Streetwise Professor

June 28, 2018

A Tarnished GEM: A Casualty of Regulation, Spread Explosions, or Both?

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 6:28 pm

Geneva Energy Markets LLC, a large independent oil market maker, has been shuttered.  Bloomberg and the FT have stories on GEM’s demise.  The Bloomberg piece primarily communicates the firm’s official explanation: the imposition of the Basel III leverage ratio on GEM’s clearer raised the FCM’s capital requirement, and it responded by forcing GEM to reduce its positions sharply.  The FT story contains the same explanation, but adds this: “Geneva Energy Markets, which traded between 50m and 100m barrels a day of oil, has sold its trading book after taking ‘significant losses’ in oil futures and options, a person close to the company said.”

These stories are of course not mutually exclusive, and the timing of the announcement that the firm is shutting down months after it had already been ordered to reduce positions suggests a way of reconciling them. Specifically, the firm had suffered loss that made it impossible to support even its shrunken positions.

The timing is consistent with this.  GEM is primarily a spread trader, and oil spreads have gone crazy lately.  In particular, spread position short nearby WTI has been killed in recent days due to the closure of Canadian oil sands production and the relentless exports of US oil.  The fall in supply and continued strong demand have led to a rapid fall in oil stocks, especially at Cushing.  This has been accompanied (as theory says it should be!) by a spike in the WTI backwardation, and a rise in the WTI-Brent differential (and other quality spreads with a WTI leg).  If GEM was short the calendar spread, or had a position in quality spreads that went pear-shaped with the explosion in WTI, it could have taken a big hit.  Or at least a big enough hit to make it unviable to continue to operate at a profitable scale.

Here’s a cautionary tale.  Stop me if you’ve heard it before:

“The notional value of our book was in excess of $50 billion,” Vonderheide said. “However, the actual risk of the book was always relatively low, with at value-at-risk at around $2 million at any given time.”

If I had a dollar for every time that I’ve heard/read “No worries! Our VaR is really low!” only to have the firm fold (or survive a big loss) I would be livin’ large.  VaR works.  Until it doesn’t.  At best, it tells you the minimum loss you can suffer with a certain probability: it doesn’t tell you how much worse than that it can get.  This is why VaR is being replaced or supplemented with other measures that give a better measure of downside risk (e.g., expected shortfall).

I would agree, however, with GEM managing partner Mark Vonderheide (whom I know slightly):

“The new regulation is seriously damaging the liquidity in the energy market,” Vonderheide said. “If the regulation was intending to create a safer and more efficient market, it has done completely the opposite.”

It makes it costlier to make markets, which erodes market liquidity, thereby making it costlier for firms to hedge, and more difficult to enter and exit positions.  Liquidity reductions resulting from this type of regulation tend to be most acute during periods of high volatility–which can exacerbate the volatility, perversely.  Moreover, like much of Frankendodd and its foreign fellow monsters, it tends to hit small to medium sized firms worse than bigger ones, and thereby contributes to greater concentration in the markets–exactly the opposite of the stated purpose.

As Reagan said: “The most terrifying words in the English language are: I’m from the government and I’m here to help.” Just ask GEM about that.

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  1. Meanwhile, the non-Reagan has, in short order, organized trade wars with Canada and the EU and indicated he wants to bring a gangster into G7 because reasons. All clearly in US interest and not in Putin’s.

    Whatever the rhetoric, Obama can be proud his greatest legacy of undermining allies and rewarding enemies survives and thrives.

    Comment by Ivan — June 28, 2018 @ 10:17 pm

  2. “like much of Frankendodd”: is that an allusion to what I think of as DankFraud?

    Comment by dearieme — June 29, 2018 @ 5:50 am

  3. These new effects are by no means limited to energy markets. Credit especially has gotten more much more volatile and illiquid. Price moves in Bahraini and Argentine debt are just this weeks’ examples. Add to that two structural shifts and you have a recipe for much more pain for both asset managers and investors. The first, which affects Volatility more, is the now decades long reallocation from active management to passive management. The more an asset falls the more passive money must sell to maintain index weights. This becomes a Negative feedback loop that just cannot be absorbed by overly constrained market makers. The second is the ever greater mismatch between liquidity provided to end investors and that available in underlying assets. (This is less a problem for hedge funds than for real money and especially etfs). Cash levels have to be kept higher to meet redemptions. returns to leverage suffer even more. This reduces everyone’s overall return. Kiss yesterday’s sharpe ratios goodbye. You’ll never see them again. GEM will be the first of many.

    Comment by Dh — June 30, 2018 @ 5:33 pm

  4. “Vonderheide said. “If the regulation was intending to create a safer and more efficient market, it has done completely the opposite.”

    SP: “It makes it costlier to make markets…”

    Is it possible, the opposite is exactly what the EU intended?

    Given the way it’s structured and given its political philosophy, one suspects the EU government is more interested in a command economy than in a market economy. With, of course, EU bureaucrats in command.

    Comment by Pat Frank — July 2, 2018 @ 8:37 pm

  5. @dearieme–yes it is!

    The ProfessorComment by The Professor — July 3, 2018 @ 7:25 pm

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