Streetwise Professor

March 19, 2013

Can They Really Be This Stupid?

Filed under: Economics,Financial Crisis II,Politics — The Professor @ 2:46 pm

I’m talking about the Brussels Bozos, so the post title is a completely rhetorical question.

What I’m referring to specifically is that the Eurocrats were supposedly “blind-sided” by the opposition to the depositor bail-in in Cyprus, and the impending defeat of the proposal in the legislature.

What, did they think that Cyprus would roll over and sheepishly-and I do mean sheepishly-comply with the EU’s dictates?  Did they really think that local politics wouldn’t rear its ugly head, and disrupt their orderly little world?

The sad thing is that I think the answers to those questions is “yes.”  Or, more accurately, “YES!”  The EU is an elite project and the elites presume that the hoi polloi will slavishly adhere to their master’s dictates.  That’s probably true on small matters.  Even medium-sized matters.  Perhaps many big matters.  But to Cyprus, this is an existential matter.  What does Cyprus have to lose?  Yes, the EU-and the Cypriot government-are telling horror stories about the nasties that await if they reject the monster mash bailout/bail-in, but the consequences of the monster mash are bad enough that it is perfectly understandable-to normal, sentient people, anyways-if the hoi polloi are willing to take a roll of the dice.  What’s more, such a reaction to a dictate from afar is more than perfectly understandable.  Human beings being human beings, damn them, will often refuse to take their medicine just because they are being forced to.  But I guess I am expecting way too much when I suggest that the Eurotards should actually condition their policies on an understanding of human nature in its fallen, tragic state.

The Euros choices were two: bailout Cyprus completely, or do the monster mash of bailout and bail-in.  Helluva choice.  Either alternative would have pernicious consequences in Spain, Italy, etc.   Encourage runs, or encourage moral hazard and brinksmanship.  And the fact that those are the choices is exactly why the Eurozone and the EU are beyond absurd.

Whoops! They Did It Again!, or, Put some ICE on That

Filed under: Clearing,Derivatives,Economics,Politics,Regulation — The Professor @ 12:18 pm

The clearing and reporting requirements of Frankendodd have barely gone into effect, and the unintended consequences are already beginning to pile up.  Who coulda seen that coming, eh?

Even I couldn’t have made up the bestest of them.  Namely, as a result of the SEC’s bizarre portfolio margining rule, ICE has said that it will not clear single-name CDS.  You know, the weapons of financial mass destruction that were supposed to be the reason for needing a clearing mandate in the first place.  So ICE won’t clear the poster children for the clearing mandate.  Like I say: you cannot make up this stuff.

From Risk:

Ice Clear Credit has shelved plans to clear single-name credit default swaps (CDSs) for clients of its member firms, as a result of a new Securities and Exchange Commission (SEC) policy on portfolio margining. Under the terms of that policy, circulated late on March 8 – the last working day before the start of mandatory clearing for CDX index trades in the US – clients would be able to benefit from risk offsets between cleared index and single-name contracts, but the vast majority would be charged twice the margin calculated by a central counterparty (CCP).

The move sparked a furious response from some buy-side firms and has now dissuaded Ice’s CDS clearing house from offering the service at all.

“Last Friday, the SEC issued a temporary approval requiring broker-dealer futures commission merchants (FCMs) to charge two times the initial margin requirement of the CCPs. This was unfortunate, so we made a decision, based upon that unexpected development – news of which we received very late in the day on Friday – and based upon input from many clients, that it would be better not to offer single-name clearing under those conditions than to make single names available,” Peter Barsoom, chief operating officer of Ice Clear Credit, told attendees at the Futures Industry Association (FIA) annual conference in Florida last week.

The SEC policy gives temporary approval for an FCM to allow cross-margining if it collects 150% of the margin required by a CCP, but only if the client has “virtually no credit risk”. For all other clients, 200% must be collected on positions held in the portfolio margin account, which participants say would apply to most buy-side firms.

Portfolio margining across asset classes is theoretically beneficial, but practically dicey due to the instability of correlations, which often result in positions being undermargined during conditions of market stress.  And yes, individual name CDS and indices can diverge, again particularly during periods of financial stress.  But a portfolio consisting of a position in an index and offsetting positions in single names (especially names in the index) is less risky than either leg on its own.  This means that it is possible to improve capital efficiency while holding risk level constant by giving margining offsets for portfolio benefits.  But noooooooooooo.  In its infinite wisdom, SEC has decided to punitively margin these portfolios.  This reduces substantially the benefits of clearing individual name CDS, so ICE says to hell with it.

Again, the irony is almost too much.  The risks of single-name CDS were constantly invoked to justify the clearing mandate.  Those arguments were largely bogus, but regardless, due to regulations adopted to implement the mandate, single-name CDS will not be cleared for the foreseeable future.  Yay!

This is yet another example of the perverse effects of regulatory setting of margin levels.  I’ve been saying this so much I’m blue in the face: you could call me the smurfwiseprofessor.   For the zillionth time: regulatory margin setting is a form of price control, risk price control specifically.  Price controls never work.  Worse than that, price controls always lead to distortions.  First with futurization and now with portfolio margining, we are seeing these distortions appearing, big time.  And they’ll likely only get worse, when margins on non-cleared swaps are finalized.

Regulators have neither the information or incentives to set these prices right.  They bewail regulatory arbitrage, but their attempts at price control are the destined to set off a regulatory arbitrage land rush.


But it gets better!  Even the seemingly banal task of reporting swap trades is overwhelming the CFTC.  According to Scott O’Malia, they cannot find a London Whale in a phone booth:

Dodd-Frank Act derivatives rules are failing to give regulators a full picture of the swaps market and wouldn’t help them detect a loss similar to JPMorgan Chase & Co. (JPM)’s London Whale trades, according to Commodity Futures Trading Commission member Scott O’Malia.

Swap-trade data the agency has been receiving since the end of last year from repositories including the Depository Trust and Clearing Corp. is inadequate to identify large positions and have overwhelmed government computer systems, O’Malia said in a speech prepared for a Securities Industry and Financial Markets Association conference in Phoenix.

The data “is not usable in its current form,” said O’Malia, 45, one of the agency’s five commissioners. “The problem is so bad that staff have indicated that they currently cannot find the London Whale in the current data files.”

. . . .

Different swap dealers and trading counter-parties are using their own reporting formats because the government failed to specify standards, O’Malia said.

“It means that for each category of swap identified by the 70-plus reporting swap dealers, those swaps will be reported in 70-plus different data formats because each swap dealer has its own proprietary data format it uses in its internal systems,” he said. “The permutations of data language are staggering. Doesn’t that sound like a reporting nightmare?”

The CFTC’s computer systems are failing to handle the incoming data. “None of our computer programs load this data without crashing,” O’Malia said.

This should be no surprise.  The issues with CFTC computers particularly.  The GAO issued reports in the ’80s ripping the agency for its IT dysfunctions.

Frankendodd has barely come to life, and it is already wreaking havoc.  I am sure there are more good times to come!

And I am totally, totally sure that Obamacare will work just as well.  No prospect for unintended consequences there!

March 18, 2013

Cyprus: The Essence of FUBAR

Filed under: Economics,Financial Crisis II,Politics — The Professor @ 7:50 pm

If you’ve been waiting your entire life to witness the pure, un-adulturated, distilled essence of FUBAR, your dreams have been answered: for behold Cyprus!

For in one fell swoop, the with their monster mash of a bailout-bail-in of Cyprus, the Eurotards have succeeded in: gutting the rule of law and due process; riding roughshod over democratic institutions; increasing the risk of a catastrophic bank run in the event any Eurozone country (e.g., Spain) is believed to need to seek assistance; and sparking a huge diplomatic row with Russia.  Well played! Well played, indeed!

For those dwelling under a rock: as part of a 10 billion euro bailout for Cyprus, the Euros (meaning primarily Germany) required the imposition of a tax on deposits in Cypriot banks: a 6.75 percent tax on deposits below 100,000 euros, and 9.99 percent on deposits above 100K euros.

The bail-in essentially guts deposit insurance, which allegedly protects deposits below 100K.  A run on Cypriot banks is almost inevitable, because who is to say that this haircut is the last?  What’s worse, depositors in other peripheral banks have to take seriously the prospect that they will be similarly expropriated, in the event that their banks and/or sovereigns (to the extent this distinction has any meaning) require a Eurozone bailout.  This makes them much more likely to run at the first hint of trouble.  And of course, these things can be self-fulfilling.  If, say, Spanish depositors become more worried about the financial condition of the country’s banks, fearing having some of their deposits confiscated they might start to pull their funds from the banks; in the event, unable to fund themselves, the banks-and the Spanish government-may be forced to throw themselves to the tender mercies of the Germans, et al, leading to the imposition of the dreaded deposit tax.

The dynamics in these situations are always complicated, and highly dependent on beliefs, but it cannot be gainsaid that the actions in Cyprus increase appreciably the odds of a destabilizing run somewhere in the Eurozone, especially on the periphery.  Therefore, it is worthwhile to keep an eye on deposits at peripheral banks for any evidence of the beginnings of a run.  Relatedly, keep an eye on Target2 balances; an uptick in German Target2 assets could indicate attempts by peripheral depositors to move their funds to core banks.

The best-only?-hope of avoiding such an outcome is that Spaniards, Greeks, Italians, etc., believe that Cyprus is truly an exceptional, one-off case as the Eurocrats claim.  Which leads to the question: what differentiates Cyprus to such an extent that events in Cyprus do not cause depositors in Spain, etc., to update their beliefs regarding the probability they will be similarly expropriated in the event of a bailout of their countries’ banks?

There is one obvious answer: Russia.  Or, more properly, Russian money.

Cyprus has been the most popular destination for Russian funds leaving the country, and most notably dirty money: much of the money stolen in the Hermitage/Magnitsky fraud, for instance, went to Cyprus initially.  Germany’s intelligence service, the BND, said in a leaked report that a Euro bailout of Cypriot banks would largely benefit Russian depositors whose money has dubious origins.

This became a huge political issue in Germany.  The Social Democrats made a bailout of Cypriot banks political poison for Merkel: No bailout of Russian thieves!  She is ramping up for an election campaign, and in no way could be seen as bailing out dirty Russian money.

Supposedly she (and the IMF) wanted to force uninsured depositors (including many of the Russian depositors) to bear the entire burden of the bail-in, but Cyprus’s government refused.  Hence sharing the pain with smaller depositors.  But that has unleashed a furious reaction in Cyprus, and it is likely that the deal will be redone so as to put more of the burden on the uninsured (read-Russian) deposits and less on the insured deposits.

Which will only infuriate the Russians more.  And they are already plenty furious.  Putin just about lost his sh*t today, calling the original deal “unjust, unprofessional, and dangerous.”  And that’s before any adjustment of the deal to the further detriment of Russian depositors.

Any initial schadenfreud should be stifled: yes, the Russians are the masters of unjust expropriation, but two wrongs don’t make a right.  If some Russian money in Cyprus is dirty, being laundered, etc., the right way to handle it is to investigate and provide protections of due process to ensure that the guilty are identified and punished, and the innocent are spared: the Eurotard approach is Red Queen justice: “Sentence first! Trial later!”  The innocent are swept up with the guilty.  This is why the Euro approach guts the rule of law, with all of the pernicious effects that inevitably accompany such actions.

In some respects, Putin’s reaction is a surprise.  Given his declamations against tax evasion and the off-shoring of Russian money, there are some benefits to closing down an offshore bolt-hole for Russian money that Putin would prefer to remain in Russia.  But the unilateral Euro action no doubt rankles deeply, and no doubt strikes very close to home for Putin and some of his cronies.

It is very interesting to note that Russian stocks and the ruble took a far bigger hit from the Cyprus news than did Eurozone stocks.  The loss (about 2 percent on the major Russian indices, MICEX and RTS, and a .7 percent decline in the ruble, as compared to less than 1 pct declines in European stocks) cannot be explained by the direct effect of the expropriation.  Estimates are that there are about 30 billion euros in Russian deposits in Cyprus: 10 percent of that is only 3 billion euros, far less than the decline in Russian market capitalization.  Meaning that there is some indirect channel by which the expropriation is hitting Russian corporations: I am still trying to think through what that channel might be, but haven’t arrived at any opinions yet.

Whatever the reason, the market reaction demonstrates just how important the Cyprus issue is to Russian interests.  It will further stoke Russian paranoia-an amazing accomplishment.  It could cause a major diplomatic fallout between Germany and Russia, which would have substantial geopolitical implications.

All in all, it is hard to imagine how the Eurocrats could have played this any worse.  They didn’t really solve Cyprus’s debt problem.  They made it all the harder to deal with debt and banking problems outside of Cyprus.  They committed a major foreign policy blunder.  A truly amazing trifecta.

One final thought.  This points out the absurdity of the Euro project.  If tiny Cyprus is too big to fail, if the effects of its default would be so horrible that the Euro mandarins feel it necessary to take such a desperate and dangerous measure to prevent it, how can the Euro be anything but an absurdity?

Gary Knows Best: Not Good Enough, Even for Government Work.

Filed under: Commodities,Derivatives,Economics,Regulation — The Professor @ 11:51 am

Sorry about the silence, folks.  I was in Geneva doing my annual teaching in the University of Geneva’s Masters program in International Trading, Commodity Finance, and Shipping.  It is a very unique program, and a joy to teach in.  I also spoke at the annual Trading Forum sponsored by the Geneva Trading and Shipping Association (which also sponsors the Masters program).  I spoke about Frankendodd, which is somewhat ironic given that Mary Shelley wrote Frankenstein on the shores of Lac Leman a few miles from Geneva.

Some quick catch up.

First, Bloomberg is threatening to sue the CFTC for discriminating in favor of futures and against swaps.  Bloomberg plans to launch a SEF, and (rightly) believes that the discrimination regarding the margin requirements will seriously impair the prospects for its success.

At the annual FIA gathering in Boca, Gary Gensler doubled down in his support for the discrimination (a Risk Magazine link, so a subscription is required):

“Under clearing rules finalised in 2011, swaps executed on a designated contract market or a Sef have the same margin requirement – one day for energy, metals and agriculture, which is where we as a market have been for years. Interest rate swaps have been cleared for nearly 10 years on LCH.Clearnet. They have used a practice for many years around five-day minimum margining,” Gensler told Risk, after his prepared remarks yesterday at the Futures Industry Association annual conference in Florida.

How’s that for an answer lacking any intellectual content or analysis?  LCH’s done it that way in interest rates for many years, so everybody should do that for everything going forward.

Got it.  Why think when you can merely defer to precedent, regardless of how relevant that precedent is?

Someone is thinking, and echoes my analysis of the inanity of treating economically equivalent instruments differently just because one is called a “future” (good!) and the other a “swap” (bad! bad! bad!):

“If there are two products that are equally standardised, that take the same time to liquidate, that have the same risk, volatility and liquidity characteristics, then both of them should be subject to the same margin requirement. Collateral should be determined on the characteristics of the product in question, not the wrapper,” said Sunil Hirani, chief executive of fledgling interest rate swap and futures exchange TrueEx, speaking on the sidelines of the conference.

“If a contract takes five days to liquidate then it should be subject to five-day value-at-risk, and a one-day liquidation product should be subject to one-day VAR. If a futures contract has worse risk, liquidity and time-to-liquidation characteristics than a swap, but then receives a more favourable margin treatment because it’s in a futures wrapper, that is an injustice,” he added.

My only quibble is that it’s not an injustice, it’s a recipe for regulatory arbitrage and potentially for systemic risk.

Speaking of SEFs, Scott O’Malia told Risk that progress on writing the SEF rules-which had been expected any day-is slow.  Tiresomely, this also bears the fingerprints of Gensler’s meddling hand:

Nonetheless, at a panel discussion on Sefs held earlier in the day, O’Malia recited the Dodd-Frank definition of a Sef and observed pointedly that “the word five does not appear anywhere in there” – an allusion to the controversial proposal that any request for quote (RFQ) via a Sef must go to a minimum of five dealers.

“[CFTC chairman] Gary Gensler’s original position was that he did not want Sefs to include RFQ capability at all,” says one chief executive of a trading platform that plans to register as a Sef. “His initial hope was to restrict all these new venues to a central limit order book model, but when it became clear that an order book would only work for the most liquid swap contracts, he conceded the need to permit RFQ as an execution method, but included the stipulation that quotes must be sought from a minimum of five market-makers.”

And some dealers claim this is now the major impasse, with Gensler said to be refusing to drop the so-called RFQ5 provision from the final language or bring it into line with corresponding Securities and Exchange Commission rules for securities-based Sefs, which state that an RFQ can be sent to a single dealer.

So again, Gensler wants to dictate market structure: every SEF has to have a CLOB foot.  One size fits all.  No appreciation whatsoever for the fact that there is a diversity of market participants and interests that may well be served by a diversity of execution mechanisms.  No appreciation for the fact that the supposed beneficiaries of Gensler’s would-be fiat might actually know their own interests better than he does.  No appreciation for the fact that the discovery process of competition can result in the creation of a set of SEFs that best matches the diverse needs of market users, and that this competition may spur innovation that would result in the creation of an as yet undreamed of trading mechanism that meets market users’ needs far better than a CLOB.

Keeping this Gary Knows Best attitude in mind, be afraid, be very afraid when you read this story of about the next potential target of CFTC inquiries: price setting mechanisms. Taking inspiration from the Li(e)bor issue, the Commission is now (informally) discussing the possibility of investigating other benchmarks, notably the London gold and silver fixes:

“The idea that pervasive manipulation, or attempted manipulation [of interest rates], is so widespread should make us all query the veracity of the other key marks,” said CFTC Commissioner Bart Chilton at a Feb. 26 roundtable in Washington on financial benchmarks. “What about energy, swaps, the gold and silver fixes in London and the whole litany of ‘bors’?” he said, referring to Libor, Euribor and other benchmarks.

What’s rather disturbing is the linking of the gold and silver fixes and “bors”.  These things are very different.  The main problem with Li(e)bor, etc., is that they are not set on the basis of transactions: on this I agree with Gensler, having been making this point in an interest rate and commodity context for going onto 20 years.  (In my 1992 book Grain Futures Markets: An Economic Appraisal, I criticized proposals for cash settled grain contracts due to the lack of cash transactions on which to base an index.)

In contrast, the LBMA fixes are centralized auction mechanisms (Note to Gar: nearly a CLOB!)  Indeed, they are textbook examples of a Walrasian auction.  An initial price is mooted, and the participants indicate the amount they want to purchase or sell at that price: the quantity announced by each participating bank includes customer bids and offers, so buying and selling interest reflects more than just the proprietary trades of the fixing banks.  If at the initial price there are more buys (sells) than sells (buys), the price is increased (decreased), and each fixing participant again indicates its trading interest at the new price.  The process continues until buys equal sells, i.e., until the market clears.

Crucially, participants in the auction who are buyers (sellers) at the clearing price take (make) delivery of metal in an amount equal to their bid (offer) quantity at that price.  That is, the clearing price results in actual trades.  This is miles different than Li(e)bor.

This is not to say that a Walrasian auction cannot be manipulated: for instance, a company with a large long derivatives position that has a payoff tied to the fixing price might want to put in large buy orders in the fix to drive up the clearing price in order to impact favorably the payoff of the derivative.  Here the relevant issue would be the impact of orders on the clearing price.  That’s a totally different issue than in Li(e)bor, but I’m quite concerned that CFTC views all benchmarks as indistinguishable pieces in a mass.

And Gensler’s analysis-free treatment of futurization and SEFs only fuels those concerns. Good policy needs to be predicated on good analysis, not the prejudices and suspicion of the policymaker.  Gary Says So ain’t good enough, even for government work.  But too often that’s what we are getting.  We’ve seen it with futurization and SEFs, which raises legitimate concerns that the same will occur with benchmarks.  The confabulation of LBMA fixes with ‘bors only heightens those concerns.

A side note (added later): The suggestion that the CFTC can examine the London fixes betrays incredible hubris.  How could the US CFTC possibly have any jurisdiction over a UK entity-the LBMA-or the conduct of banks, only one of which (HSBC USA) is a US entity?  Especially given that as far as I am aware there is no CFTC regulated derivatives contract tied to the London gold or silver fixes.  But Gensler is all about extraterritoriality, so don’t put it past him to try.  I hope he tries, actually.  The Brits will go totally ballistic if he does.  Perhaps that’s exactly what’s needed to constrain GiGi’s imperial ambitions.

One other thing.  I didn’t mention anything about clearing, but Gensler’s analysis-free approach has been particularly prominent there.  To say that his “analysis” of clearing over the past 4 years has epitomized a comic book approach to the issue is an insult to the intellectual rigor of comic books.

March 8, 2013

Thanks for Playing, John, But Your Effort Doesn’t Even Warrant a Parting Gift

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,Politics — The Professor @ 7:44 pm

John Kemp pixeled a rather lame response to my criticism of his earlier piece on “Broken Brent.”  I say lame because he did not even attempt to address any of the analysis I laid out.  Specifically, Kemp originally pointed to the dramatic drop in correlations between spot and forward prices and the different behavior of the curve in 2008 vs. 2012-2013 as evidence that fundamentals were somehow no longer driving oil prices.  I pointed out that that a fundamentals-based model would predict exactly such a pattern due to the pronounced backwardation in Brent and the substantial decline in macro volatility; I further pointed out that I had presented theoretical models that made this prediction and empirical evidence supporting it going back to the early-to-mid-1990s.  That’s what we call science.

Kemp’s response?  <Crickets.>

The most plausible explanation for his failure to rebut my analysis is that he can’t.  So instead he doubles down on “the hedge funds done it.”  Although he does it in a much more circumspect, passive way the second time around:

In a recent column, I suggested most of the short-term movements in Brent (and WTI) prices since mid-2010 could be traced to changes in money managers’ positions rather than fundamentals.

Read his original piece, and you’ll see that he did more than “suggest.” Accuse is more like it.

Kemp’s evidence consists of a few graphs depicting managed money futures positions and prices.  Point 1: eyeballs are not reliable evidence. Point 2: reliable evidence would involve some rigorous statistical analysis, which Kemp does not provide.  Point 3: said statistical analysis should attempt to control for other relevant factors, notably fundamentals.

But Kemp breezily dismisses the possibility that fundamentals could explain price movements in recent months.  After all, his original post is titled “static fundamentals”, and in that article and his response to me he asserts-and merely asserts-that fundamentals cannot explain price movements.  Since he does not even attempt to control for any fundamentals-related variable, Kemp’s analysis is plagued by omitted variables bias.  And that’s being charitable, because that phrase is usually employed to criticize statistical/econometric analyses, rather than gazes at graphs.

Sorry, John, but that doesn’t cut it.  In a commodity characterized by extremely inelastic supply and demand, such as oil, small fluctuations in supply and demand fundamentals can cause appreciable price movements.  Indeed, in a low macro volatility environment, fundamentals-based models imply that price movements are driven by highly technical, transient supply and demand shocks, and that moreover, these shocks cause substantial volatility in the shape of the forward curve.  That is, they cause low correlations between spot and futures prices.

In such an environment, seemingly minor factors such as the shut down of a refinery or regulatory perversities (such as the impact of RIN credits) drive movements in prices and the slope of the curve.  People who understand the fine structure of energy markets-people like Phil Verleger-realize this. Phil’s 18 February “Notes at the Margin” (which he kindly sent to me) provides a very detailed analysis of how low gasoline stocks and the closure of a Hess refinery are combining to increase gasoline cracks, which in turn are causing European refineries to buy and process Brent crude for sale to the US gasoline markets, which is in turn supporting Brent prices and backs.  As Phil characterizes it, the tight US East Coast gasoline market tail is wagging the Brent crude dog.  Fundamentals 101.

Phil analyzes these things carefully.  John couldn’t be bothered.  Instead, he squints at a few charts of COT data and prices, and declares fundamentals don’t matter.  If he could show that after correcting for the kinds of factors Phil Verleger analyzes carefully week after week that managed money position movements were associated with price changes, he would have established that a necessary condition for speculative price impact would hold: merely a necessary condition, but not a sufficient condition, because it could well be the case that the fundamentals were driving the managed money trades.  (To his credit, Kemp recognizes this possibility in his original article, though he dismisses it too readily.)

In brief, John Kemp’s attempt to show that hedge fund trading is causing movements in Brent crude prices and that fundamentals do not is plagued by numerous flaws.  Methodologically, graph gazing is the start of an analysis, not the culmination.  Furthermore, fundamentals-based models explain many of the phenomena Kemp finds anomalous.  What’s more, a micro-level analysis of supply and demand factors in the oil and product markets can account for many of the price movements that mystify Kemp.  When he confronts these issues head on, I’ll take him more seriously.

Climateer Investing weighs in on Kemp-Pirrong, and wonders why I felt obliged to go into smack down mode.  The answer is simple.  There are too many regulators and legislators and rabble-rousers (e.g., Oxfam)  who are more than willing to seize upon any claim that evil speculators are distorting markets in order to justify interference, in the form of position limits or transaction taxes or just general harassment of those engaged in legitimate and beneficial activities: yes, speculation is a legitimate and beneficial activity.  I have written and lectured extensively on the subject, and understand that speculation can, in exceptional circumstances, distort markets, but that such distortions leave distinctive tracks in quantities (e.g., inventories).  If you believe speculation has distorted markets, provide evidence that those tracks indeed exist.  Superficial examinations not grounded in well-established theoretical and empirical work don’t cut it, but feed prejudices that in turn too often lead to wrongheaded and destructive interventions into markets that cause real distortions (e.g., the rather cowardly decision of some European banks to exit the ag markets because of the propaganda campaigns waged by Oxfam and others).  When people writing for reputable sources like Reuters lazily encourage these prejudices, I will respond.  And being a Chicago guy, from a school where econ seminars are the academic equivalent of the MMA or UFC, my responses tend to be rather blunt and uncompromising.  If you can’t take it, don’t get in the ring.

And as to Climateer’s claim that the fall in oil prices from the $140s in July 08 to the $30s in early ’09 is some sort of “gotcha!” QED of the impact of speculation.  Please.  If you want me to take you seriously, you have to do a lot better than that.  A major adverse macro shock that causes the most severe, protracted economic contraction in decades following a period of robust demand (and again I commend Phil Verleger’s analysis of the summer of 2008 as the go-to source to understand what drove prices in that period) will cause a precipitous drop in the price of an inelastically supplied commodity.  Every time.  It would be anomalous if they didn’t.

March 7, 2013


Filed under: Derivatives,Financial crisis,Politics,Regulation — The Professor @ 10:01 pm

There has been considerable hue-and-cry over reports that the CFTC’s SEF rule will require market participants to solicit only two quotes instead of five when using a Request for Quote (RFQ) in a swaps trade.  This is being portrayed as a concession to the dealer banks that will permit them to perpetuate their alleged oligopoly.

I have always been harshly critical of the SEF mandate, and of regulations dictating how market participants execute transactions.  Indeed, I named the SEF mandate the Worst of Frankendodd.  And believe me, the competition is so intense, so hell to the victor.

There are diverse market participants trading diverse instruments, and there is no one-size-fits-all best execution mechanism: diverse execution mechanisms have evolved to accommodate diversity in products and transactors.

This is true of RFQ mandates too.  Indeed, it is passing strange that anyone believes that requiring end users to get more quotes is in their benefit.  If the goal of the execution mandates is to help end users by breaking the dealers’ alleged stranglehold on the market, why should you impose constraints/requirements on the end users?  Why can’t they determine what the right number of quotes to solicit is?  Don’t they know their own interests?  Can’t they trade off the alleged benefits of soliciting more quotes-namely, greater competition to take the other side of the trade-against potential costs-such as information leakage?  The regulation seems to be extremely paternalistic.  Like end users are children who need to be made to eat their Brussels Sprouts, because they don’t know what’s good for them.

But, in fact, end users-including extremely sophisticated buy side firms like Blackrock and Pimco and FMC-know quite well what works for them.  Indeed, ISDA and SIFMA just released the results of a poll showing that buy side firms-non-dealers, in other words-heartily oppose the 5 quote rule.  Actually, “heartily oppose” is a putting it mildly.  They hate it.  By wide margins they think it will reduce liquidity and raise their execution costs.  More than 80 percent of poll respondents expressed concerns about information leakage.

Ironically, 68 percent of the respondents said that they would try to trade instruments not subject to the SEF requirement.  In other words, a regulation intended to ensure that swaps were traded on open, transparent, exchange-like platforms will instead cause traders to attempt to avoid them.

Another example of “we’re from the government and here to help you” in action.

The histrionics over the “weakening” of execution mandates also betrays the intellectual incoherence of Frankendodd and it’s advocates.  The putative purpose of the law is to reduce systemic risk.  Its focus on derivatives is predicated on the belief that these instruments are inherently systemically risky, and that derivatives markets are too big and need to be cut down to size.

If that’s what you believe, then you should favor of the exercise of market power by dealers.  You should love-love!-a dealer oligopoly that raises the price of execution, because that reduces the size of derivative markets.  You believe that derivatives markets are too big, and should be taxed: and practically speaking, a dealer oligopoly that inflates execution costs serves as a tax.  It is equivalent in many ways to a transaction tax.  What’s more, the rents created by such supercompetitive prices are like a boost to the capital of dealer banks which reduces the likelihood that they will need a bailout.  That is, a dealer oligopoly reduces systemic risk, and increasing competition increases systemic risk.

In other words, if you believe derivatives markets are too big, you should *NOT* want to make execution more efficient.  You should love love love dealer market power, and strive to do anything to enhance it, rather than reduce it.  This is the theory of the second best in action.

But, sadly, intellectual coherence has never been the strong point of Frankendodd advocates. Which goes a long way to explaining what a mess it is, and what havoc it will wreak.

March 6, 2013

It’s Gotta Be the Judo

Filed under: Russia — The Professor @ 9:36 pm

Two of Putin’s judo buddies-Gennady Timchenko and Arkady Rotenberg-have been rocketing up the ranks of Russian billionaires.

I am totally sure-totally-that it’s the judo, not the connection to Putin.  Obviously the discipline and intensity the sport requires propel one to greatness.  Because judo competitors are over-represented among the world’s richest, right?  Carlos Slim, Bill Gates, and Warren Buffet have black belts, don’t they?  Right?

I don’t know what I’d do for laughs without stuff like this:

Timchenko admits he has known Putin for many years, but he has repeatedly denied the friendship has helped his meteoric rise.

“Gennady Timchenko’s success in business is in no way linked to President Putin,” Kurevin said.

Timchenko was the 12th richest man in Russia in 2012, now he is the 9th richest.

I’m dying here  Gotta be the judo.  Gotta.  The connection to Putin-merest of coincidences.

BTW, Timchenko is in Houston for CERA Week.  Maybe I should drop by and say hey to Gennady after giving Igor a high five.  And if I miss him here, I’ll be in Geneva next week, so maybe I’ll just knock on the door of the Gunvor offices and say hi.

More hilarity:

Another alleged acquaintance of Putin, Arkady Rotenberg, has also been multiplying his fortune at prodigious speed.

Rotenberg, an old judo sparring partner of Putin’s who has stakes in construction, pipe-building and financial companies, has more than tripled his personal wealth in the last year, shooting up 61 places in the latest list to be placed as Russia’s 31st richest man with $3.3 billion.

Alleged acquaintance?  WTF?  Rotenberg and Putin go way back to St. Petersburg.  They sparred together.  They were in the same judo club.  So I’m sure the “shooting up 61 places” was pure coincidence-and judo!

Some final guffaws:

Although a close relationship with Putin gives no businessman a legal advantage, it provides their companies with a competitive edge because it instills fear amongst officials, said political analyst Pavel Sali.

Legal advantage?  LOL! Tell me another one! Since when did the law have anything to do with it?  Illegal advantage is more like it. “Fear amongst officials.”  Who knew?

To think of all the time I wasted swimming competitively in my youth.  If I’d have been thinking, I would have taken up judo.  If I had, I’d be a billionaire by now.  No doubt.  Because it’s judo that matters, not being a Putin pal, right?  Right?

Ethics in Action

Filed under: Uncategorized — The Professor @ 11:29 am

I received a mass-distribution from Russell Baker (not that Russell Baker), the Executive Director of the Academic and Business Research Institute.  It reads, in part:

I have recently been made aware of a case of plagiarism in one of our journals. The Journal of Academic and Business Ethics Volume 5 contained an article with a significant amount of plagiarism that went undetected in the review and publication process.

You can’t make up stuff like that.

March 5, 2013

Riding His Anti-Hedge Fund, Anti-Speculation Hobby Horse

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Financial crisis,Regulation — The Professor @ 11:37 am

John Kemp of Reuters-accompanied by cheerleading by Izabella Kaminska at FT Alphavilleis going on about the “disconnect” between nearby and deferred Brent.  He blames-wait for it-hedge funds.  Natch.

The Brent market is currently in a steep backwardation.  I demonstrated empirically almost 20 years ago that backwardation is associated with low correlations between spot and futures prices for oil and a variety of other commodities.  Indeed, my 1994 criticism of the Metallgesellschaft 1992-1993 “hedging” strategy-which led to several confrontations with Merton Miller-was based on the fact that MG’s “hedge” of long the nearby against distant deferred short positions was in fact risk increasing due to the fact that MG implemented this strategy during a backwardation, and this reduced substantially correlations thereby making the MG position very risky.  My 2011 book provides a robust model that predicts exactly this result.

The intuition is quite straightforward-as I’ve been teaching for about 20 years too.  Inventory is what connects spot and futures prices.  When inventories are large, the market is in contango, and spot and futures prices move together: cash-and-carry arbitrage connects these prices.  In contrast, when inventories are low, the market is in backwardation, cash-and-carry arbitrage doesn’t link the spot and the futures, and the correlation between these prices can go very low.  Hence the association between contango and high correlations.

Note: hedge funds, speculation, yadda yadda yadda have nothing to do with this.

Kemp does note that there is physical tightness that does explain the backwardation:

Overlaying all these broader factors are continuing problems with production of the four North Sea crude streams (Brent, Forties, Oseberg and Ekofisk) that physically underpin the Brent futures prices. BFOE crudes remain in short supply, keeping the market in a steep backwardation, with futures prices tending to rise sharply in the run up to contract expiry.

But then he discards this fundamental fact, and mounts his favorite hobby horse of bashing hedge funds and speculation.

Note even in this paragraph there is a telling piece of information that contradicts his view: “with futures prices tending to rise sharply in the run up to contract expiry.”  Uhm, that’s exactly when hedgies and other speculators are liquidating-selling-their nearby contracts and rolling them into the deferred months.  This should put downward pressure on nearby prices, if the speculators were really  in command. Completely inconsistent with his assertion that hedge funds are driving the disconnect between spot and futures.

Kemp also makes a comparison to spot price and curve movements in 2008 to more recent movements.  But as I also show in my book, to explain commodity price dynamics you need multiple shocks of differing persistence.  Curve shape is driven mainly by transitory shocks: that’s what inventory is used to smooth out.  The level of the curve is largely driven by persistent, business-cycle type shocks.  This means that conditioning on price levels alone is insufficient to make an apples-to-apples comparison.  The 2007-2008 boom was driven more by long run, secular factors-namely the Asian/Chinese growth boom.  This resulted in a rise in the price level and only a modest increase in backwardation.  That is completely different from current conditions-hence the different behavior.

Similarly, the differences between high correlations pre-2010 and low correlations now are readily explicable.  The market was much more abundantly supplied in 2009-2010 due to the severe economic contraction following the financial crisis, and as a result, the market was in contango most of that time-at times in a “supercontango”.  Again, one would expect this to be associated with high spot-futures correlations.

Moreover, there is a big difference in the composition of shocks, and the magnitude of these shocks that also explains the observed declines in correlations.  The 2009-2011 period was dominated by macro uncertainty driven by the financial crisis and then the Eurozone crisis.  These shocks tend to be persistent, affecting both current and expected future economic conditions in the same way, thereby contributing to high correlations between points on the curve; moreover, they tend to affect all commodities and asset classes similarly, leading to high correlations across commodities and asset classes.

At that time, macro volatility-as measured by the VIX-was high.   In early ’09, VIX was in the 30-50 percent range, and remained above 20 percent for most of 2010-2011, with spikes up to 35-40 percent.  Now VIX is tame, with levels in the low-teens, just like during the period of the “Great Moderation.”  High macro volatility tends to lead to high correlations along the curve and across commodities and between commodities and equities: common shocks dominate, especially when they are big.  The decline in macro volatility means that commodity-specific, relatively transient shocks tend to dominate: this tends to depress correlations along curves and across commodities, and between commodities and equities.  These are exactly the patterns observed in the past months.

That said, there are reasons to suspect the backwardation and the decline in correlations might be overdone, but not because of the malign influence of hedge funds.  Specifically, given the declining Brent supply base, it is reasonable to ask whether the backwardation is excessive.  At present, Forties is cheapest-t0-deliver, and this represents only about 350kbd of production.  Overall BFOE production is only about 1mmbpd.  Given the immense open interest in Brent futures and OTC derivatives, it is more that possible that large players are exercising market power by taking delivery of too much physical oil, thereby exacerbating the backwardation (i.e., creating an artificial scarcity).

If you want to identify who might be doing that, look at who is taking the physical cargoes.  Those parties would be the squeezers.  If hedge funds are the culprits, they should be taking a lot of physical supply.  Kemp certainly doesn’t provide any evidence of this, and his piece suggests these players are just playing with paper barrels, not wet ones: that’s my understanding too.  Historically, the Brent market has been the scene of many squeezes, but the squeezers have tended to be trading companies (e.g., Arcadia) or perhaps supermajors.

Brent was a squeezers paradise in the 1990s due to declining physical volumes and growing paper volumes.  Platts’s addition of Forties, Ekofisk and Oseberg to the delivery slate increased supply sufficiently to mitigate the manipulation problems.  But the decline in production has continued inexorably, and Brent is increasingly vulnerable to squeezes.  Which is why Platts and Shell have competing plans to tweak the pricing mechanism, namely by providing premiums for OE (Platts) or BOE (Shell), thereby reducing the delivery pressure on the cheapest-to-deliver Forties.

Squeeze-driven backwardation also tends to reduce spot-forward correlations.  The spot price is driven by squeeze-related technicals, the forward price by longer run fundamentals.  Squeezes also distort the inventory holding decision, and cause a breakdown in the cash-and-carry arb mechanism.  As I show in another book (and many articles).

So Brent may indeed be broken, but hedge funds haven’t broken it.  It is a classic problem in derivatives markets: a burgeoning derivatives market balancing on top of a declining deliverable supply.  I often analogize this to an inverted pyramid: and in Brent, the base of the pyramid (the paper market) is growing while its point (the physical market) is getting sharper.

Fixing Brent requires enhancing deliverable supply.  Not an easy thing to do.

Again contrast Brent and WTI.  Brent boosters have constantly bashed the WTI disconnect.  But this can be fixed by investments in infrastructure, which are being made, though not as fast as expected or as needed.  But building infrastructure is a helluva lot easier than building  a new Buzzard. Trust me on this.

So in the medium term, I expect Brent will get broker, and WTI will get better, leading to a shift of much futures and index trading activity (including hedge fund trades) back to WTI, which will no doubt lead John Kemp to saddle up his hobby horse and ride west into the Oklahoma sunset.

This is Better Than the Murphys Coming to H-Town

Filed under: Energy,Politics,Russia — The Professor @ 10:59 am

Rosneft CEO and Putin henchman Igor Sechin will be in Houston for CERA Week.  While there, he will preview Rosneft’s future strategy: he choose to do so in the US (on only his second visit to the country) to emphasize Rosneft’s new international horizons.  It’s not just for Russia anymore, apparently.

I’m so stoked.  I think I’ll head over to CERA Week to see if I can get a glimpse of him. I’d better remind myself of what he looks like:

No. No. Sorry. Wrong Igor.

Here we go:

Darn it. Wrong one again. Here we go:

I ask you: which one is the most campily horrifying?

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