Streetwise Professor

January 31, 2014

Ukraine: (Relative) Calm Before the Storm

Filed under: History,Military,Politics,Russia — The Professor @ 8:36 pm

The situation in Ukraine has taken a turn, but not necessarily for the better.  Although the prospect for a major confrontation on the streets in Kiev has abated due to Yanukovych’s decision to repeal the anti-protest laws and offer a form of conditional amnesty to protestors, the opposition has not been appeased.  Moreover, the government has seemingly shifted tactics, targeting individual leaders of the protest movement rather than threatening to assault the barricades.

The most appalling case is that of Dmytro Bulatov, one of the leaders of AutoMaidan, a group that launches quick-strike protests in automobiles.  He was disappeared for a week, turning up yesterday horribly beaten and mutilated: his tormenters cut off an ear, and he claims they “crucified” him.  After he was released, the militia attempted to arrest him in the hospital, where they were thwarted by quick thinking protestors.  But warrants have been issued for other AutoMaidan leaders, and there are report of a rising tide of arrests on the streets.

Furthermore, the regime appears to be relying more on “titushki” thugs who are roaming the streets looking for, and attacking, oppositionists.

Moreover, the opposition is deeply suspicious-and rightly so-of the amnesty, because it is conditional on the protesters evacuating the buildings they have occupied and the barricades on the street.  In other words, the government is saying: give up all your leverage, and trust us.  Needless to say, trust is in short supply and the opposition has rejected this.  Trust is further undermined by the arrests, disappearances and beatings.

And Russia-and Putin-loom overhead, casting a broad shadow.  I was wrong that Azarov was Putin’s man-he has decamped to Austria after having resigned as PM.  But it is clear that Putin is still pulling the strings.  There are continued rumors that Russian forces are on the ground in Ukraine: Bulatov claims that those who abducted him spoke “with Russian accents.”

Mixed signals emerged from Russia after Yanukovych sacked the government. Putin played his typical double game.  Initially Russia claimed that the the departure of Azarov would lead it to revocation of December’s aid package.  Then Putin came out and instructed the government to “honor its agreements to lend Ukraine $15 billion to Ukraine and cut the price of gas it sells to its crisis-hit neighbor.”  But the very same day he said that the $15 billion plus cut rate gas deal would be put on hold until Ukraine formed a new government, a process that could take 60 days.  One has to parse Putin’s statements very carefully.  He will often state a broad principal (“Russia will honor its agreements”) and then walk it back by adding conditions and caveats. This is one of those cases.

Then there was a more ominous statement emerging from Moscow:

An adviser to Russia’s president Vladimir Putin has warned that Ukraine’s president, Viktor Yanukovich, risks losing power unless he suppresses the “insurgency” in the country.

. . . .

Mr Yanukovich “is now in a situation of creeping revolution, and to some extent he functions as the guarantee of the constitution, security and integrity of Ukraine, therefore the president has no choice,” Mr Glaziev said in an interview with the corporate magazine of Russian state gas company, Gazprom, published on the editor’s blog on Friday.

“Either he protects Ukrainian statehood and suppresses the insurgency, which is provoked and financed by external forces, or he risks losing power, and then Ukraine faces growing chaos and internal conflict from which no exit is visible.”

Add to this that the army has issued a similar warning:

After two months of unrest, Ukraine’s army got involved in the ongoing political crisis, when the Ministry of Defense unexpectedly issued  a Jan. 31 statement, asking President Viktor Yanukovych to “apply measures for stabilizing of situation in the country.”

The commanders called protesters’ occupation of government buildings “inadmissible” and said that “further escalation of confrontation threatens to integrity of the country.”

The decision to send Yanukovych a special letter was made at a general meeting of the ministry’s office the day before and, according to Anatoliy Hrytsenko, an opposition lawmaker and former defense minister, the officers had been pressured to support Yanukovych.

“I know for sure that officers, who were not agreeing to the ‘common approval’ are now being pressured by their commanders and chiefs,” Hrytsenko said on his Facebook page. In its separate statement, the Defense Ministry also denied the reports that army was allegedly involved in assisting the police during the ongoing political crisis.

This report suggests that the army is divided, but is under pressure from the top.  And the top is no doubt under pressure from Moscow.

All this suggests to me that a full-blown crackdown is being held in abeyance until the end of Sochi.  In the meantime, the regime will wage a guerrilla war against the opposition.  The opposition-and especially its leadership-will be terrorized by nightriders and roving gangs and “law enforcement.”  Putin will give Yanukovych his marching orders.  And sometime in late February, expect things to come to a climax.  What we see now is a relative calm before a storm.

And what will the storm winds blow?  I fear civil war, largely on regional lines, but not completely.  Even parts of eastern Ukraine are restive.  And if it comes to that, Putin will no doubt find a pretext for a more direct intervention, reprising the role of Nicholas I, “the gendarme of Europe,” who intervened to crush rebellions in Poland and the Hapsburg Empire. I do not think that Yanukovych has the forces to subjugate a country as large as Ukraine, especially if those forces are largely conscripts who will not be enthusiastic about attacking-and killing-their friends and family.  I don’t know if Putin does either, but I cannot see him sitting idly by while Ukraine spins out of control.

January 30, 2014

Igor Sechin: Poster Boy for Sovokistan

Filed under: Commodities,Economics,Energy,History,Politics,Russia — The Professor @ 11:03 pm

Bloomberg Business Week has a long profile of Igor Sechin that illustrates perfectly why Putinism is an economic dead end.  Huge, inefficient state companies run by Putin cronies who have no clue about economics or how to create value.  But you’ll say: “Sechin has a PhD in economics!”  Well, a PhD in economics from a Soviet university is best described as an advanced degree in idiocy.

The piece describes Sechin as having an encyclopedic knowledge of Communist Party congresses dating from before the Revolution. So yeah, that definitely comes in handy in maximizing the value of the largest oil reserves of any publicly traded oil company.

Sechin refused to be interviewed for the article (probably a wise idea), but Putin’s Carney, Dmitri Peskov shared this description of Sechin’s penetrating economic philosophy:

“Sechin is a believer in the role of the state in his economic philosophy while at the same time not excluding a free-market approach. And he is firm in pursuing his viewpoint.”

Clear as mud. Problem is, I am sure that  it is an accurate characterization of Sechin’s muddled thinking.

Peskov is actually quite revealing, though almost certainly unintentionally so, in revealing the “thinking” that is propelling Russia into an economic cul de sac:

“For example, in shipbuilding it’s absolutely pointless to carry out privatization,” he says. “You can privatize enterprises, but they won’t be competitive; they will be doomed to failure. So consolidating the assets under the state’s wing is the only way to preserve key sectors of the economy.”

The reason for relying on markets, and privatization, is to determine the industries and firms that are economically viable.  The ones that generate more value than it costs to produce it.  Propping up those that would otherwise fail using state resources-which, never forget, are extracted by force from the citizenry-destroys wealth.   If Russian shipbuilding can’t compete against the Chinese or Koreans, it’s because Russian costs are higher.  Since costs are driven by the value of resources in alternative uses, the losses suffered by Russian shipbuilders in open competition means that the resources the Russian companies use would generate more value if deployed elsewhere.

That is, the success or failure of firms in the market is the mechanism that communicates where resources should be deployed, and where they shouldn’t be.  But that’s not the way statists-and Putinists-think.   Rather than having the market reveal which firms and industries should survive, the Putinists stand things on their head: they decide what industries they think are important, and provide the state resources necessary to ensure their survival. Their determination of the importance of industries is driven largely by history and political economy: the managers (and some workers) of legacy industries importune the state for support, and through personal and political connections largely succeed.  Thus the dead hand of the past rules the present and the future.  Rather than embracing the creative destruction of unviable firms and sectors, Putin embraces the destructive maintenance of legacy companies and industries.

It is a fundamentally uncreative system, because it is bounded by the cramped imaginations and interests of those who benefit from the status quo.  The interests of those who run the state are inherently biased to the status quo.  The more dominant the state becomes, the greater the tendency to stasis, and the greater the resistance to dynamism and change.

This affects even industries that are viable: the Russian oil and gas industries are clearly viable, due to the the capriciousness of nature which has endowed the country with bounteous reserves.  But the statist, Putinist system squanders that bounty.  The statistics don’t lie:

Compared with non-state-owned energy giants such as Exxon, Rosneft is inefficient. Even though Rosneft’s lifting costs — the cost of getting oil out of the ground — are less than a third of Exxon’s, the Russian company’s workforce is less productive.

Net profit per employee at Rosneft was $70,815 in 2012, versus $620,026 for Exxon. Rosneft’s price earnings ratio was 5.4, compared with Exxon’s 13.2 as of Jan. 13. Rosneft shares fell 6.87 percent in 2013, while Exxon shares rose 16.93 percent during the year.

But many find the company’s reserves to be an irresistible allure:

“The main reason to hold Rosneft is the reserves,” Greenwich Capital’s Snykov says.

But the point is that the value of these reserves is radically diminished by putting them under the control of a mullet-headed ex-KGB mouth breather.

The mental world of Sechin and Putin and the like was shaped in the USSR.  They don’t want to recreate it down to every last detail, but they do want to restore its broad outlines.  This is a recipe for stagnation.

And it will only get worse.  There is no mechanism for changing the leadership: indeed, Putin’s priority project in the past several years has been to neuter-or worse-any possible challenge to the incumbents.  So the current gang-and it is a gang, in all essential features-will remain in control for the foreseeable future.  And as they age, they will become even more resistant to change, and more sentimental about the world of their youth.

I still shake my head at those who understood the problems with the existing system, and assumed that Putin would too, and would be forced to institute changes and reforms to prevent the system from lapsing into senescence. How can one be so oblivious to the implications of the interests of the rulers of a system combined with the conservative impulses of aging men? Together, these forces work relentlessly to resist change and reform, and to attempt to maintain the status quo–or even roll back the clock.

Indeed, just this week, one of the few tepid reforms instituted by Medvedev has been rolled back.  The eunuch prime minister announced that state officials will be allowed to serve on the boards of state corporations, reversing a policy instituted a few years ago.  Remember when Medvedev’s original announcement was viewed as a dire defeat for Sechin, in particular?  Hardly.  Medvedev is being kept around to serve as the sacrificial lamb to pay for Putin’s mistakes, and Sechin is the second most powerful man in Russia.

So read the BW profile to understand Russia’s past, present, and future in a single story.  For Igor Sechin is the poster boy for Sovokistan, and Sovokistan is what Putin has created.

January 28, 2014

Were the Biggest Banks Playing Brer Rabbit on the Clearing Mandate, and Was Gensler Brer Fox?

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 10:25 pm

One interesting part of the Cœuré speech was his warning that the clearing business was coming to be dominated by a few large banks, that are members of multiple CCPs:

Moreover, it appears that for many banks, indirect access is their preferred way to get access to clearing services so as to comply with the clearing obligation. Client clearing seems thus to be dominated by a few large global intermediaries. A factor contributing to this concentration may be higher compliance burdens, where only the very largest of firms are capable of taking on cross-border activity. This concentration creates a higher degree of dependency on this small group of firms.

There are also concerns about client access to this limited number of firms offering client clearing services. For example, there is some evidence of clearing firms “cherry picking” clients, while other end-users are commercially unattractive customers and hence unable to access centrally cleared markets.

These are all developments that I believe the international regulatory community may wish to carefully monitor and act on as and when needed.

And wouldn’t you know.  He supports a longstanding SWP theme: That Frankendodd and EMIR and Basel create a huge regulatory burden that is essentially a fixed cost.  This increase in fixed costs raises scale economies, and this inevitably leads to an increase in concentration-and arguably a reduction in competition, in the provision of clearing services.

It now seems rather quaint that there was a debate over whether CCPs should be required to lower the minimum capital threshold for membership to $50 million.  That’s not the barrier to entry/participation.  It’s the regulatory overhead.

It’s actually an old story.  I remember a Maloney and McCormick paper from the 80s-hell, maybe even the late 70s-about the effects of the regulation of particulates in textile factories (if I recall).  The cost of complying with the regulation was essentially fixed, and the law essentially favored big firms and they profited from it.  It raised the costs of their smaller rivals, led to their exit, and resulted in higher prices and the big firms profited.  Similarly, I recall that  several papers by the late Peter Pashigian (a member of my PhD committee) found that environmental regulations favored large firms.

The Cœuré speech suggests this may be happening here: note the part about client access to a “limited number of clearing firms.”

And it’s not just pipsqueaks that are exiting the clearing business.  The largest custodian bank-BNY Mellon-is closing up shop:

More banks are expected to follow BNY Mellon’s lead and pull out of client clearing, as flows have concentrated among half a dozen major players following the roll-out of mandatory clearing in the US last year.

The decision of the world’s largest custodian bank to shutter its US clearing unit was the first real indication of how much institutions are struggling with spiralling costs and complexity associated with clearing clients’ swaps trades – a business once viewed as the cash cow of the new regulatory regime.

You might recall that BNY Mellon was one of the firms that complained loudest about the high capital requirements of becoming a member of ICE Trust and LCH.  Again: it’s not the CCP capital requirements that are the issue.  It’s the other substantial cost of providing client clearing services, and regulatory/compliance costs are a big part of that.

Ah yes, another Gensler argument down in flames.  Remember how he constantly told us-lectured us, actually-that Frankendodd would dramatically increase competition in derivatives?  That it would break the dealer hammerlock on the OTC market?

Remember how I called bull?

Whose call looks better now?  Sometimes I wonder if JP Morgan, Goldman, Barclays, etc., weren’t playing the role of Brer Rabbit, and Gensler was playing Brer Fox. For he done trown dem into dat brer patch, sure ’nuff.

Though it must be said that this was not Gensler’s biggest contribution to reducing competition in derivatives markets in the name of increasing competition.  His insane extraterritoriality decisions have fragmented the OTC derivatives markets, with Europeans reluctant to trade with Americans.  The fragmentation of the markets reduces counterparty choice in both Europe and the US, thereby limiting competition.

This is not just a matter of competition.  There are systemic issues involved as well, and these also make a mockery of the Frankendodd evangelists.  They assured the world that Frankendodd and clearing mandates would reduce reliance on a few large, highly interconnected intermediaries in the derivatives markets. That is proving to be another lie, on the order of “if you like your health plan, you can keep your health plan.”  The old system relied on a baker’s dozen or so large, highly interconnected dealers.  The new system will rely on probably a handful or two large, highly interconnected clearing firms.

The most important elements in the clearing system are a small number of major banks that are clearing members at several global CCPs.  The failure or financial distress of any one of these would wreak havoc in the derivatives markets and the clearing mechanism, just as the failure of a major dealer firm would shake the bilateral OTC markets to the core.

Just think about one issue: portability.  If there are only a small number of huge clearing firms, is it really feasible to port the clients of one of them to the few remaining CMs, especially during times of market stress when these might not have the capital to take on a large number of new clients?

What happens then?

I don’t want to think about it: there’s only so much I can handle.

But Cœuré assures us the regulators are on top of it.  Or at least they are thinking about getting on top of it: “the international regulatory community may wish to carefully monitor and act on as and when needed.”  “May wish to act as needed.”  Sure. Take your time! What’s the hurry? What’s the worry?

I won’t dwell on the  irony of those who advocated the measures that got us into this situation pulling their chins and telling us this might be a matter of concern, especially since they were deaf to warnings made back when they could have avoided leading us down the path that led us to this oh-so-predictable destination.

January 26, 2014

Disconnected About Interconnections: Regulators Still Don’t Get the Systemic Risks in Central Clearing

A board member of the ECB, Benoît Cœuré, gave a speech that discussed “the new risks associated with central clearing.” It is evident that Cœuré is a proponent of central clearing, though it is annoying to see him identify multilateral netting as the main benefit (<holds head in hands>).  But it is good to see yet again that central bankers are aware that central clearing does create new risks, and that regulators must be proactive in addressing them.

The problem is that he overlooks the most important risks.  Reading between the lines, like most regulators, Cœuré focuses on the solvency risks of CCPs, and about policy tools that can limit the probability of CCP insolvency and mitigate the adverse impacts of such an insolvency.

But as I’ve written repeatedly in the past, it’s not the insolvency risk per se that should keep people up at night.  Indeed, the measures taken to address the solvency risk can actually exacerbate the real risk a dramatic expansion of central clearing creates for the financial system: liquidity risk.

Liquidity crises are what threaten to bring down financial systems.  For most financial institutions, there is a connection between liquidity risk and solvency: banks become illiquid because (in a world of imperfect information) people believe they might become insolvent.  Maturity mismatches plus imperfect information plus possibility of insolvency combine to create liquidity crises.

CCPs don’t have the maturity mismatches, and they aren’t leveraged.  They cannot experience liquidity crises in the same way banks can.  The direct liquidity risk of CCPs is related to their ability to turn collateral into cash in the event of a member default.

But as I’ve said over and over, clearing affects the needs for liquidity by market participants.  Central clearing can be a source of, or accelerant of, liquidity crises.  Big price moves lead to big margin calls lead to spikes in liquidity demand. These are most likely to occur during periods of financial stress, and can greatly exacerbate that stress.  Moreover, failure of a CCP is most likely to occur due to the inability of traders to fund margin calls due to the shortage of liquidity.   This old article by Andrew Brimmer discusses two episodes I’ve analyzed on several occasions-the Hunts in silver and Black Monday-and shows how it is liquidity/credit/funding of margin calls for CCPs that can create stresses in the financial system.

This is where the systemic risk of clearing arises.  But the subject is totally absent from Cœuré’s speech.  Which is worrisome.

There is also the fallacy of composition problem.  The measures that Cœuré advocates to make CCPs stronger do NOT necessarily make the system stronger.  Strengthening CCPs can actually exacerbate the liquidity problems that clearing causes during a crisis.  The CCP may survive, due to these measures, but the stresses communicated to the rest of the system (and the stress has to go somewhere) can cause other institutions to fail.

This is what scares the bejeezus out of me.  Regulators don’t seem to get the fallacy of composition, and aren’t focused on the liquidity implications of greatly expanded central clearing.

These fears are heightened by reading this DTCC report about collateral and collateral management.

It contains this heading that should make every central banker and financial regulator soil his armor:

Margin Call activity to increase By up to 1000%

Then there’s this:

Operational Capabilities and Settlement Exceptions Management: The potential ten-fold increase in margin call volumes, and the resulting complexity due to market changes, could overwhelm the current operational processes and system infra-structures within banks, buy-side firms and their administrators. As a result, firms will need to invest in technology and also reengineer the settlement, exceptions management and dispute resolution processes in place today. According to a 2011 De- loitte paper, investments in operations required to build and sustain advanced collateral capabilities is estimated at upwards of $50 million annually for top-tier banks.

Be afraid.  Be very, very, very afraid.

The dramatic increase in the scope of clearing substantially increases the operational complexity of the system.  More importantly, it increases the system’s operational rigidity, because cash has to flow quickly, and according to a very precise schedule.  From client to FCM to CCP to FCM to client.  Any failures in that chain can bring down the entire system.

I say again.  Systemic risk in financial systems is largely due to the fact that these systems are tightly coupled.  Clearing increases tight coupling.  This almost certainly increases systemic risk.

More players have to move more money in more jurisdictions as a result of clearing mandates.  As the DTCC report makes plain, this is a new responsibility for many of these players, and they do not have the capability or experience or systems.  Greater operational complexity involving more parties, many of whom are relatively inexperienced, creates grave risks in a tightly coupled financial system.

The irony of all this is that the evangelists of clearing, including notably Timmy! and GiGi in the US, argued that central clearing would reduce the interconnectedness of the financial markets.  Wrong. Wrong. Wrong. Wrong.

It reconfigures the interconnections.  The entire collateral management system the DTCC document describes is a dense web of interconnections.  And to reiterate: under central clearing (and the mandate to margin and mark-to-market uncleared derivatives) these connections (couplings) are tighter than in the old system.  Both old and new systems are highly interconnected.  The connections in the new system are tighter, and are more vulnerable to failure as a result.

I’ll tell you what makes me have to go change my armor: the regulators seem oblivious to this.  To the extent they are focused on collateral, they are focused on initial margin. No! It is variation margin calls during periods of large market movements that will threaten the stability of the system. Now there will be more such calls–1000 pct more, according to DTCC–and more participants are involved, meaning that there are more links and nodes.  The tightly coupled nature of the system means that the breakdown of a few links can bring down the entire thing.

In other words, there seems to be a disconnect on interconnections, most specifically on how clearing has not reduced interconnections but reshaped them, and how the new system’s interconnections are much more rigid, tightly coupled, and time-sensitive.

Not to pick on Cœuré: his speech is just one example of that disconnect.  The thing is that most speeches by regulators and central bankers exhibit the same disconnect.  Target fixation on making CCPs invulnerable does not address the main systemic risk that an expansion of clearing creates.  That systemic risk involves the financial/funding and operational risks of meeting large margin calls in a stressed environment on a precise time schedule.

It’s about liquidity, liquidity, liquidity.  Clearing transforms credit/solvency risk into liquidity risk.  The operational aspects of clearing-the need to move cash and collateral around in large amounts on a tight time schedule-affects the demand for liquidity, and also create points of failure that can cause the liquidity mechanism to seize up, threatening the entire system.

This is what should be the focus, but I’m seeing precious little evidence that it is.  Someday we’ll pay the price.

January 25, 2014

Putin’s Dilemma, or, Using Judo on VVP

Filed under: History,Military,Politics,Russia — The Professor @ 10:06 pm

Today was a fraught day in Ukraine. The day started with Yanukovych’s offer to the opposition: Fatherland Party head Yatsenyuk as PM, Klitschko as Vice PM, amnesty for Maidan arrestees, a reconsideration of the anti-protest laws.

This was an anti-Godfather offer.  Rather than making an offer Yatsunyuk could not refuse, Yanukovich made him an offer he had to refuse.  The Maidan would have totally rejected Yatsunyuk and Klitschko had they accepted.  If they had gone ahead regardless, they would have been complicit in what has happened and what would happen.

Yanukovych-and Putin-knew this.  And it suits them just fine.  Now they can portray the opposition as obdurate, radical and unwilling to compromise. This allows them to rationalize a crackdown.  Indeed, the Interior Minister foreshadowed this theme:

The interior minister said the opposition was no longer able to control “radical forces” and was putting civilians in danger.

“The events of the last days in the Ukrainian capital have shown that our attempts to solve the conflict peacefully, without recourse to a confrontation of force, remain futile,” Mr Zakharchenko said in a statement on Saturday

If negotiation is futile, the only alternative is force, right?

But this was not the most important event of the day.  That occurred at Ukraine House.  A group of troops (presumably Internal Troops, or VV) secreted themselves in the House, apparently in preparation of attacking the rear of the barricades on Grushevsky Street.  Their presence was discovered (How? An informant?) and opposition members rushed to the House and surrounded it.  They broke windows, fired fireworks into the building, and set tires alight in the lobby.

The potential for disaster here was extreme.  What could have happened?  Some possibilities, all of them ugly.  First, the troops (referred to as “cadets” and “conscripts” on Twitter, suggesting they were hardly hardened shock troops) could have been incinerated or died of smoke inhalation.  The deaths of so many troopers would have provided the perfect rationale for the government to go medieval on the protests, on mass scale. (They have gone medieval on a small scale, killing and torturing some opposition members.)  Second, the government could have launched a rescue mission that would have resulted in a bloody clash.  This too would have greatly escalated the conflict, and likely resulted in a full-blown revolution and civil war.

But after a while, the fires went out.  Someone apparently convinced those at the building to cool it, and not risk bringing to pass the foregoing scenarios.  Things devolved into a standoff.  The oppositionists surrounding the building left a path open for those inside to leave, and shouted for them to surrender.  Sometime during this period, Klitschko negotiated the peaceful withdrawal of the troops inside.  The situation subsided 4.5 hours after it began.

This is an important victory for the opposition generally, and Klitschko personally.  It is also a humiliating defeat for the government and the security forces.

And therein lay the future danger.  A humiliation of the regime–which comes after other humiliations in which protestors seized government buildings throughout western Ukraine–can lead to its collapse.  The humiliations embolden the opposition, who will be more willing to risk confrontation because they perceive the security forces will back down.  If they turn out to be right, the humiliations snowball and before long the government collapses.

Or it can lead the government to decide that the time for half-measures is over.  In which case, the blood will flow in earnest.

Perhaps more to the point, it can lead Putin to decide that the time for half-measures is over.  He may push the government for a more aggressive response, or go around the government and push the security forces to attack.  (NB: as elmer notes in his comment, many Ukrainians are already convinced that Russian units are already present in Kiev.)  Or he may decide that the current leadership in Ukraine is too pusillanimous, and decide on the Kabul Option, and order spetsnaz units, and FSB Alpha and Vimpel troops, supported by paratroopers, into Kiev to carry out a putsch, and install a more reliable regime that will crush the opposition.

The wildcard in all this is Sochi–as I mentioned some time back.  If Putin waits to act until after the Olympics are over, things could spin out of his control, and by March his dreams of subordinating Ukraine could become the nightmare of the Orange Revolution on steroids. But if he decides that a whiff of grapeshot is necessary and tries to play the role of Nicholas I (“the policeman of Europe”) and crush the rebellion before or during Sochi, his $50 billion triumph will turn into a fiasco.

Difficult dilemma for our VVP.

It seems to me that he has fallen victim to the typical autocrat’s conceit, believing that he can control events.  But revolutionary situations are never-ever-subject to the control of any will.  The spontaneous events at Ukraine House came within a trice of catastrophe.  But who is to say that it will be so the next time?

And there will be a next time.  If you have followed events, you will note a pattern.  An intensification of conflict, but a pullback by one side or the other or both before full-blown warfare erupts.  But each subsequent peak is higher, more intense than the one before.  And it only takes an accidental shot to cause things to spin out of control.

I don’t know where things are going.  Revolutionary situations are radically unpredictable.  No one controls events, and a sort of spontaneous disorder exists.  The independent actions of many people can lead to a shot that his heard ’round the world.

But if you can’t reliably predict the expected outcome, you can reliably predict that the variance becomes extreme.  Anything is possible, even probable, and many of them are quite horrific.

The dynamic, and the choices inherent in it, are pretty clear though. If the government continues to avoid a brutal crackdown, the dynamic favors the opposition: they will become emboldened, and success will produce more success.  That very fact shapes the thinking of the government, andcracking down to stop the opposition’s momentum becomes more and more sensible as an option, even knowing that it will make the regime a pariah, both domestically and abroad. Better to be a live pariah than dead or imprisoned.

Putin knows that autocracies fall not because they are too brutal, but because they are not brutal enough.  He must have absorbed that lesson watching the collapse of the USSR.  I fear he may be intent on not repeating the experience.

For this reason, Sochi may be a godsend. At the very least, it puts Putin on the horns of a dilemma: no Sochi, and his choice would be quite simple. With Sochi, not so simple.

This may provide the US and the EU with the only leverage it really has.  Both should make plain that unless the regime in Kiev capitulates, and forms a national unity government, that they will boycott Sochi.  They should make it plain that they view Yanukovych’s government to be Putin’s puppet, and that he is responsible for what goes on there.

And irony of ironies: Putin’s triumphalism after browbeating Ukraine into turning its back on the EU and accepting Russia’s loving embrace makes it plain that he is the puppet master. By using his triumphalism against him, judo-like, the US and the EU may take him to the mat.

Alas, I doubt either has the stones to do it.  But they should.  It is the best way  to give Ukraine a chance.

Update: A timeline in the Kyiv Post (which is now offline, which could be ominous, or it could be nothing) contradicts part of the Ukraine House story that I told above.  According to the KP piece, troops had been stationed in Ukraine House since November, and this was known.  Perhaps there were rumors that the troops that were there were about to launch an attack, and that’s what precipitated the storming of the place by protestors.  Or maybe the more confrontational elements in the movement initiated the clash.  Or perhaps provocateurs did.  But it apparently is not correct that the presence of the troops was just discovered and that led the protestors to fear an impending assault on their rear.  Either there developed in the crowd a belief that the posture of the troops was about to change from passive/defensive to aggressive/offensive.  Or perhaps elements in the opposition were looking to precipitate a clash: spreading rumors of an impending attack would be a way of doing that.  All in all, the situation looks more ambiguous to me than it did initially.

But this doesn’t change my judgment about the ultimate outcome.  Whatever precipitated the assault, the retreat of the government forces in the building was a humiliating blow to the government. I have the same opinions about the implications of that humiliation.  Similarly, I still believe that the clash is symptomatic of increasing tensions and escalating violence.

Today’s Twitter stream from Ukraine contained several warnings (including one with a video) claiming that busloads of Berkut had departed from Donets and Odessa, headed for Kiev.  Nine was the number of buses attributed to Donets, 10 in Odessa.

There  are only 3500-4000 Berkut troops in the entire country, so perhaps these were not Berkut.  And whether the rumors are true or not will not be known for some time.  Whoever is on those buses is not going to debark and immediately begin an assault.  Some planning and familiarization with the new surroundings would be required first.  One possibility is that they are to be ready for action by Tuesday, when the Rada meets, and when-according to yet more rumors-Yanukovych may declare a state of emergency.  (The head of the Justice Ministry demanded such a declaration if the protestors do not evacuate her ministry building, which they occupied today.)

Even if that’s all true, it indicates a certain desperation by the regime (and Putin), and also an element of futility.  Protests have spread around the country, and government buildings have been occupied in several towns.  The country is in ferment-not just Kiev.  Reinforcing Kiev makes the rest of the country more vulnerable to protestors seizing government buildings and ousting regime loyalists.  A bloody crackdown in Kiev would likely ignite greater efforts in areas denuded of troops.

I just don’t think the regime has enough reliable manpower to be able to maintain control everywhere. Yes, the capital is the center of gravity and its security is paramount to the regime: holding it is necessary to ensure the regime’s survival.  But holding the capital is not sufficient to quash a rebellion that breaks out in multiple areas of a large country.

Dawn is about to break there now, and things seem quiet.  But things can change rapidly, and Tuesday could be another important day.  The fluidity of the situation, and the lack of reliable information makes prognostication a mug’s game.

January 23, 2014

What Tangled Webs We Weave When First We Practice to Deceive

Filed under: Military,Politics,Russia — The Professor @ 11:44 pm

Business Week just published a long piece on Tor-The Onion Router.  It is interesting, though it somewhat buys into the Tor propaganda about it being a tool to protect dissidents, rather than pedophiles.

One thing is passing strange.  Not a single mention of Jake Appelbaum, the primary evangelist of Tor.  How can that be? Did @ioerror refuse to cooperate?  That would be odd, given that Appelbaum has been something of a press whore on the subject of the wonderfulness of Tor as a weapon in the war for privacy and liberty.  And if he refused to cooperate, why didn’t the reporter mention that?

Or is it that the reporter just got the impression that Appelbaum is nothing more than a front man, and not really that important?

I don’t know, but I find it very puzzling.  Appelbaum and Tor are almost synonymous, so to read an article about Tor that doesn’t mention Appelbaum is curious in the extreme.

The best part of the article is that the reporter interviewed Paul Syverson of the US Navy Research Lab: he is one of Tor’s creators, and also someone who has published research on its vulnerabilities.

Here’s the key Syverson quote:

For the onion router to work properly, the Navy needed to step back from running it. A cloaking system is not useful if all the cloaks say “Navy” on them. “If you have a system that’s only a Navy system, anything popping out of it is obviously from the Navy,” Syverson says. “You need to have a network that carries traffic for other people as well.” Tor Project was incorporated as a nonprofit in 2006 to manage operations.

Translation: the US Navy, and presumably other government agencies, want to use Tor to send communications that are extremely difficult to trace.  But it needs to hide its activities.  Just bouncing the messages around isn’t much help if all the messages are known to be from a particular source.  So it needs to attract other users so that US government communications can hide in the stream of other traffic.  And apparently the government isn’t  that concerned if the other traffic is child pornography and drug transactions.   This is the noise that obscures the signals that the Navy wants to conceal from prying eyes, and any noise serves the Navy’s purposes .  It’s not picky.

This opportunistic use of Tor by the govenment raises further questions about what other purposes the government might use it for.  In particular, is it used as some sort of trap, intended to attract use by hackers and others so that the government can monitor them–and apprehend them if need be?  In which case, articles like this which emphasize the civil liberty/privacy benefits of Tor would suit the government just fine.  All the better to lure the flies into the flytrap.

I don’t know.  Just throwing that out there.  But if you think about those possibilities, it makes the association of outspokenly anti-US government Jake Appelbaum with the Tor project all the more puzzling: he could actually be baiting a trap.  And it makes his absence from the article all the more peculiar. The tension between the government sponsorship and use of Tor and its use (and evangelization) by ardent anti-government (and anti-American government) types is obvious and deserves explanation, but the article doesn’t pick up on that.

There are other issues too.  For instance, something like the idealized Tor would potentially be of great benefit to the opposition in Ukraine, which desperately needs secure communications.  But the real Tor network is not so ideal: it has been infiltrated by 18 malicious exit nodes in Russia: everything emanating from those nodes is vulnerable to being read by the operator of those relays.   So the Ukrainian opposition would be in grave danger of being monitored by Russia if it used Tor.   And that is tantamount to suicide.

And to loop back to Appelbaum one more time.  He, of course, is a confederate–co-conspirator, actually–of Snowden, who is in the grips of the FSB.  Which means that Appelbaum could be helping to bait a trap in Russia, using those 18 malicious relays.

Moreover, it means that via Appelbaum, the United States Navy is connected to Edward Snowden (and hence the FSB): who, by the way, has been photographed with Tor decals displayed prominently on his laptop.  This is a much closer connection than the Six Degrees of Kevin Bacon variety.  If Obama has his way, the NSA will be limited to two “hops” to connect terrorists with American citizens.  The US Navy is two hops away from Edward Snowden, with Tor being the connection.  Navy->Appelbaum->Snowden/FSB.  With Tor providing the common link.

In other words, there are few more tangled webs than Tor.  So tangled as to be virtually incomprehensible: my head spins trying to sort through it all.  But with Jake Appelbaum’s involvement, I say: beware.  For he not just practices to deceive, he is deception incarnate.

Update.  From another article indicating why the Navy would prefer to have more Tor users in order to better anonymize its own traffic:

In that way, the recent surge of new Tor users, whatever the reason, could do a lot to boost security. The more people on the network, the more volunteers there are to host a relay or exit relay, the harder it is for a would-be attacker to trace and expose the identity of an individual user.

And for the idea of attracting farmers from Iowa, as opposed to pedophiles and drug dealers, to provide traffic to an anonymized network: please. Farmers don’t need anonymizing.  Criminals do.  The former are unlikely to have any reason to put up with the hassle and reduced performance of using Tor: the latter have many reasons, including 15 to 20 (or more) in the penitentiary.

The Die Is Cast in Kiev: Who Cast It? I Say: Putin.

Filed under: History,Military,Politics,Russia — The Professor @ 8:45 pm

The situation in Ukraine has escalated significantly in the last few days, with the deaths of five protestors, two killed by gunshots allegedly fired by Ukrainian security forces (sometimes said to be “snipers”), and one being tortured and left to die in the woods.  An opposition aid station was attacked, and its patients taken away, by security forces.  The security forces are also going through hospitals looking for injured protestors.

A line has been crossed.  The beatings that had occurred periodically before were bad, but the deliberate murder of protestors who did not pose a direct threat to the police is a Rubicon.  Opposition leaders including Klitschko have been trying to negotiate with Yanukovych, but this has only angered the Maidan movement rank-and-file., who now see that compromise with murderers is pointless-and wrong.  Throughout western Ukraine government buildings are being seized, and Yanukovych appointed officials (such as the governor of Lviv) forced to resign.  The country is on the brink of civil war.  The killings have made civil war all the more likely.

The shootings were not something analogous to Kent State: panicked weekend warriors opening fire on rioters/protestors.  They were, apparently, carried out with malice aforethought.

Which raises the question: who decided to pull the trigger?  Who authorized the premeditated use of deadly violence?

The protestors blame Yanukovych, and yes, he is ultimately responsible, in the sense that his intransigence, and his forcing through draconian laws outlawing protest, are a necessary condition for the escalation that culminated in five deaths.

But I have my doubts that he authorized such action.  He seems to me to be an indecisive, temporizing figure.  He does not want to back down, because he knows that if he cedes power he will likely end up in prison, and will lose all of the corrupt spoils that he has gained.  But he seems reluctant to order a full-scale repression.

Which no doubt angers hardliners.  I surmise that those hardliners, disgusted with Yanukovych’s vacillation, ordered the killing of a few protestors to bring the pre-revolutionary situation to a climax, and to eliminate the possibility of any compromise.

The hardliners’ determination to force the issue would no doubt be intensified by dissension within the ranks of the military and the security forces.  There are reports that some officers have refused orders to attack the barricades on Hrushevskovo Street.  This would make it all the more imperative to hardliners to escalate the confrontation.

Which raises the question: who are the hardliners?  Angry colonels?  (I think of the Serbian army officers who supported the Black Hand, and Princeps, in the assassination of Archduke Ferdinand.)  Or perhaps angry colonels acting under the direction of Russia/Putin/the FSB? Or angry colonels acting under the direction of a Ukrainian agent of the Kremlin?

I think this is the most likely alternative.  Moreover, I think it quite likely that the authorization-or orders-originated with the Ukrainian prime minister, Mykola Azarov.  He is not Ukrainian: he is of Russian extraction, born in Kaluga, and has been called “the most Russophile member of the new cabinet.”  He is a latter-day Ukrainian, only moving there in the 1980s.  If he is anything, he is an old school Sovok, and no doubt an eager supporter of Putin’s drive to restore at least a simulacrum of the USSR.  He has employed brutal rhetoric, praising the Berkut for its patriotism.  He is quite the favorite of Putin: a perusal of some of the images of when they are together suggests more than the forced comradery between officials of different nations: there seems to be a real rapport (h/t @libertylynx).  Have you ever seen Putin look that way at Medvedev, let alone Merkel-or Obama?

I think Azarov is Putin’s man in Ukraine.  The one who is there to ensure that no Second Orange Revolution occurs.  The First Orange Revolution was a stunning defeat for Putin, and you know that it left a mark: that the hatred and resentment still burns.  Never Again.  He wants any protest movement crushed, but he wants to hide his hand.  Azarov is the natural man to do the dirty work.  A few provocative killings are precisely what is required to ensure that Yanukovych (a venal man, obviously, but one who doesn’t strike me as a hard man like Putin or Azarov–hence the problem for them, and why he must be denied an out) cannot go back.  The orders go from Russia to their creatures in Ukraine.  People die.  The battle lines harden.  Things escalate, and eventually the crackdown happens.

Maybe Azarov is not in the chain.  No doubt the Russians have direct contacts with angry colonels.  But regardless, I strongly suspect the ultimate source of the decision to kill is in Moscow.

Something else struck me.  When watching via the Espresso TV live feed the brief assault of the police/Berkut on Tuesday, when they stormed the barricades and tore them down, and then retreated, I noticed one of the Berkut/police picking up a Ukrainian flag a protestor had dropped.  He carried it back as a trophy, but not with respect.  He dragged it behind him.  Then there is this video of a Berkut/policeman disdainfully hacking down a Ukrainian flag from a vehicle (another @libertylynx h/t).  These are not the actions of Ukrainian patriots.  Most likely they are ethnically Russian Ukrainians, perhaps Crimeans (who @libertylynx says strive to be more Russian-y than Russians), or Russian speakers from eastern Ukraine.  They no doubt would be quite happy with Ukraine being re-united with Russia, or at least its vassal: the good little brother.  Men like these would be more than willing to kill protestors in order to advance that cause.

The die has been cast in Kiev.  The most reasonable explanation is that Putin is the die-maker.  He wants to bring Ukraine to heel, and to someone of his bloody-minded outlook, foreclosing any compromise and forcing a confrontation is the best way to do that.  And murdering a few protestors is perfectly suited to accomplishing that end.

Sadly, there are many in Ukraine who would provide willing hands to do the the dirty work.  Those desecrating the Ukrainian flags are emblematic of that.  But those who pulled the triggers in Kiev (and those who gave the orders) are the real Orcs, doing Sauron’s/Putin’s bidding.

Update: Just saw Edward Lucas’s column from yesterday, in which he states that a source told him last year that Putin had ordered Yanukovych to “dip his hands in blood.” Says Lucas: “Only by forcing an irreversible breach with Europe and America could the Kremlin be sure that its Ukrainian satrap would behave.”  That’s similar to my conjecture: that the killings were intended to foreclose any possibility of political compromise or settlement, though I think this was intended primarily to affect the situation within Ukraine, rather than to affect American or European actions.  The long lag between the alleged order and the actual shootings suggests, moreover, that Yanukovych resisted.  Maybe he eventually capitulated, but I think it is more plausible that the Russians worked through members of the Ukrainian government, or directly with their connections in the security forces.  Putin/the Russians were tired of waiting, in other words, and forced the issue.  From their perspective, it doesn’t matter.  In the popular Ukrainian mind, Yanukovych is responsible, and the any political compromise between Yanukovych and the opposition that would inevitably reduce Russian influence (a la the Orange Revolution) has been fatally damaged.  Yanukovych now realizes he can’t negotiate his way out, and is thus more likely to escalate, seeing that as the only way he can survive. Which is fine with Putin.  Indeed, it makes the Ukrainian government all the more dependent on Putin and Russia.

January 21, 2014

SWP Is Not Alone in Judging Obama’s Syria Policy “Feckless” and “Incoherent”

Filed under: History,Military,Politics — The Professor @ 10:37 pm

This article in the American Interest (a fairly middle of the road publication overseen by Walter Russell Mead) presents a useful, if exceedingly depressing, dissection of the Obama administration’s policy in Syria.  I raised many of the same points, in real time.  I think the most important ones are related to Iran: (1) that Syria was of strategic interest to the US precisely because it was Iran’s major Arab ally, and that a primary strategic rationale for intervening in a way that increased the odds of Assad’s downfall  was because it would undermine Iran, but (2) that a major reason that Obama shied away is precisely because he was trying to achieve a rapprochement with Iran.

Strategically misguided, and a humanitarian disaster.

Read the whole thing.

Author Adam Garfinkle’s succinct summary about Obama’s policy also uses two words I have used, on more than one occasion: feckless and incoherent.

Recognizing this doesn’t require penetrating insight.  Just an ability (and perhaps more importantly, a willingness) to recognize the obvious.

And it is only getting worse.  The debacle unfolding in Montreux is so comical (in a tragic way) that it seems befitting, given the town’s most famous resident, Charlie Chaplin.  (Psst. Don’t tell the Russians and the Iranians about the Freddie Mercury statue.  Putin will try to outlaw it as gay propaganda and the Iranians will try to hang it.)

January 20, 2014

Day of the Mifid, or, To Stupidity and Beyond!

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Russia — The Professor @ 7:03 pm

After years of wending through to what is to an American an incomprehensible legislative process that involves a three body problem (the trialogue of the Commission, the EU Parliament, and member states), Europe has agreed on its version of the trade execution portion of Frankendodd: Mifid II.  (The clearing and OTC collateralization equivalents are covered under a different law, EMIR.)  A good summary is here.

It contains many of the objectionable features of Frankendodd, namely, a mandate that swaps be executed on SEF-like entities (Organized Trading Facilities, or OTFs, in Euro parlance), and commodity position limits.  The former were pretty much a done deal after the Pittsburgh G20 meeting, the latter a reflection of the global suspicions of “speculation” in commodities, but intensified by European NGO convictions that speculation in food is evil.  (The shade of Adam Smith is shaking his head, noting that his observation about the equivalence between the popular terrors and suspicions against speculation and  the popular terrors and suspicions involving witchcraft is as apt today as it was in 1776.  Except that witchcraft is probably much more socially acceptable these days.)

But the EU has added its own idiosyncratic idiocies to its law.  Two things stand out.

First, the EU has mandated open access to derivatives exchange CCPs, in an attempt to demolish the vertical silo model.  Yes, the mandate is delayed-by as much as 5 years-but “I will wait 5 years to be stupid” hardly seems to be much of  a defense.  As I’ve written for years-a year or two before SWP began, in point of fact-the vertical silo makes economic sense (from a transactions cost economics perspective), and the pro-competition justification for it (namely, to encourage competition in execution) is inconsistent with what economists have known since the 1960s (the “one monopoly rent” theorem).

Second, and even more inanely, Mifid II caps the dark pool share in the trading of any individual equity at 8 percent.  Overlooking the operational difficulties of enforcing a collective constraint on volume across multiple venues, this reflects a suspicion of dark pools (a pejorative name in itself) that is again not grounded in good economics.  In a second best world, where competition between exchanges is imperfect, off-exchange venues (block markets in the old days, internalization, dark pools) can be welfare enhancing.  The fact that many market participants find them the lowest-cost venue to transact in should at least give pause to regulators, and ask them to inquire why this is true, and do the appropriate cost-benefit analysis of the trade-offs involved.  But no, fools rush in.

It strikes me that the  Euros have created a new Pixar character.  Buzz Darkpool: “To stupidity and beyond!” Derivatives trading mandates and position limits are stupid, but they’ve decided to go beyond that.

Meaning that the US can perhaps adopt what I’ve often said is the Russophile motto: “Not the worst!”

Why History is Useful: Some Perspective on Liquidity Supply in Floor and Electronic Markets

Filed under: Derivatives,Economics,Exchanges,HFT,Regulation — The Professor @ 11:37 am

One of the annoying things about the debate over HFT, particularly related to the quality of liquidity supplied by HFT traders, is the lack of any historical context.  HFT firms are criticized for pulling liquidity suddenly, particularly when volatility ticks up, thereby exacerbating price moves and the impact of order flow on prices.

The thing is, that market makers/liquidity suppliers have been doing this since time immemorial. Liquidity suppliers have always chosen flight over fight.

I’ve written about that in the past (focusing, for instance, on Black Monday).  This recent blog post provides some excellent historical color that illustrates the point quite well.

Having traded the markets since 1985, I would like to explain what market liquidity actually meant in the pre-electronic days and what it means in the world of electronic trading.

During the 1987 October crash, Black Monday, I was a junior trader in government bonds and futures. Black Monday was not a crash which was over in seconds or minutes; no, the world stopped turning actually for days. The mini crash of 1989 had a similar pattern. Chernobyl 1986, Gorbachev crisis in 1991 and UK election day in 1992, were all similar liquidity gap events seen by market traders.

The beauty of those days (the late 80s) for a trader, was that markets were very often in a ‘fast market’ condition. This meant that one was able to trade at any price and all rules were thrown overboard until the board officials were able to control the pit again. Without computers, we simply could not deal with the enormous amount of activity in the markets at those times and simply stopped (or delayed) sending price information out, not just for seconds, but minutes and even (during the week of Black Monday) days. Clearers had backlogs to clients for days.

What investors, customers, institutions looked at in those days were screen prices on systems like Reuters or Bloomberg: feeds fed by the voice of the official. If the official did not yell a price in the mic, the data group would not enter a price, and the world would never see this price. Under fast markets no prices were entered and the screen would just read ‘fast’ (if you were lucky). Future and option prices on screen were seen as tradeable prices and in slow markets they may have been pretty close to the truth. In fast markets they were inaccurate and it was not possible to trade the price indicated on the Reuters screen. Yet the world still thought this was the correct price.

Being in the pit, one cannot keep buying or selling an instrument, so traders would hedge their positions. Hundreds of times I have been in situations where there was simply no bid or offer in the instrument to hedge in. The signal from a broker out of the futures pit simply stated, ‘no bid, no bid’, yet all the screens where showing a bid or an offer. Was this liquidity? The world clearly thought it was, but we all knew there was panic on the floor and you were lucky to trade one lot.

Yes, I know Mr. Spanbroek is talking his book.  (The EPTA represents HFT firms.)  But what he writes about the good old days on the floor are accurate.  They were good days mainly for the guys on the floor, who would supply liquidity when it was profitable, but would head for the exits when the order flow was toxic.  Ditto traders upstairs in the OTC markets.  This is a characteristic of liquidity supply and liquidity suppliers pretty much everywhere and always.

This subject always brings to mind a legendary-and I mean legendary-trader, who told me in the early-00s he was all in favor of the markets going electronic because he was “sick of getting raped by the floor.”  About 2 years ago he told me that he couldn’t compete with HFT.  I guess there was a Goldilocks “just right” era in between, say 2002-2007 or so, but the criticisms of liquidity suppliers is a hardy perennial.  And there is some justice to the charges.  The point is that it is not new, and it is not unique to HFT.  It is inherent in the economics of liquidity supply.

And there is no easy policy solution.  A policy intended to fix one problem will just create others.  Again, the problems inhere in the economics of liquidity supply.

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