Streetwise Professor

Given the dreary news emanating from about everywhere, a little levity is needed. And what better way to enjoy a Friday than to exult in Putin’s embarrassment.

Putin went to a rather flamboyantly decorated room to watch the launch of Russia’s new rocket, the Angara. And he sat and watched. And sat and watched. And sat and watched. And nothing happened.

Due to a technical problem, the launch had to be scrubbed.

Some obviously scared military officials reported the bad news to him. (One hopes they planned ahead and wore their Depends!) Then Putin went off on them, saying something like “Yeah-it didn’t work.” (Echoes of his response to a question about the Kursk: “It sank.” I think the “it didn’t work” line was sarcastic. Sort of “no shit Sherlock. Tell me something I can’t see with my own effing eyes.”) He is obviously furious.

But I’d like to help out Vlad. I think I have found the culprit. Look at the gophers that appear at about the 25 second mark in this video:

Obviously Amerikan agents and saboteurs! After all, if the evil Zionists can train sharks and vultures to carry out their fiendish plots, the Americans could train gophers to carry out theirs. Because remember, according to some Russian officials, American plots were responsible for the crashes of the Sukhoi Superjet and the Phobos-Grunt space probe. The theories advanced in those cases were about as plausible as the Gopher Saboteur theory.

And I have video proof of the destructive power of American gophers!

Just ask Bill Murray about them. I’m sure the FSB is trying to get ahold of him now for advice on how to deal with them.

Even if the theory advanced does not involve rodents, I think it’s only a matter of time before there are dark mutterings about the role of the US in this.

Which will only add to the levity.

If the vaults are in China, that is. Over the weekend I posted on the fraudulent commodity-based lending (collateralized by aluminum) in Qingdao. Now a Chinese government auditor claims that the gold used as collateral in $15 billion of loans does not exist.

To put this into context, Goldman (ha!) estimates that there are about $80 billion in loans in China collateralized by gold. Thus, the auditor’s report means that at least 20 percent of those loans are fraudulent. Given that it is likely easier to verify the existence of gold pledged as collateral than is the case for copper or soybeans, this suggests that even higher percentages of these other commodity-based loans (totaling another $80 billion) are backed by warehouse receipts that aren’t worth the paper they are printed on.

This situation creates the conditions for a horrific information contagion, which is the worst sort of systemic risk. Many analyses of systemic risk focus on counterparty credit risk, where the failure of one institution topples a set of interconnected dominoes. But historically, the domino problem has been less of a source of financial crises than information contagion. For instance, information contagion was arguably a far more important cause of the 2008 crisis than counterparty contagion.

Information contagion is a panic that results when the quality of assets in one part of the financial system leads people to question the value of other assets, usually similar but not always. For instance, in 2008,  the problems at Bear and Lehman were the result of bad mortgage investments by these firms. This raised questions about the solvency of other financial institutions that held, or were believed to hold, similar assets. Suddenly all banks became suspect, and had problems funding their assets. They started dumping assets to raise cash, which cratered prices and thereby created problems in institutions that had to mark their assets to a (now depressed) market. Banks that had extended liquidity support to SIVs had to bring them back on their balance sheets, threatening to make them undercapitalized.

Information contagion is most likely to occur, and is most severe when it does, when (a) asset values and balance sheets are opaque, and (b) financial institutions engage in a lot of maturity transformation (i.e., borrowing short to lend long). When asset values and balance sheets are opaque, market participants are more likely to draw inferences from revelations about the values of other firms/assets, because they can’t evaluate the firms/assets directly. In these circumstances, bad news about one firm or one type of asset can lead to a massive loss in confidence in other firms and assets. When these assets are funded with short term borrowings, firms can’t roll over their loans under these conditions, and are more likely to go bankrupt. Moreover, they are more likely to dump assets in fire sales that impose externalities on other firms holding similar assets.

China’s financial system is nothing if opaque. This is particularly true of the shadow banking system, but the banking system is also incredibly murky. For instance, the actual quality of loans on bank books is very difficult to assess. A lot of loans reported as performing are actually quite dodgy.

Information contagion is especially likely because the nature of the revelations about commodity loans raises serious questions about the monitoring of loans and the evaluation of the creditworthiness of borrowers and the quality (and existence!) of their collateral by financial institutions. If banks do a bad job at evaluating commodity loans and borrowers, and commodity collateral, it is reasonable to infer that they do a bad job at monitoring other loans and evaluating other borrowers. It is these sorts of inferences that lead to information contagion.

Moreover, maturity transformation is ubiquitous in China. This is especially true in the shadow banking system.

What this means is that although a few tens of billions of loans backed by non-existent collateral may not seem like a big deal in a financial system with about $17 trillion in credit outstanding (about 35 percent of which is in the shadow sector), the ramifications are far more serious than the value of these commodity loans suggest. There is a serious risk that doubts about the quality of the commodity loans will lead to growing doubts about the quality of other assets, especially in the shadow banking sector.  This creates the potential for panics and runs in that sector, and given the connections between shadow financial institutions and mainstream banks (connections which are themselves opaque) this could spillover into the conventional sector.

In other words, the potential for information contagion in a highly leveraged (with credit at about 250 percent of GDP), highly maturity transformed, and exceedingly opaque financial system is what makes the fraudulent commodity loans a big deal. Potentially a very big deal.

Both the US and Germany are making noise about ratcheting up sanctions on Russia. Kerry told the Russians to disarm separatists “within hours” or else. That was hours ago, and nothing has happened.

Germany’s Merkel has also toughened “sanctions talk.”

Angela Merkel, German chancellor, has raised the prospect of broader economic sanctions against Russia, just two days before an EU summit at which her hardening stance against Moscow is expected to steer the diplomatic agenda.

One theory is that Merkel and Steinmeier are playing good cop, bad cop, with Angela in the role of the heavy. If Merkel is the bad cop, Putin and his clique have absolutely nothing to worry about.

Merkel has talked (relatively) tough before, but has always found some reason to back off. This time, no doubt Putin’s transparently phony call for his senate (and it is his, in the same sense that his dog is his) to repeal the authorization to invade Ukraine will give Merkel the excuse she needs to keep her finger off the sanctions trigger. That plus Putin’s typically convoluted (and contradictory) support for a ceasefire. Meanwhile, the war of subversion in Donbas goes on, transparently supported by Russia. Only those who will not see don’t understand this.

But Angela has found someone to sanction: the US, or more specifically, US telecom Verizon. German outrage over the Snowden revelations was a major reason for the decision.

Yes, there is reason for outrage here–outrage directed at Germany. Here is a nation that bends over backwards to find reasons not to sanction any Russian company. Even the pathetic sanctions  it has meted out (as part of the EU) are directed primarily at individuals, most of whom are nobodies. Talk of sanctioning Russian companies elicits howls of anger and pain from the German business community. There is constant talk of the need to “understand” the Russians, with the result being described by the French proverb “to understand all is to forgive all.” All including the anschluss in Crimea and the ongoing subversion in Ukraine. There is even a German phrase to describe this lot: Putin Verstehers. Putin understanders. Germans-and Merkel in particular-look for the slightest sign of compromise by Putin, and when they see it, they back off doing anything to penalize him, Russia, or any Russian company. Russia/Putin get the benefit of every German doubt.

But evidently the US does not get the benefit of any German doubt. So they sanction Verizon (not my favorite company, by the way) in their very narcissistic pique and outrage over US surveillance of Germany. No attempt to understand the US whatsoever, let alone an attempt to be as understanding as the Germans are with the corrupt autocrat and oligarchic thugs and espionage-crazy security service in the nation to their east.

But oh, there is a lot that the Germans need to understand about why they are a surveillance target, and not given the same deference as the Five Eyes nations. (I will let pass in silence the fact that Germany’s intelligence service the BND has long cooperated with the US.) One thing to understand: the fact that 911 hijackers made themselves at home in Germany. Another thing to understand: German politics and government has long been penetrated by Soviet, and then Russian, agents and collaborators. And yet another thing to understand: the fact that the German business community and government have clearly been suborned by Russian money. German companies (notably Siemens) have been deeply involved in corrupt dealings in Russia. And yet another thing: although it has cleaned up its act some lately, for a long time German businesses assisted Iran in its efforts to develop nuclear weapons.

In brief: Germany has earned the scrutiny that it has received from the NSA. Indeed, its continued enabling of Putin’s behavior just provides further evidence that it is an unreliable partner and uncertain ally that needs watching.

Germany only has the luxury to engage in its moral preening and biting American ankles and corrupt canoodling with the Russians because the US kept out the Russians for 45 years. And I thought the French were ingrates.

Today’s big news is the suit filed by NY Attorney General Eric Schneiderman alleging that Barclays defrauded the customers of its LX dark pool.

In the current hothouse environment of US equity market structure, this will inevitably unleash a torrent of criticism of dark pools. When evaluating the ensuing rhetoric, it is important to distinguish between criticism of dark pools generally, and this one dark pool in particular. That is, there are two distinct questions that are likely to be all tangled up. Are dark pools bad? Or, are dark pools good (or at least not bad), but did Barclays  not do what dark pools are supposed to do while claiming that it did?

What dark pools are supposed to do is protect traders (mainly institutional traders who can be considered uninformed) from predatory traders. Predatory traders can be those with better information, or those with a speed advantage (which often confers an information advantage, through arbitrage or order anticipation). Whether dark pools in general are good or bad depends on the effects of the segmentation of the market. By “cream skimming” the (relatively) uninformed order flow, dark pools make the exchanges less liquid. Order flow on the exchanges tends to be more “toxic” (i.e., informed), and these information asymmetries widen spreads and reduce depth, which raises trading costs for the uninformed traders who cannot avail themselves of the dark pool and who trade on the lit market instead. This means that the trading costs of some uninformed traders (those who can use the dark pools) goes down and the trading costs of some uninformed traders (those who can’t use dark pools) goes up. The distributive effect is one thing that makes dark pools controversial: the losers don’t like them. The net effect is impossible to determine in general, and depends on the competitiveness of the exchange market among other things: even if dark pools reduce liquidity on the exchange, they can provide a source of competition that generates benefits if the exchange markets are imperfectly competitive.

What’s more, dark pools reduce the returns to informed trading.  The efficiency effects of this are also ambiguous, because some informed trading enhances efficiency (by improving the informativeness of prices, and thereby leading to better investment decisions), but other informed trading is rent seeking.

In other words, it’s complicated. There is no “yes” or “no” answer to the first question. This is precisely why market structure debates are so intense and enduring.

The second question is what is at issue in the Barclays case. The NYAG alleges that Barclays promised to protect its customers from predatory HFT sharks, but failed to do so. Indeed, according to the complaint, Barclays actively tried to attract sharks to its pool. (This is one of the problematic aspects of the complaint, as I will show). So, the complaint really doesn’t take a view on whether dark pools that indeed protect customers from sharks are good or bad. It just claims that if dark pools claim to provide shark repellent, but don’t, they have defrauded their customers.

Barclays clearly did make bold claims that it was making strenuous efforts to protect its customers from predatory traders, including predatory HFT. This FAQ sets out its various anti-gaming procedures. In particular, LX performed “Liquidity Profiling” that evaluated the users of the dark pool on various dimensions. One dimension was aggressiveness: did they make quotes or execute against them? Another dimension was profitability. Traders that earn consistent profits over one second intervals are more likely to be informed, and costly for others without information to trade with. Based on this information, Barclays ranked traders on a 0 to 5 scale, with 0 being profitable, aggressive, predatory sharks, and 5 representing passive, gentle blue whales.

Furthermore, Barclays claimed that it allowed its customers to limit their trading to counterparties with certain liquidity profiles, and to certain types of counterparties. For instance, a user could choose not to be matched with a trader with an aggressive profile. Similarly, a customer could choose not to trade against an electronic liquidity provider. In addition, Barclays said that it would exclude traders who consistently brought toxic order flow to the market. That is, Barclays claimed that it was constantly on alert for sharks, and kept the sharks away from the minnows and dolphins and gentle whales.

The NYAG alleges this was a tissue of lies. There are several allegations.

The first is that in its marketing materials, Barclays misrepresented the composition of the order flow in the pool. Specifically,  a graph that  depicted Barclays’ “Liquidity Landscape” purported to show that very little of the trading in the pool was aggressive/predatory. The NYAG alleges that this chart is “false” because it did not include “one of the largest and most toxic participants  [Tradebot] in Barclays’ dark pool.” Further, the NYAG alleges that Barclays deceptively under-reported the amount of predatory HFT trading activity in the pool.

The second basic allegation is that Barclays did not exclude the sharks, and that by failing to update trader profiles, the ability to avoid trading with a firm with a 0 or 1 liquidity profile ranking was useless. Some firms that should have been labeled 0’s were labeled 4’s or 5’s, leaving those that tried to limit their counterparties to the 4’s or 5’s vulnerable to being preyed on by the 0’s. Further, the AG alleges that Barclays promised to exclude the 0’s, but didn’t.

(The complaint also makes allegations about Barclays order routing procedures for its customers, but that’s something of a separate issue, so I won’t discuss that here).

Fraud and misrepresentation are objectionable, and should be punished for purposes of deterrence. They are objectionable because they result in the production of goods and services that are worth less than the cost of producing them. Thus, if Barclays did engage in fraud and misrepresentation, punishment is in order.

One should always be cautious about making judgments on guilt based on a complaint, which by definition is a one-sided representation of the facts. This is particularly true where the complaint relies on selective quotes from emails, and the statements of ex-employees. This is why we have an adversarial process to determine guilt, to permit a thorough vetting of the evidence presented by the plaintiff, and to allow the defendant to present exculpatory evidence (including contextualizing the emails, presenting material that contradicts what is in the proffered emails, and evidence about the motives and reliability of the ex-employees).

Given all this, based on the complaint there is a colorable case, but not a slam dunk.

There is also the question of whether the alleged misrepresentations had a material impact on investors’ decisions regarding whether to trade on LX or not: any fraud would have led to a social harm only to the extent too many investors used LX, or traded too much on it. Here there is reason to doubt whether the misrepresentations mattered all that much.

Trading is an “experience good.” That is, one gets information about the quality of the good by consuming it. Someone may be induced to consume a shoddy good once by deceptive marketing, but if consuming it reveals that it is shoddy, the customer won’t be back. If the product is viable only if it gets repeat customers, deception and fraud are typically unviable strategies. You might convince me to try manure on a cone by telling me it’s ice cream, but once I’ve tried it, I won’t buy it again. If your business profits only if it gets repeat customers, this strategy won’t succeed.

Execution services provided by a dark pool are an experience good that relies on repeat purchases. The dark pool provides an experience good because it is intended to reduce execution costs, and market participants can evaluate/quantify these costs, either by themselves, or by employing consultants that specialize in estimating these costs. Moreover, most traders who trade on dark pools don’t trade on a single pool. They trade on several (and on lit venues too) and can compare execution costs on various venues. If Barclays had indeed failed to protect its customers against the sharks, those customers would have figured that out when they evaluated their executions on LX and found out that their execution costs were high compared to their expectations, and to other venues.  Moreover, dark pool customers trade day after day after day. A dark pool generates succeeds by reducing execution costs, and if it doesn’t it won’t generate persistently large and growing volumes.

Barclays LX generated large and growing volumes. It became the second largest dark pool. I am skeptical that it could have done so had it really been a sham that promised superior execution by protecting customers from sharks when in fact it was doing nothing to keep them out. This suggests that the material effect of the fraud might have been small even had it occurred. This is germane for determining the damages arising from the fraud.

It should also be noted that the complaint alleges that not only did Barclays not do what it promised to keep sharks out, it actively recruited sharks. This theory is highly problematic. According to the complaint, Barclays attracted predatory HFT firms by allowing them to trade essentially for free.

But how does that work, exactly? Yes, the HFT firms generate a lot of volume, but a price of zero times a volume of a zillion generates revenues of zero. You don’t make any money that way. What’s more, the presence of these sharks would have raised the trading costs of the fee-paying minnows, dolphins, and whales, who would have had every incentive to find safer waters, thereby depriving Barclays of any revenues from them. Thus, I am highly skeptical that the AG’s story regarding Barclays’ strategy makes any economic sense. It requires that the non-HFT paying customers must have been enormously stupid, and unaware that they were being served up as bait. Indeed, that they were so stupid that they paid for the privilege of being bait.

It would make sense for Barclays to offer inducements to HFT firms that supply liquidity, because that would reduce the trading costs of the other customers, attracting their volume and making them willing to pay higher fees to trade in the pool.

All we have to go on now is the complaint, and some basic economics. Based on this information, my initial conclusion is that it is plausible that Barclays did misrepresent/overstate the advantages of LX, but that this resulted in modest harm to investors, and that even if the customers of LX got less than they had expected, they did better than they would have trading on another venue.

But this is just an initial impression. The adversarial process generates information that (hopefully) allows more discriminating and precise judgments. I would focus on three types of evidence. First, a forensic evaluation of the LX trading system: did the Liquidity Profile mechanism really allow users to limit their exposure to toxic/predatory order flow? Second, an appraisal of the operation of the system: did it accurately categorize traders, or did Barclays, as alleged in the complaint, systematically mis-categorize predatory traders as benign, thereby exposing traders who wanted to avoid the sharks to their tender mercies? Third, a quantification of the performance of the system in delivering lower execution costs. If LX was indeed doing what a dark pool should do, users should have paid lower execution costs than they would have on other venues. If LX was in fact a massive fraud that attracted customers with promises of protection from predatory traders, but then set the sharks on them, these customers would have in fact incurred higher execution costs than they could have obtained on other venues. At root, the AG alleges that LX promised to lower execution costs, but failed to do so because it did not protect customers from predatory traders: the proof of that pudding is in the eating.

The adversarial judicial process makes it likely that such evidence will be produced, and evaluated by the trier of fact. The process is costly, and often messy, but given the stakes I am sure that these analyses will be performed and that justice will be done, if perhaps roughly.

My bigger concern is  in the adversarial political process. Particularly in the aftermath of Flash Boys, all equity market structure market issues are extremely contentious. Dark pools are a particularly fraught issue. The exchanges (NYSE/ICE and NASDAQ) resent the loss of order flow to dark pools, and want to kneecap them. Many in Congress are sympathetic to their pleas. As I noted at the outset, although the efficiency effects of dark pools are uncertain, their distributive effects are not: dark pools create winners (those who can trade on them, mainly) and losers (those who can’t trade on them, and rent seeking informed traders who lose the opportunity to exploit those who trade on dark pools). Distributive issues are inherently political, and given the sums at stake these political battles are well-funded.

There is thus the potential that the specifics of the Barclays case are interpreted to tar dark pools generally, resulting in a legislative and regulatory over-reaction that kills the good dark pools as well as the bad ones. The facts that AGs are by nature grand-standers generally, and that Schneiderman in particular is a crusader on the make, make such an outcome even more likely.

Given this, I will endeavor to provide an economics-based, balanced analysis of developments going forward. As I have written so often, equity market issues are seldom black and white. Given the nature of equity trading, specifically the central role played by information in it, it is hard to analyze the efficiency effects of various structures and policies. We are in a second best world, and comparisons are complex and messy in that world. In such a world, it is quite possible that both Barclays and the AG are wrong. We’ll see, and I’ll call it as I see it.

News from Iraq careens from bad to worse. In response, Obama is pressuring for changes in the Iraqi government, and providing a minimal force (300 special forces personnel) to aid in the training of Iraqi military and potentially providing targeting for future US airstrikes.

Obama is mainly doing two things. First, saying what he is not going to do, e.g., commit US troops. Second, playing revisionist historian.

Obama is desperate to avoid any blame for the current Middle East sh*t show. So whereas during the 2012 he trumpeted the total withdrawal as US troops, and took credit for ending the war in Iraq, now he says that the bugout was not his doing, but that of the Iraqi government.

The revisionism gets better, which of course means worse. In an interview yesterday, he minimized the importance of ISIS, by comparing it to other Islamic terror organizations like AQAP and Boko Haram:

“Their extreme ideology poses a medium and long-term threat,” the president said, of the group now taking control of large swaths of Iraq.

. . . .

He added that the immediate problem is that ISIS is “destabilizing a country that could spill over,” but they are “just one of a number of organizations that we need to stay focused on,” including al-Qaeda in Yemen and Boko Haram.

To put this in context, consider how Obama described AQAP in his speech justifying his drone campaign (and no, I’m not referring to John Kerry’s diplomacy):

But despite our strong preference for the detention and prosecution of terrorists, sometimes this approach is foreclosed. Al Qaeda and its affiliates try to gain foothold in some of the most distant and unforgiving places on Earth.  They take refuge in remote tribal regions.  They hide in caves and walled compounds.  They train in empty deserts and rugged mountains.

In some of these places — such as parts of Somalia and Yemen — the state only has the most tenuous reach into the territory.  In other cases, the state lacks the capacity or will to take action.  And it’s also not possible for America to simply deploy a team of Special Forces to capture every terrorist.  Even when such an approach may be possible, there are places where it would pose profound risks to our troops and local civilians — where a terrorist compound cannot be breached without triggering a firefight with surrounding tribal communities, for example, that pose no threat to us; times when putting U.S. boots on the ground may trigger a major international crisis.

In other words, mere months ago, Obama characterized AQAP and other groups as “lethal yet less capable al Qaeda affiliates” marooned in far away places. Now he compares ISIS to these groups. This comparison is farcical.

First, the ISIS threat is immediate, not medium to near term. Second, the ISIS threat is far more severe than either AQAP or Boko Haram, because it is a large force capable of taking on main force Iraqi units; it is extremely well-funded (some call it the richest jihadi group ever), and it is located in the cockpit of the Middle East, controlling vast swathes of two major countries, rather than being located in caves and villages in the “most distant and unforgiving places on earth.” What’s more, it’s not just the ideology that matters: it’s the fact that the adherents to this ideology have the power to create a base from which those espousing that ideology can launch attacks on vital US interests.

To equate ISIS with AQAP or Boko Haram is an outrageous distortion of the real threat that ISIS poses. It is grotesque for Obama to minimize this group’s importance, especially because his primary reason for doing so is to attempt to shift blame.

ISIS is wreaking havoc in Iraq now, but for the last couple of years the focus of its activity was Syria. As the Syrian war dragged on, the opposition to Assad became progressively radicalized. ISIS thrived in this environment. What’s more, there is reason to believe that Assad actually supported ISIS by releasing radicals from prison, for instance, and not attacking ISIS the way his forces attacked other opposition groups. This made sense for Assad, because ISIS fought against other opposition groups, including Al Qaeda-linked groups like Al Nusra as well as the Free Syrian Army.

The fact that ISIS metastasized in the years that the Syrian civil war dragged on also makes it necessary for Obama to argue that there was nothing that could have been done to bring the war to a quicker conclusion. And so he does:

The president rejected the idea that the power “vacuum” in Syria, and thus the current threat from ISIS, could have been averted if the U.S. had backed moderate rebels in Syria against Bashar Assad.

“I think this notion that somehow there was this ready-made moderate Syrian force that was ready to defeat al-Assad was simply not true,” he said. “The idea that they could have defeated” Assad and jihadist groups, he added, “if we just sent a few arms, was a fantasy.”

What would an Obama defense be without the ritual slaying of numerous straw men? “Ready made.” “A few arms.” Who ever said these things?

The fact is that the Obama CIA, Pentagon and State Department (!) all recommended arming the opposition, and Obama refused. Meaning that Obama is basically accusing the entire national security establishment-including his appointments to the top jobs in that establishment-of being fantasists.

Of course it is impossible to know whether this would have been decisive, but it is hard to imagine how it could have turned out any worse than it has.

I would further note that Assad was indeed tottering for a time. His bases were falling. Major cities were falling. Troops were deserting. At that time, additional help to the rebels could have been decisive. But Obama demurred. Russia and Iran did not. They rushed support-arms and fuel and money (literally-Putin flew in planeloads of currency) from Russia, arms and fighters (primarily from Hezbollah but also from the Qods force) from Iran. Assad was brought back from the brink, the war turned into stalemate, and the opposition became increasingly radicalized.

Obama is not entirely to blame here, of course. This is the culmination of years of US policy under both Bushes and Clinton. But in Iraq, Obama was like a doctor who ended an antibiotic treatment prematurely, allowing an infection that had been controlled to come back more virulent than before. And the abdication of any role in Syria made inevitable that the opposition would radicalize.

This is where we are. We are confronted with a choice between a pile of dung and a pile of manure. In other words, no good choices. Allying with Iran is insane. Putting in a token force of 300, which will serve in smaller groups that will have to spend most of their time watching their backs because even our ostensible allies hate Americans and are more than willing to kill us, seems a recipe for disaster. The only non-insane, non-virulently anti-American , and militarily capable force in the region is the Kurds. Maybe we should just throw in with them as a way of containing ISIS.

But our biggest obstacle is that the man that has to make the hard choices has proven utterly incompetent in his past decisions, and what’s more, is totally unwilling to acknowledge that he has made any mistakes in the past. Indeed, rather than acknowledge past misjudgments, he engages in wholesale historical revisionism, and misrepresentations of the current threat, in order to deflect blame. With that attitude and mindset, it is almost inevitable that further debacles will follow on his past blunders. Satayana said those who don’t remember the past are condemned to repeat it. The outcome has to be even worse when someone not just doesn’t remember history, but actively and aggressively distorts it, as Obama is doing now.

Stephen Blank, formerly of the Army War College and now of the American Foreign Policy Council, is one of my favorite analysts of Russia. And not just because he is a Chicago PhD. He has written some of the most incisive analyses of Russian foreign policy in the Putin era that I have read.

As an illustration, consider this piece written in 2008. Read it, and you’ll have a very good understanding of what Putin is doing in Ukraine and why.

Two things stand out in Blank’s analysis that are particularly apposite today.

The first relates to Putin’s objectives. Blank shows quite clearly that Putin does not accept the post-Soviet settlement in Europe, and will not countenance any FSU state entering into a formal relationship with the EU, let alone NATO. (Indeed, Putin and the Russian elite do not really recognize Ukraine or Georgia or Armenia or Moldova as sovereign states.)

The second relates to means. The Russians have used frozen conflicts-not war, not peace-to make these places unsuitable for closer integration with Europe.

Both elements are clearly present in Ukraine. Ukraine’s move towards the EU is what precipitated the current crisis. What is going on in Donbas is creating a frozen conflict there. It is more on the not peace end of the not war, not peace spectrum, but Putin has abstained from outright invasion. But as long as the conflict persists, Ukraine will find it very difficult to make the changes necessary to integrate more closely with Europe, and Europe will be reluctant to embrace Ukraine closely.

So Putin does not need to rule Ukraine in order to achieve his primary objective: he just needs to keep it away from Europe. Low level conflict is a proven way of achieving that objective. Putin has employed this in Moldova/Transnistria, Georgia, and Nagorno-Karabakh. It’s worked before, and it is working now. Expect Putin to continue to use this method as long as it continues to work.

He will certainly continue to use it in Ukraine. One needs to ask whether he will attempt to employ it elsewhere. Like the Baltics.

Russia has apparently been developing and implementing the doctrine of low intensity, frozen conflict since the mid-2000s.  The west has proved utterly unable to deal with this. Unless that changes, and NATO develops an effective counter-doctrine, the FSU and eastern Europe may experience an ice age of conflict. Stephen Blank recognized this years ago, and too few paid attention to him. It would be wise to pay heed to him now.

Back in the early-60s, a guy named Tino de Angelis*, owner of the Allied Crude Vegetable Oil Refining Corporation, carried out a huge scam based on commodity finance. He bought soybean oil, against with American Express issued warehouse receipts. De Angelis took the warehouse receipts to banks, who took them as collateral against loans issued to Allied. And not just banks. Companies like Bunge and Proctor and Gamble also lent against the warehouse receipts.

So far, this is routine: commodity traders and processors routinely use their inventories as collateral against loans they use to finance them. The scam came in the fact that Allied obtained loans on non-existent bean oil. De Angelis had a variety of schemes to fool Amex into believing he owned more bean oil than he really did. Some of the tanks at Allied’s facilities did have oil in them, and those would be shown to Amex inspectors. The inspectors would then be led through the firm’s labyrinthine facility, allegedly to another tank to inspect. Except they’d been led back to the tank they had already inspected, but the number on the tank had been changed. Another con was to fill the tanks with water, with some oil sitting on top of the water. Allied also linked the tanks with pipes, and would shuttle the oil between tanks to keep ahead of the inspectors.

Through these means, de Angelis amassed warehouse receipts for quantities of oil that exceeded the entire amount in the US, and borrowed about $200 million against the phantom inventories (well over $1 billion in current dollars). Eventually, inspectors figured out the scheme, and the fraud was uncovered. The revelation caused Amex’s stock price to plummet (Warren Buffet scooped up some and made good money off the deal). Moreover, soybean oil futures also crashed.

De Angelis went to jail. Went released, he tried to run a Ponzi scheme.

This all happened more than 50 years ago: the scam was revealed a few days before JFK was assassinated. But a replay appears to be occurring in China, in the port of Qingdao specifically (though there are concerns that other ports may have similar problems). One trading firm has found to have borrowed large sums collateralized by non-existent aluminum allegedly stored in the port.

This is a major concern because commodity-based lending is a big deal in China, and if the practice is indeed widespread it could result in large losses. Commodity-based lending has been used in carry trades involving using letters of credit to borrow dollars buy commodities (initially mainly copper, but now other metals, iron ore, and ag products) that are imported into China and put in warehouses. The warehouse receipts are then used to collateralize loans in China, the proceeds of which are invested in high yielding, speculative endeavors.

This entire structure was already very fragile (because carry trades are inherently fragile), but if it turns out that even of a modest proportion of the collateral doesn’t exist it could collapse altogether. This could impose substantial losses on many banks. CITIC and Standard Charter are facing losses on the loans to the Qingdao trader. If there are many others, many more banks (and perhaps some western trading firms) could be hit hard.

One note of caution: some (notably Zero Hedge) are saying that collateral has been “rehypothecated.” This is not correct. Rehypothecation involves the lender pledging the collateral received from the original buyer as collateral to a loan. This process may occur several times. This results in the issuance of gross debt that is a multiple of the value of the collateral (the multiple could be as large as the inverse of the “haircut” on the collateral). But the net debt is approximately equal to the value of the collateral, and fraudulent receipts are not created. These collateral chains are potentially fragile, but the fragility does not result from the creation of fraudulent receipts.

In contrast, as described, the Qingdao scheme is like de Angelis’s, in that receipts are issued on non-existent goods. In this scheme, fraudulent receipts are created, and the net debt exceeds the value of the actual collateral. Of course, if the fraudulent receipts are rehypothecated, things will get uglier still.

Dealing with this mess would be hard enough in a jurisdiction with a solid and transparent legal system, reliable judges, and the rule of law. One can just imagine how this will play out in China, which has none of the above.

Then there are potentially broader implications. The commodity loans are one part of China’s vast shadow banking system. Concerns about the fragility of this system abound. If (a) the commodity loan problems are more pervasive, and (b) these problems are symptomatic of shoddy and fraudulent practices in the shadow banking system more generally, there is an appreciable risk of a financial crisis in China.

* Interestingly, de Angelis made money primarily on government programs, namely the National School Lunch Act and Food for Peace.

NATO Secretary-General Anders Fogh Rasmussen has asserted publicly that Russia is covertly funding and coordinating with anti-fracking environmental groups in Europe:

“I have met allies who can report that Russia, as part of their sophisticated information and disinformation operations, engaged actively with so-called non-governmental organisations – environmental organisations working against shale gas – to maintain European dependence on imported Russian gas,” Mr Rasmussen, former Danish prime minister, told an audience at Chatham House, the international affairs think-tank.

This is a classic KGB MO. One that was employed throughout the Cold War. Then peace and disarmament groups were the primary targets. No doubt the Russians have also covertly supported anti-fracking efforts here in the US, but Europe is the focus of their efforts because increased gas production on that continent competes directly with Russian gas, whereas US production is a very indirect, and somewhat distant, threat.

Europe is totally compromised by Russian influence operations, propaganda, and money.  With a few exceptions (e.g., the antitrust action against Gazprom) Europe has been completely feckless in its dealings with Russia. Its energy policies have been particularly self-destructive, putting the EU at the mercy of Russia for the foreseeable future. Some of these self-inflicted wounds would have been suffered even without direct Russian influence (energiewende, for instance, is largely the product of dreamy German romanticism about energy), but by co-opting European energy companies and manipulating European environmental sensitivities Russia has tightened its grip on European energy markets. It exploits this grip for both economic and political gain, with Ukraine being a prominent example of the latter.

I can only imagine the flack that Rasmussen is going to catch for this. For he has committed a mortal sin: speaking a very embarrassing truth. Killing the messenger is the usual remedy.

Putin responded to Ukraine’s promise to sign an Association Agreement with the EU by threatening to raise customs duties on imports from Ukraine. Putin’s justification for this was classic gobbledygook:

“We agreed on the start of consultations at the level of experts,” he recalled, voicing the hope that they would be held at the level of department chiefs and would raise to a ministerial level somewhat later.

“I hope these contacts will begin and we’ll be able to show in detail what the subject of our concerns is,” Putin said as he addressed a conference on agriculture.

He repeated once again what kind of a threat the AA between the EU and Ukraine was posing for Russia. “If specific economic problems arise we won’t be able to keep the zero rate for import customs fees,” Putin said.

Then he gave away the game:

“This doesn’t have anything to do with politics or with the options one or another state selects because each sovereign state has the right to choose its original pathway.”

Meaning, in fact, that it is all about politics and constraining the right of a sovereign state to choose its own pathway.

Putin is willing to accept a negative outcome in Ukraine. That is, his main goal is to prevent Ukraine from moving closer to the west. If it is isolated from the west, he can control it, more or less, without having to actually take over the place. Creating a new frozen conflict serves this purpose. This threat is intended to achieve the same objective.

However, whereas Yanukovych was vulnerable to economic pressure on issues like duties, I don’t think the current government is. That Rubicon has been crossed. So Putin will inflict pain on Ukraine, but it will be unlikely to keep it from moving west, if only because it now understands that it faces a choice between integrating with the west or utter subjugation to Putin and Russia.

In other news, Russian forces are again building up on the Ukrainian border. This is consistent with what I wrote in May. That the drawdown was not a concession by Putin, but was driven by the expiration of the terms of one set of conscripts and the need to muster them out and replace them with   the 2014 cohort. That process completed, the units that have been withdrawn are moving back to the border.

Unfortunately, the political “leadership” in the west sees what it wants to see. It desperately wants to believe that Putin is willing to de-escalate.

Hardly. He wants to maintain the pressure, but with respect to regular military units operates subject to the severe constraints of a decrepit manpower system.

While I’m doing the SWP Itoldyasopalooza, three more items.

First, the CFTC has reopened comments on the position limits proposed rule. The CFTC has taken intense incoming fire on the issue of hedge exemptions in particular, and with good reason. There are many problems, but the most egregious is the restriction on “cross hedges” (e.g., using gas futures as a hedge against electricity price risk).

I discussed this issue in my comment letter to the CFTC. Here’s the gist of the problem. The CFTC calculates the hedging effectiveness (measured by the R2 in a regression) of nearby NG futures for spot electricity prices. It finds the effectiveness is low (i.e., the R2 in the relevant regression is small). Looking past the issue of how some risk reduction is better than nothing, this analysis betrays a complete misunderstanding of electricity pricing and how NG futures are used as hedges.

Spot electricity prices are driven by fuel prices, but the main drivers are short term factors such as load shocks (which are driven by weather) and outages. However, these spot-price drivers mean revert rapidly. A weather or outage shock damps out very quickly.

This means that forward power prices are primarily driven by forward fuel prices, because fuel price shocks are persistent while weather and outage shocks are not. So it makes perfect sense to hedge forward power price exposure with gas futures/forwards. The CFTC analysis totally misses the point. Firms don’t use gas forwards/futures to hedge spot power prices. They are using the more liquid gas futures to hedge forward power prices. This is a classic example of hedgers choosing their hedging instrument to balance liquidity and hedging effectiveness. Gas forwards provide a pretty good hedge of power forward prices, and are are more liquid than power forwards. Yes, power forwards may provide a more effective hedge, but that’s little comfort if they turn out to be roach motels that a hedger can check into, but can’t leave if/when it doesn’t need the hedge any more.

The CFTC  ignores liquidity, by the way. How is that possible?

Market participants have strong incentives to make the liquidity-hedging effectiveness trade off efficiently. They do it all the time. Hedgers live with basis risk (e.g., hedging heavy crude with WTI futures) because of the liquidity benefits of more heavily traded contracts. The CFTC position limit rule substitutes the agency’s judgment for that of market participants who actually bear/internalize the costs and benefits of the trade-off. This is a recipe for inefficiency, made all the more severe by the CFTC’s utter failure to understand the economics of the hedge it uses to justify its rule.

As proposed, the rule suggests that the CFTC is so paranoid about market participants using the hedge exemption to circumvent the limit that it has chosen to sharply limit permissible hedges. This is beyond perverse, because it strikes at the most important function of the derivatives markets: risk transfer.

(This issue is discussed in detail in chapter 8 of my 2011 book. I show that the “load delta” for short term power prices is high, but it is low for forward prices. Conversely, the “fuel price delta” is high for power forward prices, precisely because load/weather/outage shocks damp out quickly. The immediate implication of this is that fuel forwards can provide an effective hedge of forward power prices.)

Second, Simon Johnson opines that “Clearing houses could be the next source of chaos.” Who knew? It would have been nice had Simon stepped out on this 5 years ago.

Third, the one arguably beneficial aspect of Frankendodd and Emir-the creation of swaps data repositories-has been totally-and I mean totally-f*cked up in its implementation. Not content with the creation of a single Tower of Babel, American and European regulators have presided over the creation of several! Well played!

Reportedly, less than 30 percent of OTC deals can be matched by the repositories.

This too was predictable-and predicted (modesty prevents me from mentioning by whom). Repositories are natural monopolies and should be set up as utilities. A single repository minimizes fixed costs, and facilitates coordination and the creation of a standard. I went through this in detail in 2003 when I advocated the creation of an Energy Data Hub. But our betters decided to encourage the creation of multiple repositories (suppositories?) with a hodge-podge of reporting obligations and inconsistent reporting formats.

This brings to mind three quotes. One by Ronald Reagan: “‘I’m from the government and here to help you’ are the 8 scariest words in the English language.” The other two by Casey  Stengel. “Can’t anybody play this game?” and “He has third base so screwed up, nobody can play it right.”