Streetwise Professor

Although the Euros wring their hands at the costs they would bear if serious economic sanctions were imposed on Russia, as I’ve said, there is a huge asymmetry in vulnerability: Russia is substantially more vulnerable to a cutoff in trade, especially the energy trade.  Take gas.  Germany imports about 12b Euros of gas annually.  Its GDP is about 2.5t Euros.  So natural gas expenditures are about .5 percent of GDP, and even a substantial price increase would represent a relatively small burden on German expenditures.  In contrast, Russian energy exports (63 percent of which are to Europe) account for 50 percent of the country’s budget.  So trade restrictions would be an inconvenience for Europe, and pose an existential challenge for Russia.

Such are the wages of being a petrostate.  Using the energy weapon is national economic suicide.

FT Alphaville has a nice overview of this and other asymmetries.

One quibble, related to this:

In response to Iran-style sanctions, Russia could muster one unprecedented measure. It and its allies could stop buying euros, dollars, and Western government debt. However, Western governments should be able to brush this manoeuvre aside.

If it comes to a trade and finance showdown, it won’t have the money to be buying anything.  So a cutoff of purchases of dollars, euros, etc., is not something that Russia could threaten: it would be an inevitable consequence of a trade and finance war.  And Russia is not such a big buyer that it would make all that much of a difference anyways.

The FTA piece also dispatches the fantasy Russians and their fellow travelers are peddling: that China will assist Russia by waging economic combat against the West.  China is a huge dollar and UST long, so it would be an incredible act of economic masochism to dump dollars or Treasuries.  And Russian fantasies aside, China is not that into them.

The asymmetry of power, especially economic power, couldn’t be more obvious.  But that is counterbalanced by an asymmetry in will, and heretofore that has proved the decisive difference.  Putin has wagered that Europe is unwilling to suffer any discomfort to counterattack against Putin’s anschluss.  So far, he has been right.

In my post from Sunday I mentioned how commodity trading firms require dollar funding and trade in dollars, and that anything that touches a dollar is vulnerable to US sanctions.  This detailed post from The Banker’s Umbrella shows just how much leverage the US has over foreign banks, as a result of the Patriot Act.  The most interesting thing is that you can do a deal in Euros or any other non-dollar currency, but you are vulnerable to asset seizure as long as your bank has a correspondent account at a US bank.  Money quote (pun intended):

So as you can see, from a purely technical perspective, bringing Russia and Putin to his knees is really not that difficult a task. The legislative framework is there and it is brutally effective. The question is does the USA have the political will and the stomach to face the inevitable repercussions of such actions, or is it just easier to say a few words of support in favour of the Ukraine and then let things carry on as before?

Putin surely knows this.  And apropos Obama’s mantra that Russia is acting out of weakness rather than strength, he can only have calculated that the USA (not to mention the Euros) does not “have the political will and stomach” to exploit its strengths and Russia’s weaknesses.

It is remarkable that Gazprom in particular has not been subject to sanctions, given that it will receive stolen property: gas blocks off the Crimean coast, blocks that Ukraine was going to explore.  It is a state company, that helps bankroll the state.  If it isn’t sanctions bait, what company is? And as the Banker’s Umbrella shows, like any other Russian company, it would be extremely vulnerable.

I heard a hilarious story the other day about an incident that occurred when European Commission investigators raided a trading shop in connection with the Brent investigation.  While going through trader emails and documents, one of the crack investigative team came across numerous documents about trading on ICE.  The investigator was puzzled, so he asked the a lawyer for the trading company: “You trade ice?”  Lawyer: “Yes, we trade on ICE.”  Investigator: “You mean you really trade ice?  Frozen water?”  Lawyer: This is my please-tell-me-you’re-sh*tting-me face.

No prizes for figuring out which was Abbot, and which was Costello.

We are in the best of hands.  The best of hands.

With all the Ukraine stuff, and Gunvor, and travel, some things got lost in my spindle.  Time to catch up.

One story is this article about a debate between NASDAQ OMX’s Robert Greifeld and CME Group’s Phupinder Gill.  The “vertical silo” in which an exchange owns both an execution venue and a clearinghouse was a matter of contention:

Nasdaq OMX Group Inc. CEO Robert Greifeld was asked yesterday about the vertical silo and whether it hurts investors.

“Monopolies are great if you own one,” he said during a panel discussion at the annual Futures Industry Association conference in Boca Raton, Florida, paraphrasing a quote he recalled hearing from an investor. His exchanges don’t use this system. “We have yet to find a customer who is in favor of the vertical model,” he said.

A very retro topic here on SWP.  I blogged about it quite a bit in 2006-2007.  Despite that, it’s still a misunderstood subject 😛

Presumably Greifeld believes that eliminating the vertical silo would open up competition in execution.  Yes, there would be competition, but the outcome would likely still be a monopoly in execution given the rules in futures markets.  Under current futures market regulations, there is nothing analogous to RegNMS which effectively socializes order flow by requiring each execution venue to direct orders to any other venue displaying a better price.  Under current futures market regulations, there is no linkage between different execution venues, and no obligation to direct orders to a better priced market.  This leads traders to submit orders to the venue that they expect will be offering the best price.   In this environment, liquidity attracts liquidity, and order flow tips exclusively to a single market.

So opening up clearing would still result in a monopoly execution venue.  There would be competition to be the monopoly, but at the end of the day only one market would remain standing.  Most likely the incumbent (CME in most cases, ICE in some others.)

It is precisely the fact that competition in clearing and execution would lead to bilateral monopolies that drives the formation of a vertical silo.  This eliminates double marginalization problems and reduces the transactions costs arising from opportunism and bargaining that are inherent to bilateral monopoly situations.

Breaking up the vertical silo primarily affects who earns the monopoly rent, and in what form. These outcomes depend on how the silo is broken up.

One alternative is to require the integrated exchange to offer access to its clearinghouse on non-discriminatory terms.  In this case, the one monopoly rent theorem implies that the clearing natural monopoly could extract the entire monopoly rent via its clearing fee.  Indeed, it would have an incentive to encourage competition in execution because this would maximize the derived demand for clearing, and hence maximize the monopoly price.  (This would also allow the integrated exchange to be compensated for its investment in the creation of new contracts, a point Gill emphasizes.  In my opinion, this is a minor consideration.)

Another alternative (which seems to be what Greifeld is advocating) would be to create a utility CCP (a la DTCC) that provides clearing services at cost.  In this case, the winning execution venue will capture the monopoly rent.

To a first approximation, market users would pay the same cost to trade under either alternative. And most likely, the dominant incumbent (CME) would capture the monopoly rent, either in execution fees, or clearing fees, or a combination of the two.  Crucially, however, total costs would arguably be higher with the utility clearer-monopoly execution venue setup, due to the transactions costs associated with coordination, bargaining, and opportunism between separate clearing and execution venues.  (Unfortunately, the phrase “transactions costs” does double duty in this context.  There are the costs that traders incur to transact, and the costs of operating and governing the trading and clearing venues.)

A third alternative would be to move to a structure like that in the US equity market, with a utility clearer and a RegNMS-type socialization of order flow.  Which would result in all the integration and fragmentation nightmares that are currently the subject of so much angst in the equity world.  Do we really want to inflict that on the futures markets?

As I’ve written ad nauseum over the years, there is no Nirvana in trading market structure.  You have a choice between inefficiencies arising from monopoly, or inefficiencies arising from fragmentation.   Not an easy choice, and I don’t know the right answer.

What I do know is that the vertical silo per se is not the problem.  The silo is an economizing response to the natural monopoly tendencies in clearing and execution (when there is no obligation to direct order flow to venues displaying better prices).  The sooner we get away from assuming differently (and the Boca debate is yet another example of our failure to do so) the sooner we will have realistic discussions of the real trade-offs in trading market structure.

That would be me.  At least according to the Google translate version of this profile of me in Neue Zürcher Zeitung. It’s a nice piece, and a fair one (in contrast to some other articles I won’t mention).  Except I am really a mild mannered guy.  Really!

A couple of stray thoughts regarding the Gunvor story.

First, virtually all of the oil trade (and the global commodities trade generally) is done in dollars.  Gunvor needs dollar financing to carry out its trading.  Anything done in dollars puts the provider of the dollar finance in the crosshairs of a panoply of US regulators.

Case in point is RBS, which paid $100 million in settlements to the Fed and the New York Department of Financial Services for violating sanctions on Iran, Burma, Sudan, and Cuba.  One law firm concluded:

A lesson that foreign financial institutions and other multinational companies should draw from these cases is that they continue to face significant risk if they engage in any business related to parties or countries (particularly Iran, Cuba and Sudan) that are restricted under US economic sanctions provisions, even if their activities may have appeared to be lawful at the time.  Such activities create risk when they have even a minimal nexus with the United States, including clearing financial transactions in US dollars, furnishing financial services through institutions in the United States, processing payments through foreign branches of US financial institutions, or knowingly relying on services provided by US persons anywhere in the world to facilitate, participate in, approve, or support restricted transactions.

Foreign persons providing a variety of financial services, including banking, money remittance, insurance, reinsurance, investment, foreign exchange, mortgages and secured transaction/letter of credit services, should recognize the inherent US enforcement risk in concealing or intentionally omitting identifying information from payment messages involving a sanctioned country, entity or person, when the transaction has some nexus to the United States or US persons (including US dollar exchange).  Deceptive activity also formed the basis for part of the recent settlement against Weatherford International Ltd. (see our advisory on Weatherford). [Emphasis added.]

To reiterate.  A “minimal nexus” with the US puts a foreign financial institution at risk when it deals with a sanctioned entity.

Here is an Economist piece on how the US uses merely touching a dollar as a basis for aggressive prosecution.  Here is the Telegraph screeching about how the US has extracted billions of dollars in settlements from British banks for engaging in transactions in dollars.

The basic issue is that any transactions done in US dollars, even between foreign entities, have a US bank involved at some point to process the dollar transactions.  You do a deal in dollars with a US-sanctioned entity, you are at huge risk of prosecution.

The implication is that even if Gunvor deals only with non-US banks, as long as it deals in dollars, if the firm becomes a sanctioned entity anyone who is on the other side of the dollar transaction is at risk.  FUD is most acute with any transaction that touches the dollar.  And you can’t engage in the international oil trade (or commodities trade generally) without dealing in dollars.

Second, a somewhat related issue. Let’s say that Törnqvist really did buy out Timchenko’s shares.  Let’s say he didn’t pay with a note.  Where can Timchenko stash the cash? Paying in Euros or CHF could perhaps avoid the problems discussed above, but even so, what western financial institution wants to take Timchenko’s money?  Even Sberbank might have some reservations.

Just landed at O’Hare on my way back from Brussels and Geneva.  Right before taking off I saw that Gunvor’s bond price tanked at the open.  It closed yesterday yielding 10.9 percent, and spiked at the open to 13 percent.  I understand it is still tanked.

In other words, the market either totally disbelieves the story that Timchenko sold out, or thinks that the sale is irrelevant in determining the company’s vulnerability to sanctions or investigation.

My suspicion is the latter, because of the Treasury’s deviously, devilishly clever strategy.  Recall that UST said that Putin is a part owner of Gunvor.  No hedging about that claim, no “may be a part owner”:  a flat statement that Putin is an investor.  It said that Putin might have access to Gunvor funds.

So regardless of whether Timchenko sold, or commits ritual public suicide tomorrow, Treasury has put the Mark of Cain on the company.  Every counterparty, every lender has to have serious, serious concerns that the company may be sanctioned due to the Putin connection.

The tanking bond price makes it clear that the credit markets have serious doubts about the company’s survival prospects.  No doubt this reflects bankers’ serious reluctance to continue to finance a company that the US government has publicly tied to Putin.

Yes, most of Gunvor’s lenders are European banks, but ask Swiss banks about the joy of taking on the US government when it has an important policy objective in mind.  And think of all the leverage the US has over European banks given the myriad ongoing investigations of Libor, FX, ISDA Fix, and on and on.   Even if the Euros don’t sanction Timchenko (or Gunvor) (and they abstained from doing so today, waiting to announce that until I’d left Brussels, the cowards), the US has plenty of leverage over European banks.

The company has the weekend to try to turn things around.  But that Treasury statement casts a huge shadow.   In the current environment, bankers are afraid of their own shadows, let alone the shadow of a US government with blood in its eyes.

Press coverage of this story has been credulous, especially in the FT.  The stories have uncritically repeated Gunvor’s statements that Timchenko sold at fair value, and that there is no option for Timchenko to repurchase.  But they would say that, wouldn’t they?  And the stories don’t point out that the bond market is basically calling BS on Gunvor.

Speaking of fair value, I know Torbjörn Törnqvist is not an idiot.  He can go through the game tree, and realize that there is large probability that his shares, and the ones he purchased from Timchenko, will be worthless.  Meaning that he won’t have paid Timchenko book value, or anything even close.

Which raises the interesting question: if Timchenko is really just a front man for Putin, as the US government asserts, any big discount comes right out of Putin’s pocket.

Which is pretty much the point, isn’t it?  That’s exactly why UST’s statement is a big flashing neon light arrow pointing right at Putin.

Obama finally did something halfway serious about Putin.  The Treasury Department added several prominent names in Putin’s inner circle to the sanctions list.  Prominently featured were several judo buddies, the Rotenberg brothers and Gennady Timchenko of Gunvor and Novatek.  Also sanctioned were Ivanov and Yakunin.

Timchenko is of particular interest.  The Treasury Department specifically alleged that Putin is a part owner of Gunvor, and might have access to Gunvor funds.  I don’t know, but would love to know, whether this is based on information that UST has developed, or is just a repeat of the allegations from Milov and others that have been made in the past.  If the former . . . that would be a bombshell.

This puts Gunvor in a very delicate position.  Some of its contracts likely have illegality clauses which could conceivably permit counterparties to void the contracts.  Gunvor would no doubt fight this.  But the main threat is that no company is likely to want to deal with Gunvor going forward, and more importantly, that banks are very like to cut or pull altogether credit lines.  These lines are the lifeblood of any commodity trader.  It cannot finance inventories and trades without access to credit.

The fading away of counterparties and banks can set off a death spiral that causes the rapid demise of a trading firm.

The market is already hammering the firm.  Yield on its bond rose 340 basis points to 10.91 percent.

Meaning that we may soon get a live test of an argument that I’ve been making for over a year now, and which I made today at a conference in Brussels (and made to various European regulators yesterday): namely, that commodity trading firms are not systemically important like banks are.  Commodity trading firms can die, without fear of contagion that affects the broader economy.

Gunvor announced that Timchenko has sold his shares to co-founder Törnqvist (a Swede).  I doubt this will clear the serious doubts now swirling around Gunvor.  Banks and potential counterparties will wonder whether there is an explicit or tacit option for Timchenko to repurchase his shares.

Trading firms depend very heavily on reputation, and the trust of counterparties and lenders.  Gunvor is so closely associated with Timchenko-and Putin-that it is hard to see how counterparties and banks would be willing to take the risk of dealing with the firm.   How can they be sure that the firm is out of any threat from action by the US (or the EU, if it follows suit)?  Will they really trust this claim of a miraculous sale that severs all ties between Timchenko and Gunvor?  (If the bond price doesn’t rebound tomorrow, we’ll have our answer.)

There is no doubt that Fear, Uncertainty, and Doubt are swirling around Gunvor right now, and there is little that Timchenko or the company can do to dispel it.  And FUD is often more than enough to kill a trading firm.

The US government can feed the FUD by opening an investigation, not just of the alleged sale, but of other Gunvor activities.  I am sure there is more than enough grounds: the hint,hint; nudge, nudge about the connection between Gunvor and Putin is alone sufficient to give those thinking of dealing with Gunvor the yips.  And the announcement of an investigation, particularly in this environment, is likely to be as fatal as a conviction would be.

I will note that in the aftermath of the Georgia War I specifically called out Gunvor as a firm that deserved special scrutiny as a way of pressuring Putin.  It’s about damn time.

The storm that is brewing around Gunvor will be a gentle spring breeze by comparison to the tempest that would occur if the administration moves to add a name conspicuously absent from today’s list: Igor Sechin.  Again, illegality clauses are likely to come into play, which could permit the banks to pull the prefinancing that was provided in conjunction with prepay contracts between Rosneft and Glencore, Vitol, and Trafigura.  Invocation of these clauses would require Rosneft to repay the loans immediately.  The sums involved are immense, totaling around $12 billion.  Rosneft had announced it was looking to go to the capital markets to raise funds.  Those plans would likely have to be scuppered if Sechin gets named to the Treasury list.

But that’s for another day.  For the immediate future, all eyes on Gunvor.  Let’s see if it can find some legal maneuver to convince lenders and counterparties that it has severed all ties with Timchenko, and therefore has no exposure to punitive actions by the Treasury.  I suspect that many will argue that the downside exposure is so great, that they are unwilling to run that risk.  If that happens, Gunvor will soon implode.  The question is: will much of Putin’s wealth implode with it?

Finally, a personal note. I have had several excellent students in the Masters Program in Commodity Trading and Finance at the University of Geneva who work for Gunvor.  I feel very badly for them.  I know that being young, and bright, and having general human capital  they will wind up on their feet.  But I do sincerely regret what they must be going through now.

Russian government officials and Duma members  have threatened that if the US and/or EU impose financial sanctions in response to Crimea/Ukraine, Russian corporates will just default on their debt:

A Kremlin aide warned last week that Moscow might refuse to pay off loans to U.S. banks as a retaliation measure against sanctions.

Mikhail Yemelianov from pro-Kremlin party A Just Russia went even further: “If they (the West) freeze our assets, then our companies could stop paying foreign debts. The Russian corporate debt exceeds $700 billion”.

Please.

Banks don’t lend to Russia in large sums on an unsecured basis.  One of the things that caused Putin to freak out in 2008-2009 was that Russian companies (notably Deripaska’s Rusal) had pledged stock as collateral against loans.  Putin got Russian government banks (Sberbank, VTB) to extend credit to these companies so they could pay off the loans to western banks, thereby preventing them from defaulting and having large blocks of shares pass out of Russian hands.

I don’t know about all $700 billion of Russian debt, but I do know a bit about loans to one company mentioned in the linked article: Rosneft.

Rosneft borrowed upwards of $10 billion to finance the TNK-BP acquisition.  The structure of the borrowing shows just how dodgy even the biggest, most politically connected, state enterprises are viewed by western banks.

The loans were structured as prepays, and included trading firms Glencore, Vitol, and Trafigura as part of the structures.  Rosneft entered into off-take agreements with the trading firms that obligate the Russian company to deliver oil to them over the next several years.  The trading firms will then sell the oil, and send the receipts from the sales to the lending banks, thereby paying off the loans.  That is, the banks do not trust Rosneft to pay.  Rosneft never touches the money from the oil sales.   It goes from the trading companies directly to the banks.

In other words, Rosneft’s oil is security for the loans.  And as I noted when the deals were done, real supermajors (as opposed to pretend ones) don’t have to pledge such security in order to borrow.

So what would happen if Rosneft carries through on Yemelianov’s threat?

The only way to do that would be to default on the off-take agreements, i.e.,  to fail to deliver the contracted volumes to  Vitol et al.

Good luck with that.  The second Rosneft fails to deliver on the off-takes, and tries to sell  cargoes pledged to the trading companies on the open market, the trading companies will take legal measures to seize those cargoes to enforce their legal rights.  Knowing that, no buyer in his right mind will contract with Rosneft once it has stiffed Vitol, Glencore, and Traf.  Meaning that Rosneft cannot just walk away from its debt, if it ever wants to export a barrel of oil ever again.

In Rosneft’s case, therefore, the threat to walk away is an empty one.  The banks and trading companies have seen to that in the way the deals are structured.  Precisely because they don’t trust Russian companies enough to lend on an unsecured basis.

I don’t know the structure of every loan provided by western banks to Russian corporates.  But the structure of the Rosneft loans tells you that the banks have zero trust with Russian companies, and demand some form of security against the credit extended: the form of security will vary by the borrower and type of loan.  Meaning that Russian corporates that attempt to retaliate against sanctions by defaulting on obligations to western creditors will suffer major, major pain.

So I say: call the Russians’ bluff.  Impose sanctions.  If Putin forces Russian companies to default in response, they-and he-will pay a far higher cost than anything inflicted on the nations sanctioning Russia.

ExxonMobil’s CEO Rex Tillerson (whose first name gives you an idea of his self-image) has decided to suspend offshore gas exploration projects in Ukraine, while continuing extensive cooperation with Russia (including a project very close to Crimea).

Talk about shivving someone when they are down.  Although any project like that the one that Exxon shelved would only produce years from now, if ever, a necessary condition for Ukraine to escape the Russian yoke is that it reduce its dependence on Russian energy, particularly Russian natural gas.  The Exxon decision makes that prospect ever more unlikely.  Ukraine’s bargaining power vis a vis Putin has just taken a big hit.  The Exxon betrayal also has huge symbolic importance: it indicates that energy companies are likely to deal with the devil-Putin-and willingly throw Ukraine on his tender mercies.  This will further convince Ukraine, and the Euros, that the country’s only option is to kneel before Don Vladimir.

Tillerson claims that he has no qualms about continuing to work with Russia, because he perceives no political risk:

“As for the current situation, obviously it’s early days,” he said. “There’s been no impact on any activities or plans at this point, nor would we expect there to be any, barring governments taking steps beyond our control.

“In terms of our view of country risk, geopolitical risk, other than things like sanctions, we don’t see any new challenges out of the current situation,” he said.

If you don’t see any new challenges relating to political risks in Russia arising from this situation, Rex, you need to get an eye test.  The substantial sell-off in Russian stocks was all about political risk.  And a victory in Ukraine would embolden Putin and make him more likely to expropriate western energy companies, including Exxon.

But maybe Tillerson’s vision is just fine. As I wrote about a couple of years ago, Exxon has tried to manage that expropriation risk by tying its ventures in Russia to cooperating with Rosneft in the Gulf of Mexico in what is effectively an exchange of hostages: if Russia takes from Exxon in Russia, Exxon can retaliate against Rosneft here. Maybe that’s what convinced Tillerson he can deal with the devil.  He gets the devil’s goodwill by abandoning Ukraine, and feels confident that the hostage he holds in the GOM will protect XOM against future Russian predations.

Arguably this is a smart bargain from the perspective of Exxon shareholders. But there are huge externalities here. Ukraine is obviously a big loser.  But so are other investors in Russia who are not so fortunate as to have valuable hostages as does Exxon.  But US national interests, and the interests of myriad US allies, notably Poland and the Baltic states, are also severely damaged by Tillerson’s cynical calculation.

This is precisely the circumstance in which it is justifiable, and indeed necessary and desirable, for the government to address a serious collective action problem through the imposition of sanctions on Russia and companies that provide it material and moral support (as Exxon is doing), and through the use of carrots and sticks to cajole companies like Exxon to provide aid and comfort to Ukraine.

But, cynic that I am, I doubt that this will happen.   The reason that Germany and the UK are so adamant against sanctions or any other economic measures against Russia in response to Ukraine is that it hits their businesses’ bottom line, and those businesses are are pressuring their governments very hard to take a soft line on Putin.  No doubt Exxon is doing the same.

Lenin was right about at least one thing, perhaps.  That capitalists would sell you the rope you use to hang them.  Or in this instance, Exxon will gladly sell Russia the rope Putin uses to hang Ukraine.