Streetwise Professor

June 15, 2019

If They Didn’t Have Double Standards, They’d Have No Standards At All

Filed under: Politics,Russia — cpirrong @ 6:09 pm

Just when I think politics could not get any more retarded, I’m proven wrong. The latest example being the meltdown freakout over Trump’s statement that he would listen to “dirt” on an opposing candidate passed on by a foreign source.

The mind boggles. Those melting down and freaking out are Democrats to the last he, she, and xe of them. (Mitt Romney et al are basically eunuchs who follow the lead of the Democrats who unmanned them, and whose approval they crave.) They are all die hard Hillary supporters.

This would be the Democratic Party that actively solicited compromising information on Trump and Trump campaign figures from the Ukrainian government. Last time I checked, Ukraine was not the 51st state. Or even the 58th.

This would be the Hillary Clinton whose campaign hired a foreigner to solicit foreigners–Russians, no less, rather than the benign Norwegians whom Trump referred to in his answer–to collect dirt on Trump.

And alleged information passed on by Alexander Downer (who speaks with a funny accent and so I’m pretty sure he’s a furriner) was apparently totally copacetic.

A consistent application of the standards implicit in the meltdown freakout would require those melting down and freaking out to demand the banning of the Democratic Party and Hillary’s incarceration.

Consistent application. Sometimes I crack myself up. If these people didn’t have double standards, they’d have no standards at all.

A few other observations. Does truth matter? That is, should the information provided be ignored and even criminalized merely because it is from a foreign source, even if it is true?

Hypothetical. A source within the FSB provides documentation showing that while honeymooning in the USSR a certain candidate for president agreed to become a source for the KGB, and had in fact regularly provided information to the KGB and then the FSB in the past 30+ years. Is that information to be suppressed, merely because of the source? Isn’t it meddling in an election to keep this information secret? (Any reasonable definition of the word “meddling” would involve an action that affects the outcome of an election, and keeping information secret can impact the outcome just as much as its revelation. Which is precisely why candidates want to suppress compromising information.)

Indeed, some information can only come from foreign sources. So it’s better to accept an increased risk of electing someone who canoodled with foreigners, than to accept information that would disclose such canoodling, because the information came from the foreigners that s/he canoodled with?

The controversy over the DNC emails suggests that truth is not a relevant consideration. The veracity of those emails, and the damaging information in them, were never disputed. Yet their release was supposedly scandalous, and sufficient in the minds of many to rule them out of bounds for discussion.

Moving on. Isn’t the obsession with the foreign-ness of the source of the dirt, oh, I dunno, kinda nationalist? Isn’t it passing strange that people who are willing to accept the illegal immigration of every last Guatemalan to the US (transportation courtesy of a Mexican drug cartel) believe that it is utterly unacceptable for a campaign to accept information provided by a Norwegian or whoever who may never set foot on the fruited plain nor see the amber waves of grain? So citizenship should be totally irrelevant for residency and employment and receiving government benefits, but it is determinative when it comes to who can provide information on political candidates to rival political candidates?

That makes sense how, exactly?

Isn’t it also implicit in the obsessive focus on the citizenship of the provider of information that it’s totally OK for Americans to meddle in elections by passing on damaging information to opposing campaigns?

I could go on, but contemplating the outpouring of sanctimonious hypocrisy for too long makes my head hurt. Suffice it to say, the louder the scream, the more execrable the screamer.

June 13, 2019

Debunking A Valiant–But Failed–Defense of Frankendodd

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — cpirrong @ 7:40 pm

I have known CFTC Commissioner Dan Berkovitz for almost 20 years, when he was a senior staffer on the Senate Permanent Subcommittee on Investigations, and he reached out to me for guidance on market manipulation issues. I think it’s fair to say that we disagree on most important issues. He supports many regulations I strongly oppose, but despite that our relationship has been cordial and mutually respectful.

Dan’s recent speech at the FIA Commodities Symposium in Houston focuses on issues that we happen to disagree on, and needless to say, I am unpersuaded. Indeed, I think his remarks demonstrate quite clearly the fundamental intellectual failings with the regulatory measures he favors.

He focuses on two issues: competition in OTC derivatives, and speculative position limits. With respect to OTC derivatives, he says

There are now 105 swap dealers and 23 swap execution facilities registered with the Commission. Almost 89% of interest rate swaps and 96% of broad index credit default swaps are cleared through a central clearinghouse. Nearly 98% of all swap transactions involve at least one registered swap dealer. The CFTC’s swap trading rules have led to more competition, more electronic trading, better price transparency, and lower spreads for swaps traded on regulated platforms

But then he contradicts himself on competition:

Despite this progress, we have seen an increase in concentration in the trading and clearing of swaps among the bank swap dealers.  [Emphasis added.] Although we have more competition in the swaps market since the passage of Dodd-Frank, in the form of tighter bid-ask spreads and lower transaction costs, we have fewer competitors.  [Which makes me question whether the tighter spreads are the result of more competition, or other factors.] High levels of concentration present systemic risks and provide fewer choices for end-users.  [But wasn’t the point of DFA to reduce systemic risk by reducing concentration? GiGi sure said so.] One of the purposes of the Commodity Exchange Act (“Act” or “CEA”) is to promote fair competition.  The Commission therefore has an obligation to address this issue.

How concentrated are our derivative markets?  For swaps trading, five registered bank swap dealers are party to 70% of all swaps and 80% of the total notional amount traded. And for clearing services, the five largest FCMs—all affiliated with large banks—clear about 80% of cleared swaps.[  The eight largest firms clear 96% of cleared swaps.  I am concerned about what could happen if one of those providers fails.  I am also concerned about the impact on the price of derivatives for end users.

Even prior to Frankendodd, I predicted that the regulations would lead to greater concentration, precisely because regulatory burdens create fixed costs, which favor scale. The concentration among FCMs is particularly worrisome from a systemic risk perspective, and has been exacerbated by the way clearing regulations have been implemented. Not all of these are the CFTC’s fault: it has attempted to push back on the Fed’s implementation of the liquidity ratio, which creates unnecessary capital charges associated with segregated margins. Dan alludes to that issue thus: “We must find ways to increase bank capital standards without discouraging the availability of clearing and other risk-management tools available to end users.” But the basic conclusion remains: measures intended to reduce concentration in order to reduce systemic risk have not achieved that objective, and have in fact likely increased concentration.

The biggest weakness in Dan’s speech is his valiant, but tellingly and painfully strained, justification for position limits.

The CFTC has a long history with speculative position limits, and their benefits to the market are well established.  Section 3 of the Act identifies risk management and price discovery as fundamental purposes of U.S. derivatives markets. Meaningful position limits coupled with appropriate hedge exemptions are crucial to advancing those purposes.  Position limits help prevent corners, squeezes, and other forms of manipulation.  They prevent distortions in the prices of many major commodities in interstate commerce—ranging, for example, from wheat to gold to coffee to oil.  The Hunt brothers’ attempts to corner the silver market, the Ferruzzi squeeze of the soybean market, and the Amaranth hedge fund’s excessively large positions in the natural gas futures and swaps markets are clear examples of why position limits are needed to prevent the price distortions and real-world impacts that can result from excessive speculation.  Episodes such as these validate Congress’ and the CFTC’s long-held view that position limits are “necessary as a prophylactic measure” to deter sudden or unreasonable price fluctuations and preserve the integrity of price discovery and risk mitigation on U.S. derivatives markets.

Insofar as prevention of market power manipulations (squeezes and corners) are concerned, this can be achieved through spot month limits and does not require restrictions on the positions held prior to the delivery month, and across all months, as the Commission’s previous proposals would impose. Meaning that the proposed regulations are over-inclusive and an unduly restrictive means of achieving their stated objective.

Further, insofar as the examples are concerned, they provide no support for the types of expansive limits that have been proposed. None.

As I’ve said repeatedly about the Hunt episode (the CFTC’s favorite go-to example): when do we get to the Trojan War? That episode is ancient history, and is more the exception that proves the rule than a warning of a clear and present danger. I have said this repeatedly only because the CFTC brings up the example repeatedly. If they stop, I will!

Ferruzzi is interesting, because Ferruzzi cornered a market with position limits, from which the company had an exemption. Indeed, it was the CFTC’s and CBOT’s revocation of Ferruzzi’s hedge exemption during the spot month that broke the company’s corner (and launched my academic career in commodities!–thanks to all!) I can think of other examples in which long hedgers with exemptions executed market power manipulations, and indeed, long hedgers with exemptions are the most dangerous manipulators. Meaning that position limits on speculators are beside the point when it comes to addressing market power manipulation.

With regards to Amaranth, Dan states

The Amaranth episode provides another clear example of how large speculative positions can distort market prices.  At one point, Amaranth held 100,000 natural gas contracts, or approximately 5% of all natural gas used in the U.S. in a year. “Amaranth accumulated such large positions and traded such large volumes of natural gas futures that it distorted market prices, widened the spreads, and increased price volatility.”

The quotations are to a Senate Permanent Subcommittee report (which Dan was an author) . I can say definitively that the analysis underlying those conclusions is completely unpersuasive, and would fail to pass muster in any manipulation litigation. The analysis lacks statistical rigor, and demonstrates neither “artificial” prices or that Amaranth caused these artificial prices (intentionally or otherwise).

Indeed, the CFTC did not pursue Amaranth for distorting natural gas prices through its immense OTC derivatives positions (the 100,000 contracts Dan refers to) outside the delivery month. Instead, it (and FERC) went after the fund and its head trader Brian Hunter for three “bang the close” manipulations in 2006. (Full disclosure: I was an expert for plaintiffs on those manipulations in a private lawsuit.) Position limit regulations would not have prevented those manipulations.

Indeed, other manipulation cases the CFTC has pursued, including bang the settle type cases against Optiver and Parnon and Moore Capital (which I was also an expert in in related private litigation) also would not have been impacted by position limits. That is, limits would not have prevented them. In another recent CFTC case (just settled, and again, I am an expert in related private litigation), the party accused by the CFTC (Kraft) was a long hedger with a hedge exemption.

In brief, neither Dan nor anyone else has presented an example of a post-Trojan War alleged manipulation that position limits would have prevented.

So what’s the point? Can position limits reduce the risk of distortion arising from something non-manipulative?

Dan has an answer, and the answer is “no!” (though he says “record before us demonstrates that the answer is ‘yes.'”)

What speculative position limits are intended to do is to prevent a single market participant from moving markets away from fundamentals of supply and demand through the accumulation of large speculative positions.  [Emphasis added.] In this regard, it’s important to note that speculative position limits focus on the positions held by a single trader or trading entity, not on the overall level of speculation in a market.  The Commission’s task in setting speculative position limits is not to determine how the collective level of speculation in a market might affect prices.  [Emphasis added.] Nor is it to try to determine the “correct” level of speculation that should be permitted in a market.  Instead, the Commission must focus on the single speculator and the impact of large speculative positions on the market.

But this demolishes the argument for limits that was made with increasing intensity around 2006, and peaking (along with oil prices) in mid-2008. Those advocating position limits then could point to no single large trader that was distorting prices. Instead, they blamed (to use Dan’s phrase) “the collective level of speculation” to justify limits–which is exactly what Dan (rightly) says the limits won’t and can’t constrain. Meaning that the CFTC’s proposed limits represent a bait-and-switch: by a limit supporting CFTC commissioner’s own admission, the proposed limits won’t address the supposed ill that led Congress to legislate them in the first place.

To summarize: Position limits outside the spot month are unnecessary to prevent market power manipulations (and other deterrent measures can enhance spot month limits); position limits won’t prevent other kinds of manipulation (e.g., bang the settlement); there are no examples in decades of distortions that position limits of the type proposed might have mitigated; the examples that have been proposed are wrong; the most likely market power manipulators (long hedgers) would be exempted from limits; limits would not have prevented the specific manipulations the CFTC has alleged in recent years; and the limits the CFTC has proposed would not touch the kinds of allegedly multi-trader “collective” excess speculation that caused Congress to mandate position limits in the first place.

Other than that, the case for position limits is rock solid!

Dan Berkovitz manfully attempts justify limits but achieves just the opposite. The arguments and evidence he brings to bear demonstrate how bankrupt the case for limits truly is.

Given that limits will involve substantial compliance costs, and bring no benefits, the song remains the same: position limits are all pain, no gain.

June 3, 2019

Renewables VPPAs: An Interesting Pricing Problem For Aspiring Scholars

Filed under: Climate Change,Commodities,Derivatives,Economics,Energy — cpirrong @ 7:13 pm

Virtual Power Purchasing Agreements (VPPAs) have been around for a while, and play a particularly important role in securing financing for renewable energy projects, as this article from Reuters regarding VPPAs in Europe indicates. They are essentially long term swaps whereby one party (e.g., a wind or solar operation) receives a fixed price for power, and pays a floating price, usually based (in the US) on the spot price in an RTO/ISO market (e.g., PJM, or MISO).

These contracts present interesting pricing issues because of the unique nature of electricity as a commodity, and the unique nature of renewable generation in particular. Electricity is not an asset per se, and electricity price risk is not hedgeable, even theoretically, through a dynamic trading strategy in the way that the price risk in a stock option is. This means that electricity markets are “incomplete,” and that Black-Scholes-Merton-like formulas that derive prices that do not depend on risk premia do not exist for power derivatives.

The risk premia embedded in power prices can be large, though they have been falling over the years. I wrote extensively about this subject for about 10 years (late-90s to late-00s), including this article. That paper provides a way of extracting risk premia from the prices of traded claims (e.g., monthly power forward contracts). One virtue of that approach is that the primary state variable in the model is not price, but load (which is translated into price via the supply curve). Thus, the relevant price of risk is the price of load risk, which can be used in the valuation of load-dependent claims. Such claims could be full requirements deals, for example.

One challenge to the approach is that the realistic horizon of the market price of risk function estimate is that of the visible forward curve, which is typically far less than the maturity of long term electricity deals. The prices in such contracts effectively reflect a market price of risk negotiated between the two parties, in the absence of corresponding forward curve data.

Renewables VPPAs face an even bigger challenge: the variability of the output of a renewables asset. There is not only price risk (or market load risk) associated with a given region: there is the output risk of the facility, which may be material given the vicissitudes of wind and sun. Thus, the dimensionality of the pricing problem is higher, which is a problem given that the methods I employed in my 2008 paper (co-authored by Martin Jermakyan) are subject to “the curse of dimensionality.”

Furthermore, given the joint dependency on market price (or load) and project output, these are correlation-dependent claims. That is, what is the dependence between market price and wind output? This could be a particularly big issue given that high wind output is often associated with negative prices. Guaranteeing a fixed price therefore involves something of a wrong way risk.

The long tenor of VPPAs makes these issues even more devilish, given that pricing involves forecasting the relevant dynamics and parameters (including those associated with dependence among the state variables) over long horizons–horizons over which entry can occur and technology can change, making historical data of little relevance in estimation. Indeed, there is an element of endogeneity: the prices in VPPAs can affect the economics of entry, which can affect future price behavior, which is (theoretically, anyways) an input into the “right” VPPA fixed price.

All in all, a very interesting and challenging pricing problem, that like the simpler problems Martin and I tackled some years ago, require the use of advanced pricing techniques, numerical methods, and econometrics even to conceptualize, let alone solve. Sounds like an interesting problem–or problems–for aspiring scholars in energy pricing.

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