Streetwise Professor

Sunshine: The New Subprime.

Spain can no longer afford greendoggles:

The Spanish government’s latest bid to cut its growing debts to the country’s energy sector is expected to slash profits at renewable energy companies as Madrid continues to grapple with a €28bn deficit built up through years of subsidies.

Spain’s most recent reform to the energy sector will force renewable energy operators to choose between a fixed price or market price for their power – and remove a previous subsidy – while renewables subsidies will also be delinked from consumer price inflation and instead aligned with Spain’s core inflation measure.

Shares in Acciona, Spain’s second largest wind power operator, have tumbled almost 20 per cent, with Abengoa, Spain’s largest solar thermal power plant developer, also falling sharply since the changes were announced at the end of last week.

This story about the travails of the Utility Formerly Known as TXU doesn’t mention renewables-notably wind-but it should:

Energy Future Holdings Corp., the struggling Texas power company involved in a record leveraged buyout, could end up splitting as it faces significant choke points on debt and seeks counsel from Wall Street restructuring advisers.

The former TXU Corp. has been getting advice from big-name law firms and investment banks ahead of May, when it must start making cash payments on certain debt. In addition, the company faces nearly $4 billion in debt maturing in October 2014. The Dallas-based company was purchased by the private-equity firms and others in 2007 for $32 billion plus about $13 billion of debt.

After a series of complicated transactions over the past several years that rearranged its finances, the company now appears poised to start contemplating a major debt restructuring, be it through a bankruptcy filing or another means, according to a person close to the situation.

The article rightly notes that the collapse in natural gas prices has cratered generating margins (spark and dark spreads, and especially the later).  This is the main reason for EFH’s problems, but not the only reason.  The large increase in wind generation-which benefits quite nicely from  federal subsidies-has put downward pressure on power prices in Texas, and has led to negative prices for power with some regularity.  This is particularly important because Texas operates an energy-only market, with no capacity market, meaning that capital costs must be recouped from energy prices.  With wind subsidy-supressed prices, traditional generation has a hard time paying for itself.  As PUC Commissioner Donna Nelson said:

Federal incentives for renewable energy… have distorted the competitive wholesale market in ERCOT. Wind has been supported by a federal production tax credit that provides $22 per MWh of energy generated by a wind resource. With this substantial incentive, wind resources can actually bid negative prices into the market and still make a profit.

We’ve seen a number of days with a negative clearing price in the west zone of ERCOT where most of the wind resources are installed…. The market distortions caused by renewable energy incentives are one of the primary causes I believe of our current resource adequacy issue… [T]his distortion makes it difficult for other generation types to recover their cost and discourages investment in new generation.

The impact is greatest in the western part of the state, but wind weighs on prices throughout the state.  Except when it’s hot, because that’s when the wind doesn’t blow-but the power is particularly needed.  And wind also imposes substantial reliability challenges, requiring backup generation resources-which find it difficult to recoup costs due to prices that are often artificially low due to the wind subsidy.

The subsidies completely distort price signals, which in turn distort investment incentives and raise the serious risk of shortages of reliable generation resources that can operate hot or cold, rain or shine.

Other than all that stuff, wind is great.

But regulators are hell-bent on tipping the scales in favor of wind:

It’s no secret why FERC is likely to rule against the homeowners in Iowa and Minnesota. The Obama Administration’s green vision is to make wind and solar an ever-larger share of U.S. electricity production, regardless of costs. Think high-speed rail for the electric power network. The only way to make that happen without a political backlash is to spread the costs far and wide.

Wind and solar power are too expensive to compete with natural gas, coal, nuclear and hydropower without government help. The wind lobby already won an extension of its $12 billion production tax credit as part of the recent tax increase. More than half the states also have renewable energy standards forcing residents to purchase wind power. And now the greens want another subsidy for transmission lines.

Because wind makes such economic sense.  The fact that subsidies (and, in some places, the indoctrination of children) are required to support wind development tells you just how much economic sense it makes.  It is a greendoggle of the first order, and one that you might want to think about when the lights or AC go out, especially in Texas on a hot summer’s day.

While I’m on the subject of commodity spreads and transformations, I’ll turn my attention to another spread story in the commodity news: cash premiums in aluminum.  This is a matter of great interest to people in the aluminum business, but even though I highly doubt such people make up a big fraction of my readers, it’s worth some analysis here because the broader and politically charged topic of the “financialization” of commodities has come to the fore in this debate.

In brief, there is a big differential between the price of aluminum “in store” in LME warehouses, and the price of newly produced aluminum at the factory gate.  Metal outside LME warehouses trades at a big premium to ingots inside them: the premium is about $300 on a price of around $2000.  The premium has become so wide and volatile that banks are offering swaps to hedge this risk.

So we have a spread.  Spreads price transformations.  What is the transformation at issue here?  Turning metal inside warehouses into metal outside of warehouses.  So if the spread is wide, that tells us that there must be a bottleneck in getting Al out of warehouses.  And indeed there is.  It can take more than a year (!) to get some metal out of LME warehouses.  Warehouse operators (including Goldman, JP Morgan, and Glencore) are the subject of bitter criticism from aluminum consumers (e.g,. Coca Cola) for what consumers claim are unnecessarily glacial load-out rates.  File this under There is Nothing New Under the Sun.  Warehousemen and consumers have fought over load-out rates forever in every commodity.  (Look at a history of the warehouse wars in Chicago stretching back to the mid-19th century.)

As a result of the load-out bottleneck, large quantities of aluminum inventory that built up during the financial crisis and period of extended economic weakness in the US and Europe, are trapped in warehouses.  The storage facilities have become the metallic equivalent of Roach Motels: aluminum checks in, but it can’t check out.  Or maybe the metallic Hotel California: aluminum can check in, but it can never leave.

The fact that large quantities of metal are trapped in warehouses means that there are large quantities of metal that have to be carried-and financed, primarily in cash-and-carry trades hedged by forward sales.  What other alternative is there?  It ain’t going anywhere, so it has to be held and financed by somebody.  Moreover, well-capitalized banks (Morgan, Goldman, etc.) can finance the inventory cheaper than anybody else.  So just surely as day follows night, given the fundamentals in the market, and crucially the load-out bottleneck, the well-capitalized banks end up holding, financing, and hedging a big chunk of the inventory.

Here’s where the financialization meme comes in.  Many people-including some who should know better-see the co-existence of financed inventory and premiums, and conclude that it is the participation of financial institutions that is causing the wide premiums.  See! they exclaim.  Look at how the participation of financial institutions in commodity markets is distorting things! Something must be done!

This is totally back-asswards, and confuses cause and effect.  The underlying problem here is the load-out constraint.  The cash premiums clearly signal that is the problem.  Banks are not holding back metal to create profitable financing deals: time spreads adjust so that financing deals break even.  The problem is that insufficient quantities of metal can get out of warehouses.  That’s what inquiries should focus on.  Is the rate too low?  Why?  Are warehousemen exercising market power by unduly constraining load-out?  If so, why isn’t there sufficient competition between them?  (It would also seem that this would have to be an ex post holdup problem: if those storing metal anticipated the exercise of market power via slow load-out, it would reduce their derived demand for storage, thereby reducing the amount of metal stored and the rate the warehouse could charge.  This would tend to attenuate and perhaps eliminate the ability and incentive to exercise market power.  An opportunistic response to an exceptional circumstance not anticipated when metal was put into store could be what is going on.  That is, this could be a time inconsistency problem combined with an unprecedented shock.)

In other words, large financing deals are a symptom of the load-out bottleneck, and the overhang of metal in store resulting from the financial crisis.  It is not the financing deals that are holding back metal.  It is the load-out bottleneck that is holding back the metal, and driving the need to finance the metal.

One last note.  One of the biggest complainers about the situation and the involvement of banks in the aluminum market is the living proof that Neanderthals still walk the earth: Oleg Deripaska.  Yes, Putin’s favorite pen catcher.  Word to the wise: Deripaska’s whines about the causes of the aluminum cash premiums should be heavily discounted, as should always be the case when a highly financially stressed individual loudly talks his book.  Especially when the book talker has, shall we say, a rather testy relationship with banks.

There has been a spate of world-turned-upside-down stories about the US as a potential exporter of oil and refined products.  The explanation is quite simple.  Supposedly menopausal North American geology has produced a surprise energy baby.  Or, I should say “babies”, for this is a multiple birth, in fact: oil and gas in different locations.

This has resulted in substantial changes in price relationships in oil and gas.  The most visible of these is the Brent-WTI spread, which blew out again to over $20/bbl (better than 20 percent of the WTI price).  But all sorts of spreads have reached record or near record wides.  Canadian oil sells at a deep discount to WTI at Cushing, which sells at a deep discount to the price in the Gulf.  Refining margins are wide.

Commodity trading is all about transformations in space, time, and form.  Spreads price transformations: they are the shadow prices of transformations.  Time spreads price the cost and benefit of transformations in time (through storage).  Locational spreads measure the marginal cost of transformations in space (through transportation).  Spreads between processed and raw materials price the costs of refining/processing.

The spread blowouts in energy  are highly visible evidence of how the spike in domestic energy production, and notably its location and quality, has been at odds with the energy transformation infrastructure that has developed in the US in the past decades.  That transformation infrastructure was-and crucially still is-configured to transform foreign and heavier/sour crudes into refined products for domestic production.  The main direction of movement of crude was south to north, from import points at the Gulf to refineries in the Gulf and Midcontinent.

The new production is in the north, or in Eagle Ford in Texas.  It is sweeter and lighter than the oil that most domestic refineries are configured to process.  Refineries in position (in the Midcon) to process this new output (especially the Bakken) are operating at capacity, giving them fat margins.  The transportation capacity to bring the oil to the Gulf (and to East Coast refineries, many of which have been shuttered in recent years) is highly limited because it was structured to bring oil inland, not ship it to the coast either for refining or (when the law permits), export.

Meaning that in the short run, quantities cannot adjust in response to the oil output shock: there are bottlenecks in transportation, storage, and refining.  Since quantities cannot adjust, prices bear the burden, leading to dramatic movements in spreads that price these transformations.

These spreads are signals about the locations of bottlenecks in the value chain, and the value of making investments in transportation, storage, and refining capacity to ameliorate them.  These investments are expensive, and take time.  Hence, historically anomalous spread levels are like to persist for some time.

Moreover, some investments can exacerbate other bottlenecks.  For instance, building Keystone XL (which will bring oil from Bakken and Canada to the Midcontinent) without adding more Midcon refining capacity and/or more capacity to move oil from Midcon to the Gulf (and perhaps the East Coast) would actually exacerbate the refining and outbound transportation bottlenecks in the Midcontinent.  This would, most notably, cause the Brent-WTI spread to widen further.  There is essentially a race between production capacity in the Midcontinent on the one hand, and the outbound transportation and refining capacity there.  Right now production is winning.  This will tend to cause spreads to change in ways that discourage too much output expansion, and encourage expansion in the ability to consume what is produced in the Midcon.  But there will be a minuet between production and consumption that will go on for years: prices/spreads will play conductor of the music that producers and consumers dance to.

There are economic considerations that limit the speed with which quantities will respond to these price signals.

For one, investment takes time.  You can’t snap your fingers to build a pipeline or add refining capacity, and have it arrive instantaneously in a puff of smoke.

Uncertainty is another.  The ability to invest in refining or pipeline or production capacity is a real option: in the face of uncertainty, it is often optimal to delay decisions to invest pending the arrival of new information about the economic value of those investments.

Sadly, politics is another.  Whether it is a politicized pipeline approval process, Byzantine environmental laws that give enviros and nimby-ists the ability to impede energy investments, or laws that restrict exports, the legal and regulatory systems in the US inflate the cost of investment in energy infrastructure, and crucially add an element of considerable uncertainty that also slows investment due to the real option considerations I just mentioned: the vagaries of politics and political influence are volatile, hard to predict, and can have first-order effects on the profitability (or not) of an investment.   It would have taken some time regardless to make the investments necessary to reconfigure America’s energy infrastructure to accommodate the huge shock to the location and quality of oil production.  Politics and regulation will only slow that response, and make it less efficient and complete than it should be.

And it should be noted that even though much of the law and legislation will be cloaked in the language of public interest, notably environmental paeans and invocations of “jobs, jobs, jobs”, it is largely the product of nakedly self-interested calculations.  This is most notable in the debate over natural gas exports, in which domestic petrochemical producers are trying to prevent-or at least sharply constrain-in order to reduce the cost of their feedstocks and thereby increase their margins.  Similar arguments are already starting to appear in oil just as the prospect of oil exports is being mooted.  It is also notable in transportation: is it any surprise that oil pipelines (notably Keystone) are the target of much opposition, given that Warren Buffett is making oodles of money transporting oil by rail, due to his ownership of the BNSF RR and a major manufacturer of rail tank cars.  (Sort of OT: speaking of Buffet, could the fact that the USDOJ is going after S&P but not Moody’s, despite the fact that their conduct during the pre-crisis period was almost identical, have anything to do with the fact that Saint Warren has a big stake in Moody’s?)

In other words, naked rent seeking is going to play a big role in the speed and efficiency with which firms make the investments necessary to respond to the unexpected domestic energy production shock.  Sadly, the intensely politicized nature of energy, and the swollen nature of the US government and regulatory apparatus (which deems that everything is its business) will dramatically impede this adjustment process.  Meaning that we are likely to be in a world of wide spreads for some time to come.

When the government is the bookie, it’s very hard to beat the spread.  Especially when that government is all too often indistinguishable from the mob.

Last year there were concerns about a “hard landing” in China.  Those fears have dissipated with 7.8 percent growth in the fourth quarter.  Now there is widespread optimism that China’s growth will continue inexorably: the recent spike in iron ore prices (which had plunged when concerns about the Chinese economy were most acute) is a very visible sign of that.

But . . .

It appears that this rebound is the result of another dose of stimulants, notably an injection of credit.  Which (a la Michael Jackson) gives less of a lift each time it is applied.  Now it takes about 3 RMB of credit to generate a RMB of GDP growth.  Moreover, this application of stimulus has deepened the investment-dependence of the Chinese economy, and delayed its transition to a more balanced, natural system.  Furthermore, to the extent that the projects funded by this debt don’t generate sufficient returns, the borrowers will not be able to repay; this risks a solvency crisis, and of course, a liquidity crisis that can break out when lenders are solvent, but at elevated risk of becoming insolvent.

A few articles in the last few days suggest that the optimistic turn may be quite overdone, and that there are dangers lurking beneath the sea of debt.  Chinese banks are rolling over local government debt that was used to fund stimulus spending.   Chinese heavy manufacturing enterprises are becoming increasingly indebted, and are staying afloat with borrowing.  The shadow banking system is growing and mutating.

The Chinese economy is still largely centrally planned.  Not directly, but through subsidies and especially through subsidized credit.  Admittedly, my priors are that centrally planned economies are doomed to difficulty, even though they can produce spurts of measured growth.  With sufficient coercive powers, such governments can keep things going for quite a while.  But there’s a point when they can’t.  I wouldn’t be surprised if China is approaching that point.  In other words, the further injection of credit may have just deferred the hard landing . . . and made it all the harder.

This week’s big derivatives story was about a public workshop at the CFTC on the issue of futurization.  I was one of the first people to comment on this issue, last year when ICE announced it was converting all of its energy swaps into energy futures.

That was Futurization 1.0. The conversion merely consisted of renaming “swaps” “futures”.  In all economic dimensions (contract specs, execution, clearing) the contracts remained identical.  But the renaming allowed some energy swap users to escape the dreaded Swap Dealer designation.

Futurization 1.1 was the CME’s conversion.  This illustrates some of the silly impacts of Frankendodd.  The CME has cleared energy swaps for going on 10 years now.  The parties would execute a swap, and submit the swap for clearing through an Exchange of Futures for Swaps (EFS) trade.  So the originally executed swap existed only until it was submitted for clearing, when it was replaced with economically equivalent futures contracts.  But no matter how short the swap’s life, the fact that it was born a swap meant that it counted towards the volume of swaps activity used to determine whether someone was a swap dealer.  So the process has now changed, and market participants use (mainly) block trades of futures to create the positions they want, thereby cutting out the interim swap step.

The transformation of the energy derivatives landscape, and the launch of swap futures by CME and Eris are now raising the question of whether futurization will spread beyond energy.

One motive to eschew swaps in favor of futures is unlikely to exist in interest rates, credit and other financial derivatives: the biggest market participants are likely to trade enough bespoke swaps for which there are no futures equivalents, meaning that they will be treated as swap dealers regardless: this reduces their incentive to substitute futures for swaps.

The main driver of futurization outside of energy will be CFTC regulatory treatment of futures and swaps.  Differential treatment will affect the economics of futures vis a vis swaps, and the prospect of such differential treatment was the center of controversy at the CFTC meeting, and in the larger debate in the industry.

The main sources of differential treatment are execution and margining.  Swaps will have to be executed subject to (allegedly) soon-to-be announced SEF rules, and are subject to immediate reporting.  Most market participants who will substitute futures for swaps will execute these deals via privately negotiated block trades subject to exchange rules.  Crucially, reporting of block futures trades is delayed 15 minutes, a concession to fears that immediate reporting would impair liquidity because block positioners (those supplying liquidity to the block futures market) could find it difficult to lay off their risk if the fact they had just done a big trade was announced immediately.  This would induce them to require larger price concessions for doing block trades.

Which raises the question: why the difference between the futures goose and the swaps gander?  Similar considerations obtain for swaps.

Thus, this rule difference is likely to favor futures executed via block trades as opposed to swaps executed via traditional means (but with immediate post-trade transparency) or via SEFs.  (Economically material differences between the rules governing block trades and SEF trades could also affect the relative costs of trading in these disparate ways, and hence affect the choice between them.)

Margining will be different for swaps and futures.  Futures will be margined assuming a one- or two-day liquidation period (i.e., margins will be based on something analogous to a one- or two-day value at risk).  However, swaps-even cleared swaps-will require a minimum liquidation period of 5 days for calculating initial margin.

This substantially higher margin for swaps results in a substantial economic disadvantage to these contracts compared to futures contracts that generate the exact same cash flows (in the absence of default).   This will likely be another factor pushing the market towards futures-which is a major reason for the fury of swaps dealers.

This differential treatment of economically equivalent contracts just because one is called a “swap” (BAD!) and the other is called a “future” (GOOD!) makes little-or no-economic sense-and reflects the swap-o-phobia that pervades DC, and which was an animating principle behind Frankendodd.

The reason to set margins based on a liquidation period reflects the purchase of IM: it is intended to cover potential losses on a defaulted position before that position can be liquidated by the clearinghouse (i.e., the position can be assumed by another solvent market participant).  The less liquid an instrument,  the longer it takes the CCP to work out of the position, the more it is exposed to potential adverse price moves and hence the more margin cover it needs.

This liquidation period depends on the economic characteristics of the contract, how widely it is traded in the marketplace, the identity, number and capitalization of the firms that trade it, and market conditions at the time of liquidation. All of these conditions should be pretty much the same for two contracts that specify the same contingent cash flows, one of which is called a swap and the other a future.  Consider say a 10 year vanilla IRS and economically equivalent futures contracts that offer the same contingent cash flows.  Abstracting from margining differences, these contracts have identical price risks, and should attract the same kinds of users.  Why should liquidity of one differ from the liquidity of the other in the event of the default of the holder of a big position?

And don’t tell me that futures are traded in light markets and swaps are traded in dark ones.  As already noted, futures traded as substitutes for swaps are and will be typically traded in blocks outside the limit order book.

More importantly: in the event of the default of a big FCM or dealer that should be the reason to be concerned, the CCP is going to try to get rid of the defaulted portfolio in big chunks through some sort of auction process.  The firm winning the auction will then trade out of the position, likely using the central market and block trades.

This isn’t much different than how a swap CCP will handle the default process.  Indeed, LCH obligates its members to assume portions of a defaulted portfolio, and one reason for having stringent CCP membership requirements is to ensure that the members have the capital and trading expertise to manage big pieces of defaulted portfolios.

We actually have a case study of futures and swap default management processes.  When Lehman defaulted, CME auctioned off its interest rate, equity, currency, commodity, and energy positions.  These trades were done at differentials from market prices, to reflect the risk that those taking over the positions would assume and have to work off.  A couple of the positions were under-margined: the firms taking over the positions required the CME to provide more funds than the Lehman margin it had against those positions.  As it turned out, the other positions were over-margined, and across all positions the over-margining exceeded the under-margining, meaning that the CME clearinghouse did not suffer any loss as the result of the default.  But this illustrates the possibility that futures can be under-margined, and that even the putatively more liquid futures contracts can require substantial price concessions to get someone to assume them.

LCH.Clearnet handled the default of the Lehman IRS positions. These totaled $9 trillion in notional-bigger than the Lehman futures positions at CME, and arguably far larger in terms of risk.  ($1 trillion in notional of a 10 year IRS poses substantially more risk than $1 trillion in notional of Eurodollar futures.)  90 percent of the position was hedged within a week.  According to LCH.Clearnet, the costs of trading out of the defaulted position were “well within” the Lehman margins it held.

It’s hard to see much of an economic difference between the CME and LCH experiences.  It doesn’t appear that it was materially more difficult to manage the default of “swaps” than it was “futures.”   The Lehman default does not provide any evidence that swap-o-phobia is anything but a mental illness.

Further, this case study illustrates that there is no reason to believe that absent government regulation, swaps will be under-margined and futures will not.  Indeed, had the Lehman positions been held at 5 separate CCPs, two of them would have been under margined.

Indeed, there are serious reasons to be concerned that government regulations of the margining of economically similar (and in some respects identical) contracts will create systemic risks, rather than mitigate them.

The margin regulations-with larger IM imposed on swaps than futures-are a form of price control, in this case default risk price control.  And we know that price controls work out swell, especially when applied by regulators in a two-sizes-fits-all fashion across all different kinds of instruments posing different risks and cleared by CCPs with potentially disparate financial strength.

Moreover, this price control will tend to induce activity to move towards futures CCPs.  Whereas in the absence of the margin differential clearing activity in, say, interest rate derivatives would be split between futures CCPs and swap CCPs, under the differential regulation, business will tend to tip to the futures CCPs-most notably, CME.  This will tend to lead to greater concentration of credit risk.

Wasn’t the whole point of Frankendodd to reduce concentration? Just asking.

The whole conceit that regulators can set risk prices is quite dangerous, and is likely to be a source of systemic risk because these prices are set on the basis of highly limited information in a politicized process, and because mistakes in setting risk prices (especially price differences between similar products) tend to lead to crowded trades and risk concentration that is highly destabilizing during crisis periods (cf. Basel II).

The case for setting different margins (default risk prices) on very similar-and in some cases identical-derivatives contracts is particularly weak.  It is the characteristics of the products and those who trade them that will drive liquidity and liquidation periods: products called “futures” that share the same economic characteristics as products called “swaps” will pose virtually the same challenges to liquidate in the event of a large default.  Given this, the economics suggest that imposing differential margins based on a name difference-rather than economic differences-can’t make things better, and could well make them worse.

But the Sorcerer’s Apprentices know better. So futures are likely to get an artificial advantage, and swaps an artificial burden. Such distortions are quite dangerous.  My conclusion? Futurize in haste, repent at leisure.

One of the themes of my writing on clearing mandates and other aspects of post-Crisis derivatives regulation has been that although these initiatives have been sold as ways of reducing risk in the financial markets, in reality, they shift many risks, transform others, and create new ones.  It is by no means clear that these new laws and regulations have reduced the overall vulnerability of the financial system.

For instance, clearing and collateral mandates are intended to reduce the amount of credit embedded in derivative trades.  But market participants can respond to this by substituting other forms of leverage.  The effects on credit risk and leverage overall are far more equivocal than the advocates of the mandates claim.  As another example, making derivatives more expensive means that some will eschew using them to manage risk.  Risk that was passed to others able to bear it at lower cost will remain with those who bear it at a high cost.  As yet another example-and the one that worries me most-is that clearing and collateral mandates have transformed credit risk to liquidity risk.  Since true crises are usually liquidity crises, this is highly disturbing.

The CFO of Rolls Royce made similar arguments forcefully at a conference a few days back:

European regulatory measures designed to make the financial system safer don’t actually eliminate risk, they simply move it to nonfinancial companies, warns Mark Morris, the finance chief for Rolls-Royce, the British aero-engine maker. And there could be a negative impact on the economy, he says.

Speaking at a conference organized by The Economist Group (a minority owner of CFO), Morris criticized European regulators for seeking to deal with over-the-counter derivatives risk in the financial sector by requiring some contracts to be centrally cleared or to have collateral posted.

The European market infrastructure regulation, known as EMIR, took effect last August but requires the European Commission to enact a series of technical standards before the rules can be fully implemented. Most are expected to be finalized by mid-2013.

“In essence, you can’t destroy risk,” Morris said. “It morphs into something else. If you take market risk and go into a foreign exchange [hedging] transaction with a bank, you’re replacing it with counterparty risk. If you try to replace the counterparty risk by using central clearing or some form of posting of collateral, what you’re doing is you’re replacing counterparty risk with liquidity risk.”

Morris makes some other good points in the article, so I recommend you read the whole thing.

It seems that the Europeans are more sensitive to these concerns than was the case in the US.  The European Parliament may demand changes in EMIR. Apparently they are aware of the legislate/regulate in haste, repent at leisure problem.  Unfortunately, with Frankendodd dismissed such concerns.  Methinks that the repentance stage will come soon.

There is an I-told-you-so tizzy going on about the revelation of the BATS exchange that a system (or programming) error had resulted in the execution of about 450,000 orders at prices worse than the best bid/offer (BBO).  Oh, the humanity!

A little perspective here.  According to BATS, the total loss (which is a wealth transfer, mind you) totaled . . . brace yourselves now . . . $420,000.  Excuse me.  $420,360.

There seems to be some presumption that there was a Golden Era of trading, before the invasion of the dreaded machines, when intermediaries had hearts of gold rather than a hunger for it.  When bids and offers were never violated.  When there were never trading errors.

Wrong.  There was no Golden Age.  Nirvana is still just a band.

Think that the BBO was never violated on exchange floors?  Think again.  Sometimes this was inadvertent in the chaos of the pits/trading posts during active markets.  Sometimes it was very advertent (is that a word?)  May I remind everyone of the FBI sting on the CME and CBT, which discovered that some brokers would collude with locals to execute customer orders at off-market prices, and split the proceeds, sometimes delivered by bagmen-literally, guys passing paper bags of bills.   Given the relatively crude time stamping of trading cards, it was very difficult to construct an accurate audit trail.  Trades couldn’t even be sequenced with precision, and since the bid/offer were not recorded continuously or time stamped, it was impossible to see whether  a trade violated the BBO.  There were pit monitors who tried to keep an eye on things, but no human monitoring was capable of detecting all violations.  Indeed, the sociology of the floor and the member domination of exchanges (a subject I’ll turn to shortly) meant that social pressure discouraged cracking down too aggressively, particularly on the most powerful.

Enforcing the BBO on the floor was in many ways constrained by a lack of data.  If anything, current market monitors have the exact opposite problem: they are drowning in a sea of data.  But as BATS shows, it is possible to go back through years of this data and pick up mistakes that cost customers about $1 per error.

Then shall we discuss out-trades?  Out-trades-trading errors, where trade terms submitted by the buyer and seller didn’t match-were common on the floor.  Brokers were on the hook for errors, and there were stories of brokers writing six figure checks to make a customer whole for a loss.  I would not be surprised that on an inflation adjusted basis, a single broker wrote a check to a customer that exceeded $420,000 in 2013 dollars.

But this reality of the way things were doesn’t stop the hue and cry about the fallen state of today’s computerized markets.  The biggest huer-and-crier (emphasis on the crying) is Jackass Joe Saluzzi of Themis Trading.  Here Joe outdoes himself, by suggesting that we need to go back to the days of non-profit exchanges in order to restore public confidence in broken markets. (h/t Blivy.)

JJ apparently believes the old mutual non-profit exchanges were freaking charities, like the March of Dimes or something.  Uhm, no.

Let’s look at the facts.  The old mutual exchanges were cartels of intermediaries.  They restricted membership in order to enhance the rents of those members.  For decades, most of them ran brokerage cartels that fixed commissions.  Some created monopoly privileges for some members (e.g., NYSE specialists).  Others (NASDAQ comes to mind) had order handling rules that basically precluded public customers from competing with member market makers in supplying liquidity: NASDAQ was also the nexus of a flagrant conspiracy among market makers to fix spreads at supercompetitive levels.

Non-profit status had nothing whatever to do with the charitable urges of old time brokers and market makers.  As I showed in research done just as the transition from non-profit to for-profit status was occurring, exchanges chose the non-profit form because the non-distribution constraint inherent in that form prevented the exchange from choosing pricing policies that transferred wealth among heterogeneous members with very specialized human capital.  (An abbreviated version of the argument is here.  The full version was published in J. Law & Econ. in 2000.)  Electronic trading undermined the rents and the specialized assets that drove the choice of non-profit form, so the move to electronic trading in turn impelled the transformation of exchanges to for-profit entities.

In other words, non-profit form was chosen by very greedy, profit-driven individuals to protect their profits.  And a good chunk of those profits resulted from the exercise of market power and the adoption of collusive arrangements by exchanges.

So spare me nostalgia.  Indeed, methinks that a good deal of the nostalgia-and the related criticism of modern electronic markets-is a shriek of rage by those who profited under the old system, and are furious that someone ruined their racket.

Joe does get one thing right (cf. blind hog, acorn).  He attributes the specific BATS problem, and the increased complexity of the equity markets, to RegNMS.  This is correct.  The information-and-linkages approach chosen by the SEC led it to adopt regulations that socialized order flow.  This was done with the explicit goal of encouraging competition among trading platforms.

Another example of “be careful what you ask for: you might get it.”  Pre-RegNMS, NYSE executed about 85 percent of the trades in its listed stocks, and the bulk of the remainder was executed in Third Markets which did not contribute to price discovery.  NYSE was essentially the natural monopoly supplier of price discovery.  Now, NYSE market share is in the low-20s, and executions are shared pretty much equally among a handful of platforms.

But this socialized order flow model requires linkages between the execution venues.  It is that necessity that accounts for the complexity of the current equity markets.  The interconnection imperative is directly responsible for the proliferation of order types that many find so vexing, and which indeed give advantages to specialized electronic traders.  Note that the BATS error was in an order type designed to ensure compliance with RegNMS rules relating to the BBO.

You can criticize this market structure.  But if you do so, you have to grasp the nettle of the fundamental trade-off.  The choice is binary.  You can choose to socialize order flow, or not.   If you do, you get something like the current equity market structure, with intense competition among execution venues linked by a complex web of fragile connections and a proliferation of order types.  If you don’t, you get something like the pre-RegNMS market structure, or futures market structure past and present.  A market that tips to a single execution venue that exercises market power, either by restricting access (the old mutual model) or by charging supercompetitive prices (the new for-profit exchange model).

Those are the choices.  But the debate is almost never framed that way.  Instead, bat sh*t crazy people like Saluzzi (enabled by folks like the CNBC talking head in the BATS Hit video) take up all the oxygen screaming about how bad the current market structure is and retailing myths about some Golden Age that never was.

Political economy considerations almost certainly ensure that the SEC is not going to go back on RegNMS, and it is truly invested in the information-and-linkages approach it chose.  So we are likely to see a continued series of controversies over problems that are inherent in the socialized order flow model.  The SEC will pull its chin, and deal with each problem as it appears in an ad hoc way, just adding to the complexity as the new games are devised to exploit the new rules implemented to stop the old games that exploited the old rules.  This will make for never ending media appearances for the likes of Joe Saluzzi, but  don’t buy his line about the good old days.  The good old days that existed when regulation effectively opted for the other binary choice (no socialization of order flow) weren’t all that great.  There was a different set of problems, and a different set of people and firms profiting off the inefficiencies that inhere in the network nature of financial trading.

One of the predictable though unintended consequences of Frankendodd (and its European cousins) will be to increase concentration in the banking sector.  Not just predictable: predicted, including by me (notably at the JP Morgan Commodity Conference in October 2011, and here on SWP).

The logic is fairly straightforward.  Frankendodd creates a huge regulatory overhead that in turn leads to scale economies.  Smaller-to-medium-sized entities will not be able to afford these overhead costs, and will exit the business, and the bigger firms will get bigger.  The overall level of activity is likely to go down as a result of the exit and expansion, but the biggest firms are likely to get bigger even if the market overall gets smaller.  Moreover, the capital and collateral requirements in Frankendodd, including in the derivatives title, have disparate impacts on different market participants  Since the smaller entities typically have higher capital costs than the bigger ones, this increase in capital needs to support trading businesses in particular will lead the smaller market participants to contract more than the bigger ones; this increase in their capital costs may also induce them to exit altogether, especially when taken in conjunction with the increase in regulatory overhead associated with trading businesses in particular

Given that Frankendodd was allegedly intended to address the too big to fail problem, it is perverse that one of its predictable consequences is to increase concentration, and likely increase the size of the biggest firms in the market.

We may be seeing the first major move in this direction, just as Frankendodd’s big boot is starting to kick in.  Morgan Stanley announced deep job cuts, and rumors are flying that it will exit the fixed income trading business:

Now the storied company — whose take-no-prisoners trading desks have at times been rivaled only by firms like Goldman Sachs — is cutting even deeper, raising questions among some on Wall Street about whether it should spin off or ditch much of its trading business as its Swiss rival UBS has, a suggestion the firm eschews.

. . . .

Morgan Stanley’s board, said people briefed on the matter, has discussed closing its fixed-income department. Instead, the firm is shrinking the unit, arguing that it is important to offer its customers those trading services. By cutting jobs and costs and exiting lines like structured products and other complex financial investments and focusing on less risky, less capital-intensive businesses like the trading of interest rates, executives contended that the division can generate a healthy return.

So they’ve discussed it, but decided to keep it in a shrunken state.  But it may have to revisit the more drastic measure:

In recent years, the fixed-income department has not been able to make enough money to cover the cost to Morgan Stanley of this capital, according to people briefed on the matter but not authorized to speak on the record

If it hasn’t covered its cost of capital pre-Frankendodd, lotsa luck with covering it afterwards.

Frankendodd will cause a contraction of the financial sector, which isn’t necessarily a bad thing.  But the contraction will be uneven, and the fundamental nature of Frankendodd favors a relative expansion, and perhaps an absolute expansion, in the biggest-the JP Morgans and Goldmans and Deutsche Banks.

Hardly what was intended.  But that’s different to say it wasn’t predictable.

The US Senate s sometimes called the World’s Greatest Deliberative Body.  At times-most times, in fact-it seems that it would be more apt to call it the Deliberative Body With the World’s Greatest Proportion of Room Temperature IQs.  Many notable dimwits come to mind-Barbara Boxer, for instance. But the dearly departed (from the Senate, anyways) Blanche Lincoln was oh-so-special in her dimness.

As a sort of parting gift prior to her electoral rout in 2010, Blanche succeeded in inserting the eponymous Lincoln Amendment into Frankendodd.  This was the “swaps push out” provision, which precluded any “swaps entity” from receiving assistance from the Federal Reserve.  This requires banks to “push out” dealing in derivatives to separately capitalized subsidiaries that have no access to the Fed discount window, or other sources of federal support.

Crucially, the Lincoln Amendment was limited: basically, only equity derivatives, some credit derivatives, and commodity derivatives (with the exception of gold) were pushed out.  Banks were allowed to maintain their bread-and-butter rates derivatives business, as well as some of their credit trading businesses.  I guess the theory was that commodities are scary risky, but banks can’t jeopardize themselves by playing in interest rates.  Or something.

Well, that’s true of US banks, anyways.  But due to the meticulous drafting that characterizes Frankendodd, branches of foreign banks cannot avail themselves of the same exemptions.  This includes behemoths like Barclays and Deutsche Bank.

So now the Fed is trying to clean up after Congress, endeavoring to find ways to blunt the effects the provisions of the Lincoln Amendment on foreign banks.  Easier said than done, because despite the fact that “Ms Lincoln called her amendment’s treatment of foreign banks’ uninsured US branches a ‘significant oversight’ that was “unfortunate and clearly unintended. . . . the language of the legislation is clear, regulators are unable to use [Lincoln’s] statements on the Senate floor to unilaterally change the implementation of the law. ”

Good times.  Good times. Just another of the land mines lurking in Frankendodd.  Think of how many more are to be found.  And how many are buried in Obamacare.

Like I said.  Good times.

Proving again that Al will never let consistency of principle stand between him a a big payday, he is walking away from the sale of Current TV (surely you’re eyes are always glued to that, right?) to Al Jazeera with a reported $70 million.  Al Jazeera, of course, is largely funded by the Qatari government.  And Qatar is a major producer of the fossil fuels that Al dreads so much, particularly natural gas.  Indeed, Qatar is the world’s largest exporter of LNG, accounting in 2011 for 75.5 million tons out of a world total of 241.5 MT, far outdistancing number two exporter Malaysia which exports only a third of Qatar’s volumes. Quite impressive, given that Qatar only began LNG production in 1997.

But maybe there is some consistency here.  Al hates fracking.  Qatar hates fracking too.  Increases in output of gas in the US due to the fracking revolution, and the potential migration of that technology to other regions, represents a major threat to Qatari export volumes, and the price it can get from those exports.  Qatar is already cutting back spot volumes trying to lock Asian customers into long term contracts in anticipation of increased competition resulting from increased output of non-conventional gas, as well as gas offshore gas produced in Australia.

Qatar is no doubt looking for ways to crank up the propaganda war on fracking, and Current TV’s prog audience (to the extent it has an audience) is highly receptive to that message.  Need proof of that? New York governor Andrew Cuomo is allegedly spiking a state-commissioned report that demonstrates that fracking does not present a health risk. Why? Well let’s hear it from the horse’s mouth (and yeah, the other end too), the New York Times: “Mr. Cuomo, a Democrat, has long delayed making a decision, unnerved in part by strident opposition on his party’s left.”

So Current, which would not even enter into negotiations to sell to Glenn Beck because “they wanted to sell to someone they are ideologically in line with”, has apparently succeeded in that objective.  They found a fellow fracking foe to buy the network, therefore no doubt easing whatever qualms they have about selling to a network known for Jew hatred, which receives funding from a country that has become notorious of late for being the main arms trafficker for civil wars in Syria, Libya, and now Mali, with many of these weapons allegedly going to Al Qaeda affiliates.

Qatar bears watching.   It is difficult to figure out what its game is.  It is, as just noted, heavily involved in intramural Muslim conflicts in Africa and the Middle East.  Some of this is easy to understand: fighting Syria is a proxy war against arch-foe Iran.  The broader support for radical Islamic elements is far more difficult to understand, and quite troubling.   Is Qatar operating on its own?  Is it a Saudi cutout?  Qatar has also had tempestuous relations with Russia, culminating with a downgrading of relations following the battery of three Russian diplomats including the ambassador at the Doha airport: the fight erupted when Qatari securities and customs personnel attempted to wrest a diplomatic pouch from the ambassador.

But Al apparently doesn’t care about all this.  He has the green, and his green conscience is salved by a transaction with a fracking foe.  Even one whose gas exports account for 206,250,000 tons of CO2 every year, and whose oil production generates another 205,000,000 or so tons, volumes that commenter Green as Grass helpfully points out allow Qatar to claim the title of world’s largest CO2 producer per capita.  There’s an inconvenient truth for you, eh Al?