Streetwise Professor

George Orwell described “doublethink” thus: “to hold simultaneously two opinions which cancelled out, knowing them to be contradictory and believing in both of them, to use logic against logic” and “the power of holding two contradictory beliefs in one’s mind simultaneously, and accepting both of them.”   With the campaign for the Democratic presidential nomination getting underway, we are seeing numerous examples of doublethink in action. So much so, that it is more than fair to call the Democratic Party the Doublethink Party.

This is most evident when it comes to immigration. On the one hand, leftist (i.e., mainstream) Democrats lament that Central American countries like El Salvador, Honduras, and Guatemala are so wretched, poor, violent, and oppressive that it is our moral duty to admit any migrant from those countries (and others equally benighted). Indeed, during last night’s Democratic candidate debate, Kamala Harris gave an impassioned plea, saying that conditions in these countries were so brutally awful that it was perfectly understandable that a mother would subject her child to a high probability of rape, and a non-trivial probability probability of death, by paying a human trafficker (a “coyote”) to get her to the United States.

Boy, those countries must be real shitholes if it is worthwhile to pay such a price to escape them, right?

But you know, metaphysically, that the same people will call you a racist, or worse, if you make the simple declaration: “those countries are shitholes.” You know that, because that’s exactly what happened when Trump referred to immigration from “shithole countries.”

That’s 99.9 percent pure doublethink.

Another immigration-related example. No doubt you’ve heard the shrieking over the terrible conditions in which asylum seekers, children in particular, are held. Sleeping on the floor. No toothbrushes.

But the same people–yeah, I’m looking at you, oh bucktoothed bug-eyed one–fought tooth and nail against a bill funding the detention centers, and said it was totally righteous for employees of a company contracted to supply beds for the centers to walk out in protest.

Again, doublethink in its almost purest form.

Doublethink is so pervasive on the immigration issue that it is beyond certain that the Democratic Party position on the issue, and the position of every Democratic Party presidential candidate, is open borders. If a country’s corruption, violence, poverty, and oppressiveness imposes a moral duty on the US to allow anyone from those countries to claim asylum in the US, since every country south of the Rio Grande is corrupt, violent, poor, and oppressive, per the Democrat’s logic everyone from those countries has a right to enter the US. Indeed, immigrants from African and Middle Eastern nations (again uniformly corrupt, violent, poor, and oppressive) have been transiting to the US via Mexico. Meaning that they have a right to come here too.

And of course, even if the US adopted that policy, the “logic” in the Democrat’s position would be that’s not enough: we should actually provide the means for them to come here. If you doubt that, note that every Democratic presidential candidate supports free medical care for immigrants.

I am of a mixed mind on this. On the one hand, the position seems so stark raving insane that it will be political suicide for the Democrats to run on it. On the other hand, if they win . . . . Meaning that although encouraging this insanity has a positive expected value, the downside risk is severe. Especially as immigration is only one issue on which the Democratic Party is now starkers.

Although I’ve focused on immigration doublethink, this Orwellian mindset is not limited to that issue. Not at all!

One more example–I could spend all day and many days to follow adding other ones. Donald Trump is routinely lambasted for his unilateralism. But when he says things like the US should not be unilaterally responsible for securing oil flows out of the Persian/Arab Gulf, the lamabasters freak out on him for turning his back on American policy that dates back to the halcyon days of the Carter administration. I guess the “logic” is that the United States is obligated to provide security services that everyone (including rivals like China) free rides on, and is also obligated to be nice to the free riders and say only nice things about them.

One closing thought. I’ve used the word “logic” several times (in scare quotes!), but this is one way in which Orwell’s definition of Doublethink doesn’t do justice to its modern practitioners. Recall that Orwell said that doublethink “use[s] logic against logic.” But postmodernists and deconstructivists and leftists generally strenuously oppose privileging logic. To them, logic is an instrument of oppression, a weapon of the white patriarchy wielded against women, LGTBQ, “people of color,” and most of all, the intersectional (i.e., those who can check more than one of the above boxes). Orwell anticipated that logic would be twisted. He did not anticipate what has actually transpired: logic has been denied.

The objective is the same, however. Orwell portrayed Doublethink as an instrument of power and control. Since logic is a constraint on the will to power, it must be destroyed. Nothing good can come of that: indeed, many evils will follow in its train.

Vladimir Putin held his annual marathon phone-in session last week. Although Vova was taking the calls, he was the one who was clearly phoning it in. By all accounts his performance was bored and listless, and largely unresponsive to the economic and environmental (as in garbage disposal) concerns expressed by many callers.

Putin’s answers to questions regarding declining living standards bordered on the pathetic, and definitely revealed he has no answers and can offer no serious succor. The best he could do is to tell Russians that things aren’t as bad today as they were in the 90s.

If the key to success is setting low expectations, Putin certainly succeeded! Perhaps the only current world leader who is doing worse than Russia’s in the 90s is Maduro.

As for explanations, the best Putin could offer was sanctions, and low oil prices. The sanctions excuse is somewhat amusing, given that Putin had previously claimed that sanctions not only wouldn’t hurt/weren’t hurting Russia, they would actually rejuvenate the Russian economy by encouraging the development of import-substituting industries. Insofar as oil prices are concerned, Putin’s answer only underlines the failure of Russia under his watch to develop outside the resource extraction sectors.

None of this should be surprising, and I have predicted such a trajectory. Maximum Leaders get old. They get tired. They get bored. They run out of new ideas and don’t have the energy or inclination to generate them. They begin to prefer a quiet life and to abhor change and innovation. Even they get captured by vested interests who strongly favor maintaining the status quo. Moreover, authoritarian leaders like Putin inevitably become progressively more isolated and out-of-touch because they are surrounded by sycophants, and deprived of feedback from elections, a free press, and open debate.

We are witnessing the senescence of Putin, and Putinism. The most grave concern–for Russians mainly, but for the rest of the world too–is that another inherent feature of authoritarian systems like the one in Russia is that the current leader has no interest in creating a system of succession: indeed, he has an interest in NOT creating one. As he continues to age, or if he dies suddenly, the battle to succeed him will intensify, and inevitably destabilize Russia (with spillover effects around the world).

This brings to mind two closing thoughts.

First, if you think Putin is bad, you should shudder at the type who will prevail in the struggle to succeed him. (Such person will almost certainly emerge from the shadows of the security services or their allies, and you will likely not have heard of him.)

Second, for years Putin’s political hole card has been “I have given you stability.” But ironically, his creation of an increasingly ossified system creates the conditions for a resurgence of instability–perhaps as bad as the 90s–upon his demise, or even his enfeeblement.

So it is more accurate to say that Putin has perhaps delayed instability, and guaranteed that the instability will be all the more intense when it inevitably reappears.

I ask for very few things in life, because I am a firm believer in unintended consequences, as summarized by the adage: “Be careful what you ask for–you might get it.”

Recep Tayyip Erdoğan should have heeded this adage when he asked for–and got–a rerun of the Istanbul mayoral election. I guarantee he hadn’t bargained for the way his wish was granted–a humiliating loss to CHP (pronounced “jay hey pay”) candidate Ekrem İmamoğlu.

İmamoğlu had won by a mere 14,000 votes in the 31 March election that Erdoğan claimed was tainted by fraud (in a first where the opposition allegedly won by fraud, rather than the party in control): he won by over 700,000 votes today. Meaning that by insisting on a mulligan, Erdoğan succeeded in increasing his opponent’s margin of victory by a factor of a mere 50. That takes talent!

There is rejoicing in the streets of İstanbul, and elsewhere in Turkey, especially in places like İzmir. But there is no joy in Mudville, er, the massive (as in 3.2 million square feet) presidential palace in Ankara, which is symbolic of Erdoğan’s sultanic pretensions. So far, over 8 hours after the polls closed, he has been silent. Only his hapless and comically uncharismatic candidate in İstanbul, former prime minister Binali Yildirim, has made a monotone concession speech.

Erdoğan has straddled Turkish politics like a colossus for almost 20 years. This is his first major defeat, which raises questions about his future.

In the near term, İmamoğlu’s control of government in İstanbul will allow him to uncover and publicize the massive corruption of AKP/Erdoğan rule there. Further, money the the lifeblood of politics, and the CHP victory will allow it to sharply reduce the flow of this lifeblood to AKP’s pockets.

Over the longer run, there is now a credible personality to oppose Erdoğan. The national CHP leader Kemal Kılıçdaroğlu (who was almost lynched by an AKP mob near Ankara recently) is not a threat, for many reasons. He is deemed an elitist, and worse, he is Alevi, a religious group that is scorned by most Turks.

İmamoğlu’s biography has eerie parallels to Erdoğan’s. Both are from the Black Sea region who moved into national politics in İstanbul. Erdoğan gained considerable sympathy as a result of his jailing 20 years ago: denying İmamoğlu victory in March gained him considerable sympathy too. Both figures have a common touch. Unlike many in the CHP, İmamoğlu is not viewed as a hard-core secularist, or anti-Islam. Indeed, his name denotes a Muslim heritage. (An ardent secular Turk I know says he is glad that is not HIS name.)

Meaning that Erdoğan like faces the biggest political threat in his life, and it comes at a time when Turkey’s economy is teetering, and its international position is fraught.

Top at the very long list of Erdoğan’s foreign policy headaches is his testy (to say the least) relationship with the US. Matters are coming to a head here, with Erdoğan swearing that Turkey will cross a US red line, and buy S-400 SAMs from Russia.

I have been wondering for some weeks whether Erdoğan’s chest thumping on this issue has been driven by his need to look tough before a largely anti-US Turkish electorate in the runup to the rerun of the İstanbul election, and that he would back down once the results are in. He has backed down before after claiming he would never concede to Trump (on the issues of the American missionary and the NSA employee imprisoned in Turkey). It’s hard to know how the crushing defeat will affect his calculations. Will he realize that in his weakened domestic situation he can’t afford to confront the US? Or will he figure that he can’t afford to look weak now?

I don’t know, but I do know that as consummate a domestic politician as Erdoğan has been, internationally he has been a disaster for Turkey. Turkey has alienated the US and Europe, has bungled in Syria, and is at odds with Saudi Arabia and Egypt. Turkey literally has no friends or allies now, except for Qatar, which is itself isolated in the Arab world. Given this record, I think it is highly likely that Erdoğan will make the wrong choice.

We should see within days. He is to meet Trump at the G-20 this week. Perhaps Trump will offer him a face-saving way out of the dilemma he has put himself in. Whether Erdoğan is wise enough to take it is another matter.

To huge fanfare, Facebook announced the impending release of a new cryptocurrency, “Libra.” Except it isn’t–a crypto, that is. Whereas real cryptocurrencies are decentralized, anonymous, unpermissioned, and lack trusted intermediaries, Libra is centralized, permissioned, non-anomymous and chock-full o’ intermediaries in addition to Facebook. It doesn’t really utilize a blockchain either.

Other than that . . .

For the best (IMO) take on the “Zuck Buck”, I heartily recommend FT Alphaville’s extended take–and takedown. I’ll just add a few comments.

First, when it comes to finance, there is little (if anything) new under the sun, and that is clearly true of Libra. The Alphaville stories provide several historical precedents, to which I’ll just add another. It is basically like pre-National Bank Act banking system in which banks issued bank notes that circulated as hand-to-hand media of exchange, and which were theoretically convertible into currency (gold prior to the Civil War) on demand. Libra is functionally equivalent to such bank notes, with the main distinction that it is represented by bytes rather than pieces of paper.

Facebook attempts to allay concerns about such a system by requiring 100 percent backing by bank deposits or low-default-risk government bonds, but as historical experience (some as recent as 2008) demonstrates, although such systems are less subject to runs than liabilities issued by entities that invest the proceeds in illiquid assets, they are not necessarily run-proof.

Furthermore, the economic model here isn’t that different from the 19th century bank model because the issuer can profit by investing the proceeds from the issue of the currency in interest bearing assets, and pocketing the interest. Those buying the currency forego interest income, and presumably are willing to do so because of it reduces the costs of engaging in various kinds of transactions.

This type of system faces different kinds of difficulties in low and high interest rate environments. In high rate environments, the opportunity cost of holding the currency is high, which leads to lower quantity demanded. In low rate environments, the revenue stream may be insufficient to cover the costs incurred by the intermediaries. This creates an incentive for asset substitution, i.e., to allow backing the currency with higher risk assets (with higher yields) thereby increasing insolvency and run risks.

I note in passing that low interest rates destroyed the traditional FCM model which relied on interest income from customer margins as a major revenue stream (as Facebook is proposing here). Ask John Corzine about that, and look to the experience of MF Global.

Why introduce this in a low interest rate environment? Maybe this is a kind of loss-leader strategy. The opportunity cost of holding Libra is low now (given low rates), so maybe a lot of people will buy in now. Even though the benefits to the issuers/intermediaries may be low now (because the interest income is low), they may be counting on customer stickiness once there is widespread adoption. That is, those who hold Libra when the cost of doing so is low may stick around even when the cost goes up substantially. That is, Facebook and its partners in this endeavor may be counting on some sort of switching cost or some behavioral irrationality to reduce the interest-rate sensitivity of demand for Libra.

Good luck with that. (For another example of nothing new under the sun, read up on disintermediation of traditional banks when interest bearing money market mutual funds came on the scene.)

I would also suggest that Libra has some disadvantages as a medium of exchange. For one thing, since assets will be held in multiple currencies, it creates currency risk for virtually everyone who uses it. For another, it involves additional cost to move from fiat into Libra and from Libra into fiat. This reduces the value of the Libra as a medium of exchange because of the resulting difference in cost in using it for within-network and off-network uses.

This last point relates to something else in the Libra white paper, namely, the claims that the currency will be a boon to the “unbanked.” This makes zero sense.

The reason that some people don’t have bank accounts is that the cost of servicing them (reflected in fees that banks charge) is above the willingness/ability of those people to pay for those services. There is no reason to believe that Libra reduces the cost of servicing the currently unbanked. Furthermore, the value of the services provided is likely to be lower, and substantially so because inter alia (a) the lack of brick an mortar facilities that low income people need for check cashing/depositing and cash depositing, (b) the restricted network of people with whom they can transact, and (c) currency risk.  Relatedly, it’s hard to see how one can move funds into our out of Libra without having access to banking services. I see the unbanked rhetoric as mere SJW eyewash attempting to make this look like some progressive social project.

The arrogance of Facebook is also rather astounding. Again, this is not crypto–it is banking. Yet Facebook presumes that it can do this without the panoply of licenses that banks must have, and without being subject to the same kinds of regulation as banks.

Because why? Trust me? Suuuurrreee, Mark.

Along these lines, note that the most benign interpretation behind Libra is that it is a narrow bank (100 percent reserve banking). But remember the Fed recently denied approval to TNB (“The Narrow Bank”) USA NA even though it was only going to offer deposits to “the most financially secure institutions” and explicitly eschewed providing retail banking services. Yet Marky et al expect the Fed (not to mention banking regulators in every other jurisdiction on the planet) to stand aside and let Facebook offer maybe (but maybe not) narrow banking services (with added currency risk!) to the great unwashed?

On what planet?

Note the furious government reactions to this, not just in the US but in Europe. Zuckerberg et al were totally delusional if they expected anything different, especially in light of Facebooks serial privacy, free-speech, and antitrust controversies.

In sum, in my opinion Libra faces serious economic and political/regulatory obstacles. Having politicians and regulators hate you isn’t bad per se in my book–it can actually represent an endorsement! But the economics of this are incredibly dodgy. My skepticism is only increased by the misleading packaging (crypto! a boon to the unbanked!) and the congenitally misleading packager.

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.

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.

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.