Streetwise Professor

The Fed and the SEC have expressed concerns about Treasury “basis trades” wherein a firm purchases a cash Treasury security funded by repo-ing it out and sells Treasury futures. Their concern is somewhat justified. As mentioned in the linked article, and analyzed in detail in my paper in the Journal of Applied Corporate Finance (“Apocalypse Averted“) the spike in the cash-futures Treasury basis caused by COVID (or more accurately, the policy response to COVID) caused a liquidity crisis. The sharp basis change led to big margin calls (thereby creating a demand for liquidity) and also set off a feedback loop: the unwinding of positions exacerbated the basis shock, and thereby reinforced the liquidity shock.

This is just an example of the inherent systemic risk created by margining, collateralization, and leverage. The issue is not a particular trade per se–it is an inherent feature of a large swathe of trades and instruments. What made the basis trade a big issue in March 2020 was its magnitude. And per the article, it has become big again.

This is not a surprise. Treasuries are a big market, and leveraging a small arb pickup is what hedge funds and other speculators do. It is a picking-up-nickels-in-front-of-a-steamroller kind of trade. It’s usually modestly profitable, but when it goes bad, it goes really bad.

All that said, the article is full of typical harum-scarum. It says the trade is “opaque and risky.” I just discussed the risks, and its not particularly opaque. That is, the “shadowy” of the title is an exaggeration. It has been a well-known part of the Treasury market since Treasury futures were born. Hell, there’s a book about it: first edition in 1989.

Although GiGi is not wrong that basis trades can pose a systemic risk, he too engages in harum-scarum, and flogs his usual nostrums–which ironically could make the situation worse:

“There’s a risk in our capital markets today about the availability of relatively low margin — or even zero margin — funding to large, macro hedge funds,” said Gensler, in response to a Bloomberg News inquiry about the rise of the investing style.

Zero margin? Really? Is there anyone–especially a hedge fund–that can repo Treasuries with zero haircut? (A haircut–borrowing say $99 on $100 in collateral is effectively margin). And how exactly do you trade Treasury futures without a margin?

As for nostrums, “The SEC has been seeking to push more hedge-fund Treasury trades into central clearinghouses.” Er, that would exacerbate the problem, not mitigate it.

Recall that it was the increase in margins and variation margins on Treasury futures, and the increased haircuts on Treasuries, that generated the liquidity shock that the Fed addressed by a massive increase in liquidity supply–the overhang of which lasted beyond the immediate crisis and laid the groundwork for both the inflationary surge and the problems at banks like SVB.

Central clearing of cash Treasuries layers on another potential source of liquidity demand–and liquidity demand shocks. That increases the potential for systemic shocks, rather than reduces it.

In other words, even after all these years, GiGi hasn’t grasped the systemic risks inherent in clearing, and still sees it as a systemic risk panacea.

In other words, even though I agree with Gensler (and the Fed) that basis trades are a source of systemic risk that warrant watching, I disagree enough with GiGi on this issue that the apocalypse that could result from our complete agreement on anything will be averted–without the intervention of the Fed.

As the periodic debt ceiling game of chicken proceeds, you might read about the credit default swap (CDS) rate on US government debt. This is commonly (even by economists) used to quantify the market’s estimate of probability that the US government will default. Although it is related to this probability, it is not a direct measure of the “true” probability. So interpret with extreme care. Especially in the case of US government debt.

As a little background, a CDS is a contract that pays off if the underlying entity–in this case, the US government–defaults on its obligations. In that event, the purchaser of protection receives the face value of the debt minus the price of the defaulted security. If the defaulted security is worth 40 cents on the dollar at default, the “recovery rate” is 40 percent and the protection buyer receives 60 cents on the dollar.

If the protection currently costs X, you might reason that your expected payoff is p(1-R), where p is the probability of default and R is the recovery rate. Thus, you can estimate p=X/(1-R).

The problem with this logic is that p is not the real world–“physical measure” or “true”–probability of default. It is the probability of default in the so-called “equivalent measure.” Roughly speaking, this p includes a risk adjustment, a risk premium if you will. In theory the p estimated this way could be less than the actual probability of default, meaning that the premium is negative. But usually the p implied this way will be above the objective probability of default. Put simply, just like when you insure your car you will pay a premium that exceeds your expected claims, with CDS the protection purchaser will pay a premium that exceeds the expected payoff.

Indeed, the risk premium embedded in Treasury CDS is likely to be quite large. The reason is that this type of CDS will pay off in bad states of the world–and likely very bad states of the world. That is, if the US government defaults, economic chaos and a recession (perhaps a severe one) is a likely outcome. The marginal utility of income (or wealth) is high when income (or wealth) is low, as during a large recession. Thus, protection sellers are required to perform on their contracts when the marginal utility of income/wealth is higher, so they are going to charge a high price in order to assume such an obligation. The worse the economic consequences of default, the higher the risk premium, and hence the price, that they will charge.

That is, the USG CDS price must exceed the expected payout, likely by a lot, because the payouts occur in bad economic times.

Corporate CDS spreads tend to be “upward biased” measures of default rates for companies, precisely because payoffs tend to be more likely during bad economic times because that’s when companies default. This bias is likely to be especially great for USD CDS precisely because a default will likely cause a severe economic contraction.

Another way to visualize this is to realize that there is considerable “systematic risk” in USG CDS. The risk in CDS payouts cannot be diversified away, and are highly correlated with the overall financial markets. Put differently, a US government default is not really an insurable risk. Classic insurance works by diversification and pooling of independent risks. That is not possible with USG CDS.

There’s another factor at play here–counterparty risk. How much would you pay for insurance from a financially shaky insurance company? Probably not much, because it may not be around to pay when you need it.

Since a US government default is likely to have severe consequences for the financial sector, there is a material probability that the seller of protection will be unable to perform in the event of a USG default.

This would tend to work in the opposite way as the risk adjustment described earlier, that is, it would tend to reduce the cost of protection. The protection is worth less because of the risk it would not be there when you need it. This reduces your willingness to pay for it.

These risk adjustment and counterparty risk issues are likely to be particularly acute for US Treasuries, given the potentially serious economic consequences of a government default. Meaning that USG CDS rates are very unreliable measures of the likelihood of a government default: they are impacted by both the probability of default and the economic consequences thereof.

Yes, a rising CDS spread–like we’ve seen recently–likely reflects a rising estimate of the true probability of a default. But you just can’t back out that probability from the rate.

I’m often tempted to say that those in charge of our military are not serious people. But I catch myself. They are in fact very, very serious people–the problem is that they are serious about agendas that are inimical to military effectiveness and national defense.

The most virulently inimical agendas is of course DIE. The current Air Force Chief of Staff, Charles Q. Brown–leading candidate to be JCS Chair–is perhaps the most egregious example. Brown is a quota monger:

The topic of the Air Force memorandum was officer quotas set by race and gender.

Similar quotas had been issued by political appointees in a politically correct military, but they had focused on slowly boosting minority officers rather than calling for a purge of white men.

The 2014 quotas had looked for an 80 percent white, 10 percent black and 8 percent Asian officer corps. While choosing officers by any racial category rather than merit is racist, wrong and illegal under civil rights legislation, this fell short of Brown’s proposed racist purge.

Brown’s quotas limit the number of white officers to 67% and cut white men down to 43%.

The Air Force officer corps is currently 77% white: getting it down to 67%, a reduction of 10%, would require serious effort to purge white officers and bar the doors to any new ones.

That will improve military effectiveness how, exactly?

A recent AF “experiment” suggests that “how much” is a negative number:

As part of the larger military-wide effort to promote diversity in the service’s pilot ranks, the 19th Air Force command near San Antonio, Texas, “clustered” racial minorities and female trainees into one class, dubbed “America’s Class,” to find out if doing so would improve the pilots’ graduation rates. However, not only did the effort fail to boost minority and women candidates’ success rates, but officers involved say they were ordered to engage in potentially unlawful discrimination by excluding white males from the class, documents show.

Excluding white males will help how, exactly? Specifically, how will it build unit cohesion?

Obviously, it won’t. It is inimical to unit cohesion. Military units need to suppress differences to succeed, not accentuate and emphasize them. I mean, I can’t even.

What was traditional boot camp all about? Suppressing individual differences. Making everyone believe he was just a soldier or a sailor or a Marine. One of thousands.

Some of the quotes in the Front Page article just leave me shaking my head:

“I am a Black man who happens to be the Chief Master Sergeant of the Air Force,” Kaleth Wright, now retired, had tweeted  “You don’t know the anxiety, the despair, the heartache, the fear, the rage and the disappointment that comes with living in this country… every single day.”

Uhm, you have reached the highest enlisted rank in the US Air Force. Yeah, I’m sure that happens a lot in racist countries. Damned white supremacism.

Or this:

Anthony Cotton, the Commander of US Strategic Command, had claimed that, “when I see what happened to Ahmaud Arbery, Breonna Taylor, George Floyd, Rayshard Brooks—and the list goes on and on… that could be me.”

No, General-Successor-of-Curtis-Lemay, it couldn’t be you. What would be more likely to be you is the 10,000+ blacks murdered in Chicago, Philly, DC, St. Louis, etc., etc., etc. Why don’t you talk about that? Why don’t you do something about that.

There’s also a vignette in the article about Brown whining about the cosmic injustice of being questioned about a parking spot.

Three people who are living proof of the lack of discrimination against blacks in the Air Force whining about how oppressed they are.

But this should not be surprising. Today, victimhood is status, and people compete intensely to prove how victimized they are, rather than to count the blessings that they have. Just another of the fucked up aspects of 2020s US culture.

Another illustration of the Diversity Cult: Air Force Assistant Secretary for Manpower and Reserve Affairs Alex Wagner proves–PROVES I TELLS YA–the power of diversity. Because of diversity, the AF avoided the incredible faux pas of handing out the wrong kind of socks as swag at SXSW! OMG! To think that the fate of the country’s defenses were rescued by such a brave woman!

Air Force Assistant Secretary for Manpower and Reserve Affairs Alex Wagner, shares a personal story about socks…yes socks… to explain why the military needs Diversity, Equity and Inclusion (DEI).

We are not a serious country. pic.twitter.com/HYKJ7qbRXV

— Charlie Kirk (@charliekirk11) March 24, 2023

But how does diversity help when the shit really goes down, Alex? Can you give me an example of that? I’d say I wait, but I’m not into reenacting Waiting For Godot.

(As an aside, recruiting at SXSW is itself a testament to idiocy and cluelessness. It’s leftish, hipster central.)

The repeated invocations of the benefits of diversity, like Wagner’s, are catechisms. Statements of a faith. NOT empirical truths. In fact, social science research (since at least Putnam) suggests the opposite: diversity undermines trust. And there is no environment where trust is more essential than in battle. None.

I could go on.

And then of course there’s the trans obsession in the military, e.g., the Navy thinking that a drag queen is totes what is needed to rescue plummeting recruiting numbers:

I guarantee, even if it does boost recruiting numbers, it will reduce the number of recruits that the Navy should want to attract: it would be subtraction by addition.

FFS, couldn’t they have just rebooted the Village People?

Again, I could go on. . .

And there’s the green angle. And no, I don’t mean green as in the Marines are the mean green machine. No–green as in environmentalism, and specifically the climate change cult.

I’ve written before about the SECNAV prioritizing climate change. (How will that beat China, Mr. Del Toro?) But it’s a Whole of Government effort. For example, the Energy Secretary, Canadian-born Jennifer Granholm, endorsed Joe Biden’s pledge to make all US military vehicles electric by 3030. Sorry! Sorry! By 2030.

This idea is cosmically stupid on more dimensions than I could possibly explore in a lifetime–even if I was 40 years younger.

Say, just how big and heavy would a battery on an M1AE (for electric!) Abrams have to be? And, pardon my impertinence, but how would you charge it, exactly? And boy won’t it be fun for the crew when that sucker gets hit and cooks off!

Again, I could go on . . .

Although the exempli gratia are virtually endless, I think you get the point. Those in charge of the US military are serious about just about everything except fighting and winning wars.

Meanwhile, recruiting is in the toilet and the Navy is a shitshow.

If the shit does get real, these termite years of race and gender and climate obsessives will result in the loss of wars, and mass casualties.

But the corpses (especially the officers’) will be diverse. And isn’t that what really matters?

In response to the liquidity crunch in the commodity trading sector (especially in energy trading) last year, the European Union is looking to regulate commodity traders more like banks:

For decades, Europe’s commodity traders have avoided being regulated on par with other financial firms. A new proposal currently working its way through the European Union legislative system could change that.

To close “loopholes,” dontcha know:

The loophole allows industrial companies like utilities and food processors — but also commodity trading houses — to take derivative positions without the scrutiny facing investment firms. Designed to reduce the burden of managing price risk, it also means that traders aren’t subject to rules on setting aside capital or limiting positions the same way banks and hedge funds are. 

2022 certainly saw unprecedented liquidity pressures in the commodity trading sector, as firms that had sold derivatives (especially on gas and power) to hedge their exposures from supplying the European market saw huge margin calls that greatly strained credit lines and led a coalition of traders to request ECB support (which the ECB declined).

The crucial part of the previous paragraph is “to hedge.” The danger of restricting or increasing the cost of such activities through regulation of the type that is apparently under consideration is that it will constrain hedging activities, thereby (a) making these firms more vulnerable to solvency, as opposed to liquidity problems, and (b) raising the costs of commodity intermediation.

Note that the companies that received state support that are mentioned in the article are not commodity traders qua commodity traders, e.g., Vitol or Trafigura or Gunvor. They are energy suppliers who were structurally short gas and did not hedge, and hence were facing serious solvency issues when gas prices exploded in late-2021 (before the Russian invasion) and winter and spring 2022 (when the invasion occurred). That is, firms that didn’t hedge were the ones that faced insolvency and received state support. (Curiously, Uniper is missing from the list of companies in the Bloomberg article, although Fortum Oyj was collateral damage from Uniper’s collapse.)

The relevant issue in determining whether commodity trading firms should be regulated like banks or hedge funds is not whether the traders can go bust: they can. It is whether (a) they are financially fragile like banks, and (b) whether they are systemically important.

These are exactly the same issue I addressed in my Trafigura white papers in 2013 and especially 2014. To summarize, commodity trading firms engage in completely different transformations than banks and many hedge funds. Commodity traders transform commodities in space, time, and form: banks engage in liquidity and maturity transformations. The difference is crucial.

Liquidity and maturity transformations are inherently fragile–they are the reasons that bank runs occur, as the recent failures of SVB, First Republic, and Signature Bank remind us. That is, the balance sheets of banks are fragile because they finance long term, illiquid assets with liquid short term liabilities.

Commodity traders’ balance sheets are completely different. The “pure” asset light traders especially: they fund short term (“self-liquidating”) relatively liquid assets (commodity inventories) with short term relatively liquid liabilities. Further, hedging is a crucial ingredient in this structure: banks are willing to finance the inventories because the price risks can be hedged.

This is not to say that commodity traders cannot fail–they can. But they do not face the same kinds of fragility (vulnerability to runs) that entities that engage in maturity and liquidity transformations do. It is this fragility that provides the rationale for bank capital requirements and limitations on the scope of their activities. This rationale is lacking for commodity trading firms. They are intermediaries, but not all intermediaries are alike.

Further, as I also pointed out almost a decade ago, major financial firms dwarf even the largest commodity trading firms. Even a Trafigura, say, is not remotely as large or systemically important as, say, Credit Suisse. Yes, a bankruptcy of a big trader would inflict losses on its lenders, but these losses would tend to be spread widely throughout the global banking sector given that most loans and credit lines to commodity traders are widely syndicated. And the potential for these kinds of losses are exactly reason that banks hold capital and that it is prudent to impose capital requirements on banks.

As I noted in the 2014 study, virtually the entire merchant energy sector in the United States imploded in 2002-3. Lenders ate losses, but the broader economic effect was minimal, the assets of the failed firms continued to operate, and the lights stayed on.

In sum, analogizing commodity traders to banks is seriously intellectually flawed, and what’s good or justified for one is not necessarily for the other because of the huge differences between them.

Pace Bloomberg, the events of 2021-2022 did not “expose” some new, unknown risk. The liquidity risk inherent in hedging has long been known, and I analyzed it in the white papers. Indeed, it’s been a focus of my research for years, and is the underlying reason for my criticism of clearing and collateral mandates–including those embraced enthusiastically by the EU.

Thus, a more constructive approach for Europe would be not to apply mindlessly regulatory restrictions found in banking to commodity firms, but to investigate ways to facilitate liquidity supply to commodity traders under extreme situations. Direct access of commodity traders to central bank funding is inadvisable, but central bank facilitation of bank supply of margin funding to commodity traders during such extraordinary circumstances worthy of investigation.

Recall that the Federal Reserve’s response to a funding crisis originating in the Treasury futures markets was instrumental in containing the systemic risks arising from COVID in March 2020 (as described in my Journal of Applied Corporate Finance article, “Apocalypse Averted“). The Fed’s actions were extemporized (just as they were during the 1987 Crash). The EU and ECB would do well to use that experience, and that of 2021-2022, to devise contingency arrangements in advance of future shocks. That would be a more constructive approach to the risks inherent in commodity risk management than to impose regulations that could impede risk management.

It is important to note that making hedging costlier instead of making it cheaper increases the risk of extreme price disruptions. Constraining risk management means that commodity traders will supply less intermediation especially during high risk periods. This will swell margins and make commodity supply less elastic, both of which will tend to exaggerate price movements during periods of stress.

I always wonder about the political economy of such regulatory proposals. Yes, no doubt regulatory reflex is a driver: “We have to do something. Let’s take something off the shelf and make it fit!” But my experience in 2012-2014 also motivates a more cynical take.

The genesis of the Trafigura white papers was an abortive white paper I wrote for the Global Financial Markets Association, a banking industry group. The GFMA approached me to investigate the systemic riskiness of commodity trading firms, and I came up with the wrong answer, so they spiked the study. Somehow or another Trafigura got wind of this, and that was the genesis of the influential (if I do say so myself) papers I wrote for the firm.

The point being that in 2012 the banks were pushing to regulate commodity trading firms with capital requirements and the like in order to raise the costs of competitors, and were looking for intellectual cover for that endeavor–cover I did not provide after a deep dive into the commodity trading sector.

Hence, I wonder if this reprise of the ideas that were largely shelved in the mid-2010s is an example of “let no crisis go to waste,” i.e., whether there are interests in Europe pressing to regulate commodity firms for shall we say less than public spirited reasons.

The proposals are apparently very protean at this stage. But it will be interesting to see where they progress from here. And I’ll weigh in accordingly.

The big news in the Russo-Ukrainian war transpired not in Bakhmut or anywhere else on the battle lines, but in Moscow where a drone struck a flag flying over the dome of the Kremlin:

1000x more embarrassing as Matthias Rust landing a Cessna in Red Square. Moscow allegedly has the most formidable air defenses in the world. Apparently not. https://t.co/KTKFGQC9K6

— streetwiseprof (@streetwiseprof) May 3, 2023

Like all things Russia that have occurred over the last year plus (e.g., the Nordstream explosions, the Darya Dugin assassination) no one knows for sure who is responsible, or why. Hence, the theories and accusations fly fast and furious, but with no facts by which to evaluate, only competing theories of motive exist, and people make judgments based on their prejudices and their beliefs (largely shaped by their prejudices) of what motive sounds most plausible.

Yes, the Ukrainians have a motive. But they deny any involvement. You could also argue that realizing the possible reactions in Russia, they would not do this–or at least the government would not. (See below.). But there are hotheaded elements in Ukraine who would not be so restrained, and who might even want to provoke an escalation.

Putin might also have a motive–a false flag operation to blow up the flag on the Kremlin, as it were. In order to justify escalation, as wildly hypocritical as that would be: “We can invade you, bomb your capital (and many other cities), attempt to assassinate your president, but how dare you fling a few drones at us!”

Track record gives this theory credence–there is a reasonable likelihood that Putin orchestrated the apartment bombings in Ryazan in order to justify the Second Chechen War. Further, the catastrophic failures of the past 14 months mean that the regime needs to do something to distract from the disasters and the death, and to feed the narrative of Ukraine as an existential threat to Russia that must be vanquished regardless of the cost.

The hysterical Russian reaction gives further credence to this theory. A plot to assassinate Putin!!!!! FFS, to say that a couple of drones carrying the kind of explosives depicted in the video could pose a threat to Putin buried deep in the bowels of the Kremlin (even assuming that he’s there) is farcical: this was the Mouse of All Bombs, not the Mother thereof. (And he could hide under that huge table! A table saved Hitler, right?) But noted narcoleptic and boogie master Dimi Medvedev is saying that as a result of this assassination attempt Russia has now no choice but to “annihilate” Zelensky:

Oh the narcoleptic with the awesome dance moves is acting tough again. Maybe he should show Zelensky the video: he might die of laughter. https://t.co/jGylG4UaMb

Russia has no choice but to annihilate Zelensky—Medvedev https://t.co/TunFKBUGMx

— streetwiseprof (@streetwiseprof) May 4, 2023

But if so, this is a sign of true desperation. Admitting that Ukraine is able to penetrate what is supposedly the most formidable air defense of any city in the world with drones would be a confession of military ineptitude that makes the failure to prevent German teenager Matthias Rust from landing a Cessna in Red Square in 1987 look like a military triumph. (The Russian military claimed that the drones had been disabled by electronic measures–sure as hell doesn’t look like it in the video.). Would Putin/the Russians really be willing to look this weak to provide a justification for doing something extreme? Has he ever needed a justification before? FFS, he just made shit up (denazification!!!!) before he invaded last year. He could just make shit up again. And certainly will.

But . . . going further down the Russian rabbit hole, maybe someone in the siloviki did this precisely to discredit rival factions in the military in order to justify a purge.

Really, whenever dealing with Russia I have to stop myself to prevent becoming like this:

Suffice it to say that under any theory one can think of, this does not bode well for Putin. Taken at face value, the event is further demonstration of Russian military incompetence. Switching to riddle-enigma-mystery-dogs-fighting-under-the-carpet mode, the event smacks of desperation and/or internal feuding and chaos. Regardless, it bodes a continuation of a futile, pointless war until Putin goes tits up, one way or another.