Streetwise Professor

German energy giant RWE has been hurt badly by the yawning gap between spot gas prices and the prices it pays some of its suppliers, which are based on a formula tied to oil prices.  The firm has made some progress modifying those contracts with its suppliers, notably Norway’s Statoil:

RWE has managed with three of its suppliers to either end some long-term contracts – which in total account for half of the RWE’s gas purchases and run as long as 2036 – or to index them to the price of freely traded gas on European exchanges, it said on Thursday.

But one big supplier holds out.  No points for figuring out which one:

Negotiations with Russian state-owned gas monopoly Gazprom, the world’s largest natural gas producer, are continuing, RWE Finance Chief Rolf Pohlig indicated.

“It’s about a lot of money in an area where we have different opinions. That’s certainly more confrontational,” he said.

Russia is playing “hardball” said Frank Umbach, writing for the Geopolitical Information Service.

“Norway has shown a lot of flexibility so as not to lose important market share in Europe. But Russia considered itself to be in a stronger position and insisted on its long-term contracts,” he said.

The Norwegians are being more reasonable and flexible than the Russians.  Go figure.

But the 25 percent ($100/mcm) price gap between the oil-linked price and current spot prices is putting pressure on Gazprom.  It has made noises about adjusting contract prices:

A $100 gap between the forward price of gas in Europe and the current price of some Russian contract gas points to a possible deal with German consumers, who are seeking relief from high contract prices, Russia’s gas export chief said on Tuesday, Interfax reported.

Gazprom Export Chief Executive Alexander Medvedev, speaking in Lubmin, Germany, following the launch of the first phase of the new Nord Stream pipeline, which will ultimately carry 55 billion cubic metres per year to Germany from Russia along the floor of the Baltic Sea, said gas cost $500 per thousand cubic metres under some contracts this quarter.

Forward prices are now at around $400, he said. “This is a good basis for finding a good resolution with our German friends,” Medvedev was quoted as saying.

It is becoming increasingly clear that the oil-linked mechanism is becoming obsolete.  Gazprom’s arguments about the necessity of the mechanism are risible, especially in light of increasing liquidity in spot markets at European hubs.  Indeed, there is a positive feedback mechanism here.  Wider use of spot pricing mechanisms by Statoil and other suppliers increases the liquidity of trading at European hubs, which makes spot prices from these markets even more reliable as the basis for supply contract prices.  This process occurred after deregulation of gas markets in the US, and soon resulted in the evolution of liquid, deep, and transparent spot and forward markets at a variety of points.  Utilities now routinely buy gas at prices indexed to spot gas prices at these points.

And it is not just gas.  This process is also proceeding rapidly in iron ore, another commodity that historically has been bought and sold under annual negotiated contract prices.  But the development of some modest spot trading soon revealed substantial disconnects between contract and spot prices during the financial crisis of 2008-2009, which drove more activity to the spot market, which undermined the forward pricing system.  As a consequence, the industry moved to quarterly pricing, but that system is now under stress as well:

But this system is now under pressure as spot iron ore prices, at 15-month lows of $128 a tonne, are well below the quarterly price of $175, providing an incentive to steel mills to default on their contracts and buy instead on the spot market.

“This quarterly system, which has been in since late 2009, now looks to be failing,” says Rob Clifford, mining analyst at Deutsche Bank in London.

Another industry figure quoted in the article says that the movement to spot pricing is “accelerating.”  This is an illustration of the positive feedback effect at work.  The more spot trading there is, the less viable negotiated pricing becomes: the process feeds on itself with tremendous speed.

The Chinese were a big force pushing the iron ore industry towards shorter-term pricing mechanisms, and they are evidently taking this lesson to the gas market:

Russian energy giant Gazprom expects to rely heavily on liquefied natural gas (LNG) exports to Asia as talks with China on pipeline gas supply have stalled, the company’s head said on Sunday.

Gazprom has been mired in painstaking discussions with China about Russian pipeline gas supply since 2006 but the talks appeared to hit a dead-end over pricing terms.

Gazprom has insisted on the oil-linked mechanism for sales to China, but the Chinese have said no dice.  Hence the “stalled” contract talks.  Keep this in mind every time Putin or Sechin or anybody from Gazprom say that a deal with China is all but final: that is so much bull.  I know: shocking, isn’t it?  I bet you are so disillusioned.

The threat to move to LNG sales to Asia is just another Gazprom/Russian vaporcontract threat intended to put pressure on the Chinese–just as they use threats to sell to China to put pressure on the Europeans.  LNG is costlier, and definitely not Gazprom’s comparative advantage.  The gas that Gazprom would sell to China is much more efficiently sent to them via pipeline than to other Asian locations via LNG: and don’t think that the Chinese don’t know this.   Moreover, Gazprom would face much more intense competition in the LNG market from not just Qatar (mentioned in the article), but the US and soon Canada which has some geographic advantages in serving Pacific markets and which is facing declining demand for its gas in the US due to the shale boom.  This is a transparent bluff.  It will be called.

So who is Gazprom going to use as its next bogeyman buyer if it can’t use the Chinese to frighten the Europeans and other Asian markets to scare the Chinese?  Martians?

Probably not, given what just happened with Russia’s Mars mission.

In sum, cracks in Gazprom’s pricing structure are becoming more apparent by the day.  It continues its frenzied attempts to paper over these cracks, but these attempts are quite clearly futile and rather pathetic if you think about the economics.  The increase in world gas supplies and the integration of the world gas market with LNG are fundamentally undermining Gazprom’s competitive position, and rendering its pricing mechanism obsolete.  The positive feedback mechanism, in which the improvement of spot market liquidity drives more activity to the spot market and spot-based pricing mechanisms, improving spot liquidity even further, means that all of Gazprom’s frenzy will be for nought.

Which all means that last week’s much ballyhooed opening of the Nordstream pipeline does not represent the harbinger of increasing Gazprom–and Russian–power in the European energy market.  Instead, it is a day-late-and-several-billion-dollar-short (about $9 billion, to be exact) monument to the past.  Yes, Gazprom will likely sell gas through that pipeline for years to come, but it will have to do so at prices determined in increasingly liquid and competitive spot markets

Sucks to be Gazprom.  But it will be fun to watch!

FCM, investment bank, primary dealer, and wanna be Goldman MF Global declared bankruptcy today.  As is typical with financial firms, the end came quickly.  The firm’s problems metastasized quickly last week.  Another quarterly loss, a ratings downgrade, and worries about losses on trades in European government bonds led to the typical downward spiral of lost funding and lost customers.  These firms are very fragile.  When they fall, they usually don’t get up.

Ironically, MF’s FCM operation was acquired from  . . . REFCO, which cratered almost exactly 6 years ago, in October, 2005.  Will anyone dare to take on this cursed franchise?

Piecing things together, I surmise that the firm bought about $6 billion in Italian and other southern Euro bonds and repo’d them out.  Due to the decline in the prices of these bonds, and the firm’s deteriorating financial condition, the repo counterparties demanded higher haircuts.  The firm couldn’t come up with the cash, and in desperation maxed out its credit lines.  But that couldn’t stop the hemorrhaging.

The most likely explanation for all this is that the firm was already foundering, and CEO John Corzine tried to gamble on resurrection by ramping up the risk.  As is so often the case, this more often results in a more rapid descent to financial hell than resurrection.

One major irony is that MF Global was pushing hard for low capital requirements for members of OTC derivative CCPs.  How’s that idea looking now, GiGi?

Especially since suspicions are rife that MF has misused segregated customer funds, presumably to keep the resurrection gamble going.  Reports state that the firm is stonewalling regulators on turning over records, and that about $300 million in customer funds are missing.  This is one of the most egregious things a brokerage firm can do.

This is already a major fall for former Goldman CEO, US senator, and NJ governor Corzine.  He is also a major Obama fundraiser, who is presumably now a Nonperson.  If the suspicions about misuse of customer funds prove true, major fall won’t even come close to describing what lies in store for Mr. Corzine.  He will long to be merely a Nonperson.

All you clearing and market infrastructure aficionados must read Bill Hodgson’s piece on collateral transformation at DerivSource.  He points out quite accurately the new sources of fragility and vulnerability to stress that will arise from collateral transformation services that are being offered to finance CCP margins in the aftermath of clearing mandates.

The bitter irony here is that many derivatives end users (real money investment funds, industrial hedgers) did not pose any real systemic risk under bilateral structures.  But forcing them to clear drives them to utilize funding mechanisms that are systemically risky.  As one big corporate end user told me: clearing mandates have transformed credit risks into liquidity risks: I can manage the first, but the second scares me.

I continue to gape in amazement that the sorcerer’s apprentices that created these mandates did not think to step two.  They did not step back and ask: “Gee, we’re imposing a major change on the structure of financial markets.  How will market participants respond?”  This is especially unbelievable since a big component of the narrative of the financial crisis is that it was the result of excessive financial engineering.  What, did FrankenDodd, Timmy!, GiGi, the G-20, the EC, etc., think that the big changes that they imposed would not lead to a new burst of financial engineering?  Are they really that clueless?

I think I know the answer.  I think you do too.

Markets do not stand still.  Market participants will adjust contracts in response to regulations and laws motivated by beliefs that the existing system of contracts is flawed.  A useful first approximation is that these contractual adjustments will try to reproduce the economic substance of the banned or restricted contracts.  However, many of the work-arounds necessarily utilize less efficient–and often more fragile–ways to achieve that substance.  Which means that vulnerabilities have largely been relocated, rather than eliminated, and in many cases the new vulnerabilities are more dangerous than the old.

Read Bill’s piece to get an excellent illustration of this dynamic at work.  And then remember that the biggest systemic risk is government, and in particular, ill-considered government policies.  And that’s especially true when static-minded legislators and regulators attempt to impose their vision on a dynamic, strategic, reacting, self-ordering system.

Kinder Morgan’s Richard Kinder let it all hang out last week.   He laid into two of my favorite targets: the Obama administration’s unicorn-based energy policy and Gazprom.

On US energy policy:

Mr. Kinder didn’t stop there. He also regaled company employees, including many watching by webcast, with tales of his meetings with President Barack Obama and his energy secretary, Steven Chu.

He said he was “astounded” at how little consideration they gave to natural gas as a “game changer.” As time has gone on, he said, Mr. Obama and his aides have come to realize that “in the real world that the rest of us live in, you know, natural gas is really important.” But they “still like bicycles and wind,” Mr. Kinder said. And “you know, they loaned a lot of money for solar panels,” he said to laughs, in an apparent reference to the administration’s loan guarantees to Solyndra LLC.

That’s gonna leave a mark.  The White House’s response?  Pathetic:

“The President has made clear that natural gas has a central role to play in our energy economy,” a White House spokesman said in response.

Whatever.  Yes, gas will play a central role in the US’s and the world’s energy economy.  And Obama and Chu won’t have squat to do with it.  Private ingenuity and private capital are changing the game.  Public “ingenuity” and public “capital” generate waste, not power, pace the Solyndra debacle (which is only the first and most well-known of a slew of government-funded alternative energy snafus).

On Gazprom:

The bankers advising him, he said, had declared it to be the biggest pipeline company in the world. “And I said, ‘Wait a minute. What about that Russian company called Gazprom?'” he recounted at the company’s Houston headquarters. “We are not as big as [Russian Prime Minister Vladimir] Putin’s Gazprom, but then we don’t break people’s kneecaps either,” he said. “We just have to rely on ordinary persuasion, you know.”

Too true.  Too funny–in a kind of black way.  And as the previous post demonstrates, if Gazprom ever has to rely on ordinary persuasion, it is in deep trouble.

By the sounds of this speech by deputy chairman Alexander Medvedev, Gazprom is indeed feeling that its beloved oil-linked pricing mechanism is under siege.  Medvedev’s tone is very defensive, and his arguments risible.  How risible?  Let’s deconstruct.

Fail #1:

“Oil-indexed , long-term contracts that ensure the basic supply volumes from Russia, Qatar, Norway and Algeria… are exactly the mechanism that protects all the parties, since the gas market is not like, for example, the fish market, where you can catch, sell, and make a profit in one day,” Medvedev said.

Well.  Oil isn’t like fish: don’t catch, sell, and profit in a day on oil.  But there are vibrant spot and term markets for oil: oil prices aren’t linked to anything else, but fluctuate minute-to-minute with market forces.  And gas isn’t like fish either, but there is a vibrant spot and term gas market in North America.  So it’s obviously nothing inherent in gas as a commodity that precludes the development of a vigorous spot market, or necessitates oil-linked pricing.

Jeez, apparently Medvedev has been consulting with Gensler about inane market analogies.  Gensler: apples.  Medvedev: fish.  Both: lame.

Fail #2:

“Two-and-half years of abominably low spot prices in Europe have created the illusion that gas has lost its link to oil once and for all. This is not true.

So gas has decoupled from gas in the short run.  Even if they recouple in the future, gas is always coupled with gas.  A gas-based pricing mechanism can never become decoupled from gas, but gas and oil can become decoupled.  So the movement away from oil-linkages towards reliance on robust gas pricing mechanisms reduces the risk of decoupling and more efficient pricing.

Fail #3:

Spot-price trading is incapable of giving correct price signals to the market due to the small volumes and low liquidity.

Trading volume is endogenous.  Liquidity feeds liquidity.  As the US experience shows, liquid and deep cash and derivatives markets can develop very quickly given the right structural conditions: movement away from oil-linked mechanisms would accelerate this process dramatically.  What’s more, the Dutch gas hub is already pretty liquid, as is the UK’s National Balancing Point.  They certainly give better pricing signals than oil.  They will only give more accurate signals as market liquidity develops–which it will quite rapidly if oil-linked pricing and contracts fade away. Moreover, prices that don’t reflect fundamentals spur transactions that tend to eliminate inaccuracies.

Fail #4:

“US prices are so low they do not cover operating costs and in our opinion this situation will not last long. The situation there will return to normal and will make the US market attractive again.”

A lot of smart people are betting otherwise.

And here’s some whine to go with all that fail:

Medvedev also hit out at Europe’s efforts to reduce Gazprom’s dominance. “Natural gas has become a hostage of geopolitics in which there is an artificial demonisation of Gazprom,” he said. “Sometimes it seems that if even the export of bananas or coal were the largest source of budget revenues for Russia, it is in this area that political games would be played. We do not believe that there is an energy security problem in the EU.”

All at once now: awwwwwwwwww.  Boo-frickin’-hoo.  Poor, poor, persecuted Russia.  Poor, poor, misunderstood Gazprom.

Amazing.  Gazprom is a grotesquely inefficient state protected monopoly with a reputation for thuggishness, corruption, and opacity.  Gazprom isn’t demonized: it is justifiably reviled.  100 percent natural ingredients: nothing artificial about it.

Again, it warms the cockles of my heart to hear Gazprom attempt to defend an archaic pricing mechanism.  The defensiveness means they are feeling the heat: the silliness of their arguments makes it plain that the economics are inexorably consigning oil-linked contracts to oblivion.  The fundamentals of the gas market are changing as dramatically as the contracting practice: indeed, these fundamental changes will drive the move to new pricing mechanisms.

Medvedev knows that Gazprom is a Soviet relic that will face daunting difficulties in a more competitive environment in which gas fundamentals, not oil fundamentals, drive prices.  Gazprom is attempting to fight market forces, but in the end, market forces will win–with bleak consequences for Gazprom, and the parasitical class that feeds off it.

I’m in New York.  No, I’m not joining OWS down in Zuccotti Park.  Quite the opposite.  I was speaking at event sponsored by the object of their ire, at the JP Morgan Chase Commodity Forum.

I spoke about Dodd-Frank and commodity trading.  I did my shtick, and it went over pretty well: I was surprised that “Frank-n-Dodd” was something most hadn’t heard before.  The audience found the phrase amusing, and more than a few people remarked on the phrase afterwards.

Substantively, the most interesting thing I heard was said by Morgan’s head of commodities, Blythe Masters.  She noted that F-n-D imposed huge compliance and administrative burdens.  Huge.  Moreover, these are fixed costs.  So Frank-n-Dodd increases economies of scale in banking, which will favor the big over the small, and encourage the big to get bigger and the small to go away.

In other words, something ostensibly intended to address too big to fail will encourage big banks to get bigger through regulation-induced scale economies. The effect will be the exact opposite of the intent.

The road to hell is paved with good intentions.  Frank-n-Dodd just well may be the world’s largest paving company.

The CFTC voted out two rules today, one on position limits, the other on clearing.  I’ve beaten both issues to a bloody pulp over the last couple of years, so I don’t have too much to add.  Just a couple of high level comments.

Bottom line: Both rules are highly ill-advised.

Regarding position limits, some of the most inane provisions of the original proposal are gone, notably the “class” limits that constrained netting across the futures and OTC swaps.  This was a hidden constraint on market making by dealers, and made no economic sense.  Fortunately it is gone.  Also gone–for the most part–is the conditional spot month limit that treated cash-settled and delivery-settled contracts differently.  This made zero economic sense too, and it is also gone.  The one exception is that there are different limits for cash- and delivery-settled contracts for Henry Hub nat gas.  This makes zero economic sense too, and is a blatant political compromise by the Commission intended to throw a bone to ICE that lost on the conditional limit issue generally.  Laws, sausages–and CFTC rules.

My comment letter on position limits criticized both stricken provisions.  But other provisions I inveighed against, particularly those that constrain ETFs like USO and US Nat Gas funds, remain.

The partisan rancor on this issue came through loud and clear at the meeting, as this piece by Jeremy Grant makes clear.  Jill Sommers and Scott O’Malia were very outspoken:

“We went beyond the statute” by doing things like narrowing the bona fide hedge exemption, Sommers told Reuters. “Those are the things that people can use for a legal challenge.

O’Malia said: “over-reached in interpreting its statutory mandate to set position limits.”  O’Malia also emphasized the lack of empirical evidence of a need for limits, echoing my “No Theory? No Evidence? No Problem!” refrain.

As I was quoted saying in the Reuters piece, this statutory overreaching will be the basis for a legal challenge.  Not just on the hedge exemption issue, but on the more fundamental issue of whether it is necessary for the Commission to find that “excessive speculation” has indeed caused “unwarranted” fluctuations in prices, i.e., the “no evidence” point.  I would not be surprised if the cost-benefit analysis, such as it is, is not challenged as well.

The disappointing guy was Dunn, who blasted the idea of position limits, but voted for them anyways.  Not exactly a profile in courage or conviction by a retiring commissioner.

The other rule would require CCPs to admit firms with a minimum of $50 million in capital.  I think this is a terrible idea.  I understand that CCPs could potentially use excessively onerous admission requirements to reduce competition: hell, I’ve been making that point for well over a decade.  But I also understand that undercapitalized members, and members who cannot contribute constructively to the auctioning of a defaulter’s position, can undermine the effectiveness and even the safety of the clearinghouse.

There is a tension between encouraging competition, and making CCPs secure: Gensler and the majority focused on competition, and I think that is a major mistake, particularly given the fact that the clearing mandate in Dodd-Frank is intended to reduce systemic risk. Micromanaging CCP operations is a horrible, horrible idea.

Grounds for challenge?  Maybe.

No surprises here, really. Gensler is hell-bent on ramrodding through his agenda.  And that’s probably the best way to phrase it: the agenda is pretty bent, and will create some regulatory hell.

Last Friday I was part of a group of 8 economists who made presentations to the Board of Governors of the Federal Reserve.  Once or twice a year the Board invites academics to discuss a policy-relevant economic issue.  The subject of Friday’s session was Network Economics, and Alistair Milne and I spoke about network issues in clearing and trading.

The Parthian shot in my presentation was that it was essential not to ignore the unintended effects of derivatives regulation.  In particular, clearing mandates, capital and collateral rules, and the like are all intended to reduce the amount of leverage in the financial system.  But even if you require extensive collateral against derivatives trades, market participants can offset the reduction in leverage inherent in derivatives trades by using the freed up debt capacity to add leverage in other forms.  What goes out through the front door can return through the back door.  This can be particularly dangerous if you think you’ve solved the problem when Mr. Leverage walks out the front and ignore that he’s snuck back in.

Put differently, it is very hard to reduce leverage in the system as a whole by regulating just a piece of firms’ capital structure.

Another example.  Reducing derivatives counterparty credit risk through clearing and netting and collateralization works by increasing the priority of derivatives in bankruptcy.  But if you move derivatives towards the head of the line, somebody else ends up further back.  Like unsecured creditors, including money market funds who buy short term bank debt.  They can be systemically important, too, meaning that the regulations have primarily shifted the locus of systemic risk, and not really reduced it.

Focusing on the collateral issue, the numbers here are huge.  Tabb Group estimates that interest rate derivative collateral alone will total $1.4 trillion.  Credit, equity, and commodity derivatives-related collateral will likely add hundreds of billions to the total: although these markets are smaller, they are riskier, requiring more collateral per dollar of notional.

So where is all this collateral going to come from?  I’ve written about collateral management services, by which banks will effectively lend cash that can be used for margins, with the loans collateralized by assets that CCPs will not accept directly.  In other words, Mr. Leverage is  a Back Door Man.

CME Group’s Craig Donohue talked about the need for such services:

“There will be a need and a value for the collateral transformation services,” Donohue, chief executive officer of CME said today during a panel discussion at the Futures Industry Association annual conference in Chicago.

The types of accepted collateral may need to be expanded as thousands of new users seek to back trades. While cash and government securities will always be the least costly way to pay for margin, some who want to pledge “three chickens and an old Ford” will find it more expensive to have non-standard collateral transformed into acceptable form, said Jeffrey Sprecher, chief executive officer of Atlanta-based Intercontinental Exchange Inc.

The demand has created a “cottage industry” of firms and units within banks that will charge a fee to hold securities or other assets for investors in return for acceptable margin, said Richard Prager, managing director and head of global trading for BlackRock Inc. (BLK)

Cottage industry.  Somehow this brings to mind all the stories about shadow banking system in China that mushroomed after the government tried to crack down on bank lending.

And CCPs are looking to expand the assets they are willing to take as collateral.  This exposes the CCPs to higher risks, including valuation risks.  As an example, LCH.Clearnet (which has already begun accepting gold) is going to accept some corporate debt as collateral (no link yet, but it’s from a Matt Leising Bloomberg story that Matt emailed to me):

LCH.Clearnet Ltd., the biggest interest-rate swap clearinghouse, is considering accepting corporate bonds for the first time to meet an anticipated surge in demand for a broader array of collateral in the $601 trillion over-the-counter derivatives market.

“We want to be able to have more clients come to clearing,” Floyd Converse, head of U.S. sales and marketing for London-based LCH.Clearnet, said in an interview in Chicago this week at the Futures  Industry Association annual conference.  The world’s biggest swaps clearinghouses are expanding the
types of securities they accept as regulations force thousands of new users in the U.S. and Europe to use clearing. Among them, CME Group Inc., the world’s largest futures exchange, is broadening the variety of company debt it accepts as margin for its customers.

(Quick thoughts off the top.  “Investment grade” doesn’t really give the warm and fuzzies, does it?  Will corporate debt be accepted as collateral against CDS trades?  I know LCH.Clearnet doesn’t clear CDS, but there is a reason to wonder whether competitive pressure would lead to such an outcome.  Wouldn’t this expose a CCP to substantial credit correlation risk, which is devilishly difficult to quantify and manage?)

And it is becoming far more widely accepted that CCPs will require central bank liquidity during periods of extreme systemic stress.

All of these stories suggest that mandates are first and foremost just leading to a reshuffling of leverage and risk.  There is room for deep skepticism that this reshuffling will reduce systemic risks.

Indeed, if Gary Gorton is right, and shadow banking was first and foremost a mechanism designed to create informationally insensitive debt that could be posted as collateral, the potential increase in demand for collateral could catalyze a similar process.  This process is systemically risky because it increases fragility and creates substantial tail risks, as this new Gorton paper discusses.

There is also reason to doubt that this is a good use of capital, and could lead to lower growth.  Just what we need.  The cost-benefit trade-off appears particularly unfavorable with respect to collateral posting by long-only buy side investors (e.g., pension funds) and “end users” who do not pose substantial systemic risks.

So, do Ben et al get it?  My sense is that they do, although Bernanke was pretty inscrutable through the entire morning.

One person who obviously doesn’t get it, or is pretending that he doesn’t (which would be even more disturbing) is Gary Gensler.  October is sprinkled with major conferences, and Gensler has been doing the rounds.  Despite all of the advances in understanding of the complexity of the issues involved, Gensler continues to peddle his cartoonish morality play:

“While the crisis had many causes, it is evident that swaps played a central role,” Mr Gensler said. “Swaps added leverage to the financial system with more risk being backed by less capital.

“They contributed, particularly through credit default swaps, to the bubble in the housing market. They contributed to a system where large financial institutions were thought to be not only too big to fail, but too interconnected to fail. Swaps – developed to help manage and lower risk for end-users – also concentrated and heightened risk in the financial system and to the public.”

No recognition of the ability of firms to substitute swap-based leverage with other types of leverage, and their willingness to do so.  No acknowledgement of how mandates re-order priorities in bankruptcy, and the implications thereof.    No appreciation for the potentially destabilizing effects of rigid variation margin mechanisms, and the pro-cyclicality of these mechanisms.   And yeah, Gary: clearing mandates don’t concentrate risk and create their own interconnections.

Gensler is also still pushing the transparency nostrum.  He links the crisis of ’08 to the opacity of the swaps market.  Well, lack of pricing information was arguably an important problem with AIG in particular, his proposed cure–the SEF mandate–will have no effect on this.  The problem with the instruments that AIG bought wasn’t that they weren’t traded on transparent markets: it was that they weren’t traded.  Markets are not the Field of Frickin’ Dreams: If you build it, there’s no guarantee anybody will come.  Comparisons of markets for illiquid products to exchange traded futures are superficial and silly.

In sum, Gensler continues to say foolish things.  Is he a fool, or does he just believe his audience is?  He batters straw men.  He sticks to a cartoonish narrative of the events of 2008.  He pushes nostrums.  He ignores deep complexities, and the huge potential for unintended consequences of the policies he advocates.

Nonetheless, he is not shy about telling others what to do. @OTCderivatives tweets that Gensler said the CFTC should be “top dog” in IOSCO because of the size of US markets.   In London, he chided the Europeans for not including exchange traded derivatives in Emir:

It is critical, though, that those swaps traded on regulated exchanges also are subject to the clearing requirement to bring the benefits of clearing to swaps, regardless of where they are traded – on exchange or off exchange.

This will no doubt thrill the Germans, because an expansion of the Emir remit would also force open access to exchange CCPs.

But given that the Germans have been quite adept at slapping Timmy! around, I doubt that a mere agency head will give them much trouble.

[Interesting aside.  Risk Magazine’s Laurie Carver tweeted that Gensler blew him off to allow “other less aggressive journalists ask him comfy things.”   Go figure.]

To sum up.  Dodd-Frank has set off a very complex dynamic of unintended consequences, many of which will undermine the intent of the law.  One of the figures primarily responsible for implementation of Dodd-Frank has a very simplistic view of the world that ignores these complexities.  What could go wrong?

Two related stories.  The first: unofficial price controls on refined petroleum products in the runup to the Russian elections:

Russian authorities have unofficially reined in retail fuel prices, a sensitive issue for motorists before key elections, traders and sources in companies said Thursday.

The oil companies already had effectively put a lid on gasoline prices at pumping stations since mid-August, fearing a backlash from the government before the general elections in December and presidential poll in March.

Salesmen are now talking about direct verbal orders from the government not to increase prices.

“There won’t be any moves before the elections, although there are no written directives from Moscow,” said a worker at a TNK-BP retail station in Saratov, 880 kilometers southeast of Moscow.

“We were about to increase the price, but we were told to draw in our horns. ‘Are you crazy? There are elections coming!’ they told us,” said an official with LUKoil in Volgograd.

Retail prices have flatlined across the country despite skyrocketing wholesale prices for petroleum products.

After anti-monopoly regulators slapped companies with hundreds of millions of dollars of fines for expensive fuel over the past year, retail stations have been wary of raising prices, and their margins have been squeezed almost to nothing.

The second story: shortages of jet fuel:

Russian traders are alarmed at the sudden disappearance of aviation fuel from the market.

They say a hike in prices is imminent, with a fuel deficit likely before the end of October.

The main factor behind the deficit is thought to be the growing number of passengers using airlines in Russia, whereas the oil refineries around Moscow and Moscow regions ceased operating at full capacity. Additionally, in September, the Defense Ministry made a large order for aviation fuel.

Uhm, don’t believe the explanations given in the quoted bit, except to draw a direct line between the below-capacity operations of refiners, and the first story about unofficial price controls.  Although the price control article relates to motor fuel, it is highly likely that (a) there are also unofficial price controls on aviation fuel,  and/or (b) since gasoline and distillates are produced in relatively constant proportions, cutbacks in refining runs driven by the unprofitability of selling motor fuel at sub-competitive prices are also causing reductions in aviation fuel output.

This also adds credence to the earlier conjectures that the KHL air crash was the result of poor quality fuel, because reductions in quality are another predictably consequence of price controls.

No, it’s not all Kudrin all the time here at SWP.  I know there are those of you looking for your clearing fix.

A brief thought about an unintended destination on the Road to SEFdom–a vertical silo.

Long time readers will know that my transactions cost economics-based analysis predicts that dominant execution venues will vertically integrate into of post-trade services, including clearing and settlement.  Many dominant markets are already “silos” and others are moving in that direction.  The days of an execution venue obtaining post-trade services from a “horizontal” CCP or settlement provider (like LCH.Clearnet) are numbered except when regulation (like RegNMS) socializes order flow.

Horizontal, independent clearers (or settlement providers) can survive in an OTC market, where there is no centralized execution venue.  Vertical integration economizes on transactions costs and double-marginalization costs when there are back-to-back monopolies (and near monopolies).  No execution venue, no back-to-back monopoly problem.

That’s where the SEF mandate comes in.  By forcing exchange-like execution of swap transactions, there is a very real possibility that a dominant execution venue will emerge–and that the resulting frictions in the dealings between that venue and its clearer will lead to a merger between them (or some sort of long-term, exclusive contract.)

Whether this outcome occurs depends on the rules for SEFs.  There is likely to be a proliferation of SEFs early on, but rules for SEFs will determine whether a handful or one survive for a particular instrument class.  If SEF regulations (a) require them to operate auctions (rather than, say, RFQs), and (b) do not impose obligations on SEFs to direct orders to other SEFs offering better prices, then network effects will lead to tipping to a single venue.  Conversely, if there are SEF order handling rules analogous to RegNMS, multiple SEFs may survive.  Under the first alternative, integration is likely to occur.  Under the second, the likely outcome is for multiple SEFs to be served by one horizontal CCP.

SEF rules are still up in the air, and I have not seen any discussion of inter-SEF obligations–or lack thereof.  In contrast to SEC, CFTC has no tradition of even contemplating, let alone imposing, order handling rules.  The issue has never really come up.  I think the presumption in the agency is there will be rigorous competition among SEFs, but that conclusion depends crucially on SEF rules.  In particular, rules relating to the way SEFs compete.  If SEFs are required to operate auction-like mechanisms, and are under no obligation to direct orders to markets displaying better prices, markets will tip to a single SEF.  This will lead to integration.  If regulators impose order handling obligations, multiple SEFs will survive, and integration is far less likely.

Has anybody thought this through?  Are order handling rules even on the table?