Turkey.” Al-Maliki said.

The statements of the Iraqi prime minister were made on the background of an unprecedented arms deal between Iraq, fresh from saying good bye to the American occupation force, and Russia. The deal, which envisages supplies to Iraq of Russian MIG29M/M2 fighter jets, anti-aircraft systems and MI-28NE assault helicopters to the tune of $4.2 billion was described as “a breakthrough” by the Russian news agency RIA Novosti defense analyst, Konstantin Bogdanov.

In other words: Maliki is parroting the Russian/Iranian/Chinese line on Syria.  So of course this arms deal and other chumminess is completely benign.  No worries!

And speaking of making trouble, consider this, FWIW:

The regime of Syrian President Bashar al-Assad and his allies have sought to destabilize the neighboring kingdom of Jordan by manipulating peaceful demonstrations there and turning them into deadly violence, leaked files obtained by Al Arabiya show.

. . . .

If Syrian President Assad had conspired to “create chaos” in neighboring Jordan, the high-classified documents leaked to Al Arabiya expose Russia and Iran of being involved in the plot.

Harry Truman famously said “the buck stops here”-meaning at the president’s desk, that the president is ultimately responsible and accountable for what occurs in his administration.  Truman’s most recent successor in the Oval Office is the UnTruman in this respect as in so many others.  From the economy to a poor performance in a debate, there isn’t a buck that Barry won’t dodge.  There’s always an excuse.  It’s always somebody else’s fault.  Always.

The most recent, and by far most egregious, example of Buck Dodger, POTUS, is the Benghazi fiasco that is the subject of hearings in the House this morning.  It is evident, based on current reporting, that: (1) the security measures in place in Benghazi were criminally negligent; (2) the attack on the consulate that resulted in the deaths of four Americans was not a spontaneous riot, but a planned Al Qaeda assault; (3) indeed, there was no demonstration outside the consulate at all; (4) the administration was aware of the nature of the attack almost immediately after it occurred; (5) for days afterwards the administration continued to flog the “it was a riot spurred by a movie nobody ever saw, not a planned attack” line; and (6) the administration continues to make excuses for what happened in an effort to avoid accountability.

Indeed, it’s worse than that.  For Obama continues to do the Longest End Zone Dance in history, reveling in the death of Bin Laden, who has been fish food for, oh, only about 17 months now.  Even more remarkably, he asserts with a straight face that “Al Qaeda is on its heels” even in the aftermath of the events in Libya and what is going on in Syria.

There appears to be growing unease even in media quarters normally sympathetic (understatement alert!) to Obama over the abject incompetence in Benghazi, and the stonewalling (euphemism alert!) about what transpired there.  So maybe Obama will be held to account.  But no doubt he will continue to dodge furiously-at least for the next 27 days.  No doubt underlings will be sacrificed in these efforts: Susan Rice almost certainly, but perhaps Hillary as well (which could be a twofer for Obama).   Is there enough time for Buck Dodger to be held to account?  I have my doubts.

Obama blasted Romney on Middle East policy, most notably Iraq:

President Barack Obama charged on Tuesday that Mitt Romney favors a foreign policy that “gets us into wars with no plan to end them” and that if the Republican had his way American combat forces would still be in Iraq.

“Governor Romney said it was tragic to end the war in Iraq. I disagree. I think bringing our troops home to their families was the right thing to do,” Obama told some 15,000 cheering supporters on the campus of Ohio State University.

“If he’d gotten his way, those troops would still be there. In a speech yesterday, he doubled down on that belief, he said ending that war was a mistake. After nine years of war, more than $1 trillion in spending, extraordinary sacrifices by our men and women and their families, he said we should still have troops on the ground in Iraq,” Obama said.

Regardless of what you think about the prudence-or even sanity-of invading Iraq in 2003, if you are rational you have to understand that sunk costs are sunk.  You can’t undo the past.  You can’t bring back those who died in 2003-2008.  You can’t retrieve the hundreds of billions spent.

So when becoming president in 2009, the arguments for or against invading Iraq and fighting the insurgency in the years following should have been beyond irrelevant in determining the correct policy going forward.  By 2009, post-surge, Iraq was relatively stable.  It was-is-the keystone of the Middle East.  It borders Iran.  It is vulnerable to Iranian influence, and has represents a threat to Iran.  It has large oil production, but its reserves are immense, making its future potential even greater.  So even if the cost of invasion and fighting 5+ years of civil war were not worthwhile in retrospect, those costs were sunk in 2009.  The cost of maintaining a military presence going forward would have been relatively modest, and the potential geopolitical and strategic benefits would have been great.  Perhaps not so great as to justify the expenditures in life and treasure 2003-2008, but those costs were sunk by 2009.

But Obama was so obsessed with Iraq that he made withdrawal-on any terms-a priority.  So he bugged out, leaving a vacuum in Iraq.  A vacuum that local radicals and Iran have filled.  So now Iraq permits overflights of Iranian weapons to Syria, and supplies fuel to Syria.  The country is being pulled into the Iranian orbit.

And Obama thinks this is a marvelous accomplishment.  A major part of his legacy.

So, evaluated rationally, Romney has a valid point.  A very valid point: he is looking forward not backwards.  Obama, conversely, is an ideologue obsessed with the past, and is proud-proud-of succumbing to the sunk cost fallacy.

Another comparison is apposite: Afghanistan.  Afghanistan is a strategic backwater, and a logistical nightmare.  If it is worthwhile to maintain 100,000-and until recently, 130,000-troops in Afghanistan, it is a no brainer to maintain 10,000-30,000 troops in Iraq.   The cost in Iraq is lower.  The logistical burden is lower.   The intensity of the conflict is lower-now.  The strategic benefit is far greater.  But Obama persists in fighting in a half-assed way in Afghanistan: too few troops to achieve anything, and there’s not a lot to achieve in any event, but more than enough troops to consume billions of dollars and risk many lives.

Obama blasted Romney for advocating wars with “no plan to end them.”  Well, what’s his plan in Afghanistan?  His plan, such as it is, is a strategic purgatory.  It is a recipe for pointless, purposeless deaths of American (and other NATO) military personnel.

No rational person can justify abandoning Iraq and continuing the slog in Afghanistan.  But Obama can.

But this is just a piece with the bizarre and inane Obama foreign policy, especially in the Middle East.  I have few illusions about Romney, but I know he can’t be worse.  At least he isn’t proudly in thrall to the sunk cost fallacy.

Gas prices in California are topping $5/gallon, and politicians are in a frenzy, making claims of manipulation.  Diane Feinstein is taking the lead:

Feinstein, in a letter to the Federal Trade Commission (FTC), called for the agency to implement broad monitoring of oil-trading markets and investigate possible “collusion.”

“Publicly available data appears to confirm that market fundamentals are not to blame for rising gas prices in California,” she wrote, citing state data that showed gasoline production last week was almost as high as a year ago and that gasoline and blending components were equal to this time last year.

The California senator cited Reuters’ Friday report on the “short squeeze,” in which traders said refiner Tesoro Corp had to scramble to buy fuel from other companies to meet commitments.

While traders told Reuters that no single party appeared to be withholding supply intentionally and that there was no suggestion anyone conspired to drive up prices, Feinstein wrote: “An FTC investigation is likely the only way to determine whether this reported squeeze took place.”

Look.  I’ve seen this movie many times before.  There is a localized spike in gasoline prices.  Politicians start screaming “We must do something about this at once! Immediately! Immediately! Harrumph! Harrumph!”  The FTC scurries to do an investigation, and finds that fundamentals explain the spike.

They also find something I’ve included in my classes for 10+ years: that Federal environmental policy is directly culpable.  The key here is that these spikes tend to be localized.  Why? Because due to EPA regulations, there are highly localized formulas for gasoline.  Which means that when there is a supply disruption in a particular locale that requires a specific gasoline blend, supplies can’t be shipped in from other markets because the refineries serving those markets produce a different blend.

This happens in the Chicago area with some frequency.

You may think that the environmental benefits of customized gasoline blends are sufficiently great to justify the occasional-and inevitable-price spikes that such a system produces.  If so, you should STHU about the price spikes. But then you wouldn’t be a politician, who wants it all ways all the time.

This story brings up another pet peeve of mine.  (Yes, there are many.  I know.)  Specifically, the promiscuous and imprecise use of terms related to manipulation.

Feinstein seized on a statement in a Reuters report that Tesoro had been the victim of a “short squeeze.”  Now, this term can refer to a a manipulation, in which the holder of a large long forward position-a position larger than the quantity that can be delivered at the competitive price-demands excessive deliveries of the commodity, driving up the price, and liquidating some of its long position at the supercompetitive price.  The demand for excessive deliveries is an exercise of market power.  The firm demanding delivery is deliberately squeezing the shorts.

This term is also commonly used to refer to a situation where a firm or firm is short, and has to cover under tight supply conditions, but where nobody exercises market power. Here the short is squeezed by tight but competitive market conditions.

Note that the same term is used to refer to two very different situations: one in which somebody exercises market power, and one in which nobody does.

I strongly suspect that Tesoro was caught in the second kind of squeeze.  One way to determine this is to see if Tesoro bought back contracts.  If it delivered on 100 percent of its contractual obligations, one of the longs to whom it had sold couldn’t have exercised market power: that requires the liquidation of some contracts at the supercompetitive price.

But use of ambiguous terms that can have diametrically opposed implications fuels political fires from the likes of Feinstein.  (Scary thought.  She’s the smarter and more honorable of the two senators from CA.)

So my prediction. Much harrumphing for as long as prices stay high in CA. The FTC will dutifully investigate. It will conclude that the spike was produced by an adverse supply shock that could not be ameliorated by increasing supply from other markets. The politicians will greet this report with stony silence. But the harrumphing will begin anew with the next spike.

But you’ll never get a harrumph from this guy. Not until there is credible evidence of manipulation.

The UK’s Vickers Report and the EU’s recently released Liikanen Group report both recommend a fundamental structural change to the banking system to reduce systemic risk and the likelihood of taxpayer bailouts of banks: “ringfencing.”    The taxpayer guaranteed deposits of a financial institution would be inside the ringfence, and the ringfenced entity that can fund itself with these deposits can engage only in a limited array of activities that are deemed to be of low risk.  Riskier activities, such as derivatives trading and securities underwriting, would have to be undertaken through separately capitalized affiliates that cannot be funded by the ringfenced entity.

This is, in essence, a variation on the Glass-Steagall approach of separating commercial and investment banking.  The Volcker Rule is another way of achieving a separation of deposit taking and trading and underwriting activities.

These structural approaches are completely misguided, in my opinion.  They are unlikely to have the desired effect of reducing systemic risk or insulating taxpayers from the fallout of risky trading activities.

Insured deposits are a potential source of moral hazard, and there is a case to be made for limiting the risks that can be funded with insured deposits.  But historically these activity limits have proved to be a very poor defense against risk taking.  Banks have gotten into trouble while engaging in traditional lending activities; the Latin American debt crisis and the S&L crisis are two prominent examples.  Ditto Northern Rock in the UK.

Moreover, it is beyond naïve to believe that making insured depositors whole is the only, or even the most important, cause of taxpayer funded bailouts.  A failing  investment bank-or a bank-owned trading entity outside the ringfence-poses a potential systemic risk that would likely result in a bailout even if insured deposits are not directly at risk.  Its derivatives counterparties-which are likely other big financial institutions, and which could well be ringfenced banks-would suffer losses if it went other.  Its lenders-which could include, for instance, money market funds that buy its short term debt-are also at risk.   This could lead to destabilizing runs on the money markets.  In brief, even entities outside the ringfence would be highly interconnected with the broader financial system, and with entities inside the ringfence.  The Fed or the ECB would likely deem problems at such interconnected institutions to be systemically threatening, and would find a way to provide support to prevent a failure.

Put differently, an investment bank-like entity outside the ringfence can be too big to fail.

Indeed, looking at the 2008 experience, the most vulnerable institutions were not funded by deposits.  Bear Stearns was an investment bank-it was bailed out.  AIG was not deposit funded-it was bailed out, in large part (IMO) to prevent the failure of another non-deposit funded entity, Goldman Sachs (i.e., the AIG bailout was in part, and likely in large part, a backdoor bailout of Goldman).  Merrill was foisted on Bank of America to prevent its failure.  And of course there is Lehman.  It wasn’t bailed out-but you can be metaphysically certain that inaction won’t be repeated again.

It is quite easy to envision that there will be firms outside the ringfence that are deemed TBTF.  If one of these firms looks acutely vulnerable, central bankers and regulators concerned about systemic contagion will find some way to prop it up.  Taxpayer money will be at risk.

Moreover, the ringfencing idea creates a particular kind of vulnerability that proved to be an acute problem in 2008, and which is pretty well understood theoretically.  The funding of non-deposit funded entities is often quite fragile, and vulnerable to runs.  Like investment banks in ’08, entities outside the ringfence are likely to depend on short-term wholesale funding that can-and will-run if the entity looks shaky, and there is doubt that a bailout would be forthcoming.

Deposit funding is stickier, and a destabilizing-and inefficient coordination game equilibrium-run is less likely to occur with sticky funding.  Thus, putting trading activities outsie the ringfence, and funding these risky activities through the wholesale markets exacerbates a source of financial fragility.

Thus ringfencing increases the risk of liquidity/funding crises that trigger a bailout.  It exacerbates a form of fragility that was devastating in 2008, when it was financial institutions that were outside the Glass-Steagall ringfence that proved most vulnerable to the fallout from the decline in real estate prices.

The knotty issue here is why the funding of trading, market making, securities underwriting and similar activities is typically quite fragile.  The Diamond-Rajan story is that runs are a way of disciplining opportunistic intermediaries.  With the potential for externalities from runs (due to contagion effects) one could make a case that funding is excessively fragile.  But that is hardly an argument for ringfencing, which precludes the ability to use less run-prone deposits to fund these activities: indeed, if anything, it is an argument against ringfencing.

The nostalgia for Glass-Steagall-like structural “fixes” is pervasive.  But structural separation of certain forms of financial intermediation, and separation of certain forms of activity from deposit taking, don’t address a fundamental source of systemic risk: the reliance on short-term, wholesale funding that is vulnerable to runs.  Indeed, it likely makes the problem worse because it increases the reliance of the segments outside the ringfence on such funding.  It is delusional to think that just because taxpayer-guaranteed deposits are not directly at risk, that taxpayers are not on the hook for bailouts.  If a big, interconnected entity that sits outside the ringfence teeters on the brink, regulators and central banks may well deem it too big to fail: No More Lehmans is their motto.  Ringfencing does not isolate derivatives trading, underwriting, etc., from the broader financial system: entities outside the ringfence will still be interconnected.

So even if there is no explicit taxpayer obligation (as with insured deposits), there is an implicit one.  We’ve seen that implicit guarantee invoked before, and we could see it again.  Ringfencing does not address the problem of a non-depository SIFI that is highly interconnected.  Indeed, by increasing the number and size of such entities, it almost certainly makes this problem worse.

It’s hard to know what is more appalling: the administration’s handling of Benghazi before the assault on the consulate and the killing of Ambassador Stevens and 3 other Americans, or its handling of the aftermath.

The ranking doesn’t matter really, because both are off the charts bad.

It is now abundantly clear that the security situation in Benghazi was atrocious before September 11, and that there were myriad warnings that Al Qaeda was active in the city.  The Brits withdrew their personnel from the city in July.  American State Department personnel asked for more security-and were turned down.

It is now acknowledged that the judgment of the intelligence community within 24 hours of the attack was that it was a planned terrorist attack by Al Qaeda.

Well, duh.

Even a cursory review of what happened made the administration’s “spontaneous flash mob in response to a movie nobody saw” narrative obvious bullshit.

But in some respects the planned vs. unplanned debate is a red herring.  Would it actually be better for the administration and the State Department if the consulate and the ambassador were so vulnerable to an extemporaneous, unplanned attack that such an assault could overwhelm security in minutes and kill 4 Americans?  It’s a defense that American security was so bad that an ad hoc attack could kill the ambassador?

The only thing that really matters is that there were armed, hostile elements in the vicinity and that American security was completely insufficient to handle it.

Now there are reports that Obama-personally-refused to commit US military forces to respond to the attack on the consulate because it would violate Libyan sovereignty and “inflame the situation.”

Inflame the situation.  Consider that choice of words, after viewing photographs of the conflagration that engulfed the consulate.  How could the situation have gotten any more inflamed-literally?  Do these people have a freaking clue when they open their mouths?

And who really gives a rat’s ass about Libyan sovereignty?  Especially inasmuch as whatever sovereignty they have is largely courtesy of the USAF and USN.  And inasmuch as the facility under attack was sovereign US property.

But for days after the administration knew the truth, it insisted on the bullshit narrative.

And now, when confronted with the truth, it refuses comment.  The execrable Jay Carney (and execrable hardly does justice) responded thus to the charge by the chairman of the House Oversight and Government Reform Committee Darrell Issa that consular personnel had been denied repeated requests for additional security:

“I’m not going to get into a situation under review by the State Department and the FBI,” Carney said. …

The press secretary said that “from the moment our facility was attacked” the president has been focused on providing security to all diplomatic posts “and bringing the killers to justice.”

About the list of security issues, Carney said it was a “known fact that Libya is in transition” and that in the eastern part of Libya in particular there are militant groups and “a great number of armed individuals and militias.”

If it was a known fact, why the hell was security so appallingly bad?  Again: that’s a defense? That’s the best he can do?

Oh, and another thing: Thanks, carnival barker, for bringing up the “review by the FBI.”

First, note that he didn’t say “investigation.”  Because that would require, you know, people actually on the ground investigating.  But the FBI isn’t in Benghazi investigating anything-despite the fact that earlier Carney and the rest of the administration had suggested the FBI was conducting an investigation.  They won’t go there without military escort.

So there is, in fact, no real investigation to defer to when refusing comment.  Though it is very convenient that the investigation be delayed indefinitely, thereby extending the “I can’t comment while the investigation is underway” excuse indefinitely.

And yeah.  More than two weeks after the events I am sure an investigation will reveal just loads of information.

Memo to carnival barker: Anderson Cooper-and the terrorist assailants-have already picked the “crime scene” clean of any useful information.

Second, putting the FBI in charge suggests that this is a crime, not an act of war.  Another devastating revelation of the mindset of this lot.

This is a military/intelligence matter, not a law enforcement matter.

And speaking of intelligence, sources within the intelligence community rate the aftermath of the attack as a 10 out of 10 on the disaster scale.  A failure to predict, and one that reportedly resulted in the complete disruption of anti-Al Qaeda intelligence operations in the area.

If anyone was president other than Obama, this would be a huge scandal.  Who would need an October surprise?  The September surprise would have torpedoed his candidacy more thoroughly than the USS Indianapolis, and anyone surviving the explosion would be consumed by media sharks.

But the “bumps in the road” outrage goes almost totally unremarked.  The preening over killing Osama, which allegedly proved the end of Al Qaeda, and which makes Bush’s “Mission Accomplished” boasting look Julian-Assange-pale by comparison, draws no criticism.

And that may be the most appalling thing of all.

The Bank of Canada has decided that Canadian entities can meet their G-20 clearing obligations by clearing with international CCPs like LCH or CME.

The alternative-which was seriously considered, until fairly recently-was to require the formation of a domestic Canadian CCP through which Canadian financial institutions would be required to clear.  The Bank of Canada was leaning towards a “Canadian solution” because it believed that it could monitor such an institution more effectively, that a domestic CCP would insulate Canada from global financial shocks, and that it would be easier to provide C$ liquidity support to a domestic entity.

I co-authored a study for the Canadian Market Infrastructure Committee (CMIC) which argued that (a) these benefits were illusory because there would be C$ swaps traded by non-Canadian entities and non-Canadian entities would likely be important members of a Canadian CCP due to scale and scope economies, and (b) mandating clearing via a domestic CCP would dramatically increase collateral and liquidity costs of trading C$ swaps due to the fragmentation of netting sets (among other reasons).  As a result, I/CMIC recommended that Canadian banks, investment funds, and insurers be permitted to meet their G-20 obligations with an international clearer that could margin more efficiently.

It’s good to see that BoC acknowledged the force of these arguments, despite its initial preference for a domestic CCP.  Reason sometimes prevails.

I’m less enamored with BoC Deputy Director Timothy Lane’s argument that commodity trading firms (e.g., Cargill, Glencore, Vitol, Trafigura, Dreyfus) are systemically important.  Much more on that subject soon-it consumed much of my summer.  Hopefully he’s open to persuasion on this issue, as he was on the necessity of mandating the use of a domestic CCP for Canadian IRS.  But it would be gratuitous of me to make too much of a bother of the global commodity trading firm (“GCTF”) matter now.  So I say kudos to Mr. Lane, and the BoC, for setting priors aside; evaluating the arguments and evidence; and coming to the right choice (IMO) with respect to clearing of C$ swaps.

HFT is under continued assault, both in the press and from regulators and legislators.  Europe is taking the lead on this, and Mifid II will impose some restrictions on HFT.  The Germans are particularly hot on restricting it, and are proposing other measures as well.

One goal of these regulations is to increase liquidity, and to improve the quality of liquidity.  Perversely, however, certain of the regulations intended to have these effects will do the exact opposite.

In particular, as I’ve argued since soon after the Flash Crash when many of these ideas were first proposed, things like minimum resting times for limit orders will reduce liquidity and make sudden reductions of liquidity more likely precisely when order flows become more toxic.  Limit orders are like options granted by the market maker, and extending the lifetime of the option increases its cost-particularly during times of high volatility and high order flow toxicity.  If you increase the costs that market makers, including those using HFT strategies to make markets,  incur to quote, they will quote wider, they will quote less, and their quotes will become particularly wide and particularly scarce during periods of elevated uncertainty.

In other words: there is no free lunch.  You raise the costs of market making, and liquidity costs go up.  Period.

Larry Tabb makes the point quite well:

So what will happen? If we mandate longer time in force periods, lower cancellation ratios, and higher market maker participation rates, liquidity providers will just widen their spreads to compensate them for the greater risk.

Won’t this force real investors to come in and bid? They may, however investors don’t quote on both sides of a market. They either buy or sell and not both. So many more quoting investors would be needed to make up for fewer market makers and HFT.

But, will HFTs actually leave? Market makers may leave but high-speed traders probably won’t; they will just change their stripes. Liquidity providers will flip to liquidity takers. Given a speed advantage, if it no longer serves a high-speed trader’s purpose to provide liquidity, they can just as easily take it. And since market makers and quoting investors are locked into providing liquidity for at least 500 milliseconds, HFTs will be the first to pick off every stale quote. And with a half second quoting mandate, there will be plenty of stale quotes to go around.

This last point is particularly powerful.  The regulations will penalize liquidity suppliers not just directly, but indirectly, by actively encouraging predatory/opportunistic algorithmic/HFT strategies that look for and pounce on quotes that are stale and not reflective of current information because of the restrictions on the time quotes must be enforced, and on cancellation and participation ratios.  (Note: these last restrictions are likely to create some rather complex time dependencies that can create some unanticipated sources of instability.  A trader’s current quoting behavior will depend on his past cancellation and participation rates, not just on current market conditions.  That adds a complex new feedback to an already complex process.)

The elimination of tiered pricing (e.g., differential pricing for quote makers and quote takers) will also tend to reduce liquidity.  Why don’t exchanges have the incentive and the information to get that right?  They are much better incentivized and informed than regulators.

So as Larry indicates, the regulations will reduce liquidity by raising the cost of quoting directly, and indirectly as well by encouraging predators to feast on those brave enough to quote:

So let’s combine points. Market makers will leave, spreads will widen, investors will post quotes, but HFTs instead of posting will take quotes. With investors’ quotes being frozen, HFTs will just pick off those investors. And once these investors learn this game they will stop posting, and then there will be little incentive for anyone to post quotes as the value of the limit order option grows just as the compensation to the option poster falls.

But won’t HFTs run afoul of HFT rules, you ask. Not really, since many of these rules focus on liquidity posting and not liquidity taking. If you take liquidity, there is no need to post or cancel, so cancellation rates decline to zero, and time-in force rules become immaterial.

Great.

Mifid II will also restrict those scary dark pools, in particular by banning crossing networks.  Which, as Tabb notes, will expose those seeking liquidity to predatory HFT, and other predatory strategies that raise execution costs.  For dark pools exist precisely to reduce the execution costs of those who are uninformed liquidity demanders. They swim in a (dark) pool because they don’t want to swim with the sharks in the open waters of the public markets.   Mifid will deprive them of that safe harbor, with the predictable result that Larry describes:

If all of this comes to pass, spreads will widen, depth will evaporate and there will be fewer places to hide as broker dark pools will face restriction. And the life of the buy-side trader, instead of becoming easier, will become much harder. And who suffers? The people who always suffer: the investors.

In other words, the Sorcerer’s Apprentices are at it again.  They claim to work magic that will make investors’ lives easier, but will in fact unleash forces that will wreak havoc.  And, no doubt, they will use the resulting havoc as the justification for yet more magical regulatory spells.

Not all HFT is good.  Not all algorithmic trading is efficiency enhancing.  It would be worthwhile to explore ways of curbing the inefficient forms of computerized trading without harming good forms.  There is justification for some regulation that can reduce the likelihood and impact of bad algos.   Mifid II is unlikely to have these effects.  Indeed, in my opinion-and in Larry Tabb’s too-it will likely have the exact opposite effect, and will disproportionately damage the beneficial forms of computerized trading and off-exchange trading.

Like the old joke says.  The Euros want to fix computerized trading in the worst way.  And they are succeeding.

I had a chance to read Judge Wilkins’s decision in the position limits litigation on a flight over to London, where I am speaking on the impact of financial regulation, at a conference put on by Lloyds Bank.

There is virtually no economics in the opinion-it is a highly technical analysis of issues related to administrative procedure, statutory interpretation, and the like.  The perfect thing to read while trying to get sleepy as part of my jet lag management strategy.

How technical?  The placement of commas technical.

There are essentially two parts to the decision.  The first relates to § 6a(a)(1) of Frankendodd.  This part is straightforward.  Judge Wilkins ruled that it was unambiguous that the CFTC had to make a finding of the necessity of position limits.  It didn’t.  Back to the drawing board, GiGi.

The second part relates to sections 6a(a)(2), (a)(3) and (a)(5).  Here you have to get into the weeds.  These Judge Wilkins found to be ambiguous.  The ambiguity relates to the words “as appropriate,” as in:

Section 6a(a)(2)(A):

In accordance with the standards set forth in paragraph (1) of this subsection . . . the Commission shall by rule, regulation, or order establish limits on the amount of positions, as appropriate, other than bona fide hedge positions, that may be held by any person . . .

Section 6a(a)(3):

In establishing the limits required in paragraph (2), the Commission, as appropriate, shall set limits –

(A)on the number of positions that may be held by any person for the spot month, each other month, and the aggregate number of positions that may be held by any person for all months; and . . .  [Emphasis added.]

What Judge Wilkins could not determine unambiguously was whether “as appropriate” referred to the setting of limits at all, or the specific quantity of the limits.  The plaintiffs (ISDA and SIFMA) argued that the CFTC had to determine whether it was appropriate to set limits at all.  The CFTC argued that it had to set some limits, and Congress directed it to set the specific quantities appropriately.

This is where the commas come in.  I won’t bore you with the details, but if you are planning any intercontinental travel, I direct your attention to pp. 29-30 of the ruling.  You don’t have to thank me for easing your jet lag.

This matter of ambiguity turns out to be mightily important under the Chevron doctrine which determines whether a court need show deference to an agency’s decision.  And here the CFTC (and yes, I’m looking at you, Gary) is hoist on its own petard.

For the CFTC claimed that the language in the statute is NOT ambiguous.  Citing the Peter Pan (!) case, the Judge ruled that by claiming that the ambiguous wasn’t, the CFTC wasn’t owed any deference, and that there is precedent in his Circuit to vacate and remand the rule:

It is well-settled in this Circuit that “deference to an agency’s interpretation of a statute is not appropriate when the agency wrongly believes that interpretation is compelled by Congress.” Peter Pan, 471 F.3d at 1352, 1354 (internal quotation marks and citations omitted) (vacating and remanding agency decision because agency “premised its construction on the plain language of the statute, which it treated as unambiguous, and because we find that the statutory language is in fact ambiguous . . . .”).

Whoops.  By adamantly asserting that there was no ambiguity in the relevant sections of Frankendodd that the judge did find ambiguous, the CFTC lost any claim to deference.

Where do things go from here?  Probably a ping pong game, with the rule bouncing back between the agency and the courts.

Presumably the CFTC will stitch up some justification for a necessity finding, and go into a long disquisition to meet step two of the Chevron test:

“[I]t is incumbent upon the agency not to rest simply on its parsing of the statutory language. It must bring its experience and expertise to bear in light of competing interests at stake” to resolve the ambiguities in the statute.

I don’t know whether a justification of a necessity finding that is based on bad economics or bad (or no) empirical evidence is vulnerable to legal challenge.  I suspect it would be difficult for the plaintiffs to get the rule overturned because of a weak justification for the necessity finding.  I also suspect that CFTC will be able to pass the Chevron tests if it does recognize the ambiguity-which makes me wonder why they didn’t so recognize it at the outset.

My guess, therefore, is that the CFTC can, after yet more hearings, and comments, and time, correct what Judge Wilkins found wanting.  But that doesn’t mean that it’s out of the woods yet.  Not by a long shot.  For the plaintiffs made four additional challenges of the rule.  The judge did not feel it necessary to rule on these additional charges because he found sufficient grounds in the first to remand the rule back to the agency.

Notable among the additional grounds for challenging the rule is “Insufficient Evaluation of Costs and Benefits under 7 U.S.C. § 19(a).”  Will the CFTC stand pat on its existing cost-benefit analysis, which gives the word “perfunctory” new meaning?  Or will it feel obliged to gin up something better, given that the court was obviously not impressed with some of its other legal reasoning, and given that the SEC has lost a major case due to its failure to do a proper cost-benefit analysis?

The other challenges relate more to the specifics of the rules.

In brief, they have not yet begun to litigate (apologies to John Paul Jones).  The position limit rule has a long, long way to go before it becomes a reality.

This also raises the question of whether other Frankendodd-spawned rules will be challenged.  I’m guessing yes.  And there will be much rejoicing-among lawyers, anyways.

It is a good thing when bad rules are stopped.  The ongoing uncertainty pending definitive legal resolution is more problematic, however.  But that’s our reality, and will be for some time, on position limits, and other aspects of Frankendodd.