Streetwise Professor

In earlier posts I pointed out a couple of loopholes in the sanctions related to derivatives. Derivatives were explicitly excluded from the mid-July US sanctions imposed on Rosneft and other companies.

One loophole is that US persons can effectively provide credit to Rosneft and other firms subject to US sanctions but not to sanctions by the EU (or other foreign jurisdictions) by selling credit protection on the sanctioned companies to non-US person financial institutions, who could then expand their lending to offset the effect of the inability of US financial institutions to lend directly.

The other loophole is that a sanctioned firm (even one sanctioned by the EU, because its sanctions will evidently include the same loophole) can synthetically create a long-term bond that it cannot issue directly due to the sanctions by borrowing for 90 days, rolling the borrowing, and entering into a payer swap. The swap would effectively convert the floating, short-term rate into a longer-term fixed rate, thereby substituting for a prohibited long-term loan or debt security.

Neither of these is perfect substitutes for the banned transactions, but they are fairly close substitutes.

According to Bloomberg, the US Treasury is considering adding derivatives and short term borrowings to the list of transactions prohibited under the sanctions:

The U.S. might move to limit derivatives trading and short-term loans with Russian companies if sanctions already imposed fail to sway President Vladimir Putin to end support for rebels in eastern Ukraine.

U.S. citizens and businesses are still permitted to trade in outstanding debt of any maturity and new short-term debt and derivatives with sanctioned Russian companies. Restrictions on money-market financing and derivatives could be imposed if tougher penalties are necessary, said a Treasury Department official who asked not to be named because further options are still being discussed.

These limits would close off the loopholes that exploit derivatives and short-term borrowing.

I wonder whether these moves had been considered all along, or whether UST learned that financial institutions and sanctioned companies were exploring those loopholes. Interesting development, regardless.

I’ve been meaning to write about how derivatives are treated in bankruptcy, but it’s a big topic and I haven’t been able to get my hands around it. But this article from Bloomberg merits some comment, because it suggests that market participants, led by ISDA, are moving to a partial change that could make things worse if the bankruptcy code treatment of derivatives remains the same.

Derivatives benefit from a variety of “safe harbors” in bankruptcy. They are treated very differently than other financial contracts. If a firm goes bankrupt, its derivatives counterparties can offset winning against losing trades, and determine a net amount. In contrast, with normal debts, such offsets are not permitted, and the bankruptcy trustee can “cherry pick” by not performing on losing contracts and insisting on performance on winning ones. Derivatives counterparties can immediately access the collateral posted by a bankrupt counterparty. Other secured debtors do not have immediate access to collateral. Derivatives counterparties are not subject to preference or fraudulent conveyance rules: the bankruptcy trustee can claw back cash taken out of a firm up to 90 days prior to its bankruptcy, except in the case of cash taken by derivatives (and repo) counterparties. Derivatives counterparties can immediately terminate their trades upon the bankruptcy of a trading partner, collect collateral to cover the bankrupt’s obligations, and become an unsecured creditor on the remainder.

It is this ability to terminate and grab collateral that proved so devastating to Lehman in 2008. Cash is a vital asset for a financial firm, and any chance Lehman had to survive or be reorganized disappeared with the cash that went out the door when derivatives were terminated and collateral seized. It is this problem that ISDA is trying to fix, by writing a temporary stay on the ability of derivatives counterparties to terminate derivatives contracts of a failed firm into standard derivatives contract terms.

That sounds wonderful, until you go back to previous steps in the game tree. The new contract term affects the calculations of derivatives counterparties before a tottering firm actually declares bankruptcy. Indeed, as long as preference/fraudulent conveyance safe harbor remains, the new rule actually increases the incentives of the derivatives counterparties to run on a financially distressed, but not yet bankrupt, firm. This increases the likelihood that a distressed firm actually fails.

The logic is this. If the counterparties keep their positions open until the firm is bankrupt, the stay prevents them from terminating their positions, and they are at the mercy of the resolution authority. They are at risk of not being able to get their collateral immediately. However, if they use some of the methods that Duffie describes in How Big Banks Fail, derivatives counterparties can reduce their exposures to the distressed firm before it declares bankruptcy, and crucially, get their hands on their collateral without having to worry about a stay, or having the money clawed back as a preference or fraudulent conveyance.

Thus, staying derivatives in a bankrupt firm, but retaining the safe harbor from preference/fraudulent conveyance claims, gives derivatives counterparties an incentive to run earlier. Under the contracts with the stay, they are in a weaker position if they wait until a formal insolvency than they are under the current way of doing business. They therefore are more likely to run early if derivatives are stayed.

This means that this unbalanced change in the terms of derivatives contracts actually increases the likelihood that a financial firm with a large derivatives book will implode due to a run by its counterparties. The stay may make things better conditional on being in bankruptcy, but increase the likelihood that a firm will default. This is almost certainly a bad trade-off. We want rules that reduce the likelihood of runs. This combination of contract terms and bankruptcy rules increases the likelihood of runs.

This illustrates the dangers of piecemeal changes to complex financial systems. Strengthening one part can make the entire system more vulnerable to failure. Changing one part effects how the other parts work, and not always for the better.

Rather than fixing single parts one at a time, it is essential to recognize the interdependencies between the pieces. The bankruptcy rules have a lot of interdependencies. Indeed, the rules on preferences/fraudulent conveyance are necessary precisely because of the perverse incentives that would exist prior to bankruptcy if claims are stayed in bankruptcy, but creditors can get their money out of a firm before bankruptcy. Stays alone can make things worse if the behavior of creditors prior to a formal filing is not constrained. All the pieces have to fit together.

The Bloomberg article notes that the international nature of the derivatives business complicates the job of devising a comprehensive treatment of derivatives in bankruptcy: harmonizing bankruptcy laws across many countries is a nightmare. But the inability to change the entire set of derivatives-related bankruptcy rules doesn’t mean that fixing one aspect of them by a contractual change makes things better. It can actually make things worse.  It is highly likely that imposing a stay in bankruptcy, but leaving the rest of the safe harbors intact, will do exactly that.

ISDA appears to want to address in the worst way the problems that derivatives can cause in bankruptcy. And unfortunately, it just might succeed. ISDA should stay its hand, and not derivatives in bankruptcy, unless other parts of the bankruptcy code are adjusted in response to the new contract term.

This story from the Independent has gone viral, and for understandable reasons: it claims that Germany and Russia are negotiating a scurrilous deal behind Ukraine’s back.

More controversially, if Ms Merkel’s deal were to be acceptable to the Russians, the international community would need to recognise Crimea’s independence and its annexation by Russia, a move that some members of the United Nations might find difficult to stomach.

Sources close to the secret negotiations claim that the first part of the stabilisation plan requires Russia to withdraw its financial and military support for the various pro-separatist groups operating in eastern Ukraine. As part of any such agreement, the region would be allowed some devolved powers.

At the same time, the Ukrainian President would agree not to apply to join Nato. In return, President Putin would not seek to block or interfere with the Ukraine’s new trade relations with the European Union under a pact signed a few weeks ago.

Second, the Ukraine would be offered a new long-term agreement with Russia’s Gazprom, the giant gas supplier, for future gas supplies and pricing. At present, there is no gas deal in place; Ukraine’s gas supplies are running low and are likely to run out before this winter, which would spell economic and social ruin for the country.

As part of the deal, Russia would compensate Ukraine with a billion-dollar financial package for the loss of the rent it used to pay for stationing its fleets in the Crimea and at the port of Sevastopol on the Black Sea until Crimea voted for independence in March.

However, these attempts by Ms Merkel to act as a broker between President Putin and the Ukraine’s President, Petro Poroshenko, were put on the back-burner following the shooting down of the MH17 plane in eastern Ukraine.

But insiders who are party to the discussions said yesterday that the “German peace plan is still on the table and the only deal around. Negotiations have stalled because of the MH17 disaster but they are expected to restart once the investigation has taken place.”

Pretty explosive stuff. So explosive, in fact, I have a difficult time accepting that the story is anywhere near true, at least insofar as the implication that this is Merkel’s plan is concerned.

If it was true, and Merkel were indeed negotiating a deal along these lines, she would indeed deserve the Frau Ribbentrop epithet that has been hurled at her, especially after her chumminess with Putin in Rio.

There are so many issues here.

First, it is not Germany’s place to negotiate a deal that binds Ukraine, even as a broker that intends to present the deal to Ukraine for its approval later. That would rightly be seen as a stab in the back. Germany’s imprimatur on such a deal-and the fact that it negotiated the deal would inevitably lead people to conclude that Germany vouches for it-would be perceived by Ukraine as a betrayal and abandonment, and an exertion of tremendous pressure to capitulate by a country that it had counted on to be a supporter.

Second, no Ukrainian government could possibly accept these terms. So Merkel is either delusional to think that they would, or she is setting up the Ukrainians to take the blame for rejecting a chance at “peace”, thereby allowing her to wash her hands of the situation and let Putin do as he will. Delusional or Machiavellian manipulator. Quite the choice.

Third, the recognition of Russia’s theft of Crimea, even if compensated by thirty pieces of silver in exchange for lost rent on Sevastapol, would completely undermine a fundamental principle of the modern international order, namely that the border of no state should be changed by force. For a country like Germany, which portrays itself as a Rechtsstaat on international as well as domestic matters, this would be an amazing and despicable action. The precedent would be very ominous indeed. It is hard to imagine anything more threatening to peace and stability as such an endorsement of revanchism, irredentism, and the dominance of might over right.

Fourth, the US and UK, and perhaps other countries, would in no way countenance such an outcome, in part because of the dangerous precedent it would set.

Fifth, Ukraine is looking to free itself from abject dependence on Russian gas, rather than to cement that dependence into the distant future.

These considerations are so grave that I cannot believe that Germany would be doing what the Independent alleges.

So what is the real story here?

The Independent is owned by Alexander Lebedev, an ex-KGB officer and ex-billionaire. He has had a fraught relationship with Putin. He co-owns, along with Gorbachev, the opposition paper Novaya Gazeta. On the surface he is not an obvious Putin shill, and may be an opponent: maybe he ran the story to torpedo a deal that Putin wants. But he could be under pressure. Or he could be wanting to curry favor in Moscow, and thinks this would help him do so. So maybe the story has its roots in the murky world of Putin and rich Russians.

The story paints Merkel in a very bad light: maybe it has been leaked (and slanted) by one of her foes, domestic or foreign. Or maybe someone thinks that she will have to distance herself from the allegations of treachery by becoming more stern in her stance against Putin.

Or maybe this has been planted by the Russians. It could be their statement of the terms they are willing to offer, and to accept. Perhaps Putin even presented it to Merkel, and maybe more than once. Perhaps Merkel rejected it, or she presented a counterproposal and continues to talk, which could be twisted by the Russians to suggest that she has endorsed the basics of the proposal.

I don’t know. But I do know one thing. It is precisely this sort of story, and the possibility that it has its roots in the truth, that makes it imperative that the United States collect intelligence on Germany, German leaders, and German dealings with foreign governments-especially governments like Russia’s. This is exactly why we spy, and why large and important countries that endeavor to exercise their sovereign right to craft and implement an independent foreign policy, are legitimate targets of spying. Germany pursues its interests, and in that pursuit, it might seriously damage American interests. Thus, it is in our vital national interest to know what Germany is up to.*

That’s the price you pay when you want to be an independent actor on the world stage, so Germans from Angela on down can spare us their outraged protests at American espionage.

* Which suggests yet another explanation for the Independent story. Namely, the source is US (or UK, or Ukrainian, or . . . even German) intelligence, which is leaking it to torpedo a perfidious Merkel deal.

I owe the Euros an apology. It turns out that they did implement most of the sanctions recommended in the “non-paper.” So it proved to be more than an orphan straw man.

That said, upon further consideration, there is less here than could have been hoped for. Indeed, these sanctions will impose little real damage on Russia.

There are three major pieces of the new European sanctions. First, Europeans (including foreign subsidiaries and branches of non-EU banks) are prohibited from buying new equity or debt with maturity of greater than 90 days from Russian banks with more than 50 percent state ownership. Second, there is a ban on the sale of oil technology and equipment. Third, there is an arms sales ban.

The US has implemented similar measures, with one peculiar exception: Sberbank is not included in the US sanctions, though it is in the European sanctions.

The bank sanctions are getting the most attention, but they are hardly devastating. I only had enough time today to look at the international borrowings of Sberbank, VTB, and VEB. Sberbank’s foreign debt borrowings total only about 4 percent of its total liabilities, and only a small fraction of those mature in the next year. Therefore, the sanctions put no immediate pressure on Sberbank, especially since it still can borrow from US persons. VTB’s foreign debt with maturities in 2014 and 2015 is no more than 6 percent of its total liabilities: I can’t be more precise because its financial statements only report broad maturity categories. VEB’s total Eurobond issues are about 8 percent of its liabilities: again, only a fraction of these are due in the next year or so.

Loss of this funding would be something of a strain, but the sums involved could readily be replaced by drawing on Russian foreign reserves and borrowing from non-EU and non-US banks.

What’s more, a little financial engineering permits these institutions to circumvent the effect of the sanctions. It seems that they can still enter into derivatives trades: derivatives are explicitly excluded from US sanctions. Since under the sanctions the banks can still borrow with 90 day maturities, they can create a synthetic long term loan with a fixed interest rate by borrowing for 90 days on a rolling basis, and enter into receive floating-pay fix swaps. Yes, there still is some risk here: if sanctions are extended to prevent even short term borrowings, the banks following this strategy would have a short swap position and no offsetting floating rate borrowings.

In brief, the sanctioned banks aren’t heavily dependent on European or US debt markets for their funding; the Russian government has the resources to cover this funding gap; and there is a somewhat riskier alternative (borrow short-term and hedge via swaps). Thus, although it would be unfair to say that the financial sanctions merely damage a few capillaries, it is definitely the case that they don’t come anywhere close to striking at Russia’s financial jugular. They are annoyance, and no more.

It is also important to note that the European sanctions do not target Rosneft. So the Russian oil company still has access to European (and Asian) debt and equity markets. As I noted before, this significantly cushions the blow on the Russian firm.

Insofar as the weapons ban is considered, it is largely symbolic because Russia builds most of its own weaponry. Predictably, existing deals are exempted. Meaning that France can continue with its sales of Mistral assault ships.

A bigger threat to the second Mistral sale is yesterday’s arbitration verdict in the Yukos litigation. If Russia doesn’t pay the $50 billion by January-a metaphysical certainty-the winning claimants can move to seize non-diplomatic Russian government assets in countries that are signatories to the New York Arbitration Convention. Conceivably the claimants could attempt to seize the second Mistral-the Vladivostok, ominously slated for service in the Med and Black Seas-while it is still in France. But no doubt the Russians and French could circumvent this by transferring ownership only after the ship had sailed to Russia. (As an aside, the main effect of the arbitration verdict will be to ensure employment of large number of lawyers for years, because the Russians will fight every attempt to enforce the award by seizing government assets abroad tooth and nail. It is a welcome verdict, but its immediate financial impact on Russia will be pretty much nil.)

The sanctions on oil equipment will have little impact in the near term, and since the European sanctions are time limited, their effect will be diminished even further.

In sum, the new sanctions are far beyond what had been imposed before, but they are still not that damaging to Russia. Putin can legitimately say “’tis but a scratch,” and not in the Black Knight, Monty Python, I’m not going to admit I’m wounded sense.

The United States in particular still has the power to leave Putin financially limbless and bleeding, pitifully claiming his invincibility. But that would require hacking away with a real banking broadsword: cutting off Russian access to dollar markets altogether. But there is no appetite to do this in the west: the Europeans had to screw up their courage to the sticking place to implement even these limited sanctions. And Obama has little appetite for this either: his sanction announcement today was delivered in a listless, phone-it-in fashion, before he ran off to fly to Kansas City for some silly event involving meeting people who had written him letters. He is obviously not engaged in this at all.

The Europeans and Obama believe that they are engaged in a nuanced strategy of graduated escalation that will convince Putin that continued attempts to subvert Ukraine through force will eventually result in Russia incurring unbearable financial costs, and that this will deter him from going further.

Ask the shades of LBJ and McNamara about how hardened dictators interpret graduated escalation. They interpret it as a signal of weakness, not resolve. If anything, it urges them to go further. I would anticipate that this will be true today, with Putin.

Going back to the original round of sanctions, I have been arguing that the terms of US sanctions have been left deliberately vague in order to make  banks and investors very cautious about dealing with sanctioned firms. Spreading fear, uncertainty, and doubt-FUD-leverages the effect of sanctions.

When I read the last round of sanctions, I had many questions, and hence many doubts about actually how far the sanctions would reach. I was not alone. Professionals-lawyers at banks and Wall Street law firms-are also uncertain:

But compliance officers at some U.S. banks and broker-dealers say the sanctions, issued by Treasury’s Office of Foreign Assets Control (OFAC), are not clear enough. That has left financial institutions guessing, in certain instances, at how to comply. They worry they are vulnerable to punitive action by U.S. regulators.

Fear, uncertainty, and doubt, all in one paragraph. The fear part is particularly interesting, and quite real, especially in the aftermath of the truly punitive action by U.S. regulators in the BNP-Paribas case.

OFAC-The Office of Foreign Asset Control, which is in charge of overseeing the sanctions-is in no hurry to clarify matters:

Another senior compliance officer at a major U.S. bank said bankers “are frustrated that OFAC is not providing more guidance.”

The day after the sanctions were issued, OFAC held a conference call with hundreds of financial services industry professionals in an effort to answer concerns. Although some issues were cleared up, others were left undecided, said two sources who were on the call.

Dear Mr. Senior Compliance Officer: that’s on purpose. Believe me.

A new round of sanctions may be imminent. I am hoping to be proven wrong in my forecasts, because reports are that the Europeans are going to do something serious. Add serious doubts to serious action, and American and European banks won’t touch most Russian banks or major companies with a 10 foot pole while wearing a hazmat suit. That will cause some major economic problems for Putin and Russia. Not 1998-magnitude problems, but maybe something bordering on 2008 problems, although a $100+ oil price will help contain the damage, despite the added difficulties that sanctions will create for the Russians to cash the checks for that oil.

Then it will be Vlad’s move. What that move will be, I do not know.

The NYT ran a long article yesterday describing the administration’s Hamlet-like agonizing over whether to provide Ukraine with real time intelligence useful for targeting rebel forces. (For the record, I called for this in the immediate aftermath of the flight of Yanukovych. It should be an easy decision.)

One part jumped out at me:

“We’ve been cautious to date about things that could directly hit Russia — principally its territory,” but also its equipment, the official said. A proposal to give the Ukrainians real-time information “hasn’t gotten to the president yet,” the official said, in part because the White House has been focused on rallying support among European allies for more stringent economic sanctions against Moscow, and on gaining access for investigators to the Malaysia Airlines crash site.

There in a nutshell is the passivity of this president, and his negation of executive leadership.

An active and engaged leader would not be waiting for things to reach him. He would be demanding that a full range of options be presented to him immediately, if not sooner. This situation has been metastasizing for months. What’s more, in the aftermath of the MH17 atrocity, and the rebels’ ongoing use of artillery and MLRS systems against civilian targets, the suppression of their weapons systems is both a military and humanitarian imperative. The time for action passed long ago, but it is incomprehensible that 10 days after MH17 that Obama has personally avoided considering, let alone ordering, a reasonable, measured US action that would materially assist Ukraine to defend itself, and which would not put one US serviceman or woman at risk.

Also look at the excuse: he’s focused on the diplomatic channel. This is particularly rich a week after Obama flacks in the administration and media responded to criticisms about his fundraiser-dominated schedule by saying that he can multi-task. So, he can’t simultaneously push the Europeans and evaluate steps to aid the Ukrainian government? What happened to that vaunted multi-tasking capability?

Further, military and diplomatic measures are complementary, and need to be processed in parallel rather than serially.

Another thing that stands out in the article is the hand-wringing about “provoking Russia”:

“The debate is over how much to help Ukraine without provoking Russia,” said a senior official participating in the American discussions.

Look. To Putin, anything short of outright capitulation by Ukraine, and the complete abandonment of Ukraine by the US and the EU is a provocation. Let’s not forget what “provoked” this crisis in the first place: Ukraine’s temerity in moving to sign a trade deal with the EU. Continued Ukrainian resistance is all the provocation Putin needs. Anything the US or EU does will have the merest of effects on Putin’s insatiable desire to subjugate Ukraine.

That’s not quite true, actually. Continued passivity, and waiting for the USPS to deliver military options to POTUS, encourages Putin’s aggressiveness. Weakness and passivity are extremely provocative to Putin.

As to another objection-that disloyal individuals in the Ukrainian leadership will provide the information to Russia: this is a non-issue. Yes, such leaks could undermine the effectiveness of the intelligence, by permitting the rebels to move to avoid a strike. But if they are moving, they aren’t shooting. What’s more, given the realities of communication, it is highly unlikely that  truly real-time information useful for targeting could make it to the rebels before it reached the Ukrainian air or artillery units tasked to strike them. Further, attempts by disloyal elements to communicate with the rebels could actually facilitate their discovery, especially if the information is tightly compartmentalized.

As for the Ukrainians getting to rambunctious if they have better information, the US has the option to cut off the information at any time, and to place conditions on its use. If anything, provision of this intelligence will focus Ukrainian military efforts leading to less risk of misguided strikes on civilians or Russia.

In sum, this should be about as easy a decision as a commander in chief should have to make. But because he has clearly signaled that he wants to distance himself from serious involvement with the Ukrainian military efforts against insurrectionists, subordinates and bureaucrats are consciously choosing not to present him with the options that a real leader would be demanding from them.

Tomorrow is the 150th anniversary of the Battle of Ezra Church, the third of Hood’s assaults against Sherman’s army that attempted to stop the encirclement of Atlanta.

The story of the battle is relatively simple. After cutting the rail line leading into the city from the east, Sherman moved in what has been characterized as one of his whip-like movements to cut the line running in from Macon to the west. As always, the Army of the Tennessee was the tip of the whip. As it moved south to the west of the city, Hood moved Stephen D. Lee’s and Alexander P. Stewart’s corps out of the city’s defenses in the hopes of surprising the Army of the Tennessee (now under the command of very Eastern general Oliver O. Howard, much to the chagrin of very Western general John A. Logan). But the Union troops anticipated the attack, deployed from their marching formation and formed a V-shaped line. Like veterans on all fronts by the summer of 1864, they immediately started to dig in. Not so much dig, really as collect logs, lumber, and even the pews from Ezra Church, which they piled up to form a makeshift breastwork. Here are some contemporary woodcuts that show the impromptu entrenchments:

The battle itself was never really in doubt. The Confederates gained ground on the Union right flank, but Logan (back in command of the XVth Corps) led a counterattack by two regiments (the 40th Illinois and 6th Iowa) which drove off the Rebels. The Iowans lost Major Ennis, a beloved officer who had served since Shiloh.

The 46th Ohio fought at Ezra Church. One of its members, Sergeant Harry Davis, won the Medal of Honor by advancing in front of the lines to wrest a flag from its dying bearer, as illustrated here in another contemporary print:

Other than the fleeting success on the Union right, the Confederate assaults made no progress. The casualties tell the tale. The Union lost about 650 men, the Confederates almost 5 times as many. Of the three assaults in July, this was the one with most disparate losses and the least tactical success. Whereas the Confederates did achieve some local successes at Peachtree Creek and Atlanta. They achieved none at Ezra Church.

The responsibility for actually carrying out the attack lies with Stephen D. Lee. Hood was performing the role of army commander, remaining at his headquarters in Atlanta.

Speaking of Hood, my Battle of Atlanta post generated several thoughtful comments about him. Serendipitously, this weekend I saw a program on CSPAN3 (yes, I am that much of a geek about this stuff) in which a biographer of Hood, Stephen Hood (a distant relation) made a pretty persuasive case that Hood has been unfairly maligned. He presented evidence that many of the anecdotes told at Hood’s expense were specious. He was particularly critical of historian Wiley Sword (whom I know some) for distorting the evidence in his savage attacks on Hood’s generalship, his humanity, and indeed his mental health. He further claims that there is no evidence that Hood actually used opiates, though of course absence of evidence is not definitive evidence of absence.

Overall, his defense was somewhat persuasive, though it cannot and did not answer the brutal facts of Franklin and Nashville. When time permits, I might dig into the sources cited by Hood and Sword to see who gets the better of the argument. Maybe I’ll have a chance to do that by the end of November, when the sesquicentennial of Franklin rolls around.

The Daily Beast (what a moronic name, but whatever) ran an article yesterday quoting the commander in the Donetsk People’s Republic, Igor Girkin, whinging about the impending doom of his forces, and the lack of support from Putin. (And no, I will not indulge his vanity by referring to him by his self-chosen nom de guerre.)

Maybe. But coming as it did barely a week after the destruction of MH17 by Girkin’s forces, I can think of another explanation. By seemingly attacking Putin, Girkin is actually helping him.

Putin has been striving mightily to maintain the fiction that the forces in Donetsk and Luhansk are not under his control. That they are an indigenous movement battling against the fascist regime in Kiev.

The need to do this has only increased in the aftermath of the shoot down of the Malaysian jetliner, and the murder of 298 individuals. Now the connection between Russia and the rebels is even more threatening to Putin.

What better way to do this than have the head of the rebels complain about a lack of Russian support?

So maybe Girkin’s complaints are genuine. But it is all to convenient for Putin for him to claim that he has been abandoned by the Russian president, precisely at the time when connections with the rebels are a threat to Putin. Yes, that could cause problems for Putin with the nationalists in Russia, but he likely figures that he can control internal dissenters. The international dynamic is more threatening. The Girkin complaint therefore on balance works for Putin.

Note that this is occurring at a time when if anything, Russian support for the insurgents in the Donbas is increasing, with the US claiming that Russia is shelling Ukraine from Russian territory, and arranging to dispatch even more powerful multiple rocket launch systems over the border.

So take anything that Girkin says with a huge dose of skepticism. Paradoxically, Putin is better able to provide more support to the rebels, the more plausibly he can disclaim that he is supporting them. Girkin is providing Putin the cover he needs.

We are dealing with KGB/FSB and GRU spooks here: Putin, obviously, and Girkin is allegedly a long-time FSB operative. Deception and misdirection are their most tried and true methods. You cannot take anything they say at face value. Public pronouncements are constructed to achieve a strategic or tactical objective. Right now, Putin needs to blur the connection with the Russian combatants in Ukraine. And lo and behold, Girkin delivers. It is Putin that is in the pickle, and Girkin is doing his best to get him out.

Pricing benchmarks have been one of the casualties of the financial crisis. Not because the benchmarks-like Libor, Platts’ Brent window, ISDA Fix, the Reuters FX window or the gold fix-contributed in an material way to the crisis. Instead, the post-crisis scrutiny of the financial sector turned over a lot of rocks, and among the vermin crawling underneath were abuses of benchmarks.

Every major benchmark has fallen under deep suspicion, and has been the subject of regulatory action or class action lawsuits. Generalizations are difficult because every benchmark has its own problems. It is sort of like what Tolstoy said about unhappy families: every flawed benchmark is flawed in its own way. Some, like Libor, are vulnerable to abuse because they are constructed from the estimates/reports of interested parties. Others, like the precious metals fixes, are problematic due to a lack of transparency and limited participation. Declining production and large parcel sizes bedevil Brent.

But some basic conclusions can be drawn.

First-and this should have been apparent in the immediate aftermath of the natural gas price reporting scandals of the early-2000s-benchmarks based on the reports of self-interested parties, rather than actual transactions, are fundamentally flawed. In my energy derivatives class I tell the story of AEP, which the government discovered kept a file called “Bogus IFERC.xls” (IFERC being an abbreviation for Inside Ferc, the main price reporting publication for gas and electricity) that included thousands of fake transactions that the utility reported to Platts.

Second, and somewhat depressingly, although benchmarks based on actual transactions are preferable to those based on reports, in many markets the number of transactions is small. Even if transactors do not attempt to manipulate, the limited number of transactions tends to inject some noise into the benchmark value. What’s more, benchmarks based on a small number of transactions can be influenced by a single trade or a small number of trades, thereby creating the potential for manipulation.

I refer to this as the bricks without straw problem. Just like the Jews in Egypt were confounded by Pharoh’s command to make bricks without straw, modern market participants are stymied in their attempts to create benchmarks without trades. This is a major problem in some big markets, notably Libor (where there are few interbank unsecured loans) and Brent (where large parcel sizes and declining Brent production mean that there are relatively few trades: Platts has attempted to address this problem by expanding the eligible cargoes to include Ekofisk, Oseberg, and Forties, and some baroque adjustments based on CFD and spread trades and monthly forward trades). This problem is not amenable to an easy fix.

Third, and perhaps even more depressingly, even transaction-based benchmarks derived from markets with a decent amount of trading activity are vulnerable to manipulation, and the incentive to manipulate is strong. Some changes can be made to mitigate these problems, but they can’t be eliminated through benchmark design alone. Some deterrence mechanism is necessary.

The precious metals fixes provide a good example of this. The silver and gold fixes have historically been based on transactions prices from an auction that Walras would recognize. But participation was limited, and some participants had the market power and the incentive to use it, and have evidently pushed prices to benefit related positions. For instance, in the recent allegation against Barclays, the bank could trade in sufficient volume to move the fix price sufficiently to benefit related positions in digital options. When there is a large enough amount of derivatives positions with payoffs tied to a benchmark, someone has the incentive to manipulate that benchmark, and many have the market power to carry out those manipulations.

The problems with the precious metals fixes have led to their redesign: a new silver fix method has been established and will go into effect next month, and the gold fix will be modified, probably along similar lines. The silver fix will replace the old telephone auction that operated via a few members trading on their own account and representing customer orders with a more transparent electronic auction operated by CME and Reuters. This will address some of the problems with the old fix. In particular, it will reduce the information advantage that the fixing dealers had that allowed them to trade profitably on other markets (e.g.,. gold futures and OTC forwards and options) based on the order flow information they could observe during the auction. Now everyone will be able to observe the auction via a screen, and will be less vulnerable to being picked off in other markets. It is unlikely, however, that the new mechanism will mitigate the market power problem. Big trades will move markets in the new auction, and firms with positions that have payoffs that depend on the auction price may have an incentive to make those big trades to advantage those positions.

Along these lines, it is important to note that many liquid and deep futures markets have been plagued by “bang the close” problems. For instance, Amaranth traded large volumes in the settlement period of expiring natural gas futures during three months of 2006 in order to move prices in ways that benefited its OTC swaps positions. The CFTC recently settled with the trading firm Optiver that allegedly banged the close in crude, gasoline, and heating oil in March, 2007. These are all liquid and deep markets, but are still vulnerable to “bullying” (as one Optiver trader characterized it) by large traders.

The incentives to cause an artificial price for any major benchmark will always exist, because one of the main purposes of benchmarks is to provide a mechanisms for determining cash flows for derivatives. The benchmark-derivatives market situation resembles an inverted pyramid, with large amounts cash flows from derivatives trades resting on a relatively small number of spot transactions used to set the benchmark value.

One way to try to ameliorate this problem is to expand the number of transactions at the point of the pyramid by expanding the window of time over which transactions are collected for the purpose of calculating the benchmark value: this has been suggested for the Platts Brent market, and for the FX fix. A couple of remarks. First, although this would tend to mitigate market power, it may not be sufficient to eliminate the problem: Amaranth manipulated a price that was based on a VWAP over a relatively long 30 minute interval. In contrast, in the Moore case (a manipulation case involving platinum and palladium brought by the CFTC) and Optiver, the windows were only two minutes long. Second, there are some disadvantages of widening the window. Some market participants prefer a benchmark that reflects a snapshot of the market at a point in time, rather than an average over a period of time. This is why Platts vociferously resists calls to extend the duration of its pricing window. There is a tradeoff in sources of noise. A short window is more affected by the larger sampling error inherent in the smaller number of transactions that occurs in a shorter interval, and the noise resulting from greater susceptibility to manipulation when a benchmark is based on smaller number of trades. However, an average taken over a time interval is a noisy estimate of the price at any point of time during that interval due to the random fluctuations in the “true” price driven by information flow. I’ve done some numerical experiments, and either the sampling error/manipulation noise has to be pretty large, or the volatility of the “true” price must be pretty low for it to be desirable to move to a longer interval.

Other suggestions include encouraging diversity in benchmarks. The other FSB-the Financial Stability Board-recommends this. Darrel Duffie and Jeremy Stein lay out the case here (which is a lot easier read than the 750+ pages of the longer FSB report).

Color me skeptical. Duffie and Stein recognize that the market has a tendency to concentrate on a single benchmark. It is easier to get into and out of positions in a contract which is similar to what everyone else is trading. This leads to what Duffie and Stein call “the agglomeration effect,” which I would refer to as a “tipping” effect: the market tends to tip to a single benchmark. This is what happened in Libor. Diversity is therefore unlikely in equilibrium, and the benchmark that survives is likely to be susceptible to either manipulation, or the bricks without straw problem.

Of course not all potential benchmarks are equally susceptible. So it would be good if market participants coordinated on the best of the possible alternatives. As Duffie and Stein note, there is no guarantee that this will be the case. This brings to mind the as yet unresolved debate over standard setting generally, in which some argue that the market’s choice of VHS over the allegedly superior Betamax technology, or the dominance of QWERTY over the purportedly better Dvorak keyboard (or Word vs. Word Perfect) demonstrate that the selection of a standard by a market process routinely results in a suboptimal outcome, but where others (notably Stan Lebowitz and Stephen Margolis) argue that  these stories of market failure are fairy tales that do not comport with the actual histories. So the relevance of the “bad standard (benchmark) market failure” is very much an open question.

Darrel and Jeremy suggest that a wise government can make things better:

This is where national policy makers come in. By speaking publicly about the advantages of reform — or, if necessary, by using their power to regulate — they can guide markets in the desired direction. In financial benchmarks as in tap water, markets might not reach the best solution on their own.

Putting aside whether government regulators are indeed so wise in their judgments, there is  the issue of how “better” is measured. Put differently: governments may desire a different direction than market participants.

Take one of the suggestions that Duffie and Stein raise as an alternative to Libor: short term Treasuries. It is almost certainly true that there is more straw in the Treasury markets than in any other rates market. Thus, a Treasury bill-based benchmark is likely to be less susceptible to manipulation than any other market. (Though not immune altogether, as the Pimco episode in June ’05 10 Year T-notes, the squeezes in the long bond in the mid-to-late-80s, the Salomon 2 year squeeze in 92, and the chronic specialness in some Treasury issues prove.)

But that’s not of much help if the non-manipulated benchmark is not representative of the rates that market participants want to hedge. Indeed, when swap markets started in the mid-80s, many contracts used Treasury rates to set the floating leg. But the basis between Treasury rates, and the rates at which banks borrowed and lent, was fairly variable. So a Treasury-based swap contract had more basis risk than Libor-based contracts. This is precisely why the market moved to Libor, and when the tipping process was done, Libor was the dominant benchmark not just for derivatives but floating rate loans, mortgages, etc.

Thus, there may be a trade-off between basis risk and susceptibility to manipulation (or to noise arising from sampling error due to a small number of transactions or averaging over a wide time window). Manipulation can lead to basis risk, but it can be smaller than the basis risk arising from a quality mismatch (e.g., a credit risk mismatch between default risk-free Treasury rates and a defaultable rate that private borrowers pay). I would wager that regulators would prefer a standard that is less subject to manipulation, even if it has more basis risk, because they don’t internalize the costs associated with basis risk. Market participants may have a very different opinion. Therefore, the “desired direction” may depend very much on whom you ask.

Putting all this together, I conclude we live in a fallen world. There is no benchmark Eden. Benchmark problems are likely to be chronic for the foreseeable future. And beyond. Some improvements are definitely possible, but benchmarks will always be subject to abuse. Their very source of utility-that they are a visible price that can be used to determine payoffs on vast sums of other contracts-always provides a temptation to manipulate.

Moving to transactions-based mechanisms eliminates outright lying as a manipulation strategy, but it does not eliminate the the potential for market power abuses. The benchmarks that would be least vulnerable to market power abuses are not necessarily the ones that best reflect the exposures that market participants face.

Thus, we cannot depend on benchmark design alone to address manipulation problems. The means, motive, and opportunity to manipulate even transactions-based benchmarks will endure. This means that reducing the frequency of manipulation requires some sort of deterrence mechanism, either through government action (as in the Libor, Optiver, Moore, and Amaranth cases) or private litigation (examples of which include all the aforementioned cases, plus some more, like Brent).  It will not be possible to “solve” the benchmark problems by designing better mechanisms, then riding off into the sunset like the Lone Ranger. Our work here will never be done, Kimo Sabe.*

* Stream of consciousness/biographical detail of the day. The phrase “Kimo Sabe” was immortalized by Jay Silverheels-Tonto in the original Lone Ranger TV series. My GGGGF, Abel Sherman, was slain and scalped by an Indian warrior named Silverheels during the Indian War in Ohio in 1794. Silverheels made the mistake of bragging about his feat to a group of lumbermen, who just happened to include Abel’s son. Silverheels was found dead on a trail in the woods the next day, shot through the heart. Abel (a Revolutionary War vet) was reputedly the last white man slain by Indians in Washington County, OH. His tombstone is on display in the Campus Martius museum in Marietta. The carving on the headstone is very un-PC. It reads:

Here lyes the body of Abel Sherman who fell by the hand of the Savage on the 15th of August 1794, and in the 50th year of  his age.

Here’s a picture of it:

The stream by which Abel was killed is still known as Dead Run, or Dead Man’s Run.

Stamps. That’s the proof.

Russians are obsessed with stamps. Nothing is official unless it is stamped. The most trivial document must be stamped. Preferably several times.

Stamps have magical power. They transform a simple piece of paper with dry, nondescript prose into something talismanic.

Consider this from a long (and horribly written and edited) WSJ piece on the process of brokering a deal between Malaysia and the mouth breathers of the Donetsk People’s Republic to obtain the black boxes from MH17:

Just after 1 a.m., Col. Sakri signed an agreement with a top separatist official confirming the handover of the black boxes.

The stamp of the National Security Council of Malaysia is misspelled, “Sekurity,” suggesting a hasty effort to fulfill bureaucratic protocol by having the stamp made locally.

I know exactly what happened. The deal was painstakingly negotiated over hours. Then the time for signing came. And the mouth breathers said: “It’s not official unless it is stamped.” The Malaysians looked at one another, then replied: “Stamped? WTF?” “It must have your stamp.” So the Malaysians scrambled around, desperately seeking someone who would make them a stamp. They found Ivan the Stampmaker, who of course would pronounce “c” as “s” and spell a hard “c” with a “k”.  But the mouth breathers didn’t know any better-indeed, they might have been suspiciously of a “c”-and were satisfied. They had their stamp. The deal was well and truly official.

It is absurd. It is Kafkaesque.

It is Russian.