Streetwise Professor

Before the massacre over Donetsk, the big Russia-related story was the new sanctions imposed on Wednesday. Although those sanctions were overshadowed by yesterday’s atrocity, the wanton destruction of MH17 raises the possibility that more intense sanctions will be forthcoming. Therefore, it is worthwhile to examine what the US did Wednesday to see what would be necessary to impose truly crippling costs on Russian companies and the Russian economy generally. (Forget what the Euros did. That is so embarrassing that it should be passed over in silence.)

The sanctions imposed Wednesday are very weak beer. (Here is an FAQ from the Treasury outlining them.) They were different than previous sanctions in that these were directed at companies, rather than individuals. Moreover, some of the targeted companies are on the commanding heights of the Russian economy: Rosneft, VTB, Gazprombank, and Novatek. (Notable absences: Gazprom and Sberbank.)

Under the sanctions, “US Persons” (which can include US subsidiaries in foreign countries) are prohibited from buying new debt from or new making loans to these companies with maturities of 90 days. (Existing loans/bonds are not affected.)  US persons are also precluded from buying “new” equity from the financial firms: they can buy new equity from Rosneft and Novatek.

Since US banks are major lenders to foreign companies, this might seem to be a major impediment to the affected companies, and indeed  Rosneft’s and Novatek’s stock prices were both down more than 5 percent on the news. But in my opinion, this reaction is more related to how the announcement raised the likelihood of more severe sanctions in the future, rather than the direct effects of these new sanctions.

That’s because although the sanctions will constrain the capital pool that Rosneft and the others can borrow from, other lenders in Europe and Asia can step into the breach. The sanctions do make it more difficult for the sanctioned companies to borrow dollars even from foreign banks, because although the sanctions do not bar foreign banks and investors from accessing the US dollar clearing system for most transactions, they could be interpreted to make it illegal to process the banned debt and equity deals:

U.S. financial institutions may continue to maintain correspondent accounts and process U.S. dollar-clearing transactions for the persons identified in the directives, so long as those activities do not involve transacting in, providing financing for, or otherwise dealing in prohibited transaction types identified by these directives.

Some have argued that this is a serious constraint that will effectively preclude the sanctioned companies from borrowing dollars other than on a very short-term basis. This is allegedly a big problem for Rosneft, because its export revenues are in dollars, and borrowing in other currencies would expose the company to substantial exchange rate risk.

I disagree, because there are ways around this. A company could borrow in Euros, for instance, and  sell the Euros for dollars. It could then deposit, invest, or spend the dollars just like the proceeds from dollar loans because it would have access to the dollar clearing system. Alternatively, the companies could borrow in Euros and immediately swap the Euros into dollars. This is because derivatives transactions are not included in the sanctions, and the payments on those could also be cleared. This would add some expense and complexity, but not too much.

The sanctions even permit  financial engineering that would allow US banks  effectively to provide credit for the sanctioned firms because derivatives on debt and equity of the sanctioned firms are explicitly exempted from the sanctions. For instance, a US bank could sell credit protection on Rosneft to a European bank that would increase the capacity of the European bank to extend credit to Rosneft. Syndication is one way that US banks can get credit exposure to Rosneft and reduce the amount of credit exposure that foreign banks have to incur, and even though the sanctions preclude US banks from participating in syndicates, the same allocation of credit risk could be implemented through the CDS market. This would permit foreign banks to increase their lending to the sanctioned firms to offset the decline of US direct lending. (This would still involve the need to convert foreign currency into dollars if the sanctioned borrower wanted dollars.)

Unlike real super majors (who can borrow unsecured, or secured by physical assets), Rosneft is unusually dependent on prepaid oil sales for funding, and these agreements are almost exclusively in dollars. This has led to some debate over whether the sanctions will seriously cramp Rosneft’s ability to use prepays.

There are a couple of reasons to doubt this. First, after the initial round of sanctions raised the specter of the imposition of sanctions on Rosneft, many prepay deals were re-worked to include sanctions clauses. For instance, they permit the payment currency to be switched to Euros, or to another currency in the off chance that the Europeans grow a pair and shut Rosneft out of the Euro payment system. Again, as long as access to the dollar system is not blocked altogether, those non-dollar currencies could be converted into dollars.

Second, there is some ambiguity as to whether prepays would even be covered. The sanctions specify the kinds of transactions that are covered:

The term debt includes bonds, loans, extensions of credit, loan guarantees, letters of credit, drafts, bankers acceptances, discount notes or bills, or commercial paper.

It is not obvious that prepays as usually structured would fall into any of these categories, and prepays are not specifically mentioned. A standard prepay structure is for a syndicate of banks to extend a non-recourse loan to a commodity trading firm like Glencore, Vitol, Trafigura, or BP. The trading firm uses the loan proceeds to make a prepayment for oil to Rosneft. In return, the trading firm gets an off take agreement that obligates Rosneft to deliver oil at a discounted price: the discount is effectively an interest payment.

The banks lend to the trading companies, not Rosneft. But (except for a small participation of 5-10 percent by the traders) the banks have the credit exposure. So this does not fall under any of the listed categories, except for perhaps “extension of credit.” Insofar as the trading firm is the borrower who faces the banks, it’s not clear the banks fall afoul of the sanctions even though that banks bear Rosneft’s credit risk. What about the trading firm? It’s not a US person, and a prepayment is not explicitly listed as a type of debt under the sanctions: again, this would turn on the “extensions of credit” provision. Under prepays, payment is usually with an irrevocable letter of credit, but these generally have maturities of less than 90 days, so that’s free of any sanctions problem.

So, there’s a colorable argument that prepays aren’t subject to the sanctions. But there is a colorable argument that they are. Economically they are clearly loans to Rosneft, though done via a trading firm acting as a conduit. But whether they are “debt” legally under the sanctions definition is not clear.

But especially in this regulatory environment, bank (and trading firm) tolerance for ambiguity is  pretty low. So the FUD factor kicks in: even though they could make a plausible legal argument that prepays fall outside the definition of debt under the Treasury rules, the risk of having that argument fail may be sufficient to dissuade them from doing dollar prepays. This is especially true in the post BNP Paribas world. So it is likely that future prepays may be in currencies other than the dollar, and as long as dollar clearing is open to it, Rosneft will just have to convert or swap the Euros or Sterling or Swiss Francs or whatever  into dollars if it really wants to borrow dollars. Again, an inconvenience and an added expense, but not a major hurdle.

All this means that the most recent round of sanctions are  sound and fury, signifying not very much. Indeed, by deliberately avoiding the truly devastating sanction, this round signifies a continued reluctance to hit Putin and Russia where it really hurts. Someone like Putin likely interprets this as a sign of weakness.

What would the devastating sanction that was deliberately avoided be? Cutting off altogether access to the dollar clearing system. Recall that the just-imposed sanctions say “U.S. financial institutions may continue to maintain correspondent accounts and process U.S. dollar-clearing transactions for the persons identified in the directives.” Change that to “U.S. financial institutions are prohibited from maintaining correspondent accounts and processing U.S. dollar-clearing transactions for the persons identified in the directives” and it would be a whole new ballgame. This would mean that the sanctioned companies could not receive, spend, deposit, or invest a dollar. (Well, they could if they could find a bank insane enough to be the next BNP Paribas. Good luck with that.)

I discussed how this would work in a post in March, and the Banker’s Umbrella provided a very readable and definitive discussion about that time. Basically, every dollar transaction, even one handled by a foreign bank, involves a correspondent account at a US bank. Cut off access to those accounts, and the sanctioned company can’t touch a dollar.

This would close off the various workarounds I discussed above. The sanctioned companies would have to restructure their operations and financing pretty dramatically. This would be particularly challenging for Rosneft, given that the currency of choice in oil transactions is the USD. This would be like the sanctions that have been imposed on Iran and on Sudan.

This would represent the only truly powerful sanction. And that’s one of the issues. Anything short of cutting off all access to the dollar market is at most an irritant to the sanctioned companies. Cutting off all access imposes a major cost. There’s not much in between. It’s a choice between a pinprick and a sledgehammer blow, with little in-between.

But if a Rubicon hasn’t been crossed now, with the murder of 298 people and continued battles in places like Luhansk waged by Russian-armed rebels, it’s hard to imagine it will ever be. If Putin and Russia are going to pay a real price for their wanton conduct, the sledgehammer is the only choice.

To further the last sentence of my last post: I am not sanguine about those who hold office in the US and Europe to rise to the challenge that Putin has laid before the world.

Obama, certainly, was less than Churchillian or Reaganesque in his first response to the crime over Donetsk. Sayeth Barry: “It looks like it may be a terrible tragedy.”

First: it was not a tragedy. It was an atrocity.

Second: “looks like”? “May be”?

Go out on a limb there, Barry.

Words fail. Truly.

With that box checked, Barry went on to tell some jokes. And give a banal speech about infrastructure or some such. Then he jetted off to a fundraiser. Or maybe it was (according to CBS News) a “political meeting”, as if that makes it all better.

I have a serious question. I mean it. I ask this in all seriousness: Just what would it take for Obama to cancel a fundraiser? Anything short of Armageddon? For we have yet to see any atrocity sufficiently horrific (Benghazi, Donetsk, the chaos on the Rio Grand) sufficient to deflect Barry from his appointed rounds of feeding red meat to the partisan faithful, and raking in their dough.

I guess we can be grateful that he did not give a shoutout to Joe Medicine Crow. So there’s that. He’s growing in the job.

Some have praised him for being “no drama Obama.” I have a different take. I view his behavior in response to atrocity as revealing a  lack of affect that is deeply disturbing.

Regardless of the psychological roots for his behavior, it is all too clear that Obama is not up to the challenge that Putin poses, because of a lack of ability, a lack of interest, or more likely, both. Narcissist that he is, the only thing that is likely to engage him is if he believes that Putin has insulted or slighted him. But I doubt that even that is sufficient to rouse him to actions appropriate to the circumstances.

There are pros and cons of both parliamentary systems, and the US system. One of the disadvantages of the US system is that we are cursed to endure incompetent chief executives until their terms expire. Think of James Buchanan, dithering in the White House while Kansas bled and the nation spiraled into Civil War. In contrast, Chamberlain was ousted after the debacle in May, 1940. But we-and by that I mean the world, not just the US-have to endure Obama until 20 January, 2017. An incompetent, disengaged, lame duck holds the Office Formerly Known As Leader of the Free World. What havoc can occur in 30 months with such a man holding the highest office in the land, and the most powerful position in the world.

I had been planning to write on the latest round of sanctions, but of course that story has been overtaken by an utterly horrific event: the shooting down, by a surface-to-air missile, of a Malaysian Air 777 flying over Donetsk.

This is an unspeakable crime. Unspeakable.

I can state with near metaphysical certainty that this was the work of Russian-supported and inspired rebels from the Donetsk People’s Republic, or perhaps even the Russian military itself. The jet was downed in the same area where two Ukrainian military planes were destroyed by SAM fire in the last couple of days. The ex-FSB (or maybe not ex-) creature Girkin (aka “Strelkov”-the recent event gives new meaning to the word “shooter”) bragged on V Kontakte about shooting down a Ukrainian transport plane today . . . and then scrubbed the site once it was revealed that a civilian airliner had been destroyed. The rebels had bragged about, and Russian state media had bragged about, the rebels possession of an SA-17 Buk SAM system-which they now deny. Ukraine released transcripts of communications between rebels, and between rebels and one of their freakazoid Cossack contacts in Russia, blaming the shootdown on Cossacks rebels stationed near the border.

I could go on, but it’s not necessary.

I would hope that this is the KAL 007 moment of the New Cold War. The KAL 007 moment of Putinism. For those old enough to remember-and my memories are extremely vivid-in the aftermath of the KAL atrocity the Soviets denied, denied, denied. Then Jeanne Kirkpatrick made a presentation at the UN Security Council that played intercepted communications between the Soviet pilots that shot down the plane and Soviet air defense commanders that made it clear beyond all possible doubt that the Soviets had shot down the plane.

We certainly have the national technical means to determine who launched the weapon, and from where. We have the means to intercept communications. Satellites will have recorded exactly where the weapon was launched. Depending on the sensors we have deployed, or the Ukrainians may have deployed, we can monitor and record the radar transmissions of any air defense systems in the area. The radar signature of different systems is unique, so this would permit definitive identification of missile type as well as location.

Let’s put that all out there in the UNSC, and watch the loathsome Vitaly Churkin squirm.

But that should only be the beginning. The crucial task is to lay out information connecting the rebels to the Russian government, military, and intelligence services. Again, we no doubt have such information, even if (as is likely) that Snowden information revealed weaknesses in Russian communications security that they have closed. But I doubt that things have gone totally dark for us. What’s more, we have the means, motive, and opportunity to track movements of equipment from Russia to the Donbas.

This is the time where the NSA, CIA, DIA, and National Reconnaissance Organization demonstrate their true functions and capabilities. It’s not about snooping on Fritz’s Amazon’s purchases: it’s about uncovering Ivan’s evil acts.

Moreover, just consider the fact that the Russians would not be  so nuts as to allow a SAM battery (or even a single launcher) operate right on the border, in an area where Russian military and civilian aircraft are operating and within range, without coordinating with Russian air defense system controllers and Russian air traffic control. Hell, given what control freaks the Russians are, it’s highly likely that the Russians have to give permission for that battery to fire.

We have to lay all this out there. Put Putin on the spot. Show the world just what he has done, and what he is doing, in Ukraine. Of course, anyone who is willing to look at the facts objectively already knows, but that category excludes vast swathes of Europeans and many Americans. Maybe 295 dead, innocent Dutch, French Germans, Brits, etc., including 80 children, will be enough to get them to face reality. There are none so blind as those who will not see. Make them see, and shame them mercilessly if they still resist.

Merkel is now on the spot. France too: if it goes ahead with the Mistral sale after this, we should sink the damn things. And then text Hollande pictures of the dead babies strapped in their seats, lying bloodied in the Ukrainian dirt.

The KAL shootdown was a turning point in the Cold War. It revealed the Soviet leadership to be both evil and drastically out of touch. Their handling of the affair was utterly embarrassing. Indeed, it helped usher in the rise of Gorbachev, and had a dramatic effect on European public opinion: after having resisted, Germany approved deployment of Pershing II missiles post-KAL 007, in large part because of what it revealed about the true nature of Soviet leadership. (Think on that one, Angela. Think hard.)

We should hope that out of this horror something positive like that occurs now. Putin is doing his part, blaming the shootdown on Ukraine for failing to capitulate to the Russian proxy invasion. Russian state media has gone one better, claiming that the Ukrainians shot down the plane while they were targeting Putin’s.

In other words, this event has the potential to be like Napoleon’s assassination of the Duc d’Enghien: as Talleyrand said, “it was worse than a crime. It was a blunder.”

295 innocent people should not have died: or, to be more accurate, 295 innocent people should not have been murdered. But if their deaths hasten the demise of the criminal Putin regime, at least they will not have died in vain. It is the duty-if they understand the meaning of the word-of people like Obama and Merkel to make sure that the innocents’ sacrifice was not in vain.

Are they-are we-“highly resolved that the dead shall not have died in vain”?

I wish I were more sanguine about the answer to that question.

A recent working paper by Pradeep Yadav, Michel Robe and Vikas Raman tackles a very interesting issue: do electronic market makers (EMMs, typically HFT firms) supply liquidity differently than locals on the floor during its heyday? The paper has attracted a good deal of attention, including this article in Bloomberg.

The most important finding is that EMMs in crude oil futures do tend to reduce liquidity supply during high volatility/stressed periods, whereas crude futures floor locals did not. They explain this by invoking an argument I did 20 years ago in my research comparing the liquidity of floor-based LIFFE to the electronic DTB: the anonymity of electronic markets makes market makers there more vulnerable to adverse selection. From this, the authors conclude that an obligation to supply liquidity may be desirable.

These empirical conclusions seem supported by the data, although as I describe below the scant description of the methodology and some reservations based on my knowledge of the data make me somewhat circumspect in my evaluation.

But my biggest problem with the paper is that it seems to miss the forest for the trees. The really interesting question is whether electronic markets are more liquid than floor markets, and whether the relative liquidity in electronic and floor markets varies between stressed and non-stressed markets. The paper provides some intriguing results that speak to that question, but then the authors ignore it altogether.

Specifically, Table 1 has data on spreads in from the electronic NYMEX crude oil market in 2011, and from the floor NYMEX crude oil market in 2006. The mean and median spreads in the electronic market: .01 percent. Given a roughly $100 price, this corresponds to one tick ($.01) in the crude oil market. The mean and median spreads in the floor market: .35 percent and .25 percent, respectively.

Think about that for a minute. Conservatively, spreads were 25 times higher in the floor market. Even adjusting for the fact that prices in 2011 were almost double than in 2006, we’re talking a 12-fold difference in absolute (rather than percentage) spreads. That is just huge.

So even if EMMs are more likely to run away during stressed market conditions, the electronic market wins hands down in the liquidity race on average. Hell, it’s not even a race. Indeed, the difference is so large I have a hard time believing it, which raises questions about the data and methodologies.

This raises another issue with the paper. The paper compares at the liquidity supply mechanism in electronic and floor markets. Specifically, it examines the behavior of market makers in the two different types of markets. What we are really interested is the outcome of these mechanisms. Therefore, given the rich data set, the authors should compare measures of liquidity in stressed and non-stressed periods, and make comparisons between the electronic and floor markets. What’s more, they should examine a variety of different liquidity measures. There are multiple measures of spreads, some of which specifically measure adverse selection costs. It would be very illuminating to see those measures across trading mechanisms and market environments. Moreover, depth and price impact are also relevant. Let’s see those comparisons too.

It is quite possible that the ratio of liquidity measures in good and bad times is worse in electronic trading than on the floor, but in any given environment, the electronic market is more liquid. That’s what we really want to know about, but the paper is utterly silent on this. I find that puzzling and rather aggravating, actually.

Insofar as the policy recommendation is concerned, as I’ve been writing since at least 2010, the fact that market makers withdraw supply during periods of market stress does not necessarily imply that imposing obligations to make markets even during stressed periods is efficiency enhancing. Such obligations force market makers to incur losses when the constraints bind. Since entry into market making is relatively free, and the market is likely to be competitive (the paper states that there are 52 active EMMS in the sample), raising costs in some state of the world, and reducing returns to market making in these states, will lead to the exit of market making capacity. This will reduce liquidity during unstressed periods, and could even lead to less liquidity supply in stressed periods: fewer firms offering more liquidity than they would otherwise choose due to an obligation may supply less liquidity in aggregate than a larger number of firms that can each reduce liquidity supply during stressed periods (because they are not obligated to supply a minimum amount of liquidity).

In other words, there is no free lunch. Even assuming that EMMs are more likely to reduce supply during stressed periods than locals, it does not follow that a market making obligation is desirable in electronic environments. The putatively higher cost of supplying liquidity in an electronic environment is a feature of that environment. Requiring EMMs to bear that cost means that they have to recoup it at other times. Higher cost is higher cost, and the piper must be paid. The finding of the paper may be necessary to justify a market maker obligation, but it is clearly not sufficient.

There are some other issues that the authors really need to address. The descriptions of the methodologies in the paper are far too scanty. I don’t believe that I could replicate their analysis based on the description in the paper. As an example, they say “Bid-Ask Spreads are calculated as in the prior literature.” Well, there are many papers, and many ways of calculating spreads. Hell, there are multiple measures of spreads. A more detailed statement of the actual calculation is required in order to know exactly what was done, and to replicate it or to explore alternatives.

Comparisons between electronic and open outcry markets are challenging because the nature of the data are very different. We can observe the order book at every instant of time in an electronic market. We can also sequence everything-quotes, cancellations and trades-with exactitude. (In futures markets, anyways. Due to the lack of clock synchronization across trading venues, this is a problem in a fragmented market like US equities.) These factors mean that it is possible to see whether EMMs take liquidity or supply it: since we can observe the quote, we know that if an EMM sells (buys) at the offer (bid) it is supplying liquidity, but if it buys (sells) at the offer (bid) it is consuming liquidity.

Things are not nearly so neat in floor trading data. I have worked quite a bit with exchange Street Books. They convey much less information than the order book and the record of executed trades in electronic markets like Globex. Street Books do not report the prevailing bids and offers, so I don’t see how it is possible to determine definitively whether a local is supplying or consuming liquidity in a particular trade. The mere fact that a local (CTI1) is trading with a customer (CTI4) does not mean the local is supplying liquidity: he could be hitting the bid/lifting the offer of a customer limit order, but since we can’t see order type, we don’t know. Moreover, even to the extent that there are some bids and offers in the time and sales record, they tend to be incomplete (especially during fast markets) and time sequencing is highly problematic. I just don’t see how it is possible to do an apples-to-apples comparison of liquidity supply (and particularly the passivity/aggressiveness of market makers) between floor and electronic markets just due to the differences in data. Nonetheless, the paper purports to do that. Another reason to see more detailed descriptions of methodology and data.

One red flag that indicates that the floor data may have some problems. The reported maximum bid-ask spread in the floor sample is 26.48 percent!!! 26.48 percent? Really? The 75th percentile spread is .47 percent. Given a $60 price, that’s almost 30 ticks. Color me skeptical. Another reason why a much more detailed description of methodologies is essential.

Another technical issue is endogeneity. Liquidity affects volatility, but the paper uses volatility as one of its measures of stressed markets in its study of how stress affects liquidity. This creates an endogeneity (circularity, if you will) problem. It would be preferable to use some instrument for stressed market conditions. Instruments are always hard to come up with, and I don’t have one off the top of my head, but Yanev et al should give some serious thought to identifying/creating such an instrument.

Moreover, the main claim of the paper is that EMMs’ liquidity supply is more sensitive to the toxicity of order flow than locals’ liquidity supply. The authors use order imbalance (CTI4 buys minus CTI4 sells, or the absolute value thereof more precisely), which is one measure of toxicity, but there are others. I would prefer a measure of customer (CTI4) alpha. Toxic (i.e., informed) order flow predicts future price movements, and hence when customer orders realize high alphas, it is likely that customers are more informed than usual and earn positive alphas. It would therefore be interesting to see the sensitivities of liquidity supply in the different trading environments to order flow toxicity as measured by CTI4 alphas.

I will note yet again that market maker actions to cut liquidity supply when adverse selection problems are severe is not necessarily a bad thing. Informed trading can be a form of rent seeking, and if EMMs are better able to detect informed trading and withdraw liquidity when informed trading is rampant, this form of rent seeking may be mitigated. Thus, greater sensitivity to toxicity could be a feature, not a bug.

All that said, I consider this paper a laudable effort that asks serious questions, and attempts to answer them in a rigorous way. The results are interesting and plausible, but the sketchy descriptions of the methodologies gives me reservations about these results. But by far the biggest issue is that of the forest and trees. What is really interesting is whether electronic markets are more or less liquid in different market environments than floor markets. Even if liquidity supply is flightier in electronic markets, they can still outperform floor based markets in both unstressed and stressed environments. The huge disparity in spreads reported in the paper suggests a vast difference in liquidity on average, which suggests a vast difference in liquidity in all different market environments, stressed and unstressed. What we really care about is liquidity outcomes, as measured by spreads, depth, price impact, etc. This is the really interesting issue, but one that the paper does not explore.

But that’s the beauty of academic research, right? Milking the same data for multiple papers. So I suggest that Pradeep, Michel and Vikas keep sitting on that milking stool and keep squeezing that . . . data 😉 Or provide the data to the rest of us out their and let us give it a tug.

Germany has won the World Cup, which is somewhat annoying because they will become even more insufferable. And that is saying something given their recent behavior, especially with regards to Russia, and the spying imbroglio with the US.

Regarding Russia, it was particularly nauseating to see Merkel being quite chummy with Putin at the Cup final game. The Euros had pressured Ukrainian president Poroshenko to go as well, so that he could have a chat with Vlad. Poroshenko wisely begged off, staying home to direct the counterattack against the Russia-supported, inspired, and supplied rebellion in two eastern provinces. He no doubt realized that he would be sandbagged if he went to Rio, and for that he could have blamed it on Angela.

For despite her reputation as the bad cop in dealing with Putin (earned only by comparison with outright enablers, understanders, and collaborators like Steinmeier and Schroeder), Merkel has been putting much more pressure on the beleaguered Poroshenko than on Putin. The Euros, led by Germany, have been pushing Ukraine to negotiate directly with the freakazoid “leaders” of the “republics” of Donetsk and Luhansk. Moreover, Merkel tutted that Ukraine’s counterattack should be “proportionate.”

Well, “proportionality” is usually trotted out by the friends of those who are losing to stymie the advance of the stronger side that is winning by preventing it from exploiting its advantages. In this instance, moreover, “proportionate” would involve Ukraine sending armor across the border into Belgorod and Voronezh, and supporting separatists in Dagestan and Chechnya. BUt somehow I don’t think that’s what Angela means. I think she means that Ukraine should not fight to win, and that suits Putin just fine.

The Ukrainians are fighting a rebel force that has inflicted large casualties on it; has embedded itself in civilian areas; committed (per the UN) widespread “stomach churning” atrocities; destroyed bridges and rail lines; and deployed landmines and booby traps. Under the circumstances, Poroshenko has been restrained.

But Angela is running interference for her soccer buddy. In other ways as well. For instance, she is resisting the permanent deployment of NATO troops in new eastern European member states, like Poland and the Baltics. She brought up the NATO-Russia Founding Act in order to rationalize her position, but this has absolutely nothing to do with the deployment of conventional troops: it only discusses the deployment of nuclear weapons in former Warsaw Pact states.

Then there’s the spying issue, which contrary to usual practice, the Germans are making into a major public spectacle, culminating in its request that the head CIA official in Germany depart the country.

The Germans really need to get over themselves on this one. As I’ve written before, they have earned the scrutiny they get. Indeed, their heel-dragging on Russia warrants skepticism about them. They have often worked against the US within NATO. The rejection of Georgia and Ukraine in 2008 is one example. Libya is another. It has contributed to the rejuvenation of the Russian military (a tradition going back to the 1920s). It is an important country that bears watching. Not just for those reasons, but because (as I have noted before) the country is well-known to have been heavily penetrated by Soviet then Russian intelligence, and its businesses are rather notorious for their use of bribery to get international sales and contracts: this summary of Siemens’ sins over the years makes for enlightening reading. Since the US can have little confidence that Germany will advance US interests, and since the US has strong reasons to believe Germany might actually work against US interests, it is definitely in our interest to know what Germany is thinking and planning.

In other words, Germany wants it both ways, in a very adolescent way. It wants to pursue an independent policy that is often at odds with US policy and interests, but it also expects the US to treat it like a country whose interests are strongly aligned with ours. Sorry. If you want to act routinely contrary to US interests, the US is more than justified in not trusting, and verifying. And that involves espionage.

One of the things that has exercised the Germans most about the current spy scandal is that the man in question, “Marcus R,” passed documents relating to a German parliamentary investigation of the Snowden allegations. Well, that brings up another thing, doesn’t it? Snowden inflicted major damage on the US, and his collaborators (notably Appelbaum and Poitras) are living large in Berlin. A good part of the German establishment has been very supportive of Snowden. All of these things are rather hostile to the US, so what, we’re supposed to shrug and say “whatever”? Given Snowden’s current location, this also plays into the earlier-mentioned problem of German enabling of Putin and Russia. German dealings with Snowden are very much a matter of American national security.

It’s also rather annoying that the Germans are getting so exercised about American espionage, but direct no outrage whatsoever at Russian activities in the country.

The linked article says that public pressure has forced Merkel to act. With respect to the most recent spying issue, that’s not much of an excuse: the public pressure is the result of Germany’s publicizing the episode.

What’s more, Germany made claims that it had uncovered a second US spy, but that story pretty much evaporated on exposure to the sunlight. It now appears that the military officer in question was in touch with the State Department, not the CIA or any other US intelligence agency. Moreover, a search of the man’s home revealed nothing. So the Germans went off half-cocked and inflamed an already difficult situation, rather than acting in a more responsible way in an attempt to tamp down the passions. Another adolescent and self-absorbed political move.

Perhaps the only good thing to come of this is that it has united Congress and the administration on at least one thing. Both are heartily annoyed at the German teenage temper tantrum.

The bottom line for the US is that its interests and those of Germany are not closely aligned, especially on issues relating to Russia. So be it. But this is precisely why Obama’s policy of largely deferring to Europe (which de facto means largely deferring to Germany) on policy towards Russia and Ukraine is so problematic. Yes, the Germans (and Italians and Austrians etc.) will squeal. But doing things their way will embolden Putin, and that will just lay the groundwork for even bigger problems in the future. If Angela Merkel is the bad cop, Putin has it made.

Today is the 25th anniversary of the most important event in my professional life. On 11 July, 1989, the Chicago Board of Trade issued an Emergency Order requiring all firms with positions in July 1989 soybean futures in excess of the speculative limit to reduce those positions to the limit over five business days in a pro rata fashion (i.e., 20 percent per day, or faster). Only one firm was impacted by the order, Italian conglomerate Ferruzzi, SA.

Ferruzzi was in the midst of an attempt to corner the market, as it had done in May, 1989. The EO resulted in a sharp drop in soybean futures prices and a jump in the basis: for instance, by the time the contract went off the board on 20 July, the basis at NOLA had gone from zero to about 50 cents, by far the largest jump in that relationship in the historical record.

The EO set off a flurry of legal action. Ferruzzi tried to obtain an injunction against the CBT. Subsequently, farmers (some of whom had dumped truckloads of beans at the door of the CBT) sued the exchange. Moreover, a class action against Ferruzzi was also filed. These cases took years to wend their ways through the legal system. The farmer litigation (in the form of Sanner v. CBT) wasn’t decided (in favor of the CBT) until the fall of 2002. The case against Ferruzzi lasted somewhat less time, but still didn’t settle until 2006.

I was involved as an expert in both cases. Why?

Well, pretty much everything in my professional career post-1990 is connected to the Ferruzzi corner and CBT EO, in a knee-bone-connected-to-the-thigh-bone kind of way.

The CBT took a lot of heat for the EO. My senior colleague, the late Roger Kormendi, convinced the exchange to fund an independent analysis of its grain and oilseed markets to attempt to identify changes that could prevent a recurrence of the episode. Roger came into my office at Michigan, and told me about the funding. Knowing that I had worked in the futures markets before, asked me to participate in the study. I said that I had only worked in financial futures, but I could learn about commodities, so I signed on: it sounded interesting, my current research was at something of a standstill, and I am always up for learning something new. I ended up doing about 90 percent of the work and getting 20 percent of the money 😛 but it was well worth it, because of the dividends it paid in the subsequent quarter century. (Putting it that way makes me feel old. But this all happened when I was a small child. Really!)

The report I (mainly) wrote for the CBT turned into a book, Grain Futures Contracts: An Economic Appraisal. (Available on Amazon! Cheap! Buy two! I see exactly $0.00 of your generous purchases.) Moreover, I saw the connection between manipulation and industrial organization economics (which was my specialization in grad school): market power is a key concept in both. So I wrote several papers on market power manipulation, which turned into a book . (Also available on Amazon! And on Kindle: for some strange reason, it was one of the first books published on Kindle.)

The issue of manipulation led me to try to understand how it could best be prevented or deterred. This led me to research self-regulation, because self-regulation was often advanced as the best way to tackle manipulation. This research (and the anthropological field work I did working on the CBT study) made me aware that exchange governance played a crucial role, and that exchange  governance was intimately related to the fact that exchanges are non-profit firms. So of course I had to understand why exchanges were non-profits (which seemed weird given that those who trade on them are about as profit-driven as you can get), and why they were governed in the byzantine, committee-dominated way they were. Moreover, many advocates of self-regulation argued that competition forced exchanges to adopt efficient rules. Observing that exchanges in fact tended to be monopolies, I decided I needed to understand the economics of competition between execution venues in exchange markets. This caused me to write my papers on market macrostructure, which is still an active area of investigation: I am writing a book on that subject. This in turn produced many of the conclusions that I have drawn about HFT, RegNMS, etc.

Moreover, given that I concluded that self-regulation was in fact a poor way to address manipulation (because I found exchanges had poor incentives to do so), I examined whether government regulation or private legal action could do better. This resulted in my work on the efficiency of ex post deterrence of manipulation. My conclusions about the efficiency of ex post deterrence rested on my findings that manipulated prices could be distinguished reliably from competitive prices. This required me to understand the determinants of competitive prices, which led to my research on the dynamics of storable commodity prices that culminated in my 2011 book. (Now available in paperback on Amazon! Kindle too.)

In other words, pretty much everything in my CV traces back to Ferruzzi. Even the clearing-related research, which also has roots in the 1987 Crash, is due to Ferruzzi: I wouldn’t have been researching any derivatives-related topics otherwise.

My consulting work, and in particular my expert witness work, stems from Ferruzzi. The lead counsel in the class action against Ferruzzi came across Grain Futures Contracts in the CBT bookstore (yes, they had such a thing back in the day), and thought that I could help him as an expert. After some hesitation (attorneys being very risk averse, and hence reluctant to hire someone without testimonial experience) he hired me. The testimony went well, and that was the launching pad for my expert work.

I also did work helping to redesign the corn and soybean contracts at the CBT, and the canola contract in Winnipeg: these redesigned contracts (based on shipping receipts) are the ones traded today. Again, this work traces its lineage to Ferruzzi.

Hell, this was even my introduction to the conspiratorial craziness that often swirls around commodity markets. Check out this wild piece, which links Ferruzzi (“the Pope’s soybean company”) to Marc Rich, the Bushes, Hillary Clinton, Vince Foster, and several federal judges. You cannot make up this stuff. Well, you can, I guess, as a quick read will soon convince you.

I have other, even stranger connections to Hillary and Vince Foster which in a more indirect way also traces its way back to Ferruzzi. But that’s a story for another day.

There’s even a Russian connection. One of Ferruzzi’s BS cover stories for amassing a huge position was that it needed the beans to supply big export sales to the USSR. These sales were in fact fictitious.

Ferruzzi was a rather outlandish company that eventually collapsed in 1994. Like many Italian companies, it was leveraged out the wazoo. Moreover, it had become enmeshed in the Italian corruption/mob investigations of the early 1990s, and its chairman Raul Gardini, committed suicide in the midst of the scandal.

The traders who carried out the corners were located in stylish Paris, but they were real commodity cowboys of the old school. Learning about that was educational too.

To put things in a nutshell. Some crazy Italians, and English and American traders who worked for them, get the credit-or the blame-for creating the Streetwise Professor. Without them, God only knows what the hell I would have done for the last 25 years. But because of them, I raced down the rabbit hole of commodity markets. And man, have I seen some strange and interesting things on that trip. Hopefully I will see some more, and if I do, I’ll share them with you right here.

There was another hearing on HFT on Capitol Hill today, in the Senate. The best way to summarize it was that it reminded me of an evening at the local bookstore, with authors reading selections from their books.

Two examples suffice. Citadel’s Ken Griffin (whom I called out for talking his book on Frankendodd years ago) heavily criticized dark pools, and called for much heavier regulation of them. But he sang the praises of purchased order flow, and warned against any regulation of it.

So, go out on a limb and bet that (a) Citadel does not operate a dark pool, and (b) Citadel is one of the biggest purchasers of order flow, and you’ll be a winner!

The intellectually respectable case against dark pools and payment for order flow is the same. Both “cream skim” uninformed orders from the exchanges, leaving the exchange order flow more informed (i.e., more toxic), thereby reducing exchange liquidity by increasing adverse selection costs. I’m not saying that I agree with this case, but I do recognize that it is at least grounded in economics, and that an intellectually consistent critic of dark pools would also criticize purchased order flow.

But some people have books to sell.

The other example is Jeffrey Sprecher of ICE, which owns and operates the NYSE. Sprecher lamented the fragmentation of the equity markets, and praised the lack of fragmentation of futures markets. But he went further. He said that futures markets were competitive and not fragmented.

Tell me another one.

Yes, there is limited head-to-head competition in some futures contracts, such as WTI and Brent. But these are the exceptions, not the rule. Futures exchanges do not compete head to head in any other major contract. Execution in the equity market is far more competitive than in the futures market. Multiple equities exchanges compete vigorously, and the socialization of order flow due to RegNMS makes that competition possible. This is why the equities exchange business is low margin, and not very profitable. Futures exchanges own their order flow, and since liquidity attracts liquidity, one exchange tends to dominate trading in a particular instrument. So yes, futures markets are not fragmented, but no, they are not competitive. These things go together, regardless of what Sprecher says.  He wants to go back to the day when the NYSE was the dominant exchange and its members earned huge rents. That requires undoing a lot of what is in RegNMS.

Those were some of the gems from the witness side of the table. From the questioner side, we were treated to another display of Elizabeth Warren’s arrogant ignorance and idiocy. The scary thought is that the left views her as the next Obama who will deny Hillary and vault to the presidency. God save us.

Overall the hearing demonstrated what I’ve been saying for years. Market structure, and the regulations that drive market structure, have huge distributive effects. Everybody says that they are in favor of efficient markets, but I’m sure you’ll be shocked to learn that their definition of what is efficient happens to correspond with what benefits their firms. The nature of securities/derivatives trading creates rents. The battle over market structure is a classic rent seeking struggle. In rent seeking struggles, everybody reads out of their books. Everybody.

The military and diplomatic situations in Ukraine are fluid and highly uncertain.

Under pressure from the Ukrainian army’s “Anti-Terrorist Operation” (“ATO”),  “separatists” in Slavyansk decamped suddenly for the city of Donetsk. Their shadowy commander, Girkin, offered another plea for Russian assistance, which has not been forthcoming-in the form of an outright invasion, anyways. The Ukrainian army is advancing elsewhere in the Donbas.

One would have thought that the fleeing rebels would have been extremely vulnerable to air attack, but most reports indicate that they made it to Donetsk largely unhindered. (I did see one Tweet that purports to show rebel vehicles that had been destroyed on the road, but one must be cautious about the veracity of Tweets, and even the Ukrainian government reports that the separatists are regrouping in Donetsk and does not claim to have mauled the rebels in their retreat.) This suggests (a) that the separatists left in a hurry,  (b) poor intelligence and reconnaissance by the Ukrainians, or (c) Ukrainian fear of MANPADS that have brought down several of their aircraft: the retreating column would have been vulnerable to air attack while on the run.

The priority for Ukraine should be to secure the border and to cut off the rebels from Russian logistical support. Deprived of supplies, arms, and reinforcements, the separatist force will surrender, disintegrate, or just fade away.

This puts Putin on the horns of a dilemma. He is already being blasted for abandoning the Russophone/Russophile forces. But overt intervention risks a more robust Western response, and the prospect of a military quagmire.

Of these, the military problem is more acute. Russia’s military still has (conscripted) feet of clay, and the invasion and occupation of a large territory is almost certainly beyond its capability.

What’s more, every signal emanating from the West is equivocal at best.

Multi-party talks last week saw Germany and France putting pressure on Ukraine to make concessions. The talks were held in Berlin, but Munich would have been a more appropriate setting for the appeasement and pressuring the victim of aggression that was on display:

Germany’s Foreign Affairs Minister, Frank-Walter Steinmeier, convened this meeting as an emergency response to Ukraine’s June 30 resumption of military operations against Russia’s proxy forces on Ukraine’s territory. Those forces had inflicted serious losses on Ukraine during the ten days’ ceasefire that Ukraine had unilaterally adhered to. Berlin had nudged Kyiv into that unilateral ceasefire (see EDM, June 21 through June 30).

Recognizing that the pro-Russia forces breached the ceasefire massively, Germany now seeks to establish a bilateral ceasefire and follow-up negotiations between the Ukrainian government and the pro-Russia secessionists, in a framework that includes Russia while excluding the West. These elements form the basis of a Russo-German consensus regarding Ukraine.

The “Joint Declaration by the Foreign Ministers of Germany, France, Russia, and Ukraine” (www.auswaertiges-amt.de, July 2) “stress[es] the necessity of a sustainable ceasefire to be agreed upon swiftly and observed by all concerned…Ministers agree to take all necessary measures and use their influence on the concerned parties with a view to achieving this goal.”

That implies: a) an unconditional ceasefire, thereby throwing out Ukrainian President Petro Poroshenko’s June 20 peace plan, in which ceasefire is conditional upon disarmament of pro-Russia forces (in return for amnesty) and/or the evacuation of those forces from Ukraine to Russia; b) treating the “parties” (Ukrainian government and Russia’s armed proxies) on an equal footing by the Berlin document; c) Russia is asked to control its protégés in the field more tightly, in return for Germany and other West-European governments pressing Ukraine into giving up its right to self-defense.

Insofar as the British are concerned, Cameron gave a deadline of June 30 for Russia to bring the separatists into line. That deadline has passed, with not a peep from the UK. And the US is no better. On June 26, Kerry told Russia to disarm the separatists “within hours.” That is now more than 240 hours ago. And the US has done nothing. Not even the usual Kerry bluster followed by Obama inaction. Just. Nothing.

Yes, there are stories that Merkel is losing patience, and taking a “harder stance.” Maybe in the sense that pasta cooked for 15 minutes is harder than pasta cooked for 20. But it’s still limp. And you know that in the face of  intense whinging by big German businesses like that quoted in the linked FT story, and the even more intense opposition of the Putin understanders (especially in the SDP) she’ll find a pressing reason to do nothing, to find some hint of a “de-escalation” (ugh) by Putin. The fact that Nato just announced that it will not admit new members out of fear of offending Russia will only strengthen Putin’s conviction that the West not confront him in Ukraine even if he continues, or even increases, his support for the rebellion.

This all makes the current situation highly unpredictable. The military momentum has shifted decisively in favor of the Ukrainian government. Even though its military is a shambolic Sovok relic, it still overawes the rebels. Unless the rebels are reinforced, or the Russian military invades, the rebellion will eventually be crushed (or suffocated). This would be a stinging defeat for Putin.

Putin’s military instrument is superior to Ukraine’s, but only in the sense of being somewhat less shambolic. Moreover, its mission in Ukraine would be more challenging than what the Ukrainians are attempting. Moreover, the West might stir to do something that seriously hurts Russia if Putin escalates, and particularly if he invades. But there is substantial uncertainty about what the Western response would be, and it has been sufficiently pusillanimous heretofore that Putin could reasonably conclude that he could intervene more robustly without triggering a serious response.

My best guess is that due to the frailties of his military, and the risk of serious sanctions, Putin will not go all in and invade. He can achieve his basic objectives by maintaining a frozen conflict in eastern Ukraine. As long as the Ukrainian government does not achieve a decisive victory, and as long as the rebels remain a force-in-being that occupy some major cities, Ukraine will be deprived a victory and will be hamstrung in its ability to reform and integrate more closely with Europe.

This means that it is imperative that Putin prevent the Ukrainians from sealing the border, and that he maintain a corridor to Donetsk and wherever else the separatists dig in. Maybe he will achieve this through the oxymoronic “peacekeeper” gambit employed previously in Abkhazia, South Ossetia, and Transnistria. Maybe he will employ artillery and air power, and justify this by claiming it is a response to a Ukrainian incursion into Russia. I don’t know, exactly. But in my view, Putin will try to modulate the violence. Just enough to keep a frozen conflict alive, but not so much as to compel the Euros and US to take actions that would hurt Russia seriously. Unfortunately, the obvious reluctance of Merkel, Obama, and Cameron, not to mention Hollande, to do anything serious gives Putin  considerable latitude.

If Ukraine does move robustly to seal the border things will come to a head quickly. No doubt the Euros will put pressure on Ukraine not to do that (and Obama will vote “present”-or maybe even “not present”). If this pressure prevails, the conflict will continue to simmer. If the Ukrainians buck the pressure, it will be Putin’s move. I doubt he will back down. I doubt that he will double down. He will instead strive for some middling way that will keep the rebellion alive but not provoke a serious confrontation with the West.

In news that should shock no one, Russian hackers have unleashed a Stuxnet-like virus against American and European energy companies. One of the security firms that discovered the intrusion has labeled it “Energetic Bear”. Energetic because it involves energy. Bear because it involves Russia. The Russian link is based on time stamps and the presence of Cyrillic in the code. Moreover, the sophistication of the software strongly suggests (Russian) state involvement.

Though most of the attacks appear to be designed to collect information about the industrial control systems used by these energy companies, that is cold comfort: careful attackers collect intelligence to identify vulnerabilities before mounting an attack. This is also a way of sending a message: You are vulnerable. You mess with us, we can mess with you.

The news of the Russian hack was announced by Kaspersky, the famous cybersecurity firm.

Just kidding. I’m such a card. This revelation came from 2 US firms. Kaspersky has been as quiet as a mouse. A dead mouse.

Which is always the way when there is a Russian hack. When there is an American operation, e.g., Stuxnet, Kaspersky trumpets it for all the world to hear.

One other thing. The names of the SCANA producers targeted have not been revealed. But note that Siemens, the most vocal corporate supporter of Russia in Germany and the most vehement opponent to sanctions, is one of the world leaders in SCANA systems. So it is almost certain that Siemens has been a target of Energetic Bear. But Siemens has been as silent as Kaspersky.

The silences are far more revealing than the story itself.

Vladimir Putin played his favorite game today: divide and conquer. He weighed in on the $9 billion US fine of French bank BNP Paribas for its flagrant and repeated violations of US sanctions on Sudan and Iran. He took a typically narcissistic view: according to Vova, the US offered to relent on its prosecution of BNPP if France terminated its sales of Mistral attack ships to Russia:

“We know about the pressure which our U.S. partners are applying on France not to supply the Mistrals to Russia,” Putin told Russian diplomats in Moscow today. “And we even know they hinted that if the French don’t deliver the Mistrals, they would quietly get rid of the sanctions against the bank, or at least minimize them,” he said without naming BNP Paribas.

He knows this how, exactly? Electronic surveillance? (Don’t tell Angela!) A leak from the French?

Certainly Putin is trying to stir trouble between the US and France, and exploiting the French anger at the US penalties. (To which I say: the anger should be directed at the mangers of BNP Paribas, especially the offenders in its Geneva commodity finance operation who violated sanctions against malign regimes with malice aforethought.)

But the chronology is way off. The US prosecution of BNP began long before Ukraine exploded. Years before. The USDOJ was particularly furious at the French bank’s flagrant attempts to conceal its sanctions busting: the bank eliminated identifying information from the transactions in order to evade detection, a sure sign of a specific intent to commit a violation. This fury was well-stoked long before Putin’s adventurism in Ukraine/Crimea. What’s more, US prosecutors operate very independently, and those involved in the BNP case would be outraged at attempts to interfere in their case against the French by a White House playing geopolitical games, especially given the years and blood, sweat, and tears involved in the prosecution. Prosecutors do not take orders from on high, especially in big cases like this.

This is likely another example of Putin projection. This is how Putin would have instructed his prosecutors to act, and they would have implemented his instructions without question: he just presumes that the same would happen in the US. But the US is very different in that regard. Indeed, I would wager that if the White House did attempt to interfere in this way, the prosecutors would have leaked.

Of course Putin has another agenda here. He realizes that the biggest threat he faces is US sanctions that would be enforced (via the financial provisions of the Patriot Act) by prosecuting any sanctions violator who deals in dollars just as the US has prosecuted BNP. By emphasizing the existential legal threat that European banks would face under a sanctions regime, Putin is attempting to fuel opposition to sanctions: since Obama has made it plain that he will not proceed with sanctions without European support, by fomenting European opposition he can counter the US. To the Europeans (and probably American banks too), the easiest way to avoid severe punishments for sanctions violations is to have no sanctions at all. Which is what Putin wants.

In other words, Putin’s mischievous comment on the BNP Paribas case is a tell. He is revealing what he really fears.  So let’s take the hint, and make his nightmares reality.