Streetwise Professor

It’s been known for centuries that comparative advantage and relative factor endowments should drive trade patterns.   The fracking revolution has led to a dramatic change in US comparative advantage and factor endowments.  Basic economics tells us that this should drive a change in trading patterns, and in particular, it makes it efficient for the US to export natural gas, once the requisite infrastructure is in place.

Prices tell the story.  There is a a yawning gap between prices in Europe and Asia, and prices in the US.  Price signals are screaming: invest in export infrastructure, and export gas.

But politicians are deaf to basic economics, and to policies that promote efficiency.  They listen to the importuning of organized interests, and these interests are often diametrically opposed to economic efficiency.

Natural gas is a case in point.  Rep. Ed Markey (D-MA) has long been beating the drum to restrict natural gas exports.  And now he has company, Senator Ron Wyden (D-OR):

New discoveries of natural gas are beginning to transform the U.S. economy, and energy companies say exporting it is the next logical step. But a call for restraint is coming from Sen. Ron Wyden.

The Oregon Democrat, who will have a powerful perch in Congress to influence the debate, has been fielding substantial home-state opposition to such exports. The brewing fight illustrates how energy abundance can be just as divisive in Washington as a shortage, a theme likely to play out in coming years as the U.S. deals with growing energy supplies.

. . . .

Hours after the report came out, Mr. Wyden was sitting at Bistro Cacao, a French restaurant a few blocks from the Capitol, with Andrew Liveris, chief executive of Dow Chemical Co.,  one of the largest natural-gas-consuming companies in the U.S.

. . . .

“I want to make sure we look for the opportunities…to the greatest extent possible, to export value-added products rather than the raw material,” the senator said in a recent interview.

“Natural gas is a strategic American advantage,” he added. “We’ve got it. The whole world wants it.”

And the market is the best way to determine the most efficient way to exploit that advantage. But Sen. Wyden, thinks he is Goldilocks, and knows the price that is just right:

That is one reason Mr. Wyden hasn’t proposed an outright energy export ban. Instead, he suggests softer restrictions such as a cap. “How can policy makers look to find a sweet spot where you can allow exports to keep wells in production without letting exports drive prices so high that they hurt the American manufacturers?” he said.

This is an illustration of the Peltzman-Becker theory of regulation in action.  Politicians buy political support by balancing between competing interests.  Wyden is trying to buy support from domestic gas consumers by proposing to restrict exports, thereby keeping prices lower.  But he doesn’t want prices too low, because that would lead to fierce opposition from energy producers.  So he is looking for “softer restrictions.” He wants to take, but not too much.

How generous of him.  But it’s not generosity, really.  It is the logic of the stationary bandit, and the optimizing politician balancing support and opposition.

Distributive effects drive politics and regulation, not efficiency.  Efficiency is not irrelevant, because politicians like to have a bigger pie to divvy out, but they are willing to incur substantial efficiency penalties in order to achieve distributive goals.  Here, Wyden is proposing to deliver a big gift to Dow and other chemical producers (and other major industrial consumers of gas).  But for every dollar Dow gets, somebody else loses a dollar, and crucially, some cents are destroyed.  There will be deadweight losses.   Too little gas will be produced.  Too little gas will be exported.  Too much will be consumed domestically.

This is just one example of how politics and regulation destroys wealth.  Multiply this thousands of time over, in just about every good and service you can think of.  Everything from haircuts to energy to medicine.  These things kill income and growth, by a thousand cuts.

The amazing-and disturbing-thing about the Wyden article is the very matter-of-fact treatment Wyden’s threatened intervention gets in the article.  It’s the natural order of things that a senator can just arrogate to himself the power to shift around billions at a whim.

And the whim part is important.  Any investment, and plan, is vulnerable to the whims of politicians looking to redistribute wealth to favored interests.  You do something that creates a substantial amount of wealth, you attract those who believe it is their God given right to redistribute it.  In essence, politicians have an option on innovation and the fruits of hard work: tails you lose, heads you share .   This uncertainty, this risk, and the innovators’ short option position are drags on investment and hence growth.  Moreover, management of this risk involves the direction of valuable resources-including the time of top management-into rent seeking activities.  More waste, another drag on growth.

All the yammering over the “fiscal cliff” is a distraction, a near irrelevance.  All the fear mongering is predicated on Keynesian mumbo jumbo, so it will be more of a pothole than a cliff.  The real threat is the accumulation of interventions like those that Wyden is proposing, that collectively serve to reduce wealth and income, and sap growth.   That is the real cliff we have to worry about.  All of the budgetary and fiscal issues become far more more intractable, the lower is growth.   The sclerosis that results from the overbearing interventions in matters large and small will make a fiscal crisis far more likely, because our ability to create wealth will not be able to accommodate the insatiable demands of the entitlement state.

I laughed out loud, and very hard, watching this video (from RT, no less, though via Tabb Group) about HFT.  It is an interview with David Greenberg, who spent 25 years trading CL on the floor of the NYMEX.

What made me laugh?  The part (starting around the 1:30 mark) where Greenberg notes that when public news comes out, HFT traders pull their quotes “in nanoseconds.”  But back on the floor, there would be brokers who would be quoting customer limit orders, and “before his clerk could grab him on his neck, I could go ‘SOLD!'”

Let me translate.  Floor traders had a speed advantage over customers off the floor who were trading by limit order.  When market-moving news came out, floor traders like Greenberg could exploit their speed advantage, and trade against stale customer limit orders that were entered before the information was released. In so doing, the locals, due to their time-and-space advantage, took money from customers.

Yeah, it didn’t happen in a nanosecond, but that doesn’t mean jack.  What matters is that even on the floor, the faster took money from the slower: seconds, nanoseconds, whatever.  This was true in 1990, 1890, and hell, in 1790 or 1690 in the Osaka rice market.  Locals on the floor had a speed advantage over those off the floor, which they exploited ruthlessly .  And this inevitably resulted in wider markets, as off-floor traders quoted wider spreads precisely because of their vulnerability to being picked off.

Not to go all Einstein on you (as if), but speed is relative.  The stale quote problem is not a function of the absolute speed with which some traders can react, but the relative speed.  Humanoid locals in the pit were pitifully slow, compared to robot traders-especially customers who had to play telephone (literally) to yank their orders.  But that doesn’t mean that predatory trading-taking advantage of the slowest gnu in the herd-was less severe on the floor than in an electronic market.  What drives the losses from stale quotes is relative speed.  And I would argue that relative speed differences were even greater in the floor days than now.

And what ticks off old-timers like Greenberg is that the easy pickings aren’t there for the taking anymore.  HFT traders, through their tremendous speed, and their ability to scrape numerous sources of electronic information, can pull their quotes in an instant when market-moving news comes out.  They thereby protect themselves from being picked off.

Which is precisely why they can quote very tight markets.  And which is precisely why guys like Greenberg hate them.  They have ruined a total racket.  How dare they?!?!

Greenberg also talks about how in the floor days prices would move in stages to a new level after information was released.  Now the movement is much faster.  That’s bad how, exactly?

One could argue that if HFT completely withdraw their quotes, that the market will overshoot.  Prices move a lot because HFT traders totally pull their quotes.   Once the information has been digested, they quote again, and presumably the new quote level is between the pre-information release price and the quote/price immediately following the pulling of HFT quotes.

This has a testable prediction: price reversals should be larger in electronic markets than floor markets.  Or to refine the test: price reversals in the aftermath of big price moves (in response to the release of particularly salient information) should be bigger in electronic than floor markets.  To refine the test: the magnitude of price reversals should vary directly with the prevalence of HFT.

This all brings to mind two conversations, held more than 10 years apart, with a legendary trader.  A guy who made 100s of millions of dollars.  In about 2000, this trader told me he was ecstatic about the advent of electronic trading because he was “tired of getting raped by the floor.”  (Exact quote.)  In 2012, he was lamenting the advent of electronic trading because he couldn’t keep up with HFT.

Keep this in mind when you hear laments about HFT, especially from market veterans.  It’s all about whose gnu is gored, or about how the gnus have become so fast that it’s hard to gore them anymore.

I’m sure you would never peg me as a green type, but I have decided to join the recycling movement!

I am doing so in response to the call by Barney Frank (the Frank of Frankendodd) to merge the SEC and the CFTC.  This idea has itself been recycled many times, dating back to the 1980s and the birth of stock index futures.

One of the recycling efforts was by Hank Paulson, in the spring of 2008, in his proposal to reform the financial markets.  A centerpiece of this proposal was the org chart shuffling.  What I said then holds true today, so I’ll conserve scarce resources (mainly my time), and merely recycle:

The biggest headline was that the recommendation for the merger of the SEC and the CFTC. This puts in me in mind of two quotes. The first is by Churchill: “A fanatic is one who can’t change his mind and won’t change the subject.” Whenever anything happens in the financial markets, the cry immediately goes up to merge the SEC and the CFTC. Many people are apparently fanatical, because they never change about their minds about the desirability of the merger, and the subject always seems to return to it.

The second quote is by somebody slightly–well, a lot actually–less famous; that would be me. In a 2001 Regulation Magazine piece on the Clinton regulatory legacy, I wrote that the SEC-CFTC combination was a solution in search of a problem.

I am always somewhat mystified by the substance of the arguments for the merger. The most commonly mentioned benefit is a harmonization of margins between stocks and stock index futures. What, it’s not possible to harmonize without going merging the two bodies? Moreover, given the myriad other more important issues facing the two agencies, this seems like a very thin reed on which to rest a major reshaping of the regulatory structure.

In reality, there is very little overlap between the regulatory responsibilities of the two agencies. What’s more, there are huge swathes of the trading landscape that fall outside the jurisdiction of either agency. So merger will hardly reduce that much duplicative or contradictory regulation, and will not fill any regulatory gaps. So what’s the point?

Indeed, there are many sources of potential danger in a merger. One, very underappreciated in my view, is that it sacrifices the advantages of specialization. There are issues unique to securities markets and derivatives markets. Specialized agencies can develop the expertise needed for each market space. Of course the staff at a merged agency could specialize, but major policy, rulemaking, and interpretive decisions are made at the commissioner level. Right now SEC commissioners, for example, need to deal with arcane issues of accounting, disclosure, securities intermediation, and securities trading practices in stock, option, and fixed income markets. This is an already daunting task. Adding new areas of responsibility involving different markets and different instruments with different issues will further tax the already limited expertise of the commissioners of the merged agency.

The inevitable outcome of this dilution of expertise and specialization will be to enhance the power of staff, and degrade the quality of commission decision making. Neither outcome is desirable.

Indeed, I would argue that the SEC is already underspecialized. The agency operates subject to three statutes, the Securities Act of 1933, the Exchange Act of 1934, which focus on primary and secondary markets for securities, respectively; and the Investment Company Act of 1940, which focuses on mutual funds and the like. The agency has responsibility over the issuers of securities, and the markets and intermediaries that trade securities. There is little overlap between these areas. Issues of disclosure and accounting can be conceptually and operationally distinguished from issues of market structure and organization.

A second area of concern is that a unified agency will provide a mechanism to reduce and distort competition between different sectors of the financial markets. There are many on Wall Street that would love to throttle the futures exchanges in order to reduce competition for the securities business. (The margin issue is a perfect example of this. The securities firms would love to force an increase in margins on futures to drive some business from the futures exchanges to the stock market.) The regulatory autonomy of the CFTC has largely precluded such an outcome. The SEC has indeed tried in the past to impede the development and introduction of futures products that compete closely with securities markets but has largely failed in these endeavors because it does not have the necessary authority or jurisdiction.

Now, of course, a merger would change agency politics. Under the current framework, the SEC is largely responsive to securities firms and exchanges, and the CFTC is responsive to the futures exchanges and the FCMs. A merged entity would be responsive to the interests of all of these parties. But that is not necessarily a good thing, as one very likely outcome is that the merged entity would implement regulations that would reduce competition between the varying constituencies.

A more sensible, but still problematic, regulatory reorganization would involve (1) stripping out the primary market, accounting, and disclosure responsibilities from the SEC and putting them in a separate agency focusing on these corporate finance issues, and (2) creating a separate agency responsible for trading and market structure issues in securities and derivatives markets. This second agency, call it the “Commission for Financial Trading and Markets” (“CFTM”) would focus on issues relating to manipulation; fraud; the financial adequacy of intermediaries (securities and derivatives brokerages); and facilitating competitive market structures in financial markets. Arguably the manipulation, fraud and competition responsibilities should give the CFTM some authority in the OTC markets.

This approach would be far preferable to mashing together two disparate agencies with very different histories and cultures in the hope that something beneficial will come out of the unnatural coupling. It would permit the development of some specialization, and many issues of fraud, manipulation, and market structure are common across securities and derivatives markets, so the specialization could be applied to a variety of related markets. This alternative is still problematic, however, because the CFTM could easily become a mechanism for stifling competition between different methods of allocating risks and discovering prices.

All that said, there is little likelihood that the merger (or the creation of a CFTM) will come to pass in any event. The idea has been around for decades, and has never even come close to implementation. This is no surprise. There are powerful political forces in the way. Most notably, the futures exchanges, their members, and the FCMs have fought the SEC’s loving embrace vociferously, and found vocal support in Congress. Moreover, whereas the SEC falls under the congressional banking committees (e.g., the Senate Banking Committee and the Securities, Insurance and Investment Subcomittee), the CFTC is under the ag committees. Neither is about to readily cede jurisdiction over a large, well-heeled, and generous industry.

What he, er I, said.

Expecting miracles from mashing together org charts is insane.  At best, it has no effect.  The more likely outcome is to make things worse.  (Want an example?  Look at the effects of the reorganization of the intelligence community post-911.)   The point about specialization is particularly apposite, IMO (naturally, since I brought it up!)  The five commissioners of the CFTC and the five commissioners of the SEC are already overwhelmed by their complex responsibilities, and can devote relatively little time to becoming expert in any one particular area.  Extending the scope of the commissioners’ responsibilities is supposed to make that problem better?

In the end, nothing is likely to happen.  This is a lame duck kerfuffle.  The people who will have skin in the game in the next Congress will want nothing to do with this, as has been the case for about the last 15 Congresses.

John Parsons and Antonio Mello at Betting the Business rightly slam the SEC’s evaluation of JP Morgan’s application to create a physical copper ETF. They are spot on that the SEC’s Division of Risk, Strategy, and Financial Innovation’s analysis was superficial, and quite frankly, silly.  Who knew that there was no connection between copper prices and inventories?

That said, I think that Parsons & Mello are far too generous in their praise for the comment letter submitted by the Americans for Financial Reform (an advocacy organization with strong ties to organized labor).  That letter posits some very speculative feedback loops: prices go up, people get excited about copper, they buy more of the ETF shares, driving up the price, and on and on.  If that mechanism exists, wouldn’t it exist even without the ETF?  And I’m dubious about the strength of that mechanism if it exists, and in fact doubt its very existence.

The only real concern is that the physical ETF somehow constrains the response of inventories to supply and demand shocks.  Inventories should rise when there are surprise negative demand shocks or positive supply shocks, and should fall with surprise positive demand shocks or negative supply shocks.  Speculative storage adjusts inventory in response to changes in fundamental conditions, and the forward curve is determined simultaneously.

If the ETF somehow impeded inventory adjustments, there would be a problem.  Here it should be noted that there is an asymmetry.  It is hard to see how that the ETF could in any way constrain increases in inventories.  If demand declines, for instance,  there is nothing to preclude traditional speculative storers from adding to inventories.

Things are conceivably different when inventories should decline.  One can at least consider the possibility that holders of the ETF would lock up inventory.

There is a redemption mechanism that limits this possibility.   “Authorized participants” (basically broker-dealers) can redeem ETF shares and receive physical copper in return: these firms would likely be ones that act as speculative storers in the absence of the ETF.  Thus, an ETF share is effectively a perfect substitute for copper warrants, and its creation does not obviously alter the market mechanism in a fundamental way.

I guess one could tell a story that goes something like this.  Irrational investors (not participants in the physical markets) hold onto ETF shares even if some of those shares should be redeemed and inventories released onto the market.  As a result, prices become too high.  Due to the excessively high prices, the Authorized Participants don’t buy and redeem the ETFs, cancel the warehouse receipts and load out copper when it should be loaded out.

For this price distortion to occur, the quantity held by the stubborn, irrational ETF investors must represent a binding constraint: they must end up holding the entire inventory.  Thus, a necessary condition-but not a sufficient one-for the ETF to distort inventory holdings (and hence prices) is that the ETF holds 100 percent of inventories.  (Note: things are a little more complicated because LME warehouses are located around the world, but the JPM ETF’s copper holdings will be limited to its Henry Bath warehouses.  It is conceivable that some inventory should be taken out of Bath warehouses, but isn’t due to the stubbornly irrational ETF holders.  So ETF holdings=100 percent of Bath inventories could be a symptom of a distortion, even if there are inventories in other LME regular warehouses.  However, to the extent that inventories in other locations are close substitutes for Bath inventories, the potential for a distortion is limited.   That’s one reason to have multiple delivery locations.)

Moreover, stubborn ETF holders who distort prices present a great short selling opportunity.  That also tends to limit the potential for a price distortion, particularly a large, enduring one.

My take on the JPM phyz ETF is therefore Alfred E. Newman-esque.  What?  Me worry?  One can imagine circumstances where it causes a problem, but the symptoms of this are clear: the ETF owns all the copper.  If those symptoms don’t arise, there’s no problem.  If they do-an unlikely event, IMO-take a look at it then, and figure out what to do in that event.

In other words: don’t borrow trouble.  Deal with trouble when-and if-it arises.

Mere days after the collapse of MF Global, I was told by someone who would have reason to know that the key to unraveling the MF mystery was Edith O’Brien, the firm’s assistant treasurer.  A year later, Ms. O’Brien is still in limbo, refusing to testify without immunity from prosecution.

The likelihood that Ms. O’Brien would have conceived of and executed a massive fraud-the looting of MF Global customer segregated funds-is close to zero.  If there was a crime, it would have been conceived of and directed by someone far higher in the firm than Ms. O’Brien.

Prosecutors routinely give immunity to low-level employees in order to build a case against higher executives.  Prosecutors in the MF Global matter seem to be deviating from that routine.  This raises questions, the most notable of which is: are they departing from SOP because the individual who could be implicated is a well-known and highly connected Democratic politician, a former governor and senator, and bundler for Obama?

Maybe there’s a different explanation, but I’m hard pressed to think of one.

I doubt that he’s making the trip in a sealed train, but an important and shadowy Russian figure is leaving Geneva, Switzerland to return to Russia.  That would be Gennady Timchenko, co-owner of the trading firm Gunvor.  You know, the one that is frequently linked with the guy Timchenko claims to know only slightly, Vladimir Putin.

Now, this isn’t comparable to Lenin returning to Russia to foment a revolution, but why would anyone in their right mind want to leave Geneva for Moscow?  And no, starting a construction holding company is not a good reason.  At least he didn’t say he wants to spend more time with his family.

A major risk that commodity trading firms face is legal risk-particularly if they deal with unsavory regimes.  Gunvor’s activities in the Congo are one example that has apparently drawn the scrutiny of Swiss investigators. Gunvor was also the subject of an article in the Economist about oil price manipulation, specifically, manipulating the market for Urals crude.  That has apparently attracted scrutiny of the Justice Department here in the states.  Although some have said that this is likely to be a civil investigation, that’s not my read: CFTC handles civil manipulation cases under the CEA, but Justice handles criminal. (Ask BP.)

And I wonder if there is any connection between the questions about Gunvor’s manipulation of the Urals market and its recent failure to win any tenders in that market, which it once dominated:

Trading house Gunvor – dubbed by dealers the king of Kremlin oil – has been left with no Russian crude to sell. That was the surprise outcome of the latest big Russian crude oil sales tender, for long routinely won by Gunvor.

The result has sparked an intense debate in the industry about whether Gunvor’s co-owner Gennady Timchenko is out of favour with the Kremlin – or whether the firm is merely fine-tuning its strategy before embarking on yet another phase of spectacular growth.

Could be a coincidence, but an interesting one, no?

Given the legal heat, perhaps there’s good reason for Gennady to decamp to a far chillier, but more legally congenial, climate.  A place where he almost certainly has protection from the chief protector, and one that doesn’t extradite.

Very much worth watching.

The NYT has a very long piece on how E&P companies are singing the blues about the low prices following on the unexpected surge in natural gas production.  Stop the presses.

What’s interesting to me is a point made in the article that I’ve seen raised repeatedly, and which I find curious, given my Coasean bent.  Specifically, that lease terms force companies to continue drilling to maintain leases, even if the wells can’t make money in a low price environment.  That is, the leases have use-it-or-lose-it-clauses:

The land that the natural gas companies had leased, in most cases, came with “use it or lose it” clauses that required them to start drilling within three years and begin paying royalties to the landowners or lose the leases.

. . . .

Exco, Chesapeake and others initially boasted about how many acres they had managed to lock up. But after paying bonuses of up to $20,000 an acre to the landowners, the companies could not afford to lose the leases, even if the low price of natural gas meant that drilling more wells was a losing proposition.

. . . .

The bust has certainly hit the Haynesville hard. Some local landowners, having spent their initial lease bonuses, are now deeply in debt. Local restaurants and other businesses are suffering steep losses now that so many drillers have left town.

The Coasean reply is to say: if drilling is inefficient, why not negotiate out of the use-it-or-lose-it-clauses?  There is a pot of money-the costs of excessive or premature drilling-that could be divided between the company and the lessor.  Why can’t the lessors and the lessees strike a deal to split that pot of money?  What are the transactions costs that preclude renegotiations that reduce excessive and premature drilling/production?  Is it the large number of lessors?  That is, are the costs of renegotiating each lease bigger than the benefit to be gained from rationalizing drilling and production?  Then why don’t companies like Cheseapeake just offer a standard deal to lessors, such as a fixed payment, or a fixed fraction of the original lease, or a fraction of the royalties from production, and let lessors take it or leave it?  Why are these clauses in the leases in the first place?

Interesting TCE questions.  I’d love to hear some answers, because I’m stumped.

Speaking of Haynesville, Gregory Kallenberg, the director of the movie Haynesville, has produced a series of short films (sponsored by Shell) about the future of energy.  The series is called “The Rational Middle.”  I appear-briefly-in several of the films, which can be viewed at the link.  I participated in a screening/panel discussion in Houston last Wednesday, and recorded material on conservation and efficiency that may appear in the next round of pieces.

The jaw-to-jaw square up moment during last night’s Presidential Debate was over energy policy, of all things.  Politicians discussing energy is usually less than edifying, and last night was no exception.  But Obama took the prize for ignorance, complete with a huge dollop of arrogance-always a charming combination.  But it is his métier, non?

Specifically, in response to Romney’s attacks on administration policy regarding drilling leases on public land, Obama lauded the administration’s move to “use-it-or-lose-it” leases.  So let’s get this straight, absent his genius, oil companies would spend money to buy leases, and just sit on them out of spite?  Or something.

A lease is essentially an option.  It is an option to explore, develop, and produce.  There is optionality within each of these steps.  For instance, a leaseholder can undertake some preliminary exploration, and conditional on the results of that, decide to engage in additional exploration.

The value of this option depends on its maturity.  It also depends on the uncertainty regarding the geology.  Crucially, it depends on market prices-the price of oil or gas, the price of inputs needed for exploration, development, and production.  It also depends on the volatilities of these prices-which is true of any option.  It also depends on the amount of time required for each “sub-option”, e.g., each step of the exploration process.  This depends on the particular property at issue.

Use-it-or-lose-it basically means to shorten effective lease terms.  This reduces the value of the option.   By how much depends on all the factors I just mentioned.

So to the extent that “use-it-or-lose-it” means anything, it means that the administration is shortening the effective maturity of leases.   This reduces the value of the option . . . which reduces the amount companies will pay for leases . . . which reduces government revenue.  So Obama is bragging about a policy that reduces government revenue.  Got it.

Indeed, some companies will figure the leases are worth zero under the restrictions.  So leasing will decline.

There’s another way to see why this policy is so wrongheaded.  The E&P business is pretty competitive.  And E&P companies are not in the business of leaving money lying around.   If there’s money to be had by leasing a property and developing it optimally, a lot of companies will compete to do that.  In this competitive environment, lease prices will reflect pretty well the value of the property and the value of the options to develop it.  Inefficiently constrain those options, and competition will force down the prices of leases.

But we know that Obama has no clue as to how businesses, competition, and markets work.  This is just another superfluous data point in that empirical exercise.

That’s not all.  When you look at output, and the pattern of output over time, inefficient restrictions on the terms of options will lead to lower production, and inefficient exploitation of resources over time.  Some resources will be developed too quickly.  Others too slowly, or not at all.

This will, in turn, tend to increase prices.

And a bonus: inefficient production of hydrocarbons fro public lands will reduce government royalties from production.  Another revenue hit.

In summary: Obama bragged about a policy that is completely counterproductive.

But he is the smartest president EVAH.  Just ask him!

Idiocy updates: Some other Obama energy gems from last night.

The complete dodge on the Keystone XL pipeline:

And with respect to this pipeline that Governor Romney keeps on talking about, we’ve — we’ve built enough pipeline to wrap around the entire earth once.

That’s called bait-and-switch: asked about one thing, he answers about something else.  Furthermore, the other pipelines are neither here nor there.  Keystone should be evaluated on its own merits, which are quite strong.  And who is this “we” he is talking about?  Are he and Valerie and Michelle moonlighting on pipeline construction crews?

Favoring throwing good dollars after bad renmibi and Euros.  With respect to renewables, he said:

Because China, Germany, they’re making these investments. And I’m not going to cede those jobs of the future to those countries.

Yeah, they’re making these investments.  And losing money hand over fist on them.  Note to Barry: you don’t gain “jobs of the future” by taxing people engaged in wealth-creating activities to pay subsidies to those who engage in wealth-destroying activities.  Yeah, you might see the guy working on the wind farm (but don’t look at the dead bats!) but you don’t see the people who aren’t working, or who are working less, or who are working less productively because of the deadweight losses of taxes needed to finance the Green Unicorns.

It is beyond pathetic that solar companies-in China, the US, German, Spain, wherever-can’t make money even if they are subsidized.

This is something to imitate?  No.  This is something to observe-and avoid like the plague.

But the Genius President knows bettah.

This afternoon I attended the Working Group on Financial Markets at the Chicago Fed.  The scintillating topic was segregation models.  Really!  It was scintillating!  For a certain kind of geek, of which I am one.

It was scary, actually.

Segregation of customer money has been a subject of discussion post-Frankendodd, and I have written several posts on the subject.  Segregation has received even more discussion post-MF Global (AKA Corzine-gate, but since he’s a made man I guess he will skate).  The model that has been implemented for cleared swaps, and which (according to clearing maven John McPartland of the Chicago Fed) is likely to be adopted for cleared futures is LSOC-legally segregated, operationally commingled.

Back in the summer of 2011, I wrote that segregation could make the markets more fragile, because it would tend to reduce credit (mainly intraday credit) used to finance variation margin.  This is important, because the markets depend on using credit to fund margin payments.  If this credit freezes up, the markets will freeze up.  Indeed, a cleared system works on such tight deadlines that an interruption of credit can be catastrophic.  If margin calls aren’t met in a timely fashion, absent credit, margin payments don’t flow to those on the winning side of trades.  When this happens, the clearing system breaks down.  And in a Frankendodd world dependent on clearing, a breakdown in clearing means a meltdown in the markets.

Indeed, even delays of hours or even minutes in making margin payouts, or doubts that CCPs will make margin payments in a timely fashion, can be catastrophic.  Almost exactly 25 years ago, on 19 October, 1987, the mere rumor that the CME would not pay out variation margin led to a run on FCMs and the CME clearinghouse that almost brought the market to a crashing halt.

One of the speakers at today’s event, Barclays’ Kevin Murphy, noted that under segregated models FCMs don’t have a lien on  the collateral in customer accounts.  Which means they won’t extend credit to customers because there is no collateral backing the loans.  Murphy said that broker intraday credit is likely to be a thing of the past under greater segregation.

Think of the consequences on a day when markets move a lot.  Those on the winning side are expecting to receive variation margin payments.  Those on the losing side will be scrambling for cash to meet their VM obligations.  Where will they get it?  Not from their FCMs.  From their banks?  Uncertain-even if the customers arrange credit lines, banks can often find reasons to delay providing the credit, or not providing it at all.

This all means that there is a risk that VM owes will not be paid in time.  With no credit being extended, or the amount of credit being sharply constrained, there is a serious risk that VM pays will not be made on time.   If that happens, particularly during a period of market stress, all bets are off.  Almost literally.  People will fear that CCPs are insolvent, and there will be runs on them-people will liquidate positions to recover their margin money.

That would be very ugly indeed.  Again, a cleared system is very tightly coupled, more tightly coupled than OTC markets.  Tightly coupled systems are more prone to going non-linear, and failing catastrophically.  Segregation increases the tightness of the coupling.   Connect the dots.

Of course, markets don’t stand still.  People will recognize the need for contingent liquidity, and make arrangements for it.  But will those arrangements be as robust as the system we have now?  There is serious room for doubt.  If more robust alternatives are available, why weren’t they chosen before?  I know this argument is not dispositive, given the coordination issues involved, but there are strong incentives to adopt better systems.   We should be very leery of changes that implicitly assume that market participants with large amounts of money and risk in the game systematically choose wrong.

The whole move to clearing has been intended to wring credit risk from the derivatives markets.  But every move to reduce credit risk-including moves to greater segregation-almost always involve creating greater liquidity risk.

If given a choice between credit and liquidity risk, I would choose credit risk every time .

In other words, you have to pick your poison: credit risk or liquidity risk.  Yeah, credit risk may be like arsenic.  But liquidity risk is more like cyanide.

I know which one I would choose.

Jerry Dicolo of the WSJ has a piece on allegedly disruptive high frequency trading strategies that have been employed in the natural gas futures markets immediately surrounding the release of the weekly storage report.  Exactly what is going on here is hard to surmise, but what makes most sense to me is that the HFT traders at issue are gunning the stops.  That is, they are entering big orders to blow through the standing limit orders, moving prices, hoping to trigger buy stops (if they are buying) or sell stops if they are selling: the triggering of the stops creates the kind of short term momentum that the HFT traders can profit from by taking the other side of the stops.

Another example, as if one is needed, of the dangers of stops.

And it should be noted that gunning the stops is not the product of this newfangled electronic trading.  It happened on the floor with some frequency.  There are manipulation cases from the 1960s, if memory serves, related to gunning stops.

It’s also worth noting that there is exactly one data point in the story, August 16th.  It would be worthwhile to see if similarly allegedly anomalous price action took place prior to late-2006 when the market migrated to the screens.  I’m betting you could find more than one.

The article suggests that what is attracting HFT to the gas market is not the opportunity to play games for a few minutes once a week.  Instead, entry of HFT is being spurred by wide spreads in the gas market, as compared to equities.  HFT competition has narrowed spreads to virtually nothing in equities, so HFT traders are looking for markets with fatter margins.  Which is why they are moving into commodities:

High-frequency firms—whose activities can range from market-making on behalf of clients to trading for their own accounts—have wrung profits from the stock and other markets for years. But recently, their increased action in commodities, natural gas in particular, is spooking some veteran traders. That could leave the market reliant on computerized trading systems and potentially reduce liquidity when it is most needed.

“We can fight over fractions of a penny in stocks, or full pennies and more in natural gas,” said a programmer at a New York high-frequency trading fund.

Uhm, that’s the way markets are supposed to work.  Entry reduces prices and drives returns to just cover the cost of capital.  Which is exactly why some “veteran traders” are “spooked.”  They can’t compete against HFT.  Their oxen are being gored, just as traditional market makers’ oxen were gored in equities.

The new entrants may play shenanigans like gunning stops-but “veteran traders” did that too-another reason for “veterans” to resent HFT, for elbowing in on their racket.  Such shenanigans should be addressed by more targeted deterrents, rather than Euro-esque attempts to hamstring HFT.

I expect that spreads in natural gas, and commodities generally, will narrow as HFT technology and capital moves into those markets.  As for fears that this liquidity will dry up when it is needed most, again, this is not unique to electronic markets or HFT.  It is a feature of market making general.  Market makers reduce their supply of liquidity when they suspect order flow is toxic, or when risk is rising substantially.  It was so when market makers wore handle bar mustaches and button up shoes and stood in trading pits.  It will be so when market makers are co-located servers.  It’s inherent in the nature of market making, not in the technology.