Streetwise Professor

There was another fiery derailment of a train carrying crude oil, this one in Lynchburg, Virginia. Some of the cars plunged into the James River, spilling oil into the stream that runs through Virginia via Richmond to the Chesapeake.

This is just the latest of a spate of such accidents. This is, to some extent, the inevitable consequence of the oil boom in the Bakken and Texas. The boom means that more oil has to move, and rail can adjust most rapidly to accommodate that need. Pipelines are cheaper and safer, but they take a while to build. Unfortunately, regulatory obstacles had impeded the more rapid buildout of pipelines.

To give an idea of how unexpected the oil-by-rail movement is, note that the US government (namely the Energy Information Agency) does not collect data on the volume of rail shipments. It tracks shipments by barge and pipeline, but not rail. Because oil by rail volumes were basically rounding error until the shale oil boom.

The recent spate of accidents has led Warren Buffett to call for stronger regulation, most notably, a requirement for safer rail cars.  Buffett’s Berkshire Hathaway of course owns the nation’s second largest rail carrier, BNSF.

That Warren, always looking out for the public interest, and willing to sacrifice the interests of one of his major holdings to benefit us hoi polloi.

Not.

First, it’s long been known that some firms in an industry can benefit from the imposition of more stringent safety regulations. Yes, these regulations raise everybody’s costs, but some firms’ costs rise more than others. The less-impacted firms have an incentive to press for the regulations in order to raise their rivals’ costs. This raises market price. The effect on price more than offsets the effect on cost for the less cost-impacted firms.

Which means: always look askance at people like Buffett who are calling for regulation of their industry.

And this goes double for Buffett. For in addition to BNSF, Berkshire Hathaway owns the Union Tank Car Company, one of the largest manufacturers of oil tanker railcars. Meaning that some of the costs from requiring the purchase of more robust railcars goes from Buffett’s BNSF pocket into his UTLX pocket. He is, effectively, hedged against the rise in BNSF’s costs that would result from regulations requiring the use of safer cars. What’s more, his UTLX also pockets some of the costs incurred by his rivals. That’s a double win for Buffett. His rivals’ costs go up, raising prices for rail freight which benefits BNSF, and Buffett also books as profit (at UTLX) some of the higher costs his rivals incur.

Great work if you can get it.

So yeah, Buffett’s call for more stringent regulation of oil carrying railcars is totally altruistic. Totally.

It never ceases to amaze me how Buffett’s kindly grandfather shtick fools the world. He is utterly cynical in his actions and public statements. He demonizes derivatives, but engages in some huge exotic options trades. He claims he supports the estate tax out of interest of fairness and equity, not mentioning that his insurance businesses profit immensely from the estate tax (and that he can of course largely circumvent the tax). He has manipulated the silver market. And he poses as a defender of public safety, not mentioning his very strong economic interests in such regulation.

It’s not surprising that Buffett conceals his interests. What’s more surprising, and more discouraging, is that none of the media stories on his calls for tougher regulation that I have seen mention his economic interest. Reporters are either intimidated,  gulled by his shtick, or shockingly ignorant of how Buffett would benefit from rules requiring railroads to upgrade their car fleets.

Just because reporters are credulous dupes doesn’t mean you have to be. Don’t fall for the Buffett shtick. Don’t pay attention to what he says. Evaluate the costs and benefits of increased safety standards on oil-by-rail shipments on the merits.

And don’t limit your analysis to rail shipments alone. Consider too the effects of expediting the approval and building of oil pipelines. Pipelines aren’t perfect, but they have a much better safety record than rail. Not that Grandpa Warren will tell you that.

Back in Houston, with a few moments to catch up.

I mentioned Obama’s press conference in the Philippines yesterday. It deserves a more detailed treatment, because it is quite an amazing performance.

The incredible petulance-an Obama trademark-jumps out in even a cursory reading. But when you drill down, you’ll see a rather stunning farrago of shoddy reasoning and logical fallacies (with straw men and false choices taking center stage).

Here’s my annotated take on the presser, with my parenthetical comments in bold face:

PRESIDENT OBAMA:  Well, Ed, I doubt that I’m going to have time to lay out my entire foreign policy doctrine.  [Because he’d have to think it up first.] And there are actually some complimentary pieces as well about my foreign policy, but I’m not sure you ran them.

Here’s I think the general takeaway from this trip.  Our alliances in the Asia Pacific have never been stronger; I can say that unequivocally.  Our relationship with ASEAN countries in Southeast Asia have never been stronger.  I don’t think that’s subject to dispute.  As recently as a decade ago, there were great tensions between us and Malaysia, for example.  And I think you just witnessed the incredible warmth and strength of the relationship between those two countries.

We’re here in the Philippines signing a defense agreement.  Ten years ago, fifteen years ago there was enormous tensions around our defense relationship with the Philippines.  And so it’s hard to square whatever it is that the critics are saying with facts on the ground, events on the ground here in the Asia Pacific region.  Typically, criticism of our foreign policy has been directed at the failure to use military force.  [Really? This is typical?] And the question I think I would have is, why is it that everybody is so eager to use military force [Everybody? Please name five even moderately prominent national office holders or media figures who espouse this view. OK: Three. OK: One.] after we’ve just gone through a decade of war at enormous costs to our troops and to our budget?  And what is it exactly that these critics think would have been accomplished?

My job as Commander-in-Chief is to deploy military force as a last resort, and to deploy it wisely.  And, frankly, most [Most? Really?] of the foreign policy commentators that have questioned our policies would go headlong into a bunch of military adventures that the American people had no interest in participating in and would not advance our core security interests. [Again. Name names. As many as Three Finger Brown could count on his pitching hand.]

So if you look at Syria, for example, our interest is in helping the Syrian people, but nobody suggests that us being involved in a land war in Syria would necessarily accomplish this goal.  [That’s right, actually. No one has suggested a land war in Syria.] And I would note that those who criticize our foreign policy with respect to Syria, they themselves say, no, no, no, we don’t mean sending in troops.  Well, what do you mean?  Well, you should be assisting the opposition — well, we’re assisting the opposition.  [Please. The US assistance is minimal, and explicitly does not include weaponry, especially the kind of weaponry the opposition needs to have a fighting chance. Throughout this answer, Obama avoids addressing head on the specific policies that those criticizing him have advocated. He bashes straw men, attacking things that haven’t been suggested, and ignoring the things that have been.] What else do you mean?  Well, perhaps you should have taken a strike in Syria to get chemical weapons out of Syria.  Well, it turns out we’re getting chemical weapons out of Syria without having initiated a strike.  [Intelligence agencies, including those in Israel and the US, believe that Syria has not disclosed all its CW or the facilities to produce them. More to the point: it is Obama that fetishized chemical weapons. Assad is wreaking a humanitarian crisis using conventional weapons and barrel bombs and the old standby of starvation. Obama ignores this, with his obsessive focus on CW. What’s more, even from a bloodless, geopolitical perspective, American inaction and indifference is handing a strategic victory to Iran and Russia.] So what else are you talking about?  And at that point it kind of trails off. [No. It doesn’t trail off, Barry. You just ignore it.]

In Ukraine, what we’ve done is mobilize the international community. [Who you gonna believe? Me or your lyin’ eyes? Obama is deferring to the least common denominator, compromised countries like Austria. This mobilization has obviously had a huge impact on VVP. Huge I’m tellin’ ya.]  Russia has never been more isolated. [And Putin obviously doesn’t give a sh*t. To deter someone you have to credibly threaten the ability to damage something they care about, not what you care about. Putin is consciously and publicly attempting to isolate Russia from the west, politically and culturally. In other words, Barry: you are Br’er Fox and Putin is Br’er Rabbit. By isolating him you are throwing him in the brier patch, which is exactly where he wants to be. Well played. Well played. And truth be told, the isolation that Putin might care about-namely cutting Russia off from the world financial system-has been avoided like the plague.]  A country that used to be clearly in its orbit now is looking much more towards Europe and the West, because they’ve seen that the arrangements that have existed for the last 20 years weren’t working for them.  And Russia is having to engage in activities that have been rejected uniformly around the world.  [And this rejection does what for Ukraine, actually? Putin is moving, through asymmetric means, virtually unopposed. All the moral dudgeon in Europe and the US won’t help Ukraine one whit.] And we’ve been able to mobilize the international community to not only put diplomatic pressure on Russia, but also we’ve been able to organize European countries who many were skeptical would do anything to work with us in applying sanctions to Russia.  [American sanctions are a joke. European sanctions would have to be put in steroids in order to achieve joke status.] Well, what else should we be doing?  Well, we shouldn’t be putting troops in, the critics will say.  That’s not what we mean.  Well, okay, what are you saying?  Well, we should be arming the Ukrainians more.  Do people actually think that somehow us sending some additional arms into Ukraine could potentially deter the Russian army?  [Yes. It’s not unreasonable. At all. The “correlation of forces” does not heavily favor Russia, especially when one considers the implications of occupying Ukraine, rather than just attacking it. Even modest increases in Ukrainian military capacity could tip the correlation against Putin.] Or are we more likely to deter them by applying the sort of international pressure, diplomatic pressure and economic pressure that we’re applying? [What? These things are mutually exclusive? Hardly. Why not both? And the opponents of your policy are advocating more robust economic actions against Putin and Russia. Again, you ignore the actual policies that your critics advocate, and wear yourself out attacking things they have never proposed.]

The point is that for some reason many who were proponents of what I consider to be a disastrous decision to go into Iraq haven’t really learned the lesson of the last decade, and they keep on just playing the same note over and over again.  [What a slur. Just who is advocating this, actually? Indeed, one major  lesson of Iraq-the challenge of occupation-favors arming the Ukrainians. The Russians have no doubt studied Iraq, and realize that a well-armed irregular force would make any attempt to occupy hell. So why not do it?] Why?  I don’t know.  [There’s a lot you don’t know, Barry.] But my job as Commander-in-Chief is to look at what is it that is going to advance our security interests over the long term, to keep our military in reserve for where we absolutely need it.  There are going to be times where there are disasters and difficulties and challenges all around the world, and not all of those are going to be immediately solvable by us.

But we can continue to speak out clearly about what we believe.  Where we can make a difference using all the tools we’ve got in the toolkit, well, we should do so.  And if there are occasions where targeted, clear actions can be taken that would make a difference, then we should take them.  We don’t do them because somebody sitting in an office in Washington or New York think it would look strong.  That’s not how we make foreign policy.  And if you look at the results of what we’ve done over the last five years, it is fair to say that our alliances are stronger, our partnerships are stronger, and in the Asia Pacific region, just to take one example, we are much better positioned to work with the peoples here on a whole range of issues of mutual interest.

And that may not always be sexy.  That may not always attract a lot of attention, and it doesn’t make for good argument on Sunday morning shows.  But it avoids errors.  You hit singles, you hit doubles; every once in a while we may be able to hit a home run.  But we steadily advance the interests of the American people and our partnership with folks around the world.

Obama came to prominence as a critic of the Iraq War. That’s how he made his mark, and it is clear that is how he defines himself. He is the un-general, un-fighting the last war. He has Iraq Syndrome, which is like Viet Nam Syndrome, except worse.

In his mental universe, the US policy establishment is populated with mouth-breathing warmongers who see only military solutions to strategic and geopolitical problems. In his mind, Obama is Horatio at the Bridge, holding back these barbarian hordes. This is profoundly insulting to those of goodwill who happen to disagree with Obama. But Obama cannot possibly conceive that anyone who disagrees with him is of goodwill. His is a truly Manichean worldview: those who agree with him are good, those who disagree are evil.

In fact, many of his critics have argued consistently that his deference to the Assads and Putins and Khamenis of the world has made military conflict (and conflict waged on terms unfavorable to the US) more likely, not less. With respect to Putin in particular, the critics have argued that acquiescing to South Ossetia and Abkhazia, terminating missile defense in eastern Europe, signaling a willingness to be “flexible” after re-election, and most notably, utterly caving in Syria has greatly emboldened Putin, thereby increasing not reducing the risk of military conflict. (When Obama took office, who was seriously discussing the credibility of our commitment to enforce Article 5 of the Nato Charter in the event of a Russian attack on Estonia, Latvia, or Lithuania?)

But Obama either will not or cannot see this. He is completely convinced that he is enlightened and good, and that his critics are benighted and  evil. Seeing the world in these harsh contrasts, he is incapable of change in response to reality.

Bush was criticized, and rightly so, for his black-and-white view of the world. But Bush was capable of making mid-course corrections in response to incontrovertible evidence of failure.

By contrast, Obama makes Bush look like a paragon of subtlety and flexibility.

In The Sound and the Fury, Faulkner wrote: “For every Southern boy fourteen years old, not once but whenever he wants it, there is the instant when it’s still not yet two o’clock on that July afternoon in 1863 [i.e., the moments before Pickett’s Charge].” Obama is far worse. In his mind, every instant, it is Iraq, circa March 2003. He sees everything through that prism. This is a crippling limitation. And a crippled United States unleashes the most reprobate actors in the world, the most notable of whom at present is Vladimir Vladimirovich Putin.

The day that Geneva was announced, I ridiculed the idea that the OSCE would be able to enforce any deal to withdraw anti-Kiev forces from government buildings, check points, etc.  The seizure of an OSCE delegation in Slavyansk by the Russians/Russian tools, and the subsequent public display of the European members of this team, proves that ridicule was more than justified. It is the punchline to the joke that is Geneva.

Despite the seizure and humiliation of a group of European military personnel carrying diplomatic passports, the Euros are still shrinking from doing anything that might risk offending Vlad. Because he might turn off their precious gas. Or maybe Siemens won’t get as much business.

The NYT reports that the administration is shrinking right along with them, not wanting to embarrass the poor dears by imposing punitive sanctions.

Speaking of jokes, here is Obama’s standup routine:

“The notion that for us to go forward with sectoral sanctions on our own without the Europeans would be the most effective deterrent to Mr. Putin, I think, is factually wrong,” Mr. Obama told reporters in Asia, where he is traveling. “We’re going to be in a stronger position to deter Mr. Putin when he sees that the world is unified.” He added: “For example, say we’re not going to allow certain arms sales to Russia — just to take an example — but every European defense contractor backfills what we do, then it’s not very effective.”

Sorry. The world unified in pusillanimity is hardly a deterrent to Putin. The US and a few stalwart allies acting on their own in a robust way would be much more effective.

Obama totally lost it in Asia in response to a question by Fox News’s Ed Henry:

“As you end this trip, I don’t think I have to remind you there have been a lot of unflattering portraits of your foreign policy right now,” Henry said. “And rather than get into all the details or red lines, excedera, I’d like to give you a chance to lay out what your vision is more than five years into office, what you think the Obama doctrine is in terms of what your guiding principle is on all of these crises, and how you answer those critics who say they think the doctrine is weakness.”

“Well, Ed, I doubt that I’m going to have time to lay out my entire foreign policy doctrine,” the President responded, adding “And there are actually some complimentary pieces as well about my foreign policy, but I’m not sure you ran them.”

The President then went on to attack those criticisms, point by point, noting that “Typically, criticism of our foreign policy has been directed at the failure to use military force,” and asking “why is it that everybody is so eager to use military force after we’ve just gone through a decade of war at enormous costs to our troops and to our budget? And what is it exactly that these critics think would have been accomplished?”

“My job as Commander-in-Chief is to deploy military force as a last resort, and to deploy it wisely,” he continued. “And, frankly, most of the foreign policy commentators that have questioned our policies would go headlong into a bunch of military adventures that the American people had no interest in participating in and would not advance our core security interests.”

On Syria, the President pointed out that his critics “say, no, no, no, we don’t mean sending in troops,” and asked “Well, what do you mean?”

“Well, you should be assisting the opposition — well, we’re assisting the opposition,” President Obama said, then asked “What else do you mean? Well, perhaps you should have taken a strike in Syria to get chemical weapons out of Syria. Well, it turns out we’re getting chemical weapons out of Syria without having initiated a strike. So what else are you talking about? And at that point it kind of trails off.”

On Ukraine, the President asked of those critics, “What else should we be doing? Well, we shouldn’t be putting troops in, the critics will say. That’s not what we mean. Well, okay, what are you saying? Well, we should be arming the Ukrainians more. Do people actually think that somehow us sending some additional arms into Ukraine could potentially deter the Russian army? Or are we more likely to deter them by applying the sort of international pressure, diplomatic pressure and economic pressure that we’re applying?”

“The point is that for some reason many who were proponents of what I consider to be a disastrous decision to go into Iraq haven’t really learned the lesson of the last decade, and they keep on just playing the same note over and over again,” the President said. “Why? I don’t know.”

Appalling. Proof that Obama is the thinnest skinned president ever. And his response has the opposite effect of what he intended: it lends credence to the criticism. It is also classic Obama. Dishonest and partisan. Blaming his political opponents or his long-departed predecessors for his failures. Total war against an army of straw men.

No one is seriously arguing for military involvement in Ukraine. But they-we, for I am included-are arguing for far more robust economic measures.  Funny Obama totally ignores that. He knocks down arguments no one makes and ignores the ones they do.

That’s our Obama.

Henry, or someone else, should have demanded that Obama name one serious figure advocating a replay of Iraq in Ukraine. One.

The record speaks for itself. Obama’s foreign policy is a concatenation of clusterf*cks. Syria. Ukraine. Israel-Palestine.

Speaking of the last issue. Kerry was quoted making a remark saying that if it continues on its present course, Israel will turn into an apartheid state. He made these remarks in front of Russians. Who duly leaked them.

Why would he say anything with any Russian in earshot, especially in the aftermath of the “f*ck the EU” leak fiasco?

With such clueless morons in charge, no wonder US credibility and influence is imploding. But if you challenge Obama on the implosion, he explodes.

This is where we are, and it is not a good place to be.

Traveling and family obligations, so limited time to comment on events. But an opportunity (sitting at the gate in Greenville) to take a few quick hits.

The US announced some additional sanctions today. To indicate how lame these sanctions are, the Russian market (MICEX) was up 2.35 percent when the names on the list (or more accurately, the names that weren’t on the list) were announced.

One notable name: Sechin. Roseneft was down 1.7 percent, and BP, tied to the hip with Rosneft, was down about two percent.

Other than that. Zip. In an inversion of the usual expression, this was a situation to sell the rumor and buy the fact.

The Euro list comes out tomorrow. It is rumored to be even more lame than the US list.

Over the weekend in Malaysia, Obama made it clear that he would coordinate sanctions with the Euros, and that the US would not impose unilaterally sanctions that were much tougher than what the Europeans will agree with. Meaning that given that the EU requires unanimous approval for its actions, Obama is deferring to the Austrians and the Slovenians and the Germans, who are utterly compromised by Russian influence and cash.

Most likely, Obama really wants to do nothing. This allows him to do that while claiming he’s all for solidarity and diplomacy and action. This is the negation of leadership. Leading from behind doesn’t even come close to describing this.

And to think that Obama ran on eliminating cynicism from US foreign policy.

We’ve seen this script before, in Syria. Kerry comes out and makes an angry denunciation, followed by threats. Followed by  . . . nothing.

All the circumstances in Syria were much more favorable to justify action. A true humanitarian crisis. Viable military options, not least because there would not be a direct confrontation with Russia. Crimes against humanity.

Kerry compared Assad to Hitler. Obama threatened to attack. But then the US grabbed the first fig leaf Putin proffered, and bugged out.

If the US will not act aggressively in Syria, it won’t act aggressively-even with respect to sanctions-in Ukraine.

The US sanctions announced today were intended to strike at Putin’s inner circle, but not at Putin himself. Presumably the threat is that he could be targeted next. The NYT ran an article over the weekend about trying to track down Putin’s money.

Fat chance.

First, even if Putin’s name is listed at the owner of some company or companies, they would be separated from the real money by a labyrinth of shell companies, trusts, etc.

Second, paper and electronic records or ownership are essential in countries subject to the rule of law because third party enforcement is relied upon to protect property rights and ownership.

That is NOT the way Putin needs to rely on such mechanisms to enforce his access to and control over his property. Russians are notorious for making huge deals verbally, and relying on, umm, informal means to enforce contracts. Putin’s deals are sealed with a handshake-if that. Maybe there is a piece of paper in his safe. But he has the power of a very scary security apparatus at his beck and call. That is what he relies on to secure his property. No need for the formalities of ownership when the real enforcers are under one’s command.

And this is precisely why he so desperately needs to hold onto power. That power secures his wealth. This also means that trying to trace his wealth and property is a fool’s errand.

There is a Midas-like aspect to Putin’s fortune. There are constraints on his ability to consume it. But he definitely cannot consume it if he loses power. Which is why, like all autocrats, he will only leave office horizontally, at room temperature.

With that happy image in mind, some musical entertainment in honor of Igor Sechin, today’s only meaningful sanctions target. The man with the hockey hair.

I have been working since last year on a whitepaper (sponsored by Trafigura) on The Economics of Commodity Trading Firms. After about a month of limited theatrical release, the paper is now publicly available at the link.

Even if I do say so myself, the paper provides a pretty thorough overview of commodity trading firms, ranging from their economic function as “agents of transformation” (of commodities in space, time, and form), to risks and risk management, to corporate structure (private vs. public), to capital structure, to asset ownership, to the systemic risks (or lack thereof) of commodity trading.

One of the main takeaways for me was the diversity of commodity trading firms. Making generalizations is difficult. Another takeaway (related, in a way) is that some of the conventional wisdom about these firms (e.g., there is a general trend to asset ownership and vertical integration) is not correct.

But rather than discuss the report extensively here, I leave it to you all to read it. Comments welcome.

An exchange chairman believes that all trading should take place on exchanges. In commenting on securities market structure, CME Group Chairman Terry Duffy criticizes fragmentation-especially the existence of dark pools-and touts the lack of fragmentation in futures trading.

The concentration of trading activity on futures exchanges, as opposed to the fragmentation across different exchanges (as well as off-exchange venues) in equities is due to a major difference in the treatment of orders. In futures markets, exchanges own their order flow: hypothetically, if there was another exchange posting a better price in a particular product, CME would not be obligated to direct an order to that better-priced market. When exchanges own their order flow in this way, traders direct orders to the exchange where they expect to get the best price. This is typically the market where most traders are. This creates a centripetal force that causes all activity to tip to a single dominant exchange. That is why CME, Eurex, ICE, etc., have monopolies or near monopolies in the products they trade. (And yes, Terry, even though no one is stopping anyone from competing with you, this order flow effect means that no one can do so effectively, leaving you a de facto monopoly. Only LIFFE’s idiocy in its battle with Eurex in 1998 allowed the Germans to get trading in the Bund futures to tip their way.)

This is the way it used to be in equities too. Prior to the late-2000s, the NYSE effectively owned its order flow, and 80-85 percent of trading volume in NYSE listings took place on the NYSE. The remainder occurred on “third markets” that catered to the verifiably uninformed (more on this below).  But in 2005 the SEC changed the rules in a fundamental way. It passed RegNMS, which socialized order flow by requiring exchanges to route orders to others displaying better prices. Within a very short period, a handful of exchanges executing between 8-20 percent of volume competed fiercely with one another. The NYSE’s effective monopoly had been broken.  This is why Goldman paid $6.5 billion for a specialist unit in 2000, and sold it for $30 million this year. The 2000 price capitalized monopoly rents: there are none to capitalize in 2014.

Duffy says he’s fine with this kind of fragmentation  of trading across exchanges with the associated intense competition (though that’s very easy for him to say because he doesn’t have to worry about that outcome given the lack of a RegNMS-type rule in futures markets), but he thinks dark pools should be shut down.

To evaluate this position, you need to understand what role dark pools play. Just like third markets and block markets of the pre-RegNMS era, dark pools (and internalization of retail order flow) are a ways of screening out informed traders. This reduces the costs of the uninformed who can trade on dark pools be reducing their vulnerability to adverse selection. This is good for them, but the overall effects are much harder to understand. Order flow on exchanges becomes more toxic (i.e., a higher proportion of the order flow is informed) which raises adverse selection costs on exchanges, and thereby raises trading costs there.

The net effect of this is very difficult to determine. This is another application of the second best. Since exchanges may have market power, the additional competition from off-exchange venues can improve efficiency even if it raises adverse selection costs for some traders. Moreover, as I’ve argued in my HFT posts recently, since some informed trading is of the rent seeking variety, by reducing the returns to informed trading dark pools can reduce wasteful investments in information.

This means that Duffy’s criticism of dark pools might be right. But it might be wrong.

One thing is definitely true. Market structure has huge distributive effects. Although the rules on dark pools have very uncertain efficiency effects, there is no doubt that these rules affect the distribution of costs and benefits across different types of traders. It is precisely these distributive effects which make the battles over market structure so divisive and protracted.

I’d also note that Duffy ignoring some features of futures markets, and derivatives markets generally, that perform functions similar to dark pools. For instance, CME allows block trading. Indeed, it is engaged in a tussle with the CFTC, which wants to reduce the amount of block trading in order to force more volume into the order book.

But block trades are a way that less-informed large traders can reduce adverse selection costs. They have long performed this function in equity markets, and are now doing so in futures. And by stripping out that order flow from the order book, block trades have the same effects as dark pools.  Blocks are a form of fragmentation.

Block markets are non-anonymous: that’s how they screen out the informed. Block traders won’t deal with those they believe likely to be informed, and by trading face-to-face traders can develop reputations for not being informed and profiting systematically at the expense of their counterparties.

Well, wouldn’t you know it, but this is how OTC derivatives markets work too. The lack of price transparency in OTC markets is often bewailed, but OTC markets are transparent in another important way that exchanges are not: they offer counterparty transparency, whereas exchanges are counterparty opaque. This benefits, say, firms that are trading to hedge in large volume (who are likely to be uninformed). It’s not a surprise that trading activity migrated from OTC to blocks on CME and ICE after Frankendodd made swaps trading more expensive. Both futures blocks and swaps are ways of reducing the execution costs of large, likely uninformed traders.

Put differently: blocks (and swaps) are a form of fragmentation, in the sense that they divert trading activity away from the limit order book. So Duffy shouldn’t be quite so sure about the superiority of the futures market model. It is fragmented in its own way, and has a lot more market power. But of course Duffy likes the last part, though he would never admit it.

Marx said that history repeats itself, first as tragedy, then as farce.

Perhaps the best interpretation of Geneva, 2014, is that it is the farcical doppelgänger of Munich, 1938.

It was apparent to anyone not willfully blind that Geneva was doomed to failure. There was no enforcement mechanism. And within hours, it became clear that the Russians intended to use the agreement as a reason to ratchet up its offensive against the Kiev government, and had no intention to force evacuation of any buildings by its forces in eastern Ukraine. The Russians are demanding that the Kiev government go after any group that Moscow does not like.

And you know what will happen. The Russians will use the failure of Kiev  to bend to their will as a pretext for refusing to do anything in Donestk, and for invading or supporting separatists.

I have to conclude that Kerry enjoys getting punked by Lavrov in Geneva. If he doesn’t, why does he do it so regularly?

Insofar as enforcement is concerned, the Geneva agreement lays out a special role for the OSCE. But check out this organizations description of its activities in Ukraine. Totally passive. Merely an observer. I’ve heard of alpha males. I’ve heard of beta males. OSCE comes off as omega males. Who have been eunuched.

And not surprisingly, the Russian forces in eastern Ukraine are totally blowing them off.

But don’t worry, OSCE is going to persuade them with sweet reason!:

After a meeting in Kiev on Saturday with diplomats from the four parties to the Geneva accord, Swiss envoy Christian Schoenenberger, whose country is chair of the OSCE, said its monitors had already spoken to the separatists: “For the time being the political will is not there to move out,” he said.

“That’s the task of the monitors, to create this political will, inform the people, so eventually they will understand that the best option for them is to move out,” he told reporters.

I don’t know whether to laugh, cry, or pound my head against the wall.

The article I linked to is titled “Surrender talks set with separatists in Ukraine.” It is beyond obvious that it is OSCE whose surrender is being negotiated.

But the farce does not end with Geneva. Perhaps stung by the criticism of his dancing to organ grinder Vladimir’s tune, Eddie Snowden penned a defense of his conduct that ran in the Guardian. Never fear, people, the article had its allotted content of narcissistic Snowden gasbaggery. (Just how many times do you have to mention risking your life, Ed.) But the best (and by best, I mean worst) part was this:

Moreover, I hoped that Putin’s answer – whatever it was – would provide opportunities for serious journalists and civil society to push the discussion further.

When this event comes around next year, I hope we’ll see more questions on surveillance programs and other controversial policies. But we don’t have to wait until then. For example, journalists might ask for clarification as to how millions of individuals’ communications are not being intercepted, analysed or stored, when, at least on a technical level, the systems that are in place must do precisely that in order to function.

I have to say it. What planet does this guy live on?

Journalists? You mean the ones that are beaten or killed if they challenge Putin? (The name Politkovskaya ring a bell, Ed?) Civil society? You mean the individuals and organizations that Putin and the Russian state have relentlessly ground into the dust over the past several years?

And just what answer would Snowden expect Putin to deliver to any journalist-with-a-death-wish who poses these questions?

Snowden’s Guardian piece comes off as more of a taunt than serious defense. He was only allowed to ask his question because the FSB approved it, and set up the entire apparatus for him to ask it. The Guardian article means nothing, because the Russians have to at least attempt to maintain the pretense that Snowden is not the organ grinder’s monkey that he actually is.

To show how farcical this is, check out Kucherena’s explanation of the situation:

Mr. Snowden’s Russian lawyer, Anatoly Kucherena, denied his client had been pressured to participate.

“He decided to do this himself. There was no negotiation with the Kremlin,” he said. “Edward had the opportunity, so he asked the question.” Questions could be submitted ahead of the event in writing or in video form via a website or mobile application.

Um, just how did this “opportunity” magically appear?

Kucherena’s risible attempt to claim that this was not an FSB-arranged performance is the most telling proof that it was an FSB-arranged circus.

One more item in the farcical chronicles.  German FM Frank-Walter Steinmeier is pimping for Putin harder than ever:

German Foreign Minister Frank-Walter Steinmeier said he wished as much emphasis would be placed on preventing an escalation of tensions with Russia over Ukraine as there is at the moment in threatening economic sanctions.

In an interview to appear in Germany’s Bild am Sonntag newspaper on Sunday, Steinmeier appeared to be referring to threats from the United States as well as from within Germany about the need for economic sanctions against Russia.

“I sometimes wish that the same engagement being used for the debate about sanctions would also exist when it comes to avoiding a further escalation,” Steinmeier told the Sunday newspaper, according to excerpts released before publication.

Yeah, because Putin is putting so much effort into avoiding escalation.

Steinmeier is a snake at the bosom of the western alliance. Germany is totally compromised, and the US must accept that when crafting its own actions, such as they are. Germany is giving more proof by the day that whatever resources NSA devoted to spying on it, it was not enough.

One piece of news is that the US is considering going after Putin’s billions. I’ll believe it when I see it. For now, that appears to be just another part of the FUD campaign that the US is waging in place of actually doing something. But FUD doesn’t work unless the threats are credible, and the threats aren’t credible unless you carry through on them. Obama has repeatedly failed to do so, and as a result, these whispered and leaked threats will have zero effect whatsoever.

I fear the farce will be with us, for many years to come. The current farce stems from a fatal lack of will in the west, and that is not going away anytime soon.

In his Atlanta Fed paper, Stiglitz uses second best considerations in his argument against HFT. My basic response is that second best considerations cut both ways.

Put simply, second best considerations mean that if one optimality condition is violated, then it may be efficiency enhancing to violate another optimality condition: or, one “market failure” can mitigate another. A simple example would be that it might be better for a polluting industry to be monopolistic or oligopolistic instead of competitive.  The monopolist’s reduction of output offsets the incentive to produce too much that occurs when there is an externality.

In the context of HFT, my second best argument is that since informed trading can be rent seeking, things that might otherwise be inefficient, such as anticipating orders or engaging in “arms races” to enhance trading speed, can be efficiency enhancing.

This is not a new theme with me. In fact, it’s quite old. I wrote a paper in 1998 titled “Third Markets and the Second Best” that applied this argument to off-exchange trading, and the free riding off of price discovery on exchanges. I discussed this further in my 2002 JLEO paper, “Securities Market Macrostructure: Property Rights and the Efficiency of Securities Trading“.

In these papers, I showed that off exchange trading venues-third markets-that free ride off of the prices produced by exchanges and limit trading to the verifiably uninformed can be efficiency enhancing even if this exacerbates adverse selection problems on the exchange because this free riding mitigates two problems: the market power of dominant exchanges (where the market power arises from the liquidity network effect) and rent seeking informed trading (i.e., the expenditure of real resources to obtain information in order to extract profits by trading with the less-informed who buy and sell for portfolio balance or risk management reasons).

Similar arguments can be applied to dark pools today. Indeed, many dark pools (and internalization) perform a similar function to third markets back in the day: they are venues that use various means to screen out informed traders, in order to reduce execution costs for the verifiably less-informed. This loss of uninformed order flow on “lit” exchanges tends to increase adverse selection costs there, but the same competition and rent seeking informed trading second best considerations arise here, meaning that the costs of lower liquidity on exchanges may be more than offset by other benefits.

And many of the very same considerations apply to HFT. Thus, contra Stiglitz, second best considerations do not unambiguously favor the adoption of restrictions on HFT.

Indeed, the thing that is most striking about the trading of financial instruments is that there are so many potential violations of optimality conditions that the entire analysis of market structure becomes an exercise in the theory of the second best.

Which can be a problem. For as George Stigler said, “Well, there are second best considerations” is a conversation stopper. But the conversation about market structure isn’t going to stop anytime soon, so we have to grasp the nettle of the second best if that conversation is going to shed more light than heat. It is good that Stiglitz makes the second best issue explicity. If only he had applied this reasoning more consistently, and recognized that informed trading can be a deviation from optimality which can be addressed by things that seem in isolation to be inefficient.

The battle over bank participation in physical commodities is reaching a climax. The deadline for commenting on potential Federal Reserve regulation of this activity is approaching, and many letters from groups representing banks (‘natch) but also from energy and commodity industry groups plead with the Fed to permit continued bank involvement in the markets. However, on Capitol Hill the sentiment largely runs the other way, and Senators Sherrod Brown and Elizabeth Warren submitted a letter demanding that the Fed defenestrate banks’ commodities businesses.

Most of the Brown-Warren letter is stuff I’ve written about before, so I won’t comment more on it now. But this part stood out to me, and deserves a rebuttal:

Commodities activities present risks that are different from financial-market risks, are idiosyncratic, and have the potential to disrupt more than just the financial system. Global supply chain disruptions can affect industries in the broader economy that rely upon raw materials.

First, from a systemic risk perspective, the fact that commodities risks are idiosyncratic, and different (i.e., less correlated) with other risks in the banking system is a good thing. Diversification is beneficial in this regard.

I have looked at some evidence that speaks directly to this issue. Over the period of the crisis, the profits of the biggest physical commodity trading firms (the Glencores, Cargills, Vitols, etc.) did not suffer the same extreme drop as bank profits. Indeed, with a few exceptions (Bunge) profits of the major commodity trading firms rose from 2008 to 2009, when bank profits were in freefall.

This lack of cyclicality in trading firm profits, which is in stark contrast to the extreme cyclicality in prices (especially for energy and metals) is readily understood. Physical trading is a margin and volume business: these factors, not flat prices, drive profits. Due to the inelasticity of supply and demand for commodities, margins and volumes tend to be much more stable than flat prices. Prices, rather than quantities, tend to bear the bulk of the burden of responding to demand shocks. Moreover, some commodity trading activities-notably storage-tend to be countercyclical, providing a source of profit to physical commodity traders during recessions.

Commodity trading firms actually had more issues when prices spiked in 2008, because it was difficult for them to finance inventories at very high prices, and the low prices of 2009 eased these financing constraints.

The lack of cyclicality, which contrasts starkly to the pronounced cyclicality of earnings in traditional banking and capital market activities, means that physical commodity trading could reduce the systemic risk posed by banks. The effect will not be large, because even for the biggest banks  commodity trading revenues are small relative to those generated by the more traditional activities. But directionally, this lack of cyclicality in physical trading profitability makes it an attractive part of a bank’s portfolio, especially from a systemic risk perspective.

Second, the Brown-Warren warning about disruptions beyond the financial system are vastly overblown. Presumably what they mean is that if a large bank or several large banks with commodity trading operations were to run into financial trouble, this could disrupt global supply chains. But especially for the commodities that banks tend to focus on (particularly energy), they represent a small fraction of total physical market trading activity. If they disappeared overnight, others could step in and handle most of the business at a slightly higher cost. (Not to mention that it is kind of strange to justify driving banks out of the business by saying that if they leave the business it could disrupt global supply chains.)

But even more importantly, we know that even major disruptions in global supply chains are likely to have only trivial impacts on the global economy. Look at the Japanese earthquake and tsunami of 2011. It devastated supply chains throughout Asia, far more than the loss of even several major commodity trading firms could have. Yet the effects on global growth were minimal. Several central banks examined the issue, and found that the catastrophe reduced global growth by around .1 percent for a couple of quarters. Even in Asia, the effect was minor.

As another example, the implosion of the merchant energy sector in the US in 2002 had no marked effect on US economic activity.

Another concern raised about bank participation in physical markets is environmental risk. This is potentially a serious concern, but even there legal protections (notably dealing through subsidiaries that protect a bank or bank holding company from liability) and insurance can sharply reduce the risk that legal exposure arising from an oil spill or the like could threaten the viability of a large financial institution. Also, since different commodity trading activities pose different environmental risks, a blanket restriction on commodity trading activities, some of which are not particularly environmentally risky, is not warranted.

In sum, the Brown-Warren arguments are not persuasive. Financially, the nature of physical commodity trading tends to reduce the cyclicality of of bank profits, which tends to reduce systemic risk. The fears about threats to global supply chains from the failure of any major commodity trader leading to adverse macroeconomic consequences are vastly overblown. Finally, the environmental/legal risk issues can be allocated away from banks through organizational structure and insurance. Since there also complementarities between traditional banking activities and commodity trading (which I discussed in posts from last summer) some commodity producers and consumers would pay higher costs if they could not enter into physical trading deals with banks: this is one reason why some of these producers and consumers object to limitations on bank participation in these markets. It’s hard to see the benefits of a ban (or restriction), but some costs are evident.

I doubt that will matter much in the end though. Commodities are a politically sensitive issue. Banks are a politically sensitive issue. Put them together, and the sensitivities are acute. Meaning that politics will largely drive the outcome.

Update. One other amusing part of the Brown-Warren letter. They say:

Some have argued it is preferable to allow commodities activities and physical asset ownership within the regulated banking system, rather than at the more lightly regulated commodity trading houses. As a general matter, the CFTC maintains authority to police fraud and manipulation in the commodities markets, regardless of the party engaging in such behavior.

So are banks somehow less subject to deterrence by the threat of CFTC action? If the objective  is to reduce the amount of manipulation and fraud, to justify forcing banks to eschew commodity trading it is necessary to argue that banks are  somehow less responsive to CFTC action than commodity trading houses. Maybe, but it’s not obviously true and I’ve seen no evidence that would support my view.

This relates to a point I made in earlier posts, namely, that if the economics are such that banks find it tempting to manipulate, non-banks will also find it tempting. Meaning that moving a business (e.g., metal warehousing) from a bank to a non-bank is unlikely to reduce the amount of manipulation.

One other thing needs to be said in this context. The Brown-Warren point is correct to the extent that it demonstrates that the term “lightly regulated” is used far too sloppily. Yes, trading houses are less subject to less of some kinds of regulation than banks, but they are subject to anti-fraud and anti-manipulation rules just as banks are. Similarly,  environmental laws and anti-trust laws and many other laws apply to these firms. “Lightly regulated” does not apply uniformly to all forms of bad conduct. The fact that commodity traders are not subject to some regulations that banks are (e.g., capital requirements) makes sense, given the differences between them.

Whenever anyone says “unregulated” or “lightly regulated”, I get suspicious and skeptical. Often those using these phrases are playing a shell game.

Joe Stiglitz presented a paper on HFT at the Atlanta Fed conference earlier this week that has received a lot of attention. The paper is worth reading, but I actually recommend Felix Salmon’s synopsis, which breaks out the issues nicely.

I agree with Stiglitz in part, and disagree in part. The agreement is that Stiglitz hits many of the themes of my recent posts on HFT, notably that when there is private information, financial markets are unlikely to reach first best outcomes, and that making welfare comparisons is very difficult: I would say nigh-on to impossible, actually. Stiglitz also recognizes that HFT affects the incentives to collect information, which is another theme that I’ve emphasized.

Where I disagree is that Stiglitz (like DeLong) concludes from these insights that HFT is wasteful and should be restricted. This conclusion does not follow at all, and can be traced to some implicit assumptions about the nature of informed trading by non-HFT traders.

Stiglitz says “HFT discourages the acquisition of information which would make the market more informative in a relevant sense.” And by “relevant sense” he means fundamental information about the real economy. He laments that HFT “can be thought of as stealing the information rents that otherwise would have gone to those who had invested in information.” Further, he criticizes that much of what HFT does is merely accelerate the revelation of this information, and this acceleration is so small that it cannot improve any decision on any margin, and hence the resources used by HFT are wasted.

But this implicitly assumes that the information produced by non-HFT traders, the collection of which is reduced by the “stealing of information rents”, is in fact fundamental information that would improve decisions. But as I’ve noted repeatedly, many of the informed traders who HFT firms sniff out are producing information that does not improve any economic decision on any margin. Getting better information about an impending earnings report can be very profitable, but revelation of this information doesn’t improve decision making.

By assuming that non-HFT informed traders are producing information that invariably improves decisions, Stiglitz misunderstands what a great deal of informed trading is about, and thereby ignores a benefit of HFT order anticipation-based trading, and crucially, of HFT quote adjustments that cause markets to run away from big traders and thereby limits their ability to profit on their information.

One way to think about it is that there is cash flow relevant information, and decision relevant information. Pretty much all decision relevant information is cash flow relevant, but not all cash flow information is decision relevant. One major example is what Stiglitz emphasizes: the slight acceleration of revelation of information. But I claim that a lot of the information produced by institutional traders is of exactly this type. Stiglitz (and DeLong) ignore this, which leads them to biased appraisals of the efficiency of HFT.

That is, once one recognizes that some informed trading is rent seeking, and socially wasteful, “stealing of information rents” by HFT can be a feature, not a bug.

Stiglitz also ignores that even if HFT reduces the amount of decision relevant information produced and incorporated into prices, reducing this source of private information still reduces the adverse selection costs incurred by uninformed investors trading for portfolio rebalancing or hedging reasons. This reduction in adverse selection costs tends to improve the allocation of risk. This benefit must be weighed against any cost arising from the reduction in the production of decision relevant information.

In brief, Stiglitz and I agree that HFT reduces the incentive to collect information. Where we differ is that Stiglitz believes this is an unmitigated bad, whereas I strongly believe that this is totally wrong, because Stiglitz’s characterization of informed trading is very unrealistic. My point is that non-HFT informed trading can be parasitic, but Stiglitz does not recognize this or account for it in his analysis.

Stiglitz also complains that HFT liquidity is junk liquidity. In particular, prices move before large orders can be executed.

This is a variant on the criticism that HFT reduces information rents. Moreover, Stiglitz fails to make comparisons between realistic alternatives. The ability to adjust quotes faster reduces adverse selection costs, and allows HFT to quote tighter markets. Restricting HFT in some way will lead to wider spreads and lower quoted depth. Either way, big orders will have a price impact.

Stiglitz also claims that HFT reduces other, better forms of liquidity. Salmon actually explains this point more clearly:

HFT does not improve the important type of liquidity.

If you’re a small retail investor, you have access to more stock market liquidity than ever. Whatever stock you want to buy or sell, you can do so immediately, at the best market price. But that’s not the kind of liquidity which is most valuable, societally speaking. That kind of liquidity is what you see when market makers step in with relatively patient balance sheets, willing to take a position off somebody else’s book and wait until they can find a counterparty to whom they can willingly offset it. Those market makers may or may not have been important in the past, but they’re certainly few and far between today.

HFT also reduces natural liquidity.

Let’s say I do a lot of homework on a stock, and I determine that it’s a good buy at $35 per share. So I put in a large order at $35 per share. If the stock ever drops to that price, I’ll be willing to buy there. I’m providing natural liquidity to the market at the $35 level. In the age of HFT, however, it’s silly to just post a big order and keep it there, since it’s likely that your entire order will be filled — within a blink of an eye, much faster than you can react — if and only if some information comes out which would be likely to change your fair-value calculation. As a result, you only place your order for a tiny fraction of a second yourself. And in turn, the market becomes less liquid.

These points are pretty dubious. The kinds of market makers that HFT displaces (locals on futures exchanges, specialists, day traders) were hardly characterized by “relatively patient balance sheets.” Their holding periods were also quite short. Indeed, one of the filters academics use to identify HFT traders is firms that end the day flat: this exactly what most locals and specialists strove to do. And most traders that “do a lot of homework on a stock” were not doing so to supply liquidity through limit orders that they did not adjust frequently. Those who do a lot of homework are usually liquidity takers, not liquidity suppliers.

In sum, although Stiglitz’s analytical framework and broad conclusions are correct, his specific conclusions about HFT are not. They are not correct primarily because he has a very unrealistic view of the nature of informed trading. Once one recognizes that much informed trading is a form of rent seeking-the point that Hirshleifer made over 40 years ago-most of Stiglitz’s objections to HFT dissolve. Put differently, Stiglitz is right to believe that the financial sector may be too big, in part because there can be excessively strong incentives to collect information and trade on it, but he fails to take this point to its logical conclusion when evaluating HFT.

I do find it rather odd that strongly left-leaning economists like Stiglitz and DeLong who are broadly skeptical of financial markets focus their criticism on one new feature of those markets-HFT-without considering the implications of their broader critiques of the financial sector. At root, their criticism is that much financial market activity is rent seeking. If you believe that, you have to consider how HFT affects these rent seeking activities. Once you do that, it is impossible to sustain the critiques of HFT, because even if there are rent seeking aspects to HFT, it also can reduce other forms of rent seeking.